Split (1)

train · 4.9k rows

date timestamp[ns]	title stringlengths 19 231	description stringlengths 32 418	text stringlengths 263 106k	mistral_ocr stringlengths 13 95.6k	author stringclasses 117 values	country stringclasses 2 values	url stringlengths 38 46	clean_text stringlengths 0 80.9k
1996-12-19T00:00:00	Ms. Rivlin discusses the prudential regulation of banks and how to improve it (Central Bank Articles and Speeches, 19 Dec 96)	Remarks by the Vice Chairman of the Board of Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, at the The Brookings Institution National Issues Forum in Washington on 19/12/96.	Ms. Rivlin discusses the prudential regulation of banks and how to improve it Remarks by the Vice Chairman of the Board of Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, at the The Brookings Institution National Issues Forum in Washington on 19/12/96. I discovered when I joined the Board of Governors of the Federal Reserve System about six months ago that most of my friends -- including my sophisticated public policy oriented friends -- had only a hazy notion what their central bank did. Many of them said, enthusiastically, "Congratulations!" Then they asked with a bit of embarrassment, "Is it a full-time job?" or "What will you find to do between meetings?" The meetings they were aware of, of course, were those of the Federal Open Market Committee. They knew that the FOMC meets every six weeks or so to "set interest rates." That sounds like real power, so the FOMC gets a lot of press attention even when, as happened again this week, we meet and decide to do absolutely nothing at all. The group gathered here today, however, realizes that monetary policy, while important, is not actually very time-consuming. If you cared enough to come to this conference, you also have a strong conviction that the health and vigor of the American economy depends not only on good macro-economic policy, although that certainly helps, but also on the safety, soundness and efficiency of the banking system. We need a banking system that works well and one in which citizens and businesses, foreign and domestic, have high and well placed confidence. So I want to talk today, as seems appropriate on the fifth anniversary of FDICIA, about the subject that occupies much of our attention at the Federal Reserve: the prudential regulation of banks and how to improve it. Indeed, I want to focus today, not so much on what Congress needs to do to ensure the safety and soundness of the bank system in this rapidly changing world -- there are others on the program to take on that task -- but more narrowly on how bank regulators should go about their jobs of supervising bank risk-taking. The evolving search for policies that would guarantee a safe, sound and efficient banking system has featured learning from experience. In the 1930s, Americans learned, expensively, about the hazards of not having a safety net in a crisis that almost wiped out the banking system. In the 1980s, they learned a lot about the hazards of having a safety net, especially about the moral hazard associated with deposit insurance. Deposit insurance, which had seemed so benign and so successful in building confidence and preventing runs on banks, suddenly revealed its downside for all to see. Some insured institutions, mostly thrifts, but also savings banks, and not a few commercial banks, were taking on risks with a "heads I win, tails you lose" attitude -- sometimes collecting on high stakes bets but often leaving deposit insurance funds to pick up the pieces. At the same time, some regulators, especially the old FSLIC, which was notably strapped for funds, were compounding the problem -- and greatly increasing the ultimate cost of its resolution -- by engaging in regulatory "forbearance" when faced with technically insolvent institutions. The lessons were costly, but Americans do learn from their mistakes. The advocates of banking reform, many of them participants in this conference, saw the problems posed by moral hazard in the context of ineffectual supervision and set out to design a better system. Essentially, the reform agenda had two main components: * First, expanded powers for depository institutions that would permit them to diversify in ways that might reduce risks and improve operating efficiency; * Second, improving the effectiveness of regulation and supervision by instructing regulators, in effect, to act more like the market itself when conducting prudential regulation. FDICIA was a first step toward meeting the second challenge -- how to make regulators act more like the market. It called for a reduction in the potential for regulatory "forbearance" by laying down the conditions under which conservatorship and receivership should be initiated. It called for supervisory sanctions based on measurable performance (in particular, the Prompt Corrective Action provisions that based supervisory action on a bank's risk-based capital ratio). The Act required the FDIC and RTC to resolve failed institutions on a least-cost basis. In other words, the Act required the depository receivers to act as if the insurance funds were private insurers, rather than continue the past policy of protecting uninsured depositors and other bank creditors. Finally, FDICIA placed limitations on the doctrine of "Too Big To Fail," by requiring agency consensus and administration concurrence in order to prop up any large, failing bank. In a few places, however, FDICIA went too far. The provisions of the Act that dealt with micro management by regulators were immediately seen to be "over the top," and were later repealed. The Act provided a framework for regulators to invoke market-like discipline. It left room for them to move their own regulatory techniques in this direction -- a subject to which I will return in a minute. The other objective of reform -- diversification of bank activities through an expansion of bank powers -- has not yet resulted in legislation and is still very much an on-going debate. In part, this failure to take legislative action reflected the long-running ability of the nonbank competition to use its political muscle to forestall increased powers for banks. But the inaction on expanded powers also reflected a Congressional concern that additional powers might be used to take on additional risk, which, on the heels of the banking collapse of the late 1980s, represented poor timing, to say the least. There was also some Congressional disposition to punish "greedy bankers," who were seen as the reason for the collapse and the diversion of taxpayer funds to pay for thrift insolvencies. Whatever the reasons, not only did the 102nd Congress fail to enact expanded bank powers, but so did the next two Congresses. We are hopeful that the 105th Congress will succeed where its predecessors have failed. Meanwhile, the regulatory agencies have acted to expand bank powers within the limits of existing law. The Federal Reserve has proposed both liberalization of Section 20 activities and expedited procedures for processing applications under Regulation Y. The OCC has acted to liberalize banks' insurance agency powers and, most recently, to liberalize procedures for operating subsidiaries of national banks. Of course, I would have to turn in my Federal Reserve badge and give up my parking pass if I did not mention that we at the Fed believe that some activities are best carried out in a subsidiary of the holding company rather than a subsidiary of the bank. We believe that the more distance between the bank and its new, nonbank operations, the more likely that we can separate one from the other and avoid the spreading of the subsidy associated with the safety net. While the regulators can move in the right direction, it is still imperative that Congress act. Artificial barriers between and among various forms of financial activity are harmful to the best interests of the consumers of financial services, to the providers of those services, and to the general stability and well-being of our financial system, most broadly defined. Congress should consider this issue and take the next steps. Let me turn now to what I consider to be one of the most critical issues facing regulators, especially in a future in which financial markets likely will dictate significant further increases in the scope and complexity of banking activities. I am referring to the issue of how to conduct optimal supervision of banks. Fortunately, there appears actually to be an evolving consensus at least on the general principle. Regulators, including the Federal Reserve, strongly support the basic approach embodied in FDICIA; namely that regulators should place limits on depository institutions in such a way as to replicate, as closely as possible, the discipline that would be imposed by a marketplace consisting of informed participants and devoid of the moral hazard associated with the safety net. Unfortunately, as always, the devil is in the details. The difficult question is how should a regulator use "market-based" or "performance-based" measures in determining which, if any, supervisory sanctions or limits to place on a bank. FDICIA's approach was straightforward. Supervisory sanctions under Prompt Corrective Action were to be based on the bank's risk performance as measured by its levels of regulatory capital, in particular its leverage ratio and total risk-based capital ratio under the Basle capital standards. These standards now seem well-intended but rather outdated. Certainly, the Basle capital standards did the job for which they were designed, namely stopping the secular decline in bank capital levels that, by the late 1980s, threatened general safety and soundness. But the scope and complexity of banking activities has proceeded apace during the last two decades or so, and standard capital measures, at least for our very largest and most complex organizations, are no longer adequate measures on which to base supervisory action for several reasons: * The regulatory capital standards apportion capital only for credit risk and, most recently, for market risk of trading activities. Interest rate risk is dealt with subjectively, and other forms of risk, including operating risk, are not treated within the standards. * Also, the capital standards are, despite the appellation "risk-based," very much a "one-size-fits-all" rule. For example, all non-mortgage loans to corporations and households receive the same arbitrary 8 percent capital requirement. A secured loan to a triple-A rated company receives the same treatment as an unsecured loan to a junk-rated company. In other words, the capital standards don't measure credit risk although they represent a crude proxy for such risk within broad categories of banking assets. * Finally, the capital standards give insufficient consideration to hedging or mitigating risk through the use of credit derivatives or effective portfolio diversification. These shortcomings of the regulatory capital standards were beginning to be understood even as they were being implemented, but no consistent, consensus technology existed at that time for invoking a more sophisticated standard than the Basle norms. To be sure, more sophisticated standards were being used by bank supervisors, during the examination process, to determine the adequacy of capital at any individual institution. These supervisory determinations of capital adequacy on a bank-by-bank basis, reflected in the CAMEL ratings given to banks and the BOPEC ratings given to bank holding companies, are much more inclusive than the Basle standards. Research shows that CAMEL ratings are much better predictors of bank insolvency than "risk-based" capital ratios. But, a bank-by-bank supervision, of course, is not the same thing as the writing of regulations that apply to all banks. It is now evident that the simple regulatory capital standards that apply to all banks can be quite misleading. Nominally high regulatory capital ratios -- even risk-based capital ratios that are 50 or 100 percent higher than the minimums -- are no longer indicators of bank soundness. Meanwhile, however, some of our largest and most sophisticated banks have been getting ahead of the regulators and doing the two things one must do in order to properly manage risk and determine capital adequacy. First, they are statistically quantifying risk by estimating the shape of loss probability distributions associated with their risk positions. These quantitative measures of risk are calculated by asset type, by product line, and, in some cases, even down to the individual customer level. Second, the more sophisticated banks are calculating economic capital, or "risk capital," to be allocated to each asset, each line of business, and even to each customer, in order to determine risk-adjusted profitability of each type of bank activity. In making these risk capital allocations, banks are defining and meeting internal corporate standards for safety and soundness. For example, a banker might desire to achieve at least a single-A rating on his own corporate debt. He sees that, over history, single-A debt has a default probability of less than one-tenth of one percent over a one year time horizon. So the banker sets an internal corporate goal to allocate enough capital so that the probability of losses exceeding capital is less than 0.1 percent. In the language of statistics, this means that allocated capital must "cover" 99.9 percent of the estimated loss probability distribution. Once the banker estimates risk and allocates capital to that risk, the internal capital allocations can be used in a variety of ways -- for example, in so-called RAROC or risk-adjusted return on capital models that measure the relative profitability of bank activities. If a particular bank product generates a return to allocated capital that is too low, the bank can seek to cut expenses, reprice the product, or focus its efforts on other, more profitable ventures. These profitability analyses, moreover, are conducted on an "apples-to-apples" basis, since the profitability of each business line is adjusted to reflect the riskiness of the business line. What these bankers have actually done themselves, in calculating these internal capital requirements, is something regulators have never done -- defined a bank soundness target. What regulator, for example, has said that he wants capital to be high enough to reduce to 0.1 percent the probability of insolvency? Regulators have said only that capital ratios should be no lower than some number (8 percent in the case of the Basle standards). But as we should all be aware, a high capital ratio, if it is accompanied by a highly risky portfolio composition, can result in a bank with a high probability of insolvency. The question should not be how high is the bank's capital ratio, but how low is its failure probability. In sharp contrast to our 8 percent one-size-fits-all capital standard, the internal risk-capital calculations of banks result in a very wide range of capital allocations, even within a particular category of credit instrument. For example, for an unsecured commercial credit line, typical internal capital allocations might range from less than 1 percent for a triple-A or double-A rated obligor, to well over 20 percent for an obligor in one of the lowest rating categories. The range of internal capital allocations widens even more when we look at capital calculations for complex risk positions such as various forms of credit derivatives. This great diversity in economic capital allocations, as compared to regulatory capital allocations, creates at least two types of problem. * When the regulatory capital requirement is higher than the economic capital allocation, the bank must either engage in costly regulatory arbitrage to evade the regulatory requirement or change its portfolio, possibly leading to suboptimal resource allocation. * When the regulatory requirement is lower than the economic capital requirement, the bank may choose to hold capital above the regulatory requirement but below the economic requirement; in this case, the bank's nominally high capital ratio may mask the true nature of its risk position. Measuring bank soundness and overall bank performance is becoming more critical as the risk activities of banks become more complex. This condition is especially evident in the various nontraditional activities of banks. In fact, "nontraditional" is no longer a very good adjective to describe much of what goes on at our larger institutions. Take asset securitization, for example. No longer do our largest banks simply take in deposit funds and lend out the money to borrowers. Currently, well over $200 billion in assets that, in times past, have resided on the books of banks, now are owned by remote securitization conduits sponsored by banks. Sponsorship of securitization, which is now almost solely a large bank phenomenon, holds the potential for completely transforming the traditional paradigm of "banking." Now, loans are made directly by the conduits, or are made by the banks and then immediately sold to the conduits. To finance the origination or purchase of the loans, a conduit issues several classes of asset-backed securities collateralized by the loans. Most of the conduit's debt is issued to investors who require that the senior securities be highly rated, generally double-A and triple-A. In order to achieve these ratings, the conduit obtains credit enhancements insulating the senior security holders from defaults on the underlying loans. Generally, it is the bank sponsor that provides these credit enhancements, which can be in the form of standby letters of credit to the conduit, or via the purchase of the most junior/subordinated securities issued by the conduit. In return for providing the credit protection, as well as the loan origination and servicing functions, the bank lays claim to all residual spreads between the yields on the loans and the interest and non-interest cost of the conduit's securities, net of any loan losses. In other words, securitization results in banks taking on almost identically the same risks as if the loans were kept on the books of the bank the old-fashioned way. But while the credit risk of a securitized loan pool may be the same as the credit risk of holding that loan pool on the books, our capital standards do not always recognize this fact. For example, by supplying a standby letter of credit covering so-called "first-dollar" losses for the conduit, a bank might be able to reduce its regulatory capital requirement, for some of its activities, by 90 percent or more compared with what would be required if the bank held the loans directly on its own books. The question, of course, is whether the bank's internal capital allocation systems recognize the similarity in risk between, on the one hand, owning the whole loans and, on the other hand, providing a credit enhancement to a securitization conduit. If the risk measurement and management systems of the bank are faulty, then holding a nominally high capital ratio -- say, 10 percent -- is little consolation. In fact, nominally high capital ratios can be deceiving to market participants. If, for example, the bank's balance sheet is less than transparent, potential investors or creditors, seeing the nominally high 10 percent capital, but not recognizing that the economic risk capital allocation should, in percentage terms, be much higher, could direct an inappropriately high level of scarce resources toward the bank. Credit derivatives are another example of the evolution. The bottom line is that, as we move into the 21st century, traditional notions of "capital adequacy" will become less useful in determining the safety and soundness of our largest, most sophisticated, banking organizations. This growing discrepancy is important because "performance-based" solutions likely will continue to be touted as the basis for expanded bank powers or reductions in burdensome regulation. For example, the Federal Reserve's recent proposed liberalization of procedures for Regulation Y activities applies to banking companies that are "well-capitalized" and "well-managed." Similarly, the OCC's recent proposed liberalization of rules for bank operating subsidiaries applies to "well-capitalized" institutions. Also, industry participants continue to call for expanded powers and/or reduced regulatory burden based on "market tests" of good management and adequate capital. It will not be easy reaching consensus on how to measure bank soundness and overall bank performance. It cannot simply be done by observing market indicators. For example, we cannot easily use the public ratings of holding company debt. The ratings, after all, are achieved given the existence of the safety net. The ratings are biased, therefore, from the perspective of achieving our stated goal -- to impose prudential limits on banks as if there were no net. In addition, I am sure that there would be disagreement between market participants and regulators over what should be acceptable debt ratings. The solution may be for the regulators to use the analytical tools developed by the market participants themselves for risk and performance assessment. Regulators already have begun to move in this direction. For example, beginning in January 1998, qualifying large multinational banks will be able to use their internal Value-at-Risk models to help set capital requirements for the market risk inherent in their trading activities. The Federal Reserve is also conducting a pilot test of the pre-commitment approach to capital for market risk. In this approach, banks can choose their own capital allocations, but would be sanctioned heavily if cumulative trading losses during a quarter were to exceed their chosen capital allocations. These new and innovative methods for treating the age-old problem of capital adequacy are likely to be followed by an unending, evolutionary flow of improvements in the prudential supervisory process. As the industry makes technological advances in risk measurement, these advances will become imbedded in the supervisory process. For example, the banking agencies have announced programs to place an increased emphasis on banks' internal risk measurement and management processes within the assessment of overall management quality -- that is, how well a bank employs modern technology to manage risk will be reflected in the "M" portion of the bank's CAMEL rating. In a similar vein, now that VaR models are being used to assess regulatory capital for market risk, it is easy to envision that, down the road, banks' internal credit risk models and associated internal capital allocations will also be used to help set regulatory capital requirements. Regulation and supervision, like industry practices themselves, are continually evolving processes. As supervisors, our goal must be to stay abreast of best practices, incorporate these practices into our own procedures where appropriate, and do so in a way that allows banks to remain sufficiently flexible and competitive. In conducting prudential regulation we should always remember that the optimal number of bank failures is not zero. Indeed, "market-based" performance means that some institutions, either through poor management choices, or just because of plain old bad luck, will fail. As regulators, we must carefully balance these market-like results with concerns over systemic risk. And, as regulators of banks, we must always remember that we do not operate in a vacuum -- the activities of nonbank financial institutions are also important to the general well-being of our financial system and the macro economy. Regulators, of course, can only work with the framework laid down by Congress. Let me conclude with the hope that this Congress will build on the experience of the last few years, including the experience with FDICIA, and take the next steps toward creating a structural and regulatory framework appropriate to the 21st century.	---[PAGE_BREAK]--- # Ms. Rivlin discusses the prudential regulation of banks and how to improve it Remarks by the Vice Chairman of the Board of Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, at the The Brookings Institution National Issues Forum in Washington on 19/12/96. I discovered when I joined the Board of Governors of the Federal Reserve System about six months ago that most of my friends -- including my sophisticated public policy oriented friends -- had only a hazy notion what their central bank did. Many of them said, enthusiastically, "Congratulations!" Then they asked with a bit of embarrassment, "Is it a full-time job?" or "What will you find to do between meetings?" The meetings they were aware of, of course, were those of the Federal Open Market Committee. They knew that the FOMC meets every six weeks or so to "set interest rates." That sounds like real power, so the FOMC gets a lot of press attention even when, as happened again this week, we meet and decide to do absolutely nothing at all. The group gathered here today, however, realizes that monetary policy, while important, is not actually very time-consuming. If you cared enough to come to this conference, you also have a strong conviction that the health and vigor of the American economy depends not only on good macro-economic policy, although that certainly helps, but also on the safety, soundness and efficiency of the banking system. We need a banking system that works well and one in which citizens and businesses, foreign and domestic, have high and well placed confidence. So I want to talk today, as seems appropriate on the fifth anniversary of FDICIA, about the subject that occupies much of our attention at the Federal Reserve: the prudential regulation of banks and how to improve it. Indeed, I want to focus today, not so much on what Congress needs to do to ensure the safety and soundness of the bank system in this rapidly changing world -- there are others on the program to take on that task -- but more narrowly on how bank regulators should go about their jobs of supervising bank risk-taking. The evolving search for policies that would guarantee a safe, sound and efficient banking system has featured learning from experience. In the 1930s, Americans learned, expensively, about the hazards of not having a safety net in a crisis that almost wiped out the banking system. In the 1980s, they learned a lot about the hazards of having a safety net, especially about the moral hazard associated with deposit insurance. Deposit insurance, which had seemed so benign and so successful in building confidence and preventing runs on banks, suddenly revealed its downside for all to see. Some insured institutions, mostly thrifts, but also savings banks, and not a few commercial banks, were taking on risks with a "heads I win, tails you lose" attitude -- sometimes collecting on high stakes bets but often leaving deposit insurance funds to pick up the pieces. At the same time, some regulators, especially the old FSLIC, which was notably strapped for funds, were compounding the problem -- and greatly increasing the ultimate cost of its resolution -- by engaging in regulatory "forbearance" when faced with technically insolvent institutions. The lessons were costly, but Americans do learn from their mistakes. The advocates of banking reform, many of them participants in this conference, saw the problems posed by moral hazard in the context of ineffectual supervision and set out to design a better system. ---[PAGE_BREAK]--- Essentially, the reform agenda had two main components: * First, expanded powers for depository institutions that would permit them to diversify in ways that might reduce risks and improve operating efficiency; * Second, improving the effectiveness of regulation and supervision by instructing regulators, in effect, to act more like the market itself when conducting prudential regulation. FDICIA was a first step toward meeting the second challenge -- how to make regulators act more like the market. It called for a reduction in the potential for regulatory "forbearance" by laying down the conditions under which conservatorship and receivership should be initiated. It called for supervisory sanctions based on measurable performance (in particular, the Prompt Corrective Action provisions that based supervisory action on a bank's risk-based capital ratio). The Act required the FDIC and RTC to resolve failed institutions on a least-cost basis. In other words, the Act required the depository receivers to act as if the insurance funds were private insurers, rather than continue the past policy of protecting uninsured depositors and other bank creditors. Finally, FDICIA placed limitations on the doctrine of "Too Big To Fail," by requiring agency consensus and administration concurrence in order to prop up any large, failing bank. In a few places, however, FDICIA went too far. The provisions of the Act that dealt with micro management by regulators were immediately seen to be "over the top," and were later repealed. The Act provided a framework for regulators to invoke market-like discipline. It left room for them to move their own regulatory techniques in this direction -- a subject to which I will return in a minute. The other objective of reform -- diversification of bank activities through an expansion of bank powers -- has not yet resulted in legislation and is still very much an on-going debate. In part, this failure to take legislative action reflected the long-running ability of the nonbank competition to use its political muscle to forestall increased powers for banks. But the inaction on expanded powers also reflected a Congressional concern that additional powers might be used to take on additional risk, which, on the heels of the banking collapse of the late 1980s, represented poor timing, to say the least. There was also some Congressional disposition to punish "greedy bankers," who were seen as the reason for the collapse and the diversion of taxpayer funds to pay for thrift insolvencies. Whatever the reasons, not only did the 102nd Congress fail to enact expanded bank powers, but so did the next two Congresses. We are hopeful that the 105th Congress will succeed where its predecessors have failed. Meanwhile, the regulatory agencies have acted to expand bank powers within the limits of existing law. The Federal Reserve has proposed both liberalization of Section 20 activities and expedited procedures for processing applications under Regulation Y. The OCC has acted to liberalize banks' insurance agency powers and, most recently, to liberalize procedures for operating subsidiaries of national banks. Of course, I would have to turn in my Federal Reserve badge and give up my parking pass if I did not mention that we at the Fed believe that some activities are best carried out in a subsidiary of the holding company rather than a subsidiary of the bank. We believe that the more distance between the bank and its new, nonbank operations, the more likely that we can separate one from the other and avoid the spreading of the subsidy associated with the safety net. While the regulators can move in the right direction, it is still imperative that Congress act. Artificial barriers between and among various forms of financial activity are harmful to the best interests of the consumers of financial services, to the providers of those ---[PAGE_BREAK]--- services, and to the general stability and well-being of our financial system, most broadly defined. Congress should consider this issue and take the next steps. Let me turn now to what I consider to be one of the most critical issues facing regulators, especially in a future in which financial markets likely will dictate significant further increases in the scope and complexity of banking activities. I am referring to the issue of how to conduct optimal supervision of banks. Fortunately, there appears actually to be an evolving consensus at least on the general principle. Regulators, including the Federal Reserve, strongly support the basic approach embodied in FDICIA; namely that regulators should place limits on depository institutions in such a way as to replicate, as closely as possible, the discipline that would be imposed by a marketplace consisting of informed participants and devoid of the moral hazard associated with the safety net. Unfortunately, as always, the devil is in the details. The difficult question is how should a regulator use "market-based" or "performance-based" measures in determining which, if any, supervisory sanctions or limits to place on a bank. FDICIA's approach was straightforward. Supervisory sanctions under Prompt Corrective Action were to be based on the bank's risk performance as measured by its levels of regulatory capital, in particular its leverage ratio and total risk-based capital ratio under the Basle capital standards. These standards now seem well-intended but rather outdated. Certainly, the Basle capital standards did the job for which they were designed, namely stopping the secular decline in bank capital levels that, by the late 1980s, threatened general safety and soundness. But the scope and complexity of banking activities has proceeded apace during the last two decades or so, and standard capital measures, at least for our very largest and most complex organizations, are no longer adequate measures on which to base supervisory action for several reasons: * The regulatory capital standards apportion capital only for credit risk and, most recently, for market risk of trading activities. Interest rate risk is dealt with subjectively, and other forms of risk, including operating risk, are not treated within the standards. * Also, the capital standards are, despite the appellation "risk-based," very much a "one-size-fits-all" rule. For example, all non-mortgage loans to corporations and households receive the same arbitrary 8 percent capital requirement. A secured loan to a triple-A rated company receives the same treatment as an unsecured loan to a junk-rated company. In other words, the capital standards don't measure credit risk although they represent a crude proxy for such risk within broad categories of banking assets. * Finally, the capital standards give insufficient consideration to hedging or mitigating risk through the use of credit derivatives or effective portfolio diversification. These shortcomings of the regulatory capital standards were beginning to be understood even as they were being implemented, but no consistent, consensus technology existed at that time for invoking a more sophisticated standard than the Basle norms. To be sure, more sophisticated standards were being used by bank supervisors, during the examination process, to determine the adequacy of capital at any individual institution. These supervisory determinations of capital adequacy on a bank-by-bank basis, reflected in the CAMEL ratings given to banks and the BOPEC ratings given to bank holding companies, are much more inclusive than the Basle standards. Research shows that CAMEL ratings are much better predictors of bank insolvency than "risk-based" capital ratios. But, a bank-by-bank supervision, of course, is not the same thing as the writing of regulations that apply to all banks. ---[PAGE_BREAK]--- It is now evident that the simple regulatory capital standards that apply to all banks can be quite misleading. Nominally high regulatory capital ratios -- even risk-based capital ratios that are 50 or 100 percent higher than the minimums -- are no longer indicators of bank soundness. Meanwhile, however, some of our largest and most sophisticated banks have been getting ahead of the regulators and doing the two things one must do in order to properly manage risk and determine capital adequacy. First, they are statistically quantifying risk by estimating the shape of loss probability distributions associated with their risk positions. These quantitative measures of risk are calculated by asset type, by product line, and, in some cases, even down to the individual customer level. Second, the more sophisticated banks are calculating economic capital, or "risk capital," to be allocated to each asset, each line of business, and even to each customer, in order to determine risk-adjusted profitability of each type of bank activity. In making these risk capital allocations, banks are defining and meeting internal corporate standards for safety and soundness. For example, a banker might desire to achieve at least a single-A rating on his own corporate debt. He sees that, over history, single-A debt has a default probability of less than one-tenth of one percent over a one year time horizon. So the banker sets an internal corporate goal to allocate enough capital so that the probability of losses exceeding capital is less than 0.1 percent. In the language of statistics, this means that allocated capital must "cover" 99.9 percent of the estimated loss probability distribution. Once the banker estimates risk and allocates capital to that risk, the internal capital allocations can be used in a variety of ways -- for example, in so-called RAROC or risk-adjusted return on capital models that measure the relative profitability of bank activities. If a particular bank product generates a return to allocated capital that is too low, the bank can seek to cut expenses, reprice the product, or focus its efforts on other, more profitable ventures. These profitability analyses, moreover, are conducted on an "apples-to-apples" basis, since the profitability of each business line is adjusted to reflect the riskiness of the business line. What these bankers have actually done themselves, in calculating these internal capital requirements, is something regulators have never done -- defined a bank soundness target. What regulator, for example, has said that he wants capital to be high enough to reduce to 0.1 percent the probability of insolvency? Regulators have said only that capital ratios should be no lower than some number ( 8 percent in the case of the Basle standards). But as we should all be aware, a high capital ratio, if it is accompanied by a highly risky portfolio composition, can result in a bank with a high probability of insolvency. The question should not be how high is the bank's capital ratio, but how low is its failure probability. In sharp contrast to our 8 percent one-size-fits-all capital standard, the internal risk-capital calculations of banks result in a very wide range of capital allocations, even within a particular category of credit instrument. For example, for an unsecured commercial credit line, typical internal capital allocations might range from less than 1 percent for a triple-A or double-A rated obligor, to well over 20 percent for an obligor in one of the lowest rating categories. The range of internal capital allocations widens even more when we look at capital calculations for complex risk positions such as various forms of credit derivatives. This great diversity in economic capital allocations, as compared to regulatory capital allocations, creates at least two types of problem. * When the regulatory capital requirement is higher than the economic capital allocation, the bank must either engage in costly regulatory arbitrage to evade ---[PAGE_BREAK]--- the regulatory requirement or change its portfolio, possibly leading to suboptimal resource allocation. * When the regulatory requirement is lower than the economic capital requirement, the bank may choose to hold capital above the regulatory requirement but below the economic requirement; in this case, the bank's nominally high capital ratio may mask the true nature of its risk position. Measuring bank soundness and overall bank performance is becoming more critical as the risk activities of banks become more complex. This condition is especially evident in the various nontraditional activities of banks. In fact, "nontraditional" is no longer a very good adjective to describe much of what goes on at our larger institutions. Take asset securitization, for example. No longer do our largest banks simply take in deposit funds and lend out the money to borrowers. Currently, well over $\$ 200$ billion in assets that, in times past, have resided on the books of banks, now are owned by remote securitization conduits sponsored by banks. Sponsorship of securitization, which is now almost solely a large bank phenomenon, holds the potential for completely transforming the traditional paradigm of "banking." Now, loans are made directly by the conduits, or are made by the banks and then immediately sold to the conduits. To finance the origination or purchase of the loans, a conduit issues several classes of asset-backed securities collateralized by the loans. Most of the conduit's debt is issued to investors who require that the senior securities be highly rated, generally double-A and triple-A. In order to achieve these ratings, the conduit obtains credit enhancements insulating the senior security holders from defaults on the underlying loans. Generally, it is the bank sponsor that provides these credit enhancements, which can be in the form of standby letters of credit to the conduit, or via the purchase of the most junior/subordinated securities issued by the conduit. In return for providing the credit protection, as well as the loan origination and servicing functions, the bank lays claim to all residual spreads between the yields on the loans and the interest and non-interest cost of the conduit's securities, net of any loan losses. In other words, securitization results in banks taking on almost identically the same risks as if the loans were kept on the books of the bank the old-fashioned way. But while the credit risk of a securitized loan pool may be the same as the credit risk of holding that loan pool on the books, our capital standards do not always recognize this fact. For example, by supplying a standby letter of credit covering so-called "first-dollar" losses for the conduit, a bank might be able to reduce its regulatory capital requirement, for some of its activities, by 90 percent or more compared with what would be required if the bank held the loans directly on its own books. The question, of course, is whether the bank's internal capital allocation systems recognize the similarity in risk between, on the one hand, owning the whole loans and, on the other hand, providing a credit enhancement to a securitization conduit. If the risk measurement and management systems of the bank are faulty, then holding a nominally high capital ratio -- say, 10 percent -- is little consolation. In fact, nominally high capital ratios can be deceiving to market participants. If, for example, the bank's balance sheet is less than transparent, potential investors or creditors, seeing the nominally high 10 percent capital, but not recognizing that the economic risk capital allocation should, in percentage terms, be much higher, could direct an inappropriately high level of scarce resources toward the bank. Credit derivatives are another example of the evolution. The bottom line is that, as we move into the 21 st century, traditional notions of "capital adequacy" will become less useful in determining the safety and soundness of our largest, most sophisticated, banking organizations. This growing discrepancy is important because "performance-based" solutions ---[PAGE_BREAK]--- likely will continue to be touted as the basis for expanded bank powers or reductions in burdensome regulation. For example, the Federal Reserve's recent proposed liberalization of procedures for Regulation Y activities applies to banking companies that are "well-capitalized" and "well-managed." Similarly, the OCC's recent proposed liberalization of rules for bank operating subsidiaries applies to "well-capitalized" institutions. Also, industry participants continue to call for expanded powers and/or reduced regulatory burden based on "market tests" of good management and adequate capital. It will not be easy reaching consensus on how to measure bank soundness and overall bank performance. It cannot simply be done by observing market indicators. For example, we cannot easily use the public ratings of holding company debt. The ratings, after all, are achieved given the existence of the safety net. The ratings are biased, therefore, from the perspective of achieving our stated goal -- to impose prudential limits on banks as if there were no net. In addition, I am sure that there would be disagreement between market participants and regulators over what should be acceptable debt ratings. The solution may be for the regulators to use the analytical tools developed by the market participants themselves for risk and performance assessment. Regulators already have begun to move in this direction. For example, beginning in January 1998, qualifying large multinational banks will be able to use their internal Value-at-Risk models to help set capital requirements for the market risk inherent in their trading activities. The Federal Reserve is also conducting a pilot test of the pre-commitment approach to capital for market risk. In this approach, banks can choose their own capital allocations, but would be sanctioned heavily if cumulative trading losses during a quarter were to exceed their chosen capital allocations. These new and innovative methods for treating the age-old problem of capital adequacy are likely to be followed by an unending, evolutionary flow of improvements in the prudential supervisory process. As the industry makes technological advances in risk measurement, these advances will become imbedded in the supervisory process. For example, the banking agencies have announced programs to place an increased emphasis on banks' internal risk measurement and management processes within the assessment of overall management quality -- that is, how well a bank employs modern technology to manage risk will be reflected in the "M" portion of the bank's CAMEL rating. In a similar vein, now that VaR models are being used to assess regulatory capital for market risk, it is easy to envision that, down the road, banks' internal credit risk models and associated internal capital allocations will also be used to help set regulatory capital requirements. Regulation and supervision, like industry practices themselves, are continually evolving processes. As supervisors, our goal must be to stay abreast of best practices, incorporate these practices into our own procedures where appropriate, and do so in a way that allows banks to remain sufficiently flexible and competitive. In conducting prudential regulation we should always remember that the optimal number of bank failures is not zero. Indeed, "market-based" performance means that some institutions, either through poor management choices, or just because of plain old bad luck, will fail. As regulators, we must carefully balance these market-like results with concerns over systemic risk. And, as regulators of banks, we must always remember that we do not operate in a vacuum -- the activities of nonbank financial institutions are also important to the general well-being of our financial system and the macro economy. Regulators, of course, can only work with the framework laid down by Congress. Let me conclude with the hope that this Congress will build on the experience of the last few years, including the experience with FDICIA, and take the next steps toward creating a structural and regulatory framework appropriate to the 21 st century.	Alice M Rivlin	United States	https://www.bis.org/review/r970108b.pdf	it Remarks by the Vice Chairman of the Board of Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, at the The Brookings Institution National Issues Forum in Washington on 19/12/96. I discovered when I joined the Board of Governors of the Federal Reserve System about six months ago that most of my friends -- including my sophisticated public policy oriented friends -- had only a hazy notion what their central bank did. Many of them said, enthusiastically, "Congratulations!" Then they asked with a bit of embarrassment, "Is it a full-time job?" or "What will you find to do between meetings?" The meetings they were aware of, of course, were those of the Federal Open Market Committee. They knew that the FOMC meets every six weeks or so to "set interest rates." That sounds like real power, so the FOMC gets a lot of press attention even when, as happened again this week, we meet and decide to do absolutely nothing at all. The group gathered here today, however, realizes that monetary policy, while important, is not actually very time-consuming. If you cared enough to come to this conference, you also have a strong conviction that the health and vigor of the American economy depends not only on good macro-economic policy, although that certainly helps, but also on the safety, soundness and efficiency of the banking system. We need a banking system that works well and one in which citizens and businesses, foreign and domestic, have high and well placed confidence. So I want to talk today, as seems appropriate on the fifth anniversary of FDICIA, about the subject that occupies much of our attention at the Federal Reserve: the prudential regulation of banks and how to improve it. Indeed, I want to focus today, not so much on what Congress needs to do to ensure the safety and soundness of the bank system in this rapidly changing world -- there are others on the program to take on that task -- but more narrowly on how bank regulators should go about their jobs of supervising bank risk-taking. The evolving search for policies that would guarantee a safe, sound and efficient banking system has featured learning from experience. In the 1930s, Americans learned, expensively, about the hazards of not having a safety net in a crisis that almost wiped out the banking system. In the 1980s, they learned a lot about the hazards of having a safety net, especially about the moral hazard associated with deposit insurance. Deposit insurance, which had seemed so benign and so successful in building confidence and preventing runs on banks, suddenly revealed its downside for all to see. Some insured institutions, mostly thrifts, but also savings banks, and not a few commercial banks, were taking on risks with a "heads I win, tails you lose" attitude -- sometimes collecting on high stakes bets but often leaving deposit insurance funds to pick up the pieces. At the same time, some regulators, especially the old FSLIC, which was notably strapped for funds, were compounding the problem -- and greatly increasing the ultimate cost of its resolution -- by engaging in regulatory "forbearance" when faced with technically insolvent institutions. The lessons were costly, but Americans do learn from their mistakes. The advocates of banking reform, many of them participants in this conference, saw the problems posed by moral hazard in the context of ineffectual supervision and set out to design a better system. Essentially, the reform agenda had two main components: First, expanded powers for depository institutions that would permit them to diversify in ways that might reduce risks and improve operating efficiency;. Second, improving the effectiveness of regulation and supervision by instructing regulators, in effect, to act more like the market itself when conducting prudential regulation. FDICIA was a first step toward meeting the second challenge -- how to make regulators act more like the market. It called for a reduction in the potential for regulatory "forbearance" by laying down the conditions under which conservatorship and receivership should be initiated. It called for supervisory sanctions based on measurable performance (in particular, the Prompt Corrective Action provisions that based supervisory action on a bank's risk-based capital ratio). The Act required the FDIC and RTC to resolve failed institutions on a least-cost basis. In other words, the Act required the depository receivers to act as if the insurance funds were private insurers, rather than continue the past policy of protecting uninsured depositors and other bank creditors. Finally, FDICIA placed limitations on the doctrine of "Too Big To Fail," by requiring agency consensus and administration concurrence in order to prop up any large, failing bank. In a few places, however, FDICIA went too far. The provisions of the Act that dealt with micro management by regulators were immediately seen to be "over the top," and were later repealed. The Act provided a framework for regulators to invoke market-like discipline. It left room for them to move their own regulatory techniques in this direction -- a subject to which I will return in a minute. The other objective of reform -- diversification of bank activities through an expansion of bank powers -- has not yet resulted in legislation and is still very much an on-going debate. In part, this failure to take legislative action reflected the long-running ability of the nonbank competition to use its political muscle to forestall increased powers for banks. But the inaction on expanded powers also reflected a Congressional concern that additional powers might be used to take on additional risk, which, on the heels of the banking collapse of the late 1980s, represented poor timing, to say the least. There was also some Congressional disposition to punish "greedy bankers," who were seen as the reason for the collapse and the diversion of taxpayer funds to pay for thrift insolvencies. Whatever the reasons, not only did the 102nd Congress fail to enact expanded bank powers, but so did the next two Congresses. We are hopeful that the 105th Congress will succeed where its predecessors have failed. Meanwhile, the regulatory agencies have acted to expand bank powers within the limits of existing law. The Federal Reserve has proposed both liberalization of Section 20 activities and expedited procedures for processing applications under Regulation Y. The OCC has acted to liberalize banks' insurance agency powers and, most recently, to liberalize procedures for operating subsidiaries of national banks. Of course, I would have to turn in my Federal Reserve badge and give up my parking pass if I did not mention that we at the Fed believe that some activities are best carried out in a subsidiary of the holding company rather than a subsidiary of the bank. We believe that the more distance between the bank and its new, nonbank operations, the more likely that we can separate one from the other and avoid the spreading of the subsidy associated with the safety net. While the regulators can move in the right direction, it is still imperative that Congress act. Artificial barriers between and among various forms of financial activity are harmful to the best interests of the consumers of financial services, to the providers of those services, and to the general stability and well-being of our financial system, most broadly defined. Congress should consider this issue and take the next steps. Let me turn now to what I consider to be one of the most critical issues facing regulators, especially in a future in which financial markets likely will dictate significant further increases in the scope and complexity of banking activities. I am referring to the issue of how to conduct optimal supervision of banks. Fortunately, there appears actually to be an evolving consensus at least on the general principle. Regulators, including the Federal Reserve, strongly support the basic approach embodied in FDICIA; namely that regulators should place limits on depository institutions in such a way as to replicate, as closely as possible, the discipline that would be imposed by a marketplace consisting of informed participants and devoid of the moral hazard associated with the safety net. Unfortunately, as always, the devil is in the details. The difficult question is how should a regulator use "market-based" or "performance-based" measures in determining which, if any, supervisory sanctions or limits to place on a bank. FDICIA's approach was straightforward. Supervisory sanctions under Prompt Corrective Action were to be based on the bank's risk performance as measured by its levels of regulatory capital, in particular its leverage ratio and total risk-based capital ratio under the Basle capital standards. These standards now seem well-intended but rather outdated. Certainly, the Basle capital standards did the job for which they were designed, namely stopping the secular decline in bank capital levels that, by the late 1980s, threatened general safety and soundness. But the scope and complexity of banking activities has proceeded apace during the last two decades or so, and standard capital measures, at least for our very largest and most complex organizations, are no longer adequate measures on which to base supervisory action for several reasons: The regulatory capital standards apportion capital only for credit risk and, most recently, for market risk of trading activities. Interest rate risk is dealt with subjectively, and other forms of risk, including operating risk, are not treated within the standards. Also, the capital standards are, despite the appellation "risk-based," very much a "one-size-fits-all" rule. For example, all non-mortgage loans to corporations and households receive the same arbitrary 8 percent capital requirement. A secured loan to a triple-A rated company receives the same treatment as an unsecured loan to a junk-rated company. In other words, the capital standards don't measure credit risk although they represent a crude proxy for such risk within broad categories of banking assets. Finally, the capital standards give insufficient consideration to hedging or mitigating risk through the use of credit derivatives or effective portfolio diversification. These shortcomings of the regulatory capital standards were beginning to be understood even as they were being implemented, but no consistent, consensus technology existed at that time for invoking a more sophisticated standard than the Basle norms. To be sure, more sophisticated standards were being used by bank supervisors, during the examination process, to determine the adequacy of capital at any individual institution. These supervisory determinations of capital adequacy on a bank-by-bank basis, reflected in the CAMEL ratings given to banks and the BOPEC ratings given to bank holding companies, are much more inclusive than the Basle standards. Research shows that CAMEL ratings are much better predictors of bank insolvency than "risk-based" capital ratios. But, a bank-by-bank supervision, of course, is not the same thing as the writing of regulations that apply to all banks. It is now evident that the simple regulatory capital standards that apply to all banks can be quite misleading. Nominally high regulatory capital ratios -- even risk-based capital ratios that are 50 or 100 percent higher than the minimums -- are no longer indicators of bank soundness. Meanwhile, however, some of our largest and most sophisticated banks have been getting ahead of the regulators and doing the two things one must do in order to properly manage risk and determine capital adequacy. First, they are statistically quantifying risk by estimating the shape of loss probability distributions associated with their risk positions. These quantitative measures of risk are calculated by asset type, by product line, and, in some cases, even down to the individual customer level. Second, the more sophisticated banks are calculating economic capital, or "risk capital," to be allocated to each asset, each line of business, and even to each customer, in order to determine risk-adjusted profitability of each type of bank activity. In making these risk capital allocations, banks are defining and meeting internal corporate standards for safety and soundness. For example, a banker might desire to achieve at least a single-A rating on his own corporate debt. He sees that, over history, single-A debt has a default probability of less than one-tenth of one percent over a one year time horizon. So the banker sets an internal corporate goal to allocate enough capital so that the probability of losses exceeding capital is less than 0.1 percent. In the language of statistics, this means that allocated capital must "cover" 99.9 percent of the estimated loss probability distribution. Once the banker estimates risk and allocates capital to that risk, the internal capital allocations can be used in a variety of ways -- for example, in so-called RAROC or risk-adjusted return on capital models that measure the relative profitability of bank activities. If a particular bank product generates a return to allocated capital that is too low, the bank can seek to cut expenses, reprice the product, or focus its efforts on other, more profitable ventures. These profitability analyses, moreover, are conducted on an "apples-to-apples" basis, since the profitability of each business line is adjusted to reflect the riskiness of the business line. What these bankers have actually done themselves, in calculating these internal capital requirements, is something regulators have never done -- defined a bank soundness target. What regulator, for example, has said that he wants capital to be high enough to reduce to 0.1 percent the probability of insolvency? Regulators have said only that capital ratios should be no lower than some number ( 8 percent in the case of the Basle standards). But as we should all be aware, a high capital ratio, if it is accompanied by a highly risky portfolio composition, can result in a bank with a high probability of insolvency. The question should not be how high is the bank's capital ratio, but how low is its failure probability. In sharp contrast to our 8 percent one-size-fits-all capital standard, the internal risk-capital calculations of banks result in a very wide range of capital allocations, even within a particular category of credit instrument. For example, for an unsecured commercial credit line, typical internal capital allocations might range from less than 1 percent for a triple-A or double-A rated obligor, to well over 20 percent for an obligor in one of the lowest rating categories. The range of internal capital allocations widens even more when we look at capital calculations for complex risk positions such as various forms of credit derivatives. This great diversity in economic capital allocations, as compared to regulatory capital allocations, creates at least two types of problem. When the regulatory capital requirement is higher than the economic capital allocation, the bank must either engage in costly regulatory arbitrage to evade the regulatory requirement or change its portfolio, possibly leading to suboptimal resource allocation. When the regulatory requirement is lower than the economic capital requirement, the bank may choose to hold capital above the regulatory requirement but below the economic requirement; in this case, the bank's nominally high capital ratio may mask the true nature of its risk position. Measuring bank soundness and overall bank performance is becoming more critical as the risk activities of banks become more complex. This condition is especially evident in the various nontraditional activities of banks. In fact, "nontraditional" is no longer a very good adjective to describe much of what goes on at our larger institutions. Take asset securitization, for example. No longer do our largest banks simply take in deposit funds and lend out the money to borrowers. Currently, well over $\$ 200$ billion in assets that, in times past, have resided on the books of banks, now are owned by remote securitization conduits sponsored by banks. Sponsorship of securitization, which is now almost solely a large bank phenomenon, holds the potential for completely transforming the traditional paradigm of "banking." Now, loans are made directly by the conduits, or are made by the banks and then immediately sold to the conduits. To finance the origination or purchase of the loans, a conduit issues several classes of asset-backed securities collateralized by the loans. Most of the conduit's debt is issued to investors who require that the senior securities be highly rated, generally double-A and triple-A. In order to achieve these ratings, the conduit obtains credit enhancements insulating the senior security holders from defaults on the underlying loans. Generally, it is the bank sponsor that provides these credit enhancements, which can be in the form of standby letters of credit to the conduit, or via the purchase of the most junior/subordinated securities issued by the conduit. In return for providing the credit protection, as well as the loan origination and servicing functions, the bank lays claim to all residual spreads between the yields on the loans and the interest and non-interest cost of the conduit's securities, net of any loan losses. In other words, securitization results in banks taking on almost identically the same risks as if the loans were kept on the books of the bank the old-fashioned way. But while the credit risk of a securitized loan pool may be the same as the credit risk of holding that loan pool on the books, our capital standards do not always recognize this fact. For example, by supplying a standby letter of credit covering so-called "first-dollar" losses for the conduit, a bank might be able to reduce its regulatory capital requirement, for some of its activities, by 90 percent or more compared with what would be required if the bank held the loans directly on its own books. The question, of course, is whether the bank's internal capital allocation systems recognize the similarity in risk between, on the one hand, owning the whole loans and, on the other hand, providing a credit enhancement to a securitization conduit. If the risk measurement and management systems of the bank are faulty, then holding a nominally high capital ratio -- say, 10 percent -- is little consolation. In fact, nominally high capital ratios can be deceiving to market participants. If, for example, the bank's balance sheet is less than transparent, potential investors or creditors, seeing the nominally high 10 percent capital, but not recognizing that the economic risk capital allocation should, in percentage terms, be much higher, could direct an inappropriately high level of scarce resources toward the bank. Credit derivatives are another example of the evolution. The bottom line is that, as we move into the 21 st century, traditional notions of "capital adequacy" will become less useful in determining the safety and soundness of our largest, most sophisticated, banking organizations. This growing discrepancy is important because "performance-based" solutions likely will continue to be touted as the basis for expanded bank powers or reductions in burdensome regulation. For example, the Federal Reserve's recent proposed liberalization of procedures for Regulation Y activities applies to banking companies that are "well-capitalized" and "well-managed." Similarly, the OCC's recent proposed liberalization of rules for bank operating subsidiaries applies to "well-capitalized" institutions. Also, industry participants continue to call for expanded powers and/or reduced regulatory burden based on "market tests" of good management and adequate capital. It will not be easy reaching consensus on how to measure bank soundness and overall bank performance. It cannot simply be done by observing market indicators. For example, we cannot easily use the public ratings of holding company debt. The ratings, after all, are achieved given the existence of the safety net. The ratings are biased, therefore, from the perspective of achieving our stated goal -- to impose prudential limits on banks as if there were no net. In addition, I am sure that there would be disagreement between market participants and regulators over what should be acceptable debt ratings. The solution may be for the regulators to use the analytical tools developed by the market participants themselves for risk and performance assessment. Regulators already have begun to move in this direction. For example, beginning in January 1998, qualifying large multinational banks will be able to use their internal Value-at-Risk models to help set capital requirements for the market risk inherent in their trading activities. The Federal Reserve is also conducting a pilot test of the pre-commitment approach to capital for market risk. In this approach, banks can choose their own capital allocations, but would be sanctioned heavily if cumulative trading losses during a quarter were to exceed their chosen capital allocations. These new and innovative methods for treating the age-old problem of capital adequacy are likely to be followed by an unending, evolutionary flow of improvements in the prudential supervisory process. As the industry makes technological advances in risk measurement, these advances will become imbedded in the supervisory process. For example, the banking agencies have announced programs to place an increased emphasis on banks' internal risk measurement and management processes within the assessment of overall management quality -- that is, how well a bank employs modern technology to manage risk will be reflected in the "M" portion of the bank's CAMEL rating. In a similar vein, now that VaR models are being used to assess regulatory capital for market risk, it is easy to envision that, down the road, banks' internal credit risk models and associated internal capital allocations will also be used to help set regulatory capital requirements. Regulation and supervision, like industry practices themselves, are continually evolving processes. As supervisors, our goal must be to stay abreast of best practices, incorporate these practices into our own procedures where appropriate, and do so in a way that allows banks to remain sufficiently flexible and competitive. In conducting prudential regulation we should always remember that the optimal number of bank failures is not zero. Indeed, "market-based" performance means that some institutions, either through poor management choices, or just because of plain old bad luck, will fail. As regulators, we must carefully balance these market-like results with concerns over systemic risk. And, as regulators of banks, we must always remember that we do not operate in a vacuum -- the activities of nonbank financial institutions are also important to the general well-being of our financial system and the macro economy. Regulators, of course, can only work with the framework laid down by Congress. Let me conclude with the hope that this Congress will build on the experience of the last few years, including the experience with FDICIA, and take the next steps toward creating a structural and regulatory framework appropriate to the 21 st century.
1997-01-05T00:00:00	Mr. Meyer examines the role for structural macroeconomic models in the monetary policy process (Central Bank Articles and Speeches, 5 Jan 97)	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the AEA Panel on Monetary and Fiscal Policy held in New Orleans on 5/1/97.	Mr. Meyer examines the role for structural macroeconomic models in the monetary policy process Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the AEA Panel on Monetary and Fiscal Policy held in New Orleans on 5/1/97. The Role for Structural Macroeconomic Models I am in the middle of my third interesting and active encounter with the development and/or use of macroeconometric models for forecasting and policy analysis. My journey began at MIT as a research assistant to Professors Franco Modigiliani and Albert Ando during the period of development of the MPS model, continued at Laurence H. Meyer & Associates with the development of The Washington University Macro Model under the direction of my partner, Joel Prakken, and the use of that model for both forecasting and policy analysis, and now has taken me to the Board of Governors where macro models have long played an important role in forecasting and policy analysis and the MPS model has recently been replaced by the FRB-US model. I bring to this panel a perspective shaped by both my earlier experience and my new responsibilities. I will focus my presentation on the role of structural macro models in the monetary policy process, compare the use of models at the Board with their use at Laurence H. Meyer & Associates, and discuss how the recently introduced innovations in the Federal Reserve model might further advance the usefulness of models in the monetary policy process. I. Structural Models and Monetary Policy Analysis I want to focus on three contributions of models to the monetary policy process: as an input to the forecast process; as a vehicle for analyzing alternative scenarios; and a vehicle for developing a strategy for implementing monetary policy that disciplines the juggling of multiple objectives and ensures a bridge from short-run policy to long-run objectives. 1. The forecast context for monetary policy decisions Because monetary policy has the ability to adjust quickly to changing economic conditions and because lags in the response to monetary policy make it important that monetary policy be forward-looking, monetary policy is very much influenced both by incoming data and by forecasts of spending and price developments. Forecasts are central to monetary policy setting. Models make a valuable contribution to forecasting. Therefore, models can make an important contribution to the setting of monetary policy. Models capture historical regularities, identify key assumptions that must be made to condition the forecast, embody estimates of the effects of past and future policy actions on the economy, and provide a disciplined approach to learning from past errors. I attribute much of the forecasting success of myself and my partners at LHM&A to the way in which we allowed our model to discipline our judgment in making the forecast. A model also helps to defend and communicate the forecast, by providing a coherent story that ties together the details of the forecast. It also helps to isolate the source of disagreements about the forecast, helping to separate differences in assumptions (oil prices, fiscal policy, etc.) from disagreements about the structure of the economy or judgments about special factors that the model may not fully capture. At the Board, the staff forecast, presented in the Green Book prior to each of the eight FOMC meetings each year, is fundamentally judgmental. It is developed by a team of sector specialists who consult, but are not bound by, a number of structural econometric equations describing their sectors, and further armed, in some cases, with reduced-form equations and atheoretical time series models. The team develops the forecast within the context of agreed-upon conditioning assumptions, including, for example, a path for short-term interest rates, fiscal policy, oil prices, and foreign economic policies. They begin with an income constraint and then participate in an interactive process of revisions to ensure that the aggregation of sector forecasts is consistent with the evolving forecast for the overall level of output. Models play an important supporting role in the development of the staff forecast. A separate model group uses a formal structural macroeconometric model, the FRB-US Model, to make a "pure model" forecast which is also available to the FOMC and is an input to the judgmental forecast process. The model forecast is conditioned by the same set of assumptions as the judgmental forecast and statistical models are used to generate the path of adjustment factors, avoiding any role for judgment in the forecast. The members of the model group also actively participate in the discussions as the judgmental forecast evolves, focusing in particular on the consistency between the adjustment factors that would be required to impose the judgmental forecast on the model and the pattern of adjustment factors in the "pure" model forecast. There are two important differences from the private sector use of models for forecasting, at least based on my experience at LHM&A. First, the staff is not truly making a forecast of economic activity, prices, etc., because the staff forecast is usually conditioned on an unchanged path of the funds rate. Thus the staff is projecting how the economy would evolve if there were no change in the federal funds rate (which does not even always translate cleanly into no change in monetary policy). The rationale for this procedure is to separate the forecast process from the policy-making process, and therefore avoid appearing to prejudge the FOMC's decisions. This procedure may be modified when there is a strong presumption that conditions will unambiguously call for significant action if the Committee is to achieve its objectives. But it does, nevertheless, make the forecast process at the Board fundamentally different from that in the private sector where one of the key decisions in the forecast is the direction of monetary policy. It is ironic that, at the Board, where the staff is presumably more knowledgeable about the direction of policy than in the private sector, forecasting is constrained from using that information in developing the forecast. On the other hand, the practice at the Board may be very well suited to the process of making policy by forcing the FOMC to confront the implications of maintaining an unchanged path for the funds rate. A second difference relative to my experience in the private sector has to do with the way in which judgment and model interact in the development of the forecast. My first impression of the process at the Board was that the judgmental team made its forecast without a model and the model team made its forecast without judgment, leaving the blending of model and judgment to be worked out in the process of discussion and iteration as the judgmental group looks at the model output and the model group joins the discussion of the forecast. The process is, I have come to appreciate, more complicated and subtle than this caricature. For example, when there have been important shocks (e.g., unexpected rise in oil prices or an increase in the minimum wage), model simulations of the effect of the shocks will provide a point of departure for the initial judgmental forecast. But it is, nevertheless, a different way of combining model and judgment than we used at LHM&A where the model played a more central role in the forecast process. An advantage of the Board's approach is that it makes the forecast less dependent on a single model (perhaps desirable given the diversity of views on the FOMC) and forces recognition of uncertainties in the outlook when alternative sector models yield very different forecasts. 2. Policy alternatives and alternative scenarios to support FOMC policy decisions A second valuable contribution of models is to provide alternative scenarios around a base forecast. I will focus on three examples of this use of models at the Board, though there is also, of course, widespread use of alternative model-based scenario analysis in the private sector. First, the staff regularly provides alternative forecasts roughly corresponding to the policy options that will be considered at the upcoming FOMC meeting. The staff first imposes the judgmental forecast on the FRB-US model and then uses the model to provide alternative scenarios for a policy of rising rates and a policy of declining rates, bracketing the staff forecast which assumes an unchanged federal funds rate. While this is the most direct use of the model in the forecast process, it is recognized that it has become a problematical one, especially given the structure of the new FRB-US model that otherwise treats policy as determined by a rule, a prerequisite to the forward-looking approach to expectations formation that is a major innovation in the new model. Indeed, it might well be that the presentation of a forecast that incorporates a simple monetary policy rule might be a more useful complement to the staff's judgmental forecast than the mechanical bracketing of the judgmental forecast with pre-determined paths of rising or falling rates. Second, the staff, on occasion, uses the model to provide information about the projected effects of significant contingencies: e.g., the return of Iraq to oil exporting under the U.N. agreement for humanitarian aid or the effect of an increase in the minimum wage. Models are particularly well suited to providing this information. Third, the model can be used to evaluate the consistency of alternative policies with the Federal Reserve's long-run objective of price stability. One of the challenges of monetary policy making is to ensure that the meeting-to-meeting policy deliberations maintain a disciplined focus on the Federal Reserve's long-term price stability objective. To facilitate this focus, five-year simulations under alternative policy assumptions are generally run semi-annually, to coincide with the FOMC meetings preceding the preparation of the Humphrey-Hawkins report and the Chairman's testimony on monetary policy before Congress. These simulations have recently focused on policy options allowing for more gradual or more rapid convergence over time to long-run inflation targets, allowing the FOMC to focus on both the different time-paths to achieve the long-run objective and the alternative paths of output and employment during the transition to the long-run target. 3. Policy rules to inform discretionary monetary policy A third contribution of models to the monetary policy process is through simulations with alternative rules for Federal Reserve action. At LHM&A we designed our model to offer users four policy regimes: setting paths for the money supply, nonborrowed reserves or the federal funds rate or turning on a reaction function according to which the federal funds rate responds to developments in output, unemployment and inflation. While we increasingly used the reaction function in our analysis of alternative fiscal policies, we did not routinely take advantage of the reaction function to forecast monetary policy. Another irony is that there is a much more active interest in the implications of monetary policy rules at the Board, where discretionary policy is made, than in the private sector, where estimated rules might be effectively used to forecast monetary policy. The staff has examined a number of alternative rules, including those based on monetary aggregates, commodity prices, exchange rates, nominal income, and, most recently, Taylor-type rules. These rules, in effect, adjust the real federal funds rate relative to some long-run equilibrium level in response to the gaps between actual and potential output and between inflation and some long-run inflation target. Such a rule can be interpreted as either a descriptive or normative guide to policy. If the parameters of the policy rule are estimated over some recent sample period, the rule may describe the average response of the FOMC over the period. Alternatively, parameters can be derived from some optimizing framework, dependent on a specific objective function and model of the economy. Stochastic simulations with such a rule can provide some confidence that following the rule will contribute to both short-run stabilization and long-term inflation goals in response to historical shocks to the economy and the rule, in turn, can provide discipline to discretionary policy by providing guidance on when and how aggressively to move interest rates in response to movements in output and inflation. The focus on rules is much more important under an interest rate operating procedure than under an operating procedure focused directly on monetary aggregate targets and is also more important under an interest rate operating procedure when the monetary aggregates, as has been the case for some time, do not bear a stable relationship to overall economic performance and therefore do not provide useful information about when and how aggressively to change interest rates. Taylor-type rules, in this environment, provide a disciplined approach to varying interest rates in response to economic developments that both ensures a pro-cyclical response of interest rates to demand shocks and imposes a nominal anchor in much the same way as would be the case under a monetary aggregate strategy with a stable money demand function. For this reason, I like to refer to the strategy implicit in such rules as "monetarism without money." This should not suggest that we can write a rule that is appropriate, in all circumstances, to all varieties of shocks, and to all the varieties of cyclical experience. Rules, at best, can discipline judgment rather than replace judgment. A particular problem with Taylor-type rules is that we do not know the equilibrium real federal funds rate and, whatever it might be at one point in time, it likely varies over time. There is considerable research under way at the Board in an effort to find specifications and parameters for rules which achieve an efficient balancing of inflation and output variability and provide guidance about patterns and aggressiveness of interest rate adjustments consistent with the stabilizing properties of high-performing rules. II. The FRB-US Model: Rational Expectations in a Sticky-Price Model The newly redesigned model at the Board, the FRB-US model, replaces the MPS model. The MPS model, developed in the mid to late-1960s, revolutionized macroeconometric modeling and set the standard for a considerable period of time. The Board participated in the development of the MPS model and then became its home and the Board staff kept the faith alive during the lean years when such models lost respectability in academic circles, even as their usefulness and value in forecasting and practical policy analysis was growing in the "real" world. The FRB-US model retains much of the underlying structure in terms of equilibrium relationships and even more of the fundamental simulation properties of the MPS model, but significantly modernizes the estimation of the model and the treatment of expectations. The vision in the new work is to separate macro-dynamics into adjustment cost and expectations formation components, with adjustment costs imposing a degree of inertia and expectations introducing a forward-looking element into the dynamics. The net result is a structure that integrates rational expectations into a sticky-price model. In this respect, the new model follows closely the approach pioneered by John Taylor. Finally, the estimation technique makes use of co-integration and an error-correction framework. Financial and exchange rate relationships are based on arbitrage equations, with no adjustment costs but with explicitly forward-looking expectations. The specification of nonfinancial equations, in contrast, incorporates both adjustment costs and rational expectations. Rational expectations are implemented in two alternative ways. First, expectations can be specified as "model-consistent" expectations; that is, the expectations about future inflation can be set to equal future inflation (perfect foresight) through iterative solutions of the model. Model-consistent expectations may, but need not, assume that the private sector has complete knowledge of the policy rule being followed by the Federal Reserve. In the second approach, expectations are also viewed as being model-consistent, but in this case the model relevant to expectations is not precisely the same as the FRB-US model. Instead, expectations are formed based on a simpler VAR model of the economy. The VAR model always includes three variables -- the output gap, a short-term interest rate, and inflation. When expectations of additional sector-specific variables are required, the system is expanded to include the additional variable. A unique aspect of the VAR expectations is that these equations also incorporate explicit forward-looking information through an error-correction specification. For example, the VAR equations include a term for the gap between actual inflation and the public's "long-run" expectations of inflation, based on survey measures of long-run inflation expectations which, in turn, might be viewed as based on a combination of the public's perception of the Federal Reserve's reaction function, including its tolerance of inflation over the long run. The equations also include the gap between actual short-term interest rates and the public's long-run expectations of short-term rates, gleaned from the yield curve. The model retains the neo-Classical synthesis vision of the MPS model -short-run output dynamics based on sticky prices and long-run Classical properties associated with price flexibility -- and therefore produces multiplier results, both in the short and longer runs, that are very similar to those produced by the MPS model. The result is that the model produces, for the most part, what may be the best of two worlds - a modern form and traditional results! But the better articulated role of expectations in the new model also allows a richer analysis of the response to those policy actions which might have immediate impacts on inflation and/or interest rate expectations. The model has several advantages. The first is it may be more credible to a wider audience because of its modernization in terms of cointegration and error-learning specification on the one hand and explicit use of rational expectations on the other hand. Second, the model is much more flexible in terms of research potential. It allows one to study in particular how the response to monetary or fiscal policies depends on features of the expectation formation process. Third, the model forces the user to make assumptions explicitly about expectations formation that otherwise could be avoided or hidden. Let me give two examples of policy options that can be analyzed more effectively in the new model. First, consider a deficit reduction package that is credible and promises to lower interest rates in the future. In models like MPS and WUMM, the mechanical fiscal policy simulation would ignore any "bond market effect" associated with changed expectations about future short-term rates. One could, of course, add-factor downward the long-term bond rate in the term structure equation to impose a bond market effect, but the structure of the model neither immediately points you in this direction nor provides any guidance about how to intervene. In FRB-US, in contrast, one cannot avoid making an explicit assumption about the credibility of such a policy (through assumptions about future short-term interest rates in the VAR expectations or in the context of model-consistent expectations) and the assumption made about credibility will importantly affect the short-run dynamics though not the long-run effects of the policy. Second, consider the transitional costs of reducing inflation. The transitional effects on output depend importantly on the assumptions made about the credibility of the inflation commitment. Note, however, that there are significant transitional output costs of disinflation even under full credibility and the model-consistent specification of rational expectations, arising from the sticky price implication of the adjustment cost specification. For my part, I prefer the FRB-US simulations based on limited rather than perfect credibility, because I do not believe that credibility effects significantly diminish the transition costs of lowering inflation. But I also value having a disciplined approach to showing how the costs of disinflation would vary with the differing degrees of credibility. ___________________ References Brayton, F., A. Levin, R. Tryon, and J. Williams. "The Evolution of Macro Models at the Federal Reserve Board." mimeo. Board of Governors of the Federal Reserve System, November 1996. Brayton, F. and P. Tinsley. "A Guide to FRB/US: A Macroeconometric Model of the United States." FEDS 96-42, 1996. Reifschneider, D., D. Stockton, and D. Wilcox. "Econometric Models and the Monetary Policy Process." mimeo. Board of Governors of the Federal Reserve System, November 1996. Taylor, J. "Discretion versus Policy Rules in Practice." Carnegie Rochester Conference Series on Public Policy, vol. 39, 1993.	---[PAGE_BREAK]--- # Mr. Meyer examines the role for structural macroeconomic models in the monetary policy process Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the AEA Panel on Monetary and Fiscal Policy held in New Orleans on 5/1/97. ## The Role for Structural Macroeconomic Models I am in the middle of my third interesting and active encounter with the development and/or use of macroeconometric models for forecasting and policy analysis. My journey began at MIT as a research assistant to Professors Franco Modigiliani and Albert Ando during the period of development of the MPS model, continued at Laurence H. Meyer \& Associates with the development of The Washington University Macro Model under the direction of my partner, Joel Prakken, and the use of that model for both forecasting and policy analysis, and now has taken me to the Board of Governors where macro models have long played an important role in forecasting and policy analysis and the MPS model has recently been replaced by the FRB-US model. I bring to this panel a perspective shaped by both my earlier experience and my new responsibilities. I will focus my presentation on the role of structural macro models in the monetary policy process, compare the use of models at the Board with their use at Laurence H. Meyer \& Associates, and discuss how the recently introduced innovations in the Federal Reserve model might further advance the usefulness of models in the monetary policy process. ## I. Structural Models and Monetary Policy Analysis I want to focus on three contributions of models to the monetary policy process: as an input to the forecast process; as a vehicle for analyzing alternative scenarios; and a vehicle for developing a strategy for implementing monetary policy that disciplines the juggling of multiple objectives and ensures a bridge from short-run policy to long-run objectives. ## 1. The forecast context for monetary policy decisions Because monetary policy has the ability to adjust quickly to changing economic conditions and because lags in the response to monetary policy make it important that monetary policy be forward-looking, monetary policy is very much influenced both by incoming data and by forecasts of spending and price developments. Forecasts are central to monetary policy setting. Models make a valuable contribution to forecasting. Therefore, models can make an important contribution to the setting of monetary policy. Models capture historical regularities, identify key assumptions that must be made to condition the forecast, embody estimates of the effects of past and future policy actions on the economy, and provide a disciplined approach to learning from past errors. I attribute much of the forecasting success of myself and my partners at LHM\&A to the way in which we allowed our model to discipline our judgment in making the forecast. A model also helps to defend and communicate the forecast, by providing a coherent story that ties together the details of the forecast. It also helps to isolate the source of disagreements about the forecast, helping to separate differences in assumptions (oil prices, fiscal policy, etc.) from disagreements about the structure of the economy or judgments about special factors that the model may not fully capture. ---[PAGE_BREAK]--- At the Board, the staff forecast, presented in the Green Book prior to each of the eight FOMC meetings each year, is fundamentally judgmental. It is developed by a team of sector specialists who consult, but are not bound by, a number of structural econometric equations describing their sectors, and further armed, in some cases, with reduced-form equations and atheoretical time series models. The team develops the forecast within the context of agreed-upon conditioning assumptions, including, for example, a path for short-term interest rates, fiscal policy, oil prices, and foreign economic policies. They begin with an income constraint and then participate in an interactive process of revisions to ensure that the aggregation of sector forecasts is consistent with the evolving forecast for the overall level of output. Models play an important supporting role in the development of the staff forecast. A separate model group uses a formal structural macroeconometric model, the FRB-US Model, to make a "pure model" forecast which is also available to the FOMC and is an input to the judgmental forecast process. The model forecast is conditioned by the same set of assumptions as the judgmental forecast and statistical models are used to generate the path of adjustment factors, avoiding any role for judgment in the forecast. The members of the model group also actively participate in the discussions as the judgmental forecast evolves, focusing in particular on the consistency between the adjustment factors that would be required to impose the judgmental forecast on the model and the pattern of adjustment factors in the "pure" model forecast. There are two important differences from the private sector use of models for forecasting, at least based on my experience at LHM\&A. First, the staff is not truly making a forecast of economic activity, prices, etc., because the staff forecast is usually conditioned on an unchanged path of the funds rate. Thus the staff is projecting how the economy would evolve if there were no change in the federal funds rate (which does not even always translate cleanly into no change in monetary policy). The rationale for this procedure is to separate the forecast process from the policy-making process, and therefore avoid appearing to prejudge the FOMC's decisions. This procedure may be modified when there is a strong presumption that conditions will unambiguously call for significant action if the Committee is to achieve its objectives. But it does, nevertheless, make the forecast process at the Board fundamentally different from that in the private sector where one of the key decisions in the forecast is the direction of monetary policy. It is ironic that, at the Board, where the staff is presumably more knowledgeable about the direction of policy than in the private sector, forecasting is constrained from using that information in developing the forecast. On the other hand, the practice at the Board may be very well suited to the process of making policy by forcing the FOMC to confront the implications of maintaining an unchanged path for the funds rate. A second difference relative to my experience in the private sector has to do with the way in which judgment and model interact in the development of the forecast. My first impression of the process at the Board was that the judgmental team made its forecast without a model and the model team made its forecast without judgment, leaving the blending of model and judgment to be worked out in the process of discussion and iteration as the judgmental group looks at the model output and the model group joins the discussion of the forecast. The process is, I have come to appreciate, more complicated and subtle than this caricature. For example, when there have been important shocks (e.g., unexpected rise in oil prices or an increase in the minimum wage), model simulations of the effect of the shocks will provide a point of departure for the initial judgmental forecast. But it is, nevertheless, a different way of combining model and judgment than we used at LHM\&A where the model played a more central role in the forecast process. An advantage of the Board's approach is that it makes the ---[PAGE_BREAK]--- forecast less dependent on a single model (perhaps desirable given the diversity of views on the FOMC) and forces recognition of uncertainties in the outlook when alternative sector models yield very different forecasts. # 2. Policy alternatives and alternative scenarios to support FOMC policy decisions A second valuable contribution of models is to provide alternative scenarios around a base forecast. I will focus on three examples of this use of models at the Board, though there is also, of course, widespread use of alternative model-based scenario analysis in the private sector. First, the staff regularly provides alternative forecasts roughly corresponding to the policy options that will be considered at the upcoming FOMC meeting. The staff first imposes the judgmental forecast on the FRB-US model and then uses the model to provide alternative scenarios for a policy of rising rates and a policy of declining rates, bracketing the staff forecast which assumes an unchanged federal funds rate. While this is the most direct use of the model in the forecast process, it is recognized that it has become a problematical one, especially given the structure of the new FRB-US model that otherwise treats policy as determined by a rule, a prerequisite to the forward-looking approach to expectations formation that is a major innovation in the new model. Indeed, it might well be that the presentation of a forecast that incorporates a simple monetary policy rule might be a more useful complement to the staff's judgmental forecast than the mechanical bracketing of the judgmental forecast with pre-determined paths of rising or falling rates. Second, the staff, on occasion, uses the model to provide information about the projected effects of significant contingencies: e.g., the return of Iraq to oil exporting under the U.N. agreement for humanitarian aid or the effect of an increase in the minimum wage. Models are particularly well suited to providing this information. Third, the model can be used to evaluate the consistency of alternative policies with the Federal Reserve's long-run objective of price stability. One of the challenges of monetary policy making is to ensure that the meeting-to-meeting policy deliberations maintain a disciplined focus on the Federal Reserve's long-term price stability objective. To facilitate this focus, five-year simulations under alternative policy assumptions are generally run semi-annually, to coincide with the FOMC meetings preceding the preparation of the Humphrey-Hawkins report and the Chairman's testimony on monetary policy before Congress. These simulations have recently focused on policy options allowing for more gradual or more rapid convergence over time to long-run inflation targets, allowing the FOMC to focus on both the different time-paths to achieve the long-run objective and the alternative paths of output and employment during the transition to the long-run target. ## 3. Policy rules to inform discretionary monetary policy A third contribution of models to the monetary policy process is through simulations with alternative rules for Federal Reserve action. At LHM\&A we designed our model to offer users four policy regimes: setting paths for the money supply, nonborrowed reserves or the federal funds rate or turning on a reaction function according to which the federal funds rate responds to developments in output, unemployment and inflation. While we increasingly used the reaction function in our analysis of alternative fiscal policies, we did not routinely take advantage of the reaction function to forecast monetary policy. Another irony is that there is a much more active interest in the implications of monetary policy rules at the ---[PAGE_BREAK]--- Board, where discretionary policy is made, than in the private sector, where estimated rules might be effectively used to forecast monetary policy. The staff has examined a number of alternative rules, including those based on monetary aggregates, commodity prices, exchange rates, nominal income, and, most recently, Taylor-type rules. These rules, in effect, adjust the real federal funds rate relative to some long-run equilibrium level in response to the gaps between actual and potential output and between inflation and some long-run inflation target. Such a rule can be interpreted as either a descriptive or normative guide to policy. If the parameters of the policy rule are estimated over some recent sample period, the rule may describe the average response of the FOMC over the period. Alternatively, parameters can be derived from some optimizing framework, dependent on a specific objective function and model of the economy. Stochastic simulations with such a rule can provide some confidence that following the rule will contribute to both short-run stabilization and long-term inflation goals in response to historical shocks to the economy and the rule, in turn, can provide discipline to discretionary policy by providing guidance on when and how aggressively to move interest rates in response to movements in output and inflation. The focus on rules is much more important under an interest rate operating procedure than under an operating procedure focused directly on monetary aggregate targets and is also more important under an interest rate operating procedure when the monetary aggregates, as has been the case for some time, do not bear a stable relationship to overall economic performance and therefore do not provide useful information about when and how aggressively to change interest rates. Taylor-type rules, in this environment, provide a disciplined approach to varying interest rates in response to economic developments that both ensures a pro-cyclical response of interest rates to demand shocks and imposes a nominal anchor in much the same way as would be the case under a monetary aggregate strategy with a stable money demand function. For this reason, I like to refer to the strategy implicit in such rules as "monetarism without money." This should not suggest that we can write a rule that is appropriate, in all circumstances, to all varieties of shocks, and to all the varieties of cyclical experience. Rules, at best, can discipline judgment rather than replace judgment. A particular problem with Taylor-type rules is that we do not know the equilibrium real federal funds rate and, whatever it might be at one point in time, it likely varies over time. There is considerable research under way at the Board in an effort to find specifications and parameters for rules which achieve an efficient balancing of inflation and output variability and provide guidance about patterns and aggressiveness of interest rate adjustments consistent with the stabilizing properties of high-performing rules. # II. The FRB-US Model: Rational Expectations in a Sticky-Price Model The newly redesigned model at the Board, the FRB-US model, replaces the MPS model. The MPS model, developed in the mid to late-1960s, revolutionized macroeconometric modeling and set the standard for a considerable period of time. The Board participated in the development of the MPS model and then became its home and the Board staff kept the faith alive during the lean years when such models lost respectability in academic circles, even as their usefulness and value in forecasting and practical policy analysis was growing in the "real" world. The FRB-US model retains much of the underlying structure in terms of equilibrium ---[PAGE_BREAK]--- relationships and even more of the fundamental simulation properties of the MPS model, but significantly modernizes the estimation of the model and the treatment of expectations. The vision in the new work is to separate macro-dynamics into adjustment cost and expectations formation components, with adjustment costs imposing a degree of inertia and expectations introducing a forward-looking element into the dynamics. The net result is a structure that integrates rational expectations into a sticky-price model. In this respect, the new model follows closely the approach pioneered by John Taylor. Finally, the estimation technique makes use of co-integration and an error-correction framework. Financial and exchange rate relationships are based on arbitrage equations, with no adjustment costs but with explicitly forward-looking expectations. The specification of nonfinancial equations, in contrast, incorporates both adjustment costs and rational expectations. Rational expectations are implemented in two alternative ways. First, expectations can be specified as "model-consistent" expectations; that is, the expectations about future inflation can be set to equal future inflation (perfect foresight) through iterative solutions of the model. Model-consistent expectations may, but need not, assume that the private sector has complete knowledge of the policy rule being followed by the Federal Reserve. In the second approach, expectations are also viewed as being model-consistent, but in this case the model relevant to expectations is not precisely the same as the FRB-US model. Instead, expectations are formed based on a simpler VAR model of the economy. The VAR model always includes three variables -- the output gap, a short-term interest rate, and inflation. When expectations of additional sector-specific variables are required, the system is expanded to include the additional variable. A unique aspect of the VAR expectations is that these equations also incorporate explicit forward-looking information through an error-correction specification. For example, the VAR equations include a term for the gap between actual inflation and the public's "long-run" expectations of inflation, based on survey measures of long-run inflation expectations which, in turn, might be viewed as based on a combination of the public's perception of the Federal Reserve's reaction function, including its tolerance of inflation over the long run. The equations also include the gap between actual short-term interest rates and the public's long-run expectations of short-term rates, gleaned from the yield curve. The model retains the neo-Classical synthesis vision of the MPS model -short-run output dynamics based on sticky prices and long-run Classical properties associated with price flexibility -- and therefore produces multiplier results, both in the short and longer runs, that are very similar to those produced by the MPS model. The result is that the model produces, for the most part, what may be the best of two worlds - a modern form and traditional results! But the better articulated role of expectations in the new model also allows a richer analysis of the response to those policy actions which might have immediate impacts on inflation and/or interest rate expectations. The model has several advantages. The first is it may be more credible to a wider audience because of its modernization in terms of cointegration and error-learning specification on the one hand and explicit use of rational expectations on the other hand. Second, the model is much more flexible in terms of research potential. It allows one to study in particular how the response to monetary or fiscal policies depends on features of the expectation formation process. Third, the model forces the user to make assumptions explicitly about expectations formation that otherwise could be avoided or hidden. ---[PAGE_BREAK]--- Let me give two examples of policy options that can be analyzed more effectively in the new model. First, consider a deficit reduction package that is credible and promises to lower interest rates in the future. In models like MPS and WUMM, the mechanical fiscal policy simulation would ignore any "bond market effect" associated with changed expectations about future short-term rates. One could, of course, add-factor downward the long-term bond rate in the term structure equation to impose a bond market effect, but the structure of the model neither immediately points you in this direction nor provides any guidance about how to intervene. In FRB-US, in contrast, one cannot avoid making an explicit assumption about the credibility of such a policy (through assumptions about future short-term interest rates in the VAR expectations or in the context of model-consistent expectations) and the assumption made about credibility will importantly affect the short-run dynamics though not the long-run effects of the policy. Second, consider the transitional costs of reducing inflation. The transitional effects on output depend importantly on the assumptions made about the credibility of the inflation commitment. Note, however, that there are significant transitional output costs of disinflation even under full credibility and the model-consistent specification of rational expectations, arising from the sticky price implication of the adjustment cost specification. For my part, I prefer the FRB-US simulations based on limited rather than perfect credibility, because I do not believe that credibility effects significantly diminish the transition costs of lowering inflation. But I also value having a disciplined approach to showing how the costs of disinflation would vary with the differing degrees of credibility. # References Brayton, F., A. Levin, R. Tryon, and J. Williams. "The Evolution of Macro Models at the Federal Reserve Board." mimeo. Board of Governors of the Federal Reserve System, November 1996. Brayton, F. and P. Tinsley. "A Guide to FRB/US: A Macroeconometric Model of the United States." FEDS 96-42, 1996. Reifschneider, D., D. Stockton, and D. Wilcox. "Econometric Models and the Monetary Policy Process." mimeo. Board of Governors of the Federal Reserve System, November 1996. Taylor, J. "Discretion versus Policy Rules in Practice." Carnegie Rochester Conference Series on Public Policy, vol. 39, 1993.	Laurence H Meyer	United States	https://www.bis.org/review/r970108a.pdf	monetary policy process Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the AEA Panel on Monetary and Fiscal Policy held in New Orleans on 5/1/97. I am in the middle of my third interesting and active encounter with the development and/or use of macroeconometric models for forecasting and policy analysis. My journey began at MIT as a research assistant to Professors Franco Modigiliani and Albert Ando during the period of development of the MPS model, continued at Laurence H. Meyer \& Associates with the development of The Washington University Macro Model under the direction of my partner, Joel Prakken, and the use of that model for both forecasting and policy analysis, and now has taken me to the Board of Governors where macro models have long played an important role in forecasting and policy analysis and the MPS model has recently been replaced by the FRB-US model. I bring to this panel a perspective shaped by both my earlier experience and my new responsibilities. I will focus my presentation on the role of structural macro models in the monetary policy process, compare the use of models at the Board with their use at Laurence H. Meyer \& Associates, and discuss how the recently introduced innovations in the Federal Reserve model might further advance the usefulness of models in the monetary policy process. I want to focus on three contributions of models to the monetary policy process: as an input to the forecast process; as a vehicle for analyzing alternative scenarios; and a vehicle for developing a strategy for implementing monetary policy that disciplines the juggling of multiple objectives and ensures a bridge from short-run policy to long-run objectives. Because monetary policy has the ability to adjust quickly to changing economic conditions and because lags in the response to monetary policy make it important that monetary policy be forward-looking, monetary policy is very much influenced both by incoming data and by forecasts of spending and price developments. Forecasts are central to monetary policy setting. Models make a valuable contribution to forecasting. Therefore, models can make an important contribution to the setting of monetary policy. Models capture historical regularities, identify key assumptions that must be made to condition the forecast, embody estimates of the effects of past and future policy actions on the economy, and provide a disciplined approach to learning from past errors. I attribute much of the forecasting success of myself and my partners at LHM\&A to the way in which we allowed our model to discipline our judgment in making the forecast. A model also helps to defend and communicate the forecast, by providing a coherent story that ties together the details of the forecast. It also helps to isolate the source of disagreements about the forecast, helping to separate differences in assumptions (oil prices, fiscal policy, etc.) from disagreements about the structure of the economy or judgments about special factors that the model may not fully capture. At the Board, the staff forecast, presented in the Green Book prior to each of the eight FOMC meetings each year, is fundamentally judgmental. It is developed by a team of sector specialists who consult, but are not bound by, a number of structural econometric equations describing their sectors, and further armed, in some cases, with reduced-form equations and atheoretical time series models. The team develops the forecast within the context of agreed-upon conditioning assumptions, including, for example, a path for short-term interest rates, fiscal policy, oil prices, and foreign economic policies. They begin with an income constraint and then participate in an interactive process of revisions to ensure that the aggregation of sector forecasts is consistent with the evolving forecast for the overall level of output. Models play an important supporting role in the development of the staff forecast. A separate model group uses a formal structural macroeconometric model, the FRB-US Model, to make a "pure model" forecast which is also available to the FOMC and is an input to the judgmental forecast process. The model forecast is conditioned by the same set of assumptions as the judgmental forecast and statistical models are used to generate the path of adjustment factors, avoiding any role for judgment in the forecast. The members of the model group also actively participate in the discussions as the judgmental forecast evolves, focusing in particular on the consistency between the adjustment factors that would be required to impose the judgmental forecast on the model and the pattern of adjustment factors in the "pure" model forecast. There are two important differences from the private sector use of models for forecasting, at least based on my experience at LHM\&A. First, the staff is not truly making a forecast of economic activity, prices, etc., because the staff forecast is usually conditioned on an unchanged path of the funds rate. Thus the staff is projecting how the economy would evolve if there were no change in the federal funds rate (which does not even always translate cleanly into no change in monetary policy). The rationale for this procedure is to separate the forecast process from the policy-making process, and therefore avoid appearing to prejudge the FOMC's decisions. This procedure may be modified when there is a strong presumption that conditions will unambiguously call for significant action if the Committee is to achieve its objectives. But it does, nevertheless, make the forecast process at the Board fundamentally different from that in the private sector where one of the key decisions in the forecast is the direction of monetary policy. It is ironic that, at the Board, where the staff is presumably more knowledgeable about the direction of policy than in the private sector, forecasting is constrained from using that information in developing the forecast. On the other hand, the practice at the Board may be very well suited to the process of making policy by forcing the FOMC to confront the implications of maintaining an unchanged path for the funds rate. A second difference relative to my experience in the private sector has to do with the way in which judgment and model interact in the development of the forecast. My first impression of the process at the Board was that the judgmental team made its forecast without a model and the model team made its forecast without judgment, leaving the blending of model and judgment to be worked out in the process of discussion and iteration as the judgmental group looks at the model output and the model group joins the discussion of the forecast. The process is, I have come to appreciate, more complicated and subtle than this caricature. For example, when there have been important shocks (e.g., unexpected rise in oil prices or an increase in the minimum wage), model simulations of the effect of the shocks will provide a point of departure for the initial judgmental forecast. But it is, nevertheless, a different way of combining model and judgment than we used at LHM\&A where the model played a more central role in the forecast process. An advantage of the Board's approach is that it makes the forecast less dependent on a single model (perhaps desirable given the diversity of views on the FOMC) and forces recognition of uncertainties in the outlook when alternative sector models yield very different forecasts. A second valuable contribution of models is to provide alternative scenarios around a base forecast. I will focus on three examples of this use of models at the Board, though there is also, of course, widespread use of alternative model-based scenario analysis in the private sector. First, the staff regularly provides alternative forecasts roughly corresponding to the policy options that will be considered at the upcoming FOMC meeting. The staff first imposes the judgmental forecast on the FRB-US model and then uses the model to provide alternative scenarios for a policy of rising rates and a policy of declining rates, bracketing the staff forecast which assumes an unchanged federal funds rate. While this is the most direct use of the model in the forecast process, it is recognized that it has become a problematical one, especially given the structure of the new FRB-US model that otherwise treats policy as determined by a rule, a prerequisite to the forward-looking approach to expectations formation that is a major innovation in the new model. Indeed, it might well be that the presentation of a forecast that incorporates a simple monetary policy rule might be a more useful complement to the staff's judgmental forecast than the mechanical bracketing of the judgmental forecast with pre-determined paths of rising or falling rates. Second, the staff, on occasion, uses the model to provide information about the projected effects of significant contingencies: e.g., the return of Iraq to oil exporting under the U.N. agreement for humanitarian aid or the effect of an increase in the minimum wage. Models are particularly well suited to providing this information. Third, the model can be used to evaluate the consistency of alternative policies with the Federal Reserve's long-run objective of price stability. One of the challenges of monetary policy making is to ensure that the meeting-to-meeting policy deliberations maintain a disciplined focus on the Federal Reserve's long-term price stability objective. To facilitate this focus, five-year simulations under alternative policy assumptions are generally run semi-annually, to coincide with the FOMC meetings preceding the preparation of the Humphrey-Hawkins report and the Chairman's testimony on monetary policy before Congress. These simulations have recently focused on policy options allowing for more gradual or more rapid convergence over time to long-run inflation targets, allowing the FOMC to focus on both the different time-paths to achieve the long-run objective and the alternative paths of output and employment during the transition to the long-run target. A third contribution of models to the monetary policy process is through simulations with alternative rules for Federal Reserve action. At LHM\&A we designed our model to offer users four policy regimes: setting paths for the money supply, nonborrowed reserves or the federal funds rate or turning on a reaction function according to which the federal funds rate responds to developments in output, unemployment and inflation. While we increasingly used the reaction function in our analysis of alternative fiscal policies, we did not routinely take advantage of the reaction function to forecast monetary policy. Another irony is that there is a much more active interest in the implications of monetary policy rules at the Board, where discretionary policy is made, than in the private sector, where estimated rules might be effectively used to forecast monetary policy. The staff has examined a number of alternative rules, including those based on monetary aggregates, commodity prices, exchange rates, nominal income, and, most recently, Taylor-type rules. These rules, in effect, adjust the real federal funds rate relative to some long-run equilibrium level in response to the gaps between actual and potential output and between inflation and some long-run inflation target. Such a rule can be interpreted as either a descriptive or normative guide to policy. If the parameters of the policy rule are estimated over some recent sample period, the rule may describe the average response of the FOMC over the period. Alternatively, parameters can be derived from some optimizing framework, dependent on a specific objective function and model of the economy. Stochastic simulations with such a rule can provide some confidence that following the rule will contribute to both short-run stabilization and long-term inflation goals in response to historical shocks to the economy and the rule, in turn, can provide discipline to discretionary policy by providing guidance on when and how aggressively to move interest rates in response to movements in output and inflation. The focus on rules is much more important under an interest rate operating procedure than under an operating procedure focused directly on monetary aggregate targets and is also more important under an interest rate operating procedure when the monetary aggregates, as has been the case for some time, do not bear a stable relationship to overall economic performance and therefore do not provide useful information about when and how aggressively to change interest rates. Taylor-type rules, in this environment, provide a disciplined approach to varying interest rates in response to economic developments that both ensures a pro-cyclical response of interest rates to demand shocks and imposes a nominal anchor in much the same way as would be the case under a monetary aggregate strategy with a stable money demand function. For this reason, I like to refer to the strategy implicit in such rules as "monetarism without money." This should not suggest that we can write a rule that is appropriate, in all circumstances, to all varieties of shocks, and to all the varieties of cyclical experience. Rules, at best, can discipline judgment rather than replace judgment. A particular problem with Taylor-type rules is that we do not know the equilibrium real federal funds rate and, whatever it might be at one point in time, it likely varies over time. There is considerable research under way at the Board in an effort to find specifications and parameters for rules which achieve an efficient balancing of inflation and output variability and provide guidance about patterns and aggressiveness of interest rate adjustments consistent with the stabilizing properties of high-performing rules. The newly redesigned model at the Board, the FRB-US model, replaces the MPS model. The MPS model, developed in the mid to late-1960s, revolutionized macroeconometric modeling and set the standard for a considerable period of time. The Board participated in the development of the MPS model and then became its home and the Board staff kept the faith alive during the lean years when such models lost respectability in academic circles, even as their usefulness and value in forecasting and practical policy analysis was growing in the "real" world. The FRB-US model retains much of the underlying structure in terms of equilibrium relationships and even more of the fundamental simulation properties of the MPS model, but significantly modernizes the estimation of the model and the treatment of expectations. The vision in the new work is to separate macro-dynamics into adjustment cost and expectations formation components, with adjustment costs imposing a degree of inertia and expectations introducing a forward-looking element into the dynamics. The net result is a structure that integrates rational expectations into a sticky-price model. In this respect, the new model follows closely the approach pioneered by John Taylor. Finally, the estimation technique makes use of co-integration and an error-correction framework. Financial and exchange rate relationships are based on arbitrage equations, with no adjustment costs but with explicitly forward-looking expectations. The specification of nonfinancial equations, in contrast, incorporates both adjustment costs and rational expectations. Rational expectations are implemented in two alternative ways. First, expectations can be specified as "model-consistent" expectations; that is, the expectations about future inflation can be set to equal future inflation (perfect foresight) through iterative solutions of the model. Model-consistent expectations may, but need not, assume that the private sector has complete knowledge of the policy rule being followed by the Federal Reserve. In the second approach, expectations are also viewed as being model-consistent, but in this case the model relevant to expectations is not precisely the same as the FRB-US model. Instead, expectations are formed based on a simpler VAR model of the economy. The VAR model always includes three variables -- the output gap, a short-term interest rate, and inflation. When expectations of additional sector-specific variables are required, the system is expanded to include the additional variable. A unique aspect of the VAR expectations is that these equations also incorporate explicit forward-looking information through an error-correction specification. For example, the VAR equations include a term for the gap between actual inflation and the public's "long-run" expectations of inflation, based on survey measures of long-run inflation expectations which, in turn, might be viewed as based on a combination of the public's perception of the Federal Reserve's reaction function, including its tolerance of inflation over the long run. The equations also include the gap between actual short-term interest rates and the public's long-run expectations of short-term rates, gleaned from the yield curve. The model retains the neo-Classical synthesis vision of the MPS model -short-run output dynamics based on sticky prices and long-run Classical properties associated with price flexibility -- and therefore produces multiplier results, both in the short and longer runs, that are very similar to those produced by the MPS model. The result is that the model produces, for the most part, what may be the best of two worlds - a modern form and traditional results! But the better articulated role of expectations in the new model also allows a richer analysis of the response to those policy actions which might have immediate impacts on inflation and/or interest rate expectations. The model has several advantages. The first is it may be more credible to a wider audience because of its modernization in terms of cointegration and error-learning specification on the one hand and explicit use of rational expectations on the other hand. Second, the model is much more flexible in terms of research potential. It allows one to study in particular how the response to monetary or fiscal policies depends on features of the expectation formation process. Third, the model forces the user to make assumptions explicitly about expectations formation that otherwise could be avoided or hidden. Let me give two examples of policy options that can be analyzed more effectively in the new model. First, consider a deficit reduction package that is credible and promises to lower interest rates in the future. In models like MPS and WUMM, the mechanical fiscal policy simulation would ignore any "bond market effect" associated with changed expectations about future short-term rates. One could, of course, add-factor downward the long-term bond rate in the term structure equation to impose a bond market effect, but the structure of the model neither immediately points you in this direction nor provides any guidance about how to intervene. In FRB-US, in contrast, one cannot avoid making an explicit assumption about the credibility of such a policy (through assumptions about future short-term interest rates in the VAR expectations or in the context of model-consistent expectations) and the assumption made about credibility will importantly affect the short-run dynamics though not the long-run effects of the policy. Second, consider the transitional costs of reducing inflation. The transitional effects on output depend importantly on the assumptions made about the credibility of the inflation commitment. Note, however, that there are significant transitional output costs of disinflation even under full credibility and the model-consistent specification of rational expectations, arising from the sticky price implication of the adjustment cost specification. For my part, I prefer the FRB-US simulations based on limited rather than perfect credibility, because I do not believe that credibility effects significantly diminish the transition costs of lowering inflation. But I also value having a disciplined approach to showing how the costs of disinflation would vary with the differing degrees of credibility. Brayton, F., A. Levin, R. Tryon, and J. Williams. "The Evolution of Macro Models at the Federal Reserve Board." mimeo. Board of Governors of the Federal Reserve System, November 1996. Brayton, F. and P. Tinsley. "A Guide to FRB/US: A Macroeconometric Model of the United States." FEDS 96-42, 1996. Reifschneider, D., D. Stockton, and D. Wilcox. "Econometric Models and the Monetary Policy Process." mimeo. Board of Governors of the Federal Reserve System, November 1996. Taylor, J. "Discretion versus Policy Rules in Practice." Carnegie Rochester Conference Series on Public Policy, vol. 39, 1993.
1997-01-14T00:00:00	Mr. Greenspan addresses some key roles of a central bank (Central Bank Articles and Speeches, 14 Jan 97)	Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Catholic University of Leuven on 14/1/97.	Remarks by the Mr. Greenspan addresses some key roles of a central bank Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Catholic University of Leuven on 14/1/97. Mr. Prime Minister, Minister of Finance, Minister of Budget, Rector Oosterlinck, Professor Peeters, ladies and gentlemen, it is a distinct honor, and a great personal pleasure, to be here today to receive this degree from such a distinguished and historic university. Central bankers, because of the continuity of our institutions and the nature of our responsibilities, typically are said to take a long-term view. By that, I mean we try to look beyond the current calendar quarter to the next year or maybe even a few years beyond. Standing here in this university, which was founded more than 500 years ago and had already become a leading university in Europe by the 16th century, gives a meaningful perspective to what central bankers consider the longer term. Today, I shall address the various roles of a central bank encompassing: bank supervision, the provision of financial services, and, of course, monetary policy. I recognize that not all central banks are the same, and in particular that the central bank's role in bank supervision varies considerably from one country to another. However, I view these three elements of a central bank's responsibilities as closely interrelated and mutually supporting, in ways that I will endeavor to elaborate. Before doing so, I might note that the global financial environment in which central banks operate has become an increasingly important factor in carrying out our responsibilities. This is obviously true of smaller and more open economies like Belgium, but it is true also of countries like the United States that are sometimes thought to be self-contained. Monetary policy in all countries must take account of its effects on, and feedback from, the rest of the world. Many financial services provided by central banks involve cross-border transactions of one kind or another. These international relationships add still one more degree of complexity to the already complex lives of central bankers. That is one of our challenges. One of the rewards is the international cooperation that these complexities have spawned. That process of cooperation has been especially deep and long-standing among central banks of the G-10 countries, but it involves finance ministries and officials from other agencies and other countries, as well. I call this one of the rewards not just because it has enhanced the policy process but also, on a more personal level, because it has enabled me to develop good friendships with many of my counterparts, including Alfons Verplaetse of the National Bank of Belgium. Let me begin with the fundamental observation, that a nation's sovereign credit rating lies at the base of its current fiscal, monetary, and, indirectly, regulatory policy. When there is confidence in the integrity of government, monetary authorities -- the central bank and the finance ministry -- can issue unlimited claims denominated in their own currencies and can guarantee or stand ready to guarantee the obligations of private issuers as they see fit. This power has profound implications for both good and ill for our economies. Central banks can issue currency, a non-interest-bearing claim on the government, effectively without limit. They can discount loans and other assets of banks or other private depository institutions, thereby converting potentially illiquid private assets into riskless claims on the government in the form of deposits at the central bank. That all of these claims on government are readily accepted reflects the fact that a government cannot become insolvent with respect to obligations in its own currency. A fiat money system, like the ones we have today, can produce such claims without limit. To be sure, if a central bank produces too many, inflation will inexorably rise as will interest rates, and economic activity will inevitably be constrained by the misallocation of resources induced by inflation. If it produces too few, the economy's expansion also will presumably be constrained by a shortage of the necessary lubricant for transactions. Authorities must struggle continuously to find the proper balance. It was not always thus. For most of the period prior to the early 1930s, obligations of governments in major countries were payable in gold. This meant the whole outstanding debt of government was subject to redemption in a medium, the quantity of which could not be altered at the will of government. Hence, debt issuance and budget deficits were constrained by the potential market response to an inflated economy. It was even possible in such a monetary regime for a government to become insolvent. Indeed, the United States skirted on the edges of bankruptcy in 1895 when our government gold stock shrank ominously and was bailed out by a last minute gold loan, underwritten by a Wall Street syndicate. There is little doubt that under the gold standard the restraint on both public and private credit creation limited price inflation, but it was also increasingly perceived as too restrictive to government discretion. The abandonment of the domestic convertibility of gold effectively augmented the power of the monetary authorities to create claims. Possibly as a consequence, post-World War II fluctuations in gross domestic product have been somewhat less than those prior to the 1930s, and no major economic contraction of the dimensions experienced in earlier years has occurred in major industrial countries. On the other hand, peace-time inflation has been far more virulent. Today, the widespread presumption is that, as a consequence of expectations of continuing inflation over the longer run, both nominal and real long-term interest rates are currently higher than they would otherwise be. Arguably, at root is the potential, however remote, of unconstrained issuance of claims unsupported by the production of goods and services and the accumulation of real assets. Pressures for increased credit unrelated to the needs of markets emerge not only as a consequence of new government debt obligations, both direct and contingent, but also because of government regulations that induce private sector expenditure and borrowing. All of these government-derived demands on resources must be satisfied. Hence, when those demands increase, interest rates tend to rise to crowd out other types of spending. Any employment of the sovereign credit rating for the issuance of government debt, the guaranteeing of the liabilities of depository institutions, or the liquification of assets of depository institutions enables the preemption of real private resources by government fiat. Increased availability of a central bank credit facility, even if not drawn upon, can induce increased credit extension by banks and increased activity by their customers, since creditors of banks are more willing to finance banks' activities with such a governmental backstop available. If that takes place in an environment of strained resource availability, expanded subsidies to depository institutions -- which are often referred to as the "safety net" -- can only augment the pressures. An accommodative monetary policy can ease the strain, but only temporarily and only at the risk of inflation at a later date unless interest rates are eventually allowed to rise. This dilemma is most historically evident in its extreme form during times of war, when governments must choose whether to finance part of the increased war outlays through increased central bank credit or depend wholly on taxes and borrowing from private sources. Accordingly central banks, and finance ministries, must remain especially vigilant in maintaining a proper balance between a safety net that fosters economic and financial stabilization and one that does not. It is in this context of competing demands for resources and the government's unique position that we should consider the role of the central bank in interfacing with banks, and in some instances with other private financial institutions, as lenders of last resort, supervisors, and providers of financial services. Relationship to banks and bank supervision It is important to remember that many of the benefits banks provide modern societies derive from their willingness to take risks and from their use of a relatively high degree of financial leverage. Through leverage, in the form principally of taking deposits, banks perform a critical role in the financial intermediation process; they provide savers with additional investment choices and borrowers with a greater range of sources of credit, thereby facilitating a more efficient allocation of resources and contributing importantly to greater economic growth. Indeed, it has been the evident value of intermediation and leverage that has shaped the development of our financial systems from the earliest times -- certainly since Renaissance goldsmiths discovered that lending out deposited gold was feasible and profitable. Central bank provision of a mechanism for converting highly illiquid portfolios into liquid ones in extraordinary circumstances has led to a greater degree of leverage in banking than market forces alone would support. Traditionally this has been accomplished by making discount or Lombard facilities available, so that individual depositories could turn illiquid assets into liquid resources and not exacerbate unsettled market conditions by the forced selling of such assets or the calling of loans. More broadly, open market operations, in situations like that which followed the crash of stock markets around the world in 1987, satisfy increased needs for liquidity for the system as a whole that otherwise could feed cumulative, self-reinforcing, contractions across many financial markets. Of course, this same leverage and risk-taking also greatly increase the possibility of bank failures. Without leverage, losses from risk-taking would be absorbed by a bank's owners, virtually eliminating the chance that the bank would be unable to meet its obligations in the case of a "failure." Some failures can be of a bank's own making, resulting, for example, from poor credit judgments. For the most part, these failures are a normal and important part of the market process and provide discipline and information to other participants regarding the level of business risks. However, because of the important roles that banks and other financial intermediaries play in our financial systems, such failures could have large ripple effects that spread throughout business and financial markets at great cost. Any use of sovereign credit -- even its potential use -- creates moral hazard, that is, a distortion of incentives that occurs when the party that determines the level of risk receives the gains from, but does not bear the full costs of, the risks taken. At the extreme, monetary authorities could guarantee all private liabilities, which might assuage any immediate crisis but leave a long-term legacy of distorted incentives and presumably thwarted growth potential. Thus, governments, including central banks, have to strive for a balanced use of the sovereign credit rating. It is a difficult tradeoff, but we are seeking a balance in which we can ensure the desired degree of intermediation even in times of financial stress without engendering an unacceptable degree of moral hazard. The disconnect between risk-taking by banks and banks' cost of capital, which has been reduced by the presence of the safety net, has made necessary a degree of supervision and regulation that would not be necessary without the existence of the safety net. That is, regulators are compelled to act as a surrogate for market discipline since the market signals that usually accompany excessive risk-taking are substantially muted, and because the prices to banks of government deposit guarantees, or of access to the safety net more generally, do not, and probably cannot, vary sufficiently with risk to mimic market prices. The problems that arise from the retarding of the pressures of market discipline have led us increasingly to understand that the ideal strategy for supervision and regulation is to endeavor to simulate the market responses that would occur if there were no safety net, but without giving up the basic requirement that financial market disruptions be minimized. To be sure, we should recognize that if we choose to have the advantages of a leveraged system of financial intermediaries, the burden of managing risk in the financial system will not lie with the private sector alone. With leveraging there will always exist a remote possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked. Only a central bank, with its unlimited power to create money, can with a high probability thwart such a process before it becomes destructive. Hence, central banks will of necessity be drawn into becoming lenders of last resort. But implicit in the existence of such a role is that there will be some sort of allocation between the public and private sectors of the burden of risk of extreme outcomes. Thus, central banks are led to provide what essentially amounts to catastrophic financial insurance coverage. Such a public subsidy should be reserved for only the rarest of disasters. If the owners or managers of private financial institutions were to anticipate being propped up frequently by government support, it would only encourage reckless and irresponsible practices. In theory, the allocation of responsibility for risk-bearing between the private sector and the central bank depends upon an evaluation of the private cost of capital. In order to attract, or at least retain, capital, a private financial institution must earn at minimum the overall economy's rate of return, adjusted for risk. In competitive financial markets, the greater the leverage, the higher the rate of return, before adjustment for risk. If private financial institutions have to absorb all financial risk, then the degree to which they can leverage will be limited, the financial sector smaller, and its contribution to the economy more limited. On the other hand, if central banks effectively insulate private institutions from the largest potential losses, however incurred, increased laxity could threaten a major drain on taxpayers or produce inflationary instability as a consequence of excess money creation. In practice, the policy choice of how much, if any, of the extreme market risk that government authorities should absorb is fraught with many complexities. Yet we central bankers make this decision every day, either explicitly or by default. Moreover, we can never know for sure whether the decisions we made were appropriate. The question is not whether our actions are seen to have been necessary in retrospect; the absence of a fire does not mean that we should not have paid for fire insurance. Rather, the question is whether, ex ante, the probability of a systemic collapse was sufficient to warrant intervention. Often, we cannot wait to see whether, in hindsight, the problem will be judged to have been an isolated event and largely benign. Thus, governments, including central banks, have been given certain responsibilities related to their banking and financial systems that must be balanced. We have the responsibility to prevent major financial market disruptions through development and enforcement of prudent regulatory standards and, if necessary in rare circumstances, through direct intervention in market events. But we also have the responsibility to ensure that private sector institutions have the capacity to take prudent and appropriate risks, even though such risks will sometimes result in unanticipated bank losses or even bank failures. Our goal as supervisors, therefore, should not be to prevent all bank failures, but to maintain sufficient prudential standards so that banking problems that do occur do not become widespread. We try to achieve the proper balance through official regulations, as well as through formal and informal supervisory policies and procedures. To some extent, we do this over time by signalling to the market, through our actions, the kinds of circumstances in which we might be willing to intervene to quell financial turmoil, and conversely, what levels of difficulties we expect private institutions to resolve by themselves. The market, then, responds by adjusting the cost of capital to banks. Throughout most of this century, we central bankers have made our decisions largely in a domestic context. However, in recent decades that situation has changed markedly for many countries and, obviously, is changing rapidly here in Europe. While failures will inevitably occur in a dynamic market, the safety net -- not to mention concerns over systemic risk -- requires that regulators not be indifferent to how banks manage their risks. To avoid having to resort to numbing micromanagement, regulators have increasingly insisted that banks put in place systems that allow management to have both the information and procedures to be aware of their own true risk exposures on a global basis and to be able to modify such exposures. The better these risk information and control systems, the more risk a bank can prudently assume. The revolution in information and data processing technology has transformed our financial markets and the way our financial institutions conduct their operations. In most respects, these technological advances have enhanced the potential for reducing transactions costs, to the benefit of consumers of financial services, and for managing risks. But in some respects they have increased the potential for more rapid and widespread disruption. The efficiency of global financial markets, engendered by the rapid proliferation of financial products, has the capability of transmitting mistakes at a far faster pace throughout the financial system in ways that were unknown a generation ago, and not even remotely imagined in the 19th century. Financial crises in the early 19th century, for example, particularly those associated with the Napoleonic Wars, were often related to military and other events in faraway places. Communication was still comparatively primitive. An investor's speculative position could be wiped out by a military setback, and he might not even know about it for days or even weeks. Similarly, the collapse of Barings Brothers in 1995 showed how much more rapidly losses can be generated in the current environment relative to a century earlier when Barings Brothers confronted a similar episode. Current technology enables single individuals to initiate massive transactions with very rapid execution. Clearly, not only has the productivity of global finance increased markedly, but so, obviously, has the ability to generate losses at a previously inconceivable rate. Whether we think about risk in financial markets from a national or, increasingly, international perspective, we should recognize that, if it is technology that has imparted occasional stress to markets, technology can be employed to contain it. Enhancements to financial institutions' internal risk-management systems arguably constitute one of the most effective countermeasures to the increased potential instability of the global financial system. Because the evolution of new technologies takes time, I suspect that we have tended to exaggerate the negative effects of information and data processing technologies on financial markets. We have focussed on the ability of financial market participants to increase their leverage beyond the elusive optimum point. That is, some have voiced concern that the subsidy embodied in the safety net has supported a greater degree of risk-taking than might be appropriate. This is obviously a legitimate concern. Nonetheless, although we may not yet fully appreciate the benefits of recent technological advances, the availability of new technology and new derivative financial instruments already has facilitated more rigorous approaches to the conceptualization, measurement, and management of risk by financial institutions. There are, of course, limitations to the statistical models used in such systems owing to the necessity of overly simplifying assumptions. Consequently, human judgments, based on analytically less precise but far more realistic evaluations of what the future may hold, are of critical importance in risk management. Although a sophisticated understanding of statistical modeling techniques is important to risk management, an intimate knowledge of the markets in which an institution trades, and of the customers it serves, is turning out to be far more important. The diminishing of legal, institutional, and now technological barriers to international financial activities has provided strong impetus to the process of cooperation I referred to earlier. The efforts of bank supervisors meeting at the Bank for International Settlements in Basel have been especially prominent, and deservedly so. They have set minimum standards for sound banking for the world's major banks and have sensitized all of us to the risks that banks must manage. However, their work is not done. Our concepts of appropriate standards continue to evolve just as the technology of risk management evolves. In addition, supervisors from the G-10 countries must continue their efforts to bring supervisors from other countries, including the emerging and transition economies of Asia, Latin America, and Eastern Europe into the process of cooperation -- both to learn from their experiences and to encourage other countries to strengthen their own supervisory systems. Financial services While I do not intend to say much about the provision of financial services by central banks, I might distinguish -- in an oversimplified fashion -- two types of functions. One includes issuing currency, acting as fiscal agent for the government, and other functions that are reasonably straightforward and primarily, though not exclusively, domestic in character. I say straightforward, although I recognize that central bankers in Europe are devoting an extraordinary amount of effort to making sure that such functions will be performed well even as the monetary side of the European Union evolves. These are crucial functions that central banks naturally perform. Nevertheless, one should consider from time to time the extent to which the private sector could perform some of these functions more effectively. The other type of function relates more closely to the principal thrust of my remarks today and involves the need to ensure that the global financial system operates smoothly. What I have in mind specifically is a central bank's role in large value or interbank payment systems: on the one hand, setting standards for risk controls and monitoring the systems; on the other hand, providing certainty, or "finality," to payments made among participants in the system and, when necessary and appropriate, providing liquidity to participants. Any private bank, or for that matter any private business organization, can provide payment services with final settlement. The difficulty is that the final claim on the books of any private institution is not risk-free. Only a central bank is in a position to perform these functions under all circumstances. That, of course, is an element of the safety net, and it therefore raises the same issues of moral hazard and potential abuse of a nation's sovereign credit rating. To be sure, private financial institutions themselves must work to develop the infrastructure for ensuring that payments and settlements can take place with reasonable confidence and that the risks other than those absorbed by the central bank are well understood and properly managed. Those risks will not be eliminated entirely; reducing "float" in the payment system to zero, which would eliminate settlement risk, must be balanced by the capital costs of doing so. It has been just in the last year or so that the risks associated with settlement of the enormous volume of foreign exchange transactions have been fully appreciated, more than 20 years after an incident involving Bank Herstatt in Germany brought this issue to international attention. A report produced last year by a G-10 central bank committee elaborated on these risks and urged the private sector to respond with appropriate institutions and risk controls. I am encouraged that much progress seems to be underway in this area, as in others. Monetary policy This brings me, finally, to the area of monetary policy -- the fundamental responsibility of a modern central bank. In this area, I am pleased to say, there have been positive developments, especially with regard to inflation. The recent record on inflation reduction in industrial countries has been impressive. Measured consumer price inflation in G10 countries averaged only about 2-1/4 percent last year, down more than 3 percentage points from what it was in 1990. Consumer price increases on average in the G-10 have been kept under 3 percent for the past five years -- the longest such period of sustained low inflation in more than three decades. Inflation performance in developing countries also has improved substantially. This success reflects in large part a thorough conceptual overhaul of economic thinking and policymaking. A consensus gradually emerged starting in the late 1970s that inflation destroyed jobs, or at least could not create them. This view has become particularly evident in the communiques that have emanated from the high-level international gatherings of the past two decades. We should take care, however, that our recent success not make us complacent. It is becoming increasingly evident that a key ingredient in achieving the highest possible levels of productivity, real incomes, and living standards over the long run is maintenance of price stability. But to sustain good inflation performance, we need to understand the other factors that lie behind our recent success, in addition to the policy consensus of governments, which must not be allowed to ebb as memories of the stagflation in the 1970s fade. Internally, various steps are being implemented that free up markets and intensify competition, not just in product markets, but in labor markets and financial sectors as well. On the external side, emerging nations, especially in Asia and Latin America, have become increasingly important as production sites and markets and thus as competitors. Faced with this broadened foreign competition, firms in many countries now find it less easy than in the past to raise prices during periods of rising demand at home. The process of adjustment has not been entirely painless. Industrial economies in particular are going through an extended period of economic and financial restructuring that has hit some sectors, firms, and groups of workers particularly hard. The fact that in the past these groups may have felt insulated from such forces probably heightened the consequent stress, and may have contributed to some general uncertainty and insecurity. As a result, workers at present, to a greater extent than usual, trade aspirations for higher levels of earnings for job security. Clearly it takes some time for an economy to realize the full benefits of transition from a high- or even moderate-inflation environment -- with associated uncertainties about future inflation -- to one where inflation is low and under control. Inflation expectations throughout the economy must fall, and financial-market premia related to inflation uncertainty have to dissipate. I doubt the tasks of central bankers will become any easier as we move into the 21st century. Clearly price stability should and will remain the central goal of our activities. But we are having increasing difficulty in pinning down the notion of what constitutes a stable price level. When industrial product was the centerpiece of the advanced economies during the first two-thirds of this century, our overall price indexes served us well. Pricing a pound of electrolytic copper presented few definitional problems. The price of a ton of cold rolled steel sheet, or a linear yard of cotton broad woven fabric, could be reasonably compared over a period of years. But as the century draws to a close, the simple notion of price has turned decidedly ambiguous. What is the price of a unit of software or a legal opinion? How does one evaluate the change in the price of a cataract operation over a ten-year period when the nature of the procedure and its impact on the patient has changed so radically. Indeed, how will we measure inflation, and the associated financial and real implications, in the 21st century when our data -- using current techniques -- could become increasingly less adequate to trace price trends over time? So long as individuals make contractual arrangements for future payments valued in dollars, or marks, or francs, there must be a presumption on the part of those involved in the transaction about the future purchasing power of money. No matter how complex individual products become, there will always be some general sense of the purchasing power of money both across time and across goods and services. Hence, we must assume that embodied in all products is some unit of output and hence of price that is recognizable to producers and consumers and upon which they will base their decisions. Doubtless, we will develop new techniques of price measurement to unearth them as the years go on. It is crucial that we do, for inflation can destabilize an economy even if faulty price indexes fail to reveal it. However such conceptual and technical issues are resolved, central bankers need to err on the side of caution. Working in the context of our individual political environments, we are the ultimate protectors and preservers of the value of our currencies. A central banker cannot be exempted from one very basic fact: In the long run inflation is essentially a monetary phenomenon. Accordingly, the best approach is to maintain a steady course with an appropriate level of restraint. Countries whose currencies are widely used internationally, like the United States, have a special responsibility to provide an anchor of stability for themselves and the world at large. Conclusion In conclusion, let me bring together three aspects of central bank responsibilities. Monetary policy must aim to provide a stable macroeconomic environment, to promote sustainable long-term economic growth without inflation and to allow financial markets to operate without excessive uncertainty. Central banks provide direct support to financial markets through their role in the safety net, that is, the extension to the financial system, under certain circumstances, of the nation's sovereign credit rating. This element of subsidy requires a degree of supervision and regulation to ensure that the safety net is not abused. The payment system, and the central banks' involvement in it, is a key element of the safety net and is, as well, at the core of the financial system through which monetary policy is implemented. Central banks, like everyone else, operate in a global financial market. I can say with some confidence that everywhere, not just in Europe, the concept of a domestic market will have even less meaning in a decade than it does today. It is much more difficult to predict what the world will look like in all its dimensions, but my hope and expectation is that central banks will play a positive part. As all industrial countries are likely to experience similar forces, cooperation is key to our continued success.	---[PAGE_BREAK]--- Mr. Greenspan addresses some key roles of a central bank Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Catholic University of Leuven on 14/1/97. Mr. Prime Minister, Minister of Finance, Minister of Budget, Rector Oosterlinck, Professor Peeters, ladies and gentlemen, it is a distinct honor, and a great personal pleasure, to be here today to receive this degree from such a distinguished and historic university. Central bankers, because of the continuity of our institutions and the nature of our responsibilities, typically are said to take a long-term view. By that, I mean we try to look beyond the current calendar quarter to the next year or maybe even a few years beyond. Standing here in this university, which was founded more than 500 years ago and had already become a leading university in Europe by the 16th century, gives a meaningful perspective to what central bankers consider the longer term. Today, I shall address the various roles of a central bank encompassing: bank supervision, the provision of financial services, and, of course, monetary policy. I recognize that not all central banks are the same, and in particular that the central bank's role in bank supervision varies considerably from one country to another. However, I view these three elements of a central bank's responsibilities as closely interrelated and mutually supporting, in ways that I will endeavor to elaborate. Before doing so, I might note that the global financial environment in which central banks operate has become an increasingly important factor in carrying out our responsibilities. This is obviously true of smaller and more open economies like Belgium, but it is true also of countries like the United States that are sometimes thought to be self-contained. Monetary policy in all countries must take account of its effects on, and feedback from, the rest of the world. Many financial services provided by central banks involve cross-border transactions of one kind or another. These international relationships add still one more degree of complexity to the already complex lives of central bankers. That is one of our challenges. One of the rewards is the international cooperation that these complexities have spawned. That process of cooperation has been especially deep and long-standing among central banks of the G-10 countries, but it involves finance ministries and officials from other agencies and other countries, as well. I call this one of the rewards not just because it has enhanced the policy process but also, on a more personal level, because it has enabled me to develop good friendships with many of my counterparts, including Alfons Verplaetse of the National Bank of Belgium. Let me begin with the fundamental observation, that a nation's sovereign credit rating lies at the base of its current fiscal, monetary, and, indirectly, regulatory policy. When there is confidence in the integrity of government, monetary authorities -- the central bank and the finance ministry -- can issue unlimited claims denominated in their own currencies and can guarantee or stand ready to guarantee the obligations of private issuers as they see fit. This power has profound implications for both good and ill for our economies. Central banks can issue currency, a non-interest-bearing claim on the government, effectively without limit. They can discount loans and other assets of banks or other private depository institutions, thereby converting potentially illiquid private assets into riskless claims on the government in the form of deposits at the central bank. ---[PAGE_BREAK]--- That all of these claims on government are readily accepted reflects the fact that a government cannot become insolvent with respect to obligations in its own currency. A fiat money system, like the ones we have today, can produce such claims without limit. To be sure, if a central bank produces too many, inflation will inexorably rise as will interest rates, and economic activity will inevitably be constrained by the misallocation of resources induced by inflation. If it produces too few, the economy's expansion also will presumably be constrained by a shortage of the necessary lubricant for transactions. Authorities must struggle continuously to find the proper balance. It was not always thus. For most of the period prior to the early 1930s, obligations of governments in major countries were payable in gold. This meant the whole outstanding debt of government was subject to redemption in a medium, the quantity of which could not be altered at the will of government. Hence, debt issuance and budget deficits were constrained by the potential market response to an inflated economy. It was even possible in such a monetary regime for a government to become insolvent. Indeed, the United States skirted on the edges of bankruptcy in 1895 when our government gold stock shrank ominously and was bailed out by a last minute gold loan, underwritten by a Wall Street syndicate. There is little doubt that under the gold standard the restraint on both public and private credit creation limited price inflation, but it was also increasingly perceived as too restrictive to government discretion. The abandonment of the domestic convertibility of gold effectively augmented the power of the monetary authorities to create claims. Possibly as a consequence, post-World War II fluctuations in gross domestic product have been somewhat less than those prior to the 1930s, and no major economic contraction of the dimensions experienced in earlier years has occurred in major industrial countries. On the other hand, peace-time inflation has been far more virulent. Today, the widespread presumption is that, as a consequence of expectations of continuing inflation over the longer run, both nominal and real long-term interest rates are currently higher than they would otherwise be. Arguably, at root is the potential, however remote, of unconstrained issuance of claims unsupported by the production of goods and services and the accumulation of real assets. Pressures for increased credit unrelated to the needs of markets emerge not only as a consequence of new government debt obligations, both direct and contingent, but also because of government regulations that induce private sector expenditure and borrowing. All of these government-derived demands on resources must be satisfied. Hence, when those demands increase, interest rates tend to rise to crowd out other types of spending. Any employment of the sovereign credit rating for the issuance of government debt, the guaranteeing of the liabilities of depository institutions, or the liquification of assets of depository institutions enables the preemption of real private resources by government fiat. Increased availability of a central bank credit facility, even if not drawn upon, can induce increased credit extension by banks and increased activity by their customers, since creditors of banks are more willing to finance banks' activities with such a governmental backstop available. If that takes place in an environment of strained resource availability, expanded subsidies to depository institutions -- which are often referred to as the "safety net" -- can only augment the pressures. An accommodative monetary policy can ease the strain, but only temporarily and only at the risk of inflation at a later date unless interest rates are eventually allowed to rise. This dilemma is most historically evident in its extreme form during times of war, when governments must choose whether to finance part of the increased war outlays ---[PAGE_BREAK]--- through increased central bank credit or depend wholly on taxes and borrowing from private sources. Accordingly central banks, and finance ministries, must remain especially vigilant in maintaining a proper balance between a safety net that fosters economic and financial stabilization and one that does not. It is in this context of competing demands for resources and the government's unique position that we should consider the role of the central bank in interfacing with banks, and in some instances with other private financial institutions, as lenders of last resort, supervisors, and providers of financial services. # Relationship to banks and bank supervision It is important to remember that many of the benefits banks provide modern societies derive from their willingness to take risks and from their use of a relatively high degree of financial leverage. Through leverage, in the form principally of taking deposits, banks perform a critical role in the financial intermediation process; they provide savers with additional investment choices and borrowers with a greater range of sources of credit, thereby facilitating a more efficient allocation of resources and contributing importantly to greater economic growth. Indeed, it has been the evident value of intermediation and leverage that has shaped the development of our financial systems from the earliest times -- certainly since Renaissance goldsmiths discovered that lending out deposited gold was feasible and profitable. Central bank provision of a mechanism for converting highly illiquid portfolios into liquid ones in extraordinary circumstances has led to a greater degree of leverage in banking than market forces alone would support. Traditionally this has been accomplished by making discount or Lombard facilities available, so that individual depositories could turn illiquid assets into liquid resources and not exacerbate unsettled market conditions by the forced selling of such assets or the calling of loans. More broadly, open market operations, in situations like that which followed the crash of stock markets around the world in 1987, satisfy increased needs for liquidity for the system as a whole that otherwise could feed cumulative, self-reinforcing, contractions across many financial markets. Of course, this same leverage and risk-taking also greatly increase the possibility of bank failures. Without leverage, losses from risk-taking would be absorbed by a bank's owners, virtually eliminating the chance that the bank would be unable to meet its obligations in the case of a "failure." Some failures can be of a bank's own making, resulting, for example, from poor credit judgments. For the most part, these failures are a normal and important part of the market process and provide discipline and information to other participants regarding the level of business risks. However, because of the important roles that banks and other financial intermediaries play in our financial systems, such failures could have large ripple effects that spread throughout business and financial markets at great cost. Any use of sovereign credit -- even its potential use -- creates moral hazard, that is, a distortion of incentives that occurs when the party that determines the level of risk receives the gains from, but does not bear the full costs of, the risks taken. At the extreme, monetary authorities could guarantee all private liabilities, which might assuage any immediate crisis but leave a long-term legacy of distorted incentives and presumably thwarted growth potential. Thus, governments, including central banks, have to strive for a balanced use of the sovereign credit rating. It is a difficult tradeoff, but we are seeking a balance in which we can ensure the desired degree of intermediation even in times of financial stress without engendering an unacceptable degree of moral hazard. ---[PAGE_BREAK]--- The disconnect between risk-taking by banks and banks' cost of capital, which has been reduced by the presence of the safety net, has made necessary a degree of supervision and regulation that would not be necessary without the existence of the safety net. That is, regulators are compelled to act as a surrogate for market discipline since the market signals that usually accompany excessive risk-taking are substantially muted, and because the prices to banks of government deposit guarantees, or of access to the safety net more generally, do not, and probably cannot, vary sufficiently with risk to mimic market prices. The problems that arise from the retarding of the pressures of market discipline have led us increasingly to understand that the ideal strategy for supervision and regulation is to endeavor to simulate the market responses that would occur if there were no safety net, but without giving up the basic requirement that financial market disruptions be minimized. To be sure, we should recognize that if we choose to have the advantages of a leveraged system of financial intermediaries, the burden of managing risk in the financial system will not lie with the private sector alone. With leveraging there will always exist a remote possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked. Only a central bank, with its unlimited power to create money, can with a high probability thwart such a process before it becomes destructive. Hence, central banks will of necessity be drawn into becoming lenders of last resort. But implicit in the existence of such a role is that there will be some sort of allocation between the public and private sectors of the burden of risk of extreme outcomes. Thus, central banks are led to provide what essentially amounts to catastrophic financial insurance coverage. Such a public subsidy should be reserved for only the rarest of disasters. If the owners or managers of private financial institutions were to anticipate being propped up frequently by government support, it would only encourage reckless and irresponsible practices. In theory, the allocation of responsibility for risk-bearing between the private sector and the central bank depends upon an evaluation of the private cost of capital. In order to attract, or at least retain, capital, a private financial institution must earn at minimum the overall economy's rate of return, adjusted for risk. In competitive financial markets, the greater the leverage, the higher the rate of return, before adjustment for risk. If private financial institutions have to absorb all financial risk, then the degree to which they can leverage will be limited, the financial sector smaller, and its contribution to the economy more limited. On the other hand, if central banks effectively insulate private institutions from the largest potential losses, however incurred, increased laxity could threaten a major drain on taxpayers or produce inflationary instability as a consequence of excess money creation. In practice, the policy choice of how much, if any, of the extreme market risk that government authorities should absorb is fraught with many complexities. Yet we central bankers make this decision every day, either explicitly or by default. Moreover, we can never know for sure whether the decisions we made were appropriate. The question is not whether our actions are seen to have been necessary in retrospect; the absence of a fire does not mean that we should not have paid for fire insurance. Rather, the question is whether, ex ante, the probability of a systemic collapse was sufficient to warrant intervention. Often, we cannot wait to see whether, in hindsight, the problem will be judged to have been an isolated event and largely benign. Thus, governments, including central banks, have been given certain responsibilities related to their banking and financial systems that must be balanced. We have the responsibility to prevent major financial market disruptions through development and enforcement of prudent regulatory standards and, if necessary in rare circumstances, through ---[PAGE_BREAK]--- direct intervention in market events. But we also have the responsibility to ensure that private sector institutions have the capacity to take prudent and appropriate risks, even though such risks will sometimes result in unanticipated bank losses or even bank failures. Our goal as supervisors, therefore, should not be to prevent all bank failures, but to maintain sufficient prudential standards so that banking problems that do occur do not become widespread. We try to achieve the proper balance through official regulations, as well as through formal and informal supervisory policies and procedures. To some extent, we do this over time by signalling to the market, through our actions, the kinds of circumstances in which we might be willing to intervene to quell financial turmoil, and conversely, what levels of difficulties we expect private institutions to resolve by themselves. The market, then, responds by adjusting the cost of capital to banks. Throughout most of this century, we central bankers have made our decisions largely in a domestic context. However, in recent decades that situation has changed markedly for many countries and, obviously, is changing rapidly here in Europe. While failures will inevitably occur in a dynamic market, the safety net -- not to mention concerns over systemic risk -- requires that regulators not be indifferent to how banks manage their risks. To avoid having to resort to numbing micromanagement, regulators have increasingly insisted that banks put in place systems that allow management to have both the information and procedures to be aware of their own true risk exposures on a global basis and to be able to modify such exposures. The better these risk information and control systems, the more risk a bank can prudently assume. The revolution in information and data processing technology has transformed our financial markets and the way our financial institutions conduct their operations. In most respects, these technological advances have enhanced the potential for reducing transactions costs, to the benefit of consumers of financial services, and for managing risks. But in some respects they have increased the potential for more rapid and widespread disruption. The efficiency of global financial markets, engendered by the rapid proliferation of financial products, has the capability of transmitting mistakes at a far faster pace throughout the financial system in ways that were unknown a generation ago, and not even remotely imagined in the 19th century. Financial crises in the early 19th century, for example, particularly those associated with the Napoleonic Wars, were often related to military and other events in faraway places. Communication was still comparatively primitive. An investor's speculative position could be wiped out by a military setback, and he might not even know about it for days or even weeks. Similarly, the collapse of Barings Brothers in 1995 showed how much more rapidly losses can be generated in the current environment relative to a century earlier when Barings Brothers confronted a similar episode. Current technology enables single individuals to initiate massive transactions with very rapid execution. Clearly, not only has the productivity of global finance increased markedly, but so, obviously, has the ability to generate losses at a previously inconceivable rate. Whether we think about risk in financial markets from a national or, increasingly, international perspective, we should recognize that, if it is technology that has imparted occasional stress to markets, technology can be employed to contain it. Enhancements ---[PAGE_BREAK]--- to financial institutions' internal risk-management systems arguably constitute one of the most effective countermeasures to the increased potential instability of the global financial system. Because the evolution of new technologies takes time, I suspect that we have tended to exaggerate the negative effects of information and data processing technologies on financial markets. We have focussed on the ability of financial market participants to increase their leverage beyond the elusive optimum point. That is, some have voiced concern that the subsidy embodied in the safety net has supported a greater degree of risk-taking than might be appropriate. This is obviously a legitimate concern. Nonetheless, although we may not yet fully appreciate the benefits of recent technological advances, the availability of new technology and new derivative financial instruments already has facilitated more rigorous approaches to the conceptualization, measurement, and management of risk by financial institutions. There are, of course, limitations to the statistical models used in such systems owing to the necessity of overly simplifying assumptions. Consequently, human judgments, based on analytically less precise but far more realistic evaluations of what the future may hold, are of critical importance in risk management. Although a sophisticated understanding of statistical modeling techniques is important to risk management, an intimate knowledge of the markets in which an institution trades, and of the customers it serves, is turning out to be far more important. The diminishing of legal, institutional, and now technological barriers to international financial activities has provided strong impetus to the process of cooperation I referred to earlier. The efforts of bank supervisors meeting at the Bank for International Settlements in Basel have been especially prominent, and deservedly so. They have set minimum standards for sound banking for the world's major banks and have sensitized all of us to the risks that banks must manage. However, their work is not done. Our concepts of appropriate standards continue to evolve just as the technology of risk management evolves. In addition, supervisors from the G-10 countries must continue their efforts to bring supervisors from other countries, including the emerging and transition economies of Asia, Latin America, and Eastern Europe into the process of cooperation -- both to learn from their experiences and to encourage other countries to strengthen their own supervisory systems. # Financial services While I do not intend to say much about the provision of financial services by central banks, I might distinguish -- in an oversimplified fashion -- two types of functions. One includes issuing currency, acting as fiscal agent for the government, and other functions that are reasonably straightforward and primarily, though not exclusively, domestic in character. I say straightforward, although I recognize that central bankers in Europe are devoting an extraordinary amount of effort to making sure that such functions will be performed well even as the monetary side of the European Union evolves. These are crucial functions that central banks naturally perform. Nevertheless, one should consider from time to time the extent to which the private sector could perform some of these functions more effectively. The other type of function relates more closely to the principal thrust of my remarks today and involves the need to ensure that the global financial system operates smoothly. What I have in mind specifically is a central bank's role in large value or interbank payment systems: on the one hand, setting standards for risk controls and monitoring the systems; on the other hand, providing certainty, or "finality," to payments made among ---[PAGE_BREAK]--- participants in the system and, when necessary and appropriate, providing liquidity to participants. Any private bank, or for that matter any private business organization, can provide payment services with final settlement. The difficulty is that the final claim on the books of any private institution is not risk-free. Only a central bank is in a position to perform these functions under all circumstances. That, of course, is an element of the safety net, and it therefore raises the same issues of moral hazard and potential abuse of a nation's sovereign credit rating. To be sure, private financial institutions themselves must work to develop the infrastructure for ensuring that payments and settlements can take place with reasonable confidence and that the risks other than those absorbed by the central bank are well understood and properly managed. Those risks will not be eliminated entirely; reducing "float" in the payment system to zero, which would eliminate settlement risk, must be balanced by the capital costs of doing so. It has been just in the last year or so that the risks associated with settlement of the enormous volume of foreign exchange transactions have been fully appreciated, more than 20 years after an incident involving Bank Herstatt in Germany brought this issue to international attention. A report produced last year by a G-10 central bank committee elaborated on these risks and urged the private sector to respond with appropriate institutions and risk controls. I am encouraged that much progress seems to be underway in this area, as in others. # Monetary policy This brings me, finally, to the area of monetary policy -- the fundamental responsibility of a modern central bank. In this area, I am pleased to say, there have been positive developments, especially with regard to inflation. The recent record on inflation reduction in industrial countries has been impressive. Measured consumer price inflation in G10 countries averaged only about 2-1/4 percent last year, down more than 3 percentage points from what it was in 1990. Consumer price increases on average in the G-10 have been kept under 3 percent for the past five years -- the longest such period of sustained low inflation in more than three decades. Inflation performance in developing countries also has improved substantially. This success reflects in large part a thorough conceptual overhaul of economic thinking and policymaking. A consensus gradually emerged starting in the late 1970s that inflation destroyed jobs, or at least could not create them. This view has become particularly evident in the communiques that have emanated from the high-level international gatherings of the past two decades. We should take care, however, that our recent success not make us complacent. It is becoming increasingly evident that a key ingredient in achieving the highest possible levels of productivity, real incomes, and living standards over the long run is maintenance of price stability. But to sustain good inflation performance, we need to understand the other factors that lie behind our recent success, in addition to the policy consensus of governments, which must not be allowed to ebb as memories of the stagflation in the 1970s fade. Internally, various steps are being implemented that free up markets and intensify competition, not just in product markets, but in labor markets and financial sectors as well. On the external side, emerging nations, especially in Asia and Latin America, have become increasingly important as production sites and markets and thus as competitors. Faced with this broadened foreign competition, firms in many countries now find it less easy than in the past to raise prices during periods of rising demand at home. ---[PAGE_BREAK]--- The process of adjustment has not been entirely painless. Industrial economies in particular are going through an extended period of economic and financial restructuring that has hit some sectors, firms, and groups of workers particularly hard. The fact that in the past these groups may have felt insulated from such forces probably heightened the consequent stress, and may have contributed to some general uncertainty and insecurity. As a result, workers at present, to a greater extent than usual, trade aspirations for higher levels of earnings for job security. Clearly it takes some time for an economy to realize the full benefits of transition from a high- or even moderate-inflation environment -- with associated uncertainties about future inflation -- to one where inflation is low and under control. Inflation expectations throughout the economy must fall, and financial-market premia related to inflation uncertainty have to dissipate. I doubt the tasks of central bankers will become any easier as we move into the 21 st century. Clearly price stability should and will remain the central goal of our activities. But we are having increasing difficulty in pinning down the notion of what constitutes a stable price level. When industrial product was the centerpiece of the advanced economies during the first two-thirds of this century, our overall price indexes served us well. Pricing a pound of electrolytic copper presented few definitional problems. The price of a ton of cold rolled steel sheet, or a linear yard of cotton broad woven fabric, could be reasonably compared over a period of years. But as the century draws to a close, the simple notion of price has turned decidedly ambiguous. What is the price of a unit of software or a legal opinion? How does one evaluate the change in the price of a cataract operation over a ten-year period when the nature of the procedure and its impact on the patient has changed so radically. Indeed, how will we measure inflation, and the associated financial and real implications, in the 21 st century when our data -- using current techniques -- could become increasingly less adequate to trace price trends over time? So long as individuals make contractual arrangements for future payments valued in dollars, or marks, or francs, there must be a presumption on the part of those involved in the transaction about the future purchasing power of money. No matter how complex individual products become, there will always be some general sense of the purchasing power of money both across time and across goods and services. Hence, we must assume that embodied in all products is some unit of output and hence of price that is recognizable to producers and consumers and upon which they will base their decisions. Doubtless, we will develop new techniques of price measurement to unearth them as the years go on. It is crucial that we do, for inflation can destabilize an economy even if faulty price indexes fail to reveal it. However such conceptual and technical issues are resolved, central bankers need to err on the side of caution. Working in the context of our individual political environments, we are the ultimate protectors and preservers of the value of our currencies. A central banker cannot be exempted from one very basic fact: In the long run inflation is essentially a monetary phenomenon. Accordingly, the best approach is to maintain a steady course with an appropriate level of restraint. Countries whose currencies are widely used internationally, like the United States, have a special responsibility to provide an anchor of stability for themselves and the world at large. ---[PAGE_BREAK]--- # Conclusion In conclusion, let me bring together three aspects of central bank responsibilities. Monetary policy must aim to provide a stable macroeconomic environment, to promote sustainable long-term economic growth without inflation and to allow financial markets to operate without excessive uncertainty. Central banks provide direct support to financial markets through their role in the safety net, that is, the extension to the financial system, under certain circumstances, of the nation's sovereign credit rating. This element of subsidy requires a degree of supervision and regulation to ensure that the safety net is not abused. The payment system, and the central banks' involvement in it, is a key element of the safety net and is, as well, at the core of the financial system through which monetary policy is implemented. Central banks, like everyone else, operate in a global financial market. I can say with some confidence that everywhere, not just in Europe, the concept of a domestic market will have even less meaning in a decade than it does today. It is much more difficult to predict what the world will look like in all its dimensions, but my hope and expectation is that central banks will play a positive part. As all industrial countries are likely to experience similar forces, cooperation is key to our continued success.	Alan Greenspan	United States	https://www.bis.org/review/r970116.pdf	Mr. Greenspan addresses some key roles of a central bank Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Catholic University of Leuven on 14/1/97. Mr. Prime Minister, Minister of Finance, Minister of Budget, Rector Oosterlinck, Professor Peeters, ladies and gentlemen, it is a distinct honor, and a great personal pleasure, to be here today to receive this degree from such a distinguished and historic university. Central bankers, because of the continuity of our institutions and the nature of our responsibilities, typically are said to take a long-term view. By that, I mean we try to look beyond the current calendar quarter to the next year or maybe even a few years beyond. Standing here in this university, which was founded more than 500 years ago and had already become a leading university in Europe by the 16th century, gives a meaningful perspective to what central bankers consider the longer term. Today, I shall address the various roles of a central bank encompassing: bank supervision, the provision of financial services, and, of course, monetary policy. I recognize that not all central banks are the same, and in particular that the central bank's role in bank supervision varies considerably from one country to another. However, I view these three elements of a central bank's responsibilities as closely interrelated and mutually supporting, in ways that I will endeavor to elaborate. Before doing so, I might note that the global financial environment in which central banks operate has become an increasingly important factor in carrying out our responsibilities. This is obviously true of smaller and more open economies like Belgium, but it is true also of countries like the United States that are sometimes thought to be self-contained. Monetary policy in all countries must take account of its effects on, and feedback from, the rest of the world. Many financial services provided by central banks involve cross-border transactions of one kind or another. These international relationships add still one more degree of complexity to the already complex lives of central bankers. That is one of our challenges. One of the rewards is the international cooperation that these complexities have spawned. That process of cooperation has been especially deep and long-standing among central banks of the G-10 countries, but it involves finance ministries and officials from other agencies and other countries, as well. I call this one of the rewards not just because it has enhanced the policy process but also, on a more personal level, because it has enabled me to develop good friendships with many of my counterparts, including Alfons Verplaetse of the National Bank of Belgium. Let me begin with the fundamental observation, that a nation's sovereign credit rating lies at the base of its current fiscal, monetary, and, indirectly, regulatory policy. When there is confidence in the integrity of government, monetary authorities -- the central bank and the finance ministry -- can issue unlimited claims denominated in their own currencies and can guarantee or stand ready to guarantee the obligations of private issuers as they see fit. This power has profound implications for both good and ill for our economies. Central banks can issue currency, a non-interest-bearing claim on the government, effectively without limit. They can discount loans and other assets of banks or other private depository institutions, thereby converting potentially illiquid private assets into riskless claims on the government in the form of deposits at the central bank. That all of these claims on government are readily accepted reflects the fact that a government cannot become insolvent with respect to obligations in its own currency. A fiat money system, like the ones we have today, can produce such claims without limit. To be sure, if a central bank produces too many, inflation will inexorably rise as will interest rates, and economic activity will inevitably be constrained by the misallocation of resources induced by inflation. If it produces too few, the economy's expansion also will presumably be constrained by a shortage of the necessary lubricant for transactions. Authorities must struggle continuously to find the proper balance. It was not always thus. For most of the period prior to the early 1930s, obligations of governments in major countries were payable in gold. This meant the whole outstanding debt of government was subject to redemption in a medium, the quantity of which could not be altered at the will of government. Hence, debt issuance and budget deficits were constrained by the potential market response to an inflated economy. It was even possible in such a monetary regime for a government to become insolvent. Indeed, the United States skirted on the edges of bankruptcy in 1895 when our government gold stock shrank ominously and was bailed out by a last minute gold loan, underwritten by a Wall Street syndicate. There is little doubt that under the gold standard the restraint on both public and private credit creation limited price inflation, but it was also increasingly perceived as too restrictive to government discretion. The abandonment of the domestic convertibility of gold effectively augmented the power of the monetary authorities to create claims. Possibly as a consequence, post-World War II fluctuations in gross domestic product have been somewhat less than those prior to the 1930s, and no major economic contraction of the dimensions experienced in earlier years has occurred in major industrial countries. On the other hand, peace-time inflation has been far more virulent. Today, the widespread presumption is that, as a consequence of expectations of continuing inflation over the longer run, both nominal and real long-term interest rates are currently higher than they would otherwise be. Arguably, at root is the potential, however remote, of unconstrained issuance of claims unsupported by the production of goods and services and the accumulation of real assets. Pressures for increased credit unrelated to the needs of markets emerge not only as a consequence of new government debt obligations, both direct and contingent, but also because of government regulations that induce private sector expenditure and borrowing. All of these government-derived demands on resources must be satisfied. Hence, when those demands increase, interest rates tend to rise to crowd out other types of spending. Any employment of the sovereign credit rating for the issuance of government debt, the guaranteeing of the liabilities of depository institutions, or the liquification of assets of depository institutions enables the preemption of real private resources by government fiat. Increased availability of a central bank credit facility, even if not drawn upon, can induce increased credit extension by banks and increased activity by their customers, since creditors of banks are more willing to finance banks' activities with such a governmental backstop available. If that takes place in an environment of strained resource availability, expanded subsidies to depository institutions -- which are often referred to as the "safety net" -- can only augment the pressures. An accommodative monetary policy can ease the strain, but only temporarily and only at the risk of inflation at a later date unless interest rates are eventually allowed to rise. This dilemma is most historically evident in its extreme form during times of war, when governments must choose whether to finance part of the increased war outlays through increased central bank credit or depend wholly on taxes and borrowing from private sources. Accordingly central banks, and finance ministries, must remain especially vigilant in maintaining a proper balance between a safety net that fosters economic and financial stabilization and one that does not. It is in this context of competing demands for resources and the government's unique position that we should consider the role of the central bank in interfacing with banks, and in some instances with other private financial institutions, as lenders of last resort, supervisors, and providers of financial services. It is important to remember that many of the benefits banks provide modern societies derive from their willingness to take risks and from their use of a relatively high degree of financial leverage. Through leverage, in the form principally of taking deposits, banks perform a critical role in the financial intermediation process; they provide savers with additional investment choices and borrowers with a greater range of sources of credit, thereby facilitating a more efficient allocation of resources and contributing importantly to greater economic growth. Indeed, it has been the evident value of intermediation and leverage that has shaped the development of our financial systems from the earliest times -- certainly since Renaissance goldsmiths discovered that lending out deposited gold was feasible and profitable. Central bank provision of a mechanism for converting highly illiquid portfolios into liquid ones in extraordinary circumstances has led to a greater degree of leverage in banking than market forces alone would support. Traditionally this has been accomplished by making discount or Lombard facilities available, so that individual depositories could turn illiquid assets into liquid resources and not exacerbate unsettled market conditions by the forced selling of such assets or the calling of loans. More broadly, open market operations, in situations like that which followed the crash of stock markets around the world in 1987, satisfy increased needs for liquidity for the system as a whole that otherwise could feed cumulative, self-reinforcing, contractions across many financial markets. Of course, this same leverage and risk-taking also greatly increase the possibility of bank failures. Without leverage, losses from risk-taking would be absorbed by a bank's owners, virtually eliminating the chance that the bank would be unable to meet its obligations in the case of a "failure." Some failures can be of a bank's own making, resulting, for example, from poor credit judgments. For the most part, these failures are a normal and important part of the market process and provide discipline and information to other participants regarding the level of business risks. However, because of the important roles that banks and other financial intermediaries play in our financial systems, such failures could have large ripple effects that spread throughout business and financial markets at great cost. Any use of sovereign credit -- even its potential use -- creates moral hazard, that is, a distortion of incentives that occurs when the party that determines the level of risk receives the gains from, but does not bear the full costs of, the risks taken. At the extreme, monetary authorities could guarantee all private liabilities, which might assuage any immediate crisis but leave a long-term legacy of distorted incentives and presumably thwarted growth potential. Thus, governments, including central banks, have to strive for a balanced use of the sovereign credit rating. It is a difficult tradeoff, but we are seeking a balance in which we can ensure the desired degree of intermediation even in times of financial stress without engendering an unacceptable degree of moral hazard. The disconnect between risk-taking by banks and banks' cost of capital, which has been reduced by the presence of the safety net, has made necessary a degree of supervision and regulation that would not be necessary without the existence of the safety net. That is, regulators are compelled to act as a surrogate for market discipline since the market signals that usually accompany excessive risk-taking are substantially muted, and because the prices to banks of government deposit guarantees, or of access to the safety net more generally, do not, and probably cannot, vary sufficiently with risk to mimic market prices. The problems that arise from the retarding of the pressures of market discipline have led us increasingly to understand that the ideal strategy for supervision and regulation is to endeavor to simulate the market responses that would occur if there were no safety net, but without giving up the basic requirement that financial market disruptions be minimized. To be sure, we should recognize that if we choose to have the advantages of a leveraged system of financial intermediaries, the burden of managing risk in the financial system will not lie with the private sector alone. With leveraging there will always exist a remote possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked. Only a central bank, with its unlimited power to create money, can with a high probability thwart such a process before it becomes destructive. Hence, central banks will of necessity be drawn into becoming lenders of last resort. But implicit in the existence of such a role is that there will be some sort of allocation between the public and private sectors of the burden of risk of extreme outcomes. Thus, central banks are led to provide what essentially amounts to catastrophic financial insurance coverage. Such a public subsidy should be reserved for only the rarest of disasters. If the owners or managers of private financial institutions were to anticipate being propped up frequently by government support, it would only encourage reckless and irresponsible practices. In theory, the allocation of responsibility for risk-bearing between the private sector and the central bank depends upon an evaluation of the private cost of capital. In order to attract, or at least retain, capital, a private financial institution must earn at minimum the overall economy's rate of return, adjusted for risk. In competitive financial markets, the greater the leverage, the higher the rate of return, before adjustment for risk. If private financial institutions have to absorb all financial risk, then the degree to which they can leverage will be limited, the financial sector smaller, and its contribution to the economy more limited. On the other hand, if central banks effectively insulate private institutions from the largest potential losses, however incurred, increased laxity could threaten a major drain on taxpayers or produce inflationary instability as a consequence of excess money creation. In practice, the policy choice of how much, if any, of the extreme market risk that government authorities should absorb is fraught with many complexities. Yet we central bankers make this decision every day, either explicitly or by default. Moreover, we can never know for sure whether the decisions we made were appropriate. The question is not whether our actions are seen to have been necessary in retrospect; the absence of a fire does not mean that we should not have paid for fire insurance. Rather, the question is whether, ex ante, the probability of a systemic collapse was sufficient to warrant intervention. Often, we cannot wait to see whether, in hindsight, the problem will be judged to have been an isolated event and largely benign. Thus, governments, including central banks, have been given certain responsibilities related to their banking and financial systems that must be balanced. We have the responsibility to prevent major financial market disruptions through development and enforcement of prudent regulatory standards and, if necessary in rare circumstances, through direct intervention in market events. But we also have the responsibility to ensure that private sector institutions have the capacity to take prudent and appropriate risks, even though such risks will sometimes result in unanticipated bank losses or even bank failures. Our goal as supervisors, therefore, should not be to prevent all bank failures, but to maintain sufficient prudential standards so that banking problems that do occur do not become widespread. We try to achieve the proper balance through official regulations, as well as through formal and informal supervisory policies and procedures. To some extent, we do this over time by signalling to the market, through our actions, the kinds of circumstances in which we might be willing to intervene to quell financial turmoil, and conversely, what levels of difficulties we expect private institutions to resolve by themselves. The market, then, responds by adjusting the cost of capital to banks. Throughout most of this century, we central bankers have made our decisions largely in a domestic context. However, in recent decades that situation has changed markedly for many countries and, obviously, is changing rapidly here in Europe. While failures will inevitably occur in a dynamic market, the safety net -- not to mention concerns over systemic risk -- requires that regulators not be indifferent to how banks manage their risks. To avoid having to resort to numbing micromanagement, regulators have increasingly insisted that banks put in place systems that allow management to have both the information and procedures to be aware of their own true risk exposures on a global basis and to be able to modify such exposures. The better these risk information and control systems, the more risk a bank can prudently assume. The revolution in information and data processing technology has transformed our financial markets and the way our financial institutions conduct their operations. In most respects, these technological advances have enhanced the potential for reducing transactions costs, to the benefit of consumers of financial services, and for managing risks. But in some respects they have increased the potential for more rapid and widespread disruption. The efficiency of global financial markets, engendered by the rapid proliferation of financial products, has the capability of transmitting mistakes at a far faster pace throughout the financial system in ways that were unknown a generation ago, and not even remotely imagined in the 19th century. Financial crises in the early 19th century, for example, particularly those associated with the Napoleonic Wars, were often related to military and other events in faraway places. Communication was still comparatively primitive. An investor's speculative position could be wiped out by a military setback, and he might not even know about it for days or even weeks. Similarly, the collapse of Barings Brothers in 1995 showed how much more rapidly losses can be generated in the current environment relative to a century earlier when Barings Brothers confronted a similar episode. Current technology enables single individuals to initiate massive transactions with very rapid execution. Clearly, not only has the productivity of global finance increased markedly, but so, obviously, has the ability to generate losses at a previously inconceivable rate. Whether we think about risk in financial markets from a national or, increasingly, international perspective, we should recognize that, if it is technology that has imparted occasional stress to markets, technology can be employed to contain it. Enhancements to financial institutions' internal risk-management systems arguably constitute one of the most effective countermeasures to the increased potential instability of the global financial system. Because the evolution of new technologies takes time, I suspect that we have tended to exaggerate the negative effects of information and data processing technologies on financial markets. We have focussed on the ability of financial market participants to increase their leverage beyond the elusive optimum point. That is, some have voiced concern that the subsidy embodied in the safety net has supported a greater degree of risk-taking than might be appropriate. This is obviously a legitimate concern. Nonetheless, although we may not yet fully appreciate the benefits of recent technological advances, the availability of new technology and new derivative financial instruments already has facilitated more rigorous approaches to the conceptualization, measurement, and management of risk by financial institutions. There are, of course, limitations to the statistical models used in such systems owing to the necessity of overly simplifying assumptions. Consequently, human judgments, based on analytically less precise but far more realistic evaluations of what the future may hold, are of critical importance in risk management. Although a sophisticated understanding of statistical modeling techniques is important to risk management, an intimate knowledge of the markets in which an institution trades, and of the customers it serves, is turning out to be far more important. The diminishing of legal, institutional, and now technological barriers to international financial activities has provided strong impetus to the process of cooperation I referred to earlier. The efforts of bank supervisors meeting at the Bank for International Settlements in Basel have been especially prominent, and deservedly so. They have set minimum standards for sound banking for the world's major banks and have sensitized all of us to the risks that banks must manage. However, their work is not done. Our concepts of appropriate standards continue to evolve just as the technology of risk management evolves. In addition, supervisors from the G-10 countries must continue their efforts to bring supervisors from other countries, including the emerging and transition economies of Asia, Latin America, and Eastern Europe into the process of cooperation -- both to learn from their experiences and to encourage other countries to strengthen their own supervisory systems. While I do not intend to say much about the provision of financial services by central banks, I might distinguish -- in an oversimplified fashion -- two types of functions. One includes issuing currency, acting as fiscal agent for the government, and other functions that are reasonably straightforward and primarily, though not exclusively, domestic in character. I say straightforward, although I recognize that central bankers in Europe are devoting an extraordinary amount of effort to making sure that such functions will be performed well even as the monetary side of the European Union evolves. These are crucial functions that central banks naturally perform. Nevertheless, one should consider from time to time the extent to which the private sector could perform some of these functions more effectively. The other type of function relates more closely to the principal thrust of my remarks today and involves the need to ensure that the global financial system operates smoothly. What I have in mind specifically is a central bank's role in large value or interbank payment systems: on the one hand, setting standards for risk controls and monitoring the systems; on the other hand, providing certainty, or "finality," to payments made among participants in the system and, when necessary and appropriate, providing liquidity to participants. Any private bank, or for that matter any private business organization, can provide payment services with final settlement. The difficulty is that the final claim on the books of any private institution is not risk-free. Only a central bank is in a position to perform these functions under all circumstances. That, of course, is an element of the safety net, and it therefore raises the same issues of moral hazard and potential abuse of a nation's sovereign credit rating. To be sure, private financial institutions themselves must work to develop the infrastructure for ensuring that payments and settlements can take place with reasonable confidence and that the risks other than those absorbed by the central bank are well understood and properly managed. Those risks will not be eliminated entirely; reducing "float" in the payment system to zero, which would eliminate settlement risk, must be balanced by the capital costs of doing so. It has been just in the last year or so that the risks associated with settlement of the enormous volume of foreign exchange transactions have been fully appreciated, more than 20 years after an incident involving Bank Herstatt in Germany brought this issue to international attention. A report produced last year by a G-10 central bank committee elaborated on these risks and urged the private sector to respond with appropriate institutions and risk controls. I am encouraged that much progress seems to be underway in this area, as in others. This brings me, finally, to the area of monetary policy -- the fundamental responsibility of a modern central bank. In this area, I am pleased to say, there have been positive developments, especially with regard to inflation. The recent record on inflation reduction in industrial countries has been impressive. Measured consumer price inflation in G10 countries averaged only about 2-1/4 percent last year, down more than 3 percentage points from what it was in 1990. Consumer price increases on average in the G-10 have been kept under 3 percent for the past five years -- the longest such period of sustained low inflation in more than three decades. Inflation performance in developing countries also has improved substantially. This success reflects in large part a thorough conceptual overhaul of economic thinking and policymaking. A consensus gradually emerged starting in the late 1970s that inflation destroyed jobs, or at least could not create them. This view has become particularly evident in the communiques that have emanated from the high-level international gatherings of the past two decades. We should take care, however, that our recent success not make us complacent. It is becoming increasingly evident that a key ingredient in achieving the highest possible levels of productivity, real incomes, and living standards over the long run is maintenance of price stability. But to sustain good inflation performance, we need to understand the other factors that lie behind our recent success, in addition to the policy consensus of governments, which must not be allowed to ebb as memories of the stagflation in the 1970s fade. Internally, various steps are being implemented that free up markets and intensify competition, not just in product markets, but in labor markets and financial sectors as well. On the external side, emerging nations, especially in Asia and Latin America, have become increasingly important as production sites and markets and thus as competitors. Faced with this broadened foreign competition, firms in many countries now find it less easy than in the past to raise prices during periods of rising demand at home. The process of adjustment has not been entirely painless. Industrial economies in particular are going through an extended period of economic and financial restructuring that has hit some sectors, firms, and groups of workers particularly hard. The fact that in the past these groups may have felt insulated from such forces probably heightened the consequent stress, and may have contributed to some general uncertainty and insecurity. As a result, workers at present, to a greater extent than usual, trade aspirations for higher levels of earnings for job security. Clearly it takes some time for an economy to realize the full benefits of transition from a high- or even moderate-inflation environment -- with associated uncertainties about future inflation -- to one where inflation is low and under control. Inflation expectations throughout the economy must fall, and financial-market premia related to inflation uncertainty have to dissipate. I doubt the tasks of central bankers will become any easier as we move into the 21 st century. Clearly price stability should and will remain the central goal of our activities. But we are having increasing difficulty in pinning down the notion of what constitutes a stable price level. When industrial product was the centerpiece of the advanced economies during the first two-thirds of this century, our overall price indexes served us well. Pricing a pound of electrolytic copper presented few definitional problems. The price of a ton of cold rolled steel sheet, or a linear yard of cotton broad woven fabric, could be reasonably compared over a period of years. But as the century draws to a close, the simple notion of price has turned decidedly ambiguous. What is the price of a unit of software or a legal opinion? How does one evaluate the change in the price of a cataract operation over a ten-year period when the nature of the procedure and its impact on the patient has changed so radically. Indeed, how will we measure inflation, and the associated financial and real implications, in the 21 st century when our data -- using current techniques -- could become increasingly less adequate to trace price trends over time? So long as individuals make contractual arrangements for future payments valued in dollars, or marks, or francs, there must be a presumption on the part of those involved in the transaction about the future purchasing power of money. No matter how complex individual products become, there will always be some general sense of the purchasing power of money both across time and across goods and services. Hence, we must assume that embodied in all products is some unit of output and hence of price that is recognizable to producers and consumers and upon which they will base their decisions. Doubtless, we will develop new techniques of price measurement to unearth them as the years go on. It is crucial that we do, for inflation can destabilize an economy even if faulty price indexes fail to reveal it. However such conceptual and technical issues are resolved, central bankers need to err on the side of caution. Working in the context of our individual political environments, we are the ultimate protectors and preservers of the value of our currencies. A central banker cannot be exempted from one very basic fact: In the long run inflation is essentially a monetary phenomenon. Accordingly, the best approach is to maintain a steady course with an appropriate level of restraint. Countries whose currencies are widely used internationally, like the United States, have a special responsibility to provide an anchor of stability for themselves and the world at large. In conclusion, let me bring together three aspects of central bank responsibilities. Monetary policy must aim to provide a stable macroeconomic environment, to promote sustainable long-term economic growth without inflation and to allow financial markets to operate without excessive uncertainty. Central banks provide direct support to financial markets through their role in the safety net, that is, the extension to the financial system, under certain circumstances, of the nation's sovereign credit rating. This element of subsidy requires a degree of supervision and regulation to ensure that the safety net is not abused. The payment system, and the central banks' involvement in it, is a key element of the safety net and is, as well, at the core of the financial system through which monetary policy is implemented. Central banks, like everyone else, operate in a global financial market. I can say with some confidence that everywhere, not just in Europe, the concept of a domestic market will have even less meaning in a decade than it does today. It is much more difficult to predict what the world will look like in all its dimensions, but my hope and expectation is that central banks will play a positive part. As all industrial countries are likely to experience similar forces, cooperation is key to our continued success.
1997-01-16T00:00:00	Mr. Meyer reviews the economic outlook and challenges for monetary policy in the United States (Central Bank Articles and Speeches, 16 Jan 97)	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the Charlotte Economics Club, Charlotte, North Carolina on 16/1/97.	Mr. Meyer reviews the economic outlook and challenges for monetary policy in the United States Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the Charlotte Economics Club, Charlotte, North Carolina on 16/1/97. 1996 was an extraordinarily good year for the economy. Measured on a fourth quarter to fourth quarter basis, it appears that GDP advanced around 3% and prices, measured by the chain price index for GDP, increased just above 2%. A little historical perspective will help us further appreciate recent economic performance. Inflation in 1996, measured by the chain price index for GDP or the core CPI, was the lowest in 30 years. And this was not a one-year fluke. Last year was the fifth consecutive year that inflation, measured by the chain GDP price index, was 2.6% or lower and the 5-year compound annual inflation rate is now 2.5%, the lowest since 1967. The extraordinary achievement of 1996, of course, was reaching such low levels of unemployment and inflation at the same time. The 5.4% unemployment rate in 1996 was the lowest annual rate since 1988 and before that since 1973. Specifically, the surprise was a decline in measures of core inflation for consumer and producer goods and in the inflation rate for the GDP price index during a year when the unemployment rate declined and averaged more than 1⁄2 percentage point below levels that in the past had been associated with stable inflation. In the second half of the year, growth slowed, the unemployment rate stabilized, and inflation remained well contained. There is little evidence of imbalances that would jeopardize the expansion. As a result, the consensus forecast projects growth near trend and relatively stable inflation and unemployment rates. We should not, however, let ourselves be overcome by our good fortune. The business cycle is not dead and monetary policy is certain to be challenged again. At the moment, trend growth near full employment appears to be a reasonable prospect in the year ahead. Still we want to remain alert for challenges that might lie just over the horizon. In particular, there remains some uncertainty as to whether the current unemployment rate will prove consistent with stable inflation over time and we need to pay some attention to the challenge of how we approach our longer-term goal of achieving and maintaining price stability. First I will discuss the risks in the outlook. Next I will consider some explanations for the surprisingly good recent inflation performance and implications for inflation going forward. I'll end with a discussion of challenges for the Federal Reserve: three it has faced and met in this expansion, one still in play, and one that may deserve further attention. Balanced Risks Going Forward When I arrived at the Board in late June of last year, the risks appeared to be one-sided. The economy was near capacity and growing above trend. There was a clear risk of overheating, and monetary policy was poised to tighten if necessary. But the forecast was that growth would slow toward trend and, given how well behaved inflation remained, we believed we could afford to be patient and give economic growth a chance to moderate and, so far at least, that patience appears to have been justified. During the second half of 1996, the risks in the outlook became more balanced. The most recent data suggest stronger growth in the fourth quarter than in the third quarter, but growth in the second half of 1996 seems to have been slower than in the first half of the year, and the recent data have not altered my expectation that the economy will grow near trend over the next year. What factors might disturb this benign picture? I want to focus on two basic risks in the outlook - what I will refer to as utilization risk and the growth risk. Let's start with the utilization risk. There is a risk that the current unemployment rate is already below its critical threshold, the full employment unemployment rate, also known as the non-accelerating inflation rate of unemployment, or NAIRU. In this case, trend growth would sustain the prevailing unemployment rate and would therefore be accompanied by modest upward pressure on the inflation rate. Compensation per hour has been edging upward, consistent with the unemployment rate being slightly below NAIRU; on the other hand, core measures of inflation have been trending lower, with the opposite implication. This contrast has kept the Federal Reserve alert, but on the sidelines. But it would be unwise to ignore this risk factor. The growth risk is the risk that growth will be above or below trend. Higher trend growth is unquestionably desirable and should, of course, be accommodated by monetary policy. But above-trend growth implies rising utilization rates. Given that the economy is already near capacity, such an increase in utilization rates would raise the risk of higher inflation. When you are near full employment with stable inflation and growing at trend, both higher and lower growth become risk factors. Another way of making this point is that the downside of such excellent economic performance is that virtually any alternative scenario will represent a deterioration. It's like being at the top of a mountain. There is an exhilaration from getting there and the view is great, but all paths are downhill. Still, history suggests that expansions do not usually end because aggregate demand spontaneously weakens, but rather as a result of excessively buoyant demand, resulting in an overheated economy and an associated acceleration of inflation. On balance, taking into account the possibility that we are already slightly below NAIRU and historical precedent, I have slightly greater concern that inflation will increase than that the economy will lapse into persistent below trend growth and face rising unemployment and further disinflation. This modest asymmetry relative to the base forecast suggests that we need to balance our celebration over recent economic performance with a vigilance with respect to future developments to ensure that the progress we have made with respect to inflation over the last fifteen years is not eroded. The Inflation - Unemployment Rate Puzzle The recent surprisingly good inflation performance challenges our understanding of inflation dynamics. The equation relied on in most structural macro models to explain inflation, the Phillips Curve, has recently been over-predicting inflation. Some will no doubt argue that there should be no great surprise here because the Phillips Curve regularity between short-run movements in inflation and unemployment was long ago theoretically discredited and historically repudiated. When I hear such remarks, and I often do, I know I am listening to someone who has not bothered to look at the data and probably has never estimated a Phillips Curve nor tried his or her hand at forecasting inflation. The truth is that the Philips Curve, in its modern, expectations-augmented form, was the single most stable and useful econometric tool in a forecaster's arsenal for most of the last fifteen years. During this period at Laurence H. Meyer & Associates, our excellent inflation forecasting record was based on one simple rule: don't try to outguess our Phillips Curve. We did not always, of course, religiously follow our own rule. I remember vividly one episode when inflation accelerated early in the year and I convinced my partners to adjust our inflation forecast upward by add-factoring our Phillips Curve. One of our clients called to brag that he was going to make a better inflation forecast for the year than we were. His secret: he was going to ignore our judgment and listen to our model instead. He suggested we do likewise. He was right. Our equation once again distinguished itself. Over the last couple of years, however, estimated Phillips Curves have generally been subject to systematic over-prediction errors; that is, the inflation rate is lower than would have been expected based on the historical relationship and given the prevailing unemployment rate. One possibility is that the equilibrium unemployment rate, or NAIRU, has declined. The estimated value of NAIRU is generally determined in the process of estimating the Phillips Curve; it is the value of the unemployment rate consistent with equality between actual and expected inflation where expected inflation is typically proxied by lagged inflation. Historically, NAIRU has been estimated as a constant, or as a time-varying series that changes over time only due to demographic changes in the labor force. Recently, several studies have used time-varying parameter estimation techniques to look for evidence of a recent decline in NAIRU. Bob Gordon, for example, finds that, based on time-varying parameter estimates, NAIRU has declined from a relatively constant value of 6% over the previous decade to near 5 1⁄2% recently. If the claim that NAIRU has declined recently is correct, it would obviously help explain why we were able to achieve simultaneously low rates of inflation and unemployment in 1996. But, to build confidence in this result, we would like to be able to tell a qualitative story that explains why NAIRU may have declined and find evidence in labor markets, beyond the time varying parameter estimates of NAIRU, that is consistent with it. The source of the decline in NAIRU will, hopefully, help us to answer a very important related question. To the extent that there has been a decline in NAIRU, is it likely to be permanent or transitory? This may have important implications for the inflation forecast over the coming year. I am going to develop two sets of explanations for the surprisingly good performance of inflation relative to unemployment. The first is that there have been a series of favorable supply shocks that have temporarily lowered inflation, for a given unemployment rate, resulting in the appearance of a decline in NAIRU. In this case, absent further favorable supply shocks, inflation performance will not be as favorable for any given unemployment rate as we return to the historical relationship between inflation and unemployment. Second, there may have been a longer-lasting change in the bargaining power of workers relative to firms and/or in the competitive pressure on firms that has resulted in unusual restraint in wage gains and price increases. One explanation in this genre is the "job insecurity" hypothesis and a second is the "absence of pricing leverage" hypothesis. Both are consistent with anecdotal accounts we read about almost daily in the newspapers and hear from businesses, but both of these explanations are difficult to quantify and therefore to test. Let's begin with the favorable supply shock story. We start with a simple version of the Phillips Curve which relates inflation to expected inflation and the gap between unemployment rate and NAIRU. Estimated versions of such a Phillips Curve typically also take some supply shocks into account. Supply shocks refer to exogenous changes in sectoral prices (or wages) which may affect the overall price (or wage) level and, at least temporarily, the overall inflation rate. The classic examples would be legislated changes in the minimum wage, weather-related movements in food prices, and politically inspired changes in energy prices. An adverse supply shock -- an increase in oil prices, for example -- would raise the rate of inflation at any given unemployment rate. Traditionally, NAIRU is estimated assuming an absence of supply shocks. It is the unemployment rate that is consistent with stable inflation in the long run, or, alternatively, is consistent with stable inflation in the absence of supply shocks. We can also calculate a short-run or effective NAIRU as the unemployment rate consistent with stable inflation given whatever supply shocks are in play at the moment. In the case of an adverse supply shock, for example, the short-run or effective NAIRU would be higher than the long-run NAIRU. This simply means that the unemployment rate required to hold overall inflation constant in the face of an increase in oil prices has to be high enough so that inflation in the non-oil sectors will slow on average. Before we can tell the story about favorable supply shocks, I should note that 1996 featured an unusual coincidence of adverse supply shocks. First, the minimum wage was increased; this should boost overall wage gains, labor costs and hence prices. Second, both food and energy prices increased faster than other prices. As a result of the food and energy price increases, there were wide gaps between overall and core measures of inflation for both the PPI and the CPI. The overall CPI increased about 3⁄4 percentage point more than the core CPI and overall PPI increased more than two percentage points faster than core PPI. However, because minimum wage increases, food and energy price increases are routinely included as shock terms in estimated Phillips Curves, these adverse shocks should not result in a systematic under-prediction of inflation and hence any sign of a change in NAIRU. But, despite the acceleration in the overall CPI from 2.5% over 1995 to 3.3% over 1996, the inflation performance was judged to be extraordinarily good because core measures of inflation declined. The core CPI fell, for example, from 3% to 2.6%. Even the overall GDP price index declined, reflecting the combination of a decline in core inflation, a larger weight for computer prices, different treatment of medical costs, and a smaller weight for food and energy in the GDP price index compared with the CPI. It is this well-contained behavior of the core CPI and the GDP price index that is not predicted by typical Phillips Curves and therefore suggests a decline in NAIRU. One explanation of this decline in core inflation is a series of favorable supply shocks in play over the last year or two. The key is that these supply shocks are generally not included in estimated Phillips Curves, so that Phillips Curves missed their effects and over-predicted inflation. The first favorable supply shock is the widely celebrated decline in health care costs, associated with the movement of firms to managed care plans and changes in the medical care market which lowered medical price inflation; this reduced benefit costs to firms, lowered the increase in overall labor costs, and reduced the pressure to raise prices. The second favorable supply shock is the especially rapid decline in computer prices over the past year or two. Third, import prices declined over 1996, due to both lower inflation abroad and the recent appreciation of the dollar. The decline in import prices has a direct effect on the core CPI through the lower cost of purchasing imported goods and an indirect effect on the GDP deflator through the restraint of lower import prices on pricing decisions by U.S. producers. I am not going to support this discussion today with a full recitation of the data. However, each of these developments can be measured, each works to lower "core" inflation over the last year or two, and, collectively, these favorable supply shocks explain at least some portion of the apparent decline in NAIRU. Because the supply shocks are likely to be temporary, part of the apparent decline in NAIRU is likely to be transitory and we may therefore see some gradual increase in core inflation this year, depending to be sure, on what happens to computer prices, benefit costs, and import prices. On the other hand, any resulting increase in core inflation may be more than offset in 1997 by a slowing of the increase in food prices and a partial reversal of the recent increase in energy prices. Let me now turn to the more challenging stories, job insecurity and absence of pricing leverage. The anecdotal "evidence" in each case is impressive, but it is, nevertheless, difficult to quantify these forces and therefore test their significance and measure their importance. But let's at least make an effort to understand the stories. The worker insecurity hypothesis seeks to explain the recent favorable inflation performance as a labor market event, in which workers have been cowed by the recent spate of job losses (or threats of job losses) and, as a result, are less likely to push for additional wage increases, even in tight labor markets. Two issues have to be addressed relative to this hypothesis. Is there evidence in labor market data, other than via Phillips Curve equations, to support this hypothesis? Is the decline in NAIRU resulting from worker insecurity permanent or temporary? There are two types of evidence supporting the hypothesis that workers have become less secure about their jobs. The first is that the proportion of workers who have suffered a permanent job loss in recent years looks high relative to the late 1980s when the aggregate unemployment rate was similar to its current level; this is consistent with the increased reports of corporate downsizing we've seen in this decade. For example, according to data BLS released this past fall, the percent of workers who were displaced from their job between 1993 and 1995 was nearly as high as in the previous recession, and well above the displacement rates seen in the late 1980s. Similarly, the percentage of unemployed who were permanently separated from their job has continued to trend up. These surveys also suggest that a broader spectrum of workers have been affected by permanent job losses. The idea that unskilled blue-collar workers are the only group with significant risk of a permanent job loss is no longer valid. Job displacement rates are up for white-collar workers, more educated workers, and those with greater tenure. The second piece of evidence supporting the job insecurity story is that workers appear reluctant to voluntarily leave their jobs because of an increased apprehension about the difficulty in finding a comparable new job. Although there is anecdotal evidence that fears about skill obsolescence and loss of health insurance are important factors influencing worker concerns, the sources of worker anxiety are difficult to measure with any accuracy. Nonetheless, there does appear to be a smaller flow of quits into unemployment than would be expected at this stage of the expansion. In a sense, the deterioration in workers' perception of their job security can be viewed as an outward shift in their labor supply schedule -- a decline in the reservation wage, if you will. The result of this shift in the supply curve is a decline in the real wage to a new equilibrium level. And during the transition to this new equilibrium, nominal wage growth will fall short of its normal relationship to prices and the unemployment rate, appearing as transitory decline in NAIRU. Whether the decline in job security also leads to a permanent decline in NAIRU is a more difficult issue to assess. An alternative or complementary explanation for the surprising inflation performance is the perception of an absence of pricing leverage on the part of firms. In this story, the dynamics of the inflation process seem almost reversed from the way I have traditionally modeled them. The traditional econometric model specifies prices as set in relation to costs. The mark-up may vary cyclically, but the major source of cyclical rise in inflation is via a cyclical rise in costs, primarily through cyclical increases in wage costs, in turn due to demand pressure in the labor market. The firm passes forward such increases in costs. The real action is in the labor market. Today, by contrast, it appears that the dynamics have been reversed. The point of departure is the perceived inability of firms to pass forward increases in costs. That dictates an obsession by firms with containing costs. That means bargaining aggressively to avoid increases in wage costs, intensive efforts to offset any wage increases with productivity gains, and the necessity of absorbing in profit margins increases in costs that cannot be offset. The absence of pricing leverage is generally attributed to a perception of increased competition. Every firm fears being the first to raise prices and suffer, as a consequence, an increase in its relative prices and a decline in market share. There are at least two problems with this explanation. First, we have to identify the source of the fundamental change in competitive pressure. Second, an exogenous increase in competitive pressure should initially compress profit margins, whereas firm profitability has remained very high. The absence of pricing leverage may simply reflect the fact that product markets are not tight, compared to labor markets. There may be some excess demand in labor markets, but the effect on wages and prices is being offset for the moment by favorable supply shocks. On the other hand, capacity utilization rates show no signs of excess demand in product markets. It is excess demand that gives pricing leverage to firms. The absence of pricing leverage by firms, as a result of an absence of demand pressure, induces firms to work hard to restrain wage increases or to offset them with productivity gains. Let me sum up my interpretation of the recent unemployment and inflation experience. Economic performance has truly been excellent over the past year with a particularly impressive combination of low core inflation and low unemployment in 1996. But this performance does not suggest that the business cycle is dead or that the Phillips Curve is no longer relevant. The decline in core inflation during 1996 most likely reflects the role of a coincidence of favorable supply shocks. Developments in labor markets over the last few years do provide a hint of a modest decline in NAIRU, but the evidence is not definitive and it remains uncertain whether any decline in NAIRU is temporary or permanent. Consequently, a prudent monetary policy would be based on a working assumption that the underlying trend of inflation has been stabilized in the past couple of years and that we shall have to maintain a close watch for signs that inflationary pressures are mounting. Challenges for Monetary Policy Let me turn now to the implications of the economic outlook for challenges to monetary policy. I'll discuss five challenges, three faced and met earlier in the expansion, one currently in play, and a fifth that deserves attention. The first challenge was the more erratic and, on average, slower pace of recovery following the last recession. This was due, in large measure, to the weight of a series of structural imbalances inherited from the previous expansion. In response to the unique features of the recovery, monetary policy remained unusually stimulative long into the expansion, with the Federal Reserve maintaining a 3% nominal federal funds rate and near-zero real federal funds rate for three years into the current expansion. The next challenge came when the "headwinds" began to abate and the economy was poised to move to more robust growth in 1994, at a time when the unemployment rate had already declined from its cyclical high to closer to estimates of full employment. The timing and aggressiveness of Federal Reserve tightening over 1994 met the second challenge, preventing overheating. The third challenge was to adjust monetary policy, once the economy showed signs of slowing in early 1995, to avoid overkill and set the foundation for trend growth near full employment with stable inflation. The two most common errors in cyclical monetary policy are, first, waiting too long to tighten and then not tightening aggressively enough in the initial stages; and, second, eventually overdoing tightening as a result of the lags in monetary policy. When monetary policy moves to tighten, the effects are initially, because of lags, small and hard to detect. So the temptation is to continue to tighten until the economy does slow. By this time the delayed effects of past tightening are building and threaten a sharper than desired slowdown. In late 1995 and early 1996, monetary policy reversed a small measure of the tightening over the previous year, preventing the sharp rise in interest rates over 1994 from producing a more persistent period of below-trend growth or even a recession. The fourth challenge, which we continue to face, is to preserve the expansion without allowing an acceleration in inflation. This challenge is heightened by uncertainty about the level of NAIRU and about the permanence of an apparent recent decline in NAIRU. Because of the lags, it is widely appreciated that it is desirable for monetary policy to be forward looking. But forward looking policy is predicated on confidence in a model that can predict how current and prospective economic conditions will affect inflation going forward. Uncertainty about NAIRU has, in my view, made monetary policy more cautious in responding to forecasts of inflation that depend on the relationship between the current unemployment rate and some estimate of NAIRU. At the prevailing unemployment rate, the challenge is to be especially watchful for early signs of mounting price pressures and, if necessary, to be at least swiftly reactive to limit and then reverse any acceleration of inflation that might occur. If the unemployment rate declines, however, a more forward-looking approach may quickly become appropriate. The fifth challenge is to embed what has, to date, clearly been excellent short-run adjustments of policy to sustain the expansion and prevent an acceleration of inflation in an overall approach that will achieve the Federal Reserve's long-run objective of price stability. Achieving price stability is in our legislative mandate because it is the contribution we can make over the long run to enhancing economic efficiency and setting the foundation for sustainable growth. Perhaps, this would be a good place for me to stop and you to register your opinions on some of the issues I have covered here.	---[PAGE_BREAK]--- # Mr. Meyer reviews the economic outlook and challenges for monetary policy in the United States Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the Charlotte Economics Club, Charlotte, North Carolina on 16/1/97. 1996 was an extraordinarily good year for the economy. Measured on a fourth quarter to fourth quarter basis, it appears that GDP advanced around $3 \%$ and prices, measured by the chain price index for GDP, increased just above $2 \%$. A little historical perspective will help us further appreciate recent economic performance. Inflation in 1996, measured by the chain price index for GDP or the core CPI, was the lowest in 30 years. And this was not a one-year fluke. Last year was the fifth consecutive year that inflation, measured by the chain GDP price index, was $2.6 \%$ or lower and the 5 -year compound annual inflation rate is now $2.5 \%$, the lowest since 1967. The extraordinary achievement of 1996, of course, was reaching such low levels of unemployment and inflation at the same time. The $5.4 \%$ unemployment rate in 1996 was the lowest annual rate since 1988 and before that since 1973. Specifically, the surprise was a decline in measures of core inflation for consumer and producer goods and in the inflation rate for the GDP price index during a year when the unemployment rate declined and averaged more than $1 / 2$ percentage point below levels that in the past had been associated with stable inflation. In the second half of the year, growth slowed, the unemployment rate stabilized, and inflation remained well contained. There is little evidence of imbalances that would jeopardize the expansion. As a result, the consensus forecast projects growth near trend and relatively stable inflation and unemployment rates. We should not, however, let ourselves be overcome by our good fortune. The business cycle is not dead and monetary policy is certain to be challenged again. At the moment, trend growth near full employment appears to be a reasonable prospect in the year ahead. Still we want to remain alert for challenges that might lie just over the horizon. In particular, there remains some uncertainty as to whether the current unemployment rate will prove consistent with stable inflation over time and we need to pay some attention to the challenge of how we approach our longer-term goal of achieving and maintaining price stability. First I will discuss the risks in the outlook. Next I will consider some explanations for the surprisingly good recent inflation performance and implications for inflation going forward. I'll end with a discussion of challenges for the Federal Reserve: three it has faced and met in this expansion, one still in play, and one that may deserve further attention. ## Balanced Risks Going Forward When I arrived at the Board in late June of last year, the risks appeared to be one-sided. The economy was near capacity and growing above trend. There was a clear risk of overheating, and monetary policy was poised to tighten if necessary. But the forecast was that growth would slow toward trend and, given how well behaved inflation remained, we believed we could afford to be patient and give economic growth a chance to moderate and, so far at least, that patience appears to have been justified. ---[PAGE_BREAK]--- During the second half of 1996, the risks in the outlook became more balanced. The most recent data suggest stronger growth in the fourth quarter than in the third quarter, but growth in the second half of 1996 seems to have been slower than in the first half of the year, and the recent data have not altered my expectation that the economy will grow near trend over the next year. What factors might disturb this benign picture? I want to focus on two basic risks in the outlook - what I will refer to as utilization risk and the growth risk. Let's start with the utilization risk. There is a risk that the current unemployment rate is already below its critical threshold, the full employment unemployment rate, also known as the non-accelerating inflation rate of unemployment, or NAIRU. In this case, trend growth would sustain the prevailing unemployment rate and would therefore be accompanied by modest upward pressure on the inflation rate. Compensation per hour has been edging upward, consistent with the unemployment rate being slightly below NAIRU; on the other hand, core measures of inflation have been trending lower, with the opposite implication. This contrast has kept the Federal Reserve alert, but on the sidelines. But it would be unwise to ignore this risk factor. The growth risk is the risk that growth will be above or below trend. Higher trend growth is unquestionably desirable and should, of course, be accommodated by monetary policy. But above-trend growth implies rising utilization rates. Given that the economy is already near capacity, such an increase in utilization rates would raise the risk of higher inflation. When you are near full employment with stable inflation and growing at trend, both higher and lower growth become risk factors. Another way of making this point is that the downside of such excellent economic performance is that virtually any alternative scenario will represent a deterioration. It's like being at the top of a mountain. There is an exhilaration from getting there and the view is great, but all paths are downhill. Still, history suggests that expansions do not usually end because aggregate demand spontaneously weakens, but rather as a result of excessively buoyant demand, resulting in an overheated economy and an associated acceleration of inflation. On balance, taking into account the possibility that we are already slightly below NAIRU and historical precedent, I have slightly greater concern that inflation will increase than that the economy will lapse into persistent below trend growth and face rising unemployment and further disinflation. This modest asymmetry relative to the base forecast suggests that we need to balance our celebration over recent economic performance with a vigilance with respect to future developments to ensure that the progress we have made with respect to inflation over the last fifteen years is not eroded. # The Inflation - Unemployment Rate Puzzle The recent surprisingly good inflation performance challenges our understanding of inflation dynamics. The equation relied on in most structural macro models to explain inflation, the Phillips Curve, has recently been over-predicting inflation. Some will no doubt argue that there should be no great surprise here because the Phillips Curve regularity between short-run movements in inflation and unemployment was long ago theoretically discredited and historically repudiated. When I hear such remarks, and I often do, I know I am listening to someone who has not bothered to look at the data and probably has never estimated a Phillips Curve nor tried his or her hand at forecasting inflation. The truth is that the Philips Curve, in its modern, expectations-augmented form, was the single most stable and useful econometric tool in a forecaster's arsenal for most of the last fifteen years. ---[PAGE_BREAK]--- During this period at Laurence H. Meyer \& Associates, our excellent inflation forecasting record was based on one simple rule: don't try to outguess our Phillips Curve. We did not always, of course, religiously follow our own rule. I remember vividly one episode when inflation accelerated early in the year and I convinced my partners to adjust our inflation forecast upward by add-factoring our Phillips Curve. One of our clients called to brag that he was going to make a better inflation forecast for the year than we were. His secret: he was going to ignore our judgment and listen to our model instead. He suggested we do likewise. He was right. Our equation once again distinguished itself. Over the last couple of years, however, estimated Phillips Curves have generally been subject to systematic over-prediction errors; that is, the inflation rate is lower than would have been expected based on the historical relationship and given the prevailing unemployment rate. One possibility is that the equilibrium unemployment rate, or NAIRU, has declined. The estimated value of NAIRU is generally determined in the process of estimating the Phillips Curve; it is the value of the unemployment rate consistent with equality between actual and expected inflation where expected inflation is typically proxied by lagged inflation. Historically, NAIRU has been estimated as a constant, or as a time-varying series that changes over time only due to demographic changes in the labor force. Recently, several studies have used time-varying parameter estimation techniques to look for evidence of a recent decline in NAIRU. Bob Gordon, for example, finds that, based on time-varying parameter estimates, NAIRU has declined from a relatively constant value of $6 \%$ over the previous decade to near $5 \frac{1}{2} \%$ recently. If the claim that NAIRU has declined recently is correct, it would obviously help explain why we were able to achieve simultaneously low rates of inflation and unemployment in 1996. But, to build confidence in this result, we would like to be able to tell a qualitative story that explains why NAIRU may have declined and find evidence in labor markets, beyond the time varying parameter estimates of NAIRU, that is consistent with it. The source of the decline in NAIRU will, hopefully, help us to answer a very important related question. To the extent that there has been a decline in NAIRU, is it likely to be permanent or transitory? This may have important implications for the inflation forecast over the coming year. I am going to develop two sets of explanations for the surprisingly good performance of inflation relative to unemployment. The first is that there have been a series of favorable supply shocks that have temporarily lowered inflation, for a given unemployment rate, resulting in the appearance of a decline in NAIRU. In this case, absent further favorable supply shocks, inflation performance will not be as favorable for any given unemployment rate as we return to the historical relationship between inflation and unemployment. Second, there may have been a longer-lasting change in the bargaining power of workers relative to firms and/or in the competitive pressure on firms that has resulted in unusual restraint in wage gains and price increases. One explanation in this genre is the "job insecurity" hypothesis and a second is the "absence of pricing leverage" hypothesis. Both are consistent with anecdotal accounts we read about almost daily in the newspapers and hear from businesses, but both of these explanations are difficult to quantify and therefore to test. Let's begin with the favorable supply shock story. We start with a simple version of the Phillips Curve which relates inflation to expected inflation and the gap between unemployment rate and NAIRU. Estimated versions of such a Phillips Curve typically also take some supply shocks into account. Supply shocks refer to exogenous changes in sectoral prices (or wages) which may affect the overall price (or wage) level and, at least temporarily, the overall inflation rate. The classic examples would be legislated changes in the minimum wage, ---[PAGE_BREAK]--- weather-related movements in food prices, and politically inspired changes in energy prices. An adverse supply shock -- an increase in oil prices, for example -- would raise the rate of inflation at any given unemployment rate. Traditionally, NAIRU is estimated assuming an absence of supply shocks. It is the unemployment rate that is consistent with stable inflation in the long run, or, alternatively, is consistent with stable inflation in the absence of supply shocks. We can also calculate a short-run or effective NAIRU as the unemployment rate consistent with stable inflation given whatever supply shocks are in play at the moment. In the case of an adverse supply shock, for example, the short-run or effective NAIRU would be higher than the long-run NAIRU. This simply means that the unemployment rate required to hold overall inflation constant in the face of an increase in oil prices has to be high enough so that inflation in the non-oil sectors will slow on average. Before we can tell the story about favorable supply shocks, I should note that 1996 featured an unusual coincidence of adverse supply shocks. First, the minimum wage was increased; this should boost overall wage gains, labor costs and hence prices. Second, both food and energy prices increased faster than other prices. As a result of the food and energy price increases, there were wide gaps between overall and core measures of inflation for both the PPI and the CPI. The overall CPI increased about $3 / 4$ percentage point more than the core CPI and overall PPI increased more than two percentage points faster than core PPI. However, because minimum wage increases, food and energy price increases are routinely included as shock terms in estimated Phillips Curves, these adverse shocks should not result in a systematic under-prediction of inflation and hence any sign of a change in NAIRU. But, despite the acceleration in the overall CPI from $2.5 \%$ over 1995 to $3.3 \%$ over 1996, the inflation performance was judged to be extraordinarily good because core measures of inflation declined. The core CPI fell, for example, from $3 \%$ to $2.6 \%$. Even the overall GDP price index declined, reflecting the combination of a decline in core inflation, a larger weight for computer prices, different treatment of medical costs, and a smaller weight for food and energy in the GDP price index compared with the CPI. It is this well-contained behavior of the core CPI and the GDP price index that is not predicted by typical Phillips Curves and therefore suggests a decline in NAIRU. One explanation of this decline in core inflation is a series of favorable supply shocks in play over the last year or two. The key is that these supply shocks are generally not included in estimated Phillips Curves, so that Phillips Curves missed their effects and over-predicted inflation. The first favorable supply shock is the widely celebrated decline in health care costs, associated with the movement of firms to managed care plans and changes in the medical care market which lowered medical price inflation; this reduced benefit costs to firms, lowered the increase in overall labor costs, and reduced the pressure to raise prices. The second favorable supply shock is the especially rapid decline in computer prices over the past year or two. Third, import prices declined over 1996, due to both lower inflation abroad and the recent appreciation of the dollar. The decline in import prices has a direct effect on the core CPI through the lower cost of purchasing imported goods and an indirect effect on the GDP deflator through the restraint of lower import prices on pricing decisions by U.S. producers. I am not going to support this discussion today with a full recitation of the data. However, each of these developments can be measured, each works to lower "core" inflation over the last year or two, and, collectively, these favorable supply shocks explain at least some ---[PAGE_BREAK]--- portion of the apparent decline in NAIRU. Because the supply shocks are likely to be temporary, part of the apparent decline in NAIRU is likely to be transitory and we may therefore see some gradual increase in core inflation this year, depending to be sure, on what happens to computer prices, benefit costs, and import prices. On the other hand, any resulting increase in core inflation may be more than offset in 1997 by a slowing of the increase in food prices and a partial reversal of the recent increase in energy prices. Let me now turn to the more challenging stories, job insecurity and absence of pricing leverage. The anecdotal "evidence" in each case is impressive, but it is, nevertheless, difficult to quantify these forces and therefore test their significance and measure their importance. But let's at least make an effort to understand the stories. The worker insecurity hypothesis seeks to explain the recent favorable inflation performance as a labor market event, in which workers have been cowed by the recent spate of job losses (or threats of job losses) and, as a result, are less likely to push for additional wage increases, even in tight labor markets. Two issues have to be addressed relative to this hypothesis. Is there evidence in labor market data, other than via Phillips Curve equations, to support this hypothesis? Is the decline in NAIRU resulting from worker insecurity permanent or temporary? There are two types of evidence supporting the hypothesis that workers have become less secure about their jobs. The first is that the proportion of workers who have suffered a permanent job loss in recent years looks high relative to the late 1980s when the aggregate unemployment rate was similar to its current level; this is consistent with the increased reports of corporate downsizing we've seen in this decade. For example, according to data BLS released this past fall, the percent of workers who were displaced from their job between 1993 and 1995 was nearly as high as in the previous recession, and well above the displacement rates seen in the late 1980s. Similarly, the percentage of unemployed who were permanently separated from their job has continued to trend up. These surveys also suggest that a broader spectrum of workers have been affected by permanent job losses. The idea that unskilled blue-collar workers are the only group with significant risk of a permanent job loss is no longer valid. Job displacement rates are up for white-collar workers, more educated workers, and those with greater tenure. The second piece of evidence supporting the job insecurity story is that workers appear reluctant to voluntarily leave their jobs because of an increased apprehension about the difficulty in finding a comparable new job. Although there is anecdotal evidence that fears about skill obsolescence and loss of health insurance are important factors influencing worker concerns, the sources of worker anxiety are difficult to measure with any accuracy. Nonetheless, there does appear to be a smaller flow of quits into unemployment than would be expected at this stage of the expansion. In a sense, the deterioration in workers' perception of their job security can be viewed as an outward shift in their labor supply schedule -- a decline in the reservation wage, if you will. The result of this shift in the supply curve is a decline in the real wage to a new equilibrium level. And during the transition to this new equilibrium, nominal wage growth will fall short of its normal relationship to prices and the unemployment rate, appearing as transitory decline in NAIRU. Whether the decline in job security also leads to a permanent decline in NAIRU is a more difficult issue to assess. ---[PAGE_BREAK]--- An alternative or complementary explanation for the surprising inflation performance is the perception of an absence of pricing leverage on the part of firms. In this story, the dynamics of the inflation process seem almost reversed from the way I have traditionally modeled them. The traditional econometric model specifies prices as set in relation to costs. The mark-up may vary cyclically, but the major source of cyclical rise in inflation is via a cyclical rise in costs, primarily through cyclical increases in wage costs, in turn due to demand pressure in the labor market. The firm passes forward such increases in costs. The real action is in the labor market. Today, by contrast, it appears that the dynamics have been reversed. The point of departure is the perceived inability of firms to pass forward increases in costs. That dictates an obsession by firms with containing costs. That means bargaining aggressively to avoid increases in wage costs, intensive efforts to offset any wage increases with productivity gains, and the necessity of absorbing in profit margins increases in costs that cannot be offset. The absence of pricing leverage is generally attributed to a perception of increased competition. Every firm fears being the first to raise prices and suffer, as a consequence, an increase in its relative prices and a decline in market share. There are at least two problems with this explanation. First, we have to identify the source of the fundamental change in competitive pressure. Second, an exogenous increase in competitive pressure should initially compress profit margins, whereas firm profitability has remained very high. The absence of pricing leverage may simply reflect the fact that product markets are not tight, compared to labor markets. There may be some excess demand in labor markets, but the effect on wages and prices is being offset for the moment by favorable supply shocks. On the other hand, capacity utilization rates show no signs of excess demand in product markets. It is excess demand that gives pricing leverage to firms. The absence of pricing leverage by firms, as a result of an absence of demand pressure, induces firms to work hard to restrain wage increases or to offset them with productivity gains. Let me sum up my interpretation of the recent unemployment and inflation experience. Economic performance has truly been excellent over the past year with a particularly impressive combination of low core inflation and low unemployment in 1996. But this performance does not suggest that the business cycle is dead or that the Phillips Curve is no longer relevant. The decline in core inflation during 1996 most likely reflects the role of a coincidence of favorable supply shocks. Developments in labor markets over the last few years do provide a hint of a modest decline in NAIRU, but the evidence is not definitive and it remains uncertain whether any decline in NAIRU is temporary or permanent. Consequently, a prudent monetary policy would be based on a working assumption that the underlying trend of inflation has been stabilized in the past couple of years and that we shall have to maintain a close watch for signs that inflationary pressures are mounting. # Challenges for Monetary Policy Let me turn now to the implications of the economic outlook for challenges to monetary policy. I'll discuss five challenges, three faced and met earlier in the expansion, one currently in play, and a fifth that deserves attention. The first challenge was the more erratic and, on average, slower pace of recovery following the last recession. This was due, in large measure, to the weight of a series of structural imbalances inherited from the previous expansion. In response to the unique features of the recovery, monetary policy remained unusually stimulative long into the expansion, with ---[PAGE_BREAK]--- the Federal Reserve maintaining a 3\% nominal federal funds rate and near-zero real federal funds rate for three years into the current expansion. The next challenge came when the "headwinds" began to abate and the economy was poised to move to more robust growth in 1994, at a time when the unemployment rate had already declined from its cyclical high to closer to estimates of full employment. The timing and aggressiveness of Federal Reserve tightening over 1994 met the second challenge, preventing overheating. The third challenge was to adjust monetary policy, once the economy showed signs of slowing in early 1995, to avoid overkill and set the foundation for trend growth near full employment with stable inflation. The two most common errors in cyclical monetary policy are, first, waiting too long to tighten and then not tightening aggressively enough in the initial stages; and, second, eventually overdoing tightening as a result of the lags in monetary policy. When monetary policy moves to tighten, the effects are initially, because of lags, small and hard to detect. So the temptation is to continue to tighten until the economy does slow. By this time the delayed effects of past tightening are building and threaten a sharper than desired slowdown. In late 1995 and early 1996, monetary policy reversed a small measure of the tightening over the previous year, preventing the sharp rise in interest rates over 1994 from producing a more persistent period of below-trend growth or even a recession. The fourth challenge, which we continue to face, is to preserve the expansion without allowing an acceleration in inflation. This challenge is heightened by uncertainty about the level of NAIRU and about the permanence of an apparent recent decline in NAIRU. Because of the lags, it is widely appreciated that it is desirable for monetary policy to be forward looking. But forward looking policy is predicated on confidence in a model that can predict how current and prospective economic conditions will affect inflation going forward. Uncertainty about NAIRU has, in my view, made monetary policy more cautious in responding to forecasts of inflation that depend on the relationship between the current unemployment rate and some estimate of NAIRU. At the prevailing unemployment rate, the challenge is to be especially watchful for early signs of mounting price pressures and, if necessary, to be at least swiftly reactive to limit and then reverse any acceleration of inflation that might occur. If the unemployment rate declines, however, a more forward-looking approach may quickly become appropriate. The fifth challenge is to embed what has, to date, clearly been excellent short-run adjustments of policy to sustain the expansion and prevent an acceleration of inflation in an overall approach that will achieve the Federal Reserve's long-run objective of price stability. Achieving price stability is in our legislative mandate because it is the contribution we can make over the long run to enhancing economic efficiency and setting the foundation for sustainable growth. Perhaps, this would be a good place for me to stop and you to register your opinions on some of the issues I have covered here.	Laurence H Meyer	United States	https://www.bis.org/review/r970121a.pdf	in the United States Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the Charlotte Economics Club, Charlotte, North Carolina on 16/1/97. 1996 was an extraordinarily good year for the economy. Measured on a fourth quarter to fourth quarter basis, it appears that GDP advanced around $3 \%$ and prices, measured by the chain price index for GDP, increased just above $2 \%$. A little historical perspective will help us further appreciate recent economic performance. Inflation in 1996, measured by the chain price index for GDP or the core CPI, was the lowest in 30 years. And this was not a one-year fluke. Last year was the fifth consecutive year that inflation, measured by the chain GDP price index, was $2.6 \%$ or lower and the 5 -year compound annual inflation rate is now $2.5 \%$, the lowest since 1967. The extraordinary achievement of 1996, of course, was reaching such low levels of unemployment and inflation at the same time. The $5.4 \%$ unemployment rate in 1996 was the lowest annual rate since 1988 and before that since 1973. Specifically, the surprise was a decline in measures of core inflation for consumer and producer goods and in the inflation rate for the GDP price index during a year when the unemployment rate declined and averaged more than $1 / 2$ percentage point below levels that in the past had been associated with stable inflation. In the second half of the year, growth slowed, the unemployment rate stabilized, and inflation remained well contained. There is little evidence of imbalances that would jeopardize the expansion. As a result, the consensus forecast projects growth near trend and relatively stable inflation and unemployment rates. We should not, however, let ourselves be overcome by our good fortune. The business cycle is not dead and monetary policy is certain to be challenged again. At the moment, trend growth near full employment appears to be a reasonable prospect in the year ahead. Still we want to remain alert for challenges that might lie just over the horizon. In particular, there remains some uncertainty as to whether the current unemployment rate will prove consistent with stable inflation over time and we need to pay some attention to the challenge of how we approach our longer-term goal of achieving and maintaining price stability. First I will discuss the risks in the outlook. Next I will consider some explanations for the surprisingly good recent inflation performance and implications for inflation going forward. I'll end with a discussion of challenges for the Federal Reserve: three it has faced and met in this expansion, one still in play, and one that may deserve further attention. When I arrived at the Board in late June of last year, the risks appeared to be one-sided. The economy was near capacity and growing above trend. There was a clear risk of overheating, and monetary policy was poised to tighten if necessary. But the forecast was that growth would slow toward trend and, given how well behaved inflation remained, we believed we could afford to be patient and give economic growth a chance to moderate and, so far at least, that patience appears to have been justified. During the second half of 1996, the risks in the outlook became more balanced. The most recent data suggest stronger growth in the fourth quarter than in the third quarter, but growth in the second half of 1996 seems to have been slower than in the first half of the year, and the recent data have not altered my expectation that the economy will grow near trend over the next year. What factors might disturb this benign picture? I want to focus on two basic risks in the outlook - what I will refer to as utilization risk and the growth risk. Let's start with the utilization risk. There is a risk that the current unemployment rate is already below its critical threshold, the full employment unemployment rate, also known as the non-accelerating inflation rate of unemployment, or NAIRU. In this case, trend growth would sustain the prevailing unemployment rate and would therefore be accompanied by modest upward pressure on the inflation rate. Compensation per hour has been edging upward, consistent with the unemployment rate being slightly below NAIRU; on the other hand, core measures of inflation have been trending lower, with the opposite implication. This contrast has kept the Federal Reserve alert, but on the sidelines. But it would be unwise to ignore this risk factor. The growth risk is the risk that growth will be above or below trend. Higher trend growth is unquestionably desirable and should, of course, be accommodated by monetary policy. But above-trend growth implies rising utilization rates. Given that the economy is already near capacity, such an increase in utilization rates would raise the risk of higher inflation. When you are near full employment with stable inflation and growing at trend, both higher and lower growth become risk factors. Another way of making this point is that the downside of such excellent economic performance is that virtually any alternative scenario will represent a deterioration. It's like being at the top of a mountain. There is an exhilaration from getting there and the view is great, but all paths are downhill. Still, history suggests that expansions do not usually end because aggregate demand spontaneously weakens, but rather as a result of excessively buoyant demand, resulting in an overheated economy and an associated acceleration of inflation. On balance, taking into account the possibility that we are already slightly below NAIRU and historical precedent, I have slightly greater concern that inflation will increase than that the economy will lapse into persistent below trend growth and face rising unemployment and further disinflation. This modest asymmetry relative to the base forecast suggests that we need to balance our celebration over recent economic performance with a vigilance with respect to future developments to ensure that the progress we have made with respect to inflation over the last fifteen years is not eroded. The recent surprisingly good inflation performance challenges our understanding of inflation dynamics. The equation relied on in most structural macro models to explain inflation, the Phillips Curve, has recently been over-predicting inflation. Some will no doubt argue that there should be no great surprise here because the Phillips Curve regularity between short-run movements in inflation and unemployment was long ago theoretically discredited and historically repudiated. When I hear such remarks, and I often do, I know I am listening to someone who has not bothered to look at the data and probably has never estimated a Phillips Curve nor tried his or her hand at forecasting inflation. The truth is that the Philips Curve, in its modern, expectations-augmented form, was the single most stable and useful econometric tool in a forecaster's arsenal for most of the last fifteen years. During this period at Laurence H. Meyer \& Associates, our excellent inflation forecasting record was based on one simple rule: don't try to outguess our Phillips Curve. We did not always, of course, religiously follow our own rule. I remember vividly one episode when inflation accelerated early in the year and I convinced my partners to adjust our inflation forecast upward by add-factoring our Phillips Curve. One of our clients called to brag that he was going to make a better inflation forecast for the year than we were. His secret: he was going to ignore our judgment and listen to our model instead. He suggested we do likewise. He was right. Our equation once again distinguished itself. Over the last couple of years, however, estimated Phillips Curves have generally been subject to systematic over-prediction errors; that is, the inflation rate is lower than would have been expected based on the historical relationship and given the prevailing unemployment rate. One possibility is that the equilibrium unemployment rate, or NAIRU, has declined. The estimated value of NAIRU is generally determined in the process of estimating the Phillips Curve; it is the value of the unemployment rate consistent with equality between actual and expected inflation where expected inflation is typically proxied by lagged inflation. Historically, NAIRU has been estimated as a constant, or as a time-varying series that changes over time only due to demographic changes in the labor force. Recently, several studies have used time-varying parameter estimation techniques to look for evidence of a recent decline in NAIRU. Bob Gordon, for example, finds that, based on time-varying parameter estimates, NAIRU has declined from a relatively constant value of $6 \%$ over the previous decade to near $5 \frac{1}{2} \%$ recently. If the claim that NAIRU has declined recently is correct, it would obviously help explain why we were able to achieve simultaneously low rates of inflation and unemployment in 1996. But, to build confidence in this result, we would like to be able to tell a qualitative story that explains why NAIRU may have declined and find evidence in labor markets, beyond the time varying parameter estimates of NAIRU, that is consistent with it. The source of the decline in NAIRU will, hopefully, help us to answer a very important related question. To the extent that there has been a decline in NAIRU, is it likely to be permanent or transitory? This may have important implications for the inflation forecast over the coming year. I am going to develop two sets of explanations for the surprisingly good performance of inflation relative to unemployment. The first is that there have been a series of favorable supply shocks that have temporarily lowered inflation, for a given unemployment rate, resulting in the appearance of a decline in NAIRU. In this case, absent further favorable supply shocks, inflation performance will not be as favorable for any given unemployment rate as we return to the historical relationship between inflation and unemployment. Second, there may have been a longer-lasting change in the bargaining power of workers relative to firms and/or in the competitive pressure on firms that has resulted in unusual restraint in wage gains and price increases. One explanation in this genre is the "job insecurity" hypothesis and a second is the "absence of pricing leverage" hypothesis. Both are consistent with anecdotal accounts we read about almost daily in the newspapers and hear from businesses, but both of these explanations are difficult to quantify and therefore to test. Let's begin with the favorable supply shock story. We start with a simple version of the Phillips Curve which relates inflation to expected inflation and the gap between unemployment rate and NAIRU. Estimated versions of such a Phillips Curve typically also take some supply shocks into account. Supply shocks refer to exogenous changes in sectoral prices (or wages) which may affect the overall price (or wage) level and, at least temporarily, the overall inflation rate. The classic examples would be legislated changes in the minimum wage, weather-related movements in food prices, and politically inspired changes in energy prices. An adverse supply shock -- an increase in oil prices, for example -- would raise the rate of inflation at any given unemployment rate. Traditionally, NAIRU is estimated assuming an absence of supply shocks. It is the unemployment rate that is consistent with stable inflation in the long run, or, alternatively, is consistent with stable inflation in the absence of supply shocks. We can also calculate a short-run or effective NAIRU as the unemployment rate consistent with stable inflation given whatever supply shocks are in play at the moment. In the case of an adverse supply shock, for example, the short-run or effective NAIRU would be higher than the long-run NAIRU. This simply means that the unemployment rate required to hold overall inflation constant in the face of an increase in oil prices has to be high enough so that inflation in the non-oil sectors will slow on average. Before we can tell the story about favorable supply shocks, I should note that 1996 featured an unusual coincidence of adverse supply shocks. First, the minimum wage was increased; this should boost overall wage gains, labor costs and hence prices. Second, both food and energy prices increased faster than other prices. As a result of the food and energy price increases, there were wide gaps between overall and core measures of inflation for both the PPI and the CPI. The overall CPI increased about $3 / 4$ percentage point more than the core CPI and overall PPI increased more than two percentage points faster than core PPI. However, because minimum wage increases, food and energy price increases are routinely included as shock terms in estimated Phillips Curves, these adverse shocks should not result in a systematic under-prediction of inflation and hence any sign of a change in NAIRU. But, despite the acceleration in the overall CPI from $2.5 \%$ over 1995 to $3.3 \%$ over 1996, the inflation performance was judged to be extraordinarily good because core measures of inflation declined. The core CPI fell, for example, from $3 \%$ to $2.6 \%$. Even the overall GDP price index declined, reflecting the combination of a decline in core inflation, a larger weight for computer prices, different treatment of medical costs, and a smaller weight for food and energy in the GDP price index compared with the CPI. It is this well-contained behavior of the core CPI and the GDP price index that is not predicted by typical Phillips Curves and therefore suggests a decline in NAIRU. One explanation of this decline in core inflation is a series of favorable supply shocks in play over the last year or two. The key is that these supply shocks are generally not included in estimated Phillips Curves, so that Phillips Curves missed their effects and over-predicted inflation. The first favorable supply shock is the widely celebrated decline in health care costs, associated with the movement of firms to managed care plans and changes in the medical care market which lowered medical price inflation; this reduced benefit costs to firms, lowered the increase in overall labor costs, and reduced the pressure to raise prices. The second favorable supply shock is the especially rapid decline in computer prices over the past year or two. Third, import prices declined over 1996, due to both lower inflation abroad and the recent appreciation of the dollar. The decline in import prices has a direct effect on the core CPI through the lower cost of purchasing imported goods and an indirect effect on the GDP deflator through the restraint of lower import prices on pricing decisions by U.S. producers. I am not going to support this discussion today with a full recitation of the data. However, each of these developments can be measured, each works to lower "core" inflation over the last year or two, and, collectively, these favorable supply shocks explain at least some portion of the apparent decline in NAIRU. Because the supply shocks are likely to be temporary, part of the apparent decline in NAIRU is likely to be transitory and we may therefore see some gradual increase in core inflation this year, depending to be sure, on what happens to computer prices, benefit costs, and import prices. On the other hand, any resulting increase in core inflation may be more than offset in 1997 by a slowing of the increase in food prices and a partial reversal of the recent increase in energy prices. Let me now turn to the more challenging stories, job insecurity and absence of pricing leverage. The anecdotal "evidence" in each case is impressive, but it is, nevertheless, difficult to quantify these forces and therefore test their significance and measure their importance. But let's at least make an effort to understand the stories. The worker insecurity hypothesis seeks to explain the recent favorable inflation performance as a labor market event, in which workers have been cowed by the recent spate of job losses (or threats of job losses) and, as a result, are less likely to push for additional wage increases, even in tight labor markets. Two issues have to be addressed relative to this hypothesis. Is there evidence in labor market data, other than via Phillips Curve equations, to support this hypothesis? Is the decline in NAIRU resulting from worker insecurity permanent or temporary? There are two types of evidence supporting the hypothesis that workers have become less secure about their jobs. The first is that the proportion of workers who have suffered a permanent job loss in recent years looks high relative to the late 1980s when the aggregate unemployment rate was similar to its current level; this is consistent with the increased reports of corporate downsizing we've seen in this decade. For example, according to data BLS released this past fall, the percent of workers who were displaced from their job between 1993 and 1995 was nearly as high as in the previous recession, and well above the displacement rates seen in the late 1980s. Similarly, the percentage of unemployed who were permanently separated from their job has continued to trend up. These surveys also suggest that a broader spectrum of workers have been affected by permanent job losses. The idea that unskilled blue-collar workers are the only group with significant risk of a permanent job loss is no longer valid. Job displacement rates are up for white-collar workers, more educated workers, and those with greater tenure. The second piece of evidence supporting the job insecurity story is that workers appear reluctant to voluntarily leave their jobs because of an increased apprehension about the difficulty in finding a comparable new job. Although there is anecdotal evidence that fears about skill obsolescence and loss of health insurance are important factors influencing worker concerns, the sources of worker anxiety are difficult to measure with any accuracy. Nonetheless, there does appear to be a smaller flow of quits into unemployment than would be expected at this stage of the expansion. In a sense, the deterioration in workers' perception of their job security can be viewed as an outward shift in their labor supply schedule -- a decline in the reservation wage, if you will. The result of this shift in the supply curve is a decline in the real wage to a new equilibrium level. And during the transition to this new equilibrium, nominal wage growth will fall short of its normal relationship to prices and the unemployment rate, appearing as transitory decline in NAIRU. Whether the decline in job security also leads to a permanent decline in NAIRU is a more difficult issue to assess. An alternative or complementary explanation for the surprising inflation performance is the perception of an absence of pricing leverage on the part of firms. In this story, the dynamics of the inflation process seem almost reversed from the way I have traditionally modeled them. The traditional econometric model specifies prices as set in relation to costs. The mark-up may vary cyclically, but the major source of cyclical rise in inflation is via a cyclical rise in costs, primarily through cyclical increases in wage costs, in turn due to demand pressure in the labor market. The firm passes forward such increases in costs. The real action is in the labor market. Today, by contrast, it appears that the dynamics have been reversed. The point of departure is the perceived inability of firms to pass forward increases in costs. That dictates an obsession by firms with containing costs. That means bargaining aggressively to avoid increases in wage costs, intensive efforts to offset any wage increases with productivity gains, and the necessity of absorbing in profit margins increases in costs that cannot be offset. The absence of pricing leverage is generally attributed to a perception of increased competition. Every firm fears being the first to raise prices and suffer, as a consequence, an increase in its relative prices and a decline in market share. There are at least two problems with this explanation. First, we have to identify the source of the fundamental change in competitive pressure. Second, an exogenous increase in competitive pressure should initially compress profit margins, whereas firm profitability has remained very high. The absence of pricing leverage may simply reflect the fact that product markets are not tight, compared to labor markets. There may be some excess demand in labor markets, but the effect on wages and prices is being offset for the moment by favorable supply shocks. On the other hand, capacity utilization rates show no signs of excess demand in product markets. It is excess demand that gives pricing leverage to firms. The absence of pricing leverage by firms, as a result of an absence of demand pressure, induces firms to work hard to restrain wage increases or to offset them with productivity gains. Let me sum up my interpretation of the recent unemployment and inflation experience. Economic performance has truly been excellent over the past year with a particularly impressive combination of low core inflation and low unemployment in 1996. But this performance does not suggest that the business cycle is dead or that the Phillips Curve is no longer relevant. The decline in core inflation during 1996 most likely reflects the role of a coincidence of favorable supply shocks. Developments in labor markets over the last few years do provide a hint of a modest decline in NAIRU, but the evidence is not definitive and it remains uncertain whether any decline in NAIRU is temporary or permanent. Consequently, a prudent monetary policy would be based on a working assumption that the underlying trend of inflation has been stabilized in the past couple of years and that we shall have to maintain a close watch for signs that inflationary pressures are mounting. Let me turn now to the implications of the economic outlook for challenges to monetary policy. I'll discuss five challenges, three faced and met earlier in the expansion, one currently in play, and a fifth that deserves attention. The first challenge was the more erratic and, on average, slower pace of recovery following the last recession. This was due, in large measure, to the weight of a series of structural imbalances inherited from the previous expansion. In response to the unique features of the recovery, monetary policy remained unusually stimulative long into the expansion, with the Federal Reserve maintaining a 3\% nominal federal funds rate and near-zero real federal funds rate for three years into the current expansion. The next challenge came when the "headwinds" began to abate and the economy was poised to move to more robust growth in 1994, at a time when the unemployment rate had already declined from its cyclical high to closer to estimates of full employment. The timing and aggressiveness of Federal Reserve tightening over 1994 met the second challenge, preventing overheating. The third challenge was to adjust monetary policy, once the economy showed signs of slowing in early 1995, to avoid overkill and set the foundation for trend growth near full employment with stable inflation. The two most common errors in cyclical monetary policy are, first, waiting too long to tighten and then not tightening aggressively enough in the initial stages; and, second, eventually overdoing tightening as a result of the lags in monetary policy. When monetary policy moves to tighten, the effects are initially, because of lags, small and hard to detect. So the temptation is to continue to tighten until the economy does slow. By this time the delayed effects of past tightening are building and threaten a sharper than desired slowdown. In late 1995 and early 1996, monetary policy reversed a small measure of the tightening over the previous year, preventing the sharp rise in interest rates over 1994 from producing a more persistent period of below-trend growth or even a recession. The fourth challenge, which we continue to face, is to preserve the expansion without allowing an acceleration in inflation. This challenge is heightened by uncertainty about the level of NAIRU and about the permanence of an apparent recent decline in NAIRU. Because of the lags, it is widely appreciated that it is desirable for monetary policy to be forward looking. But forward looking policy is predicated on confidence in a model that can predict how current and prospective economic conditions will affect inflation going forward. Uncertainty about NAIRU has, in my view, made monetary policy more cautious in responding to forecasts of inflation that depend on the relationship between the current unemployment rate and some estimate of NAIRU. At the prevailing unemployment rate, the challenge is to be especially watchful for early signs of mounting price pressures and, if necessary, to be at least swiftly reactive to limit and then reverse any acceleration of inflation that might occur. If the unemployment rate declines, however, a more forward-looking approach may quickly become appropriate. The fifth challenge is to embed what has, to date, clearly been excellent short-run adjustments of policy to sustain the expansion and prevent an acceleration of inflation in an overall approach that will achieve the Federal Reserve's long-run objective of price stability. Achieving price stability is in our legislative mandate because it is the contribution we can make over the long run to enhancing economic efficiency and setting the foundation for sustainable growth. Perhaps, this would be a good place for me to stop and you to register your opinions on some of the issues I have covered here.
1997-01-21T00:00:00	Mr. Greenspan gives some personal perspectives on the current economic situation in the United States (Central Bank Articles and Speeches, 21 Jan 97)	Testimony of the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on the Budget of the US Senate on 21/1/97.	Mr. Greenspan gives some personal perspectives on the current economic situation in the United States Testimony of the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on the Budget of the US Senate on 21/1/97. Mr. Chairman and members of the Committee, I am pleased to appear here today. In just a few weeks the Federal Reserve Board will submit its semiannual report on monetary policy to the Congress. That report and my accompanying testimony will cover in detail our assessment of the outlook for the U.S. economy and the challenges facing monetary policy. This morning, I would like to offer some personal perspectives on the current economic situation. I think it is fair to say that the overall performance of the U.S. economy has continued to surpass most forecasters' expectations. The current cyclical upswing is now approaching six years in duration, and the economy has retained considerable vigor, with few signs of the imbalances and inflationary tensions that have disrupted past expansions. Although the data for the fourth quarter are still incomplete, it is apparent that real gross domestic product posted an increase in the neighborhood of 3 percent over the four quarters of 1996. This increase may seem quite moderate compared with the gains registered in some earlier years of the postwar period; however, at a time when the working-age population is expanding relatively slowly and unemployment is already low, this economic growth is appreciable indeed. It was enough to generate more than 21⁄2 million new payroll jobs last year and to cause the unemployment rate to edge down to 51⁄4 percent -- a figure roughly matching the low of the last cyclical upswing, in the late 1980s. But, in contrast to that earlier period, we have not experienced a broad increase in inflation; in fact, by some important measures of price trends, inflation actually slowed a bit in 1996. The balance and solidity of the expansion last year can be seen in the composition of the growth. Notably, consumers appear to have been rather conservative in their spending. In some instances, they may have been constrained by the debt-service burdens accumulated over the previous few years; but in the aggregate, households experienced an enormous further accretion of net worth as the stock market continued to climb at a breathtaking rate. Judging from historical patterns, such an increase in wealth might have inspired households to spend an enlarged share of their current income; but, if we take the available data at face value, households appear instead to have set aside a greater share of their income for financial investment. Perhaps Americans are finally becoming conscious of the need to accumulate additional assets to ensure not only that they can handle temporary interruptions in employment but also that they will have the wherewithal to enjoy a lengthy retirement down the road. Be that as it may, the increased flow of private savings -- and a reduced call upon those savings by the Treasury -- helped to fund substantial increases in fixed investment last year. Homebuilding activity was up considerably; notably, single-family housing starts were robust once again and helped to push the nation's homeownership rate to a fifteen-year high. In addition, business fixed investment posted another strong advance. Firms acquired large amounts of computing and telecommunications equipment in particular, seeking to enhance the efficiency of their operations as well as their overall productive capacity. At the same time, they accumulated inventories rather cautiously: Stock-to-sales ratios, which had risen in 1995, were in many cases near historic lows as of November 1996, the most recent month for which statistical information is available. The growing economy had beneficial effects on the finances of many states and localities, which consequently could spend more on needed infrastructure and vital services and, in some instances, trim taxes. Of course, overall government sector purchases were held down by the ongoing efforts to reduce the federal deficit. It clearly was private demand that drove economic growth last year. To be more specific, it was domestic private demand that did so, for net exports fell, on balance, in 1996. The volume of goods and services we sold abroad grew appreciably, despite moderate economic expansion by our major trading partners, but our imports continued to grow at a rapid clip. In fact, imports provided a safety valve in a U.S. economy marked by a high degree of resource utilization. I've already noted that our unemployment rate reached the lowest level in some time. Moreover, throughout the year, we heard reports from around the country that qualified workers were in tight supply. Although increases in hourly compensation remained relatively subdued -- an important fact to which I shall return in a few moments -- they did become more sizable, and they raised unit costs when employers were unable to enhance productivity commensurately. Thanks to the very substantial additions to facilities in the past few years, physical capacity in the manufacturing sector was not greatly strained. The question is, of course, where do we go from here? Can we continue to achieve significant gains in real activity while avoiding inflationary excesses? Because monetary policy works with a lag, it is not the conditions prevailing today that are critical but rather those likely to prevail six to twelve months, or even longer, from now. Hence, as difficult as it is, we must arrive at some judgment about the most probable direction of the economy and the distribution of risks around that expectation. Fortunately, economic events are not wholly random and unforecastable. There are certain principles, and certain empirical regularities in behavioral relations, that we can follow with some degree of confidence. For example, capital investment responds in a predictable way to the rate of growth of the economy, expected profitability, and the cost of capital. Similarly, housing activity, with some qualifications, moves inversely with mortgage rates. And the largest component of final demand, personal consumption expenditures, generally follows income over time. Many of these relationships are embedded in the traditional notion of the business cycle developed by Wesley Clair Mitchell three-quarters of a century ago and worked out with Arthur F. Burns, one of my predecessors, in the definitive tome, Measuring Business Cycles. Their insights remain relevant today. Even so, each cycle tends to have its own identifying characteristic. For example, in the late 1980s and the recessionary period of the early 1990s, the economy was dominated by the sharp fall in the market value of commercial real estate; because such real estate served as a major source of loan collateral, the drop in its value had a profoundly restrictive influence on the willingness and ability of commercial banks to lend. As you may recall, at that time, I characterized the economy as trying to advance in the face of fifty-mile-an-hour headwinds. The severe credit restraint was only grudgingly responsive to the extended efforts of the Federal Reserve to ease monetary conditions. Similarly, the dramatic rise of inflation and of inflation expectations in the 1970s was key in shaping the cyclical patterns of that period. One manifestation was the impetus to spending on houses, cars, and other consumer durables from buyers' efforts to beat future price increases. Countering this inflation required a major monetary tightening, which moved both nominal and real interest rates up sharply and led to substantial contractions in housing and other interest-sensitive sectors in the early 1980s. In contrast, as I've mentioned several times to the Congress over the past few years, perhaps the dominant characteristic of the current expansion is low inflation and quiescent inflation expectations, which have helped create a financial environment conducive to strong capital spending and longer-range planning generally. I emphasized this point in our HumphreyHawkins testimony of a year ago. Since then, increases in hourly compensation as measured by the employment cost index have continued to fall far short of what they would have been had historical relationships between compensation gains and the degree of labor market tightness held. Reaching some judgment about the reasons for this departure from past patterns is important. As I see it, heightened job insecurity explains a significant part of the restraint on compensation and the consequent muted price inflation. Surveys of workers have highlighted this extraordinary state of affairs. In 1991, at the bottom of the recession, a survey of workers at large firms indicated that 25 percent feared being laid off. In 1996, despite the sharply lower unemployment rate and the demonstrably tighter labor market, the same survey organization found that 46 percent were fearful of a job layoff. The continued reluctance of workers to leave their jobs to seek other employment as the labor market has tightened provides further evidence of such concern, as does the tendency toward longer labor union contracts. For many decades, contracts rarely exceeded three years. Today, one can point to five- and six-year contracts -- contracts that are commonly characterized by an emphasis on job security and that involve only modest wage increases. The low level of work stoppages of recent years also attests to concern about job security. Thus, the willingness of workers to trade off smaller increases in wages for greater job security seems to be reasonably well-documented for this particular business-cycle expansion. The unanswered question is why this insecurity has persisted even as the labor market has, by all objective measures, tightened considerably. One possibility is the ongoing concern of workers about job skill obsolescence. The reality of this obsolescence is evidenced by the marked expansion of on-the-job training programs, especially in technical areas, in many of the nation's corporations. No longer can one expect to obtain all of one's lifetime job skills with a high-school or college diploma. Indeed, continuing adult education is perceived to be increasingly necessary to retain a job. Certainly, there are other possible explanations of the softness in compensation growth in the past few years. The sharp deceleration in health care costs, of course, is cited frequently. Another possibility is the heightened pressure on firms and their workers in industries that compete internationally. Domestic deregulation has had similar effects on the intensity of competitive forces in some industries. In addition, the continued decline in the share of the private workforce in labor unions has likely made wages more responsive to market forces -- indeed, the converse is also true in that the new competitive realities have in many instances undermined union strength. In any event, although I do not doubt that all these explanations are relevant, I would be surprised if any were dominant. Another potential explanation is that persistently low price inflation is constraining wage increases. Historical evidence clearly indicates that price inflation is a factor in wage change. But, if the causation is running mainly from product markets, where prices are set, to labor markets, where wages are set, then we would expect to see some squeeze on profit margins. Clearly, this is not the case at present. Rather, owing in part to the subdued behavior of wages, profits and rates of return on capital have risen to high levels. The high rates of return, in turn, seem to be inducing competitive pressures that limit the ability of firms to raise prices relative to their underlying cost structures because they fear that competitors anxious to capture a greater share of the market will not follow suit. Thus, the evidence seems more consistent with the view that wage restraint is damping price increases than the other way around. If the job insecurity paradigm that I have outlined is the key, then we must recognize that, as I indicated in last February's Humphrey-Hawkins testimony, "suppressed wage cost growth as a consequence of job insecurity can be carried only so far. At some point in the future, the trade-off of subdued wage growth for job security has to come to an end." In short, this implies that even if the level of real wages remains permanently lower as a result of the experience of the past few years, the relatively modest wage gains we've seen are a transitional rather than a lasting phenomenon. The unknown is how long the transition will last. Indeed, the recent pickup in some measures of wages suggests that the transition may already be running its course. If so, the important question from a monetary policy point of view is whether prospective labor market conditions will be consistent with the maintenance of satisfactory price performance. I would like to conclude with a brief discussion of some issues of measurement and economic data that may be useful as you begin your deliberations on the 1998 budget. One issue you will have to grapple with is the growing consensus that the consumer price index -and other broad price measures that rely heavily on CPI data in their construction -- are substantially overstating changes in the true cost of living. From your perspective, one important implication of the CPI bias is that it creates an automatic and presumably unintended real increase in social security and other indexed federal benefits and a real cut in indexed individual income taxes each year. Less widely recognized is the fact that, for a given level of nominal spending, the upward bias in the CPI in many cases is mirrored in a downward bias in estimates of real spending; this muddies the interpretation of both recent economic developments and longer-run trends in our economic performance. Several researchers have attempted to quantify the bias in the CPI and other broad measures of prices. One set of studies has examined the detailed microstatistical evidence on price measurement. The Boskin Commission drew heavily on these studies and concluded that the CPI is currently overstating changes in the true cost of living by approximately 1 percentage point per year. In addition to some technical factors associated with its construction, the CPI overstates inflation because of the slow introduction of new products and inadequate adjustment for quality improvements. Recently, researchers at the Federal Reserve Board have looked at the measurement issue from a macroeconomic perspective. This analysis, which questions whether the pattern implied by the published price, output, and productivity statistics makes sense, also suggests that the inflation rate is overstated. In particular, the research finds that measured real output and productivity in the service sector of the economy are implausibly weak, given that the return to the owners of these businesses that is implicit in our aggregate statistics on GDP apparently has been well-maintained. The published data indicate that the level of output per hour in several service-producing industries has been falling for more than two decades -- that is, that firms in these industries have been getting less and less efficient for more than twenty years. This pattern is highly unlikely. Price mismeasurement seems to be the most probable explanation of the data anomalies, and the order of magnitude appears consistent with the microstatistical results. The evidence that inflation has been slower and that real growth has been faster than the official measures indicate is welcome, in part because it suggests that the nation's current level of economic well-being is higher than we had thought. But I want to make clear that revising our historical estimates of real growth to incorporate better price data would have no material effect on measures of the degree of resource utilization, because such a revision implies faster growth in potential output, as well as actual output; accordingly, it does not alter the relationship between resource utilization and inflation. Nor does it change the outlook for the federal budget deficit, apart from any modifications to the indexing formulas for entitlements and income taxes. Certainly, the judgment that aggregate productivity has been growing faster than indicated by the official statistics seems reasonable in light of the significant business restructurings and extraordinary improvements in technology in recent years. I do not mean to imply, however, that we should assume that the full productivity gain from information technology has already been reaped. Clearly, it takes some time for firms to adopt production techniques that translate a major new technology into increased output. In an intriguing parallel, electric motors in the late nineteenth century were well-known as a technology but were initially integrated into production systems that were designed for steam-driven power plants. Not until the gradual conversion of previously vertical factories into horizontal facilities, mainly in the 1920s, were firms able to take full advantage of the synergies implicit in the electric dynamo and thus achieve dramatic increases in productivity. Analogously, not all of today's production systems can be easily integrated with new information and communication technologies. Some existing equipment cannot be controlled by computer, for example. Thus, the full exploitation of even the current generation of information and communication equipment may occur over quite a few years and only after a considerably updated stock of physical capital has been put in place. While such a scenario is quite plausible, we cannot be certain when, or if, it will occur. Thus, we must be vigilant to ensure that our economy remains sufficiently flexible for entrepreneurial initiatives. And we must continue our efforts to further enhance productivity growth by raising national saving and spurring capital formation. Attaining a higher national saving rate quite soon is crucial, particularly in view of the anticipated shift in the nation's demographics and associated pressures on federal retirement and health programs in the first few decades of the next century. Reducing the size of the federal budget deficit, and over time moving the unified budget into surplus, would go a substantial way in that direction.	---[PAGE_BREAK]--- # Mr. Greenspan gives some personal perspectives on the current economic situation in the United States Testimony of the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on the Budget of the US Senate on 21/1/97. Mr. Chairman and members of the Committee, I am pleased to appear here today. In just a few weeks the Federal Reserve Board will submit its semiannual report on monetary policy to the Congress. That report and my accompanying testimony will cover in detail our assessment of the outlook for the U.S. economy and the challenges facing monetary policy. This morning, I would like to offer some personal perspectives on the current economic situation. I think it is fair to say that the overall performance of the U.S. economy has continued to surpass most forecasters' expectations. The current cyclical upswing is now approaching six years in duration, and the economy has retained considerable vigor, with few signs of the imbalances and inflationary tensions that have disrupted past expansions. Although the data for the fourth quarter are still incomplete, it is apparent that real gross domestic product posted an increase in the neighborhood of 3 percent over the four quarters of 1996. This increase may seem quite moderate compared with the gains registered in some earlier years of the postwar period; however, at a time when the working-age population is expanding relatively slowly and unemployment is already low, this economic growth is appreciable indeed. It was enough to generate more than $2^{1 / 2}$ million new payroll jobs last year and to cause the unemployment rate to edge down to $5^{1 / 4}$ percent -- a figure roughly matching the low of the last cyclical upswing, in the late 1980s. But, in contrast to that earlier period, we have not experienced a broad increase in inflation; in fact, by some important measures of price trends, inflation actually slowed a bit in 1996. The balance and solidity of the expansion last year can be seen in the composition of the growth. Notably, consumers appear to have been rather conservative in their spending. In some instances, they may have been constrained by the debt-service burdens accumulated over the previous few years; but in the aggregate, households experienced an enormous further accretion of net worth as the stock market continued to climb at a breathtaking rate. Judging from historical patterns, such an increase in wealth might have inspired households to spend an enlarged share of their current income; but, if we take the available data at face value, households appear instead to have set aside a greater share of their income for financial investment. Perhaps Americans are finally becoming conscious of the need to accumulate additional assets to ensure not only that they can handle temporary interruptions in employment but also that they will have the wherewithal to enjoy a lengthy retirement down the road. Be that as it may, the increased flow of private savings -- and a reduced call upon those savings by the Treasury -- helped to fund substantial increases in fixed investment last year. Homebuilding activity was up considerably; notably, single-family housing starts were robust once again and helped to push the nation's homeownership rate to a fifteen-year high. In addition, business fixed investment posted another strong advance. Firms acquired large amounts of computing and telecommunications equipment in particular, seeking to enhance the efficiency of their operations as well as their overall productive capacity. At the same time, they accumulated inventories rather cautiously: Stock-to-sales ratios, which had risen in 1995, were in many cases near historic lows as of November 1996, the most recent month for which statistical information is available. The growing economy had beneficial effects on the finances of many states and localities, which consequently could spend more on needed infrastructure and vital services and, ---[PAGE_BREAK]--- in some instances, trim taxes. Of course, overall government sector purchases were held down by the ongoing efforts to reduce the federal deficit. It clearly was private demand that drove economic growth last year. To be more specific, it was domestic private demand that did so, for net exports fell, on balance, in 1996. The volume of goods and services we sold abroad grew appreciably, despite moderate economic expansion by our major trading partners, but our imports continued to grow at a rapid clip. In fact, imports provided a safety valve in a U.S. economy marked by a high degree of resource utilization. I've already noted that our unemployment rate reached the lowest level in some time. Moreover, throughout the year, we heard reports from around the country that qualified workers were in tight supply. Although increases in hourly compensation remained relatively subdued -- an important fact to which I shall return in a few moments -- they did become more sizable, and they raised unit costs when employers were unable to enhance productivity commensurately. Thanks to the very substantial additions to facilities in the past few years, physical capacity in the manufacturing sector was not greatly strained. The question is, of course, where do we go from here? Can we continue to achieve significant gains in real activity while avoiding inflationary excesses? Because monetary policy works with a lag, it is not the conditions prevailing today that are critical but rather those likely to prevail six to twelve months, or even longer, from now. Hence, as difficult as it is, we must arrive at some judgment about the most probable direction of the economy and the distribution of risks around that expectation. Fortunately, economic events are not wholly random and unforecastable. There are certain principles, and certain empirical regularities in behavioral relations, that we can follow with some degree of confidence. For example, capital investment responds in a predictable way to the rate of growth of the economy, expected profitability, and the cost of capital. Similarly, housing activity, with some qualifications, moves inversely with mortgage rates. And the largest component of final demand, personal consumption expenditures, generally follows income over time. Many of these relationships are embedded in the traditional notion of the business cycle developed by Wesley Clair Mitchell three-quarters of a century ago and worked out with Arthur F. Burns, one of my predecessors, in the definitive tome, Measuring Business Cycles. Their insights remain relevant today. Even so, each cycle tends to have its own identifying characteristic. For example, in the late 1980s and the recessionary period of the early 1990s, the economy was dominated by the sharp fall in the market value of commercial real estate; because such real estate served as a major source of loan collateral, the drop in its value had a profoundly restrictive influence on the willingness and ability of commercial banks to lend. As you may recall, at that time, I characterized the economy as trying to advance in the face of fifty-mile-an-hour headwinds. The severe credit restraint was only grudgingly responsive to the extended efforts of the Federal Reserve to ease monetary conditions. Similarly, the dramatic rise of inflation and of inflation expectations in the 1970s was key in shaping the cyclical patterns of that period. One manifestation was the impetus to spending on houses, cars, and other consumer durables from buyers' efforts to beat future price increases. Countering this inflation required a major monetary tightening, which moved both nominal and real interest rates up sharply and led to substantial contractions in housing and other interest-sensitive sectors in the early 1980s. ---[PAGE_BREAK]--- In contrast, as I've mentioned several times to the Congress over the past few years, perhaps the dominant characteristic of the current expansion is low inflation and quiescent inflation expectations, which have helped create a financial environment conducive to strong capital spending and longer-range planning generally. I emphasized this point in our HumphreyHawkins testimony of a year ago. Since then, increases in hourly compensation as measured by the employment cost index have continued to fall far short of what they would have been had historical relationships between compensation gains and the degree of labor market tightness held. Reaching some judgment about the reasons for this departure from past patterns is important. As I see it, heightened job insecurity explains a significant part of the restraint on compensation and the consequent muted price inflation. Surveys of workers have highlighted this extraordinary state of affairs. In 1991, at the bottom of the recession, a survey of workers at large firms indicated that 25 percent feared being laid off. In 1996, despite the sharply lower unemployment rate and the demonstrably tighter labor market, the same survey organization found that 46 percent were fearful of a job layoff. The continued reluctance of workers to leave their jobs to seek other employment as the labor market has tightened provides further evidence of such concern, as does the tendency toward longer labor union contracts. For many decades, contracts rarely exceeded three years. Today, one can point to five- and six-year contracts -- contracts that are commonly characterized by an emphasis on job security and that involve only modest wage increases. The low level of work stoppages of recent years also attests to concern about job security. Thus, the willingness of workers to trade off smaller increases in wages for greater job security seems to be reasonably well-documented for this particular business-cycle expansion. The unanswered question is why this insecurity has persisted even as the labor market has, by all objective measures, tightened considerably. One possibility is the ongoing concern of workers about job skill obsolescence. The reality of this obsolescence is evidenced by the marked expansion of on-the-job training programs, especially in technical areas, in many of the nation's corporations. No longer can one expect to obtain all of one's lifetime job skills with a high-school or college diploma. Indeed, continuing adult education is perceived to be increasingly necessary to retain a job. Certainly, there are other possible explanations of the softness in compensation growth in the past few years. The sharp deceleration in health care costs, of course, is cited frequently. Another possibility is the heightened pressure on firms and their workers in industries that compete internationally. Domestic deregulation has had similar effects on the intensity of competitive forces in some industries. In addition, the continued decline in the share of the private workforce in labor unions has likely made wages more responsive to market forces -- indeed, the converse is also true in that the new competitive realities have in many instances undermined union strength. In any event, although I do not doubt that all these explanations are relevant, I would be surprised if any were dominant. Another potential explanation is that persistently low price inflation is constraining wage increases. Historical evidence clearly indicates that price inflation is a factor in wage change. But, if the causation is running mainly from product markets, where prices are set, to labor markets, where wages are set, then we would expect to see some squeeze on profit margins. Clearly, this is not the case at present. Rather, owing in part to the subdued behavior of ---[PAGE_BREAK]--- wages, profits and rates of return on capital have risen to high levels. The high rates of return, in turn, seem to be inducing competitive pressures that limit the ability of firms to raise prices relative to their underlying cost structures because they fear that competitors anxious to capture a greater share of the market will not follow suit. Thus, the evidence seems more consistent with the view that wage restraint is damping price increases than the other way around. If the job insecurity paradigm that I have outlined is the key, then we must recognize that, as I indicated in last February's Humphrey-Hawkins testimony, "suppressed wage cost growth as a consequence of job insecurity can be carried only so far. At some point in the future, the trade-off of subdued wage growth for job security has to come to an end." In short, this implies that even if the level of real wages remains permanently lower as a result of the experience of the past few years, the relatively modest wage gains we've seen are a transitional rather than a lasting phenomenon. The unknown is how long the transition will last. Indeed, the recent pickup in some measures of wages suggests that the transition may already be running its course. If so, the important question from a monetary policy point of view is whether prospective labor market conditions will be consistent with the maintenance of satisfactory price performance. I would like to conclude with a brief discussion of some issues of measurement and economic data that may be useful as you begin your deliberations on the 1998 budget. One issue you will have to grapple with is the growing consensus that the consumer price index -and other broad price measures that rely heavily on CPI data in their construction -- are substantially overstating changes in the true cost of living. From your perspective, one important implication of the CPI bias is that it creates an automatic and presumably unintended real increase in social security and other indexed federal benefits and a real cut in indexed individual income taxes each year. Less widely recognized is the fact that, for a given level of nominal spending, the upward bias in the CPI in many cases is mirrored in a downward bias in estimates of real spending; this muddies the interpretation of both recent economic developments and longer-run trends in our economic performance. Several researchers have attempted to quantify the bias in the CPI and other broad measures of prices. One set of studies has examined the detailed microstatistical evidence on price measurement. The Boskin Commission drew heavily on these studies and concluded that the CPI is currently overstating changes in the true cost of living by approximately 1 percentage point per year. In addition to some technical factors associated with its construction, the CPI overstates inflation because of the slow introduction of new products and inadequate adjustment for quality improvements. Recently, researchers at the Federal Reserve Board have looked at the measurement issue from a macroeconomic perspective. This analysis, which questions whether the pattern implied by the published price, output, and productivity statistics makes sense, also suggests that the inflation rate is overstated. In particular, the research finds that measured real output and productivity in the service sector of the economy are implausibly weak, given that the return to the owners of these businesses that is implicit in our aggregate statistics on GDP apparently has been well-maintained. The published data indicate that the level of output per hour in several service-producing industries has been falling for more than two decades -- that is, that firms in these industries have been getting less and less efficient for more than twenty years. This pattern is highly unlikely. Price mismeasurement seems to be the most probable explanation of the data anomalies, and the order of magnitude appears consistent with the microstatistical results. ---[PAGE_BREAK]--- The evidence that inflation has been slower and that real growth has been faster than the official measures indicate is welcome, in part because it suggests that the nation's current level of economic well-being is higher than we had thought. But I want to make clear that revising our historical estimates of real growth to incorporate better price data would have no material effect on measures of the degree of resource utilization, because such a revision implies faster growth in potential output, as well as actual output; accordingly, it does not alter the relationship between resource utilization and inflation. Nor does it change the outlook for the federal budget deficit, apart from any modifications to the indexing formulas for entitlements and income taxes. Certainly, the judgment that aggregate productivity has been growing faster than indicated by the official statistics seems reasonable in light of the significant business restructurings and extraordinary improvements in technology in recent years. I do not mean to imply, however, that we should assume that the full productivity gain from information technology has already been reaped. Clearly, it takes some time for firms to adopt production techniques that translate a major new technology into increased output. In an intriguing parallel, electric motors in the late nineteenth century were well-known as a technology but were initially integrated into production systems that were designed for steam-driven power plants. Not until the gradual conversion of previously vertical factories into horizontal facilities, mainly in the 1920s, were firms able to take full advantage of the synergies implicit in the electric dynamo and thus achieve dramatic increases in productivity. Analogously, not all of today's production systems can be easily integrated with new information and communication technologies. Some existing equipment cannot be controlled by computer, for example. Thus, the full exploitation of even the current generation of information and communication equipment may occur over quite a few years and only after a considerably updated stock of physical capital has been put in place. While such a scenario is quite plausible, we cannot be certain when, or if, it will occur. Thus, we must be vigilant to ensure that our economy remains sufficiently flexible for entrepreneurial initiatives. And we must continue our efforts to further enhance productivity growth by raising national saving and spurring capital formation. Attaining a higher national saving rate quite soon is crucial, particularly in view of the anticipated shift in the nation's demographics and associated pressures on federal retirement and health programs in the first few decades of the next century. Reducing the size of the federal budget deficit, and over time moving the unified budget into surplus, would go a substantial way in that direction.	Alan Greenspan	United States	https://www.bis.org/review/r970122a.pdf	situation in the United States Testimony of the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on the Budget of the US Senate on 21/1/97. Mr. Chairman and members of the Committee, I am pleased to appear here today. In just a few weeks the Federal Reserve Board will submit its semiannual report on monetary policy to the Congress. That report and my accompanying testimony will cover in detail our assessment of the outlook for the U.S. economy and the challenges facing monetary policy. This morning, I would like to offer some personal perspectives on the current economic situation. I think it is fair to say that the overall performance of the U.S. economy has continued to surpass most forecasters' expectations. The current cyclical upswing is now approaching six years in duration, and the economy has retained considerable vigor, with few signs of the imbalances and inflationary tensions that have disrupted past expansions. Although the data for the fourth quarter are still incomplete, it is apparent that real gross domestic product posted an increase in the neighborhood of 3 percent over the four quarters of 1996. This increase may seem quite moderate compared with the gains registered in some earlier years of the postwar period; however, at a time when the working-age population is expanding relatively slowly and unemployment is already low, this economic growth is appreciable indeed. It was enough to generate more than $2^{1 / 2}$ million new payroll jobs last year and to cause the unemployment rate to edge down to $5^{1 / 4}$ percent -- a figure roughly matching the low of the last cyclical upswing, in the late 1980s. But, in contrast to that earlier period, we have not experienced a broad increase in inflation; in fact, by some important measures of price trends, inflation actually slowed a bit in 1996. The balance and solidity of the expansion last year can be seen in the composition of the growth. Notably, consumers appear to have been rather conservative in their spending. In some instances, they may have been constrained by the debt-service burdens accumulated over the previous few years; but in the aggregate, households experienced an enormous further accretion of net worth as the stock market continued to climb at a breathtaking rate. Judging from historical patterns, such an increase in wealth might have inspired households to spend an enlarged share of their current income; but, if we take the available data at face value, households appear instead to have set aside a greater share of their income for financial investment. Perhaps Americans are finally becoming conscious of the need to accumulate additional assets to ensure not only that they can handle temporary interruptions in employment but also that they will have the wherewithal to enjoy a lengthy retirement down the road. Be that as it may, the increased flow of private savings -- and a reduced call upon those savings by the Treasury -- helped to fund substantial increases in fixed investment last year. Homebuilding activity was up considerably; notably, single-family housing starts were robust once again and helped to push the nation's homeownership rate to a fifteen-year high. In addition, business fixed investment posted another strong advance. Firms acquired large amounts of computing and telecommunications equipment in particular, seeking to enhance the efficiency of their operations as well as their overall productive capacity. At the same time, they accumulated inventories rather cautiously: Stock-to-sales ratios, which had risen in 1995, were in many cases near historic lows as of November 1996, the most recent month for which statistical information is available. The growing economy had beneficial effects on the finances of many states and localities, which consequently could spend more on needed infrastructure and vital services and, in some instances, trim taxes. Of course, overall government sector purchases were held down by the ongoing efforts to reduce the federal deficit. It clearly was private demand that drove economic growth last year. To be more specific, it was domestic private demand that did so, for net exports fell, on balance, in 1996. The volume of goods and services we sold abroad grew appreciably, despite moderate economic expansion by our major trading partners, but our imports continued to grow at a rapid clip. In fact, imports provided a safety valve in a U.S. economy marked by a high degree of resource utilization. I've already noted that our unemployment rate reached the lowest level in some time. Moreover, throughout the year, we heard reports from around the country that qualified workers were in tight supply. Although increases in hourly compensation remained relatively subdued -- an important fact to which I shall return in a few moments -- they did become more sizable, and they raised unit costs when employers were unable to enhance productivity commensurately. Thanks to the very substantial additions to facilities in the past few years, physical capacity in the manufacturing sector was not greatly strained. The question is, of course, where do we go from here? Can we continue to achieve significant gains in real activity while avoiding inflationary excesses? Because monetary policy works with a lag, it is not the conditions prevailing today that are critical but rather those likely to prevail six to twelve months, or even longer, from now. Hence, as difficult as it is, we must arrive at some judgment about the most probable direction of the economy and the distribution of risks around that expectation. Fortunately, economic events are not wholly random and unforecastable. There are certain principles, and certain empirical regularities in behavioral relations, that we can follow with some degree of confidence. For example, capital investment responds in a predictable way to the rate of growth of the economy, expected profitability, and the cost of capital. Similarly, housing activity, with some qualifications, moves inversely with mortgage rates. And the largest component of final demand, personal consumption expenditures, generally follows income over time. Many of these relationships are embedded in the traditional notion of the business cycle developed by Wesley Clair Mitchell three-quarters of a century ago and worked out with Arthur F. Burns, one of my predecessors, in the definitive tome, Measuring Business Cycles. Their insights remain relevant today. Even so, each cycle tends to have its own identifying characteristic. For example, in the late 1980s and the recessionary period of the early 1990s, the economy was dominated by the sharp fall in the market value of commercial real estate; because such real estate served as a major source of loan collateral, the drop in its value had a profoundly restrictive influence on the willingness and ability of commercial banks to lend. As you may recall, at that time, I characterized the economy as trying to advance in the face of fifty-mile-an-hour headwinds. The severe credit restraint was only grudgingly responsive to the extended efforts of the Federal Reserve to ease monetary conditions. Similarly, the dramatic rise of inflation and of inflation expectations in the 1970s was key in shaping the cyclical patterns of that period. One manifestation was the impetus to spending on houses, cars, and other consumer durables from buyers' efforts to beat future price increases. Countering this inflation required a major monetary tightening, which moved both nominal and real interest rates up sharply and led to substantial contractions in housing and other interest-sensitive sectors in the early 1980s. In contrast, as I've mentioned several times to the Congress over the past few years, perhaps the dominant characteristic of the current expansion is low inflation and quiescent inflation expectations, which have helped create a financial environment conducive to strong capital spending and longer-range planning generally. I emphasized this point in our HumphreyHawkins testimony of a year ago. Since then, increases in hourly compensation as measured by the employment cost index have continued to fall far short of what they would have been had historical relationships between compensation gains and the degree of labor market tightness held. Reaching some judgment about the reasons for this departure from past patterns is important. As I see it, heightened job insecurity explains a significant part of the restraint on compensation and the consequent muted price inflation. Surveys of workers have highlighted this extraordinary state of affairs. In 1991, at the bottom of the recession, a survey of workers at large firms indicated that 25 percent feared being laid off. In 1996, despite the sharply lower unemployment rate and the demonstrably tighter labor market, the same survey organization found that 46 percent were fearful of a job layoff. The continued reluctance of workers to leave their jobs to seek other employment as the labor market has tightened provides further evidence of such concern, as does the tendency toward longer labor union contracts. For many decades, contracts rarely exceeded three years. Today, one can point to five- and six-year contracts -- contracts that are commonly characterized by an emphasis on job security and that involve only modest wage increases. The low level of work stoppages of recent years also attests to concern about job security. Thus, the willingness of workers to trade off smaller increases in wages for greater job security seems to be reasonably well-documented for this particular business-cycle expansion. The unanswered question is why this insecurity has persisted even as the labor market has, by all objective measures, tightened considerably. One possibility is the ongoing concern of workers about job skill obsolescence. The reality of this obsolescence is evidenced by the marked expansion of on-the-job training programs, especially in technical areas, in many of the nation's corporations. No longer can one expect to obtain all of one's lifetime job skills with a high-school or college diploma. Indeed, continuing adult education is perceived to be increasingly necessary to retain a job. Certainly, there are other possible explanations of the softness in compensation growth in the past few years. The sharp deceleration in health care costs, of course, is cited frequently. Another possibility is the heightened pressure on firms and their workers in industries that compete internationally. Domestic deregulation has had similar effects on the intensity of competitive forces in some industries. In addition, the continued decline in the share of the private workforce in labor unions has likely made wages more responsive to market forces -- indeed, the converse is also true in that the new competitive realities have in many instances undermined union strength. In any event, although I do not doubt that all these explanations are relevant, I would be surprised if any were dominant. Another potential explanation is that persistently low price inflation is constraining wage increases. Historical evidence clearly indicates that price inflation is a factor in wage change. But, if the causation is running mainly from product markets, where prices are set, to labor markets, where wages are set, then we would expect to see some squeeze on profit margins. Clearly, this is not the case at present. Rather, owing in part to the subdued behavior of wages, profits and rates of return on capital have risen to high levels. The high rates of return, in turn, seem to be inducing competitive pressures that limit the ability of firms to raise prices relative to their underlying cost structures because they fear that competitors anxious to capture a greater share of the market will not follow suit. Thus, the evidence seems more consistent with the view that wage restraint is damping price increases than the other way around. If the job insecurity paradigm that I have outlined is the key, then we must recognize that, as I indicated in last February's Humphrey-Hawkins testimony, "suppressed wage cost growth as a consequence of job insecurity can be carried only so far. At some point in the future, the trade-off of subdued wage growth for job security has to come to an end." In short, this implies that even if the level of real wages remains permanently lower as a result of the experience of the past few years, the relatively modest wage gains we've seen are a transitional rather than a lasting phenomenon. The unknown is how long the transition will last. Indeed, the recent pickup in some measures of wages suggests that the transition may already be running its course. If so, the important question from a monetary policy point of view is whether prospective labor market conditions will be consistent with the maintenance of satisfactory price performance. I would like to conclude with a brief discussion of some issues of measurement and economic data that may be useful as you begin your deliberations on the 1998 budget. One issue you will have to grapple with is the growing consensus that the consumer price index -and other broad price measures that rely heavily on CPI data in their construction -- are substantially overstating changes in the true cost of living. From your perspective, one important implication of the CPI bias is that it creates an automatic and presumably unintended real increase in social security and other indexed federal benefits and a real cut in indexed individual income taxes each year. Less widely recognized is the fact that, for a given level of nominal spending, the upward bias in the CPI in many cases is mirrored in a downward bias in estimates of real spending; this muddies the interpretation of both recent economic developments and longer-run trends in our economic performance. Several researchers have attempted to quantify the bias in the CPI and other broad measures of prices. One set of studies has examined the detailed microstatistical evidence on price measurement. The Boskin Commission drew heavily on these studies and concluded that the CPI is currently overstating changes in the true cost of living by approximately 1 percentage point per year. In addition to some technical factors associated with its construction, the CPI overstates inflation because of the slow introduction of new products and inadequate adjustment for quality improvements. Recently, researchers at the Federal Reserve Board have looked at the measurement issue from a macroeconomic perspective. This analysis, which questions whether the pattern implied by the published price, output, and productivity statistics makes sense, also suggests that the inflation rate is overstated. In particular, the research finds that measured real output and productivity in the service sector of the economy are implausibly weak, given that the return to the owners of these businesses that is implicit in our aggregate statistics on GDP apparently has been well-maintained. The published data indicate that the level of output per hour in several service-producing industries has been falling for more than two decades -- that is, that firms in these industries have been getting less and less efficient for more than twenty years. This pattern is highly unlikely. Price mismeasurement seems to be the most probable explanation of the data anomalies, and the order of magnitude appears consistent with the microstatistical results. The evidence that inflation has been slower and that real growth has been faster than the official measures indicate is welcome, in part because it suggests that the nation's current level of economic well-being is higher than we had thought. But I want to make clear that revising our historical estimates of real growth to incorporate better price data would have no material effect on measures of the degree of resource utilization, because such a revision implies faster growth in potential output, as well as actual output; accordingly, it does not alter the relationship between resource utilization and inflation. Nor does it change the outlook for the federal budget deficit, apart from any modifications to the indexing formulas for entitlements and income taxes. Certainly, the judgment that aggregate productivity has been growing faster than indicated by the official statistics seems reasonable in light of the significant business restructurings and extraordinary improvements in technology in recent years. I do not mean to imply, however, that we should assume that the full productivity gain from information technology has already been reaped. Clearly, it takes some time for firms to adopt production techniques that translate a major new technology into increased output. In an intriguing parallel, electric motors in the late nineteenth century were well-known as a technology but were initially integrated into production systems that were designed for steam-driven power plants. Not until the gradual conversion of previously vertical factories into horizontal facilities, mainly in the 1920s, were firms able to take full advantage of the synergies implicit in the electric dynamo and thus achieve dramatic increases in productivity. Analogously, not all of today's production systems can be easily integrated with new information and communication technologies. Some existing equipment cannot be controlled by computer, for example. Thus, the full exploitation of even the current generation of information and communication equipment may occur over quite a few years and only after a considerably updated stock of physical capital has been put in place. While such a scenario is quite plausible, we cannot be certain when, or if, it will occur. Thus, we must be vigilant to ensure that our economy remains sufficiently flexible for entrepreneurial initiatives. And we must continue our efforts to further enhance productivity growth by raising national saving and spurring capital formation. Attaining a higher national saving rate quite soon is crucial, particularly in view of the anticipated shift in the nation's demographics and associated pressures on federal retirement and health programs in the first few decades of the next century. Reducing the size of the federal budget deficit, and over time moving the unified budget into surplus, would go a substantial way in that direction.
1997-01-24T00:00:00	Mr. Meyer looks at the need to rationalize the structure of the financial services industry in the United States (Central Bank Articles and Speeches, 24 Jan 97)	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the 99th Assembly for Bank Directors, Southwestern Graduate School of Banking, Westin Regina Resort, Puerto Vallarta, Mexico on 24/1/97.	Mr. Meyer looks at the need to rationalize the structure of the financial services industry in the United States Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the 99th Assembly for Bank Directors, Southwestern Graduate School of Banking, Westin Regina Resort, Puerto Vallarta, Mexico on 24/1/97. My topic this morning is financial modernization. Financial modernization today refers to legislative and regulatory reform to remove limitations on permissible activities for banking, securities, and other financial services firms. Financial modernization in the United States is sometimes used to refer specifically to the repeal of the Glass-Steagall Act which limits banks' involvement in security underwriting and dealing. I will use a broader interpretation that includes, in addition, the revision of the Bank Holding Company Act to allow banks to engage in insurance and other financial activities, the establishment of a two-way street that allows banks to affiliate with securities and insurance firms and insurance and security firms to affiliate with banks, a rationalization of the regulatory framework for banks and other financial services firms appropriate to the expanded powers and structural reforms, and at least a careful consideration of a common charter for commercial banks and thrift institutions and the mixing of banking and commerce. The financial services industry is moving in the direction of expanded activities and increased competition, with or without Congressional action, driven by market realities, financial innovations, technological change and global competition. Federal banking regulators are cooperating in this process, often reluctantly, but recognizing already existing erosions to regulations. Their ability to do so is often limited by statutory constraints, however, and, as a result, a clean and full rationalization of the structure of the financial services industry cannot be achieved without Congressional action. Nevertheless, what lies ahead is less a revolution than the completion of an ongoing process of financial market evolution. There are important disagreements about the breadth of expanded activities appropriate in banking organizations, the costs and benefits of structural restrictions to protect banks from added risks, and the appropriate regulatory framework for the reformed financial services industry. Nonetheless, I believe that policy makers have come to the conclusion that, while their hand may be forced by events, there are significant benefits from expanding the permissible activities of banks and other financial services firms. These benefits include increased competition in the financial services industry, and increased efficiency and consumer convenience in the provision of financial services. Allowing securities firms to compete directly with banks and banks with securities firms and each to compete with insurance firms will clearly enhance competition in the financial services industry. Economic theory and historical experience suggest that competition lowers costs, increases pressure for innovation, and increases attentiveness to the needs and convenience of customers. Financial modernization would allow financial services firms to serve better the needs and convenience of their customers both by lowering the costs of financial services and by facilitating one-stop shopping. The Edge Act already permits U.S. banks to compete on more equal terms outside the U.S. by permitting the Federal Reserve to authorize U.S. banks to do abroad certain activities, e.g., securities underwriting and dealing, not authorized directly to U.S. banks in the U.S. Moreover, U.S. banks are consistently evaluated by foreigners as the most innovative in the world. Nonetheless, easing of regulations would enhance marginally the international competitiveness of U.S. banks. Financial modernization also promotes efficiency in the production of financial services by allowing increased diversification of income sources by financial services firms and by allowing such firms to take advantage of economies of scope, that is, efficiencies that arise from producing related products. Think of financial modernization as a puzzle involving domestic and foreign financial service providers and consumers, the permissible activities, the organizational structures, the safeguards, the regulators, the legislators, and the Administration. The Administration and the legislators, with input from the regulators, have to decide which activities go to which providers in what organizational structures subject to what safeguards, under the oversight of which regulators, all for the maximum benefit of consumers. It may not be quite as simple as it sounds! The providers are the institutions whose future hangs in the balance: thrifts, banks, and nonbank financial services firms. Banks and thrifts may be combined and thrifts may therefore not survive as a separate entity. And, once the legislation is passed, affiliations may occur across commercial banks, investment banks, and insurance firms. In any case, only a subset of providers would be allowed to participate in this game. For example, only banking institutions that were found to be well capitalized and well managed and had adequate internal controls would be allowed to engage in the expanded activities. This is part of the trend to incentive-based regulation in which expanded activities and more streamlined regulation are confined to banking firms whose strength and performance suggest they can handle the increased risk. The permissible activities include those that banks are currently allowed to engage in directly; the somewhat broader and evolving set of financial activities that bank holding companies have been allowed to engage in through their subsidiaries; additional activities that fill out the spectrum of financial activities; and finally, possibly, commercial activities. The choices for organizational structures include a universal banking model, where all activities are conducted inside the bank; the operating subsidiary model, favored by the Comptroller of the Currency, in which some activities are restricted to operating subsidiaries of banks; and the bank holding company model, the traditional preference of the Board of Governors, in which some activities are restricted to subsidiaries of the bank holding company. Safeguards refer to prudential limitations on activities between the bank and its subsidiaries (and affiliates) in order to protect the public from conflicts of interest and other abuses, but primarily to limit the risks to the bank from the activities in the subsidiaries as well as to limit the transfer of the subsidy inherent in the safety net to bank subsidiaries and affiliates. The most widely enforced prudential limitations are those associated with sections 23A and 23B of the Federal Reserve Act which limit financial transactions between a bank and its affiliates. Such transactions must be at arms-length and collateralized and, except for those collateralized by U.S. government securities, are subject to quantitative limits based on bank capital. In addition, banking regulators have sometimes imposed firewalls (including, for example, physical separation of banks and their affiliates and limitations on employee and director interlocks) to provide further protection and insulation of the bank from activities conducted by subsidiaries. The regulators include the three federal banking agencies (OCC for national banks, the FDIC for state nonmember banks, and the Federal Reserve for state member banks and all bank holding companies), the OTS (the regulator of thrifts, other than credit unions), and the regulators of nonbank financial services activities (e.g., the SEC for securities and state insurance authorities for insurance). The legislators include the members of the House and Senate, with special focus on the Senate and House Banking Committees where financial modernization legislation will be written. The Administration effort is led by Treasury. Before I identify the key issues that have to be settled before the puzzle can be addressed, it will be useful to set the stage by explaining why banks are regulated. This will help motivate why bank activities have traditionally been restricted and why restrictions and prudential limitations are generally imposed when expanded activities are allowed in banking organizations. This will also help to motivate my subsequent discussion of the Board's views on expanded power and structural restrictions. Two special characteristics of banking are critical to understanding why banks are regulated. First, banks have access to a government safety net through deposit insurance, the discount window, and payment system guarantees. Because deposit insurance can never be fully and accurately priced, it is necessary to monitor and sometimes to act to control bank risks in order to protect the potential call on taxpayers. The result is that banks are, in effect, subsidized by the government. This subsidy, in turn, creates incentives for banks to take more risk. That is, the safety net creates moral hazard incentives for risk-taking, because the safety net -- and potentially taxpayers -- may absorb most of the losses if the gamble fails. In effect, the incentive for the creditors of the bank to monitor banks' risk taking -- the kind of monitoring that goes on for, say, finance companies -- and the market pressures to have high capital to absorb losses are simply blunted for entities with access to the safety net. That monitoring and pressure for capital has been taken over by the grantor of the safety net: the government. The second characteristic of banking is that banks -- especially large ones -- are capable of being the conduits of systemic risk and crisis in financial markets. A breakdown of the payments system or other contagion effect that hampers the ability of banks to intermediate credit flows could have serious consequences for the economy. The challenge is to maintain sufficient regulation to protect taxpayers, avoid unnecessary extensions of the safety net, and mitigate moral hazard incentives without undermining the competitiveness of the banking industry and its ability to take risk. Some have suggested that the government safety net, instead of being a subsidy to banks, has become a weight around their neck in the form of burdensome regulation that makes it difficult for banks to compete successfully against less regulated financial services firms. A solution might therefore be to limit or even eliminate the government safety net or at least charge deposit premiums that better price the risks involved. But the safety net has effectively eradicated the threat of runs on banks, has become capitalized in the value of bank equity, and in any case is so politically popular as to be unassailable. Our point of departure is therefore to assume that the government safety net will remain in place and will not be priced high enough to make it moot. Indeed, none of the legislative reform proposals in Congress would alter the access of banks to the government safety net. There will no doubt be continued efforts to reduce the net subsidy of the safety net. In addition to efforts to price insurance and access to central bank credit and the payments system more "accurately," I anticipate that the government will continue other efforts. For example, I think the correct way to read prompt corrective action and high capital requirements is as an offset to safety net incentives that create moral hazards. More generally, we can discern five regulatory approaches that traditionally have been employed to limit the extension of the subsidy, control moral hazard incentives, and limit the risk to the taxpayer associated with access by banks to the government safety net. First, banks can be required to hold enough capital in relation to risks so that moral hazard incentives are minimized. Second, supervision and examination of banks by their regulators can insure that banking organizations maintain effective internal controls and implement an effective risk management process so that the safety and soundness of banks is protected and the risk to taxpayers minimized. Third, banks can be restricted to activities that do not present undue risks. Fourth, banking organizations can be required to conduct their riskier activities outside the bank itself, so that the bank is insulated from those greater risks. Fifth, prudential limitations can be enforced to reduce the prospect that transactions between the banks and their affiliates housing riskier activities could threaten the safety and soundness of banks. Financial modernization represents a reconsideration of these regulatory approaches in the context of reform intended to reduce the segmentation of the financial services industry and increase competition. The regulatory approach to maintaining the safety and soundness of banks has evolved over the period beginning from the banking and financial market reforms of the Great Depression era through today. From the 1930s through most of the 1970s, regulators focused on keeping the banking industry safe and sound by insulating banks from competition and limiting the activities in which they could compete. As a result, the financial services industry became highly segmented into separate entities providing commercial banking, investment banking, insurance services, etc. By the late 1970s, the changed economic environment along with advances in technology, financial innovation, and globalization were presenting U.S. banks with increased competition from not only foreign banks, but from domestic thrifts, nondepository financial institutions, and the securities market as well. Banks responded by replacing lost business and lower margins with expanded off-balance sheet activities such as securitization, back-up lines of credit and guarantees, and derivatives. These responses helped banks to substitute fee and trading income for some of the interest income lost through competition with other financial intermediaries. Moreover, the larger banks generally sought expanded securities powers, so that they could stem the loss of customer business to capital markets. Regulators responded by reducing, in so far as they could under the law, the regulatory limits on banks and creating a more level playing field for banks and nonbanking firms. Financial modernization would further advance this process that has already blurred the distinction among financial services firms. Next the puzzle of powers, structures, and regulators must be solved. We need some guiding principles. The primary standard by which all modifications should be measured is the benefit to consumers of financial services. Would it make such services cheaper, more easily available, more convenient? Would it facilitate and foster innovation and competition? Modernization reforms that only increase provider profits -- say, by eliminating outdated and costly regulation -- are desirable, but only if, at a minimum, they do not reduce competition and consumer service. Given that primary principle, a second standard is to rely, in so far as compatible with the other goals, on the market. Thus, within such constraints, the scope of financial activities of banking organizations should be decided by the organizations themselves. When the special nature of banking makes reliance on the market impossible, the regulator should try to simulate market responses. Prompt corrective action is an example. Third, we should not lose sight of the special characteristics of banking that dictate regulation. These continue to suggest that there must be appropriate capital requirements, structure, supervision, and examination in banking organizations. Fourth, at the same time, the regulatory framework for financial services should be simplified and refined. In resolving the key regulatory issues, we should address three questions: First, what expanded activities should banks be allowed to conduct? Second, what organizational restrictions, if any, should be imposed on these new activities? The task here is to balance the benefits from achieving potential synergies among related activities and efficiencies from diversification and economies of scope, on the one hand, with the need to protect the safety net, that is, the taxpayer, on the other. Third, what regulatory framework most appropriately accommodates expanded activities, while also adequately protecting the safety and soundness of banks, controlling systemic risk, and promoting effective monetary policy? I will outline the key issues each question raises, beginning in each case with the Board's position. Activities The discussion of expanded activities centers really on securities and insurance. I will therefore begin by setting out the current limitations on such activities in banking organizations, explain the Board's position on expanded powers, and then turn to unsettled substantive issues. The Glass-Steagall Act of 1933 prohibits banks from underwriting or dealing in securities, with the exceptions of U.S. government and agency issues, and municipal general obligation bonds. Nonbank affiliates of Federal Reserve member banks are also prohibited from being "principally engaged" in underwriting or dealing in non-exempt securities. Since 1987, the Board has allowed member banks to conduct limited non-exempt securities activities through subsidiaries of a bank holding company, referred to as section 20 affiliates, because section 20 of Glass-Steagall prohibited affiliation on the "principally engaged" criterion. In the 1980s, the Board initially determined that an affiliate was not "principally engaged" in prohibited activities if no more than 5% of its revenues came from non-exempt sources. That limit was subsequently raised to 10%, and in December of 1996, the Board expanded the non-exempt revenue limit to 25%. Most major U.S. banks, I might add, have had experience in securities activities through their foreign affiliates. Most of these foreign activities, in turn, are conducted, subject to certain percentage and dollar limitations, through their Edge corporations, which are generally subsidiaries of the bank. By statute, Edge corporations are permitted to engage in activities abroad not permitted in the U.S. if necessary to compete on an equal basis with local rivals. The Board has concluded that eligible securities activities, section 20 experience with ineligible securities, and activities through Edge corporations, have provided banks with considerable experience with securities activities. In addition, banks have been permitted to conduct private placements, provide discount and full service brokerage services, offer financial advisory services, and broker proprietary mutual funds. The repeal of the statutory limitation on securities activities by a bank affiliate would only extend an already significant presence of banks in securities activities and build upon a base of existing experience. In addition, it would provide increased competition without -- by the record -- increasing bank risks significantly. Moreover, the Glass-Steagall restrictions on securities activities were motivated by concern that abuses of such powers had contributed to the banking crises of the great Depression era. Subsequent research, however, has found that these concerns were greatly exaggerated and that there was no evidence that abuses in securities activities played a significant role in the banking crisis. As a result, there is little controversy about the merits of repeal of Glass Steagall. Bank holding companies have been prohibited from insurance sales and underwriting since 1982, although existing activities were grandfathered. National banks located towns with a population of 5000 or less are allowed to serve as a general insurance agent. The Comptroller, supported by recent court decisions, has allowed such banks to engage in national sales from offices located in such towns. A number of states allow banks they charter to engage in insurance agency activities quite broadly. At the same time, the FDIC Improvement Act in 1991 prohibits state banks insured by the FDIC from engaging in underwriting insurance beyond the extent permitted for national banks. As a result, banks are gaining some experience in insurance agency activities, but have quite limited experience with insurance underwriting activities. Nonetheless, there is a growing consensus that selling all types of insurance and possibly underwriting life insurance would not present undue risks to banks and would benefit consumers. It is important to note that securities and insurance activities are the only financial activities prohibited to banking organizations by statute. With the exceptions perhaps of property and casualty insurance, both activities seem to reflect manageable risks for banks. Consequently both activities would seem compatible with present organizational structures and prudential limitations. Indeed, the diversification of income sources might suggest that the extension of activities to include securities and insurance activities could, on balance, reduce the overall riskiness of the consolidated enterprise. However, commercial activities raise greater concerns. Think of a continuum of powers, including those currently permissible for banks and those under consideration with a ranking from low to greater risk. Where do securities underwriting and dealing and insurance agency and underwriting fall on this spectrum? While the answer may not be clear, I think that it is fair to argue that brokering, underwriting, and dealing in life insurance or securities are generally less risky than most of the credit risks banks have taken with their traditional lending activities. As we have seen in recent years with commercial real estate, energy, agricultural, and developing country loans, lending is hardly risk-free. Securities and insurance brokerage, in contrast, contain little risk, per se, and with their reliance on actuarial tables, life insurance underwriting activities would seem to present risks that banks could easily manage and control. Underwriting of casualty and property insurance, might, however, be beyond the higher end of the current risk spectrum. The Board of Governors has supported both a repeal of the Glass-Steagall Act to permit banking organizations to underwrite and deal in securities and also a reform of the Bank Holding Company Act to permit banks broader powers regarding insurance brokerage and underwriting. The possible exception involves casualty and property underwriting, which the Board historically has felt raised concerns about risk. The Board has not, however, supported affiliations between banking and commercial firms. While it does not object in principle to such affiliations, it has taken the position that it is perhaps best for banking organizations and their regulators to gain experience with new financial activities before considering broader combinations. The benefits simply appear less certain and the risks greater. The Board would therefore prefer to proceed with the expansion in financial services and to defer any discussion of commercial activities. Admittedly, such an approach could complicate the modernization process, since some unitary thrifts and insurance firms are already affiliated with commercial firms. Would they need to divest such activities, or could they be satisfactorily grandfathered if either the thrift and bank charters are combined or banks are permitted to affiliate with securities and insurance firms? Organizational Structure The Board's position has been that any meaningful expansion of new activities should take place in nonbank subsidiaries of bank holding companies. In contrast, the Comptroller of the Currency has proposed allowing such activities in subsidiaries of national banks. Some have viewed this difference as simply a battle over turf. The Federal Reserve supervises bank holding companies and would therefore expand its regulatory reach if new powers were forced into the BHC model. The OCC supervises national banks and would potentially expand its influence relative to the Federal Reserve if nonbank activities were permitted in operating subsidiaries of banks. But much more is at stake here than turf. The location in the organizational structure of nonbanking activities raises fundamental questions about the safety net. Recall my earlier comments about the fundamental tension between risk-taking and market orientation, on the one hand, and the stabilization and moral hazard implications of the safety net, on the other. Such tensions focus, I submit, on the special benefits -- the subsidy, if you will -- that recipients of the safety net receive and the regulation that goes with it. We in the United States should be careful not to inadvertently extend the safety net -- and, almost for certain, bank-like regulations -- in the process of dealing with financial reform and organizational structure. This is a difficult issue, requiring balance and judgment, and I would hope that Congress would carefully review the options and their full implications. Regulatory Framework Currently, all bank holding companies are subject to consolidated supervision by the Federal Reserve; banks are regulated by state banking agencies, the OCC, the FDIC, and/or the Federal Reserve depending on their charter, and, for state banks, on their choice, and there is some functional regulation of specialized activities of holding company subsidiaries. Consolidated bank holding company supervision includes holding company capital requirements, examinations, and reporting requirements. Two substantive issues are important as we consider the regulatory framework most appropriate for accommodating financial modernization. First, to what degree is consolidated supervision and regulation appropriate? Second, what role should the Federal Reserve have in regulating banks and financial conglomerates that include banks? Both the operating subsidiary and bank holding company models facilitate functional regulation by putting specialized activities that might be subject to functional regulation into separate entities. For example, securities activities subject to SEC capital requirements and other regulations would be put into a separate subsidiary and similarly with insurance activities subject to regulation by state insurance departments. Under a pure functional regulation scheme, bank regulators would supervise only the bank, and there would be no consolidated supervision of the entire entity. This appears, on the surface, clean and efficient, reflecting the benefits of specialization and division of labor among regulators. But it is completely out of step with emerging risk management practices at financial services firms and with norms for global banks and financial services firms around the world. Banking organizations are increasingly managing risks without regard to legal entities. For them to do otherwise would ignore the powerful concepts of portfolio theory and the gains they can achieve both from diversification and from managing risks on a consolidated basis. If financial services firms engage in consolidated risk management, regulators must insist on some measure of consolidated regulation that permits effective oversight of the consolidated entity. The U.S. participates actively in world forums with regulators of banking and other financial services. There is a growing emphasis in these meetings on sharing information and clear recognition of the value of consolidated supervision. If there is consolidated regulation, it could be carried out by the Federal Reserve, in line with the system's current role as regulator of bank holding companies. For example under Congressman Leach's bill, the Federal Reserve would be the umbrella regulator for the financial services holding companies that replace bank holding companies. An alternative model, however, might be for the regulator of the lead bank to be the umbrella regulator of the consolidated entity. That approach has the advantage of limiting the number of separate regulators of a given entity. It has the disadvantage, though, that the regulation of financial services holding companies would be disbursed among several agencies and that each agency could adopt different policies. A third model would have a single bank regulator for financial services holding companies whose predominant activity is banking and the SEC where the predominant activity involves securities. The second issue is what role the Federal Reserve should have in banking regulation. You may recall that the Administration proposed in 1993 a consolidation of banking regulation that would have taken all regulatory, supervisory, and examination responsibilities away from the Federal Reserve and consolidated the current responsibilities of the OCC, and the supervisory and regulatory responsibilities of the FDIC and the Federal Reserve into a new federal banking commission. The Federal Reserve opposed consolidated supervision and regulation and strongly asserted the importance of maintaining a hands-on supervisory role for the Federal Reserve. That role is especially critical for large, global banking organizations, but also for at least a cross section of smaller banks. The Federal Reserve believes that such an active supervisory role is essential for it to conduct monetary policy and prevent or manage financial crises most effectively. For example, the information examiners developed about the severity of the credit crunch in the early 1990s contributed to the Federal Reserve's decision to maintain an unusually stimulative monetary policy well into the current expansion. That policy, in turn, helped to support the economy while banking institutions were returning to health and reestablishing their ability to provide credit to support a healthy expansion. As the nation's central bank, the Federal Reserve also has critical responsibilities to prevent or resolve major problems in financial markets that cannot be adequately met without timely and in-depth knowledge of the operating practices, risk-management procedures, and financial exposures of the banking system. In conclusion, the case for expanded financial activities for banks and other financial services firms is compelling. But it is important that differences in opinion about structural and prudential safeguards and the resulting regulatory framework be resolved, so that these disagreements do not block financial modernization efforts.	---[PAGE_BREAK]--- # Mr. Meyer looks at the need to rationalize the structure of the financial services industry in the United States Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the 99th Assembly for Bank Directors, Southwestern Graduate School of Banking, Westin Regina Resort, Puerto Vallarta, Mexico on 24/1/97. My topic this morning is financial modernization. Financial modernization today refers to legislative and regulatory reform to remove limitations on permissible activities for banking, securities, and other financial services firms. Financial modernization in the United States is sometimes used to refer specifically to the repeal of the Glass-Steagall Act which limits banks' involvement in security underwriting and dealing. I will use a broader interpretation that includes, in addition, the revision of the Bank Holding Company Act to allow banks to engage in insurance and other financial activities, the establishment of a two-way street that allows banks to affiliate with securities and insurance firms and insurance and security firms to affiliate with banks, a rationalization of the regulatory framework for banks and other financial services firms appropriate to the expanded powers and structural reforms, and at least a careful consideration of a common charter for commercial banks and thrift institutions and the mixing of banking and commerce. The financial services industry is moving in the direction of expanded activities and increased competition, with or without Congressional action, driven by market realities, financial innovations, technological change and global competition. Federal banking regulators are cooperating in this process, often reluctantly, but recognizing already existing erosions to regulations. Their ability to do so is often limited by statutory constraints, however, and, as a result, a clean and full rationalization of the structure of the financial services industry cannot be achieved without Congressional action. Nevertheless, what lies ahead is less a revolution than the completion of an ongoing process of financial market evolution. There are important disagreements about the breadth of expanded activities appropriate in banking organizations, the costs and benefits of structural restrictions to protect banks from added risks, and the appropriate regulatory framework for the reformed financial services industry. Nonetheless, I believe that policy makers have come to the conclusion that, while their hand may be forced by events, there are significant benefits from expanding the permissible activities of banks and other financial services firms. These benefits include increased competition in the financial services industry, and increased efficiency and consumer convenience in the provision of financial services. Allowing securities firms to compete directly with banks and banks with securities firms and each to compete with insurance firms will clearly enhance competition in the financial services industry. Economic theory and historical experience suggest that competition lowers costs, increases pressure for innovation, and increases attentiveness to the needs and convenience of customers. Financial modernization would allow financial services firms to serve better the needs and convenience of their customers both by lowering the costs of financial services and by facilitating one-stop shopping. The Edge Act already permits U.S. banks to compete on more equal terms outside the U.S. by permitting the Federal Reserve to authorize U.S. banks to do abroad certain activities, e.g., securities underwriting and dealing, not authorized directly to U.S. banks in the U.S. Moreover, U.S. banks are consistently evaluated by foreigners as the most innovative in the world. Nonetheless, easing of regulations would enhance marginally the international competitiveness of U.S. banks. Financial modernization also promotes efficiency in the production of financial services by allowing increased diversification of income sources by ---[PAGE_BREAK]--- financial services firms and by allowing such firms to take advantage of economies of scope, that is, efficiencies that arise from producing related products. Think of financial modernization as a puzzle involving domestic and foreign financial service providers and consumers, the permissible activities, the organizational structures, the safeguards, the regulators, the legislators, and the Administration. The Administration and the legislators, with input from the regulators, have to decide which activities go to which providers in what organizational structures subject to what safeguards, under the oversight of which regulators, all for the maximum benefit of consumers. It may not be quite as simple as it sounds! The providers are the institutions whose future hangs in the balance: thrifts, banks, and nonbank financial services firms. Banks and thrifts may be combined and thrifts may therefore not survive as a separate entity. And, once the legislation is passed, affiliations may occur across commercial banks, investment banks, and insurance firms. In any case, only a subset of providers would be allowed to participate in this game. For example, only banking institutions that were found to be well capitalized and well managed and had adequate internal controls would be allowed to engage in the expanded activities. This is part of the trend to incentive-based regulation in which expanded activities and more streamlined regulation are confined to banking firms whose strength and performance suggest they can handle the increased risk. The permissible activities include those that banks are currently allowed to engage in directly; the somewhat broader and evolving set of financial activities that bank holding companies have been allowed to engage in through their subsidiaries; additional activities that fill out the spectrum of financial activities; and finally, possibly, commercial activities. The choices for organizational structures include a universal banking model, where all activities are conducted inside the bank; the operating subsidiary model, favored by the Comptroller of the Currency, in which some activities are restricted to operating subsidiaries of banks; and the bank holding company model, the traditional preference of the Board of Governors, in which some activities are restricted to subsidiaries of the bank holding company. Safeguards refer to prudential limitations on activities between the bank and its subsidiaries (and affiliates) in order to protect the public from conflicts of interest and other abuses, but primarily to limit the risks to the bank from the activities in the subsidiaries as well as to limit the transfer of the subsidy inherent in the safety net to bank subsidiaries and affiliates. The most widely enforced prudential limitations are those associated with sections 23A and 23B of the Federal Reserve Act which limit financial transactions between a bank and its affiliates. Such transactions must be at arms-length and collateralized and, except for those collateralized by U.S. government securities, are subject to quantitative limits based on bank capital. In addition, banking regulators have sometimes imposed firewalls (including, for example, physical separation of banks and their affiliates and limitations on employee and director interlocks) to provide further protection and insulation of the bank from activities conducted by subsidiaries. The regulators include the three federal banking agencies (OCC for national banks, the FDIC for state nonmember banks, and the Federal Reserve for state member banks and all bank holding companies), the OTS (the regulator of thrifts, other than credit unions), and the regulators of nonbank financial services activities (e.g., the SEC for securities and state insurance authorities for insurance). ---[PAGE_BREAK]--- The legislators include the members of the House and Senate, with special focus on the Senate and House Banking Committees where financial modernization legislation will be written. The Administration effort is led by Treasury. Before I identify the key issues that have to be settled before the puzzle can be addressed, it will be useful to set the stage by explaining why banks are regulated. This will help motivate why bank activities have traditionally been restricted and why restrictions and prudential limitations are generally imposed when expanded activities are allowed in banking organizations. This will also help to motivate my subsequent discussion of the Board's views on expanded power and structural restrictions. Two special characteristics of banking are critical to understanding why banks are regulated. First, banks have access to a government safety net through deposit insurance, the discount window, and payment system guarantees. Because deposit insurance can never be fully and accurately priced, it is necessary to monitor and sometimes to act to control bank risks in order to protect the potential call on taxpayers. The result is that banks are, in effect, subsidized by the government. This subsidy, in turn, creates incentives for banks to take more risk. That is, the safety net creates moral hazard incentives for risk-taking, because the safety net -- and potentially taxpayers -- may absorb most of the losses if the gamble fails. In effect, the incentive for the creditors of the bank to monitor banks' risk taking -- the kind of monitoring that goes on for, say, finance companies -- and the market pressures to have high capital to absorb losses are simply blunted for entities with access to the safety net. That monitoring and pressure for capital has been taken over by the grantor of the safety net: the government. The second characteristic of banking is that banks -- especially large ones -- are capable of being the conduits of systemic risk and crisis in financial markets. A breakdown of the payments system or other contagion effect that hampers the ability of banks to intermediate credit flows could have serious consequences for the economy. The challenge is to maintain sufficient regulation to protect taxpayers, avoid unnecessary extensions of the safety net, and mitigate moral hazard incentives without undermining the competitiveness of the banking industry and its ability to take risk. Some have suggested that the government safety net, instead of being a subsidy to banks, has become a weight around their neck in the form of burdensome regulation that makes it difficult for banks to compete successfully against less regulated financial services firms. A solution might therefore be to limit or even eliminate the government safety net or at least charge deposit premiums that better price the risks involved. But the safety net has effectively eradicated the threat of runs on banks, has become capitalized in the value of bank equity, and in any case is so politically popular as to be unassailable. Our point of departure is therefore to assume that the government safety net will remain in place and will not be priced high enough to make it moot. Indeed, none of the legislative reform proposals in Congress would alter the access of banks to the government safety net. There will no doubt be continued efforts to reduce the net subsidy of the safety net. In addition to efforts to price insurance and access to central bank credit and the payments system more "accurately," I anticipate that the government will continue other efforts. For example, I think the correct way to read prompt corrective action and high capital requirements is as an offset to safety net incentives that create moral hazards. ---[PAGE_BREAK]--- More generally, we can discern five regulatory approaches that traditionally have been employed to limit the extension of the subsidy, control moral hazard incentives, and limit the risk to the taxpayer associated with access by banks to the government safety net. First, banks can be required to hold enough capital in relation to risks so that moral hazard incentives are minimized. Second, supervision and examination of banks by their regulators can insure that banking organizations maintain effective internal controls and implement an effective risk management process so that the safety and soundness of banks is protected and the risk to taxpayers minimized. Third, banks can be restricted to activities that do not present undue risks. Fourth, banking organizations can be required to conduct their riskier activities outside the bank itself, so that the bank is insulated from those greater risks. Fifth, prudential limitations can be enforced to reduce the prospect that transactions between the banks and their affiliates housing riskier activities could threaten the safety and soundness of banks. Financial modernization represents a reconsideration of these regulatory approaches in the context of reform intended to reduce the segmentation of the financial services industry and increase competition. The regulatory approach to maintaining the safety and soundness of banks has evolved over the period beginning from the banking and financial market reforms of the Great Depression era through today. From the 1930s through most of the 1970s, regulators focused on keeping the banking industry safe and sound by insulating banks from competition and limiting the activities in which they could compete. As a result, the financial services industry became highly segmented into separate entities providing commercial banking, investment banking, insurance services, etc. By the late 1970s, the changed economic environment along with advances in technology, financial innovation, and globalization were presenting U.S. banks with increased competition from not only foreign banks, but from domestic thrifts, nondepository financial institutions, and the securities market as well. Banks responded by replacing lost business and lower margins with expanded off-balance sheet activities such as securitization, back-up lines of credit and guarantees, and derivatives. These responses helped banks to substitute fee and trading income for some of the interest income lost through competition with other financial intermediaries. Moreover, the larger banks generally sought expanded securities powers, so that they could stem the loss of customer business to capital markets. Regulators responded by reducing, in so far as they could under the law, the regulatory limits on banks and creating a more level playing field for banks and nonbanking firms. Financial modernization would further advance this process that has already blurred the distinction among financial services firms. Next the puzzle of powers, structures, and regulators must be solved. We need some guiding principles. The primary standard by which all modifications should be measured is the benefit to consumers of financial services. Would it make such services cheaper, more easily available, more convenient? Would it facilitate and foster innovation and competition? Modernization reforms that only increase provider profits -- say, by eliminating outdated and costly regulation -- are desirable, but only if, at a minimum, they do not reduce competition and consumer service. Given that primary principle, a second standard is to rely, in so far as compatible with the other goals, on the market. Thus, within such constraints, the scope of financial activities of banking organizations should be decided by the organizations themselves. When the special nature of banking makes reliance on the market impossible, the regulator should try to simulate market responses. Prompt corrective action is an example. ---[PAGE_BREAK]--- Third, we should not lose sight of the special characteristics of banking that dictate regulation. These continue to suggest that there must be appropriate capital requirements, structure, supervision, and examination in banking organizations. Fourth, at the same time, the regulatory framework for financial services should be simplified and refined. In resolving the key regulatory issues, we should address three questions: First, what expanded activities should banks be allowed to conduct? Second, what organizational restrictions, if any, should be imposed on these new activities? The task here is to balance the benefits from achieving potential synergies among related activities and efficiencies from diversification and economies of scope, on the one hand, with the need to protect the safety net, that is, the taxpayer, on the other. Third, what regulatory framework most appropriately accommodates expanded activities, while also adequately protecting the safety and soundness of banks, controlling systemic risk, and promoting effective monetary policy? I will outline the key issues each question raises, beginning in each case with the Board's position. # Activities The discussion of expanded activities centers really on securities and insurance. I will therefore begin by setting out the current limitations on such activities in banking organizations, explain the Board's position on expanded powers, and then turn to unsettled substantive issues. The Glass-Steagall Act of 1933 prohibits banks from underwriting or dealing in securities, with the exceptions of U.S. government and agency issues, and municipal general obligation bonds. Nonbank affiliates of Federal Reserve member banks are also prohibited from being "principally engaged" in underwriting or dealing in non-exempt securities. Since 1987, the Board has allowed member banks to conduct limited non-exempt securities activities through subsidiaries of a bank holding company, referred to as section 20 affiliates, because section 20 of Glass-Steagall prohibited affiliation on the "principally engaged" criterion. In the 1980s, the Board initially determined that an affiliate was not "principally engaged" in prohibited activities if no more than $5 \%$ of its revenues came from non-exempt sources. That limit was subsequently raised to $10 \%$, and in December of 1996, the Board expanded the non-exempt revenue limit to $25 \%$. Most major U.S. banks, I might add, have had experience in securities activities through their foreign affiliates. Most of these foreign activities, in turn, are conducted, subject to certain percentage and dollar limitations, through their Edge corporations, which are generally subsidiaries of the bank. By statute, Edge corporations are permitted to engage in activities abroad not permitted in the U.S. if necessary to compete on an equal basis with local rivals. The Board has concluded that eligible securities activities, section 20 experience with ineligible securities, and activities through Edge corporations, have provided banks with considerable experience with securities activities. In addition, banks have been permitted to conduct private placements, provide discount and full service brokerage services, offer financial advisory services, and broker proprietary mutual funds. The repeal of the statutory limitation on securities activities by a bank affiliate would only extend an already significant presence of banks in securities activities and build upon a base of existing experience. In addition, it would provide increased competition without -- by the record -- increasing bank risks significantly. Moreover, the Glass-Steagall restrictions on securities activities were motivated by concern that abuses of such powers had contributed to the banking crises of the great Depression era. Subsequent ---[PAGE_BREAK]--- research, however, has found that these concerns were greatly exaggerated and that there was no evidence that abuses in securities activities played a significant role in the banking crisis. As a result, there is little controversy about the merits of repeal of Glass Steagall. Bank holding companies have been prohibited from insurance sales and underwriting since 1982, although existing activities were grandfathered. National banks located towns with a population of 5000 or less are allowed to serve as a general insurance agent. The Comptroller, supported by recent court decisions, has allowed such banks to engage in national sales from offices located in such towns. A number of states allow banks they charter to engage in insurance agency activities quite broadly. At the same time, the FDIC Improvement Act in 1991 prohibits state banks insured by the FDIC from engaging in underwriting insurance beyond the extent permitted for national banks. As a result, banks are gaining some experience in insurance agency activities, but have quite limited experience with insurance underwriting activities. Nonetheless, there is a growing consensus that selling all types of insurance and possibly underwriting life insurance would not present undue risks to banks and would benefit consumers. It is important to note that securities and insurance activities are the only financial activities prohibited to banking organizations by statute. With the exceptions perhaps of property and casualty insurance, both activities seem to reflect manageable risks for banks. Consequently both activities would seem compatible with present organizational structures and prudential limitations. Indeed, the diversification of income sources might suggest that the extension of activities to include securities and insurance activities could, on balance, reduce the overall riskiness of the consolidated enterprise. However, commercial activities raise greater concerns. Think of a continuum of powers, including those currently permissible for banks and those under consideration with a ranking from low to greater risk. Where do securities underwriting and dealing and insurance agency and underwriting fall on this spectrum? While the answer may not be clear, I think that it is fair to argue that brokering, underwriting, and dealing in life insurance or securities are generally less risky than most of the credit risks banks have taken with their traditional lending activities. As we have seen in recent years with commercial real estate, energy, agricultural, and developing country loans, lending is hardly risk-free. Securities and insurance brokerage, in contrast, contain little risk, per se, and with their reliance on actuarial tables, life insurance underwriting activities would seem to present risks that banks could easily manage and control. Underwriting of casualty and property insurance, might, however, be beyond the higher end of the current risk spectrum. The Board of Governors has supported both a repeal of the Glass-Steagall Act to permit banking organizations to underwrite and deal in securities and also a reform of the Bank Holding Company Act to permit banks broader powers regarding insurance brokerage and underwriting. The possible exception involves casualty and property underwriting, which the Board historically has felt raised concerns about risk. The Board has not, however, supported affiliations between banking and commercial firms. While it does not object in principle to such affiliations, it has taken the position that it is perhaps best for banking organizations and their regulators to gain experience with new financial activities before considering broader combinations. The benefits simply appear less certain and the risks greater. The Board would therefore prefer to proceed with the expansion in financial services and to defer any discussion of commercial activities. Admittedly, such an approach could complicate the modernization process, since some unitary thrifts and insurance firms are already affiliated with commercial firms. Would they ---[PAGE_BREAK]--- need to divest such activities, or could they be satisfactorily grandfathered if either the thrift and bank charters are combined or banks are permitted to affiliate with securities and insurance firms? # Organizational Structure The Board's position has been that any meaningful expansion of new activities should take place in nonbank subsidiaries of bank holding companies. In contrast, the Comptroller of the Currency has proposed allowing such activities in subsidiaries of national banks. Some have viewed this difference as simply a battle over turf. The Federal Reserve supervises bank holding companies and would therefore expand its regulatory reach if new powers were forced into the BHC model. The OCC supervises national banks and would potentially expand its influence relative to the Federal Reserve if nonbank activities were permitted in operating subsidiaries of banks. But much more is at stake here than turf. The location in the organizational structure of nonbanking activities raises fundamental questions about the safety net. Recall my earlier comments about the fundamental tension between risk-taking and market orientation, on the one hand, and the stabilization and moral hazard implications of the safety net, on the other. Such tensions focus, I submit, on the special benefits -- the subsidy, if you will -- that recipients of the safety net receive and the regulation that goes with it. We in the United States should be careful not to inadvertently extend the safety net -- and, almost for certain, bank-like regulations -- in the process of dealing with financial reform and organizational structure. This is a difficult issue, requiring balance and judgment, and I would hope that Congress would carefully review the options and their full implications. ## Regulatory Framework Currently, all bank holding companies are subject to consolidated supervision by the Federal Reserve; banks are regulated by state banking agencies, the OCC, the FDIC, and/or the Federal Reserve depending on their charter, and, for state banks, on their choice, and there is some functional regulation of specialized activities of holding company subsidiaries. Consolidated bank holding company supervision includes holding company capital requirements, examinations, and reporting requirements. Two substantive issues are important as we consider the regulatory framework most appropriate for accommodating financial modernization. First, to what degree is consolidated supervision and regulation appropriate? Second, what role should the Federal Reserve have in regulating banks and financial conglomerates that include banks? Both the operating subsidiary and bank holding company models facilitate functional regulation by putting specialized activities that might be subject to functional regulation into separate entities. For example, securities activities subject to SEC capital requirements and other regulations would be put into a separate subsidiary and similarly with insurance activities subject to regulation by state insurance departments. Under a pure functional regulation scheme, bank regulators would supervise only the bank, and there would be no consolidated supervision of the entire entity. This appears, on the surface, clean and efficient, reflecting the benefits of specialization and division of labor among regulators. But it is completely out of step with emerging risk management practices at financial services firms and with norms for global banks and financial services firms around the world. ---[PAGE_BREAK]--- Banking organizations are increasingly managing risks without regard to legal entities. For them to do otherwise would ignore the powerful concepts of portfolio theory and the gains they can achieve both from diversification and from managing risks on a consolidated basis. If financial services firms engage in consolidated risk management, regulators must insist on some measure of consolidated regulation that permits effective oversight of the consolidated entity. The U.S. participates actively in world forums with regulators of banking and other financial services. There is a growing emphasis in these meetings on sharing information and clear recognition of the value of consolidated supervision. If there is consolidated regulation, it could be carried out by the Federal Reserve, in line with the system's current role as regulator of bank holding companies. For example under Congressman Leach's bill, the Federal Reserve would be the umbrella regulator for the financial services holding companies that replace bank holding companies. An alternative model, however, might be for the regulator of the lead bank to be the umbrella regulator of the consolidated entity. That approach has the advantage of limiting the number of separate regulators of a given entity. It has the disadvantage, though, that the regulation of financial services holding companies would be disbursed among several agencies and that each agency could adopt different policies. A third model would have a single bank regulator for financial services holding companies whose predominant activity is banking and the SEC where the predominant activity involves securities. The second issue is what role the Federal Reserve should have in banking regulation. You may recall that the Administration proposed in 1993 a consolidation of banking regulation that would have taken all regulatory, supervisory, and examination responsibilities away from the Federal Reserve and consolidated the current responsibilities of the OCC, and the supervisory and regulatory responsibilities of the FDIC and the Federal Reserve into a new federal banking commission. The Federal Reserve opposed consolidated supervision and regulation and strongly asserted the importance of maintaining a hands-on supervisory role for the Federal Reserve. That role is especially critical for large, global banking organizations, but also for at least a cross section of smaller banks. The Federal Reserve believes that such an active supervisory role is essential for it to conduct monetary policy and prevent or manage financial crises most effectively. For example, the information examiners developed about the severity of the credit crunch in the early 1990s contributed to the Federal Reserve's decision to maintain an unusually stimulative monetary policy well into the current expansion. That policy, in turn, helped to support the economy while banking institutions were returning to health and reestablishing their ability to provide credit to support a healthy expansion. As the nation's central bank, the Federal Reserve also has critical responsibilities to prevent or resolve major problems in financial markets that cannot be adequately met without timely and in-depth knowledge of the operating practices, risk-management procedures, and financial exposures of the banking system. In conclusion, the case for expanded financial activities for banks and other financial services firms is compelling. But it is important that differences in opinion about structural and prudential safeguards and the resulting regulatory framework be resolved, so that these disagreements do not block financial modernization efforts.	Laurence H Meyer	United States	https://www.bis.org/review/r970129.pdf	services industry in the United States Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the 99th Assembly for Bank Directors, Southwestern Graduate School of Banking, Westin Regina Resort, Puerto Vallarta, Mexico on 24/1/97. My topic this morning is financial modernization. Financial modernization today refers to legislative and regulatory reform to remove limitations on permissible activities for banking, securities, and other financial services firms. Financial modernization in the United States is sometimes used to refer specifically to the repeal of the Glass-Steagall Act which limits banks' involvement in security underwriting and dealing. I will use a broader interpretation that includes, in addition, the revision of the Bank Holding Company Act to allow banks to engage in insurance and other financial activities, the establishment of a two-way street that allows banks to affiliate with securities and insurance firms and insurance and security firms to affiliate with banks, a rationalization of the regulatory framework for banks and other financial services firms appropriate to the expanded powers and structural reforms, and at least a careful consideration of a common charter for commercial banks and thrift institutions and the mixing of banking and commerce. The financial services industry is moving in the direction of expanded activities and increased competition, with or without Congressional action, driven by market realities, financial innovations, technological change and global competition. Federal banking regulators are cooperating in this process, often reluctantly, but recognizing already existing erosions to regulations. Their ability to do so is often limited by statutory constraints, however, and, as a result, a clean and full rationalization of the structure of the financial services industry cannot be achieved without Congressional action. Nevertheless, what lies ahead is less a revolution than the completion of an ongoing process of financial market evolution. There are important disagreements about the breadth of expanded activities appropriate in banking organizations, the costs and benefits of structural restrictions to protect banks from added risks, and the appropriate regulatory framework for the reformed financial services industry. Nonetheless, I believe that policy makers have come to the conclusion that, while their hand may be forced by events, there are significant benefits from expanding the permissible activities of banks and other financial services firms. These benefits include increased competition in the financial services industry, and increased efficiency and consumer convenience in the provision of financial services. Allowing securities firms to compete directly with banks and banks with securities firms and each to compete with insurance firms will clearly enhance competition in the financial services industry. Economic theory and historical experience suggest that competition lowers costs, increases pressure for innovation, and increases attentiveness to the needs and convenience of customers. Financial modernization would allow financial services firms to serve better the needs and convenience of their customers both by lowering the costs of financial services and by facilitating one-stop shopping. The Edge Act already permits U.S. banks to compete on more equal terms outside the U.S. by permitting the Federal Reserve to authorize U.S. banks to do abroad certain activities, e.g., securities underwriting and dealing, not authorized directly to U.S. banks in the U.S. Moreover, U.S. banks are consistently evaluated by foreigners as the most innovative in the world. Nonetheless, easing of regulations would enhance marginally the international competitiveness of U.S. banks. Financial modernization also promotes efficiency in the production of financial services by allowing increased diversification of income sources by financial services firms and by allowing such firms to take advantage of economies of scope, that is, efficiencies that arise from producing related products. Think of financial modernization as a puzzle involving domestic and foreign financial service providers and consumers, the permissible activities, the organizational structures, the safeguards, the regulators, the legislators, and the Administration. The Administration and the legislators, with input from the regulators, have to decide which activities go to which providers in what organizational structures subject to what safeguards, under the oversight of which regulators, all for the maximum benefit of consumers. It may not be quite as simple as it sounds! The providers are the institutions whose future hangs in the balance: thrifts, banks, and nonbank financial services firms. Banks and thrifts may be combined and thrifts may therefore not survive as a separate entity. And, once the legislation is passed, affiliations may occur across commercial banks, investment banks, and insurance firms. In any case, only a subset of providers would be allowed to participate in this game. For example, only banking institutions that were found to be well capitalized and well managed and had adequate internal controls would be allowed to engage in the expanded activities. This is part of the trend to incentive-based regulation in which expanded activities and more streamlined regulation are confined to banking firms whose strength and performance suggest they can handle the increased risk. The permissible activities include those that banks are currently allowed to engage in directly; the somewhat broader and evolving set of financial activities that bank holding companies have been allowed to engage in through their subsidiaries; additional activities that fill out the spectrum of financial activities; and finally, possibly, commercial activities. The choices for organizational structures include a universal banking model, where all activities are conducted inside the bank; the operating subsidiary model, favored by the Comptroller of the Currency, in which some activities are restricted to operating subsidiaries of banks; and the bank holding company model, the traditional preference of the Board of Governors, in which some activities are restricted to subsidiaries of the bank holding company. Safeguards refer to prudential limitations on activities between the bank and its subsidiaries (and affiliates) in order to protect the public from conflicts of interest and other abuses, but primarily to limit the risks to the bank from the activities in the subsidiaries as well as to limit the transfer of the subsidy inherent in the safety net to bank subsidiaries and affiliates. The most widely enforced prudential limitations are those associated with sections 23A and 23B of the Federal Reserve Act which limit financial transactions between a bank and its affiliates. Such transactions must be at arms-length and collateralized and, except for those collateralized by U.S. government securities, are subject to quantitative limits based on bank capital. In addition, banking regulators have sometimes imposed firewalls (including, for example, physical separation of banks and their affiliates and limitations on employee and director interlocks) to provide further protection and insulation of the bank from activities conducted by subsidiaries. The regulators include the three federal banking agencies (OCC for national banks, the FDIC for state nonmember banks, and the Federal Reserve for state member banks and all bank holding companies), the OTS (the regulator of thrifts, other than credit unions), and the regulators of nonbank financial services activities (e.g., the SEC for securities and state insurance authorities for insurance). The legislators include the members of the House and Senate, with special focus on the Senate and House Banking Committees where financial modernization legislation will be written. The Administration effort is led by Treasury. Before I identify the key issues that have to be settled before the puzzle can be addressed, it will be useful to set the stage by explaining why banks are regulated. This will help motivate why bank activities have traditionally been restricted and why restrictions and prudential limitations are generally imposed when expanded activities are allowed in banking organizations. This will also help to motivate my subsequent discussion of the Board's views on expanded power and structural restrictions. Two special characteristics of banking are critical to understanding why banks are regulated. First, banks have access to a government safety net through deposit insurance, the discount window, and payment system guarantees. Because deposit insurance can never be fully and accurately priced, it is necessary to monitor and sometimes to act to control bank risks in order to protect the potential call on taxpayers. The result is that banks are, in effect, subsidized by the government. This subsidy, in turn, creates incentives for banks to take more risk. That is, the safety net creates moral hazard incentives for risk-taking, because the safety net -- and potentially taxpayers -- may absorb most of the losses if the gamble fails. In effect, the incentive for the creditors of the bank to monitor banks' risk taking -- the kind of monitoring that goes on for, say, finance companies -- and the market pressures to have high capital to absorb losses are simply blunted for entities with access to the safety net. That monitoring and pressure for capital has been taken over by the grantor of the safety net: the government. The second characteristic of banking is that banks -- especially large ones -- are capable of being the conduits of systemic risk and crisis in financial markets. A breakdown of the payments system or other contagion effect that hampers the ability of banks to intermediate credit flows could have serious consequences for the economy. The challenge is to maintain sufficient regulation to protect taxpayers, avoid unnecessary extensions of the safety net, and mitigate moral hazard incentives without undermining the competitiveness of the banking industry and its ability to take risk. Some have suggested that the government safety net, instead of being a subsidy to banks, has become a weight around their neck in the form of burdensome regulation that makes it difficult for banks to compete successfully against less regulated financial services firms. A solution might therefore be to limit or even eliminate the government safety net or at least charge deposit premiums that better price the risks involved. But the safety net has effectively eradicated the threat of runs on banks, has become capitalized in the value of bank equity, and in any case is so politically popular as to be unassailable. Our point of departure is therefore to assume that the government safety net will remain in place and will not be priced high enough to make it moot. Indeed, none of the legislative reform proposals in Congress would alter the access of banks to the government safety net. There will no doubt be continued efforts to reduce the net subsidy of the safety net. In addition to efforts to price insurance and access to central bank credit and the payments system more "accurately," I anticipate that the government will continue other efforts. For example, I think the correct way to read prompt corrective action and high capital requirements is as an offset to safety net incentives that create moral hazards. More generally, we can discern five regulatory approaches that traditionally have been employed to limit the extension of the subsidy, control moral hazard incentives, and limit the risk to the taxpayer associated with access by banks to the government safety net. First, banks can be required to hold enough capital in relation to risks so that moral hazard incentives are minimized. Second, supervision and examination of banks by their regulators can insure that banking organizations maintain effective internal controls and implement an effective risk management process so that the safety and soundness of banks is protected and the risk to taxpayers minimized. Third, banks can be restricted to activities that do not present undue risks. Fourth, banking organizations can be required to conduct their riskier activities outside the bank itself, so that the bank is insulated from those greater risks. Fifth, prudential limitations can be enforced to reduce the prospect that transactions between the banks and their affiliates housing riskier activities could threaten the safety and soundness of banks. Financial modernization represents a reconsideration of these regulatory approaches in the context of reform intended to reduce the segmentation of the financial services industry and increase competition. The regulatory approach to maintaining the safety and soundness of banks has evolved over the period beginning from the banking and financial market reforms of the Great Depression era through today. From the 1930s through most of the 1970s, regulators focused on keeping the banking industry safe and sound by insulating banks from competition and limiting the activities in which they could compete. As a result, the financial services industry became highly segmented into separate entities providing commercial banking, investment banking, insurance services, etc. By the late 1970s, the changed economic environment along with advances in technology, financial innovation, and globalization were presenting U.S. banks with increased competition from not only foreign banks, but from domestic thrifts, nondepository financial institutions, and the securities market as well. Banks responded by replacing lost business and lower margins with expanded off-balance sheet activities such as securitization, back-up lines of credit and guarantees, and derivatives. These responses helped banks to substitute fee and trading income for some of the interest income lost through competition with other financial intermediaries. Moreover, the larger banks generally sought expanded securities powers, so that they could stem the loss of customer business to capital markets. Regulators responded by reducing, in so far as they could under the law, the regulatory limits on banks and creating a more level playing field for banks and nonbanking firms. Financial modernization would further advance this process that has already blurred the distinction among financial services firms. Next the puzzle of powers, structures, and regulators must be solved. We need some guiding principles. The primary standard by which all modifications should be measured is the benefit to consumers of financial services. Would it make such services cheaper, more easily available, more convenient? Would it facilitate and foster innovation and competition? Modernization reforms that only increase provider profits -- say, by eliminating outdated and costly regulation -- are desirable, but only if, at a minimum, they do not reduce competition and consumer service. Given that primary principle, a second standard is to rely, in so far as compatible with the other goals, on the market. Thus, within such constraints, the scope of financial activities of banking organizations should be decided by the organizations themselves. When the special nature of banking makes reliance on the market impossible, the regulator should try to simulate market responses. Prompt corrective action is an example. Third, we should not lose sight of the special characteristics of banking that dictate regulation. These continue to suggest that there must be appropriate capital requirements, structure, supervision, and examination in banking organizations. Fourth, at the same time, the regulatory framework for financial services should be simplified and refined. In resolving the key regulatory issues, we should address three questions: First, what expanded activities should banks be allowed to conduct? Second, what organizational restrictions, if any, should be imposed on these new activities? The task here is to balance the benefits from achieving potential synergies among related activities and efficiencies from diversification and economies of scope, on the one hand, with the need to protect the safety net, that is, the taxpayer, on the other. Third, what regulatory framework most appropriately accommodates expanded activities, while also adequately protecting the safety and soundness of banks, controlling systemic risk, and promoting effective monetary policy? I will outline the key issues each question raises, beginning in each case with the Board's position. The discussion of expanded activities centers really on securities and insurance. I will therefore begin by setting out the current limitations on such activities in banking organizations, explain the Board's position on expanded powers, and then turn to unsettled substantive issues. The Glass-Steagall Act of 1933 prohibits banks from underwriting or dealing in securities, with the exceptions of U.S. government and agency issues, and municipal general obligation bonds. Nonbank affiliates of Federal Reserve member banks are also prohibited from being "principally engaged" in underwriting or dealing in non-exempt securities. Since 1987, the Board has allowed member banks to conduct limited non-exempt securities activities through subsidiaries of a bank holding company, referred to as section 20 affiliates, because section 20 of Glass-Steagall prohibited affiliation on the "principally engaged" criterion. In the 1980s, the Board initially determined that an affiliate was not "principally engaged" in prohibited activities if no more than $5 \%$ of its revenues came from non-exempt sources. That limit was subsequently raised to $10 \%$, and in December of 1996, the Board expanded the non-exempt revenue limit to $25 \%$. Most major U.S. banks, I might add, have had experience in securities activities through their foreign affiliates. Most of these foreign activities, in turn, are conducted, subject to certain percentage and dollar limitations, through their Edge corporations, which are generally subsidiaries of the bank. By statute, Edge corporations are permitted to engage in activities abroad not permitted in the U.S. if necessary to compete on an equal basis with local rivals. The Board has concluded that eligible securities activities, section 20 experience with ineligible securities, and activities through Edge corporations, have provided banks with considerable experience with securities activities. In addition, banks have been permitted to conduct private placements, provide discount and full service brokerage services, offer financial advisory services, and broker proprietary mutual funds. The repeal of the statutory limitation on securities activities by a bank affiliate would only extend an already significant presence of banks in securities activities and build upon a base of existing experience. In addition, it would provide increased competition without -- by the record -- increasing bank risks significantly. Moreover, the Glass-Steagall restrictions on securities activities were motivated by concern that abuses of such powers had contributed to the banking crises of the great Depression era. Subsequent research, however, has found that these concerns were greatly exaggerated and that there was no evidence that abuses in securities activities played a significant role in the banking crisis. As a result, there is little controversy about the merits of repeal of Glass Steagall. Bank holding companies have been prohibited from insurance sales and underwriting since 1982, although existing activities were grandfathered. National banks located towns with a population of 5000 or less are allowed to serve as a general insurance agent. The Comptroller, supported by recent court decisions, has allowed such banks to engage in national sales from offices located in such towns. A number of states allow banks they charter to engage in insurance agency activities quite broadly. At the same time, the FDIC Improvement Act in 1991 prohibits state banks insured by the FDIC from engaging in underwriting insurance beyond the extent permitted for national banks. As a result, banks are gaining some experience in insurance agency activities, but have quite limited experience with insurance underwriting activities. Nonetheless, there is a growing consensus that selling all types of insurance and possibly underwriting life insurance would not present undue risks to banks and would benefit consumers. It is important to note that securities and insurance activities are the only financial activities prohibited to banking organizations by statute. With the exceptions perhaps of property and casualty insurance, both activities seem to reflect manageable risks for banks. Consequently both activities would seem compatible with present organizational structures and prudential limitations. Indeed, the diversification of income sources might suggest that the extension of activities to include securities and insurance activities could, on balance, reduce the overall riskiness of the consolidated enterprise. However, commercial activities raise greater concerns. Think of a continuum of powers, including those currently permissible for banks and those under consideration with a ranking from low to greater risk. Where do securities underwriting and dealing and insurance agency and underwriting fall on this spectrum? While the answer may not be clear, I think that it is fair to argue that brokering, underwriting, and dealing in life insurance or securities are generally less risky than most of the credit risks banks have taken with their traditional lending activities. As we have seen in recent years with commercial real estate, energy, agricultural, and developing country loans, lending is hardly risk-free. Securities and insurance brokerage, in contrast, contain little risk, per se, and with their reliance on actuarial tables, life insurance underwriting activities would seem to present risks that banks could easily manage and control. Underwriting of casualty and property insurance, might, however, be beyond the higher end of the current risk spectrum. The Board of Governors has supported both a repeal of the Glass-Steagall Act to permit banking organizations to underwrite and deal in securities and also a reform of the Bank Holding Company Act to permit banks broader powers regarding insurance brokerage and underwriting. The possible exception involves casualty and property underwriting, which the Board historically has felt raised concerns about risk. The Board has not, however, supported affiliations between banking and commercial firms. While it does not object in principle to such affiliations, it has taken the position that it is perhaps best for banking organizations and their regulators to gain experience with new financial activities before considering broader combinations. The benefits simply appear less certain and the risks greater. The Board would therefore prefer to proceed with the expansion in financial services and to defer any discussion of commercial activities. Admittedly, such an approach could complicate the modernization process, since some unitary thrifts and insurance firms are already affiliated with commercial firms. Would they need to divest such activities, or could they be satisfactorily grandfathered if either the thrift and bank charters are combined or banks are permitted to affiliate with securities and insurance firms? The Board's position has been that any meaningful expansion of new activities should take place in nonbank subsidiaries of bank holding companies. In contrast, the Comptroller of the Currency has proposed allowing such activities in subsidiaries of national banks. Some have viewed this difference as simply a battle over turf. The Federal Reserve supervises bank holding companies and would therefore expand its regulatory reach if new powers were forced into the BHC model. The OCC supervises national banks and would potentially expand its influence relative to the Federal Reserve if nonbank activities were permitted in operating subsidiaries of banks. But much more is at stake here than turf. The location in the organizational structure of nonbanking activities raises fundamental questions about the safety net. Recall my earlier comments about the fundamental tension between risk-taking and market orientation, on the one hand, and the stabilization and moral hazard implications of the safety net, on the other. Such tensions focus, I submit, on the special benefits -- the subsidy, if you will -- that recipients of the safety net receive and the regulation that goes with it. We in the United States should be careful not to inadvertently extend the safety net -- and, almost for certain, bank-like regulations -- in the process of dealing with financial reform and organizational structure. This is a difficult issue, requiring balance and judgment, and I would hope that Congress would carefully review the options and their full implications. Currently, all bank holding companies are subject to consolidated supervision by the Federal Reserve; banks are regulated by state banking agencies, the OCC, the FDIC, and/or the Federal Reserve depending on their charter, and, for state banks, on their choice, and there is some functional regulation of specialized activities of holding company subsidiaries. Consolidated bank holding company supervision includes holding company capital requirements, examinations, and reporting requirements. Two substantive issues are important as we consider the regulatory framework most appropriate for accommodating financial modernization. First, to what degree is consolidated supervision and regulation appropriate? Second, what role should the Federal Reserve have in regulating banks and financial conglomerates that include banks? Both the operating subsidiary and bank holding company models facilitate functional regulation by putting specialized activities that might be subject to functional regulation into separate entities. For example, securities activities subject to SEC capital requirements and other regulations would be put into a separate subsidiary and similarly with insurance activities subject to regulation by state insurance departments. Under a pure functional regulation scheme, bank regulators would supervise only the bank, and there would be no consolidated supervision of the entire entity. This appears, on the surface, clean and efficient, reflecting the benefits of specialization and division of labor among regulators. But it is completely out of step with emerging risk management practices at financial services firms and with norms for global banks and financial services firms around the world. Banking organizations are increasingly managing risks without regard to legal entities. For them to do otherwise would ignore the powerful concepts of portfolio theory and the gains they can achieve both from diversification and from managing risks on a consolidated basis. If financial services firms engage in consolidated risk management, regulators must insist on some measure of consolidated regulation that permits effective oversight of the consolidated entity. The U.S. participates actively in world forums with regulators of banking and other financial services. There is a growing emphasis in these meetings on sharing information and clear recognition of the value of consolidated supervision. If there is consolidated regulation, it could be carried out by the Federal Reserve, in line with the system's current role as regulator of bank holding companies. For example under Congressman Leach's bill, the Federal Reserve would be the umbrella regulator for the financial services holding companies that replace bank holding companies. An alternative model, however, might be for the regulator of the lead bank to be the umbrella regulator of the consolidated entity. That approach has the advantage of limiting the number of separate regulators of a given entity. It has the disadvantage, though, that the regulation of financial services holding companies would be disbursed among several agencies and that each agency could adopt different policies. A third model would have a single bank regulator for financial services holding companies whose predominant activity is banking and the SEC where the predominant activity involves securities. The second issue is what role the Federal Reserve should have in banking regulation. You may recall that the Administration proposed in 1993 a consolidation of banking regulation that would have taken all regulatory, supervisory, and examination responsibilities away from the Federal Reserve and consolidated the current responsibilities of the OCC, and the supervisory and regulatory responsibilities of the FDIC and the Federal Reserve into a new federal banking commission. The Federal Reserve opposed consolidated supervision and regulation and strongly asserted the importance of maintaining a hands-on supervisory role for the Federal Reserve. That role is especially critical for large, global banking organizations, but also for at least a cross section of smaller banks. The Federal Reserve believes that such an active supervisory role is essential for it to conduct monetary policy and prevent or manage financial crises most effectively. For example, the information examiners developed about the severity of the credit crunch in the early 1990s contributed to the Federal Reserve's decision to maintain an unusually stimulative monetary policy well into the current expansion. That policy, in turn, helped to support the economy while banking institutions were returning to health and reestablishing their ability to provide credit to support a healthy expansion. As the nation's central bank, the Federal Reserve also has critical responsibilities to prevent or resolve major problems in financial markets that cannot be adequately met without timely and in-depth knowledge of the operating practices, risk-management procedures, and financial exposures of the banking system. In conclusion, the case for expanded financial activities for banks and other financial services firms is compelling. But it is important that differences in opinion about structural and prudential safeguards and the resulting regulatory framework be resolved, so that these disagreements do not block financial modernization efforts.
1997-01-24T00:00:00	Mr. Patrikis discusses the monetary policy and regulatory implications of banking on the Internet	Address by the Vice-President of the Federal Reserve Bank of New York, Mr. Ernest T. Patrikis, at the Queen Mary &amp; Westfield College University of London &amp; UNISYS International Management Centre held in Saint Paul de Vence, France from 22-24/1/97.	Mr. Patrikis discusses the monetary policy and regulatory implications of banking on the Internet Address by the Vice-President of the Federal Reserve Bank of New York, Mr. Ernest T. Patrikis, at the Queen Mary & Westfield College University of London & UNISYS International Management Centre held in Saint Paul de Vence, France from 22-24/1/97. A. Introduction I want to share with you today some observations and speculations gathered this and last year about banking and the Internet. I will be speaking in my capacity as a central banker -- which includes monetary policy, banking services, bank supervision, and payments system oversight -- and as a surfer of the 'Net. Let me state, at the outset, that, while the Federal Reserve Bank of New York does not conduct "Internet banking" as such, we do have a home page (http://www.ny.frb.org) with much useful information about our institution, with over three million recorded hits to date. Finally, let me add that some of what I say here today could, very easily, be obsolete in two months' or even two weeks' time. But I will try to point out those areas in advance. The title of this portion of the program gives rise to two issues of definition. The first is "What is the Internet?" The second is "What is banking?" As I am sure you are well aware, in the United States we are a litigious sort. We even have a legal definition of the Internet. According to one recent case, the "Internet" is "an international computer 'supernetwork' of over 15,000 computer networks used by about 30 million individuals, corporations, organizations, and educational institutions worldwide."1 Another case described the "Internet" as "a global communications network linked principally by modems which transmit electronic data over telephone lines [with] approximately 20 million to 30 million users."2 "Banking" raises a host of issues in the United States. There is commercial banking and investment banking. The products offered by "banking" firms range from deposit taking (including payment services), investment advisory and management services, trading in financial instruments, brokering and underwriting financial instruments, lending, and trust services. A bank can offer all of these services on the Internet. For the purposes of this discussion, I will basically confine myself to deposit taking (including payment services) and lending. A Central Banker's View From a United States central bank perspective, the most fundamental question of banking and the Internet is: What are the monetary-policy implications, especially were we to assume the enormous, widespread scale that some have been predicting? From this perspective, the answer appears to be: probably not much. If the Internet is used merely to facilitate existing banking and payment transactions, such as executing electronic bill payments or transferring funds from one bank account to another (which more or less describes what electronic bill payment really is anyway), the combination of banking and the Internet should have few, if any, implications for the conduct of United States monetary policy, or the measurement of the United States money supply. "Money," as defined by M1, M2, or M3, would still be held in accounts at 1 Panavision Int'l, L.P. v. Toeppen, 938 F. Supp. 616, 617 (C.D. Cal. 1996). 2 In Systems, Inc. v. Instruction Set, Inc., 937 F. Supp. 161, 164 (D. Conn. 1996). The most comprehensive judicial description of the Internet can be found in American Civil Liberties Union v. Reno, 929 F. Supp. 824, 830-48 (E.D.P.A. 1996). banks that would be reported to the Board of Governors of the Federal Reserve System through the existing mechanisms that such funds are reported today. If, however, Internet banking evolved to the point where digital "coins," account-based cards and PCs, or other private-sector initiatives produced electronic representations of money that began to be used and circulated like currency, the potential implications for United States monetary policy are much greater. The key questions here are related to amount and velocity -- that is, (1) how would digital bills or notes, or digital coins, be represented on the books of a bank or depository institution; and (2) how many times would this electronic coin or bill circulate in the general economy without somehow being processed and recorded by a bank? In this regard, the October 1996 Bank for International Settlements report "Implications for Central Banks of the Development of Electronic Money" states "E-money could lead to shifts in the velocity of money which might temporarily reduce the usefulness of the monetary aggregates, especially narrower ones, for countries that rely on them as targets or indicators." In a June 1996 speech before a cyber-payments conference, Governor Edward Kelley of the Board of Governors stated that, with respect to a bank's liabilities incurred through issuing stored-value cards, such liabilities should be included in the statistical reports that banks must currently submit to the Board of Governors.3 It is difficult to argue that bank liabilities resulting from the issuance of electronic "coins" or electronic "bills and notes" should be reported any differently. A more problematic question arises when considering the matter of nonbank issuance of electronic coins or bills. Currently, the largest nonbank issuers of travelers checks are not required, but do volunteer to the Fed, the outstanding balances of their travelers checks, so that this information can be statistically recorded and reported in United States monetary aggregates by the Fed. If the issuance of private electronic money grows to a significant level in the real economy, and if much of that growth is provided by nonbank issuers of electronic money, there could be a similar request for nonbank issuers to provide information about the volume of their issuance and their outstanding electronic money liabilities, to the extent these liabilities are not recorded on the books of a bank every time they are circulated in the general economy. A Bank Supervisor's View From this perspective, combining banking and the Internet offers both great opportunity and great potential risk. First, the good news -- it is primarily cost-related. It has been reported by several banking studies that the cost of a typical transaction at a bank branch is now over $1.00; the cost of an ATM transaction is approximately $0.25. The cost of an Internet transaction, however, has been estimated at about a penny. I do not vouch for this statistic, but the difference is substantial. Such figures make a compelling argument for banks to get on the Internet sooner rather than later, and to move as many of their customers on to electronic or Internet banking as soon as they possibly can. Indeed, some banks offer low-fee accounts where the customer is not expected to enter an office physically -- mail, phone, and ATM are sufficient. As stated by Board of Governors Chairman Alan Greenspan: "it is useful...to begin by reminding ourselves just why there is bank supervision and regulation. At bottom, of course, is the historical experience of the effects on the real economy of financial market disruptions and bank failures, especially when the disruptions and failures spread beyond the initial impetus."4 A bank supervisor should have concerns other than cost, and these comprise the bad news -- the "risk" aspect of banking on the Internet. In the simplest terms, while we strive to ensure that banks remain efficient and cost-effective, we also have to ensure that banks know what they are getting into, and that they are capable of handling the risks that accompany banking on the Internet. The tension between the two is very constant and real, particularly because the technology today seems to be moving so much faster than bankers or bank supervisors can fully absorb. At the Federal Reserve Bank of New York, we are being proactive in this area. We currently conduct on-site, information systems examinations of State member banks in our district -- in addition to commercial, trust, trading, and compliance examinations -- in which we try to review and constructively criticize the examined bank's entire MIS infrastructure. There is no separate, independent electronic or Internet bank exam as such. However, a part of the information systems examination reviews the bank's electronic and Internet activities and plans, and all examiners ask general questions that we feel that any bank offering on-line banking services should be able to answer responsively. In addition, we have convened a special task force at the Federal Reserve Bank of New York to review security issues involving on-line and Internet banking. The goal of this task force is two-fold: (1) to gather, review, and benchmark current and future on-line security procedures and policies of State member banks in our district; and (2) to then somehow disseminate, without unduly disadvantaging any specific depository institution that provided us with its information, the best of these policies and procedures into a kind of "sound practices" security guide for banks to use for their electronic and Internet banking services. The task force should issue its first report in the summer of 1997. In a similar vein, I believe that the United States Federal bank supervisors, while mindful of the risks, have tried to be as supportive of electronic and Internet banking as possible. Each of the various bank supervisory agencies, i.e., the Board of Governors, the Office of Thrift Supervision ("OTS"), the Federal Deposit Insurance Corporation ("FDIC"), and the Office of the Comptroller of the Currency ("OCC"), has dealt in some immediate way with the issues posed by electronic and Internet banking. Both the OTS and the Board of Governors have dealt directly with Internet banking through the bank applications approval process. In May of 1995, the OTS approved the application of a new thrift, the Security First Network Bank ("SFNB"), that sought explicitly to provide the majority of its electronic banking services over the Internet.5 In May of 1996, the Board of Governors approved the application of SFNB's parent, a bank holding company, for SFNB to acquire a data-processing firm specializing in data processing activities that would provide nationwide banking and financial services over the Internet.6 In December of 1996, the Board of Governors approved the application of a Minnesota bank holding company and two foreign banks to join a consortium of 15 North American banks and IBM to form Integrion Financial Network, LLC.7 Integrion itself has announced that it will not provide electronic or home banking services, but will instead design and operate a secure electronic gateway or interface system linking bank customers to their depository institutions, including links via the Internet.8 Finally, the Federal Reserve Bank of New York and the Board of Governors are currently processing an application from a foreign bank, with a United States securities brokerage subsidiary, to acquire a software firm planning to design software for customers of brokerage firms to place securities buy-and-sell orders over the Internet.9 The OCC, meanwhile, confirmed in correspondence in August of 1996 that, in addition to providing home banking services to its customers through the Internet, a national bank subsidiary could also provide Internet access to customers and nonbank customers in the bank's service area.10 In the midst of all this supervisory "support," however, I should also mention some of the as-yet unsettled issues dealing with the unique regulatory burdens facing depository institutions offering financial services over the Internet. Among the most difficult will be the proper application of the Community Reinvestment Act ("CRA"), a United States statute that requires depository institutions to meet the credit needs of the communities where they accept deposits. What exactly is a deposit community in cyberspace? Nobody really knows. This has not yet become a significant issue because most depository institutions offering on-line services still have brick-and-mortar branches, on to which current definitions of a CRA community are based. Still, for exclusively on-line depository institutions, the CRA issue will become increasingly important as their market share grows. Some early discussions with the relevant compliance supervisors may be in order. I also note that this also raises interesting questions on the definition of the relevant geographic market in the analysis of bank mergers. Furthermore, considering the CRA issue brings forth another, broader issue: what is the role of nonbanks in the realm of Internet financial services, particularly payment services, which are still largely the province of banks and other regulated depository institutions? Because banks have been so intricately involved in the United States payments system, banks today face unique regulatory burdens: CRA, reserve requirements, deposit insurance premiums, and the costs of good supervision and good supervisors. If nonbanks begin to take significant market share away from banks because of an inherently lower cost structure, that raises real questions about a level playing field and whether or not banks can ever fairly compete. If nonbanks begin offering through the Internet many of the payment services, or alternatives to the payment services now offered exclusively by banks, that raises real concerns about the ultimate value of a bank charter, and what it really means to be a "bank." Or is this "banking"? Another issue that may be relevant here is the implication of a firm that has a balance sheet that looks like that of a bank but does not have direct access to the lender-of-last resort. Finally, and especially in light of the issues just raised, I think it is important for me to emphasize that the bank supervisors have expressed a clear willingness to listen to what the banking community has had to say on the issues involving electronic and Internet banking. Regulation E, promulgated by the Board of Governors, implements the Electronic Funds Transfer Act of 1978, and establishes primarily for consumer protection purposes the basic rights, liabilities, and responsibilities of consumers who use, and financial institutions who offer, retail electronic funds transfer services.11 Among the protections provided are required disclosures, error resolution procedures, and loss protection. In 1996, when the Board of Governors issued its proposed regulations concerning the applicability of Regulation E to stored-value cards, the Board of Governors explicitly requested that commenters to the proposed revisions indicate whether the commenters believed that part or all of Regulation E should apply to electronic "money" or "value" residing on a computer system or a personal-computer hard drive.12 Similarly, the FDIC, while holding public hearings on its General Counsel Opinion No. 8 on stored-value cards and Federal deposit insurance coverage,13 specifically requested additional commentary on Federal deposit insurance coverage and electronic value represented on computer systems or personal computers. I believe the message is clear: as bank supervisors, we are open to what the banking community has to say on this rapidly evolving market. New ideas and reasoned arguments are welcome. We must try not to restrain important new services developed by the banking industry but should remain vigilant as banking-type services are offered by nonbank institutions. A Payments Systems Overseer's View From the perspective of a payments system overseer, I see much activity, but thus far, few genuinely revolutionary innovations with respect to banking and the Internet in the United States. Mainly, I see the application of faster, cheaper electronic processing of older, more established paper-based methods of transferring payments between parties. Credit card payments on the Internet are one example. Instead of using a telephone, a normal card reader, and a customer's signature, one leading Internet payments company has devised a secure method of allowing a bank customer to shop on-line with a credit card, by never releasing "in the clear" the customer's credit card number on the Internet itself. Instead, the company only releases the credit card number and a merchant's request for payment to the customer's issuing bank, away from the Internet, after verifying on-line with the customer that the purchase was authentically made. The bank processes the transaction as it would any other credit card purchase; the value added by the company is that the customer's credit card number is never on-line, a benefit indeed in today's security-poor Internet. It is not hard to imagine that another step in this direction is for a third-party organization (perhaps even a bank subsidiary) to issue secure, encrypted electronic checks on the Internet on behalf of bank customers, or even unaffiliated parties, wishing to make purchases on-line. Much legal uncertainty remains in the United States about establishing such a process, however. Basic questions remain unanswered. What, exactly, would be an authorized signature on an electronic check? Put another way, what types of entities would be authorized to act as certification authorities on the Internet for such commercial conveniences as electronic purchase orders, electronic negotiable instruments, or their bases, digital signatures? Would these certification authorities be entirely private sector derived? Or would they be established and operated by the government, by the individual states, some of whom already have enacted digital signature statutes? What is the role of banks in this process? In particular, what are the risks to the bank, in allowing a nonaffiliated third party to act as a certifying authority for electronic checks drawn from the accounts of bank customers? I could ask some even more basic commercial law questions about banking in cyberspace. When is an Internet payment final? More specifically, when a payment over the Internet is made, has the maker of the payment made a provisional payment, as with writing a check, or a final payment, as with giving a certified check or making a wire transfer? Articles 3, 4 and 4A of the Uniform Commercial Code ("UCC") govern the above circumstances, but have nothing to say on Internet payments. Currently, private contract law governs; agreements between each of the parties in an on-line transaction should be very carefully drafted and reviewed. Still, if Internet banking and commercial transactions were to grow in volume and complexity, it is quite possible that private contract law could evolve into a specialized commercial law of cyberspace, and eventually be codified into parts of the UCC. On a less theoretical note, I should mention that a multi-national Task Force on the Security of Electronic Money, established by the Committee on Payment and Settlement Systems and the Group of Computer Experts of the Group of Ten Central Bank Governors, and chaired by Israel Sendrovic of the Federal Reserve Bank of New York, issued a report on its findings entitled "Security of Electronic Money" in August 1996. This Task Force examined primarily consumer-oriented stored-value payment products by, among other activities, surveying the leading global suppliers of both card-based and software-based stored-value systems, and concluded that the technical security measures of these systems are being designed to achieve an adequate level of security relative to other forms of common retail payment, assuming they are implemented appropriately. I recommend the report to anyone interested in a general discussion about security issues and stored-value systems, Internet-based or not. Moving away from consumer banking and the Internet, and looking perhaps not-so-distantly into the future, I have also had occasion to question what the repercussions are for large-value payments transfer systems, such as Fedwire, with the emergence of a different, much more secure Internet. Generally speaking, the Internet today is a "somewhat" secure environment in which to conduct banking and financial service activity. The current level of security is not adequate for large-value payments. Some Internet-based payment products are becoming more secure, but only after the creators of these products have spent a great deal of time, effort and resources making their products secure. Consistent fast transmission and processing are also essential for large-value payments. The Internet today has no authorized, universal means of prioritizing specific electronic messages from other messages. Faster and better hardware helps, certainly, but offers no guarantee. One of my responsibilities is to serve as the Product Director of the Wholesale Payments Product Office of the twelve Federal Reserve Banks. This includes the Fedwire transfer of funds, transfers of securities against payment, and net settlement. In providing these payment services, the Reserve Banks must charge a fee designed to cover their costs, plus what we refer to as a "private sector adjustment factor," a proxy for the capital, taxes, and other costs incurred by private-sector service providers. Thus, I am keenly interested in the next stage of the Internet. If messages sent across the Internet could be made timely, become much more secure at reasonable cost, and, if a widely-accepted prioritization scheme for electronic messages could be implemented so that large-value payment messages could move instantaneously, it is not inconceivable that the effect on existing large-value payments transfer systems could be substantial. Within a five-to-ten year time frame, I could see at least a portion of Fedwire large-volume transfers of funds and securities -- with real-time gross-settlement -- handled over the Internet. Please do not ask me exactly when this will come about. On the other hand, with potentially enormous, secure, bilateral netting arrangements occurring between clearing banks in real time over the Internet, volume on existing large-value transfer systems could decrease dramatically. The clearing banks could, conceivably, save themselves some real money. Jurisdictional Issues Any discussion of banking or any form of commerce over the Internet today would not be complete without at least a few words on the legal jurisdictional issues that the Internet presents. This is arguably the area of law most in flux, the most subject to change on a monthly or even daily basis, depending on the specific jurisdiction and long-arm statute under discussion. In the United States, cases have already been decided regarding court jurisdiction and the Internet over alleged trademark violations,14 contract disputes,15 and advertising disputes.16 Although I am as yet unaware of any banking organizations that have become embroiled in litigation over jurisdictional issues from being on the Internet, I cannot promise you that such a suit will never occur. If a State banking agency or a State attorney general decided one day that a Web-site or an Internet-based transaction conferred sufficient minimum contacts with a state resident so that the state's long-arm statute applied to the bank, a suit could easily be filed. Minnesota Attorney General Hubert Humphrey III filed six lawsuits in 1995 against six companies accusing them of engaging in illegal business practices or running outright pyramid schemes over the Internet, although none of the six companies was based in Minnesota, and no Minnesota citizen ever came forward to complain about the companies. The fact that a Minnesota resident could have accessed the scams run by the companies, claimed Attorney General Humphrey, was sufficient to confer jurisdiction of his lawsuits in the Minnesota courts. Lest this argument sound wildly and improbably expansive, it should be noted that the "Internet access = jurisdiction" idea has already been accepted by some of the Federal district courts that have decided such cases, although it must also be noted that these courts' decisions have been inconsistent, have all had slightly different facts, and have taken great pains to distinguish themselves from one another. New case law on the issue of jurisdiction conferred by Internet access is undoubtedly being made as we speak. At a minimum, then, banks offering services through the Internet should have signed contracts with electronic and Internet banking customers that specify to the courts where claims or disputes may be brought. Web-sites designed merely to advertise a bank's financial services should be designed to be as controversy-free as possible, although that may be difficult without making the sites content-free as well. Banks should err on the side of caution until the jurisdictional issues have had more time to sort themselves out. I would like to present a hypothetical fact situation to you which I think demonstrates some of the thorny legal and supervisory issues that could be raised by the existence of offshore banking entities doing business over the Internet with individuals in our jurisdictions. I travel to the island of Atlantis, where I obtain a Class Z banking charter. I am permitted under this charter to engage in the business of banking every place in the world, except with residents of Atlantis. As you have probably suspected, Atlantis is founded on the principle of free and open markets, unfettered by supervision and regulation of banks with Class Z charters. Atlantis also provides for strict adherence of the principles of banking secrecy. My bank is named The Internet International Bank ("IIB"). The IIB offers a full spectrum of banking services to Atlantis nonresidents. Being a modern bank, it conducts business principally on the Internet. IIB has a series of quite attractive Internet pages where its products are offered. These pages spell out the products, deposit terms and interest rates, and loan terms and interest rates. All agreements are governed by the law of Atlantis. All deposits are deemed received over IIB's "counters" in Atlantis, and all loans are paid out of Atlantis. Atlantis has an enjoyable ambiance even exceeding that of Nice and Saint Paul de Vence; therefore, I see no need to leave the island. I do receive and entertain customers when they visit Atlantis. I do place telephone calls to customers who have responded to my Internet page, but I do not make cold calls to customers. Communications with customers over the Internet are state-of-the-art secure. Customers receive account statements over the Internet, issue payment instruments to IIB over the Internet, and request loans over the Internet. All payments to and from accounts are made by wire transfer to IIB's correspondent account maintained on the books of Atlantis Bank, the only bank chartered under Atlantis law authorized to engage in banking transactions with Atlantis residents. Customers may instruct IIB to make payments for their account. These too are consummated by means of payments out of IIB's account at Atlantis Bank. Loans are disbursed and paid the same way. The question presented is whether IIB is violating the law of the countries in which its customers are located. While I have my own views as to the application of United States banking and securities laws to this fact situation, I prefer not to spell those out in my prepared remarks. Instead, we all might prosper by sharing our views as to the proper application of our home country's laws to individuals in our countries who might do business with IIB. I should note that this fact situation is a pure figment of my imagination. The cooperative efforts of bank supervisors over the world should be designed to ensure precisely against this sort of bank. In other words, like Atlantis, IIB should never surface above water. Our discussion should include responses to the following questions: (1) is IIB engaged in an impermissible activity in your home country; (2) if it is impermissible, what authority has responsibility for enforcing that law; (3) if impermissible, is that a civil or criminal violation; (4) if impermissible, is there any way for IIB to qualify to do business in your home country; and finally, (5) does your home-country court have jurisdiction to hear cases brought by a customer against IIB? Conclusion To conclude, I simply wish to commend the banking and legal communities for learning as much about electronic and Internet banking as they can, now, and for trying to stay ahead of the curve of ever evolving and improving technology. I fully agree with the philosophy of letting the markets decide what will work and what will not. We, as supervisor and central banker, will try to stay out of the way as much as possible, unless because of criminal activities or systemic risk concerns we have to jump in. The private sector seems to have done fairly well so far. To this end, I point out a recent creation of the Banker's Roundtable, an organization composed of some of the largest United States banks, in organizing the Banking Industry Technology Secretariat ("BITS"). BITS, as I understand it, is in the process of designing and implementing common technological standards for the inter-operability of systems linking banks and their customers, and is also hoping to act as a certification authority for its member banks for third-party system and software providers, to ensure that when an electronic or Internet banking transaction takes place, the bank's name is the only name the customer ever sees. Similarly, a certified software or systems provider would agree that the customer's payment information would stay with the bank and not the provider. I mention this not as an endorsement of BITS, but as an example of the type of innovation and cooperative or collaborative effort that can occur when the banking community realizes the enormous challenge and opportunity it has in the next few years. Central banks and bank supervisors must also be equal to these challenges. In order for us to fulfill our responsibilities, it will be necessary for the private sector financial institutions to keep educating and challenging us. It is those dynamics that will help ensure good public policy in banking supervision and regulation of banking transactions over the Internet.	---[PAGE_BREAK]--- # Mr. Patrikis discusses the monetary policy and regulatory implications of banking on the Internet Address by the Vice-President of the Federal Reserve Bank of New York, Mr. Ernest T. Patrikis, at the Queen Mary \& Westfield College University of London \& UNISYS International Management Centre held in Saint Paul de Vence, France from 22-24/1/97. ## A. Introduction I want to share with you today some observations and speculations gathered this and last year about banking and the Internet. I will be speaking in my capacity as a central banker -- which includes monetary policy, banking services, bank supervision, and payments system oversight -- and as a surfer of the 'Net. Let me state, at the outset, that, while the Federal Reserve Bank of New York does not conduct "Internet banking" as such, we do have a home page (http://www.ny.frb.org) with much useful information about our institution, with over three million recorded hits to date. Finally, let me add that some of what I say here today could, very easily, be obsolete in two months' or even two weeks' time. But I will try to point out those areas in advance. The title of this portion of the program gives rise to two issues of definition. The first is "What is the Internet?" The second is "What is banking?" As I am sure you are well aware, in the United States we are a litigious sort. We even have a legal definition of the Internet. According to one recent case, the "Internet" is "an international computer 'supernetwork' of over 15,000 computer networks used by about 30 million individuals, corporations, organizations, and educational institutions worldwide." 1 Another case described the "Internet" as "a global communications network linked principally by modems which transmit electronic data over telephone lines [with] approximately 20 million to 30 million users." $\underline{2}$ "Banking" raises a host of issues in the United States. There is commercial banking and investment banking. The products offered by "banking" firms range from deposit taking (including payment services), investment advisory and management services, trading in financial instruments, brokering and underwriting financial instruments, lending, and trust services. A bank can offer all of these services on the Internet. For the purposes of this discussion, I will basically confine myself to deposit taking (including payment services) and lending. ## A Central Banker's View From a United States central bank perspective, the most fundamental question of banking and the Internet is: What are the monetary-policy implications, especially were we to assume the enormous, widespread scale that some have been predicting? From this perspective, the answer appears to be: probably not much. If the Internet is used merely to facilitate existing banking and payment transactions, such as executing electronic bill payments or transferring funds from one bank account to another (which more or less describes what electronic bill payment really is anyway), the combination of banking and the Internet should have few, if any, implications for the conduct of United States monetary policy, or the measurement of the United States money supply. "Money," as defined by M1, M2, or M3, would still be held in accounts at [^0] [^0]: 1 Panavision Int'l, L.P. v. Toeppen, 938 F. Supp. 616, 617 (C.D. Cal. 1996). 2 In Systems, Inc. v. Instruction Set, Inc., 937 F. Supp. 161, 164 (D. Conn. 1996). The most comprehensive judicial description of the Internet can be found in American Civil Liberties Union v. Reno, 929 F. Supp. 824, 830-48 (E.D.P.A. 1996). ---[PAGE_BREAK]--- banks that would be reported to the Board of Governors of the Federal Reserve System through the existing mechanisms that such funds are reported today. If, however, Internet banking evolved to the point where digital "coins," account-based cards and PCs, or other private-sector initiatives produced electronic representations of money that began to be used and circulated like currency, the potential implications for United States monetary policy are much greater. The key questions here are related to amount and velocity -- that is, (1) how would digital bills or notes, or digital coins, be represented on the books of a bank or depository institution; and (2) how many times would this electronic coin or bill circulate in the general economy without somehow being processed and recorded by a bank? In this regard, the October 1996 Bank for International Settlements report "Implications for Central Banks of the Development of Electronic Money" states "E-money could lead to shifts in the velocity of money which might temporarily reduce the usefulness of the monetary aggregates, especially narrower ones, for countries that rely on them as targets or indicators." In a June 1996 speech before a cyber-payments conference, Governor Edward Kelley of the Board of Governors stated that, with respect to a bank's liabilities incurred through issuing stored-value cards, such liabilities should be included in the statistical reports that banks must currently submit to the Board of Governors. ${ }^{3}$ It is difficult to argue that bank liabilities resulting from the issuance of electronic "coins" or electronic "bills and notes" should be reported any differently. A more problematic question arises when considering the matter of nonbank issuance of electronic coins or bills. Currently, the largest nonbank issuers of travelers checks are not required, but do volunteer to the Fed, the outstanding balances of their travelers checks, so that this information can be statistically recorded and reported in United States monetary aggregates by the Fed. If the issuance of private electronic money grows to a significant level in the real economy, and if much of that growth is provided by nonbank issuers of electronic money, there could be a similar request for nonbank issuers to provide information about the volume of their issuance and their outstanding electronic money liabilities, to the extent these liabilities are not recorded on the books of a bank every time they are circulated in the general economy. # A Bank Supervisor's View From this perspective, combining banking and the Internet offers both great opportunity and great potential risk. First, the good news -- it is primarily cost-related. It has been reported by several banking studies that the cost of a typical transaction at a bank branch is now over $\$ 1.00$; the cost of an ATM transaction is approximately $\$ 0.25$. The cost of an Internet transaction, however, has been estimated at about a penny. I do not vouch for this statistic, but the difference is substantial. Such figures make a compelling argument for banks to get on the Internet sooner rather than later, and to move as many of their customers on to electronic or Internet banking as soon as they possibly can. Indeed, some banks offer low-fee accounts where the customer is not expected to enter an office physically -- mail, phone, and ATM are sufficient. As stated by Board of Governors Chairman Alan Greenspan: "it is useful...to begin by reminding ourselves just why there is bank supervision and regulation. At bottom, of course, is the historical experience of the effects on the real economy of financial market [^0] [^0]: 3 Remarks of Edward W. Kelley, Jr., Member of the Board of Governors of the Federal Reserve System, at the Cyberpayments Conference '96 (June 18, 1996). ---[PAGE_BREAK]--- disruptions and bank failures, especially when the disruptions and failures spread beyond the initial impetus." 4 A bank supervisor should have concerns other than cost, and these comprise the bad news -- the "risk" aspect of banking on the Internet. In the simplest terms, while we strive to ensure that banks remain efficient and cost-effective, we also have to ensure that banks know what they are getting into, and that they are capable of handling the risks that accompany banking on the Internet. The tension between the two is very constant and real, particularly because the technology today seems to be moving so much faster than bankers or bank supervisors can fully absorb. At the Federal Reserve Bank of New York, we are being proactive in this area. We currently conduct on-site, information systems examinations of State member banks in our district -- in addition to commercial, trust, trading, and compliance examinations -- in which we try to review and constructively criticize the examined bank's entire MIS infrastructure. There is no separate, independent electronic or Internet bank exam as such. However, a part of the information systems examination reviews the bank's electronic and Internet activities and plans, and all examiners ask general questions that we feel that any bank offering on-line banking services should be able to answer responsively. In addition, we have convened a special task force at the Federal Reserve Bank of New York to review security issues involving on-line and Internet banking. The goal of this task force is two-fold: (1) to gather, review, and benchmark current and future on-line security procedures and policies of State member banks in our district; and (2) to then somehow disseminate, without unduly disadvantaging any specific depository institution that provided us with its information, the best of these policies and procedures into a kind of "sound practices" security guide for banks to use for their electronic and Internet banking services. The task force should issue its first report in the summer of 1997. In a similar vein, I believe that the United States Federal bank supervisors, while mindful of the risks, have tried to be as supportive of electronic and Internet banking as possible. Each of the various bank supervisory agencies, i.e., the Board of Governors, the Office of Thrift Supervision ("OTS"), the Federal Deposit Insurance Corporation ("FDIC"), and the Office of the Comptroller of the Currency ("OCC"), has dealt in some immediate way with the issues posed by electronic and Internet banking. Both the OTS and the Board of Governors have dealt directly with Internet banking through the bank applications approval process. In May of 1995, the OTS approved the application of a new thrift, the Security First Network Bank ("SFNB"), that sought explicitly to provide the majority of its electronic banking services over the Internet. ${ }^{5}$ In May of 1996, the Board of Governors approved the application of SFNB's parent, a bank holding company, for SFNB to acquire a data-processing firm specializing in data processing activities that would provide nationwide banking and financial services over the Internet. ${ }^{6}$ In December of 1996, the Board of Governors approved the application of a Minnesota bank holding company and two foreign banks to join a consortium of 15 North [^0] [^0]: 4 Alan Greenspan, Banking in the Global Marketplace, address before the Federation of Bankers Associations of Japan (Nov. 18, 1996). 5 See OTS Order No. 95-88 (May 8, 1995). 6 See Cardinal Bancshares, Inc., 82 Fed. Res. Bull. 674 (1996). In this Board Order, the Board stated that "The Board believes the provision of computer banking services by SFNB to its customers in accordance with the authority granted by the OTS, and as specifically described in this proposal, is consistent with Cardinal's existing authority under the [Bank Holding Company Act] and Regulation Y to operate a savings association." Id. at n.1. ---[PAGE_BREAK]--- American banks and IBM to form Integrion Financial Network, LLC. ${ }^{7}$ Integrion itself has announced that it will not provide electronic or home banking services, but will instead design and operate a secure electronic gateway or interface system linking bank customers to their depository institutions, including links via the Internet. ${ }^{8}$ Finally, the Federal Reserve Bank of New York and the Board of Governors are currently processing an application from a foreign bank, with a United States securities brokerage subsidiary, to acquire a software firm planning to design software for customers of brokerage firms to place securities buy-and-sell orders over the Internet. 9 The OCC, meanwhile, confirmed in correspondence in August of 1996 that, in addition to providing home banking services to its customers through the Internet, a national bank subsidiary could also provide Internet access to customers and nonbank customers in the bank's service area. ${ }^{10}$ In the midst of all this supervisory "support," however, I should also mention some of the as-yet unsettled issues dealing with the unique regulatory burdens facing depository institutions offering financial services over the Internet. Among the most difficult will be the proper application of the Community Reinvestment Act ("CRA"), a United States statute that requires depository institutions to meet the credit needs of the communities where they accept deposits. What exactly is a deposit community in cyberspace? Nobody really knows. This has not yet become a significant issue because most depository institutions offering on-line services still have brick-and-mortar branches, on to which current definitions of a CRA community are based. Still, for exclusively on-line depository institutions, the CRA issue will become increasingly important as their market share grows. Some early discussions with the relevant compliance supervisors may be in order. I also note that this also raises interesting questions on the definition of the relevant geographic market in the analysis of bank mergers. Furthermore, considering the CRA issue brings forth another, broader issue: what is the role of nonbanks in the realm of Internet financial services, particularly payment services, which are still largely the province of banks and other regulated depository institutions? Because banks have been so intricately involved in the United States payments system, banks today face unique regulatory burdens: CRA, reserve requirements, deposit insurance premiums, and the costs of good supervision and good supervisors. If nonbanks begin to take significant market share away from banks because of an inherently lower cost structure, that raises real questions about a level playing field and whether or not banks can ever fairly compete. If nonbanks begin offering through the Internet many of the payment services, or alternatives to the payment services now offered exclusively by banks, that raises real concerns about the ultimate value of a bank charter, and what it really means to be a "bank." Or is this "banking"? Another issue that may be relevant here is the implication of a firm that has a balance sheet that looks like that of a bank but does not have direct access to the lender-of-last resort. Finally, and especially in light of the issues just raised, I think it is important for me to emphasize that the bank supervisors have expressed a clear willingness to listen to what the banking community has had to say on the issues involving electronic and Internet banking. Regulation E, promulgated by the Board of Governors, implements the Electronic Funds Transfer Act of 1978, and establishes primarily for consumer protection purposes the basic [^0] [^0]: 7 See Royal Bank of Canada, et al., 83 Fed. Res. Bull. $\qquad$ (Order approved Dec. 2, 1996). 8 Integrion also stated that it will not function as an Internet service provider, but will provide a secure electronic link to one. 9 See Notification to the Board of Governors Regarding Investment in Marketware International Inc. of Toronto Dominion Bank (Dec. 19, 1996). 10 See OCC Interp. Letter No. 742 (Aug. 19, 1996). ---[PAGE_BREAK]--- rights, liabilities, and responsibilities of consumers who use, and financial institutions who offer, retail electronic funds transfer services. 11 Among the protections provided are required disclosures, error resolution procedures, and loss protection. In 1996, when the Board of Governors issued its proposed regulations concerning the applicability of Regulation E to stored-value cards, the Board of Governors explicitly requested that commenters to the proposed revisions indicate whether the commenters believed that part or all of Regulation E should apply to electronic "money" or "value" residing on a computer system or a personal-computer hard drive. 12 Similarly, the FDIC, while holding public hearings on its General Counsel Opinion No. 8 on stored-value cards and Federal deposit insurance coverage, 13 specifically requested additional commentary on Federal deposit insurance coverage and electronic value represented on computer systems or personal computers. I believe the message is clear: as bank supervisors, we are open to what the banking community has to say on this rapidly evolving market. New ideas and reasoned arguments are welcome. We must try not to restrain important new services developed by the banking industry but should remain vigilant as banking-type services are offered by nonbank institutions. # A Payments Systems Overseer's View From the perspective of a payments system overseer, I see much activity, but thus far, few genuinely revolutionary innovations with respect to banking and the Internet in the United States. Mainly, I see the application of faster, cheaper electronic processing of older, more established paper-based methods of transferring payments between parties. Credit card payments on the Internet are one example. Instead of using a telephone, a normal card reader, and a customer's signature, one leading Internet payments company has devised a secure method of allowing a bank customer to shop on-line with a credit card, by never releasing "in the clear" the customer's credit card number on the Internet itself. Instead, the company only releases the credit card number and a merchant's request for payment to the customer's issuing bank, away from the Internet, after verifying on-line with the customer that the purchase was authentically made. The bank processes the transaction as it would any other credit card purchase; the value added by the company is that the customer's credit card number is never on-line, a benefit indeed in today's security-poor Internet. It is not hard to imagine that another step in this direction is for a third-party organization (perhaps even a bank subsidiary) to issue secure, encrypted electronic checks on the Internet on behalf of bank customers, or even unaffiliated parties, wishing to make purchases on-line. Much legal uncertainty remains in the United States about establishing such a process, however. Basic questions remain unanswered. What, exactly, would be an authorized signature on an electronic check? Put another way, what types of entities would be authorized to act as certification authorities on the Internet for such commercial conveniences as electronic purchase orders, electronic negotiable instruments, or their bases, digital signatures? Would these [^0] [^0]: 11 See 12 C.F.R. Part 205. 12 I should note here that other consumer-protection regulations issued by the Board of Governors address consumer credit transactions. 13 FDIC General Counsel Opinion No. 8 stated, in essence, that the FDIC would consider granting Federal deposit insurance coverage for electronic value residing on stored value cards issued by a bank, only if the value on the stored value card represented an obligation definitively linked to an existing bank customer's deposit account. ---[PAGE_BREAK]--- certification authorities be entirely private sector derived? Or would they be established and operated by the government, by the individual states, some of whom already have enacted digital signature statutes? What is the role of banks in this process? In particular, what are the risks to the bank, in allowing a nonaffiliated third party to act as a certifying authority for electronic checks drawn from the accounts of bank customers? I could ask some even more basic commercial law questions about banking in cyberspace. When is an Internet payment final? More specifically, when a payment over the Internet is made, has the maker of the payment made a provisional payment, as with writing a check, or a final payment, as with giving a certified check or making a wire transfer? Articles 3, 4 and 4A of the Uniform Commercial Code ("UCC") govern the above circumstances, but have nothing to say on Internet payments. Currently, private contract law governs; agreements between each of the parties in an on-line transaction should be very carefully drafted and reviewed. Still, if Internet banking and commercial transactions were to grow in volume and complexity, it is quite possible that private contract law could evolve into a specialized commercial law of cyberspace, and eventually be codified into parts of the UCC. On a less theoretical note, I should mention that a multi-national Task Force on the Security of Electronic Money, established by the Committee on Payment and Settlement Systems and the Group of Computer Experts of the Group of Ten Central Bank Governors, and chaired by Israel Sendrovic of the Federal Reserve Bank of New York, issued a report on its findings entitled "Security of Electronic Money" in August 1996. This Task Force examined primarily consumer-oriented stored-value payment products by, among other activities, surveying the leading global suppliers of both card-based and software-based stored-value systems, and concluded that the technical security measures of these systems are being designed to achieve an adequate level of security relative to other forms of common retail payment, assuming they are implemented appropriately. I recommend the report to anyone interested in a general discussion about security issues and stored-value systems, Internet-based or not. Moving away from consumer banking and the Internet, and looking perhaps not-so-distantly into the future, I have also had occasion to question what the repercussions are for large-value payments transfer systems, such as Fedwire, with the emergence of a different, much more secure Internet. Generally speaking, the Internet today is a "somewhat" secure environment in which to conduct banking and financial service activity. The current level of security is not adequate for large-value payments. Some Internet-based payment products are becoming more secure, but only after the creators of these products have spent a great deal of time, effort and resources making their products secure. Consistent fast transmission and processing are also essential for large-value payments. The Internet today has no authorized, universal means of prioritizing specific electronic messages from other messages. Faster and better hardware helps, certainly, but offers no guarantee. One of my responsibilities is to serve as the Product Director of the Wholesale Payments Product Office of the twelve Federal Reserve Banks. This includes the Fedwire transfer of funds, transfers of securities against payment, and net settlement. In providing these payment services, the Reserve Banks must charge a fee designed to cover their costs, plus what we refer to as a "private sector adjustment factor," a proxy for the capital, taxes, and other costs incurred by private-sector service providers. Thus, I am keenly interested in the next stage of the Internet. If messages sent across the Internet could be made timely, become much more secure at reasonable cost, and, if a widely-accepted prioritization scheme for electronic messages ---[PAGE_BREAK]--- could be implemented so that large-value payment messages could move instantaneously, it is not inconceivable that the effect on existing large-value payments transfer systems could be substantial. Within a five-to-ten year time frame, I could see at least a portion of Fedwire large-volume transfers of funds and securities -- with real-time gross-settlement -- handled over the Internet. Please do not ask me exactly when this will come about. On the other hand, with potentially enormous, secure, bilateral netting arrangements occurring between clearing banks in real time over the Internet, volume on existing large-value transfer systems could decrease dramatically. The clearing banks could, conceivably, save themselves some real money. # Jurisdictional Issues Any discussion of banking or any form of commerce over the Internet today would not be complete without at least a few words on the legal jurisdictional issues that the Internet presents. This is arguably the area of law most in flux, the most subject to change on a monthly or even daily basis, depending on the specific jurisdiction and long-arm statute under discussion. In the United States, cases have already been decided regarding court jurisdiction and the Internet over alleged trademark violations, ${ }^{14}$ contract disputes, ${ }^{15}$ and advertising disputes. ${ }^{16}$ Although I am as yet unaware of any banking organizations that have become embroiled in litigation over jurisdictional issues from being on the Internet, I cannot promise you that such a suit will never occur. If a State banking agency or a State attorney general decided one day that a Web-site or an Internet-based transaction conferred sufficient minimum contacts with a state resident so that the state's long-arm statute applied to the bank, a suit could easily be filed. Minnesota Attorney General Hubert Humphrey III filed six lawsuits in 1995 against six companies accusing them of engaging in illegal business practices or running outright pyramid schemes over the Internet, although none of the six companies was based in Minnesota, and no Minnesota citizen ever came forward to complain about the companies. The fact that a Minnesota resident could have accessed the scams run by the companies, claimed Attorney General Humphrey, was sufficient to confer jurisdiction of his lawsuits in the Minnesota courts. Lest this argument sound wildly and improbably expansive, it should be noted that the "Internet access = jurisdiction" idea has already been accepted by some of the Federal district courts that have decided such cases, although it must also be noted that these courts' decisions have been inconsistent, have all had slightly different facts, and have taken great pains to distinguish themselves from one another. New case law on the issue of jurisdiction conferred by Internet access is undoubtedly being made as we speak. At a minimum, then, banks offering services through the Internet should have signed contracts with electronic and Internet banking customers that specify to the courts where claims or disputes may be brought. Web-sites designed merely to advertise a bank's financial services should be designed to be as controversy-free as possible, although that may be difficult without making the sites content-free as well. Banks should err on the side of caution until the jurisdictional issues have had more time to sort themselves out. I would like to present a hypothetical fact situation to you which I think demonstrates some of the thorny legal and supervisory issues that could be raised by the existence of offshore banking entities doing business over the Internet with individuals in our [^0] [^0]: 14 See Panavision Int'l, L.P. v. Toeppen, 938 F. Supp. 616, (C.D. Cal. 1996) ; Bensusan Restaurant Corp. v. King, 937 F. Supp. 295 (S.D.N.Y. 1996) ; Playboy Enterprises, Inc. v. Chuckleberry Publishing, Inc., 939 F. Supp. 1032 (S.D.N.Y 1996). 15 See CompuServe, Inc. v. Patterson, 89 F.3d 1257 (6th Cir. 1996) ; Edias Software Int'l, LLC v. Basis Int'l Corp., 1996 U.S. Dist. LEXIS 18279 (D. Ariz. 1996). 16 See Maritz, Inc. v. Cybergold, Inc., 1996 U.S. Dist. LEXIS 14978 (E.D. Mo. 1996) ; Inset Systems, Inc. v. Instruction Set, Inc., 937 F. Supp. 161 (D. Conn. 1996). ---[PAGE_BREAK]--- jurisdictions. I travel to the island of Atlantis, where I obtain a Class Z banking charter. I am permitted under this charter to engage in the business of banking every place in the world, except with residents of Atlantis. As you have probably suspected, Atlantis is founded on the principle of free and open markets, unfettered by supervision and regulation of banks with Class Z charters. Atlantis also provides for strict adherence of the principles of banking secrecy. My bank is named The Internet International Bank ("IIB"). The IIB offers a full spectrum of banking services to Atlantis nonresidents. Being a modern bank, it conducts business principally on the Internet. IIB has a series of quite attractive Internet pages where its products are offered. These pages spell out the products, deposit terms and interest rates, and loan terms and interest rates. All agreements are governed by the law of Atlantis. All deposits are deemed received over IIB's "counters" in Atlantis, and all loans are paid out of Atlantis. Atlantis has an enjoyable ambiance even exceeding that of Nice and Saint Paul de Vence; therefore, I see no need to leave the island. I do receive and entertain customers when they visit Atlantis. I do place telephone calls to customers who have responded to my Internet page, but I do not make cold calls to customers. Communications with customers over the Internet are state-of-the-art secure. Customers receive account statements over the Internet, issue payment instruments to IIB over the Internet, and request loans over the Internet. All payments to and from accounts are made by wire transfer to IIB's correspondent account maintained on the books of Atlantis Bank, the only bank chartered under Atlantis law authorized to engage in banking transactions with Atlantis residents. Customers may instruct IIB to make payments for their account. These too are consummated by means of payments out of IIB's account at Atlantis Bank. Loans are disbursed and paid the same way. The question presented is whether IIB is violating the law of the countries in which its customers are located. While I have my own views as to the application of United States banking and securities laws to this fact situation, I prefer not to spell those out in my prepared remarks. Instead, we all might prosper by sharing our views as to the proper application of our home country's laws to individuals in our countries who might do business with IIB. I should note that this fact situation is a pure figment of my imagination. The cooperative efforts of bank supervisors over the world should be designed to ensure precisely against this sort of bank. In other words, like Atlantis, IIB should never surface above water. Our discussion should include responses to the following questions: (1) is IIB engaged in an impermissible activity in your home country; (2) if it is impermissible, what authority has responsibility for enforcing that law; (3) if impermissible, is that a civil or criminal violation; (4) if impermissible, is there any way for IIB to qualify to do business in your home country; and finally, (5) does your home-country court have jurisdiction to hear cases brought by a customer against IIB? # Conclusion To conclude, I simply wish to commend the banking and legal communities for learning as much about electronic and Internet banking as they can, now, and for trying to stay ahead of the curve of ever evolving and improving technology. I fully agree with the philosophy of letting the markets decide what will work and what will not. We, as supervisor and central banker, will try to stay out of the way as much as possible, unless because of criminal activities or systemic risk concerns we have to jump in. The private sector seems to have done fairly well so far. To this end, I point out a recent creation of the Banker's Roundtable, an organization composed of some of the largest United States banks, in organizing the Banking Industry Technology Secretariat ("BITS"). ---[PAGE_BREAK]--- BITS, as I understand it, is in the process of designing and implementing common technological standards for the inter-operability of systems linking banks and their customers, and is also hoping to act as a certification authority for its member banks for third-party system and software providers, to ensure that when an electronic or Internet banking transaction takes place, the bank's name is the only name the customer ever sees. Similarly, a certified software or systems provider would agree that the customer's payment information would stay with the bank and not the provider. I mention this not as an endorsement of BITS, but as an example of the type of innovation and cooperative or collaborative effort that can occur when the banking community realizes the enormous challenge and opportunity it has in the next few years. Central banks and bank supervisors must also be equal to these challenges. In order for us to fulfill our responsibilities, it will be necessary for the private sector financial institutions to keep educating and challenging us. It is those dynamics that will help ensure good public policy in banking supervision and regulation of banking transactions over the Internet.	Ernest T Patrikis	United States	https://www.bis.org/review/r970227e.pdf	I want to share with you today some observations and speculations gathered this and last year about banking and the Internet. I will be speaking in my capacity as a central banker -- which includes monetary policy, banking services, bank supervision, and payments system oversight -- and as a surfer of the 'Net. Let me state, at the outset, that, while the Federal Reserve Bank of New York does not conduct "Internet banking" as such, we do have a home page (http://www.ny.frb.org) with much useful information about our institution, with over three million recorded hits to date. Finally, let me add that some of what I say here today could, very easily, be obsolete in two months' or even two weeks' time. But I will try to point out those areas in advance. The title of this portion of the program gives rise to two issues of definition. The first is "What is the Internet?" The second is "What is banking?" As I am sure you are well aware, in the United States we are a litigious sort. We even have a legal definition of the Internet. According to one recent case, the "Internet" is "an international computer 'supernetwork' of over 15,000 computer networks used by about 30 million individuals, corporations, organizations, and educational institutions worldwide." 1 Another case described the "Internet" as "a global communications network linked principally by modems which transmit electronic data over telephone lines approximately 20 million to 30 million users." "Banking" raises a host of issues in the United States. There is commercial banking and investment banking. The products offered by "banking" firms range from deposit taking (including payment services), investment advisory and management services, trading in financial instruments, brokering and underwriting financial instruments, lending, and trust services. A bank can offer all of these services on the Internet. For the purposes of this discussion, I will basically confine myself to deposit taking (including payment services) and lending. From a United States central bank perspective, the most fundamental question of banking and the Internet is: What are the monetary-policy implications, especially were we to assume the enormous, widespread scale that some have been predicting? From this perspective, the answer appears to be: probably not much. If the Internet is used merely to facilitate existing banking and payment transactions, such as executing electronic bill payments or transferring funds from one bank account to another (which more or less describes what electronic bill payment really is anyway), the combination of banking and the Internet should have few, if any, implications for the conduct of United States monetary policy, or the measurement of the United States money supply. "Money," as defined by M1, M2, or M3, would still be held in accounts at banks that would be reported to the Board of Governors of the Federal Reserve System through the existing mechanisms that such funds are reported today. If, however, Internet banking evolved to the point where digital "coins," account-based cards and PCs, or other private-sector initiatives produced electronic representations of money that began to be used and circulated like currency, the potential implications for United States monetary policy are much greater. The key questions here are related to amount and velocity -- that is, (1) how would digital bills or notes, or digital coins, be represented on the books of a bank or depository institution; and (2) how many times would this electronic coin or bill circulate in the general economy without somehow being processed and recorded by a bank? In this regard, the October 1996 Bank for International Settlements report "Implications for Central Banks of the Development of Electronic Money" states "E-money could lead to shifts in the velocity of money which might temporarily reduce the usefulness of the monetary aggregates, especially narrower ones, for countries that rely on them as targets or indicators." In a June 1996 speech before a cyber-payments conference, Governor Edward Kelley of the Board of Governors stated that, with respect to a bank's liabilities incurred through issuing stored-value cards, such liabilities should be included in the statistical reports that banks must currently submit to the Board of Governors. It is difficult to argue that bank liabilities resulting from the issuance of electronic "coins" or electronic "bills and notes" should be reported any differently. A more problematic question arises when considering the matter of nonbank issuance of electronic coins or bills. Currently, the largest nonbank issuers of travelers checks are not required, but do volunteer to the Fed, the outstanding balances of their travelers checks, so that this information can be statistically recorded and reported in United States monetary aggregates by the Fed. If the issuance of private electronic money grows to a significant level in the real economy, and if much of that growth is provided by nonbank issuers of electronic money, there could be a similar request for nonbank issuers to provide information about the volume of their issuance and their outstanding electronic money liabilities, to the extent these liabilities are not recorded on the books of a bank every time they are circulated in the general economy. From this perspective, combining banking and the Internet offers both great opportunity and great potential risk. First, the good news -- it is primarily cost-related. It has been reported by several banking studies that the cost of a typical transaction at a bank branch is now over $\$ 1.00$; the cost of an ATM transaction is approximately $\$ 0.25$. The cost of an Internet transaction, however, has been estimated at about a penny. I do not vouch for this statistic, but the difference is substantial. Such figures make a compelling argument for banks to get on the Internet sooner rather than later, and to move as many of their customers on to electronic or Internet banking as soon as they possibly can. Indeed, some banks offer low-fee accounts where the customer is not expected to enter an office physically -- mail, phone, and ATM are sufficient. As stated by Board of Governors Chairman Alan Greenspan: "it is useful.to begin by reminding ourselves just why there is bank supervision and regulation. At bottom, of course, is the historical experience of the effects on the real economy of financial market disruptions and bank failures, especially when the disruptions and failures spread beyond the initial impetus." 4 A bank supervisor should have concerns other than cost, and these comprise the bad news -- the "risk" aspect of banking on the Internet. In the simplest terms, while we strive to ensure that banks remain efficient and cost-effective, we also have to ensure that banks know what they are getting into, and that they are capable of handling the risks that accompany banking on the Internet. The tension between the two is very constant and real, particularly because the technology today seems to be moving so much faster than bankers or bank supervisors can fully absorb. At the Federal Reserve Bank of New York, we are being proactive in this area. We currently conduct on-site, information systems examinations of State member banks in our district -- in addition to commercial, trust, trading, and compliance examinations -- in which we try to review and constructively criticize the examined bank's entire MIS infrastructure. There is no separate, independent electronic or Internet bank exam as such. However, a part of the information systems examination reviews the bank's electronic and Internet activities and plans, and all examiners ask general questions that we feel that any bank offering on-line banking services should be able to answer responsively. In addition, we have convened a special task force at the Federal Reserve Bank of New York to review security issues involving on-line and Internet banking. The goal of this task force is two-fold: (1) to gather, review, and benchmark current and future on-line security procedures and policies of State member banks in our district; and (2) to then somehow disseminate, without unduly disadvantaging any specific depository institution that provided us with its information, the best of these policies and procedures into a kind of "sound practices" security guide for banks to use for their electronic and Internet banking services. The task force should issue its first report in the summer of 1997. In a similar vein, I believe that the United States Federal bank supervisors, while mindful of the risks, have tried to be as supportive of electronic and Internet banking as possible. Each of the various bank supervisory agencies, i.e., the Board of Governors, the Office of Thrift Supervision ("OTS"), the Federal Deposit Insurance Corporation ("FDIC"), and the Office of the Comptroller of the Currency ("OCC"), has dealt in some immediate way with the issues posed by electronic and Internet banking. Both the OTS and the Board of Governors have dealt directly with Internet banking through the bank applications approval process. In May of 1995, the OTS approved the application of a new thrift, the Security First Network Bank ("SFNB"), that sought explicitly to provide the majority of its electronic banking services over the Internet. In December of 1996, the Board of Governors approved the application of a Minnesota bank holding company and two foreign banks to join a consortium of 15 North American banks and IBM to form Integrion Financial Network, LLC. In the midst of all this supervisory "support," however, I should also mention some of the as-yet unsettled issues dealing with the unique regulatory burdens facing depository institutions offering financial services over the Internet. Among the most difficult will be the proper application of the Community Reinvestment Act ("CRA"), a United States statute that requires depository institutions to meet the credit needs of the communities where they accept deposits. What exactly is a deposit community in cyberspace? Nobody really knows. This has not yet become a significant issue because most depository institutions offering on-line services still have brick-and-mortar branches, on to which current definitions of a CRA community are based. Still, for exclusively on-line depository institutions, the CRA issue will become increasingly important as their market share grows. Some early discussions with the relevant compliance supervisors may be in order. I also note that this also raises interesting questions on the definition of the relevant geographic market in the analysis of bank mergers. Furthermore, considering the CRA issue brings forth another, broader issue: what is the role of nonbanks in the realm of Internet financial services, particularly payment services, which are still largely the province of banks and other regulated depository institutions? Because banks have been so intricately involved in the United States payments system, banks today face unique regulatory burdens: CRA, reserve requirements, deposit insurance premiums, and the costs of good supervision and good supervisors. If nonbanks begin to take significant market share away from banks because of an inherently lower cost structure, that raises real questions about a level playing field and whether or not banks can ever fairly compete. If nonbanks begin offering through the Internet many of the payment services, or alternatives to the payment services now offered exclusively by banks, that raises real concerns about the ultimate value of a bank charter, and what it really means to be a "bank." Or is this "banking"? Another issue that may be relevant here is the implication of a firm that has a balance sheet that looks like that of a bank but does not have direct access to the lender-of-last resort. Finally, and especially in light of the issues just raised, I think it is important for me to emphasize that the bank supervisors have expressed a clear willingness to listen to what the banking community has had to say on the issues involving electronic and Internet banking. Regulation E, promulgated by the Board of Governors, implements the Electronic Funds Transfer Act of 1978, and establishes primarily for consumer protection purposes the basic rights, liabilities, and responsibilities of consumers who use, and financial institutions who offer, retail electronic funds transfer services. Among the protections provided are required disclosures, error resolution procedures, and loss protection. In 1996, when the Board of Governors issued its proposed regulations concerning the applicability of Regulation E to stored-value cards, the Board of Governors explicitly requested that commenters to the proposed revisions indicate whether the commenters believed that part or all of Regulation E should apply to electronic "money" or "value" residing on a computer system or a personal-computer hard drive. Similarly, the FDIC, while holding public hearings on its General Counsel Opinion No. 8 on stored-value cards and Federal deposit insurance coverage, 13 specifically requested additional commentary on Federal deposit insurance coverage and electronic value represented on computer systems or personal computers. I believe the message is clear: as bank supervisors, we are open to what the banking community has to say on this rapidly evolving market. New ideas and reasoned arguments are welcome. We must try not to restrain important new services developed by the banking industry but should remain vigilant as banking-type services are offered by nonbank institutions. From the perspective of a payments system overseer, I see much activity, but thus far, few genuinely revolutionary innovations with respect to banking and the Internet in the United States. Mainly, I see the application of faster, cheaper electronic processing of older, more established paper-based methods of transferring payments between parties. Credit card payments on the Internet are one example. Instead of using a telephone, a normal card reader, and a customer's signature, one leading Internet payments company has devised a secure method of allowing a bank customer to shop on-line with a credit card, by never releasing "in the clear" the customer's credit card number on the Internet itself. Instead, the company only releases the credit card number and a merchant's request for payment to the customer's issuing bank, away from the Internet, after verifying on-line with the customer that the purchase was authentically made. The bank processes the transaction as it would any other credit card purchase; the value added by the company is that the customer's credit card number is never on-line, a benefit indeed in today's security-poor Internet. It is not hard to imagine that another step in this direction is for a third-party organization (perhaps even a bank subsidiary) to issue secure, encrypted electronic checks on the Internet on behalf of bank customers, or even unaffiliated parties, wishing to make purchases on-line. Much legal uncertainty remains in the United States about establishing such a process, however. Basic questions remain unanswered. What, exactly, would be an authorized signature on an electronic check? Put another way, what types of entities would be authorized to act as certification authorities on the Internet for such commercial conveniences as electronic purchase orders, electronic negotiable instruments, or their bases, digital signatures? Would these certification authorities be entirely private sector derived? Or would they be established and operated by the government, by the individual states, some of whom already have enacted digital signature statutes? What is the role of banks in this process? In particular, what are the risks to the bank, in allowing a nonaffiliated third party to act as a certifying authority for electronic checks drawn from the accounts of bank customers? I could ask some even more basic commercial law questions about banking in cyberspace. When is an Internet payment final? More specifically, when a payment over the Internet is made, has the maker of the payment made a provisional payment, as with writing a check, or a final payment, as with giving a certified check or making a wire transfer? Articles 3, 4 and 4A of the Uniform Commercial Code ("UCC") govern the above circumstances, but have nothing to say on Internet payments. Currently, private contract law governs; agreements between each of the parties in an on-line transaction should be very carefully drafted and reviewed. Still, if Internet banking and commercial transactions were to grow in volume and complexity, it is quite possible that private contract law could evolve into a specialized commercial law of cyberspace, and eventually be codified into parts of the UCC. On a less theoretical note, I should mention that a multi-national Task Force on the Security of Electronic Money, established by the Committee on Payment and Settlement Systems and the Group of Computer Experts of the Group of Ten Central Bank Governors, and chaired by Israel Sendrovic of the Federal Reserve Bank of New York, issued a report on its findings entitled "Security of Electronic Money" in August 1996. This Task Force examined primarily consumer-oriented stored-value payment products by, among other activities, surveying the leading global suppliers of both card-based and software-based stored-value systems, and concluded that the technical security measures of these systems are being designed to achieve an adequate level of security relative to other forms of common retail payment, assuming they are implemented appropriately. I recommend the report to anyone interested in a general discussion about security issues and stored-value systems, Internet-based or not. Moving away from consumer banking and the Internet, and looking perhaps not-so-distantly into the future, I have also had occasion to question what the repercussions are for large-value payments transfer systems, such as Fedwire, with the emergence of a different, much more secure Internet. Generally speaking, the Internet today is a "somewhat" secure environment in which to conduct banking and financial service activity. The current level of security is not adequate for large-value payments. Some Internet-based payment products are becoming more secure, but only after the creators of these products have spent a great deal of time, effort and resources making their products secure. Consistent fast transmission and processing are also essential for large-value payments. The Internet today has no authorized, universal means of prioritizing specific electronic messages from other messages. Faster and better hardware helps, certainly, but offers no guarantee. One of my responsibilities is to serve as the Product Director of the Wholesale Payments Product Office of the twelve Federal Reserve Banks. This includes the Fedwire transfer of funds, transfers of securities against payment, and net settlement. In providing these payment services, the Reserve Banks must charge a fee designed to cover their costs, plus what we refer to as a "private sector adjustment factor," a proxy for the capital, taxes, and other costs incurred by private-sector service providers. Thus, I am keenly interested in the next stage of the Internet. If messages sent across the Internet could be made timely, become much more secure at reasonable cost, and, if a widely-accepted prioritization scheme for electronic messages could be implemented so that large-value payment messages could move instantaneously, it is not inconceivable that the effect on existing large-value payments transfer systems could be substantial. Within a five-to-ten year time frame, I could see at least a portion of Fedwire large-volume transfers of funds and securities -- with real-time gross-settlement -- handled over the Internet. Please do not ask me exactly when this will come about. On the other hand, with potentially enormous, secure, bilateral netting arrangements occurring between clearing banks in real time over the Internet, volume on existing large-value transfer systems could decrease dramatically. The clearing banks could, conceivably, save themselves some real money. Any discussion of banking or any form of commerce over the Internet today would not be complete without at least a few words on the legal jurisdictional issues that the Internet presents. This is arguably the area of law most in flux, the most subject to change on a monthly or even daily basis, depending on the specific jurisdiction and long-arm statute under discussion. In the United States, cases have already been decided regarding court jurisdiction and the Internet over alleged trademark violations, Although I am as yet unaware of any banking organizations that have become embroiled in litigation over jurisdictional issues from being on the Internet, I cannot promise you that such a suit will never occur. If a State banking agency or a State attorney general decided one day that a Web-site or an Internet-based transaction conferred sufficient minimum contacts with a state resident so that the state's long-arm statute applied to the bank, a suit could easily be filed. Minnesota Attorney General Hubert Humphrey III filed six lawsuits in 1995 against six companies accusing them of engaging in illegal business practices or running outright pyramid schemes over the Internet, although none of the six companies was based in Minnesota, and no Minnesota citizen ever came forward to complain about the companies. The fact that a Minnesota resident could have accessed the scams run by the companies, claimed Attorney General Humphrey, was sufficient to confer jurisdiction of his lawsuits in the Minnesota courts. Lest this argument sound wildly and improbably expansive, it should be noted that the "Internet access = jurisdiction" idea has already been accepted by some of the Federal district courts that have decided such cases, although it must also be noted that these courts' decisions have been inconsistent, have all had slightly different facts, and have taken great pains to distinguish themselves from one another. New case law on the issue of jurisdiction conferred by Internet access is undoubtedly being made as we speak. At a minimum, then, banks offering services through the Internet should have signed contracts with electronic and Internet banking customers that specify to the courts where claims or disputes may be brought. Web-sites designed merely to advertise a bank's financial services should be designed to be as controversy-free as possible, although that may be difficult without making the sites content-free as well. Banks should err on the side of caution until the jurisdictional issues have had more time to sort themselves out. I would like to present a hypothetical fact situation to you which I think demonstrates some of the thorny legal and supervisory issues that could be raised by the existence of offshore banking entities doing business over the Internet with individuals in our jurisdictions. I travel to the island of Atlantis, where I obtain a Class Z banking charter. I am permitted under this charter to engage in the business of banking every place in the world, except with residents of Atlantis. As you have probably suspected, Atlantis is founded on the principle of free and open markets, unfettered by supervision and regulation of banks with Class Z charters. Atlantis also provides for strict adherence of the principles of banking secrecy. My bank is named The Internet International Bank ("IIB"). The IIB offers a full spectrum of banking services to Atlantis nonresidents. Being a modern bank, it conducts business principally on the Internet. IIB has a series of quite attractive Internet pages where its products are offered. These pages spell out the products, deposit terms and interest rates, and loan terms and interest rates. All agreements are governed by the law of Atlantis. All deposits are deemed received over IIB's "counters" in Atlantis, and all loans are paid out of Atlantis. Atlantis has an enjoyable ambiance even exceeding that of Nice and Saint Paul de Vence; therefore, I see no need to leave the island. I do receive and entertain customers when they visit Atlantis. I do place telephone calls to customers who have responded to my Internet page, but I do not make cold calls to customers. Communications with customers over the Internet are state-of-the-art secure. Customers receive account statements over the Internet, issue payment instruments to IIB over the Internet, and request loans over the Internet. All payments to and from accounts are made by wire transfer to IIB's correspondent account maintained on the books of Atlantis Bank, the only bank chartered under Atlantis law authorized to engage in banking transactions with Atlantis residents. Customers may instruct IIB to make payments for their account. These too are consummated by means of payments out of IIB's account at Atlantis Bank. Loans are disbursed and paid the same way. The question presented is whether IIB is violating the law of the countries in which its customers are located. While I have my own views as to the application of United States banking and securities laws to this fact situation, I prefer not to spell those out in my prepared remarks. Instead, we all might prosper by sharing our views as to the proper application of our home country's laws to individuals in our countries who might do business with IIB. I should note that this fact situation is a pure figment of my imagination. The cooperative efforts of bank supervisors over the world should be designed to ensure precisely against this sort of bank. In other words, like Atlantis, IIB should never surface above water. Our discussion should include responses to the following questions: (1) is IIB engaged in an impermissible activity in your home country; (2) if it is impermissible, what authority has responsibility for enforcing that law; (3) if impermissible, is that a civil or criminal violation; (4) if impermissible, is there any way for IIB to qualify to do business in your home country; and finally, (5) does your home-country court have jurisdiction to hear cases brought by a customer against IIB? To conclude, I simply wish to commend the banking and legal communities for learning as much about electronic and Internet banking as they can, now, and for trying to stay ahead of the curve of ever evolving and improving technology. I fully agree with the philosophy of letting the markets decide what will work and what will not. We, as supervisor and central banker, will try to stay out of the way as much as possible, unless because of criminal activities or systemic risk concerns we have to jump in. The private sector seems to have done fairly well so far. To this end, I point out a recent creation of the Banker's Roundtable, an organization composed of some of the largest United States banks, in organizing the Banking Industry Technology Secretariat ("BITS"). BITS, as I understand it, is in the process of designing and implementing common technological standards for the inter-operability of systems linking banks and their customers, and is also hoping to act as a certification authority for its member banks for third-party system and software providers, to ensure that when an electronic or Internet banking transaction takes place, the bank's name is the only name the customer ever sees. Similarly, a certified software or systems provider would agree that the customer's payment information would stay with the bank and not the provider. I mention this not as an endorsement of BITS, but as an example of the type of innovation and cooperative or collaborative effort that can occur when the banking community realizes the enormous challenge and opportunity it has in the next few years. Central banks and bank supervisors must also be equal to these challenges. In order for us to fulfill our responsibilities, it will be necessary for the private sector financial institutions to keep educating and challenging us. It is those dynamics that will help ensure good public policy in banking supervision and regulation of banking transactions over the Internet.
1997-01-28T00:00:00	Ms. Phillips examines whether national financial market regulatory systems should be harmonised in the light of international competition (Central Bank Articles and Speeches, 28 Jan 97)	Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at the Seminar on Banking Soundness and Monetary Policy in a World of Global Capital Markets sponsored by the International Monetary Fund and held in Washington on 28/1/97.	Ms. Phillips examines whether national financial market regulatory systems should be harmonised in the light of international competition Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at the Seminar on Banking Soundness and Monetary Policy in a World of Global Capital Markets sponsored by the International Monetary Fund and held in Washington on 28/1/97. It is a pleasure to be here today to discuss a topic that has become more important in a world of global financial markets -- the matter of coordinating and harmonizing our national regulatory systems. On the conference agenda, the topic was phrased as a question, that is, whether we should harmonize our systems. In a sense, the question is somewhat moot -- the globalization of the markets and the breadth of international conglomerate financial institutions is forcing us in that direction. But I would quickly add that one definition of "harmony" is "a pleasing combination of elements." We can sing compatible and pleasant-sounding notes, without singing the same note. It is in that sense that I believe harmonization of our regulatory systems will develop. In my comments this afternoon, I will mention some of the efforts underway in which the United States is working with other countries to develop more consistent supervisory and regulatory systems, particularly for large financial conglomerates. That experience may provide others with ideas about how they might pursue similar efforts, either on a bilateral or multilateral basis. Perhaps more importantly, though, I will also offer my views on where our interests are likely to be most similar and why and how regulators around the world are likely to continue working toward compatible or "harmonized" systems. Let me begin with those thoughts. The Importance of Compatible Regulatory Regimes One cannot have dealt with U.S. and world financial markets during the past few decades without being thoroughly impressed with the rapid pace of change and the manner in which technology and financial innovation have affected market practice. The improvements in communications and transportation and, importantly, the gains from technology and the miniaturization of the goods we produce have fueled a growing volume of international trade. Our financial institutions, in turn, have sought constantly to find more effective and efficient ways to facilitate and finance these activities, and at the same time manage the related risks. As a result, we have seen dramatic growth in financial derivatives, strong support within the industry for new clearinghouses and netting procedures to reduce counterparty credit risk, a growing need to clarify our laws and regulations regarding financial contracts, and financial markets that are far more closely linked today than they were even a decade ago. In the area of bank regulation and supervision, substantial progress has been made in developing capital standards that help to ensure the financial strength of internationally active banks and that promote greater competition. Simply put, firms in need of international financial services will utilize domestic or foreign financial institutions to the extent their prices are competitive and their financial stability can be assured. As a result, regulators are recognizing the need to harmonize laws and regulations in order to promote economic growth and to deal with important and oftentimes increasingly complex matters that are of common interest to us all. We are recognizing also the need to enhance financial systems -- including supervision and regulation -- in the emerging market economies, primarily for the sake of those economies, themselves, but also because of their increasing importance in international financial markets. Indeed, G-7 leaders at their summit meeting in Lyon last summer identified this goal as an important element in efforts to promote international financial stability. That we need some level of conformity seems, I'm sure, quite clear. Otherwise, the inconsistency and incompatibility of rules and regulations across countries may make it difficult, if not impossible, for some firms to engage in global business activities. Such barriers are detrimental to the efficiency of international trade and finance, generally. The difficulty, of course, is the precise nature and level of conformity that is necessary to maintain an efficient and equitable world financial system. Here I submit that it may be less important that we standardize particular banking laws and regulations, than it is for us to pursue similar goals, as we independently develop our domestic regulation and supervisory structures. Specifically, if we apply market-based incentives in our regulatory structures, that, alone, should keep our rules sufficiently similar and compatible. We must also recognize that technology and financial innovation are permitting banks today to become ever-more adept at avoiding regulatory barriers and other restrictions that artificially constrain their activities. Moreover, to the extent they are effective, such restrictions can work against local institutions, businesses, or consumers by making banks less competitive internationally or by withholding from their customers the benefits that competition can bring. Regulatory regimes are likely to be more effective in the long run for financial institutions and for domestic economic growth if they are market-compatible. Areas of Common Interests In our roles as central bankers, bank supervisors, and regulators, what are the areas of greatest common interest to us for which we should develop compatible rules and regulations? To keep it simple, let me suggest two. First, to maintain a healthy, responsive, and financially strong banking and financial system will facilitate the growing needs of our domestic economies. Second, to build and maintain an adequate legal and regulatory structure will permit our institutions to compete safely on an equal and nondiscriminatory basis, both domestically and abroad. These thoughts may not sound original; they're not. They are essentially the two reasons the Basle Committee on Supervision exists, and they underpin most other international efforts to coordinate banking issues. When I consider the past successes in coordinating international bank supervisory or regulatory policies, I think first of the Bank for International Settlements and the work of the supervisors' committee. After all, the BIS has been the principal forum for developing international supervisory standards for banks in industrialized countries and, by their voluntary adoption, for banks and bank supervisors in other countries throughout the world. Bilateral discussions can also serve useful functions either where particular issues are of concern or as a basis for subsequent broader dissemination. Nearly a decade ago, such bilateral and -- through the BIS -- multilateral efforts produced the risk-based capital standard, known as the Basle Accord. Since then, we have produced numerous other policy statements dealing with sound risk management practices for banks. These statements related first to derivatives activities and most recently involve the management of interest rate risk. Dr. Padoa-Schioppa, chairman of the supervisors' committee, has probably already discussed these initiatives with you. One of the Committee's most recent accomplishments, however, is the development of new capital standards for market risk in trading activities. That standard is notable because it reflects a new approach for constructing international banking standards. In particular, the internal models approach contained within that standard builds on leading industry practices and helps supervisors to promote risk management in banks. Promoting sound risk management is a goal we should all pursue more aggressively in considering new banking policies and regulations. It is also the type of approach I had in mind when I said earlier that our laws and regulations should be compatible with underlying economics and market demands. To the extent we can continue building on "best" or sound banking practices in designing our rules and regulations, we will be working toward a common end. As we work together identifying those practices and deciding how to apply them as supervisory or regulatory standards, we will also be strengthening relations among ourselves that can prove invaluable in times of market stress. Not to over-use the example of the market risk standard, but it illustrates another useful point, as well. Reliance on a bank's own risk measurement and modeling process in determining regulatory capital standards also acknowledges that no single or specific technique is best for everyone. Each institution should tailor its risk measurement and management process to its own needs. While adhering to basic principles, each institution must determine for itself the proper incentives and techniques for managing its affairs. No two banks or banking markets are identical in their operations, structure, or historical development. Permitting a range of compatible responses to similar situations encourages experimentation, innovation, and growth. Accommodating a certain level of flexibility is necessary for banks, and it is necessary for regulators, too. Indeed, flexibility may be even more important for non-G-10 countries than it is for those of us with large, developed financial systems because of the greater range of capital market and economic infrastructures among developing countries. Materially different situations typically require different solutions. Accommodating differences, though, does not reduce the need for minimum regulatory or supervisory standards based upon well-known principles of sound banking. It is up to supervisors and, if necessary, legislators to craft regulations and laws consistent with internationally recognized standards, but accommodative to local customs and economic needs. In developing sufficiently flexible, market-compatible regulations, I believe we should rely as much as prudently possible on market discipline and on banks' internal incentives to perform well. This approach requires that the public have information about the risk exposures of banks and about their procedures for managing those risks. As regulators, we can encourage this process by requiring or prodding banks to disclose information to the markets that is both relevant and comparable among institutions. Whether such disclosures are imposed by official regulations or evolve through more subtle efforts, supervisors can help guide the process by considering carefully the kinds of information the private sector needs and that banks use -- or should use -- to manage risk. Even in the United States, where surveys show disclosure is relatively good, supervisors make available to the public data collected on Call Reports. In countries where disclosure practices are minimal at best, bank regulators may be able to perform a particularly important role by publicly disclosing some, if not much, of the information banks report to them. By fueling market information in this way, regulators may stimulate greater investor interest in banks and the growth of local capital markets. Improved disclosure practices by banks may, in turn, also spill over to other industries. One thing we know for sure is that investors dislike uncertainty. By shedding light on a bank's condition and future prospects, some of that uncertainty should disappear. While it is important that key prudential standards be sufficiently robust and consistent among countries, certain variations in the details and applications of these standards can be useful. As with private markets, some level of competition among regulators can stimulate improvements and change. I will grant that the United States may take regulatory competition to an extreme, but it also demonstrates, I believe, the advantages that derive from accommodating different views and permitting financial institutions alternative ways to do business. In my view, and considering the political difficulties we have faced in trying to change U.S. banking laws, our current regulatory structure, offering some choice in charter that is administered by multiple regulators, has provided financial institutions with more freedom and expanded powers than they would likely have received with a single regulator. Supervisors must be careful, however, as they try new or different techniques, that they do not impair their oversight efforts or relax them beyond prudent bounds. In such global markets as we have today, weak or ineffective supervision in either large or small countries can have far reaching consequences. Those concerns were at the heart of early work of the Basle Committee and its efforts to identify the respective roles and responsibilities of home and host authorities for internationally active banks. It is important for supervisors to be able to rely on their counterparts in other countries to administer agreed-upon standards of financial institution safety and soundness. Whether we conduct our own on-site examinations, rely on external auditors, or use combinations of other supervisory techniques, we need to assure ourselves that all banking offices are adequately managed and supervised. I would note here that among G-10 countries a more consistent approach may begin to emerge. We in the United States are making greater use of the findings of a bank's internal and external auditors to guide or supplement our on-site examinations, while some of our counterparts abroad are recognizing more the benefits of onsite exams. Financial Conglomerates Some of the greatest challenges to bank supervisors may arise when organizations link banking activities with other financial or nonfinancial businesses. Such financial conglomerates, which often combine banking, insurance, and securities activities, are not currently allowed to provide a full array of financial services in the United States, but they may do so abroad. The existence of such firms -- and the fact that some of them are headquartered in this country -- have required regulators and supervisors in the United States to work with counterparts abroad to discuss oversight arrangements and develop ways to deal with matters in times of crises. This very issue is one of our current challenges. I have to say that this is not a particularly quick or easy process and is further complicated by the diverse regulatory structures, both here and abroad, involving banking, securities, and sometimes insurance regulators. These discussions often raise difficult issues, since they tend to break new ground in supervision. For example, what approach should be taken regarding nonbank -- or even nonfinancial -- activities of companies that own banks? In the context of these conglomerates, what does or should "consolidated supervision" mean? Within the context of consolidated supervision, how can the traditional safety-and-soundness approach used by bank supervisors be reconciled with the disclosure/self-regulatory approach used by many securities regulators? Moreover, do the diverse operating structures of conglomerates imply an extension of the safety net that virtually all governments currently extend to banks? One thing is clear: as we address the challenges of promoting a more consistent bank supervisory and regulatory process worldwide, we cannot always take official descriptions of regulatory and oversight regimes at face value. We need to dig deeper to understand how laws are interpreted and how individual banking agencies monitor and enforce safe banking. Different countries necessarily have different banking and financial systems that face unique combinations of exposures and business risks. Even within the United States, for example, we have a relatively uniform supervisory approach for all banks and a risk-based capital standard that applies to them all. In practice, however, the activities of our banks, their capital levels, and their operating practices are quite diverse, and our oversight efforts take those differences into account. Small banks, themselves, recognize the greater risks they face from their lack of size and diversity, and have consistently maintained higher capital ratios than do money center banks. But they also have less formal procedures and internal controls, simply because their staffing and operations are so much smaller. The point is that even a uniform set of rules within a given country can and should be implemented differently as conditions demand. Conclusion It seems clear that as financial markets become more and more integrated, bank regulators around the world will be seeing more of each other than they have in the past. Even in countries that have no internationally active domestic banks, authorities need to ensure that the banks operating in their markets are sound and subject to adequate supervision, whether by home or host authorities. Banks operating imprudently and without proper supervision are the ones most likely to mismeasure their risks, misprice their products, and disrupt the markets. Detecting and deterring such institutions does not require us to have uniform regulatory or supervisory systems, but it does require a certain level of cooperation and coordination and a material level of consistency in our regulatory regimes. Our experience in the United States suggests that achieving an appropriate convergence takes time, not only to develop but to maintain. Progress we have seen through the European Union and the BIS goes far in coordinating, or harmonizing, banking laws, regulations, and operating standards, but that's just a start. As managers of large financial institutions develop more sophisticated and more comprehensive risk management systems, they are paying less attention every day to the peculiar legal structure of their organizations. As regulators, we need to understand how banking organizations manage and control risks and the full implications of their practices for the financial safety of depository institutions. By doing so, we can do much to protect our own interests while still recognizing and accommodating the business needs of banks. In developing our laws and regulations we need to work together, for sure. But perhaps more importantly, we need to understand the market forces and incentives that banks face. If we keep those factors in mind in developing our individual rules, we may go far in developing regulatory systems that are both compatible among countries and less intrusive to the institutions we oversee.	---[PAGE_BREAK]--- # Ms. Phillips examines whether national financial market regulatory systems should be harmonised in the light of international competition Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at the Seminar on Banking Soundness and Monetary Policy in a World of Global Capital Markets sponsored by the International Monetary Fund and held in Washington on 28/1/97. It is a pleasure to be here today to discuss a topic that has become more important in a world of global financial markets -- the matter of coordinating and harmonizing our national regulatory systems. On the conference agenda, the topic was phrased as a question, that is, whether we should harmonize our systems. In a sense, the question is somewhat moot -- the globalization of the markets and the breadth of international conglomerate financial institutions is forcing us in that direction. But I would quickly add that one definition of "harmony" is "a pleasing combination of elements." We can sing compatible and pleasant-sounding notes, without singing the same note. It is in that sense that I believe harmonization of our regulatory systems will develop. In my comments this afternoon, I will mention some of the efforts underway in which the United States is working with other countries to develop more consistent supervisory and regulatory systems, particularly for large financial conglomerates. That experience may provide others with ideas about how they might pursue similar efforts, either on a bilateral or multilateral basis. Perhaps more importantly, though, I will also offer my views on where our interests are likely to be most similar and why and how regulators around the world are likely to continue working toward compatible or "harmonized" systems. Let me begin with those thoughts. ## The Importance of Compatible Regulatory Regimes One cannot have dealt with U.S. and world financial markets during the past few decades without being thoroughly impressed with the rapid pace of change and the manner in which technology and financial innovation have affected market practice. The improvements in communications and transportation and, importantly, the gains from technology and the miniaturization of the goods we produce have fueled a growing volume of international trade. Our financial institutions, in turn, have sought constantly to find more effective and efficient ways to facilitate and finance these activities, and at the same time manage the related risks. As a result, we have seen dramatic growth in financial derivatives, strong support within the industry for new clearinghouses and netting procedures to reduce counterparty credit risk, a growing need to clarify our laws and regulations regarding financial contracts, and financial markets that are far more closely linked today than they were even a decade ago. In the area of bank regulation and supervision, substantial progress has been made in developing capital standards that help to ensure the financial strength of internationally active banks and that promote greater competition. Simply put, firms in need of international financial services will utilize domestic or foreign financial institutions to the extent their prices are competitive and their financial stability can be assured. As a result, regulators are recognizing the need to harmonize laws and regulations in order to promote economic growth and to deal with important and oftentimes increasingly complex matters that are of common interest to us all. We are recognizing also the need to enhance financial systems -- including supervision and regulation -- in the emerging market economies, primarily for the sake of those economies, themselves, but also because of their increasing importance in international financial ---[PAGE_BREAK]--- markets. Indeed, G-7 leaders at their summit meeting in Lyon last summer identified this goal as an important element in efforts to promote international financial stability. That we need some level of conformity seems, I'm sure, quite clear. Otherwise, the inconsistency and incompatibility of rules and regulations across countries may make it difficult, if not impossible, for some firms to engage in global business activities. Such barriers are detrimental to the efficiency of international trade and finance, generally. The difficulty, of course, is the precise nature and level of conformity that is necessary to maintain an efficient and equitable world financial system. Here I submit that it may be less important that we standardize particular banking laws and regulations, than it is for us to pursue similar goals, as we independently develop our domestic regulation and supervisory structures. Specifically, if we apply market-based incentives in our regulatory structures, that, alone, should keep our rules sufficiently similar and compatible. We must also recognize that technology and financial innovation are permitting banks today to become ever-more adept at avoiding regulatory barriers and other restrictions that artificially constrain their activities. Moreover, to the extent they are effective, such restrictions can work against local institutions, businesses, or consumers by making banks less competitive internationally or by withholding from their customers the benefits that competition can bring. Regulatory regimes are likely to be more effective in the long run for financial institutions and for domestic economic growth if they are market-compatible. # Areas of Common Interests In our roles as central bankers, bank supervisors, and regulators, what are the areas of greatest common interest to us for which we should develop compatible rules and regulations? To keep it simple, let me suggest two. First, to maintain a healthy, responsive, and financially strong banking and financial system will facilitate the growing needs of our domestic economies. Second, to build and maintain an adequate legal and regulatory structure will permit our institutions to compete safely on an equal and nondiscriminatory basis, both domestically and abroad. These thoughts may not sound original; they're not. They are essentially the two reasons the Basle Committee on Supervision exists, and they underpin most other international efforts to coordinate banking issues. When I consider the past successes in coordinating international bank supervisory or regulatory policies, I think first of the Bank for International Settlements and the work of the supervisors' committee. After all, the BIS has been the principal forum for developing international supervisory standards for banks in industrialized countries and, by their voluntary adoption, for banks and bank supervisors in other countries throughout the world. Bilateral discussions can also serve useful functions either where particular issues are of concern or as a basis for subsequent broader dissemination. Nearly a decade ago, such bilateral and -- through the BIS -- multilateral efforts produced the risk-based capital standard, known as the Basle Accord. Since then, we have produced numerous other policy statements dealing with sound risk management practices for banks. These statements related first to derivatives activities and most recently involve the management of interest rate risk. Dr. Padoa-Schioppa, chairman of the supervisors' committee, has probably already discussed these initiatives with you. ---[PAGE_BREAK]--- One of the Committee's most recent accomplishments, however, is the development of new capital standards for market risk in trading activities. That standard is notable because it reflects a new approach for constructing international banking standards. In particular, the internal models approach contained within that standard builds on leading industry practices and helps supervisors to promote risk management in banks. Promoting sound risk management is a goal we should all pursue more aggressively in considering new banking policies and regulations. It is also the type of approach I had in mind when I said earlier that our laws and regulations should be compatible with underlying economics and market demands. To the extent we can continue building on "best" or sound banking practices in designing our rules and regulations, we will be working toward a common end. As we work together identifying those practices and deciding how to apply them as supervisory or regulatory standards, we will also be strengthening relations among ourselves that can prove invaluable in times of market stress. Not to over-use the example of the market risk standard, but it illustrates another useful point, as well. Reliance on a bank's own risk measurement and modeling process in determining regulatory capital standards also acknowledges that no single or specific technique is best for everyone. Each institution should tailor its risk measurement and management process to its own needs. While adhering to basic principles, each institution must determine for itself the proper incentives and techniques for managing its affairs. No two banks or banking markets are identical in their operations, structure, or historical development. Permitting a range of compatible responses to similar situations encourages experimentation, innovation, and growth. Accommodating a certain level of flexibility is necessary for banks, and it is necessary for regulators, too. Indeed, flexibility may be even more important for non-G-10 countries than it is for those of us with large, developed financial systems because of the greater range of capital market and economic infrastructures among developing countries. Materially different situations typically require different solutions. Accommodating differences, though, does not reduce the need for minimum regulatory or supervisory standards based upon well-known principles of sound banking. It is up to supervisors and, if necessary, legislators to craft regulations and laws consistent with internationally recognized standards, but accommodative to local customs and economic needs. In developing sufficiently flexible, market-compatible regulations, I believe we should rely as much as prudently possible on market discipline and on banks' internal incentives to perform well. This approach requires that the public have information about the risk exposures of banks and about their procedures for managing those risks. As regulators, we can encourage this process by requiring or prodding banks to disclose information to the markets that is both relevant and comparable among institutions. Whether such disclosures are imposed by official regulations or evolve through more subtle efforts, supervisors can help guide the process by considering carefully the kinds of information the private sector needs and that banks use -- or should use -- to manage risk. Even in the United States, where surveys show disclosure is relatively good, supervisors make available to the public data collected on Call Reports. In countries where disclosure practices are minimal at best, bank regulators may be able to perform a particularly important role by publicly disclosing some, if not much, of the information banks report to them. By fueling market information in this way, regulators may ---[PAGE_BREAK]--- stimulate greater investor interest in banks and the growth of local capital markets. Improved disclosure practices by banks may, in turn, also spill over to other industries. One thing we know for sure is that investors dislike uncertainty. By shedding light on a bank's condition and future prospects, some of that uncertainty should disappear. While it is important that key prudential standards be sufficiently robust and consistent among countries, certain variations in the details and applications of these standards can be useful. As with private markets, some level of competition among regulators can stimulate improvements and change. I will grant that the United States may take regulatory competition to an extreme, but it also demonstrates, I believe, the advantages that derive from accommodating different views and permitting financial institutions alternative ways to do business. In my view, and considering the political difficulties we have faced in trying to change U.S. banking laws, our current regulatory structure, offering some choice in charter that is administered by multiple regulators, has provided financial institutions with more freedom and expanded powers than they would likely have received with a single regulator. Supervisors must be careful, however, as they try new or different techniques, that they do not impair their oversight efforts or relax them beyond prudent bounds. In such global markets as we have today, weak or ineffective supervision in either large or small countries can have far reaching consequences. Those concerns were at the heart of early work of the Basle Committee and its efforts to identify the respective roles and responsibilities of home and host authorities for internationally active banks. It is important for supervisors to be able to rely on their counterparts in other countries to administer agreed-upon standards of financial institution safety and soundness. Whether we conduct our own on-site examinations, rely on external auditors, or use combinations of other supervisory techniques, we need to assure ourselves that all banking offices are adequately managed and supervised. I would note here that among G-10 countries a more consistent approach may begin to emerge. We in the United States are making greater use of the findings of a bank's internal and external auditors to guide or supplement our on-site examinations, while some of our counterparts abroad are recognizing more the benefits of onsite exams. # Financial Conglomerates Some of the greatest challenges to bank supervisors may arise when organizations link banking activities with other financial or nonfinancial businesses. Such financial conglomerates, which often combine banking, insurance, and securities activities, are not currently allowed to provide a full array of financial services in the United States, but they may do so abroad. The existence of such firms -- and the fact that some of them are headquartered in this country -- have required regulators and supervisors in the United States to work with counterparts abroad to discuss oversight arrangements and develop ways to deal with matters in times of crises. This very issue is one of our current challenges. I have to say that this is not a particularly quick or easy process and is further complicated by the diverse regulatory structures, both here and abroad, involving banking, securities, and sometimes insurance regulators. These discussions often raise difficult issues, since they tend to break new ground in supervision. For example, what approach should be taken regarding nonbank -- or even nonfinancial -- activities of companies that own banks? In the context of these conglomerates, ---[PAGE_BREAK]--- what does or should "consolidated supervision" mean? Within the context of consolidated supervision, how can the traditional safety-and-soundness approach used by bank supervisors be reconciled with the disclosure/self-regulatory approach used by many securities regulators? Moreover, do the diverse operating structures of conglomerates imply an extension of the safety net that virtually all governments currently extend to banks? One thing is clear: as we address the challenges of promoting a more consistent bank supervisory and regulatory process worldwide, we cannot always take official descriptions of regulatory and oversight regimes at face value. We need to dig deeper to understand how laws are interpreted and how individual banking agencies monitor and enforce safe banking. Different countries necessarily have different banking and financial systems that face unique combinations of exposures and business risks. Even within the United States, for example, we have a relatively uniform supervisory approach for all banks and a risk-based capital standard that applies to them all. In practice, however, the activities of our banks, their capital levels, and their operating practices are quite diverse, and our oversight efforts take those differences into account. Small banks, themselves, recognize the greater risks they face from their lack of size and diversity, and have consistently maintained higher capital ratios than do money center banks. But they also have less formal procedures and internal controls, simply because their staffing and operations are so much smaller. The point is that even a uniform set of rules within a given country can and should be implemented differently as conditions demand. # Conclusion It seems clear that as financial markets become more and more integrated, bank regulators around the world will be seeing more of each other than they have in the past. Even in countries that have no internationally active domestic banks, authorities need to ensure that the banks operating in their markets are sound and subject to adequate supervision, whether by home or host authorities. Banks operating imprudently and without proper supervision are the ones most likely to mismeasure their risks, misprice their products, and disrupt the markets. Detecting and deterring such institutions does not require us to have uniform regulatory or supervisory systems, but it does require a certain level of cooperation and coordination and a material level of consistency in our regulatory regimes. Our experience in the United States suggests that achieving an appropriate convergence takes time, not only to develop but to maintain. Progress we have seen through the European Union and the BIS goes far in coordinating, or harmonizing, banking laws, regulations, and operating standards, but that's just a start. As managers of large financial institutions develop more sophisticated and more comprehensive risk management systems, they are paying less attention every day to the peculiar legal structure of their organizations. As regulators, we need to understand how banking organizations manage and control risks and the full implications of their practices for the financial safety of depository institutions. By doing so, we can do much to protect our own interests while still recognizing and accommodating the business needs of banks. In developing our laws and regulations we need to work together, for sure. But perhaps more importantly, we need to understand the market forces and incentives that banks face. If we keep those factors in mind in developing our individual rules, we may go far in developing regulatory systems that are both compatible among countries and less intrusive to the institutions we oversee.	Susan M Phillips	United States	https://www.bis.org/review/r970207b.pdf	should be harmonised in the light of international competition Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at the Seminar on Banking Soundness and Monetary Policy in a World of Global Capital Markets sponsored by the International Monetary Fund and held in Washington on 28/1/97. It is a pleasure to be here today to discuss a topic that has become more important in a world of global financial markets -- the matter of coordinating and harmonizing our national regulatory systems. On the conference agenda, the topic was phrased as a question, that is, whether we should harmonize our systems. In a sense, the question is somewhat moot -- the globalization of the markets and the breadth of international conglomerate financial institutions is forcing us in that direction. But I would quickly add that one definition of "harmony" is "a pleasing combination of elements." We can sing compatible and pleasant-sounding notes, without singing the same note. It is in that sense that I believe harmonization of our regulatory systems will develop. In my comments this afternoon, I will mention some of the efforts underway in which the United States is working with other countries to develop more consistent supervisory and regulatory systems, particularly for large financial conglomerates. That experience may provide others with ideas about how they might pursue similar efforts, either on a bilateral or multilateral basis. Perhaps more importantly, though, I will also offer my views on where our interests are likely to be most similar and why and how regulators around the world are likely to continue working toward compatible or "harmonized" systems. Let me begin with those thoughts. One cannot have dealt with U.S. and world financial markets during the past few decades without being thoroughly impressed with the rapid pace of change and the manner in which technology and financial innovation have affected market practice. The improvements in communications and transportation and, importantly, the gains from technology and the miniaturization of the goods we produce have fueled a growing volume of international trade. Our financial institutions, in turn, have sought constantly to find more effective and efficient ways to facilitate and finance these activities, and at the same time manage the related risks. As a result, we have seen dramatic growth in financial derivatives, strong support within the industry for new clearinghouses and netting procedures to reduce counterparty credit risk, a growing need to clarify our laws and regulations regarding financial contracts, and financial markets that are far more closely linked today than they were even a decade ago. In the area of bank regulation and supervision, substantial progress has been made in developing capital standards that help to ensure the financial strength of internationally active banks and that promote greater competition. Simply put, firms in need of international financial services will utilize domestic or foreign financial institutions to the extent their prices are competitive and their financial stability can be assured. As a result, regulators are recognizing the need to harmonize laws and regulations in order to promote economic growth and to deal with important and oftentimes increasingly complex matters that are of common interest to us all. We are recognizing also the need to enhance financial systems -- including supervision and regulation -- in the emerging market economies, primarily for the sake of those economies, themselves, but also because of their increasing importance in international financial markets. Indeed, G-7 leaders at their summit meeting in Lyon last summer identified this goal as an important element in efforts to promote international financial stability. That we need some level of conformity seems, I'm sure, quite clear. Otherwise, the inconsistency and incompatibility of rules and regulations across countries may make it difficult, if not impossible, for some firms to engage in global business activities. Such barriers are detrimental to the efficiency of international trade and finance, generally. The difficulty, of course, is the precise nature and level of conformity that is necessary to maintain an efficient and equitable world financial system. Here I submit that it may be less important that we standardize particular banking laws and regulations, than it is for us to pursue similar goals, as we independently develop our domestic regulation and supervisory structures. Specifically, if we apply market-based incentives in our regulatory structures, that, alone, should keep our rules sufficiently similar and compatible. We must also recognize that technology and financial innovation are permitting banks today to become ever-more adept at avoiding regulatory barriers and other restrictions that artificially constrain their activities. Moreover, to the extent they are effective, such restrictions can work against local institutions, businesses, or consumers by making banks less competitive internationally or by withholding from their customers the benefits that competition can bring. Regulatory regimes are likely to be more effective in the long run for financial institutions and for domestic economic growth if they are market-compatible. In our roles as central bankers, bank supervisors, and regulators, what are the areas of greatest common interest to us for which we should develop compatible rules and regulations? To keep it simple, let me suggest two. First, to maintain a healthy, responsive, and financially strong banking and financial system will facilitate the growing needs of our domestic economies. Second, to build and maintain an adequate legal and regulatory structure will permit our institutions to compete safely on an equal and nondiscriminatory basis, both domestically and abroad. These thoughts may not sound original; they're not. They are essentially the two reasons the Basle Committee on Supervision exists, and they underpin most other international efforts to coordinate banking issues. When I consider the past successes in coordinating international bank supervisory or regulatory policies, I think first of the Bank for International Settlements and the work of the supervisors' committee. After all, the BIS has been the principal forum for developing international supervisory standards for banks in industrialized countries and, by their voluntary adoption, for banks and bank supervisors in other countries throughout the world. Bilateral discussions can also serve useful functions either where particular issues are of concern or as a basis for subsequent broader dissemination. Nearly a decade ago, such bilateral and -- through the BIS -- multilateral efforts produced the risk-based capital standard, known as the Basle Accord. Since then, we have produced numerous other policy statements dealing with sound risk management practices for banks. These statements related first to derivatives activities and most recently involve the management of interest rate risk. Dr. Padoa-Schioppa, chairman of the supervisors' committee, has probably already discussed these initiatives with you. One of the Committee's most recent accomplishments, however, is the development of new capital standards for market risk in trading activities. That standard is notable because it reflects a new approach for constructing international banking standards. In particular, the internal models approach contained within that standard builds on leading industry practices and helps supervisors to promote risk management in banks. Promoting sound risk management is a goal we should all pursue more aggressively in considering new banking policies and regulations. It is also the type of approach I had in mind when I said earlier that our laws and regulations should be compatible with underlying economics and market demands. To the extent we can continue building on "best" or sound banking practices in designing our rules and regulations, we will be working toward a common end. As we work together identifying those practices and deciding how to apply them as supervisory or regulatory standards, we will also be strengthening relations among ourselves that can prove invaluable in times of market stress. Not to over-use the example of the market risk standard, but it illustrates another useful point, as well. Reliance on a bank's own risk measurement and modeling process in determining regulatory capital standards also acknowledges that no single or specific technique is best for everyone. Each institution should tailor its risk measurement and management process to its own needs. While adhering to basic principles, each institution must determine for itself the proper incentives and techniques for managing its affairs. No two banks or banking markets are identical in their operations, structure, or historical development. Permitting a range of compatible responses to similar situations encourages experimentation, innovation, and growth. Accommodating a certain level of flexibility is necessary for banks, and it is necessary for regulators, too. Indeed, flexibility may be even more important for non-G-10 countries than it is for those of us with large, developed financial systems because of the greater range of capital market and economic infrastructures among developing countries. Materially different situations typically require different solutions. Accommodating differences, though, does not reduce the need for minimum regulatory or supervisory standards based upon well-known principles of sound banking. It is up to supervisors and, if necessary, legislators to craft regulations and laws consistent with internationally recognized standards, but accommodative to local customs and economic needs. In developing sufficiently flexible, market-compatible regulations, I believe we should rely as much as prudently possible on market discipline and on banks' internal incentives to perform well. This approach requires that the public have information about the risk exposures of banks and about their procedures for managing those risks. As regulators, we can encourage this process by requiring or prodding banks to disclose information to the markets that is both relevant and comparable among institutions. Whether such disclosures are imposed by official regulations or evolve through more subtle efforts, supervisors can help guide the process by considering carefully the kinds of information the private sector needs and that banks use -- or should use -- to manage risk. Even in the United States, where surveys show disclosure is relatively good, supervisors make available to the public data collected on Call Reports. In countries where disclosure practices are minimal at best, bank regulators may be able to perform a particularly important role by publicly disclosing some, if not much, of the information banks report to them. By fueling market information in this way, regulators may stimulate greater investor interest in banks and the growth of local capital markets. Improved disclosure practices by banks may, in turn, also spill over to other industries. One thing we know for sure is that investors dislike uncertainty. By shedding light on a bank's condition and future prospects, some of that uncertainty should disappear. While it is important that key prudential standards be sufficiently robust and consistent among countries, certain variations in the details and applications of these standards can be useful. As with private markets, some level of competition among regulators can stimulate improvements and change. I will grant that the United States may take regulatory competition to an extreme, but it also demonstrates, I believe, the advantages that derive from accommodating different views and permitting financial institutions alternative ways to do business. In my view, and considering the political difficulties we have faced in trying to change U.S. banking laws, our current regulatory structure, offering some choice in charter that is administered by multiple regulators, has provided financial institutions with more freedom and expanded powers than they would likely have received with a single regulator. Supervisors must be careful, however, as they try new or different techniques, that they do not impair their oversight efforts or relax them beyond prudent bounds. In such global markets as we have today, weak or ineffective supervision in either large or small countries can have far reaching consequences. Those concerns were at the heart of early work of the Basle Committee and its efforts to identify the respective roles and responsibilities of home and host authorities for internationally active banks. It is important for supervisors to be able to rely on their counterparts in other countries to administer agreed-upon standards of financial institution safety and soundness. Whether we conduct our own on-site examinations, rely on external auditors, or use combinations of other supervisory techniques, we need to assure ourselves that all banking offices are adequately managed and supervised. I would note here that among G-10 countries a more consistent approach may begin to emerge. We in the United States are making greater use of the findings of a bank's internal and external auditors to guide or supplement our on-site examinations, while some of our counterparts abroad are recognizing more the benefits of onsite exams. Some of the greatest challenges to bank supervisors may arise when organizations link banking activities with other financial or nonfinancial businesses. Such financial conglomerates, which often combine banking, insurance, and securities activities, are not currently allowed to provide a full array of financial services in the United States, but they may do so abroad. The existence of such firms -- and the fact that some of them are headquartered in this country -- have required regulators and supervisors in the United States to work with counterparts abroad to discuss oversight arrangements and develop ways to deal with matters in times of crises. This very issue is one of our current challenges. I have to say that this is not a particularly quick or easy process and is further complicated by the diverse regulatory structures, both here and abroad, involving banking, securities, and sometimes insurance regulators. These discussions often raise difficult issues, since they tend to break new ground in supervision. For example, what approach should be taken regarding nonbank -- or even nonfinancial -- activities of companies that own banks? In the context of these conglomerates, what does or should "consolidated supervision" mean? Within the context of consolidated supervision, how can the traditional safety-and-soundness approach used by bank supervisors be reconciled with the disclosure/self-regulatory approach used by many securities regulators? Moreover, do the diverse operating structures of conglomerates imply an extension of the safety net that virtually all governments currently extend to banks? One thing is clear: as we address the challenges of promoting a more consistent bank supervisory and regulatory process worldwide, we cannot always take official descriptions of regulatory and oversight regimes at face value. We need to dig deeper to understand how laws are interpreted and how individual banking agencies monitor and enforce safe banking. Different countries necessarily have different banking and financial systems that face unique combinations of exposures and business risks. Even within the United States, for example, we have a relatively uniform supervisory approach for all banks and a risk-based capital standard that applies to them all. In practice, however, the activities of our banks, their capital levels, and their operating practices are quite diverse, and our oversight efforts take those differences into account. Small banks, themselves, recognize the greater risks they face from their lack of size and diversity, and have consistently maintained higher capital ratios than do money center banks. But they also have less formal procedures and internal controls, simply because their staffing and operations are so much smaller. The point is that even a uniform set of rules within a given country can and should be implemented differently as conditions demand. It seems clear that as financial markets become more and more integrated, bank regulators around the world will be seeing more of each other than they have in the past. Even in countries that have no internationally active domestic banks, authorities need to ensure that the banks operating in their markets are sound and subject to adequate supervision, whether by home or host authorities. Banks operating imprudently and without proper supervision are the ones most likely to mismeasure their risks, misprice their products, and disrupt the markets. Detecting and deterring such institutions does not require us to have uniform regulatory or supervisory systems, but it does require a certain level of cooperation and coordination and a material level of consistency in our regulatory regimes. Our experience in the United States suggests that achieving an appropriate convergence takes time, not only to develop but to maintain. Progress we have seen through the European Union and the BIS goes far in coordinating, or harmonizing, banking laws, regulations, and operating standards, but that's just a start. As managers of large financial institutions develop more sophisticated and more comprehensive risk management systems, they are paying less attention every day to the peculiar legal structure of their organizations. As regulators, we need to understand how banking organizations manage and control risks and the full implications of their practices for the financial safety of depository institutions. By doing so, we can do much to protect our own interests while still recognizing and accommodating the business needs of banks. In developing our laws and regulations we need to work together, for sure. But perhaps more importantly, we need to understand the market forces and incentives that banks face. If we keep those factors in mind in developing our individual rules, we may go far in developing regulatory systems that are both compatible among countries and less intrusive to the institutions we oversee.
1997-01-29T00:00:00	Mr. Kelley looks at the extent to which banks are still special (Central Bank Articles and Speeches, 29 Jan 97)	Remarks by Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, at the Seminar on Banking Soundness and Monetary Policy in a World of Global Capital Markets sponsored by the International Monetary Fund and held in Washington on 29/1/97.	Mr. Kelley looks at the extent to which banks are still special Remarks by Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, at the Seminar on Banking Soundness and Monetary Policy in a World of Global Capital Markets sponsored by the International Monetary Fund and held in Washington on 29/1/97. I would like to say first that it is a pleasure for me to be here today to participate in this conference and to have the opportunity to exchange views on the important issues addressed by this session in particular. I also want to thank Governor George for his fine survey on the question of whether banks remain special; his paper makes many good points and I agree with virtually all of what he has to say. As a consequence, my comments will be more in the nature of expanding upon his remarks, rather than in taking issue with any of his main points. As Governor George noted, the degree to which each of us regards banks as "special" is bound to be colored by the history and development of banking in our respective countries. Of course, the U.S. banking is quite unique in many respects. Relative to the U.K., for example, we have many more depositories (on the order of 25,000 or so) and they operate with more regulatory restrictions on their activities than in the U.K. and many other countries. Also, our system of deposit insurance is more generous than in the U.K. Bearing these differences in mind, I will attempt to address aspects of our subject today that apply more or less generically in all countries, but I will draw on U.S. experiences for illustrations. To begin, let me say that I found the seemingly simple question "Are banks still special?" to be deceptively difficult. In reading Mr. George's paper and organizing my own thoughts on the subject, I was compelled to answer for myself a series of even more basic questions such as: "How do we define a 'bank'?", "What do we mean by 'special'?", and "If banks are indeed special, what does this imply about the proper stance of government vis-à-vis the banking industry and other types of financial services providers?" For the purposes of this discussion, I will define a bank rather broadly as any financial intermediary that accepts deposits and extends loans to households or businesses. In the United States, this definition encompasses domestic commercial banks, branches of foreign banks operating in the United States, savings and loan associations, and credit unions. Defining what constitutes "specialness" is more difficult. In general terms, analogous to Governor George's definition, I will define a "special" aspect of banking as one in which there is a clear and pronounced public interest exceeding that present in other types of business and commerce. As I will note more fully in the following, my definition of "special" does not necessarily imply that the special aspect of banking in question should be isolated or insulated from competition with other financial service providers. There are at least three general aspects of banks and banking that have been deemed special by many observers -- the liquidity transformation function of banks, the provision of basic financial services such as credit extension, deposits-taking, and payments processing, and the linkage between the banking system and the conduct of monetary policy. In the following, I will take up each of these "special" aspects of banking in turn. So, is the liquidity transformation function of banks still special? By the term "liquidity transformation function" of banks, I refer to the typical balance sheet structure of banks that often features a sizable volume of highly liquid liabilities -- those that can be withdrawn at par on demand such as balances in checking accounts -- in combination with a portfolio of generally longer-term assets that often are difficult to sell or borrow against on short notice. It is probably fair to say that there is considerable agreement among central bankers and other economic policymakers that this unique balance sheet structure creates an inherent potential instability in the banking system. Rumors concerning an individual bank's financial condition -- even if ill-founded -- can spark a run by depositors and other creditors that may force the bank to unload assets at firesale prices and, in extreme situations, suspend payment on withdrawal requests. Especially if the distressed institution is large or prominent, the panic can spread to other banks, with potentially debilitating consequences for the economy as a whole. Most countries with private banking systems have experienced episodes of bank panics to some degree, and in the United States, such panics occurred with some frequency in the late nineteenth century and were a major factor exacerbating the Great Depression of the 1930s. While institutional regimes differ, most countries have established safeguards against banking panics that rest on three basic pillars -- some form of deposit insurance (explicit or implicit), a program of banking supervision and regulation, and an institution that can act as lender of last resort. To come back to our basic question of whether the liquidity transformation function of banks and the associated instability remains "special," I would say that there is simply no doubt about it. Wherever banking panics have occurred, their effects on economic performance have been crippling. Thus, developing institutions and mechanisms that can prevent or short-circuit bank panics remains an important and "special" goal for economic policymakers. Having said this, however, recent experiences in the United States and elsewhere have underscored the importance of going about this task in a way that does not overextend the banking "safety net." In the United States, this lesson was painfully conveyed during the 1980s and early 1990s by the hundreds and hundreds of bank and thrift failures that occurred in these years. While this phenomenon was extraordinarily complex, many have argued that underpriced deposit insurance and relatively lax supervision contributed to the problem by distorting the incentives banks and thrifts faced in assessing the risks of their business decisions. In response, U.S. federal banking agencies have implemented changes that trim the banking safety net somewhat -- for example, by requiring prompt closure of troubled institutions, by applying stricter rules governing the payoffs of depositors and other creditors in bank failures, and by curtailing the practice of allowing regulatory "goodwill." In addition, new bank capital regulations such as the Basle risk-based capital standards, which have been implemented in the G-10 and have served as a blueprint for capital regulation in many other countries, have helped to provide better incentives for banks in their business decisions. To summarize, I would argue that banks remain quite special in their susceptibility to runs and in the severe consequences that a large-scale banking panic would involve today. Balancing the need for a banking "safety net" to defuse potential bank runs with the need to create the right incentives for banks in assessing and assuming risk is one of the most difficult challenges we face as central bankers. A second way in which banks have been deemed to be "special" is in the provision of basic banking services such as credit extension, deposit-taking, and payments processing. There is little question that these functions are critically important throughout society. Consumers turn to banks for safe investments such as time and savings deposits, for transactions deposits, for processing payments, and for short- and long-term credit. Large and small businesses rely on banks for payment processing, short-term credit, and backup credit lines. And governments rely on the banking system to conduct payments, distribute currency, safeguard tax receipts, and to serve as a conduit for monetary policy. In short, the basic business functions of banks are at the heart of the financial system and the economy overall. By the definition I put forward earlier, I would have to say that these basic functions performed by banks are and will remain special. However, it is far from clear that these functions can only be performed by banks or that there is always a "special" public purpose in ensuring that banks' role in performing such functions is protected. Indeed, as Governor George noted, nonbanks have made impressive inroads in markets that previously had been largely banks' domain. For example, money market mutual funds and stock and bond mutual funds have lured billions of dollars that formerly had been placed in staid bank investments such as certificates of deposits. Most mutual funds now also offer some "banking" services such as checkwriting privileges. The advent of asset securitization has allowed nonbank mortgage companies to compete successfully with banks in the home mortgage market, and nonbanks have also been important players in the explosion of new financial instruments such as derivatives and structured notes. For the most part, this blurring of the traditional lines between banks and nonbanks seems to be a positive development. New competitive forces have been unleashed, financial innovation has accelerated, and businesses and households now enjoy a far greater range of choices on their menu of financial services than they did only a decade ago. Banks have responded vigorously -- and I would say successfully, given recent trends in profitability -- to the challenges posed by nonbank competitors. To be sure, such rapid changes have also posed new risks. It is critical in this environment that policymakers stay abreast of market developments to ensure that banks and nonbanks face the right incentives in assessing the risks of their business decisions, and likewise to ensure that consumers and investors have the best possible information available to them when choosing among financial services and products. Thus, while I agree that the basic functions of banks in making credit available, in providing safe investment choices (deposits) for households, and in processing payments are special, I see little to be gained by insisting that banks always be the only type of entity that can provide such services. The case of electronic money helps to illustrate the point I am trying to make. It remains to be seen how popular this form of payment will become in the United States, but the question of whether nonbank institutions should be allowed to issue electronic money is actively being debated in many countries. Some argue that issuing money is a special bank function and that electronic money should properly remain exclusively a bank product. For the time being, however, I along with other policymakers at the Federal Reserve have concluded that any decision to reserve the nascent market for smart cards and other forms of electronic money as a province for banks alone might well stifle both competition and technological innovation in this area. Thus, while most would agree that providing efficient payment media for small dollar transactions is a "special" function that banks currently perform, it does not follow that only banks should be allowed to perform the function. As a corollary, I would also say that there is not a "special" public purpose in constraining banks from competing in many other markets traditionally dominated by nonbank financial institutions. This is a subject which is especially topical in the United States because our domestic banks are more restricted in the business activities in which they can engage than are banks in many other countries. As you know, the Federal Reserve has pushed to expand banks' ability to compete with investment houses in underwriting securities, and the scope for U.S. banks to sell insurance-related products has also expanded recently. The third general aspect of banking that is often deemed special is the linkage between the banking system and monetary policy. Of course, this is a topic that has spawned a truly vast economic literature. Without venturing into this thicket, I would simply like to note as fact that through much of the 1990-1994 period, growth of the broad U.S. monetary aggregates such as M2 was quite at odds with historical relationships to nominal income growth. Perhaps the most important factor underlying this development has been a fundamental realignment of household financial assets away from bank deposits in favor of bond and stock mutual funds and other capital market investments. This "decoupling" of banking system deposit liabilities and nominal GDP became so pronounced during the first half of the 1990s that the Federal Open Market Committee downgraded the status of M2 as a policy variable. Today M2 remains only one of the many variables reviewed by the FOMC in the course of its policy deliberations. I raise this example because financial innovations and shifts in financial structure affecting the monetary aggregates in other countries have similarly created complications in their implementation of monetary policy. Indeed, the difficulties in guiding monetary policy during periods of rapid financial innovation have been a factor contributing to greater experimentation among central banks with alternative targets such as inflation or nominal GDP growth. Thus, I believe one could argue that the growth of aggregate bank deposits or money is probably less "special" today as a policy variable in many countries than in the past. Ironically, while the growth of bank deposits may be less special as a policy guide, the special role of the banking sector as the primary vehicle in implementing monetary policy in most countries remains unchallenged. Most central banks seek to achieve their objectives through some form of interest rate management. Control over short-term interest rates is achieved in every case I am aware of by manipulating the supply of central bank reserves available to satisfy banks' demand for reserves. Banks' demand for reserves is similarly influenced by central banks either directly by setting reserve requirements or indirectly by allowing only banks to access the payment system and then setting the rules regarding the management of their central bank accounts. To conclude, I would like to return to one of the questions posed at the outset of these remarks: If banks are special, what does this imply about the proper stance of government vis-à-vis the banking industry? As I hope my previous comments make clear, regulatory and supervisory policies must recognize the dynamic forces at play in the financial sector. Such policies must promote and exploit the competitive process in order to foster efficient delivery of services while encouraging financial and economic stability. These objectives are not likely to be achieved by regulations that arbitrarily identify and rigidly segment bank and nonbank financial markets. Rather, our goal as policymakers should be to establish rules of the game that provide proper incentives for financial institutions to accurately assess and manage the risks inherent in their business decisions. Likewise, we should foster reporting standards and information flows so that the consumers of financial services and products are as well informed as possible about the risks and returns of the financial services and products they buy. To the maximum extent possible, market forces should determine which bundles of financial services and products are provided by banks and other types of financial service providers. As a final comment, I would note that sound macroeconomic policies are one of the most important ways to encourage the efficient delivery of financial services and the safety and soundness of financial institutions. Conversely, policies that result in significant macroeconomic imbalances frequently have serious adverse implications for financial institutions and banks in particular. In reviewing the past two decades in the United States, for example, one cannot help but notice that the most severe problems in our banking and thrift industries during the 1980s stemmed from serious macroeconomic imbalances -- including the accelerating inflation of the late 1970s and the costly but necessary steps to reverse that trend in the 1980s. By contrast, macroeconomic policies that encourage sustainable economic growth with low inflation -- like those in recent years -- have a strong positive influence on the overall health of the banking sector and other financial institutions as well.	---[PAGE_BREAK]--- Mr. Kelley looks at the extent to which banks are still special Remarks by Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, at the Seminar on Banking Soundness and Monetary Policy in a World of Global Capital Markets sponsored by the International Monetary Fund and held in Washington on 29/1/97. I would like to say first that it is a pleasure for me to be here today to participate in this conference and to have the opportunity to exchange views on the important issues addressed by this session in particular. I also want to thank Governor George for his fine survey on the question of whether banks remain special; his paper makes many good points and I agree with virtually all of what he has to say. As a consequence, my comments will be more in the nature of expanding upon his remarks, rather than in taking issue with any of his main points. As Governor George noted, the degree to which each of us regards banks as "special" is bound to be colored by the history and development of banking in our respective countries. Of course, the U.S. banking is quite unique in many respects. Relative to the U.K., for example, we have many more depositories (on the order of 25,000 or so) and they operate with more regulatory restrictions on their activities than in the U.K. and many other countries. Also, our system of deposit insurance is more generous than in the U.K. Bearing these differences in mind, I will attempt to address aspects of our subject today that apply more or less generically in all countries, but I will draw on U.S. experiences for illustrations. To begin, let me say that I found the seemingly simple question "Are banks still special?" to be deceptively difficult. In reading Mr. George's paper and organizing my own thoughts on the subject, I was compelled to answer for myself a series of even more basic questions such as: "How do we define a 'bank'?", "What do we mean by 'special'?", and "If banks are indeed special, what does this imply about the proper stance of government vis-à-vis the banking industry and other types of financial services providers?" For the purposes of this discussion, I will define a bank rather broadly as any financial intermediary that accepts deposits and extends loans to households or businesses. In the United States, this definition encompasses domestic commercial banks, branches of foreign banks operating in the United States, savings and loan associations, and credit unions. Defining what constitutes "specialness" is more difficult. In general terms, analogous to Governor George's definition, I will define a "special" aspect of banking as one in which there is a clear and pronounced public interest exceeding that present in other types of business and commerce. As I will note more fully in the following, my definition of "special" does not necessarily imply that the special aspect of banking in question should be isolated or insulated from competition with other financial service providers. There are at least three general aspects of banks and banking that have been deemed special by many observers -- the liquidity transformation function of banks, the provision of basic financial services such as credit extension, deposits-taking, and payments processing, and the linkage between the banking system and the conduct of monetary policy. In the following, I will take up each of these "special" aspects of banking in turn. So, is the liquidity transformation function of banks still special? By the term "liquidity transformation function" of banks, I refer to the typical balance sheet structure of banks that often features a sizable volume of highly liquid liabilities -- those that can be withdrawn at par on demand such as balances in checking accounts -- in combination with a ---[PAGE_BREAK]--- portfolio of generally longer-term assets that often are difficult to sell or borrow against on short notice. It is probably fair to say that there is considerable agreement among central bankers and other economic policymakers that this unique balance sheet structure creates an inherent potential instability in the banking system. Rumors concerning an individual bank's financial condition -- even if ill-founded -- can spark a run by depositors and other creditors that may force the bank to unload assets at firesale prices and, in extreme situations, suspend payment on withdrawal requests. Especially if the distressed institution is large or prominent, the panic can spread to other banks, with potentially debilitating consequences for the economy as a whole. Most countries with private banking systems have experienced episodes of bank panics to some degree, and in the United States, such panics occurred with some frequency in the late nineteenth century and were a major factor exacerbating the Great Depression of the 1930s. While institutional regimes differ, most countries have established safeguards against banking panics that rest on three basic pillars -- some form of deposit insurance (explicit or implicit), a program of banking supervision and regulation, and an institution that can act as lender of last resort. To come back to our basic question of whether the liquidity transformation function of banks and the associated instability remains "special," I would say that there is simply no doubt about it. Wherever banking panics have occurred, their effects on economic performance have been crippling. Thus, developing institutions and mechanisms that can prevent or short-circuit bank panics remains an important and "special" goal for economic policymakers. Having said this, however, recent experiences in the United States and elsewhere have underscored the importance of going about this task in a way that does not overextend the banking "safety net." In the United States, this lesson was painfully conveyed during the 1980s and early 1990s by the hundreds and hundreds of bank and thrift failures that occurred in these years. While this phenomenon was extraordinarily complex, many have argued that underpriced deposit insurance and relatively lax supervision contributed to the problem by distorting the incentives banks and thrifts faced in assessing the risks of their business decisions. In response, U.S. federal banking agencies have implemented changes that trim the banking safety net somewhat -- for example, by requiring prompt closure of troubled institutions, by applying stricter rules governing the payoffs of depositors and other creditors in bank failures, and by curtailing the practice of allowing regulatory "goodwill." In addition, new bank capital regulations such as the Basle risk-based capital standards, which have been implemented in the G-10 and have served as a blueprint for capital regulation in many other countries, have helped to provide better incentives for banks in their business decisions. To summarize, I would argue that banks remain quite special in their susceptibility to runs and in the severe consequences that a large-scale banking panic would involve today. Balancing the need for a banking "safety net" to defuse potential bank runs with the need to create the right incentives for banks in assessing and assuming risk is one of the most difficult challenges we face as central bankers. A second way in which banks have been deemed to be "special" is in the provision of basic banking services such as credit extension, deposit-taking, and payments processing. There is little question that these functions are critically important throughout society. Consumers turn to banks for safe investments such as time and savings deposits, for transactions deposits, for processing payments, and for short- and long-term credit. Large and small businesses rely on banks for payment processing, short-term credit, and backup credit ---[PAGE_BREAK]--- lines. And governments rely on the banking system to conduct payments, distribute currency, safeguard tax receipts, and to serve as a conduit for monetary policy. In short, the basic business functions of banks are at the heart of the financial system and the economy overall. By the definition I put forward earlier, I would have to say that these basic functions performed by banks are and will remain special. However, it is far from clear that these functions can only be performed by banks or that there is always a "special" public purpose in ensuring that banks' role in performing such functions is protected. Indeed, as Governor George noted, nonbanks have made impressive inroads in markets that previously had been largely banks' domain. For example, money market mutual funds and stock and bond mutual funds have lured billions of dollars that formerly had been placed in staid bank investments such as certificates of deposits. Most mutual funds now also offer some "banking" services such as checkwriting privileges. The advent of asset securitization has allowed nonbank mortgage companies to compete successfully with banks in the home mortgage market, and nonbanks have also been important players in the explosion of new financial instruments such as derivatives and structured notes. For the most part, this blurring of the traditional lines between banks and nonbanks seems to be a positive development. New competitive forces have been unleashed, financial innovation has accelerated, and businesses and households now enjoy a far greater range of choices on their menu of financial services than they did only a decade ago. Banks have responded vigorously -- and I would say successfully, given recent trends in profitability -- to the challenges posed by nonbank competitors. To be sure, such rapid changes have also posed new risks. It is critical in this environment that policymakers stay abreast of market developments to ensure that banks and nonbanks face the right incentives in assessing the risks of their business decisions, and likewise to ensure that consumers and investors have the best possible information available to them when choosing among financial services and products. Thus, while I agree that the basic functions of banks in making credit available, in providing safe investment choices (deposits) for households, and in processing payments are special, I see little to be gained by insisting that banks always be the only type of entity that can provide such services. The case of electronic money helps to illustrate the point I am trying to make. It remains to be seen how popular this form of payment will become in the United States, but the question of whether nonbank institutions should be allowed to issue electronic money is actively being debated in many countries. Some argue that issuing money is a special bank function and that electronic money should properly remain exclusively a bank product. For the time being, however, I along with other policymakers at the Federal Reserve have concluded that any decision to reserve the nascent market for smart cards and other forms of electronic money as a province for banks alone might well stifle both competition and technological innovation in this area. Thus, while most would agree that providing efficient payment media for small dollar transactions is a "special" function that banks currently perform, it does not follow that only banks should be allowed to perform the function. As a corollary, I would also say that there is not a "special" public purpose in constraining banks from competing in many other markets traditionally dominated by nonbank financial institutions. This is a subject which is especially topical in the United States because our domestic banks are more restricted in the business activities in which they can engage than are banks in many other countries. As you know, the Federal Reserve has pushed to expand banks' ability to compete with investment houses in underwriting securities, and the scope for U.S. banks to sell insurance-related products has also expanded recently. ---[PAGE_BREAK]--- The third general aspect of banking that is often deemed special is the linkage between the banking system and monetary policy. Of course, this is a topic that has spawned a truly vast economic literature. Without venturing into this thicket, I would simply like to note as fact that through much of the 1990-1994 period, growth of the broad U.S. monetary aggregates such as M2 was quite at odds with historical relationships to nominal income growth. Perhaps the most important factor underlying this development has been a fundamental realignment of household financial assets away from bank deposits in favor of bond and stock mutual funds and other capital market investments. This "decoupling" of banking system deposit liabilities and nominal GDP became so pronounced during the first half of the 1990s that the Federal Open Market Committee downgraded the status of M2 as a policy variable. Today M2 remains only one of the many variables reviewed by the FOMC in the course of its policy deliberations. I raise this example because financial innovations and shifts in financial structure affecting the monetary aggregates in other countries have similarly created complications in their implementation of monetary policy. Indeed, the difficulties in guiding monetary policy during periods of rapid financial innovation have been a factor contributing to greater experimentation among central banks with alternative targets such as inflation or nominal GDP growth. Thus, I believe one could argue that the growth of aggregate bank deposits or money is probably less "special" today as a policy variable in many countries than in the past. Ironically, while the growth of bank deposits may be less special as a policy guide, the special role of the banking sector as the primary vehicle in implementing monetary policy in most countries remains unchallenged. Most central banks seek to achieve their objectives through some form of interest rate management. Control over short-term interest rates is achieved in every case I am aware of by manipulating the supply of central bank reserves available to satisfy banks' demand for reserves. Banks' demand for reserves is similarly influenced by central banks either directly by setting reserve requirements or indirectly by allowing only banks to access the payment system and then setting the rules regarding the management of their central bank accounts. To conclude, I would like to return to one of the questions posed at the outset of these remarks: If banks are special, what does this imply about the proper stance of government vis-à-vis the banking industry? As I hope my previous comments make clear, regulatory and supervisory policies must recognize the dynamic forces at play in the financial sector. Such policies must promote and exploit the competitive process in order to foster efficient delivery of services while encouraging financial and economic stability. These objectives are not likely to be achieved by regulations that arbitrarily identify and rigidly segment bank and nonbank financial markets. Rather, our goal as policymakers should be to establish rules of the game that provide proper incentives for financial institutions to accurately assess and manage the risks inherent in their business decisions. Likewise, we should foster reporting standards and information flows so that the consumers of financial services and products are as well informed as possible about the risks and returns of the financial services and products they buy. To the maximum extent possible, market forces should determine which bundles of financial services and products are provided by banks and other types of financial service providers. As a final comment, I would note that sound macroeconomic policies are one of the most important ways to encourage the efficient delivery of financial services and the safety and soundness of financial institutions. Conversely, policies that result in significant macroeconomic imbalances frequently have serious adverse implications for financial institutions and banks in particular. In reviewing the past two decades in the United States, for example, one cannot help but notice that the most severe problems in our banking and thrift ---[PAGE_BREAK]--- industries during the 1980s stemmed from serious macroeconomic imbalances -- including the accelerating inflation of the late 1970s and the costly but necessary steps to reverse that trend in the 1980s. By contrast, macroeconomic policies that encourage sustainable economic growth with low inflation -- like those in recent years -- have a strong positive influence on the overall health of the banking sector and other financial institutions as well.	Edward W Kelley, Jr	United States	https://www.bis.org/review/r970214d.pdf	Mr. Kelley looks at the extent to which banks are still special Remarks by Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, at the Seminar on Banking Soundness and Monetary Policy in a World of Global Capital Markets sponsored by the International Monetary Fund and held in Washington on 29/1/97. I would like to say first that it is a pleasure for me to be here today to participate in this conference and to have the opportunity to exchange views on the important issues addressed by this session in particular. I also want to thank Governor George for his fine survey on the question of whether banks remain special; his paper makes many good points and I agree with virtually all of what he has to say. As a consequence, my comments will be more in the nature of expanding upon his remarks, rather than in taking issue with any of his main points. As Governor George noted, the degree to which each of us regards banks as "special" is bound to be colored by the history and development of banking in our respective countries. Of course, the U.S. banking is quite unique in many respects. Relative to the U.K., for example, we have many more depositories (on the order of 25,000 or so) and they operate with more regulatory restrictions on their activities than in the U.K. and many other countries. Also, our system of deposit insurance is more generous than in the U.K. Bearing these differences in mind, I will attempt to address aspects of our subject today that apply more or less generically in all countries, but I will draw on U.S. experiences for illustrations. To begin, let me say that I found the seemingly simple question "Are banks still special?" to be deceptively difficult. In reading Mr. George's paper and organizing my own thoughts on the subject, I was compelled to answer for myself a series of even more basic questions such as: "How do we define a 'bank'?", "What do we mean by 'special'?", and "If banks are indeed special, what does this imply about the proper stance of government vis-à-vis the banking industry and other types of financial services providers?" For the purposes of this discussion, I will define a bank rather broadly as any financial intermediary that accepts deposits and extends loans to households or businesses. In the United States, this definition encompasses domestic commercial banks, branches of foreign banks operating in the United States, savings and loan associations, and credit unions. Defining what constitutes "specialness" is more difficult. In general terms, analogous to Governor George's definition, I will define a "special" aspect of banking as one in which there is a clear and pronounced public interest exceeding that present in other types of business and commerce. As I will note more fully in the following, my definition of "special" does not necessarily imply that the special aspect of banking in question should be isolated or insulated from competition with other financial service providers. There are at least three general aspects of banks and banking that have been deemed special by many observers -- the liquidity transformation function of banks, the provision of basic financial services such as credit extension, deposits-taking, and payments processing, and the linkage between the banking system and the conduct of monetary policy. In the following, I will take up each of these "special" aspects of banking in turn. So, is the liquidity transformation function of banks still special? By the term "liquidity transformation function" of banks, I refer to the typical balance sheet structure of banks that often features a sizable volume of highly liquid liabilities -- those that can be withdrawn at par on demand such as balances in checking accounts -- in combination with a portfolio of generally longer-term assets that often are difficult to sell or borrow against on short notice. It is probably fair to say that there is considerable agreement among central bankers and other economic policymakers that this unique balance sheet structure creates an inherent potential instability in the banking system. Rumors concerning an individual bank's financial condition -- even if ill-founded -- can spark a run by depositors and other creditors that may force the bank to unload assets at firesale prices and, in extreme situations, suspend payment on withdrawal requests. Especially if the distressed institution is large or prominent, the panic can spread to other banks, with potentially debilitating consequences for the economy as a whole. Most countries with private banking systems have experienced episodes of bank panics to some degree, and in the United States, such panics occurred with some frequency in the late nineteenth century and were a major factor exacerbating the Great Depression of the 1930s. While institutional regimes differ, most countries have established safeguards against banking panics that rest on three basic pillars -- some form of deposit insurance (explicit or implicit), a program of banking supervision and regulation, and an institution that can act as lender of last resort. To come back to our basic question of whether the liquidity transformation function of banks and the associated instability remains "special," I would say that there is simply no doubt about it. Wherever banking panics have occurred, their effects on economic performance have been crippling. Thus, developing institutions and mechanisms that can prevent or short-circuit bank panics remains an important and "special" goal for economic policymakers. Having said this, however, recent experiences in the United States and elsewhere have underscored the importance of going about this task in a way that does not overextend the banking "safety net." In the United States, this lesson was painfully conveyed during the 1980s and early 1990s by the hundreds and hundreds of bank and thrift failures that occurred in these years. While this phenomenon was extraordinarily complex, many have argued that underpriced deposit insurance and relatively lax supervision contributed to the problem by distorting the incentives banks and thrifts faced in assessing the risks of their business decisions. In response, U.S. federal banking agencies have implemented changes that trim the banking safety net somewhat -- for example, by requiring prompt closure of troubled institutions, by applying stricter rules governing the payoffs of depositors and other creditors in bank failures, and by curtailing the practice of allowing regulatory "goodwill." In addition, new bank capital regulations such as the Basle risk-based capital standards, which have been implemented in the G-10 and have served as a blueprint for capital regulation in many other countries, have helped to provide better incentives for banks in their business decisions. To summarize, I would argue that banks remain quite special in their susceptibility to runs and in the severe consequences that a large-scale banking panic would involve today. Balancing the need for a banking "safety net" to defuse potential bank runs with the need to create the right incentives for banks in assessing and assuming risk is one of the most difficult challenges we face as central bankers. A second way in which banks have been deemed to be "special" is in the provision of basic banking services such as credit extension, deposit-taking, and payments processing. There is little question that these functions are critically important throughout society. Consumers turn to banks for safe investments such as time and savings deposits, for transactions deposits, for processing payments, and for short- and long-term credit. Large and small businesses rely on banks for payment processing, short-term credit, and backup credit lines. And governments rely on the banking system to conduct payments, distribute currency, safeguard tax receipts, and to serve as a conduit for monetary policy. In short, the basic business functions of banks are at the heart of the financial system and the economy overall. By the definition I put forward earlier, I would have to say that these basic functions performed by banks are and will remain special. However, it is far from clear that these functions can only be performed by banks or that there is always a "special" public purpose in ensuring that banks' role in performing such functions is protected. Indeed, as Governor George noted, nonbanks have made impressive inroads in markets that previously had been largely banks' domain. For example, money market mutual funds and stock and bond mutual funds have lured billions of dollars that formerly had been placed in staid bank investments such as certificates of deposits. Most mutual funds now also offer some "banking" services such as checkwriting privileges. The advent of asset securitization has allowed nonbank mortgage companies to compete successfully with banks in the home mortgage market, and nonbanks have also been important players in the explosion of new financial instruments such as derivatives and structured notes. For the most part, this blurring of the traditional lines between banks and nonbanks seems to be a positive development. New competitive forces have been unleashed, financial innovation has accelerated, and businesses and households now enjoy a far greater range of choices on their menu of financial services than they did only a decade ago. Banks have responded vigorously -- and I would say successfully, given recent trends in profitability -- to the challenges posed by nonbank competitors. To be sure, such rapid changes have also posed new risks. It is critical in this environment that policymakers stay abreast of market developments to ensure that banks and nonbanks face the right incentives in assessing the risks of their business decisions, and likewise to ensure that consumers and investors have the best possible information available to them when choosing among financial services and products. Thus, while I agree that the basic functions of banks in making credit available, in providing safe investment choices (deposits) for households, and in processing payments are special, I see little to be gained by insisting that banks always be the only type of entity that can provide such services. The case of electronic money helps to illustrate the point I am trying to make. It remains to be seen how popular this form of payment will become in the United States, but the question of whether nonbank institutions should be allowed to issue electronic money is actively being debated in many countries. Some argue that issuing money is a special bank function and that electronic money should properly remain exclusively a bank product. For the time being, however, I along with other policymakers at the Federal Reserve have concluded that any decision to reserve the nascent market for smart cards and other forms of electronic money as a province for banks alone might well stifle both competition and technological innovation in this area. Thus, while most would agree that providing efficient payment media for small dollar transactions is a "special" function that banks currently perform, it does not follow that only banks should be allowed to perform the function. As a corollary, I would also say that there is not a "special" public purpose in constraining banks from competing in many other markets traditionally dominated by nonbank financial institutions. This is a subject which is especially topical in the United States because our domestic banks are more restricted in the business activities in which they can engage than are banks in many other countries. As you know, the Federal Reserve has pushed to expand banks' ability to compete with investment houses in underwriting securities, and the scope for U.S. banks to sell insurance-related products has also expanded recently. The third general aspect of banking that is often deemed special is the linkage between the banking system and monetary policy. Of course, this is a topic that has spawned a truly vast economic literature. Without venturing into this thicket, I would simply like to note as fact that through much of the 1990-1994 period, growth of the broad U.S. monetary aggregates such as M2 was quite at odds with historical relationships to nominal income growth. Perhaps the most important factor underlying this development has been a fundamental realignment of household financial assets away from bank deposits in favor of bond and stock mutual funds and other capital market investments. This "decoupling" of banking system deposit liabilities and nominal GDP became so pronounced during the first half of the 1990s that the Federal Open Market Committee downgraded the status of M2 as a policy variable. Today M2 remains only one of the many variables reviewed by the FOMC in the course of its policy deliberations. I raise this example because financial innovations and shifts in financial structure affecting the monetary aggregates in other countries have similarly created complications in their implementation of monetary policy. Indeed, the difficulties in guiding monetary policy during periods of rapid financial innovation have been a factor contributing to greater experimentation among central banks with alternative targets such as inflation or nominal GDP growth. Thus, I believe one could argue that the growth of aggregate bank deposits or money is probably less "special" today as a policy variable in many countries than in the past. Ironically, while the growth of bank deposits may be less special as a policy guide, the special role of the banking sector as the primary vehicle in implementing monetary policy in most countries remains unchallenged. Most central banks seek to achieve their objectives through some form of interest rate management. Control over short-term interest rates is achieved in every case I am aware of by manipulating the supply of central bank reserves available to satisfy banks' demand for reserves. Banks' demand for reserves is similarly influenced by central banks either directly by setting reserve requirements or indirectly by allowing only banks to access the payment system and then setting the rules regarding the management of their central bank accounts. To conclude, I would like to return to one of the questions posed at the outset of these remarks: If banks are special, what does this imply about the proper stance of government vis-à-vis the banking industry? As I hope my previous comments make clear, regulatory and supervisory policies must recognize the dynamic forces at play in the financial sector. Such policies must promote and exploit the competitive process in order to foster efficient delivery of services while encouraging financial and economic stability. These objectives are not likely to be achieved by regulations that arbitrarily identify and rigidly segment bank and nonbank financial markets. Rather, our goal as policymakers should be to establish rules of the game that provide proper incentives for financial institutions to accurately assess and manage the risks inherent in their business decisions. Likewise, we should foster reporting standards and information flows so that the consumers of financial services and products are as well informed as possible about the risks and returns of the financial services and products they buy. To the maximum extent possible, market forces should determine which bundles of financial services and products are provided by banks and other types of financial service providers. As a final comment, I would note that sound macroeconomic policies are one of the most important ways to encourage the efficient delivery of financial services and the safety and soundness of financial institutions. Conversely, policies that result in significant macroeconomic imbalances frequently have serious adverse implications for financial institutions and banks in particular. In reviewing the past two decades in the United States, for example, one cannot help but notice that the most severe problems in our banking and thrift industries during the 1980s stemmed from serious macroeconomic imbalances -- including the accelerating inflation of the late 1970s and the costly but necessary steps to reverse that trend in the 1980s. By contrast, macroeconomic policies that encourage sustainable economic growth with low inflation -- like those in recent years -- have a strong positive influence on the overall health of the banking sector and other financial institutions as well.
1997-01-30T00:00:00	Mr. Greenspan dicusses the accuracy of the US consumer price index (Central Bank Articles and Speeches, 30 Jan 97)	Testimony of the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on Finance of the US Senate on 30/1/97.	Mr. Greenspan dicusses the accuracy of the US consumer price index Testimony of the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on Finance of the US Senate on 30/1/97. Mr. Chairman and members of the Committee, I appreciate the opportunity to appear before you today. The Committee is faced with a number of complex policy issues that will have an important bearing on the fiscal health of the nation and the welfare of our people well into the next century. I will be happy to respond to questions relating to any of those issues, but in my formal comments this morning I intend to focus on the accuracy of the consumer price index. I would like to begin by commending this Committee for having done so much to bring the issue of possible bias in the CPI to the attention of the Congress and of the nation in general. The hearings conducted by this Committee in 1995, as well as the report produced by the advisory commission that was sponsored by this Committee, have advanced the discussion considerably. These efforts, along with the continuing contributions of the Bureau of Labor Statistics' research staff, have added importantly to our understanding of the sources of measurement error in the CPI. Any index that endeavors to measure the cost of living should aim to be unbiased. That is, a serious examination of all available evidence should yield the conclusion that there is just as great a chance that the index understates the rate of growth of the target concept as there is that it overstates the truth. The present-day consumer price index does not meet this standard. In fact, the best available evidence suggests that there is virtually no chance that the CPI as currently published understates the rate of growth of the appropriate concept. In other words, there is almost a 100 percent probability that we are overcompensating the average social security recipient for increases in the cost of living, and almost a 100 percent probability that we are causing the inflation-adjusted burden of the income tax system to decline more rapidly than I presume the Congress intends. A major reason for this is that consumers respond to changes in relative prices by changing the composition of their actual marketbasket. At present, however, the marketbasket used in constructing the CPI changes only once every decade or so. Moreover, new goods and services deliver value to consumers even at the relatively elevated prices that often prevail early in their life cycles; currently, that value is not reflected in the CPI. For that and other reasons outlined in the Boskin Commission report and other studies, we know with near certainty that the current CPI is off. We do not know precisely by how much, however. There is, nonetheless, a very high probability that the upward bias ranges between 1⁄2 percentage point per year and 11⁄2 percentage points per year. Although this range happens to coincide with the one I gave two years ago, it does reflect both the improvements in the index that the BLS has implemented since then and the emergence of evidence suggesting that the initial problem was of a slightly greater dimension than had previously been estimated. This estimate is consistent with a number of microstatistical studies as well as an independently derived macroevaluation by staff at the Federal Reserve Board, which I will discuss shortly. In judging these evaluations, it is incumbent upon us to resist the evident strong inclination to believe that precision is the equivalent of accuracy in price bias estimation. If we cannot find a precise estimate for a certain bias, we should not implicitly choose zero as though that was a more scientifically supportable estimate. There is no sharp dividing line between a pristine estimate of a price and one that is not. All of the estimates in the CPI are approximations, in some cases very rough approximations. Further, even very rough approximations can give us a far better judgment of the cost of living, than holding to a false precision of accuracy. We would be far better served following the wise admonition of John Maynard Keynes that "it is better to be roughly right than precisely wrong." Estimates of the magnitude of the bias in our price measures are available from a number of sources. Most have been developed from detailed examinations of the microstatistical evidence. However, recent work by staff economists at the Federal Reserve Board has added strong corroborating evidence of price mismeasurement using a macroeconomic approach that is essentially independent of the exercises performed by other researchers, including those on the Boskin Commission. In particular, employing the statistical system from which the Commerce Department estimates the national income and product accounts, the research finds that measured real output and productivity in the service sector are implausibly weak, given that the return to owners of businesses in that sector apparently has been well-maintained. Taken at face value, the published data indicate that the level of output per hour in a number of service-producing industries has been falling for more than two decades. In other words, the data imply that firms in these industries have been becoming less and less efficient for more than twenty years. These circumstances simply are not credible. On the reasonable assumption that nominal output and hours worked and paid of the various industries are accurately measured, faulty price statistics are almost surely the likely cause of the implausible productivity trends. The source of a very large segment of these prices is the CPI. For this exercise, the study used the GDP chain-weight price measures. Although these price measures are based on many of the same individual price indexes included in the CPI, they do not suffer from upper-level substitution bias. Hence, the price mismeasurement revealed by this data system largely reflects shortcomings in quality adjustment and in the treatment of new goods and services. If, instead of declining, productivity in these selected service industries was flat, to up a modest 1 percentage point per year, the implicit aggregate price bias associated with these service industries alone would be on the order of 1/2 percentage point or so per annum in recent years -- very similar in magnitude to the Boskin Commission estimate of total quality adjustment and new products bias. To be sure, it is theoretically possible that some of the measured productivity declines in these service industries merely reflect mispricing of intermediate transfers among various industries. Such an occurrence would cause an understatement of productivity in some sectors, but a corresponding overstatement in others. But the available evidence suggests that for these particular service industries this theoretical possibility is not of a sufficiently large empirical magnitude to overturn the basic conclusion that there are serious measurement problems in our price statistics. Moreover, the study did not attempt to evaluate possible quality and new products bias in other industries. Some observers who are skeptical that the bias in the CPI could be very large have noted that the evidence on the magnitude of unmeasured quality change and the importance of new items bias is incomplete and inconclusive. Without a doubt, quality change and new items are among the most difficult of the problems currently confronting the BLS. But since I raised this issue two years ago in my testimony before this Committee, a number of studies have documented significant new examples of cases in which the current treatment in the CPI results in an overstatement of the rate of growth of the cost of living. There doubtless are certain components of the CPI that are biased downward because quality change is handled inappropriately. One instance in which there may well be a problem in this regard pertains to new vehicles, where it may be more appropriate to treat pollution control and mandatory safety equipment, at least in part, as raising price to a consumer rather than improving quality, as is the present practice. But the potential downward bias introduced by current methodology for such equipment can only be slight. We should be prepared to embrace credible new research on quality adjustment, regardless of whether that research points to additional sources of upward bias or previously undetected instances of downward bias. Nonetheless, currently available evidence very strongly supports the view that, on balance, the bias is decidedly toward failing to appropriately capture quality improvements in our price indexes. There is little reason to believe that this conclusion will change unless we alter our procedures. A more difficult quality related issue is whether to reflect changes in broad environmental and social conditions in price measures that are used for indexing various components of federal outlays and receipts. That is, should the CPI reflect the influence of factors such as the level of crime, air and water quality, and the emergence of new diseases, which are not specifically related to products that consumers purchase? There is little in the record to suggest that, when it enacted the indexation of social security benefits in 1972, the Congress intended for the beneficiaries of that program to be compensated for changes in such environmental and social factors. Nor do these issues appear to have been raised when Congress debated the indexation of various tax parameters during the 1980s. Taking account of such conditions, particularly those that lie outside of the markets for goods and services, would be an interesting exercise in its own right, but would appear to extend well beyond the original intent of the Congress. A considerable professional consensus already exists for at least two actions that would almost surely bring the CPI into closer alignment with a true cost-of-living index. First, we should move away from the concept of a fixed marketbasket at the upper level of aggregation, and move toward an aggregation formula that takes into account the tendency of consumers to alter the composition of their purchases in response to changes in relative prices. The BLS already calculates such an index on an experimental basis with a lag of about a year. If the Bureau adopts the Boskin Commission's recommendation that it publish a "best practice" version of the CPI with a lag of a year, it should, without question, build that index on the foundation of a variable marketbasket. There is a somewhat more difficult issue as to whether the concept of a variable marketbasket can be applied in "real time," that is, with the same degree of timeliness that characterizes the current CPI. It is not possible to implement the textbook versions of any of the so-called "superlative" index formulas in real time, because those formulas require contemporaneous data on expenditures, and those data are not presently available until about a year after the fact. However, this hardly forecloses the possibility of implementing an approximation to a superlative formula, and work should continue on the development of such an approximation. A second area that will require attention is the aggregation of prices at the most detailed level of the index. This is a highly technical area, and an important example of how research by the staff at the BLS has advanced our knowledge. Without going into the details of the matter, it is sufficient to say that a selective move away from the current aggregation formula is warranted, and would probably make a modest further contribution to bringing the index more in line with the concept of a cost-of-living index. Beyond these rather limited steps, most of the needed developments will require time, effort, and quite possibly additional resources. It is important that the Congress provide the Bureau with sufficient resources to pursue the agenda vigorously. These are difficult problems, and they cannot be solved tomorrow or next week. But with adequate support and diligent effort, the pace of improvement should quicken. Moreover, an accelerated pace of BLS activity, and heightened congressional interest should galvanize analysts outside the government to contribute to the research effort. Where will this longer-term effort be required? One of the key areas, by all accounts, is quality adjustment. As the Bureau has rightly noted, they do indeed already employ a variety of methods to control for quality change, but available evidence suggests that these are not sufficient to the task. Unfortunately, making improvements on this front will be difficult: Each item will have to be considered on its own, and there may well be limited transfer of knowledge from one item to the next. Another key area on the longer-term agenda will be the estimation of the value of new products to consumers. Significant innovations, such as the personal computer, the cellular telephone, and the heart bypass operation create value for consumers, even at their typically high initial prices; moreover, this value is even greater at the much lower prices that often prevail when new products are, in fact, introduced into the CPI. A true cost-of-living index would reflect this value and its implication for the true rate of growth of the cost of living. The CPI does not reflect it, and accordingly fails to capture a significant offset to price rises in other products. Deriving an estimate of this value and building it into the CPI will not be an easy undertaking. But conceptually, it is unquestionably the right direction to be heading, and some recent research suggests that it could measurably affect the index. Over time, we will need to investigate alternative sources of data. Already, there is interesting work being done to develop techniques for processing data collected from bar-code scanners at the check-out counter. Scanner data will allow the BLS to track not just a small sample of products, but virtually the entire universe of products in selected lines of business and, perhaps most importantly, virtually the universe of transactions, regardless of whether those transactions happen on a weekday, at night, or on a holiday. We should also move to improve our understanding of the value that consumers place on their own time. Absent such knowledge, it will be impossible for the BLS to estimate the value of many goods and services that mainly serve to enhance convenience and save time. Finally, we will have to attempt to build an understanding of why consumers shop at the places they do: What characteristics of an outlet are important, and how much so? Location, hours of operation, inventory, and quality of service all are likely influences on the value that consumers place on their shopping experience, and all will be important in helping the BLS to develop a more sophisticated statistical method for dealing with the appearance of new consumer outlets, including those that operate over the Internet. Even if the BLS moves aggressively, some upward bias will almost surely remain in the CPI, at least for the next several years. Two years ago, in testimony before this Committee, I suggested that a workable structure for dealing with this situation might involve a two-track approach. That suggestion still seems to me to make sense. The first track would involve action by the BLS to address those aspects of the bias that can be dealt with in relatively short order, say within the next year. The second track would involve the establishment of an independent national commission to set annual cost-of-living adjustment factors for federal receipt and outlay programs. The Commission would examine available evidence on a periodic basis, and estimate the bias in the CPI taking into account both the latest research on the sources and magnitudes of the bias, and any corrective actions that had been taken by the BLS. This type of approach would have the benefit of being objective, nonpartisan, and sufficiently flexible to take full account of the latest information. Moreover, there is no reason why the two tracks could not proceed in parallel. Without the second track, we are implicitly assuming, contrary to overwhelming evidence, that the most accurate estimate of the bias is zero. There has been considerable objection that such a second track procedure would be a political fix. To the contrary, assuming zero for the remaining bias is the political fix. On this issue, we should let evidence, not politics, drive policy. We have an overarching national interest in building a better measure of consumer prices and in implementing more rational indexation procedures. Through these efforts, we are most likely to ensure that the original intent of the relevant pieces of legislation will be fulfilled in insulating taxpayers and benefit recipients from the effects of ongoing changes in the cost of living. At present this objective is not being met.	---[PAGE_BREAK]--- # Mr. Greenspan discusses the accuracy of the US consumer price index Testimony of the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on Finance of the US Senate on 30/1/97. Mr. Chairman and members of the Committee, I appreciate the opportunity to appear before you today. The Committee is faced with a number of complex policy issues that will have an important bearing on the fiscal health of the nation and the welfare of our people well into the next century. I will be happy to respond to questions relating to any of those issues, but in my formal comments this morning I intend to focus on the accuracy of the consumer price index. I would like to begin by commending this Committee for having done so much to bring the issue of possible bias in the CPI to the attention of the Congress and of the nation in general. The hearings conducted by this Committee in 1995, as well as the report produced by the advisory commission that was sponsored by this Committee, have advanced the discussion considerably. These efforts, along with the continuing contributions of the Bureau of Labor Statistics' research staff, have added importantly to our understanding of the sources of measurement error in the CPI. Any index that endeavors to measure the cost of living should aim to be unbiased. That is, a serious examination of all available evidence should yield the conclusion that there is just as great a chance that the index understates the rate of growth of the target concept as there is that it overstates the truth. The present-day consumer price index does not meet this standard. In fact, the best available evidence suggests that there is virtually no chance that the CPI as currently published understates the rate of growth of the appropriate concept. In other words, there is almost a 100 percent probability that we are overcompensating the average social security recipient for increases in the cost of living, and almost a 100 percent probability that we are causing the inflation-adjusted burden of the income tax system to decline more rapidly than I presume the Congress intends. A major reason for this is that consumers respond to changes in relative prices by changing the composition of their actual marketbasket. At present, however, the marketbasket used in constructing the CPI changes only once every decade or so. Moreover, new goods and services deliver value to consumers even at the relatively elevated prices that often prevail early in their life cycles; currently, that value is not reflected in the CPI. For that and other reasons outlined in the Boskin Commission report and other studies, we know with near certainty that the current CPI is off. We do not know precisely by how much, however. There is, nonetheless, a very high probability that the upward bias ranges between $1 / 2$ percentage point per year and $11 / 2$ percentage points per year. Although this range happens to coincide with the one I gave two years ago, it does reflect both the improvements in the index that the BLS has implemented since then and the emergence of evidence suggesting that the initial problem was of a slightly greater dimension than had previously been estimated. This estimate is consistent with a number of microstatistical studies as well as an independently derived macroevaluation by staff at the Federal Reserve Board, which I will discuss shortly. In judging these evaluations, it is incumbent upon us to resist the evident strong inclination to believe that precision is the equivalent of accuracy in price bias estimation. If we cannot find a precise estimate for a certain bias, we should not implicitly choose zero as though that was a more scientifically supportable estimate. ---[PAGE_BREAK]--- There is no sharp dividing line between a pristine estimate of a price and one that is not. All of the estimates in the CPI are approximations, in some cases very rough approximations. Further, even very rough approximations can give us a far better judgment of the cost of living, than holding to a false precision of accuracy. We would be far better served following the wise admonition of John Maynard Keynes that "it is better to be roughly right than precisely wrong." Estimates of the magnitude of the bias in our price measures are available from a number of sources. Most have been developed from detailed examinations of the microstatistical evidence. However, recent work by staff economists at the Federal Reserve Board has added strong corroborating evidence of price mismeasurement using a macroeconomic approach that is essentially independent of the exercises performed by other researchers, including those on the Boskin Commission. In particular, employing the statistical system from which the Commerce Department estimates the national income and product accounts, the research finds that measured real output and productivity in the service sector are implausibly weak, given that the return to owners of businesses in that sector apparently has been well-maintained. Taken at face value, the published data indicate that the level of output per hour in a number of service-producing industries has been falling for more than two decades. In other words, the data imply that firms in these industries have been becoming less and less efficient for more than twenty years. These circumstances simply are not credible. On the reasonable assumption that nominal output and hours worked and paid of the various industries are accurately measured, faulty price statistics are almost surely the likely cause of the implausible productivity trends. The source of a very large segment of these prices is the CPI. For this exercise, the study used the GDP chain-weight price measures. Although these price measures are based on many of the same individual price indexes included in the CPI, they do not suffer from upper-level substitution bias. Hence, the price mismeasurement revealed by this data system largely reflects shortcomings in quality adjustment and in the treatment of new goods and services. If, instead of declining, productivity in these selected service industries was flat, to up a modest 1 percentage point per year, the implicit aggregate price bias associated with these service industries alone would be on the order of $1 / 2$ percentage point or so per annum in recent years -- very similar in magnitude to the Boskin Commission estimate of total quality adjustment and new products bias. To be sure, it is theoretically possible that some of the measured productivity declines in these service industries merely reflect mispricing of intermediate transfers among various industries. Such an occurrence would cause an understatement of productivity in some sectors, but a corresponding overstatement in others. But the available evidence suggests that for these particular service industries this theoretical possibility is not of a sufficiently large empirical magnitude to overturn the basic conclusion that there are serious measurement problems in our price statistics. Moreover, the study did not attempt to evaluate possible quality and new products bias in other industries. Some observers who are skeptical that the bias in the CPI could be very large have noted that the evidence on the magnitude of unmeasured quality change and the importance of new items bias is incomplete and inconclusive. Without a doubt, quality change and new items are among the most difficult of the problems currently confronting the BLS. But since I raised this issue two years ago in my testimony before this Committee, a number of studies have ---[PAGE_BREAK]--- documented significant new examples of cases in which the current treatment in the CPI results in an overstatement of the rate of growth of the cost of living. There doubtless are certain components of the CPI that are biased downward because quality change is handled inappropriately. One instance in which there may well be a problem in this regard pertains to new vehicles, where it may be more appropriate to treat pollution control and mandatory safety equipment, at least in part, as raising price to a consumer rather than improving quality, as is the present practice. But the potential downward bias introduced by current methodology for such equipment can only be slight. We should be prepared to embrace credible new research on quality adjustment, regardless of whether that research points to additional sources of upward bias or previously undetected instances of downward bias. Nonetheless, currently available evidence very strongly supports the view that, on balance, the bias is decidedly toward failing to appropriately capture quality improvements in our price indexes. There is little reason to believe that this conclusion will change unless we alter our procedures. A more difficult quality related issue is whether to reflect changes in broad environmental and social conditions in price measures that are used for indexing various components of federal outlays and receipts. That is, should the CPI reflect the influence of factors such as the level of crime, air and water quality, and the emergence of new diseases, which are not specifically related to products that consumers purchase? There is little in the record to suggest that, when it enacted the indexation of social security benefits in 1972, the Congress intended for the beneficiaries of that program to be compensated for changes in such environmental and social factors. Nor do these issues appear to have been raised when Congress debated the indexation of various tax parameters during the 1980s. Taking account of such conditions, particularly those that lie outside of the markets for goods and services, would be an interesting exercise in its own right, but would appear to extend well beyond the original intent of the Congress. A considerable professional consensus already exists for at least two actions that would almost surely bring the CPI into closer alignment with a true cost-of-living index. First, we should move away from the concept of a fixed marketbasket at the upper level of aggregation, and move toward an aggregation formula that takes into account the tendency of consumers to alter the composition of their purchases in response to changes in relative prices. The BLS already calculates such an index on an experimental basis with a lag of about a year. If the Bureau adopts the Boskin Commission's recommendation that it publish a "best practice" version of the CPI with a lag of a year, it should, without question, build that index on the foundation of a variable marketbasket. There is a somewhat more difficult issue as to whether the concept of a variable marketbasket can be applied in "real time," that is, with the same degree of timeliness that characterizes the current CPI. It is not possible to implement the textbook versions of any of the so-called "superlative" index formulas in real time, because those formulas require contemporaneous data on expenditures, and those data are not presently available until about a year after the fact. However, this hardly forecloses the possibility of implementing an approximation to a superlative formula, and work should continue on the development of such an approximation. A second area that will require attention is the aggregation of prices at the most detailed level of the index. This is a highly technical area, and an important example of how research by the staff at the BLS has advanced our knowledge. Without going into the details of ---[PAGE_BREAK]--- the matter, it is sufficient to say that a selective move away from the current aggregation formula is warranted, and would probably make a modest further contribution to bringing the index more in line with the concept of a cost-of-living index. Beyond these rather limited steps, most of the needed developments will require time, effort, and quite possibly additional resources. It is important that the Congress provide the Bureau with sufficient resources to pursue the agenda vigorously. These are difficult problems, and they cannot be solved tomorrow or next week. But with adequate support and diligent effort, the pace of improvement should quicken. Moreover, an accelerated pace of BLS activity, and heightened congressional interest should galvanize analysts outside the government to contribute to the research effort. Where will this longer-term effort be required? One of the key areas, by all accounts, is quality adjustment. As the Bureau has rightly noted, they do indeed already employ a variety of methods to control for quality change, but available evidence suggests that these are not sufficient to the task. Unfortunately, making improvements on this front will be difficult: Each item will have to be considered on its own, and there may well be limited transfer of knowledge from one item to the next. Another key area on the longer-term agenda will be the estimation of the value of new products to consumers. Significant innovations, such as the personal computer, the cellular telephone, and the heart bypass operation create value for consumers, even at their typically high initial prices; moreover, this value is even greater at the much lower prices that often prevail when new products are, in fact, introduced into the CPI. A true cost-of-living index would reflect this value and its implication for the true rate of growth of the cost of living. The CPI does not reflect it, and accordingly fails to capture a significant offset to price rises in other products. Deriving an estimate of this value and building it into the CPI will not be an easy undertaking. But conceptually, it is unquestionably the right direction to be heading, and some recent research suggests that it could measurably affect the index. Over time, we will need to investigate alternative sources of data. Already, there is interesting work being done to develop techniques for processing data collected from bar-code scanners at the check-out counter. Scanner data will allow the BLS to track not just a small sample of products, but virtually the entire universe of products in selected lines of business and, perhaps most importantly, virtually the universe of transactions, regardless of whether those transactions happen on a weekday, at night, or on a holiday. We should also move to improve our understanding of the value that consumers place on their own time. Absent such knowledge, it will be impossible for the BLS to estimate the value of many goods and services that mainly serve to enhance convenience and save time. Finally, we will have to attempt to build an understanding of why consumers shop at the places they do: What characteristics of an outlet are important, and how much so? Location, hours of operation, inventory, and quality of service all are likely influences on the value that consumers place on their shopping experience, and all will be important in helping the BLS to develop a more sophisticated statistical method for dealing with the appearance of new consumer outlets, including those that operate over the Internet. Even if the BLS moves aggressively, some upward bias will almost surely remain in the CPI, at least for the next several years. Two years ago, in testimony before this Committee, I suggested that a workable structure for dealing with this situation might involve a ---[PAGE_BREAK]--- two-track approach. That suggestion still seems to me to make sense. The first track would involve action by the BLS to address those aspects of the bias that can be dealt with in relatively short order, say within the next year. The second track would involve the establishment of an independent national commission to set annual cost-of-living adjustment factors for federal receipt and outlay programs. The Commission would examine available evidence on a periodic basis, and estimate the bias in the CPI taking into account both the latest research on the sources and magnitudes of the bias, and any corrective actions that had been taken by the BLS. This type of approach would have the benefit of being objective, nonpartisan, and sufficiently flexible to take full account of the latest information. Moreover, there is no reason why the two tracks could not proceed in parallel. Without the second track, we are implicitly assuming, contrary to overwhelming evidence, that the most accurate estimate of the bias is zero. There has been considerable objection that such a second track procedure would be a political fix. To the contrary, assuming zero for the remaining bias is the political fix. On this issue, we should let evidence, not politics, drive policy. We have an overarching national interest in building a better measure of consumer prices and in implementing more rational indexation procedures. Through these efforts, we are most likely to ensure that the original intent of the relevant pieces of legislation will be fulfilled in insulating taxpayers and benefit recipients from the effects of ongoing changes in the cost of living. At present this objective is not being met.	Alan Greenspan	United States	https://www.bis.org/review/r970205a.pdf	Testimony of the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on Finance of the US Senate on 30/1/97. Mr. Chairman and members of the Committee, I appreciate the opportunity to appear before you today. The Committee is faced with a number of complex policy issues that will have an important bearing on the fiscal health of the nation and the welfare of our people well into the next century. I will be happy to respond to questions relating to any of those issues, but in my formal comments this morning I intend to focus on the accuracy of the consumer price index. I would like to begin by commending this Committee for having done so much to bring the issue of possible bias in the CPI to the attention of the Congress and of the nation in general. The hearings conducted by this Committee in 1995, as well as the report produced by the advisory commission that was sponsored by this Committee, have advanced the discussion considerably. These efforts, along with the continuing contributions of the Bureau of Labor Statistics' research staff, have added importantly to our understanding of the sources of measurement error in the CPI. Any index that endeavors to measure the cost of living should aim to be unbiased. That is, a serious examination of all available evidence should yield the conclusion that there is just as great a chance that the index understates the rate of growth of the target concept as there is that it overstates the truth. The present-day consumer price index does not meet this standard. In fact, the best available evidence suggests that there is virtually no chance that the CPI as currently published understates the rate of growth of the appropriate concept. In other words, there is almost a 100 percent probability that we are overcompensating the average social security recipient for increases in the cost of living, and almost a 100 percent probability that we are causing the inflation-adjusted burden of the income tax system to decline more rapidly than I presume the Congress intends. A major reason for this is that consumers respond to changes in relative prices by changing the composition of their actual marketbasket. At present, however, the marketbasket used in constructing the CPI changes only once every decade or so. Moreover, new goods and services deliver value to consumers even at the relatively elevated prices that often prevail early in their life cycles; currently, that value is not reflected in the CPI. For that and other reasons outlined in the Boskin Commission report and other studies, we know with near certainty that the current CPI is off. We do not know precisely by how much, however. There is, nonetheless, a very high probability that the upward bias ranges between $1 / 2$ percentage point per year and $11 / 2$ percentage points per year. Although this range happens to coincide with the one I gave two years ago, it does reflect both the improvements in the index that the BLS has implemented since then and the emergence of evidence suggesting that the initial problem was of a slightly greater dimension than had previously been estimated. This estimate is consistent with a number of microstatistical studies as well as an independently derived macroevaluation by staff at the Federal Reserve Board, which I will discuss shortly. In judging these evaluations, it is incumbent upon us to resist the evident strong inclination to believe that precision is the equivalent of accuracy in price bias estimation. If we cannot find a precise estimate for a certain bias, we should not implicitly choose zero as though that was a more scientifically supportable estimate. There is no sharp dividing line between a pristine estimate of a price and one that is not. All of the estimates in the CPI are approximations, in some cases very rough approximations. Further, even very rough approximations can give us a far better judgment of the cost of living, than holding to a false precision of accuracy. We would be far better served following the wise admonition of John Maynard Keynes that "it is better to be roughly right than precisely wrong." Estimates of the magnitude of the bias in our price measures are available from a number of sources. Most have been developed from detailed examinations of the microstatistical evidence. However, recent work by staff economists at the Federal Reserve Board has added strong corroborating evidence of price mismeasurement using a macroeconomic approach that is essentially independent of the exercises performed by other researchers, including those on the Boskin Commission. In particular, employing the statistical system from which the Commerce Department estimates the national income and product accounts, the research finds that measured real output and productivity in the service sector are implausibly weak, given that the return to owners of businesses in that sector apparently has been well-maintained. Taken at face value, the published data indicate that the level of output per hour in a number of service-producing industries has been falling for more than two decades. In other words, the data imply that firms in these industries have been becoming less and less efficient for more than twenty years. These circumstances simply are not credible. On the reasonable assumption that nominal output and hours worked and paid of the various industries are accurately measured, faulty price statistics are almost surely the likely cause of the implausible productivity trends. The source of a very large segment of these prices is the CPI. For this exercise, the study used the GDP chain-weight price measures. Although these price measures are based on many of the same individual price indexes included in the CPI, they do not suffer from upper-level substitution bias. Hence, the price mismeasurement revealed by this data system largely reflects shortcomings in quality adjustment and in the treatment of new goods and services. If, instead of declining, productivity in these selected service industries was flat, to up a modest 1 percentage point per year, the implicit aggregate price bias associated with these service industries alone would be on the order of $1 / 2$ percentage point or so per annum in recent years -- very similar in magnitude to the Boskin Commission estimate of total quality adjustment and new products bias. To be sure, it is theoretically possible that some of the measured productivity declines in these service industries merely reflect mispricing of intermediate transfers among various industries. Such an occurrence would cause an understatement of productivity in some sectors, but a corresponding overstatement in others. But the available evidence suggests that for these particular service industries this theoretical possibility is not of a sufficiently large empirical magnitude to overturn the basic conclusion that there are serious measurement problems in our price statistics. Moreover, the study did not attempt to evaluate possible quality and new products bias in other industries. Some observers who are skeptical that the bias in the CPI could be very large have noted that the evidence on the magnitude of unmeasured quality change and the importance of new items bias is incomplete and inconclusive. Without a doubt, quality change and new items are among the most difficult of the problems currently confronting the BLS. But since I raised this issue two years ago in my testimony before this Committee, a number of studies have documented significant new examples of cases in which the current treatment in the CPI results in an overstatement of the rate of growth of the cost of living. There doubtless are certain components of the CPI that are biased downward because quality change is handled inappropriately. One instance in which there may well be a problem in this regard pertains to new vehicles, where it may be more appropriate to treat pollution control and mandatory safety equipment, at least in part, as raising price to a consumer rather than improving quality, as is the present practice. But the potential downward bias introduced by current methodology for such equipment can only be slight. We should be prepared to embrace credible new research on quality adjustment, regardless of whether that research points to additional sources of upward bias or previously undetected instances of downward bias. Nonetheless, currently available evidence very strongly supports the view that, on balance, the bias is decidedly toward failing to appropriately capture quality improvements in our price indexes. There is little reason to believe that this conclusion will change unless we alter our procedures. A more difficult quality related issue is whether to reflect changes in broad environmental and social conditions in price measures that are used for indexing various components of federal outlays and receipts. That is, should the CPI reflect the influence of factors such as the level of crime, air and water quality, and the emergence of new diseases, which are not specifically related to products that consumers purchase? There is little in the record to suggest that, when it enacted the indexation of social security benefits in 1972, the Congress intended for the beneficiaries of that program to be compensated for changes in such environmental and social factors. Nor do these issues appear to have been raised when Congress debated the indexation of various tax parameters during the 1980s. Taking account of such conditions, particularly those that lie outside of the markets for goods and services, would be an interesting exercise in its own right, but would appear to extend well beyond the original intent of the Congress. A considerable professional consensus already exists for at least two actions that would almost surely bring the CPI into closer alignment with a true cost-of-living index. First, we should move away from the concept of a fixed marketbasket at the upper level of aggregation, and move toward an aggregation formula that takes into account the tendency of consumers to alter the composition of their purchases in response to changes in relative prices. The BLS already calculates such an index on an experimental basis with a lag of about a year. If the Bureau adopts the Boskin Commission's recommendation that it publish a "best practice" version of the CPI with a lag of a year, it should, without question, build that index on the foundation of a variable marketbasket. There is a somewhat more difficult issue as to whether the concept of a variable marketbasket can be applied in "real time," that is, with the same degree of timeliness that characterizes the current CPI. It is not possible to implement the textbook versions of any of the so-called "superlative" index formulas in real time, because those formulas require contemporaneous data on expenditures, and those data are not presently available until about a year after the fact. However, this hardly forecloses the possibility of implementing an approximation to a superlative formula, and work should continue on the development of such an approximation. A second area that will require attention is the aggregation of prices at the most detailed level of the index. This is a highly technical area, and an important example of how research by the staff at the BLS has advanced our knowledge. Without going into the details of the matter, it is sufficient to say that a selective move away from the current aggregation formula is warranted, and would probably make a modest further contribution to bringing the index more in line with the concept of a cost-of-living index. Beyond these rather limited steps, most of the needed developments will require time, effort, and quite possibly additional resources. It is important that the Congress provide the Bureau with sufficient resources to pursue the agenda vigorously. These are difficult problems, and they cannot be solved tomorrow or next week. But with adequate support and diligent effort, the pace of improvement should quicken. Moreover, an accelerated pace of BLS activity, and heightened congressional interest should galvanize analysts outside the government to contribute to the research effort. Where will this longer-term effort be required? One of the key areas, by all accounts, is quality adjustment. As the Bureau has rightly noted, they do indeed already employ a variety of methods to control for quality change, but available evidence suggests that these are not sufficient to the task. Unfortunately, making improvements on this front will be difficult: Each item will have to be considered on its own, and there may well be limited transfer of knowledge from one item to the next. Another key area on the longer-term agenda will be the estimation of the value of new products to consumers. Significant innovations, such as the personal computer, the cellular telephone, and the heart bypass operation create value for consumers, even at their typically high initial prices; moreover, this value is even greater at the much lower prices that often prevail when new products are, in fact, introduced into the CPI. A true cost-of-living index would reflect this value and its implication for the true rate of growth of the cost of living. The CPI does not reflect it, and accordingly fails to capture a significant offset to price rises in other products. Deriving an estimate of this value and building it into the CPI will not be an easy undertaking. But conceptually, it is unquestionably the right direction to be heading, and some recent research suggests that it could measurably affect the index. Over time, we will need to investigate alternative sources of data. Already, there is interesting work being done to develop techniques for processing data collected from bar-code scanners at the check-out counter. Scanner data will allow the BLS to track not just a small sample of products, but virtually the entire universe of products in selected lines of business and, perhaps most importantly, virtually the universe of transactions, regardless of whether those transactions happen on a weekday, at night, or on a holiday. We should also move to improve our understanding of the value that consumers place on their own time. Absent such knowledge, it will be impossible for the BLS to estimate the value of many goods and services that mainly serve to enhance convenience and save time. Finally, we will have to attempt to build an understanding of why consumers shop at the places they do: What characteristics of an outlet are important, and how much so? Location, hours of operation, inventory, and quality of service all are likely influences on the value that consumers place on their shopping experience, and all will be important in helping the BLS to develop a more sophisticated statistical method for dealing with the appearance of new consumer outlets, including those that operate over the Internet. Even if the BLS moves aggressively, some upward bias will almost surely remain in the CPI, at least for the next several years. Two years ago, in testimony before this Committee, I suggested that a workable structure for dealing with this situation might involve a two-track approach. That suggestion still seems to me to make sense. The first track would involve action by the BLS to address those aspects of the bias that can be dealt with in relatively short order, say within the next year. The second track would involve the establishment of an independent national commission to set annual cost-of-living adjustment factors for federal receipt and outlay programs. The Commission would examine available evidence on a periodic basis, and estimate the bias in the CPI taking into account both the latest research on the sources and magnitudes of the bias, and any corrective actions that had been taken by the BLS. This type of approach would have the benefit of being objective, nonpartisan, and sufficiently flexible to take full account of the latest information. Moreover, there is no reason why the two tracks could not proceed in parallel. Without the second track, we are implicitly assuming, contrary to overwhelming evidence, that the most accurate estimate of the bias is zero. There has been considerable objection that such a second track procedure would be a political fix. To the contrary, assuming zero for the remaining bias is the political fix. On this issue, we should let evidence, not politics, drive policy. We have an overarching national interest in building a better measure of consumer prices and in implementing more rational indexation procedures. Through these efforts, we are most likely to ensure that the original intent of the relevant pieces of legislation will be fulfilled in insulating taxpayers and benefit recipients from the effects of ongoing changes in the cost of living. At present this objective is not being met.
1997-02-11T00:00:00	Mr. McDonough assesses the role of the central bank in ensuring a stable price and financial environment and fostering sustainable growth (Central Bank Articles and Speeches, 11 Feb 97)	Remarks by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough, at the Society of Investment Analysts in Dublin on 11/2/97.	Mr. McDonough assesses the role of the central bank in ensuring a stable price and financial environment and fostering sustainable growth Remarks by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough, at the Society of Investment Analysts in Dublin on 11/2/97. I am delighted to have the opportunity to address the Society of Investment Analysts here in Ireland, home of my forebears. In my remarks this evening, I want to say a few words on a topic of great importance to both our professions: the role of central banks in ensuring a stable price and financial environment, and fostering sustainable growth. I would also like to offer some thoughts on the importance of a safe and sound banking system for the wellbeing of the economy. As members of the financial community, we all recognize the importance of price stability to the successful long-run performance of the economy. Indeed, there now seems to be a worldwide convergence of views among central bankers and investors alike on the importance of price stability as the primary goal of monetary policy. For me personally, stable prices have always been the prism for making monetary policy decisions. As I see it, price stability must be viewed in a long-run context as an ongoing goal, not a one-time objective. That goal requires monetary policy to be oriented beyond the horizon of its immediate or near-term impact on inflation and the economy. The primary purpose of near-term policy actions should be to set the economy on a long-term, permanent path to price stability and sound economic growth. This orientation puts the focus of policy on inflation expectations over the long term -- the time horizon that is appropriate for most saving and investment decisions. Businesses and households are understandably concerned about the long-term consequences of inflation and price level uncertainty. This is the frame of reference reflected in the conceptual definition of price stability offered by the chairman of the Federal Reserve, Alan Greenspan -- that price stability is achieved when people do not consider inflation a factor in their business and economic decisions. Long-term inflation expectations must be anchored to a transparent and rigorous commitment by the central bank to a well-defined standard of price stability, and unavoidable deviations from the goal of price stability must be explained with reference to that standard. In my view, price stability is a means to an end -- the promotion of sustainable economic growth. Only with long-term price stability can the economy expect to achieve the maximum levels of productivity and living standards. Price stability is both important and desirable because a rising price level, even at moderate rates, imposes substantial economic costs on society. These costs emanate from a variety of sources, including: -increased uncertainty about the outcome of business decisions and profitability; -adverse effects on the cost of capital resulting from the interaction of inflation with the tax system; -reduced effectiveness of the price and market systems; and -distortions that create perverse incentives to engage in nonproductive activities. As a former commercial banker, I am especially aware of the negative effects of one particular type of nonproductive activity induced by inflation's distortion of incentives -- the overinvestment of resources in the financial sector. It is well known that, in high-inflation economies, the resources diverted from productive activities to nonproductive financial transactions are enormous. But even moderate inflation rates can cause substantial diversion to nonproductive financial activities, and this diversion deserves greater attention than it often receives in economists' list of the costs of inflation. As I look back over the last ten years or so, I am pleased that the Federal Reserve and many other central banks have been successful in controlling price pressures and putting inflation on a long-run downward track. Success in dealing with inflation clearly enhances the credibility of monetary policy and policy makers. From my perspective, the continuing challenge for central banks is to ensure long-term credibility for monetary policy by sustaining low inflation environments. Central banks are generally better able to meet this challenge if they are substantially immunized from short-term political pressures, and are firmly committed to price stability as the overriding goal of monetary policy. Empirical research in recent years has shown that both the average rate of inflation and its variability tend to decline in tandem with increased independence for central banks. This is why so many governments, including those among the emerging market economies, have been providing their central banks with increased autonomy. Of course, it is possible to have low inflation or price stability even with a limited degree of legal central bank independence, but the record clearly shows that a country is more likely to have low inflation if its central bank is independent. One important reason for this is that the fiscal authorities in many countries have not proven to be highly disciplined. Of course, some would argue that focusing on price stability as the primary goal of monetary policy means that central banks would no longer be concerned about output or job growth. I believe this view simply is wrong. A stable price and financial environment almost certainly enhances the capacity of monetary policy to fight occasions of cyclical weakness in the economy. A central bank's commitment to price stability over the longer term does not mean that monetary policy can ignore the short-term impact of economic events. It is important to recognize that, even when an economy is set on the path to price stability, and price expectations are contained, it does not necessarily mean that all potential sources of inflationary shocks have been eliminated. Moreover, while there is no long-run trade-off between unemployment, or output, and inflation, both formal evidence and common sense observation on wage and price rigidities attest to the existence of such a trade-off in the short run. In the long run, however, monetary policy's impact is only on inflation; potential output primarily is determined by advances in technology, growth in human and physical capital and other real resources. Because of the uncertainty about the timing and significance of short-term monetary policy effects on economic activity, as well as all other uncertainties concerning the economy, there are always differences of view about the speed with which policy should be adjusted, and on the balance of risks in dealing with ongoing economic developments. These conflicts become more marked when an economy confronts supply shocks that drive up prices sharply and suddenly -- such as the two oil shocks of the 1970s. In those circumstances, from my perspective, the appropriate course, consistent with maintaining longer term price stability, should be to bring inflation down somewhat gradually, as the economy adjusts to the shift in relative prices. As I see it, monetary policy must be formulated cautiously, and cannot ignore business cycle developments. In establishing price stability as the primary goal of monetary policy, therefore, it is best to recognize that monetary policy does affect output in the short run. A central bank can appropriately be assigned the task of promoting sustainable economic growth, while maintaining long-term price stability and ensuring the health of the financial system. This way of articulating policy goals has the advantage of meeting the public's need to understand the basis for monetary policy decisions, and may help, therefore, to enhance the democratic accountability of monetary policy. Once monetary policy is firmly committed to price stability, how can a central bank best reach that goal? Clearly, at an operational level, no single formula or implementation strategy can be expected to succeed in all countries and under all circumstances; possible approaches can take many different forms. The choices depend on a country's history, economic conditions, traditions and institutions. But all successful approaches share two important features: first, they focus on a long-term time horizon and, second, they provide a clear and public standard for the assessment of policy. What is most significant is not the specific way a central bank chooses to seek price stability, but rather the underlying commitment to that goal. While monetary policy aimed at long-run price stability is critical to fostering sustainable economic growth, central banks' role in promoting growth and, more generally, a healthy economy goes beyond the conduct of monetary policy. Through involvement in financial regulation and supervision, as well as in the oversight of payments system operations, central banks play a key role in preserving and enhancing the safety and soundness of the banking and financial system. All of these central bank functions are mutually dependent and, together, highlight the fact that the structure and workings of the banking system are integral to a country's financial stability and economic growth. Clearly, monetary policy cannot succeed in its mission if the underlying financial system is unstable. The importance of an efficient, safe and sound banking and financial system for a country's long-term economic prospects cannot be overstated. In any market economy, the banking and financial system plays a central role in mobilizing a society's savings and in channeling these savings into investment and other productive uses. This intermediation process is one of the core determinants of the pace of a country's economic development. Moreover, the banking and financial system must facilitate transactions in an economy by ensuring that they can be effected safely and swiftly on an ongoing basis. Both buyers and sellers of goods and services must have confidence that instruments used to make payments will be honored and accepted by all parties. These crucial functions of transforming savings into productive uses and making payments are often taken for granted. But, in fact, it can be difficult to ensure that the legal and institutional framework within which these functions are performed is consistent with the often conflicting goals of free choice, economic efficiency, safety and financial market stability. Experience has proven that there is no easy way to shape financial institutions in a manner that appropriately balances these goals under changing economic conditions. Today, numerous countries -- including Ireland and the United States -- are considering which paths to follow in reforming and modernizing their banking industries. These deliberations are of great importance, because a well-functioning and stable banking and financial system is a critical foundation for long-run growth and prosperity of an economy. And such reform is inevitably difficult, for reasons which are a classic blend of political and economic considerations rooted in the crucial functions the banking system must perform in a market economy. Moreover, banking system reform is made all the more challenging by the fact that such reforms cannot be viewed in isolation from reforms in the central bank, or independent of those in the capital markets. In fact, the greatest challenge may lie in forging these individual pieces in such a way that they fit together in a cohesive whole that serves the dictates of stability, growth, and public confidence. For a financial system to mobilize and allocate a society's savings successfully and facilitate day-to-day transactions, there must be a class of financial institutions and instruments that the public views as safe and convenient outlets for its savings. Of course, the single dominant class of institution that performs this crucial dual role as repository of a large part of society's liquid savings, and the entity through which payments are made is the commercial bank. This is true even in countries with highly developed capital markets, especially when it is kept in mind that participants in the capital markets rely heavily on the banking system for their financing facilities. Banks cannot play an effective role in the financial intermediation process unless the public has the utmost confidence in the banking system. This confidence is a key reason why banking institutions and banking instruments are crucial to a country's economic growth and development. The combination of functions typically provided by commercial banks, however, also carries with it the risk that a loss of confidence in an individual institution can spread to the system as a whole, the so-called systemic risk phenomenon. Instances in which a country experiences a loss of confidence in its financial institutions usually result in major damage to the economy. Given the indispensable role that financial institutions play in the success of a country's economy, governments clearly have a responsibility to subject financial institutions to some form of regulation or oversight. But here again, there is need for balance. Restrictions placed on banks by the financial oversight apparatus cannot be allowed to discourage risk-taking per se, because risk-taking is an inherent part of banking and finance in market economies. To perform successfully, a commercial banking system requires a delicate balance between risk-taking and maintaining public confidence. Because of the importance and the difficulties inherent in the balancing act, banking systems are generally subject to a higher degree of official oversight and regulation than are most other forms of private enterprise, and supported by some form of a broad safety net. While the specifics can differ appreciably across countries, these safety nets are usually constructed along similar lines. They generally include oversight of the affairs of banking institutions in the form of inspection and examination of the institutions for compliance with a broad set of safety and soundness standards; some type of protection against losses for small depositors and investors; and some form of emergency liquidity facility for banking institutions and, occasionally, for other financial institutions as well. Finally, the payments system, a crucial link in any financial system, generally includes some form of official regulation of or participation in its operations. These important aspects of the safety net often feed into one or more of the functions performed by central banks. For this reason, the central bank usually plays a major role in the operation of one or more of these facets of the safety net. For example, the emergency liquidity facility is almost always the discount window of the central bank. In many countries -including Ireland and the United States -- the central bank also plays an important role in the supervision of banking institutions and in the oversight of payments system operations. The important role played by the central bank in helping to build and maintain confidence in the underlying stability of the financial system in turn implies that there must be a high degree of public confidence in the central bank itself. This brings me back full circle: achieving and maintaining that public confidence depends first and foremost on the success of the central bank in discharging its monetary policy responsibilities. A sound economy and sound money are virtually synonymous, which is why monetary policy stands at the center of central bank functions. The importance of monetary policy is also the reason why central banks need special independent status within the governments they serve. In my view, it is particularly critical that the central bank not be directly responsible for financing government budget deficits; such a responsibility can, over time, compromise the financial integrity of the central bank, and thereby, public confidence in it. Note, however, that even without any involvement in direct financing of government budget deficits, central banks have a major stake in the development and maintenance of a smoothly-functioning government securities market, which can provide substantial benefits to the economy beyond those emanating from private sector financing of government budget deficits. In closing, I want to stress that the commitment to price stability as the primary goal of monetary policy in no way implies that the health of the economy or of the financial system should be sacrificed. On the contrary, what is important to bear in mind is that by ensuring a stable price and financial environment, the central bank helps foster economic growth. I believe that no central bank can maintain price stability over the longer term without public support for the necessary policies. Only with the confidence of the public in their policies and their own lasting dedication to non-inflationary growth together with a well-functioning financial system can central banks succeed in achieving and maintaining price and financial stability.	---[PAGE_BREAK]--- Mr. McDonough assesses the role of the central bank in ensuring a stable price and financial environment and fostering sustainable growth Remarks by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough, at the Society of Investment Analysts in Dublin on 11/2/97. I am delighted to have the opportunity to address the Society of Investment Analysts here in Ireland, home of my forebears. In my remarks this evening, I want to say a few words on a topic of great importance to both our professions: the role of central banks in ensuring a stable price and financial environment, and fostering sustainable growth. I would also like to offer some thoughts on the importance of a safe and sound banking system for the wellbeing of the economy. As members of the financial community, we all recognize the importance of price stability to the successful long-run performance of the economy. Indeed, there now seems to be a worldwide convergence of views among central bankers and investors alike on the importance of price stability as the primary goal of monetary policy. For me personally, stable prices have always been the prism for making monetary policy decisions. As I see it, price stability must be viewed in a long-run context as an ongoing goal, not a one-time objective. That goal requires monetary policy to be oriented beyond the horizon of its immediate or near-term impact on inflation and the economy. The primary purpose of near-term policy actions should be to set the economy on a long-term, permanent path to price stability and sound economic growth. This orientation puts the focus of policy on inflation expectations over the long term -- the time horizon that is appropriate for most saving and investment decisions. Businesses and households are understandably concerned about the long-term consequences of inflation and price level uncertainty. This is the frame of reference reflected in the conceptual definition of price stability offered by the chairman of the Federal Reserve, Alan Greenspan -- that price stability is achieved when people do not consider inflation a factor in their business and economic decisions. Long-term inflation expectations must be anchored to a transparent and rigorous commitment by the central bank to a well-defined standard of price stability, and unavoidable deviations from the goal of price stability must be explained with reference to that standard. In my view, price stability is a means to an end -- the promotion of sustainable economic growth. Only with long-term price stability can the economy expect to achieve the maximum levels of productivity and living standards. Price stability is both important and desirable because a rising price level, even at moderate rates, imposes substantial economic costs on society. These costs emanate from a variety of sources, including: - increased uncertainty about the outcome of business decisions and profitability; - adverse effects on the cost of capital resulting from the interaction of inflation with the tax system; - $\quad$ reduced effectiveness of the price and market systems; and - $\quad$ distortions that create perverse incentives to engage in nonproductive activities. ---[PAGE_BREAK]--- As a former commercial banker, I am especially aware of the negative effects of one particular type of nonproductive activity induced by inflation's distortion of incentives -- the overinvestment of resources in the financial sector. It is well known that, in high-inflation economies, the resources diverted from productive activities to nonproductive financial transactions are enormous. But even moderate inflation rates can cause substantial diversion to nonproductive financial activities, and this diversion deserves greater attention than it often receives in economists' list of the costs of inflation. As I look back over the last ten years or so, I am pleased that the Federal Reserve and many other central banks have been successful in controlling price pressures and putting inflation on a long-run downward track. Success in dealing with inflation clearly enhances the credibility of monetary policy and policy makers. From my perspective, the continuing challenge for central banks is to ensure long-term credibility for monetary policy by sustaining low inflation environments. Central banks are generally better able to meet this challenge if they are substantially immunized from short-term political pressures, and are firmly committed to price stability as the overriding goal of monetary policy. Empirical research in recent years has shown that both the average rate of inflation and its variability tend to decline in tandem with increased independence for central banks. This is why so many governments, including those among the emerging market economies, have been providing their central banks with increased autonomy. Of course, it is possible to have low inflation or price stability even with a limited degree of legal central bank independence, but the record clearly shows that a country is more likely to have low inflation if its central bank is independent. One important reason for this is that the fiscal authorities in many countries have not proven to be highly disciplined. Of course, some would argue that focusing on price stability as the primary goal of monetary policy means that central banks would no longer be concerned about output or job growth. I believe this view simply is wrong. A stable price and financial environment almost certainly enhances the capacity of monetary policy to fight occasions of cyclical weakness in the economy. A central bank's commitment to price stability over the longer term does not mean that monetary policy can ignore the short-term impact of economic events. It is important to recognize that, even when an economy is set on the path to price stability, and price expectations are contained, it does not necessarily mean that all potential sources of inflationary shocks have been eliminated. Moreover, while there is no long-run trade-off between unemployment, or output, and inflation, both formal evidence and common sense observation on wage and price rigidities attest to the existence of such a trade-off in the short run. In the long run, however, monetary policy's impact is only on inflation; potential output primarily is determined by advances in technology, growth in human and physical capital and other real resources. Because of the uncertainty about the timing and significance of short-term monetary policy effects on economic activity, as well as all other uncertainties concerning the economy, there are always differences of view about the speed with which policy should be adjusted, and on the balance of risks in dealing with ongoing economic developments. These conflicts become more marked when an economy confronts supply shocks that drive up prices ---[PAGE_BREAK]--- sharply and suddenly -- such as the two oil shocks of the 1970s. In those circumstances, from my perspective, the appropriate course, consistent with maintaining longer term price stability, should be to bring inflation down somewhat gradually, as the economy adjusts to the shift in relative prices. As I see it, monetary policy must be formulated cautiously, and cannot ignore business cycle developments. In establishing price stability as the primary goal of monetary policy, therefore, it is best to recognize that monetary policy does affect output in the short run. A central bank can appropriately be assigned the task of promoting sustainable economic growth, while maintaining long-term price stability and ensuring the health of the financial system. This way of articulating policy goals has the advantage of meeting the public's need to understand the basis for monetary policy decisions, and may help, therefore, to enhance the democratic accountability of monetary policy. Once monetary policy is firmly committed to price stability, how can a central bank best reach that goal? Clearly, at an operational level, no single formula or implementation strategy can be expected to succeed in all countries and under all circumstances; possible approaches can take many different forms. The choices depend on a country's history, economic conditions, traditions and institutions. But all successful approaches share two important features: first, they focus on a long-term time horizon and, second, they provide a clear and public standard for the assessment of policy. What is most significant is not the specific way a central bank chooses to seek price stability, but rather the underlying commitment to that goal. While monetary policy aimed at long-run price stability is critical to fostering sustainable economic growth, central banks' role in promoting growth and, more generally, a healthy economy goes beyond the conduct of monetary policy. Through involvement in financial regulation and supervision, as well as in the oversight of payments system operations, central banks play a key role in preserving and enhancing the safety and soundness of the banking and financial system. All of these central bank functions are mutually dependent and, together, highlight the fact that the structure and workings of the banking system are integral to a country's financial stability and economic growth. Clearly, monetary policy cannot succeed in its mission if the underlying financial system is unstable. The importance of an efficient, safe and sound banking and financial system for a country's long-term economic prospects cannot be overstated. In any market economy, the banking and financial system plays a central role in mobilizing a society's savings and in channeling these savings into investment and other productive uses. This intermediation process is one of the core determinants of the pace of a country's economic development. Moreover, the banking and financial system must facilitate transactions in an economy by ensuring that they can be effected safely and swiftly on an ongoing basis. Both buyers and sellers of goods and services must have confidence that instruments used to make payments will be honored and accepted by all parties. These crucial functions of transforming savings into productive uses and making payments are often taken for granted. But, in fact, it can be difficult to ensure that the legal and institutional framework within which these functions are performed is consistent with the often conflicting goals of free choice, economic efficiency, safety and financial market stability. ---[PAGE_BREAK]--- Experience has proven that there is no easy way to shape financial institutions in a manner that appropriately balances these goals under changing economic conditions. Today, numerous countries -- including Ireland and the United States -- are considering which paths to follow in reforming and modernizing their banking industries. These deliberations are of great importance, because a well-functioning and stable banking and financial system is a critical foundation for long-run growth and prosperity of an economy. And such reform is inevitably difficult, for reasons which are a classic blend of political and economic considerations rooted in the crucial functions the banking system must perform in a market economy. Moreover, banking system reform is made all the more challenging by the fact that such reforms cannot be viewed in isolation from reforms in the central bank, or independent of those in the capital markets. In fact, the greatest challenge may lie in forging these individual pieces in such a way that they fit together in a cohesive whole that serves the dictates of stability, growth, and public confidence. For a financial system to mobilize and allocate a society's savings successfully and facilitate day-to-day transactions, there must be a class of financial institutions and instruments that the public views as safe and convenient outlets for its savings. Of course, the single dominant class of institution that performs this crucial dual role as repository of a large part of society's liquid savings, and the entity through which payments are made is the commercial bank. This is true even in countries with highly developed capital markets, especially when it is kept in mind that participants in the capital markets rely heavily on the banking system for their financing facilities. Banks cannot play an effective role in the financial intermediation process unless the public has the utmost confidence in the banking system. This confidence is a key reason why banking institutions and banking instruments are crucial to a country's economic growth and development. The combination of functions typically provided by commercial banks, however, also carries with it the risk that a loss of confidence in an individual institution can spread to the system as a whole, the so-called systemic risk phenomenon. Instances in which a country experiences a loss of confidence in its financial institutions usually result in major damage to the economy. Given the indispensable role that financial institutions play in the success of a country's economy, governments clearly have a responsibility to subject financial institutions to some form of regulation or oversight. But here again, there is need for balance. Restrictions placed on banks by the financial oversight apparatus cannot be allowed to discourage risk-taking per se, because risk-taking is an inherent part of banking and finance in market economies. To perform successfully, a commercial banking system requires a delicate balance between risk-taking and maintaining public confidence. Because of the importance and the difficulties inherent in the balancing act, banking systems are generally subject to a higher degree of official oversight and regulation than are most other forms of private enterprise, and supported by some form of a broad safety net. While the specifics can differ appreciably across countries, these safety nets are usually constructed along similar lines. They generally include oversight of the affairs of banking institutions in the form of inspection and examination of the institutions for compliance with a broad set of safety and soundness standards; some type of protection against losses for ---[PAGE_BREAK]--- small depositors and investors; and some form of emergency liquidity facility for banking institutions and, occasionally, for other financial institutions as well. Finally, the payments system, a crucial link in any financial system, generally includes some form of official regulation of or participation in its operations. These important aspects of the safety net often feed into one or more of the functions performed by central banks. For this reason, the central bank usually plays a major role in the operation of one or more of these facets of the safety net. For example, the emergency liquidity facility is almost always the discount window of the central bank. In many countries -including Ireland and the United States -- the central bank also plays an important role in the supervision of banking institutions and in the oversight of payments system operations. The important role played by the central bank in helping to build and maintain confidence in the underlying stability of the financial system in turn implies that there must be a high degree of public confidence in the central bank itself. This brings me back full circle: achieving and maintaining that public confidence depends first and foremost on the success of the central bank in discharging its monetary policy responsibilities. A sound economy and sound money are virtually synonymous, which is why monetary policy stands at the center of central bank functions. The importance of monetary policy is also the reason why central banks need special independent status within the governments they serve. In my view, it is particularly critical that the central bank not be directly responsible for financing government budget deficits; such a responsibility can, over time, compromise the financial integrity of the central bank, and thereby, public confidence in it. Note, however, that even without any involvement in direct financing of government budget deficits, central banks have a major stake in the development and maintenance of a smoothly-functioning government securities market, which can provide substantial benefits to the economy beyond those emanating from private sector financing of government budget deficits. In closing, I want to stress that the commitment to price stability as the primary goal of monetary policy in no way implies that the health of the economy or of the financial system should be sacrificed. On the contrary, what is important to bear in mind is that by ensuring a stable price and financial environment, the central bank helps foster economic growth. I believe that no central bank can maintain price stability over the longer term without public support for the necessary policies. Only with the confidence of the public in their policies and their own lasting dedication to non-inflationary growth together with a well-functioning financial system can central banks succeed in achieving and maintaining price and financial stability.	William J McDonough	United States	https://www.bis.org/review/r970227d.pdf	Mr. McDonough assesses the role of the central bank in ensuring a stable price and financial environment and fostering sustainable growth Remarks by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough, at the Society of Investment Analysts in Dublin on 11/2/97. I am delighted to have the opportunity to address the Society of Investment Analysts here in Ireland, home of my forebears. In my remarks this evening, I want to say a few words on a topic of great importance to both our professions: the role of central banks in ensuring a stable price and financial environment, and fostering sustainable growth. I would also like to offer some thoughts on the importance of a safe and sound banking system for the wellbeing of the economy. As members of the financial community, we all recognize the importance of price stability to the successful long-run performance of the economy. Indeed, there now seems to be a worldwide convergence of views among central bankers and investors alike on the importance of price stability as the primary goal of monetary policy. For me personally, stable prices have always been the prism for making monetary policy decisions. As I see it, price stability must be viewed in a long-run context as an ongoing goal, not a one-time objective. That goal requires monetary policy to be oriented beyond the horizon of its immediate or near-term impact on inflation and the economy. The primary purpose of near-term policy actions should be to set the economy on a long-term, permanent path to price stability and sound economic growth. This orientation puts the focus of policy on inflation expectations over the long term -- the time horizon that is appropriate for most saving and investment decisions. Businesses and households are understandably concerned about the long-term consequences of inflation and price level uncertainty. This is the frame of reference reflected in the conceptual definition of price stability offered by the chairman of the Federal Reserve, Alan Greenspan -- that price stability is achieved when people do not consider inflation a factor in their business and economic decisions. Long-term inflation expectations must be anchored to a transparent and rigorous commitment by the central bank to a well-defined standard of price stability, and unavoidable deviations from the goal of price stability must be explained with reference to that standard. In my view, price stability is a means to an end -- the promotion of sustainable economic growth. Only with long-term price stability can the economy expect to achieve the maximum levels of productivity and living standards. Price stability is both important and desirable because a rising price level, even at moderate rates, imposes substantial economic costs on society. These costs emanate from a variety of sources, including: increased uncertainty about the outcome of business decisions and profitability;. adverse effects on the cost of capital resulting from the interaction of inflation with the tax system;. $\quad$ reduced effectiveness of the price and market systems; and. $\quad$ distortions that create perverse incentives to engage in nonproductive activities. As a former commercial banker, I am especially aware of the negative effects of one particular type of nonproductive activity induced by inflation's distortion of incentives -- the overinvestment of resources in the financial sector. It is well known that, in high-inflation economies, the resources diverted from productive activities to nonproductive financial transactions are enormous. But even moderate inflation rates can cause substantial diversion to nonproductive financial activities, and this diversion deserves greater attention than it often receives in economists' list of the costs of inflation. As I look back over the last ten years or so, I am pleased that the Federal Reserve and many other central banks have been successful in controlling price pressures and putting inflation on a long-run downward track. Success in dealing with inflation clearly enhances the credibility of monetary policy and policy makers. From my perspective, the continuing challenge for central banks is to ensure long-term credibility for monetary policy by sustaining low inflation environments. Central banks are generally better able to meet this challenge if they are substantially immunized from short-term political pressures, and are firmly committed to price stability as the overriding goal of monetary policy. Empirical research in recent years has shown that both the average rate of inflation and its variability tend to decline in tandem with increased independence for central banks. This is why so many governments, including those among the emerging market economies, have been providing their central banks with increased autonomy. Of course, it is possible to have low inflation or price stability even with a limited degree of legal central bank independence, but the record clearly shows that a country is more likely to have low inflation if its central bank is independent. One important reason for this is that the fiscal authorities in many countries have not proven to be highly disciplined. Of course, some would argue that focusing on price stability as the primary goal of monetary policy means that central banks would no longer be concerned about output or job growth. I believe this view simply is wrong. A stable price and financial environment almost certainly enhances the capacity of monetary policy to fight occasions of cyclical weakness in the economy. A central bank's commitment to price stability over the longer term does not mean that monetary policy can ignore the short-term impact of economic events. It is important to recognize that, even when an economy is set on the path to price stability, and price expectations are contained, it does not necessarily mean that all potential sources of inflationary shocks have been eliminated. Moreover, while there is no long-run trade-off between unemployment, or output, and inflation, both formal evidence and common sense observation on wage and price rigidities attest to the existence of such a trade-off in the short run. In the long run, however, monetary policy's impact is only on inflation; potential output primarily is determined by advances in technology, growth in human and physical capital and other real resources. Because of the uncertainty about the timing and significance of short-term monetary policy effects on economic activity, as well as all other uncertainties concerning the economy, there are always differences of view about the speed with which policy should be adjusted, and on the balance of risks in dealing with ongoing economic developments. These conflicts become more marked when an economy confronts supply shocks that drive up prices sharply and suddenly -- such as the two oil shocks of the 1970s. In those circumstances, from my perspective, the appropriate course, consistent with maintaining longer term price stability, should be to bring inflation down somewhat gradually, as the economy adjusts to the shift in relative prices. As I see it, monetary policy must be formulated cautiously, and cannot ignore business cycle developments. In establishing price stability as the primary goal of monetary policy, therefore, it is best to recognize that monetary policy does affect output in the short run. A central bank can appropriately be assigned the task of promoting sustainable economic growth, while maintaining long-term price stability and ensuring the health of the financial system. This way of articulating policy goals has the advantage of meeting the public's need to understand the basis for monetary policy decisions, and may help, therefore, to enhance the democratic accountability of monetary policy. Once monetary policy is firmly committed to price stability, how can a central bank best reach that goal? Clearly, at an operational level, no single formula or implementation strategy can be expected to succeed in all countries and under all circumstances; possible approaches can take many different forms. The choices depend on a country's history, economic conditions, traditions and institutions. But all successful approaches share two important features: first, they focus on a long-term time horizon and, second, they provide a clear and public standard for the assessment of policy. What is most significant is not the specific way a central bank chooses to seek price stability, but rather the underlying commitment to that goal. While monetary policy aimed at long-run price stability is critical to fostering sustainable economic growth, central banks' role in promoting growth and, more generally, a healthy economy goes beyond the conduct of monetary policy. Through involvement in financial regulation and supervision, as well as in the oversight of payments system operations, central banks play a key role in preserving and enhancing the safety and soundness of the banking and financial system. All of these central bank functions are mutually dependent and, together, highlight the fact that the structure and workings of the banking system are integral to a country's financial stability and economic growth. Clearly, monetary policy cannot succeed in its mission if the underlying financial system is unstable. The importance of an efficient, safe and sound banking and financial system for a country's long-term economic prospects cannot be overstated. In any market economy, the banking and financial system plays a central role in mobilizing a society's savings and in channeling these savings into investment and other productive uses. This intermediation process is one of the core determinants of the pace of a country's economic development. Moreover, the banking and financial system must facilitate transactions in an economy by ensuring that they can be effected safely and swiftly on an ongoing basis. Both buyers and sellers of goods and services must have confidence that instruments used to make payments will be honored and accepted by all parties. These crucial functions of transforming savings into productive uses and making payments are often taken for granted. But, in fact, it can be difficult to ensure that the legal and institutional framework within which these functions are performed is consistent with the often conflicting goals of free choice, economic efficiency, safety and financial market stability. Experience has proven that there is no easy way to shape financial institutions in a manner that appropriately balances these goals under changing economic conditions. Today, numerous countries -- including Ireland and the United States -- are considering which paths to follow in reforming and modernizing their banking industries. These deliberations are of great importance, because a well-functioning and stable banking and financial system is a critical foundation for long-run growth and prosperity of an economy. And such reform is inevitably difficult, for reasons which are a classic blend of political and economic considerations rooted in the crucial functions the banking system must perform in a market economy. Moreover, banking system reform is made all the more challenging by the fact that such reforms cannot be viewed in isolation from reforms in the central bank, or independent of those in the capital markets. In fact, the greatest challenge may lie in forging these individual pieces in such a way that they fit together in a cohesive whole that serves the dictates of stability, growth, and public confidence. For a financial system to mobilize and allocate a society's savings successfully and facilitate day-to-day transactions, there must be a class of financial institutions and instruments that the public views as safe and convenient outlets for its savings. Of course, the single dominant class of institution that performs this crucial dual role as repository of a large part of society's liquid savings, and the entity through which payments are made is the commercial bank. This is true even in countries with highly developed capital markets, especially when it is kept in mind that participants in the capital markets rely heavily on the banking system for their financing facilities. Banks cannot play an effective role in the financial intermediation process unless the public has the utmost confidence in the banking system. This confidence is a key reason why banking institutions and banking instruments are crucial to a country's economic growth and development. The combination of functions typically provided by commercial banks, however, also carries with it the risk that a loss of confidence in an individual institution can spread to the system as a whole, the so-called systemic risk phenomenon. Instances in which a country experiences a loss of confidence in its financial institutions usually result in major damage to the economy. Given the indispensable role that financial institutions play in the success of a country's economy, governments clearly have a responsibility to subject financial institutions to some form of regulation or oversight. But here again, there is need for balance. Restrictions placed on banks by the financial oversight apparatus cannot be allowed to discourage risk-taking per se, because risk-taking is an inherent part of banking and finance in market economies. To perform successfully, a commercial banking system requires a delicate balance between risk-taking and maintaining public confidence. Because of the importance and the difficulties inherent in the balancing act, banking systems are generally subject to a higher degree of official oversight and regulation than are most other forms of private enterprise, and supported by some form of a broad safety net. While the specifics can differ appreciably across countries, these safety nets are usually constructed along similar lines. They generally include oversight of the affairs of banking institutions in the form of inspection and examination of the institutions for compliance with a broad set of safety and soundness standards; some type of protection against losses for small depositors and investors; and some form of emergency liquidity facility for banking institutions and, occasionally, for other financial institutions as well. Finally, the payments system, a crucial link in any financial system, generally includes some form of official regulation of or participation in its operations. These important aspects of the safety net often feed into one or more of the functions performed by central banks. For this reason, the central bank usually plays a major role in the operation of one or more of these facets of the safety net. For example, the emergency liquidity facility is almost always the discount window of the central bank. In many countries -including Ireland and the United States -- the central bank also plays an important role in the supervision of banking institutions and in the oversight of payments system operations. The important role played by the central bank in helping to build and maintain confidence in the underlying stability of the financial system in turn implies that there must be a high degree of public confidence in the central bank itself. This brings me back full circle: achieving and maintaining that public confidence depends first and foremost on the success of the central bank in discharging its monetary policy responsibilities. A sound economy and sound money are virtually synonymous, which is why monetary policy stands at the center of central bank functions. The importance of monetary policy is also the reason why central banks need special independent status within the governments they serve. In my view, it is particularly critical that the central bank not be directly responsible for financing government budget deficits; such a responsibility can, over time, compromise the financial integrity of the central bank, and thereby, public confidence in it. Note, however, that even without any involvement in direct financing of government budget deficits, central banks have a major stake in the development and maintenance of a smoothly-functioning government securities market, which can provide substantial benefits to the economy beyond those emanating from private sector financing of government budget deficits. In closing, I want to stress that the commitment to price stability as the primary goal of monetary policy in no way implies that the health of the economy or of the financial system should be sacrificed. On the contrary, what is important to bear in mind is that by ensuring a stable price and financial environment, the central bank helps foster economic growth. I believe that no central bank can maintain price stability over the longer term without public support for the necessary policies. Only with the confidence of the public in their policies and their own lasting dedication to non-inflationary growth together with a well-functioning financial system can central banks succeed in achieving and maintaining price and financial stability.
1997-02-13T00:00:00	Mr. Greenspan presents the views of the Federal Reserve Board on some broad issues associated with financial modernization (Central Bank Articles and Speeches, 13 Feb 97)	Testimony of the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Banking and Financial Services of the US House of Representatives on 13/2/97.	Mr. Greenspan presents the views of the Federal Reserve Board on some broad issues associated with financial modernization Testimony of the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Banking and Financial Services of the US House of Representatives on 13/2/97. Madam Chairwoman, members of the Subcommittee on Financial Institutions and Consumer Credit, it is a pleasure to appear here today to present the views of the Federal Reserve Board on some broad issues associated with financial modernization. The unremitting pressures of technology and the market are drastically changing the financial landscape and eroding traditional positions of competitors, inducing new competitive strategies and participants, forcing new regulatory responses, and building pressures on the Congress to shape developments in the public interest. Madam Chairwoman, I know that you have been an active sponsor and supporter of legislation to modernize the financial system. The Board also has been a strong proponent both of expanded financial activities for banking organizations and enhanced opportunities for nonbank financial institutions to enter banking. We continue to support financial modernization because we believe it would provide improved financial services for our citizens. Moreover, both our experience and analysis suggest that the additional risks of new financial products are modest and manageable. Indeed, technology already has resulted in a blurring of product and service-defining lines so dramatic as to make many financial products virtually indistinguishable from each other and the old rules inapplicable. In the process, we have already seen the public benefits, benefits that removal of old barriers could only enhance. But, as we proceed down the path of reform, reforms both desired for their benefits to the public and required by global markets and new technologies, the Board urges that any modifications be tested against certain standards. In particular, the Board believes that the changes we adopt should be consistent with (1) continuing the safety and soundness of the banking system; (2) limiting systemic risks; (3) contributing to macroeconomic stability; and (4) limiting the spread of both the moral hazard and the subsidy implicit in the safety net. Thus, if my comments today sound cautious, I want the subcommittee to understand that my observations do not reflect opposition to further freeing of constraints on financial competition. To the contrary. We strongly urge an extensive increase in the activities permitted to banking organizations and other financial institutions, provided these activities are financed at nonsubsidized market rates and do not pose unacceptable risks to our financial system. While a level playing field requires broader powers, it does not require subsidized ones. Safety Net Implications In this century the Congress has delegated the use of the sovereign credit -- the power to create money and borrow unlimited funds at the lowest possible rate -- to support the banking system. It has done so indirectly as a consequence of deposit insurance, Federal Reserve discount window access, and final riskless settlement of payment system transactions. The public policy purpose was to protect depositors, stem bank runs, and lower the level of risk to the financial system from the insolvency of individual institutions. In insuring depositors, the government, through the FDIC, substituted its unsurpassable credit rating for those of banks. Similarly, provisions of the Federal Reserve Act enabled banks to convert illiquid assets, such as loans, into riskless assets (deposits at the central bank) through the discount window, and to complete payments using Federal Reserve credits. All these uses of the sovereign credit have dramatically improved the soundness of our banking system and the public's confidence in it. In the process, it has profoundly altered the risks and returns in banking. Sovereign credit guarantees have significantly reduced the amount of capital that banks and other depositories need to hold, since creditors demand less of a buffer to protect themselves from the failure of institutions that are the beneficiaries of such guarantees. In different language, these entities have been able to operate with a much higher degree of leverage -- that is, to obtain more of their funds from other than the owners of the organization -- than virtually all other financial institutions. At the same time, depositories have been able to take greater risk in their portfolios than would otherwise be the case, because private creditors -- depositors and others -- are less affected by the illiquidity of, or losses on, the banks' portfolios. The end result has been a higher risk-adjusted rate of return on depository institution equity. Moreover, the enhanced ability to take risk has contributed to economic growth, while the discount window and deposit insurance have contributed to our macroeconomic stability. But all good things have their price. The use of the sovereign credit in banking -- even its potential use -- creates a moral hazard that distorts the incentives for banks: the banks determine the level of risk-taking and receive the gains therefrom, but do not bear the full costs of that risk. The remainder of the risk is transferred to the government. This then creates the necessity for the government to limit the degree of risk it absorbs by writing rules under which banks operate, and imposing on these entities supervision by its agents -- the banking regulators -- to assure adherence to these rules. The experience in the 1980s with many insured thrift institutions showed just how dangerous lax enforcement of supervisory rules can be. In the end, some hard lessons were learned, many of which were legislated into the FDIC Improvement Act of 1991. The subsidy to the banking and other depositories created by the use of the unsurpassable sovereign credit rating of the United States government is an undesirable but unavoidable consequence of creating a safety net. Indeed, one measure of the effectiveness of a safety net is our ability to minimize the subsidy and limit its incidence outside of the area to which it was directed. Some of the value of the subsidy has been passed to depositors of, and borrowers from, banks, for example, as well as to the original bank shareholders. But, the United States government has been remarkably successful in containing the value of most of the subsidy within depository institutions. The bank holding company organizational structure has, on balance, provided an effective means of limiting the use of the sovereign credit subsidy by other parts of the banking organization. To be sure, bank holding companies have indirectly benefited from the subsidy because their major assets are subsidiary banks. The value of the subsidy given to the subsidiary banks has no doubt been capitalized in part into the share prices of holding companies and has improved their debt ratings, lowering their cost of capital. But, holding companies also own nonsubsidized entities that have no direct access to the safety net. Accordingly, both bank holding companies and their nonbank subsidiaries have a higher cost of capital than banks. This is clear in the debt ratings of bank subsidiaries of bank holding companies, which are virtually always higher than those of their parent holding companies. Moreover, existing law and regulation under Sections 23A and 23B of the Federal Reserve Act require that any credit extended by a bank to its parent or affiliate not only be totally collateralized and subject to quantitative limits, but also be extended at arms-length and at market rates, making a direct transfer of the safety net subsidy difficult. It is true that a bank could pay dividends from its earnings, earnings which have been enhanced by the safety net subsidy, to fund its parent's nonbank affiliates. However, the evidence appears to be that such transfers generally do not occur. Existing holding company powers are limited and do not offer a broad spectrum of profitable opportunities. Accordingly, it is not surprising that data for the top 50 bank holding companies indicate that transfers from bank subsidiaries to their parents which, like dividends, embody the subsidy, appear to have approximately equaled holding company net transfers to their own shareholders and long-term creditors. This indicates that few subsidized dollars in the aggregate found their way into the equity accounts of holding company nonbank affiliates from the upstreaming of bank funds. We must, I think, be continually on guard that the subsidy provided by the safety net does not leak outside the institutions for which it was intended and provide a broad subsidy to other kinds of activities. Put another way, we must remain especially vigilant in maintaining a proper balance between a safety net that fosters economic and financial stabilization and one that benefits the competitive position of private businesses for no particular public purpose. As I noted, safety net subsidies have costs in terms of distorted incentives and misallocated resources. That is why the Congress must be cautious in how the sovereign credit is used. It has been suggested that the bank holding company structure imposes inefficiencies on banking organizations, and that these organizations should thus be given the option of conducting expanded financial activities in a direct subsidiary of the bank. The bank subsidiary may be a marginally more efficient way of delivering such services, but we believe it cannot avoid being a funnel for transferring the sovereign credit subsidy directly from the bank to finance the new powers, thereby imparting a subsidized competitive advantage to the subsidiary of the bank. One can devise rules -- such as 23A and 23B -- to assure that loans from the bank to its own subsidiaries are limited and at market rates. One can even devise rules to limit the aggregate equity investment made by banks in their subsidiaries. But one cannot eliminate the fact that the equity invested in subsidiaries is funded by the sum of insured deposits and other bank borrowings that directly benefit from the subsidy of the safety net. Thus, inevitably, a bank subsidiary must have lower costs of capital than an independent entity and even a subsidiary of the bank's parent. Indeed, one would expect that a rational banking organization would, as much as possible, shift its nonbank activity from the bank holding company structure to the bank subsidiary structure. Such a shift from affiliates to bank subsidiaries would increase the subsidy and the competitive advantage of the entire banking organization relative to its nonbank competitors. I am aware that these are often viewed as only highly technical issues, and hence ones that are in the end, of little significance. I do not think so. The issue of the use of the sovereign credit is central to how our financial system will allocate credit, and hence real resources, the kinds of risk it takes, and the degree of supervision it requires. If the Congress wants to extend the use of the sovereign credit further, to achieve a wider range over which the benefits of doing so can accrue, it ought to make that decision explicitly, and accept the consequences of the subsidy on the financial system that come with it. But, it should not, in the name of some technical change, or in search of some minor efficiency, inadvertently expand the use of the sovereign credit. This issue would not be so important were we not in the process of addressing what must surely be a watershed in the revamping of our regulatory structure. We must avoid inadvertently extending the safety net and its associated subsidy without a thorough understanding of the implications of such an extension to the competitive balance and systemic risks of our financial system. Central to the Board's choice of a financial structure is its desire for one that will be most effective in fostering both a viable financial system and a vibrant economy. These objectives, in our view, would be thwarted if the safety net subsidy directly benefited new activities. With the safety net comes the moral hazard of which I spoke earlier, and its attendant misallocation of resources, and uneven competitive playing field. If the government subsidies directed to banks were channeled to bank subsidiaries, in my judgement, both the benefits and enumerated costs to the financial system and the public would occur. If banks were permitted to engage in new activities in their own subsidiaries, inevitably virtually all holding companies would shift those activities now conducted in holding company affiliates to bank subsidiaries, eviscerating the holding company structure. Were such shifts to happen solely as the result of operational efficiencies, no one, including the Board, should mourn the demise of the holding company. But if, as I suspect, such shifts occurred because of the attraction of a government subsidy, we should be concerned because the insidious effects of such subsidies would have spread. The evidence from flows between banks and their parents, relative bond ratings, and the administration of Sections 23A and B of the Federal Reserve Act, all strongly suggest that the holding company structure is far more capable of containing the sovereign credit subsidy whose purpose is support of the safety net, not providing expanded competitive advantage. As new activities hopefully expand for banking organizations, we believe that it is essential that we assure they are financed at market rates, not subsidized ones. This will not always be easy. Containment of subsidies is often implemented through firewalls and other devices which could also inhibit the very synergies which the expansion of activities is meant to achieve. But we have dealt with these trade-offs before and should be able to in the future as well. Umbrella Supervision Whether new activities are authorized in bank subsidiaries, bank holding companies, or both, Congress, in its review of financial modernization, must consider legal entity supervision versus umbrella supervision. The Board believes that umbrella supervision is a realistic necessity for the protection of our financial system and to limit any misuse of the sovereign credit. The bank holding company organization is increasingly being managed so as to take advantage of the synergies between its component parts in order to deliver better products to the market and higher returns to stockholders. Such synergies cannot occur if the model of the holding company is one in which the parent is just, in effect, a portfolio investor in its subsidiary. Indeed, virtually all of the large holding companies now operate as integrated units and are managed as such. As bank holding companies began to widen their activities, and as new technologies permitted not only the development of new products but also the systems for controlling them, the banking organization was impelled to develop centralized risk control techniques that crossed legal entities. Today, risk management for the entire company is increasingly centralized not only at the larger and more sophisticated banking organizations, but at other large financial services providers as well. This development reflects the demands of the marketplace, which views banks and their affiliates and other financial businesses and their affiliates as integrated organizations in terms of financial condition, management, and reputation. To understand the risk controls of the bank, we have first to come to grips with the fact that the organization is interested in risk and its control, not by instrument or legal entity, but for the entire business. This type of control is being adopted by more and more organizations each year, and can only increase as more activities are authorized by the regulators and the Congress. Regulatory policies and operating procedures have had to respond to these realities, to focus on the process of decisionmaking for the total organization. Thus, the Federal Reserve -- the historical umbrella supervisor -- also has found it necessary to concentrate more on the process that banking organizations use to manage market, credit, operating and exchange rate risk, and less on the traditional after-the-fact evaluation of balance sheets that can and often do change dramatically the day after they have been reviewed by the supervisors. In such a world, process, if not everything, is critical, and that process is determined increasingly at the parent holding company for all of the units of the organization on a consolidated basis. One could argue -- as several witnesses appearing before this subcommittee did on Tuesday -- that regulators should only be interested in the entities they regulate and, hence, review the risk evaluation process only as it relates to their regulated entity. Presumably each regulator of each entity -- the bank regulators, the SEC, the state insurance and finance company authorities -- would look only at how the risk management process affected their units. It is our belief that this simply will not be adequate. Risks managed on a consolidated basis cannot be reviewed on an individual legal entity basis by different supervisors. Indeed, our experience has been that a problem in one legal entity can have a contagion effect in other entities. If a bank affiliate begins to have difficulty, the market evaluates the problem as the consolidated entity's problem and can bring pressure on all the units. These pressures usually take the form of funding or liquidity difficulties, as creditors seek to reduce their exposure to all units of an organization that seems to be having trouble. Better safe than sorry. Indeed, it is in the cauldron of the payments and settlement system, where decisions involving large sums must be made in short periods, that this contagion effect might be first seen as participants understandably seek to protect themselves from the uncertainty that accompanies this contagion effect. And that is how crises often begin. These concerns were part of the motivation for the congressional decision just five years ago to require that foreign banks could enter the United States if, and only if, they were subject to consolidated supervision. This decision, which is consistent with the international standards for consolidated supervision of banking organizations, was a good decision then. It is a good decision today, especially for those banking organizations whose disruption could cause major financial disturbances in United States and foreign markets. For foreign and for U.S. banking organizations, retreat from consolidated supervision would, the Board believes, be a significant step backward. We have to be careful, however, that consolidated umbrella supervision does not inadvertently so hamper the decisionmaking process of banking organizations as to render them ineffectual. The Federal Reserve Board is accordingly in the process of reviewing its supervisory structure and other procedures in order to reflect the aforementioned market-directed shift from conventional balance sheet auditing to evaluation of the internal risk management process. Although focused on the key risk management processes, it would sharply reduce routine supervisory umbrella presence in holding companies. As the committee knows, the Board has recently published for comment proposals to expedite the applications process, and the legislation Congress enacted last year eased such procedures as well. Nonetheless, the Board requests even greater modification to its existing statutory mandate so that the required applications process could be sharply cut back, particularly in the area of nonbank financial services. We would hope that should the Congress authorize wider activities for financial services holding companies that it recognize that a bank which is a minor part of such an organization (and its associated safety net) can be protected through adequate bank capital requirements and the application of Sections 23A and 23B of the Federal Reserve Act. The case is weak, in our judgment, for umbrella supervision of a holding company which, because it owns only a small bank, does not have material access to the safety net. As I noted when discussing the safety net and bank subsidiaries, attached to all uses of the sovereign credit come efforts by the government to protect the taxpayer. Those entities interested in banks are really interested in access to the safety net, since it is far easier to engage in the nonsafety net activities of banks without acquiring a bank. If an organization chooses to deliver some of its services with the aid of the sovereign credit by acquiring a bank, it should not be excused from efforts of the government to look out for the stability of the overall financial system. For bank holding companies that own more than a small bank, this implies umbrella supervision. Although that process will increasingly be designed to reduce supervisory presence and be as nonintrusive as possible, umbrella supervision should not be eliminated, but recognized for what it is: the cost of obtaining a subsidy. Banking and Commerce Finally, let me turn to an issue that has bedeviled supervisory and regulatory discussions for years: the potential separation of commerce and banking. As I indicated earlier, it is clear that rapidly changing technologies are altering the nature of what constitutes finance. Indeed, just as the lines between banking and other financial institutions are often already difficult to discern, the boundaries between finance and nonfinance are likely to become increasingly indistinct as we move into the 21st century. For example, computer and software firms will certainly be offering ever more sophisticated financial products. And doubtless financial firms will be offering an increasingly sophisticated array of nonfinancial services. In addition, some of the financial firms who mainly produce products and services that many observers believe should be permissible to banks are also engaged in, or affiliated with, nonfinancial businesses. Newer technologies will make it highly unlikely that the walling off of any ownership of financial institutions by nonfinancial businesses and vice-versa can be continued very far into the 21st century. Nonetheless, the Board has concluded that it would be wise to move with caution in addressing the removal of the current legal barriers between commerce and banking. The free and open legal association of banking and commerce would be a profound and surely irreversible structural change in the American economy. Hence, we must be careful to assure ourselves that whatever changes are made in our supervisory structure, that it not distort our evolution to the most efficient financial structure as we move into the next century. Were we fully confident of how the structure would evolve, we could presumably construct today the regulations which would foster that evolution. But we cannot be certain. We thus run the risk of locking in a set of inappropriate regulations that could adversely alter the development of market structures. We cannot be confident we know what the true synergies between finance and nonfinance will be in ten or even five years. Our ability to foresee accurately the future implications of technologies and market developments in banking, as in other industries, has not been particularly impressive. As Professor Rosenberg of Stanford University has pointed out, ". . . mistaken forecasts of future structure litter our financial landscape." Consider the view of the 1960s that the "cashless society" was imminent. Nonetheless, the public preference for paper has declined only gradually. Similarly, just a few years ago conventional wisdom argued that banks were dinosaurs that were becoming extinct. The reality today is far from it. Even more recently, it was argued that banks and nonfinancial firms had to merge in order to save the capital-starved banking system. Today, as you know, virtually all of our banks are very well capitalized. All these examples suggest that if we change the rules now about banking and commerce under circumstances of uncertainty about future synergies between finance and nonfinance, we might end up doing more harm than good. And, as with all rule changes by government, we are likely to find it impossible to correct our errors promptly. Modifications of such a fundamental structural rule as the separation of banking and commerce should accordingly proceed at a deliberate pace, testing the response of markets and technological innovation to the altered rules in the years ahead. The public needs to have confidence in the regulatory structure, implying that we proceed slowly and cautiously. Excessive delay, however, would doubtless produce some inequities. Expanded financial activities for banking organizations requires, the Board believes, that those firms operating in markets that banks can enter should, in turn, be authorized to engage in banking. However, some of these nonbanking financial firms already own -- or are owned by -nonfinancial entities. A complete commerce and banking prohibition would thus require the divestiture of all nonfinancial activities by those organizations that wanted to acquire or establish banks. The principle of caution suggests an approach which may prove useful. Perhaps those organizations that either have or establish well-capitalized and well-managed bank subsidiaries should be permitted a small basket of nonfinancial assets -- a certain percentage of either consolidated assets or capital. A small permissible basket would establish, in effect, a pilot program to evaluate the efficacy of further breaching of the banking and commerce wall. We found that such a slow and deliberate policy worked well with Section 20 affiliates. Of course, some nonbanking firms would find that their nonfinancial activities would exceed a small basket exemption. Such excess nonconforming assets might be addressed on a case-by-case basis with a scheduled longer-term divestiture to avoid the worst short-term inequities. A basket clause plus case-by-case review of individual situations might also provide a way to make available a common bank and thrift charter to those unitary thrifts that are affiliated with nonfinancial businesses. The Board has no firm opinion on just exactly how such trade-offs might be made, constrained only by the general concerns I summarized earlier.	---[PAGE_BREAK]--- # Mr. Greenspan presents the views of the Federal Reserve Board on some broad issues associated with financial modernization Testimony of the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Banking and Financial Services of the US House of Representatives on 13/2/97. Madam Chairwoman, members of the Subcommittee on Financial Institutions and Consumer Credit, it is a pleasure to appear here today to present the views of the Federal Reserve Board on some broad issues associated with financial modernization. The unremitting pressures of technology and the market are drastically changing the financial landscape and eroding traditional positions of competitors, inducing new competitive strategies and participants, forcing new regulatory responses, and building pressures on the Congress to shape developments in the public interest. Madam Chairwoman, I know that you have been an active sponsor and supporter of legislation to modernize the financial system. The Board also has been a strong proponent both of expanded financial activities for banking organizations and enhanced opportunities for nonbank financial institutions to enter banking. We continue to support financial modernization because we believe it would provide improved financial services for our citizens. Moreover, both our experience and analysis suggest that the additional risks of new financial products are modest and manageable. Indeed, technology already has resulted in a blurring of product and service-defining lines so dramatic as to make many financial products virtually indistinguishable from each other and the old rules inapplicable. In the process, we have already seen the public benefits, benefits that removal of old barriers could only enhance. But, as we proceed down the path of reform, reforms both desired for their benefits to the public and required by global markets and new technologies, the Board urges that any modifications be tested against certain standards. In particular, the Board believes that the changes we adopt should be consistent with (1) continuing the safety and soundness of the banking system; (2) limiting systemic risks; (3) contributing to macroeconomic stability; and (4) limiting the spread of both the moral hazard and the subsidy implicit in the safety net. Thus, if my comments today sound cautious, I want the subcommittee to understand that my observations do not reflect opposition to further freeing of constraints on financial competition. To the contrary. We strongly urge an extensive increase in the activities permitted to banking organizations and other financial institutions, provided these activities are financed at nonsubsidized market rates and do not pose unacceptable risks to our financial system. While a level playing field requires broader powers, it does not require subsidized ones. ## Safety Net Implications In this century the Congress has delegated the use of the sovereign credit -- the power to create money and borrow unlimited funds at the lowest possible rate -- to support the banking system. It has done so indirectly as a consequence of deposit insurance, Federal Reserve discount window access, and final riskless settlement of payment system transactions. The public policy purpose was to protect depositors, stem bank runs, and lower the level of risk to the financial system from the insolvency of individual institutions. In insuring depositors, the government, through the FDIC, substituted its unsurpassable credit rating for those of banks. Similarly, provisions of the Federal Reserve Act enabled banks to convert illiquid assets, such as loans, into riskless assets (deposits at the central bank) through the discount window, and to ---[PAGE_BREAK]--- complete payments using Federal Reserve credits. All these uses of the sovereign credit have dramatically improved the soundness of our banking system and the public's confidence in it. In the process, it has profoundly altered the risks and returns in banking. Sovereign credit guarantees have significantly reduced the amount of capital that banks and other depositories need to hold, since creditors demand less of a buffer to protect themselves from the failure of institutions that are the beneficiaries of such guarantees. In different language, these entities have been able to operate with a much higher degree of leverage -- that is, to obtain more of their funds from other than the owners of the organization -- than virtually all other financial institutions. At the same time, depositories have been able to take greater risk in their portfolios than would otherwise be the case, because private creditors -- depositors and others -- are less affected by the illiquidity of, or losses on, the banks' portfolios. The end result has been a higher risk-adjusted rate of return on depository institution equity. Moreover, the enhanced ability to take risk has contributed to economic growth, while the discount window and deposit insurance have contributed to our macroeconomic stability. But all good things have their price. The use of the sovereign credit in banking -- even its potential use -- creates a moral hazard that distorts the incentives for banks: the banks determine the level of risk-taking and receive the gains therefrom, but do not bear the full costs of that risk. The remainder of the risk is transferred to the government. This then creates the necessity for the government to limit the degree of risk it absorbs by writing rules under which banks operate, and imposing on these entities supervision by its agents -- the banking regulators -- to assure adherence to these rules. The experience in the 1980s with many insured thrift institutions showed just how dangerous lax enforcement of supervisory rules can be. In the end, some hard lessons were learned, many of which were legislated into the FDIC Improvement Act of 1991. The subsidy to the banking and other depositories created by the use of the unsurpassable sovereign credit rating of the United States government is an undesirable but unavoidable consequence of creating a safety net. Indeed, one measure of the effectiveness of a safety net is our ability to minimize the subsidy and limit its incidence outside of the area to which it was directed. Some of the value of the subsidy has been passed to depositors of, and borrowers from, banks, for example, as well as to the original bank shareholders. But, the United States government has been remarkably successful in containing the value of most of the subsidy within depository institutions. The bank holding company organizational structure has, on balance, provided an effective means of limiting the use of the sovereign credit subsidy by other parts of the banking organization. To be sure, bank holding companies have indirectly benefited from the subsidy because their major assets are subsidiary banks. The value of the subsidy given to the subsidiary banks has no doubt been capitalized in part into the share prices of holding companies and has improved their debt ratings, lowering their cost of capital. But, holding companies also own nonsubsidized entities that have no direct access to the safety net. Accordingly, both bank holding companies and their nonbank subsidiaries have a higher cost of capital than banks. This is clear in the debt ratings of bank subsidiaries of bank holding companies, which are virtually always higher than those of their parent holding companies. Moreover, existing law and regulation under Sections 23A and 23B of the Federal Reserve Act require that any credit extended by a bank to its parent or affiliate not only be totally collateralized and subject to quantitative limits, but also be extended at arms-length and at market rates, making a direct transfer of the safety net subsidy difficult. ---[PAGE_BREAK]--- It is true that a bank could pay dividends from its earnings, earnings which have been enhanced by the safety net subsidy, to fund its parent's nonbank affiliates. However, the evidence appears to be that such transfers generally do not occur. Existing holding company powers are limited and do not offer a broad spectrum of profitable opportunities. Accordingly, it is not surprising that data for the top 50 bank holding companies indicate that transfers from bank subsidiaries to their parents which, like dividends, embody the subsidy, appear to have approximately equaled holding company net transfers to their own shareholders and long-term creditors. This indicates that few subsidized dollars in the aggregate found their way into the equity accounts of holding company nonbank affiliates from the upstreaming of bank funds. We must, I think, be continually on guard that the subsidy provided by the safety net does not leak outside the institutions for which it was intended and provide a broad subsidy to other kinds of activities. Put another way, we must remain especially vigilant in maintaining a proper balance between a safety net that fosters economic and financial stabilization and one that benefits the competitive position of private businesses for no particular public purpose. As I noted, safety net subsidies have costs in terms of distorted incentives and misallocated resources. That is why the Congress must be cautious in how the sovereign credit is used. It has been suggested that the bank holding company structure imposes inefficiencies on banking organizations, and that these organizations should thus be given the option of conducting expanded financial activities in a direct subsidiary of the bank. The bank subsidiary may be a marginally more efficient way of delivering such services, but we believe it cannot avoid being a funnel for transferring the sovereign credit subsidy directly from the bank to finance the new powers, thereby imparting a subsidized competitive advantage to the subsidiary of the bank. One can devise rules -- such as 23 A and 23 B -- to assure that loans from the bank to its own subsidiaries are limited and at market rates. One can even devise rules to limit the aggregate equity investment made by banks in their subsidiaries. But one cannot eliminate the fact that the equity invested in subsidiaries is funded by the sum of insured deposits and other bank borrowings that directly benefit from the subsidy of the safety net. Thus, inevitably, a bank subsidiary must have lower costs of capital than an independent entity and even a subsidiary of the bank's parent. Indeed, one would expect that a rational banking organization would, as much as possible, shift its nonbank activity from the bank holding company structure to the bank subsidiary structure. Such a shift from affiliates to bank subsidiaries would increase the subsidy and the competitive advantage of the entire banking organization relative to its nonbank competitors. I am aware that these are often viewed as only highly technical issues, and hence ones that are in the end, of little significance. I do not think so. The issue of the use of the sovereign credit is central to how our financial system will allocate credit, and hence real resources, the kinds of risk it takes, and the degree of supervision it requires. If the Congress wants to extend the use of the sovereign credit further, to achieve a wider range over which the benefits of doing so can accrue, it ought to make that decision explicitly, and accept the consequences of the subsidy on the financial system that come with it. But, it should not, in the name of some technical change, or in search of some minor efficiency, inadvertently expand the use of the sovereign credit. This issue would not be so important were we not in the process of addressing what must surely be a watershed in the revamping of our regulatory structure. We must avoid inadvertently extending the safety net and its associated subsidy without a thorough understanding of the implications of such an extension to the competitive balance and systemic risks of our financial system. ---[PAGE_BREAK]--- Central to the Board's choice of a financial structure is its desire for one that will be most effective in fostering both a viable financial system and a vibrant economy. These objectives, in our view, would be thwarted if the safety net subsidy directly benefited new activities. With the safety net comes the moral hazard of which I spoke earlier, and its attendant misallocation of resources, and uneven competitive playing field. If the government subsidies directed to banks were channeled to bank subsidiaries, in my judgement, both the benefits and enumerated costs to the financial system and the public would occur. If banks were permitted to engage in new activities in their own subsidiaries, inevitably virtually all holding companies would shift those activities now conducted in holding company affiliates to bank subsidiaries, eviscerating the holding company structure. Were such shifts to happen solely as the result of operational efficiencies, no one, including the Board, should mourn the demise of the holding company. But if, as I suspect, such shifts occurred because of the attraction of a government subsidy, we should be concerned because the insidious effects of such subsidies would have spread. The evidence from flows between banks and their parents, relative bond ratings, and the administration of Sections 23A and B of the Federal Reserve Act, all strongly suggest that the holding company structure is far more capable of containing the sovereign credit subsidy whose purpose is support of the safety net, not providing expanded competitive advantage. As new activities hopefully expand for banking organizations, we believe that it is essential that we assure they are financed at market rates, not subsidized ones. This will not always be easy. Containment of subsidies is often implemented through firewalls and other devices which could also inhibit the very synergies which the expansion of activities is meant to achieve. But we have dealt with these trade-offs before and should be able to in the future as well. # Umbrella Supervision Whether new activities are authorized in bank subsidiaries, bank holding companies, or both, Congress, in its review of financial modernization, must consider legal entity supervision versus umbrella supervision. The Board believes that umbrella supervision is a realistic necessity for the protection of our financial system and to limit any misuse of the sovereign credit. The bank holding company organization is increasingly being managed so as to take advantage of the synergies between its component parts in order to deliver better products to the market and higher returns to stockholders. Such synergies cannot occur if the model of the holding company is one in which the parent is just, in effect, a portfolio investor in its subsidiary. Indeed, virtually all of the large holding companies now operate as integrated units and are managed as such. As bank holding companies began to widen their activities, and as new technologies permitted not only the development of new products but also the systems for controlling them, the banking organization was impelled to develop centralized risk control techniques that crossed legal entities. Today, risk management for the entire company is increasingly centralized not only at the larger and more sophisticated banking organizations, but at other large financial services providers as well. This development reflects the demands of the marketplace, which views banks and their affiliates and other financial businesses and their affiliates as integrated organizations in terms of financial condition, management, and reputation. ---[PAGE_BREAK]--- To understand the risk controls of the bank, we have first to come to grips with the fact that the organization is interested in risk and its control, not by instrument or legal entity, but for the entire business. This type of control is being adopted by more and more organizations each year, and can only increase as more activities are authorized by the regulators and the Congress. Regulatory policies and operating procedures have had to respond to these realities, to focus on the process of decisionmaking for the total organization. Thus, the Federal Reserve -- the historical umbrella supervisor -- also has found it necessary to concentrate more on the process that banking organizations use to manage market, credit, operating and exchange rate risk, and less on the traditional after-the-fact evaluation of balance sheets that can and often do change dramatically the day after they have been reviewed by the supervisors. In such a world, process, if not everything, is critical, and that process is determined increasingly at the parent holding company for all of the units of the organization on a consolidated basis. One could argue -- as several witnesses appearing before this subcommittee did on Tuesday -- that regulators should only be interested in the entities they regulate and, hence, review the risk evaluation process only as it relates to their regulated entity. Presumably each regulator of each entity -- the bank regulators, the SEC, the state insurance and finance company authorities -- would look only at how the risk management process affected their units. It is our belief that this simply will not be adequate. Risks managed on a consolidated basis cannot be reviewed on an individual legal entity basis by different supervisors. Indeed, our experience has been that a problem in one legal entity can have a contagion effect in other entities. If a bank affiliate begins to have difficulty, the market evaluates the problem as the consolidated entity's problem and can bring pressure on all the units. These pressures usually take the form of funding or liquidity difficulties, as creditors seek to reduce their exposure to all units of an organization that seems to be having trouble. Better safe than sorry. Indeed, it is in the cauldron of the payments and settlement system, where decisions involving large sums must be made in short periods, that this contagion effect might be first seen as participants understandably seek to protect themselves from the uncertainty that accompanies this contagion effect. And that is how crises often begin. These concerns were part of the motivation for the congressional decision just five years ago to require that foreign banks could enter the United States if, and only if, they were subject to consolidated supervision. This decision, which is consistent with the international standards for consolidated supervision of banking organizations, was a good decision then. It is a good decision today, especially for those banking organizations whose disruption could cause major financial disturbances in United States and foreign markets. For foreign and for U.S. banking organizations, retreat from consolidated supervision would, the Board believes, be a significant step backward. We have to be careful, however, that consolidated umbrella supervision does not inadvertently so hamper the decisionmaking process of banking organizations as to render them ineffectual. The Federal Reserve Board is accordingly in the process of reviewing its supervisory structure and other procedures in order to reflect the aforementioned market-directed shift from conventional balance sheet auditing to evaluation of the internal risk management process. Although focused on the key risk management processes, it would sharply reduce routine supervisory umbrella presence in holding companies. As the committee knows, the Board has recently published for comment proposals to expedite the applications process, and the legislation Congress enacted last year eased such procedures as well. Nonetheless, the Board requests even greater modification to its existing statutory mandate so that the required ---[PAGE_BREAK]--- applications process could be sharply cut back, particularly in the area of nonbank financial services. We would hope that should the Congress authorize wider activities for financial services holding companies that it recognize that a bank which is a minor part of such an organization (and its associated safety net) can be protected through adequate bank capital requirements and the application of Sections 23A and 23B of the Federal Reserve Act. The case is weak, in our judgment, for umbrella supervision of a holding company which, because it owns only a small bank, does not have material access to the safety net. As I noted when discussing the safety net and bank subsidiaries, attached to all uses of the sovereign credit come efforts by the government to protect the taxpayer. Those entities interested in banks are really interested in access to the safety net, since it is far easier to engage in the nonsafety net activities of banks without acquiring a bank. If an organization chooses to deliver some of its services with the aid of the sovereign credit by acquiring a bank, it should not be excused from efforts of the government to look out for the stability of the overall financial system. For bank holding companies that own more than a small bank, this implies umbrella supervision. Although that process will increasingly be designed to reduce supervisory presence and be as nonintrusive as possible, umbrella supervision should not be eliminated, but recognized for what it is: the cost of obtaining a subsidy. # Banking and Commerce Finally, let me turn to an issue that has bedeviled supervisory and regulatory discussions for years: the potential separation of commerce and banking. As I indicated earlier, it is clear that rapidly changing technologies are altering the nature of what constitutes finance. Indeed, just as the lines between banking and other financial institutions are often already difficult to discern, the boundaries between finance and nonfinance are likely to become increasingly indistinct as we move into the 21 st century. For example, computer and software firms will certainly be offering ever more sophisticated financial products. And doubtless financial firms will be offering an increasingly sophisticated array of nonfinancial services. In addition, some of the financial firms who mainly produce products and services that many observers believe should be permissible to banks are also engaged in, or affiliated with, nonfinancial businesses. Newer technologies will make it highly unlikely that the walling off of any ownership of financial institutions by nonfinancial businesses and vice-versa can be continued very far into the 21 st century. Nonetheless, the Board has concluded that it would be wise to move with caution in addressing the removal of the current legal barriers between commerce and banking. The free and open legal association of banking and commerce would be a profound and surely irreversible structural change in the American economy. Hence, we must be careful to assure ourselves that whatever changes are made in our supervisory structure, that it not distort our evolution to the most efficient financial structure as we move into the next century. Were we fully confident of how the structure would evolve, we could presumably construct today the regulations which would foster that evolution. But we cannot be certain. We thus run the risk of locking in a set of inappropriate regulations that could adversely alter the development of market structures. We cannot be confident we know what the true synergies between finance and nonfinance will be in ten or even five years. Our ability to foresee accurately the future implications of technologies and market developments in banking, as in ---[PAGE_BREAK]--- other industries, has not been particularly impressive. As Professor Rosenberg of Stanford University has pointed out, ". . . mistaken forecasts of future structure litter our financial landscape." Consider the view of the 1960s that the "cashless society" was imminent. Nonetheless, the public preference for paper has declined only gradually. Similarly, just a few years ago conventional wisdom argued that banks were dinosaurs that were becoming extinct. The reality today is far from it. Even more recently, it was argued that banks and nonfinancial firms had to merge in order to save the capital-starved banking system. Today, as you know, virtually all of our banks are very well capitalized. All these examples suggest that if we change the rules now about banking and commerce under circumstances of uncertainty about future synergies between finance and nonfinance, we might end up doing more harm than good. And, as with all rule changes by government, we are likely to find it impossible to correct our errors promptly. Modifications of such a fundamental structural rule as the separation of banking and commerce should accordingly proceed at a deliberate pace, testing the response of markets and technological innovation to the altered rules in the years ahead. The public needs to have confidence in the regulatory structure, implying that we proceed slowly and cautiously. Excessive delay, however, would doubtless produce some inequities. Expanded financial activities for banking organizations requires, the Board believes, that those firms operating in markets that banks can enter should, in turn, be authorized to engage in banking. However, some of these nonbanking financial firms already own -- or are owned by -nonfinancial entities. A complete commerce and banking prohibition would thus require the divestiture of all nonfinancial activities by those organizations that wanted to acquire or establish banks. The principle of caution suggests an approach which may prove useful. Perhaps those organizations that either have or establish well-capitalized and well-managed bank subsidiaries should be permitted a small basket of nonfinancial assets -- a certain percentage of either consolidated assets or capital. A small permissible basket would establish, in effect, a pilot program to evaluate the efficacy of further breaching of the banking and commerce wall. We found that such a slow and deliberate policy worked well with Section 20 affiliates. Of course, some nonbanking firms would find that their nonfinancial activities would exceed a small basket exemption. Such excess nonconforming assets might be addressed on a case-by-case basis with a scheduled longer-term divestiture to avoid the worst short-term inequities. A basket clause plus case-by-case review of individual situations might also provide a way to make available a common bank and thrift charter to those unitary thrifts that are affiliated with nonfinancial businesses. The Board has no firm opinion on just exactly how such trade-offs might be made, constrained only by the general concerns I summarized earlier.	Alan Greenspan	United States	https://www.bis.org/review/r970219b.pdf	Madam Chairwoman, members of the Subcommittee on Financial Institutions and Consumer Credit, it is a pleasure to appear here today to present the views of the Federal Reserve Board on some broad issues associated with financial modernization. The unremitting pressures of technology and the market are drastically changing the financial landscape and eroding traditional positions of competitors, inducing new competitive strategies and participants, forcing new regulatory responses, and building pressures on the Congress to shape developments in the public interest. Madam Chairwoman, I know that you have been an active sponsor and supporter of legislation to modernize the financial system. The Board also has been a strong proponent both of expanded financial activities for banking organizations and enhanced opportunities for nonbank financial institutions to enter banking. We continue to support financial modernization because we believe it would provide improved financial services for our citizens. Moreover, both our experience and analysis suggest that the additional risks of new financial products are modest and manageable. Indeed, technology already has resulted in a blurring of product and service-defining lines so dramatic as to make many financial products virtually indistinguishable from each other and the old rules inapplicable. In the process, we have already seen the public benefits, benefits that removal of old barriers could only enhance. But, as we proceed down the path of reform, reforms both desired for their benefits to the public and required by global markets and new technologies, the Board urges that any modifications be tested against certain standards. In particular, the Board believes that the changes we adopt should be consistent with (1) continuing the safety and soundness of the banking system; (2) limiting systemic risks; (3) contributing to macroeconomic stability; and (4) limiting the spread of both the moral hazard and the subsidy implicit in the safety net. Thus, if my comments today sound cautious, I want the subcommittee to understand that my observations do not reflect opposition to further freeing of constraints on financial competition. To the contrary. We strongly urge an extensive increase in the activities permitted to banking organizations and other financial institutions, provided these activities are financed at nonsubsidized market rates and do not pose unacceptable risks to our financial system. While a level playing field requires broader powers, it does not require subsidized ones. In this century the Congress has delegated the use of the sovereign credit -- the power to create money and borrow unlimited funds at the lowest possible rate -- to support the banking system. It has done so indirectly as a consequence of deposit insurance, Federal Reserve discount window access, and final riskless settlement of payment system transactions. The public policy purpose was to protect depositors, stem bank runs, and lower the level of risk to the financial system from the insolvency of individual institutions. In insuring depositors, the government, through the FDIC, substituted its unsurpassable credit rating for those of banks. Similarly, provisions of the Federal Reserve Act enabled banks to convert illiquid assets, such as loans, into riskless assets (deposits at the central bank) through the discount window, and to complete payments using Federal Reserve credits. All these uses of the sovereign credit have dramatically improved the soundness of our banking system and the public's confidence in it. In the process, it has profoundly altered the risks and returns in banking. Sovereign credit guarantees have significantly reduced the amount of capital that banks and other depositories need to hold, since creditors demand less of a buffer to protect themselves from the failure of institutions that are the beneficiaries of such guarantees. In different language, these entities have been able to operate with a much higher degree of leverage -- that is, to obtain more of their funds from other than the owners of the organization -- than virtually all other financial institutions. At the same time, depositories have been able to take greater risk in their portfolios than would otherwise be the case, because private creditors -- depositors and others -- are less affected by the illiquidity of, or losses on, the banks' portfolios. The end result has been a higher risk-adjusted rate of return on depository institution equity. Moreover, the enhanced ability to take risk has contributed to economic growth, while the discount window and deposit insurance have contributed to our macroeconomic stability. But all good things have their price. The use of the sovereign credit in banking -- even its potential use -- creates a moral hazard that distorts the incentives for banks: the banks determine the level of risk-taking and receive the gains therefrom, but do not bear the full costs of that risk. The remainder of the risk is transferred to the government. This then creates the necessity for the government to limit the degree of risk it absorbs by writing rules under which banks operate, and imposing on these entities supervision by its agents -- the banking regulators -- to assure adherence to these rules. The experience in the 1980s with many insured thrift institutions showed just how dangerous lax enforcement of supervisory rules can be. In the end, some hard lessons were learned, many of which were legislated into the FDIC Improvement Act of 1991. The subsidy to the banking and other depositories created by the use of the unsurpassable sovereign credit rating of the United States government is an undesirable but unavoidable consequence of creating a safety net. Indeed, one measure of the effectiveness of a safety net is our ability to minimize the subsidy and limit its incidence outside of the area to which it was directed. Some of the value of the subsidy has been passed to depositors of, and borrowers from, banks, for example, as well as to the original bank shareholders. But, the United States government has been remarkably successful in containing the value of most of the subsidy within depository institutions. The bank holding company organizational structure has, on balance, provided an effective means of limiting the use of the sovereign credit subsidy by other parts of the banking organization. To be sure, bank holding companies have indirectly benefited from the subsidy because their major assets are subsidiary banks. The value of the subsidy given to the subsidiary banks has no doubt been capitalized in part into the share prices of holding companies and has improved their debt ratings, lowering their cost of capital. But, holding companies also own nonsubsidized entities that have no direct access to the safety net. Accordingly, both bank holding companies and their nonbank subsidiaries have a higher cost of capital than banks. This is clear in the debt ratings of bank subsidiaries of bank holding companies, which are virtually always higher than those of their parent holding companies. Moreover, existing law and regulation under Sections 23A and 23B of the Federal Reserve Act require that any credit extended by a bank to its parent or affiliate not only be totally collateralized and subject to quantitative limits, but also be extended at arms-length and at market rates, making a direct transfer of the safety net subsidy difficult. It is true that a bank could pay dividends from its earnings, earnings which have been enhanced by the safety net subsidy, to fund its parent's nonbank affiliates. However, the evidence appears to be that such transfers generally do not occur. Existing holding company powers are limited and do not offer a broad spectrum of profitable opportunities. Accordingly, it is not surprising that data for the top 50 bank holding companies indicate that transfers from bank subsidiaries to their parents which, like dividends, embody the subsidy, appear to have approximately equaled holding company net transfers to their own shareholders and long-term creditors. This indicates that few subsidized dollars in the aggregate found their way into the equity accounts of holding company nonbank affiliates from the upstreaming of bank funds. We must, I think, be continually on guard that the subsidy provided by the safety net does not leak outside the institutions for which it was intended and provide a broad subsidy to other kinds of activities. Put another way, we must remain especially vigilant in maintaining a proper balance between a safety net that fosters economic and financial stabilization and one that benefits the competitive position of private businesses for no particular public purpose. As I noted, safety net subsidies have costs in terms of distorted incentives and misallocated resources. That is why the Congress must be cautious in how the sovereign credit is used. It has been suggested that the bank holding company structure imposes inefficiencies on banking organizations, and that these organizations should thus be given the option of conducting expanded financial activities in a direct subsidiary of the bank. The bank subsidiary may be a marginally more efficient way of delivering such services, but we believe it cannot avoid being a funnel for transferring the sovereign credit subsidy directly from the bank to finance the new powers, thereby imparting a subsidized competitive advantage to the subsidiary of the bank. One can devise rules -- such as 23 A and 23 B -- to assure that loans from the bank to its own subsidiaries are limited and at market rates. One can even devise rules to limit the aggregate equity investment made by banks in their subsidiaries. But one cannot eliminate the fact that the equity invested in subsidiaries is funded by the sum of insured deposits and other bank borrowings that directly benefit from the subsidy of the safety net. Thus, inevitably, a bank subsidiary must have lower costs of capital than an independent entity and even a subsidiary of the bank's parent. Indeed, one would expect that a rational banking organization would, as much as possible, shift its nonbank activity from the bank holding company structure to the bank subsidiary structure. Such a shift from affiliates to bank subsidiaries would increase the subsidy and the competitive advantage of the entire banking organization relative to its nonbank competitors. I am aware that these are often viewed as only highly technical issues, and hence ones that are in the end, of little significance. I do not think so. The issue of the use of the sovereign credit is central to how our financial system will allocate credit, and hence real resources, the kinds of risk it takes, and the degree of supervision it requires. If the Congress wants to extend the use of the sovereign credit further, to achieve a wider range over which the benefits of doing so can accrue, it ought to make that decision explicitly, and accept the consequences of the subsidy on the financial system that come with it. But, it should not, in the name of some technical change, or in search of some minor efficiency, inadvertently expand the use of the sovereign credit. This issue would not be so important were we not in the process of addressing what must surely be a watershed in the revamping of our regulatory structure. We must avoid inadvertently extending the safety net and its associated subsidy without a thorough understanding of the implications of such an extension to the competitive balance and systemic risks of our financial system. Central to the Board's choice of a financial structure is its desire for one that will be most effective in fostering both a viable financial system and a vibrant economy. These objectives, in our view, would be thwarted if the safety net subsidy directly benefited new activities. With the safety net comes the moral hazard of which I spoke earlier, and its attendant misallocation of resources, and uneven competitive playing field. If the government subsidies directed to banks were channeled to bank subsidiaries, in my judgement, both the benefits and enumerated costs to the financial system and the public would occur. If banks were permitted to engage in new activities in their own subsidiaries, inevitably virtually all holding companies would shift those activities now conducted in holding company affiliates to bank subsidiaries, eviscerating the holding company structure. Were such shifts to happen solely as the result of operational efficiencies, no one, including the Board, should mourn the demise of the holding company. But if, as I suspect, such shifts occurred because of the attraction of a government subsidy, we should be concerned because the insidious effects of such subsidies would have spread. The evidence from flows between banks and their parents, relative bond ratings, and the administration of Sections 23A and B of the Federal Reserve Act, all strongly suggest that the holding company structure is far more capable of containing the sovereign credit subsidy whose purpose is support of the safety net, not providing expanded competitive advantage. As new activities hopefully expand for banking organizations, we believe that it is essential that we assure they are financed at market rates, not subsidized ones. This will not always be easy. Containment of subsidies is often implemented through firewalls and other devices which could also inhibit the very synergies which the expansion of activities is meant to achieve. But we have dealt with these trade-offs before and should be able to in the future as well. Whether new activities are authorized in bank subsidiaries, bank holding companies, or both, Congress, in its review of financial modernization, must consider legal entity supervision versus umbrella supervision. The Board believes that umbrella supervision is a realistic necessity for the protection of our financial system and to limit any misuse of the sovereign credit. The bank holding company organization is increasingly being managed so as to take advantage of the synergies between its component parts in order to deliver better products to the market and higher returns to stockholders. Such synergies cannot occur if the model of the holding company is one in which the parent is just, in effect, a portfolio investor in its subsidiary. Indeed, virtually all of the large holding companies now operate as integrated units and are managed as such. As bank holding companies began to widen their activities, and as new technologies permitted not only the development of new products but also the systems for controlling them, the banking organization was impelled to develop centralized risk control techniques that crossed legal entities. Today, risk management for the entire company is increasingly centralized not only at the larger and more sophisticated banking organizations, but at other large financial services providers as well. This development reflects the demands of the marketplace, which views banks and their affiliates and other financial businesses and their affiliates as integrated organizations in terms of financial condition, management, and reputation. To understand the risk controls of the bank, we have first to come to grips with the fact that the organization is interested in risk and its control, not by instrument or legal entity, but for the entire business. This type of control is being adopted by more and more organizations each year, and can only increase as more activities are authorized by the regulators and the Congress. Regulatory policies and operating procedures have had to respond to these realities, to focus on the process of decisionmaking for the total organization. Thus, the Federal Reserve -- the historical umbrella supervisor -- also has found it necessary to concentrate more on the process that banking organizations use to manage market, credit, operating and exchange rate risk, and less on the traditional after-the-fact evaluation of balance sheets that can and often do change dramatically the day after they have been reviewed by the supervisors. In such a world, process, if not everything, is critical, and that process is determined increasingly at the parent holding company for all of the units of the organization on a consolidated basis. One could argue -- as several witnesses appearing before this subcommittee did on Tuesday -- that regulators should only be interested in the entities they regulate and, hence, review the risk evaluation process only as it relates to their regulated entity. Presumably each regulator of each entity -- the bank regulators, the SEC, the state insurance and finance company authorities -- would look only at how the risk management process affected their units. It is our belief that this simply will not be adequate. Risks managed on a consolidated basis cannot be reviewed on an individual legal entity basis by different supervisors. Indeed, our experience has been that a problem in one legal entity can have a contagion effect in other entities. If a bank affiliate begins to have difficulty, the market evaluates the problem as the consolidated entity's problem and can bring pressure on all the units. These pressures usually take the form of funding or liquidity difficulties, as creditors seek to reduce their exposure to all units of an organization that seems to be having trouble. Better safe than sorry. Indeed, it is in the cauldron of the payments and settlement system, where decisions involving large sums must be made in short periods, that this contagion effect might be first seen as participants understandably seek to protect themselves from the uncertainty that accompanies this contagion effect. And that is how crises often begin. These concerns were part of the motivation for the congressional decision just five years ago to require that foreign banks could enter the United States if, and only if, they were subject to consolidated supervision. This decision, which is consistent with the international standards for consolidated supervision of banking organizations, was a good decision then. It is a good decision today, especially for those banking organizations whose disruption could cause major financial disturbances in United States and foreign markets. For foreign and for U.S. banking organizations, retreat from consolidated supervision would, the Board believes, be a significant step backward. We have to be careful, however, that consolidated umbrella supervision does not inadvertently so hamper the decisionmaking process of banking organizations as to render them ineffectual. The Federal Reserve Board is accordingly in the process of reviewing its supervisory structure and other procedures in order to reflect the aforementioned market-directed shift from conventional balance sheet auditing to evaluation of the internal risk management process. Although focused on the key risk management processes, it would sharply reduce routine supervisory umbrella presence in holding companies. As the committee knows, the Board has recently published for comment proposals to expedite the applications process, and the legislation Congress enacted last year eased such procedures as well. Nonetheless, the Board requests even greater modification to its existing statutory mandate so that the required applications process could be sharply cut back, particularly in the area of nonbank financial services. We would hope that should the Congress authorize wider activities for financial services holding companies that it recognize that a bank which is a minor part of such an organization (and its associated safety net) can be protected through adequate bank capital requirements and the application of Sections 23A and 23B of the Federal Reserve Act. The case is weak, in our judgment, for umbrella supervision of a holding company which, because it owns only a small bank, does not have material access to the safety net. As I noted when discussing the safety net and bank subsidiaries, attached to all uses of the sovereign credit come efforts by the government to protect the taxpayer. Those entities interested in banks are really interested in access to the safety net, since it is far easier to engage in the nonsafety net activities of banks without acquiring a bank. If an organization chooses to deliver some of its services with the aid of the sovereign credit by acquiring a bank, it should not be excused from efforts of the government to look out for the stability of the overall financial system. For bank holding companies that own more than a small bank, this implies umbrella supervision. Although that process will increasingly be designed to reduce supervisory presence and be as nonintrusive as possible, umbrella supervision should not be eliminated, but recognized for what it is: the cost of obtaining a subsidy. Finally, let me turn to an issue that has bedeviled supervisory and regulatory discussions for years: the potential separation of commerce and banking. As I indicated earlier, it is clear that rapidly changing technologies are altering the nature of what constitutes finance. Indeed, just as the lines between banking and other financial institutions are often already difficult to discern, the boundaries between finance and nonfinance are likely to become increasingly indistinct as we move into the 21 st century. For example, computer and software firms will certainly be offering ever more sophisticated financial products. And doubtless financial firms will be offering an increasingly sophisticated array of nonfinancial services. In addition, some of the financial firms who mainly produce products and services that many observers believe should be permissible to banks are also engaged in, or affiliated with, nonfinancial businesses. Newer technologies will make it highly unlikely that the walling off of any ownership of financial institutions by nonfinancial businesses and vice-versa can be continued very far into the 21 st century. Nonetheless, the Board has concluded that it would be wise to move with caution in addressing the removal of the current legal barriers between commerce and banking. The free and open legal association of banking and commerce would be a profound and surely irreversible structural change in the American economy. Hence, we must be careful to assure ourselves that whatever changes are made in our supervisory structure, that it not distort our evolution to the most efficient financial structure as we move into the next century. Were we fully confident of how the structure would evolve, we could presumably construct today the regulations which would foster that evolution. But we cannot be certain. We thus run the risk of locking in a set of inappropriate regulations that could adversely alter the development of market structures. We cannot be confident we know what the true synergies between finance and nonfinance will be in ten or even five years. Our ability to foresee accurately the future implications of technologies and market developments in banking, as in other industries, has not been particularly impressive. As Professor Rosenberg of Stanford University has pointed out, ". . . mistaken forecasts of future structure litter our financial landscape." Consider the view of the 1960s that the "cashless society" was imminent. Nonetheless, the public preference for paper has declined only gradually. Similarly, just a few years ago conventional wisdom argued that banks were dinosaurs that were becoming extinct. The reality today is far from it. Even more recently, it was argued that banks and nonfinancial firms had to merge in order to save the capital-starved banking system. Today, as you know, virtually all of our banks are very well capitalized. All these examples suggest that if we change the rules now about banking and commerce under circumstances of uncertainty about future synergies between finance and nonfinance, we might end up doing more harm than good. And, as with all rule changes by government, we are likely to find it impossible to correct our errors promptly. Modifications of such a fundamental structural rule as the separation of banking and commerce should accordingly proceed at a deliberate pace, testing the response of markets and technological innovation to the altered rules in the years ahead. The public needs to have confidence in the regulatory structure, implying that we proceed slowly and cautiously. Excessive delay, however, would doubtless produce some inequities. Expanded financial activities for banking organizations requires, the Board believes, that those firms operating in markets that banks can enter should, in turn, be authorized to engage in banking. However, some of these nonbanking financial firms already own -- or are owned by -nonfinancial entities. A complete commerce and banking prohibition would thus require the divestiture of all nonfinancial activities by those organizations that wanted to acquire or establish banks. The principle of caution suggests an approach which may prove useful. Perhaps those organizations that either have or establish well-capitalized and well-managed bank subsidiaries should be permitted a small basket of nonfinancial assets -- a certain percentage of either consolidated assets or capital. A small permissible basket would establish, in effect, a pilot program to evaluate the efficacy of further breaching of the banking and commerce wall. We found that such a slow and deliberate policy worked well with Section 20 affiliates. Of course, some nonbanking firms would find that their nonfinancial activities would exceed a small basket exemption. Such excess nonconforming assets might be addressed on a case-by-case basis with a scheduled longer-term divestiture to avoid the worst short-term inequities. A basket clause plus case-by-case review of individual situations might also provide a way to make available a common bank and thrift charter to those unitary thrifts that are affiliated with nonfinancial businesses. The Board has no firm opinion on just exactly how such trade-offs might be made, constrained only by the general concerns I summarized earlier.
1997-02-21T00:00:00	Mr. Greenspan offers some considerations as a guide for government decisions on regulating the financial markets (Central Bank Articles and Speeches, 21 Feb 97)	Remarks by Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Financial Markets Conference of the Federal Reserve Bank of Atlanta held in Coral Gables, Florida on 21/2/97.	Mr. Greenspan offers some considerations as a guide for government decisions on regulating the financial markets Remarks by Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Financial Markets Conference of the Federal Reserve Bank of Atlanta held in Coral Gables, Florida on 21/2/97. I am pleased to participate once again in the Federal Reserve Bank of Atlanta's annual Financial Markets Conference. As in previous years, the Reserve Bank has developed a conference program that is quite timely. Changes in technology have permitted the development in recent years of increasingly diverse financial instruments and intensely competitive market structures. The rapid evolution of products and markets has led many to conclude that market regulatory structures, many of which were established in the 1920s and 1930s, have become increasingly outdated. Some see new products and markets not covered by government regulation and fear the consequences of so-called "regulatory gaps." Others see old government regulations applied to new instruments and markets and fear the unintended consequences of what seems unnecessary and burdensome regulation. Nowhere have these tensions been more evident than in the ongoing debate over the appropriate government regulation of derivative contracts, a debate which has varied in intensity but has never fully subsided for at least ten years. Recent efforts by members of the Senate Agriculture Committee to clarify and rationalize the regulation of derivative contracts under the Commodity Exchange Act have once again placed these contentious issues on the front burner. In my remarks today I shall proffer a set of considerations that I find quite valuable as a guide to decisions about the need for government regulation of financial markets. I shall then review the history of government regulation of derivative contracts and markets in the United States and consider the current regulatory structure for those products and markets in light of these considerations. Market Regulation I would argue that the first imperative when evaluating market regulation is to enunciate clearly the public policy objectives that government regulation would be intended to promote. What market characteristics do policymakers seek to encourage? Efficiency? Fair and open access? What phenomena do we wish to discourage or eliminate? Fraud, manipulation, or other unfair practices? Systemic instability? Without explicit answers to these questions, government regulation is unlikely to be effective. More likely, it will prove unnecessary, burdensome, and perhaps even contrary to what more careful consideration would reveal to be the underlying objectives. A second imperative, once public policy objectives are clearly specified, is to evaluate whether government regulation is necessary for those purposes. In making such evaluations, it is critically important to recognize that no market is ever truly unregulated. The self-interest of market participants generates private market regulation. Thus, the real question is not whether a market should be regulated. Rather, the real question is whether government intervention strengthens or weakens private regulation. If incentives for private market regulation are weak or if market participants lack the capabilities to pursue their interests effectively, then the introduction of government regulation may improve regulation. But if private market regulation is effective, then government regulation is at best unnecessary. At worst, the introduction of government regulation may actually weaken the effectiveness of regulation if government regulation is itself ineffective or undermines incentives for private market regulation. We must be aware that government regulation unavoidably involves some element of moral hazard -- if private market participants believe that government is protecting their interests, their own efforts to protect their interests will diminish to some degree. Whether government regulation is needed, and if so, what form of government regulation is optimal, depends critically on a market's characteristics. A "one-size-fits-all" approach to financial market regulation is almost never appropriate. The degree and type of government regulation needed, if any, depends on the types of instruments traded, the types of market participants, and the nature of the relationships among market participants. To cite just one example, a government regulatory framework designed to protect retail investors from fraud or insolvency of brokers is unlikely to be necessary -- and is almost sure to be suboptimal -- if applied to a market in which large institutions transact on a principal-to-principal basis. Recognizing that a one-size-fits-all approach is seldom appropriate, it may be useful to offer transactors a choice between seeking the benefits and accepting the burdens of government regulation, or forgoing those benefits and avoiding those burdens by transacting in financial markets that are only privately regulated. In such circumstances, the privately regulated markets in effect provide a market test of the net benefits of government regulation. Migration of activity from government-regulated to privately regulated markets sends a signal to government regulators that many transactors believe the costs of regulation exceed the benefits. When such migration occurs, government regulators should consider carefully whether less regulation or different regulation would provide a better cost-benefit tradeoff without compromising public policy objectives. Historical Development of U.S. Government Regulation of Derivative Markets Before evaluating the current regulation of derivatives in light of these considerations, it is quite useful to know something of the history of these instruments and their regulation. Derivative contracts (forward contracts and options) appear to have been utilized throughout American history. Indeed, it will probably come as a surprise even to this audience that 15 to 25 percent of trades on the New York Stock Exchange in its early years were time bargains, that is, forward contracts, rather than transactions for cash settlement (in those days, same-day settlement) or regular-way settlement (next-day settlement). In the case of commodities, forward contracts for corn, wheat, and other grains came into common use by 1850 in Chicago, where they were known as "to arrive" contracts. The first organized futures exchange in the United States, the Chicago Board of Trade, evolved through the progressive standardization of the terms of "to arrive" contracts, including lot sizes, grades of grain, and delivery periods. Trading apparently was centralized on the Board of Trade by 1859, and in 1865 it set out detailed rules for the trading of highly standardized contracts quite similar to the grain futures contracts traded today. The first recorded instance of federal government regulation of derivatives was the Anti-Gold Futures Act of 1864, which prohibited the trading of gold futures. The government had been unhappy that its fiat currency issues, the infamous greenbacks, were at that time trading at a substantial discount to gold. Unwilling to accept this result as evidence of failure of the government's monetary policies, Congress concluded that it was evidence of a serious failure of private market regulation. In the event, Congress's action was followed by a further sharp drop in the value of the greenbacks. Although it took the government many years to restore monetary policy to a sound footing, it took Congress only two weeks to conclude that its prohibition of gold futures was having unintended consequences and to repeal the act. It has been the trading of agricultural futures, however, that from its inception has produced calls for government intervention. Throughout the late nineteenth and early twentieth centuries, farmers were often opposed to futures trading, particularly during periods when prices of their products were low or declining. They presumed that dreaded speculators were depressing their prices. The states were the first to respond to calls for government regulation of futures. For the most part, state legislation on futures was limited to prohibitions on bucket shops, that is, operations that purport to act as brokers of exchange-traded futures but "bucket" rather than execute their clients' trades. An Illinois statute of 1874 signaled early concerns about market integrity. The statute criminalized the spreading of false rumors to influence commodity prices and attempts to corner commodity markets. After its misadventure with futures regulation during the Civil War, the federal government appears not to have given further consideration to regulating futures trading until 1883, when a bill was introduced in Congress to prohibit use of the mails to market futures. Thereafter, repeated efforts were made to regulate or prohibit trading of futures and options on agricultural products. When the Agriculture Department reviewed the Congressional Record in 1920, it found that 164 measures of this sort had previously been introduced. These efforts culminated in passage of the Futures Trading Act of 1921. That act was promptly declared unconstitutional by the Supreme Court, on the grounds that it was a regulatory measure masquerading as a tax measure. But in 1922 Congress restated the purpose of the 1921 act as "an act for the prevention and removal of obstructions and burdens upon interstate commerce in grain, by regulating transactions on grain futures exchanges," and renamed it the Grain Futures Act of 1922. As an explicitly regulatory measure, it was later upheld by the Court. The objective of the Grain Futures Act was to reduce or eliminate "sudden or unreasonable fluctuations" in the prices of grain on futures exchanges. The framers of the act believed that such sudden or unreasonable fluctuations of grain futures prices reflected their susceptibility to "speculation, manipulation, or control." Moreover, such fluctuations in price were seen to have broad ramifications that affected the national public interest. Grain futures contracts were widely used by producers and distributors of grain to hedge the risks of price fluctuations. Futures prices also were widely disseminated and widely used as the basis for pricing grain transactions off the futures exchanges. Indeed, given the relative size of the agricultural sector of the time, fluctuations in futures prices no doubt had the potential to affect the economy as a whole. It is not entirely clear that the view that futures trading was exacerbating volatility in agricultural prices was well-founded. To be sure, evidence abounds that market participants talked incessantly about corners and bear raids. Moreover, the design of the contracts may, indeed, have made such contracts susceptible to manipulation. However, empirical studies of more recent experience cast doubt on whether the use of derivatives adds to price volatility. And, while charges of market manipulation are heard to this day, they typically are difficult, if not impossible, to prove. Professional speculators were easy to blame for fluctuations in market prices that actually reflected fundamental shifts in supply or demand, as they are today. The market clearing process is a very abstract concept. It is sometimes far easier to envisage price changes as the consequence of individual manipulators. Indeed, for a lot of nineteenth-century ring traders, it was some measure of manhood (women were few) that they could squeeze or corner a market. The evidence suggests that this was largely Walter Middy-type fantasy. In any event, the Grain Futures Act of 1922 established many of the key elements of our current regulatory framework for derivatives. In general, the act was designed to confine futures trading to regulated futures exchanges. The act made it unlawful to trade futures on exchanges other than those designated as contract markets by the Secretary of Agriculture. The Secretary was permitted to so designate an exchange only if certain conditions were met. These included the establishment of procedures for recordkeeping and reporting of futures transactions, for prevention of dissemination of false or misleading crop or market information, and for prevention of price manipulation or cornering of markets. Finally, the act recognized the need to permit bona fide derivatives transactions to be executed off of the regulated exchanges; it explicitly excluded forward contracts for the delivery of grain from the exchange-trading requirement. Forward contracts were essentially defined as contracts for future delivery to which farmers or farm interests were counterparties or in which the seller, if not a farmer, owned the grain at the time of making the contract. The next major piece of federal legislation affecting futures regulation was the Commodity Exchange Act (CEA) of 1936. As in the case of the Grain Futures Act, an important objective of the CEA was to discourage forms of speculation that were seen as exacerbating price volatility. In addition, the CEA introduced provisions designed primarily to protect small investors in commodity futures, whose participation had been increasing and was viewed as beneficial. These provisions included requirements for the registration of futures commission merchants (FCMs), that is, futures brokers, and for the segregation of customer funds from FCM funds. The CEA also expanded the coverage of futures regulation to cover contracts for cotton, rice, and certain other specifically enumerated commodities traded on futures exchanges, and prohibited the trading of options on commodities traded on futures exchanges. The federal regulatory framework for derivatives market regulation then remained substantially unchanged until 1974, when Congress enacted the Commodity Futures Trading Commission Act. The act did not make any fundamental changes in the objectives of derivatives regulation. However, it expanded the scope of the CEA quite significantly. In addition to creating the Commodity Futures Trading Commission (CFTC) as an independent agency and giving the CFTC exclusive jurisdiction over commodity futures and options, the 1974 amendments expanded the CEA's definition of "commodity" beyond a specific list of agricultural commodities to include "all other goods and articles, except onions, . . . and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in." In one respect, this was sweeping deregulation, in that it explicitly allowed the trading on futures exchanges of contracts on virtually any underlying assets, including financial instruments. Only onion futures, banned in 1958 as the presumed favorite plaything of manipulators, remained beyond the pale. In another respect, however, this was a sweeping extension of regulation. Given this broad definition of a commodity and an equally broad interpretation of what constitutes a futures contract, this change brought a tremendous range of off-exchange transactions potentially within the scope of the CEA. In particular, it could be interpreted to extend the broad prohibition on off-exchange trading of futures to an immense volume of diverse transactions that never had been traded on exchanges. The potential for the legality of a wider range of transactions to be called into question did not go unnoticed during debate on the 1974 act. In particular, the Treasury Department proposed language excluding off-exchange derivative transactions in foreign currency, government securities, and certain other financial instruments from the newly expanded CEA. This proposal was adopted by Congress and is known as the Treasury Amendment. In proposing the amendment, Treasury was primarily concerned with protecting foreign exchange markets from what it considered unnecessary and potentially harmful regulation. The foreign exchange markets clearly have quite different characteristics from markets for agricultural futures -- the markets for the major currencies are deep and, as some central banks have learned the hard way, they are extremely difficult to manipulate. Furthermore, participants in those markets, primarily banks and other financial institutions, and large corporations, would not seem to need, and certainly are not seeking, the protection of the CEA. Thus, there was, and is, no reason to presume that the regulatory framework of the CEA needs to be applied to the foreign exchange markets to achieve the public policy objectives that motivated the CEA. Indeed, the wholesale foreign exchange markets provide a clear and compelling example of how private parties can regulate markets quite effectively without government assistance.	---[PAGE_BREAK]--- Mr. Greenspan offers some considerations as a guide for government decisions on regulating the financial markets Remarks by Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Financial Markets Conference of the Federal Reserve Bank of Atlanta held in Coral Gables, Florida on 21/2/97. I am pleased to participate once again in the Federal Reserve Bank of Atlanta's annual Financial Markets Conference. As in previous years, the Reserve Bank has developed a conference program that is quite timely. Changes in technology have permitted the development in recent years of increasingly diverse financial instruments and intensely competitive market structures. The rapid evolution of products and markets has led many to conclude that market regulatory structures, many of which were established in the 1920s and 1930s, have become increasingly outdated. Some see new products and markets not covered by government regulation and fear the consequences of so-called "regulatory gaps." Others see old government regulations applied to new instruments and markets and fear the unintended consequences of what seems unnecessary and burdensome regulation. Nowhere have these tensions been more evident than in the ongoing debate over the appropriate government regulation of derivative contracts, a debate which has varied in intensity but has never fully subsided for at least ten years. Recent efforts by members of the Senate Agriculture Committee to clarify and rationalize the regulation of derivative contracts under the Commodity Exchange Act have once again placed these contentious issues on the front burner. In my remarks today I shall proffer a set of considerations that I find quite valuable as a guide to decisions about the need for government regulation of financial markets. I shall then review the history of government regulation of derivative contracts and markets in the United States and consider the current regulatory structure for those products and markets in light of these considerations. # Market Regulation I would argue that the first imperative when evaluating market regulation is to enunciate clearly the public policy objectives that government regulation would be intended to promote. What market characteristics do policymakers seek to encourage? Efficiency? Fair and open access? What phenomena do we wish to discourage or eliminate? Fraud, manipulation, or other unfair practices? Systemic instability? Without explicit answers to these questions, government regulation is unlikely to be effective. More likely, it will prove unnecessary, burdensome, and perhaps even contrary to what more careful consideration would reveal to be the underlying objectives. A second imperative, once public policy objectives are clearly specified, is to evaluate whether government regulation is necessary for those purposes. In making such evaluations, it is critically important to recognize that no market is ever truly unregulated. The self-interest of market participants generates private market regulation. Thus, the real question is not whether a market should be regulated. Rather, the real question is whether government intervention strengthens or weakens private regulation. If incentives for private market regulation are weak or if market participants lack the capabilities to pursue their interests effectively, then the introduction of government regulation may improve regulation. But if private market regulation is effective, then government regulation is at best unnecessary. At worst, the introduction of government regulation may actually weaken the effectiveness of regulation if government regulation is itself ineffective or undermines incentives for private market regulation. We must be aware that government regulation unavoidably involves some ---[PAGE_BREAK]--- element of moral hazard -- if private market participants believe that government is protecting their interests, their own efforts to protect their interests will diminish to some degree. Whether government regulation is needed, and if so, what form of government regulation is optimal, depends critically on a market's characteristics. A "one-size-fits-all" approach to financial market regulation is almost never appropriate. The degree and type of government regulation needed, if any, depends on the types of instruments traded, the types of market participants, and the nature of the relationships among market participants. To cite just one example, a government regulatory framework designed to protect retail investors from fraud or insolvency of brokers is unlikely to be necessary -- and is almost sure to be suboptimal -- if applied to a market in which large institutions transact on a principal-to-principal basis. Recognizing that a one-size-fits-all approach is seldom appropriate, it may be useful to offer transactors a choice between seeking the benefits and accepting the burdens of government regulation, or forgoing those benefits and avoiding those burdens by transacting in financial markets that are only privately regulated. In such circumstances, the privately regulated markets in effect provide a market test of the net benefits of government regulation. Migration of activity from government-regulated to privately regulated markets sends a signal to government regulators that many transactors believe the costs of regulation exceed the benefits. When such migration occurs, government regulators should consider carefully whether less regulation or different regulation would provide a better cost-benefit tradeoff without compromising public policy objectives. # Historical Development of U.S. Government Regulation of Derivative Markets Before evaluating the current regulation of derivatives in light of these considerations, it is quite useful to know something of the history of these instruments and their regulation. Derivative contracts (forward contracts and options) appear to have been utilized throughout American history. Indeed, it will probably come as a surprise even to this audience that 15 to 25 percent of trades on the New York Stock Exchange in its early years were time bargains, that is, forward contracts, rather than transactions for cash settlement (in those days, same-day settlement) or regular-way settlement (next-day settlement). In the case of commodities, forward contracts for corn, wheat, and other grains came into common use by 1850 in Chicago, where they were known as "to arrive" contracts. The first organized futures exchange in the United States, the Chicago Board of Trade, evolved through the progressive standardization of the terms of "to arrive" contracts, including lot sizes, grades of grain, and delivery periods. Trading apparently was centralized on the Board of Trade by 1859, and in 1865 it set out detailed rules for the trading of highly standardized contracts quite similar to the grain futures contracts traded today. The first recorded instance of federal government regulation of derivatives was the Anti-Gold Futures Act of 1864, which prohibited the trading of gold futures. The government had been unhappy that its fiat currency issues, the infamous greenbacks, were at that time trading at a substantial discount to gold. Unwilling to accept this result as evidence of failure of the government's monetary policies, Congress concluded that it was evidence of a serious failure of private market regulation. In the event, Congress's action was followed by a further sharp drop in the value of the greenbacks. Although it took the government many years to restore monetary policy to a sound footing, it took Congress only two weeks to conclude that its prohibition of gold futures was having unintended consequences and to repeal the act. ---[PAGE_BREAK]--- It has been the trading of agricultural futures, however, that from its inception has produced calls for government intervention. Throughout the late nineteenth and early twentieth centuries, farmers were often opposed to futures trading, particularly during periods when prices of their products were low or declining. They presumed that dreaded speculators were depressing their prices. The states were the first to respond to calls for government regulation of futures. For the most part, state legislation on futures was limited to prohibitions on bucket shops, that is, operations that purport to act as brokers of exchange-traded futures but "bucket" rather than execute their clients' trades. An Illinois statute of 1874 signaled early concerns about market integrity. The statute criminalized the spreading of false rumors to influence commodity prices and attempts to corner commodity markets. After its misadventure with futures regulation during the Civil War, the federal government appears not to have given further consideration to regulating futures trading until 1883, when a bill was introduced in Congress to prohibit use of the mails to market futures. Thereafter, repeated efforts were made to regulate or prohibit trading of futures and options on agricultural products. When the Agriculture Department reviewed the Congressional Record in 1920, it found that 164 measures of this sort had previously been introduced. These efforts culminated in passage of the Futures Trading Act of 1921. That act was promptly declared unconstitutional by the Supreme Court, on the grounds that it was a regulatory measure masquerading as a tax measure. But in 1922 Congress restated the purpose of the 1921 act as "an act for the prevention and removal of obstructions and burdens upon interstate commerce in grain, by regulating transactions on grain futures exchanges," and renamed it the Grain Futures Act of 1922. As an explicitly regulatory measure, it was later upheld by the Court. The objective of the Grain Futures Act was to reduce or eliminate "sudden or unreasonable fluctuations" in the prices of grain on futures exchanges. The framers of the act believed that such sudden or unreasonable fluctuations of grain futures prices reflected their susceptibility to "speculation, manipulation, or control." Moreover, such fluctuations in price were seen to have broad ramifications that affected the national public interest. Grain futures contracts were widely used by producers and distributors of grain to hedge the risks of price fluctuations. Futures prices also were widely disseminated and widely used as the basis for pricing grain transactions off the futures exchanges. Indeed, given the relative size of the agricultural sector of the time, fluctuations in futures prices no doubt had the potential to affect the economy as a whole. It is not entirely clear that the view that futures trading was exacerbating volatility in agricultural prices was well-founded. To be sure, evidence abounds that market participants talked incessantly about corners and bear raids. Moreover, the design of the contracts may, indeed, have made such contracts susceptible to manipulation. However, empirical studies of more recent experience cast doubt on whether the use of derivatives adds to price volatility. And, while charges of market manipulation are heard to this day, they typically are difficult, if not impossible, to prove. Professional speculators were easy to blame for fluctuations in market prices that actually reflected fundamental shifts in supply or demand, as they are today. The market clearing process is a very abstract concept. It is sometimes far easier to envisage price changes as the consequence of individual manipulators. Indeed, for a lot of nineteenth-century ring traders, it was some measure of manhood (women were few) that they could squeeze or corner a market. The evidence suggests that this was largely Walter Middy-type fantasy. In any event, the Grain Futures Act of 1922 established many of the key elements of our current regulatory framework for derivatives. In general, the act was designed to confine futures trading to regulated futures exchanges. The act made it unlawful to trade futures on ---[PAGE_BREAK]--- exchanges other than those designated as contract markets by the Secretary of Agriculture. The Secretary was permitted to so designate an exchange only if certain conditions were met. These included the establishment of procedures for recordkeeping and reporting of futures transactions, for prevention of dissemination of false or misleading crop or market information, and for prevention of price manipulation or cornering of markets. Finally, the act recognized the need to permit bona fide derivatives transactions to be executed off of the regulated exchanges; it explicitly excluded forward contracts for the delivery of grain from the exchange-trading requirement. Forward contracts were essentially defined as contracts for future delivery to which farmers or farm interests were counterparties or in which the seller, if not a farmer, owned the grain at the time of making the contract. The next major piece of federal legislation affecting futures regulation was the Commodity Exchange Act (CEA) of 1936. As in the case of the Grain Futures Act, an important objective of the CEA was to discourage forms of speculation that were seen as exacerbating price volatility. In addition, the CEA introduced provisions designed primarily to protect small investors in commodity futures, whose participation had been increasing and was viewed as beneficial. These provisions included requirements for the registration of futures commission merchants (FCMs), that is, futures brokers, and for the segregation of customer funds from FCM funds. The CEA also expanded the coverage of futures regulation to cover contracts for cotton, rice, and certain other specifically enumerated commodities traded on futures exchanges, and prohibited the trading of options on commodities traded on futures exchanges. The federal regulatory framework for derivatives market regulation then remained substantially unchanged until 1974, when Congress enacted the Commodity Futures Trading Commission Act. The act did not make any fundamental changes in the objectives of derivatives regulation. However, it expanded the scope of the CEA quite significantly. In addition to creating the Commodity Futures Trading Commission (CFTC) as an independent agency and giving the CFTC exclusive jurisdiction over commodity futures and options, the 1974 amendments expanded the CEA's definition of "commodity" beyond a specific list of agricultural commodities to include "all other goods and articles, except onions, . . . and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in." In one respect, this was sweeping deregulation, in that it explicitly allowed the trading on futures exchanges of contracts on virtually any underlying assets, including financial instruments. Only onion futures, banned in 1958 as the presumed favorite plaything of manipulators, remained beyond the pale. In another respect, however, this was a sweeping extension of regulation. Given this broad definition of a commodity and an equally broad interpretation of what constitutes a futures contract, this change brought a tremendous range of off-exchange transactions potentially within the scope of the CEA. In particular, it could be interpreted to extend the broad prohibition on off-exchange trading of futures to an immense volume of diverse transactions that never had been traded on exchanges. The potential for the legality of a wider range of transactions to be called into question did not go unnoticed during debate on the 1974 act. In particular, the Treasury Department proposed language excluding off-exchange derivative transactions in foreign currency, government securities, and certain other financial instruments from the newly expanded CEA. This proposal was adopted by Congress and is known as the Treasury Amendment. In proposing the amendment, Treasury was primarily concerned with protecting foreign exchange markets from what it considered unnecessary and potentially harmful regulation. The foreign exchange markets clearly have quite different characteristics from markets for agricultural futures -- the markets for the major currencies are deep and, as some central banks have learned the hard way, they are extremely difficult to manipulate. ---[PAGE_BREAK]--- Furthermore, participants in those markets, primarily banks and other financial institutions, and large corporations, would not seem to need, and certainly are not seeking, the protection of the CEA. Thus, there was, and is, no reason to presume that the regulatory framework of the CEA needs to be applied to the foreign exchange markets to achieve the public policy objectives that motivated the CEA. Indeed, the wholesale foreign exchange markets provide a clear and compelling example of how private parties can regulate markets quite effectively without government assistance.	Alan Greenspan	United States	https://www.bis.org/review/r970227a.pdf	Mr. Greenspan offers some considerations as a guide for government decisions on regulating the financial markets Remarks by Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Financial Markets Conference of the Federal Reserve Bank of Atlanta held in Coral Gables, Florida on 21/2/97. I am pleased to participate once again in the Federal Reserve Bank of Atlanta's annual Financial Markets Conference. As in previous years, the Reserve Bank has developed a conference program that is quite timely. Changes in technology have permitted the development in recent years of increasingly diverse financial instruments and intensely competitive market structures. The rapid evolution of products and markets has led many to conclude that market regulatory structures, many of which were established in the 1920s and 1930s, have become increasingly outdated. Some see new products and markets not covered by government regulation and fear the consequences of so-called "regulatory gaps." Others see old government regulations applied to new instruments and markets and fear the unintended consequences of what seems unnecessary and burdensome regulation. Nowhere have these tensions been more evident than in the ongoing debate over the appropriate government regulation of derivative contracts, a debate which has varied in intensity but has never fully subsided for at least ten years. Recent efforts by members of the Senate Agriculture Committee to clarify and rationalize the regulation of derivative contracts under the Commodity Exchange Act have once again placed these contentious issues on the front burner. In my remarks today I shall proffer a set of considerations that I find quite valuable as a guide to decisions about the need for government regulation of financial markets. I shall then review the history of government regulation of derivative contracts and markets in the United States and consider the current regulatory structure for those products and markets in light of these considerations. I would argue that the first imperative when evaluating market regulation is to enunciate clearly the public policy objectives that government regulation would be intended to promote. What market characteristics do policymakers seek to encourage? Efficiency? Fair and open access? What phenomena do we wish to discourage or eliminate? Fraud, manipulation, or other unfair practices? Systemic instability? Without explicit answers to these questions, government regulation is unlikely to be effective. More likely, it will prove unnecessary, burdensome, and perhaps even contrary to what more careful consideration would reveal to be the underlying objectives. A second imperative, once public policy objectives are clearly specified, is to evaluate whether government regulation is necessary for those purposes. In making such evaluations, it is critically important to recognize that no market is ever truly unregulated. The self-interest of market participants generates private market regulation. Thus, the real question is not whether a market should be regulated. Rather, the real question is whether government intervention strengthens or weakens private regulation. If incentives for private market regulation are weak or if market participants lack the capabilities to pursue their interests effectively, then the introduction of government regulation may improve regulation. But if private market regulation is effective, then government regulation is at best unnecessary. At worst, the introduction of government regulation may actually weaken the effectiveness of regulation if government regulation is itself ineffective or undermines incentives for private market regulation. We must be aware that government regulation unavoidably involves some element of moral hazard -- if private market participants believe that government is protecting their interests, their own efforts to protect their interests will diminish to some degree. Whether government regulation is needed, and if so, what form of government regulation is optimal, depends critically on a market's characteristics. A "one-size-fits-all" approach to financial market regulation is almost never appropriate. The degree and type of government regulation needed, if any, depends on the types of instruments traded, the types of market participants, and the nature of the relationships among market participants. To cite just one example, a government regulatory framework designed to protect retail investors from fraud or insolvency of brokers is unlikely to be necessary -- and is almost sure to be suboptimal -- if applied to a market in which large institutions transact on a principal-to-principal basis. Recognizing that a one-size-fits-all approach is seldom appropriate, it may be useful to offer transactors a choice between seeking the benefits and accepting the burdens of government regulation, or forgoing those benefits and avoiding those burdens by transacting in financial markets that are only privately regulated. In such circumstances, the privately regulated markets in effect provide a market test of the net benefits of government regulation. Migration of activity from government-regulated to privately regulated markets sends a signal to government regulators that many transactors believe the costs of regulation exceed the benefits. When such migration occurs, government regulators should consider carefully whether less regulation or different regulation would provide a better cost-benefit tradeoff without compromising public policy objectives. Before evaluating the current regulation of derivatives in light of these considerations, it is quite useful to know something of the history of these instruments and their regulation. Derivative contracts (forward contracts and options) appear to have been utilized throughout American history. Indeed, it will probably come as a surprise even to this audience that 15 to 25 percent of trades on the New York Stock Exchange in its early years were time bargains, that is, forward contracts, rather than transactions for cash settlement (in those days, same-day settlement) or regular-way settlement (next-day settlement). In the case of commodities, forward contracts for corn, wheat, and other grains came into common use by 1850 in Chicago, where they were known as "to arrive" contracts. The first organized futures exchange in the United States, the Chicago Board of Trade, evolved through the progressive standardization of the terms of "to arrive" contracts, including lot sizes, grades of grain, and delivery periods. Trading apparently was centralized on the Board of Trade by 1859, and in 1865 it set out detailed rules for the trading of highly standardized contracts quite similar to the grain futures contracts traded today. The first recorded instance of federal government regulation of derivatives was the Anti-Gold Futures Act of 1864, which prohibited the trading of gold futures. The government had been unhappy that its fiat currency issues, the infamous greenbacks, were at that time trading at a substantial discount to gold. Unwilling to accept this result as evidence of failure of the government's monetary policies, Congress concluded that it was evidence of a serious failure of private market regulation. In the event, Congress's action was followed by a further sharp drop in the value of the greenbacks. Although it took the government many years to restore monetary policy to a sound footing, it took Congress only two weeks to conclude that its prohibition of gold futures was having unintended consequences and to repeal the act. It has been the trading of agricultural futures, however, that from its inception has produced calls for government intervention. Throughout the late nineteenth and early twentieth centuries, farmers were often opposed to futures trading, particularly during periods when prices of their products were low or declining. They presumed that dreaded speculators were depressing their prices. The states were the first to respond to calls for government regulation of futures. For the most part, state legislation on futures was limited to prohibitions on bucket shops, that is, operations that purport to act as brokers of exchange-traded futures but "bucket" rather than execute their clients' trades. An Illinois statute of 1874 signaled early concerns about market integrity. The statute criminalized the spreading of false rumors to influence commodity prices and attempts to corner commodity markets. After its misadventure with futures regulation during the Civil War, the federal government appears not to have given further consideration to regulating futures trading until 1883, when a bill was introduced in Congress to prohibit use of the mails to market futures. Thereafter, repeated efforts were made to regulate or prohibit trading of futures and options on agricultural products. When the Agriculture Department reviewed the Congressional Record in 1920, it found that 164 measures of this sort had previously been introduced. These efforts culminated in passage of the Futures Trading Act of 1921. That act was promptly declared unconstitutional by the Supreme Court, on the grounds that it was a regulatory measure masquerading as a tax measure. But in 1922 Congress restated the purpose of the 1921 act as "an act for the prevention and removal of obstructions and burdens upon interstate commerce in grain, by regulating transactions on grain futures exchanges," and renamed it the Grain Futures Act of 1922. As an explicitly regulatory measure, it was later upheld by the Court. The objective of the Grain Futures Act was to reduce or eliminate "sudden or unreasonable fluctuations" in the prices of grain on futures exchanges. The framers of the act believed that such sudden or unreasonable fluctuations of grain futures prices reflected their susceptibility to "speculation, manipulation, or control." Moreover, such fluctuations in price were seen to have broad ramifications that affected the national public interest. Grain futures contracts were widely used by producers and distributors of grain to hedge the risks of price fluctuations. Futures prices also were widely disseminated and widely used as the basis for pricing grain transactions off the futures exchanges. Indeed, given the relative size of the agricultural sector of the time, fluctuations in futures prices no doubt had the potential to affect the economy as a whole. It is not entirely clear that the view that futures trading was exacerbating volatility in agricultural prices was well-founded. To be sure, evidence abounds that market participants talked incessantly about corners and bear raids. Moreover, the design of the contracts may, indeed, have made such contracts susceptible to manipulation. However, empirical studies of more recent experience cast doubt on whether the use of derivatives adds to price volatility. And, while charges of market manipulation are heard to this day, they typically are difficult, if not impossible, to prove. Professional speculators were easy to blame for fluctuations in market prices that actually reflected fundamental shifts in supply or demand, as they are today. The market clearing process is a very abstract concept. It is sometimes far easier to envisage price changes as the consequence of individual manipulators. Indeed, for a lot of nineteenth-century ring traders, it was some measure of manhood (women were few) that they could squeeze or corner a market. The evidence suggests that this was largely Walter Middy-type fantasy. In any event, the Grain Futures Act of 1922 established many of the key elements of our current regulatory framework for derivatives. In general, the act was designed to confine futures trading to regulated futures exchanges. The act made it unlawful to trade futures on exchanges other than those designated as contract markets by the Secretary of Agriculture. The Secretary was permitted to so designate an exchange only if certain conditions were met. These included the establishment of procedures for recordkeeping and reporting of futures transactions, for prevention of dissemination of false or misleading crop or market information, and for prevention of price manipulation or cornering of markets. Finally, the act recognized the need to permit bona fide derivatives transactions to be executed off of the regulated exchanges; it explicitly excluded forward contracts for the delivery of grain from the exchange-trading requirement. Forward contracts were essentially defined as contracts for future delivery to which farmers or farm interests were counterparties or in which the seller, if not a farmer, owned the grain at the time of making the contract. The next major piece of federal legislation affecting futures regulation was the Commodity Exchange Act (CEA) of 1936. As in the case of the Grain Futures Act, an important objective of the CEA was to discourage forms of speculation that were seen as exacerbating price volatility. In addition, the CEA introduced provisions designed primarily to protect small investors in commodity futures, whose participation had been increasing and was viewed as beneficial. These provisions included requirements for the registration of futures commission merchants (FCMs), that is, futures brokers, and for the segregation of customer funds from FCM funds. The CEA also expanded the coverage of futures regulation to cover contracts for cotton, rice, and certain other specifically enumerated commodities traded on futures exchanges, and prohibited the trading of options on commodities traded on futures exchanges. The federal regulatory framework for derivatives market regulation then remained substantially unchanged until 1974, when Congress enacted the Commodity Futures Trading Commission Act. The act did not make any fundamental changes in the objectives of derivatives regulation. However, it expanded the scope of the CEA quite significantly. In addition to creating the Commodity Futures Trading Commission (CFTC) as an independent agency and giving the CFTC exclusive jurisdiction over commodity futures and options, the 1974 amendments expanded the CEA's definition of "commodity" beyond a specific list of agricultural commodities to include "all other goods and articles, except onions, . . . and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in." In one respect, this was sweeping deregulation, in that it explicitly allowed the trading on futures exchanges of contracts on virtually any underlying assets, including financial instruments. Only onion futures, banned in 1958 as the presumed favorite plaything of manipulators, remained beyond the pale. In another respect, however, this was a sweeping extension of regulation. Given this broad definition of a commodity and an equally broad interpretation of what constitutes a futures contract, this change brought a tremendous range of off-exchange transactions potentially within the scope of the CEA. In particular, it could be interpreted to extend the broad prohibition on off-exchange trading of futures to an immense volume of diverse transactions that never had been traded on exchanges. The potential for the legality of a wider range of transactions to be called into question did not go unnoticed during debate on the 1974 act. In particular, the Treasury Department proposed language excluding off-exchange derivative transactions in foreign currency, government securities, and certain other financial instruments from the newly expanded CEA. This proposal was adopted by Congress and is known as the Treasury Amendment. In proposing the amendment, Treasury was primarily concerned with protecting foreign exchange markets from what it considered unnecessary and potentially harmful regulation. The foreign exchange markets clearly have quite different characteristics from markets for agricultural futures -- the markets for the major currencies are deep and, as some central banks have learned the hard way, they are extremely difficult to manipulate. Furthermore, participants in those markets, primarily banks and other financial institutions, and large corporations, would not seem to need, and certainly are not seeking, the protection of the CEA. Thus, there was, and is, no reason to presume that the regulatory framework of the CEA needs to be applied to the foreign exchange markets to achieve the public policy objectives that motivated the CEA. Indeed, the wholesale foreign exchange markets provide a clear and compelling example of how private parties can regulate markets quite effectively without government assistance.
1997-02-26T00:00:00	Mr. Greenspan presents the views of the Federal Reserve in its semi-annual report on monetary policy (Central Bank Articles and Speeches, 26 Feb 97)	Testimony of the Chairman of the Board of Governors of the Federal Reserve System, Mr. Alan Greenspan, before the Senate Banking Committee on 26/2/97.	Mr. Greenspan presents the views of the Federal Reserve in its semi-annual report on monetary policy Testimony of the Chairman of the Board of Governors of the Federal Reserve System, Mr. Alan Greenspan, before the Senate Banking Committee on 26/2/97. I appreciate the opportunity to appear before this Committee to present the Federal Reserve's semiannual report on monetary policy. The performance of the U.S. economy over the past year has been quite favorable. Real GDP growth has picked up to more than three percent over the four quarters of 1996, as the economy progressed through its sixth year of expansion. Employers added more than two-and-a-half million workers to their payrolls in 1996, and the unemployment rate fell further. Nominal wages and salaries have increased faster than prices, meaning workers have gained ground in real terms, reflecting the benefits of rising productivity. Outside the food and energy sectors, increases in consumer prices actually have continued to edge lower, with core CPI inflation only 21⁄2 percent over the past twelve months. Low inflation last year was both a symptom and a cause of the good economy. It was symptomatic of the balance and solidity of the expansion and the evident absence of major strains on resources. At the same time, continued low levels of inflation and inflation expectations have been a key support for healthy economic performance. They have helped to create a financial and economic environment conducive to strong capital spending and longer-range planning generally, and so to sustained economic expansion. Consequently, the Federal Open Market Committee (FOMC) believes it is crucial to keep inflation contained in the near term and ultimately to move toward price stability. Looking ahead, the members of the FOMC expect inflation to remain low and the economy to grow appreciably further. However, as I shall be discussing, the unusually good inflation performance of recent years seems to owe in large part to some temporary factors, of uncertain longevity. Thus, the FOMC continues to see the distribution of inflation risks skewed to the upside and must remain especially alert to the possible emergence of imbalances in financial and product markets that ultimately could endanger the maintenance of the low-inflation environment. Sustainable economic expansion for 1997 and beyond depends on it. For some, the benign inflation outcome of 1996 might be considered surprising, as resource utilization rates -- particularly of labor -- were in the neighborhood of those that historically have been associated with building inflation pressures. To be sure, an acceleration in nominal labor compensation, especially its wage component, became evident over the past year. But the rate of pay increase still was markedly less than historical relationships with labor market conditions would have predicted. A typical restraint on compensation increases has been evident for a few years now and appears to be mainly the consequence of greater worker insecurity. In 1991, at the bottom of the recession, a survey of workers at large firms by International Survey Research Corporation indicated that 25 percent feared being laid off. In 1996, despite the sharply lower unemployment rate and the tighter labor market, the same survey organization found that 46 percent were fearful of a job layoff. The reluctance of workers to leave their jobs to seek other employment as the labor market tightened has provided further evidence of such concern, as has the tendency toward longer labor union contracts. For many decades, contracts rarely exceeded three years. Today, one can point to five- and six-year contracts -- contracts that are commonly characterized by an emphasis on job security and that involve only modest wage increases. The low level of work stoppages of recent years also attests to concern about job security. Thus, the willingness of workers in recent years to trade off smaller increases in wages for greater job security seems to be reasonably well documented. The unanswered question is why this insecurity persisted even as the labor market, by all objective measures, tightened considerably. One possibility may lie in the rapid evolution of technologies in use in the work place. Technological change almost surely has been an important impetus behind corporate restructuring and downsizing. Also, it contributes to the concern of workers that their job skills may become inadequate. No longer can one expect to obtain all of one's lifetime job skills with a high-school or college diploma. Indeed, continuing education is perceived to be increasingly necessary to retain a job. The more pressing need to update job skills is doubtless also a factor in the marked expansion of on-the-job training programs, especially in technical areas, in many of the nation's corporations. Certainly, other factors have contributed to the softness in compensation growth in the past few years. The sharp deceleration in health care costs, of course, is cited frequently. Another is the heightened pressure on firms and their workers in industries that compete internationally. Domestic deregulation has had similar effects on the intensity of competitive forces in some industries. In any event, although I do not doubt that all these factors are relevant, I would be surprised if they were nearly as important as job insecurity. If heightened job insecurity is the most significant explanation of the break with the past in recent years, then it is important to recognize that, as I indicated in last February's Humphrey-Hawkins testimony, suppressed wage cost growth as a consequence of job insecurity can be carried only so far. At some point, the tradeoff of subdued wage growth for job security has to come to an end. In other words, the relatively modest wage gains we have experienced are a temporary rather than a lasting phenomenon because there is a limit to the value of additional job security people are willing to acquire in exchange for lesser increases in living standards. Even if real wages were to remain permanently on a lower upward track than otherwise as a result of the greater sense of insecurity, the rate of change of wages would revert at some point to a normal relationship with inflation. The unknown is when this transition period will end. Indeed, some recent evidence suggests that the labor markets bear especially careful watching for signs that the return to more normal patterns may be in process. The Bureau of Labor Statistics reports that people were somewhat more willing to quit their jobs to seek other employment in January than previously. The possibility that this reflects greater confidence by workers accords with a recent further rise in the percent of households responding to a Conference Board survey who perceive that job availability is plentiful. Of course, the job market has continued to be quite good recently; employment in January registered robust growth and initial claims for unemployment insurance have been at a relatively low level of late. Wages rose faster in 1996 than in 1995 by most measures, perhaps also raising questions about whether the transitional period of unusually slow wage gains may be drawing to a close. To be sure, the pickup in wage gains has not shown through to underlying price inflation. Increases in the core CPI, as well as in several broader measures of prices, have stayed subdued or even edged off further in recent months. As best we can judge, faster productivity growth last year meant that rising compensation gains did not cause labor costs per unit of output to increase any more rapidly. Non-labor costs, which are roughly a quarter of total consolidated costs of the nonfinancial corporate sector, were little changed in 1996. Owing in part to this subdued behavior of unit costs, profits and rates of return on capital have risen to high levels. As a consequence, businesses believe that, were they to raise prices to boost profits further, competitors with already ample profit margins would not follow suit; instead, they would use the occasion to capture a greater market share. This interplay is doubtless a significant factor in the evident loss of pricing power in American business. Intensifying global competition also may be further restraining domestic firms' ability to hike prices as well as wages. Clearly, the appreciation of the dollar on balance over the past eighteen months or so, together with low inflation in many of our trading partners, has resulted in a marked decline in non-oil import prices that has helped to damp domestic inflation pressures. Yet it is important to emphasize that these influences, too, would be holding down inflation only temporarily; they represent a transition to a lower price level than would otherwise prevail, not to a permanently lower rate of inflation. Against the background of all these considerations, the FOMC has recognized the need to remain vigilant for signs of potentially inflationary imbalances that might, if not corrected promptly, undermine our economic expansion. The FOMC in fact has signaled a state of heightened alert for possible policy tightening since last July in its policy directives. But, we have also taken care not to act prematurely. The FOMC refrained from changing policy last summer, despite expectations of a near-term policy firming by many financial market participants. In light of the developments I've just discussed affecting wages and prices, we thought inflation might well remain damped, and in any case was unlikely to pick up very rapidly, in part because the economic expansion appeared likely to slow to a more sustainable pace. In the event, inflation has remained quiescent since then. Given the lags with which monetary policy affects the economy, however, we cannot rule out a situation in which a preemptive policy tightening may become appropriate before any sign of actual higher inflation becomes evident. If the FOMC were to implement such an action, it would be judging that the risks to the economic expansion of waiting longer had increased unduly and had begun to outweigh the advantages of waiting for uncertainties to be reduced by the accumulation of more information about economic trends. Indeed, the hallmark of a successful policy to foster sustainable economic growth is that inflation does not rise. I find it ironic that our actions in 1994-95 were criticized by some because inflation did not turn upward. That outcome, of course, was the intent of the tightening, and I am satisfied that our actions then were both necessary and effective, and helped to foster the continued economic expansion. To be sure, 1997 is not 1994. The real federal funds rate today is significantly higher than it was three years ago. Then we had just completed an extended period of monetary ease which addressed the credit stringencies of the early 1990s, and with the abatement of the credit crunch, the low real funds rate of early 1994 was clearly incompatible with containing inflation and sustaining growth going forward. In February 1997, in contrast, our concern is a matter of relative risks rather than of expected outcomes. The real funds rate, judging by core inflation, is only slightly below its early 1995 peak for this cycle and might be at a level that will promote continued non-inflationary growth, especially considering the recent rise in the exchange value of the dollar. Nonetheless, we cannot be sure. And the risks of being wrong are clearly tilted to the upside. I wish it were possible to lay out in advance exactly what conditions have to prevail to portend a buildup of inflation pressures or inflationary psychology. However, the circumstances that have been associated with increasing inflation in the past have not followed a single pattern. The processes have differed from cycle to cycle, and what may have been a useful leading indicator in one instance has given off misleading signals in another. I have already discussed the key role of labor market developments in restraining inflation in the current cycle and our careful monitoring of signs that the transition phase of trading off lower real wages for greater job security might be coming to a close. As always, with resource utilization rates high, we would need to watch closely a situation in which demand was clearly unsustainable because it was producing escalating pressures on resources, which could destabilize the economy. And we would need to be watchful that the progress we have made in keeping inflation expectations damped was not eroding. In general, though, our analysis will need to encompass all potentially relevant information, from financial markets as well as the economy, especially when some signals, like those in the labor market, have not been following their established patterns. The ongoing economic expansion to date has reinforced our conviction about the importance of low inflation -- and the public's confidence in continued low inflation. The economic expansion almost surely would not have lasted nearly so long had monetary policy supported an unsustainable acceleration of spending that induced a buildup of inflationary imbalances. The Federal Reserve must not acquiesce in an upcreep in inflation, for acceding to higher inflation would countenance an insidious weakening of our chances for sustaining long-run economic growth. Inflation interferes with the efficient allocation of resources by confusing price signals, undercutting a focus on the longer run, and distorting incentives. This year overall inflation is anticipated to stay restrained. The central tendency of the forecasts made by the Board members and Reserve Bank presidents has the increase in the total CPI slipping back into a range of 23⁄4 to 3 percent over the four quarters of the year. This slight falloff from last year's pace is expected to owe in part to a slower rise in food prices as some of last year's supply limitations ease. More importantly, world oil supplies are projected by most analysts to increase relative to world oil demand, and futures markets project a further decline in prices, at least in the near term. The recent and prospective declines in crude oil prices not only should affect retail gasoline and home heating oil prices but also should relieve inflation pressures through lower prices for other petroleum products, which are imbedded in the economy's underlying cost structure. Nonetheless, the trend in inflation rates in the core CPI and in broader price measures may be somewhat less favorable than in recent years. A continued tight labor market, whose influence on costs would be augmented by the scheduled increase in the minimum wage later in the year and perhaps by higher growth of benefits now that considerable health-care savings already have been realized, could put upward pressure on core inflation. Moreover, the effects of the sharp rise in the dollar over the last eighteen months in pushing down import prices are likely to ebb over coming quarters. The unemployment rate, according to Board members and Bank presidents, should stay around 51⁄4 to 51⁄2 percent through the fourth quarter, consistent with their projections of measured real GDP growth of 2 to 21⁄4 percent over the four quarters of the year. Such a growth rate would represent some downshifting in output expansion from that of last year. The projected moderation of growth likely would reflect several influences: (1) declines in real federal government purchases should be exerting a modest degree of restraint on overall demand; (2) the lagged effects of the increase in the exchange value of the dollar in recent months likely will damp U.S. net exports somewhat this year; and (3) residential construction is unlikely to repeat the gains of 1996. On the other hand, we do not see evidence of widespread imbalances either in business inventories or in stocks of equipment and consumer durables that would lead to a substantial cutback in spending. And financial conditions overall remain supportive; real interest rates are not high by historical standards and credit is readily available from intermediaries and in the market. The usual uncertainties in the overall outlook are especially focused on the behavior of consumers. Consumption should rise roughly in line with the projected moderate expansion of disposable income, but both upside and downside risks are present. According to various surveys, sentiment is decidedly upbeat. Consumers have enjoyed healthy gains in their real incomes along with the extraordinary stock-market driven rise in their financial wealth over the last couple of years. Indeed, econometric models suggest that the more than $4 trillion rise in equity values since late 1994 should have had a larger positive influence on consumer spending than seems to have actually occurred. It is possible, however, that households have been reluctant to spend much of their added wealth because they see a greater need to keep it to support spending in retirement. Many households have expressed heightened concern about their financial security in old age, which reportedly has led to increased provision for retirement. The results of a survey conducted annually by the Roper Organization, which asks individuals about their confidence in the Social Security system, shows that between 1992 and 1996 the percent of respondents expressing little or no confidence in the system jumped from about 45 percent to more than 60 percent. Moreover, consumer debt burdens are near historical highs, while credit card delinquencies and personal bankruptcies have risen sharply over the past year. These circumstances may make both borrowers and lenders a bit more cautious, damping spending. In fact, we may be seeing both wealth and debt effects already at work for different segments of the population, to an approximately offsetting extent. Saving out of current income by households in the upper income quintile, who own nearly three-fourths of all non-pension equities held by households, evidently has declined in recent years. At the same time, the use of credit for purchases appears to have leveled off after a sharp runup from 1993 to 1996, perhaps because some households are becoming debt constrained and, as a result, are curtailing their spending. The Federal Reserve will be weighing these influences as it endeavors to help extend the current period of sustained growth. Participants in financial markets seem to believe that in the current benign environment the FOMC will succeed indefinitely. There is no evidence, however, that the business cycle has been repealed. Another recession will doubtless occur some day owing to circumstances that could not be, or at least were not, perceived by policymakers and financial market participants alike. History demonstrates that participants in financial markets are susceptible to waves of optimism, which can in turn foster a general process of asset-price inflation that can feed through into markets for goods and services. Excessive optimism sows the seeds of its own reversal in the form of imbalances that tend to grow over time. When unwarranted expectations ultimately are not realized, the unwinding of these financial excesses can act to amplify a downturn in economic activity, much as they can amplify the upswing. As you know, last December I put the question this way: "...how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions ...?" We have not been able, as yet, to provide a satisfying answer to this question, but there are reasons in the current environment to keep this question on the table. Clearly, when people are exposed to long periods of relative economic tranquility, they seem inevitably prone to complacency about the future. This is understandable. We have had fifteen years of economic expansion interrupted by only one recession -- and that was six years ago. As the memory of such past events fades, it naturally seems ever less sensible to keep up one's guard against an adverse event in the future. Thus, it should come as no surprise that, after such a long period of balanced expansion, risk premiums for advancing funds to businesses in virtually all financial markets have declined to near-record lows. Is it possible that there is something fundamentally new about this current period that would warrant such complacency? Yes, it is possible. Markets may have become more efficient, competition is more global, and information technology has doubtless enhanced the stability of business operations. But, regrettably, history is strewn with visions of such "new eras" that, in the end, have proven to be a mirage. In short, history counsels caution. Such caution seems especially warranted with regard to the sharp rise in equity prices during the past two years. These gains have obviously raised questions of sustainability. Analytically, current stock-price valuations at prevailing long-term interest rates could be justified by very strong earnings growth expectations. In fact, the long-term earnings projections of financial analysts have been marked up noticeably over the last year and seem to imply very high earnings growth and continued rising profit margins, at a time when such margins are already up appreciably from their depressed levels of five years ago. It could be argued that, although margins are the highest in a generation, they are still below those that prevailed in the 1960s. Nonetheless, further increases in these margins would evidently require continued restraint on costs: labor compensation continuing to grow at its current pace and productivity growth picking up. Neither, of course, can be ruled out. But we should keep in mind that, at these relatively low long-term interest rates, small changes in long-term earnings expectations could have outsized impacts on equity prices. Caution also seems warranted by the narrow yield spreads that suggest perceptions of low risk, possibly unrealistically low risk. Considerable optimism about the ability of businesses to sustain this current healthy financial condition seems, as I indicated earlier, to be influencing the setting of risk premiums, not just in the stock market but throughout the financial system. This optimistic attitude has become especially evident in quality spreads on high-yield corporate bonds -- what we used to call "junk bonds." In addition, banks have continued to ease terms and standards on business loans, and margins on many of these loans are now quite thin. Many banks are pulling back a little from consumer credit card lending as losses exceed expectations. Nonetheless, some bank and nonbank lenders have been expanding aggressively into the home equity loan market and so-called "subprime" auto lending, although recent problems in the latter may already be introducing a sense of caution. Why should the central bank be concerned about the possibility that financial markets may be overestimating returns or mispricing risk? It is not that we have a firm view that equity prices are necessarily excessive right now or risk spreads patently too low. Our goal is to contribute as best we can to the highest possible growth of income and wealth over time, and we would be pleased if the favorable economic environment projected in markets actually comes to pass. Rather, the FOMC has to be sensitive to indications of even slowly building imbalances, whatever their source, that, by fostering the emergence of inflation pressures, would ultimately threaten healthy economic expansion. Unfortunately, because the monetary aggregates were subject to an episode of aberrant behavioral patterns in the early 1990s, they are likely to be of only limited help in making this judgment. For three decades starting in the early 1960s, the public's demand for the broader monetary aggregates, especially M2, was reasonably predictable. In the intermediate term, M2 velocity -- nominal income divided by the stock of M2 -- tended to vary directly with the difference between money market yields and the return on M2 assets -- that is, with its short-term opportunity cost. In the long run, as adjustments in deposit rates caused the opportunity cost to revert to an equilibrium, M2 velocity also tended to return to an associated stable equilibrium level. For several years in the early 1990s, however, the velocities of M2 and M3 exhibited persisting upward shifts that departed markedly from these historical patterns. In the last two to three years, velocity patterns seem to have returned to those historical relationships, after allowing for a presumed permanent upward shift in the levels of velocity. Even so, given the abnormal velocity behavior during the early 1990s, FOMC members continue to see considerable uncertainty in the relationship of broad money to opportunity costs and nominal income. Concern about the possibility of aberrant behavior has made the FOMC hesitant to upgrade the role of these measures in monetary policy. Against this background, at its February meeting, the FOMC reaffirmed the provisional ranges set last July for money and debt growth this year: 1 to 5 percent for M2, 2 to 6 percent for M3, and 3 to 7 percent for the debt of domestic nonfinancial sectors. The M2 and M3 ranges again are designed to be consistent with the FOMC's long-run goal of price stability: For, if the velocities of the broader monetary aggregates were to continue behaving as they did before 1990, then money growth around the middle portions of the ranges would be consistent with noninflationary, sustainable economic expansion. But, even with such velocity behavior this year, when inflation is expected to still be higher than is consistent with our long-run objective of reasonable price stability, the broader aggregates could well grow around the upper bounds of these ranges. The debt aggregate probably will expand around the middle of its range this year. I will conclude on the same upbeat note about the U.S. economy with which I began. Although a central banker's occupational responsibility is to stay on the lookout for trouble, even I must admit that our economic prospects in general are quite favorable. The flexibility of our market system and the vibrancy of our private sector remain examples for the whole world to emulate. The Federal Reserve will endeavor to do its part by continuing to foster a monetary framework under which our citizens can prosper to the fullest possible extent.	---[PAGE_BREAK]--- # Mr. Greenspan presents the views of the Federal Reserve in its semi-annual report on monetary policy Testimony of the Chairman of the Board of Governors of the Federal Reserve System, Mr. Alan Greenspan, before the Senate Banking Committee on 26/2/97. I appreciate the opportunity to appear before this Committee to present the Federal Reserve's semiannual report on monetary policy. The performance of the U.S. economy over the past year has been quite favorable. Real GDP growth has picked up to more than three percent over the four quarters of 1996, as the economy progressed through its sixth year of expansion. Employers added more than two-and-a-half million workers to their payrolls in 1996, and the unemployment rate fell further. Nominal wages and salaries have increased faster than prices, meaning workers have gained ground in real terms, reflecting the benefits of rising productivity. Outside the food and energy sectors, increases in consumer prices actually have continued to edge lower, with core CPI inflation only $21 / 2$ percent over the past twelve months. Low inflation last year was both a symptom and a cause of the good economy. It was symptomatic of the balance and solidity of the expansion and the evident absence of major strains on resources. At the same time, continued low levels of inflation and inflation expectations have been a key support for healthy economic performance. They have helped to create a financial and economic environment conducive to strong capital spending and longer-range planning generally, and so to sustained economic expansion. Consequently, the Federal Open Market Committee (FOMC) believes it is crucial to keep inflation contained in the near term and ultimately to move toward price stability. Looking ahead, the members of the FOMC expect inflation to remain low and the economy to grow appreciably further. However, as I shall be discussing, the unusually good inflation performance of recent years seems to owe in large part to some temporary factors, of uncertain longevity. Thus, the FOMC continues to see the distribution of inflation risks skewed to the upside and must remain especially alert to the possible emergence of imbalances in financial and product markets that ultimately could endanger the maintenance of the low-inflation environment. Sustainable economic expansion for 1997 and beyond depends on it. For some, the benign inflation outcome of 1996 might be considered surprising, as resource utilization rates -- particularly of labor -- were in the neighborhood of those that historically have been associated with building inflation pressures. To be sure, an acceleration in nominal labor compensation, especially its wage component, became evident over the past year. But the rate of pay increase still was markedly less than historical relationships with labor market conditions would have predicted. A typical restraint on compensation increases has been evident for a few years now and appears to be mainly the consequence of greater worker insecurity. In 1991, at the bottom of the recession, a survey of workers at large firms by International Survey Research Corporation indicated that 25 percent feared being laid off. In 1996, despite the sharply lower unemployment rate and the tighter labor market, the same survey organization found that 46 percent were fearful of a job layoff. The reluctance of workers to leave their jobs to seek other employment as the labor market tightened has provided further evidence of such concern, as has the tendency toward longer labor union contracts. For many decades, contracts rarely exceeded three years. Today, one can point to five- and six-year contracts -- contracts that are commonly characterized ---[PAGE_BREAK]--- by an emphasis on job security and that involve only modest wage increases. The low level of work stoppages of recent years also attests to concern about job security. Thus, the willingness of workers in recent years to trade off smaller increases in wages for greater job security seems to be reasonably well documented. The unanswered question is why this insecurity persisted even as the labor market, by all objective measures, tightened considerably. One possibility may lie in the rapid evolution of technologies in use in the work place. Technological change almost surely has been an important impetus behind corporate restructuring and downsizing. Also, it contributes to the concern of workers that their job skills may become inadequate. No longer can one expect to obtain all of one's lifetime job skills with a high-school or college diploma. Indeed, continuing education is perceived to be increasingly necessary to retain a job. The more pressing need to update job skills is doubtless also a factor in the marked expansion of on-the-job training programs, especially in technical areas, in many of the nation's corporations. Certainly, other factors have contributed to the softness in compensation growth in the past few years. The sharp deceleration in health care costs, of course, is cited frequently. Another is the heightened pressure on firms and their workers in industries that compete internationally. Domestic deregulation has had similar effects on the intensity of competitive forces in some industries. In any event, although I do not doubt that all these factors are relevant, I would be surprised if they were nearly as important as job insecurity. If heightened job insecurity is the most significant explanation of the break with the past in recent years, then it is important to recognize that, as I indicated in last February's Humphrey-Hawkins testimony, suppressed wage cost growth as a consequence of job insecurity can be carried only so far. At some point, the tradeoff of subdued wage growth for job security has to come to an end. In other words, the relatively modest wage gains we have experienced are a temporary rather than a lasting phenomenon because there is a limit to the value of additional job security people are willing to acquire in exchange for lesser increases in living standards. Even if real wages were to remain permanently on a lower upward track than otherwise as a result of the greater sense of insecurity, the rate of change of wages would revert at some point to a normal relationship with inflation. The unknown is when this transition period will end. Indeed, some recent evidence suggests that the labor markets bear especially careful watching for signs that the return to more normal patterns may be in process. The Bureau of Labor Statistics reports that people were somewhat more willing to quit their jobs to seek other employment in January than previously. The possibility that this reflects greater confidence by workers accords with a recent further rise in the percent of households responding to a Conference Board survey who perceive that job availability is plentiful. Of course, the job market has continued to be quite good recently; employment in January registered robust growth and initial claims for unemployment insurance have been at a relatively low level of late. Wages rose faster in 1996 than in 1995 by most measures, perhaps also raising questions about whether the transitional period of unusually slow wage gains may be drawing to a close. To be sure, the pickup in wage gains has not shown through to underlying price inflation. Increases in the core CPI, as well as in several broader measures of prices, have stayed subdued or even edged off further in recent months. As best we can judge, faster productivity growth last year meant that rising compensation gains did not cause labor costs per unit of output to increase any more rapidly. Non-labor costs, which are roughly a quarter of total consolidated costs of the nonfinancial corporate sector, were little changed in 1996. ---[PAGE_BREAK]--- Owing in part to this subdued behavior of unit costs, profits and rates of return on capital have risen to high levels. As a consequence, businesses believe that, were they to raise prices to boost profits further, competitors with already ample profit margins would not follow suit; instead, they would use the occasion to capture a greater market share. This interplay is doubtless a significant factor in the evident loss of pricing power in American business. Intensifying global competition also may be further restraining domestic firms' ability to hike prices as well as wages. Clearly, the appreciation of the dollar on balance over the past eighteen months or so, together with low inflation in many of our trading partners, has resulted in a marked decline in non-oil import prices that has helped to damp domestic inflation pressures. Yet it is important to emphasize that these influences, too, would be holding down inflation only temporarily; they represent a transition to a lower price level than would otherwise prevail, not to a permanently lower rate of inflation. Against the background of all these considerations, the FOMC has recognized the need to remain vigilant for signs of potentially inflationary imbalances that might, if not corrected promptly, undermine our economic expansion. The FOMC in fact has signaled a state of heightened alert for possible policy tightening since last July in its policy directives. But, we have also taken care not to act prematurely. The FOMC refrained from changing policy last summer, despite expectations of a near-term policy firming by many financial market participants. In light of the developments I've just discussed affecting wages and prices, we thought inflation might well remain damped, and in any case was unlikely to pick up very rapidly, in part because the economic expansion appeared likely to slow to a more sustainable pace. In the event, inflation has remained quiescent since then. Given the lags with which monetary policy affects the economy, however, we cannot rule out a situation in which a preemptive policy tightening may become appropriate before any sign of actual higher inflation becomes evident. If the FOMC were to implement such an action, it would be judging that the risks to the economic expansion of waiting longer had increased unduly and had begun to outweigh the advantages of waiting for uncertainties to be reduced by the accumulation of more information about economic trends. Indeed, the hallmark of a successful policy to foster sustainable economic growth is that inflation does not rise. I find it ironic that our actions in 1994-95 were criticized by some because inflation did not turn upward. That outcome, of course, was the intent of the tightening, and I am satisfied that our actions then were both necessary and effective, and helped to foster the continued economic expansion. To be sure, 1997 is not 1994. The real federal funds rate today is significantly higher than it was three years ago. Then we had just completed an extended period of monetary ease which addressed the credit stringencies of the early 1990s, and with the abatement of the credit crunch, the low real funds rate of early 1994 was clearly incompatible with containing inflation and sustaining growth going forward. In February 1997, in contrast, our concern is a matter of relative risks rather than of expected outcomes. The real funds rate, judging by core inflation, is only slightly below its early 1995 peak for this cycle and might be at a level that will promote continued non-inflationary growth, especially considering the recent rise in the exchange value of the dollar. Nonetheless, we cannot be sure. And the risks of being wrong are clearly tilted to the upside. I wish it were possible to lay out in advance exactly what conditions have to prevail to portend a buildup of inflation pressures or inflationary psychology. However, the circumstances that have been associated with increasing inflation in the past have not followed a ---[PAGE_BREAK]--- single pattern. The processes have differed from cycle to cycle, and what may have been a useful leading indicator in one instance has given off misleading signals in another. I have already discussed the key role of labor market developments in restraining inflation in the current cycle and our careful monitoring of signs that the transition phase of trading off lower real wages for greater job security might be coming to a close. As always, with resource utilization rates high, we would need to watch closely a situation in which demand was clearly unsustainable because it was producing escalating pressures on resources, which could destabilize the economy. And we would need to be watchful that the progress we have made in keeping inflation expectations damped was not eroding. In general, though, our analysis will need to encompass all potentially relevant information, from financial markets as well as the economy, especially when some signals, like those in the labor market, have not been following their established patterns. The ongoing economic expansion to date has reinforced our conviction about the importance of low inflation -- and the public's confidence in continued low inflation. The economic expansion almost surely would not have lasted nearly so long had monetary policy supported an unsustainable acceleration of spending that induced a buildup of inflationary imbalances. The Federal Reserve must not acquiesce in an upcreep in inflation, for acceding to higher inflation would countenance an insidious weakening of our chances for sustaining long-run economic growth. Inflation interferes with the efficient allocation of resources by confusing price signals, undercutting a focus on the longer run, and distorting incentives. This year overall inflation is anticipated to stay restrained. The central tendency of the forecasts made by the Board members and Reserve Bank presidents has the increase in the total CPI slipping back into a range of $23 / 4$ to 3 percent over the four quarters of the year. This slight falloff from last year's pace is expected to owe in part to a slower rise in food prices as some of last year's supply limitations ease. More importantly, world oil supplies are projected by most analysts to increase relative to world oil demand, and futures markets project a further decline in prices, at least in the near term. The recent and prospective declines in crude oil prices not only should affect retail gasoline and home heating oil prices but also should relieve inflation pressures through lower prices for other petroleum products, which are imbedded in the economy's underlying cost structure. Nonetheless, the trend in inflation rates in the core CPI and in broader price measures may be somewhat less favorable than in recent years. A continued tight labor market, whose influence on costs would be augmented by the scheduled increase in the minimum wage later in the year and perhaps by higher growth of benefits now that considerable health-care savings already have been realized, could put upward pressure on core inflation. Moreover, the effects of the sharp rise in the dollar over the last eighteen months in pushing down import prices are likely to ebb over coming quarters. The unemployment rate, according to Board members and Bank presidents, should stay around $5^{1 / 4}$ to $5^{1 / 2}$ percent through the fourth quarter, consistent with their projections of measured real GDP growth of 2 to $2^{1 / 4}$ percent over the four quarters of the year. Such a growth rate would represent some downshifting in output expansion from that of last year. The projected moderation of growth likely would reflect several influences: (1) declines in real federal government purchases should be exerting a modest degree of restraint on overall demand; (2) the lagged effects of the increase in the exchange value of the dollar in recent months likely will damp U.S. net exports somewhat this year; and (3) residential construction is unlikely to repeat the gains of 1996. On the other hand, we do not see evidence of widespread imbalances either in business inventories or in stocks of equipment and consumer durables that would lead to a substantial cutback in spending. And financial conditions overall remain ---[PAGE_BREAK]--- supportive; real interest rates are not high by historical standards and credit is readily available from intermediaries and in the market. The usual uncertainties in the overall outlook are especially focused on the behavior of consumers. Consumption should rise roughly in line with the projected moderate expansion of disposable income, but both upside and downside risks are present. According to various surveys, sentiment is decidedly upbeat. Consumers have enjoyed healthy gains in their real incomes along with the extraordinary stock-market driven rise in their financial wealth over the last couple of years. Indeed, econometric models suggest that the more than $\$ 4$ trillion rise in equity values since late 1994 should have had a larger positive influence on consumer spending than seems to have actually occurred. It is possible, however, that households have been reluctant to spend much of their added wealth because they see a greater need to keep it to support spending in retirement. Many households have expressed heightened concern about their financial security in old age, which reportedly has led to increased provision for retirement. The results of a survey conducted annually by the Roper Organization, which asks individuals about their confidence in the Social Security system, shows that between 1992 and 1996 the percent of respondents expressing little or no confidence in the system jumped from about 45 percent to more than 60 percent. Moreover, consumer debt burdens are near historical highs, while credit card delinquencies and personal bankruptcies have risen sharply over the past year. These circumstances may make both borrowers and lenders a bit more cautious, damping spending. In fact, we may be seeing both wealth and debt effects already at work for different segments of the population, to an approximately offsetting extent. Saving out of current income by households in the upper income quintile, who own nearly three-fourths of all non-pension equities held by households, evidently has declined in recent years. At the same time, the use of credit for purchases appears to have leveled off after a sharp runup from 1993 to 1996, perhaps because some households are becoming debt constrained and, as a result, are curtailing their spending. The Federal Reserve will be weighing these influences as it endeavors to help extend the current period of sustained growth. Participants in financial markets seem to believe that in the current benign environment the FOMC will succeed indefinitely. There is no evidence, however, that the business cycle has been repealed. Another recession will doubtless occur some day owing to circumstances that could not be, or at least were not, perceived by policymakers and financial market participants alike. History demonstrates that participants in financial markets are susceptible to waves of optimism, which can in turn foster a general process of asset-price inflation that can feed through into markets for goods and services. Excessive optimism sows the seeds of its own reversal in the form of imbalances that tend to grow over time. When unwarranted expectations ultimately are not realized, the unwinding of these financial excesses can act to amplify a downturn in economic activity, much as they can amplify the upswing. As you know, last December I put the question this way: "...how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions ...?" We have not been able, as yet, to provide a satisfying answer to this question, but there are reasons in the current environment to keep this question on the table. Clearly, when people are exposed to long periods of relative economic tranquility, they seem inevitably prone to complacency about the future. This is understandable. We have had fifteen years of economic expansion interrupted by only one recession -- and that was six years ago. As the memory of such past events fades, it naturally seems ever less sensible to keep up one's guard against an ---[PAGE_BREAK]--- adverse event in the future. Thus, it should come as no surprise that, after such a long period of balanced expansion, risk premiums for advancing funds to businesses in virtually all financial markets have declined to near-record lows. Is it possible that there is something fundamentally new about this current period that would warrant such complacency? Yes, it is possible. Markets may have become more efficient, competition is more global, and information technology has doubtless enhanced the stability of business operations. But, regrettably, history is strewn with visions of such "new eras" that, in the end, have proven to be a mirage. In short, history counsels caution. Such caution seems especially warranted with regard to the sharp rise in equity prices during the past two years. These gains have obviously raised questions of sustainability. Analytically, current stock-price valuations at prevailing long-term interest rates could be justified by very strong earnings growth expectations. In fact, the long-term earnings projections of financial analysts have been marked up noticeably over the last year and seem to imply very high earnings growth and continued rising profit margins, at a time when such margins are already up appreciably from their depressed levels of five years ago. It could be argued that, although margins are the highest in a generation, they are still below those that prevailed in the 1960s. Nonetheless, further increases in these margins would evidently require continued restraint on costs: labor compensation continuing to grow at its current pace and productivity growth picking up. Neither, of course, can be ruled out. But we should keep in mind that, at these relatively low long-term interest rates, small changes in long-term earnings expectations could have outsized impacts on equity prices. Caution also seems warranted by the narrow yield spreads that suggest perceptions of low risk, possibly unrealistically low risk. Considerable optimism about the ability of businesses to sustain this current healthy financial condition seems, as I indicated earlier, to be influencing the setting of risk premiums, not just in the stock market but throughout the financial system. This optimistic attitude has become especially evident in quality spreads on high-yield corporate bonds -- what we used to call "junk bonds." In addition, banks have continued to ease terms and standards on business loans, and margins on many of these loans are now quite thin. Many banks are pulling back a little from consumer credit card lending as losses exceed expectations. Nonetheless, some bank and nonbank lenders have been expanding aggressively into the home equity loan market and so-called "subprime" auto lending, although recent problems in the latter may already be introducing a sense of caution. Why should the central bank be concerned about the possibility that financial markets may be overestimating returns or mispricing risk? It is not that we have a firm view that equity prices are necessarily excessive right now or risk spreads patently too low. Our goal is to contribute as best we can to the highest possible growth of income and wealth over time, and we would be pleased if the favorable economic environment projected in markets actually comes to pass. Rather, the FOMC has to be sensitive to indications of even slowly building imbalances, whatever their source, that, by fostering the emergence of inflation pressures, would ultimately threaten healthy economic expansion. Unfortunately, because the monetary aggregates were subject to an episode of aberrant behavioral patterns in the early 1990s, they are likely to be of only limited help in making this judgment. For three decades starting in the early 1960s, the public's demand for the broader monetary aggregates, especially M2, was reasonably predictable. In the intermediate term, M2 velocity -- nominal income divided by the stock of M2 -- tended to vary directly with the difference between money market yields and the return on M2 assets -- that is, with its ---[PAGE_BREAK]--- short-term opportunity cost. In the long run, as adjustments in deposit rates caused the opportunity cost to revert to an equilibrium, M2 velocity also tended to return to an associated stable equilibrium level. For several years in the early 1990s, however, the velocities of M2 and M3 exhibited persisting upward shifts that departed markedly from these historical patterns. In the last two to three years, velocity patterns seem to have returned to those historical relationships, after allowing for a presumed permanent upward shift in the levels of velocity. Even so, given the abnormal velocity behavior during the early 1990s, FOMC members continue to see considerable uncertainty in the relationship of broad money to opportunity costs and nominal income. Concern about the possibility of aberrant behavior has made the FOMC hesitant to upgrade the role of these measures in monetary policy. Against this background, at its February meeting, the FOMC reaffirmed the provisional ranges set last July for money and debt growth this year: 1 to 5 percent for M2, 2 to 6 percent for M3, and 3 to 7 percent for the debt of domestic nonfinancial sectors. The M2 and M3 ranges again are designed to be consistent with the FOMC's long-run goal of price stability: For, if the velocities of the broader monetary aggregates were to continue behaving as they did before 1990, then money growth around the middle portions of the ranges would be consistent with noninflationary, sustainable economic expansion. But, even with such velocity behavior this year, when inflation is expected to still be higher than is consistent with our long-run objective of reasonable price stability, the broader aggregates could well grow around the upper bounds of these ranges. The debt aggregate probably will expand around the middle of its range this year. I will conclude on the same upbeat note about the U.S. economy with which I began. Although a central banker's occupational responsibility is to stay on the lookout for trouble, even I must admit that our economic prospects in general are quite favorable. The flexibility of our market system and the vibrancy of our private sector remain examples for the whole world to emulate. The Federal Reserve will endeavor to do its part by continuing to foster a monetary framework under which our citizens can prosper to the fullest possible extent.	Alan Greenspan	United States	https://www.bis.org/review/r970305b.pdf	I appreciate the opportunity to appear before this Committee to present the Federal Reserve's semiannual report on monetary policy. The performance of the U.S. economy over the past year has been quite favorable. Real GDP growth has picked up to more than three percent over the four quarters of 1996, as the economy progressed through its sixth year of expansion. Employers added more than two-and-a-half million workers to their payrolls in 1996, and the unemployment rate fell further. Nominal wages and salaries have increased faster than prices, meaning workers have gained ground in real terms, reflecting the benefits of rising productivity. Outside the food and energy sectors, increases in consumer prices actually have continued to edge lower, with core CPI inflation only $21 / 2$ percent over the past twelve months. Low inflation last year was both a symptom and a cause of the good economy. It was symptomatic of the balance and solidity of the expansion and the evident absence of major strains on resources. At the same time, continued low levels of inflation and inflation expectations have been a key support for healthy economic performance. They have helped to create a financial and economic environment conducive to strong capital spending and longer-range planning generally, and so to sustained economic expansion. Consequently, the Federal Open Market Committee (FOMC) believes it is crucial to keep inflation contained in the near term and ultimately to move toward price stability. Looking ahead, the members of the FOMC expect inflation to remain low and the economy to grow appreciably further. However, as I shall be discussing, the unusually good inflation performance of recent years seems to owe in large part to some temporary factors, of uncertain longevity. Thus, the FOMC continues to see the distribution of inflation risks skewed to the upside and must remain especially alert to the possible emergence of imbalances in financial and product markets that ultimately could endanger the maintenance of the low-inflation environment. Sustainable economic expansion for 1997 and beyond depends on it. For some, the benign inflation outcome of 1996 might be considered surprising, as resource utilization rates -- particularly of labor -- were in the neighborhood of those that historically have been associated with building inflation pressures. To be sure, an acceleration in nominal labor compensation, especially its wage component, became evident over the past year. But the rate of pay increase still was markedly less than historical relationships with labor market conditions would have predicted. A typical restraint on compensation increases has been evident for a few years now and appears to be mainly the consequence of greater worker insecurity. In 1991, at the bottom of the recession, a survey of workers at large firms by International Survey Research Corporation indicated that 25 percent feared being laid off. In 1996, despite the sharply lower unemployment rate and the tighter labor market, the same survey organization found that 46 percent were fearful of a job layoff. The reluctance of workers to leave their jobs to seek other employment as the labor market tightened has provided further evidence of such concern, as has the tendency toward longer labor union contracts. For many decades, contracts rarely exceeded three years. Today, one can point to five- and six-year contracts -- contracts that are commonly characterized by an emphasis on job security and that involve only modest wage increases. The low level of work stoppages of recent years also attests to concern about job security. Thus, the willingness of workers in recent years to trade off smaller increases in wages for greater job security seems to be reasonably well documented. The unanswered question is why this insecurity persisted even as the labor market, by all objective measures, tightened considerably. One possibility may lie in the rapid evolution of technologies in use in the work place. Technological change almost surely has been an important impetus behind corporate restructuring and downsizing. Also, it contributes to the concern of workers that their job skills may become inadequate. No longer can one expect to obtain all of one's lifetime job skills with a high-school or college diploma. Indeed, continuing education is perceived to be increasingly necessary to retain a job. The more pressing need to update job skills is doubtless also a factor in the marked expansion of on-the-job training programs, especially in technical areas, in many of the nation's corporations. Certainly, other factors have contributed to the softness in compensation growth in the past few years. The sharp deceleration in health care costs, of course, is cited frequently. Another is the heightened pressure on firms and their workers in industries that compete internationally. Domestic deregulation has had similar effects on the intensity of competitive forces in some industries. In any event, although I do not doubt that all these factors are relevant, I would be surprised if they were nearly as important as job insecurity. If heightened job insecurity is the most significant explanation of the break with the past in recent years, then it is important to recognize that, as I indicated in last February's Humphrey-Hawkins testimony, suppressed wage cost growth as a consequence of job insecurity can be carried only so far. At some point, the tradeoff of subdued wage growth for job security has to come to an end. In other words, the relatively modest wage gains we have experienced are a temporary rather than a lasting phenomenon because there is a limit to the value of additional job security people are willing to acquire in exchange for lesser increases in living standards. Even if real wages were to remain permanently on a lower upward track than otherwise as a result of the greater sense of insecurity, the rate of change of wages would revert at some point to a normal relationship with inflation. The unknown is when this transition period will end. Indeed, some recent evidence suggests that the labor markets bear especially careful watching for signs that the return to more normal patterns may be in process. The Bureau of Labor Statistics reports that people were somewhat more willing to quit their jobs to seek other employment in January than previously. The possibility that this reflects greater confidence by workers accords with a recent further rise in the percent of households responding to a Conference Board survey who perceive that job availability is plentiful. Of course, the job market has continued to be quite good recently; employment in January registered robust growth and initial claims for unemployment insurance have been at a relatively low level of late. Wages rose faster in 1996 than in 1995 by most measures, perhaps also raising questions about whether the transitional period of unusually slow wage gains may be drawing to a close. To be sure, the pickup in wage gains has not shown through to underlying price inflation. Increases in the core CPI, as well as in several broader measures of prices, have stayed subdued or even edged off further in recent months. As best we can judge, faster productivity growth last year meant that rising compensation gains did not cause labor costs per unit of output to increase any more rapidly. Non-labor costs, which are roughly a quarter of total consolidated costs of the nonfinancial corporate sector, were little changed in 1996. Owing in part to this subdued behavior of unit costs, profits and rates of return on capital have risen to high levels. As a consequence, businesses believe that, were they to raise prices to boost profits further, competitors with already ample profit margins would not follow suit; instead, they would use the occasion to capture a greater market share. This interplay is doubtless a significant factor in the evident loss of pricing power in American business. Intensifying global competition also may be further restraining domestic firms' ability to hike prices as well as wages. Clearly, the appreciation of the dollar on balance over the past eighteen months or so, together with low inflation in many of our trading partners, has resulted in a marked decline in non-oil import prices that has helped to damp domestic inflation pressures. Yet it is important to emphasize that these influences, too, would be holding down inflation only temporarily; they represent a transition to a lower price level than would otherwise prevail, not to a permanently lower rate of inflation. Against the background of all these considerations, the FOMC has recognized the need to remain vigilant for signs of potentially inflationary imbalances that might, if not corrected promptly, undermine our economic expansion. The FOMC in fact has signaled a state of heightened alert for possible policy tightening since last July in its policy directives. But, we have also taken care not to act prematurely. The FOMC refrained from changing policy last summer, despite expectations of a near-term policy firming by many financial market participants. In light of the developments I've just discussed affecting wages and prices, we thought inflation might well remain damped, and in any case was unlikely to pick up very rapidly, in part because the economic expansion appeared likely to slow to a more sustainable pace. In the event, inflation has remained quiescent since then. Given the lags with which monetary policy affects the economy, however, we cannot rule out a situation in which a preemptive policy tightening may become appropriate before any sign of actual higher inflation becomes evident. If the FOMC were to implement such an action, it would be judging that the risks to the economic expansion of waiting longer had increased unduly and had begun to outweigh the advantages of waiting for uncertainties to be reduced by the accumulation of more information about economic trends. Indeed, the hallmark of a successful policy to foster sustainable economic growth is that inflation does not rise. I find it ironic that our actions in 1994-95 were criticized by some because inflation did not turn upward. That outcome, of course, was the intent of the tightening, and I am satisfied that our actions then were both necessary and effective, and helped to foster the continued economic expansion. To be sure, 1997 is not 1994. The real federal funds rate today is significantly higher than it was three years ago. Then we had just completed an extended period of monetary ease which addressed the credit stringencies of the early 1990s, and with the abatement of the credit crunch, the low real funds rate of early 1994 was clearly incompatible with containing inflation and sustaining growth going forward. In February 1997, in contrast, our concern is a matter of relative risks rather than of expected outcomes. The real funds rate, judging by core inflation, is only slightly below its early 1995 peak for this cycle and might be at a level that will promote continued non-inflationary growth, especially considering the recent rise in the exchange value of the dollar. Nonetheless, we cannot be sure. And the risks of being wrong are clearly tilted to the upside. I wish it were possible to lay out in advance exactly what conditions have to prevail to portend a buildup of inflation pressures or inflationary psychology. However, the circumstances that have been associated with increasing inflation in the past have not followed a single pattern. The processes have differed from cycle to cycle, and what may have been a useful leading indicator in one instance has given off misleading signals in another. I have already discussed the key role of labor market developments in restraining inflation in the current cycle and our careful monitoring of signs that the transition phase of trading off lower real wages for greater job security might be coming to a close. As always, with resource utilization rates high, we would need to watch closely a situation in which demand was clearly unsustainable because it was producing escalating pressures on resources, which could destabilize the economy. And we would need to be watchful that the progress we have made in keeping inflation expectations damped was not eroding. In general, though, our analysis will need to encompass all potentially relevant information, from financial markets as well as the economy, especially when some signals, like those in the labor market, have not been following their established patterns. The ongoing economic expansion to date has reinforced our conviction about the importance of low inflation -- and the public's confidence in continued low inflation. The economic expansion almost surely would not have lasted nearly so long had monetary policy supported an unsustainable acceleration of spending that induced a buildup of inflationary imbalances. The Federal Reserve must not acquiesce in an upcreep in inflation, for acceding to higher inflation would countenance an insidious weakening of our chances for sustaining long-run economic growth. Inflation interferes with the efficient allocation of resources by confusing price signals, undercutting a focus on the longer run, and distorting incentives. This year overall inflation is anticipated to stay restrained. The central tendency of the forecasts made by the Board members and Reserve Bank presidents has the increase in the total CPI slipping back into a range of $23 / 4$ to 3 percent over the four quarters of the year. This slight falloff from last year's pace is expected to owe in part to a slower rise in food prices as some of last year's supply limitations ease. More importantly, world oil supplies are projected by most analysts to increase relative to world oil demand, and futures markets project a further decline in prices, at least in the near term. The recent and prospective declines in crude oil prices not only should affect retail gasoline and home heating oil prices but also should relieve inflation pressures through lower prices for other petroleum products, which are imbedded in the economy's underlying cost structure. Nonetheless, the trend in inflation rates in the core CPI and in broader price measures may be somewhat less favorable than in recent years. A continued tight labor market, whose influence on costs would be augmented by the scheduled increase in the minimum wage later in the year and perhaps by higher growth of benefits now that considerable health-care savings already have been realized, could put upward pressure on core inflation. Moreover, the effects of the sharp rise in the dollar over the last eighteen months in pushing down import prices are likely to ebb over coming quarters. The unemployment rate, according to Board members and Bank presidents, should stay around $5^{1 / 4}$ to $5^{1 / 2}$ percent through the fourth quarter, consistent with their projections of measured real GDP growth of 2 to $2^{1 / 4}$ percent over the four quarters of the year. Such a growth rate would represent some downshifting in output expansion from that of last year. The projected moderation of growth likely would reflect several influences: (1) declines in real federal government purchases should be exerting a modest degree of restraint on overall demand; (2) the lagged effects of the increase in the exchange value of the dollar in recent months likely will damp U.S. net exports somewhat this year; and (3) residential construction is unlikely to repeat the gains of 1996. On the other hand, we do not see evidence of widespread imbalances either in business inventories or in stocks of equipment and consumer durables that would lead to a substantial cutback in spending. And financial conditions overall remain supportive; real interest rates are not high by historical standards and credit is readily available from intermediaries and in the market. The usual uncertainties in the overall outlook are especially focused on the behavior of consumers. Consumption should rise roughly in line with the projected moderate expansion of disposable income, but both upside and downside risks are present. According to various surveys, sentiment is decidedly upbeat. Consumers have enjoyed healthy gains in their real incomes along with the extraordinary stock-market driven rise in their financial wealth over the last couple of years. Indeed, econometric models suggest that the more than $\$ 4$ trillion rise in equity values since late 1994 should have had a larger positive influence on consumer spending than seems to have actually occurred. It is possible, however, that households have been reluctant to spend much of their added wealth because they see a greater need to keep it to support spending in retirement. Many households have expressed heightened concern about their financial security in old age, which reportedly has led to increased provision for retirement. The results of a survey conducted annually by the Roper Organization, which asks individuals about their confidence in the Social Security system, shows that between 1992 and 1996 the percent of respondents expressing little or no confidence in the system jumped from about 45 percent to more than 60 percent. Moreover, consumer debt burdens are near historical highs, while credit card delinquencies and personal bankruptcies have risen sharply over the past year. These circumstances may make both borrowers and lenders a bit more cautious, damping spending. In fact, we may be seeing both wealth and debt effects already at work for different segments of the population, to an approximately offsetting extent. Saving out of current income by households in the upper income quintile, who own nearly three-fourths of all non-pension equities held by households, evidently has declined in recent years. At the same time, the use of credit for purchases appears to have leveled off after a sharp runup from 1993 to 1996, perhaps because some households are becoming debt constrained and, as a result, are curtailing their spending. The Federal Reserve will be weighing these influences as it endeavors to help extend the current period of sustained growth. Participants in financial markets seem to believe that in the current benign environment the FOMC will succeed indefinitely. There is no evidence, however, that the business cycle has been repealed. Another recession will doubtless occur some day owing to circumstances that could not be, or at least were not, perceived by policymakers and financial market participants alike. History demonstrates that participants in financial markets are susceptible to waves of optimism, which can in turn foster a general process of asset-price inflation that can feed through into markets for goods and services. Excessive optimism sows the seeds of its own reversal in the form of imbalances that tend to grow over time. When unwarranted expectations ultimately are not realized, the unwinding of these financial excesses can act to amplify a downturn in economic activity, much as they can amplify the upswing. As you know, last December I put the question this way: ".how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions .?" We have not been able, as yet, to provide a satisfying answer to this question, but there are reasons in the current environment to keep this question on the table. Clearly, when people are exposed to long periods of relative economic tranquility, they seem inevitably prone to complacency about the future. This is understandable. We have had fifteen years of economic expansion interrupted by only one recession -- and that was six years ago. As the memory of such past events fades, it naturally seems ever less sensible to keep up one's guard against an adverse event in the future. Thus, it should come as no surprise that, after such a long period of balanced expansion, risk premiums for advancing funds to businesses in virtually all financial markets have declined to near-record lows. Is it possible that there is something fundamentally new about this current period that would warrant such complacency? Yes, it is possible. Markets may have become more efficient, competition is more global, and information technology has doubtless enhanced the stability of business operations. But, regrettably, history is strewn with visions of such "new eras" that, in the end, have proven to be a mirage. In short, history counsels caution. Such caution seems especially warranted with regard to the sharp rise in equity prices during the past two years. These gains have obviously raised questions of sustainability. Analytically, current stock-price valuations at prevailing long-term interest rates could be justified by very strong earnings growth expectations. In fact, the long-term earnings projections of financial analysts have been marked up noticeably over the last year and seem to imply very high earnings growth and continued rising profit margins, at a time when such margins are already up appreciably from their depressed levels of five years ago. It could be argued that, although margins are the highest in a generation, they are still below those that prevailed in the 1960s. Nonetheless, further increases in these margins would evidently require continued restraint on costs: labor compensation continuing to grow at its current pace and productivity growth picking up. Neither, of course, can be ruled out. But we should keep in mind that, at these relatively low long-term interest rates, small changes in long-term earnings expectations could have outsized impacts on equity prices. Caution also seems warranted by the narrow yield spreads that suggest perceptions of low risk, possibly unrealistically low risk. Considerable optimism about the ability of businesses to sustain this current healthy financial condition seems, as I indicated earlier, to be influencing the setting of risk premiums, not just in the stock market but throughout the financial system. This optimistic attitude has become especially evident in quality spreads on high-yield corporate bonds -- what we used to call "junk bonds." In addition, banks have continued to ease terms and standards on business loans, and margins on many of these loans are now quite thin. Many banks are pulling back a little from consumer credit card lending as losses exceed expectations. Nonetheless, some bank and nonbank lenders have been expanding aggressively into the home equity loan market and so-called "subprime" auto lending, although recent problems in the latter may already be introducing a sense of caution. Why should the central bank be concerned about the possibility that financial markets may be overestimating returns or mispricing risk? It is not that we have a firm view that equity prices are necessarily excessive right now or risk spreads patently too low. Our goal is to contribute as best we can to the highest possible growth of income and wealth over time, and we would be pleased if the favorable economic environment projected in markets actually comes to pass. Rather, the FOMC has to be sensitive to indications of even slowly building imbalances, whatever their source, that, by fostering the emergence of inflation pressures, would ultimately threaten healthy economic expansion. Unfortunately, because the monetary aggregates were subject to an episode of aberrant behavioral patterns in the early 1990s, they are likely to be of only limited help in making this judgment. For three decades starting in the early 1960s, the public's demand for the broader monetary aggregates, especially M2, was reasonably predictable. In the intermediate term, M2 velocity -- nominal income divided by the stock of M2 -- tended to vary directly with the difference between money market yields and the return on M2 assets -- that is, with its short-term opportunity cost. In the long run, as adjustments in deposit rates caused the opportunity cost to revert to an equilibrium, M2 velocity also tended to return to an associated stable equilibrium level. For several years in the early 1990s, however, the velocities of M2 and M3 exhibited persisting upward shifts that departed markedly from these historical patterns. In the last two to three years, velocity patterns seem to have returned to those historical relationships, after allowing for a presumed permanent upward shift in the levels of velocity. Even so, given the abnormal velocity behavior during the early 1990s, FOMC members continue to see considerable uncertainty in the relationship of broad money to opportunity costs and nominal income. Concern about the possibility of aberrant behavior has made the FOMC hesitant to upgrade the role of these measures in monetary policy. Against this background, at its February meeting, the FOMC reaffirmed the provisional ranges set last July for money and debt growth this year: 1 to 5 percent for M2, 2 to 6 percent for M3, and 3 to 7 percent for the debt of domestic nonfinancial sectors. The M2 and M3 ranges again are designed to be consistent with the FOMC's long-run goal of price stability: For, if the velocities of the broader monetary aggregates were to continue behaving as they did before 1990, then money growth around the middle portions of the ranges would be consistent with noninflationary, sustainable economic expansion. But, even with such velocity behavior this year, when inflation is expected to still be higher than is consistent with our long-run objective of reasonable price stability, the broader aggregates could well grow around the upper bounds of these ranges. The debt aggregate probably will expand around the middle of its range this year. I will conclude on the same upbeat note about the U.S. economy with which I began. Although a central banker's occupational responsibility is to stay on the lookout for trouble, even I must admit that our economic prospects in general are quite favorable. The flexibility of our market system and the vibrancy of our private sector remain examples for the whole world to emulate. The Federal Reserve will endeavor to do its part by continuing to foster a monetary framework under which our citizens can prosper to the fullest possible extent.
1997-03-03T00:00:00	Ms. Phillips discusses recent developments in supervision and regulation and how they affect the debate on financial modernization (Central Bank Articles and Speeches, 3 Mar 97)	Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at the Annual Washington Conference of the Institute of International Bankers on 3/3/97.	Ms. Phillips discusses recent developments in supervision and regulation and how they affect the debate on financial modernization Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at the Annual Washington Conference of the Institute of International Bankers on 3/3/97. I am pleased to have the opportunity to address this group at a time when developments in global financial markets are presenting particular challenges for market participants and market regulators alike. I was asked to talk with you today about both developments in Federal Reserve supervision and regulation, as well as the approaches to financial modernization being debated in the Congress. I won't try to cover the full waterfront on these topics, but would like to share with you some of the Board's considerable rethinking about the way we supervise and regulate bank holding companies. I will also describe how I believe the recent Board initiatives coming out of this process may well alter the debate about the structure and supervision of financial services in the United States -- a topic I believe has received insufficient attention in the legislative debate so far. I will focus my discussion of recent Board actions on the supervisory process and on three regulatory changes made or proposed by the Board: changes to the application and nonbanking provisions of Regulation Y, changes and proposed changes to the Board-imposed "firewalls" between a bank and a securities affiliate, and changes to the Board's anti-tying rules. I stress these three not necessarily because they are the most important undertaken by the Board, but because I believe that they most directly affect the debate about how financial services should be supervised. Supervisory Changes The cornerstone of the bank supervisory process is the verification of prudent practices and financial condition through on-site examinations, coupled with off-site surveillance. Traditionally, on-site examinations of bank holding companies and their nonbank subsidiaries have focused on verifying compliance and determining the financial condition of an institution at the time of the examination by reviewing their loans and by testing other transactions. This process is changing. The Federal Reserve's supervisory oversight at the bank holding company level is increasingly directed at evaluating risk management, internal controls, and decision making processes that are shared between a bank and its parent, rather than focusing on transactions and positions at nonbank affiliates. This focus is necessary given the continuing trend toward integrated management of financial activities on a consolidated basis. Testing the adequacy of risk management and internal control helps us understand the financial condition of the consolidated organization and the potential impact of consolidated risk management policies and internal controls on the operations of the insured depository institution. To implement this approach, the Federal Reserve last year began assigning a formal rating to risk management in our holding company and bank examination reports. Changes have come not just in what we examine, but also in how we examine. We are making greater use of internal risk management reports, the results of internal risk models, and the work of internal and external auditors. For example, the Federal Reserve is now collecting internal loan classification reports prepared by most of our larger banks, as well as other information generated by their internal risk management systems. This approach has a further advantage in that it can generally be conducted off-site, at less burden to the firm. Our examinations are also becoming more efficient through pre-visitation planning that better identifies those areas of a company's activities that pose the greatest risk. We are also making greater use of computer technology in the examination process and using automated systems that permit examiners to analyze data on their personal computers. And, of course, whenever possible we rely upon examination and inspection reports prepared by regulators of the individual entities within the bank holding company. Like examinations, disclosure practices of the past also focused narrowly on the financial condition of an institution at a point in time, using conventional accounting and regulatory measures. Today, however, disclosures are expanding to reveal not only the current risks of the balance sheet, but also management's philosophy for managing and controlling risk. Disclosure is an important aid to us as supervisors and, we hope, to market analysts. Improved disclosure has already been put into practice for derivatives and market risks, and we will continue to urge better and more broadly based disclosure of all major activities and exposures. The Effect of Supervisory Changes on Legislation As the issue of consolidated or "umbrella" supervision is debated in the legislative process, I believe it is important to examine how these supervisory developments alter that debate. There are those who argue that umbrella supervision of a diverse financial services holding company would either be an impossible task or an intolerable burden. But the risk-analysis and surveillance techniques that we have decided are the most effective for bank holding companies should also be adaptable to more diverse financial organizations that include banking operations. Clearly, we must all give additional thought to how such an adaptation would work so that we minimize the intrusion into new activities. Perhaps there should be some kind of carve-out for firms whose banking operations are a small part of the organization or if the firm is otherwise regulated. Nevertheless, to be successful, a financial services company should reap synergy gains not only by marketing a variety of products to customers but also by pooling and jointly managing diverse financial risks. Thus, the movement toward use of one treasury, one risk management policy, and one set of exposure limits would continue. It is those policies and risks that an umbrella supervisor must understand in order to gauge the risks to the insured institution. In fact, as I am sure this group will recall in the wake of BCCI, the Congress also became convinced of the importance of consolidated supervision of any banking organization. Through the Foreign Bank Supervision Enhancement Act, the United States not only recognized the importance of consolidated supervision, but strongly encouraged it as an international principle of banking supervision by requiring that any foreign bank seeking to enter the United States be subject to consolidated home country supervision. Subsequent history has confirmed that judgment. As I've noted, virtually all of the large holding companies now operate as integrated units and are managed as such. Thus, the Federal Reserve remains convinced that one supervisor must have the task of evaluating the organization as a whole. This view is now commonly accepted around the world. The idea has for some time been endorsed by the Basle Committee on Banking Supervision, and many countries are adopting similar approaches. Still, I can certainly understand why some advocates of a more diversified financial services holding company would wish to abandon consolidated supervision. Consolidated supervision raises hard questions -- the kind of questions that can bog down legislation and splinter coalitions -- and questions that engage us even now. What authority should a consolidated supervisor have over non-financial activities, if they are allowed? How should the consolidated supervisor work with the primary supervisor of a bank, or a broker-dealer, or an insurance company? How much burden must consolidated supervision entail? As we all pursue the answers to these questions, perhaps the Federal Reserve's risk-based approach to supervision can provide insights into how umbrella supervision of an expanded organization could work. Regulatory Changes Just as with supervision, the regulatory side of the Federal Reserve has undergone profound changes of late. Just a few weeks ago, the Board approved a comprehensive streamlining of Regulation Y that should substantially diminish the regulatory burden on bank holding companies and foreign banks wishing to expand or innovate in the United States. First, the Board concluded that review of an application should focus on how the proposed acquisition or activity would affect the organization. The application should not become a vehicle for comprehensively evaluating and addressing supervisory and compliance issues at the applicant organization. This principle is also the basis for recent Congressional action to eliminate the prior approval requirement for engaging in Board-approved nonbanking activities under section 4 of the Bank Holding Company Act, provided the company meets specified standards for capital and management at the time of its last examination. As a result, the Board has significantly streamlined the process for well-capitalized, well-run companies to acquire a bank or nonbank and eliminated the prior approval process for such companies to engage de novo in Board-approved nonbanking activities. Second, the Board concluded that bank holding companies should be permitted to conduct nonbanking activities to the fullest extent permissible under the Bank Holding Company Act, and that Regulation Y should be sufficiently flexible to allow for industry changes in permissible activities without requiring additional regulatory filings. Accordingly, the Board removed restrictions on investment advisory activities, derivatives trading activities, leasing, and other activities whenever those restrictions impeded efficiency or imposed costs without conferring corresponding benefits to safety and soundness. The Board also permitted a data processing or management consulting subsidiary to derive up to 30 percent of its revenue from nonfinancial data processing or nonfinancial management consulting. And the Board has indicated that it will be pro-active in approving new activities. The next area where the Board has been particularly active concerns firewalls between a bank and an affiliated securities firm, better known as a section 20 affiliate. Experience with these section 20 affiliates, and other affiliates engaging in similar activities without such restrictions, led the Board to conduct a comprehensive review of the firewalls. Much of the potential for conflicts of interest between a bank and a securities firm is addressed by other laws such as the registration and disclosure requirements and the anti-fraud provisions of the securities laws. Legislative and regulatory enactments, many adopted since the Board's initial 1987 section 20 order, also provide important insulation between a bank and a section 20 affiliate by imposing qualitative and quantitative limits on inter-affiliate transactions and requiring that a customer receive disclosures detailing the identity of its counterparty and the product being purchased. Accordingly, the Board has repealed its restriction on cross-marketing between a bank and a section 20 affiliate, eliminated a blanket restriction on employee interlocks, and scaled back a blanket restriction on officer interlocks to include only a chief executive officer. The Board has also proposed to eliminate a firewall prohibiting a bank from providing any funding to a section 20 affiliate and three restrictions on a bank's extending credit or offering credit enhancements in support of securities being underwritten by its section 20 affiliate. The Board's proposal recognized that as financial intermediation has evolved, corporate customers frequently seek to obtain a variety of funding mechanisms from one source. By prohibiting banks from providing routine credit enhancements in tandem with a section 20 affiliate, the existing firewalls hamper the ability of bank holding companies to operate as one-stop financial services providers, thereby reducing options for customers. Instead, the Board has proposed to require that internal controls and operating standards ensure that a bank use independent credit judgment whenever it is acting in tandem with its section 20 affiliate. Finally, the Board has taken action to allow greater packaging of products by bank holding companies. Since the 1970s, banks and bank holding companies have been prohibited from packaging their products unless the arrangement involved a traditional bank product. While this exception softened the impact of the statute, bank holding companies were nonetheless at a considerable disadvantage to their competitors, particularly as bundling of services has become a marketing imperative on both the retail and wholesale side of the business. After reviewing its experience with the statute, the Board recently repealed a regulation that had extended to bank holding companies and their nonbank subsidiaries the statutory prohibition on tying arrangements by banks. Experience taught us that these non-banks did not have the type of market power that Congress presumed banks possessed when it enacted an anti-tying statute. The Board has also created exceptions to the statute to allow package arrangements between bank holding company affiliates to the same extent as the statute allows them within the bank. Lastly, and perhaps of greatest interest to you, the Board created a safe harbor to clarify that any transaction with a foreign customer was not covered by the statute. Thus, for example, a U.S. branch of a foreign bank can participate in a syndicated loan to a European firm, even if the loan is offered only as part of a package of services that would otherwise run afoul of the anti-tying law. The Effect of the Regulatory Climate on Legislation I think it worth noting how all these reforms may affect the debate about the corporate structure of bank holding companies -- specifically whether bank holding companies should be granted the option of moving activities prohibited to the bank into a subsidiary of the bank, and thereby funding those activities with subsidized funds. Descriptions of how the subsidy works and examples of the funding advantages it confers are plentiful. But I believe that it is so ingrained in our thinking that we sometimes take it for granted. Think how obvious the subsidy would be if it involved another industry -- for example, if the government guaranteed that commercial paper holders of the automobile industry would be repaid in full. To complete the other strands of the safety net -- the discount window and the payment system -- let us assume that automobile companies experiencing liquidity problems could borrow from the Federal Reserve for the purpose of repaying commercial paper, and that they are able to achieve risk-free settlement. The effects of extending such a subsidy are not difficult to imagine. Automakers would find it very easy to place their commercial paper, and would be able to pay a below-market yield. And, to the extent the hypothetical allowed, I would not be surprised to see automakers use this funding advantage to enter other businesses. So it is with banks -- and with subsidiaries of banks. Regulators can limit a bank's ability to subsidize its subsidiary through loans by capping their amount or regulating the rates the subsidiary must pay. But although one can limit the aggregate investment a bank can make in its subsidiary by requiring that such injections be deducted from the capital of the bank, the equity investment in the subsidiary is still funded from subsidized resources, and that subsidy transfer cannot be eliminated. Thus, both analytically and practically, I think it difficult to deny that banks and their subsidiaries benefit from a federal subsidy, and benefit in ways that an affiliate of the bank does not. Nevertheless, some argue that a parent-subsidiary structure is more efficient than a sibling structure, and must be allowed for a broader range of activities. But in light of the recent regulatory changes that I have described, I believe that this argument is now questionable. A bank and an affiliate can now avoid a redundant work force and duplication of effort by having employees serve in a dual capacity, or by allowing reporting lines to cross. For example, a common back office or treasury can be maintained. Furthermore, the two companies can market their products jointly to both retail and corporate customers. With these regulatory changes, banks and bank holding companies have opportunities to make considerable adjustments to their organizational structures and operating procedures as well as to offer new products to customers in new ways. Conclusion Let me conclude by pointing out that the legislative debate has only just begun. Opinions are still developing, new ideas are still being presented, and positions are not yet cast in concrete. But even as new legislation is being debated, those of us who must try to interpret and administer existing laws recognize that we must do so in a developing global marketplace. I believe that the steps the Board has taken to make its regulatory and supervisory systems less burdensome and more risk focused will stand us in good stead in this changing financial environment. Nevertheless, comprehensive financial reform legislation is still needed to allow banking and other financial institutions to compete internationally and to offer the full range of financial services needed and demanded by their customers.	---[PAGE_BREAK]--- # Ms. Phillips discusses recent developments in supervision and regulation and how they affect the debate on financial modernization Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at the Annual Washington Conference of the Institute of International Bankers on 3/3/97. I am pleased to have the opportunity to address this group at a time when developments in global financial markets are presenting particular challenges for market participants and market regulators alike. I was asked to talk with you today about both developments in Federal Reserve supervision and regulation, as well as the approaches to financial modernization being debated in the Congress. I won't try to cover the full waterfront on these topics, but would like to share with you some of the Board's considerable rethinking about the way we supervise and regulate bank holding companies. I will also describe how I believe the recent Board initiatives coming out of this process may well alter the debate about the structure and supervision of financial services in the United States -- a topic I believe has received insufficient attention in the legislative debate so far. I will focus my discussion of recent Board actions on the supervisory process and on three regulatory changes made or proposed by the Board: changes to the application and nonbanking provisions of Regulation Y, changes and proposed changes to the Board-imposed "firewalls" between a bank and a securities affiliate, and changes to the Board's anti-tying rules. I stress these three not necessarily because they are the most important undertaken by the Board, but because I believe that they most directly affect the debate about how financial services should be supervised. ## Supervisory Changes The cornerstone of the bank supervisory process is the verification of prudent practices and financial condition through on-site examinations, coupled with off-site surveillance. Traditionally, on-site examinations of bank holding companies and their nonbank subsidiaries have focused on verifying compliance and determining the financial condition of an institution at the time of the examination by reviewing their loans and by testing other transactions. This process is changing. The Federal Reserve's supervisory oversight at the bank holding company level is increasingly directed at evaluating risk management, internal controls, and decision making processes that are shared between a bank and its parent, rather than focusing on transactions and positions at nonbank affiliates. This focus is necessary given the continuing trend toward integrated management of financial activities on a consolidated basis. Testing the adequacy of risk management and internal control helps us understand the financial condition of the consolidated organization and the potential impact of consolidated risk management policies and internal controls on the operations of the insured depository institution. To implement this approach, the Federal Reserve last year began assigning a formal rating to risk management in our holding company and bank examination reports. Changes have come not just in what we examine, but also in how we examine. We are making greater use of internal risk management reports, the results of internal risk models, and the work of internal and external auditors. For example, the Federal Reserve is now collecting internal loan classification reports prepared by most of our larger banks, as well as ---[PAGE_BREAK]--- other information generated by their internal risk management systems. This approach has a further advantage in that it can generally be conducted off-site, at less burden to the firm. Our examinations are also becoming more efficient through pre-visitation planning that better identifies those areas of a company's activities that pose the greatest risk. We are also making greater use of computer technology in the examination process and using automated systems that permit examiners to analyze data on their personal computers. And, of course, whenever possible we rely upon examination and inspection reports prepared by regulators of the individual entities within the bank holding company. Like examinations, disclosure practices of the past also focused narrowly on the financial condition of an institution at a point in time, using conventional accounting and regulatory measures. Today, however, disclosures are expanding to reveal not only the current risks of the balance sheet, but also management's philosophy for managing and controlling risk. Disclosure is an important aid to us as supervisors and, we hope, to market analysts. Improved disclosure has already been put into practice for derivatives and market risks, and we will continue to urge better and more broadly based disclosure of all major activities and exposures. # The Effect of Supervisory Changes on Legislation As the issue of consolidated or "umbrella" supervision is debated in the legislative process, I believe it is important to examine how these supervisory developments alter that debate. There are those who argue that umbrella supervision of a diverse financial services holding company would either be an impossible task or an intolerable burden. But the risk-analysis and surveillance techniques that we have decided are the most effective for bank holding companies should also be adaptable to more diverse financial organizations that include banking operations. Clearly, we must all give additional thought to how such an adaptation would work so that we minimize the intrusion into new activities. Perhaps there should be some kind of carve-out for firms whose banking operations are a small part of the organization or if the firm is otherwise regulated. Nevertheless, to be successful, a financial services company should reap synergy gains not only by marketing a variety of products to customers but also by pooling and jointly managing diverse financial risks. Thus, the movement toward use of one treasury, one risk management policy, and one set of exposure limits would continue. It is those policies and risks that an umbrella supervisor must understand in order to gauge the risks to the insured institution. In fact, as I am sure this group will recall in the wake of BCCI, the Congress also became convinced of the importance of consolidated supervision of any banking organization. Through the Foreign Bank Supervision Enhancement Act, the United States not only recognized the importance of consolidated supervision, but strongly encouraged it as an international principle of banking supervision by requiring that any foreign bank seeking to enter the United States be subject to consolidated home country supervision. Subsequent history has confirmed that judgment. As I've noted, virtually all of the large holding companies now operate as integrated units and are managed as such. Thus, the Federal Reserve remains convinced that one supervisor must have the task of evaluating the organization as a whole. ---[PAGE_BREAK]--- This view is now commonly accepted around the world. The idea has for some time been endorsed by the Basle Committee on Banking Supervision, and many countries are adopting similar approaches. Still, I can certainly understand why some advocates of a more diversified financial services holding company would wish to abandon consolidated supervision. Consolidated supervision raises hard questions -- the kind of questions that can bog down legislation and splinter coalitions -- and questions that engage us even now. What authority should a consolidated supervisor have over non-financial activities, if they are allowed? How should the consolidated supervisor work with the primary supervisor of a bank, or a broker-dealer, or an insurance company? How much burden must consolidated supervision entail? As we all pursue the answers to these questions, perhaps the Federal Reserve's risk-based approach to supervision can provide insights into how umbrella supervision of an expanded organization could work. # Regulatory Changes Just as with supervision, the regulatory side of the Federal Reserve has undergone profound changes of late. Just a few weeks ago, the Board approved a comprehensive streamlining of Regulation Y that should substantially diminish the regulatory burden on bank holding companies and foreign banks wishing to expand or innovate in the United States. First, the Board concluded that review of an application should focus on how the proposed acquisition or activity would affect the organization. The application should not become a vehicle for comprehensively evaluating and addressing supervisory and compliance issues at the applicant organization. This principle is also the basis for recent Congressional action to eliminate the prior approval requirement for engaging in Board-approved nonbanking activities under section 4 of the Bank Holding Company Act, provided the company meets specified standards for capital and management at the time of its last examination. As a result, the Board has significantly streamlined the process for well-capitalized, well-run companies to acquire a bank or nonbank and eliminated the prior approval process for such companies to engage de novo in Board-approved nonbanking activities. Second, the Board concluded that bank holding companies should be permitted to conduct nonbanking activities to the fullest extent permissible under the Bank Holding Company Act, and that Regulation Y should be sufficiently flexible to allow for industry changes in permissible activities without requiring additional regulatory filings. Accordingly, the Board removed restrictions on investment advisory activities, derivatives trading activities, leasing, and other activities whenever those restrictions impeded efficiency or imposed costs without conferring corresponding benefits to safety and soundness. The Board also permitted a data processing or management consulting subsidiary to derive up to 30 percent of its revenue from nonfinancial data processing or nonfinancial management consulting. And the Board has indicated that it will be pro-active in approving new activities. The next area where the Board has been particularly active concerns firewalls between a bank and an affiliated securities firm, better known as a section 20 affiliate. ---[PAGE_BREAK]--- Experience with these section 20 affiliates, and other affiliates engaging in similar activities without such restrictions, led the Board to conduct a comprehensive review of the firewalls. Much of the potential for conflicts of interest between a bank and a securities firm is addressed by other laws such as the registration and disclosure requirements and the anti-fraud provisions of the securities laws. Legislative and regulatory enactments, many adopted since the Board's initial 1987 section 20 order, also provide important insulation between a bank and a section 20 affiliate by imposing qualitative and quantitative limits on inter-affiliate transactions and requiring that a customer receive disclosures detailing the identity of its counterparty and the product being purchased. Accordingly, the Board has repealed its restriction on cross-marketing between a bank and a section 20 affiliate, eliminated a blanket restriction on employee interlocks, and scaled back a blanket restriction on officer interlocks to include only a chief executive officer. The Board has also proposed to eliminate a firewall prohibiting a bank from providing any funding to a section 20 affiliate and three restrictions on a bank's extending credit or offering credit enhancements in support of securities being underwritten by its section 20 affiliate. The Board's proposal recognized that as financial intermediation has evolved, corporate customers frequently seek to obtain a variety of funding mechanisms from one source. By prohibiting banks from providing routine credit enhancements in tandem with a section 20 affiliate, the existing firewalls hamper the ability of bank holding companies to operate as one-stop financial services providers, thereby reducing options for customers. Instead, the Board has proposed to require that internal controls and operating standards ensure that a bank use independent credit judgment whenever it is acting in tandem with its section 20 affiliate. Finally, the Board has taken action to allow greater packaging of products by bank holding companies. Since the 1970s, banks and bank holding companies have been prohibited from packaging their products unless the arrangement involved a traditional bank product. While this exception softened the impact of the statute, bank holding companies were nonetheless at a considerable disadvantage to their competitors, particularly as bundling of services has become a marketing imperative on both the retail and wholesale side of the business. After reviewing its experience with the statute, the Board recently repealed a regulation that had extended to bank holding companies and their nonbank subsidiaries the statutory prohibition on tying arrangements by banks. Experience taught us that these non-banks did not have the type of market power that Congress presumed banks possessed when it enacted an anti-tying statute. The Board has also created exceptions to the statute to allow package arrangements between bank holding company affiliates to the same extent as the statute allows them within the bank. Lastly, and perhaps of greatest interest to you, the Board created a safe harbor to clarify that any transaction with a foreign customer was not covered by the statute. Thus, for example, a U.S. branch of a foreign bank can participate in a syndicated loan to a European firm, even if the loan is offered only as part of a package of services that would otherwise run afoul of the anti-tying law. # The Effect of the Regulatory Climate on Legislation I think it worth noting how all these reforms may affect the debate about the ---[PAGE_BREAK]--- corporate structure of bank holding companies -- specifically whether bank holding companies should be granted the option of moving activities prohibited to the bank into a subsidiary of the bank, and thereby funding those activities with subsidized funds. Descriptions of how the subsidy works and examples of the funding advantages it confers are plentiful. But I believe that it is so ingrained in our thinking that we sometimes take it for granted. Think how obvious the subsidy would be if it involved another industry -- for example, if the government guaranteed that commercial paper holders of the automobile industry would be repaid in full. To complete the other strands of the safety net -- the discount window and the payment system -- let us assume that automobile companies experiencing liquidity problems could borrow from the Federal Reserve for the purpose of repaying commercial paper, and that they are able to achieve risk-free settlement. The effects of extending such a subsidy are not difficult to imagine. Automakers would find it very easy to place their commercial paper, and would be able to pay a below-market yield. And, to the extent the hypothetical allowed, I would not be surprised to see automakers use this funding advantage to enter other businesses. So it is with banks -- and with subsidiaries of banks. Regulators can limit a bank's ability to subsidize its subsidiary through loans by capping their amount or regulating the rates the subsidiary must pay. But although one can limit the aggregate investment a bank can make in its subsidiary by requiring that such injections be deducted from the capital of the bank, the equity investment in the subsidiary is still funded from subsidized resources, and that subsidy transfer cannot be eliminated. Thus, both analytically and practically, I think it difficult to deny that banks and their subsidiaries benefit from a federal subsidy, and benefit in ways that an affiliate of the bank does not. Nevertheless, some argue that a parent-subsidiary structure is more efficient than a sibling structure, and must be allowed for a broader range of activities. But in light of the recent regulatory changes that I have described, I believe that this argument is now questionable. A bank and an affiliate can now avoid a redundant work force and duplication of effort by having employees serve in a dual capacity, or by allowing reporting lines to cross. For example, a common back office or treasury can be maintained. Furthermore, the two companies can market their products jointly to both retail and corporate customers. With these regulatory changes, banks and bank holding companies have opportunities to make considerable adjustments to their organizational structures and operating procedures as well as to offer new products to customers in new ways. # Conclusion Let me conclude by pointing out that the legislative debate has only just begun. Opinions are still developing, new ideas are still being presented, and positions are not yet cast in concrete. But even as new legislation is being debated, those of us who must try to interpret and administer existing laws recognize that we must do so in a developing global marketplace. I believe that the steps the Board has taken to make its regulatory and supervisory systems less burdensome and more risk focused will stand us in good stead in this changing financial environment. Nevertheless, comprehensive financial reform legislation is still needed to allow banking and other financial institutions to compete internationally and to offer the full range of financial services needed and demanded by their customers.	Susan M Phillips	United States	https://www.bis.org/review/r970305f.pdf	how they affect the debate on financial modernization Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at the Annual Washington Conference of the Institute of International Bankers on 3/3/97. I am pleased to have the opportunity to address this group at a time when developments in global financial markets are presenting particular challenges for market participants and market regulators alike. I was asked to talk with you today about both developments in Federal Reserve supervision and regulation, as well as the approaches to financial modernization being debated in the Congress. I won't try to cover the full waterfront on these topics, but would like to share with you some of the Board's considerable rethinking about the way we supervise and regulate bank holding companies. I will also describe how I believe the recent Board initiatives coming out of this process may well alter the debate about the structure and supervision of financial services in the United States -- a topic I believe has received insufficient attention in the legislative debate so far. I will focus my discussion of recent Board actions on the supervisory process and on three regulatory changes made or proposed by the Board: changes to the application and nonbanking provisions of Regulation Y, changes and proposed changes to the Board-imposed "firewalls" between a bank and a securities affiliate, and changes to the Board's anti-tying rules. I stress these three not necessarily because they are the most important undertaken by the Board, but because I believe that they most directly affect the debate about how financial services should be supervised. The cornerstone of the bank supervisory process is the verification of prudent practices and financial condition through on-site examinations, coupled with off-site surveillance. Traditionally, on-site examinations of bank holding companies and their nonbank subsidiaries have focused on verifying compliance and determining the financial condition of an institution at the time of the examination by reviewing their loans and by testing other transactions. This process is changing. The Federal Reserve's supervisory oversight at the bank holding company level is increasingly directed at evaluating risk management, internal controls, and decision making processes that are shared between a bank and its parent, rather than focusing on transactions and positions at nonbank affiliates. This focus is necessary given the continuing trend toward integrated management of financial activities on a consolidated basis. Testing the adequacy of risk management and internal control helps us understand the financial condition of the consolidated organization and the potential impact of consolidated risk management policies and internal controls on the operations of the insured depository institution. To implement this approach, the Federal Reserve last year began assigning a formal rating to risk management in our holding company and bank examination reports. Changes have come not just in what we examine, but also in how we examine. We are making greater use of internal risk management reports, the results of internal risk models, and the work of internal and external auditors. For example, the Federal Reserve is now collecting internal loan classification reports prepared by most of our larger banks, as well as other information generated by their internal risk management systems. This approach has a further advantage in that it can generally be conducted off-site, at less burden to the firm. Our examinations are also becoming more efficient through pre-visitation planning that better identifies those areas of a company's activities that pose the greatest risk. We are also making greater use of computer technology in the examination process and using automated systems that permit examiners to analyze data on their personal computers. And, of course, whenever possible we rely upon examination and inspection reports prepared by regulators of the individual entities within the bank holding company. Like examinations, disclosure practices of the past also focused narrowly on the financial condition of an institution at a point in time, using conventional accounting and regulatory measures. Today, however, disclosures are expanding to reveal not only the current risks of the balance sheet, but also management's philosophy for managing and controlling risk. Disclosure is an important aid to us as supervisors and, we hope, to market analysts. Improved disclosure has already been put into practice for derivatives and market risks, and we will continue to urge better and more broadly based disclosure of all major activities and exposures. As the issue of consolidated or "umbrella" supervision is debated in the legislative process, I believe it is important to examine how these supervisory developments alter that debate. There are those who argue that umbrella supervision of a diverse financial services holding company would either be an impossible task or an intolerable burden. But the risk-analysis and surveillance techniques that we have decided are the most effective for bank holding companies should also be adaptable to more diverse financial organizations that include banking operations. Clearly, we must all give additional thought to how such an adaptation would work so that we minimize the intrusion into new activities. Perhaps there should be some kind of carve-out for firms whose banking operations are a small part of the organization or if the firm is otherwise regulated. Nevertheless, to be successful, a financial services company should reap synergy gains not only by marketing a variety of products to customers but also by pooling and jointly managing diverse financial risks. Thus, the movement toward use of one treasury, one risk management policy, and one set of exposure limits would continue. It is those policies and risks that an umbrella supervisor must understand in order to gauge the risks to the insured institution. In fact, as I am sure this group will recall in the wake of BCCI, the Congress also became convinced of the importance of consolidated supervision of any banking organization. Through the Foreign Bank Supervision Enhancement Act, the United States not only recognized the importance of consolidated supervision, but strongly encouraged it as an international principle of banking supervision by requiring that any foreign bank seeking to enter the United States be subject to consolidated home country supervision. Subsequent history has confirmed that judgment. As I've noted, virtually all of the large holding companies now operate as integrated units and are managed as such. Thus, the Federal Reserve remains convinced that one supervisor must have the task of evaluating the organization as a whole. This view is now commonly accepted around the world. The idea has for some time been endorsed by the Basle Committee on Banking Supervision, and many countries are adopting similar approaches. Still, I can certainly understand why some advocates of a more diversified financial services holding company would wish to abandon consolidated supervision. Consolidated supervision raises hard questions -- the kind of questions that can bog down legislation and splinter coalitions -- and questions that engage us even now. What authority should a consolidated supervisor have over non-financial activities, if they are allowed? How should the consolidated supervisor work with the primary supervisor of a bank, or a broker-dealer, or an insurance company? How much burden must consolidated supervision entail? As we all pursue the answers to these questions, perhaps the Federal Reserve's risk-based approach to supervision can provide insights into how umbrella supervision of an expanded organization could work. Just as with supervision, the regulatory side of the Federal Reserve has undergone profound changes of late. Just a few weeks ago, the Board approved a comprehensive streamlining of Regulation Y that should substantially diminish the regulatory burden on bank holding companies and foreign banks wishing to expand or innovate in the United States. First, the Board concluded that review of an application should focus on how the proposed acquisition or activity would affect the organization. The application should not become a vehicle for comprehensively evaluating and addressing supervisory and compliance issues at the applicant organization. This principle is also the basis for recent Congressional action to eliminate the prior approval requirement for engaging in Board-approved nonbanking activities under section 4 of the Bank Holding Company Act, provided the company meets specified standards for capital and management at the time of its last examination. As a result, the Board has significantly streamlined the process for well-capitalized, well-run companies to acquire a bank or nonbank and eliminated the prior approval process for such companies to engage de novo in Board-approved nonbanking activities. Second, the Board concluded that bank holding companies should be permitted to conduct nonbanking activities to the fullest extent permissible under the Bank Holding Company Act, and that Regulation Y should be sufficiently flexible to allow for industry changes in permissible activities without requiring additional regulatory filings. Accordingly, the Board removed restrictions on investment advisory activities, derivatives trading activities, leasing, and other activities whenever those restrictions impeded efficiency or imposed costs without conferring corresponding benefits to safety and soundness. The Board also permitted a data processing or management consulting subsidiary to derive up to 30 percent of its revenue from nonfinancial data processing or nonfinancial management consulting. And the Board has indicated that it will be pro-active in approving new activities. The next area where the Board has been particularly active concerns firewalls between a bank and an affiliated securities firm, better known as a section 20 affiliate. Experience with these section 20 affiliates, and other affiliates engaging in similar activities without such restrictions, led the Board to conduct a comprehensive review of the firewalls. Much of the potential for conflicts of interest between a bank and a securities firm is addressed by other laws such as the registration and disclosure requirements and the anti-fraud provisions of the securities laws. Legislative and regulatory enactments, many adopted since the Board's initial 1987 section 20 order, also provide important insulation between a bank and a section 20 affiliate by imposing qualitative and quantitative limits on inter-affiliate transactions and requiring that a customer receive disclosures detailing the identity of its counterparty and the product being purchased. Accordingly, the Board has repealed its restriction on cross-marketing between a bank and a section 20 affiliate, eliminated a blanket restriction on employee interlocks, and scaled back a blanket restriction on officer interlocks to include only a chief executive officer. The Board has also proposed to eliminate a firewall prohibiting a bank from providing any funding to a section 20 affiliate and three restrictions on a bank's extending credit or offering credit enhancements in support of securities being underwritten by its section 20 affiliate. The Board's proposal recognized that as financial intermediation has evolved, corporate customers frequently seek to obtain a variety of funding mechanisms from one source. By prohibiting banks from providing routine credit enhancements in tandem with a section 20 affiliate, the existing firewalls hamper the ability of bank holding companies to operate as one-stop financial services providers, thereby reducing options for customers. Instead, the Board has proposed to require that internal controls and operating standards ensure that a bank use independent credit judgment whenever it is acting in tandem with its section 20 affiliate. Finally, the Board has taken action to allow greater packaging of products by bank holding companies. Since the 1970s, banks and bank holding companies have been prohibited from packaging their products unless the arrangement involved a traditional bank product. While this exception softened the impact of the statute, bank holding companies were nonetheless at a considerable disadvantage to their competitors, particularly as bundling of services has become a marketing imperative on both the retail and wholesale side of the business. After reviewing its experience with the statute, the Board recently repealed a regulation that had extended to bank holding companies and their nonbank subsidiaries the statutory prohibition on tying arrangements by banks. Experience taught us that these non-banks did not have the type of market power that Congress presumed banks possessed when it enacted an anti-tying statute. The Board has also created exceptions to the statute to allow package arrangements between bank holding company affiliates to the same extent as the statute allows them within the bank. Lastly, and perhaps of greatest interest to you, the Board created a safe harbor to clarify that any transaction with a foreign customer was not covered by the statute. Thus, for example, a U.S. branch of a foreign bank can participate in a syndicated loan to a European firm, even if the loan is offered only as part of a package of services that would otherwise run afoul of the anti-tying law. I think it worth noting how all these reforms may affect the debate about the corporate structure of bank holding companies -- specifically whether bank holding companies should be granted the option of moving activities prohibited to the bank into a subsidiary of the bank, and thereby funding those activities with subsidized funds. Descriptions of how the subsidy works and examples of the funding advantages it confers are plentiful. But I believe that it is so ingrained in our thinking that we sometimes take it for granted. Think how obvious the subsidy would be if it involved another industry -- for example, if the government guaranteed that commercial paper holders of the automobile industry would be repaid in full. To complete the other strands of the safety net -- the discount window and the payment system -- let us assume that automobile companies experiencing liquidity problems could borrow from the Federal Reserve for the purpose of repaying commercial paper, and that they are able to achieve risk-free settlement. The effects of extending such a subsidy are not difficult to imagine. Automakers would find it very easy to place their commercial paper, and would be able to pay a below-market yield. And, to the extent the hypothetical allowed, I would not be surprised to see automakers use this funding advantage to enter other businesses. So it is with banks -- and with subsidiaries of banks. Regulators can limit a bank's ability to subsidize its subsidiary through loans by capping their amount or regulating the rates the subsidiary must pay. But although one can limit the aggregate investment a bank can make in its subsidiary by requiring that such injections be deducted from the capital of the bank, the equity investment in the subsidiary is still funded from subsidized resources, and that subsidy transfer cannot be eliminated. Thus, both analytically and practically, I think it difficult to deny that banks and their subsidiaries benefit from a federal subsidy, and benefit in ways that an affiliate of the bank does not. Nevertheless, some argue that a parent-subsidiary structure is more efficient than a sibling structure, and must be allowed for a broader range of activities. But in light of the recent regulatory changes that I have described, I believe that this argument is now questionable. A bank and an affiliate can now avoid a redundant work force and duplication of effort by having employees serve in a dual capacity, or by allowing reporting lines to cross. For example, a common back office or treasury can be maintained. Furthermore, the two companies can market their products jointly to both retail and corporate customers. With these regulatory changes, banks and bank holding companies have opportunities to make considerable adjustments to their organizational structures and operating procedures as well as to offer new products to customers in new ways. Let me conclude by pointing out that the legislative debate has only just begun. Opinions are still developing, new ideas are still being presented, and positions are not yet cast in concrete. But even as new legislation is being debated, those of us who must try to interpret and administer existing laws recognize that we must do so in a developing global marketplace. I believe that the steps the Board has taken to make its regulatory and supervisory systems less burdensome and more risk focused will stand us in good stead in this changing financial environment. Nevertheless, comprehensive financial reform legislation is still needed to allow banking and other financial institutions to compete internationally and to offer the full range of financial services needed and demanded by their customers.
1997-03-04T23:00:00	Mr. Davies reviews current debates on regulatory structures governing the financial system	Speech by the Deputy Governor of the Bank of England, Mr. Howard Davies, held on 22/2/97 at the Federal Reserve Bank of Atlanta"s Financial Markets Conference entitled "Market and Regulatory Structures in a Global Environment".	Mr. Davies reviews current debates on regulatory structures governing the financial system Speech by the Deputy Governor of the Bank of England, Mr. Howard Davies, held on 22/2/97 at the Federal Reserve Bank of Atlanta's Financial Markets Conference entitled 'Market and Regulatory Structures in a Global Environment'. It is conventional, and polite to say, at the beginning of a speech of this kind, that one is thrilled to have been asked to speak on the subject of the structure of financial regulation and that the topic is, of all the many preoccupations of human kind through the centuries, the one which generates the most enthusiasm and excitement in one's breast. But I cannot bring myself to do it. You may think me ill-brought up to say this if so blame my parents - but I find the question of the structure of regulation to be quite resistible. I know that there are those who like nothing better than to draw new organigrams and to explore the manifold interfaces between regulatory agencies. (There are also people who find self-fulfilment collecting airline sick bags, or watching synchronised swimming. That is a matter for them.) But my lack of enthusiasm for the topic of regulatory structure is, I hope, not an emotional response. It is rationally based on two prior beliefs. First, that the relationship between structure and effectiveness is loose. I know of little evidence that structural reforms are quickly followed by an enhancement of the effectiveness of the activity in which those agencies are engaged. Secondly, my prejudice is to believe that regulatory structure should follow market structure, rather than the other way round. Regulators should seek to respond to changing markets which, in turn, respond to changing customer demand and new product availability, rather than seeking to dictate either. So we should always ask ourselves whether the regulatory framework we adopt makes sense to market participants, rather than requiring them to structure their business to fit in with some governmentally imposed view of the way product delivery should be organised. But I recognise that, in practice, we cannot avoid constant attention to the maintenance of the regulatory framework. Firstly, because while good structure will not necessarily generate effectiveness, a faulty, out of date framework will certainly make it very hard for regulators to do their jobs well. And, of course, the market is not in an 'original condition'. The financial markets we have now are heavily conditioned by the legislative and regulatory framework within which they have grown up. That is particularly true in the United States. It is hard to imagine that, absent Glass-Steagall, regulation Q and all the rest, the financial landscape in North America would look as it does today. So I conclude that the debate on regulatory structure should be a constant dialogue between the markets and the regulators, but with a prejudice in favour of the former. Our ultimate task as regulators is to ensure that markets work efficiently, and in the interests of consumers. Against that background, how is this dialogue proceeding in the UK at present? For we too are addressing the questions which preoccupy you in the United States, in our quaint, olde worlde British fashion. But before I review the current debate on regulatory structure in the UK, I should say a little about the way we define the objectives of financial regulation. We think of five: to protect the economy against systemic risk; to protect individual depositors, investors and insurance policy holders against loss from the failure of their intermediary; to protect customers against business misconduct; to assist society at large in the fight against crime (for instance by making sure firms have in place systems to detect and report laundered drug money and other proceeds of organised crime); and, last but not least, to create and sustain fair markets. Described bluntly, these objectives make the job of regulators look impossibly daunting. But of course they are not absolute aims. Regulators cannot, and should not, offer blanket assurances to investors and depositors. They cannot, because the tools and resources to do so are simply not available. And they should not, because it would be quite wrong to remove from investors and firms the responsibility for assessing, taking and monitoring financial risks. This is a very important point, which Alan Greenspan has helpfully underlined on a number of occasions recently. UK regulatory structure and proposals for change Across the world we see a lively debate on how the regulatory cake should be cut. There has been change in France. The Australian Government has set up the Wallis Commission to look at the institutional arrangements there. Their first report has just been published. Reforms are in progress in Japan. In the US the new legislative season is about to open, with a number of runners and riders already saddled up in the financial regulation steeplechase. Similarly, in the UK, a variety of think tanks, and the opposition Labour Party, have produced proposals to amend, or in some cases fundamentally reorder, our regulatory structure. But, before describing these exciting proposals, perhaps a brief description of the British system would be in order. Responsibility for financial regulation in the UK is divided between two Government Departments. STRUCTURE OF UK Department of HM Treasury FINANCIAL REGULATION Trade and Industry Insurance Banking Financial Companies Act 1987 Services Act 1982 Act 1986 Bank of England Securities and Investments Board Personal Investment Authority Investment Management Retail Regulator Regulatory Organisation Securities And Futures Authority Banks Financial Securities Insurance Fund Companies Advisers Houses Managers Most falls to the Treasury, but prudential supervision of insurance companies is the responsibility of the Department of Trade and Industry (DTI). The DTI carries out its supervisory responsibilities using its own staff; the Treasury, on the other hand, while setting the legal framework and policy directions for regulation, leaves most of the detailed regulatory functions to others. Under one piece of legislation - the 1987 Banking Act - the Bank of England carries out prudential supervision of banks. Under another, the 1986 Financial Services Act, the Treasury delegates its powers to the Securities and Investments Board, which in turn recognises a number of front-line regulators. These front-line regulators cover different sections of the market. One, the Securities and Futures Authority (SFA), is responsible for securities houses; another, the Investment Management Regulatory Organisation (IMRO), for fund managers. These two regulators undertake both prudential supervision and conduct of business regulation. The third, the Personal Investments Authority (PIA), is responsible for the retail sector, and has principally a conduct of business remit although it is responsible for the prudential supervision of independent financial advisers (IFAs). So, in effect, there is a layered approach to the regulation of financial services in the UK, with different powers held at each level. (To complete the picture, the Building Societies Commission supervises building societies (Savings and Loans) - though the largest of them are now converting to bank status. And the Department of Social Security is responsible for the supervision of occupational pension schemes.) This brief description of the legislative framework might lead one to suppose that the UK system is primarily statutory - yet the securities side is often described, at least by comparison with the US system, as one of self-regulation. Indeed, some argue that it is excessively self-regulating and, therefore, unreasonably lax. We would reject that last charge. And, in practice, the distinction between statutory and self-regulation is not black and white. The UK system has elements of both. Prudential supervision of insurance firms is carried out directly by a government ministry, which is unambiguously Government regulation. Banking supervision is carried out by the Bank of England. Constitutionally, this is not 'Government' regulation, but rather regulation by a public body which is authorised by specific Act of Parliament. Certainly no one describes what we do as self-regulation, even though the Bank of England is a bank. On the investment side, the picture is more complicated. The Government has delegated its powers to the Securities and Investments Board. The SIB's governing board includes people who are active in financial services, but they are appointed by the Treasury and the Bank of England (indeed I am one of them) and are required to act in the public interest. Again, this does not look like self-regulation. However, the various front-line regulators are called, in the Act itself, 'self regulating organisations' (SROs). Their boards include a high proportion of active practitioners, elected by the industry to represent its views. Practitioners are also heavily involved in policy discussions, rule-making and enforcement functions. But, like the SIB, the SROs operate indirectly under statute, and have a duty to regulate in the public interest. We therefore have no self-regulation in the strict sense, rather a variety of statutory and statute-backed bodies with practitioner involvement, each with different relationships with the industry and with Government. Effective regulation needs the input of all participants in the market if it is to offer appropriate protection without stifling innovation. Regulators can benefit greatly from effective practitioner input but to retain the confidence of the investing public they must persuade them that regulation puts their interests, and not those of the firms and their shareholders, first. The system we now have is undoubtedly capable of achieving an appropriate balance between market sensitivity and consumer confidence; it has, in many respects, worked well. But it has been stress-tested in a number of difficult episodes: the Maxwell affair, the private pension mis-selling saga, the collapse of BCCI, Barings Bank and Sumitomo. These episodes have taught us something about the strengths and weaknesses of our system, just as the S&L crisis and the Daiwa New York problem have done in the US. Furthermore, markets themselves have moved on. The financial landscape of today is almost unrecognisable from the one which informed legislators' views in the early 1980s, before the Banking and Financial Services Acts were put on the statute book. It is therefore not surprising that over there, as well as over here, there is criticism of the existing structure, and pressure for change. Our own system, with its monopolistic approach to the origination of legislation, does not generate competing draft bills. But the marketplace for ideas on regulatory reform is, I can assure you, just as well contested. Critics of the existing British system object on three counts: 1 that the failures of the last decade demonstrate its inability to cope with strains and crises; 2 that it is unnecessarily complex, with overlapping and sometimes even conflicting responsibilities; and 3 that it has failed to keep pace with changes in institutional and market structures; the distinctions on which it was based no longer effectively apply. It is not my aim today to give a comprehensive assessment of the validity of all these arguments. And, in any event, just as in the US, there is a heavy political dimension to this debate. But I would make a few observations on the arguments advanced for change. The UK system is complex, although it is no more complicated than the equivalent arrangements in some other countries with similarly sophisticated financial markets. (Indeed, were I not a guest here, I might say that the US system was rather more labyrinthine than ours.) Those who argue for simplification point to duplication of function and cost, especially between the SIB and the front-line financial services regulators. There is undoubtedly a case to answer in that area, as both the SIB and the SROs would acknowledge. But the legislation we have explicitly dictates a two-tier structure. It is also true that institutions now tend to be involved in a variety of different businesses. Banks own securities houses, fund managers, and insurance companies. Insurance companies are diversifying into banking, and so on. So that even though there should always be a lead regulator, looking at the overall position of the business, institutions still face the costs of complying with the requirements of several regulators. But the question underlying these arguments about complexity and overlap is more fundamental. Should regulation be based around institutions (it is institutions which fail, after all) or around functions or types of business which call for specialist regulatory knowledge? The UK system is organised neither along wholly functional nor wholly institutional lines. In today's markets, where firms are a mass of subsidiaries and business units, no major market participant deals with a single regulator across all its businesses. Similarly, no regulator has unique responsibility for regulating one function of each business. The insurance operation of a firm, for example, is covered by separate prudential and conduct of business regulators. Most people involved in financial regulation would recognise this description of the problem. But determining how to resolve it is not straightforward, as evidenced by the wide variety of proposals for change which have been advanced. Some proponents of reorganisation would like to begin by making all financial regulation the responsibility of a single Government Department - the Treasury. They suggest that this would clear up accountability for the legislative framework, and for the powers and sanctions in the regulatory regime and create consistency of regulatory approach across sectors. Straightforward administrative tidiness may also be a factor. While there may be merit in both these arguments, such machinery of Government questions are for the Government to determine, and I happily leave such matters to them. Most of the discussion about regulatory structure in the UK has concentrated on the area covered by the SIB and the front-line financial services regulators. It is in this part of the system that the arguments about duplication of function, unnecessary cost and poor communication are most often heard. The various alternative models all feature some degree of consolidation, and some would go as far as to fold all the main financial services regulators into a single body. Others propose two bodies, each reporting directly to the Treasury, with one covering wholesale business and one covering retail, acknowledging the different regulatory imperatives, especially in the conduct of business field, of the two sectors. The aim would be to reduce the number of domestic regulators large institutions would have to deal with, and to improve the match of regulation to function. Even more radical changes have been proposed, encompassing not only the SIB area, but the prudential supervision of banks and insurance companies as well. One model, colloquially known as 'Twin Peaks', would replace the whole of the present system with two Commissions: a Financial Stability Commission, with responsibility for systemic risk, the prudential supervision of all major institutions, and conduct of business regulation of wholesale activities, and a Consumer Protection Commission, which would be in charge of conduct of business regulation in retail markets, as well as detecting market manipulation and insider dealing. It would also carry out prudential supervision of those stock brokers and fund managers who deal with private clients, and of independent intermediaries. The advocates of this model argue that it would better match regulation with both institutions and functions, in particular on the wholesale side. The underlying contention is that the traditional separation between banking, securities and insurance is breaking down, so that there is now a less meaningful difference between institutions and functions. I am not persuaded of the merits of this case. Although the activities of banks and securities firms do overlap at the margin, this is not true of the core activities. Banks in particular continue to have a number of distinctive characteristics. First, there are the risks associated with the maturity transformation seen in their balance sheets. Banks experiencing a drain in their liquidity, perhaps because of a classic 'run', could be driven into insolvency through the forced realisation of illiquid assets at 'fire-sale' prices. Second, there is the risk of contagion - problems at one bank can spread to others - not just through direct financial linkages but also because, in the absence of timely, transparent information on bank assets, depositors become concerned about other banks which they see as similar. Finally, banks play a central role in payments systems, including payment flows generated by FX trading. The conclusion I draw is that there is enough that is special about banks for their prudential supervision to be retained as a separate activity in any new regulatory structure, and that this argument at present outweighs the case for change. Whether prudential supervision of banks should be a function of the central bank is a separate question. Some argue that other central banking responsibilities (such as the conduct of monetary policy) make for conflicts of interest and therefore that supervision should not be carried out by the central bank. I am not persuaded by these arguments either. Nor am I aware of many examples where the suggested conflicts between a supervisory role for the central bank and its other responsibilities have arisen in practice. Indeed, there are important synergies between the supervisory function and other central bank responsibilities. It makes sense for the 'micro' supervision of individual banks in the system to be carried out by the same body that carries out the 'macro' function of maintaining the stability of the financial system as a whole, stability which is essential if monetary policy is to be executed effectively and efficiently. It is no accident that in all major countries the central bank has a significant role in the supervision of banks, even if in some cases others have been given the legal powers to carry out the front-line tasks. Having as supervisors tried their best to limit the likelihood of failure, when faced with it central bankers are uniquely well placed to provide assistance, whether to the institution in trouble, to the market at large, or both. Those who wish to separate banking supervision from central banking must acknowledge that there are certain things that only the central bank can do, and that therefore there needs to be a strong link between the central bank and any new regulator. In Germany, for instance, the Bundesaufsichtsamt is the supervisor of commercial banks. But the Bundesbank has an important role in the day-to-day job of collecting prudential returns, and must be consulted on liquidity and capital requirements, which bear most directly on its role in an emergency. The logic of these arguments might point instead to a 'Holy Trinity', rather than a 'Twin Peaks' model, based on three agencies, focused respectively on financial services, banking and insurance. That might allow the most sensible match - albeit not complete - of regulation to function and institution. It would also have the advantage of evolving fairly readily out of the present structure. - 7 - HM Treasury Consolidated Securities Insurance and Investments Bank of England Supervisor Supervisor(s) Insurance Investment Firms, Markets Banks Companies and Exchanges This last is not a trivial point, since the cost and disruption caused by reorganisation would be considerable, and higher in proportion to the degree of change. The process would inevitably generate uncertainty among firms and the public, and make the regulatory system more difficult to manage in the meantime. This argues for building on the present arrangements, if at all possible, rather than beginning again with an entirely new structure that could take years to settle down. Furthermore, what matters to the financial system, and to the public, is that regulators are effective. Effectiveness necessitates good communication, consolidated supervision and close co-operation to maintain protection across the piece. Whether structural change (including bringing functions together under one umbrella) would improve communication and co-operation and so increase effectiveness, is a key question, and the answer is far from clear. We have been making considerable efforts recently to enhance communication between different supervisors in the UK. That has involved, as you would expect, the usual paraphernalia of Memoranda of Understanding. But, in addition, we have sought to achieve cross-membership of some of our most important institutions. For example, Sir Andrew Large, the Chairman of the Securities and Investments Board, has become a member of the Bank of England's Board of Banking Supervision and, reciprocally, I have joined the SIB. Of course one should not exaggerate the importance of individual appointments of this kind. But they do help to create a climate of co-operation, and give a signal to the respective staffs of the two institutions that they are expected to work together as closely as possible, and a signal to the outside that they can expect this to happen. The Approach to Regulation in the UK The discussion of regulatory approaches is often phrased in terms of rules versus judgement or, as academics tend to put it, rules versus discretion. Should supervisors simply set the rules, and shoot those who break them? Or does that create too rigid a framework, one which stifles initiative and imagination? There is no simple answer. The Bank of England imposes an increasing number of rules: it has, for example, implemented detailed regimes for capital adequacy introduced by the Basle Committee and the European Union. We set capital requirements to cover the more readily quantifiable risks; we enforce limits on banks' large exposures to individual counterparties; we have rules on banks' liquidity; and we seek to ensure that banks have robust systems and controls, as well as management with the skill and integrity to ensure, in that delightful US phrase, that the bank is 'safe and sound'. But our judgmental approach - allowing supervisors the discretion to exercise informed judgement within approved guidelines - still contrasts with that of many other regulators. This flexibility allows us to be tough where appropriate, but to avoid inappropriate requirements - tailoring the requirements to the nature of the bank's activities. Most fundamentally, perhaps, we can ask questions, and attempt to take advantage of all the information at our disposal to form a judgement of the risks facing depositors and investors, as well as of the quality of a bank's management. So in addition to enforcing rules and looking for problems, we can help management. We can spread knowledge of best practice: asking banks about the full range of risks they face (including those - like reputational and settlement risk that they would often rather ignore); and pointing out to complex groups the extent to which their managerial and organisational systems have moved away from their legal structure. It is true that, in addition to being less rule-bound than most other supervisors, the Bank is commonly viewed as doing relatively little on-site supervision. Of course, this depends on how you define the term. Accountants are well aware that the Bank does, for example, make extensive use of reports prepared by auditors - who, of course, operate on-site - in order to assess the adequacy of internal controls. In particular, the Bank regularly instructs banks to appoint reporting accountants to report on systems and controls and on the accuracy of prudential returns. The Bank's supervisors also spend a growing amount of time on-site. Since 1986, Review Teams have carried out focused visits to banks to evaluate the level of risk in an institution as well as the risk management systems in place to identify, monitor, and control these risks. And in 1995 we introduced a Traded Markets Team to focus on banks' pre-processing models which can be recognised under the CAD (Capital Adequacy Directive) as well as sophisticated risk modelling techniques used by the banks to manage treasury activities. These teams spend on average about three days on banks' premises, which may seem short, but the visits are highly focused, reflecting a great deal of work carried out in advance, not just between team members and the line supervisors of the bank in question but also by the bank itself in providing detailed answers to a series of questions. At the same time, the Bank has recognised the need to be more systematic in its approach to risk assessment and has announced its intention to introduce a more formal approach based on a common approach, known as the RATE model, to identify - using a series of qualitative and quantitative measures - the risks faced by the bank. RATE is an acronym for the three stages of the process: of supervision and Risk Assessment, Tools Evaluation. In the future, by performing periodic risk assessments, we aim to gain a better understanding of the quality of management, the characteristics of the business and the risks the banks face. The greater degree of consistency across banks embodied in the new approach will allow the Bank to be more focused in performing its supervision. The tools of supervision, such as Review Team Visits and Reporting Accountants Reports on internal controls, will be targeted at the areas of greater risk and concern in individual banks. We shall very shortly be issuing a consultation paper setting out how we plan to implement the model in practice. That paper will show that we have tried to model parts of our approach on best practice in the US. The City of London may not always have been a preferred habitat for camels, but you may well see some genetically modified examples on the streets there quite soon. A better understanding of the risk profile of each supervised institution will assist the Bank in setting risk asset ratios. As you all know, Basle sets a minimum capital ratio of 8 percent of risk weighted assets. The 8 percent ratio is sometimes interpreted as a 'one-size-fitsall' standard. The Bank, however, sets the trigger capital ratio for each authorised bank at, or above, the 8 percent floor and considers an adjustment to that trigger ratio whenever we see a substantial change in that bank's risk profile. Where does this all leave us in comparison with other regulators? I suggested earlier that our flexible, judgmental approach is somewhat distinctive. But we are no longer, if indeed we ever were, outliers on the supervisory spectrum. While the Bank has decided to implement a more systematic approach to risk assessment, other supervisors - who traditionally operate a rule book - are (in a fast moving marketplace characterised by rapid product innovation) moving towards a regime that gives more scope for supervisory judgement. But the fact that regulators internationally are converging in their approach does not necessarily mean that they are right. They may all be converging on an inappropriate model. Indeed some would argue that regulators do as much to create problems as to solve them: that regulators create perverse incentives - even as we speak bankers may be designing products whose whole rationale is to exploit anomalies in our rules. Perhaps we would all be far better employed elsewhere, leaving the market to regulate itself. Why should we not facilitate that process by concentrating on rules of disclosure, obliging banks to publish accurate information on their capital adequacy and risk profiles, and leaving the rest up to the market - perhaps with some safety net for small depositors and investors? As you know, the New Zealanders have made an interesting move in this direction in the last couple of years. Should we then get out of the business and leave it all to the markets? To answer that question, it may be helpful to go back to first principles. Back in 1958, Modigliani and Miller demonstrated that in a frictionless world a firm's capital structure cannot affect its value. In the real world, however, departures from the M&M assumptions - such as taxes, bankruptcy costs and agency costs - may influence the capital decision of any firm; capital may after all be costly. But banks differ substantially from most other firms because their soundness and safety is crucial to maintaining systemic stability; without capital requirements some will exploit this fact by taking large risks with little of their money, in the hope that the taxpayer will bail them out. In other words, some may believe that they are (partially) insulated from potential market discipline. From a regulatory perspective, banks must therefore be required to have capital to absorb the possible losses that result from risk-taking and still remain solvent. What is our position in this debate? It is tempting to conclude that the only problem is a perception of a government-funded safety net for large banks; remove that and our problems will be solved. But systemic risk cannot be wished away as easily as that, even though we in the UK have demonstrated by our actions that we do not rescue every bank which gets into problems. So, while we try to stay clear from ever more detailed rules, we do not believe everything can be left to the market; certain minimum 'regulatory' capital standards are in our view necessary. Of course, we must aim for a credible and comprehensible regime which does not require constant updating and elaboration, is not immensely costly, and is reasonably consistent. The value-at-risk approach is an attempt in that direction. It recognises that there is a crucial role for judgement in supervision, and that one size really will not fit all. It does not prescribe the key qualitative factors in legalistic detail. But it does set out the parameters so as to ensure that there is a framework in place which will deliver broad consistency and also some degree of prudence. Some have argued that regulators should go further than the value-at-risk approach: rather than defining the key parameters and endorsing particular model types, why not leave it to the banks, and give them an incentive to improve their internal models as much as possible? Under this pre-commitment approach a bank would specify the maximum portfolio loss on its trading activities and this would become the institution's market risk capital requirement. Banks exceeding their pre-committed maximum loss (that is breaching their capital commitment) would be penalised in one way or another. Such penalties could be financial, or could entail corrective supervisory action. In some ways pre-commitment can be seen as an extension of the model-approval approach we already adopt. The aim, which we endorse, is to ensure that supervisors work with the grain of the business, and monitor ratios which are seen as meaningful by those who run banks themselves. To that extent, we support it. But there are potential drawbacks. It could amplify the moral hazard problem: if the bank wins, its shareholders - as well as its traders under their bonus packages - pocket the profit, and if it loses, the regulator/tax-payer ends up with the bill. A penalty would not act as a deterrent to a bank prepared to gamble its capital because that bank would not be affected by such a penalty when it was 'down and out'. Furthermore, regulators could over time become less familiar with banks' risk management systems, which might make them less effective in a crisis. Early supervisory intervention is more difficult if supervisors only become aware of problems ex-post, after the limit has been breached. It may be possible to devise an approach to pre-commitment which avoids these potential handicaps. But for the time being our attitude remains somewhat hesitant. Finally, a discussion about rules is not complete without touching on the question of a 'level playing field'; an odd analogy, I think, since in field sports there is no such thing. If there were, why would teams change ends at half time? (In American football, of course, teams change ends three times - and in baseball they resolve the problem by running round in circles.) When banks and securities houses do similar business it seems only fair to apply similar capital rules. But while this is true at the margin, when we look at the total business of banks and securities houses, the picture is still vastly different. A major part of a bank's regulatory capital is held against credit risk. By contrast, securities houses invest primarily in liquid, marketable assets which can be readily sold, with illiquid assets typically a small proportion of the total, generally 2% or so, and the bulk of a securities firm's regulatory capital tends to be maintained for market risk purposes. It is therefore not obvious that we need to set the same detailed rules for banks and securities houses. That is not to say that we should entirely ignore differences in supervisory regimes, but rather that we should focus on areas where those differences are on a scale which seriously distorts competition. In other words, we should spend rather less of our time discussing risk weights, and rather more discussing risks. Globalisation and the Regulatory Response How far do these general principles, which I have discussed so far in relation to the UK, apply to regulatory structures in a global environment? One issue for supervisors is increasing globalisation. The biggest institutions now span 50 or more countries and may have 300 or more entities within the group. This is not new; globalisation in this sense has been a feature of banking certainly since the 1970s. What is rather newer is the way in which the firms are centralising the controls for all these far flung entities. With the recognition that similar risks are being run in different subsidiaries (for example a Japanese bank might have exposure to US interest rate risk from its activities both in London and New York), there has been a move to consolidate these homogeneous risks and manage them centrally within a group. This means control lines which transcend or cross the entity structures and a matrix management structure. It means that the head office can exercise much stronger control over the volume of a particular type of risk being run across the group. For example, for some UK banks, the management of their global foreign exchange book will be managed in London during London office hours, then it will switch to the US operation but under strict limits set by London; after the US close it will move again, to the Far East, but still under the control of limits set by London. The increasing development of whole book value at risk models has also encouraged this centralisation of control. In the foreign exchange example, the value at risk model used by the group will be maintained and run in London. So the riskiness of positions across the world wide group will be assessed according to the London model. But centralisation of controls goes even further. Oversight of credit and key credit risk decisions may well also be centralised. Oversight of FX settlement risk is sometimes centralised in London as well as control of the position risk. Likewise various aspects of the internal audit function may well be centralised. So for global groups, the control of the activities in the various legal entities scattered across the planet will hinge on the adequacy of controls located not in those particular countries but centrally. In a way it is simply an extension of the vulnerability of banking entities to problems arising elsewhere in the group. But in this case solvency of the individual entities will depend on the adequacy of systems and controls located in another part of the group. Massive intra-group transactions to move risk between entities will also affect the position of the various subsidiaries. One obvious question is why firms do not dispense with such a plethora of legal entities and operate a simpler branch structure. The answer seems to be that differences in tax structures and even regulatory requirements in some countries still encourage the use of legal entities in different jurisdictions. In that case should regulators try to lean against this centralisation? Here I think the answer must be that the regulators should not try to discourage greater central control of risk. Where a firm is running one type of risk in different locations it must make sense for the total risk to be controlled centrally. But this does create a problem for supervisors because supervision has to be structured along legal entity lines (given that it is legal entities which fail). Responsibility for legal entities cannot be transferred between supervisors. Each supervisor must therefore take a view about the soundness of the entity in its jurisdiction, even where this hinges on controls located elsewhere. How have regulators responded to these trends? In summary, they have increasingly sought ways of increasing co-operation amongst themselves, including agreeing their respective responsibilities and setting up arrangements for information sharing. In the banking sector, at least, they have also supplemented solo supervision of individual entities with consolidated supervision of groups as a whole. When the Basle Committee on Banking Supervision was established by the central bank governors of the G10 countries at the end of 1974, its initial focus was to define the role and responsibilities of home and host supervisors of internationally active banks. These were set out in the 1975 Concordat which established how supervisory responsibility for banks' foreign branches and subsidiaries should be shared between host and parent supervisors, and which has been updated on a number of occasions since. Securities supervisors too have a long tradition of international co-operation, including arrangements for information sharing and mutual assistance in enforcement, with IOSCO playing a key role in facilitating such co-operation internationally. There is also a long history of discussion between Basle and IOSCO. Individual supervisors in both the banking and securities industries have chosen to reinforce co-operation arrangements with formal bilateral agreements with their overseas counterparts. Partly as a consequence, there have been an increasing number of informal meetings between line supervisors with operational responsibility for different parts of financial groups. The importance of international regulatory co-operation is now widely acknowledged and is on the agenda of inter-governmental meetings. At last June's G7 summit in Lyon, the heads of state called for maximum progress preceding the Denver summit in June 1997 on "enhancing co-operation among the authorities responsible for supervision of internationally active institutions, importantly by clarifying their roles and responsibilities." Ahead of the Lyon Summit, Basle and IOSCO had announced a joint initiative to strengthen cooperation in this area, referring to the work of the Joint Forum of banking, securities and insurance supervisors, which was set up to promote information exchange on international financial conglomerates, and consider establishing for each a lead regulator. The need for the international regulatory community to address successfully the challenge of supervising multi-functional global financial conglomerates is an issue of particular significance to the UK. This is because of the international nature of the London markets uniquely so amongst the world's major financial centres. The failure of one or more major overseas firms may cause systemic problems in London where at the end of last year, overseas banks accounted for 57% of the total assets of the UK monetary sector, with US banks contributing 8%. Furthermore, almost three quarters of the 478 banks which take deposits in the UK are branches or subsidiaries of overseas financial institutions, including 37 from the US. US firms have, of course, particular importance in certain markets. Our April 1995 derivatives survey showed US firms (including securities houses) accounting for around 40% of turnover in both foreign exchange and interest rate derivatives. We therefore attach particular importance to international regulatory cooperation; and as the trend towards globalisation and multi-functionality continues it is becoming increasingly necessary. The Barings and Daiwa cases have highlighted the difficulty that banks can experience in controlling operations which are far from their head offices. Barings, in particular, demonstrated that losses in a subsidiary in a remote location, in a unit which was not thought to be assuming any significant market risk, can be big enough to bring about the failure of the parent. So home and host supervisors have a mutual interest in the health of the subsidiaries. Regulators will rightly be blamed if any reluctance on their part to work together either exacerbates a crisis or fails to prevent one that could otherwise have been avoided. It is possible to argue that an individual regulator can successfully meet his own objectives, by seeking to build firewalls between his entity and the rest of the group to which it belongs. These might include restrictions or even prohibitions on both financial exposures and operational interlinkages. In addition capital adequacy and other requirements might be set at a more onerous level than if the potential for parental support was taken into account. Such measures may be the best that can be achieved at present; they certainly provide host supervisors with a measure of comfort. But they are, and always will be, a second best. There will always, for example, be a risk of reputational contagion. Counterparties might refuse to deal with a member of a failed group because they are unwilling to take the risk that the firewalls may be flawed, or that cultural or control weaknesses which led to the failure are repeated in that entity also. This, of course, is a hypothetical risk but one which does concern supervisors. Secondly, as the firm will incur additional costs in order to comply with these ringfencing arrangements, while possibly at the same time being denied the risk reducing benefits of group wide controls, it is unlikely to provide the most efficient solution. Concern about these deficiencies has heightened as we have learned more about the way in which many global financial groups are managed. The lack of overlap between legal entities and the management of business lines means that the amount of true ring-fencing which is possible for a globally managed institution is open to debate. The creation of ring-fenced islands of activity seems to me contrary both to the trend in markets and second-best in terms of regulatory efficiency. The Bank of England has always believed that effective supervision of financial groups must involve consolidated supervision. As Alan Greenspan said last week in his testimony to the Congressional SubCommittee on Financial Institutions and Consumer Credit, "Risks managed on a consolidated basis cannot be reviewed on an individual legal entity basis by different supervisors". It is important to define the term "consolidated supervision". The underlying philosophy is that for, say, a bank operating in a large financial group, it is necessary to look not only at the soundness of the bank itself but also of the group as a whole. This will require both a quantitative and a qualitative assessment. The quantitative element involves examining the financial strength of the whole group. The basic measures here are capital adequacy and large exposures. In the Bank of England, we look at these against the minimum standards set out in the EU Directives and against the more stringent criteria which we have developed ourselves and apply to individual banking groups in ways that take account of their particular circumstances. It is worth noting that both the EU Directives and the Basle Capital Accord set these minimum standards on a consolidated basis only. The qualitative element involves assessing factors such as the group's risk management process, internal systems and controls, capability of key personnel, culture and business strategy. Any supervisor will hardly need reminding that, in the Barings case, weaknesses in a subsidiary in just these areas brought about the collapse of the parent. As the need for consolidated supervision is written into the Basle Concordat we can be confident that all regulators of internationally active commercial banks, including of course those in the US, subscribe to its principles. Consolidated supervision is a relatively widely understood concept involving the range of activities set out above. Alan Greenspan last week talked of "umbrella supervision", which he described as a "realistic necessity for the protection of our financial system". (Of course we are not experts on umbrellas: it rarely rains in London, as you know.) But I also referred earlier to a "lead regulator" - though the term 'co-ordinating supervisor' is gaining currency in some quarters. As noted, one of the tasks of the Joint Forum is to define the role of such a person. So far there have been extensive discussions of the role. Among the possibilities suggested have been: Carrying out a quantitative and qualitative assessment of the group as a whole. (This is the consolidated supervisor's role and, where there is already a consolidated supervisor, the lead regulator would normally be the same body); b) Taking a primary role in managing emergencies should they arise; c) Acting to facilitate the exchange of information between the relevant regulators in a group; d) (In the longer term) considering ways in which supervisors' efforts could be better co-ordinated when looking at (e.g.) controls. It should be stressed that the existence of either a lead regulator or a consolidated supervisor in no way affects the legal responsibilities of the individual regulatory authorities which are responsible for regulating the different entities within the group. The objective is not to shift the balance of supervisory responsibility from host to home supervisors. Rather, the intention is that each host authority should be able to carry out these responsibilities more effectively by relying to some extent on the work of others. It cannot possibly make sense for, say, 30 different supervisors to crawl over the controls centralised and concentrated in one location? We are keen to examine the practicability of allowing one co-ordinator to carry out the role defined above. Enthusiasm from the US has been more muted, although commercial banks are, of course, already subjected to consolidated supervision. Here I know there are political issues at stake too, and any foreigner is well advised to tread carefully. I would hope, nevertheless, that these important issues can be considered carefully. More problematic is the position of the US investment banking groups who, uniquely amongst the banking and securities industries in major countries, are not subject to legislation requiring consolidated supervision. Some have banking subsidiaries in the UK, owned by companies established under Article XII of the New York State Banking Act. Accordingly these companies and their UK subsidiaries are subject to consolidated supervision by the New York State Banking Department. The involvement of a home country supervisor in this way gives us a degree of comfort which allows the ring-fencing to be less stringent than it would otherwise be. However this clearly falls a long way short of comprehensive consolidated supervision of the entire investment banking group. There is a lively debate in the US at the moment about the most appropriate regulatory structure for all financial institutions, and particularly for investment banks. This tends to be regarded in the US largely as an internal matter. But the fact that the large US financial institutions have a global reach inevitably makes that debate a matter of great interest and concern to the international financial community. We are optimistic that legislation will soon be enacted to address these concerns. It would certainly be disappointing if it is not. Conclusions Though I have attempted this morning to identify some features of regulation on which we might well agree, I doubt whether there is such a thing as an 'optimal' regulatory structure. Each country has its own legacy of supervisory structures and approaches. But an appropriate international structure is one which works as seamlessly as possible and has clear lines of responsibility (at least, that is what we expect from international banking groups' controls). One co-ordinating regulator for each institution could play a crucial role in such a structure. The question of the number of regulators is, in my view, less important; no one has yet suggested we set up one body world-wide to carry out all supervision, so whatever our own vision of an optimal regulatory structure, it will have at its centre a requirement for supervisors from different disciplines and in different countries to communicate effectively with one another. This weekend's conference is a good opportunity to do that.	---[PAGE_BREAK]--- # Mr. Davies reviews current debates on regulatory structures governing the financial system Speech by the Deputy Governor of the Bank of England, Mr. Howard Davies, held on 22/2/97 at the Federal Reserve Bank of Atlanta's Financial Markets Conference entitled 'Market and Regulatory Structures in a Global Environment'. It is conventional, and polite to say, at the beginning of a speech of this kind, that one is thrilled to have been asked to speak on the subject of the structure of financial regulation and that the topic is, of all the many preoccupations of human kind through the centuries, the one which generates the most enthusiasm and excitement in one's breast. But I cannot bring myself to do it. You may think me ill-brought up to say this if so blame my parents - but I find the question of the structure of regulation to be quite resistible. I know that there are those who like nothing better than to draw new organigrams and to explore the manifold interfaces between regulatory agencies. (There are also people who find self-fulfilment collecting airline sick bags, or watching synchronised swimming. That is a matter for them.) But my lack of enthusiasm for the topic of regulatory structure is, I hope, not an emotional response. It is rationally based on two prior beliefs. First, that the relationship between structure and effectiveness is loose. I know of little evidence that structural reforms are quickly followed by an enhancement of the effectiveness of the activity in which those agencies are engaged. Secondly, my prejudice is to believe that regulatory structure should follow market structure, rather than the other way round. Regulators should seek to respond to changing markets which, in turn, respond to changing customer demand and new product availability, rather than seeking to dictate either. So we should always ask ourselves whether the regulatory framework we adopt makes sense to market participants, rather than requiring them to structure their business to fit in with some governmentally imposed view of the way product delivery should be organised. But I recognise that, in practice, we cannot avoid constant attention to the maintenance of the regulatory framework. Firstly, because while good structure will not necessarily generate effectiveness, a faulty, out of date framework will certainly make it very hard for regulators to do their jobs well. And, of course, the market is not in an 'original condition'. The financial markets we have now are heavily conditioned by the legislative and regulatory framework within which they have grown up. That is particularly true in the United States. It is hard to imagine that, absent Glass-Steagall, regulation Q and all the rest, the financial landscape in North America would look as it does today. So I conclude that the debate on regulatory structure should be a constant dialogue between the markets and the regulators, but with a prejudice in favour of the former. Our ultimate task as regulators is to ensure that markets work efficiently, and in the interests of consumers. Against that background, how is this dialogue proceeding in the UK at present? For we too are addressing the questions which preoccupy you in the United States, in our quaint, olde worlde British fashion. But before I review the current debate on regulatory structure in the UK, I should say a little about the way we define the objectives of financial regulation. We think of five: to ---[PAGE_BREAK]--- protect the economy against systemic risk; to protect individual depositors, investors and insurance policy holders against loss from the failure of their intermediary; to protect customers against business misconduct; to assist society at large in the fight against crime (for instance by making sure firms have in place systems to detect and report laundered drug money and other proceeds of organised crime); and, last but not least, to create and sustain fair markets. Described bluntly, these objectives make the job of regulators look impossibly daunting. But of course they are not absolute aims. Regulators cannot, and should not, offer blanket assurances to investors and depositors. They cannot, because the tools and resources to do so are simply not available. And they should not, because it would be quite wrong to remove from investors and firms the responsibility for assessing, taking and monitoring financial risks. This is a very important point, which Alan Greenspan has helpfully underlined on a number of occasions recently. # UK regulatory structure and proposals for change Across the world we see a lively debate on how the regulatory cake should be cut. There has been change in France. The Australian Government has set up the Wallis Commission to look at the institutional arrangements there. Their first report has just been published. Reforms are in progress in Japan. In the US the new legislative season is about to open, with a number of runners and riders already saddled up in the financial regulation steeplechase. Similarly, in the UK, a variety of think tanks, and the opposition Labour Party, have produced proposals to amend, or in some cases fundamentally reorder, our regulatory structure. But, before describing these exciting proposals, perhaps a brief description of the British system would be in order. Responsibility for financial regulation in the UK is divided between two Government Departments. ![img-0.jpeg](img-0.jpeg) ---[PAGE_BREAK]--- Most falls to the Treasury, but prudential supervision of insurance companies is the responsibility of the Department of Trade and Industry (DTI). The DTI carries out its supervisory responsibilities using its own staff; the Treasury, on the other hand, while setting the legal framework and policy directions for regulation, leaves most of the detailed regulatory functions to others. Under one piece of legislation - the 1987 Banking Act - the Bank of England carries out prudential supervision of banks. Under another, the 1986 Financial Services Act, the Treasury delegates its powers to the Securities and Investments Board, which in turn recognises a number of front-line regulators. These front-line regulators cover different sections of the market. One, the Securities and Futures Authority (SFA), is responsible for securities houses; another, the Investment Management Regulatory Organisation (IMRO), for fund managers. These two regulators undertake both prudential supervision and conduct of business regulation. The third, the Personal Investments Authority (PIA), is responsible for the retail sector, and has principally a conduct of business remit although it is responsible for the prudential supervision of independent financial advisers (IFAs). So, in effect, there is a layered approach to the regulation of financial services in the UK, with different powers held at each level. (To complete the picture, the Building Societies Commission supervises building societies (Savings and Loans) - though the largest of them are now converting to bank status. And the Department of Social Security is responsible for the supervision of occupational pension schemes.) This brief description of the legislative framework might lead one to suppose that the UK system is primarily statutory - yet the securities side is often described, at least by comparison with the US system, as one of self-regulation. Indeed, some argue that it is excessively self-regulating and, therefore, unreasonably lax. We would reject that last charge. And, in practice, the distinction between statutory and self-regulation is not black and white. The UK system has elements of both. Prudential supervision of insurance firms is carried out directly by a government ministry, which is unambiguously Government regulation. Banking supervision is carried out by the Bank of England. Constitutionally, this is not 'Government' regulation, but rather regulation by a public body which is authorised by specific Act of Parliament. Certainly no one describes what we do as self-regulation, even though the Bank of England is a bank. On the investment side, the picture is more complicated. The Government has delegated its powers to the Securities and Investments Board. The SIB's governing board includes people who are active in financial services, but they are appointed by the Treasury and the Bank of England (indeed I am one of them) and are required to act in the public interest. Again, this does not look like self-regulation. However, the various front-line regulators are called, in the Act itself, 'self regulating organisations' (SROs). Their boards include a high proportion of active practitioners, elected by the industry to represent its views. Practitioners are also heavily involved in policy discussions, rule-making and enforcement functions. But, like the SIB, the SROs operate indirectly under statute, and have a duty to regulate in the public interest. We therefore have no self-regulation in the strict sense, rather a variety of statutory and statute-backed bodies with practitioner involvement, each with different relationships with the industry and with Government. Effective regulation needs the input of all ---[PAGE_BREAK]--- participants in the market if it is to offer appropriate protection without stifling innovation. Regulators can benefit greatly from effective practitioner input but to retain the confidence of the investing public they must persuade them that regulation puts their interests, and not those of the firms and their shareholders, first. The system we now have is undoubtedly capable of achieving an appropriate balance between market sensitivity and consumer confidence; it has, in many respects, worked well. But it has been stress-tested in a number of difficult episodes: the Maxwell affair, the private pension mis-selling saga, the collapse of BCCI, Barings Bank and Sumitomo. These episodes have taught us something about the strengths and weaknesses of our system, just as the S\&L crisis and the Daiwa New York problem have done in the US. Furthermore, markets themselves have moved on. The financial landscape of today is almost unrecognisable from the one which informed legislators' views in the early 1980s, before the Banking and Financial Services Acts were put on the statute book. It is therefore not surprising that over there, as well as over here, there is criticism of the existing structure, and pressure for change. Our own system, with its monopolistic approach to the origination of legislation, does not generate competing draft bills. But the marketplace for ideas on regulatory reform is, I can assure you, just as well contested. Critics of the existing British system object on three counts: 1 that the failures of the last decade demonstrate its inability to cope with strains and crises; 2 that it is unnecessarily complex, with overlapping and sometimes even conflicting responsibilities; and 3 that it has failed to keep pace with changes in institutional and market structures; the distinctions on which it was based no longer effectively apply. It is not my aim today to give a comprehensive assessment of the validity of all these arguments. And, in any event, just as in the US, there is a heavy political dimension to this debate. But I would make a few observations on the arguments advanced for change. The UK system is complex, although it is no more complicated than the equivalent arrangements in some other countries with similarly sophisticated financial markets. (Indeed, were I not a guest here, I might say that the US system was rather more labyrinthine than ours.) Those who argue for simplification point to duplication of function and cost, especially between the SIB and the front-line financial services regulators. There is undoubtedly a case to answer in that area, as both the SIB and the SROs would acknowledge. But the legislation we have explicitly dictates a two-tier structure. It is also true that institutions now tend to be involved in a variety of different businesses. Banks own securities houses, fund managers, and insurance companies. Insurance companies are diversifying into banking, and so on. So that even though there should always be a lead regulator, looking at the overall position of the business, institutions still face the costs of complying with the requirements of several regulators. ---[PAGE_BREAK]--- But the question underlying these arguments about complexity and overlap is more fundamental. Should regulation be based around institutions (it is institutions which fail, after all) or around functions or types of business which call for specialist regulatory knowledge? The UK system is organised neither along wholly functional nor wholly institutional lines. In today's markets, where firms are a mass of subsidiaries and business units, no major market participant deals with a single regulator across all its businesses. Similarly, no regulator has unique responsibility for regulating one function of each business. The insurance operation of a firm, for example, is covered by separate prudential and conduct of business regulators. Most people involved in financial regulation would recognise this description of the problem. But determining how to resolve it is not straightforward, as evidenced by the wide variety of proposals for change which have been advanced. Some proponents of reorganisation would like to begin by making all financial regulation the responsibility of a single Government Department - the Treasury. They suggest that this would clear up accountability for the legislative framework, and for the powers and sanctions in the regulatory regime and create consistency of regulatory approach across sectors. Straightforward administrative tidiness may also be a factor. While there may be merit in both these arguments, such machinery of Government questions are for the Government to determine, and I happily leave such matters to them. Most of the discussion about regulatory structure in the UK has concentrated on the area covered by the SIB and the front-line financial services regulators. It is in this part of the system that the arguments about duplication of function, unnecessary cost and poor communication are most often heard. The various alternative models all feature some degree of consolidation, and some would go as far as to fold all the main financial services regulators into a single body. Others propose two bodies, each reporting directly to the Treasury, with one covering wholesale business and one covering retail, acknowledging the different regulatory imperatives, especially in the conduct of business field, of the two sectors. The aim would be to reduce the number of domestic regulators large institutions would have to deal with, and to improve the match of regulation to function. Even more radical changes have been proposed, encompassing not only the SIB area, but the prudential supervision of banks and insurance companies as well. One model, colloquially known as 'Twin Peaks', would replace the whole of the present system with two Commissions: a Financial Stability Commission, with responsibility for systemic risk, the prudential supervision of all major institutions, and conduct of business regulation of wholesale activities, and a Consumer Protection Commission, which would be in charge of conduct of business regulation in retail markets, as well as detecting market manipulation and insider dealing. It would also carry out prudential supervision of those stock brokers and fund managers who deal with private clients, and of independent intermediaries. The advocates of this model argue that it would better match regulation with both institutions and functions, in particular on the wholesale side. The underlying contention is that the traditional separation between banking, securities and insurance is breaking down, so that there is now a less meaningful difference between institutions and functions. ---[PAGE_BREAK]--- I am not persuaded of the merits of this case. Although the activities of banks and securities firms do overlap at the margin, this is not true of the core activities. Banks in particular continue to have a number of distinctive characteristics. First, there are the risks associated with the maturity transformation seen in their balance sheets. Banks experiencing a drain in their liquidity, perhaps because of a classic 'run', could be driven into insolvency through the forced realisation of illiquid assets at 'fire-sale' prices. Second, there is the risk of contagion - problems at one bank can spread to others - not just through direct financial linkages but also because, in the absence of timely, transparent information on bank assets, depositors become concerned about other banks which they see as similar. Finally, banks play a central role in payments systems, including payment flows generated by FX trading. The conclusion I draw is that there is enough that is special about banks for their prudential supervision to be retained as a separate activity in any new regulatory structure, and that this argument at present outweighs the case for change. Whether prudential supervision of banks should be a function of the central bank is a separate question. Some argue that other central banking responsibilities (such as the conduct of monetary policy) make for conflicts of interest and therefore that supervision should not be carried out by the central bank. I am not persuaded by these arguments either. Nor am I aware of many examples where the suggested conflicts between a supervisory role for the central bank and its other responsibilities have arisen in practice. Indeed, there are important synergies between the supervisory function and other central bank responsibilities. It makes sense for the 'micro' supervision of individual banks in the system to be carried out by the same body that carries out the 'macro' function of maintaining the stability of the financial system as a whole, stability which is essential if monetary policy is to be executed effectively and efficiently. It is no accident that in all major countries the central bank has a significant role in the supervision of banks, even if in some cases others have been given the legal powers to carry out the front-line tasks. Having as supervisors tried their best to limit the likelihood of failure, when faced with it central bankers are uniquely well placed to provide assistance, whether to the institution in trouble, to the market at large, or both. Those who wish to separate banking supervision from central banking must acknowledge that there are certain things that only the central bank can do, and that therefore there needs to be a strong link between the central bank and any new regulator. In Germany, for instance, the Bundesaufsichtsamt is the supervisor of commercial banks. But the Bundesbank has an important role in the day-to-day job of collecting prudential returns, and must be consulted on liquidity and capital requirements, which bear most directly on its role in an emergency. The logic of these arguments might point instead to a 'Holy Trinity', rather than a 'Twin Peaks' model, based on three agencies, focused respectively on financial services, banking and insurance. That might allow the most sensible match - albeit not complete - of regulation to function and institution. It would also have the advantage of evolving fairly readily out of the present structure. ---[PAGE_BREAK]--- ![img-1.jpeg](img-1.jpeg) This last is not a trivial point, since the cost and disruption caused by reorganisation would be considerable, and higher in proportion to the degree of change. The process would inevitably generate uncertainty among firms and the public, and make the regulatory system more difficult to manage in the meantime. This argues for building on the present arrangements, if at all possible, rather than beginning again with an entirely new structure that could take years to settle down. Furthermore, what matters to the financial system, and to the public, is that regulators are effective. Effectiveness necessitates good communication, consolidated supervision and close co-operation to maintain protection across the piece. Whether structural change (including bringing functions together under one umbrella) would improve communication and co-operation and so increase effectiveness, is a key question, and the answer is far from clear. We have been making considerable efforts recently to enhance communication between different supervisors in the UK. That has involved, as you would expect, the usual paraphernalia of Memoranda of Understanding. But, in addition, we have sought to achieve cross-membership of some of our most important institutions. For example, Sir Andrew Large, the Chairman of the Securities and Investments Board, has become a member of the Bank of England's Board of Banking Supervision and, reciprocally, I have joined the SIB. Of course one should not exaggerate the importance of individual appointments of this kind. But they do help to create a climate of co-operation, and give a signal to the respective staffs of the two institutions that they are expected to work together as closely as possible, and a signal to the outside that they can expect this to happen. # The Approach to Regulation in the UK The discussion of regulatory approaches is often phrased in terms of rules versus judgement or, as academics tend to put it, rules versus discretion. Should supervisors simply set ---[PAGE_BREAK]--- the rules, and shoot those who break them? Or does that create too rigid a framework, one which stifles initiative and imagination? There is no simple answer. The Bank of England imposes an increasing number of rules: it has, for example, implemented detailed regimes for capital adequacy introduced by the Basle Committee and the European Union. We set capital requirements to cover the more readily quantifiable risks; we enforce limits on banks' large exposures to individual counterparties; we have rules on banks' liquidity; and we seek to ensure that banks have robust systems and controls, as well as management with the skill and integrity to ensure, in that delightful US phrase, that the bank is 'safe and sound'. But our judgmental approach - allowing supervisors the discretion to exercise informed judgement within approved guidelines - still contrasts with that of many other regulators. This flexibility allows us to be tough where appropriate, but to avoid inappropriate requirements - tailoring the requirements to the nature of the bank's activities. Most fundamentally, perhaps, we can ask questions, and attempt to take advantage of all the information at our disposal to form a judgement of the risks facing depositors and investors, as well as of the quality of a bank's management. So in addition to enforcing rules and looking for problems, we can help management. We can spread knowledge of best practice: asking banks about the full range of risks they face (including those - like reputational and settlement risk that they would often rather ignore); and pointing out to complex groups the extent to which their managerial and organisational systems have moved away from their legal structure. It is true that, in addition to being less rule-bound than most other supervisors, the Bank is commonly viewed as doing relatively little on-site supervision. Of course, this depends on how you define the term. Accountants are well aware that the Bank does, for example, make extensive use of reports prepared by auditors - who, of course, operate on-site - in order to assess the adequacy of internal controls. In particular, the Bank regularly instructs banks to appoint reporting accountants to report on systems and controls and on the accuracy of prudential returns. The Bank's supervisors also spend a growing amount of time on-site. Since 1986, Review Teams have carried out focused visits to banks to evaluate the level of risk in an institution as well as the risk management systems in place to identify, monitor, and control these risks. And in 1995 we introduced a Traded Markets Team to focus on banks' pre-processing models which can be recognised under the CAD (Capital Adequacy Directive) as well as sophisticated risk modelling techniques used by the banks to manage treasury activities. These teams spend on average about three days on banks' premises, which may seem short, but the visits are highly focused, reflecting a great deal of work carried out in advance, not just between team members and the line supervisors of the bank in question but also by the bank itself in providing detailed answers to a series of questions. At the same time, the Bank has recognised the need to be more systematic in its approach to risk assessment and has announced its intention to introduce a more formal approach based on a common approach, known as the RATE model, to identify - using a series of qualitative and quantitative measures - the risks faced by the bank. RATE is an acronym for the three stages of the process: Risk Assessment, Tools of supervision and Evaluation. ---[PAGE_BREAK]--- In the future, by performing periodic risk assessments, we aim to gain a better understanding of the quality of management, the characteristics of the business and the risks the banks face. The greater degree of consistency across banks embodied in the new approach will allow the Bank to be more focused in performing its supervision. The tools of supervision, such as Review Team Visits and Reporting Accountants Reports on internal controls, will be targeted at the areas of greater risk and concern in individual banks. We shall very shortly be issuing a consultation paper setting out how we plan to implement the model in practice. That paper will show that we have tried to model parts of our approach on best practice in the US. The City of London may not always have been a preferred habitat for camels, but you may well see some genetically modified examples on the streets there quite soon. A better understanding of the risk profile of each supervised institution will assist the Bank in setting risk asset ratios. As you all know, Basle sets a minimum capital ratio of 8 percent of risk weighted assets. The 8 percent ratio is sometimes interpreted as a 'one-size-fitsall' standard. The Bank, however, sets the trigger capital ratio for each authorised bank at, or above, the 8 percent floor and considers an adjustment to that trigger ratio whenever we see a substantial change in that bank's risk profile. Where does this all leave us in comparison with other regulators? I suggested earlier that our flexible, judgmental approach is somewhat distinctive. But we are no longer, if indeed we ever were, outliers on the supervisory spectrum. While the Bank has decided to implement a more systematic approach to risk assessment, other supervisors - who traditionally operate a rule book - are (in a fast moving marketplace characterised by rapid product innovation) moving towards a regime that gives more scope for supervisory judgement. But the fact that regulators internationally are converging in their approach does not necessarily mean that they are right. They may all be converging on an inappropriate model. Indeed some would argue that regulators do as much to create problems as to solve them: that regulators create perverse incentives - even as we speak bankers may be designing products whose whole rationale is to exploit anomalies in our rules. Perhaps we would all be far better employed elsewhere, leaving the market to regulate itself. Why should we not facilitate that process by concentrating on rules of disclosure, obliging banks to publish accurate information on their capital adequacy and risk profiles, and leaving the rest up to the market - perhaps with some safety net for small depositors and investors? As you know, the New Zealanders have made an interesting move in this direction in the last couple of years. Should we then get out of the business and leave it all to the markets? To answer that question, it may be helpful to go back to first principles. Back in 1958, Modigliani and Miller demonstrated that in a frictionless world a firm's capital structure cannot affect its value. In the real world, however, departures from the M\&M assumptions - such as taxes, bankruptcy costs and agency costs - may influence the capital decision of any firm; capital may after all be costly. But banks differ substantially from most other firms because their soundness and safety is crucial to maintaining systemic stability; without capital requirements some will exploit this fact by taking large risks with little of their money, in the hope that the taxpayer will bail them out. In other words, some may believe that they are (partially) insulated from potential market discipline. From a regulatory perspective, banks must therefore be required to have capital to absorb the possible losses that result from risk-taking and still remain solvent. ---[PAGE_BREAK]--- What is our position in this debate? It is tempting to conclude that the only problem is a perception of a government-funded safety net for large banks; remove that and our problems will be solved. But systemic risk cannot be wished away as easily as that, even though we in the UK have demonstrated by our actions that we do not rescue every bank which gets into problems. So, while we try to stay clear from ever more detailed rules, we do not believe everything can be left to the market; certain minimum 'regulatory' capital standards are in our view necessary. Of course, we must aim for a credible and comprehensible regime which does not require constant updating and elaboration, is not immensely costly, and is reasonably consistent. The value-at-risk approach is an attempt in that direction. It recognises that there is a crucial role for judgement in supervision, and that one size really will not fit all. It does not prescribe the key qualitative factors in legalistic detail. But it does set out the parameters so as to ensure that there is a framework in place which will deliver broad consistency and also some degree of prudence. Some have argued that regulators should go further than the value-at-risk approach: rather than defining the key parameters and endorsing particular model types, why not leave it to the banks, and give them an incentive to improve their internal models as much as possible? Under this pre-commitment approach a bank would specify the maximum portfolio loss on its trading activities and this would become the institution's market risk capital requirement. Banks exceeding their pre-committed maximum loss (that is breaching their capital commitment) would be penalised in one way or another. Such penalties could be financial, or could entail corrective supervisory action. In some ways pre-commitment can be seen as an extension of the model-approval approach we already adopt. The aim, which we endorse, is to ensure that supervisors work with the grain of the business, and monitor ratios which are seen as meaningful by those who run banks themselves. To that extent, we support it. But there are potential drawbacks. It could amplify the moral hazard problem: if the bank wins, its shareholders - as well as its traders under their bonus packages - pocket the profit, and if it loses, the regulator/tax-payer ends up with the bill. A penalty would not act as a deterrent to a bank prepared to gamble its capital because that bank would not be affected by such a penalty when it was 'down and out'. Furthermore, regulators could over time become less familiar with banks' risk management systems, which might make them less effective in a crisis. Early supervisory intervention is more difficult if supervisors only become aware of problems ex-post, after the limit has been breached. It may be possible to devise an approach to pre-commitment which avoids these potential handicaps. But for the time being our attitude remains somewhat hesitant. Finally, a discussion about rules is not complete without touching on the question of a 'level playing field'; an odd analogy, I think, since in field sports there is no such thing. If there were, why would teams change ends at half time? (In American football, of course, teams change ends three times - and in baseball they resolve the problem by running round in circles.) When banks and securities houses do similar business it seems only fair to apply similar capital rules. But while this is true at the margin, when we look at the total business of banks and securities houses, the picture is still vastly different. A major part of a bank's regulatory capital is held against credit risk. By contrast, securities houses invest primarily in liquid, marketable assets which can be readily sold, with illiquid assets typically a small ---[PAGE_BREAK]--- proportion of the total, generally $2 \%$ or so, and the bulk of a securities firm's regulatory capital tends to be maintained for market risk purposes. It is therefore not obvious that we need to set the same detailed rules for banks and securities houses. That is not to say that we should entirely ignore differences in supervisory regimes, but rather that we should focus on areas where those differences are on a scale which seriously distorts competition. In other words, we should spend rather less of our time discussing risk weights, and rather more discussing risks. # Globalisation and the Regulatory Response How far do these general principles, which I have discussed so far in relation to the UK, apply to regulatory structures in a global environment? One issue for supervisors is increasing globalisation. The biggest institutions now span 50 or more countries and may have 300 or more entities within the group. This is not new; globalisation in this sense has been a feature of banking certainly since the 1970s. What is rather newer is the way in which the firms are centralising the controls for all these far flung entities. With the recognition that similar risks are being run in different subsidiaries (for example a Japanese bank might have exposure to US interest rate risk from its activities both in London and New York), there has been a move to consolidate these homogeneous risks and manage them centrally within a group. This means control lines which transcend or cross the entity structures and a matrix management structure. It means that the head office can exercise much stronger control over the volume of a particular type of risk being run across the group. For example, for some UK banks, the management of their global foreign exchange book will be managed in London during London office hours, then it will switch to the US operation but under strict limits set by London; after the US close it will move again, to the Far East, but still under the control of limits set by London. The increasing development of whole book value at risk models has also encouraged this centralisation of control. In the foreign exchange example, the value at risk model used by the group will be maintained and run in London. So the riskiness of positions across the world wide group will be assessed according to the London model. But centralisation of controls goes even further. Oversight of credit and key credit risk decisions may well also be centralised. Oversight of FX settlement risk is sometimes centralised in London as well as control of the position risk. Likewise various aspects of the internal audit function may well be centralised. So for global groups, the control of the activities in the various legal entities scattered across the planet will hinge on the adequacy of controls located not in those particular countries but centrally. In a way it is simply an extension of the vulnerability of banking entities to problems arising elsewhere in the group. But in this case solvency of the individual entities will depend on the adequacy of systems and controls located in another part of the group. Massive intra-group transactions to move risk between entities will also affect the position of the various subsidiaries. One obvious question is why firms do not dispense with such a plethora of legal entities and operate a simpler branch structure. The answer seems to be that differences in tax structures and even regulatory requirements in some countries still encourage the use of legal entities in different jurisdictions. In that case should regulators try to lean against this ---[PAGE_BREAK]--- centralisation? Here I think the answer must be that the regulators should not try to discourage greater central control of risk. Where a firm is running one type of risk in different locations it must make sense for the total risk to be controlled centrally. But this does create a problem for supervisors because supervision has to be structured along legal entity lines (given that it is legal entities which fail). Responsibility for legal entities cannot be transferred between supervisors. Each supervisor must therefore take a view about the soundness of the entity in its jurisdiction, even where this hinges on controls located elsewhere. How have regulators responded to these trends? In summary, they have increasingly sought ways of increasing co-operation amongst themselves, including agreeing their respective responsibilities and setting up arrangements for information sharing. In the banking sector, at least, they have also supplemented solo supervision of individual entities with consolidated supervision of groups as a whole. When the Basle Committee on Banking Supervision was established by the central bank governors of the G10 countries at the end of 1974, its initial focus was to define the role and responsibilities of home and host supervisors of internationally active banks. These were set out in the 1975 Concordat which established how supervisory responsibility for banks' foreign branches and subsidiaries should be shared between host and parent supervisors, and which has been updated on a number of occasions since. Securities supervisors too have a long tradition of international co-operation, including arrangements for information sharing and mutual assistance in enforcement, with IOSCO playing a key role in facilitating such co-operation internationally. There is also a long history of discussion between Basle and IOSCO. Individual supervisors in both the banking and securities industries have chosen to reinforce co-operation arrangements with formal bilateral agreements with their overseas counterparts. Partly as a consequence, there have been an increasing number of informal meetings between line supervisors with operational responsibility for different parts of financial groups. The importance of international regulatory co-operation is now widely acknowledged and is on the agenda of inter-governmental meetings. At last June's G7 summit in Lyon, the heads of state called for maximum progress preceding the Denver summit in June 1997 on "enhancing co-operation among the authorities responsible for supervision of internationally active institutions, importantly by clarifying their roles and responsibilities." Ahead of the Lyon Summit, Basle and IOSCO had announced a joint initiative to strengthen cooperation in this area, referring to the work of the Joint Forum of banking, securities and insurance supervisors, which was set up to promote information exchange on international financial conglomerates, and consider establishing for each a lead regulator. The need for the international regulatory community to address successfully the challenge of supervising multi-functional global financial conglomerates is an issue of particular significance to the UK. This is because of the international nature of the London markets uniquely so amongst the world's major financial centres. The failure of one or more major overseas firms may cause systemic problems in London where at the end of last year, overseas banks accounted for $57 \%$ of the total assets of the UK monetary sector, with US banks contributing $8 \%$. Furthermore, almost three quarters of the 478 banks which take deposits in the ---[PAGE_BREAK]--- UK are branches or subsidiaries of overseas financial institutions, including 37 from the US. US firms have, of course, particular importance in certain markets. Our April 1995 derivatives survey showed US firms (including securities houses) accounting for around $40 \%$ of turnover in both foreign exchange and interest rate derivatives. We therefore attach particular importance to international regulatory cooperation; and as the trend towards globalisation and multi-functionality continues it is becoming increasingly necessary. The Barings and Daiwa cases have highlighted the difficulty that banks can experience in controlling operations which are far from their head offices. Barings, in particular, demonstrated that losses in a subsidiary in a remote location, in a unit which was not thought to be assuming any significant market risk, can be big enough to bring about the failure of the parent. So home and host supervisors have a mutual interest in the health of the subsidiaries. Regulators will rightly be blamed if any reluctance on their part to work together either exacerbates a crisis or fails to prevent one that could otherwise have been avoided. It is possible to argue that an individual regulator can successfully meet his own objectives, by seeking to build firewalls between his entity and the rest of the group to which it belongs. These might include restrictions or even prohibitions on both financial exposures and operational interlinkages. In addition capital adequacy and other requirements might be set at a more onerous level than if the potential for parental support was taken into account. Such measures may be the best that can be achieved at present; they certainly provide host supervisors with a measure of comfort. But they are, and always will be, a second best. There will always, for example, be a risk of reputational contagion. Counterparties might refuse to deal with a member of a failed group because they are unwilling to take the risk that the firewalls may be flawed, or that cultural or control weaknesses which led to the failure are repeated in that entity also. This, of course, is a hypothetical risk but one which does concern supervisors. Secondly, as the firm will incur additional costs in order to comply with these ringfencing arrangements, while possibly at the same time being denied the risk reducing benefits of group wide controls, it is unlikely to provide the most efficient solution. Concern about these deficiencies has heightened as we have learned more about the way in which many global financial groups are managed. The lack of overlap between legal entities and the management of business lines means that the amount of true ring-fencing which is possible for a globally managed institution is open to debate. The creation of ring-fenced islands of activity seems to me contrary both to the trend in markets and second-best in terms of regulatory efficiency. The Bank of England has always believed that effective supervision of financial groups must involve consolidated supervision. As Alan Greenspan said last week in his testimony to the Congressional SubCommittee on Financial Institutions and Consumer Credit, "Risks managed on a consolidated basis cannot be reviewed on an individual legal entity basis by different supervisors". It is important to define the term "consolidated supervision". The underlying philosophy is that for, say, a bank operating in a large financial group, it is necessary to look not only at the soundness of the bank itself but also of the group as a whole. This will require both a quantitative and a qualitative assessment. The quantitative element involves examining the financial strength of the whole group. The basic measures here are capital adequacy and large ---[PAGE_BREAK]--- exposures. In the Bank of England, we look at these against the minimum standards set out in the EU Directives and against the more stringent criteria which we have developed ourselves and apply to individual banking groups in ways that take account of their particular circumstances. It is worth noting that both the EU Directives and the Basle Capital Accord set these minimum standards on a consolidated basis only. The qualitative element involves assessing factors such as the group's risk management process, internal systems and controls, capability of key personnel, culture and business strategy. Any supervisor will hardly need reminding that, in the Barings case, weaknesses in a subsidiary in just these areas brought about the collapse of the parent. As the need for consolidated supervision is written into the Basle Concordat we can be confident that all regulators of internationally active commercial banks, including of course those in the US, subscribe to its principles. Consolidated supervision is a relatively widely understood concept involving the range of activities set out above. Alan Greenspan last week talked of "umbrella supervision", which he described as a "realistic necessity for the protection of our financial system". (Of course we are not experts on umbrellas: it rarely rains in London, as you know.) But I also referred earlier to a "lead regulator" - though the term 'co-ordinating supervisor' is gaining currency in some quarters. As noted, one of the tasks of the Joint Forum is to define the role of such a person. So far there have been extensive discussions of the role. Among the possibilities suggested have been: Carrying out a quantitative and qualitative assessment of the group as a whole. (This is the consolidated supervisor's role and, where there is already a consolidated supervisor, the lead regulator would normally be the same body); b) Taking a primary role in managing emergencies should they arise; c) Acting to facilitate the exchange of information between the relevant regulators in a group; d) (In the longer term) considering ways in which supervisors' efforts could be better co-ordinated when looking at (e.g.) controls. It should be stressed that the existence of either a lead regulator or a consolidated supervisor in no way affects the legal responsibilities of the individual regulatory authorities which are responsible for regulating the different entities within the group. The objective is not to shift the balance of supervisory responsibility from host to home supervisors. Rather, the intention is that each host authority should be able to carry out these responsibilities more effectively by relying to some extent on the work of others. It cannot possibly make sense for, say, 30 different supervisors to crawl over the controls centralised and concentrated in one location? We are keen to examine the practicability of allowing one co-ordinator to carry out the role defined above. Enthusiasm from the US has been more muted, although commercial ---[PAGE_BREAK]--- banks are, of course, already subjected to consolidated supervision. Here I know there are political issues at stake too, and any foreigner is well advised to tread carefully. I would hope, nevertheless, that these important issues can be considered carefully. More problematic is the position of the US investment banking groups who, uniquely amongst the banking and securities industries in major countries, are not subject to legislation requiring consolidated supervision. Some have banking subsidiaries in the UK, owned by companies established under Article XII of the New York State Banking Act. Accordingly these companies and their UK subsidiaries are subject to consolidated supervision by the New York State Banking Department. The involvement of a home country supervisor in this way gives us a degree of comfort which allows the ring-fencing to be less stringent than it would otherwise be. However this clearly falls a long way short of comprehensive consolidated supervision of the entire investment banking group. There is a lively debate in the US at the moment about the most appropriate regulatory structure for all financial institutions, and particularly for investment banks. This tends to be regarded in the US largely as an internal matter. But the fact that the large US financial institutions have a global reach inevitably makes that debate a matter of great interest and concern to the international financial community. We are optimistic that legislation will soon be enacted to address these concerns. It would certainly be disappointing if it is not. # Conclusions Though I have attempted this morning to identify some features of regulation on which we might well agree, I doubt whether there is such a thing as an 'optimal' regulatory structure. Each country has its own legacy of supervisory structures and approaches. But an appropriate international structure is one which works as seamlessly as possible and has clear lines of responsibility (at least, that is what we expect from international banking groups' controls). One co-ordinating regulator for each institution could play a crucial role in such a structure. The question of the number of regulators is, in my view, less important; no one has yet suggested we set up one body world-wide to carry out all supervision, so whatever our own vision of an optimal regulatory structure, it will have at its centre a requirement for supervisors from different disciplines and in different countries to communicate effectively with one another. This weekend's conference is a good opportunity to do that.	Mervyn King	United States	https://www.bis.org/review/r970305e.pdf	financial system Speech by the Deputy Governor of the Bank of England, Mr. Howard Davies, held on 22/2/97 at the Federal Reserve Bank of Atlanta's Financial Markets Conference entitled 'Market and Regulatory Structures in a Global Environment'. It is conventional, and polite to say, at the beginning of a speech of this kind, that one is thrilled to have been asked to speak on the subject of the structure of financial regulation and that the topic is, of all the many preoccupations of human kind through the centuries, the one which generates the most enthusiasm and excitement in one's breast. But I cannot bring myself to do it. You may think me ill-brought up to say this if so blame my parents - but I find the question of the structure of regulation to be quite resistible. I know that there are those who like nothing better than to draw new organigrams and to explore the manifold interfaces between regulatory agencies. (There are also people who find self-fulfilment collecting airline sick bags, or watching synchronised swimming. That is a matter for them.) But my lack of enthusiasm for the topic of regulatory structure is, I hope, not an emotional response. It is rationally based on two prior beliefs. First, that the relationship between structure and effectiveness is loose. I know of little evidence that structural reforms are quickly followed by an enhancement of the effectiveness of the activity in which those agencies are engaged. Secondly, my prejudice is to believe that regulatory structure should follow market structure, rather than the other way round. Regulators should seek to respond to changing markets which, in turn, respond to changing customer demand and new product availability, rather than seeking to dictate either. So we should always ask ourselves whether the regulatory framework we adopt makes sense to market participants, rather than requiring them to structure their business to fit in with some governmentally imposed view of the way product delivery should be organised. But I recognise that, in practice, we cannot avoid constant attention to the maintenance of the regulatory framework. Firstly, because while good structure will not necessarily generate effectiveness, a faulty, out of date framework will certainly make it very hard for regulators to do their jobs well. And, of course, the market is not in an 'original condition'. The financial markets we have now are heavily conditioned by the legislative and regulatory framework within which they have grown up. That is particularly true in the United States. It is hard to imagine that, absent Glass-Steagall, regulation Q and all the rest, the financial landscape in North America would look as it does today. So I conclude that the debate on regulatory structure should be a constant dialogue between the markets and the regulators, but with a prejudice in favour of the former. Our ultimate task as regulators is to ensure that markets work efficiently, and in the interests of consumers. Against that background, how is this dialogue proceeding in the UK at present? For we too are addressing the questions which preoccupy you in the United States, in our quaint, olde worlde British fashion. But before I review the current debate on regulatory structure in the UK, I should say a little about the way we define the objectives of financial regulation. We think of five: to protect the economy against systemic risk; to protect individual depositors, investors and insurance policy holders against loss from the failure of their intermediary; to protect customers against business misconduct; to assist society at large in the fight against crime (for instance by making sure firms have in place systems to detect and report laundered drug money and other proceeds of organised crime); and, last but not least, to create and sustain fair markets. Described bluntly, these objectives make the job of regulators look impossibly daunting. But of course they are not absolute aims. Regulators cannot, and should not, offer blanket assurances to investors and depositors. They cannot, because the tools and resources to do so are simply not available. And they should not, because it would be quite wrong to remove from investors and firms the responsibility for assessing, taking and monitoring financial risks. This is a very important point, which Alan Greenspan has helpfully underlined on a number of occasions recently. Across the world we see a lively debate on how the regulatory cake should be cut. There has been change in France. The Australian Government has set up the Wallis Commission to look at the institutional arrangements there. Their first report has just been published. Reforms are in progress in Japan. In the US the new legislative season is about to open, with a number of runners and riders already saddled up in the financial regulation steeplechase. Similarly, in the UK, a variety of think tanks, and the opposition Labour Party, have produced proposals to amend, or in some cases fundamentally reorder, our regulatory structure. But, before describing these exciting proposals, perhaps a brief description of the British system would be in order. Most falls to the Treasury, but prudential supervision of insurance companies is the responsibility of the Department of Trade and Industry (DTI). The DTI carries out its supervisory responsibilities using its own staff; the Treasury, on the other hand, while setting the legal framework and policy directions for regulation, leaves most of the detailed regulatory functions to others. Under one piece of legislation - the 1987 Banking Act - the Bank of England carries out prudential supervision of banks. Under another, the 1986 Financial Services Act, the Treasury delegates its powers to the Securities and Investments Board, which in turn recognises a number of front-line regulators. These front-line regulators cover different sections of the market. One, the Securities and Futures Authority (SFA), is responsible for securities houses; another, the Investment Management Regulatory Organisation (IMRO), for fund managers. These two regulators undertake both prudential supervision and conduct of business regulation. The third, the Personal Investments Authority (PIA), is responsible for the retail sector, and has principally a conduct of business remit although it is responsible for the prudential supervision of independent financial advisers (IFAs). So, in effect, there is a layered approach to the regulation of financial services in the UK, with different powers held at each level. This brief description of the legislative framework might lead one to suppose that the UK system is primarily statutory - yet the securities side is often described, at least by comparison with the US system, as one of self-regulation. Indeed, some argue that it is excessively self-regulating and, therefore, unreasonably lax. We would reject that last charge. And, in practice, the distinction between statutory and self-regulation is not black and white. The UK system has elements of both. Prudential supervision of insurance firms is carried out directly by a government ministry, which is unambiguously Government regulation. Banking supervision is carried out by the Bank of England. Constitutionally, this is not 'Government' regulation, but rather regulation by a public body which is authorised by specific Act of Parliament. Certainly no one describes what we do as self-regulation, even though the Bank of England is a bank. On the investment side, the picture is more complicated. The Government has delegated its powers to the Securities and Investments Board. The SIB's governing board includes people who are active in financial services, but they are appointed by the Treasury and the Bank of England (indeed I am one of them) and are required to act in the public interest. Again, this does not look like self-regulation. However, the various front-line regulators are called, in the Act itself, 'self regulating organisations' (SROs). Their boards include a high proportion of active practitioners, elected by the industry to represent its views. Practitioners are also heavily involved in policy discussions, rule-making and enforcement functions. But, like the SIB, the SROs operate indirectly under statute, and have a duty to regulate in the public interest. We therefore have no self-regulation in the strict sense, rather a variety of statutory and statute-backed bodies with practitioner involvement, each with different relationships with the industry and with Government. Effective regulation needs the input of all participants in the market if it is to offer appropriate protection without stifling innovation. Regulators can benefit greatly from effective practitioner input but to retain the confidence of the investing public they must persuade them that regulation puts their interests, and not those of the firms and their shareholders, first. The system we now have is undoubtedly capable of achieving an appropriate balance between market sensitivity and consumer confidence; it has, in many respects, worked well. But it has been stress-tested in a number of difficult episodes: the Maxwell affair, the private pension mis-selling saga, the collapse of BCCI, Barings Bank and Sumitomo. These episodes have taught us something about the strengths and weaknesses of our system, just as the S\&L crisis and the Daiwa New York problem have done in the US. Furthermore, markets themselves have moved on. The financial landscape of today is almost unrecognisable from the one which informed legislators' views in the early 1980s, before the Banking and Financial Services Acts were put on the statute book. It is therefore not surprising that over there, as well as over here, there is criticism of the existing structure, and pressure for change. Our own system, with its monopolistic approach to the origination of legislation, does not generate competing draft bills. But the marketplace for ideas on regulatory reform is, I can assure you, just as well contested. Critics of the existing British system object on three counts: 1 that the failures of the last decade demonstrate its inability to cope with strains and crises; 2 that it is unnecessarily complex, with overlapping and sometimes even conflicting responsibilities; and 3 that it has failed to keep pace with changes in institutional and market structures; the distinctions on which it was based no longer effectively apply. It is not my aim today to give a comprehensive assessment of the validity of all these arguments. And, in any event, just as in the US, there is a heavy political dimension to this debate. But I would make a few observations on the arguments advanced for change. The UK system is complex, although it is no more complicated than the equivalent arrangements in some other countries with similarly sophisticated financial markets. (Indeed, were I not a guest here, I might say that the US system was rather more labyrinthine than ours.) Those who argue for simplification point to duplication of function and cost, especially between the SIB and the front-line financial services regulators. There is undoubtedly a case to answer in that area, as both the SIB and the SROs would acknowledge. But the legislation we have explicitly dictates a two-tier structure. It is also true that institutions now tend to be involved in a variety of different businesses. Banks own securities houses, fund managers, and insurance companies. Insurance companies are diversifying into banking, and so on. So that even though there should always be a lead regulator, looking at the overall position of the business, institutions still face the costs of complying with the requirements of several regulators. But the question underlying these arguments about complexity and overlap is more fundamental. Should regulation be based around institutions (it is institutions which fail, after all) or around functions or types of business which call for specialist regulatory knowledge? The UK system is organised neither along wholly functional nor wholly institutional lines. In today's markets, where firms are a mass of subsidiaries and business units, no major market participant deals with a single regulator across all its businesses. Similarly, no regulator has unique responsibility for regulating one function of each business. The insurance operation of a firm, for example, is covered by separate prudential and conduct of business regulators. Most people involved in financial regulation would recognise this description of the problem. But determining how to resolve it is not straightforward, as evidenced by the wide variety of proposals for change which have been advanced. Some proponents of reorganisation would like to begin by making all financial regulation the responsibility of a single Government Department - the Treasury. They suggest that this would clear up accountability for the legislative framework, and for the powers and sanctions in the regulatory regime and create consistency of regulatory approach across sectors. Straightforward administrative tidiness may also be a factor. While there may be merit in both these arguments, such machinery of Government questions are for the Government to determine, and I happily leave such matters to them. Most of the discussion about regulatory structure in the UK has concentrated on the area covered by the SIB and the front-line financial services regulators. It is in this part of the system that the arguments about duplication of function, unnecessary cost and poor communication are most often heard. The various alternative models all feature some degree of consolidation, and some would go as far as to fold all the main financial services regulators into a single body. Others propose two bodies, each reporting directly to the Treasury, with one covering wholesale business and one covering retail, acknowledging the different regulatory imperatives, especially in the conduct of business field, of the two sectors. The aim would be to reduce the number of domestic regulators large institutions would have to deal with, and to improve the match of regulation to function. Even more radical changes have been proposed, encompassing not only the SIB area, but the prudential supervision of banks and insurance companies as well. One model, colloquially known as 'Twin Peaks', would replace the whole of the present system with two Commissions: a Financial Stability Commission, with responsibility for systemic risk, the prudential supervision of all major institutions, and conduct of business regulation of wholesale activities, and a Consumer Protection Commission, which would be in charge of conduct of business regulation in retail markets, as well as detecting market manipulation and insider dealing. It would also carry out prudential supervision of those stock brokers and fund managers who deal with private clients, and of independent intermediaries. The advocates of this model argue that it would better match regulation with both institutions and functions, in particular on the wholesale side. The underlying contention is that the traditional separation between banking, securities and insurance is breaking down, so that there is now a less meaningful difference between institutions and functions. I am not persuaded of the merits of this case. Although the activities of banks and securities firms do overlap at the margin, this is not true of the core activities. Banks in particular continue to have a number of distinctive characteristics. First, there are the risks associated with the maturity transformation seen in their balance sheets. Banks experiencing a drain in their liquidity, perhaps because of a classic 'run', could be driven into insolvency through the forced realisation of illiquid assets at 'fire-sale' prices. Second, there is the risk of contagion - problems at one bank can spread to others - not just through direct financial linkages but also because, in the absence of timely, transparent information on bank assets, depositors become concerned about other banks which they see as similar. Finally, banks play a central role in payments systems, including payment flows generated by FX trading. The conclusion I draw is that there is enough that is special about banks for their prudential supervision to be retained as a separate activity in any new regulatory structure, and that this argument at present outweighs the case for change. Whether prudential supervision of banks should be a function of the central bank is a separate question. Some argue that other central banking responsibilities (such as the conduct of monetary policy) make for conflicts of interest and therefore that supervision should not be carried out by the central bank. I am not persuaded by these arguments either. Nor am I aware of many examples where the suggested conflicts between a supervisory role for the central bank and its other responsibilities have arisen in practice. Indeed, there are important synergies between the supervisory function and other central bank responsibilities. It makes sense for the 'micro' supervision of individual banks in the system to be carried out by the same body that carries out the 'macro' function of maintaining the stability of the financial system as a whole, stability which is essential if monetary policy is to be executed effectively and efficiently. It is no accident that in all major countries the central bank has a significant role in the supervision of banks, even if in some cases others have been given the legal powers to carry out the front-line tasks. Having as supervisors tried their best to limit the likelihood of failure, when faced with it central bankers are uniquely well placed to provide assistance, whether to the institution in trouble, to the market at large, or both. Those who wish to separate banking supervision from central banking must acknowledge that there are certain things that only the central bank can do, and that therefore there needs to be a strong link between the central bank and any new regulator. In Germany, for instance, the Bundesaufsichtsamt is the supervisor of commercial banks. But the Bundesbank has an important role in the day-to-day job of collecting prudential returns, and must be consulted on liquidity and capital requirements, which bear most directly on its role in an emergency. This last is not a trivial point, since the cost and disruption caused by reorganisation would be considerable, and higher in proportion to the degree of change. The process would inevitably generate uncertainty among firms and the public, and make the regulatory system more difficult to manage in the meantime. This argues for building on the present arrangements, if at all possible, rather than beginning again with an entirely new structure that could take years to settle down. Furthermore, what matters to the financial system, and to the public, is that regulators are effective. Effectiveness necessitates good communication, consolidated supervision and close co-operation to maintain protection across the piece. Whether structural change (including bringing functions together under one umbrella) would improve communication and co-operation and so increase effectiveness, is a key question, and the answer is far from clear. We have been making considerable efforts recently to enhance communication between different supervisors in the UK. That has involved, as you would expect, the usual paraphernalia of Memoranda of Understanding. But, in addition, we have sought to achieve cross-membership of some of our most important institutions. For example, Sir Andrew Large, the Chairman of the Securities and Investments Board, has become a member of the Bank of England's Board of Banking Supervision and, reciprocally, I have joined the SIB. Of course one should not exaggerate the importance of individual appointments of this kind. But they do help to create a climate of co-operation, and give a signal to the respective staffs of the two institutions that they are expected to work together as closely as possible, and a signal to the outside that they can expect this to happen. The discussion of regulatory approaches is often phrased in terms of rules versus judgement or, as academics tend to put it, rules versus discretion. Should supervisors simply set the rules, and shoot those who break them? Or does that create too rigid a framework, one which stifles initiative and imagination? There is no simple answer. The Bank of England imposes an increasing number of rules: it has, for example, implemented detailed regimes for capital adequacy introduced by the Basle Committee and the European Union. We set capital requirements to cover the more readily quantifiable risks; we enforce limits on banks' large exposures to individual counterparties; we have rules on banks' liquidity; and we seek to ensure that banks have robust systems and controls, as well as management with the skill and integrity to ensure, in that delightful US phrase, that the bank is 'safe and sound'. But our judgmental approach - allowing supervisors the discretion to exercise informed judgement within approved guidelines - still contrasts with that of many other regulators. This flexibility allows us to be tough where appropriate, but to avoid inappropriate requirements - tailoring the requirements to the nature of the bank's activities. Most fundamentally, perhaps, we can ask questions, and attempt to take advantage of all the information at our disposal to form a judgement of the risks facing depositors and investors, as well as of the quality of a bank's management. So in addition to enforcing rules and looking for problems, we can help management. We can spread knowledge of best practice: asking banks about the full range of risks they face (including those - like reputational and settlement risk that they would often rather ignore); and pointing out to complex groups the extent to which their managerial and organisational systems have moved away from their legal structure. It is true that, in addition to being less rule-bound than most other supervisors, the Bank is commonly viewed as doing relatively little on-site supervision. Of course, this depends on how you define the term. Accountants are well aware that the Bank does, for example, make extensive use of reports prepared by auditors - who, of course, operate on-site - in order to assess the adequacy of internal controls. In particular, the Bank regularly instructs banks to appoint reporting accountants to report on systems and controls and on the accuracy of prudential returns. The Bank's supervisors also spend a growing amount of time on-site. Since 1986, Review Teams have carried out focused visits to banks to evaluate the level of risk in an institution as well as the risk management systems in place to identify, monitor, and control these risks. And in 1995 we introduced a Traded Markets Team to focus on banks' pre-processing models which can be recognised under the CAD (Capital Adequacy Directive) as well as sophisticated risk modelling techniques used by the banks to manage treasury activities. These teams spend on average about three days on banks' premises, which may seem short, but the visits are highly focused, reflecting a great deal of work carried out in advance, not just between team members and the line supervisors of the bank in question but also by the bank itself in providing detailed answers to a series of questions. At the same time, the Bank has recognised the need to be more systematic in its approach to risk assessment and has announced its intention to introduce a more formal approach based on a common approach, known as the RATE model, to identify - using a series of qualitative and quantitative measures - the risks faced by the bank. RATE is an acronym for the three stages of the process: Risk Assessment, Tools of supervision and Evaluation. In the future, by performing periodic risk assessments, we aim to gain a better understanding of the quality of management, the characteristics of the business and the risks the banks face. The greater degree of consistency across banks embodied in the new approach will allow the Bank to be more focused in performing its supervision. The tools of supervision, such as Review Team Visits and Reporting Accountants Reports on internal controls, will be targeted at the areas of greater risk and concern in individual banks. We shall very shortly be issuing a consultation paper setting out how we plan to implement the model in practice. That paper will show that we have tried to model parts of our approach on best practice in the US. The City of London may not always have been a preferred habitat for camels, but you may well see some genetically modified examples on the streets there quite soon. A better understanding of the risk profile of each supervised institution will assist the Bank in setting risk asset ratios. As you all know, Basle sets a minimum capital ratio of 8 percent of risk weighted assets. The 8 percent ratio is sometimes interpreted as a 'one-size-fitsall' standard. The Bank, however, sets the trigger capital ratio for each authorised bank at, or above, the 8 percent floor and considers an adjustment to that trigger ratio whenever we see a substantial change in that bank's risk profile. Where does this all leave us in comparison with other regulators? I suggested earlier that our flexible, judgmental approach is somewhat distinctive. But we are no longer, if indeed we ever were, outliers on the supervisory spectrum. While the Bank has decided to implement a more systematic approach to risk assessment, other supervisors - who traditionally operate a rule book - are (in a fast moving marketplace characterised by rapid product innovation) moving towards a regime that gives more scope for supervisory judgement. But the fact that regulators internationally are converging in their approach does not necessarily mean that they are right. They may all be converging on an inappropriate model. Indeed some would argue that regulators do as much to create problems as to solve them: that regulators create perverse incentives - even as we speak bankers may be designing products whose whole rationale is to exploit anomalies in our rules. Perhaps we would all be far better employed elsewhere, leaving the market to regulate itself. Why should we not facilitate that process by concentrating on rules of disclosure, obliging banks to publish accurate information on their capital adequacy and risk profiles, and leaving the rest up to the market - perhaps with some safety net for small depositors and investors? As you know, the New Zealanders have made an interesting move in this direction in the last couple of years. Should we then get out of the business and leave it all to the markets? To answer that question, it may be helpful to go back to first principles. Back in 1958, Modigliani and Miller demonstrated that in a frictionless world a firm's capital structure cannot affect its value. In the real world, however, departures from the M\&M assumptions - such as taxes, bankruptcy costs and agency costs - may influence the capital decision of any firm; capital may after all be costly. But banks differ substantially from most other firms because their soundness and safety is crucial to maintaining systemic stability; without capital requirements some will exploit this fact by taking large risks with little of their money, in the hope that the taxpayer will bail them out. In other words, some may believe that they are (partially) insulated from potential market discipline. From a regulatory perspective, banks must therefore be required to have capital to absorb the possible losses that result from risk-taking and still remain solvent. What is our position in this debate? It is tempting to conclude that the only problem is a perception of a government-funded safety net for large banks; remove that and our problems will be solved. But systemic risk cannot be wished away as easily as that, even though we in the UK have demonstrated by our actions that we do not rescue every bank which gets into problems. So, while we try to stay clear from ever more detailed rules, we do not believe everything can be left to the market; certain minimum 'regulatory' capital standards are in our view necessary. Of course, we must aim for a credible and comprehensible regime which does not require constant updating and elaboration, is not immensely costly, and is reasonably consistent. The value-at-risk approach is an attempt in that direction. It recognises that there is a crucial role for judgement in supervision, and that one size really will not fit all. It does not prescribe the key qualitative factors in legalistic detail. But it does set out the parameters so as to ensure that there is a framework in place which will deliver broad consistency and also some degree of prudence. Some have argued that regulators should go further than the value-at-risk approach: rather than defining the key parameters and endorsing particular model types, why not leave it to the banks, and give them an incentive to improve their internal models as much as possible? Under this pre-commitment approach a bank would specify the maximum portfolio loss on its trading activities and this would become the institution's market risk capital requirement. Banks exceeding their pre-committed maximum loss (that is breaching their capital commitment) would be penalised in one way or another. Such penalties could be financial, or could entail corrective supervisory action. In some ways pre-commitment can be seen as an extension of the model-approval approach we already adopt. The aim, which we endorse, is to ensure that supervisors work with the grain of the business, and monitor ratios which are seen as meaningful by those who run banks themselves. To that extent, we support it. But there are potential drawbacks. It could amplify the moral hazard problem: if the bank wins, its shareholders - as well as its traders under their bonus packages - pocket the profit, and if it loses, the regulator/tax-payer ends up with the bill. A penalty would not act as a deterrent to a bank prepared to gamble its capital because that bank would not be affected by such a penalty when it was 'down and out'. Furthermore, regulators could over time become less familiar with banks' risk management systems, which might make them less effective in a crisis. Early supervisory intervention is more difficult if supervisors only become aware of problems ex-post, after the limit has been breached. It may be possible to devise an approach to pre-commitment which avoids these potential handicaps. But for the time being our attitude remains somewhat hesitant. Finally, a discussion about rules is not complete without touching on the question of a 'level playing field'; an odd analogy, I think, since in field sports there is no such thing. If there were, why would teams change ends at half time? (In American football, of course, teams change ends three times - and in baseball they resolve the problem by running round in circles.) When banks and securities houses do similar business it seems only fair to apply similar capital rules. But while this is true at the margin, when we look at the total business of banks and securities houses, the picture is still vastly different. A major part of a bank's regulatory capital is held against credit risk. By contrast, securities houses invest primarily in liquid, marketable assets which can be readily sold, with illiquid assets typically a small proportion of the total, generally $2 \%$ or so, and the bulk of a securities firm's regulatory capital tends to be maintained for market risk purposes. It is therefore not obvious that we need to set the same detailed rules for banks and securities houses. That is not to say that we should entirely ignore differences in supervisory regimes, but rather that we should focus on areas where those differences are on a scale which seriously distorts competition. In other words, we should spend rather less of our time discussing risk weights, and rather more discussing risks. How far do these general principles, which I have discussed so far in relation to the UK, apply to regulatory structures in a global environment? One issue for supervisors is increasing globalisation. The biggest institutions now span 50 or more countries and may have 300 or more entities within the group. This is not new; globalisation in this sense has been a feature of banking certainly since the 1970s. What is rather newer is the way in which the firms are centralising the controls for all these far flung entities. With the recognition that similar risks are being run in different subsidiaries (for example a Japanese bank might have exposure to US interest rate risk from its activities both in London and New York), there has been a move to consolidate these homogeneous risks and manage them centrally within a group. This means control lines which transcend or cross the entity structures and a matrix management structure. It means that the head office can exercise much stronger control over the volume of a particular type of risk being run across the group. For example, for some UK banks, the management of their global foreign exchange book will be managed in London during London office hours, then it will switch to the US operation but under strict limits set by London; after the US close it will move again, to the Far East, but still under the control of limits set by London. The increasing development of whole book value at risk models has also encouraged this centralisation of control. In the foreign exchange example, the value at risk model used by the group will be maintained and run in London. So the riskiness of positions across the world wide group will be assessed according to the London model. But centralisation of controls goes even further. Oversight of credit and key credit risk decisions may well also be centralised. Oversight of FX settlement risk is sometimes centralised in London as well as control of the position risk. Likewise various aspects of the internal audit function may well be centralised. So for global groups, the control of the activities in the various legal entities scattered across the planet will hinge on the adequacy of controls located not in those particular countries but centrally. In a way it is simply an extension of the vulnerability of banking entities to problems arising elsewhere in the group. But in this case solvency of the individual entities will depend on the adequacy of systems and controls located in another part of the group. Massive intra-group transactions to move risk between entities will also affect the position of the various subsidiaries. One obvious question is why firms do not dispense with such a plethora of legal entities and operate a simpler branch structure. The answer seems to be that differences in tax structures and even regulatory requirements in some countries still encourage the use of legal entities in different jurisdictions. In that case should regulators try to lean against this centralisation? Here I think the answer must be that the regulators should not try to discourage greater central control of risk. Where a firm is running one type of risk in different locations it must make sense for the total risk to be controlled centrally. But this does create a problem for supervisors because supervision has to be structured along legal entity lines (given that it is legal entities which fail). Responsibility for legal entities cannot be transferred between supervisors. Each supervisor must therefore take a view about the soundness of the entity in its jurisdiction, even where this hinges on controls located elsewhere. How have regulators responded to these trends? In summary, they have increasingly sought ways of increasing co-operation amongst themselves, including agreeing their respective responsibilities and setting up arrangements for information sharing. In the banking sector, at least, they have also supplemented solo supervision of individual entities with consolidated supervision of groups as a whole. When the Basle Committee on Banking Supervision was established by the central bank governors of the G10 countries at the end of 1974, its initial focus was to define the role and responsibilities of home and host supervisors of internationally active banks. These were set out in the 1975 Concordat which established how supervisory responsibility for banks' foreign branches and subsidiaries should be shared between host and parent supervisors, and which has been updated on a number of occasions since. Securities supervisors too have a long tradition of international co-operation, including arrangements for information sharing and mutual assistance in enforcement, with IOSCO playing a key role in facilitating such co-operation internationally. There is also a long history of discussion between Basle and IOSCO. Individual supervisors in both the banking and securities industries have chosen to reinforce co-operation arrangements with formal bilateral agreements with their overseas counterparts. Partly as a consequence, there have been an increasing number of informal meetings between line supervisors with operational responsibility for different parts of financial groups. The importance of international regulatory co-operation is now widely acknowledged and is on the agenda of inter-governmental meetings. At last June's G7 summit in Lyon, the heads of state called for maximum progress preceding the Denver summit in June 1997 on "enhancing co-operation among the authorities responsible for supervision of internationally active institutions, importantly by clarifying their roles and responsibilities." Ahead of the Lyon Summit, Basle and IOSCO had announced a joint initiative to strengthen cooperation in this area, referring to the work of the Joint Forum of banking, securities and insurance supervisors, which was set up to promote information exchange on international financial conglomerates, and consider establishing for each a lead regulator. The need for the international regulatory community to address successfully the challenge of supervising multi-functional global financial conglomerates is an issue of particular significance to the UK. This is because of the international nature of the London markets uniquely so amongst the world's major financial centres. The failure of one or more major overseas firms may cause systemic problems in London where at the end of last year, overseas banks accounted for $57 \%$ of the total assets of the UK monetary sector, with US banks contributing $8 \%$. Furthermore, almost three quarters of the 478 banks which take deposits in the UK are branches or subsidiaries of overseas financial institutions, including 37 from the US. US firms have, of course, particular importance in certain markets. Our April 1995 derivatives survey showed US firms (including securities houses) accounting for around $40 \%$ of turnover in both foreign exchange and interest rate derivatives. We therefore attach particular importance to international regulatory cooperation; and as the trend towards globalisation and multi-functionality continues it is becoming increasingly necessary. The Barings and Daiwa cases have highlighted the difficulty that banks can experience in controlling operations which are far from their head offices. Barings, in particular, demonstrated that losses in a subsidiary in a remote location, in a unit which was not thought to be assuming any significant market risk, can be big enough to bring about the failure of the parent. So home and host supervisors have a mutual interest in the health of the subsidiaries. Regulators will rightly be blamed if any reluctance on their part to work together either exacerbates a crisis or fails to prevent one that could otherwise have been avoided. It is possible to argue that an individual regulator can successfully meet his own objectives, by seeking to build firewalls between his entity and the rest of the group to which it belongs. These might include restrictions or even prohibitions on both financial exposures and operational interlinkages. In addition capital adequacy and other requirements might be set at a more onerous level than if the potential for parental support was taken into account. Such measures may be the best that can be achieved at present; they certainly provide host supervisors with a measure of comfort. But they are, and always will be, a second best. There will always, for example, be a risk of reputational contagion. Counterparties might refuse to deal with a member of a failed group because they are unwilling to take the risk that the firewalls may be flawed, or that cultural or control weaknesses which led to the failure are repeated in that entity also. This, of course, is a hypothetical risk but one which does concern supervisors. Secondly, as the firm will incur additional costs in order to comply with these ringfencing arrangements, while possibly at the same time being denied the risk reducing benefits of group wide controls, it is unlikely to provide the most efficient solution. Concern about these deficiencies has heightened as we have learned more about the way in which many global financial groups are managed. The lack of overlap between legal entities and the management of business lines means that the amount of true ring-fencing which is possible for a globally managed institution is open to debate. The creation of ring-fenced islands of activity seems to me contrary both to the trend in markets and second-best in terms of regulatory efficiency. The Bank of England has always believed that effective supervision of financial groups must involve consolidated supervision. As Alan Greenspan said last week in his testimony to the Congressional SubCommittee on Financial Institutions and Consumer Credit, "Risks managed on a consolidated basis cannot be reviewed on an individual legal entity basis by different supervisors". It is important to define the term "consolidated supervision". The underlying philosophy is that for, say, a bank operating in a large financial group, it is necessary to look not only at the soundness of the bank itself but also of the group as a whole. This will require both a quantitative and a qualitative assessment. The quantitative element involves examining the financial strength of the whole group. The basic measures here are capital adequacy and large exposures. In the Bank of England, we look at these against the minimum standards set out in the EU Directives and against the more stringent criteria which we have developed ourselves and apply to individual banking groups in ways that take account of their particular circumstances. It is worth noting that both the EU Directives and the Basle Capital Accord set these minimum standards on a consolidated basis only. The qualitative element involves assessing factors such as the group's risk management process, internal systems and controls, capability of key personnel, culture and business strategy. Any supervisor will hardly need reminding that, in the Barings case, weaknesses in a subsidiary in just these areas brought about the collapse of the parent. As the need for consolidated supervision is written into the Basle Concordat we can be confident that all regulators of internationally active commercial banks, including of course those in the US, subscribe to its principles. Consolidated supervision is a relatively widely understood concept involving the range of activities set out above. Alan Greenspan last week talked of "umbrella supervision", which he described as a "realistic necessity for the protection of our financial system". (Of course we are not experts on umbrellas: it rarely rains in London, as you know.) But I also referred earlier to a "lead regulator" - though the term 'co-ordinating supervisor' is gaining currency in some quarters. As noted, one of the tasks of the Joint Forum is to define the role of such a person. So far there have been extensive discussions of the role. Among the possibilities suggested have been: Carrying out a quantitative and qualitative assessment of the group as a whole. (This is the consolidated supervisor's role and, where there is already a consolidated supervisor, the lead regulator would normally be the same body); b) Taking a primary role in managing emergencies should they arise; c) Acting to facilitate the exchange of information between the relevant regulators in a group; d) (In the longer term) considering ways in which supervisors' efforts could be better co-ordinated when looking at (e.g.) controls. It should be stressed that the existence of either a lead regulator or a consolidated supervisor in no way affects the legal responsibilities of the individual regulatory authorities which are responsible for regulating the different entities within the group. The objective is not to shift the balance of supervisory responsibility from host to home supervisors. Rather, the intention is that each host authority should be able to carry out these responsibilities more effectively by relying to some extent on the work of others. It cannot possibly make sense for, say, 30 different supervisors to crawl over the controls centralised and concentrated in one location? We are keen to examine the practicability of allowing one co-ordinator to carry out the role defined above. Enthusiasm from the US has been more muted, although commercial banks are, of course, already subjected to consolidated supervision. Here I know there are political issues at stake too, and any foreigner is well advised to tread carefully. I would hope, nevertheless, that these important issues can be considered carefully. More problematic is the position of the US investment banking groups who, uniquely amongst the banking and securities industries in major countries, are not subject to legislation requiring consolidated supervision. Some have banking subsidiaries in the UK, owned by companies established under Article XII of the New York State Banking Act. Accordingly these companies and their UK subsidiaries are subject to consolidated supervision by the New York State Banking Department. The involvement of a home country supervisor in this way gives us a degree of comfort which allows the ring-fencing to be less stringent than it would otherwise be. However this clearly falls a long way short of comprehensive consolidated supervision of the entire investment banking group. There is a lively debate in the US at the moment about the most appropriate regulatory structure for all financial institutions, and particularly for investment banks. This tends to be regarded in the US largely as an internal matter. But the fact that the large US financial institutions have a global reach inevitably makes that debate a matter of great interest and concern to the international financial community. We are optimistic that legislation will soon be enacted to address these concerns. It would certainly be disappointing if it is not. Though I have attempted this morning to identify some features of regulation on which we might well agree, I doubt whether there is such a thing as an 'optimal' regulatory structure. Each country has its own legacy of supervisory structures and approaches. But an appropriate international structure is one which works as seamlessly as possible and has clear lines of responsibility (at least, that is what we expect from international banking groups' controls). One co-ordinating regulator for each institution could play a crucial role in such a structure. The question of the number of regulators is, in my view, less important; no one has yet suggested we set up one body world-wide to carry out all supervision, so whatever our own vision of an optimal regulatory structure, it will have at its centre a requirement for supervisors from different disciplines and in different countries to communicate effectively with one another. This weekend's conference is a good opportunity to do that.
1997-03-07T00:00:00	Mr. Greenspan looks at some important issues arising from new information and communication technologies (Central Bank Articles and Speeches, 7 Mar 97)	Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Conference on Privacy in the Information Age held in Salt Lake City on 7/3/97.	Mr. Greenspan looks at some important issues arising from new information and communications technologies Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Conference on Privacy in the Information Age held in Salt Lake City on 7/3/97. It is a pleasure to be with you this afternoon as you discuss some of the most fundamental issues raised by our new information and communications technologies. The topic Senator Bennett has asked us all to address is privacy in the information age. The central dilemma in these discussions almost always involves fundamental choices about how to strike prudent balances among the needs of individuals for privacy in their financial and commercial transactions, as well as their personal communications; the needs of commerce to bring us new products and new means to communicate; and the needs of the authorities to provide for the effective administration of government and to ensure the public safety. These are not easy choices. I think we all need to have a healthy respect for all sides of the debate. Even further, we need to be aware that the balances we strike in one era may need to be reexamined as technology and circumstances change. The dictionary defines privacy as the state of being free from unsanctioned intrusion. This concept, to which Americans feel a very deep-seated attachment, is reflected in the Fourth Amendment to the Constitution, which assures "The right of the people to be secure in their persons, houses, papers, and effects, against unreasonable searches and seizures...." For the government to intrude on one's privacy is in a very fundamental sense a deprivation of freedom. It is one of those deeply sensed issues that transcends people's constitutional or legal views and delves into the realm of one's sense of person. This is why the perceived threat to privacy from burgeoning technological advance, coupled with an increasing sense of inefficacy in the face of sophisticated new technologies, has created such a stir. The fears of invasion of privacy, as a consequence of inexorable forces seemingly out of the control of the average American, has risen to a major public policy issue. A half century ago a number of writers expressed concern at a perceived ever widening intrusion of government into the lives of individuals. They feared the ultimate collectivization of our society where individualism would be significantly diminished or expunged, and the emergence of "Big Brother" would come to define and dominate our lives. 1984, the year, as well as the book made famous by George Orwell in 1949, have come and gone. The outreach of government, if anything, has receded, especially with respect to the issues of personal liberty, and its concomitant, personal privacy. I suspect that the fear of "Big Technology" when it arrives will travel the less threatening route of "Big Brother" before it. In preparation for addressing that issue, I believe it would be useful to examine some of the interesting dimensions of the concept of privacy and its application to how human society arranges itself. Indeed, when it comes to the issue of privacy, humans are distinctly ambivalent. Greta Garbo made an institution of wanting to be alone. Yet, at the same time, human beings have always sought and presumably needed the presence of others in organizing their societies, even before we economists came on the scene to inform them about the benefits of the division of labor. But the various paradigms by which we have chosen to organize ourselves were closely tied to how we viewed the relative value of individualism and its precondition, the implicit need for privacy. In recent generations, the major competing forms of government, of course, have been (1) a system based on individual rights with the role of the state largely directed at protecting those rights (the United States being the most prominent example of that form of government) and (2) the now defunct Soviet Union, and its eastern European satellites, which were the model of communist collectivization. In the latter, the individual was theoretically subject to the will of the collective but, in reality, subjugated by an elite autocratic hierarchy. In the Soviet system, rights inhered in the collective, which immediately dismisses by definition any right to privacy. State intrusiveness in the form of the KGB or the Stasi eviscerated any wall of personal separation that citizens may have sought. But, in the end, that form of government did not, probably could not, succeed. The human need for personal expression, property, and privacy, doubtless were significant in undermining those collectivist states. Indeed, since the end of World War II, we have had as close as one can come to a controlled experiment in the comparative effectiveness of alternate forms of government organization. I refer to the extraordinary divergence in post-war recovery patterns observed between West and East Germany. Both were rooted in the same historic culture and institutions, differing virtually only in the form of political and economic organization, which were adopted by those societies at war's end. Almost a half-century later, when the Berlin Wall was torn down, the results of this remarkable experiment vividly and unqualifiedly attested to the superiority of the West German free market system based on individual rights, a system where people lived with minimum fear of the state's intrusion into their daily lives. In East Germany, in contrast, to assure that society was appropriately collectivized, it was necessary to probe into the private lives of all individuals and suppress individual freedoms. Human beings had to be molded by force to achieve the East German leaders' distorted view of societal organization. Privacy was scarcely the goal or purpose of the East German state. Indeed, intrusiveness into the lives of all of the citizens was perceived to be an essential ingredient in its organization. The political and economic results of the post-war competition between East and West generally have been unequivocal. The free market capitalism of West Germany has been judged superior in all relevant respects, with very few dissenting from that conclusion. The human need for privacy surely was a major factor in that outcome. To be sure, our newer information technologies can scarcely be perceived as the type of threat to privacy as that of the Soviet state. Nonetheless, the same pressing need for privacy, which helped upend the Soviet Union, can be expected to address and overcome concerns that our newer technologies will intrude on our cherished need for privacy. Communism fell because its practice eliminated personal incentives to work and to acquire property, except in a very limited sense. The existence of such incentives requires the broad freedoms we enjoy to pursue our myriad personal goals. It was the deprivation of these incentives and the suppressing of competition among individuals, the hallmark of a growing economy, which brought Communism down. Since privacy is such an evident value in our society, where technology threatens that value, entrepreneurs can be counted on to seek means to defend it. The major resources they have devoted to encryption in the development of new communication systems attest to the economic value they place on privacy in communications. Moreover the pressures to enact legal prohibitions on the dissemination of personal records will also create incentives to produce technologies that protect them. Indeed, the most effective means to counter technology's erosion of privacy is technology itself. The marketplace is burgeoning with new devices to this end. These devices, of course, include the many advances for encrypting and filtering information. We may even see the deployment of technologies that permit individuals to make choices calibrating their degree of privacy in conducting individual transactions. With some irony, even some of the ability of the government to pursue protection of individual rights is being impaired by effective encryption. This leads to the important question of how to balance the legitimate expectations of individuals for privacy with the needs of government for information to effectively administer the laws and provide for the public safety. The most delicate care is needed in this regard to prevent unnecessary intrusion when specific government decisions are implemented and to avoid the risk of a gradual, long-term erosion of privacy. Beyond these issues are immediate questions about privacy in the delivery of professional, commercial, and financial services over open computer networks as well as personal communications through devices such as e-mail. For example, there are typically strong assumptions about privacy surrounding medical, legal, and financial communications and records. These assumptions are designed to safeguard the autonomy of the individual and to facilitate a society where special expertise can be developed and called upon, when necessary, to promote the individual's welfare. It would be a strange outcome, indeed, if traditional notions of privacy applied only at the physical office of the doctor, lawyer, or banker, but not when modern computer technologies were employed to make professional services available at lower cost and with greater convenience. It may be that some services and communications channels will be used regardless of what privacy guarantees are provided. Providing medical advice by computer network to rural areas with no resident doctors may be one example. More common services, however, such as certain cellular telephone technologies and the use of e-mail over the Internet, are subject to less privacy than some other modes of communication, although extensive efforts are currently being directed to address that. The growing use of credit cards without security measures to pay for goods and services over open networks is another example. Clearly, as these examples demonstrate, privacy concerns may be outweighed, if only for the moment, by other factors such as cost and convenience. However, given choices in the marketplace that include price, quality and differing degrees of privacy, I have little doubt that privacy would be valued and sought after. In the financial sphere, the payment systems of the United States present a paradox. Our systems, and banking arrangements, for handling high-value dollar payments are all electronic and have been for many years. Banking records, including those for loans and deposits, have been computerized since the 1960s. Securities markets also now rely on highly automated records and systems, born out of necessity following the paperwork crisis of the 1970s. Thus, it might seem strange that in transactions initiated by consumers, paper -currency and checks -- remains the payment system of choice. Debit and ATM cards, along with automated clearing house payments, account for a very small percentage of transactions. Even the use of popular credit cards has only recently begun to challenge paper's dominance. While there are many other factors involved in this anomaly, the value of privacy of transaction has clearly been a significant determinant. Paper currency is, of course, the ultimate protector of anonymity, for making ordinary payments at the retail level. It is, thus, a measure of how valued is privacy in our system that inroads into the use of currency have been slow, and halting, in the face of technologies one would assume would have quickly buried the presumed inefficiency of paper transactions. To be sure, checks leave a paper trail which can compromise privacy, but it is a less efficient and accessible trail than when available newer technologies are used. Clearly, then, the value of privacy of transactions that currency -- and to a somewhat lesser extent, checks -provide is a measure of the economic cost individuals are willing to expend when far superior efficiencies are at hand. Nonetheless, the marketplace is currently investing large sums to develop new means to automate payments as well as other retail banking and financial transactions. Projects for creating stored value cards and Internet-based payment systems, for example, are being discussed around the world. Again, as in the 1970s, articles are being written and conferences are being held to pronounce the end of paper. They may again prove premature. It is clear, however, that security and privacy will be very important if confidence is to be established in these new systems. Indeed, in many, privacy of communication is a necessary requirement. Many projects are evolving daily to meet the business requirements of potential operators and the potential service needs of businesses and consumers. There is a significant need for flexibility in allowing these technologies to adapt and grow in response to pressures in the marketplace. There is also a need to avoid building formal or burdensome regulatory systems on the shifting sands of project proposals. If we wish to foster innovation, we must be careful not to impose rules that inhibit it. I am especially concerned that we not attempt to impede unduly our newest innovation, electronic money, or more generally, our increasingly broad electronic payments system. To develop new forms of payment, the private sector will need the flexibility to experiment, without broad interference by the government. Our most intriguing challenge is whether new technologies can provide improved financial services and, at the same time, provide greater privacy and related benefits. Flexibility by industry, consumers, and government may help make such overall advances possible. Finally, I want to emphasize that the information age is not something to be feared, but may well be a vast opportunity. Personal computers, an array of software, and new communications channels have placed powerful and creative technologies directly into the hands of individuals. The current enthusiasm of society for science and technology, particularly among young people, holds great promise for the future. If history is any guide, it is from this enthusiasm that the future will be born.	---[PAGE_BREAK]--- # Mr. Greenspan looks at some important issues arising from new information and communications technologies Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Conference on Privacy in the Information Age held in Salt Lake City on 7/3/97. It is a pleasure to be with you this afternoon as you discuss some of the most fundamental issues raised by our new information and communications technologies. The topic Senator Bennett has asked us all to address is privacy in the information age. The central dilemma in these discussions almost always involves fundamental choices about how to strike prudent balances among the needs of individuals for privacy in their financial and commercial transactions, as well as their personal communications; the needs of commerce to bring us new products and new means to communicate; and the needs of the authorities to provide for the effective administration of government and to ensure the public safety. These are not easy choices. I think we all need to have a healthy respect for all sides of the debate. Even further, we need to be aware that the balances we strike in one era may need to be reexamined as technology and circumstances change. The dictionary defines privacy as the state of being free from unsanctioned intrusion. This concept, to which Americans feel a very deep-seated attachment, is reflected in the Fourth Amendment to the Constitution, which assures "The right of the people to be secure in their persons, houses, papers, and effects, against unreasonable searches and seizures...." For the government to intrude on one's privacy is in a very fundamental sense a deprivation of freedom. It is one of those deeply sensed issues that transcends people's constitutional or legal views and delves into the realm of one's sense of person. This is why the perceived threat to privacy from burgeoning technological advance, coupled with an increasing sense of inefficacy in the face of sophisticated new technologies, has created such a stir. The fears of invasion of privacy, as a consequence of inexorable forces seemingly out of the control of the average American, has risen to a major public policy issue. A half century ago a number of writers expressed concern at a perceived ever widening intrusion of government into the lives of individuals. They feared the ultimate collectivization of our society where individualism would be significantly diminished or expunged, and the emergence of "Big Brother" would come to define and dominate our lives. 1984, the year, as well as the book made famous by George Orwell in 1949, have come and gone. The outreach of government, if anything, has receded, especially with respect to the issues of personal liberty, and its concomitant, personal privacy. I suspect that the fear of "Big Technology" when it arrives will travel the less threatening route of "Big Brother" before it. In preparation for addressing that issue, I believe it would be useful to examine some of the interesting dimensions of the concept of privacy and its application to how human society arranges itself. Indeed, when it comes to the issue of privacy, humans are distinctly ambivalent. Greta Garbo made an institution of wanting to be alone. Yet, at the same time, human beings have always sought and presumably needed the presence of others in organizing their societies, even before we economists came on the scene to inform them about the benefits of the division of labor. ---[PAGE_BREAK]--- But the various paradigms by which we have chosen to organize ourselves were closely tied to how we viewed the relative value of individualism and its precondition, the implicit need for privacy. In recent generations, the major competing forms of government, of course, have been (1) a system based on individual rights with the role of the state largely directed at protecting those rights (the United States being the most prominent example of that form of government) and (2) the now defunct Soviet Union, and its eastern European satellites, which were the model of communist collectivization. In the latter, the individual was theoretically subject to the will of the collective but, in reality, subjugated by an elite autocratic hierarchy. In the Soviet system, rights inhered in the collective, which immediately dismisses by definition any right to privacy. State intrusiveness in the form of the KGB or the Stasi eviscerated any wall of personal separation that citizens may have sought. But, in the end, that form of government did not, probably could not, succeed. The human need for personal expression, property, and privacy, doubtless were significant in undermining those collectivist states. Indeed, since the end of World War II, we have had as close as one can come to a controlled experiment in the comparative effectiveness of alternate forms of government organization. I refer to the extraordinary divergence in post-war recovery patterns observed between West and East Germany. Both were rooted in the same historic culture and institutions, differing virtually only in the form of political and economic organization, which were adopted by those societies at war's end. Almost a half-century later, when the Berlin Wall was torn down, the results of this remarkable experiment vividly and unqualifiedly attested to the superiority of the West German free market system based on individual rights, a system where people lived with minimum fear of the state's intrusion into their daily lives. In East Germany, in contrast, to assure that society was appropriately collectivized, it was necessary to probe into the private lives of all individuals and suppress individual freedoms. Human beings had to be molded by force to achieve the East German leaders' distorted view of societal organization. Privacy was scarcely the goal or purpose of the East German state. Indeed, intrusiveness into the lives of all of the citizens was perceived to be an essential ingredient in its organization. The political and economic results of the post-war competition between East and West generally have been unequivocal. The free market capitalism of West Germany has been judged superior in all relevant respects, with very few dissenting from that conclusion. The human need for privacy surely was a major factor in that outcome. To be sure, our newer information technologies can scarcely be perceived as the type of threat to privacy as that of the Soviet state. Nonetheless, the same pressing need for privacy, which helped upend the Soviet Union, can be expected to address and overcome concerns that our newer technologies will intrude on our cherished need for privacy. Communism fell because its practice eliminated personal incentives to work and to acquire property, except in a very limited sense. The existence of such incentives requires the broad freedoms we enjoy to pursue our myriad personal goals. It was the deprivation of these incentives and the suppressing of competition among individuals, the hallmark of a growing economy, which brought Communism down. Since privacy is such an evident value in our society, where technology threatens that value, entrepreneurs can be counted on to seek means to defend it. The major resources they have devoted to encryption in the development of new communication systems attest to the economic value they place on privacy in communications. Moreover the pressures to enact legal ---[PAGE_BREAK]--- prohibitions on the dissemination of personal records will also create incentives to produce technologies that protect them. Indeed, the most effective means to counter technology's erosion of privacy is technology itself. The marketplace is burgeoning with new devices to this end. These devices, of course, include the many advances for encrypting and filtering information. We may even see the deployment of technologies that permit individuals to make choices calibrating their degree of privacy in conducting individual transactions. With some irony, even some of the ability of the government to pursue protection of individual rights is being impaired by effective encryption. This leads to the important question of how to balance the legitimate expectations of individuals for privacy with the needs of government for information to effectively administer the laws and provide for the public safety. The most delicate care is needed in this regard to prevent unnecessary intrusion when specific government decisions are implemented and to avoid the risk of a gradual, long-term erosion of privacy. Beyond these issues are immediate questions about privacy in the delivery of professional, commercial, and financial services over open computer networks as well as personal communications through devices such as e-mail. For example, there are typically strong assumptions about privacy surrounding medical, legal, and financial communications and records. These assumptions are designed to safeguard the autonomy of the individual and to facilitate a society where special expertise can be developed and called upon, when necessary, to promote the individual's welfare. It would be a strange outcome, indeed, if traditional notions of privacy applied only at the physical office of the doctor, lawyer, or banker, but not when modern computer technologies were employed to make professional services available at lower cost and with greater convenience. It may be that some services and communications channels will be used regardless of what privacy guarantees are provided. Providing medical advice by computer network to rural areas with no resident doctors may be one example. More common services, however, such as certain cellular telephone technologies and the use of e-mail over the Internet, are subject to less privacy than some other modes of communication, although extensive efforts are currently being directed to address that. The growing use of credit cards without security measures to pay for goods and services over open networks is another example. Clearly, as these examples demonstrate, privacy concerns may be outweighed, if only for the moment, by other factors such as cost and convenience. However, given choices in the marketplace that include price, quality and differing degrees of privacy, I have little doubt that privacy would be valued and sought after. In the financial sphere, the payment systems of the United States present a paradox. Our systems, and banking arrangements, for handling high-value dollar payments are all electronic and have been for many years. Banking records, including those for loans and deposits, have been computerized since the 1960s. Securities markets also now rely on highly automated records and systems, born out of necessity following the paperwork crisis of the 1970s. Thus, it might seem strange that in transactions initiated by consumers, paper -currency and checks -- remains the payment system of choice. Debit and ATM cards, along with automated clearing house payments, account for a very small percentage of transactions. Even ---[PAGE_BREAK]--- the use of popular credit cards has only recently begun to challenge paper's dominance. While there are many other factors involved in this anomaly, the value of privacy of transaction has clearly been a significant determinant. Paper currency is, of course, the ultimate protector of anonymity, for making ordinary payments at the retail level. It is, thus, a measure of how valued is privacy in our system that inroads into the use of currency have been slow, and halting, in the face of technologies one would assume would have quickly buried the presumed inefficiency of paper transactions. To be sure, checks leave a paper trail which can compromise privacy, but it is a less efficient and accessible trail than when available newer technologies are used. Clearly, then, the value of privacy of transactions that currency -- and to a somewhat lesser extent, checks -provide is a measure of the economic cost individuals are willing to expend when far superior efficiencies are at hand. Nonetheless, the marketplace is currently investing large sums to develop new means to automate payments as well as other retail banking and financial transactions. Projects for creating stored value cards and Internet-based payment systems, for example, are being discussed around the world. Again, as in the 1970s, articles are being written and conferences are being held to pronounce the end of paper. They may again prove premature. It is clear, however, that security and privacy will be very important if confidence is to be established in these new systems. Indeed, in many, privacy of communication is a necessary requirement. Many projects are evolving daily to meet the business requirements of potential operators and the potential service needs of businesses and consumers. There is a significant need for flexibility in allowing these technologies to adapt and grow in response to pressures in the marketplace. There is also a need to avoid building formal or burdensome regulatory systems on the shifting sands of project proposals. If we wish to foster innovation, we must be careful not to impose rules that inhibit it. I am especially concerned that we not attempt to impede unduly our newest innovation, electronic money, or more generally, our increasingly broad electronic payments system. To develop new forms of payment, the private sector will need the flexibility to experiment, without broad interference by the government. Our most intriguing challenge is whether new technologies can provide improved financial services and, at the same time, provide greater privacy and related benefits. Flexibility by industry, consumers, and government may help make such overall advances possible. Finally, I want to emphasize that the information age is not something to be feared, but may well be a vast opportunity. Personal computers, an array of software, and new communications channels have placed powerful and creative technologies directly into the hands of individuals. The current enthusiasm of society for science and technology, particularly among young people, holds great promise for the future. If history is any guide, it is from this enthusiasm that the future will be born.	Alan Greenspan	United States	https://www.bis.org/review/r970321a.pdf	and communications technologies Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Conference on Privacy in the Information Age held in Salt Lake City on 7/3/97. It is a pleasure to be with you this afternoon as you discuss some of the most fundamental issues raised by our new information and communications technologies. The topic Senator Bennett has asked us all to address is privacy in the information age. The central dilemma in these discussions almost always involves fundamental choices about how to strike prudent balances among the needs of individuals for privacy in their financial and commercial transactions, as well as their personal communications; the needs of commerce to bring us new products and new means to communicate; and the needs of the authorities to provide for the effective administration of government and to ensure the public safety. These are not easy choices. I think we all need to have a healthy respect for all sides of the debate. Even further, we need to be aware that the balances we strike in one era may need to be reexamined as technology and circumstances change. The dictionary defines privacy as the state of being free from unsanctioned intrusion. This concept, to which Americans feel a very deep-seated attachment, is reflected in the Fourth Amendment to the Constitution, which assures "The right of the people to be secure in their persons, houses, papers, and effects, against unreasonable searches and seizures." For the government to intrude on one's privacy is in a very fundamental sense a deprivation of freedom. It is one of those deeply sensed issues that transcends people's constitutional or legal views and delves into the realm of one's sense of person. This is why the perceived threat to privacy from burgeoning technological advance, coupled with an increasing sense of inefficacy in the face of sophisticated new technologies, has created such a stir. The fears of invasion of privacy, as a consequence of inexorable forces seemingly out of the control of the average American, has risen to a major public policy issue. A half century ago a number of writers expressed concern at a perceived ever widening intrusion of government into the lives of individuals. They feared the ultimate collectivization of our society where individualism would be significantly diminished or expunged, and the emergence of "Big Brother" would come to define and dominate our lives. 1984, the year, as well as the book made famous by George Orwell in 1949, have come and gone. The outreach of government, if anything, has receded, especially with respect to the issues of personal liberty, and its concomitant, personal privacy. I suspect that the fear of "Big Technology" when it arrives will travel the less threatening route of "Big Brother" before it. In preparation for addressing that issue, I believe it would be useful to examine some of the interesting dimensions of the concept of privacy and its application to how human society arranges itself. Indeed, when it comes to the issue of privacy, humans are distinctly ambivalent. Greta Garbo made an institution of wanting to be alone. Yet, at the same time, human beings have always sought and presumably needed the presence of others in organizing their societies, even before we economists came on the scene to inform them about the benefits of the division of labor. But the various paradigms by which we have chosen to organize ourselves were closely tied to how we viewed the relative value of individualism and its precondition, the implicit need for privacy. In recent generations, the major competing forms of government, of course, have been (1) a system based on individual rights with the role of the state largely directed at protecting those rights (the United States being the most prominent example of that form of government) and (2) the now defunct Soviet Union, and its eastern European satellites, which were the model of communist collectivization. In the latter, the individual was theoretically subject to the will of the collective but, in reality, subjugated by an elite autocratic hierarchy. In the Soviet system, rights inhered in the collective, which immediately dismisses by definition any right to privacy. State intrusiveness in the form of the KGB or the Stasi eviscerated any wall of personal separation that citizens may have sought. But, in the end, that form of government did not, probably could not, succeed. The human need for personal expression, property, and privacy, doubtless were significant in undermining those collectivist states. Indeed, since the end of World War II, we have had as close as one can come to a controlled experiment in the comparative effectiveness of alternate forms of government organization. I refer to the extraordinary divergence in post-war recovery patterns observed between West and East Germany. Both were rooted in the same historic culture and institutions, differing virtually only in the form of political and economic organization, which were adopted by those societies at war's end. Almost a half-century later, when the Berlin Wall was torn down, the results of this remarkable experiment vividly and unqualifiedly attested to the superiority of the West German free market system based on individual rights, a system where people lived with minimum fear of the state's intrusion into their daily lives. In East Germany, in contrast, to assure that society was appropriately collectivized, it was necessary to probe into the private lives of all individuals and suppress individual freedoms. Human beings had to be molded by force to achieve the East German leaders' distorted view of societal organization. Privacy was scarcely the goal or purpose of the East German state. Indeed, intrusiveness into the lives of all of the citizens was perceived to be an essential ingredient in its organization. The political and economic results of the post-war competition between East and West generally have been unequivocal. The free market capitalism of West Germany has been judged superior in all relevant respects, with very few dissenting from that conclusion. The human need for privacy surely was a major factor in that outcome. To be sure, our newer information technologies can scarcely be perceived as the type of threat to privacy as that of the Soviet state. Nonetheless, the same pressing need for privacy, which helped upend the Soviet Union, can be expected to address and overcome concerns that our newer technologies will intrude on our cherished need for privacy. Communism fell because its practice eliminated personal incentives to work and to acquire property, except in a very limited sense. The existence of such incentives requires the broad freedoms we enjoy to pursue our myriad personal goals. It was the deprivation of these incentives and the suppressing of competition among individuals, the hallmark of a growing economy, which brought Communism down. Since privacy is such an evident value in our society, where technology threatens that value, entrepreneurs can be counted on to seek means to defend it. The major resources they have devoted to encryption in the development of new communication systems attest to the economic value they place on privacy in communications. Moreover the pressures to enact legal prohibitions on the dissemination of personal records will also create incentives to produce technologies that protect them. Indeed, the most effective means to counter technology's erosion of privacy is technology itself. The marketplace is burgeoning with new devices to this end. These devices, of course, include the many advances for encrypting and filtering information. We may even see the deployment of technologies that permit individuals to make choices calibrating their degree of privacy in conducting individual transactions. With some irony, even some of the ability of the government to pursue protection of individual rights is being impaired by effective encryption. This leads to the important question of how to balance the legitimate expectations of individuals for privacy with the needs of government for information to effectively administer the laws and provide for the public safety. The most delicate care is needed in this regard to prevent unnecessary intrusion when specific government decisions are implemented and to avoid the risk of a gradual, long-term erosion of privacy. Beyond these issues are immediate questions about privacy in the delivery of professional, commercial, and financial services over open computer networks as well as personal communications through devices such as e-mail. For example, there are typically strong assumptions about privacy surrounding medical, legal, and financial communications and records. These assumptions are designed to safeguard the autonomy of the individual and to facilitate a society where special expertise can be developed and called upon, when necessary, to promote the individual's welfare. It would be a strange outcome, indeed, if traditional notions of privacy applied only at the physical office of the doctor, lawyer, or banker, but not when modern computer technologies were employed to make professional services available at lower cost and with greater convenience. It may be that some services and communications channels will be used regardless of what privacy guarantees are provided. Providing medical advice by computer network to rural areas with no resident doctors may be one example. More common services, however, such as certain cellular telephone technologies and the use of e-mail over the Internet, are subject to less privacy than some other modes of communication, although extensive efforts are currently being directed to address that. The growing use of credit cards without security measures to pay for goods and services over open networks is another example. Clearly, as these examples demonstrate, privacy concerns may be outweighed, if only for the moment, by other factors such as cost and convenience. However, given choices in the marketplace that include price, quality and differing degrees of privacy, I have little doubt that privacy would be valued and sought after. In the financial sphere, the payment systems of the United States present a paradox. Our systems, and banking arrangements, for handling high-value dollar payments are all electronic and have been for many years. Banking records, including those for loans and deposits, have been computerized since the 1960s. Securities markets also now rely on highly automated records and systems, born out of necessity following the paperwork crisis of the 1970s. Thus, it might seem strange that in transactions initiated by consumers, paper -currency and checks -- remains the payment system of choice. Debit and ATM cards, along with automated clearing house payments, account for a very small percentage of transactions. Even the use of popular credit cards has only recently begun to challenge paper's dominance. While there are many other factors involved in this anomaly, the value of privacy of transaction has clearly been a significant determinant. Paper currency is, of course, the ultimate protector of anonymity, for making ordinary payments at the retail level. It is, thus, a measure of how valued is privacy in our system that inroads into the use of currency have been slow, and halting, in the face of technologies one would assume would have quickly buried the presumed inefficiency of paper transactions. To be sure, checks leave a paper trail which can compromise privacy, but it is a less efficient and accessible trail than when available newer technologies are used. Clearly, then, the value of privacy of transactions that currency -- and to a somewhat lesser extent, checks -provide is a measure of the economic cost individuals are willing to expend when far superior efficiencies are at hand. Nonetheless, the marketplace is currently investing large sums to develop new means to automate payments as well as other retail banking and financial transactions. Projects for creating stored value cards and Internet-based payment systems, for example, are being discussed around the world. Again, as in the 1970s, articles are being written and conferences are being held to pronounce the end of paper. They may again prove premature. It is clear, however, that security and privacy will be very important if confidence is to be established in these new systems. Indeed, in many, privacy of communication is a necessary requirement. Many projects are evolving daily to meet the business requirements of potential operators and the potential service needs of businesses and consumers. There is a significant need for flexibility in allowing these technologies to adapt and grow in response to pressures in the marketplace. There is also a need to avoid building formal or burdensome regulatory systems on the shifting sands of project proposals. If we wish to foster innovation, we must be careful not to impose rules that inhibit it. I am especially concerned that we not attempt to impede unduly our newest innovation, electronic money, or more generally, our increasingly broad electronic payments system. To develop new forms of payment, the private sector will need the flexibility to experiment, without broad interference by the government. Our most intriguing challenge is whether new technologies can provide improved financial services and, at the same time, provide greater privacy and related benefits. Flexibility by industry, consumers, and government may help make such overall advances possible. Finally, I want to emphasize that the information age is not something to be feared, but may well be a vast opportunity. Personal computers, an array of software, and new communications channels have placed powerful and creative technologies directly into the hands of individuals. The current enthusiasm of society for science and technology, particularly among young people, holds great promise for the future. If history is any guide, it is from this enthusiasm that the future will be born.
1997-03-13T00:00:00	Mr. Heikensten talks about monetary policy and the Swedish economy (Central Bank Articles and Speeches, 13 Mar 97)	Speech by the Deputy Governor of the Bank of Sweden, Mr. Lars Heikensten, on the occasion of the 1997 Money and Capital Markets Day arranged by The Association of Local Authorities and the Federation of County Councils on 13/3/97.	Mr. Heikensten talks about monetary policy and the Swedish economy Speech by the Deputy Governor of the Bank of Sweden, Mr. Lars Heikensten, on the occasion of the 1997 Money and Capital Markets Day arranged by The Association of Local Authorities and the Federation of County Councils on 13/3/97. Today I shall be considering this field in terms of three topical issues: - First there is the path of inflation in recent years. In this context I shall dwell on the significance of transitory effects, not just for recent price tendencies but also more in principle. - Next comes the issue of employment. What can monetary policy do to help create new jobs in Sweden? - The third matter is the rule system for monetary policy. What is the point of delegating the management of monetary policy and the task of establishing low inflation to a central bank? In this connection I will also look at various proposals that are being discussed at present for amending the rules for the Riksbank. Inflation and monetary policy Price stability is the Riksbank's paramount objective, specified in the target of keeping the increase in the consumer price index to 2 per cent, with a tolerance interval of ±1 percentage point. There is a time lag of one to two years before a monetary policy measure has future its full effect on inflation. Our discussion should therefore focus on inflation. But first I want to say something about inflation in the past year. Inflation and the transitory effects The CPI is used by the Riksbank to target inflation mainly because it is familiar, published monthly with a short time lag and seldom has to be revised. However, using the CPI as a target variable is liable to face monetary policy with explanatory problems. The past year is a case in point. The low rate of inflation stemmed mainly from transitory effects; the consolidation of government finance and increased confidence in economic policy helped to strengthen the exchange rate. During 1996 it proved possible to lower the instrumental rates almost 5 percentage points. Altogether, in 1996 decreased interest costs and the stronger exchange rate had a downward effect on the CPI of around 1 percentage point. In some countries the inflation target is assessed in terms of the CPI with various components excluded, for example indirect taxes and subsidies or mortgage interest costs. It may then be asked whether the CPI is the most appropriate target variable and whether some measurement of underlying inflation might be preferable. An advantage of focusing on a single underlying indicator is that it might help the Riksbank in its contacts with the general public and make monetary policy more transparent. Analysis and debate would be concentrated on factors that monetary policy influences. This, however, presupposes the existence of an underlying yardstick that can take every conceivable transitory effect into account. Such measurements are difficult to construct. Specifying all the circumstances that have to be considered so as to obtain the best picture of underlying inflation and doing this in advance is not a simple matter. Using underlying inflation also has the drawback that essential information about the inflation process may be overlooked. For example, changes in import prices are a part of the domestic inflation process because they affect price setting in trade. In the present state of our art, the drawbacks of changing to a measure of underlying inflation for the Riksbank's monetary policy are greater than the advantages. As I have indicated, however, the CPI may be markedly affected by transitory effects. It is therefore important to monitor measurements of underlying inflation that have been stable over time. The path of the underlying inflation process is an important factor in the Riksbank's monetary policy decisions. Gradual recovery In growth terms, 1996 was weaker than 1994 and 1995. The slowdown mainly came from marked stock reductions and a contraction of public sector operations. But even the growth of final demand in the private sector tended to slacken in 1996. There are now clear signs of an economic recovery; the volume growth of exports remains high, along with indications that a stronger increase in private consumption is on the way. What, then, will be inflation's path in the years ahead? The Riksbank considers that at present the Swedish economy has unutilised resources and even if growth does pick up during 1997 and 1998, it is unlikely that these resources will be activated to such an extent that the inflation target is in danger. The scenario in the December inflation report involves a gradual increase in the rate of inflation in the coming years. The main explanation for this upward movement is that the transitory effects - from lower interest rates and a stronger exchange rate - which kept inflation down in 1996 will be fading. The registered rate of CPI inflation is then expected to approach inflation's underlying trend, which in the years ahead is judged to be more or less in line with the inflation target. Lower inflation propensity The new price and other economic information in recent months reinforces the impression that price pressure is low. To this extent, the conditions for fulfilling the inflation target have improved. On the other hand, a weaker exchange rate has already tended to stimulate activity. The outlook for inflation and the rapid progress in consolidating government finance suggest that there is room for a fall in long bond rates. Underlying economic factors indicate, moreover, that the recent depreciation has left the krona undervalued, so that it should appreciate. How should the exchange rate be assessed in connection with monetary policy decisions? According to experience in recent years, the impact of a depreciation on domestic prices is limited. But domestic demand has been weak. Provided there is stable confidence in the policy for price stability, price effects from a weakening of the exchange rate are generally transitory. A depreciation is a problem for monetary policy only when it has a lasting expansionary effect or if inflation expectations rise. The economy's inflation propensity, which seems to have decreased in recent years, is an important factor to consider when assessing the threat from future inflation. The term inflation propensity stands here for the structure of the inflation process, which is liable to be changed by various factors. If stronger competition, for example, in certain segments of trade results in lower price increases than before when consumption is rising, then the economy has a lower inflation propensity. Examples of factors that may have helped to reduce the inflation propensity are the fall in market expectations of inflation and the higher acceptance of the Riksbank's inflation target. Another cause of a decreased inflation propensity can be lower inflation as such. Price comparisons are easier for households and firms when inflation is low. Price increases are more visible and producers have more difficulty in raising prices without a relative price shift. The situation in this respect is one of the main issues that the Riksbank will have to evaluate. We shall be returning to this later in the year. All in all, the picture that emerges of the Swedish economy suggests that the monetary stance is well balanced. Major changes have occurred in the past year, for instance in the repo rate. Time is needed to assess their effects. This also motivates a cautious line in monetary policy. 2. Employment and what monetary policy can do The low inflation in the past few years has been accompanied by respectable growth. Since 1994 economic growth has averaged 2.7 per cent a year, which is higher than the normal rate in recent decades. Given the low capacity utilisation initially, the high growth as such is not remarkable. What is more surprising - and alarming - is that a recovery of employment seems to be considerably more sluggish than the upswing in total production. The problem of generating new jobs is by no means peculiar to Sweden but something we have in common with much of Europe. The situation in this respect contrasts markedly with the United States. There are also exceptions in Europe, one being the Netherlands in the past decade. This suggests that cures for the high unemployment exist, though naturally the solutions in other countries may not apply as a whole to Swedish conditions. The high unemployment in Sweden is now a subject of intensive discussion. Today I shall try to describe in principle what monetary policy is capable of doing and what it is not in a position to achieve. Restricted potential in the longer run In an analysis of monetary policy's potential for influencing employment it is natural to make a distinction between the short and the longer run. It is generally agreed that monetary policy can be used to affect production and employment in the short run. An important reason why monetary policy is capable, at least in principle, of influencing employment in this time perspective is the existence of rigidities in price and wage formation. Suppose, for example, that low wage settlements are concluded with a certain rate of inflation in mind. If monetary policy becomes more expansionary and inflation takes off, wage costs will be lower than expected in real terms. It will pay firms better to take on additional labour and employment will rise. In the short run, then, one can expect a trade-off between inflation (or the extent to which monetary policy is expansionary) and employment (or unemployment). The existence of such a short-term trade-off does not mean, however, that it will serve to raise employment permanently. This is because when actual inflation changes, economic agents (firms, employees, etc.) normally adjust their expectations of future inflation. So in the next round of wage agreements, for example, employees may demand compensation for a higher expected rate of inflation. Changing expectations mean that the trade-off between inflation and unemployment ceases to be stable. This is intuitively intelligible. If the normal rate of inflation is, say, 5 per cent, it seems reasonable that employment will rise if inflation moves up to 10 per cent because this reduces wage costs in real terms. In the figure this amounts to moving from A to B. In time, however, 10 per cent inflation will be regarded as normal and wage demands will be based on this level. With higher nominal wage increases, real wage costs will move up again and unemployment will tend to return to its initial level. In the figure this means moving from B to C. In order to boost employment in this situation, inflation would have to rise to say 15 per cent and the procedure will be repeated. All that is ultimately achieved is higher average inflation. The level of unemployment to which an economy returns when inflation expectations have adjusted is usually referred to as equilibrium unemployment. It is determined by structural factors such as demographic changes, technology and the institutional set-up in the labour market, factors that are immune to monetary policy. The important conclusion to draw from this is that permanently low unemployment cannot be achieved by accepting permanently high inflation. Under favourable circumstances, to which I will shortly return, monetary policy can promote an economic recovery; but an appreciable improvement in the unemployment situation calls for measures in many other fields, above all in the workings of the labour market and wage formation. What should monetary policy aim for? If a central bank is incapable of "creating jobs" on a permanent basis, what should be its primary task? By means of an appropriately balanced monetary policy a central bank can determine, or at least strongly influence, the rate of inflation that prevails in the economy and underlies economic decisions by firms and households. Price increases are, of course, conditioned by many other factors, such as the economic situation, the fiscal stance, wage formation and so on. But inflation is a monetary phenomenon and in the longer run the Riksbank, by controlling the supply of money in a wide sense, can also control its value in terms of inflation. The perception that the primary task of a central bank should be to maintain price stability can be said to have won general acceptance. In that low, stable inflation helps to improve the functioning of markets, it seems reasonable that, indirectly, monetary policy also promotes economic growth and employment. In their economic decisions, households and firms have one less source of uncertainty - inflation - to worry about. The inability of monetary policy to affect long-term employment and the fact that it should focus on maintaining price stability does not mean that its capacity to condition production and employment in the short run can not sometimes be used for stabilising activity. Monetary policy can contribute to an economic recovery in so far as this is feasible without jeopardising price stability. Problems may arise, however, if monetary policy is perceived as The Phillips curve T h e P h illip cu r ve Inf latio n B * A * U ne m plo ym e nt Inf latio n B C * * U ne m plo ym e nt focusing primarily on the stabilisation of employment. As we have seen, people's expectations play a major part in the inflation process. If people expect monetary policy to concentrate in the first place on stabilising employment, then firms and employees will not regard unduly high wage increases as all that serious because they will count on measures being taken to stimulate demand if employment is in danger. Sweden in the 1970s and '80s is a good illustration of the problems that may arise. Wage and price increases in that period were systematically higher than in other countries, which led to recurrent cost crises and problems with competitiveness. An important reason for the lack of adjustment to wage increases in the rest of the world was that employees and firms reckoned that the government and the Riksbank would ultimately bail them out with devaluations, which is what actually happened. In this way inflation expectations were adjusted in advance to an anticipated pattern of economic policy reactions, whereby high price and wage increases were accepted or accommodated by devaluing the krona. As a result, strong inflationary mechanisms were built into the economy. As we have seen in recent years, once such mechanisms have been established, they are difficult to change. 3. Monetary policy's rule system Experience has shown that more is needed than proud declarations from political decision-makers that they will safeguard a stable value of money and are not prepared to adapt policy to excessively high wage increases. We heard plenty of that in the 1980s. One way of enhancing credibility that has been found to work well and is supported by economic theory is for the democratically elected body to delegate monetary policy to a central bank with a clear, specified obligation to safeguard the value of money. The central bank is given full control over the instruments, principally the short interest rate, for fulfilling the stipulated objective. This arrangement limits both the room for short-run attempts to boost employment and the risk of inflationary mechanisms taking root in the economy. That also lessens the risk of a repetition of what happened in the early 1990s when the inflation bubble burst and unemployment rose. Credibility provides greater manoeuvrability It may be worth underscoring that a system where price stability is credibly delegated to the central bank can confer greater freedom of action in economic policy. This may seem paradoxical but if people feel they can rely on the central bank, in an economic slowdown it may be possible to ease the monetary stance without triggering higher inflation expectations and bond rates, because everyone counts on policy being tightened before inflation moves up. We have experienced something of this sort in Sweden in the past year. In a system with poor credibility, a monetary easing may be perceived as a sign of a lasting upward shift in inflation. This in turn may generate self-fulfilling expectations, with future problems when efforts are made to control inflation once more. It is understandable that the risk of this is seen as particularly great in economies where inflation has been high for a long time. A more independent central bank is thus in a better position not only to maintain low inflation but also to operate at times with a policy that includes an element of stabilisation (though the problems of fine tuning stabilisation policy should not be underestimated). The German central bank is one example; over a series of decades, economic slowdowns could be parried by lowering the short interest rate fairly rapidly and markedly. It may be in place to point out that credibility and, for that matter, independence can be achieved in various ways. Some countries have recently clarified their regulations so as to bring them into line with the arrangement I have just advocated. One example is New Zealand. In other countries, for instance the United States, policy has been conducted so that it has gradually earned increasing confidence within the time-honoured system. In my opinion the rule system is important; it reflects the general commitment to monetary policy and can provide a short cut to credibility. In a democratic society, however, monetary policy is ultimately founded on popular support. That is one reason why it is important for the Riksbank to operate in such a way that confidence is created in the policy of price stability. Among other things, this calls for a clear intellectual framework that can be evaluated and for an open discussion about the direction of monetary policy. Delegates accountable to a democratic body An argument that is heard from time to time in the monetary policy debate is that the delegation of monetary policy's construction to an independent central bank would be undemocratic. In my view that is incorrect. The Riksbank is an agency of the Riksdag (Sweden's parliament), which clearly can stipulate the objective which the Riksbank is to aim for. It is worth emphasising, however, that it would naturally be inappropriate for the Riksdag to set up objectives that the Riksbank is not in a position to fulfil, like that - as we saw earlier - of "creating jobs" on a permanent basis. When, but only when, the Riksbank's objective has been established, will it be possible to monitor operations effectively. It should be realised that the delegation of monetary policy to an independent central bank is a way of generating confidence that the declared policy of the Riksdag and the government will in fact be implemented. In the coming years the rule system for monetary policy will be changed. As an adherent to the Maastricht Treaty, Sweden has undertaken to make changes in, for example, the status of the Riksbank's governor. He or she shall not be dismissed except on explicit grounds of serious misconduct, etc. Neither is the Riksbank to be given instructions from third parties, e.g. government, except in a statutory form. It also looks as though the objective of the Riksbank is to be formulated in law and will be price stability. The question of eligibility to serve on the governing board will have to be reviewed. Active members of parliament are delegates in Sweden, which is entirely contrary to traditions in central Europe. The Riksbank differs from most central banks in Europe in that we are formally responsible for exchange rate policy. The Government sees this as a problem in EU cooperation and has therefore instituted an enquiry into exchange rate competence. In the light of what I have just said, these conclusions are not sound. The proposal to transfer responsibility for exchange rate policy from the Riksbank to the government makes it more difficult for the Riksbank to safeguard the value of money effectively and thereby contribute to a favourable level of interest rates and also - when this does not endanger price stability - to stimulate the economy and employment. In a world with free capital flows there is a direct link between monetary and exchange rate policies. The two policy fields may have conflicting goals. Moreover, if the government, via exchange rate decisions, can affect the ability of the Riksbank to fulfil the inflation target, there may be misunderstandings about where responsibility for the operation of monetary policy lies. In my opinion it may be reasonable - though this, too, is questioned by some economists - for the government to decide the type of exchange rate system Sweden is to have in relation to other EU countries, whether the krona should join the European exchange rate mechanism or remain flexible. There is a close connection here with the rules and regulations that apply in the rest of the EU and the matter is very much a political issue. But within a given exchange rate system, it is the Riksbank that should decide an appropriate rate for the krona or the band within which it may move. Such decisions can be made after an exchange of information with the government but in the final analysis it should be up to the Riksbank to determine whether or not they are compatible with price stability. With a flexible exchange rate, policy should operate, as today, with an inflation target, and the government should have no possibility of influencing the construction of exchange rate policy. Democratic control is important. But it should be exercised via the Riksbank's principal, the Riksdag, on whose behalf monetary policy is conducted. It should be noted that in exceptional situations, when the price stability objective may have to be suspended for the time being (e.g. a major oil price shock), both the government and the Riksbank may call on the Riksdag to amend the Riksbank's statutory objective. In that way the democratic control of monetary policy can be clearly ensured.	---[PAGE_BREAK]--- # Mr. Heikensten talks about monetary policy and the Swedish economy Speech by the Deputy Governor of the Bank of Sweden, Mr. Lars Heikensten, on the occasion of the 1997 Money and Capital Markets Day arranged by The Association of Local Authorities and the Federation of County Councils on 13/3/97. Today I shall be considering this field in terms of three topical issues: - First there is the path of inflation in recent years. In this context I shall dwell on the significance of transitory effects, not just for recent price tendencies but also more in principle. - Next comes the issue of employment. What can monetary policy do to help create new jobs in Sweden? - The third matter is the rule system for monetary policy. What is the point of delegating the management of monetary policy and the task of establishing low inflation to a central bank? In this connection I will also look at various proposals that are being discussed at present for amending the rules for the Riksbank. ## Inflation and monetary policy Price stability is the Riksbank's paramount objective, specified in the target of keeping the increase in the consumer price index to 2 per cent, with a tolerance interval of $\pm 1$ percentage point. There is a time lag of one to two years before a monetary policy measure has its full effect on inflation. Our discussion should therefore focus on future inflation. But first I want to say something about inflation in the past year. ## Inflation and the transitory effects The CPI is used by the Riksbank to target inflation mainly because it is familiar, published monthly with a short time lag and seldom has to be revised. However, using the CPI as a target variable is liable to face monetary policy with explanatory problems. The past year is a case in point. The low rate of inflation stemmed mainly from transitory effects; the consolidation of government finance and increased confidence in economic policy helped to strengthen the exchange rate. During 1996 it proved possible to lower the instrumental rates almost 5 percentage points. Altogether, in 1996 decreased interest costs and the stronger exchange rate had a downward effect on the CPI of around 1 percentage point. In some countries the inflation target is assessed in terms of the CPI with various components excluded, for example indirect taxes and subsidies or mortgage interest costs. It may then be asked whether the CPI is the most appropriate target variable and whether some measurement of underlying inflation might be preferable. An advantage of focusing on a single underlying indicator is that it might help the Riksbank in its contacts with the general public and make monetary policy more transparent. Analysis and debate would be concentrated on factors that monetary policy influences. ---[PAGE_BREAK]--- This, however, presupposes the existence of an underlying yardstick that can take every conceivable transitory effect into account. Such measurements are difficult to construct. Specifying all the circumstances that have to be considered so as to obtain the best picture of underlying inflation and doing this in advance is not a simple matter. Using underlying inflation also has the drawback that essential information about the inflation process may be overlooked. For example, changes in import prices are a part of the domestic inflation process because they affect price setting in trade. In the present state of our art, the drawbacks of changing to a measure of underlying inflation for the Riksbank's monetary policy are greater than the advantages. As I have indicated, however, the CPI may be markedly affected by transitory effects. It is therefore important to monitor measurements of underlying inflation that have been stable over time. The path of the underlying inflation process is an important factor in the Riksbank's monetary policy decisions. # Gradual recovery In growth terms, 1996 was weaker than 1994 and 1995. The slowdown mainly came from marked stock reductions and a contraction of public sector operations. But even the growth of final demand in the private sector tended to slacken in 1996. There are now clear signs of an economic recovery; the volume growth of exports remains high, along with indications that a stronger increase in private consumption is on the way. What, then, will be inflation's path in the years ahead? The Riksbank considers that at present the Swedish economy has unutilised resources and even if growth does pick up during 1997 and 1998, it is unlikely that these resources will be activated to such an extent that the inflation target is in danger. The scenario in the December inflation report involves a gradual increase in the rate of inflation in the coming years. The main explanation for this upward movement is that the transitory effects - from lower interest rates and a stronger exchange rate - which kept inflation down in 1996 will be fading. The registered rate of CPI inflation is then expected to approach inflation's underlying trend, which in the years ahead is judged to be more or less in line with the inflation target. ## Lower inflation propensity The new price and other economic information in recent months reinforces the impression that price pressure is low. To this extent, the conditions for fulfilling the inflation target have improved. On the other hand, a weaker exchange rate has already tended to stimulate activity. The outlook for inflation and the rapid progress in consolidating government finance suggest that there is room for a fall in long bond rates. Underlying economic factors indicate, moreover, that the recent depreciation has left the krona undervalued, so that it should appreciate. How should the exchange rate be assessed in connection with monetary policy decisions? According to experience in recent years, the impact of a depreciation on domestic prices is limited. But domestic demand has been weak. Provided there is stable confidence in the policy for price stability, price effects from a weakening of the exchange rate are generally ---[PAGE_BREAK]--- transitory. A depreciation is a problem for monetary policy only when it has a lasting expansionary effect or if inflation expectations rise. The economy's inflation propensity, which seems to have decreased in recent years, is an important factor to consider when assessing the threat from future inflation. The term inflation propensity stands here for the structure of the inflation process, which is liable to be changed by various factors. If stronger competition, for example, in certain segments of trade results in lower price increases than before when consumption is rising, then the economy has a lower inflation propensity. Examples of factors that may have helped to reduce the inflation propensity are the fall in market expectations of inflation and the higher acceptance of the Riksbank's inflation target. Another cause of a decreased inflation propensity can be lower inflation as such. Price comparisons are easier for households and firms when inflation is low. Price increases are more visible and producers have more difficulty in raising prices without a relative price shift. The situation in this respect is one of the main issues that the Riksbank will have to evaluate. We shall be returning to this later in the year. All in all, the picture that emerges of the Swedish economy suggests that the monetary stance is well balanced. Major changes have occurred in the past year, for instance in the repo rate. Time is needed to assess their effects. This also motivates a cautious line in monetary policy. # 2. Employment and what monetary policy can do The low inflation in the past few years has been accompanied by respectable growth. Since 1994 economic growth has averaged 2.7 per cent a year, which is higher than the normal rate in recent decades. Given the low capacity utilisation initially, the high growth as such is not remarkable. What is more surprising - and alarming - is that a recovery of employment seems to be considerably more sluggish than the upswing in total production. The problem of generating new jobs is by no means peculiar to Sweden but something we have in common with much of Europe. The situation in this respect contrasts markedly with the United States. There are also exceptions in Europe, one being the Netherlands in the past decade. This suggests that cures for the high unemployment exist, though naturally the solutions in other countries may not apply as a whole to Swedish conditions. The high unemployment in Sweden is now a subject of intensive discussion. Today I shall try to describe in principle what monetary policy is capable of doing and what it is not in a position to achieve. ## Restricted potential in the longer run In an analysis of monetary policy's potential for influencing employment it is natural to make a distinction between the short and the longer run. It is generally agreed that monetary policy can be used to affect production and employment in the short run. An important reason why monetary policy is capable, at least in principle, of influencing employment in this time perspective is the existence of rigidities in price and wage formation. Suppose, for example, that low wage settlements are concluded with a certain rate of inflation in mind. If monetary policy becomes more expansionary and inflation takes off, wage costs will be lower than expected in real terms. It will pay firms better to take on additional labour and employment will rise. In the short run, then, one can expect a trade-off between inflation (or the extent to which monetary policy is expansionary) and employment (or unemployment). ---[PAGE_BREAK]--- The existence of such a short-term trade-off does not mean, however, that it will serve to raise employment permanently. This is because when actual inflation changes, economic agents (firms, employees, etc.) normally adjust their expectations of future inflation. So in the next round of wage agreements, for example, employees may demand compensation for a higher expected rate of inflation. Changing expectations mean that the trade-off between inflation and unemployment ceases to be stable. This is intuitively intelligible. If the normal rate of inflation is, say, 5 per cent, it seems reasonable that employment will rise if inflation moves up to 10 per cent because this reduces wage costs in real terms. In the figure this amounts to moving from A to B. In time, however, 10 per cent inflation will be regarded as normal and wage demands will be based on this level. With higher nominal wage increases, real wage costs will move up again and unemployment will tend to return to its initial level. In the figure this means moving from B to C. In order to boost employment in this situation, inflation would have to rise to say 15 per cent and the procedure will be repeated. All that is ultimately achieved is higher average inflation. The level of unemployment to which an economy returns when inflation expectations have adjusted is usually referred to as equilibrium unemployment. It is determined by structural factors such as demographic changes, technology and the institutional set-up in the labour market, factors that are immune to monetary policy. The important conclusion to draw from this is that permanently low unemployment cannot be achieved by accepting permanently high inflation. Under favourable circumstances, to which I will shortly return, monetary policy can promote an economic recovery; but an appreciable improvement in the unemployment situation calls for measures in many other fields, above all in the workings of the labour market and wage formation. # What should monetary policy aim for? If a central bank is incapable of "creating jobs" on a permanent basis, what should be its primary task? By means of an appropriately balanced monetary policy a central bank can determine, or at least strongly influence, the rate of inflation that prevails in the economy and underlies economic decisions by firms and households. Price increases are, of course, conditioned by many other factors, such as the economic situation, the fiscal stance, wage formation and so on. But inflation is a monetary phenomenon and in the longer run the Riksbank, by controlling the supply of money in a wide sense, can also control its value in terms of inflation. The perception that the primary task of a central bank should be to maintain price stability can be said to have won general acceptance. In that low, stable inflation helps to improve the functioning of markets, it seems reasonable that, indirectly, monetary policy also promotes economic growth and employment. In their economic decisions, households and firms have one less source of uncertainty - inflation - to worry about. The inability of monetary policy to affect long-term employment and the fact that it should focus on maintaining price stability does not mean that its capacity to condition production and employment in the short run can not sometimes be used for stabilising activity. Monetary policy can contribute to an economic recovery in so far as this is feasible without jeopardising price stability. Problems may arise, however, if monetary policy is perceived as ---[PAGE_BREAK]--- # The Phillips curve ## Inflation ![img-0.jpeg](img-0.jpeg) ---[PAGE_BREAK]--- focusing primarily on the stabilisation of employment. As we have seen, people's expectations play a major part in the inflation process. If people expect monetary policy to concentrate in the first place on stabilising employment, then firms and employees will not regard unduly high wage increases as all that serious because they will count on measures being taken to stimulate demand if employment is in danger. Sweden in the 1970s and '80s is a good illustration of the problems that may arise. Wage and price increases in that period were systematically higher than in other countries, which led to recurrent cost crises and problems with competitiveness. An important reason for the lack of adjustment to wage increases in the rest of the world was that employees and firms reckoned that the government and the Riksbank would ultimately bail them out with devaluations, which is what actually happened. In this way inflation expectations were adjusted in advance to an anticipated pattern of economic policy reactions, whereby high price and wage increases were accepted or accommodated by devaluing the krona. As a result, strong inflationary mechanisms were built into the economy. As we have seen in recent years, once such mechanisms have been established, they are difficult to change. # 3. Monetary policy's rule system Experience has shown that more is needed than proud declarations from political decision-makers that they will safeguard a stable value of money and are not prepared to adapt policy to excessively high wage increases. We heard plenty of that in the 1980s. One way of enhancing credibility that has been found to work well and is supported by economic theory is for the democratically elected body to delegate monetary policy to a central bank with a clear, specified obligation to safeguard the value of money. The central bank is given full control over the instruments, principally the short interest rate, for fulfilling the stipulated objective. This arrangement limits both the room for short-run attempts to boost employment and the risk of inflationary mechanisms taking root in the economy. That also lessens the risk of a repetition of what happened in the early 1990s when the inflation bubble burst and unemployment rose. ## Credibility provides greater manouvrability It may be worth underscoring that a system where price stability is credibly delegated to the central bank can confer greater freedom of action in economic policy. This may seem paradoxical but if people feel they can rely on the central bank, in an economic slowdown it may be possible to ease the monetary stance without triggering higher inflation expectations and bond rates, because everyone counts on policy being tightened before inflation moves up. We have experienced something of this sort in Sweden in the past year. In a system with poor credibility, a monetary easing may be perceived as a sign of a lasting upward shift in inflation. This in turn may generate self-fulfilling expectations, with future problems when efforts are made to control inflation once more. It is understandable that the risk of this is seen as particularly great in economies where inflation has been high for a long time. A more independent central bank is thus in a better position not only to maintain low inflation but also to operate at times with a policy that includes an element of stabilisation (though the problems of fine tuning stabilisation policy should not be underestimated). The German central bank is one example; over a series of decades, economic slowdowns could be parried by lowering the short interest rate fairly rapidly and markedly. It may be in place to point out that credibility and, for that matter, independence can be achieved in various ways. Some countries have recently clarified their regulations so as to ---[PAGE_BREAK]--- bring them into line with the arrangement I have just advocated. One example is New Zealand. In other countries, for instance the United States, policy has been conducted so that it has gradually earned increasing confidence within the time-honoured system. In my opinion the rule system is important; it reflects the general commitment to monetary policy and can provide a short cut to credibility. In a democratic society, however, monetary policy is ultimately founded on popular support. That is one reason why it is important for the Riksbank to operate in such a way that confidence is created in the policy of price stability. Among other things, this calls for a clear intellectual framework that can be evaluated and for an open discussion about the direction of monetary policy. # Delegates accountable to a democratic body An argument that is heard from time to time in the monetary policy debate is that the delegation of monetary policy's construction to an independent central bank would be undemocratic. In my view that is incorrect. The Riksbank is an agency of the Riksdag (Sweden's parliament), which clearly can stipulate the objective which the Riksbank is to aim for. It is worth emphasising, however, that it would naturally be inappropriate for the Riksdag to set up objectives that the Riksbank is not in a position to fulfil, like that - as we saw earlier - of "creating jobs" on a permanent basis. When, but only when, the Riksbank's objective has been established, will it be possible to monitor operations effectively. It should be realised that the delegation of monetary policy to an independent central bank is a way of generating confidence that the declared policy of the Riksdag and the government will in fact be implemented. In the coming years the rule system for monetary policy will be changed. As an adherent to the Maastricht Treaty, Sweden has undertaken to make changes in, for example, the status of the Riksbank's governor. He or she shall not be dismissed except on explicit grounds of serious misconduct, etc. Neither is the Riksbank to be given instructions from third parties, e.g. government, except in a statutory form. It also looks as though the objective of the Riksbank is to be formulated in law and will be price stability. The question of eligibility to serve on the governing board will have to be reviewed. Active members of parliament are delegates in Sweden, which is entirely contrary to traditions in central Europe. The Riksbank differs from most central banks in Europe in that we are formally responsible for exchange rate policy. The Government sees this as a problem in EU cooperation and has therefore instituted an enquiry into exchange rate competence. In the light of what I have just said, these conclusions are not sound. The proposal to transfer responsibility for exchange rate policy from the Riksbank to the government makes it more difficult for the Riksbank to safeguard the value of money effectively and thereby contribute to a favourable level of interest rates and also - when this does not endanger price stability - to stimulate the economy and employment. In a world with free capital flows there is a direct link between monetary and exchange rate policies. The two policy fields may have conflicting goals. Moreover, if the government, via exchange rate decisions, can affect the ability of the Riksbank to fulfil the inflation target, there may be misunderstandings about where responsibility for the operation of monetary policy lies. In my opinion it may be reasonable - though this, too, is questioned by some economists - for the government to decide the type of exchange rate system Sweden is to have in relation to other EU countries, whether the krona should join the European exchange rate mechanism or remain flexible. There is a close connection here with the rules and regulations ---[PAGE_BREAK]--- that apply in the rest of the EU and the matter is very much a political issue. But within a given exchange rate system, it is the Riksbank that should decide an appropriate rate for the krona or the band within which it may move. Such decisions can be made after an exchange of information with the government but in the final analysis it should be up to the Riksbank to determine whether or not they are compatible with price stability. With a flexible exchange rate, policy should operate, as today, with an inflation target, and the government should have no possibility of influencing the construction of exchange rate policy. Democratic control is important. But it should be exercised via the Riksbank's principal, the Riksdag, on whose behalf monetary policy is conducted. It should be noted that in exceptional situations, when the price stability objective may have to be suspended for the time being (e.g. a major oil price shock), both the government and the Riksbank may call on the Riksdag to amend the Riksbank's statutory objective. In that way the democratic control of monetary policy can be clearly ensured.	Lars Heikensten	United States	https://www.bis.org/review/r970403c.pdf	Speech by the Deputy Governor of the Bank of Sweden, Mr. Lars Heikensten, on the occasion of the 1997 Money and Capital Markets Day arranged by The Association of Local Authorities and the Federation of County Councils on 13/3/97. Today I shall be considering this field in terms of three topical issues: First there is the path of inflation in recent years. In this context I shall dwell on the significance of transitory effects, not just for recent price tendencies but also more in principle. Next comes the issue of employment. What can monetary policy do to help create new jobs in Sweden. The third matter is the rule system for monetary policy. What is the point of delegating the management of monetary policy and the task of establishing low inflation to a central bank? In this connection I will also look at various proposals that are being discussed at present for amending the rules for the Riksbank. Price stability is the Riksbank's paramount objective, specified in the target of keeping the increase in the consumer price index to 2 per cent, with a tolerance interval of $\pm 1$ percentage point. There is a time lag of one to two years before a monetary policy measure has its full effect on inflation. Our discussion should therefore focus on future inflation. But first I want to say something about inflation in the past year. The CPI is used by the Riksbank to target inflation mainly because it is familiar, published monthly with a short time lag and seldom has to be revised. However, using the CPI as a target variable is liable to face monetary policy with explanatory problems. The past year is a case in point. The low rate of inflation stemmed mainly from transitory effects; the consolidation of government finance and increased confidence in economic policy helped to strengthen the exchange rate. During 1996 it proved possible to lower the instrumental rates almost 5 percentage points. Altogether, in 1996 decreased interest costs and the stronger exchange rate had a downward effect on the CPI of around 1 percentage point. In some countries the inflation target is assessed in terms of the CPI with various components excluded, for example indirect taxes and subsidies or mortgage interest costs. It may then be asked whether the CPI is the most appropriate target variable and whether some measurement of underlying inflation might be preferable. An advantage of focusing on a single underlying indicator is that it might help the Riksbank in its contacts with the general public and make monetary policy more transparent. Analysis and debate would be concentrated on factors that monetary policy influences. This, however, presupposes the existence of an underlying yardstick that can take every conceivable transitory effect into account. Such measurements are difficult to construct. Specifying all the circumstances that have to be considered so as to obtain the best picture of underlying inflation and doing this in advance is not a simple matter. Using underlying inflation also has the drawback that essential information about the inflation process may be overlooked. For example, changes in import prices are a part of the domestic inflation process because they affect price setting in trade. In the present state of our art, the drawbacks of changing to a measure of underlying inflation for the Riksbank's monetary policy are greater than the advantages. As I have indicated, however, the CPI may be markedly affected by transitory effects. It is therefore important to monitor measurements of underlying inflation that have been stable over time. The path of the underlying inflation process is an important factor in the Riksbank's monetary policy decisions. In growth terms, 1996 was weaker than 1994 and 1995. The slowdown mainly came from marked stock reductions and a contraction of public sector operations. But even the growth of final demand in the private sector tended to slacken in 1996. There are now clear signs of an economic recovery; the volume growth of exports remains high, along with indications that a stronger increase in private consumption is on the way. What, then, will be inflation's path in the years ahead? The Riksbank considers that at present the Swedish economy has unutilised resources and even if growth does pick up during 1997 and 1998, it is unlikely that these resources will be activated to such an extent that the inflation target is in danger. The scenario in the December inflation report involves a gradual increase in the rate of inflation in the coming years. The main explanation for this upward movement is that the transitory effects - from lower interest rates and a stronger exchange rate - which kept inflation down in 1996 will be fading. The registered rate of CPI inflation is then expected to approach inflation's underlying trend, which in the years ahead is judged to be more or less in line with the inflation target. The new price and other economic information in recent months reinforces the impression that price pressure is low. To this extent, the conditions for fulfilling the inflation target have improved. On the other hand, a weaker exchange rate has already tended to stimulate activity. The outlook for inflation and the rapid progress in consolidating government finance suggest that there is room for a fall in long bond rates. Underlying economic factors indicate, moreover, that the recent depreciation has left the krona undervalued, so that it should appreciate. How should the exchange rate be assessed in connection with monetary policy decisions? According to experience in recent years, the impact of a depreciation on domestic prices is limited. But domestic demand has been weak. Provided there is stable confidence in the policy for price stability, price effects from a weakening of the exchange rate are generally transitory. A depreciation is a problem for monetary policy only when it has a lasting expansionary effect or if inflation expectations rise. The economy's inflation propensity, which seems to have decreased in recent years, is an important factor to consider when assessing the threat from future inflation. The term inflation propensity stands here for the structure of the inflation process, which is liable to be changed by various factors. If stronger competition, for example, in certain segments of trade results in lower price increases than before when consumption is rising, then the economy has a lower inflation propensity. Examples of factors that may have helped to reduce the inflation propensity are the fall in market expectations of inflation and the higher acceptance of the Riksbank's inflation target. Another cause of a decreased inflation propensity can be lower inflation as such. Price comparisons are easier for households and firms when inflation is low. Price increases are more visible and producers have more difficulty in raising prices without a relative price shift. The situation in this respect is one of the main issues that the Riksbank will have to evaluate. We shall be returning to this later in the year. All in all, the picture that emerges of the Swedish economy suggests that the monetary stance is well balanced. Major changes have occurred in the past year, for instance in the repo rate. Time is needed to assess their effects. This also motivates a cautious line in monetary policy. The low inflation in the past few years has been accompanied by respectable growth. Since 1994 economic growth has averaged 2.7 per cent a year, which is higher than the normal rate in recent decades. Given the low capacity utilisation initially, the high growth as such is not remarkable. What is more surprising - and alarming - is that a recovery of employment seems to be considerably more sluggish than the upswing in total production. The problem of generating new jobs is by no means peculiar to Sweden but something we have in common with much of Europe. The situation in this respect contrasts markedly with the United States. There are also exceptions in Europe, one being the Netherlands in the past decade. This suggests that cures for the high unemployment exist, though naturally the solutions in other countries may not apply as a whole to Swedish conditions. The high unemployment in Sweden is now a subject of intensive discussion. Today I shall try to describe in principle what monetary policy is capable of doing and what it is not in a position to achieve. In an analysis of monetary policy's potential for influencing employment it is natural to make a distinction between the short and the longer run. It is generally agreed that monetary policy can be used to affect production and employment in the short run. An important reason why monetary policy is capable, at least in principle, of influencing employment in this time perspective is the existence of rigidities in price and wage formation. Suppose, for example, that low wage settlements are concluded with a certain rate of inflation in mind. If monetary policy becomes more expansionary and inflation takes off, wage costs will be lower than expected in real terms. It will pay firms better to take on additional labour and employment will rise. In the short run, then, one can expect a trade-off between inflation (or the extent to which monetary policy is expansionary) and employment (or unemployment). The existence of such a short-term trade-off does not mean, however, that it will serve to raise employment permanently. This is because when actual inflation changes, economic agents (firms, employees, etc.) normally adjust their expectations of future inflation. So in the next round of wage agreements, for example, employees may demand compensation for a higher expected rate of inflation. Changing expectations mean that the trade-off between inflation and unemployment ceases to be stable. This is intuitively intelligible. If the normal rate of inflation is, say, 5 per cent, it seems reasonable that employment will rise if inflation moves up to 10 per cent because this reduces wage costs in real terms. In the figure this amounts to moving from A to B. In time, however, 10 per cent inflation will be regarded as normal and wage demands will be based on this level. With higher nominal wage increases, real wage costs will move up again and unemployment will tend to return to its initial level. In the figure this means moving from B to C. In order to boost employment in this situation, inflation would have to rise to say 15 per cent and the procedure will be repeated. All that is ultimately achieved is higher average inflation. The level of unemployment to which an economy returns when inflation expectations have adjusted is usually referred to as equilibrium unemployment. It is determined by structural factors such as demographic changes, technology and the institutional set-up in the labour market, factors that are immune to monetary policy. The important conclusion to draw from this is that permanently low unemployment cannot be achieved by accepting permanently high inflation. Under favourable circumstances, to which I will shortly return, monetary policy can promote an economic recovery; but an appreciable improvement in the unemployment situation calls for measures in many other fields, above all in the workings of the labour market and wage formation. If a central bank is incapable of "creating jobs" on a permanent basis, what should be its primary task? By means of an appropriately balanced monetary policy a central bank can determine, or at least strongly influence, the rate of inflation that prevails in the economy and underlies economic decisions by firms and households. Price increases are, of course, conditioned by many other factors, such as the economic situation, the fiscal stance, wage formation and so on. But inflation is a monetary phenomenon and in the longer run the Riksbank, by controlling the supply of money in a wide sense, can also control its value in terms of inflation. The perception that the primary task of a central bank should be to maintain price stability can be said to have won general acceptance. In that low, stable inflation helps to improve the functioning of markets, it seems reasonable that, indirectly, monetary policy also promotes economic growth and employment. In their economic decisions, households and firms have one less source of uncertainty - inflation - to worry about. focusing primarily on the stabilisation of employment. As we have seen, people's expectations play a major part in the inflation process. If people expect monetary policy to concentrate in the first place on stabilising employment, then firms and employees will not regard unduly high wage increases as all that serious because they will count on measures being taken to stimulate demand if employment is in danger. Sweden in the 1970s and '80s is a good illustration of the problems that may arise. Wage and price increases in that period were systematically higher than in other countries, which led to recurrent cost crises and problems with competitiveness. An important reason for the lack of adjustment to wage increases in the rest of the world was that employees and firms reckoned that the government and the Riksbank would ultimately bail them out with devaluations, which is what actually happened. In this way inflation expectations were adjusted in advance to an anticipated pattern of economic policy reactions, whereby high price and wage increases were accepted or accommodated by devaluing the krona. As a result, strong inflationary mechanisms were built into the economy. As we have seen in recent years, once such mechanisms have been established, they are difficult to change. Experience has shown that more is needed than proud declarations from political decision-makers that they will safeguard a stable value of money and are not prepared to adapt policy to excessively high wage increases. We heard plenty of that in the 1980s. One way of enhancing credibility that has been found to work well and is supported by economic theory is for the democratically elected body to delegate monetary policy to a central bank with a clear, specified obligation to safeguard the value of money. The central bank is given full control over the instruments, principally the short interest rate, for fulfilling the stipulated objective. This arrangement limits both the room for short-run attempts to boost employment and the risk of inflationary mechanisms taking root in the economy. That also lessens the risk of a repetition of what happened in the early 1990s when the inflation bubble burst and unemployment rose. It may be worth underscoring that a system where price stability is credibly delegated to the central bank can confer greater freedom of action in economic policy. This may seem paradoxical but if people feel they can rely on the central bank, in an economic slowdown it may be possible to ease the monetary stance without triggering higher inflation expectations and bond rates, because everyone counts on policy being tightened before inflation moves up. We have experienced something of this sort in Sweden in the past year. In a system with poor credibility, a monetary easing may be perceived as a sign of a lasting upward shift in inflation. This in turn may generate self-fulfilling expectations, with future problems when efforts are made to control inflation once more. It is understandable that the risk of this is seen as particularly great in economies where inflation has been high for a long time. A more independent central bank is thus in a better position not only to maintain low inflation but also to operate at times with a policy that includes an element of stabilisation (though the problems of fine tuning stabilisation policy should not be underestimated). The German central bank is one example; over a series of decades, economic slowdowns could be parried by lowering the short interest rate fairly rapidly and markedly. It may be in place to point out that credibility and, for that matter, independence can be achieved in various ways. Some countries have recently clarified their regulations so as to bring them into line with the arrangement I have just advocated. One example is New Zealand. In other countries, for instance the United States, policy has been conducted so that it has gradually earned increasing confidence within the time-honoured system. In my opinion the rule system is important; it reflects the general commitment to monetary policy and can provide a short cut to credibility. In a democratic society, however, monetary policy is ultimately founded on popular support. That is one reason why it is important for the Riksbank to operate in such a way that confidence is created in the policy of price stability. Among other things, this calls for a clear intellectual framework that can be evaluated and for an open discussion about the direction of monetary policy. An argument that is heard from time to time in the monetary policy debate is that the delegation of monetary policy's construction to an independent central bank would be undemocratic. In my view that is incorrect. The Riksbank is an agency of the Riksdag (Sweden's parliament), which clearly can stipulate the objective which the Riksbank is to aim for. It is worth emphasising, however, that it would naturally be inappropriate for the Riksdag to set up objectives that the Riksbank is not in a position to fulfil, like that - as we saw earlier - of "creating jobs" on a permanent basis. When, but only when, the Riksbank's objective has been established, will it be possible to monitor operations effectively. It should be realised that the delegation of monetary policy to an independent central bank is a way of generating confidence that the declared policy of the Riksdag and the government will in fact be implemented. In the coming years the rule system for monetary policy will be changed. As an adherent to the Maastricht Treaty, Sweden has undertaken to make changes in, for example, the status of the Riksbank's governor. He or she shall not be dismissed except on explicit grounds of serious misconduct, etc. Neither is the Riksbank to be given instructions from third parties, e.g. government, except in a statutory form. It also looks as though the objective of the Riksbank is to be formulated in law and will be price stability. The question of eligibility to serve on the governing board will have to be reviewed. Active members of parliament are delegates in Sweden, which is entirely contrary to traditions in central Europe. The Riksbank differs from most central banks in Europe in that we are formally responsible for exchange rate policy. The Government sees this as a problem in EU cooperation and has therefore instituted an enquiry into exchange rate competence. In the light of what I have just said, these conclusions are not sound. The proposal to transfer responsibility for exchange rate policy from the Riksbank to the government makes it more difficult for the Riksbank to safeguard the value of money effectively and thereby contribute to a favourable level of interest rates and also - when this does not endanger price stability - to stimulate the economy and employment. In a world with free capital flows there is a direct link between monetary and exchange rate policies. The two policy fields may have conflicting goals. Moreover, if the government, via exchange rate decisions, can affect the ability of the Riksbank to fulfil the inflation target, there may be misunderstandings about where responsibility for the operation of monetary policy lies. In my opinion it may be reasonable - though this, too, is questioned by some economists - for the government to decide the type of exchange rate system Sweden is to have in relation to other EU countries, whether the krona should join the European exchange rate mechanism or remain flexible. There is a close connection here with the rules and regulations that apply in the rest of the EU and the matter is very much a political issue. But within a given exchange rate system, it is the Riksbank that should decide an appropriate rate for the krona or the band within which it may move. Such decisions can be made after an exchange of information with the government but in the final analysis it should be up to the Riksbank to determine whether or not they are compatible with price stability. With a flexible exchange rate, policy should operate, as today, with an inflation target, and the government should have no possibility of influencing the construction of exchange rate policy. Democratic control is important. But it should be exercised via the Riksbank's principal, the Riksdag, on whose behalf monetary policy is conducted. It should be noted that in exceptional situations, when the price stability objective may have to be suspended for the time being (e.g. a major oil price shock), both the government and the Riksbank may call on the Riksdag to amend the Riksbank's statutory objective. In that way the democratic control of monetary policy can be clearly ensured.
1997-03-19T00:00:00	Mr. Greenspan presents the views of the Federal Reserve Board on the supervision of US banks if they are authorized to widen their activities (Central Bank Articles and Speeches, 19 Mar 97)	Testimony of Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Subcommittee on Capital Markets, Securities and Government-Sponsored Enterprises of the Committee on Banking and Financial Services of the US House of Representatives on 19/3/97.	Mr. Greenspan presents the views of the Federal Reserve Board on the supervision of US banks if they are authorized to widen their activities Testimony of Chairman of th Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Subcommittee on Capital Markets, Securities and Government-Sponsored Enterprises of the Committee on Banking and Financial Services of the US House of Representatives on 19/3/97. Mr. Chairman, members of the Subcommittee, thank you for inviting me to present the views of the Federal Reserve Board on the supervision of our nation's banking organizations should they be authorized by the Congress to engage in a wider range of activities. As you know, the Board has supported financial modernization for many years and hopes that the Congress will act to facilitate reforms that, by enhancing competition within the financial services industry, would benefit the consumers of financial products in the United States. Financial modernization may well mean that future banking organizations will be sufficiently different from today as to require perhaps substantial changes in the supervisory process for the entire organization. Just how much modification may be needed will depend on the kinds of reforms the Congress adopts. In evaluating those modifications, I would like to underline the significant supervisory role required by the Federal Reserve to carry out its central bank responsibilities. I also would like briefly to discuss the continued importance of umbrella supervision and the implications of a wider role for bank subsidiaries in the modernization process. Supervision and Central Banking There are compelling reasons why the central bank of the United States -- the Federal Reserve -- should continue to be involved in the supervision of banks. The supervisory activities of the Federal Reserve, for example, have benefited from its economic stabilization responsibilities and its recognition that safety and soundness goals for banks must be evaluated jointly with its responsibilities for the stability and growth of the economy. The Board believes that these joint responsibilities make for better supervisory and monetary policies than would result from either a supervisor divorced from economic responsibilities or a macroeconomic policymaker with no practical experience in the review of individual bank operations. To carry out its responsibilities, the Federal Reserve has been required to develop extensive, detailed knowledge of the intricacies of the U.S., and indeed the world, financial system. That expertise is the result of dealing constantly over many decades with changing financial markets and institutions and their relationships with each other and with the economy, and from exercising supervisory responsibilities. It comes as well from ongoing interactions with central banks and financial institutions abroad. These international contacts are critical because today crises can spread more rapidly than in earlier times -- in large part reflecting new technologies -- and require a coordinated international response. Crisis Management and Systemic Risk Second only to its macrostability responsibilities is the central bank's responsibility to use its authority and expertise to forestall financial crises (including systemic disturbances in the banking system) and to manage such crises once they occur. In a crisis, the Federal Reserve, to be sure, could always flood the market with liquidity through open market operations and discount window loans; at times it has stood ready to do so, and it does not need supervisory and regulatory responsibilities to exercise that power. But while sometimes necessary in times of crises, such an approach may be costly and distortive to economic incentives and long-term growth, as well as an insufficient remedy. Supervisory and regulatory responsibilities give the Federal Reserve both the insight and the authority to use techniques that are less blunt and more precisely calibrated to the problem at hand. Such tools improve our ability to manage crises and, more importantly, to avoid them. The use of such techniques requires both the authority that comes with supervision and regulation and the understanding of the linkages among supervision and regulation, prudential standards, risk taking, relationships among banks and other financial market participants, and macroeconomic stability. Our financial system -- market oriented and characterized by innovation and rapid change -- imparts significant benefits to our economy. But one of the consequences of such a dynamic system is that it is subject to episodes of stress. In the 1980s and early 1990s we faced a series of international debt crises, a major stock market crash, the collapse of the most important player in the junk bond market, the virtual failure of the S&L industry, and extensive losses at many banking institutions. More recently, we faced another Mexican crisis and, while in the event less disruptive, the failure of a large British merchant bank. In such situations the Federal Reserve stands ready to provide liquidity, if necessary, and monitors continuously the condition of depository institutions to contain the secondary consequences of any problem. The objectives of the central bank in crisis management are to contain financial losses and prevent a contagious loss of confidence so that difficulties at one institution do not spread more widely to others. The focus of its concern is not to avoid the failure of entities that have made poor decisions or have had bad luck, but rather to see that such failures -- or threats of failures -- do not have broad and serious impacts on financial markets and the national, and indeed the global, economy. The Federal Reserve's ability to respond expeditiously to any particular incident does not necessitate comprehensive information on each banking institution. But it does require that the Federal Reserve have in-depth knowledge of how institutions of various sizes and other characteristics are likely to behave, and what resources are available to them in the event of severe financial stress. Even for those events that might, but do not, precipitate financial crises, the authorities turn first to the Federal Reserve, not only because, as former Chairman Volcker noted last month, we have the money, but also because we have the expertise and the experience. We currently gain the necessary insight by having a broad sample of banks subject to our supervision and through our authority over bank holding companies. Payment and Settlement Systems Virtually all of the U.S. dollar transactions made worldwide -- for securities transfers, foreign exchange and other international capital flows, and for payment for goods and services -- are settled in the United States banking system. A small number of transactions that comprise the vast proportion of the total value of transactions are transferred over large-dollar payment systems. Banks use two of these systems -- Fedwire, operated by the Federal Reserve, and CHIPS, operated by the New York Clearing House -- currently to transfer $1.6 trillion and $1.3 trillion a day, respectively. CHIPS settles its members' net positions on Fedwire. These interbank transfers, for banks' own accounts and for those of their customers, occur and are settled over a network and structure that is the backbone of the U.S. financial system. Indeed, it is arguably the linchpin of the international system of payments that relies on the dollar as the major international currency for trade and finance. Disruptions and disturbances in the U.S. payment system thus can easily have global implications. Fedwire, CHIPS, and the specialized depositories and clearinghouses for securities and other financial instruments, are crucial to the integrity and stability not only of our financial markets and economy, but those of the world. Similarly, adverse developments in transfers in London, Tokyo, Singapore, and a host of other centers could rapidly be transferred here, given the financial interrelationships among the individual trading nations. In all these payment and settlement systems, commercial banks play a central role, both as participants and providers of credit to nonbank participants. Day-in and day-out, the settlement of payment obligations and securities trades requires significant amounts of bank credit. In periods of stress, such credit demands surge just at the time when some banks are least willing or able to meet them. These demands, if unmet, could produce gridlock in payment and settlement systems, halting activity in financial markets. Indeed, it is in the cauldron of the payments and settlement systems, where decisions involving large sums must be made quickly, that all of the risks and uncertainties associated with problems at a single participant become focussed as participants seek to protect themselves from uncertainty. Better solvent than sorry, they might well decide, and refuse to honor a payment request. Observing that, others might follow suit. And that is how crises often begin. Limiting, if not avoiding, such disruptions and ensuring the continued operation of the payment system requires broad and indepth knowledge of banking and markets, as well as detailed knowledge and authority with respect to the payment and settlement arrangements and their linkages to banking operations. This type of understanding and authority -- as well as knowledge about the behavior of key participants -- cannot be created on an ad hoc basis. It requires broad and sustained involvement in both the payment infrastructure and the operation of the banking system. Supervisory authority over the major bank participants is a necessary element. Monetary Policy While financial crises and payment systems disruptions arise only sporadically, the Federal Reserve conducts monetary policy on an ongoing basis. In this area, too, the Federal Reserve's role in supervision and regulation provides an important perspective to the policy process. Monetary policy works through financial institutions and markets to affect the economy, and depository institutions are a key element in those markets. Indeed, banks and thrifts are more important in this regard than might be suggested by a simple arithmetic calculation of their share of total credit flows. While diverse securities markets handle the lion's share of credit flows these days, banks are the backup source of liquidity to many of the securities firms and large borrowers participating in these markets. Moreover, banks at all times are the most important source of credit to most small and intermediate-sized firms that do not have ready access to securities markets. These firms are the catalyst for U.S. economic growth and the prime source of new employment opportunities for our citizens. The Federal Reserve must make its monetary policy with a view to how banks are responding to the economic environment. This was especially important during the "credit crunch" of 1990. Our supervisory responsibilities give us important qualitative and quantitative information that not only helps us in the design of monetary policy, but provides important feedback on how our policy stance is affecting bank actions. The macroeconomic stabilization responsibilities of the Federal Reserve make us particularly sensitive to how regulatory and supervisory postures can influence bank behavior and hence how banks respond to monetary policy actions. For example, capital, liquidity, loan loss reserve, and asset quality evaluation policies of supervisors will directly influence the manner and speed with which monetary policy actions work. In the development of interagency rules and policies, the Federal Reserve brings to the table its unique concerns about the impact of these rules on credit availability, potential responses to changes in interest rates, and the consequences for the economy. We believe that, as a result, supervisory policy is improved. Federal Reserve's Supervisory Role For all of these reasons, the Board believes the Federal Reserve needs to retain a significant supervisory role in the banking system. Just exactly how that is achieved depends critically on the types of reforms the Congress enacts and the direction the banking industry takes in structuring and conducting its activities. In the Board's view, its current authority is adequate for the current structure. For today's financial system, we are able to meet our obligations by the intelligence we gain from, and the authorities we have over the modest number of large banks we directly supervise and the holding companies of these and other large banks over which we have a direct umbrella supervisory role. Our information is importantly supplemented by our supervision of a number of other banks of all sizes, namely state member banks. Currently, the latter group gives us a good representative sample of organizations of all sizes outside the largest entities. The large entities are essential if we are to address the Federal Reserve's crisis management and systemic risk responsibilities, deal with international financial issues involving foreign central banks, manage risk exposures in payment systems, and retain our practical knowledge and skill base in rapidly changing financial markets. Large bank holding companies are typically at the forefront in financial innovation and in developing sophisticated techniques for managing risks. It is crucial that the Federal Reserve stay informed of these events and understand directly how they work in practice. Directly supervising both these large organizations and a sample of others is also critical to our ability to conduct monetary policy by permitting us to gain first-hand on-the-spot intelligence on how changes in financial markets -including those induced by monetary policy -- are affecting money and credit flows. If in the future the holding company becomes a less clear window into the banking system, the Board believes that the Congress would need to change the supervisory structure if the central bank is to carry out the responsibilities I have discussed today. Umbrella Supervision The Congress, in its review of financial modernization, must consider legal entity supervision alone versus legal entity supervision supplemented by umbrella supervision. The Board believes that umbrella supervision is a realistic necessity for the protection of our financial system and to limit any misuse of the sovereign credit, that is, the government's guarantees that support the banking system through the safety net. The bank holding company organization increasingly is being managed so as to take advantage of the synergies between its component parts in order to deliver better products to the market and higher returns to stockholders. Such synergies cannot occur if the model of the holding company is one in which the parent is just, in effect, a portfolio investor in its subsidiary. Indeed, virtually all of the large holding companies now operate as integrated units and are managed as such, especially in their management of risk. One could argue that regulators should be interested only in the entities they regulate and, hence, review the risk evaluation process only as it relates to their regulated entity. Presumably each regulator of each entity -- the bank regulators, the SEC, the state insurance and any state finance company authorities -- would look only at how the risk management process affected their units. It is our belief that this simply will not be adequate. Risks managed on a consolidated basis cannot be reviewed on an individual legal entity basis by different supervisors. The latter logic motivated the congressional decision just five years ago to require that foreign banks could enter the United States if, and only if, they were subject to consolidated supervision. This decision, which is consistent with the international standards for consolidated supervision of banking organizations, was a good decision then. It is a good decision today, especially for those banking organizations whose disruption could cause major financial disturbances in United States and foreign markets. For foreign and for U.S. banking organizations, retreat from consolidated supervision would, the Board believes, be a significant step backward. We have to be careful, however, that consolidated umbrella supervision does not inadvertently so hamper the decisionmaking process of banking organizations as to render them ineffectual. The Federal Reserve Board is accordingly in the process of reviewing its supervisory structure and other procedures in order to reflect a market-directed shift from conventional balance sheet auditing to evaluation of the internal risk management process. Although focussed on the key risk management processes, it would sharply reduce routine supervisory umbrella presence in holding companies. As the Committee knows, the Board has recently published for comment proposals to expedite the applications process, and the legislation Congress enacted last year eased such procedures as well. Nonetheless, the Board requests even greater modification to its existing statutory mandate so that the required applications process could be sharply cut back, particularly in the area of nonbank financial services. In the Board's view, those entities interested in banks are really interested in access to the safety net, since it is far easier to engage in the nonsafety net activities of banks without acquiring a bank. If an organization chooses to deliver some of its services with the aid of the sovereign credit by acquiring a bank, it should not be excused from efforts of the government to look out for the stability of the overall financial system. For bank holding companies, this implies umbrella supervision. Although that process will increasingly be designed to reduce supervisory presence and be as nonintrusive as possible, umbrella supervision should not be eliminated, but recognized for what it is: the cost of obtaining a subsidy. Nonetheless, we would hope that should the Congress authorize wider activities for financial services holding companies that it recognize that a bank which is a minor part of such an organization (and its associated safety net) can be protected through adequate bank capital requirements and the application of Sections 23A and 23B of the Federal Reserve Act. The case is weak, in our judgment, for umbrella supervision of a holding company in which the bank is not the dominant unit and is not large enough to induce systemic problems should it fail. Subsidiaries, Subsidies, and Safety Nets The members of this Subcommittee are, I think, aware of the Board's concerns that the safety net constructed for banks inherently contains a subsidy, that conducting new activities in subsidiaries of banks will inadvertently extend that subsidy, and that extension of any subsidy is undesirable. The Subcommittee recently heard testimony that there is no net subsidy and, therefore, the authorization of nonbank activities in bank subsidiaries would neither inadvertently extend this undesirable side effect of the safety net nor reduce the importance of the holding company as a consequence of the increased incentives to shift activities from the holding company to the bank. Mr. Chairman, I would like briefly to comment on these latter views. Subsidy values -- net or gross -- vary from bank to bank; riskier banks clearly get a larger subsidy from the safety net than safer banks. In addition, the value of the subsidy varies over time; in good times, markets incorporate a low risk premium and when markets turn weak, financial asset holders demand to be compensated by higher yields for holding claims on riskier entities. It is at this time that subsidy values are the most noticeable. What was it worth in the late 1980s and early 1990s for a bank with a troubled loan portfolio to have deposit liabilities guaranteed by the FDIC, to be assured that it could turn illiquid to liquid assets at once through the Federal Reserve discount window, and to tell its customers that payment transfers would be settled on a riskless Federal Reserve Bank? For many, it was worth not basis points but percentage points. For some, it meant the difference between survival and failure. It is argued by some that the cost of regulation exceeds the subsidy. I have no doubt that the costs of regulation are large, too large in my judgment. But no bank has turned in its charter in order to operate without the cost of banking regulation, which would require that it operate also without deposit insurance or access to the discount window or payments system. To do so would require both higher deposit costs and higher capital. Indeed, it is a measure of the size of banks' net subsidy that most nonbank financial institutions are required by the market to operate with significantly higher capital-to-asset ratios than banks. Most finance companies, for example, with credit ratings and debenture interest costs equal to banks are forced by today's market to hold six or seven percentage points higher capital-to-asset ratios than those of banks. It is instructive that there are no private deposit insurers competing with the FDIC. For the same product offered by the FDIC, private insurers would have to charge premiums far higher than those of government insurance, and still not be able to match the certainty of payments in the event of default, the hallmark of a government insurer backed by the sovereign credit of the United States. The Federal Reserve has a similar status with respect to the availability of the discount window and riskless final settlement during a period of national economic stress. Providing such services is out of the reach of all private institutions. The markets place substantial values on these safety net subsidies, clearly in excess of the cost of regulation. To repeat, were it otherwise, some banks would be dropping their charters if there were not a net subsidy. In fact it is apparently the lower funding costs at banks that benefit directly from the subsidy of the safety net that has created the tendency for banking organizations to return to the bank and its subsidiaries many activities that are authorized to banks. These activities previously had been conducted in nonbank affiliates for reasons such as geographic and other inflexibilities, which have gradually eased. Indeed, over the last decade the share of consolidated assets of bank holding companies associated with nonbank affiliates -- other than Section 20 securities affiliates -- has declined almost half to just 5.2 percent. This tendency reflects the fact that asset growth that earlier had been associated with nonbank affiliates of bank holding companies -- consumer and commercial finance, leasing, and mortgage banking -- has most recently occurred largely in the bank or in a subsidiary of the bank. To be sure, as Chairman Helfer indicated to the Subcommittee earlier this month, many banking organizations still retain nonbank subsidiaries. Our discussions with bank holding companies, however, suggest that in some cases, these affiliates were acquired in the past and have established names and an interstate network whose value would be reduced if subsumed within a bank. There are also often adverse tax implications for the shift. And, finally, some of these activities may not be asset intensive and hence may not benefit significantly from bank funding. Clearly, the authorization of new activities in bank subsidiaries that are not now permitted either to banks or their affiliates would tend to accelerate the trend to reduce holding company activity, even if these activities were also permitted to holding company subsidiaries. The subsidy inherent in the safety net would assure that result, extending the spread of the safety net and requiring that the Federal Reserve's authority and ability to meet its responsibilities be shifted to a different paradigm. Such a result is reason enough for our concern about the spreading of the safety net subsidy. But we should also be concerned because of the distortions subsidies bring to the financial system more generally. After all, the broad premise underlying financial modernization -- with its removal of legislative and regulatory restrictions -- is that free and often intense competition will create the most efficient and customer-oriented business system. This principle has proved itself, generation by generation, with ever higher standards of living. In financial, as well as most other, markets the principle is rooted in another premise -- that the interaction of private competitive forces will, with rare exceptions, create a stable error self-correcting system. This premise is very seriously called into question if government subsidies are supplied at key balancing points. By their nature, subsidies distort the establishment of competitive market prices, and create incentives that misalign private risks with private gains. Such distortions undermine the error self-correcting mechanisms that support strong financial markets. We must be very careful that in the name of free market efficiency we do not countenance greater powers and profits subsidized directly or indirectly by government. Conclusion Mr. Chairman, in conclusion, the Board believes that as the Congress moves toward financial modernization the newly created structure of financial organizations should limit, in so far as possible, the real and perceived transfer of the subsidy inherent in the safety net to nonbank activities. To maintain a level playing field for all competitors, nonbank activities must be financed at market, not subsidized, rates. The Board also believes that financial modernization should not undermine the ability and authority of the central bank of the United States to manage crises, assure an efficient and safe payment system, and conduct monetary policy. We believe all of these require that the Federal Reserve retain a significant and important role as a bank supervisor. In today's structure, we have adequate authority and coverage to meet our responsibilities. But should erosion occur, as would likely be the case if new activities are authorized in bank subsidiaries, the Congress would have to consider what changes would be required in the Board's supervisory authority to assure that it continues to be able to meet its central bank responsibilities.	---[PAGE_BREAK]--- Mr. Greenspan presents the views of the Federal Reserve Board on the supervision of US banks if they are authorized to widen their activities Testimony of Chairman of th Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Subcommittee on Capital Markets, Securities and Government-Sponsored Enterprises of the Committee on Banking and Financial Services of the US House of Representatives on 19/3/97. Mr. Chairman, members of the Subcommittee, thank you for inviting me to present the views of the Federal Reserve Board on the supervision of our nation's banking organizations should they be authorized by the Congress to engage in a wider range of activities. As you know, the Board has supported financial modernization for many years and hopes that the Congress will act to facilitate reforms that, by enhancing competition within the financial services industry, would benefit the consumers of financial products in the United States. Financial modernization may well mean that future banking organizations will be sufficiently different from today as to require perhaps substantial changes in the supervisory process for the entire organization. Just how much modification may be needed will depend on the kinds of reforms the Congress adopts. In evaluating those modifications, I would like to underline the significant supervisory role required by the Federal Reserve to carry out its central bank responsibilities. I also would like briefly to discuss the continued importance of umbrella supervision and the implications of a wider role for bank subsidiaries in the modernization process. # Supervision and Central Banking There are compelling reasons why the central bank of the United States -- the Federal Reserve -- should continue to be involved in the supervision of banks. The supervisory activities of the Federal Reserve, for example, have benefited from its economic stabilization responsibilities and its recognition that safety and soundness goals for banks must be evaluated jointly with its responsibilities for the stability and growth of the economy. The Board believes that these joint responsibilities make for better supervisory and monetary policies than would result from either a supervisor divorced from economic responsibilities or a macroeconomic policymaker with no practical experience in the review of individual bank operations. To carry out its responsibilities, the Federal Reserve has been required to develop extensive, detailed knowledge of the intricacies of the U.S., and indeed the world, financial system. That expertise is the result of dealing constantly over many decades with changing financial markets and institutions and their relationships with each other and with the economy, and from exercising supervisory responsibilities. It comes as well from ongoing interactions with central banks and financial institutions abroad. These international contacts are critical because today crises can spread more rapidly than in earlier times -- in large part reflecting new technologies -- and require a coordinated international response. ## Crisis Management and Systemic Risk Second only to its macrostability responsibilities is the central bank's responsibility to use its authority and expertise to forestall financial crises (including systemic disturbances in the banking system) and to manage such crises once they occur. In a crisis, the Federal Reserve, to be sure, could always flood the market with liquidity through open market operations and discount window loans; at times it has stood ready to do so, and it does not need supervisory and regulatory responsibilities to exercise that power. But while sometimes ---[PAGE_BREAK]--- necessary in times of crises, such an approach may be costly and distortive to economic incentives and long-term growth, as well as an insufficient remedy. Supervisory and regulatory responsibilities give the Federal Reserve both the insight and the authority to use techniques that are less blunt and more precisely calibrated to the problem at hand. Such tools improve our ability to manage crises and, more importantly, to avoid them. The use of such techniques requires both the authority that comes with supervision and regulation and the understanding of the linkages among supervision and regulation, prudential standards, risk taking, relationships among banks and other financial market participants, and macroeconomic stability. Our financial system -- market oriented and characterized by innovation and rapid change -- imparts significant benefits to our economy. But one of the consequences of such a dynamic system is that it is subject to episodes of stress. In the 1980s and early 1990s we faced a series of international debt crises, a major stock market crash, the collapse of the most important player in the junk bond market, the virtual failure of the S\&L industry, and extensive losses at many banking institutions. More recently, we faced another Mexican crisis and, while in the event less disruptive, the failure of a large British merchant bank. In such situations the Federal Reserve stands ready to provide liquidity, if necessary, and monitors continuously the condition of depository institutions to contain the secondary consequences of any problem. The objectives of the central bank in crisis management are to contain financial losses and prevent a contagious loss of confidence so that difficulties at one institution do not spread more widely to others. The focus of its concern is not to avoid the failure of entities that have made poor decisions or have had bad luck, but rather to see that such failures -- or threats of failures -- do not have broad and serious impacts on financial markets and the national, and indeed the global, economy. The Federal Reserve's ability to respond expeditiously to any particular incident does not necessitate comprehensive information on each banking institution. But it does require that the Federal Reserve have in-depth knowledge of how institutions of various sizes and other characteristics are likely to behave, and what resources are available to them in the event of severe financial stress. Even for those events that might, but do not, precipitate financial crises, the authorities turn first to the Federal Reserve, not only because, as former Chairman Volcker noted last month, we have the money, but also because we have the expertise and the experience. We currently gain the necessary insight by having a broad sample of banks subject to our supervision and through our authority over bank holding companies. # Payment and Settlement Systems Virtually all of the U.S. dollar transactions made worldwide -- for securities transfers, foreign exchange and other international capital flows, and for payment for goods and services -- are settled in the United States banking system. A small number of transactions that comprise the vast proportion of the total value of transactions are transferred over large-dollar payment systems. Banks use two of these systems -- Fedwire, operated by the Federal Reserve, and CHIPS, operated by the New York Clearing House -- currently to transfer $\$ 1.6$ trillion and $\$ 1.3$ trillion a day, respectively. CHIPS settles its members' net positions on Fedwire. These interbank transfers, for banks' own accounts and for those of their customers, occur and are settled over a network and structure that is the backbone of the U.S. financial system. Indeed, it is arguably the linchpin of the international system of payments that relies on the dollar as the major international currency for trade and finance. Disruptions and disturbances in the U.S. payment system thus can easily have global implications. Fedwire, CHIPS, and the specialized depositories and clearinghouses for securities and other financial instruments, are crucial to the integrity and stability not only of our financial markets and ---[PAGE_BREAK]--- economy, but those of the world. Similarly, adverse developments in transfers in London, Tokyo, Singapore, and a host of other centers could rapidly be transferred here, given the financial interrelationships among the individual trading nations. In all these payment and settlement systems, commercial banks play a central role, both as participants and providers of credit to nonbank participants. Day-in and day-out, the settlement of payment obligations and securities trades requires significant amounts of bank credit. In periods of stress, such credit demands surge just at the time when some banks are least willing or able to meet them. These demands, if unmet, could produce gridlock in payment and settlement systems, halting activity in financial markets. Indeed, it is in the cauldron of the payments and settlement systems, where decisions involving large sums must be made quickly, that all of the risks and uncertainties associated with problems at a single participant become focussed as participants seek to protect themselves from uncertainty. Better solvent than sorry, they might well decide, and refuse to honor a payment request. Observing that, others might follow suit. And that is how crises often begin. Limiting, if not avoiding, such disruptions and ensuring the continued operation of the payment system requires broad and indepth knowledge of banking and markets, as well as detailed knowledge and authority with respect to the payment and settlement arrangements and their linkages to banking operations. This type of understanding and authority -- as well as knowledge about the behavior of key participants -- cannot be created on an ad hoc basis. It requires broad and sustained involvement in both the payment infrastructure and the operation of the banking system. Supervisory authority over the major bank participants is a necessary element. # Monetary Policy While financial crises and payment systems disruptions arise only sporadically, the Federal Reserve conducts monetary policy on an ongoing basis. In this area, too, the Federal Reserve's role in supervision and regulation provides an important perspective to the policy process. Monetary policy works through financial institutions and markets to affect the economy, and depository institutions are a key element in those markets. Indeed, banks and thrifts are more important in this regard than might be suggested by a simple arithmetic calculation of their share of total credit flows. While diverse securities markets handle the lion's share of credit flows these days, banks are the backup source of liquidity to many of the securities firms and large borrowers participating in these markets. Moreover, banks at all times are the most important source of credit to most small and intermediate-sized firms that do not have ready access to securities markets. These firms are the catalyst for U.S. economic growth and the prime source of new employment opportunities for our citizens. The Federal Reserve must make its monetary policy with a view to how banks are responding to the economic environment. This was especially important during the "credit crunch" of 1990. Our supervisory responsibilities give us important qualitative and quantitative information that not only helps us in the design of monetary policy, but provides important feedback on how our policy stance is affecting bank actions. The macroeconomic stabilization responsibilities of the Federal Reserve make us particularly sensitive to how regulatory and supervisory postures can influence bank behavior and hence how banks respond to monetary policy actions. For example, capital, liquidity, loan loss reserve, and asset quality evaluation policies of supervisors will directly influence the manner and speed with which monetary policy actions work. In the development of interagency rules and policies, the Federal Reserve brings to the table its unique concerns about the impact of ---[PAGE_BREAK]--- these rules on credit availability, potential responses to changes in interest rates, and the consequences for the economy. We believe that, as a result, supervisory policy is improved. # Federal Reserve's Supervisory Role For all of these reasons, the Board believes the Federal Reserve needs to retain a significant supervisory role in the banking system. Just exactly how that is achieved depends critically on the types of reforms the Congress enacts and the direction the banking industry takes in structuring and conducting its activities. In the Board's view, its current authority is adequate for the current structure. For today's financial system, we are able to meet our obligations by the intelligence we gain from, and the authorities we have over the modest number of large banks we directly supervise and the holding companies of these and other large banks over which we have a direct umbrella supervisory role. Our information is importantly supplemented by our supervision of a number of other banks of all sizes, namely state member banks. Currently, the latter group gives us a good representative sample of organizations of all sizes outside the largest entities. The large entities are essential if we are to address the Federal Reserve's crisis management and systemic risk responsibilities, deal with international financial issues involving foreign central banks, manage risk exposures in payment systems, and retain our practical knowledge and skill base in rapidly changing financial markets. Large bank holding companies are typically at the forefront in financial innovation and in developing sophisticated techniques for managing risks. It is crucial that the Federal Reserve stay informed of these events and understand directly how they work in practice. Directly supervising both these large organizations and a sample of others is also critical to our ability to conduct monetary policy by permitting us to gain first-hand on-the-spot intelligence on how changes in financial markets -including those induced by monetary policy -- are affecting money and credit flows. If in the future the holding company becomes a less clear window into the banking system, the Board believes that the Congress would need to change the supervisory structure if the central bank is to carry out the responsibilities I have discussed today. ## Umbrella Supervision The Congress, in its review of financial modernization, must consider legal entity supervision alone versus legal entity supervision supplemented by umbrella supervision. The Board believes that umbrella supervision is a realistic necessity for the protection of our financial system and to limit any misuse of the sovereign credit, that is, the government's guarantees that support the banking system through the safety net. The bank holding company organization increasingly is being managed so as to take advantage of the synergies between its component parts in order to deliver better products to the market and higher returns to stockholders. Such synergies cannot occur if the model of the holding company is one in which the parent is just, in effect, a portfolio investor in its subsidiary. Indeed, virtually all of the large holding companies now operate as integrated units and are managed as such, especially in their management of risk. One could argue that regulators should be interested only in the entities they regulate and, hence, review the risk evaluation process only as it relates to their regulated entity. Presumably each regulator of each entity -- the bank regulators, the SEC, the state insurance and any state finance company authorities -- would look only at how the risk management process ---[PAGE_BREAK]--- affected their units. It is our belief that this simply will not be adequate. Risks managed on a consolidated basis cannot be reviewed on an individual legal entity basis by different supervisors. The latter logic motivated the congressional decision just five years ago to require that foreign banks could enter the United States if, and only if, they were subject to consolidated supervision. This decision, which is consistent with the international standards for consolidated supervision of banking organizations, was a good decision then. It is a good decision today, especially for those banking organizations whose disruption could cause major financial disturbances in United States and foreign markets. For foreign and for U.S. banking organizations, retreat from consolidated supervision would, the Board believes, be a significant step backward. We have to be careful, however, that consolidated umbrella supervision does not inadvertently so hamper the decisionmaking process of banking organizations as to render them ineffectual. The Federal Reserve Board is accordingly in the process of reviewing its supervisory structure and other procedures in order to reflect a market-directed shift from conventional balance sheet auditing to evaluation of the internal risk management process. Although focussed on the key risk management processes, it would sharply reduce routine supervisory umbrella presence in holding companies. As the Committee knows, the Board has recently published for comment proposals to expedite the applications process, and the legislation Congress enacted last year eased such procedures as well. Nonetheless, the Board requests even greater modification to its existing statutory mandate so that the required applications process could be sharply cut back, particularly in the area of nonbank financial services. In the Board's view, those entities interested in banks are really interested in access to the safety net, since it is far easier to engage in the nonsafety net activities of banks without acquiring a bank. If an organization chooses to deliver some of its services with the aid of the sovereign credit by acquiring a bank, it should not be excused from efforts of the government to look out for the stability of the overall financial system. For bank holding companies, this implies umbrella supervision. Although that process will increasingly be designed to reduce supervisory presence and be as nonintrusive as possible, umbrella supervision should not be eliminated, but recognized for what it is: the cost of obtaining a subsidy. Nonetheless, we would hope that should the Congress authorize wider activities for financial services holding companies that it recognize that a bank which is a minor part of such an organization (and its associated safety net) can be protected through adequate bank capital requirements and the application of Sections 23A and 23B of the Federal Reserve Act. The case is weak, in our judgment, for umbrella supervision of a holding company in which the bank is not the dominant unit and is not large enough to induce systemic problems should it fail. # Subsidiaries, Subsidies, and Safety Nets The members of this Subcommittee are, I think, aware of the Board's concerns that the safety net constructed for banks inherently contains a subsidy, that conducting new activities in subsidiaries of banks will inadvertently extend that subsidy, and that extension of any subsidy is undesirable. The Subcommittee recently heard testimony that there is no net subsidy and, therefore, the authorization of nonbank activities in bank subsidiaries would neither inadvertently extend this undesirable side effect of the safety net nor reduce the importance of the holding company as a consequence of the increased incentives to shift activities from the holding company to the bank. ---[PAGE_BREAK]--- Mr. Chairman, I would like briefly to comment on these latter views. Subsidy values -- net or gross -- vary from bank to bank; riskier banks clearly get a larger subsidy from the safety net than safer banks. In addition, the value of the subsidy varies over time; in good times, markets incorporate a low risk premium and when markets turn weak, financial asset holders demand to be compensated by higher yields for holding claims on riskier entities. It is at this time that subsidy values are the most noticeable. What was it worth in the late 1980s and early 1990s for a bank with a troubled loan portfolio to have deposit liabilities guaranteed by the FDIC, to be assured that it could turn illiquid to liquid assets at once through the Federal Reserve discount window, and to tell its customers that payment transfers would be settled on a riskless Federal Reserve Bank? For many, it was worth not basis points but percentage points. For some, it meant the difference between survival and failure. It is argued by some that the cost of regulation exceeds the subsidy. I have no doubt that the costs of regulation are large, too large in my judgment. But no bank has turned in its charter in order to operate without the cost of banking regulation, which would require that it operate also without deposit insurance or access to the discount window or payments system. To do so would require both higher deposit costs and higher capital. Indeed, it is a measure of the size of banks' net subsidy that most nonbank financial institutions are required by the market to operate with significantly higher capital-to-asset ratios than banks. Most finance companies, for example, with credit ratings and debenture interest costs equal to banks are forced by today's market to hold six or seven percentage points higher capital-to-asset ratios than those of banks. It is instructive that there are no private deposit insurers competing with the FDIC. For the same product offered by the FDIC, private insurers would have to charge premiums far higher than those of government insurance, and still not be able to match the certainty of payments in the event of default, the hallmark of a government insurer backed by the sovereign credit of the United States. The Federal Reserve has a similar status with respect to the availability of the discount window and riskless final settlement during a period of national economic stress. Providing such services is out of the reach of all private institutions. The markets place substantial values on these safety net subsidies, clearly in excess of the cost of regulation. To repeat, were it otherwise, some banks would be dropping their charters if there were not a net subsidy. In fact it is apparently the lower funding costs at banks that benefit directly from the subsidy of the safety net that has created the tendency for banking organizations to return to the bank and its subsidiaries many activities that are authorized to banks. These activities previously had been conducted in nonbank affiliates for reasons such as geographic and other inflexibilities, which have gradually eased. Indeed, over the last decade the share of consolidated assets of bank holding companies associated with nonbank affiliates -- other than Section 20 securities affiliates -- has declined almost half to just 5.2 percent. This tendency reflects the fact that asset growth that earlier had been associated with nonbank affiliates of bank holding companies -- consumer and commercial finance, leasing, and mortgage banking -- has most recently occurred largely in the bank or in a subsidiary of the bank. To be sure, as Chairman Helfer indicated to the Subcommittee earlier this month, many banking organizations still retain nonbank subsidiaries. Our discussions with bank holding companies, however, suggest that in some cases, these affiliates were acquired in the past and have established names and an interstate network whose value would be reduced if subsumed within a bank. There are also ---[PAGE_BREAK]--- often adverse tax implications for the shift. And, finally, some of these activities may not be asset intensive and hence may not benefit significantly from bank funding. Clearly, the authorization of new activities in bank subsidiaries that are not now permitted either to banks or their affiliates would tend to accelerate the trend to reduce holding company activity, even if these activities were also permitted to holding company subsidiaries. The subsidy inherent in the safety net would assure that result, extending the spread of the safety net and requiring that the Federal Reserve's authority and ability to meet its responsibilities be shifted to a different paradigm. Such a result is reason enough for our concern about the spreading of the safety net subsidy. But we should also be concerned because of the distortions subsidies bring to the financial system more generally. After all, the broad premise underlying financial modernization -- with its removal of legislative and regulatory restrictions -- is that free and often intense competition will create the most efficient and customer-oriented business system. This principle has proved itself, generation by generation, with ever higher standards of living. In financial, as well as most other, markets the principle is rooted in another premise -- that the interaction of private competitive forces will, with rare exceptions, create a stable error self-correcting system. This premise is very seriously called into question if government subsidies are supplied at key balancing points. By their nature, subsidies distort the establishment of competitive market prices, and create incentives that misalign private risks with private gains. Such distortions undermine the error self-correcting mechanisms that support strong financial markets. We must be very careful that in the name of free market efficiency we do not countenance greater powers and profits subsidized directly or indirectly by government. # Conclusion Mr. Chairman, in conclusion, the Board believes that as the Congress moves toward financial modernization the newly created structure of financial organizations should limit, in so far as possible, the real and perceived transfer of the subsidy inherent in the safety net to nonbank activities. To maintain a level playing field for all competitors, nonbank activities must be financed at market, not subsidized, rates. The Board also believes that financial modernization should not undermine the ability and authority of the central bank of the United States to manage crises, assure an efficient and safe payment system, and conduct monetary policy. We believe all of these require that the Federal Reserve retain a significant and important role as a bank supervisor. In today's structure, we have adequate authority and coverage to meet our responsibilities. But should erosion occur, as would likely be the case if new activities are authorized in bank subsidiaries, the Congress would have to consider what changes would be required in the Board's supervisory authority to assure that it continues to be able to meet its central bank responsibilities.	Alan Greenspan	United States	https://www.bis.org/review/r970326a.pdf	Mr. Greenspan presents the views of the Federal Reserve Board on the supervision of US banks if they are authorized to widen their activities Testimony of Chairman of th Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Subcommittee on Capital Markets, Securities and Government-Sponsored Enterprises of the Committee on Banking and Financial Services of the US House of Representatives on 19/3/97. Mr. Chairman, members of the Subcommittee, thank you for inviting me to present the views of the Federal Reserve Board on the supervision of our nation's banking organizations should they be authorized by the Congress to engage in a wider range of activities. As you know, the Board has supported financial modernization for many years and hopes that the Congress will act to facilitate reforms that, by enhancing competition within the financial services industry, would benefit the consumers of financial products in the United States. Financial modernization may well mean that future banking organizations will be sufficiently different from today as to require perhaps substantial changes in the supervisory process for the entire organization. Just how much modification may be needed will depend on the kinds of reforms the Congress adopts. In evaluating those modifications, I would like to underline the significant supervisory role required by the Federal Reserve to carry out its central bank responsibilities. I also would like briefly to discuss the continued importance of umbrella supervision and the implications of a wider role for bank subsidiaries in the modernization process. There are compelling reasons why the central bank of the United States -- the Federal Reserve -- should continue to be involved in the supervision of banks. The supervisory activities of the Federal Reserve, for example, have benefited from its economic stabilization responsibilities and its recognition that safety and soundness goals for banks must be evaluated jointly with its responsibilities for the stability and growth of the economy. The Board believes that these joint responsibilities make for better supervisory and monetary policies than would result from either a supervisor divorced from economic responsibilities or a macroeconomic policymaker with no practical experience in the review of individual bank operations. To carry out its responsibilities, the Federal Reserve has been required to develop extensive, detailed knowledge of the intricacies of the U.S., and indeed the world, financial system. That expertise is the result of dealing constantly over many decades with changing financial markets and institutions and their relationships with each other and with the economy, and from exercising supervisory responsibilities. It comes as well from ongoing interactions with central banks and financial institutions abroad. These international contacts are critical because today crises can spread more rapidly than in earlier times -- in large part reflecting new technologies -- and require a coordinated international response. Second only to its macrostability responsibilities is the central bank's responsibility to use its authority and expertise to forestall financial crises (including systemic disturbances in the banking system) and to manage such crises once they occur. In a crisis, the Federal Reserve, to be sure, could always flood the market with liquidity through open market operations and discount window loans; at times it has stood ready to do so, and it does not need supervisory and regulatory responsibilities to exercise that power. But while sometimes necessary in times of crises, such an approach may be costly and distortive to economic incentives and long-term growth, as well as an insufficient remedy. Supervisory and regulatory responsibilities give the Federal Reserve both the insight and the authority to use techniques that are less blunt and more precisely calibrated to the problem at hand. Such tools improve our ability to manage crises and, more importantly, to avoid them. The use of such techniques requires both the authority that comes with supervision and regulation and the understanding of the linkages among supervision and regulation, prudential standards, risk taking, relationships among banks and other financial market participants, and macroeconomic stability. Our financial system -- market oriented and characterized by innovation and rapid change -- imparts significant benefits to our economy. But one of the consequences of such a dynamic system is that it is subject to episodes of stress. In the 1980s and early 1990s we faced a series of international debt crises, a major stock market crash, the collapse of the most important player in the junk bond market, the virtual failure of the S\&L industry, and extensive losses at many banking institutions. More recently, we faced another Mexican crisis and, while in the event less disruptive, the failure of a large British merchant bank. In such situations the Federal Reserve stands ready to provide liquidity, if necessary, and monitors continuously the condition of depository institutions to contain the secondary consequences of any problem. The objectives of the central bank in crisis management are to contain financial losses and prevent a contagious loss of confidence so that difficulties at one institution do not spread more widely to others. The focus of its concern is not to avoid the failure of entities that have made poor decisions or have had bad luck, but rather to see that such failures -- or threats of failures -- do not have broad and serious impacts on financial markets and the national, and indeed the global, economy. The Federal Reserve's ability to respond expeditiously to any particular incident does not necessitate comprehensive information on each banking institution. But it does require that the Federal Reserve have in-depth knowledge of how institutions of various sizes and other characteristics are likely to behave, and what resources are available to them in the event of severe financial stress. Even for those events that might, but do not, precipitate financial crises, the authorities turn first to the Federal Reserve, not only because, as former Chairman Volcker noted last month, we have the money, but also because we have the expertise and the experience. We currently gain the necessary insight by having a broad sample of banks subject to our supervision and through our authority over bank holding companies. Virtually all of the U.S. dollar transactions made worldwide -- for securities transfers, foreign exchange and other international capital flows, and for payment for goods and services -- are settled in the United States banking system. A small number of transactions that comprise the vast proportion of the total value of transactions are transferred over large-dollar payment systems. Banks use two of these systems -- Fedwire, operated by the Federal Reserve, and CHIPS, operated by the New York Clearing House -- currently to transfer $\$ 1.6$ trillion and $\$ 1.3$ trillion a day, respectively. CHIPS settles its members' net positions on Fedwire. These interbank transfers, for banks' own accounts and for those of their customers, occur and are settled over a network and structure that is the backbone of the U.S. financial system. Indeed, it is arguably the linchpin of the international system of payments that relies on the dollar as the major international currency for trade and finance. Disruptions and disturbances in the U.S. payment system thus can easily have global implications. Fedwire, CHIPS, and the specialized depositories and clearinghouses for securities and other financial instruments, are crucial to the integrity and stability not only of our financial markets and economy, but those of the world. Similarly, adverse developments in transfers in London, Tokyo, Singapore, and a host of other centers could rapidly be transferred here, given the financial interrelationships among the individual trading nations. In all these payment and settlement systems, commercial banks play a central role, both as participants and providers of credit to nonbank participants. Day-in and day-out, the settlement of payment obligations and securities trades requires significant amounts of bank credit. In periods of stress, such credit demands surge just at the time when some banks are least willing or able to meet them. These demands, if unmet, could produce gridlock in payment and settlement systems, halting activity in financial markets. Indeed, it is in the cauldron of the payments and settlement systems, where decisions involving large sums must be made quickly, that all of the risks and uncertainties associated with problems at a single participant become focussed as participants seek to protect themselves from uncertainty. Better solvent than sorry, they might well decide, and refuse to honor a payment request. Observing that, others might follow suit. And that is how crises often begin. Limiting, if not avoiding, such disruptions and ensuring the continued operation of the payment system requires broad and indepth knowledge of banking and markets, as well as detailed knowledge and authority with respect to the payment and settlement arrangements and their linkages to banking operations. This type of understanding and authority -- as well as knowledge about the behavior of key participants -- cannot be created on an ad hoc basis. It requires broad and sustained involvement in both the payment infrastructure and the operation of the banking system. Supervisory authority over the major bank participants is a necessary element. While financial crises and payment systems disruptions arise only sporadically, the Federal Reserve conducts monetary policy on an ongoing basis. In this area, too, the Federal Reserve's role in supervision and regulation provides an important perspective to the policy process. Monetary policy works through financial institutions and markets to affect the economy, and depository institutions are a key element in those markets. Indeed, banks and thrifts are more important in this regard than might be suggested by a simple arithmetic calculation of their share of total credit flows. While diverse securities markets handle the lion's share of credit flows these days, banks are the backup source of liquidity to many of the securities firms and large borrowers participating in these markets. Moreover, banks at all times are the most important source of credit to most small and intermediate-sized firms that do not have ready access to securities markets. These firms are the catalyst for U.S. economic growth and the prime source of new employment opportunities for our citizens. The Federal Reserve must make its monetary policy with a view to how banks are responding to the economic environment. This was especially important during the "credit crunch" of 1990. Our supervisory responsibilities give us important qualitative and quantitative information that not only helps us in the design of monetary policy, but provides important feedback on how our policy stance is affecting bank actions. The macroeconomic stabilization responsibilities of the Federal Reserve make us particularly sensitive to how regulatory and supervisory postures can influence bank behavior and hence how banks respond to monetary policy actions. For example, capital, liquidity, loan loss reserve, and asset quality evaluation policies of supervisors will directly influence the manner and speed with which monetary policy actions work. In the development of interagency rules and policies, the Federal Reserve brings to the table its unique concerns about the impact of these rules on credit availability, potential responses to changes in interest rates, and the consequences for the economy. We believe that, as a result, supervisory policy is improved. For all of these reasons, the Board believes the Federal Reserve needs to retain a significant supervisory role in the banking system. Just exactly how that is achieved depends critically on the types of reforms the Congress enacts and the direction the banking industry takes in structuring and conducting its activities. In the Board's view, its current authority is adequate for the current structure. For today's financial system, we are able to meet our obligations by the intelligence we gain from, and the authorities we have over the modest number of large banks we directly supervise and the holding companies of these and other large banks over which we have a direct umbrella supervisory role. Our information is importantly supplemented by our supervision of a number of other banks of all sizes, namely state member banks. Currently, the latter group gives us a good representative sample of organizations of all sizes outside the largest entities. The large entities are essential if we are to address the Federal Reserve's crisis management and systemic risk responsibilities, deal with international financial issues involving foreign central banks, manage risk exposures in payment systems, and retain our practical knowledge and skill base in rapidly changing financial markets. Large bank holding companies are typically at the forefront in financial innovation and in developing sophisticated techniques for managing risks. It is crucial that the Federal Reserve stay informed of these events and understand directly how they work in practice. Directly supervising both these large organizations and a sample of others is also critical to our ability to conduct monetary policy by permitting us to gain first-hand on-the-spot intelligence on how changes in financial markets -including those induced by monetary policy -- are affecting money and credit flows. If in the future the holding company becomes a less clear window into the banking system, the Board believes that the Congress would need to change the supervisory structure if the central bank is to carry out the responsibilities I have discussed today. The Congress, in its review of financial modernization, must consider legal entity supervision alone versus legal entity supervision supplemented by umbrella supervision. The Board believes that umbrella supervision is a realistic necessity for the protection of our financial system and to limit any misuse of the sovereign credit, that is, the government's guarantees that support the banking system through the safety net. The bank holding company organization increasingly is being managed so as to take advantage of the synergies between its component parts in order to deliver better products to the market and higher returns to stockholders. Such synergies cannot occur if the model of the holding company is one in which the parent is just, in effect, a portfolio investor in its subsidiary. Indeed, virtually all of the large holding companies now operate as integrated units and are managed as such, especially in their management of risk. One could argue that regulators should be interested only in the entities they regulate and, hence, review the risk evaluation process only as it relates to their regulated entity. Presumably each regulator of each entity -- the bank regulators, the SEC, the state insurance and any state finance company authorities -- would look only at how the risk management process affected their units. It is our belief that this simply will not be adequate. Risks managed on a consolidated basis cannot be reviewed on an individual legal entity basis by different supervisors. The latter logic motivated the congressional decision just five years ago to require that foreign banks could enter the United States if, and only if, they were subject to consolidated supervision. This decision, which is consistent with the international standards for consolidated supervision of banking organizations, was a good decision then. It is a good decision today, especially for those banking organizations whose disruption could cause major financial disturbances in United States and foreign markets. For foreign and for U.S. banking organizations, retreat from consolidated supervision would, the Board believes, be a significant step backward. We have to be careful, however, that consolidated umbrella supervision does not inadvertently so hamper the decisionmaking process of banking organizations as to render them ineffectual. The Federal Reserve Board is accordingly in the process of reviewing its supervisory structure and other procedures in order to reflect a market-directed shift from conventional balance sheet auditing to evaluation of the internal risk management process. Although focussed on the key risk management processes, it would sharply reduce routine supervisory umbrella presence in holding companies. As the Committee knows, the Board has recently published for comment proposals to expedite the applications process, and the legislation Congress enacted last year eased such procedures as well. Nonetheless, the Board requests even greater modification to its existing statutory mandate so that the required applications process could be sharply cut back, particularly in the area of nonbank financial services. In the Board's view, those entities interested in banks are really interested in access to the safety net, since it is far easier to engage in the nonsafety net activities of banks without acquiring a bank. If an organization chooses to deliver some of its services with the aid of the sovereign credit by acquiring a bank, it should not be excused from efforts of the government to look out for the stability of the overall financial system. For bank holding companies, this implies umbrella supervision. Although that process will increasingly be designed to reduce supervisory presence and be as nonintrusive as possible, umbrella supervision should not be eliminated, but recognized for what it is: the cost of obtaining a subsidy. Nonetheless, we would hope that should the Congress authorize wider activities for financial services holding companies that it recognize that a bank which is a minor part of such an organization (and its associated safety net) can be protected through adequate bank capital requirements and the application of Sections 23A and 23B of the Federal Reserve Act. The case is weak, in our judgment, for umbrella supervision of a holding company in which the bank is not the dominant unit and is not large enough to induce systemic problems should it fail. The members of this Subcommittee are, I think, aware of the Board's concerns that the safety net constructed for banks inherently contains a subsidy, that conducting new activities in subsidiaries of banks will inadvertently extend that subsidy, and that extension of any subsidy is undesirable. The Subcommittee recently heard testimony that there is no net subsidy and, therefore, the authorization of nonbank activities in bank subsidiaries would neither inadvertently extend this undesirable side effect of the safety net nor reduce the importance of the holding company as a consequence of the increased incentives to shift activities from the holding company to the bank. Mr. Chairman, I would like briefly to comment on these latter views. Subsidy values -- net or gross -- vary from bank to bank; riskier banks clearly get a larger subsidy from the safety net than safer banks. In addition, the value of the subsidy varies over time; in good times, markets incorporate a low risk premium and when markets turn weak, financial asset holders demand to be compensated by higher yields for holding claims on riskier entities. It is at this time that subsidy values are the most noticeable. What was it worth in the late 1980s and early 1990s for a bank with a troubled loan portfolio to have deposit liabilities guaranteed by the FDIC, to be assured that it could turn illiquid to liquid assets at once through the Federal Reserve discount window, and to tell its customers that payment transfers would be settled on a riskless Federal Reserve Bank? For many, it was worth not basis points but percentage points. For some, it meant the difference between survival and failure. It is argued by some that the cost of regulation exceeds the subsidy. I have no doubt that the costs of regulation are large, too large in my judgment. But no bank has turned in its charter in order to operate without the cost of banking regulation, which would require that it operate also without deposit insurance or access to the discount window or payments system. To do so would require both higher deposit costs and higher capital. Indeed, it is a measure of the size of banks' net subsidy that most nonbank financial institutions are required by the market to operate with significantly higher capital-to-asset ratios than banks. Most finance companies, for example, with credit ratings and debenture interest costs equal to banks are forced by today's market to hold six or seven percentage points higher capital-to-asset ratios than those of banks. It is instructive that there are no private deposit insurers competing with the FDIC. For the same product offered by the FDIC, private insurers would have to charge premiums far higher than those of government insurance, and still not be able to match the certainty of payments in the event of default, the hallmark of a government insurer backed by the sovereign credit of the United States. The Federal Reserve has a similar status with respect to the availability of the discount window and riskless final settlement during a period of national economic stress. Providing such services is out of the reach of all private institutions. The markets place substantial values on these safety net subsidies, clearly in excess of the cost of regulation. To repeat, were it otherwise, some banks would be dropping their charters if there were not a net subsidy. In fact it is apparently the lower funding costs at banks that benefit directly from the subsidy of the safety net that has created the tendency for banking organizations to return to the bank and its subsidiaries many activities that are authorized to banks. These activities previously had been conducted in nonbank affiliates for reasons such as geographic and other inflexibilities, which have gradually eased. Indeed, over the last decade the share of consolidated assets of bank holding companies associated with nonbank affiliates -- other than Section 20 securities affiliates -- has declined almost half to just 5.2 percent. This tendency reflects the fact that asset growth that earlier had been associated with nonbank affiliates of bank holding companies -- consumer and commercial finance, leasing, and mortgage banking -- has most recently occurred largely in the bank or in a subsidiary of the bank. To be sure, as Chairman Helfer indicated to the Subcommittee earlier this month, many banking organizations still retain nonbank subsidiaries. Our discussions with bank holding companies, however, suggest that in some cases, these affiliates were acquired in the past and have established names and an interstate network whose value would be reduced if subsumed within a bank. There are also often adverse tax implications for the shift. And, finally, some of these activities may not be asset intensive and hence may not benefit significantly from bank funding. Clearly, the authorization of new activities in bank subsidiaries that are not now permitted either to banks or their affiliates would tend to accelerate the trend to reduce holding company activity, even if these activities were also permitted to holding company subsidiaries. The subsidy inherent in the safety net would assure that result, extending the spread of the safety net and requiring that the Federal Reserve's authority and ability to meet its responsibilities be shifted to a different paradigm. Such a result is reason enough for our concern about the spreading of the safety net subsidy. But we should also be concerned because of the distortions subsidies bring to the financial system more generally. After all, the broad premise underlying financial modernization -- with its removal of legislative and regulatory restrictions -- is that free and often intense competition will create the most efficient and customer-oriented business system. This principle has proved itself, generation by generation, with ever higher standards of living. In financial, as well as most other, markets the principle is rooted in another premise -- that the interaction of private competitive forces will, with rare exceptions, create a stable error self-correcting system. This premise is very seriously called into question if government subsidies are supplied at key balancing points. By their nature, subsidies distort the establishment of competitive market prices, and create incentives that misalign private risks with private gains. Such distortions undermine the error self-correcting mechanisms that support strong financial markets. We must be very careful that in the name of free market efficiency we do not countenance greater powers and profits subsidized directly or indirectly by government. Mr. Chairman, in conclusion, the Board believes that as the Congress moves toward financial modernization the newly created structure of financial organizations should limit, in so far as possible, the real and perceived transfer of the subsidy inherent in the safety net to nonbank activities. To maintain a level playing field for all competitors, nonbank activities must be financed at market, not subsidized, rates. The Board also believes that financial modernization should not undermine the ability and authority of the central bank of the United States to manage crises, assure an efficient and safe payment system, and conduct monetary policy. We believe all of these require that the Federal Reserve retain a significant and important role as a bank supervisor. In today's structure, we have adequate authority and coverage to meet our responsibilities. But should erosion occur, as would likely be the case if new activities are authorized in bank subsidiaries, the Congress would have to consider what changes would be required in the Board's supervisory authority to assure that it continues to be able to meet its central bank responsibilities.
1997-03-20T00:00:00	Ms. Phillips discusses the restrictions imposed on bank holding companies by the US Federal Reserve Board (Central Bank Articles and Speeches, 20 Mar 97)	Testimony of Governor Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, before the Subcommittee on Financial Institutions and Regulatory Relief of the Committee on Banking, Housing and Urban Affairs of the United States on 20/3/97.	Ms. Phillips discusses the restrictions imposed on bank holding companies by the US Ferderal Reserve Board Testimony of Governor Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, before the Subcommittee on Financial Institutions and Regulatory Relief of the Committee on Banking, Housing and Urban Affairs of the United States on 20/3/97. I am pleased to be here today to discuss the Board's section 20 firewalls -- that is, the restrictions the Board has imposed on bank holding companies engaged in underwriting and dealing in securities. As the name suggests, the purpose of firewalls is to insulate a bank and its customers from the potential hazards of combining commercial and investment banking. Since last year the Board has been engaged in a comprehensive review of the 28 firewalls it erected in the late 1980s, and the Board has recently proposed to eliminate a majority of those restrictions. This oversight hearing provides a constructive opportunity for comment and analysis of the Board's proposal. Furthermore, if financial modernization is to move forward, the issue of firewalls will have to be confronted again. I hope that the Board's review and the public comment process can inform the legislative process as well. Today, I would like to explain why the Board proposed changes to the firewalls. I will also discuss the final changes the Board made last year to the revenue test that the Board uses to determine compliance with section 20 of the Glass-Steagall Act, and to firewalls regarding cross-marketing between a bank and a securities affiliate, and officer, director and employee interlocks between two such companies. The Firewalls in Context: Independent Protections for Banks and Consumers Before I begin this discussion, I think it is important to place the firewalls in their historical and regulatory context. Although the firewalls have served an important role, they are not the only protection against the hazards of affiliation of commercial and investment banks. One important protection is the placement of securities activities in a separate subsidiary of the bank holding company, rather than in the bank itself or a subsidiary of the bank. Because non-bank subsidiaries of a bank holding company operating under section 20 of the Glass-Steagall Act are affiliates of a bank, they are not under the bank's control, do not have their profits or losses consolidated with the bank's, and are less liable to have their creditors recover against the bank. A bank therefore has less incentive to risk its own reputation or expose itself or its customers to loss in order to assist a troubled section 20 affiliate or a failed underwriting by that affiliate. Also, because securities activities are conducted in an affiliate, banks are limited in their ability to fund those activities by sections 23A and 23B of the Federal Reserve Act. These restrictions are vitally important. Section 23A limits the total value of transactions with any one affiliate to 10 percent of the bank's capital and limits transactions with all affiliates to 20 percent of capital. It also requires that substantial collateral be pledged to the bank for any extension of credit. Section 23B requires that inter-affiliate transactions be at arm's length and on market terms, and imposes other restrictions designed to limit conflicts of interest. Thus, affiliate status prevents the bank from passing along the federal subsidy inherent in the federal safety net to its section 20 affiliate by extending credit. Regulators could conceivably limit a bank's ability to use credit to subsidize a direct securities subsidiary of the bank as well, by applying sections 23A and 23B. But the equity investment in the subsidiary would still be funded from subsidized resources backed by the federal safety net. Even if the investment were deducted from the capital of the bank, the subsidy inherent in the transfer would remain. A second protection is examination of the bank holding company, including the effect of securities activities on insured depository institution subsidiaries. The Federal Reserve as holding company regulator monitors compliance with sections 23A and 23B and other aspects of the relationship between a bank and its section 20 affiliate. In its supervision of bank holding companies, the Board increasingly pays attention to risk management systems and policies that are centralized at the holding company level and govern both the bank and its section 20 affiliate. A final series of protections is the regulatory regime that applies to all broker-dealers, including section 20 subsidiaries. The Securities Act of 1933 and the Securities Exchange Act of 1934 impose registration, capital and disclosure requirements, anti-fraud protections, and other investor-protection measures. These laws, and their enforcement by the Securities and Exchange Commission, address many of the safety and soundness and conflict-of-interest concerns about affiliation of commercial and investment banks. I note that most of these important protections were not in place when the Glass-Steagall Act passed in 1933. Thus, although proponents of high firewalls frequently cite the subtle hazards of affiliation discussed in the legislative history of that Act, the regulatory environment was far different then. I believe that the drafters of the Glass-Steagall Act would have had a very different discussion -- and passed a very different Act -- had today's statutory and regulatory protections been present in 1933. Not only were these protections largely absent in 1933, some were not even present in 1987 when the Board first erected its firewalls. Section 23B of the Federal Reserve Act had not been adopted at the time of the Board's first section 20 order in 1987. As a result, many of the firewalls overlap the restrictions of section 23B, which as I noted requires interaffiliate transactions to be at arm's length and on market terms, but also prohibits a section 20 affiliate from representing that an affiliated bank is responsible for its obligations, and prohibits a bank from purchasing certain products from a section 20 affiliate. Similarly, risk-based capital standards did not exist in 1987, and those standards now require a bank to hold capital against many of the on- and off-balance-sheet exposures it maintains in conjunction with a section 20 affiliate. Finally, the Interagency Statement on Retail Sales of Nondeposit Investment Products was not adopted until 1994. The Interagency Statement includes disclosure and other requirements that are now the primary means by which the federal banking agencies seek to ensure that retail customers are not misled about the nature of non-deposit products they are purchasing on bank premises. The Board's Review Thus, when the Board last year decided to reexamine the firewalls, we felt it important to do so with a fresh eye, benefitting from our ten years of experience supervising the section 20 affiliates, acknowledging regulatory and legal developments since 1987, and focusing on the relevance of the firewalls in today's financial markets. As we began to look at the concerns the firewalls were designed to address, we asked two questions. Does the affiliation of a commercial and an investment bank cause safety and soundness or other concerns not present with any other commercial bank affiliation -- concerns not addressed by general bank holding company regulation? Does operation of a broker-dealer within a bank holding company cause concerns that independent operation does not -- concerns not addressed by broker-dealer regulation? In some areas -- most notably, consumer protection -- we believed that the answer was "yes." In most other areas, however, the Board believed, at least pending public comment, that the answer was "no." The answers to these questions are important because the firewalls are far from costless. They impose operational inefficiencies on bank holding companies that increase their costs and reduce their competitiveness, and they limit a bank holding company's ability to market its products in a way that is both most profitable and desired by its customers. As such, the firewalls have served as a significant barrier to entry for small and mid-size bank holding companies because those companies cannot realize sufficient synergies or achieve adequate operating revenues to justify establishing a section 20 subsidiary. The loss is not just to these companies but also to their customers and market competition. Let me now discuss the most important of the firewalls to which the Board has proposed changes. The comment period closed on this proposal last week, and the comments were overwhelmingly favorable. I will not discuss all 28 firewalls but have attached a summary list and their proposed disposition. Restrictions on Funding The Board proposed to eliminate a series of firewalls that constitute a blanket prohibition on a bank's funding its section 20 affiliate, and to rely instead on the protections of sections 23A and 23B of the Federal Reserve Act. The firewalls in question prohibit a bank from extending credit to a section 20 affiliate, purchasing corporate and other non-governmental securities being underwritten by the section 20 affiliate, or purchasing from the section 20 affiliate such securities in which the affiliate makes a market. These firewalls were intended to prevent a bank from assisting a troubled affiliate by lending to it on preferential terms or by bailing out a failed underwriting by purchasing securities that cannot otherwise be sold. Except for the prohibition on purchasing securities during the underwriting period, none of these funding firewalls was applied under the Board's original 1987 order, but were added in 1989 when the range of permissible securities activities was expanded. Bank subsidiaries of the fourteen companies operating under the 1987 order have therefore been free to, and have in fact, funded their section 20 affiliates subject to sections 23A and 23B. The Board has not encountered problems arising from such funding. If the Board were to eliminate the funding restrictions for the remaining section 20 subsidiaries, sections 23A and 23B would continue to impose quantitative and qualitative restrictions on inter-affiliate transactions. In addition to requiring that the transaction be on market terms, section 23B specifically prohibits a bank from purchasing any security for which a section 20 affiliate is a principal underwriter during the existence of the underwriting or selling syndicate, unless such a purchase has been approved by a majority of the bank's board of directors who are not officers of any bank or any affiliate. If the purchase is as fiduciary, the purchase must be permitted by the instrument creating the fiduciary relationship, court order, or state law. We believe these are substantial protections, and have proposed to rely on them in place of a firewall. Prohibitions on a Bank Extending or Enhancing Credit in Support of Underwriting or Dealing by a Section 20 Affiliate Three of the Board's firewalls restrict the ability of a bank to assist a section 20 affiliate indirectly, by enhancing the marketability of its products or lending to its customers. These firewalls prohibit a bank from extending credit or offering credit enhancements in support of corporate and other non-governmental securities being underwritten by its section 20 affiliate or in which the section 20 affiliate makes a market; extending credit to issuers of securities to repay principal or interest on securities previously underwritten by a section 20 affiliate; or extending credit to customers to purchase securities currently being underwritten by a section 20 affiliate. The firewalls share a common purpose: to prevent a bank from imprudently exposing itself to loss in order to benefit the underwriting or dealing activities of its affiliate. However, as financial intermediation has evolved, corporate customers frequently seek to obtain a variety of funding mechanisms from one source. By prohibiting banks from providing routine credit or credit enhancements in tandem with a section 20 affiliate, these firewalls hamper the ability of bank holding companies to serve as full-service financial services providers. The firewall thereby reduces options for their customers. For example, existing corporate customers of a bank may wish to issue commercial paper or issue debt in some other form. Although the bank may refer the customer to its section 20 affiliate, the bank is prohibited from providing credit enhancements even though it is the institution best suited to perform a credit analysis -- and, with smaller customers, perhaps the only institution willing to do so. As another example, the restriction on lending for repayment of securities causes a bank compliance problems when renewing a company's revolving line of credit if a section 20 affiliate has underwritten an offering by that company since the credit was first extended. The bank must either recruit other lenders to participate in the renewal or amend the line of credit in order to specify that its purpose does not include repayment of interest or principal on the newly underwritten securities. Notably, even if these firewalls were lifted, a bank would still be required to hold capital against all credit enhancements and credit extended to customers of its section 20 affiliate. Section 23B of the Federal Reserve Act would require that such credit and credit enhancements be on an arm's-length basis. Similarly, the federal anti-tying statute would prohibit a bank from offering discounted credit enhancements on the condition that an issuer obtain investment banking services from a section 20 affiliate. Thus, for example, a bank could not offer such credit enhancements below market prices, or to customers who were poor credit risks, in order to generate underwriting business for a section 20 affiliate. The firewall prohibiting lending to retail customers for securities purchases during the underwriting period addresses one of the most important potential conflicts of interests arising from the affiliation of commercial and investment banking: the possibility that a bank would extend credit at below-market rates in order to induce consumers to purchase securities underwritten by its section 20 affiliate. The concern here is not only safety and soundness but customer protection. The Securities Exchange Act of 1934 already prohibits a broker-dealer (including a section 20 affiliate) from extending or arranging for credit to its customers during the underwriting period. Still, we recognize the Act would not apply in the absence of arranging and, unlike the firewall, would not cover loans to purchase a security in which a section 20 affiliate makes a market. Section 23B of the Federal Reserve Act, and to some extent section 23A, would address some of these remaining concerns, but perhaps not all. The Board will be reviewing the comments on this firewall carefully. Capital Requirements The next group of firewalls I will discuss imposes capital requirements on a bank holding company and its section 20 subsidiary. These firewalls require a bank holding company to deduct from its capital any investment in a section 20 subsidiary and most unsecured extensions of credit to a section 20 subsidiary engaged in debt and equity underwriting; they also require the section 20 subsidiary to maintain its own capital in keeping with industry norms. These requirements apply only to section 20 subsidiaries and not to any other nonbank subsidiary of a bank holding company. The Board proposed to eliminate the capital deductions for investments in, or credit extended to, a section 20 subsidiary. The original purpose of the deduction was to ensure that the holding company maintained sufficient resources to support its federally insured depository institutions. In practice, however, the deductions have created regulatory burden without strengthening the capital levels of the insured institutions. The deduction is inconsistent with Generally Accepted Accounting Practices, which require consolidation of subsidiaries for accounting purposes. The deduction therefore has created confusion and imposed costs by requiring bank holding companies to prepare statements on two bases. The deduction does not strengthen the capital of either the bank or its section 20 affiliate, and elimination of the deduction would not create or expose any incentive for a bank holding company to divert necessary capital from a depository institution to a section 20 subsidiary. One of the purposes of the system of prompt corrective action adopted in 1992 is to ensure that a bank holding company maintains the capital of its subsidiary banks. The Board also sought comment on whether it should continue to impose a special capital requirement on section 20 subsidiaries in addition to the SEC's net capital rules. The purpose of this requirement was to prevent a section 20 subsidiary from being able to leverage itself more than, and gain a competitive advantage over, its independent competitors by trading on the reputation of its affiliated bank. Although the SEC imposes capital requirements on all broker-dealers, these are minimum levels that are far below the industry norm. This capital firewall has proven confusing and controversial, as "industry norms" are difficult to determine. Federal Reserve examiners have expected section 20 subsidiaries to maintain capital to cover risk exposure in an amount approximately twice what the SEC requires, but some section 20 subsidiaries have complained that this is more than their competitors maintain. They also argue that whereas SEC capital requirements allow all capital to be concentrated in the broker-dealer and dedicated to meeting capital requirements, a bank holding company must meet capital requirements at the bank and holding company levels as well. Indeed, bank holding company capital is measured on a consolidated basis, and thus includes the capital and assets of the section 20 subsidiary. Therefore, the Board believes it may be unnecessary to impose a separate capital requirement on the bank holding company's section 20 subsidiary. Remaining Restrictions Before leaving the Board's proposal, I should also note which restrictions the Board proposed to retain. The Board proposed to reserve its authority to reimpose the funding, credit extension, and credit enhancement firewalls in the event that an affiliated bank or thrift becomes less than well capitalized and the bank holding company does not promptly restore it to the well-capitalized level. The Board considered proposing to reimpose the firewalls on less than well capitalized banks automatically -- as some recent bills introduced in the Congress would -but decided against it because a decline in a bank's capital ratios may be wholly unrelated to the bank's dealings with its section 20 affiliate. Thus, for example, forcing a bank suffering serious losses on real estate lending to desist from credit enhancements may be unproductive or -- if the business is profitable -- counterproductive. The Board also proposed to retain existing firewalls requiring adequate internal controls and documentation, including a requirement that a bank exercise independent and thorough credit judgment in any transaction involving an affiliate. Although we expect banking organizations to have such internal controls and look for them during examinations, we believe that they are sufficiently important to warrant reinforcement through the operating standards. They are especially important in the section 20 context because of the likelihood that a bank and its section 20 affiliate may be selling similar products to the same customer. Because of the potential for customer confusion as to which products are federally insured, the Board proposed to require a section 20 affiliate to make disclosures to customers similar to those that the Interagency Statement requires of a bank selling nondeposit products on bank premises. The proposal would also continue to prohibit an affiliated bank from knowingly advising a customer to purchase securities underwritten or dealt in by a section 20 affiliate unless it notifies the customer of its affiliate's role. The proposal also continues to prohibit a bank and its section 20 affiliate from sharing any nonpublic customer information without the customer's consent. Earlier Board Action on Other Firewalls and the Revenue Limit In addition to describing the Board's recent proposal, you also asked me to discuss other changes the Board finalized last year: increasing the section 20 revenue limit from 10 percent to 25 percent; allowing cross-marketing between a bank and a section 20 affiliate; permitting employee interlocks between a bank and a section 20 affiliate; and scaling back a restriction on officer and director interlocks. The review that led to changes to the cross-marketing and interlocks firewalls was akin to what the Board recently went through for all the firewalls. The Board acted on these firewalls before the rest because it had previously sought comment on them some years ago and because they were identified by commenters as among the most unduly burdensome of all the firewalls. After reviewing its experience administering these firewalls, the Board decided that they caused inefficiencies that could not be justified by any benefit to safety and soundness, and commenters agreed overwhelmingly. Repeal of the interlocks and cross-marketing restrictions allows increased synergies in the operation of a section 20 subsidiary and its bank affiliates. Persons may be employed by both companies, and the trend toward coordinated management of like business functions can accelerate, with reporting lines running between companies. Companies need not fund dual back offices or trading floors, for example. To the extent that senior bank managers may now oversee related operations at a section 20 affiliate, risk management and safety and soundness may be improved. Moreover, existing disclosure requirements adequately address concerns about customer confusion arising from increased cross-marketing and employee interlocks. Most notably, the Interagency Statement on Retail Sales of Nondeposit Products states that, prior to the initial sale of a non-deposit product by a bank employee or on bank premises, the customer must receive and acknowledge a written statement that the product being sold is not federally insured, is not a deposit or other obligation of the bank, is not guaranteed by the bank, and is subject to investment risks including loss of principal. Finally, with regard to the revenue limit, section 20 of the Glass-Steagall Act prohibits a bank from being affiliated with any company "engaged principally" in underwriting and dealing, and the Board was obliged to make a narrow, legal determination of the level of revenue at which a company becomes "engaged principally." The Board interpreted the statute to allow 25 percent of total revenue to be derived from underwriting and dealing in bank-ineligible securities. In reviewing the revenue limit, the Board was not deciding what level of underwriting and dealing was consistent with safety and soundness or public policy. If it were, the Board may well have raised the limit to 100 percent, which would have been consistent with the Board's support of repeal of section 20. I am pleased to report that early indications of the effects of these changes have been favorable. The Board currently has pending three applications to establish a section 20 subsidiary. As we had anticipated, two of these are small to mid-size bank holding companies which may previously have either found it too expensive to fund the dual staffing required by the interlocks restrictions or too difficult to generate sufficient eligible revenue to maintain compliance with a ten percent revenue limit. Furthermore, existing section 20 subsidiaries have indicated that they have been able to rationalize their organization and expand their activities given the added flexibility with respect to both staffing and revenue.	---[PAGE_BREAK]--- # Ms. Phillips discusses the restrictions imposed on bank holding companies by the US Ferderal Reserve Board Testimony of Governor Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, before the Subcommittee on Financial Institutions and Regulatory Relief of the Committee on Banking, Housing and Urban Affairs of the United States on 20/3/97. I am pleased to be here today to discuss the Board's section 20 firewalls -- that is, the restrictions the Board has imposed on bank holding companies engaged in underwriting and dealing in securities. As the name suggests, the purpose of firewalls is to insulate a bank and its customers from the potential hazards of combining commercial and investment banking. Since last year the Board has been engaged in a comprehensive review of the 28 firewalls it erected in the late 1980s, and the Board has recently proposed to eliminate a majority of those restrictions. This oversight hearing provides a constructive opportunity for comment and analysis of the Board's proposal. Furthermore, if financial modernization is to move forward, the issue of firewalls will have to be confronted again. I hope that the Board's review and the public comment process can inform the legislative process as well. Today, I would like to explain why the Board proposed changes to the firewalls. I will also discuss the final changes the Board made last year to the revenue test that the Board uses to determine compliance with section 20 of the Glass-Steagall Act, and to firewalls regarding cross-marketing between a bank and a securities affiliate, and officer, director and employee interlocks between two such companies. ## The Firewalls in Context: Independent Protections for Banks and Consumers Before I begin this discussion, I think it is important to place the firewalls in their historical and regulatory context. Although the firewalls have served an important role, they are not the only protection against the hazards of affiliation of commercial and investment banks. One important protection is the placement of securities activities in a separate subsidiary of the bank holding company, rather than in the bank itself or a subsidiary of the bank. Because non-bank subsidiaries of a bank holding company operating under section 20 of the Glass-Steagall Act are affiliates of a bank, they are not under the bank's control, do not have their profits or losses consolidated with the bank's, and are less liable to have their creditors recover against the bank. A bank therefore has less incentive to risk its own reputation or expose itself or its customers to loss in order to assist a troubled section 20 affiliate or a failed underwriting by that affiliate. Also, because securities activities are conducted in an affiliate, banks are limited in their ability to fund those activities by sections 23A and 23B of the Federal Reserve Act. These restrictions are vitally important. Section 23A limits the total value of transactions with any one affiliate to 10 percent of the bank's capital and limits transactions with all affiliates to 20 percent of capital. It also requires that substantial collateral be pledged to the bank for any extension of credit. Section 23B requires that inter-affiliate transactions be at arm's length and on market terms, and imposes other restrictions designed to limit conflicts of interest. Thus, affiliate status prevents the bank from passing along the federal subsidy inherent in the federal safety net to its section 20 affiliate by extending credit. Regulators could conceivably limit a bank's ability to use credit to subsidize a direct securities subsidiary of the bank as well, by applying sections 23A and 23B. But the equity investment in the subsidiary ---[PAGE_BREAK]--- would still be funded from subsidized resources backed by the federal safety net. Even if the investment were deducted from the capital of the bank, the subsidy inherent in the transfer would remain. A second protection is examination of the bank holding company, including the effect of securities activities on insured depository institution subsidiaries. The Federal Reserve as holding company regulator monitors compliance with sections 23A and 23B and other aspects of the relationship between a bank and its section 20 affiliate. In its supervision of bank holding companies, the Board increasingly pays attention to risk management systems and policies that are centralized at the holding company level and govern both the bank and its section 20 affiliate. A final series of protections is the regulatory regime that applies to all broker-dealers, including section 20 subsidiaries. The Securities Act of 1933 and the Securities Exchange Act of 1934 impose registration, capital and disclosure requirements, anti-fraud protections, and other investor-protection measures. These laws, and their enforcement by the Securities and Exchange Commission, address many of the safety and soundness and conflict-of-interest concerns about affiliation of commercial and investment banks. I note that most of these important protections were not in place when the Glass-Steagall Act passed in 1933. Thus, although proponents of high firewalls frequently cite the subtle hazards of affiliation discussed in the legislative history of that Act, the regulatory environment was far different then. I believe that the drafters of the Glass-Steagall Act would have had a very different discussion -- and passed a very different Act -- had today's statutory and regulatory protections been present in 1933. Not only were these protections largely absent in 1933, some were not even present in 1987 when the Board first erected its firewalls. Section 23B of the Federal Reserve Act had not been adopted at the time of the Board's first section 20 order in 1987. As a result, many of the firewalls overlap the restrictions of section 23B, which as I noted requires interaffiliate transactions to be at arm's length and on market terms, but also prohibits a section 20 affiliate from representing that an affiliated bank is responsible for its obligations, and prohibits a bank from purchasing certain products from a section 20 affiliate. Similarly, risk-based capital standards did not exist in 1987, and those standards now require a bank to hold capital against many of the on- and off-balance-sheet exposures it maintains in conjunction with a section 20 affiliate. Finally, the Interagency Statement on Retail Sales of Nondeposit Investment Products was not adopted until 1994. The Interagency Statement includes disclosure and other requirements that are now the primary means by which the federal banking agencies seek to ensure that retail customers are not misled about the nature of non-deposit products they are purchasing on bank premises. # The Board's Review Thus, when the Board last year decided to reexamine the firewalls, we felt it important to do so with a fresh eye, benefitting from our ten years of experience supervising the section 20 affiliates, acknowledging regulatory and legal developments since 1987, and focusing on the relevance of the firewalls in today's financial markets. As we began to look at the concerns the firewalls were designed to address, we asked two questions. Does the affiliation of a commercial and an investment bank cause safety and soundness or other concerns not present with any other commercial bank affiliation -- concerns not addressed by general bank holding company regulation? Does operation of a broker-dealer within a bank holding company cause ---[PAGE_BREAK]--- concerns that independent operation does not -- concerns not addressed by broker-dealer regulation? In some areas -- most notably, consumer protection -- we believed that the answer was "yes." In most other areas, however, the Board believed, at least pending public comment, that the answer was "no." The answers to these questions are important because the firewalls are far from costless. They impose operational inefficiencies on bank holding companies that increase their costs and reduce their competitiveness, and they limit a bank holding company's ability to market its products in a way that is both most profitable and desired by its customers. As such, the firewalls have served as a significant barrier to entry for small and mid-size bank holding companies because those companies cannot realize sufficient synergies or achieve adequate operating revenues to justify establishing a section 20 subsidiary. The loss is not just to these companies but also to their customers and market competition. Let me now discuss the most important of the firewalls to which the Board has proposed changes. The comment period closed on this proposal last week, and the comments were overwhelmingly favorable. I will not discuss all 28 firewalls but have attached a summary list and their proposed disposition. # Restrictions on Funding The Board proposed to eliminate a series of firewalls that constitute a blanket prohibition on a bank's funding its section 20 affiliate, and to rely instead on the protections of sections 23A and 23B of the Federal Reserve Act. The firewalls in question prohibit a bank from extending credit to a section 20 affiliate, purchasing corporate and other non-governmental securities being underwritten by the section 20 affiliate, or purchasing from the section 20 affiliate such securities in which the affiliate makes a market. These firewalls were intended to prevent a bank from assisting a troubled affiliate by lending to it on preferential terms or by bailing out a failed underwriting by purchasing securities that cannot otherwise be sold. Except for the prohibition on purchasing securities during the underwriting period, none of these funding firewalls was applied under the Board's original 1987 order, but were added in 1989 when the range of permissible securities activities was expanded. Bank subsidiaries of the fourteen companies operating under the 1987 order have therefore been free to, and have in fact, funded their section 20 affiliates subject to sections 23A and 23B. The Board has not encountered problems arising from such funding. If the Board were to eliminate the funding restrictions for the remaining section 20 subsidiaries, sections 23 A and 23 B would continue to impose quantitative and qualitative restrictions on inter-affiliate transactions. In addition to requiring that the transaction be on market terms, section 23B specifically prohibits a bank from purchasing any security for which a section 20 affiliate is a principal underwriter during the existence of the underwriting or selling syndicate, unless such a purchase has been approved by a majority of the bank's board of directors who are not officers of any bank or any affiliate. If the purchase is as fiduciary, the purchase must be permitted by the instrument creating the fiduciary relationship, court order, or state law. We believe these are substantial protections, and have proposed to rely on them in place of a firewall. ---[PAGE_BREAK]--- Prohibitions on a Bank Extending or Enhancing Credit in Support of Underwriting or Dealing by a Section 20 Affiliate Three of the Board's firewalls restrict the ability of a bank to assist a section 20 affiliate indirectly, by enhancing the marketability of its products or lending to its customers. These firewalls prohibit a bank from extending credit or offering credit enhancements in support of corporate and other non-governmental securities being underwritten by its section 20 affiliate or in which the section 20 affiliate makes a market; extending credit to issuers of securities to repay principal or interest on securities previously underwritten by a section 20 affiliate; or extending credit to customers to purchase securities currently being underwritten by a section 20 affiliate. The firewalls share a common purpose: to prevent a bank from imprudently exposing itself to loss in order to benefit the underwriting or dealing activities of its affiliate. However, as financial intermediation has evolved, corporate customers frequently seek to obtain a variety of funding mechanisms from one source. By prohibiting banks from providing routine credit or credit enhancements in tandem with a section 20 affiliate, these firewalls hamper the ability of bank holding companies to serve as full-service financial services providers. The firewall thereby reduces options for their customers. For example, existing corporate customers of a bank may wish to issue commercial paper or issue debt in some other form. Although the bank may refer the customer to its section 20 affiliate, the bank is prohibited from providing credit enhancements even though it is the institution best suited to perform a credit analysis -- and, with smaller customers, perhaps the only institution willing to do so. As another example, the restriction on lending for repayment of securities causes a bank compliance problems when renewing a company's revolving line of credit if a section 20 affiliate has underwritten an offering by that company since the credit was first extended. The bank must either recruit other lenders to participate in the renewal or amend the line of credit in order to specify that its purpose does not include repayment of interest or principal on the newly underwritten securities. Notably, even if these firewalls were lifted, a bank would still be required to hold capital against all credit enhancements and credit extended to customers of its section 20 affiliate. Section 23B of the Federal Reserve Act would require that such credit and credit enhancements be on an arm's-length basis. Similarly, the federal anti-tying statute would prohibit a bank from offering discounted credit enhancements on the condition that an issuer obtain investment banking services from a section 20 affiliate. Thus, for example, a bank could not offer such credit enhancements below market prices, or to customers who were poor credit risks, in order to generate underwriting business for a section 20 affiliate. The firewall prohibiting lending to retail customers for securities purchases during the underwriting period addresses one of the most important potential conflicts of interests arising from the affiliation of commercial and investment banking: the possibility that a bank would extend credit at below-market rates in order to induce consumers to purchase securities underwritten by its section 20 affiliate. The concern here is not only safety and soundness but customer protection. The Securities Exchange Act of 1934 already prohibits a broker-dealer (including a section 20 affiliate) from extending or arranging for credit to its customers during the underwriting period. Still, we recognize the Act would not apply in the absence of arranging and, unlike the firewall, would not cover loans to purchase a security in which a section 20 affiliate makes a market. Section 23B of the Federal Reserve Act, and to some extent section ---[PAGE_BREAK]--- 23A, would address some of these remaining concerns, but perhaps not all. The Board will be reviewing the comments on this firewall carefully. # Capital Requirements The next group of firewalls I will discuss imposes capital requirements on a bank holding company and its section 20 subsidiary. These firewalls require a bank holding company to deduct from its capital any investment in a section 20 subsidiary and most unsecured extensions of credit to a section 20 subsidiary engaged in debt and equity underwriting; they also require the section 20 subsidiary to maintain its own capital in keeping with industry norms. These requirements apply only to section 20 subsidiaries and not to any other nonbank subsidiary of a bank holding company. The Board proposed to eliminate the capital deductions for investments in, or credit extended to, a section 20 subsidiary. The original purpose of the deduction was to ensure that the holding company maintained sufficient resources to support its federally insured depository institutions. In practice, however, the deductions have created regulatory burden without strengthening the capital levels of the insured institutions. The deduction is inconsistent with Generally Accepted Accounting Practices, which require consolidation of subsidiaries for accounting purposes. The deduction therefore has created confusion and imposed costs by requiring bank holding companies to prepare statements on two bases. The deduction does not strengthen the capital of either the bank or its section 20 affiliate, and elimination of the deduction would not create or expose any incentive for a bank holding company to divert necessary capital from a depository institution to a section 20 subsidiary. One of the purposes of the system of prompt corrective action adopted in 1992 is to ensure that a bank holding company maintains the capital of its subsidiary banks. The Board also sought comment on whether it should continue to impose a special capital requirement on section 20 subsidiaries in addition to the SEC's net capital rules. The purpose of this requirement was to prevent a section 20 subsidiary from being able to leverage itself more than, and gain a competitive advantage over, its independent competitors by trading on the reputation of its affiliated bank. Although the SEC imposes capital requirements on all broker-dealers, these are minimum levels that are far below the industry norm. This capital firewall has proven confusing and controversial, as "industry norms" are difficult to determine. Federal Reserve examiners have expected section 20 subsidiaries to maintain capital to cover risk exposure in an amount approximately twice what the SEC requires, but some section 20 subsidiaries have complained that this is more than their competitors maintain. They also argue that whereas SEC capital requirements allow all capital to be concentrated in the broker-dealer and dedicated to meeting capital requirements, a bank holding company must meet capital requirements at the bank and holding company levels as well. Indeed, bank holding company capital is measured on a consolidated basis, and thus includes the capital and assets of the section 20 subsidiary. Therefore, the Board believes it may be unnecessary to impose a separate capital requirement on the bank holding company's section 20 subsidiary. ---[PAGE_BREAK]--- # Remaining Restrictions Before leaving the Board's proposal, I should also note which restrictions the Board proposed to retain. The Board proposed to reserve its authority to reimpose the funding, credit extension, and credit enhancement firewalls in the event that an affiliated bank or thrift becomes less than well capitalized and the bank holding company does not promptly restore it to the well-capitalized level. The Board considered proposing to reimpose the firewalls on less than well capitalized banks automatically -- as some recent bills introduced in the Congress would -but decided against it because a decline in a bank's capital ratios may be wholly unrelated to the bank's dealings with its section 20 affiliate. Thus, for example, forcing a bank suffering serious losses on real estate lending to desist from credit enhancements may be unproductive or -- if the business is profitable -- counterproductive. The Board also proposed to retain existing firewalls requiring adequate internal controls and documentation, including a requirement that a bank exercise independent and thorough credit judgment in any transaction involving an affiliate. Although we expect banking organizations to have such internal controls and look for them during examinations, we believe that they are sufficiently important to warrant reinforcement through the operating standards. They are especially important in the section 20 context because of the likelihood that a bank and its section 20 affiliate may be selling similar products to the same customer. Because of the potential for customer confusion as to which products are federally insured, the Board proposed to require a section 20 affiliate to make disclosures to customers similar to those that the Interagency Statement requires of a bank selling nondeposit products on bank premises. The proposal would also continue to prohibit an affiliated bank from knowingly advising a customer to purchase securities underwritten or dealt in by a section 20 affiliate unless it notifies the customer of its affiliate's role. The proposal also continues to prohibit a bank and its section 20 affiliate from sharing any nonpublic customer information without the customer's consent. ## Earlier Board Action on Other Firewalls and the Revenue Limit In addition to describing the Board's recent proposal, you also asked me to discuss other changes the Board finalized last year: increasing the section 20 revenue limit from 10 percent to 25 percent; allowing cross-marketing between a bank and a section 20 affiliate; permitting employee interlocks between a bank and a section 20 affiliate; and scaling back a restriction on officer and director interlocks. The review that led to changes to the cross-marketing and interlocks firewalls was akin to what the Board recently went through for all the firewalls. The Board acted on these firewalls before the rest because it had previously sought comment on them some years ago and because they were identified by commenters as among the most unduly burdensome of all the firewalls. After reviewing its experience administering these firewalls, the Board decided that they caused inefficiencies that could not be justified by any benefit to safety and soundness, and commenters agreed overwhelmingly. Repeal of the interlocks and cross-marketing restrictions allows increased synergies in the operation of a section 20 subsidiary and its bank affiliates. Persons may be employed by both companies, and the trend toward coordinated management of like business functions can accelerate, with reporting lines running between companies. Companies need not fund dual back offices or trading floors, for example. To the extent that senior bank managers may now oversee related operations at a section 20 affiliate, risk management and safety and soundness may be improved. ---[PAGE_BREAK]--- Moreover, existing disclosure requirements adequately address concerns about customer confusion arising from increased cross-marketing and employee interlocks. Most notably, the Interagency Statement on Retail Sales of Nondeposit Products states that, prior to the initial sale of a non-deposit product by a bank employee or on bank premises, the customer must receive and acknowledge a written statement that the product being sold is not federally insured, is not a deposit or other obligation of the bank, is not guaranteed by the bank, and is subject to investment risks including loss of principal. Finally, with regard to the revenue limit, section 20 of the Glass-Steagall Act prohibits a bank from being affiliated with any company "engaged principally" in underwriting and dealing, and the Board was obliged to make a narrow, legal determination of the level of revenue at which a company becomes "engaged principally." The Board interpreted the statute to allow 25 percent of total revenue to be derived from underwriting and dealing in bank-ineligible securities. In reviewing the revenue limit, the Board was not deciding what level of underwriting and dealing was consistent with safety and soundness or public policy. If it were, the Board may well have raised the limit to 100 percent, which would have been consistent with the Board's support of repeal of section 20 . I am pleased to report that early indications of the effects of these changes have been favorable. The Board currently has pending three applications to establish a section 20 subsidiary. As we had anticipated, two of these are small to mid-size bank holding companies which may previously have either found it too expensive to fund the dual staffing required by the interlocks restrictions or too difficult to generate sufficient eligible revenue to maintain compliance with a ten percent revenue limit. Furthermore, existing section 20 subsidiaries have indicated that they have been able to rationalize their organization and expand their activities given the added flexibility with respect to both staffing and revenue.	Susan M Phillips	United States	https://www.bis.org/review/r970403f.pdf	the US Ferderal Reserve Board Testimony of Governor Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, before the Subcommittee on Financial Institutions and Regulatory Relief of the Committee on Banking, Housing and Urban Affairs of the United States on 20/3/97. I am pleased to be here today to discuss the Board's section 20 firewalls -- that is, the restrictions the Board has imposed on bank holding companies engaged in underwriting and dealing in securities. As the name suggests, the purpose of firewalls is to insulate a bank and its customers from the potential hazards of combining commercial and investment banking. Since last year the Board has been engaged in a comprehensive review of the 28 firewalls it erected in the late 1980s, and the Board has recently proposed to eliminate a majority of those restrictions. This oversight hearing provides a constructive opportunity for comment and analysis of the Board's proposal. Furthermore, if financial modernization is to move forward, the issue of firewalls will have to be confronted again. I hope that the Board's review and the public comment process can inform the legislative process as well. Today, I would like to explain why the Board proposed changes to the firewalls. I will also discuss the final changes the Board made last year to the revenue test that the Board uses to determine compliance with section 20 of the Glass-Steagall Act, and to firewalls regarding cross-marketing between a bank and a securities affiliate, and officer, director and employee interlocks between two such companies. Before I begin this discussion, I think it is important to place the firewalls in their historical and regulatory context. Although the firewalls have served an important role, they are not the only protection against the hazards of affiliation of commercial and investment banks. One important protection is the placement of securities activities in a separate subsidiary of the bank holding company, rather than in the bank itself or a subsidiary of the bank. Because non-bank subsidiaries of a bank holding company operating under section 20 of the Glass-Steagall Act are affiliates of a bank, they are not under the bank's control, do not have their profits or losses consolidated with the bank's, and are less liable to have their creditors recover against the bank. A bank therefore has less incentive to risk its own reputation or expose itself or its customers to loss in order to assist a troubled section 20 affiliate or a failed underwriting by that affiliate. Also, because securities activities are conducted in an affiliate, banks are limited in their ability to fund those activities by sections 23A and 23B of the Federal Reserve Act. These restrictions are vitally important. Section 23A limits the total value of transactions with any one affiliate to 10 percent of the bank's capital and limits transactions with all affiliates to 20 percent of capital. It also requires that substantial collateral be pledged to the bank for any extension of credit. Section 23B requires that inter-affiliate transactions be at arm's length and on market terms, and imposes other restrictions designed to limit conflicts of interest. Thus, affiliate status prevents the bank from passing along the federal subsidy inherent in the federal safety net to its section 20 affiliate by extending credit. Regulators could conceivably limit a bank's ability to use credit to subsidize a direct securities subsidiary of the bank as well, by applying sections 23A and 23B. But the equity investment in the subsidiary would still be funded from subsidized resources backed by the federal safety net. Even if the investment were deducted from the capital of the bank, the subsidy inherent in the transfer would remain. A second protection is examination of the bank holding company, including the effect of securities activities on insured depository institution subsidiaries. The Federal Reserve as holding company regulator monitors compliance with sections 23A and 23B and other aspects of the relationship between a bank and its section 20 affiliate. In its supervision of bank holding companies, the Board increasingly pays attention to risk management systems and policies that are centralized at the holding company level and govern both the bank and its section 20 affiliate. A final series of protections is the regulatory regime that applies to all broker-dealers, including section 20 subsidiaries. The Securities Act of 1933 and the Securities Exchange Act of 1934 impose registration, capital and disclosure requirements, anti-fraud protections, and other investor-protection measures. These laws, and their enforcement by the Securities and Exchange Commission, address many of the safety and soundness and conflict-of-interest concerns about affiliation of commercial and investment banks. I note that most of these important protections were not in place when the Glass-Steagall Act passed in 1933. Thus, although proponents of high firewalls frequently cite the subtle hazards of affiliation discussed in the legislative history of that Act, the regulatory environment was far different then. I believe that the drafters of the Glass-Steagall Act would have had a very different discussion -- and passed a very different Act -- had today's statutory and regulatory protections been present in 1933. Not only were these protections largely absent in 1933, some were not even present in 1987 when the Board first erected its firewalls. Section 23B of the Federal Reserve Act had not been adopted at the time of the Board's first section 20 order in 1987. As a result, many of the firewalls overlap the restrictions of section 23B, which as I noted requires interaffiliate transactions to be at arm's length and on market terms, but also prohibits a section 20 affiliate from representing that an affiliated bank is responsible for its obligations, and prohibits a bank from purchasing certain products from a section 20 affiliate. Similarly, risk-based capital standards did not exist in 1987, and those standards now require a bank to hold capital against many of the on- and off-balance-sheet exposures it maintains in conjunction with a section 20 affiliate. Finally, the Interagency Statement on Retail Sales of Nondeposit Investment Products was not adopted until 1994. The Interagency Statement includes disclosure and other requirements that are now the primary means by which the federal banking agencies seek to ensure that retail customers are not misled about the nature of non-deposit products they are purchasing on bank premises. Thus, when the Board last year decided to reexamine the firewalls, we felt it important to do so with a fresh eye, benefitting from our ten years of experience supervising the section 20 affiliates, acknowledging regulatory and legal developments since 1987, and focusing on the relevance of the firewalls in today's financial markets. As we began to look at the concerns the firewalls were designed to address, we asked two questions. Does the affiliation of a commercial and an investment bank cause safety and soundness or other concerns not present with any other commercial bank affiliation -- concerns not addressed by general bank holding company regulation? Does operation of a broker-dealer within a bank holding company cause concerns that independent operation does not -- concerns not addressed by broker-dealer regulation? In some areas -- most notably, consumer protection -- we believed that the answer was "yes." In most other areas, however, the Board believed, at least pending public comment, that the answer was "no." The answers to these questions are important because the firewalls are far from costless. They impose operational inefficiencies on bank holding companies that increase their costs and reduce their competitiveness, and they limit a bank holding company's ability to market its products in a way that is both most profitable and desired by its customers. As such, the firewalls have served as a significant barrier to entry for small and mid-size bank holding companies because those companies cannot realize sufficient synergies or achieve adequate operating revenues to justify establishing a section 20 subsidiary. The loss is not just to these companies but also to their customers and market competition. Let me now discuss the most important of the firewalls to which the Board has proposed changes. The comment period closed on this proposal last week, and the comments were overwhelmingly favorable. I will not discuss all 28 firewalls but have attached a summary list and their proposed disposition. The Board proposed to eliminate a series of firewalls that constitute a blanket prohibition on a bank's funding its section 20 affiliate, and to rely instead on the protections of sections 23A and 23B of the Federal Reserve Act. The firewalls in question prohibit a bank from extending credit to a section 20 affiliate, purchasing corporate and other non-governmental securities being underwritten by the section 20 affiliate, or purchasing from the section 20 affiliate such securities in which the affiliate makes a market. These firewalls were intended to prevent a bank from assisting a troubled affiliate by lending to it on preferential terms or by bailing out a failed underwriting by purchasing securities that cannot otherwise be sold. Except for the prohibition on purchasing securities during the underwriting period, none of these funding firewalls was applied under the Board's original 1987 order, but were added in 1989 when the range of permissible securities activities was expanded. Bank subsidiaries of the fourteen companies operating under the 1987 order have therefore been free to, and have in fact, funded their section 20 affiliates subject to sections 23A and 23B. The Board has not encountered problems arising from such funding. If the Board were to eliminate the funding restrictions for the remaining section 20 subsidiaries, sections 23 A and 23 B would continue to impose quantitative and qualitative restrictions on inter-affiliate transactions. In addition to requiring that the transaction be on market terms, section 23B specifically prohibits a bank from purchasing any security for which a section 20 affiliate is a principal underwriter during the existence of the underwriting or selling syndicate, unless such a purchase has been approved by a majority of the bank's board of directors who are not officers of any bank or any affiliate. If the purchase is as fiduciary, the purchase must be permitted by the instrument creating the fiduciary relationship, court order, or state law. We believe these are substantial protections, and have proposed to rely on them in place of a firewall. Prohibitions on a Bank Extending or Enhancing Credit in Support of Underwriting or Dealing by a Section 20 Affiliate Three of the Board's firewalls restrict the ability of a bank to assist a section 20 affiliate indirectly, by enhancing the marketability of its products or lending to its customers. These firewalls prohibit a bank from extending credit or offering credit enhancements in support of corporate and other non-governmental securities being underwritten by its section 20 affiliate or in which the section 20 affiliate makes a market; extending credit to issuers of securities to repay principal or interest on securities previously underwritten by a section 20 affiliate; or extending credit to customers to purchase securities currently being underwritten by a section 20 affiliate. The firewalls share a common purpose: to prevent a bank from imprudently exposing itself to loss in order to benefit the underwriting or dealing activities of its affiliate. However, as financial intermediation has evolved, corporate customers frequently seek to obtain a variety of funding mechanisms from one source. By prohibiting banks from providing routine credit or credit enhancements in tandem with a section 20 affiliate, these firewalls hamper the ability of bank holding companies to serve as full-service financial services providers. The firewall thereby reduces options for their customers. For example, existing corporate customers of a bank may wish to issue commercial paper or issue debt in some other form. Although the bank may refer the customer to its section 20 affiliate, the bank is prohibited from providing credit enhancements even though it is the institution best suited to perform a credit analysis -- and, with smaller customers, perhaps the only institution willing to do so. As another example, the restriction on lending for repayment of securities causes a bank compliance problems when renewing a company's revolving line of credit if a section 20 affiliate has underwritten an offering by that company since the credit was first extended. The bank must either recruit other lenders to participate in the renewal or amend the line of credit in order to specify that its purpose does not include repayment of interest or principal on the newly underwritten securities. Notably, even if these firewalls were lifted, a bank would still be required to hold capital against all credit enhancements and credit extended to customers of its section 20 affiliate. Section 23B of the Federal Reserve Act would require that such credit and credit enhancements be on an arm's-length basis. Similarly, the federal anti-tying statute would prohibit a bank from offering discounted credit enhancements on the condition that an issuer obtain investment banking services from a section 20 affiliate. Thus, for example, a bank could not offer such credit enhancements below market prices, or to customers who were poor credit risks, in order to generate underwriting business for a section 20 affiliate. The firewall prohibiting lending to retail customers for securities purchases during the underwriting period addresses one of the most important potential conflicts of interests arising from the affiliation of commercial and investment banking: the possibility that a bank would extend credit at below-market rates in order to induce consumers to purchase securities underwritten by its section 20 affiliate. The concern here is not only safety and soundness but customer protection. The Securities Exchange Act of 1934 already prohibits a broker-dealer (including a section 20 affiliate) from extending or arranging for credit to its customers during the underwriting period. Still, we recognize the Act would not apply in the absence of arranging and, unlike the firewall, would not cover loans to purchase a security in which a section 20 affiliate makes a market. Section 23B of the Federal Reserve Act, and to some extent section 23A, would address some of these remaining concerns, but perhaps not all. The Board will be reviewing the comments on this firewall carefully. The next group of firewalls I will discuss imposes capital requirements on a bank holding company and its section 20 subsidiary. These firewalls require a bank holding company to deduct from its capital any investment in a section 20 subsidiary and most unsecured extensions of credit to a section 20 subsidiary engaged in debt and equity underwriting; they also require the section 20 subsidiary to maintain its own capital in keeping with industry norms. These requirements apply only to section 20 subsidiaries and not to any other nonbank subsidiary of a bank holding company. The Board proposed to eliminate the capital deductions for investments in, or credit extended to, a section 20 subsidiary. The original purpose of the deduction was to ensure that the holding company maintained sufficient resources to support its federally insured depository institutions. In practice, however, the deductions have created regulatory burden without strengthening the capital levels of the insured institutions. The deduction is inconsistent with Generally Accepted Accounting Practices, which require consolidation of subsidiaries for accounting purposes. The deduction therefore has created confusion and imposed costs by requiring bank holding companies to prepare statements on two bases. The deduction does not strengthen the capital of either the bank or its section 20 affiliate, and elimination of the deduction would not create or expose any incentive for a bank holding company to divert necessary capital from a depository institution to a section 20 subsidiary. One of the purposes of the system of prompt corrective action adopted in 1992 is to ensure that a bank holding company maintains the capital of its subsidiary banks. The Board also sought comment on whether it should continue to impose a special capital requirement on section 20 subsidiaries in addition to the SEC's net capital rules. The purpose of this requirement was to prevent a section 20 subsidiary from being able to leverage itself more than, and gain a competitive advantage over, its independent competitors by trading on the reputation of its affiliated bank. Although the SEC imposes capital requirements on all broker-dealers, these are minimum levels that are far below the industry norm. This capital firewall has proven confusing and controversial, as "industry norms" are difficult to determine. Federal Reserve examiners have expected section 20 subsidiaries to maintain capital to cover risk exposure in an amount approximately twice what the SEC requires, but some section 20 subsidiaries have complained that this is more than their competitors maintain. They also argue that whereas SEC capital requirements allow all capital to be concentrated in the broker-dealer and dedicated to meeting capital requirements, a bank holding company must meet capital requirements at the bank and holding company levels as well. Indeed, bank holding company capital is measured on a consolidated basis, and thus includes the capital and assets of the section 20 subsidiary. Therefore, the Board believes it may be unnecessary to impose a separate capital requirement on the bank holding company's section 20 subsidiary. Before leaving the Board's proposal, I should also note which restrictions the Board proposed to retain. The Board proposed to reserve its authority to reimpose the funding, credit extension, and credit enhancement firewalls in the event that an affiliated bank or thrift becomes less than well capitalized and the bank holding company does not promptly restore it to the well-capitalized level. The Board considered proposing to reimpose the firewalls on less than well capitalized banks automatically -- as some recent bills introduced in the Congress would -but decided against it because a decline in a bank's capital ratios may be wholly unrelated to the bank's dealings with its section 20 affiliate. Thus, for example, forcing a bank suffering serious losses on real estate lending to desist from credit enhancements may be unproductive or -- if the business is profitable -- counterproductive. The Board also proposed to retain existing firewalls requiring adequate internal controls and documentation, including a requirement that a bank exercise independent and thorough credit judgment in any transaction involving an affiliate. Although we expect banking organizations to have such internal controls and look for them during examinations, we believe that they are sufficiently important to warrant reinforcement through the operating standards. They are especially important in the section 20 context because of the likelihood that a bank and its section 20 affiliate may be selling similar products to the same customer. Because of the potential for customer confusion as to which products are federally insured, the Board proposed to require a section 20 affiliate to make disclosures to customers similar to those that the Interagency Statement requires of a bank selling nondeposit products on bank premises. The proposal would also continue to prohibit an affiliated bank from knowingly advising a customer to purchase securities underwritten or dealt in by a section 20 affiliate unless it notifies the customer of its affiliate's role. The proposal also continues to prohibit a bank and its section 20 affiliate from sharing any nonpublic customer information without the customer's consent. In addition to describing the Board's recent proposal, you also asked me to discuss other changes the Board finalized last year: increasing the section 20 revenue limit from 10 percent to 25 percent; allowing cross-marketing between a bank and a section 20 affiliate; permitting employee interlocks between a bank and a section 20 affiliate; and scaling back a restriction on officer and director interlocks. The review that led to changes to the cross-marketing and interlocks firewalls was akin to what the Board recently went through for all the firewalls. The Board acted on these firewalls before the rest because it had previously sought comment on them some years ago and because they were identified by commenters as among the most unduly burdensome of all the firewalls. After reviewing its experience administering these firewalls, the Board decided that they caused inefficiencies that could not be justified by any benefit to safety and soundness, and commenters agreed overwhelmingly. Repeal of the interlocks and cross-marketing restrictions allows increased synergies in the operation of a section 20 subsidiary and its bank affiliates. Persons may be employed by both companies, and the trend toward coordinated management of like business functions can accelerate, with reporting lines running between companies. Companies need not fund dual back offices or trading floors, for example. To the extent that senior bank managers may now oversee related operations at a section 20 affiliate, risk management and safety and soundness may be improved. Moreover, existing disclosure requirements adequately address concerns about customer confusion arising from increased cross-marketing and employee interlocks. Most notably, the Interagency Statement on Retail Sales of Nondeposit Products states that, prior to the initial sale of a non-deposit product by a bank employee or on bank premises, the customer must receive and acknowledge a written statement that the product being sold is not federally insured, is not a deposit or other obligation of the bank, is not guaranteed by the bank, and is subject to investment risks including loss of principal. Finally, with regard to the revenue limit, section 20 of the Glass-Steagall Act prohibits a bank from being affiliated with any company "engaged principally" in underwriting and dealing, and the Board was obliged to make a narrow, legal determination of the level of revenue at which a company becomes "engaged principally." The Board interpreted the statute to allow 25 percent of total revenue to be derived from underwriting and dealing in bank-ineligible securities. In reviewing the revenue limit, the Board was not deciding what level of underwriting and dealing was consistent with safety and soundness or public policy. If it were, the Board may well have raised the limit to 100 percent, which would have been consistent with the Board's support of repeal of section 20 . I am pleased to report that early indications of the effects of these changes have been favorable. The Board currently has pending three applications to establish a section 20 subsidiary. As we had anticipated, two of these are small to mid-size bank holding companies which may previously have either found it too expensive to fund the dual staffing required by the interlocks restrictions or too difficult to generate sufficient eligible revenue to maintain compliance with a ten percent revenue limit. Furthermore, existing section 20 subsidiaries have indicated that they have been able to rationalize their organization and expand their activities given the added flexibility with respect to both staffing and revenue.
1997-03-20T00:00:00	Mr. Greenspan highlights some key aspects of the current economic situation in the United States (Central Bank Articles and Speeches, 20 Mar 97)	Testimony of the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Joint Economic Committee of the United States Congress on 20/3/97.	Mr. Greenspan highlights some key aspects of the current economic situation in the United States Testimony of the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Joint Economic Committee of the United States Congress on 20/3/97. Mr. Chairman and members of the Committee, I am pleased to appear here today. Last month, the Federal Reserve Board submitted its semiannual report on monetary policy to the Congress. That report and my accompanying testimony covered in detail our assessment of the outlook for the U.S. economy. This morning, I would like to highlight some of the key aspects of the current economic situation. As I told the Congress last month, the performance of the U.S. economy remains quite favorable. Real GDP growth picked up to more than 3 percent over the four quarters of 1996. Moreover, recently released data suggest that activity has retained a great deal of vigor in early 1997. In addition, nominal hourly wages and salaries have risen faster than prices over the past several quarters, meaning that workers have reaped some of the benefits of rising productivity and thus gained ground in real terms. Outside the food and energy sectors, increases in consumer prices have actually continued to edge lower, with core CPI inflation of only 21⁄2 percent over the past twelve months. The low inflation of the past year is both a symptom and a cause of the good economy. It is symptomatic of the balance and solidity of the expansion and the evident absence of major strains on resources. At the same time, continued low levels of inflation and inflation expectations have been a key support for healthy economic performance. They have helped to create a financial and economic environment conducive to strong capital spending and longer-range planning generally, and so to sustained economic expansion. These types of results are why we stressed in our monetary policy testimony the importance of acting promptly -ideally pre-emptively -- to keep inflation low over the intermediate term and to promote price stability over time. For some, the benign inflation outcome of the past year might be considered surprising, as resource utilization rates -- particularly of labor -- have been in the neighborhood of those that historically have been associated with building inflation pressures. To be sure, nominal hourly labor compensation, especially its wage component, accelerated in 1996. But the rate of pay increase still was markedly less than historical relationships with labor market conditions would have predicted. Atypical restraint on compensation increases has been evident for a few years now. Almost certainly, it reflects a number of factors, including the sharp deceleration in health care costs and the heightened pressure on firms and workers in industries that compete internationally. Domestic deregulation has also intensified the competitive forces in some industries. But, as I outlined in some detail in testimony last month, I believe that job insecurity has played the dominant role. For example, in 1991, at the bottom of the recession, a survey of workers at large firms by International Survey Research Corporation indicated that 25 percent feared being laid off. In 1996, despite the sharply lower unemployment rate and the tighter labor market, the same survey organization found that 46 percent were fearful of a job layoff. Whatever the reasons for its persistence, job insecurity cannot suppress wage growth indefinitely. Clearly, there is a limit to how long workers will remain willing to accept smaller increases in living standards in exchange for additional job security. Even if real wages were to remain permanently on a lower upward track than otherwise as a result of the greater sense of insecurity, the rate of change of wages would revert at some point to a normal relationship with price inflation. The unknown is when a more normal pattern will resume. Indeed, the labor markets bear especially careful watching for signs that such a process is under way. So far this year, the demand for labor has stayed strong. Payroll employment grew briskly in January and February, and the unemployment rate remained around 51⁄4 percent -- roughly matching the low of the last cyclical upswing, in the late 1980s. Also, initial claims for unemployment insurance remained low into March. In addition, the percentage of households telling the Conference Board that jobs are plentiful has risen sharply of late, which suggests that workers may be growing more confident about the job situation. Finally, wages rose faster in 1996 than in 1995 by most measures -- in fact, the acceleration was quite sizable by some measures. This, too, raises questions about whether the transitional period of unusually slow wage gains may be drawing to a close. In any event, further increases in labor utilization rates would heighten the risk of additional upward pressure on wage costs, and ultimately prices. To be sure, the pickup in wage gains to date has not shown through to underlying price inflation. Increases in the core CPI, as well as in several other broad measures of prices, have stayed subdued or even edged off further of late. As best I can judge, faster productivity growth last year offset the pressure from rising compensation gains on labor costs per unit of output. And non-labor costs, which are roughly a quarter of total consolidated costs of the nonfinancial corporate sector, were little changed in 1996. Owing in part to this subdued behavior of unit costs, profits and rates of return on capital have risen to high levels. As a consequence, a substantial number of businesses apparently believe that, were they to raise prices to boost profits further, competitors with already ample profit margins would not follow suit; instead, they would use the occasion to capture a greater market share. This interplay is doubtless a significant factor in the evident loss of pricing power in American business. Intensifying global competition may also be limiting the ability of domestic firms to hike prices as well as wages. Competitive pressures here and abroad should continue to act as a restraint on inflation in the months ahead. In addition, crude oil prices have largely retraced last year's run-up, and, with the worldwide supply of oil having moved up relative to demand, futures markets project stable prices over the near term. Food prices should also rise less rapidly than they did in 1996 as some of last year's supply limitations ease. Nonetheless, the trends in the core CPI and in broader price measures are likely to come under pressure from a continued tight labor market, whose influence on costs will be augmented by the scheduled increase in the minimum wage later in the year. And, with considerable health-care savings already having been realized, larger increases in fringe benefits could put upward pressure on overall compensation. Moreover, although non-oil import prices should remain subdued in 1997 as the sharp rise in the dollar over the past year-and-a-half continues to feed through to domestic prices, their damping effects on U.S. inflation probably will not be as great as in 1996. The lagged effects of the increase in the exchange value of the dollar will also likely restrain real U.S. net exports this year. In addition, declines in real federal government purchases should exert a modest degree of restraint on overall demand, and residential construction will probably not repeat the gains of 1996. On the other hand, financial conditions overall remain supportive to the real economy, and creditworthy borrowers are finding funding to be readily available from intermediaries and in the securities markets. Moreover, we do not see evidence of widespread imbalances either in business inventories or in stocks of capital equipment and consumer durables that would lead to a substantial cutback in spending. The trends in consumer spending on items other than durables also look solid. Retail sales posted robust gains in January and February, and, according to various surveys, sentiment is decidedly upbeat. Moreover, consumers have enjoyed healthy increases in their real incomes over the past couple of years, along with the extraordinary stock-market driven rise in their financial wealth. Should the higher wealth be sustained, it could provide important support to consumption in 1997. But, looking at the data through 1996, the surging stock market does not seem to have imparted as big a boost to spending as past relationships would have predicted. The lack of a more substantial wealth effect is especially surprising because we have also seen a noticeable widening in the ownership of stocks over the past several years. Indeed, the Federal Reserve's recently released Survey of Consumer Finances suggests that of the total value of all families' holdings of publicly traded stocks and mutual funds, the share held by those with incomes below $100,000 (in 1995 dollars) rose from 32 percent in 1989 to 46 percent in 1995. It is possible, however, that the wealth effect is being offset by other factors. In particular, families may be reluctant to spend their added wealth because they see a greater need to keep it to support spending in retirement. Many have expressed heightened concern about their financial security in old age, in part because of growing skepticism about the viability of the Social Security system. This concern has reportedly led to stepped-up saving for retirement. The sharp increase in debt burdens in recent years may also be constraining spending by some families. Indeed, although our consumer survey showed that debt usage rose between 1992 and 1995 for almost all income groups, changes in financial conditions were not uniform across families. Notably, the median ratio of debt payments to income for families with debt -- a useful measure of the typical debt burden -- held steady or declined for families with incomes of at least $50,000, but it rose for those with incomes below $50,000. We don't know whether these latter families took on the additional debt because they perceived brighter future income prospects, or simply to accelerate purchases they would have made later. Nonetheless, these families are probably the most vulnerable to disruptions in income, and the rise in their debt burdens is likely to make both borrowers and lenders a bit more cautious as we move forward. Both household and business balance sheets have expanded at a pace considerably faster than income and product flows over the past decade. Accordingly, any percentage change in assets or liabilities has a greater effect on economic growth than it used to. However, identifying such influences in the aggregate data is not always easy. At present, the difficulty is compounded by concern that the currently published national statistics may not provide an accurate reading of the trends in recent years, especially for productivity. In any event, other data suggest that wealth and debt effects may be exerting a measurable influence on the consumption and saving decisions of different segments of the population. According to the Consumer Expenditure Survey conducted by the Bureau of Labor Statistics, saving out of current income by families in the upper-income quintile evidently has declined in recent years. At the same time, Federal Reserve estimates suggest that the use of credit for purchases has leveled off after a sharp run-up from 1993 to 1996, perhaps because some families are becoming debt constrained and, as a result, are curtailing their spending. The Federal Reserve, of course, will be weighing these and other influences as it makes future policy decisions. Demand has been growing quite strongly in recent months, and the FOMC, at its meeting next week, will have to judge whether that pace of expansion will be maintained, and, if so, whether it will continue to be met by solid productivity growth, as it apparently has been -- official figures to the contrary notwithstanding. Alternatively, if strong demand is expected to persist, and does not seem likely to be matched by productivity improvement, the FOMC will have to decide whether increased pressures on supply will eventually produce the types of inflationary imbalances that, if not addressed early, will undermine the long expansion. Should we choose to alter monetary policy, we know from past experience that, although the financial markets may respond immediately, the main effects on inflationary pressures may not be felt until late this year and in 1998. Because forecasts that far out are highly uncertain, we rarely think in terms of a single outlook. Rather, we endeavor to assess the likely consequences of our decisions in terms of a reasonable range of possible outcomes. Part of our evaluation is to judge not only the benefits that are likely to result from appropriate policy, but also the costs should we be wrong. In any action -- including leaving policy unchanged -- we seek to assure ourselves that the expected benefits are large enough to risk the cost of a mistake. In closing, I would like to note that the current economic expansion is now entering its seventh year. That makes it already a long upswing by historical standards. And yet, looking ahead, the prospects for sustaining the expansion are quite favorable. The flexibility of our market system and the vibrancy of our private sector remain examples for the whole world to emulate. We will endeavor to do our part by continuing to foster a monetary framework under which our citizens can prosper to the fullest possible extent.	---[PAGE_BREAK]--- # Mr. Greenspan highlights some key aspects of the current economic situation in the United States Testimony of the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Joint Economic Committee of the United States Congress on 20/3/97. Mr. Chairman and members of the Committee, I am pleased to appear here today. Last month, the Federal Reserve Board submitted its semiannual report on monetary policy to the Congress. That report and my accompanying testimony covered in detail our assessment of the outlook for the U.S. economy. This morning, I would like to highlight some of the key aspects of the current economic situation. As I told the Congress last month, the performance of the U.S. economy remains quite favorable. Real GDP growth picked up to more than 3 percent over the four quarters of 1996. Moreover, recently released data suggest that activity has retained a great deal of vigor in early 1997. In addition, nominal hourly wages and salaries have risen faster than prices over the past several quarters, meaning that workers have reaped some of the benefits of rising productivity and thus gained ground in real terms. Outside the food and energy sectors, increases in consumer prices have actually continued to edge lower, with core CPI inflation of only $2^{1 / 2}$ percent over the past twelve months. The low inflation of the past year is both a symptom and a cause of the good economy. It is symptomatic of the balance and solidity of the expansion and the evident absence of major strains on resources. At the same time, continued low levels of inflation and inflation expectations have been a key support for healthy economic performance. They have helped to create a financial and economic environment conducive to strong capital spending and longer-range planning generally, and so to sustained economic expansion. These types of results are why we stressed in our monetary policy testimony the importance of acting promptly -ideally pre-emptively -- to keep inflation low over the intermediate term and to promote price stability over time. For some, the benign inflation outcome of the past year might be considered surprising, as resource utilization rates -- particularly of labor -- have been in the neighborhood of those that historically have been associated with building inflation pressures. To be sure, nominal hourly labor compensation, especially its wage component, accelerated in 1996. But the rate of pay increase still was markedly less than historical relationships with labor market conditions would have predicted. Atypical restraint on compensation increases has been evident for a few years now. Almost certainly, it reflects a number of factors, including the sharp deceleration in health care costs and the heightened pressure on firms and workers in industries that compete internationally. Domestic deregulation has also intensified the competitive forces in some industries. But, as I outlined in some detail in testimony last month, I believe that job insecurity has played the dominant role. For example, in 1991, at the bottom of the recession, a survey of workers at large firms by International Survey Research Corporation indicated that 25 percent feared being laid off. In 1996, despite the sharply lower unemployment rate and the tighter labor market, the same survey organization found that 46 percent were fearful of a job layoff. Whatever the reasons for its persistence, job insecurity cannot suppress wage growth indefinitely. Clearly, there is a limit to how long workers will remain willing to accept smaller increases in living standards in exchange for additional job security. Even if real wages were to remain permanently on a lower upward track than otherwise as a result of the greater ---[PAGE_BREAK]--- sense of insecurity, the rate of change of wages would revert at some point to a normal relationship with price inflation. The unknown is when a more normal pattern will resume. Indeed, the labor markets bear especially careful watching for signs that such a process is under way. So far this year, the demand for labor has stayed strong. Payroll employment grew briskly in January and February, and the unemployment rate remained around $51 / 4$ percent -- roughly matching the low of the last cyclical upswing, in the late 1980s. Also, initial claims for unemployment insurance remained low into March. In addition, the percentage of households telling the Conference Board that jobs are plentiful has risen sharply of late, which suggests that workers may be growing more confident about the job situation. Finally, wages rose faster in 1996 than in 1995 by most measures -- in fact, the acceleration was quite sizable by some measures. This, too, raises questions about whether the transitional period of unusually slow wage gains may be drawing to a close. In any event, further increases in labor utilization rates would heighten the risk of additional upward pressure on wage costs, and ultimately prices. To be sure, the pickup in wage gains to date has not shown through to underlying price inflation. Increases in the core CPI, as well as in several other broad measures of prices, have stayed subdued or even edged off further of late. As best I can judge, faster productivity growth last year offset the pressure from rising compensation gains on labor costs per unit of output. And non-labor costs, which are roughly a quarter of total consolidated costs of the nonfinancial corporate sector, were little changed in 1996. Owing in part to this subdued behavior of unit costs, profits and rates of return on capital have risen to high levels. As a consequence, a substantial number of businesses apparently believe that, were they to raise prices to boost profits further, competitors with already ample profit margins would not follow suit; instead, they would use the occasion to capture a greater market share. This interplay is doubtless a significant factor in the evident loss of pricing power in American business. Intensifying global competition may also be limiting the ability of domestic firms to hike prices as well as wages. Competitive pressures here and abroad should continue to act as a restraint on inflation in the months ahead. In addition, crude oil prices have largely retraced last year's run-up, and, with the worldwide supply of oil having moved up relative to demand, futures markets project stable prices over the near term. Food prices should also rise less rapidly than they did in 1996 as some of last year's supply limitations ease. Nonetheless, the trends in the core CPI and in broader price measures are likely to come under pressure from a continued tight labor market, whose influence on costs will be augmented by the scheduled increase in the minimum wage later in the year. And, with considerable health-care savings already having been realized, larger increases in fringe benefits could put upward pressure on overall compensation. Moreover, although non-oil import prices should remain subdued in 1997 as the sharp rise in the dollar over the past year-and-a-half continues to feed through to domestic prices, their damping effects on U.S. inflation probably will not be as great as in 1996. The lagged effects of the increase in the exchange value of the dollar will also likely restrain real U.S. net exports this year. In addition, declines in real federal government purchases should exert a modest degree of restraint on overall demand, and residential construction will probably not repeat the gains of 1996. On the other hand, financial conditions overall remain supportive to the real economy, and creditworthy borrowers are finding funding to be readily available from intermediaries and in the securities markets. Moreover, we do not ---[PAGE_BREAK]--- see evidence of widespread imbalances either in business inventories or in stocks of capital equipment and consumer durables that would lead to a substantial cutback in spending. The trends in consumer spending on items other than durables also look solid. Retail sales posted robust gains in January and February, and, according to various surveys, sentiment is decidedly upbeat. Moreover, consumers have enjoyed healthy increases in their real incomes over the past couple of years, along with the extraordinary stock-market driven rise in their financial wealth. Should the higher wealth be sustained, it could provide important support to consumption in 1997. But, looking at the data through 1996, the surging stock market does not seem to have imparted as big a boost to spending as past relationships would have predicted. The lack of a more substantial wealth effect is especially surprising because we have also seen a noticeable widening in the ownership of stocks over the past several years. Indeed, the Federal Reserve's recently released Survey of Consumer Finances suggests that of the total value of all families' holdings of publicly traded stocks and mutual funds, the share held by those with incomes below $\$ 100,000$ (in 1995 dollars) rose from 32 percent in 1989 to 46 percent in 1995. It is possible, however, that the wealth effect is being offset by other factors. In particular, families may be reluctant to spend their added wealth because they see a greater need to keep it to support spending in retirement. Many have expressed heightened concern about their financial security in old age, in part because of growing skepticism about the viability of the Social Security system. This concern has reportedly led to stepped-up saving for retirement. The sharp increase in debt burdens in recent years may also be constraining spending by some families. Indeed, although our consumer survey showed that debt usage rose between 1992 and 1995 for almost all income groups, changes in financial conditions were not uniform across families. Notably, the median ratio of debt payments to income for families with debt -- a useful measure of the typical debt burden -- held steady or declined for families with incomes of at least $\$ 50,000$, but it rose for those with incomes below $\$ 50,000$. We don't know whether these latter families took on the additional debt because they perceived brighter future income prospects, or simply to accelerate purchases they would have made later. Nonetheless, these families are probably the most vulnerable to disruptions in income, and the rise in their debt burdens is likely to make both borrowers and lenders a bit more cautious as we move forward. Both household and business balance sheets have expanded at a pace considerably faster than income and product flows over the past decade. Accordingly, any percentage change in assets or liabilities has a greater effect on economic growth than it used to. However, identifying such influences in the aggregate data is not always easy. At present, the difficulty is compounded by concern that the currently published national statistics may not provide an accurate reading of the trends in recent years, especially for productivity. In any event, other data suggest that wealth and debt effects may be exerting a measurable influence on the consumption and saving decisions of different segments of the population. According to the Consumer Expenditure Survey conducted by the Bureau of Labor Statistics, saving out of current income by families in the upper-income quintile evidently has declined in recent years. At the same time, Federal Reserve estimates suggest that the use of credit for purchases has leveled off after a sharp run-up from 1993 to 1996, perhaps because some families are becoming debt constrained and, as a result, are curtailing their spending. ---[PAGE_BREAK]--- The Federal Reserve, of course, will be weighing these and other influences as it makes future policy decisions. Demand has been growing quite strongly in recent months, and the FOMC, at its meeting next week, will have to judge whether that pace of expansion will be maintained, and, if so, whether it will continue to be met by solid productivity growth, as it apparently has been -- official figures to the contrary notwithstanding. Alternatively, if strong demand is expected to persist, and does not seem likely to be matched by productivity improvement, the FOMC will have to decide whether increased pressures on supply will eventually produce the types of inflationary imbalances that, if not addressed early, will undermine the long expansion. Should we choose to alter monetary policy, we know from past experience that, although the financial markets may respond immediately, the main effects on inflationary pressures may not be felt until late this year and in 1998. Because forecasts that far out are highly uncertain, we rarely think in terms of a single outlook. Rather, we endeavor to assess the likely consequences of our decisions in terms of a reasonable range of possible outcomes. Part of our evaluation is to judge not only the benefits that are likely to result from appropriate policy, but also the costs should we be wrong. In any action -- including leaving policy unchanged -- we seek to assure ourselves that the expected benefits are large enough to risk the cost of a mistake. In closing, I would like to note that the current economic expansion is now entering its seventh year. That makes it already a long upswing by historical standards. And yet, looking ahead, the prospects for sustaining the expansion are quite favorable. The flexibility of our market system and the vibrancy of our private sector remain examples for the whole world to emulate. We will endeavor to do our part by continuing to foster a monetary framework under which our citizens can prosper to the fullest possible extent.	Alan Greenspan	United States	https://www.bis.org/review/r970403g.pdf	in the United States Testimony of the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Joint Economic Committee of the United States Congress on 20/3/97. Mr. Chairman and members of the Committee, I am pleased to appear here today. Last month, the Federal Reserve Board submitted its semiannual report on monetary policy to the Congress. That report and my accompanying testimony covered in detail our assessment of the outlook for the U.S. economy. This morning, I would like to highlight some of the key aspects of the current economic situation. As I told the Congress last month, the performance of the U.S. economy remains quite favorable. Real GDP growth picked up to more than 3 percent over the four quarters of 1996. Moreover, recently released data suggest that activity has retained a great deal of vigor in early 1997. In addition, nominal hourly wages and salaries have risen faster than prices over the past several quarters, meaning that workers have reaped some of the benefits of rising productivity and thus gained ground in real terms. Outside the food and energy sectors, increases in consumer prices have actually continued to edge lower, with core CPI inflation of only $2^{1 / 2}$ percent over the past twelve months. The low inflation of the past year is both a symptom and a cause of the good economy. It is symptomatic of the balance and solidity of the expansion and the evident absence of major strains on resources. At the same time, continued low levels of inflation and inflation expectations have been a key support for healthy economic performance. They have helped to create a financial and economic environment conducive to strong capital spending and longer-range planning generally, and so to sustained economic expansion. These types of results are why we stressed in our monetary policy testimony the importance of acting promptly -ideally pre-emptively -- to keep inflation low over the intermediate term and to promote price stability over time. For some, the benign inflation outcome of the past year might be considered surprising, as resource utilization rates -- particularly of labor -- have been in the neighborhood of those that historically have been associated with building inflation pressures. To be sure, nominal hourly labor compensation, especially its wage component, accelerated in 1996. But the rate of pay increase still was markedly less than historical relationships with labor market conditions would have predicted. Atypical restraint on compensation increases has been evident for a few years now. Almost certainly, it reflects a number of factors, including the sharp deceleration in health care costs and the heightened pressure on firms and workers in industries that compete internationally. Domestic deregulation has also intensified the competitive forces in some industries. But, as I outlined in some detail in testimony last month, I believe that job insecurity has played the dominant role. For example, in 1991, at the bottom of the recession, a survey of workers at large firms by International Survey Research Corporation indicated that 25 percent feared being laid off. In 1996, despite the sharply lower unemployment rate and the tighter labor market, the same survey organization found that 46 percent were fearful of a job layoff. Whatever the reasons for its persistence, job insecurity cannot suppress wage growth indefinitely. Clearly, there is a limit to how long workers will remain willing to accept smaller increases in living standards in exchange for additional job security. Even if real wages were to remain permanently on a lower upward track than otherwise as a result of the greater sense of insecurity, the rate of change of wages would revert at some point to a normal relationship with price inflation. The unknown is when a more normal pattern will resume. Indeed, the labor markets bear especially careful watching for signs that such a process is under way. So far this year, the demand for labor has stayed strong. Payroll employment grew briskly in January and February, and the unemployment rate remained around $51 / 4$ percent -- roughly matching the low of the last cyclical upswing, in the late 1980s. Also, initial claims for unemployment insurance remained low into March. In addition, the percentage of households telling the Conference Board that jobs are plentiful has risen sharply of late, which suggests that workers may be growing more confident about the job situation. Finally, wages rose faster in 1996 than in 1995 by most measures -- in fact, the acceleration was quite sizable by some measures. This, too, raises questions about whether the transitional period of unusually slow wage gains may be drawing to a close. In any event, further increases in labor utilization rates would heighten the risk of additional upward pressure on wage costs, and ultimately prices. To be sure, the pickup in wage gains to date has not shown through to underlying price inflation. Increases in the core CPI, as well as in several other broad measures of prices, have stayed subdued or even edged off further of late. As best I can judge, faster productivity growth last year offset the pressure from rising compensation gains on labor costs per unit of output. And non-labor costs, which are roughly a quarter of total consolidated costs of the nonfinancial corporate sector, were little changed in 1996. Owing in part to this subdued behavior of unit costs, profits and rates of return on capital have risen to high levels. As a consequence, a substantial number of businesses apparently believe that, were they to raise prices to boost profits further, competitors with already ample profit margins would not follow suit; instead, they would use the occasion to capture a greater market share. This interplay is doubtless a significant factor in the evident loss of pricing power in American business. Intensifying global competition may also be limiting the ability of domestic firms to hike prices as well as wages. Competitive pressures here and abroad should continue to act as a restraint on inflation in the months ahead. In addition, crude oil prices have largely retraced last year's run-up, and, with the worldwide supply of oil having moved up relative to demand, futures markets project stable prices over the near term. Food prices should also rise less rapidly than they did in 1996 as some of last year's supply limitations ease. Nonetheless, the trends in the core CPI and in broader price measures are likely to come under pressure from a continued tight labor market, whose influence on costs will be augmented by the scheduled increase in the minimum wage later in the year. And, with considerable health-care savings already having been realized, larger increases in fringe benefits could put upward pressure on overall compensation. Moreover, although non-oil import prices should remain subdued in 1997 as the sharp rise in the dollar over the past year-and-a-half continues to feed through to domestic prices, their damping effects on U.S. inflation probably will not be as great as in 1996. The lagged effects of the increase in the exchange value of the dollar will also likely restrain real U.S. net exports this year. In addition, declines in real federal government purchases should exert a modest degree of restraint on overall demand, and residential construction will probably not repeat the gains of 1996. On the other hand, financial conditions overall remain supportive to the real economy, and creditworthy borrowers are finding funding to be readily available from intermediaries and in the securities markets. Moreover, we do not see evidence of widespread imbalances either in business inventories or in stocks of capital equipment and consumer durables that would lead to a substantial cutback in spending. The trends in consumer spending on items other than durables also look solid. Retail sales posted robust gains in January and February, and, according to various surveys, sentiment is decidedly upbeat. Moreover, consumers have enjoyed healthy increases in their real incomes over the past couple of years, along with the extraordinary stock-market driven rise in their financial wealth. Should the higher wealth be sustained, it could provide important support to consumption in 1997. But, looking at the data through 1996, the surging stock market does not seem to have imparted as big a boost to spending as past relationships would have predicted. The lack of a more substantial wealth effect is especially surprising because we have also seen a noticeable widening in the ownership of stocks over the past several years. Indeed, the Federal Reserve's recently released Survey of Consumer Finances suggests that of the total value of all families' holdings of publicly traded stocks and mutual funds, the share held by those with incomes below $\$ 100,000$ (in 1995 dollars) rose from 32 percent in 1989 to 46 percent in 1995. It is possible, however, that the wealth effect is being offset by other factors. In particular, families may be reluctant to spend their added wealth because they see a greater need to keep it to support spending in retirement. Many have expressed heightened concern about their financial security in old age, in part because of growing skepticism about the viability of the Social Security system. This concern has reportedly led to stepped-up saving for retirement. The sharp increase in debt burdens in recent years may also be constraining spending by some families. Indeed, although our consumer survey showed that debt usage rose between 1992 and 1995 for almost all income groups, changes in financial conditions were not uniform across families. Notably, the median ratio of debt payments to income for families with debt -- a useful measure of the typical debt burden -- held steady or declined for families with incomes of at least $\$ 50,000$, but it rose for those with incomes below $\$ 50,000$. We don't know whether these latter families took on the additional debt because they perceived brighter future income prospects, or simply to accelerate purchases they would have made later. Nonetheless, these families are probably the most vulnerable to disruptions in income, and the rise in their debt burdens is likely to make both borrowers and lenders a bit more cautious as we move forward. Both household and business balance sheets have expanded at a pace considerably faster than income and product flows over the past decade. Accordingly, any percentage change in assets or liabilities has a greater effect on economic growth than it used to. However, identifying such influences in the aggregate data is not always easy. At present, the difficulty is compounded by concern that the currently published national statistics may not provide an accurate reading of the trends in recent years, especially for productivity. In any event, other data suggest that wealth and debt effects may be exerting a measurable influence on the consumption and saving decisions of different segments of the population. According to the Consumer Expenditure Survey conducted by the Bureau of Labor Statistics, saving out of current income by families in the upper-income quintile evidently has declined in recent years. At the same time, Federal Reserve estimates suggest that the use of credit for purchases has leveled off after a sharp run-up from 1993 to 1996, perhaps because some families are becoming debt constrained and, as a result, are curtailing their spending. The Federal Reserve, of course, will be weighing these and other influences as it makes future policy decisions. Demand has been growing quite strongly in recent months, and the FOMC, at its meeting next week, will have to judge whether that pace of expansion will be maintained, and, if so, whether it will continue to be met by solid productivity growth, as it apparently has been -- official figures to the contrary notwithstanding. Alternatively, if strong demand is expected to persist, and does not seem likely to be matched by productivity improvement, the FOMC will have to decide whether increased pressures on supply will eventually produce the types of inflationary imbalances that, if not addressed early, will undermine the long expansion. Should we choose to alter monetary policy, we know from past experience that, although the financial markets may respond immediately, the main effects on inflationary pressures may not be felt until late this year and in 1998. Because forecasts that far out are highly uncertain, we rarely think in terms of a single outlook. Rather, we endeavor to assess the likely consequences of our decisions in terms of a reasonable range of possible outcomes. Part of our evaluation is to judge not only the benefits that are likely to result from appropriate policy, but also the costs should we be wrong. In any action -- including leaving policy unchanged -- we seek to assure ourselves that the expected benefits are large enough to risk the cost of a mistake. In closing, I would like to note that the current economic expansion is now entering its seventh year. That makes it already a long upswing by historical standards. And yet, looking ahead, the prospects for sustaining the expansion are quite favorable. The flexibility of our market system and the vibrancy of our private sector remain examples for the whole world to emulate. We will endeavor to do our part by continuing to foster a monetary framework under which our citizens can prosper to the fullest possible extent.
1997-03-21T00:00:00	Dr. Duisenberg discusses strategies for monetary policy in EMU	Address by Dr. W.F. Duisenberg, President of the Netherlands Bank and of the Bank for International Settlements, on the occasion of the Board meeting of the Banking Federation of the European Union held in Maastricht on 20-21/3/97.	Dr. Duisenberg discusses strategies for monetary policy in EMU Address by Dr. W.F. Duisenberg, President of the Netherlands Bank and of the Bank for International Settlements, on the occasion of the Board meeting of the Banking Federation of the European Union held in Maastricht on 20-21/3/97. It is with great pleasure that I am addressing you on the European Economic and Monetary Union here in Maastricht today, the very location where that Union was pieced together. It was here that we made a concerted effort some five years ago to lay the foundations for the economic and monetary stability of Europe in the 21st century. Since then we have been busily building on these foundations with the result that we now have the outlines of the European Central Bank. The framework for monetary policy contains three main elements: its primary objective, strategy and instruments. Where the first is concerned, there can be no misunderstanding: the Maastricht Treaty prescribes that the overriding objective of ECB policy shall be price stability. Knowing you all to be distinguished financial and monetary experts, I need hardly point out to you that to attain this objective, strategy must be transparent and credible. It is not for nothing that in recent months this issue has been figuring prominently on the agenda of the European Monetary Institute, the precursor of the ECB. Let me give you a brief impression of the consultations held there. As soon as it has been decided in early 1998 which countries are to take part in EMU, the ECB will decide what monetary strategy to pursue. Generally speaking, there are two aspects to such a strategy: internal decision-making within the central bank and, equally important, the presentation of its measures to the outside world. In fact both aspects hinge on the question which variables should underlie the central banks interest rate policy and what weight should be assigned to each of these variables. After all, monetary policy is complicated by the fact that inflation reacts to the central bank's interest rate decisions with long and varied lags. Actual inflation rates are therefore not cut out to be a gauge of monetary conditions. The central bank should focus on information which provides insight into future inflation, and possibly formulate a number of intermediate objectives, the so-termed intermediate target variables: in Europe today the money supply and the exchange rate often figure as such. The exchange rate in particular plays a major role in open economies, where inflation is due largely to external factors. However, EMU will be a large and relatively closed area, where inflation is determined mainly by internal developments. There is therefore no question of the ECB conducting an active exchange rate policy vis-à-vis the dollar or the yen. That is why I will be discussing only two possible strategies for future monetary policy in Europe: monetary targeting, such as that pursued by the Deutsche Bundesbank for years already, and direct inflation targeting, the strategy applied by the Bank of England. Monetary targeting is underlain by the notion that in the medium to long term inflation is invariably caused by excessive money growth. In this line of thinking, the central bank can attain its objective of price stability simply by keeping the expansion of the money supply under control. That does not mean to say that the central bank will focus exclusively on monetary growth. Other aggregates containing information about inflationary prospects, especially in the near future, will be monitored as well. These factors act notably as "qualifiers", warning policy-makers against relying excessively on their automatic pilot. Apart from rules, this strategy therefore also provides for a certain measure of flexibility. In this context, I wish to dissociate myself emphatically from those who are wont to accuse my colleagues at the Bundesbank of "rigidity" and "monetary dogmatism". The necessary flexibility is coupled to a high degree of transparency as the central bank explains to the general public how it has determined its monetary target for the coming period, and goes to great lengths retrospectively to set out the reasons for any deviations from that target. By stressing its responsibility for monetary conditions, the central bank subjects itself to a certain discipline. For the central bank to be able to live up to this responsibility, the monetary aggregate to be chosen should meet three requirements. First of all, it should be sufficiently controllable. Generally speaking, an increase in the short-term interest rate will eventually lead to a decrease of the money supply. I deliberately say "generally speaking" because monetary policy-makers remember only too well what happened after German unification, when the reverse effect arose at first. Fortunately we now also know that such episodes may be shortlived. Secondly, there must be a sufficiently stable long-term relationship between the demand for money and its determinants, such as prices, income, interest rates and wealth. I will go into this in more detail later on. In the third place, the monetary aggregate needs to have predictive powers as to future inflation. If it does, money growth can be a useful indicator of future inflation. In the 1980s, monetary targeting was abandoned by several industrialised countries notably on the grounds that national money demand was becoming unstable as a result of financial innovations. It had thus become difficult to assess to what extent changes in monetary growth would be translated into higher prices. The central banks of some of these countries have meanwhile switched to a strategy aimed directly at the attainment of price stability. Their switch was, incidentally, often prompted by the implicit desire of policy-makers to prop up their reputation following years of relatively poor performances in terms of inflation. In 1989, my colleagues from New Zealand were the first to adopt direct inflation targeting. They were followed by Canada, the United Kingdom, Sweden, Finland, Spain and Australia. Although the name suggests otherwise, direct inflation targeting, too, makes use of an intermediate target, viz. expected inflation. As expectations are by definition hard to quantify, information variables are employed to forecast future inflation. If the predicted inflation rate deviates from the target, interest rate adjustment is called for. With a view to forecasting, direct inflation targeting employs, as I have pointed out, several information variables. Such variables are, for instance, changes in wage costs, the exchange rate, commodity prices, equity prices and the money supply. As soon as these indicators point towards rising inflation, the central bank needs to take action. However, the explicit use of a variety of indicators poses a threat to the transparency and credibility of monetary policy, because there is then no immediate way of knowing which information has prompted interest rate decisions. In order to remedy this problem, most countries pursuing inflation targeting have taken to publishing inflation reports setting out the backgrounds to policy measures. Such reports also enable the public to ascertain whether a central bank can be held accountable if the inflation target is not attained. After all, inflation may be caused by factors which are beyond the control of monetary authorities. It is for this reason that most countries cite circumstances under which the inflation target may be ignored or requires adjustment. For example, a number of central banks are not under any obligation to take corrective measures when indirect taxes are raised or when exogenous shocks such as energy price increases arise. As you can see, the two strategies are actually not as different as their names would have us believe. In practice, elements from both strategies are used, the distinction not always being as clear as it is in theory. The two strategies share the following properties: -both seek the attainment of the same ultimate goal, viz. price stability; -both are forward-looking; -and both make use of an extensive set of indicators to be able to assess whether the course pursued is the right one. In fact the different weights assigned to the money supply form the main distinction between the two strategies. If the two strategies differ so little in daily practice, how can we compare their pros and cons? To make comparison possible, it has been agreed within the EMI that the ECB will base its choice of monetary strategy on six general criteria, to wit effectiveness, accountability, transparency, medium-term orientation, continuity and consistency with the independence of the ECB. Obviously the criterion of effectiveness is more general in nature than the other five, which can be said to contribute to effectiveness each in their own way. Let us take a brief look at all of them. Any assessment of monetary targeting has always stressed the criterion of effectiveness. As I pointed out earlier, the effectiveness of this policy is determined by the controllability, the stability and the predictive powers of the monetary aggregate selected. In this context, special attention has always been paid to the stability of money demand. The EMI and other institutions have already extensively studied the stability of money demand for certain groups of EU countries. Though perhaps not quite representative of the situation in Stage Three, the results can be called encouraging so far. It turns out that European money demand functions evince greater stability than comparable relationships for individual countries, Germany included. However, the countries concerned must be sufficiently integrated and converged. Compared to monetary targeting, direct inflation targeting is harder to assess in terms of effectiveness. This is due to the fact that interest rate measures work through to inflation via all sorts of complicated macro-economic processes, with inflation right at the end of the chain. Direct inflation targeting, too, calls for a sufficient measure of stability of these relationships. Obviously effectiveness is in any case highly dependent on the quality of the inflation forecasts. Moreover, the central bank must be free to react pre-emptively and adequately to any deviations between the desired and the predicted rates of inflation. In the second place, it must be possible to hold the central bank accountable for the consequences of its policy. It must account for its decisions and explain them to the public. This enhances the confidence which the public at large has in the central bank and contributes to its credibility. As the ECB will be equipped with an adequate range of instruments, it can be held accountable for developments with regard to the money supply. But inflation is determined by more factors, some of which are less amenable to central bank control. That might let the central bank off the hook in the sense that it feels it cannot be considered wholly responsible for any overshooting of a direct inflation target. Thirdly, policy must be transparent. That means that the public must be informed on both which objectives are being pursued and how decisions have been arrived at. Those in favour of direct inflation targeting like to point out the fact that inflation is a more comprehensible concept than the money supply. On the other hand, transparency is well served when communication with the public at large centres on a single aggregate. In the case of direct inflation targeting, there is the risk that the outside world does not comprehend which indicator has been used this time, a problem which can be solved to some extent by issuing inflation reports. Fourthly, policy should not be tailored to individual developments, but should have a medium-term orientation, providing some breathing space when the target is not met in the short term. Above all this means that policy should be credible, offering a clear anchor for inflation expectations. Irrespective of the strategy chosen, monetary authorities do not react to every news item which comes their way. Wavering monetary policies only create unrest among both the public and financial market operators. In the fifth place, monetary policy should be characterised by sufficient continuity while all too frequent policy changes should be avoided. The continuity of monetary policy in Europe would be best served by monetary targeting, the strategy applied for several decades already by the most successful central bank in Europe, viz. the Bundesbank. Moreover, a large proportion of the other core group countries have attuned their exchange rate policies to Germany. One downside of direct inflation targeting as a policy option for the ECB is that little experience has been gained so far with this strategy in periods of heavy inflationary pressure. At the same time it should be kept in mind that the inflation performance of countries which have switched to direct inflation targeting has clearly improved over time. Finally, the policy strategy selected will need to be consistent with the ECB's independence. By this I mean to say that the strategy chosen must not inspire outsiders to meddle in the discussions on interest rate policy. The Maastricht Treaty is perfectly clear on this point. It would be undesirable if any inflationary differences within the Union were to lead to politicisation of the interest rate policy within the ECB Governing Council. It seems to me that this risk is greater in the case of direct inflation targeting than if monetary targeting were pursued. I am approaching the end of my address. I have told you which considerations underlie the choice of a monetary policy for the ECB and I have outlined the differences between monetary targeting and direct inflation targeting. The success of either strategy is dependent on largely identical factors. Here a key role is played by vital concepts such as credibility and transparency. It would be recommendable to inform the public regularly and in general terms of the considerations underlying interest rate measures. Furthermore, the ECB will in any case, in the daily implementation of its monetary policy, have to take into account the various indicators which contain information about future price movements. All in all the differences between the two strategies should not be exaggerated. Nevertheless, I profess that the considerations which I have set out lead me so far to have a certain preference for monetary targeting. The success of the Bundesbank shows that this strategy underpins the competence of the central bank, thus offering an optimum safeguard for its independence. Should you have a different view, then I hope that my address has contributed to a dynamic start-up of the discussion ahead.	---[PAGE_BREAK]--- Dr. Duisenberg discusses strategies for monetary policy in EMU Address by Dr. W.F. Duisenberg, President of the Netherlands Bank and of the Bank for International Settlements, on the occasion of the Board meeting of the Banking Federation of the European Union held in Maastricht on 20-21/3/97. It is with great pleasure that I am addressing you on the European Economic and Monetary Union here in Maastricht today, the very location where that Union was pieced together. It was here that we made a concerted effort some five years ago to lay the foundations for the economic and monetary stability of Europe in the 21st century. Since then we have been busily building on these foundations with the result that we now have the outlines of the European Central Bank. The framework for monetary policy contains three main elements: its primary objective, strategy and instruments. Where the first is concerned, there can be no misunderstanding: the Maastricht Treaty prescribes that the overriding objective of ECB policy shall be price stability. Knowing you all to be distinguished financial and monetary experts, I need hardly point out to you that to attain this objective, strategy must be transparent and credible. It is not for nothing that in recent months this issue has been figuring prominently on the agenda of the European Monetary Institute, the precursor of the ECB. Let me give you a brief impression of the consultations held there. As soon as it has been decided in early 1998 which countries are to take part in EMU, the ECB will decide what monetary strategy to pursue. Generally speaking, there are two aspects to such a strategy: internal decision-making within the central bank and, equally important, the presentation of its measures to the outside world. In fact both aspects hinge on the question which variables should underlie the central banks interest rate policy and what weight should be assigned to each of these variables. After all, monetary policy is complicated by the fact that inflation reacts to the central bank's interest rate decisions with long and varied lags. Actual inflation rates are therefore not cut out to be a gauge of monetary conditions. The central bank should focus on information which provides insight into future inflation, and possibly formulate a number of intermediate objectives, the so-termed intermediate target variables: in Europe today the money supply and the exchange rate often figure as such. The exchange rate in particular plays a major role in open economies, where inflation is due largely to external factors. However, EMU will be a large and relatively closed area, where inflation is determined mainly by internal developments. There is therefore no question of the ECB conducting an active exchange rate policy vis-à-vis the dollar or the yen. That is why I will be discussing only two possible strategies for future monetary policy in Europe: monetary targeting, such as that pursued by the Deutsche Bundesbank for years already, and direct inflation targeting, the strategy applied by the Bank of England. Monetary targeting is underlain by the notion that in the medium to long term inflation is invariably caused by excessive money growth. In this line of thinking, the central bank can attain its objective of price stability simply by keeping the expansion of the money supply under control. That does not mean to say that the central bank will focus exclusively on monetary growth. Other aggregates containing information about inflationary prospects, especially in the near future, will be monitored as well. These factors act notably as "qualifiers", warning policy-makers against relying excessively on their automatic pilot. Apart from rules, this strategy therefore also provides for a certain measure of flexibility. In this context, I wish to dissociate myself emphatically from those who are wont to accuse my colleagues at the Bundesbank of "rigidity" and "monetary dogmatism". The necessary flexibility is coupled to a high degree of transparency as the central bank explains to the general public how it has ---[PAGE_BREAK]--- determined its monetary target for the coming period, and goes to great lengths retrospectively to set out the reasons for any deviations from that target. By stressing its responsibility for monetary conditions, the central bank subjects itself to a certain discipline. For the central bank to be able to live up to this responsibility, the monetary aggregate to be chosen should meet three requirements. First of all, it should be sufficiently controllable. Generally speaking, an increase in the short-term interest rate will eventually lead to a decrease of the money supply. I deliberately say "generally speaking" because monetary policy-makers remember only too well what happened after German unification, when the reverse effect arose at first. Fortunately we now also know that such episodes may be shortlived. Secondly, there must be a sufficiently stable long-term relationship between the demand for money and its determinants, such as prices, income, interest rates and wealth. I will go into this in more detail later on. In the third place, the monetary aggregate needs to have predictive powers as to future inflation. If it does, money growth can be a useful indicator of future inflation. In the 1980s, monetary targeting was abandoned by several industrialised countries notably on the grounds that national money demand was becoming unstable as a result of financial innovations. It had thus become difficult to assess to what extent changes in monetary growth would be translated into higher prices. The central banks of some of these countries have meanwhile switched to a strategy aimed directly at the attainment of price stability. Their switch was, incidentally, often prompted by the implicit desire of policy-makers to prop up their reputation following years of relatively poor performances in terms of inflation. In 1989, my colleagues from New Zealand were the first to adopt direct inflation targeting. They were followed by Canada, the United Kingdom, Sweden, Finland, Spain and Australia. Although the name suggests otherwise, direct inflation targeting, too, makes use of an intermediate target, viz. expected inflation. As expectations are by definition hard to quantify, information variables are employed to forecast future inflation. If the predicted inflation rate deviates from the target, interest rate adjustment is called for. With a view to forecasting, direct inflation targeting employs, as I have pointed out, several information variables. Such variables are, for instance, changes in wage costs, the exchange rate, commodity prices, equity prices and the money supply. As soon as these indicators point towards rising inflation, the central bank needs to take action. However, the explicit use of a variety of indicators poses a threat to the transparency and credibility of monetary policy, because there is then no immediate way of knowing which information has prompted interest rate decisions. In order to remedy this problem, most countries pursuing inflation targeting have taken to publishing inflation reports setting out the backgrounds to policy measures. Such reports also enable the public to ascertain whether a central bank can be held accountable if the inflation target is not attained. After all, inflation may be caused by factors which are beyond the control of monetary authorities. It is for this reason that most countries cite circumstances under which the inflation target may be ignored or requires adjustment. For example, a number of central banks are not under any obligation to take corrective measures when indirect taxes are raised or when exogenous shocks such as energy price increases arise. As you can see, the two strategies are actually not as different as their names would have us believe. In practice, elements from both strategies are used, the distinction not always being as clear as it is in theory. The two strategies share the following properties: - both seek the attainment of the same ultimate goal, viz. price stability; - both are forward-looking; ---[PAGE_BREAK]--- - and both make use of an extensive set of indicators to be able to assess whether the course pursued is the right one. In fact the different weights assigned to the money supply form the main distinction between the two strategies. If the two strategies differ so little in daily practice, how can we compare their pros and cons? To make comparison possible, it has been agreed within the EMI that the ECB will base its choice of monetary strategy on six general criteria, to wit effectiveness, accountability, transparency, medium-term orientation, continuity and consistency with the independence of the ECB. Obviously the criterion of effectiveness is more general in nature than the other five, which can be said to contribute to effectiveness each in their own way. Let us take a brief look at all of them. Any assessment of monetary targeting has always stressed the criterion of effectiveness. As I pointed out earlier, the effectiveness of this policy is determined by the controllability, the stability and the predictive powers of the monetary aggregate selected. In this context, special attention has always been paid to the stability of money demand. The EMI and other institutions have already extensively studied the stability of money demand for certain groups of EU countries. Though perhaps not quite representative of the situation in Stage Three, the results can be called encouraging so far. It turns out that European money demand functions evince greater stability than comparable relationships for individual countries, Germany included. However, the countries concerned must be sufficiently integrated and converged. Compared to monetary targeting, direct inflation targeting is harder to assess in terms of effectiveness. This is due to the fact that interest rate measures work through to inflation via all sorts of complicated macro-economic processes, with inflation right at the end of the chain. Direct inflation targeting, too, calls for a sufficient measure of stability of these relationships. Obviously effectiveness is in any case highly dependent on the quality of the inflation forecasts. Moreover, the central bank must be free to react pre-emptively and adequately to any deviations between the desired and the predicted rates of inflation. In the second place, it must be possible to hold the central bank accountable for the consequences of its policy. It must account for its decisions and explain them to the public. This enhances the confidence which the public at large has in the central bank and contributes to its credibility. As the ECB will be equipped with an adequate range of instruments, it can be held accountable for developments with regard to the money supply. But inflation is determined by more factors, some of which are less amenable to central bank control. That might let the central bank off the hook in the sense that it feels it cannot be considered wholly responsible for any overshooting of a direct inflation target. Thirdly, policy must be transparent. That means that the public must be informed on both which objectives are being pursued and how decisions have been arrived at. Those in favour of direct inflation targeting like to point out the fact that inflation is a more comprehensible concept than the money supply. On the other hand, transparency is well served when communication with the public at large centres on a single aggregate. In the case of direct inflation targeting, there is the risk that the outside world does not comprehend which indicator has been used this time, a problem which can be solved to some extent by issuing inflation reports. Fourthly, policy should not be tailored to individual developments, but should have a medium-term orientation, providing some breathing space when the target is not met in the short term. Above all this means that policy should be credible, offering a clear anchor for inflation expectations. Irrespective of the strategy chosen, monetary authorities do not react to every news item which comes their way. Wavering monetary policies only create unrest among both the public and financial market operators. ---[PAGE_BREAK]--- In the fifth place, monetary policy should be characterised by sufficient continuity while all too frequent policy changes should be avoided. The continuity of monetary policy in Europe would be best served by monetary targeting, the strategy applied for several decades already by the most successful central bank in Europe, viz. the Bundesbank. Moreover, a large proportion of the other core group countries have attuned their exchange rate policies to Germany. One downside of direct inflation targeting as a policy option for the ECB is that little experience has been gained so far with this strategy in periods of heavy inflationary pressure. At the same time it should be kept in mind that the inflation performance of countries which have switched to direct inflation targeting has clearly improved over time. Finally, the policy strategy selected will need to be consistent with the ECB's independence. By this I mean to say that the strategy chosen must not inspire outsiders to meddle in the discussions on interest rate policy. The Maastricht Treaty is perfectly clear on this point. It would be undesirable if any inflationary differences within the Union were to lead to politicisation of the interest rate policy within the ECB Governing Council. It seems to me that this risk is greater in the case of direct inflation targeting than if monetary targeting were pursued. I am approaching the end of my address. I have told you which considerations underlie the choice of a monetary policy for the ECB and I have outlined the differences between monetary targeting and direct inflation targeting. The success of either strategy is dependent on largely identical factors. Here a key role is played by vital concepts such as credibility and transparency. It would be recommendable to inform the public regularly and in general terms of the considerations underlying interest rate measures. Furthermore, the ECB will in any case, in the daily implementation of its monetary policy, have to take into account the various indicators which contain information about future price movements. All in all the differences between the two strategies should not be exaggerated. Nevertheless, I profess that the considerations which I have set out lead me so far to have a certain preference for monetary targeting. The success of the Bundesbank shows that this strategy underpins the competence of the central bank, thus offering an optimum safeguard for its independence. Should you have a different view, then I hope that my address has contributed to a dynamic start-up of the discussion ahead.	William R White	United States	https://www.bis.org/review/r970403d.pdf	Dr. Duisenberg discusses strategies for monetary policy in EMU Address by Dr. W.F. Duisenberg, President of the Netherlands Bank and of the Bank for International Settlements, on the occasion of the Board meeting of the Banking Federation of the European Union held in Maastricht on 20-21/3/97. It is with great pleasure that I am addressing you on the European Economic and Monetary Union here in Maastricht today, the very location where that Union was pieced together. It was here that we made a concerted effort some five years ago to lay the foundations for the economic and monetary stability of Europe in the 21st century. Since then we have been busily building on these foundations with the result that we now have the outlines of the European Central Bank. The framework for monetary policy contains three main elements: its primary objective, strategy and instruments. Where the first is concerned, there can be no misunderstanding: the Maastricht Treaty prescribes that the overriding objective of ECB policy shall be price stability. Knowing you all to be distinguished financial and monetary experts, I need hardly point out to you that to attain this objective, strategy must be transparent and credible. It is not for nothing that in recent months this issue has been figuring prominently on the agenda of the European Monetary Institute, the precursor of the ECB. Let me give you a brief impression of the consultations held there. As soon as it has been decided in early 1998 which countries are to take part in EMU, the ECB will decide what monetary strategy to pursue. Generally speaking, there are two aspects to such a strategy: internal decision-making within the central bank and, equally important, the presentation of its measures to the outside world. In fact both aspects hinge on the question which variables should underlie the central banks interest rate policy and what weight should be assigned to each of these variables. After all, monetary policy is complicated by the fact that inflation reacts to the central bank's interest rate decisions with long and varied lags. Actual inflation rates are therefore not cut out to be a gauge of monetary conditions. The central bank should focus on information which provides insight into future inflation, and possibly formulate a number of intermediate objectives, the so-termed intermediate target variables: in Europe today the money supply and the exchange rate often figure as such. The exchange rate in particular plays a major role in open economies, where inflation is due largely to external factors. However, EMU will be a large and relatively closed area, where inflation is determined mainly by internal developments. There is therefore no question of the ECB conducting an active exchange rate policy vis-à-vis the dollar or the yen. That is why I will be discussing only two possible strategies for future monetary policy in Europe: monetary targeting, such as that pursued by the Deutsche Bundesbank for years already, and direct inflation targeting, the strategy applied by the Bank of England. Monetary targeting is underlain by the notion that in the medium to long term inflation is invariably caused by excessive money growth. In this line of thinking, the central bank can attain its objective of price stability simply by keeping the expansion of the money supply under control. That does not mean to say that the central bank will focus exclusively on monetary growth. Other aggregates containing information about inflationary prospects, especially in the near future, will be monitored as well. These factors act notably as "qualifiers", warning policy-makers against relying excessively on their automatic pilot. Apart from rules, this strategy therefore also provides for a certain measure of flexibility. In this context, I wish to dissociate myself emphatically from those who are wont to accuse my colleagues at the Bundesbank of "rigidity" and "monetary dogmatism". The necessary flexibility is coupled to a high degree of transparency as the central bank explains to the general public how it has determined its monetary target for the coming period, and goes to great lengths retrospectively to set out the reasons for any deviations from that target. By stressing its responsibility for monetary conditions, the central bank subjects itself to a certain discipline. For the central bank to be able to live up to this responsibility, the monetary aggregate to be chosen should meet three requirements. First of all, it should be sufficiently controllable. Generally speaking, an increase in the short-term interest rate will eventually lead to a decrease of the money supply. I deliberately say "generally speaking" because monetary policy-makers remember only too well what happened after German unification, when the reverse effect arose at first. Fortunately we now also know that such episodes may be shortlived. Secondly, there must be a sufficiently stable long-term relationship between the demand for money and its determinants, such as prices, income, interest rates and wealth. I will go into this in more detail later on. In the third place, the monetary aggregate needs to have predictive powers as to future inflation. If it does, money growth can be a useful indicator of future inflation. In the 1980s, monetary targeting was abandoned by several industrialised countries notably on the grounds that national money demand was becoming unstable as a result of financial innovations. It had thus become difficult to assess to what extent changes in monetary growth would be translated into higher prices. The central banks of some of these countries have meanwhile switched to a strategy aimed directly at the attainment of price stability. Their switch was, incidentally, often prompted by the implicit desire of policy-makers to prop up their reputation following years of relatively poor performances in terms of inflation. In 1989, my colleagues from New Zealand were the first to adopt direct inflation targeting. They were followed by Canada, the United Kingdom, Sweden, Finland, Spain and Australia. Although the name suggests otherwise, direct inflation targeting, too, makes use of an intermediate target, viz. expected inflation. As expectations are by definition hard to quantify, information variables are employed to forecast future inflation. If the predicted inflation rate deviates from the target, interest rate adjustment is called for. With a view to forecasting, direct inflation targeting employs, as I have pointed out, several information variables. Such variables are, for instance, changes in wage costs, the exchange rate, commodity prices, equity prices and the money supply. As soon as these indicators point towards rising inflation, the central bank needs to take action. However, the explicit use of a variety of indicators poses a threat to the transparency and credibility of monetary policy, because there is then no immediate way of knowing which information has prompted interest rate decisions. In order to remedy this problem, most countries pursuing inflation targeting have taken to publishing inflation reports setting out the backgrounds to policy measures. Such reports also enable the public to ascertain whether a central bank can be held accountable if the inflation target is not attained. After all, inflation may be caused by factors which are beyond the control of monetary authorities. It is for this reason that most countries cite circumstances under which the inflation target may be ignored or requires adjustment. For example, a number of central banks are not under any obligation to take corrective measures when indirect taxes are raised or when exogenous shocks such as energy price increases arise. As you can see, the two strategies are actually not as different as their names would have us believe. In practice, elements from both strategies are used, the distinction not always being as clear as it is in theory. The two strategies share the following properties: both seek the attainment of the same ultimate goal, viz. price stability;. both are forward-looking;. and both make use of an extensive set of indicators to be able to assess whether the course pursued is the right one. In fact the different weights assigned to the money supply form the main distinction between the two strategies. If the two strategies differ so little in daily practice, how can we compare their pros and cons? To make comparison possible, it has been agreed within the EMI that the ECB will base its choice of monetary strategy on six general criteria, to wit effectiveness, accountability, transparency, medium-term orientation, continuity and consistency with the independence of the ECB. Obviously the criterion of effectiveness is more general in nature than the other five, which can be said to contribute to effectiveness each in their own way. Let us take a brief look at all of them. Any assessment of monetary targeting has always stressed the criterion of effectiveness. As I pointed out earlier, the effectiveness of this policy is determined by the controllability, the stability and the predictive powers of the monetary aggregate selected. In this context, special attention has always been paid to the stability of money demand. The EMI and other institutions have already extensively studied the stability of money demand for certain groups of EU countries. Though perhaps not quite representative of the situation in Stage Three, the results can be called encouraging so far. It turns out that European money demand functions evince greater stability than comparable relationships for individual countries, Germany included. However, the countries concerned must be sufficiently integrated and converged. Compared to monetary targeting, direct inflation targeting is harder to assess in terms of effectiveness. This is due to the fact that interest rate measures work through to inflation via all sorts of complicated macro-economic processes, with inflation right at the end of the chain. Direct inflation targeting, too, calls for a sufficient measure of stability of these relationships. Obviously effectiveness is in any case highly dependent on the quality of the inflation forecasts. Moreover, the central bank must be free to react pre-emptively and adequately to any deviations between the desired and the predicted rates of inflation. In the second place, it must be possible to hold the central bank accountable for the consequences of its policy. It must account for its decisions and explain them to the public. This enhances the confidence which the public at large has in the central bank and contributes to its credibility. As the ECB will be equipped with an adequate range of instruments, it can be held accountable for developments with regard to the money supply. But inflation is determined by more factors, some of which are less amenable to central bank control. That might let the central bank off the hook in the sense that it feels it cannot be considered wholly responsible for any overshooting of a direct inflation target. Thirdly, policy must be transparent. That means that the public must be informed on both which objectives are being pursued and how decisions have been arrived at. Those in favour of direct inflation targeting like to point out the fact that inflation is a more comprehensible concept than the money supply. On the other hand, transparency is well served when communication with the public at large centres on a single aggregate. In the case of direct inflation targeting, there is the risk that the outside world does not comprehend which indicator has been used this time, a problem which can be solved to some extent by issuing inflation reports. Fourthly, policy should not be tailored to individual developments, but should have a medium-term orientation, providing some breathing space when the target is not met in the short term. Above all this means that policy should be credible, offering a clear anchor for inflation expectations. Irrespective of the strategy chosen, monetary authorities do not react to every news item which comes their way. Wavering monetary policies only create unrest among both the public and financial market operators. In the fifth place, monetary policy should be characterised by sufficient continuity while all too frequent policy changes should be avoided. The continuity of monetary policy in Europe would be best served by monetary targeting, the strategy applied for several decades already by the most successful central bank in Europe, viz. the Bundesbank. Moreover, a large proportion of the other core group countries have attuned their exchange rate policies to Germany. One downside of direct inflation targeting as a policy option for the ECB is that little experience has been gained so far with this strategy in periods of heavy inflationary pressure. At the same time it should be kept in mind that the inflation performance of countries which have switched to direct inflation targeting has clearly improved over time. Finally, the policy strategy selected will need to be consistent with the ECB's independence. By this I mean to say that the strategy chosen must not inspire outsiders to meddle in the discussions on interest rate policy. The Maastricht Treaty is perfectly clear on this point. It would be undesirable if any inflationary differences within the Union were to lead to politicisation of the interest rate policy within the ECB Governing Council. It seems to me that this risk is greater in the case of direct inflation targeting than if monetary targeting were pursued. I am approaching the end of my address. I have told you which considerations underlie the choice of a monetary policy for the ECB and I have outlined the differences between monetary targeting and direct inflation targeting. The success of either strategy is dependent on largely identical factors. Here a key role is played by vital concepts such as credibility and transparency. It would be recommendable to inform the public regularly and in general terms of the considerations underlying interest rate measures. Furthermore, the ECB will in any case, in the daily implementation of its monetary policy, have to take into account the various indicators which contain information about future price movements. All in all the differences between the two strategies should not be exaggerated. Nevertheless, I profess that the considerations which I have set out lead me so far to have a certain preference for monetary targeting. The success of the Bundesbank shows that this strategy underpins the competence of the central bank, thus offering an optimum safeguard for its independence. Should you have a different view, then I hope that my address has contributed to a dynamic start-up of the discussion ahead.
1997-03-22T00:00:00	Mr. Greenspan looks at the need for financial reform and the importance of a decentralized banking structure in the United States (Central Bank Articles and Speeches, 22 Mar 97)	Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Greenspan, at the Annual Convention of the Independent Bankers Association of America in Phoenix, Arizona, on 22/3/97.	Mr. Greenspan looks at the need for financial reform and the importance of a decentralized banking structure in the United States Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Greenspan, at the Annual Convention of the Independent Bankers Association of America in Phoenix, Arizona, on 22/3/97. As always, it is a pleasure to address this convention of the Independent Bankers Association of America. This is the sixth year I have addressed this convention, and during that time four separate Congresses have debated how best to reform the financial system. I last spoke to you about financial reform in 1994, in Orlando, and it is clear that the real world occurrences of the past three years have not diminished the relevance of those words. Therefore, I shall reemphasize some of those thoughts today in the context of legislative proposals that are now before the current Congress. Let me begin by reiterating the essential thrust of the Federal Reserve's position regarding financial reform. We believe that any changes, either in regulation or legislation, should be consistent with four basic objectives: (1) continuing the safety and soundness of the banking system; (2) limiting systemic risk; (3) contributing to macroeconomic stability; and (4) limiting the spread of both the moral hazard and the subsidy implicit in the safety net. My remarks today will focus primarily on the macroeconomic and risk implications of financial reform and how, in particular, such reform must enable community banks to maintain their critical role in the macroeconomy. The importance of the community bank Our banking system is the most innovative, responsive, and flexible in the world. At its core is a banking structure that is characterized by very large numbers of relatively small banks -- more than 7000 separate banking organizations. This banking structure is very different from that of other industrialized nations -- for example, there are less than 500 banks incorporated in England, Germany, and Canada combined. To be sure, the very largest U.S. banking organizations account for the lion's share of banking assets. Still, no one institution controls more than 6 percent of total domestic banking assets in the United States. This highly decentralized, highly diverse banking structure is almost certainly the direct result of our market economy itself. Indeed, it is revealing that the first edition of Adam Smith's Wealth of Nations was published in 1776, the year of the birth of our nation. Our market-driven economy, founded on Smith's principle of "natural liberty" in economic choice, and the banking structure that evolved within that economy, have proved to be remarkably resilient. During the banking crisis of the late 1980s -- a crisis which was felt in banking systems throughout the world -- more than one thousand U.S. banks failed. But less than a decade later, loan loss reserves and bank capital at U.S. institutions stand at their highest levels in almost a half century. Moreover, the reestablishment of equilibrium regarding safety and soundness in our banking system was accomplished without costing the taxpayers a penny. To be sure, the effects of the banking crisis, as well as the ongoing pace of consolidation within the industry, have reduced the total number of banking organizations by more than a third since 1980. Nevertheless, we remain a nation characterized by a large number of smaller community banks -- just as we are a nation characterized by a diversity and small average size of our nonfinancial businesses. Moreover, one cannot easily imagine nor desire that the decentralized, diverse nature of our banking system will fundamentally change any time soon. There is, of course, a strong connection between our banking structure and the nature of our small-business-oriented economy. Smaller banks traditionally have been the source of capital for small businesses that do not generally have access to securities markets. In turn, small, new businesses, often employing new technology, account for much of the growth in employment in our economy. The new firms come into existence often to replace old firms that were not willing or able to take on the risks associated with high-growth strategies. This replacement of stagnating firms with dynamic new firms -- what the economist Joseph Schumpeter called the "perennial gale of creative destruction" -- is at the heart of our robust, growth-oriented economy. It is this freedom to take on risk that characterizes our economy and, by extension, our banking system. Legislation and regulation of banks, in turn, generally should not aim to curtail the predilection of businesses and their banks to take on risk -- so long as the general safety and soundness of our banking system is maintained. As I have said many times, regulators and legislators should not act as if the optimal degree of bank failure were zero. Rather, policymakers must continually assess the tradeoff between, on the one hand, protecting the financial system and the taxpayers, and on the other hand, allowing banks to perform their essential risk-taking activities, including the extension of risky credit. Optimal risk-taking on the part of our banks means that some mistakes will be made and some institutions will fail. Indeed, even if a bank is well-managed, optimal risk-taking means that such a bank can simply get unlucky. Either through mistakes of management or through the vagaries of economic luck, bank failure will occur, and such failure should be viewed as part of a natural process within our competitive system. Just as regulators and legislators must accept failure, they also must not, in their zealousness to maintain a safe and sound financial system, artificially restrict competition among banks or between banks and their nonbank counterparts. For example, we should not repeat the experiment with "micromanagement" of bank activities that was embodied in the 1991 FDICIA legislation, much of which was repealed in the 1994 banking legislation. In this regard, so long as we do not place artificial regulatory roadblocks in their way, I am not overly concerned with the ability of our smaller banks to compete with their large, regional or national counterparts. Our research shows that, when a large bank enters a new market through acquisition of an existing smaller institution, typically lending to small businesses initially declines. But then existing community banks take up the slack by lending to the borrowers spurned by the larger organization. Indeed, several community bankers have commented that they welcome the entry of large institutions into their markets via the acquisition route, seeing it as an opportunity to acquire some of the customer base that often is lost by the newly acquired bank. The dual banking system and the importance of choice of federal regulators Just as our decentralized banking structure is a key to the robustness of our macroeconomy, a key to the effectiveness of our banking structure is what we term the dual banking system. Our system of both federal and state regulation of banks has fostered a steady stream of innovations that likely would not have proceeded as rapidly or as effectively if our regulatory structure were characterized by a monolithic federal regulator. For example, the NOW account was invented by a state-chartered bank. Also, the liberalization of prohibitions against interstate banking has its origin in the so-called "regional compacts" that permitted interstate affiliations for banking companies in consenting states. Adjustable rate mortgages are yet another example of innovation at the state level that has benefitted financial institutions and their customers. Just as important as the fostering of innovation is the protection the dual banking system affords against overly rigid federal regulation and supervision. The key to protecting against overzealousness in regulation is for banks to have a choice of more than one federal regulator. With two or more federal regulators, a bank can choose to change its charter thereby choosing to be supervised by another federal regulator. That possibility has served as a constraint on arbitrary and capricious policies at the federal level. True, it is possible that two or more federal agencies can engage in a "competition in laxity" -- but I worry considerably more about the possibility that a single federal regulator would become inevitably rigid and insensitive to the needs of the marketplace. So long as the existence of a federal guarantee of deposits and other elements of the safety net call for federal regulation of banks, such regulation should entail a choice of federal regulator in order to ensure the critical competitiveness of our banks. The job of a banking regulator, difficult under any circumstances and for a variety of reasons, is especially critical as it regards the connection running between banking risk and the impact of such risk-taking on the macroeconomy. As I have been pointing out, the historic purpose of banks is to take risk through the extension of credit to businesses and households -credit that is so vital to the growth and stability of the economy. But this fact creates a significant conflict for banking regulators. On the one hand, regulators are concerned with the cost of bank failure to the taxpayer and the impact of such failures on the general safety and soundness of the financial system. On the other hand, banks must take risks in order to finance economic expansion. Decisions about tradeoffs must be made. In the early 1990s, we saw how, in response to FDICIA, new regulations, weakened capital, and large loan losses, banks reduced their willingness to take risks, thereby contributing to a credit crunch and slower economic growth. This recent episode demonstrates clearly how tricky are these tradeoffs between necessary risk taking and protecting the banking system; a swing too far in either direction can create both short-term and long-term difficulties. A regulator without responsibility for macroeconomic growth and stability tends to have a bias against risk-taking. Such a regulator receives no praise if the economy is functioning well, but is criticized if there are too many bank failures. For such a regulator, the tradeoffs are one-sided and, if the decisions of such a regulator were left unchecked, the result might be a stagnant economy at whose core was a stagnant banking system. In contrast, the Federal Reserve's economic responsibilities are an important reason why we have striven to maintain a consistent bank regulatory policy, one that entails neither excessive tightness nor ease in supervisory posture. The former would lead to credit crunches, the latter, with a lag, would lead to excessive bank failures. Just as the probability of bank failure should not be the only concern of the effective regulator, bank regulation is not the only, or even the most important, factor that affects the banking business. The condition of the macroeconomy also has something to say about your success as a banker. In that regard, the generally favorable macroeconomic conditions we have been facing for the past few years suggest that bankers should now take pause and reassess the appropriateness of their lending decisions. Mistakes in lending, after all, are not generally made during recessions but when the economic outlook appears benevolent. Recent evidence of thin margins and increased nonbank competition in portions of the syndicated loan market, as well as other indicators, suggest some modest underwriting laxity has a tendency to emerge during good times. This suggests the need for a mild caution that bankers maintain sound underwriting standards and pricing practices in their lending activities. Toward financial reform without losing the strengths of our current system Let me now turn from general concerns over our regulatory structure to more specific concerns regarding the supervisory and regulatory treatment of our largest, most complex banking organizations -- a subject in which I suspect community banks have some considerable interest. As the 105th Congress contemplates financial reform legislation, it is critical to focus on the issue of how best to supervise risk-taking in these large entities and, in particular, whether there should be significant umbrella supervision for the entire banking organization. Historically, bank holding companies have been largely confined to financial activities that are similar to, often the same as, those permissible to commercial banks. Also historically, supervision of banking organizations, both large and small, has tended to focus mainly on the need to protect the bank. To some extent, this emphasis on the bank rather than the nonbank activities of the banking organization was prompted by, or permitted by, management techniques that tended not to treat risk-taking in integrated fashion across the entire holding company. The regulators' main concern was the bank, and bank safety could be analyzed more or less remotely and distinctly from the nonbank activities of the banking organization. More recently, the focus of supervision of holding companies by the Federal Reserve is being modified to parallel the changes in the management of banking companies. Most large institutions in recent years have moved toward consolidated risk management across all their bank and nonbank activities. Should the Congress permit new nonbanking activities by banking organizations it is likely that these activities too would be managed on a consolidated basis from the point of view of risk-taking, pricing, and profitability analysis. Our regulatory posture must adjust accordingly, to focus on the decision-making process for the total organization. Especially as supervisors focus more on the measurement and management of market, credit, and operating risks, supervisory review of firm-wide processes increasingly will become the appropriate principle underlying our assessment of an organization's safety and soundness. Some market participants -- especially nonbanks contemplating buying banks in the wake of any new Congressional legislation, as well as banks contemplating entering newly permissible nonbank activities -- are naturally concerned over the thought of bank-like regulation being extended to their nonbank activities. We share this concern, and last month we asked Congress to modify our mandate to permit the Fed to be more flexible on such issues as applications for new activities. At the same time, however, we believe there has been some considerable misunderstanding of our basic philosophy of holding company supervision. The focus of the Fed's inspections of nonbank activities of bank holding companies is to gain a sense of the overall strength of the individual units and their interrelations with each other and the bank. As I indicated above, emphasis is placed on the adequacy of risk management and internal control systems. Only if there is a major deficiency in these areas would we intend for a bank holding company inspection to become in any significant way "intrusive," and the number of such intrusive inspections of nonbanking activities should be quite small if managements are following prudent business practices. Some observers have questioned not only the need for umbrella supervision, but also the need for the Fed's involvement in such supervision. In addition to the reasons I cited above for central bank involvement in supervision, there is the issue of systemic risk and the fact that it is primarily the Federal Reserve's obligation to maintain stability in our financial system and that system's interface with international financial markets. This obligation cannot be met solely via open market operations and use of the discount window, as powerful as these tools may be. Financial crises, when they occur, are unpredictable and diverse in nature. Globalization means that a domestic crisis can become international or that a foreign crisis can become a domestic concern. The Federal Reserve's ability to respond quickly and effectively to any particular systemic threat rests primarily on our experience and expertise with the details of the U.S. and foreign banking and financial systems, including our familiarity with the payments and settlement system. This expertise, in turn, has been accumulated over the years primarily through our supervision of large domestic and multinational banking companies, and via our participation in large payments and settlement systems which are such a critical part of our financial infrastructure. In order to carry out our responsibility, the Fed must be directly involved in the supervision of banks of all sizes -- such as now provided by member banks -- and must also be able to address the problems of large banking companies if one or more of their activities endanger the stability of our financial system. This implies that the Federal Reserve have appropriate supervisory authority. Moreover, the new regulatory structure must retain our flexibility to respond to changes in the structure of the financial system, especially where such changes cannot easily be forecast in the wake of significant legislative changes. Systemic crises occur very rarely by their very definition. But when such crises do occur the consequences of slow or misdirected action are grave. The central bank, as the lender of last resort, must have the knowledge, the tools, and the authority necessary to act in a timely and decisive fashion. This is necessary to protect the whole financial system, not the least of which are the critical players among our community banks. Conclusions Let me conclude by reiterating two of the Federal Reserve's most basic concerns as the current Congress deliberates the issue of financial reform. First, we should recognize the increasingly evident fact that financial firms of all sorts now engage routinely in a wide variety of financial activities that, just a few decades ago, were considered to be nontraditional. Even in cases where the financial activity is currently not permitted directly, the risks and returns of the activity can be mimicked through the prudent use of financial derivative instruments such as put and call options. We should recognize these facts and, in response, structure legislation that would permit the full economic integration of these various forms of financial activity, in order to gain the maximum operating efficiencies, the best tradeoffs between risk and return, and the most flexibility in meeting the needs of the customer. But new legislation should not attempt to accomplish too much too soon. The Board believes it is prudent to delay, or to implement in stages, broad authorization of nonfinancial activities for banking companies. We want to be sure of the smooth functioning of integrated financial activity before we address potential combinations of banking and commerce. Second, in permitting broadened financial powers, legislation should strive to maintain the current roles of both the dual banking system and the central bank. Financial reform should not be interpreted to mean regulatory reform for its own sake. Banks of all sizes must have their regulatory choices preserved, just as financial firms of all sizes should be permitted to engage prudently in a wide range of financial activity. Finally, the central bank must continue to be able to monitor and address activities of large banking organizations that might threaten the stability of the system. I am confident that prudent, reasoned financial reform can be accomplished in a manner that preserves the best of the current system while introducing the improvements that we all desire.	---[PAGE_BREAK]--- # Mr. Greenspan looks at the need for financial reform and the importance of a decentralized banking structure in the United States Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Greenspan, at the Annual Convention of the Independent Bankers Association of America in Phoenix, Arizona, on 22/3/97. As always, it is a pleasure to address this convention of the Independent Bankers Association of America. This is the sixth year I have addressed this convention, and during that time four separate Congresses have debated how best to reform the financial system. I last spoke to you about financial reform in 1994, in Orlando, and it is clear that the real world occurrences of the past three years have not diminished the relevance of those words. Therefore, I shall reemphasize some of those thoughts today in the context of legislative proposals that are now before the current Congress. Let me begin by reiterating the essential thrust of the Federal Reserve's position regarding financial reform. We believe that any changes, either in regulation or legislation, should be consistent with four basic objectives: (1) continuing the safety and soundness of the banking system; (2) limiting systemic risk; (3) contributing to macroeconomic stability; and (4) limiting the spread of both the moral hazard and the subsidy implicit in the safety net. My remarks today will focus primarily on the macroeconomic and risk implications of financial reform and how, in particular, such reform must enable community banks to maintain their critical role in the macroeconomy. ## The importance of the community bank Our banking system is the most innovative, responsive, and flexible in the world. At its core is a banking structure that is characterized by very large numbers of relatively small banks -- more than 7000 separate banking organizations. This banking structure is very different from that of other industrialized nations -- for example, there are less than 500 banks incorporated in England, Germany, and Canada combined. To be sure, the very largest U.S. banking organizations account for the lion's share of banking assets. Still, no one institution controls more than 6 percent of total domestic banking assets in the United States. This highly decentralized, highly diverse banking structure is almost certainly the direct result of our market economy itself. Indeed, it is revealing that the first edition of Adam Smith's Wealth of Nations was published in 1776, the year of the birth of our nation. Our market-driven economy, founded on Smith's principle of "natural liberty" in economic choice, and the banking structure that evolved within that economy, have proved to be remarkably resilient. During the banking crisis of the late 1980s -- a crisis which was felt in banking systems throughout the world -- more than one thousand U.S. banks failed. But less than a decade later, loan loss reserves and bank capital at U.S. institutions stand at their highest levels in almost a half century. Moreover, the reestablishment of equilibrium regarding safety and soundness in our banking system was accomplished without costing the taxpayers a penny. To be sure, the effects of the banking crisis, as well as the ongoing pace of consolidation within the industry, have reduced the total number of banking organizations by more than a third since 1980. Nevertheless, we remain a nation characterized by a large number of smaller community banks -- just as we are a nation characterized by a diversity and small average size of our nonfinancial businesses. Moreover, one cannot easily imagine nor desire that the decentralized, diverse nature of our banking system will fundamentally change any time soon. There is, of course, a strong connection between our banking structure and the nature of ---[PAGE_BREAK]--- our small-business-oriented economy. Smaller banks traditionally have been the source of capital for small businesses that do not generally have access to securities markets. In turn, small, new businesses, often employing new technology, account for much of the growth in employment in our economy. The new firms come into existence often to replace old firms that were not willing or able to take on the risks associated with high-growth strategies. This replacement of stagnating firms with dynamic new firms -- what the economist Joseph Schumpeter called the "perennial gale of creative destruction" -- is at the heart of our robust, growth-oriented economy. It is this freedom to take on risk that characterizes our economy and, by extension, our banking system. Legislation and regulation of banks, in turn, generally should not aim to curtail the predilection of businesses and their banks to take on risk -- so long as the general safety and soundness of our banking system is maintained. As I have said many times, regulators and legislators should not act as if the optimal degree of bank failure were zero. Rather, policymakers must continually assess the tradeoff between, on the one hand, protecting the financial system and the taxpayers, and on the other hand, allowing banks to perform their essential risk-taking activities, including the extension of risky credit. Optimal risk-taking on the part of our banks means that some mistakes will be made and some institutions will fail. Indeed, even if a bank is well-managed, optimal risk-taking means that such a bank can simply get unlucky. Either through mistakes of management or through the vagaries of economic luck, bank failure will occur, and such failure should be viewed as part of a natural process within our competitive system. Just as regulators and legislators must accept failure, they also must not, in their zealousness to maintain a safe and sound financial system, artificially restrict competition among banks or between banks and their nonbank counterparts. For example, we should not repeat the experiment with "micromanagement" of bank activities that was embodied in the 1991 FDICIA legislation, much of which was repealed in the 1994 banking legislation. In this regard, so long as we do not place artificial regulatory roadblocks in their way, I am not overly concerned with the ability of our smaller banks to compete with their large, regional or national counterparts. Our research shows that, when a large bank enters a new market through acquisition of an existing smaller institution, typically lending to small businesses initially declines. But then existing community banks take up the slack by lending to the borrowers spurned by the larger organization. Indeed, several community bankers have commented that they welcome the entry of large institutions into their markets via the acquisition route, seeing it as an opportunity to acquire some of the customer base that often is lost by the newly acquired bank. # The dual banking system and the importance of choice of federal regulators Just as our decentralized banking structure is a key to the robustness of our macroeconomy, a key to the effectiveness of our banking structure is what we term the dual banking system. Our system of both federal and state regulation of banks has fostered a steady stream of innovations that likely would not have proceeded as rapidly or as effectively if our regulatory structure were characterized by a monolithic federal regulator. For example, the NOW account was invented by a state-chartered bank. Also, the liberalization of prohibitions against interstate banking has its origin in the so-called "regional compacts" that permitted interstate affiliations for banking companies in consenting states. Adjustable rate mortgages are yet another example of innovation at the state level that has benefitted financial institutions and their customers. ---[PAGE_BREAK]--- Just as important as the fostering of innovation is the protection the dual banking system affords against overly rigid federal regulation and supervision. The key to protecting against overzealousness in regulation is for banks to have a choice of more than one federal regulator. With two or more federal regulators, a bank can choose to change its charter thereby choosing to be supervised by another federal regulator. That possibility has served as a constraint on arbitrary and capricious policies at the federal level. True, it is possible that two or more federal agencies can engage in a "competition in laxity" -- but I worry considerably more about the possibility that a single federal regulator would become inevitably rigid and insensitive to the needs of the marketplace. So long as the existence of a federal guarantee of deposits and other elements of the safety net call for federal regulation of banks, such regulation should entail a choice of federal regulator in order to ensure the critical competitiveness of our banks. The job of a banking regulator, difficult under any circumstances and for a variety of reasons, is especially critical as it regards the connection running between banking risk and the impact of such risk-taking on the macroeconomy. As I have been pointing out, the historic purpose of banks is to take risk through the extension of credit to businesses and households -credit that is so vital to the growth and stability of the economy. But this fact creates a significant conflict for banking regulators. On the one hand, regulators are concerned with the cost of bank failure to the taxpayer and the impact of such failures on the general safety and soundness of the financial system. On the other hand, banks must take risks in order to finance economic expansion. Decisions about tradeoffs must be made. In the early 1990s, we saw how, in response to FDICIA, new regulations, weakened capital, and large loan losses, banks reduced their willingness to take risks, thereby contributing to a credit crunch and slower economic growth. This recent episode demonstrates clearly how tricky are these tradeoffs between necessary risk taking and protecting the banking system; a swing too far in either direction can create both short-term and long-term difficulties. A regulator without responsibility for macroeconomic growth and stability tends to have a bias against risk-taking. Such a regulator receives no praise if the economy is functioning well, but is criticized if there are too many bank failures. For such a regulator, the tradeoffs are one-sided and, if the decisions of such a regulator were left unchecked, the result might be a stagnant economy at whose core was a stagnant banking system. In contrast, the Federal Reserve's economic responsibilities are an important reason why we have striven to maintain a consistent bank regulatory policy, one that entails neither excessive tightness nor ease in supervisory posture. The former would lead to credit crunches, the latter, with a lag, would lead to excessive bank failures. Just as the probability of bank failure should not be the only concern of the effective regulator, bank regulation is not the only, or even the most important, factor that affects the banking business. The condition of the macroeconomy also has something to say about your success as a banker. In that regard, the generally favorable macroeconomic conditions we have been facing for the past few years suggest that bankers should now take pause and reassess the appropriateness of their lending decisions. Mistakes in lending, after all, are not generally made during recessions but when the economic outlook appears benevolent. Recent evidence of thin margins and increased nonbank competition in portions of the syndicated loan market, as well as other indicators, suggest some modest underwriting laxity has a tendency to emerge during good times. This suggests the need for a mild caution that bankers maintain sound underwriting standards and pricing practices in their lending activities. ---[PAGE_BREAK]--- # Toward financial reform without losing the strengths of our current system Let me now turn from general concerns over our regulatory structure to more specific concerns regarding the supervisory and regulatory treatment of our largest, most complex banking organizations -- a subject in which I suspect community banks have some considerable interest. As the 105th Congress contemplates financial reform legislation, it is critical to focus on the issue of how best to supervise risk-taking in these large entities and, in particular, whether there should be significant umbrella supervision for the entire banking organization. Historically, bank holding companies have been largely confined to financial activities that are similar to, often the same as, those permissible to commercial banks. Also historically, supervision of banking organizations, both large and small, has tended to focus mainly on the need to protect the bank. To some extent, this emphasis on the bank rather than the nonbank activities of the banking organization was prompted by, or permitted by, management techniques that tended not to treat risk-taking in integrated fashion across the entire holding company. The regulators' main concern was the bank, and bank safety could be analyzed more or less remotely and distinctly from the nonbank activities of the banking organization. More recently, the focus of supervision of holding companies by the Federal Reserve is being modified to parallel the changes in the management of banking companies. Most large institutions in recent years have moved toward consolidated risk management across all their bank and nonbank activities. Should the Congress permit new nonbanking activities by banking organizations it is likely that these activities too would be managed on a consolidated basis from the point of view of risk-taking, pricing, and profitability analysis. Our regulatory posture must adjust accordingly, to focus on the decision-making process for the total organization. Especially as supervisors focus more on the measurement and management of market, credit, and operating risks, supervisory review of firm-wide processes increasingly will become the appropriate principle underlying our assessment of an organization's safety and soundness. Some market participants -- especially nonbanks contemplating buying banks in the wake of any new Congressional legislation, as well as banks contemplating entering newly permissible nonbank activities -- are naturally concerned over the thought of bank-like regulation being extended to their nonbank activities. We share this concern, and last month we asked Congress to modify our mandate to permit the Fed to be more flexible on such issues as applications for new activities. At the same time, however, we believe there has been some considerable misunderstanding of our basic philosophy of holding company supervision. The focus of the Fed's inspections of nonbank activities of bank holding companies is to gain a sense of the overall strength of the individual units and their interrelations with each other and the bank. As I indicated above, emphasis is placed on the adequacy of risk management and internal control systems. Only if there is a major deficiency in these areas would we intend for a bank holding company inspection to become in any significant way "intrusive," and the number of such intrusive inspections of nonbanking activities should be quite small if managements are following prudent business practices. Some observers have questioned not only the need for umbrella supervision, but also the need for the Fed's involvement in such supervision. In addition to the reasons I cited above for central bank involvement in supervision, there is the issue of systemic risk and the fact that it is primarily the Federal Reserve's obligation to maintain stability in our financial system ---[PAGE_BREAK]--- and that system's interface with international financial markets. This obligation cannot be met solely via open market operations and use of the discount window, as powerful as these tools may be. Financial crises, when they occur, are unpredictable and diverse in nature. Globalization means that a domestic crisis can become international or that a foreign crisis can become a domestic concern. The Federal Reserve's ability to respond quickly and effectively to any particular systemic threat rests primarily on our experience and expertise with the details of the U.S. and foreign banking and financial systems, including our familiarity with the payments and settlement system. This expertise, in turn, has been accumulated over the years primarily through our supervision of large domestic and multinational banking companies, and via our participation in large payments and settlement systems which are such a critical part of our financial infrastructure. In order to carry out our responsibility, the Fed must be directly involved in the supervision of banks of all sizes -- such as now provided by member banks -- and must also be able to address the problems of large banking companies if one or more of their activities endanger the stability of our financial system. This implies that the Federal Reserve have appropriate supervisory authority. Moreover, the new regulatory structure must retain our flexibility to respond to changes in the structure of the financial system, especially where such changes cannot easily be forecast in the wake of significant legislative changes. Systemic crises occur very rarely by their very definition. But when such crises do occur the consequences of slow or misdirected action are grave. The central bank, as the lender of last resort, must have the knowledge, the tools, and the authority necessary to act in a timely and decisive fashion. This is necessary to protect the whole financial system, not the least of which are the critical players among our community banks. # Conclusions Let me conclude by reiterating two of the Federal Reserve's most basic concerns as the current Congress deliberates the issue of financial reform. First, we should recognize the increasingly evident fact that financial firms of all sorts now engage routinely in a wide variety of financial activities that, just a few decades ago, were considered to be nontraditional. Even in cases where the financial activity is currently not permitted directly, the risks and returns of the activity can be mimicked through the prudent use of financial derivative instruments such as put and call options. We should recognize these facts and, in response, structure legislation that would permit the full economic integration of these various forms of financial activity, in order to gain the maximum operating efficiencies, the best tradeoffs between risk and return, and the most flexibility in meeting the needs of the customer. But new legislation should not attempt to accomplish too much too soon. The Board believes it is prudent to delay, or to implement in stages, broad authorization of nonfinancial activities for banking companies. We want to be sure of the smooth functioning of integrated financial activity before we address potential combinations of banking and commerce. Second, in permitting broadened financial powers, legislation should strive to maintain the current roles of both the dual banking system and the central bank. Financial reform should not be interpreted to mean regulatory reform for its own sake. Banks of all sizes must have their regulatory choices preserved, just as financial firms of all sizes should be permitted to engage prudently in a wide range of financial activity. Finally, the central bank must continue to be able to monitor and address activities of large banking organizations that might threaten the stability of the system. I am confident that prudent, reasoned financial reform can be accomplished in a manner that preserves the best of the current system while introducing the improvements that we all desire.	Alan Greenspan	United States	https://www.bis.org/review/r970409b.pdf	a decentralized banking structure in the United States Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Greenspan, at the Annual Convention of the Independent Bankers Association of America in Phoenix, Arizona, on 22/3/97. As always, it is a pleasure to address this convention of the Independent Bankers Association of America. This is the sixth year I have addressed this convention, and during that time four separate Congresses have debated how best to reform the financial system. I last spoke to you about financial reform in 1994, in Orlando, and it is clear that the real world occurrences of the past three years have not diminished the relevance of those words. Therefore, I shall reemphasize some of those thoughts today in the context of legislative proposals that are now before the current Congress. Let me begin by reiterating the essential thrust of the Federal Reserve's position regarding financial reform. We believe that any changes, either in regulation or legislation, should be consistent with four basic objectives: (1) continuing the safety and soundness of the banking system; (2) limiting systemic risk; (3) contributing to macroeconomic stability; and (4) limiting the spread of both the moral hazard and the subsidy implicit in the safety net. My remarks today will focus primarily on the macroeconomic and risk implications of financial reform and how, in particular, such reform must enable community banks to maintain their critical role in the macroeconomy. Our banking system is the most innovative, responsive, and flexible in the world. At its core is a banking structure that is characterized by very large numbers of relatively small banks -- more than 7000 separate banking organizations. This banking structure is very different from that of other industrialized nations -- for example, there are less than 500 banks incorporated in England, Germany, and Canada combined. To be sure, the very largest U.S. banking organizations account for the lion's share of banking assets. Still, no one institution controls more than 6 percent of total domestic banking assets in the United States. This highly decentralized, highly diverse banking structure is almost certainly the direct result of our market economy itself. Indeed, it is revealing that the first edition of Adam Smith's Wealth of Nations was published in 1776, the year of the birth of our nation. Our market-driven economy, founded on Smith's principle of "natural liberty" in economic choice, and the banking structure that evolved within that economy, have proved to be remarkably resilient. During the banking crisis of the late 1980s -- a crisis which was felt in banking systems throughout the world -- more than one thousand U.S. banks failed. But less than a decade later, loan loss reserves and bank capital at U.S. institutions stand at their highest levels in almost a half century. Moreover, the reestablishment of equilibrium regarding safety and soundness in our banking system was accomplished without costing the taxpayers a penny. To be sure, the effects of the banking crisis, as well as the ongoing pace of consolidation within the industry, have reduced the total number of banking organizations by more than a third since 1980. Nevertheless, we remain a nation characterized by a large number of smaller community banks -- just as we are a nation characterized by a diversity and small average size of our nonfinancial businesses. Moreover, one cannot easily imagine nor desire that the decentralized, diverse nature of our banking system will fundamentally change any time soon. There is, of course, a strong connection between our banking structure and the nature of our small-business-oriented economy. Smaller banks traditionally have been the source of capital for small businesses that do not generally have access to securities markets. In turn, small, new businesses, often employing new technology, account for much of the growth in employment in our economy. The new firms come into existence often to replace old firms that were not willing or able to take on the risks associated with high-growth strategies. This replacement of stagnating firms with dynamic new firms -- what the economist Joseph Schumpeter called the "perennial gale of creative destruction" -- is at the heart of our robust, growth-oriented economy. It is this freedom to take on risk that characterizes our economy and, by extension, our banking system. Legislation and regulation of banks, in turn, generally should not aim to curtail the predilection of businesses and their banks to take on risk -- so long as the general safety and soundness of our banking system is maintained. As I have said many times, regulators and legislators should not act as if the optimal degree of bank failure were zero. Rather, policymakers must continually assess the tradeoff between, on the one hand, protecting the financial system and the taxpayers, and on the other hand, allowing banks to perform their essential risk-taking activities, including the extension of risky credit. Optimal risk-taking on the part of our banks means that some mistakes will be made and some institutions will fail. Indeed, even if a bank is well-managed, optimal risk-taking means that such a bank can simply get unlucky. Either through mistakes of management or through the vagaries of economic luck, bank failure will occur, and such failure should be viewed as part of a natural process within our competitive system. Just as regulators and legislators must accept failure, they also must not, in their zealousness to maintain a safe and sound financial system, artificially restrict competition among banks or between banks and their nonbank counterparts. For example, we should not repeat the experiment with "micromanagement" of bank activities that was embodied in the 1991 FDICIA legislation, much of which was repealed in the 1994 banking legislation. In this regard, so long as we do not place artificial regulatory roadblocks in their way, I am not overly concerned with the ability of our smaller banks to compete with their large, regional or national counterparts. Our research shows that, when a large bank enters a new market through acquisition of an existing smaller institution, typically lending to small businesses initially declines. But then existing community banks take up the slack by lending to the borrowers spurned by the larger organization. Indeed, several community bankers have commented that they welcome the entry of large institutions into their markets via the acquisition route, seeing it as an opportunity to acquire some of the customer base that often is lost by the newly acquired bank. Just as our decentralized banking structure is a key to the robustness of our macroeconomy, a key to the effectiveness of our banking structure is what we term the dual banking system. Our system of both federal and state regulation of banks has fostered a steady stream of innovations that likely would not have proceeded as rapidly or as effectively if our regulatory structure were characterized by a monolithic federal regulator. For example, the NOW account was invented by a state-chartered bank. Also, the liberalization of prohibitions against interstate banking has its origin in the so-called "regional compacts" that permitted interstate affiliations for banking companies in consenting states. Adjustable rate mortgages are yet another example of innovation at the state level that has benefitted financial institutions and their customers. Just as important as the fostering of innovation is the protection the dual banking system affords against overly rigid federal regulation and supervision. The key to protecting against overzealousness in regulation is for banks to have a choice of more than one federal regulator. With two or more federal regulators, a bank can choose to change its charter thereby choosing to be supervised by another federal regulator. That possibility has served as a constraint on arbitrary and capricious policies at the federal level. True, it is possible that two or more federal agencies can engage in a "competition in laxity" -- but I worry considerably more about the possibility that a single federal regulator would become inevitably rigid and insensitive to the needs of the marketplace. So long as the existence of a federal guarantee of deposits and other elements of the safety net call for federal regulation of banks, such regulation should entail a choice of federal regulator in order to ensure the critical competitiveness of our banks. The job of a banking regulator, difficult under any circumstances and for a variety of reasons, is especially critical as it regards the connection running between banking risk and the impact of such risk-taking on the macroeconomy. As I have been pointing out, the historic purpose of banks is to take risk through the extension of credit to businesses and households -credit that is so vital to the growth and stability of the economy. But this fact creates a significant conflict for banking regulators. On the one hand, regulators are concerned with the cost of bank failure to the taxpayer and the impact of such failures on the general safety and soundness of the financial system. On the other hand, banks must take risks in order to finance economic expansion. Decisions about tradeoffs must be made. In the early 1990s, we saw how, in response to FDICIA, new regulations, weakened capital, and large loan losses, banks reduced their willingness to take risks, thereby contributing to a credit crunch and slower economic growth. This recent episode demonstrates clearly how tricky are these tradeoffs between necessary risk taking and protecting the banking system; a swing too far in either direction can create both short-term and long-term difficulties. A regulator without responsibility for macroeconomic growth and stability tends to have a bias against risk-taking. Such a regulator receives no praise if the economy is functioning well, but is criticized if there are too many bank failures. For such a regulator, the tradeoffs are one-sided and, if the decisions of such a regulator were left unchecked, the result might be a stagnant economy at whose core was a stagnant banking system. In contrast, the Federal Reserve's economic responsibilities are an important reason why we have striven to maintain a consistent bank regulatory policy, one that entails neither excessive tightness nor ease in supervisory posture. The former would lead to credit crunches, the latter, with a lag, would lead to excessive bank failures. Just as the probability of bank failure should not be the only concern of the effective regulator, bank regulation is not the only, or even the most important, factor that affects the banking business. The condition of the macroeconomy also has something to say about your success as a banker. In that regard, the generally favorable macroeconomic conditions we have been facing for the past few years suggest that bankers should now take pause and reassess the appropriateness of their lending decisions. Mistakes in lending, after all, are not generally made during recessions but when the economic outlook appears benevolent. Recent evidence of thin margins and increased nonbank competition in portions of the syndicated loan market, as well as other indicators, suggest some modest underwriting laxity has a tendency to emerge during good times. This suggests the need for a mild caution that bankers maintain sound underwriting standards and pricing practices in their lending activities. Let me now turn from general concerns over our regulatory structure to more specific concerns regarding the supervisory and regulatory treatment of our largest, most complex banking organizations -- a subject in which I suspect community banks have some considerable interest. As the 105th Congress contemplates financial reform legislation, it is critical to focus on the issue of how best to supervise risk-taking in these large entities and, in particular, whether there should be significant umbrella supervision for the entire banking organization. Historically, bank holding companies have been largely confined to financial activities that are similar to, often the same as, those permissible to commercial banks. Also historically, supervision of banking organizations, both large and small, has tended to focus mainly on the need to protect the bank. To some extent, this emphasis on the bank rather than the nonbank activities of the banking organization was prompted by, or permitted by, management techniques that tended not to treat risk-taking in integrated fashion across the entire holding company. The regulators' main concern was the bank, and bank safety could be analyzed more or less remotely and distinctly from the nonbank activities of the banking organization. More recently, the focus of supervision of holding companies by the Federal Reserve is being modified to parallel the changes in the management of banking companies. Most large institutions in recent years have moved toward consolidated risk management across all their bank and nonbank activities. Should the Congress permit new nonbanking activities by banking organizations it is likely that these activities too would be managed on a consolidated basis from the point of view of risk-taking, pricing, and profitability analysis. Our regulatory posture must adjust accordingly, to focus on the decision-making process for the total organization. Especially as supervisors focus more on the measurement and management of market, credit, and operating risks, supervisory review of firm-wide processes increasingly will become the appropriate principle underlying our assessment of an organization's safety and soundness. Some market participants -- especially nonbanks contemplating buying banks in the wake of any new Congressional legislation, as well as banks contemplating entering newly permissible nonbank activities -- are naturally concerned over the thought of bank-like regulation being extended to their nonbank activities. We share this concern, and last month we asked Congress to modify our mandate to permit the Fed to be more flexible on such issues as applications for new activities. At the same time, however, we believe there has been some considerable misunderstanding of our basic philosophy of holding company supervision. The focus of the Fed's inspections of nonbank activities of bank holding companies is to gain a sense of the overall strength of the individual units and their interrelations with each other and the bank. As I indicated above, emphasis is placed on the adequacy of risk management and internal control systems. Only if there is a major deficiency in these areas would we intend for a bank holding company inspection to become in any significant way "intrusive," and the number of such intrusive inspections of nonbanking activities should be quite small if managements are following prudent business practices. Some observers have questioned not only the need for umbrella supervision, but also the need for the Fed's involvement in such supervision. In addition to the reasons I cited above for central bank involvement in supervision, there is the issue of systemic risk and the fact that it is primarily the Federal Reserve's obligation to maintain stability in our financial system and that system's interface with international financial markets. This obligation cannot be met solely via open market operations and use of the discount window, as powerful as these tools may be. Financial crises, when they occur, are unpredictable and diverse in nature. Globalization means that a domestic crisis can become international or that a foreign crisis can become a domestic concern. The Federal Reserve's ability to respond quickly and effectively to any particular systemic threat rests primarily on our experience and expertise with the details of the U.S. and foreign banking and financial systems, including our familiarity with the payments and settlement system. This expertise, in turn, has been accumulated over the years primarily through our supervision of large domestic and multinational banking companies, and via our participation in large payments and settlement systems which are such a critical part of our financial infrastructure. In order to carry out our responsibility, the Fed must be directly involved in the supervision of banks of all sizes -- such as now provided by member banks -- and must also be able to address the problems of large banking companies if one or more of their activities endanger the stability of our financial system. This implies that the Federal Reserve have appropriate supervisory authority. Moreover, the new regulatory structure must retain our flexibility to respond to changes in the structure of the financial system, especially where such changes cannot easily be forecast in the wake of significant legislative changes. Systemic crises occur very rarely by their very definition. But when such crises do occur the consequences of slow or misdirected action are grave. The central bank, as the lender of last resort, must have the knowledge, the tools, and the authority necessary to act in a timely and decisive fashion. This is necessary to protect the whole financial system, not the least of which are the critical players among our community banks. Let me conclude by reiterating two of the Federal Reserve's most basic concerns as the current Congress deliberates the issue of financial reform. First, we should recognize the increasingly evident fact that financial firms of all sorts now engage routinely in a wide variety of financial activities that, just a few decades ago, were considered to be nontraditional. Even in cases where the financial activity is currently not permitted directly, the risks and returns of the activity can be mimicked through the prudent use of financial derivative instruments such as put and call options. We should recognize these facts and, in response, structure legislation that would permit the full economic integration of these various forms of financial activity, in order to gain the maximum operating efficiencies, the best tradeoffs between risk and return, and the most flexibility in meeting the needs of the customer. But new legislation should not attempt to accomplish too much too soon. The Board believes it is prudent to delay, or to implement in stages, broad authorization of nonfinancial activities for banking companies. We want to be sure of the smooth functioning of integrated financial activity before we address potential combinations of banking and commerce. Second, in permitting broadened financial powers, legislation should strive to maintain the current roles of both the dual banking system and the central bank. Financial reform should not be interpreted to mean regulatory reform for its own sake. Banks of all sizes must have their regulatory choices preserved, just as financial firms of all sizes should be permitted to engage prudently in a wide range of financial activity. Finally, the central bank must continue to be able to monitor and address activities of large banking organizations that might threaten the stability of the system. I am confident that prudent, reasoned financial reform can be accomplished in a manner that preserves the best of the current system while introducing the improvements that we all desire.
1997-04-04T00:00:00	Ms. Rivlin discusses how economists might be helpful in the current and upcoming macroeconomic policy process (Central Bank Articles and Speeches, 4 Apr 97)	Remarks by the Vice Chairman of the Board of Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, at the Annual Meeting of the Eastern Economic Association in Washington, D.C. on 4/4/97.	Ms. Rivlin discusses how economists might be helpful in the current and upcoming macroeconomic policy process Remarks by the Vice Chairman of the Board of Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, at the Annual Meeting of the Eastern Economic Association in Washington, D.C. on 4/4/97. I am delighted to be here today with such a large group of my fellow economists. Economists are a very diverse group, but they share a basic kit of analytical tools that shape the way they approach problems. Economists share a useful shorthand vocabulary -- sometimes disparaged by others as jargon -- that makes it easier to communicate with each other. They share a sense of what kinds of things are known about how economies work and, far more important, an appreciation for how much is not known about the workings of any complex human system, including the economy in which we are all living and working right now. Most importantly, economists share a sense of excitement that others often find hard to fathom, about unraveling the many puzzles that abound in economic analysis. At the moment, as a relatively new governor of the Federal Reserve, I am particularly glad to be in a group of economists, because I can be quite sure they don't share the popular stereotype of a Fed governor. This stereotype has several elements: Any Fed governor or central banker is an inflation freak who thinks reducing inflation should be the only objective of monetary policy and a zero inflation economy would be heaven. Any central banker has a firm view of exactly what growth rate the economy ought not to exceed and how high the unemployment rate ought to be to avoid inflation -- that something called the NAIRU is engraved on a stone tablet somewhere high on a mountain top and all we have to do is find it. Moreover, this stereotypical central banker knows exactly what monetary policy ought to be in order to keep the economy on the desired track. This stereotype leads otherwise quite intelligent members of the press to believe that if central bankers don't reveal this secret blueprint, it's because they are being deliberately obscure and inscrutable. The media's sacred calling is to interpret what central bankers really meant but out of sheer perversity did not choose to say. So it's a pleasure to be in a room full of economists who know that: while the Fed has access to all the latest statistics and an excellent staff to analyze them, it has not found the stone tablet; those of us at the Fed are working our way through the same fascinating puzzles that confront all economists and make the profession such a lively place to be. I would like to discuss today the primary puzzles that confront those of us in the monetary policymaking arena and then offer a few thoughts about how economists might focus their energies to be helpful in the current and upcoming macroeconomic policy process. I'm afraid I don't fit the Fed Governor stereotype well at all. I'm not an inflation freak; I'm a growth freak. My answer to the question, "How fast should the economy grow?" is "As fast as it sustainably can." We don't benefit from rapid growth spurts that unleash inflation which later has to be reigned in at a high price, just as we don't benefit from growth that damages the environment and creates a need for costly repair. But we ought to try to be on the highest growth track that is sustainable and stay on it with as few ups and downs as possible, because the downs are so costly, especially in terms of lost opportunity to build human capital. Only trouble is we don't know exactly what that track is and we're sure it's not immutable. - 2 - By the same token, we ought to aim to keep unemployment as low as is sustainable. The benefits of tight labor markets are enormous, especially in a society whose future depends on continuous and persistent upgrading of the skills of the whole labor force. If we can keep labor markets at least as tight as they are now for a few years (which, judging from past history, would take an extraordinary combination of skillful policy and good luck), we can do a lot for the future standard of living of Americans. The benefit would accrue not just to those who are employed and are acquiring job skills and experience that they would not have gotten if they were unemployed. The benefit of tight labor markets is also in the signals they send to individuals and businesses that people should be employed as productively as possible, and that investment in training pays off. These are the economic conditions we need in general, but especially if we are to make welfare reform a success and establish new patterns of school and work for many young people who now see little hope for the future. Welfare reform is going to be difficult to accomplish. The best hope for success is avoiding recession for a long time. The benefits of the recent rapid job growth in the U.S. are especially evident by contrast with Europe. French and German unemployment rates have been incredibly high for a long time. French and German officials speak of their unemployment as "structural" and discuss the need to increase job training, improve the functioning of labor markets, and reduce the incentives not to work which are built into their generous benefit systems. These are all doubtless constructive things to do, but are unlikely to be very successful unless the economies are growing and jobs are being created. It is a lot easier to reduce structural unemployment when the demand for labor is brisk than when it is lagging. So this central banker believes that the goal of monetary policy, like the goal of fiscal policy, ought to be the highest sustainable growth rate and the lowest sustainable unemployment. Low inflation should not be thought of as an end in itself, but as a means to an end. Accelerating inflation has proved a threat to the sustainability of growth, and the self-perpetuating nature of inflation makes it more costly to correct than to avoid. The drafters of the Humphrey Hawkins Act gave the Fed multiple goals. They said: "The Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." That's a bit ambiguous, but it's about as good a set of instructions as any. It would be a mistake to reword the Act, as some have suggested, to give the Fed a single objective -- reducing inflation -- on which to focus monetary policy. It would be especially unfortunate to specify a zero inflation target. First, because we don't measure inflation well enough to know when we have hit an exact target. Second, because the benefits of getting all the way to zero may not be great and the costs could be substantial, especially if there is significant reluctance to reduce nominal wages. But it is the second part of the central banker stereotype that economists see as most obviously absurd; namely, that the Fed actually controls interest rates and that it knows for sure where the monetary dials ought to be set to achieve a specific growth or unemployment target. The reality is that the Fed controls -- and rather imperfectly at that -- one extremely short-term interest rate, the fed funds rate. The fed funds rate certainly has some influence on banks' ability to extend credit, but its relation to the longer term rates that really matter to investors and home buyers is uncertain at best. The most that one can say about the Fed's principal monetary policy tool is that we can safely guess the direction of the effect of moving it and that we know there is a considerable lag between the move and the effect; but we cannot specify with any degree of certainty how large the effect is or how long it takes. That's a pretty blunt instrument. - 3 - Any monetary policy move is a judgment call to be made with a great deal of humility because the judgment involves making a guess about what is likely to be happening to economic activity six months to a year or more in advance and whether resources might be underutilized by then or inflationary pressure might be building. The judgment call seems especially hard at the moment, although I suspect it almost always seems especially hard, because the economy is behaving in ways that are gratifyingly puzzling. The combination of macro-economic statistics is actually more favorable -- more growth, more employment, less budget deficit, less inflation -- than most people would have guessed possible a year or two ago. On one level, these are pleasant surprises; on another level, the behavior of the economy is revealing big challenges for the economics profession. These challenges are not likely to yield to more assiduous statistical manipulation of the same data that we already collect, but instead would require some new tools and new kinds of data. It would be a lot easier to make those judgment calls -- to move the blunt instrument so as to increase the probability of keeping labor markets tight and the economy growing at the highest sustainable rate -- if we knew a lot more about three interrelated questions. 1.What's really going on in labor markets? 2.What's really going on with prices? 3.And especially, what's really going on with productivity? The labor market puzzle is partly why low unemployment is not leading to more obvious bottlenecks, more serious skill shortages and more rapid increases in compensation than we are in fact experiencing? It's tempting to believe that the uniformity of unemployment rates around the country indicates that the information age is paying off in better functioning labor markets. Possibly, at the equilibrating margin, people now move more easily to jobs, and jobs more easily to people than they once did. Possibly the organizations that worked so hard under the pressure of competition and recession to become less rigid and more flexible have in fact done so. But those are all guesses -- or wishful thinking. We don't know for sure. The price puzzle is why prices have been so well behaved in the face of labor costs that have been rising, albeit not especially fast. Has the economy, as so many business anecdotes allege, really become more fiercely competitive both nationally and internationally? Is the ability of firms to absorb labor cost increases without raising prices and without apparent reduction in profit margins confirming the hypothesis that productivity is rising faster than we thought, or faster than the admittedly inadequate data have been telling us? Indeed, it is the productivity puzzle that may hold the key to the gratifyingly mysterious behavior of the economy. Economists have thought for some time that the increasing importance of services in the economy is confounding the ability to understand what is happening to both product and productivity. We observed an increase in manufacturing productivity, but not in service productivity. Indeed, measured productivity was generally negative in service industries even where anecdotal evidence indicated that processes had been streamlined, products had been substantially improved, as well as greatly proliferated, and the people in the industry believed they were doing a much more effective job serving their customers. Economists freely admitted they didn't quite know how to identify and measure the quality of the products that were being produced in service industries, sometimes even in manufacturing. Economists also wondered aloud why all the investment in computers and information technology that was so obviously changing the world was not having an impact on productivity. We opined that maybe people weren't using computers very well or that many things people were using computers for -- like editing everything to death or spelling things correctly -- were not actually contributing to productivity at least as we were measuring it. Now, we should turn all this speculation - 4 - into a full court press to figure out what kind of data we need and what kind of analytical methods we need to invent in order to understand better what is going on in this economy. The need to improve the accuracy of the CPI has captured the attention of the press and the politicians because the indexing of benefits and tax brackets plays such a large part in the federal budget. But the problems of identifying what consumers are buying and how the quality of the items purchased has changed is very closely related to the problem of identifying what is being produced and what inputs are going into the production. The Clinton Administration, to its credit, has recognized the need for improving both the concepts and measurement of prices and products and has asked for a modest increase in resources for the statistical agencies in the President's budget, even in the context of general budget cuts. Strong support from the users of the data is surely in order -- not just from academic economists, but from the whole community of market analysts, Fed watchers and business and financial organizations who need to understand how the economy is working in order to operate better in it. Indeed, I have been struck since I have been at the Fed by the magnitude of the resources our economy puts into analyzing, reporting and commenting upon the standard set of statistics generated by federal statistical agencies every week -- efforts by the press, the business community and the people in between, such as those who write the newsletters and poop sheets that circulate over faxes and computers. Wouldn't it be in everyone's interest to take a portion of those resources and devote them to improving the flow of statistics that are being analyzed to death? Another thought that has struck me at the Fed is the enormous usefulness of reporting on examples of real world happenings -- anecdotes if you will -- and the absence of useful data that bridge the gap between the anecdote or real world case and an aggregate statistical series. One of the unique features of the Federal Reserve is its strong regional structure. The twelve Reserve Banks are very closely tied to the economies of their regions. The Reserve Banks not only supervise and interact with the local commercial banks, but also keep in close touch with the business, farming, labor, and community leadership in their area. They have broadly representative boards and a whole network of advisory committees (as does the Board of Governors itself). This network of contacts and information makes the Reserve Bank presidents very valuable participants in the FOMC discussion. Indeed, the most interesting part of an FOMC meeting is usually the regional round-up from the Bank presidents. This regional network and set of real world interactions has given me more sense of being in touch with the whole economy than I have had in previous economic policy jobs where I was largely dependent on aggregate statistics. I am not proposing government by anecdote and I am aware of the potential dangers of non-random samples. Nevertheless, I have the sense that our understanding of the economy would be greatly advanced if economists could set themselves seriously to the task of systematizing feedback about real world dilemmas being faced and decisions being made in the economy in ways that give a more nuanced and lively picture of what is going on out there than can be gleaned from standard statistical series. Anyway, it's an exciting time to be an economist and I'm glad to see so many fellow professionals puzzling together over how the economy works and ought to work.	---[PAGE_BREAK]--- # Ms. Rivlin discusses how economists might be helpful in the current and upcoming macroeconomic policy process Remarks by the Vice Chairman of the Board of Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, at the Annual Meeting of the Eastern Economic Association in Washington, D.C. on 4/4/97. I am delighted to be here today with such a large group of my fellow economists. Economists are a very diverse group, but they share a basic kit of analytical tools that shape the way they approach problems. Economists share a useful shorthand vocabulary -- sometimes disparaged by others as jargon -- that makes it easier to communicate with each other. They share a sense of what kinds of things are known about how economies work and, far more important, an appreciation for how much is not known about the workings of any complex human system, including the economy in which we are all living and working right now. Most importantly, economists share a sense of excitement that others often find hard to fathom, about unraveling the many puzzles that abound in economic analysis. At the moment, as a relatively new governor of the Federal Reserve, I am particularly glad to be in a group of economists, because I can be quite sure they don't share the popular stereotype of a Fed governor. This stereotype has several elements: Any Fed governor or central banker is an inflation freak who thinks reducing inflation should be the only objective of monetary policy and a zero inflation economy would be heaven. Any central banker has a firm view of exactly what growth rate the economy ought not to exceed and how high the unemployment rate ought to be to avoid inflation -- that something called the NAIRU is engraved on a stone tablet somewhere high on a mountain top and all we have to do is find it. Moreover, this stereotypical central banker knows exactly what monetary policy ought to be in order to keep the economy on the desired track. This stereotype leads otherwise quite intelligent members of the press to believe that if central bankers don't reveal this secret blueprint, it's because they are being deliberately obscure and inscrutable. The media's sacred calling is to interpret what central bankers really meant but out of sheer perversity did not choose to say. So it's a pleasure to be in a room full of economists who know that: while the Fed has access to all the latest statistics and an excellent staff to analyze them, it has not found the stone tablet; those of us at the Fed are working our way through the same fascinating puzzles that confront all economists and make the profession such a lively place to be. I would like to discuss today the primary puzzles that confront those of us in the monetary policymaking arena and then offer a few thoughts about how economists might focus their energies to be helpful in the current and upcoming macroeconomic policy process. I'm afraid I don't fit the Fed Governor stereotype well at all. I'm not an inflation freak; I'm a growth freak. My answer to the question, "How fast should the economy grow?" is "As fast as it sustainably can." We don't benefit from rapid growth spurts that unleash inflation which later has to be reigned in at a high price, just as we don't benefit from growth that damages the environment and creates a need for costly repair. But we ought to try to be on the highest growth track that is sustainable and stay on it with as few ups and downs as possible, because the downs are so costly, especially in terms of lost opportunity to build human capital. Only trouble is we don't know exactly what that track is and we're sure it's not immutable. ---[PAGE_BREAK]--- By the same token, we ought to aim to keep unemployment as low as is sustainable. The benefits of tight labor markets are enormous, especially in a society whose future depends on continuous and persistent upgrading of the skills of the whole labor force. If we can keep labor markets at least as tight as they are now for a few years (which, judging from past history, would take an extraordinary combination of skillful policy and good luck), we can do a lot for the future standard of living of Americans. The benefit would accrue not just to those who are employed and are acquiring job skills and experience that they would not have gotten if they were unemployed. The benefit of tight labor markets is also in the signals they send to individuals and businesses that people should be employed as productively as possible, and that investment in training pays off. These are the economic conditions we need in general, but especially if we are to make welfare reform a success and establish new patterns of school and work for many young people who now see little hope for the future. Welfare reform is going to be difficult to accomplish. The best hope for success is avoiding recession for a long time. The benefits of the recent rapid job growth in the U.S. are especially evident by contrast with Europe. French and German unemployment rates have been incredibly high for a long time. French and German officials speak of their unemployment as "structural" and discuss the need to increase job training, improve the functioning of labor markets, and reduce the incentives not to work which are built into their generous benefit systems. These are all doubtless constructive things to do, but are unlikely to be very successful unless the economies are growing and jobs are being created. It is a lot easier to reduce structural unemployment when the demand for labor is brisk than when it is lagging. So this central banker believes that the goal of monetary policy, like the goal of fiscal policy, ought to be the highest sustainable growth rate and the lowest sustainable unemployment. Low inflation should not be thought of as an end in itself, but as a means to an end. Accelerating inflation has proved a threat to the sustainability of growth, and the self-perpetuating nature of inflation makes it more costly to correct than to avoid. The drafters of the Humphrey Hawkins Act gave the Fed multiple goals. They said: "The Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." That's a bit ambiguous, but it's about as good a set of instructions as any. It would be a mistake to reword the Act, as some have suggested, to give the Fed a single objective -- reducing inflation -- on which to focus monetary policy. It would be especially unfortunate to specify a zero inflation target. First, because we don't measure inflation well enough to know when we have hit an exact target. Second, because the benefits of getting all the way to zero may not be great and the costs could be substantial, especially if there is significant reluctance to reduce nominal wages. But it is the second part of the central banker stereotype that economists see as most obviously absurd; namely, that the Fed actually controls interest rates and that it knows for sure where the monetary dials ought to be set to achieve a specific growth or unemployment target. The reality is that the Fed controls -- and rather imperfectly at that -- one extremely short-term interest rate, the fed funds rate. The fed funds rate certainly has some influence on banks' ability to extend credit, but its relation to the longer term rates that really matter to investors and home buyers is uncertain at best. The most that one can say about the Fed's principal monetary policy tool is that we can safely guess the direction of the effect of moving it and that we know there is a considerable lag between the move and the effect; but we cannot specify with any degree of certainty how large the effect is or how long it takes. That's a pretty blunt instrument. ---[PAGE_BREAK]--- Any monetary policy move is a judgment call to be made with a great deal of humility because the judgment involves making a guess about what is likely to be happening to economic activity six months to a year or more in advance and whether resources might be underutilized by then or inflationary pressure might be building. The judgment call seems especially hard at the moment, although I suspect it almost always seems especially hard, because the economy is behaving in ways that are gratifyingly puzzling. The combination of macro-economic statistics is actually more favorable -- more growth, more employment, less budget deficit, less inflation -- than most people would have guessed possible a year or two ago. On one level, these are pleasant surprises; on another level, the behavior of the economy is revealing big challenges for the economics profession. These challenges are not likely to yield to more assiduous statistical manipulation of the same data that we already collect, but instead would require some new tools and new kinds of data. It would be a lot easier to make those judgment calls -- to move the blunt instrument so as to increase the probability of keeping labor markets tight and the economy growing at the highest sustainable rate -- if we knew a lot more about three interrelated questions. 1.What's really going on in labor markets? 2.What's really going on with prices? 3.And especially, what's really going on with productivity? The labor market puzzle is partly why low unemployment is not leading to more obvious bottlenecks, more serious skill shortages and more rapid increases in compensation than we are in fact experiencing? It's tempting to believe that the uniformity of unemployment rates around the country indicates that the information age is paying off in better functioning labor markets. Possibly, at the equilibrating margin, people now move more easily to jobs, and jobs more easily to people than they once did. Possibly the organizations that worked so hard under the pressure of competition and recession to become less rigid and more flexible have in fact done so. But those are all guesses -- or wishful thinking. We don't know for sure. The price puzzle is why prices have been so well behaved in the face of labor costs that have been rising, albeit not especially fast. Has the economy, as so many business anecdotes allege, really become more fiercely competitive both nationally and internationally? Is the ability of firms to absorb labor cost increases without raising prices and without apparent reduction in profit margins confirming the hypothesis that productivity is rising faster than we thought, or faster than the admittedly inadequate data have been telling us? Indeed, it is the productivity puzzle that may hold the key to the gratifyingly mysterious behavior of the economy. Economists have thought for some time that the increasing importance of services in the economy is confounding the ability to understand what is happening to both product and productivity. We observed an increase in manufacturing productivity, but not in service productivity. Indeed, measured productivity was generally negative in service industries even where anecdotal evidence indicated that processes had been streamlined, products had been substantially improved, as well as greatly proliferated, and the people in the industry believed they were doing a much more effective job serving their customers. Economists freely admitted they didn't quite know how to identify and measure the quality of the products that were being produced in service industries, sometimes even in manufacturing. Economists also wondered aloud why all the investment in computers and information technology that was so obviously changing the world was not having an impact on productivity. We opined that maybe people weren't using computers very well or that many things people were using computers for -- like editing everything to death or spelling things correctly -- were not actually contributing to productivity at least as we were measuring it. Now, we should turn all this speculation ---[PAGE_BREAK]--- into a full court press to figure out what kind of data we need and what kind of analytical methods we need to invent in order to understand better what is going on in this economy. The need to improve the accuracy of the CPI has captured the attention of the press and the politicians because the indexing of benefits and tax brackets plays such a large part in the federal budget. But the problems of identifying what consumers are buying and how the quality of the items purchased has changed is very closely related to the problem of identifying what is being produced and what inputs are going into the production. The Clinton Administration, to its credit, has recognized the need for improving both the concepts and measurement of prices and products and has asked for a modest increase in resources for the statistical agencies in the President's budget, even in the context of general budget cuts. Strong support from the users of the data is surely in order -- not just from academic economists, but from the whole community of market analysts, Fed watchers and business and financial organizations who need to understand how the economy is working in order to operate better in it. Indeed, I have been struck since I have been at the Fed by the magnitude of the resources our economy puts into analyzing, reporting and commenting upon the standard set of statistics generated by federal statistical agencies every week -- efforts by the press, the business community and the people in between, such as those who write the newsletters and poop sheets that circulate over faxes and computers. Wouldn't it be in everyone's interest to take a portion of those resources and devote them to improving the flow of statistics that are being analyzed to death? Another thought that has struck me at the Fed is the enormous usefulness of reporting on examples of real world happenings -- anecdotes if you will -- and the absence of useful data that bridge the gap between the anecdote or real world case and an aggregate statistical series. One of the unique features of the Federal Reserve is its strong regional structure. The twelve Reserve Banks are very closely tied to the economies of their regions. The Reserve Banks not only supervise and interact with the local commercial banks, but also keep in close touch with the business, farming, labor, and community leadership in their area. They have broadly representative boards and a whole network of advisory committees (as does the Board of Governors itself). This network of contacts and information makes the Reserve Bank presidents very valuable participants in the FOMC discussion. Indeed, the most interesting part of an FOMC meeting is usually the regional round-up from the Bank presidents. This regional network and set of real world interactions has given me more sense of being in touch with the whole economy than I have had in previous economic policy jobs where I was largely dependent on aggregate statistics. I am not proposing government by anecdote and I am aware of the potential dangers of non-random samples. Nevertheless, I have the sense that our understanding of the economy would be greatly advanced if economists could set themselves seriously to the task of systematizing feedback about real world dilemmas being faced and decisions being made in the economy in ways that give a more nuanced and lively picture of what is going on out there than can be gleaned from standard statistical series. Anyway, it's an exciting time to be an economist and I'm glad to see so many fellow professionals puzzling together over how the economy works and ought to work.	Alice M Rivlin	United States	https://www.bis.org/review/r970502c.pdf	macroeconomic policy process Remarks by the Vice Chairman of the Board of Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, at the Annual Meeting of the Eastern Economic Association in Washington, D.C. on 4/4/97. I am delighted to be here today with such a large group of my fellow economists. Economists are a very diverse group, but they share a basic kit of analytical tools that shape the way they approach problems. Economists share a useful shorthand vocabulary -- sometimes disparaged by others as jargon -- that makes it easier to communicate with each other. They share a sense of what kinds of things are known about how economies work and, far more important, an appreciation for how much is not known about the workings of any complex human system, including the economy in which we are all living and working right now. Most importantly, economists share a sense of excitement that others often find hard to fathom, about unraveling the many puzzles that abound in economic analysis. At the moment, as a relatively new governor of the Federal Reserve, I am particularly glad to be in a group of economists, because I can be quite sure they don't share the popular stereotype of a Fed governor. This stereotype has several elements: Any Fed governor or central banker is an inflation freak who thinks reducing inflation should be the only objective of monetary policy and a zero inflation economy would be heaven. Any central banker has a firm view of exactly what growth rate the economy ought not to exceed and how high the unemployment rate ought to be to avoid inflation -- that something called the NAIRU is engraved on a stone tablet somewhere high on a mountain top and all we have to do is find it. Moreover, this stereotypical central banker knows exactly what monetary policy ought to be in order to keep the economy on the desired track. This stereotype leads otherwise quite intelligent members of the press to believe that if central bankers don't reveal this secret blueprint, it's because they are being deliberately obscure and inscrutable. The media's sacred calling is to interpret what central bankers really meant but out of sheer perversity did not choose to say. So it's a pleasure to be in a room full of economists who know that: while the Fed has access to all the latest statistics and an excellent staff to analyze them, it has not found the stone tablet; those of us at the Fed are working our way through the same fascinating puzzles that confront all economists and make the profession such a lively place to be. I would like to discuss today the primary puzzles that confront those of us in the monetary policymaking arena and then offer a few thoughts about how economists might focus their energies to be helpful in the current and upcoming macroeconomic policy process. I'm afraid I don't fit the Fed Governor stereotype well at all. I'm not an inflation freak; I'm a growth freak. My answer to the question, "How fast should the economy grow?" is "As fast as it sustainably can." We don't benefit from rapid growth spurts that unleash inflation which later has to be reigned in at a high price, just as we don't benefit from growth that damages the environment and creates a need for costly repair. But we ought to try to be on the highest growth track that is sustainable and stay on it with as few ups and downs as possible, because the downs are so costly, especially in terms of lost opportunity to build human capital. Only trouble is we don't know exactly what that track is and we're sure it's not immutable. By the same token, we ought to aim to keep unemployment as low as is sustainable. The benefits of tight labor markets are enormous, especially in a society whose future depends on continuous and persistent upgrading of the skills of the whole labor force. If we can keep labor markets at least as tight as they are now for a few years (which, judging from past history, would take an extraordinary combination of skillful policy and good luck), we can do a lot for the future standard of living of Americans. The benefit would accrue not just to those who are employed and are acquiring job skills and experience that they would not have gotten if they were unemployed. The benefit of tight labor markets is also in the signals they send to individuals and businesses that people should be employed as productively as possible, and that investment in training pays off. These are the economic conditions we need in general, but especially if we are to make welfare reform a success and establish new patterns of school and work for many young people who now see little hope for the future. Welfare reform is going to be difficult to accomplish. The best hope for success is avoiding recession for a long time. The benefits of the recent rapid job growth in the U.S. are especially evident by contrast with Europe. French and German unemployment rates have been incredibly high for a long time. French and German officials speak of their unemployment as "structural" and discuss the need to increase job training, improve the functioning of labor markets, and reduce the incentives not to work which are built into their generous benefit systems. These are all doubtless constructive things to do, but are unlikely to be very successful unless the economies are growing and jobs are being created. It is a lot easier to reduce structural unemployment when the demand for labor is brisk than when it is lagging. So this central banker believes that the goal of monetary policy, like the goal of fiscal policy, ought to be the highest sustainable growth rate and the lowest sustainable unemployment. Low inflation should not be thought of as an end in itself, but as a means to an end. Accelerating inflation has proved a threat to the sustainability of growth, and the self-perpetuating nature of inflation makes it more costly to correct than to avoid. The drafters of the Humphrey Hawkins Act gave the Fed multiple goals. They said: "The Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." That's a bit ambiguous, but it's about as good a set of instructions as any. It would be a mistake to reword the Act, as some have suggested, to give the Fed a single objective -- reducing inflation -- on which to focus monetary policy. It would be especially unfortunate to specify a zero inflation target. First, because we don't measure inflation well enough to know when we have hit an exact target. Second, because the benefits of getting all the way to zero may not be great and the costs could be substantial, especially if there is significant reluctance to reduce nominal wages. But it is the second part of the central banker stereotype that economists see as most obviously absurd; namely, that the Fed actually controls interest rates and that it knows for sure where the monetary dials ought to be set to achieve a specific growth or unemployment target. The reality is that the Fed controls -- and rather imperfectly at that -- one extremely short-term interest rate, the fed funds rate. The fed funds rate certainly has some influence on banks' ability to extend credit, but its relation to the longer term rates that really matter to investors and home buyers is uncertain at best. The most that one can say about the Fed's principal monetary policy tool is that we can safely guess the direction of the effect of moving it and that we know there is a considerable lag between the move and the effect; but we cannot specify with any degree of certainty how large the effect is or how long it takes. That's a pretty blunt instrument. Any monetary policy move is a judgment call to be made with a great deal of humility because the judgment involves making a guess about what is likely to be happening to economic activity six months to a year or more in advance and whether resources might be underutilized by then or inflationary pressure might be building. The judgment call seems especially hard at the moment, although I suspect it almost always seems especially hard, because the economy is behaving in ways that are gratifyingly puzzling. The combination of macro-economic statistics is actually more favorable -- more growth, more employment, less budget deficit, less inflation -- than most people would have guessed possible a year or two ago. On one level, these are pleasant surprises; on another level, the behavior of the economy is revealing big challenges for the economics profession. These challenges are not likely to yield to more assiduous statistical manipulation of the same data that we already collect, but instead would require some new tools and new kinds of data. It would be a lot easier to make those judgment calls -- to move the blunt instrument so as to increase the probability of keeping labor markets tight and the economy growing at the highest sustainable rate -- if we knew a lot more about three interrelated questions. 1.What's really going on in labor markets? 2.What's really going on with prices? 3.And especially, what's really going on with productivity? The labor market puzzle is partly why low unemployment is not leading to more obvious bottlenecks, more serious skill shortages and more rapid increases in compensation than we are in fact experiencing? It's tempting to believe that the uniformity of unemployment rates around the country indicates that the information age is paying off in better functioning labor markets. Possibly, at the equilibrating margin, people now move more easily to jobs, and jobs more easily to people than they once did. Possibly the organizations that worked so hard under the pressure of competition and recession to become less rigid and more flexible have in fact done so. But those are all guesses -- or wishful thinking. We don't know for sure. The price puzzle is why prices have been so well behaved in the face of labor costs that have been rising, albeit not especially fast. Has the economy, as so many business anecdotes allege, really become more fiercely competitive both nationally and internationally? Is the ability of firms to absorb labor cost increases without raising prices and without apparent reduction in profit margins confirming the hypothesis that productivity is rising faster than we thought, or faster than the admittedly inadequate data have been telling us? Indeed, it is the productivity puzzle that may hold the key to the gratifyingly mysterious behavior of the economy. Economists have thought for some time that the increasing importance of services in the economy is confounding the ability to understand what is happening to both product and productivity. We observed an increase in manufacturing productivity, but not in service productivity. Indeed, measured productivity was generally negative in service industries even where anecdotal evidence indicated that processes had been streamlined, products had been substantially improved, as well as greatly proliferated, and the people in the industry believed they were doing a much more effective job serving their customers. Economists freely admitted they didn't quite know how to identify and measure the quality of the products that were being produced in service industries, sometimes even in manufacturing. Economists also wondered aloud why all the investment in computers and information technology that was so obviously changing the world was not having an impact on productivity. We opined that maybe people weren't using computers very well or that many things people were using computers for -- like editing everything to death or spelling things correctly -- were not actually contributing to productivity at least as we were measuring it. Now, we should turn all this speculation into a full court press to figure out what kind of data we need and what kind of analytical methods we need to invent in order to understand better what is going on in this economy. The need to improve the accuracy of the CPI has captured the attention of the press and the politicians because the indexing of benefits and tax brackets plays such a large part in the federal budget. But the problems of identifying what consumers are buying and how the quality of the items purchased has changed is very closely related to the problem of identifying what is being produced and what inputs are going into the production. The Clinton Administration, to its credit, has recognized the need for improving both the concepts and measurement of prices and products and has asked for a modest increase in resources for the statistical agencies in the President's budget, even in the context of general budget cuts. Strong support from the users of the data is surely in order -- not just from academic economists, but from the whole community of market analysts, Fed watchers and business and financial organizations who need to understand how the economy is working in order to operate better in it. Indeed, I have been struck since I have been at the Fed by the magnitude of the resources our economy puts into analyzing, reporting and commenting upon the standard set of statistics generated by federal statistical agencies every week -- efforts by the press, the business community and the people in between, such as those who write the newsletters and poop sheets that circulate over faxes and computers. Wouldn't it be in everyone's interest to take a portion of those resources and devote them to improving the flow of statistics that are being analyzed to death? Another thought that has struck me at the Fed is the enormous usefulness of reporting on examples of real world happenings -- anecdotes if you will -- and the absence of useful data that bridge the gap between the anecdote or real world case and an aggregate statistical series. One of the unique features of the Federal Reserve is its strong regional structure. The twelve Reserve Banks are very closely tied to the economies of their regions. The Reserve Banks not only supervise and interact with the local commercial banks, but also keep in close touch with the business, farming, labor, and community leadership in their area. They have broadly representative boards and a whole network of advisory committees (as does the Board of Governors itself). This network of contacts and information makes the Reserve Bank presidents very valuable participants in the FOMC discussion. Indeed, the most interesting part of an FOMC meeting is usually the regional round-up from the Bank presidents. This regional network and set of real world interactions has given me more sense of being in touch with the whole economy than I have had in previous economic policy jobs where I was largely dependent on aggregate statistics. I am not proposing government by anecdote and I am aware of the potential dangers of non-random samples. Nevertheless, I have the sense that our understanding of the economy would be greatly advanced if economists could set themselves seriously to the task of systematizing feedback about real world dilemmas being faced and decisions being made in the economy in ways that give a more nuanced and lively picture of what is going on out there than can be gleaned from standard statistical series. Anyway, it's an exciting time to be an economist and I'm glad to see so many fellow professionals puzzling together over how the economy works and ought to work.
1997-04-10T00:00:00	Mr. Meyer looks at issues in financial modernization in the United States (Central Bank Articles and Speeches, 10 Apr 97)	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the seventh annual Conference on Financial Structure in Annandale-on-Hudson, New York, on 10/4/97.	Mr. Meyer looks at issues in financial modernization in the United States Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the seventh annual Conference on Financial Structure in Annandale-on-Hudson, New York, on 10/4/97. It is my pleasure to take part in what has become an important annual meeting on financial policy issues. It is my job to get you warmed up for a reception and dinner. Our hosts have a curious view that a discussion of financial modernization will whet your appetite for food. Maybe so, but it will almost surely increase your thirst. It seems that people have been talking about financial modernization for a long time. Indeed, in the short-run it is easy to become discouraged about how often we talk, but how rarely we do anything, about financial modernization. However, if we step back and look over the last twenty years, it seems to me remarkable both how much progress has been achieved and how much the concerns of financial modernization have changed. Two decades ago we still had Regulation Q, the Glass-Steagall Act was widely viewed as requiring a virtual prohibition of combinations of commercial and investment banking, interstate banking and branching were barely fantasies even at the state level, and combinations of banking and insurance were off most people's radar screens. Today, many of the issues of 20 years ago have, blessedly, been resolved. But some remain, and new ones have inevitably appeared. The contemporary concerns of financial modernization include repeal of Glass-Steagall, expanded insurance activities for banking firms, the entry of insurance and securities firms into banking, the possibility of unlimited mixing of banking and commerce, and ongoing technological changes and financial innovations. Tonight I would like to address some aspects of these concerns. I will suggest to you that while financial modernization is still, as it was twenty years ago, a necessity, it is also the case that in an uncertain world characterized by rapid change caution is not a dirty word. I will begin with what for me is the easiest topic: banking and commerce. The separation of banking and commerce has a long history in English-speaking countries. Indeed, the policy can be traced back to the founding of the Bank of England in 1694. It appears that commercial firms were concerned that the Bank's monetary powers would give it a competitive advantage in mercantile activities if there were no separation of banking and commerce. The young American state governments adopted, at least in principle, this separation of banking and commerce. However, from the beginning the separation of banking and commerce was hardly complete in the U.S. banking system. State governments often saw the granting of bank charters as a way of encouraging capital intensive development projects. As a result, pre-Civil War banks were sometimes engaged in such activities as canal building, railroad construction, and even the development of public water systems. Thus, from early on the mixing of banking and commerce was a gray area in the United States. This tradition continues to this day. For example, the same individual can own a controlling share of both banking and commercial firms. Perhaps of more interest, a bank holding company may acquire up to 5 percent of the voting shares of any commercial enterprise, as long as the investment does not represent a controlling interest. In addition, the Board has permitted passive investments in commercial firms of up to 25 percent of nonvoting shares, and an investment can be as high as 49 percent if it is made through a small business investment company. Bank holding companies can own 100 percent of the equity of a small business investment company. We could all continue to give many examples, including the ownership of unitary thrifts and specialized, and not-so-specialized, finance companies by commercial firms. Indeed, some observers use these examples to argue that since the United States already has so much mixing of banking and commerce, why not go all the way? In my view, such arguments exaggerate the reality. Despite all the gray areas, I think it is fair to say that to a very substantial extent banking and commerce are essentially separate activities in the United States. Thus, we need to think carefully about whether we want to go even further down the road of combining banking with nonfinancial activities. Advocates of unrestricted mixing of banking and commerce make at least four arguments: (1) both banking and commercial firms could more easily diversify their risks, (2) a closely related argument is that such combinations would provide opportunities for synergies in cross-selling, (3) combining banking and commerce could lead to more capital in the banking industry, and (4) mixing banking and commerce would help to solve certain asymmetric information and corporate control problems associated with commercial lending. Time does not permit me to address each of these in detail. Suffice it to say that I find each of them wanting. I can find very little, if any, in our experience as a nation that gives me real confidence about the benefits of combining banking and commerce. And I can find no empirical support for any benefits for combining banking and commerce based on experience abroad. Take risk diversification. Do we really believe that in the day of stock index mutual funds, options on individual stocks, and evolving credit derivatives that any firm must own another in order to diversify its risks in virtually any way it cares to do so? I think not. If diversification of asset return risk were our only goal, financial modernization would be easy. How about synergies in crossselling? Maybe. But I think we must be skeptical here, because the admittedly weak literature on economies of scope in banking has been hard pressed to find strong evidence of significant synergies even in financial activities, although I think we all believe that there are some. The argument that we need to combine banking and commerce to attract capital to banking seems, well, pretty silly. In a market economy, capital flows to profit opportunities. If banking is viewed as a vibrant and growing industry, it is hard to see why capital will be a problem. Indeed, the banking industry just completed its fifth straight year of record profits, and it is no coincidence that by all measures capital has been flowing into the industry. If it were not profitable, I cannot see why we would want to create a structure to attract capital to banking. The notion that mixing banking and commerce would reduce information costs in bank lending, and would facilitate monitoring and management control by the bank probably has some merit. Banks that hold both a debt and equity stake in a firm would probably be better able to deter excessive risk taking by the other equity holders, and might even have access to better information about the firm. However, the internalization of these principal-agent problems would come at a price: a price that could include less vibrant money and capital markets, an unwarranted expansion of the federal safety net, potentially dangerous conflicts of interest, and excessive concentration of power. On balance, in my view, this is an area where we should be very cautious and where we need far more research before we can come to any definitive conclusions. An additional reason for caution is the necessity of modifying supervisory techniques. I believe that all of the banking agencies can meet the challenges of expanded financial activities. But adding commercial firms before we have digested the financial side of the business could well be a bridge too far. Indeed, I believe that prudent public policy requires that, for this reason alone, we get financial activities right before tackling further combinations of banking and commerce. The thorny banking and commerce problem in financial modernization is that nonbanking financial firms are already affiliated with commercial firms: some from commercial firms creating financial subsidiaries, some from financial firms acquiring nonfinancial businesses. If financial modernization allows all financial firms to affiliate, but prohibits banking and commerce, the pre-existing commercial affiliates of nonbank financial firms would have to be divested to acquire a bank, while banks could enter de novo the new nonbank financial activity without divesting any valuable assets. This is either inequitable or the cost of acquiring a bank, depending on your point of view. But, it is clearly a problem that has to be addressed. The choices are divestiture, grandfathering, long-term phase outs, basket clauses, or combining of banking and commerce. It would seem to me a poor public policy that opened up banking and commerce on pure equity grounds, rather than a disinterested analysis of societal net benefits. The Impact of Technological Change on Bank Risk Management A strong case can be made for focussing bank reform today on the expansion of permissible financial activities. The prohibitions against banking and securities and banking and insurance combinations have always, it seems to me, been difficult to support. Moreover, technological change has simply undermined the traditional distinctions among financial products and services. In a word, the existing prohibitions are anachronistic. One thing has remained consistent: Banks are in the business of taking and managing risk, have always been and always will be. The change that we must cope with is that technology has changed the ways they take risk, while at the same time improving their capability for managing it. This creation and management of risk, like much of recent economic change, would have been impossible without the dramatically lower cost of a unit of computing power. Indeed, before the computer, most of the new bank products of recent years were merely concepts, concepts that could not become operational until they were quantifiable. That's what the computer facilitated: quantification of risk, the necessary prerequisite to price it accurately and manage it effectively. Quantification did not change the fact that banks continue to deal with two very oldfashioned risks: credit risk--will the counterparty perform as promised?--and market risk--will changes in interest rates or other market factors reduce the value of my portfolio? Indeed, the special skills of banks in evaluating and taking credit and market risk is what banks have leveraged in taking part in the financial revolution spawned by the technical revolution. Nonetheless, the nature of the newer products and the relationship with counterparties have meant that risks now manifest themselves in a different way and that banks can modify their risk exposures much more rapidly than ever. Technology and the enhanced ability to capture and use data have changed risk taking and its management in several areas: securitization, credit scoring, and modeling for pricing and capital allocation, to name three. But no finer example of the revolutionary changes made possible by technology can be found than derivatives. Banks and other creators of derivatives can now slice and dice risks associated with a wide spectrum of underlying assets. Derivatives can be used to hedge risk for the bank or its customers. Examples include interest rate swaps designed to make counterparties more comfortable with their interest rate exposures and credit derivatives designed to reduce correlations of risk in a loan portfolio. Of course, either of these instruments can be used to take risk if the holder opts to hold the uncovered exposure, avoiding the cost of acquiring the underlying assets. Moreover, a bank can change its position quickly--limiting a loss, diversifying or hedging a risk, or closing out a position. Derivatives, of course, do more than allow the taking or hedging of risk. They also permit the holders to combine and separate risks to mimic virtually any financial activity. They thus limit what regulators can prohibit, blur distinctions between instruments regulated by different regulators, and virtually eliminate functional and other distinctions among commercial banks, investment banks, insurance companies, and other financial institutions. Supervising the Future Financial Services Holding Company When it comes to considering how technology and new products have affected supervision--especially of the future financial services holding company, with its wider powers--I must begin by repeating an earlier comment: Banking organizations are still in the risk business-taking it, managing it, profiting from it, and when they make the wrong decision or have bad luck, bearing losses and perhaps even failing. And the basic risks still are credit and market risks. The same expertise banks used for old-fashioned loans and their funding is still what they do for derivatives, securitizations, and credit scoring. That having been said, however, one must quickly add that the new instruments and procedures raise real questions about both managing and supervising risk by instruments and/or by legal entity. Banking organizations are doing so less and less, and as a result supervisors are following suit. Banking organizations have increasingly centralized risk management at the parent as a necessity because the credit decisions cross legal entities and certainly cross instruments. The new technology has already created a supervisory imperative that financial modernization--with its new permissible activities--can only accelerate: the need to evaluate risk policies and positions centrally-most likely by one supervisor, sharing information with all legal entity regulators. But, I must say, it is not clear to me precisely what this technology implies for the legal entity regulators. If units of an organization, through combinations of puts and calls, can simulate all the attributes of a security, or even most of the risks and returns of certain businesses, what does the term "functional regulator" mean? Historically, when a legal entity--a unit of an organization--was the only vehicle for participating in a certain function, the idea of separating regulators by functions was consistent with legal form. It is increasingly less so when a synthetic asset can be created with the same risk and return characteristics of the underlying asset. Or, how comfortable should the individual regulator feel if a hedge involves as counterparties two legal entities in the same failing organization? Will the regulator of unit A let the gains booked in his unit offset losses in unit B, regulated by another entity? Can he do so under the law? If the answer to either question is no, what good is such a hedge at a failing organization? Even without complicating the issue by failure, how does the regulator of the unit booking the loss on the hedge feel about the hedge, no matter how desirable the hedge is for the whole organization? The new reality, it seems to me, is that supervisors have to supervise risk and not instruments or entities. And that implies either that we keep organizations in old-fashioned straightjackets and permit no new activities--a strategy which the market and technology has already undermined--or we recognize that, over time, specialized regulators of banks, of securities firms, of even insurance companies--are going to have to find a new paradigm. We are, I believe, groping toward that future supervisory structure. At its center will be an evaluation of risk management procedures and policies. Historically, bank holding company supervision has dealt with an organization that was overwhelmingly a bank, and until Section 20s, whose affiliates were engaged in businesses that could be conducted within the bank. The supervisory approach was, not surprisingly, to apply bank-like supervision to the affiliates. The designers of financial modernization legislation and the holding company or umbrella supervisor must consider how to change that approach as bank affiliates increasingly are engaged in businesses not permitted to banks, and possibly even subject to regulation by a nonbank regulator. At a minimum, it is desirable to avoid redundant regulation. More basically, the necessarily intrusive supervision of banks that comes with the safety net should not be extended to these new activities. In part, such supervision would reduce efficiency and flexibility. In part, it would be unnecessary. And, in larger part, it could create a moral hazard by fostering the wrong impression that a bank supervisor has confirmed the strength of the supervised affiliate. Thus, the focus of holding company supervision, as I noted, should be evaluation of risk management policies and procedures for the organization. Safety Net Subsidies and Organizational Form Beyond regulatory structure, financial modernization--the linkage of banks to a wider range of financial activities--also raises organizational structure issues. This issue is closely linked to the subsidy provided by the federal safety net, a much discussed topic in recent weeks. By the safety net I mean deposit insurance, and access to both the Federal Reserve discount window and the Fed's payment system. While many of the questions associated with this topic are subtle and complex, I believe that some of the more basic issues regarding the safety net subsidy can be understood using straightforward economic reasoning. Unfortunately, much of the debate thus far has tended to be more obscure than it needs to be. Take, for example, the question of whether a subsidy exists. Most observers agree that there is a gross subsidy, and that the real issue is whether there is a subsidy net of regulatory costs. But here the discussion often seems to get confused. To me, it is critical at this point to distinguish clearly between the concepts of total benefits, total costs, and marginal benefits and marginal costs. We all know, at least those of us with some training in economics should know, that profit maximizing firms will equate marginal benefits with marginal costs. Applied to the subsidy debate, this principle implies that in equilibrium a profit maximizing bank should set the marginal benefits of the subsidy equal to its marginal costs. In other words, rational firms should drive the net marginal benefit of the subsidy to zero. Importantly, this implies that, at the margin, it may be very difficult to actually observe the subsidy. I suspect that this goes a long way toward explaining why efforts to estimate the marginal value of the subsidy have, to date, proved less than successful. Even though rational firms equate marginal benefits and marginal costs, they clearly do not equate total benefits and total costs. Indeed, standard microeconomic theory says that in a competitive equilibrium total benefits should exceed total costs. Again applying this concept to the subsidy debate, at any individual, profit maximizing bank the total benefits of the subsidy should exceed the subsidy's total costs, even though the subsidy's marginal net benefit is zero. This total net benefit allows the banking industry to be larger, and perhaps riskier, than it would otherwise be. The fact that we do not observe banks voluntarily giving up their charters suggests that it may well be that the safety net's total benefits exceed its total costs, even if the value of the net marginal subsidy is zero. Consider another point that derives from the distinction between total and marginal benefits. Today, we would expect banks to be maximizing their total net benefits from the subsidy using all of the activities in which they are capable of engaging. Now consider what a rational bank will do if given a new opportunity, say expanded securities powers, to maximize profit. Wouldn't we expect the bank to once again equate marginal benefits with marginal costs, including the marginal benefits and costs of the safety net subsidy? But in the resultant new equilibrium, where the value of the net marginal subsidy is again zero, would the total net benefits of the subsidy be the same as in the previous, more constrained equilibrium? Clearly the answer is no. We would expect total net benefits to be larger, and the banking industry to be larger, as it rationally sought to fully exploit the new opportunities to make profits and exploit the subsidy. Rather than focus on measuring how large the net subsidy is today, perhaps the more appropriate focus of our discussion should be on the more speculative question of how the expansion of bank powers would enhance the value of the safety net subsidy, and what would be the characteristics of the resulting competitive relationships. Another key idea to keep in mind when thinking about the value of the safety net subsidy is that we would fully expect the value of the subsidy to vary quite significantly across banks and over time. The safety net subsidy can be thought of as deriving primarily from the confidence that investors have in the belief that banks will be supported in times of financial crisis. This confidence is reflected in lower total and marginal costs of funding for banks, including lower capital requirements than otherwise would be the case. The economic value of this confidence is almost surely rather low at very healthy banks during good economic times. However, the value can be very much greater for any bank in financial distress, and can skyrocket in times of systemic financial crisis. As Chairman Greenspan noted in congressional testimony recently: What was it worth in the late 1980s and early 1990s for a bank with a troubled loan portfolio to have deposit liabilities guaranteed by the FDIC, to be assured that it could turn illiquid to liquid assets at once through the Federal Reserve discount window, and to tell its customers that payment transfers would be settled on a riskless Federal Reserve Bank? For many, it was worth not basis points but percentage points. For some, it meant the difference between survival and failure. Empirical research on the option value of deposit insurance supports the point I am trying to make. Estimates of the option value of deposit insurance, while subject to many caveats, show that riskier banks have considerably higher option values. What does all of this mean for the appropriate organizational form that future banking organizations should take? Now that is, I need not tell this audience, a complicated question! But I think the basic questions that we must answer are clear. First, assuming that one of the goals of public policy is to not expand the safety net subsidy, what organizational form minimizes the chances of such an expansion? Second, assuming that another goal of public policy is to limit the opportunities for banks to exploit the moral hazard incentives inherent to the safety net, what organizational form best ensures the safety and soundness of banks? The holding company organizational structure has a proven track record of helping to achieve both of these public policy goals. Indeed, years before I joined the Board, previous Boards worked hard at convincing market participants that there is a clear distinction, in terms of access to the safety net, between a bank and its affiliates. Market practice supports the view that we have achieved considerable success at making this distinction. To me, it seems not only logical, but highly desirable that we should build on this success as we continue to modernize our banking and financial system. When thinking about this issue, it is instructive to understand that in recent years bank holding companies have in fact tended to move activities from the holding company back into the bank. These activities had originally been put in the holding company to avoid geographic and similar restrictions. As a result of this movement back into the bank, the nonbank assets held by holding companies, excluding the assets of Section 20 securities subsidiaries, have declined by almost 50 percent over the last decade to 5.2 percent of consolidated bank holding company assets. When asked why activities are being moved back into the bank, bankers often say that it is to take advantage of the lower funding costs available at the bank. One final point on this issue. It is certainly true that prudent managements of banking organizations will weigh all the relevant factors, including the value of the safety net, when deciding on the best organizational structure for their firm. However, the key point to remember is that those organizations that stand to gain the most from the safety net in times of crisis--those with the highest net subsidy and the strongest incentives to take excessive risks--are the most likely both to prefer and to take advantage of any organizational structures that allow the greatest net subsidy. These are also the organizations that are most likely to distort competitive relationships and expose taxpayers to considerable risk. Thus, while allowing organizations a choice of organizational structure certainly increases bank management's flexibility, it is not clear that allowing such choice serves the public interest. Conclusion In closing, let me return to where I began. Financial modernization is a process that must and will continue. But in the course of embracing and adapting to the future we must take care to retain what is of value in the past, and be careful that critical public policy goals are achieved. The separation of banking and commerce is an area where we should be particularly cautious. Once we have mastered the art and science of supervising full service financial organizations, then perhaps we should consider further combining banking and commerce. Technological change and financial innovation are combining to change profoundly the way financial institutions measure, take, and manage risk. These require that financial supervisors also adapt, and we need to move forward in this endeavor. The development of full service financial organizations only reinforces the imperatives to do so. When designing a system that maintains bank safety and soundness and constrains extension of the safety net, organizational structure is not irrelevant. Here again it seems prudent that we should be cautious, and build on structures that have proven their worth. I am confident that a proper balance can be achieved between our sometimes conflicting and always complex goals. Indeed, I look forward to trying to contribute to the ongoing discussion and resolution of the challenges of financial modernization. Thank you.	---[PAGE_BREAK]--- # Mr. Meyer looks at issues in financial modernization in the United States Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the seventh annual Conference on Financial Structure in Annandale-on-Hudson, New York, on 10/4/97. It is my pleasure to take part in what has become an important annual meeting on financial policy issues. It is my job to get you warmed up for a reception and dinner. Our hosts have a curious view that a discussion of financial modernization will whet your appetite for food. Maybe so, but it will almost surely increase your thirst. It seems that people have been talking about financial modernization for a long time. Indeed, in the short-run it is easy to become discouraged about how often we talk, but how rarely we do anything, about financial modernization. However, if we step back and look over the last twenty years, it seems to me remarkable both how much progress has been achieved and how much the concerns of financial modernization have changed. Two decades ago we still had Regulation Q, the Glass-Steagall Act was widely viewed as requiring a virtual prohibition of combinations of commercial and investment banking, interstate banking and branching were barely fantasies even at the state level, and combinations of banking and insurance were off most people's radar screens. Today, many of the issues of 20 years ago have, blessedly, been resolved. But some remain, and new ones have inevitably appeared. The contemporary concerns of financial modernization include repeal of Glass-Steagall, expanded insurance activities for banking firms, the entry of insurance and securities firms into banking, the possibility of unlimited mixing of banking and commerce, and ongoing technological changes and financial innovations. Tonight I would like to address some aspects of these concerns. I will suggest to you that while financial modernization is still, as it was twenty years ago, a necessity, it is also the case that in an uncertain world characterized by rapid change caution is not a dirty word. I will begin with what for me is the easiest topic: banking and commerce. The separation of banking and commerce has a long history in English-speaking countries. Indeed, the policy can be traced back to the founding of the Bank of England in 1694. It appears that commercial firms were concerned that the Bank's monetary powers would give it a competitive advantage in mercantile activities if there were no separation of banking and commerce. The young American state governments adopted, at least in principle, this separation of banking and commerce. However, from the beginning the separation of banking and commerce was hardly complete in the U.S. banking system. State governments often saw the granting of bank charters as a way of encouraging capital intensive development projects. As a result, pre-Civil War banks were sometimes engaged in such activities as canal building, railroad construction, and even the development of public water systems. Thus, from early on the mixing of banking and commerce was a gray area in the United States. This tradition continues to this day. For example, the same individual can own a controlling share of both banking and commercial firms. Perhaps of more interest, a bank holding company may acquire up to 5 percent of the voting shares of any commercial enterprise, as long as the investment does not represent a controlling interest. In addition, the Board has permitted passive investments in commercial firms of up to 25 percent of nonvoting shares, and an investment can be as high as 49 percent if it is made through a small business investment company. Bank holding companies can own 100 percent of the equity of a small business investment company. ---[PAGE_BREAK]--- We could all continue to give many examples, including the ownership of unitary thrifts and specialized, and not-so-specialized, finance companies by commercial firms. Indeed, some observers use these examples to argue that since the United States already has so much mixing of banking and commerce, why not go all the way? In my view, such arguments exaggerate the reality. Despite all the gray areas, I think it is fair to say that to a very substantial extent banking and commerce are essentially separate activities in the United States. Thus, we need to think carefully about whether we want to go even further down the road of combining banking with nonfinancial activities. Advocates of unrestricted mixing of banking and commerce make at least four arguments: (1) both banking and commercial firms could more easily diversify their risks, (2) a closely related argument is that such combinations would provide opportunities for synergies in cross-selling, (3) combining banking and commerce could lead to more capital in the banking industry, and (4) mixing banking and commerce would help to solve certain asymmetric information and corporate control problems associated with commercial lending. Time does not permit me to address each of these in detail. Suffice it to say that I find each of them wanting. I can find very little, if any, in our experience as a nation that gives me real confidence about the benefits of combining banking and commerce. And I can find no empirical support for any benefits for combining banking and commerce based on experience abroad. Take risk diversification. Do we really believe that in the day of stock index mutual funds, options on individual stocks, and evolving credit derivatives that any firm must own another in order to diversify its risks in virtually any way it cares to do so? I think not. If diversification of asset return risk were our only goal, financial modernization would be easy. How about synergies in crossselling? Maybe. But I think we must be skeptical here, because the admittedly weak literature on economies of scope in banking has been hard pressed to find strong evidence of significant synergies even in financial activities, although I think we all believe that there are some. The argument that we need to combine banking and commerce to attract capital to banking seems, well, pretty silly. In a market economy, capital flows to profit opportunities. If banking is viewed as a vibrant and growing industry, it is hard to see why capital will be a problem. Indeed, the banking industry just completed its fifth straight year of record profits, and it is no coincidence that by all measures capital has been flowing into the industry. If it were not profitable, I cannot see why we would want to create a structure to attract capital to banking. The notion that mixing banking and commerce would reduce information costs in bank lending, and would facilitate monitoring and management control by the bank probably has some merit. Banks that hold both a debt and equity stake in a firm would probably be better able to deter excessive risk taking by the other equity holders, and might even have access to better information about the firm. However, the internalization of these principal-agent problems would come at a price: a price that could include less vibrant money and capital markets, an unwarranted expansion of the federal safety net, potentially dangerous conflicts of interest, and excessive concentration of power. On balance, in my view, this is an area where we should be very cautious and where we need far more research before we can come to any definitive conclusions. An additional reason for caution is the necessity of modifying supervisory techniques. I believe that all of the banking agencies can meet the challenges of expanded financial activities. But adding commercial firms before we have digested the financial side of the business could well be a bridge too far. Indeed, I believe that prudent public policy requires that, for this reason alone, we get financial activities right before tackling further combinations of banking and commerce. The thorny banking and commerce problem in financial modernization is that nonbanking financial firms are already affiliated with commercial firms: some from commercial firms ---[PAGE_BREAK]--- creating financial subsidiaries, some from financial firms acquiring nonfinancial businesses. If financial modernization allows all financial firms to affiliate, but prohibits banking and commerce, the pre-existing commercial affiliates of nonbank financial firms would have to be divested to acquire a bank, while banks could enter de novo the new nonbank financial activity without divesting any valuable assets. This is either inequitable or the cost of acquiring a bank, depending on your point of view. But, it is clearly a problem that has to be addressed. The choices are divestiture, grandfathering, long-term phase outs, basket clauses, or combining of banking and commerce. It would seem to me a poor public policy that opened up banking and commerce on pure equity grounds, rather than a disinterested analysis of societal net benefits. # The Impact of Technological Change on Bank Risk Management A strong case can be made for focussing bank reform today on the expansion of permissible financial activities. The prohibitions against banking and securities and banking and insurance combinations have always, it seems to me, been difficult to support. Moreover, technological change has simply undermined the traditional distinctions among financial products and services. In a word, the existing prohibitions are anachronistic. One thing has remained consistent: Banks are in the business of taking and managing risk, have always been and always will be. The change that we must cope with is that technology has changed the ways they take risk, while at the same time improving their capability for managing it. This creation and management of risk, like much of recent economic change, would have been impossible without the dramatically lower cost of a unit of computing power. Indeed, before the computer, most of the new bank products of recent years were merely concepts, concepts that could not become operational until they were quantifiable. That's what the computer facilitated: quantification of risk, the necessary prerequisite to price it accurately and manage it effectively. Quantification did not change the fact that banks continue to deal with two very oldfashioned risks: credit risk--will the counterparty perform as promised?--and market risk--will changes in interest rates or other market factors reduce the value of my portfolio? Indeed, the special skills of banks in evaluating and taking credit and market risk is what banks have leveraged in taking part in the financial revolution spawned by the technical revolution. Nonetheless, the nature of the newer products and the relationship with counterparties have meant that risks now manifest themselves in a different way and that banks can modify their risk exposures much more rapidly than ever. Technology and the enhanced ability to capture and use data have changed risk taking and its management in several areas: securitization, credit scoring, and modeling for pricing and capital allocation, to name three. But no finer example of the revolutionary changes made possible by technology can be found than derivatives. Banks and other creators of derivatives can now slice and dice risks associated with a wide spectrum of underlying assets. Derivatives can be used to hedge risk for the bank or its customers. Examples include interest rate swaps designed to make counterparties more comfortable with their interest rate exposures and credit derivatives designed to reduce correlations of risk in a loan portfolio. Of course, either of these instruments can be used to take risk if the holder opts to hold the uncovered exposure, avoiding the cost of acquiring the underlying assets. Moreover, a bank can change its position quickly--limiting a loss, diversifying or hedging a risk, or closing out a position. Derivatives, of course, do more than allow the taking or hedging of risk. They also permit the holders to combine and separate risks to mimic virtually any financial activity. They thus limit what regulators can prohibit, blur distinctions between instruments regulated by different regulators, and virtually eliminate functional and other distinctions among commercial banks, investment banks, insurance companies, and other financial institutions. ---[PAGE_BREAK]--- # Supervising the Future Financial Services Holding Company When it comes to considering how technology and new products have affected supervision--especially of the future financial services holding company, with its wider powers--I must begin by repeating an earlier comment: Banking organizations are still in the risk businesstaking it, managing it, profiting from it, and when they make the wrong decision or have bad luck, bearing losses and perhaps even failing. And the basic risks still are credit and market risks. The same expertise banks used for old-fashioned loans and their funding is still what they do for derivatives, securitizations, and credit scoring. That having been said, however, one must quickly add that the new instruments and procedures raise real questions about both managing and supervising risk by instruments and/or by legal entity. Banking organizations are doing so less and less, and as a result supervisors are following suit. Banking organizations have increasingly centralized risk management at the parent as a necessity because the credit decisions cross legal entities and certainly cross instruments. The new technology has already created a supervisory imperative that financial modernization--with its new permissible activities--can only accelerate: the need to evaluate risk policies and positions centrally-most likely by one supervisor, sharing information with all legal entity regulators. But, I must say, it is not clear to me precisely what this technology implies for the legal entity regulators. If units of an organization, through combinations of puts and calls, can simulate all the attributes of a security, or even most of the risks and returns of certain businesses, what does the term "functional regulator" mean? Historically, when a legal entity--a unit of an organization--was the only vehicle for participating in a certain function, the idea of separating regulators by functions was consistent with legal form. It is increasingly less so when a synthetic asset can be created with the same risk and return characteristics of the underlying asset. Or, how comfortable should the individual regulator feel if a hedge involves as counterparties two legal entities in the same failing organization? Will the regulator of unit A let the gains booked in his unit offset losses in unit B, regulated by another entity? Can he do so under the law? If the answer to either question is no, what good is such a hedge at a failing organization? Even without complicating the issue by failure, how does the regulator of the unit booking the loss on the hedge feel about the hedge, no matter how desirable the hedge is for the whole organization? The new reality, it seems to me, is that supervisors have to supervise risk and not instruments or entities. And that implies either that we keep organizations in old-fashioned straightjackets and permit no new activities--a strategy which the market and technology has already undermined--or we recognize that, over time, specialized regulators of banks, of securities firms, of even insurance companies--are going to have to find a new paradigm. We are, I believe, groping toward that future supervisory structure. At its center will be an evaluation of risk management procedures and policies. Historically, bank holding company supervision has dealt with an organization that was overwhelmingly a bank, and until Section 20s, whose affiliates were engaged in businesses that could be conducted within the bank. The supervisory approach was, not surprisingly, to apply bank-like supervision to the affiliates. The designers of financial modernization legislation and the holding company or umbrella supervisor must consider how to change that approach as bank affiliates increasingly are engaged in businesses not permitted to banks, and possibly even subject to regulation by a nonbank regulator. At a minimum, it is desirable to avoid redundant regulation. More basically, the necessarily intrusive supervision of banks that comes with the safety net should not be extended to these new activities. In part, such supervision would reduce efficiency and flexibility. In part, it would be unnecessary. And, in larger part, it could create a moral hazard by fostering the wrong impression that a bank supervisor ---[PAGE_BREAK]--- has confirmed the strength of the supervised affiliate. Thus, the focus of holding company supervision, as I noted, should be evaluation of risk management policies and procedures for the organization. # Safety Net Subsidies and Organizational Form Beyond regulatory structure, financial modernization--the linkage of banks to a wider range of financial activities--also raises organizational structure issues. This issue is closely linked to the subsidy provided by the federal safety net, a much discussed topic in recent weeks. By the safety net I mean deposit insurance, and access to both the Federal Reserve discount window and the Fed's payment system. While many of the questions associated with this topic are subtle and complex, I believe that some of the more basic issues regarding the safety net subsidy can be understood using straightforward economic reasoning. Unfortunately, much of the debate thus far has tended to be more obscure than it needs to be. Take, for example, the question of whether a subsidy exists. Most observers agree that there is a gross subsidy, and that the real issue is whether there is a subsidy net of regulatory costs. But here the discussion often seems to get confused. To me, it is critical at this point to distinguish clearly between the concepts of total benefits, total costs, and marginal benefits and marginal costs. We all know, at least those of us with some training in economics should know, that profit maximizing firms will equate marginal benefits with marginal costs. Applied to the subsidy debate, this principle implies that in equilibrium a profit maximizing bank should set the marginal benefits of the subsidy equal to its marginal costs. In other words, rational firms should drive the net marginal benefit of the subsidy to zero. Importantly, this implies that, at the margin, it may be very difficult to actually observe the subsidy. I suspect that this goes a long way toward explaining why efforts to estimate the marginal value of the subsidy have, to date, proved less than successful. Even though rational firms equate marginal benefits and marginal costs, they clearly do not equate total benefits and total costs. Indeed, standard microeconomic theory says that in a competitive equilibrium total benefits should exceed total costs. Again applying this concept to the subsidy debate, at any individual, profit maximizing bank the total benefits of the subsidy should exceed the subsidy's total costs, even though the subsidy's marginal net benefit is zero. This total net benefit allows the banking industry to be larger, and perhaps riskier, than it would otherwise be. The fact that we do not observe banks voluntarily giving up their charters suggests that it may well be that the safety net's total benefits exceed its total costs, even if the value of the net marginal subsidy is zero. Consider another point that derives from the distinction between total and marginal benefits. Today, we would expect banks to be maximizing their total net benefits from the subsidy using all of the activities in which they are capable of engaging. Now consider what a rational bank will do if given a new opportunity, say expanded securities powers, to maximize profit. Wouldn't we expect the bank to once again equate marginal benefits with marginal costs, including the marginal benefits and costs of the safety net subsidy? But in the resultant new equilibrium, where the value of the net marginal subsidy is again zero, would the total net benefits of the subsidy be the same as in the previous, more constrained equilibrium? Clearly the answer is no. We would expect total net benefits to be larger, and the banking industry to be larger, as it rationally sought to fully exploit the new opportunities to make profits and exploit the subsidy. Rather than focus on measuring how large the net subsidy is today, perhaps the more appropriate focus of our discussion should be on the more speculative question of how the expansion of bank powers would enhance the value of the safety net subsidy, and what would be the characteristics of the resulting competitive relationships. Another key idea to keep in mind when thinking about the value of the safety net subsidy is that we would fully expect the value of the subsidy to vary quite significantly across banks ---[PAGE_BREAK]--- and over time. The safety net subsidy can be thought of as deriving primarily from the confidence that investors have in the belief that banks will be supported in times of financial crisis. This confidence is reflected in lower total and marginal costs of funding for banks, including lower capital requirements than otherwise would be the case. The economic value of this confidence is almost surely rather low at very healthy banks during good economic times. However, the value can be very much greater for any bank in financial distress, and can skyrocket in times of systemic financial crisis. As Chairman Greenspan noted in congressional testimony recently: What was it worth in the late 1980s and early 1990s for a bank with a troubled loan portfolio to have deposit liabilities guaranteed by the FDIC, to be assured that it could turn illiquid to liquid assets at once through the Federal Reserve discount window, and to tell its customers that payment transfers would be settled on a riskless Federal Reserve Bank? For many, it was worth not basis points but percentage points. For some, it meant the difference between survival and failure. Empirical research on the option value of deposit insurance supports the point I am trying to make. Estimates of the option value of deposit insurance, while subject to many caveats, show that riskier banks have considerably higher option values. What does all of this mean for the appropriate organizational form that future banking organizations should take? Now that is, I need not tell this audience, a complicated question! But I think the basic questions that we must answer are clear. First, assuming that one of the goals of public policy is to not expand the safety net subsidy, what organizational form minimizes the chances of such an expansion? Second, assuming that another goal of public policy is to limit the opportunities for banks to exploit the moral hazard incentives inherent to the safety net, what organizational form best ensures the safety and soundness of banks? The holding company organizational structure has a proven track record of helping to achieve both of these public policy goals. Indeed, years before I joined the Board, previous Boards worked hard at convincing market participants that there is a clear distinction, in terms of access to the safety net, between a bank and its affiliates. Market practice supports the view that we have achieved considerable success at making this distinction. To me, it seems not only logical, but highly desirable that we should build on this success as we continue to modernize our banking and financial system. When thinking about this issue, it is instructive to understand that in recent years bank holding companies have in fact tended to move activities from the holding company back into the bank. These activities had originally been put in the holding company to avoid geographic and similar restrictions. As a result of this movement back into the bank, the nonbank assets held by holding companies, excluding the assets of Section 20 securities subsidiaries, have declined by almost 50 percent over the last decade to 5.2 percent of consolidated bank holding company assets. When asked why activities are being moved back into the bank, bankers often say that it is to take advantage of the lower funding costs available at the bank. One final point on this issue. It is certainly true that prudent managements of banking organizations will weigh all the relevant factors, including the value of the safety net, when deciding on the best organizational structure for their firm. However, the key point to remember is that those organizations that stand to gain the most from the safety net in times of crisis-those with the highest net subsidy and the strongest incentives to take excessive risks-are the most likely both to prefer and to take advantage of any organizational structures that allow the greatest net subsidy. These are also the organizations that are most likely to distort competitive relationships and expose taxpayers to considerable risk. Thus, while allowing organizations a choice of organizational structure certainly increases bank management's flexibility, it is not clear that allowing such choice serves the public interest. ---[PAGE_BREAK]--- # Conclusion In closing, let me return to where I began. Financial modernization is a process that must and will continue. But in the course of embracing and adapting to the future we must take care to retain what is of value in the past, and be careful that critical public policy goals are achieved. The separation of banking and commerce is an area where we should be particularly cautious. Once we have mastered the art and science of supervising full service financial organizations, then perhaps we should consider further combining banking and commerce. Technological change and financial innovation are combining to change profoundly the way financial institutions measure, take, and manage risk. These require that financial supervisors also adapt, and we need to move forward in this endeavor. The development of full service financial organizations only reinforces the imperatives to do so. When designing a system that maintains bank safety and soundness and constrains extension of the safety net, organizational structure is not irrelevant. Here again it seems prudent that we should be cautious, and build on structures that have proven their worth. I am confident that a proper balance can be achieved between our sometimes conflicting and always complex goals. Indeed, I look forward to trying to contribute to the ongoing discussion and resolution of the challenges of financial modernization. Thank you.	Laurence H Meyer	United States	https://www.bis.org/review/r970418a.pdf	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the seventh annual Conference on Financial Structure in Annandale-on-Hudson, New York, on 10/4/97. It is my pleasure to take part in what has become an important annual meeting on financial policy issues. It is my job to get you warmed up for a reception and dinner. Our hosts have a curious view that a discussion of financial modernization will whet your appetite for food. Maybe so, but it will almost surely increase your thirst. It seems that people have been talking about financial modernization for a long time. Indeed, in the short-run it is easy to become discouraged about how often we talk, but how rarely we do anything, about financial modernization. However, if we step back and look over the last twenty years, it seems to me remarkable both how much progress has been achieved and how much the concerns of financial modernization have changed. Two decades ago we still had Regulation Q, the Glass-Steagall Act was widely viewed as requiring a virtual prohibition of combinations of commercial and investment banking, interstate banking and branching were barely fantasies even at the state level, and combinations of banking and insurance were off most people's radar screens. Today, many of the issues of 20 years ago have, blessedly, been resolved. But some remain, and new ones have inevitably appeared. The contemporary concerns of financial modernization include repeal of Glass-Steagall, expanded insurance activities for banking firms, the entry of insurance and securities firms into banking, the possibility of unlimited mixing of banking and commerce, and ongoing technological changes and financial innovations. Tonight I would like to address some aspects of these concerns. I will suggest to you that while financial modernization is still, as it was twenty years ago, a necessity, it is also the case that in an uncertain world characterized by rapid change caution is not a dirty word. I will begin with what for me is the easiest topic: banking and commerce. The separation of banking and commerce has a long history in English-speaking countries. Indeed, the policy can be traced back to the founding of the Bank of England in 1694. It appears that commercial firms were concerned that the Bank's monetary powers would give it a competitive advantage in mercantile activities if there were no separation of banking and commerce. The young American state governments adopted, at least in principle, this separation of banking and commerce. However, from the beginning the separation of banking and commerce was hardly complete in the U.S. banking system. State governments often saw the granting of bank charters as a way of encouraging capital intensive development projects. As a result, pre-Civil War banks were sometimes engaged in such activities as canal building, railroad construction, and even the development of public water systems. Thus, from early on the mixing of banking and commerce was a gray area in the United States. This tradition continues to this day. For example, the same individual can own a controlling share of both banking and commercial firms. Perhaps of more interest, a bank holding company may acquire up to 5 percent of the voting shares of any commercial enterprise, as long as the investment does not represent a controlling interest. In addition, the Board has permitted passive investments in commercial firms of up to 25 percent of nonvoting shares, and an investment can be as high as 49 percent if it is made through a small business investment company. Bank holding companies can own 100 percent of the equity of a small business investment company. We could all continue to give many examples, including the ownership of unitary thrifts and specialized, and not-so-specialized, finance companies by commercial firms. Indeed, some observers use these examples to argue that since the United States already has so much mixing of banking and commerce, why not go all the way? In my view, such arguments exaggerate the reality. Despite all the gray areas, I think it is fair to say that to a very substantial extent banking and commerce are essentially separate activities in the United States. Thus, we need to think carefully about whether we want to go even further down the road of combining banking with nonfinancial activities. Advocates of unrestricted mixing of banking and commerce make at least four arguments: (1) both banking and commercial firms could more easily diversify their risks, (2) a closely related argument is that such combinations would provide opportunities for synergies in cross-selling, (3) combining banking and commerce could lead to more capital in the banking industry, and (4) mixing banking and commerce would help to solve certain asymmetric information and corporate control problems associated with commercial lending. Time does not permit me to address each of these in detail. Suffice it to say that I find each of them wanting. I can find very little, if any, in our experience as a nation that gives me real confidence about the benefits of combining banking and commerce. And I can find no empirical support for any benefits for combining banking and commerce based on experience abroad. Take risk diversification. Do we really believe that in the day of stock index mutual funds, options on individual stocks, and evolving credit derivatives that any firm must own another in order to diversify its risks in virtually any way it cares to do so? I think not. If diversification of asset return risk were our only goal, financial modernization would be easy. How about synergies in crossselling? Maybe. But I think we must be skeptical here, because the admittedly weak literature on economies of scope in banking has been hard pressed to find strong evidence of significant synergies even in financial activities, although I think we all believe that there are some. The argument that we need to combine banking and commerce to attract capital to banking seems, well, pretty silly. In a market economy, capital flows to profit opportunities. If banking is viewed as a vibrant and growing industry, it is hard to see why capital will be a problem. Indeed, the banking industry just completed its fifth straight year of record profits, and it is no coincidence that by all measures capital has been flowing into the industry. If it were not profitable, I cannot see why we would want to create a structure to attract capital to banking. The notion that mixing banking and commerce would reduce information costs in bank lending, and would facilitate monitoring and management control by the bank probably has some merit. Banks that hold both a debt and equity stake in a firm would probably be better able to deter excessive risk taking by the other equity holders, and might even have access to better information about the firm. However, the internalization of these principal-agent problems would come at a price: a price that could include less vibrant money and capital markets, an unwarranted expansion of the federal safety net, potentially dangerous conflicts of interest, and excessive concentration of power. On balance, in my view, this is an area where we should be very cautious and where we need far more research before we can come to any definitive conclusions. An additional reason for caution is the necessity of modifying supervisory techniques. I believe that all of the banking agencies can meet the challenges of expanded financial activities. But adding commercial firms before we have digested the financial side of the business could well be a bridge too far. Indeed, I believe that prudent public policy requires that, for this reason alone, we get financial activities right before tackling further combinations of banking and commerce. The thorny banking and commerce problem in financial modernization is that nonbanking financial firms are already affiliated with commercial firms: some from commercial firms creating financial subsidiaries, some from financial firms acquiring nonfinancial businesses. If financial modernization allows all financial firms to affiliate, but prohibits banking and commerce, the pre-existing commercial affiliates of nonbank financial firms would have to be divested to acquire a bank, while banks could enter de novo the new nonbank financial activity without divesting any valuable assets. This is either inequitable or the cost of acquiring a bank, depending on your point of view. But, it is clearly a problem that has to be addressed. The choices are divestiture, grandfathering, long-term phase outs, basket clauses, or combining of banking and commerce. It would seem to me a poor public policy that opened up banking and commerce on pure equity grounds, rather than a disinterested analysis of societal net benefits. A strong case can be made for focussing bank reform today on the expansion of permissible financial activities. The prohibitions against banking and securities and banking and insurance combinations have always, it seems to me, been difficult to support. Moreover, technological change has simply undermined the traditional distinctions among financial products and services. In a word, the existing prohibitions are anachronistic. One thing has remained consistent: Banks are in the business of taking and managing risk, have always been and always will be. The change that we must cope with is that technology has changed the ways they take risk, while at the same time improving their capability for managing it. This creation and management of risk, like much of recent economic change, would have been impossible without the dramatically lower cost of a unit of computing power. Indeed, before the computer, most of the new bank products of recent years were merely concepts, concepts that could not become operational until they were quantifiable. That's what the computer facilitated: quantification of risk, the necessary prerequisite to price it accurately and manage it effectively. Quantification did not change the fact that banks continue to deal with two very oldfashioned risks: credit risk--will the counterparty perform as promised?--and market risk--will changes in interest rates or other market factors reduce the value of my portfolio? Indeed, the special skills of banks in evaluating and taking credit and market risk is what banks have leveraged in taking part in the financial revolution spawned by the technical revolution. Nonetheless, the nature of the newer products and the relationship with counterparties have meant that risks now manifest themselves in a different way and that banks can modify their risk exposures much more rapidly than ever. Technology and the enhanced ability to capture and use data have changed risk taking and its management in several areas: securitization, credit scoring, and modeling for pricing and capital allocation, to name three. But no finer example of the revolutionary changes made possible by technology can be found than derivatives. Banks and other creators of derivatives can now slice and dice risks associated with a wide spectrum of underlying assets. Derivatives can be used to hedge risk for the bank or its customers. Examples include interest rate swaps designed to make counterparties more comfortable with their interest rate exposures and credit derivatives designed to reduce correlations of risk in a loan portfolio. Of course, either of these instruments can be used to take risk if the holder opts to hold the uncovered exposure, avoiding the cost of acquiring the underlying assets. Moreover, a bank can change its position quickly--limiting a loss, diversifying or hedging a risk, or closing out a position. Derivatives, of course, do more than allow the taking or hedging of risk. They also permit the holders to combine and separate risks to mimic virtually any financial activity. They thus limit what regulators can prohibit, blur distinctions between instruments regulated by different regulators, and virtually eliminate functional and other distinctions among commercial banks, investment banks, insurance companies, and other financial institutions. When it comes to considering how technology and new products have affected supervision--especially of the future financial services holding company, with its wider powers--I must begin by repeating an earlier comment: Banking organizations are still in the risk businesstaking it, managing it, profiting from it, and when they make the wrong decision or have bad luck, bearing losses and perhaps even failing. And the basic risks still are credit and market risks. The same expertise banks used for old-fashioned loans and their funding is still what they do for derivatives, securitizations, and credit scoring. That having been said, however, one must quickly add that the new instruments and procedures raise real questions about both managing and supervising risk by instruments and/or by legal entity. Banking organizations are doing so less and less, and as a result supervisors are following suit. Banking organizations have increasingly centralized risk management at the parent as a necessity because the credit decisions cross legal entities and certainly cross instruments. The new technology has already created a supervisory imperative that financial modernization--with its new permissible activities--can only accelerate: the need to evaluate risk policies and positions centrally-most likely by one supervisor, sharing information with all legal entity regulators. But, I must say, it is not clear to me precisely what this technology implies for the legal entity regulators. If units of an organization, through combinations of puts and calls, can simulate all the attributes of a security, or even most of the risks and returns of certain businesses, what does the term "functional regulator" mean? Historically, when a legal entity--a unit of an organization--was the only vehicle for participating in a certain function, the idea of separating regulators by functions was consistent with legal form. It is increasingly less so when a synthetic asset can be created with the same risk and return characteristics of the underlying asset. Or, how comfortable should the individual regulator feel if a hedge involves as counterparties two legal entities in the same failing organization? Will the regulator of unit A let the gains booked in his unit offset losses in unit B, regulated by another entity? Can he do so under the law? If the answer to either question is no, what good is such a hedge at a failing organization? Even without complicating the issue by failure, how does the regulator of the unit booking the loss on the hedge feel about the hedge, no matter how desirable the hedge is for the whole organization? The new reality, it seems to me, is that supervisors have to supervise risk and not instruments or entities. And that implies either that we keep organizations in old-fashioned straightjackets and permit no new activities--a strategy which the market and technology has already undermined--or we recognize that, over time, specialized regulators of banks, of securities firms, of even insurance companies--are going to have to find a new paradigm. We are, I believe, groping toward that future supervisory structure. At its center will be an evaluation of risk management procedures and policies. Historically, bank holding company supervision has dealt with an organization that was overwhelmingly a bank, and until Section 20s, whose affiliates were engaged in businesses that could be conducted within the bank. The supervisory approach was, not surprisingly, to apply bank-like supervision to the affiliates. The designers of financial modernization legislation and the holding company or umbrella supervisor must consider how to change that approach as bank affiliates increasingly are engaged in businesses not permitted to banks, and possibly even subject to regulation by a nonbank regulator. At a minimum, it is desirable to avoid redundant regulation. More basically, the necessarily intrusive supervision of banks that comes with the safety net should not be extended to these new activities. In part, such supervision would reduce efficiency and flexibility. In part, it would be unnecessary. And, in larger part, it could create a moral hazard by fostering the wrong impression that a bank supervisor has confirmed the strength of the supervised affiliate. Thus, the focus of holding company supervision, as I noted, should be evaluation of risk management policies and procedures for the organization. Beyond regulatory structure, financial modernization--the linkage of banks to a wider range of financial activities--also raises organizational structure issues. This issue is closely linked to the subsidy provided by the federal safety net, a much discussed topic in recent weeks. By the safety net I mean deposit insurance, and access to both the Federal Reserve discount window and the Fed's payment system. While many of the questions associated with this topic are subtle and complex, I believe that some of the more basic issues regarding the safety net subsidy can be understood using straightforward economic reasoning. Unfortunately, much of the debate thus far has tended to be more obscure than it needs to be. Take, for example, the question of whether a subsidy exists. Most observers agree that there is a gross subsidy, and that the real issue is whether there is a subsidy net of regulatory costs. But here the discussion often seems to get confused. To me, it is critical at this point to distinguish clearly between the concepts of total benefits, total costs, and marginal benefits and marginal costs. We all know, at least those of us with some training in economics should know, that profit maximizing firms will equate marginal benefits with marginal costs. Applied to the subsidy debate, this principle implies that in equilibrium a profit maximizing bank should set the marginal benefits of the subsidy equal to its marginal costs. In other words, rational firms should drive the net marginal benefit of the subsidy to zero. Importantly, this implies that, at the margin, it may be very difficult to actually observe the subsidy. I suspect that this goes a long way toward explaining why efforts to estimate the marginal value of the subsidy have, to date, proved less than successful. Even though rational firms equate marginal benefits and marginal costs, they clearly do not equate total benefits and total costs. Indeed, standard microeconomic theory says that in a competitive equilibrium total benefits should exceed total costs. Again applying this concept to the subsidy debate, at any individual, profit maximizing bank the total benefits of the subsidy should exceed the subsidy's total costs, even though the subsidy's marginal net benefit is zero. This total net benefit allows the banking industry to be larger, and perhaps riskier, than it would otherwise be. The fact that we do not observe banks voluntarily giving up their charters suggests that it may well be that the safety net's total benefits exceed its total costs, even if the value of the net marginal subsidy is zero. Consider another point that derives from the distinction between total and marginal benefits. Today, we would expect banks to be maximizing their total net benefits from the subsidy using all of the activities in which they are capable of engaging. Now consider what a rational bank will do if given a new opportunity, say expanded securities powers, to maximize profit. Wouldn't we expect the bank to once again equate marginal benefits with marginal costs, including the marginal benefits and costs of the safety net subsidy? But in the resultant new equilibrium, where the value of the net marginal subsidy is again zero, would the total net benefits of the subsidy be the same as in the previous, more constrained equilibrium? Clearly the answer is no. We would expect total net benefits to be larger, and the banking industry to be larger, as it rationally sought to fully exploit the new opportunities to make profits and exploit the subsidy. Rather than focus on measuring how large the net subsidy is today, perhaps the more appropriate focus of our discussion should be on the more speculative question of how the expansion of bank powers would enhance the value of the safety net subsidy, and what would be the characteristics of the resulting competitive relationships. Another key idea to keep in mind when thinking about the value of the safety net subsidy is that we would fully expect the value of the subsidy to vary quite significantly across banks and over time. The safety net subsidy can be thought of as deriving primarily from the confidence that investors have in the belief that banks will be supported in times of financial crisis. This confidence is reflected in lower total and marginal costs of funding for banks, including lower capital requirements than otherwise would be the case. The economic value of this confidence is almost surely rather low at very healthy banks during good economic times. However, the value can be very much greater for any bank in financial distress, and can skyrocket in times of systemic financial crisis. As Chairman Greenspan noted in congressional testimony recently: What was it worth in the late 1980s and early 1990s for a bank with a troubled loan portfolio to have deposit liabilities guaranteed by the FDIC, to be assured that it could turn illiquid to liquid assets at once through the Federal Reserve discount window, and to tell its customers that payment transfers would be settled on a riskless Federal Reserve Bank? For many, it was worth not basis points but percentage points. For some, it meant the difference between survival and failure. Empirical research on the option value of deposit insurance supports the point I am trying to make. Estimates of the option value of deposit insurance, while subject to many caveats, show that riskier banks have considerably higher option values. What does all of this mean for the appropriate organizational form that future banking organizations should take? Now that is, I need not tell this audience, a complicated question! But I think the basic questions that we must answer are clear. First, assuming that one of the goals of public policy is to not expand the safety net subsidy, what organizational form minimizes the chances of such an expansion? Second, assuming that another goal of public policy is to limit the opportunities for banks to exploit the moral hazard incentives inherent to the safety net, what organizational form best ensures the safety and soundness of banks? The holding company organizational structure has a proven track record of helping to achieve both of these public policy goals. Indeed, years before I joined the Board, previous Boards worked hard at convincing market participants that there is a clear distinction, in terms of access to the safety net, between a bank and its affiliates. Market practice supports the view that we have achieved considerable success at making this distinction. To me, it seems not only logical, but highly desirable that we should build on this success as we continue to modernize our banking and financial system. When thinking about this issue, it is instructive to understand that in recent years bank holding companies have in fact tended to move activities from the holding company back into the bank. These activities had originally been put in the holding company to avoid geographic and similar restrictions. As a result of this movement back into the bank, the nonbank assets held by holding companies, excluding the assets of Section 20 securities subsidiaries, have declined by almost 50 percent over the last decade to 5.2 percent of consolidated bank holding company assets. When asked why activities are being moved back into the bank, bankers often say that it is to take advantage of the lower funding costs available at the bank. One final point on this issue. It is certainly true that prudent managements of banking organizations will weigh all the relevant factors, including the value of the safety net, when deciding on the best organizational structure for their firm. However, the key point to remember is that those organizations that stand to gain the most from the safety net in times of crisis-those with the highest net subsidy and the strongest incentives to take excessive risks-are the most likely both to prefer and to take advantage of any organizational structures that allow the greatest net subsidy. These are also the organizations that are most likely to distort competitive relationships and expose taxpayers to considerable risk. Thus, while allowing organizations a choice of organizational structure certainly increases bank management's flexibility, it is not clear that allowing such choice serves the public interest. In closing, let me return to where I began. Financial modernization is a process that must and will continue. But in the course of embracing and adapting to the future we must take care to retain what is of value in the past, and be careful that critical public policy goals are achieved. The separation of banking and commerce is an area where we should be particularly cautious. Once we have mastered the art and science of supervising full service financial organizations, then perhaps we should consider further combining banking and commerce. Technological change and financial innovation are combining to change profoundly the way financial institutions measure, take, and manage risk. These require that financial supervisors also adapt, and we need to move forward in this endeavor. The development of full service financial organizations only reinforces the imperatives to do so. When designing a system that maintains bank safety and soundness and constrains extension of the safety net, organizational structure is not irrelevant. Here again it seems prudent that we should be cautious, and build on structures that have proven their worth. I am confident that a proper balance can be achieved between our sometimes conflicting and always complex goals. Indeed, I look forward to trying to contribute to the ongoing discussion and resolution of the challenges of financial modernization. Thank you.
1997-04-12T00:00:00	Mr. Greenspan looks at the evolution of banking in a market economy (Central Bank Articles and Speeches, 12 Apr 97)	Remarks by the Chairman of the Board of the US Federal Reserve System, Dr. Alan Greenspan, at the annual conference of the Association of Private Enterprise Education, in Arlington, Virginia on 12/4/97.	Mr. Greenspan looks at the evolution of banking in a market economy Remarks by the Chairman of the Board of the US Federal Reserve System, Dr. Alan Greenspan, at the annual conference of the Association of Private Enterprise Education, in Arlington, Virginia on 12/4/97. I am quite pleased and gratified to receive the Adam Smith Award this evening. Having been a bank regulator for ten years, I need something to remind me that the world operates just fine with a minimum of us. Fortunately, I have never lost sight of the fact that government regulation can undermine the effectiveness of private market regulation and can itself be ineffective in protecting the public interest. It is most important to recognize that no market is ever truly unregulated in that the selfinterest of participants generates private market regulation. Counterparties thoroughly scrutinize each other, often requiring collateral and special legal protections; self-regulated clearing houses and exchanges set margins and capital requirements to protect the interests of the members. Thus, the real question is not whether a market should be regulated. Rather, it is whether government intervention strengthens or weakens private regulation, and at what cost. At worst, the introduction of government rules may actually weaken the effectiveness of regulation if government regulation is itself ineffective or, more importantly, undermines incentives for private market regulation. Regulation by government unavoidably involves some element of perverse incentives. If private market participants believe that government is protecting their interests, their own efforts to do so will diminish. No doubt the potential effectiveness of private market regulation and the potential ineffectiveness of government intervention is well understood by those attending this conference on zero-based government. However, I am sure that you will not be taken aback to hear that many here in Washington are skeptical of market self-regulation and seem inclined to believe that more government regulation, especially in the case of banking, necessarily means better regulation. To a significant degree, attitudes toward banking regulation have been shaped by a perception of the history of American banking as plagued by repeated market failures that ended only with the enactment of comprehensive federal regulation. The historical record, however, is currently undergoing a healthy reevaluation. In my remarks this evening I shall touch on the evolution of the American banking system, focusing especially on the pre-Civil War period, when government regulation was less comprehensive and less intrusive and interfered less with the operation of market forces. A recent growing body of research supports the view that during that period market forces were fairly effective in assuring that individual banks constrained risktaking to prudent endeavors. Nonetheless, the then nascent system as a whole proved quite vulnerable to various macroeconomic shocks essentially unrelated to the degree of banking regulation. I shall conclude by drawing some implications for how banking regulation needs to evolve in the future, with greater reliance on private market regulation. The Roots of Banking Many of the benefits banks provide modern societies derive from their willingness to take risks and from their use of a relatively high degree of financial leverage. Through leverage, in the form principally of taking deposits, banks perform a critical role in the financial intermediation process; they provide savers with additional investment choices and borrowers with a greater range of sources of credit, thereby facilitating a more efficient allocation of resources and contributing importantly to greater economic growth. Indeed, it has been the evident value of intermediation and leverage that has shaped the development of our financial systems from the earliest times--certainly since Renaissance goldsmiths discovered that lending out deposited gold was feasible and profitable. When Adam Smith formulated his views on banking, in the Wealth of Nations, he had in view the Scottish banking system of the 1760s and 1770s. That system was a highly competitive one in which entry into the banking business was entirely free. Competitors included a large number of private, that is, unincorporated, bankers who discounted commercial paper and issued bank notes. Those private bankers sought no government assistance. - 2 - Chartered Banking (1781-1838) From the very beginning the American banking system has had an entirely different character. Although some private individuals undoubtedly circulated limited volumes of bank notes, those seeking to circulate a significant volume of notes invariably applied for a corporate charter from state or federal authorities. Entry into the banking business was far from free. Indeed, by the early 1800s chartering decisions by state authorities became heavily influenced by political considerations. Aside from restrictions on entry, for much of the antebellum period state regulation largely took the form of restrictions inserted into bank charters, which were individually negotiated and typically had a life of ten or even twenty years. The regulations were modest and appear to have been intended primarily to ensure that banks had adequate specie reserves to meet their debt obligations, especially obligations on their circulating notes. Nonetheless, the very early history of American banking was an impressive success story. Not a single bank failed until massive fraud brought down the Farmers Exchange Bank in Rhode Island in 1809. Thereafter, a series of severe macroeconomic shocks--the War of 1812, the depression of 1819-20, and the panic of 1837--produced waves of failures. What should be emphasized, however, is the stability of banking in the absence of severe macroeconomic shocks, a stability that reflected the discipline of the marketplace. A bank's ability to circulate its notes was dependent on the public's confidence in its ability to redeem its notes on demand. Then, far more than now, there was competition for reputation. The market put a high value on integrity and punished fly-by-night operators. When confidence was lacking in a bank, its notes tended to exchange at a discount to specie and to the rates of other, more creditworthy banks. This phenomenon was evident as early as the late 1790s in Boston, where large amounts of notes issued by New England country banks circulated. In 1799 the Boston banks agreed to accept notes of certain country banks only at discounts of one-half percent. Several years later they began systematically sending back country notes for redemption, and they eventually refused for a time to accept such notes, even at a discount. Early in the 1800s private money brokers seem to have made their first appearance. These brokers, our early arbitrageurs, purchased bank notes at a discount and transported them to the issuing bank, where they demanded par redemption. Difficulties in redeeming the notes of New England country banks eventually produced the first notable example of cooperative self-regulation in American banking, known as the Suffolk Bank System. The Suffolk Bank was chartered in 1818 and entered the business of collecting country bank notes in 1819. In effect, the Suffolk Bank created the first regional clearing system. By doing so, it effectively constrained the supply of notes by individual banks to prudential levels and thereby allowed the notes of all of its associated banks to circulate consistently at face value. In the 1830s, there was a large expansion of state-chartered banks, many of which were severely tested and found wanting during the panic of 1837. However, very few banks failed in New England, where the Suffolk Bank continued to provide an effective, and entirely private, creditor discipline. Free Banking (1837-1863) The intense political controversy over the charter renewal of the Second Bank of the United States and the wave of bank failures following the panic led many states to fundamentally reconsider their approach to banking regulation. In particular, in 1838 New York introduced a new approach, known as free banking, which in the following two decades was emulated by many other states. The nature of free banking and the states' experience with this approach to regulation have been the subject of profound misconceptions. Specifically, many seem to believe that free banking was banking free from government regulation and that the result was a series of debacles. They conclude that - 3 - the experience with free banking demonstrates that market forces cannot effectively constrain bank risktaking. In fact, the "free" in free banking meant free entry under the terms of a general law of incorporation rather than through a specific legislative act. The public, especially in New York, had become painfully aware that the restrictions on entry in the chartered system were producing a number of adverse effects. For one thing, in the absence of competition, access to bank credit was perceived to have become politicized--banks' boards of directors seemed to regard those who shared their political convictions as the most creditworthy borrowers. In addition, because a bank charter promised monopoly profits, bank promoters were willing to pay handsomely for the privilege and legislators apparently eagerly accepted payment, often in the form of allocations of bank stock at below-market prices. If free banking was not actually as free as commonly perceived, it also was not nearly as unstable. The perception of the free banking era as an era of "wildcat" banking marked by financial instability and, in particular, by widespread significant losses to noteholders also turns out to be wide of the mark. Recent scholarship has demonstrated that free bank failures were not as common and resulting losses to noteholders were not as severe as earlier historians had claimed. In addition, failure rates and loss rates differed significantly across states, suggesting that whatever instability was experienced was not inherent in free banking per se. In particular, widely cited losses to holders of notes issued by free banks in Indiana, Illinois, and Wisconsin appear to have resulted from banks in these states being forced to hold portfolios of risky state bonds that were not well-diversified, were not especially liquid, and too often defaulted. It was, in short, state regulation that caused the high failure rates. During the free banking era private market regulation also matured in several respects. Particularly after the panic of 1837, the public was acutely aware of the possibility that banks would prove unable to redeem their notes. Discounting of bank notes was widespread. Indeed, between 1838 and the Civil War quite a few note brokers began to publish monthly or biweekly periodicals called bank note reporters that listed prevailing discounts on thousands of individual banks. Research based on data from these publications has shown that the notes of new entrants into banking tended to trade at significant discounts. If a bank demonstrated its ability to redeem its notes, over time the discount diminished. The declining discount on a bank's notes implies a lower cost of funds, the present value of which can be considered an intangible asset, the bank's reputation. Banks had a strong incentive to avoid overissuing notes so as not to impair the value of this intangible asset. Throughout the free banking era the effectiveness of this competition for reputation imparted an increased type of market discipline, perhaps because technological change--the telegraph and the railroad--made monitoring of banks more effective and reduced the time required to send a note home for redemption. Between 1838 and 1860 the discounts on notes of new entrants diminished and discounts came to correspond more closely to objective measures of the riskiness of individual banks. Another element of the maturation of private market regulation in banking was the emergence of full-fledged bank clearing houses, beginning with the establishment of the New York Clearing House in 1853. The primary impetus for the development of clearing houses was the increasing importance of checkable deposits as a means of payment. Large merchants were making payments by checks drawn on their deposit accounts as early as the 1780s. But in the 1840s and 1850s the use of checks spread rapidly to shopkeepers, mechanics and professional men. The clearing house reduced the costs of clearing and settling the interbank obligations arising from the collection of checks and banknotes, and thereby made feasible the daily settlement in specie of each bank's multilateral net claim on, or obligation to, the other banks in the clearing house. By itself, such an efficient clearing mechanism constrained the ability of individual banks to expand their lending imprudently. From the very beginning, however, clearing houses introduced other important elements of private, selfregulation. For example, the New York Clearing House's 1854 constitution established capital requirements for admission to the clearing house and required members to submit to periodic exams of the clearing house. If an exam revealed that the bank's capital had become impaired, it could be expelled from the clearing house. - 4 - National Banking (1863-1913) One compelling piece of evidence that contemporary observers did not regard free banking as a failure is that the National Banking System, established by an act of Congress in 1863, incorporated key elements of free banking. These included free entry and collateralized bank notes. However, unlike the state laws, the federal law interfered with private market forces by imposing an aggregate limit on note issues, along with a set of geographic allocations of the limit that produced a serious maldistribution of notes. Although the aggregate limit on note issues was repealed in 1875, the collateral requirement for note issues continued to unduly restrict the longer-term growth of the money supply, eventually producing a significant price deflation and, in the 1890s, very poor economic growth. In addition, the restrictions on note issues precluded the accommodation of temporary increases in demands for currency. The inelasticity of the note issue produced strains in financial markets each spring and fall as crops were planted and then brought to market. More seriously, when depositors periodically became nervous about the health of the banks, the demands to convert deposits into well-secured bank notes simply could not be met in the aggregate, and attempts to do so resulted in withdrawals of reserves from the money centers that severely and repeatedly disrupted the money markets. Private markets innovated in ways that tempered the adverse consequences resulting from these flaws in the government regulatory framework. Most notably, the New York Clearing House effectively pooled its members' reserves by issuing clearing house loan certificates and paying them out as substitutes for reserves in interbank settlements, first in the panic of 1857 and in every subsequent panic. By 1873, clearing houses in many other cities were following the same policy. In addition, the clearing houses accepted as settlement media other currency substitutes issued by their members including certified checks and cashier's checks. In effect, the clearing houses were assuming some of the functions of central banks. But a true central bank was perceived through most of the 19th century as an infringement of states' rights. A central bank, in any event, was deemed by many as superfluous given the fully functioning gold standard of the day. It was only with the emergence of periodic credit crises late in the century and especially in 1907, that a central bank gained support. These crises were seen in part as a consequence of the inelastic currency engendered by the National Bank Act. Even with the advent of the Federal Reserve in 1913, monetary policy through the 1920s was largely governed by gold standard rules. Fiscal policy was also restrained. For most of the period prior to the early 1930s, obligations of the U.S. Treasury were payable in gold or silver. This meant the whole outstanding debt of our government was subject to redemption in a medium, the quantity of which could not be altered at the will of the government as it can with today's fiat currency. Hence, debt issuance and budget deficits were constrained by the potential market response to an economy inflated with excess credit, which would have drained the Treasury's gold stock. Indeed, the United States skirted on the edges of bankruptcy in 1895 when our government gold stock shrank ominously and was bailed out by a last minute gold loan, underwritten by a Wall Street syndicate. In the broadest sense, the existence of a gold standard delimited the capability of the banking system to expand imprudently. Creation of the Federal Safety Net When the efforts of the Federal Reserve failed to prevent the bank collapses of the 1930s, the Banking Act of 1933 created federal deposit insurance. The subsequent evidence appears persuasive that the combination of a lender of last resort (the Federal Reserve) and federal deposit insurance has contributed significantly to financial stability and has accordingly achieved wide support within the Congress. Inevitably, however, such significant government intervention has not been an unmixed blessing. The federal safety net for banks clearly has diminished the effectiveness of private market regulation and created perverse incentives in the banking system. - 5 - To cite the most obvious and painful example, without federal deposit insurance, private markets presumably would never have permitted thrift institutions to purchase the portfolios that brought down the industry insurance fund and left future generations of taxpayers responsible for huge losses. To be sure, government regulators and politicians have learned from this experience and taken significant steps to diminish the likelihood of a recurrence. Nonetheless, the safety net undoubtedly still affects decisions by creditors of depository institutions in ways that weaken the effectiveness of private market regulation and leave us all vulnerable to any future failures of government regulation. As the history of American banking demonstrates, private market regulation can be quite effective, provided that government does not get in its way. Indeed, rapidly changing technology is rendering obsolescent much of the old bank examination regime. Bank regulators are perforce being pressed to depend increasingly on ever more complex and sophisticated private market regulation. This is certainly the case for the rapidly expanding bank derivatives markets, and increasingly so for the more traditional loan products. The lessons of early American banking should encourage us in this endeavor. In closing, I should like to emphasize that the rapidly changing technology that is rendering much government bank regulation irrelevant also bids fair to undercut regulatory efforts in a much wider segment of our economy. The reason is that such regulation is inherently conservative. It endeavors to maintain the status quo and the special interests who benefit therefrom. New ideas, new products, new ways of doing things, all, of necessity, raise the riskiness of any organization, riskiness for which regulators have a profound aversion. Yet since the value of all wealth reflects its future productive capabilities, all wealth creation rests on uncertain forecasts, which means every investment is risky. Or put another way, you cannot have wealth creation without risktaking. With technological change clearly accelerating, existing regulatory structures are being bypassed, freeing market forces to enhance wealth creation and economic growth. In finance, regulatory restraints against interstate banking and combinations of investment and commercial banking are being swept away under the pressures of technological change. Much the same is true in transportation and communications. As we move into a new century, the market-stabilizing private regulatory forces should gradually displace many cumbersome, increasingly ineffective government structures. This is a likely outcome since governments, by their nature, cannot adjust sufficiently quickly to a changing environment, which too often veers in unforeseen directions. The current adult generations are having difficulty adjusting to the acceleration of the uncertainties of today's silicon driven environment. Fortunately, our children appear to thrive on it. The future accordingly looks bright.	---[PAGE_BREAK]--- #### Abstract Mr. Greenspan looks at the evolution of banking in a market economy Remarks by the Chairman of the Board of the US Federal Reserve System, Dr. Alan Greenspan, at the annual conference of the Association of Private Enterprise Education, in Arlington, Virginia on 12/4/97. I am quite pleased and gratified to receive the Adam Smith Award this evening. Having been a bank regulator for ten years, I need something to remind me that the world operates just fine with a minimum of us. Fortunately, I have never lost sight of the fact that government regulation can undermine the effectiveness of private market regulation and can itself be ineffective in protecting the public interest. It is most important to recognize that no market is ever truly unregulated in that the selfinterest of participants generates private market regulation. Counterparties thoroughly scrutinize each other, often requiring collateral and special legal protections; self-regulated clearing houses and exchanges set margins and capital requirements to protect the interests of the members. Thus, the real question is not whether a market should be regulated. Rather, it is whether government intervention strengthens or weakens private regulation, and at what cost. At worst, the introduction of government rules may actually weaken the effectiveness of regulation if government regulation is itself ineffective or, more importantly, undermines incentives for private market regulation. Regulation by government unavoidably involves some element of perverse incentives. If private market participants believe that government is protecting their interests, their own efforts to do so will diminish. No doubt the potential effectiveness of private market regulation and the potential ineffectiveness of government intervention is well understood by those attending this conference on zero-based government. However, I am sure that you will not be taken aback to hear that many here in Washington are skeptical of market self-regulation and seem inclined to believe that more government regulation, especially in the case of banking, necessarily means better regulation. To a significant degree, attitudes toward banking regulation have been shaped by a perception of the history of American banking as plagued by repeated market failures that ended only with the enactment of comprehensive federal regulation. The historical record, however, is currently undergoing a healthy reevaluation. In my remarks this evening I shall touch on the evolution of the American banking system, focusing especially on the pre-Civil War period, when government regulation was less comprehensive and less intrusive and interfered less with the operation of market forces. A recent growing body of research supports the view that during that period market forces were fairly effective in assuring that individual banks constrained risktaking to prudent endeavors. Nonetheless, the then nascent system as a whole proved quite vulnerable to various macroeconomic shocks essentially unrelated to the degree of banking regulation. I shall conclude by drawing some implications for how banking regulation needs to evolve in the future, with greater reliance on private market regulation. # The Roots of Banking Many of the benefits banks provide modern societies derive from their willingness to take risks and from their use of a relatively high degree of financial leverage. Through leverage, in the form principally of taking deposits, banks perform a critical role in the financial intermediation process; they provide savers with additional investment choices and borrowers with a greater range of sources of credit, thereby facilitating a more efficient allocation of resources and contributing importantly to greater economic growth. Indeed, it has been the evident value of intermediation and leverage that has shaped the development of our financial systems from the earliest times-certainly since Renaissance goldsmiths discovered that lending out deposited gold was feasible and profitable. When Adam Smith formulated his views on banking, in the Wealth of Nations, he had in view the Scottish banking system of the 1760 s and 1770 s. That system was a highly competitive one in which entry into the banking business was entirely free. Competitors included a large number of private, that is, unincorporated, bankers who discounted commercial paper and issued bank notes. Those private bankers sought no government assistance. ---[PAGE_BREAK]--- From the very beginning the American banking system has had an entirely different character. Although some private individuals undoubtedly circulated limited volumes of bank notes, those seeking to circulate a significant volume of notes invariably applied for a corporate charter from state or federal authorities. Entry into the banking business was far from free. Indeed, by the early 1800s chartering decisions by state authorities became heavily influenced by political considerations. Aside from restrictions on entry, for much of the antebellum period state regulation largely took the form of restrictions inserted into bank charters, which were individually negotiated and typically had a life of ten or even twenty years. The regulations were modest and appear to have been intended primarily to ensure that banks had adequate specie reserves to meet their debt obligations, especially obligations on their circulating notes. Nonetheless, the very early history of American banking was an impressive success story. Not a single bank failed until massive fraud brought down the Farmers Exchange Bank in Rhode Island in 1809. Thereafter, a series of severe macroeconomic shocks--the War of 1812, the depression of 1819-20, and the panic of 1837--produced waves of failures. What should be emphasized, however, is the stability of banking in the absence of severe macroeconomic shocks, a stability that reflected the discipline of the marketplace. A bank's ability to circulate its notes was dependent on the public's confidence in its ability to redeem its notes on demand. Then, far more than now, there was competition for reputation. The market put a high value on integrity and punished fly-by-night operators. When confidence was lacking in a bank, its notes tended to exchange at a discount to specie and to the rates of other, more creditworthy banks. This phenomenon was evident as early as the late 1790s in Boston, where large amounts of notes issued by New England country banks circulated. In 1799 the Boston banks agreed to accept notes of certain country banks only at discounts of one-half percent. Several years later they began systematically sending back country notes for redemption, and they eventually refused for a time to accept such notes, even at a discount. Early in the 1800s private money brokers seem to have made their first appearance. These brokers, our early arbitrageurs, purchased bank notes at a discount and transported them to the issuing bank, where they demanded par redemption. Difficulties in redeeming the notes of New England country banks eventually produced the first notable example of cooperative self-regulation in American banking, known as the Suffolk Bank System. The Suffolk Bank was chartered in 1818 and entered the business of collecting country bank notes in 1819. In effect, the Suffolk Bank created the first regional clearing system. By doing so, it effectively constrained the supply of notes by individual banks to prudential levels and thereby allowed the notes of all of its associated banks to circulate consistently at face value. In the 1830s, there was a large expansion of state-chartered banks, many of which were severely tested and found wanting during the panic of 1837. However, very few banks failed in New England, where the Suffolk Bank continued to provide an effective, and entirely private, creditor discipline. # Free Banking (1837-1863) The intense political controversy over the charter renewal of the Second Bank of the United States and the wave of bank failures following the panic led many states to fundamentally reconsider their approach to banking regulation. In particular, in 1838 New York introduced a new approach, known as free banking, which in the following two decades was emulated by many other states. The nature of free banking and the states' experience with this approach to regulation have been the subject of profound misconceptions. Specifically, many seem to believe that free banking was banking free from government regulation and that the result was a series of debacles. They conclude that ---[PAGE_BREAK]--- the experience with free banking demonstrates that market forces cannot effectively constrain bank risktaking. In fact, the "free" in free banking meant free entry under the terms of a general law of incorporation rather than through a specific legislative act. The public, especially in New York, had become painfully aware that the restrictions on entry in the chartered system were producing a number of adverse effects. For one thing, in the absence of competition, access to bank credit was perceived to have become politicized--banks' boards of directors seemed to regard those who shared their political convictions as the most creditworthy borrowers. In addition, because a bank charter promised monopoly profits, bank promoters were willing to pay handsomely for the privilege and legislators apparently eagerly accepted payment, often in the form of allocations of bank stock at below-market prices. If free banking was not actually as free as commonly perceived, it also was not nearly as unstable. The perception of the free banking era as an era of "wildcat" banking marked by financial instability and, in particular, by widespread significant losses to noteholders also turns out to be wide of the mark. Recent scholarship has demonstrated that free bank failures were not as common and resulting losses to noteholders were not as severe as earlier historians had claimed. In addition, failure rates and loss rates differed significantly across states, suggesting that whatever instability was experienced was not inherent in free banking per se. In particular, widely cited losses to holders of notes issued by free banks in Indiana, Illinois, and Wisconsin appear to have resulted from banks in these states being forced to hold portfolios of risky state bonds that were not well-diversified, were not especially liquid, and too often defaulted. It was, in short, state regulation that caused the high failure rates. During the free banking era private market regulation also matured in several respects. Particularly after the panic of 1837, the public was acutely aware of the possibility that banks would prove unable to redeem their notes. Discounting of bank notes was widespread. Indeed, between 1838 and the Civil War quite a few note brokers began to publish monthly or biweekly periodicals called bank note reporters that listed prevailing discounts on thousands of individual banks. Research based on data from these publications has shown that the notes of new entrants into banking tended to trade at significant discounts. If a bank demonstrated its ability to redeem its notes, over time the discount diminished. The declining discount on a bank's notes implies a lower cost of funds, the present value of which can be considered an intangible asset, the bank's reputation. Banks had a strong incentive to avoid overissuing notes so as not to impair the value of this intangible asset. Throughout the free banking era the effectiveness of this competition for reputation imparted an increased type of market discipline, perhaps because technological change--the telegraph and the railroad--made monitoring of banks more effective and reduced the time required to send a note home for redemption. Between 1838 and 1860 the discounts on notes of new entrants diminished and discounts came to correspond more closely to objective measures of the riskiness of individual banks. Another element of the maturation of private market regulation in banking was the emergence of full-fledged bank clearing houses, beginning with the establishment of the New York Clearing House in 1853. The primary impetus for the development of clearing houses was the increasing importance of checkable deposits as a means of payment. Large merchants were making payments by checks drawn on their deposit accounts as early as the 1780s. But in the 1840s and 1850s the use of checks spread rapidly to shopkeepers, mechanics and professional men. The clearing house reduced the costs of clearing and settling the interbank obligations arising from the collection of checks and banknotes, and thereby made feasible the daily settlement in specie of each bank's multilateral net claim on, or obligation to, the other banks in the clearing house. By itself, such an efficient clearing mechanism constrained the ability of individual banks to expand their lending imprudently. From the very beginning, however, clearing houses introduced other important elements of private, selfregulation. For example, the New York Clearing House's 1854 constitution established capital requirements for admission to the clearing house and required members to submit to periodic exams of the clearing house. If an exam revealed that the bank's capital had become impaired, it could be expelled from the clearing house. ---[PAGE_BREAK]--- One compelling piece of evidence that contemporary observers did not regard free banking as a failure is that the National Banking System, established by an act of Congress in 1863, incorporated key elements of free banking. These included free entry and collateralized bank notes. However, unlike the state laws, the federal law interfered with private market forces by imposing an aggregate limit on note issues, along with a set of geographic allocations of the limit that produced a serious maldistribution of notes. Although the aggregate limit on note issues was repealed in 1875, the collateral requirement for note issues continued to unduly restrict the longer-term growth of the money supply, eventually producing a significant price deflation and, in the 1890s, very poor economic growth. In addition, the restrictions on note issues precluded the accommodation of temporary increases in demands for currency. The inelasticity of the note issue produced strains in financial markets each spring and fall as crops were planted and then brought to market. More seriously, when depositors periodically became nervous about the health of the banks, the demands to convert deposits into well-secured bank notes simply could not be met in the aggregate, and attempts to do so resulted in withdrawals of reserves from the money centers that severely and repeatedly disrupted the money markets. Private markets innovated in ways that tempered the adverse consequences resulting from these flaws in the government regulatory framework. Most notably, the New York Clearing House effectively pooled its members' reserves by issuing clearing house loan certificates and paying them out as substitutes for reserves in interbank settlements, first in the panic of 1857 and in every subsequent panic. By 1873, clearing houses in many other cities were following the same policy. In addition, the clearing houses accepted as settlement media other currency substitutes issued by their members including certified checks and cashier's checks. In effect, the clearing houses were assuming some of the functions of central banks. But a true central bank was perceived through most of the 19th century as an infringement of states' rights. A central bank, in any event, was deemed by many as superfluous given the fully functioning gold standard of the day. It was only with the emergence of periodic credit crises late in the century and especially in 1907, that a central bank gained support. These crises were seen in part as a consequence of the inelastic currency engendered by the National Bank Act. Even with the advent of the Federal Reserve in 1913, monetary policy through the 1920s was largely governed by gold standard rules. Fiscal policy was also restrained. For most of the period prior to the early 1930s, obligations of the U.S. Treasury were payable in gold or silver. This meant the whole outstanding debt of our government was subject to redemption in a medium, the quantity of which could not be altered at the will of the government as it can with today's fiat currency. Hence, debt issuance and budget deficits were constrained by the potential market response to an economy inflated with excess credit, which would have drained the Treasury's gold stock. Indeed, the United States skirted on the edges of bankruptcy in 1895 when our government gold stock shrank ominously and was bailed out by a last minute gold loan, underwritten by a Wall Street syndicate. In the broadest sense, the existence of a gold standard delimited the capability of the banking system to expand imprudently. # Creation of the Federal Safety Net When the efforts of the Federal Reserve failed to prevent the bank collapses of the 1930s, the Banking Act of 1933 created federal deposit insurance. The subsequent evidence appears persuasive that the combination of a lender of last resort (the Federal Reserve) and federal deposit insurance has contributed significantly to financial stability and has accordingly achieved wide support within the Congress. Inevitably, however, such significant government intervention has not been an unmixed blessing. The federal safety net for banks clearly has diminished the effectiveness of private market regulation and created perverse incentives in the banking system. ---[PAGE_BREAK]--- To cite the most obvious and painful example, without federal deposit insurance, private markets presumably would never have permitted thrift institutions to purchase the portfolios that brought down the industry insurance fund and left future generations of taxpayers responsible for huge losses. To be sure, government regulators and politicians have learned from this experience and taken significant steps to diminish the likelihood of a recurrence. Nonetheless, the safety net undoubtedly still affects decisions by creditors of depository institutions in ways that weaken the effectiveness of private market regulation and leave us all vulnerable to any future failures of government regulation. As the history of American banking demonstrates, private market regulation can be quite effective, provided that government does not get in its way. Indeed, rapidly changing technology is rendering obsolescent much of the old bank examination regime. Bank regulators are perforce being pressed to depend increasingly on ever more complex and sophisticated private market regulation. This is certainly the case for the rapidly expanding bank derivatives markets, and increasingly so for the more traditional loan products. The lessons of early American banking should encourage us in this endeavor. In closing, I should like to emphasize that the rapidly changing technology that is rendering much government bank regulation irrelevant also bids fair to undercut regulatory efforts in a much wider segment of our economy. The reason is that such regulation is inherently conservative. It endeavors to maintain the status quo and the special interests who benefit therefrom. New ideas, new products, new ways of doing things, all, of necessity, raise the riskiness of any organization, riskiness for which regulators have a profound aversion. Yet since the value of all wealth reflects its future productive capabilities, all wealth creation rests on uncertain forecasts, which means every investment is risky. Or put another way, you cannot have wealth creation without risktaking. With technological change clearly accelerating, existing regulatory structures are being bypassed, freeing market forces to enhance wealth creation and economic growth. In finance, regulatory restraints against interstate banking and combinations of investment and commercial banking are being swept away under the pressures of technological change. Much the same is true in transportation and communications. As we move into a new century, the market-stabilizing private regulatory forces should gradually displace many cumbersome, increasingly ineffective government structures. This is a likely outcome since governments, by their nature, cannot adjust sufficiently quickly to a changing environment, which too often veers in unforeseen directions. The current adult generations are having difficulty adjusting to the acceleration of the uncertainties of today's silicon driven environment. Fortunately, our children appear to thrive on it. The future accordingly looks bright.	Alan Greenspan	United States	https://www.bis.org/review/r970502b.pdf	Mr. Greenspan looks at the evolution of banking in a market economy Remarks by the Chairman of the Board of the US Federal Reserve System, Dr. Alan Greenspan, at the annual conference of the Association of Private Enterprise Education, in Arlington, Virginia on 12/4/97. I am quite pleased and gratified to receive the Adam Smith Award this evening. Having been a bank regulator for ten years, I need something to remind me that the world operates just fine with a minimum of us. Fortunately, I have never lost sight of the fact that government regulation can undermine the effectiveness of private market regulation and can itself be ineffective in protecting the public interest. It is most important to recognize that no market is ever truly unregulated in that the selfinterest of participants generates private market regulation. Counterparties thoroughly scrutinize each other, often requiring collateral and special legal protections; self-regulated clearing houses and exchanges set margins and capital requirements to protect the interests of the members. Thus, the real question is not whether a market should be regulated. Rather, it is whether government intervention strengthens or weakens private regulation, and at what cost. At worst, the introduction of government rules may actually weaken the effectiveness of regulation if government regulation is itself ineffective or, more importantly, undermines incentives for private market regulation. Regulation by government unavoidably involves some element of perverse incentives. If private market participants believe that government is protecting their interests, their own efforts to do so will diminish. No doubt the potential effectiveness of private market regulation and the potential ineffectiveness of government intervention is well understood by those attending this conference on zero-based government. However, I am sure that you will not be taken aback to hear that many here in Washington are skeptical of market self-regulation and seem inclined to believe that more government regulation, especially in the case of banking, necessarily means better regulation. To a significant degree, attitudes toward banking regulation have been shaped by a perception of the history of American banking as plagued by repeated market failures that ended only with the enactment of comprehensive federal regulation. The historical record, however, is currently undergoing a healthy reevaluation. In my remarks this evening I shall touch on the evolution of the American banking system, focusing especially on the pre-Civil War period, when government regulation was less comprehensive and less intrusive and interfered less with the operation of market forces. A recent growing body of research supports the view that during that period market forces were fairly effective in assuring that individual banks constrained risktaking to prudent endeavors. Nonetheless, the then nascent system as a whole proved quite vulnerable to various macroeconomic shocks essentially unrelated to the degree of banking regulation. I shall conclude by drawing some implications for how banking regulation needs to evolve in the future, with greater reliance on private market regulation. Many of the benefits banks provide modern societies derive from their willingness to take risks and from their use of a relatively high degree of financial leverage. Through leverage, in the form principally of taking deposits, banks perform a critical role in the financial intermediation process; they provide savers with additional investment choices and borrowers with a greater range of sources of credit, thereby facilitating a more efficient allocation of resources and contributing importantly to greater economic growth. Indeed, it has been the evident value of intermediation and leverage that has shaped the development of our financial systems from the earliest times-certainly since Renaissance goldsmiths discovered that lending out deposited gold was feasible and profitable. When Adam Smith formulated his views on banking, in the Wealth of Nations, he had in view the Scottish banking system of the 1760 s and 1770 s. That system was a highly competitive one in which entry into the banking business was entirely free. Competitors included a large number of private, that is, unincorporated, bankers who discounted commercial paper and issued bank notes. Those private bankers sought no government assistance. From the very beginning the American banking system has had an entirely different character. Although some private individuals undoubtedly circulated limited volumes of bank notes, those seeking to circulate a significant volume of notes invariably applied for a corporate charter from state or federal authorities. Entry into the banking business was far from free. Indeed, by the early 1800s chartering decisions by state authorities became heavily influenced by political considerations. Aside from restrictions on entry, for much of the antebellum period state regulation largely took the form of restrictions inserted into bank charters, which were individually negotiated and typically had a life of ten or even twenty years. The regulations were modest and appear to have been intended primarily to ensure that banks had adequate specie reserves to meet their debt obligations, especially obligations on their circulating notes. Nonetheless, the very early history of American banking was an impressive success story. Not a single bank failed until massive fraud brought down the Farmers Exchange Bank in Rhode Island in 1809. Thereafter, a series of severe macroeconomic shocks--the War of 1812, the depression of 1819-20, and the panic of 1837--produced waves of failures. What should be emphasized, however, is the stability of banking in the absence of severe macroeconomic shocks, a stability that reflected the discipline of the marketplace. A bank's ability to circulate its notes was dependent on the public's confidence in its ability to redeem its notes on demand. Then, far more than now, there was competition for reputation. The market put a high value on integrity and punished fly-by-night operators. When confidence was lacking in a bank, its notes tended to exchange at a discount to specie and to the rates of other, more creditworthy banks. This phenomenon was evident as early as the late 1790s in Boston, where large amounts of notes issued by New England country banks circulated. In 1799 the Boston banks agreed to accept notes of certain country banks only at discounts of one-half percent. Several years later they began systematically sending back country notes for redemption, and they eventually refused for a time to accept such notes, even at a discount. Early in the 1800s private money brokers seem to have made their first appearance. These brokers, our early arbitrageurs, purchased bank notes at a discount and transported them to the issuing bank, where they demanded par redemption. Difficulties in redeeming the notes of New England country banks eventually produced the first notable example of cooperative self-regulation in American banking, known as the Suffolk Bank System. The Suffolk Bank was chartered in 1818 and entered the business of collecting country bank notes in 1819. In effect, the Suffolk Bank created the first regional clearing system. By doing so, it effectively constrained the supply of notes by individual banks to prudential levels and thereby allowed the notes of all of its associated banks to circulate consistently at face value. In the 1830s, there was a large expansion of state-chartered banks, many of which were severely tested and found wanting during the panic of 1837. However, very few banks failed in New England, where the Suffolk Bank continued to provide an effective, and entirely private, creditor discipline. The intense political controversy over the charter renewal of the Second Bank of the United States and the wave of bank failures following the panic led many states to fundamentally reconsider their approach to banking regulation. In particular, in 1838 New York introduced a new approach, known as free banking, which in the following two decades was emulated by many other states. The nature of free banking and the states' experience with this approach to regulation have been the subject of profound misconceptions. Specifically, many seem to believe that free banking was banking free from government regulation and that the result was a series of debacles. They conclude that the experience with free banking demonstrates that market forces cannot effectively constrain bank risktaking. In fact, the "free" in free banking meant free entry under the terms of a general law of incorporation rather than through a specific legislative act. The public, especially in New York, had become painfully aware that the restrictions on entry in the chartered system were producing a number of adverse effects. For one thing, in the absence of competition, access to bank credit was perceived to have become politicized--banks' boards of directors seemed to regard those who shared their political convictions as the most creditworthy borrowers. In addition, because a bank charter promised monopoly profits, bank promoters were willing to pay handsomely for the privilege and legislators apparently eagerly accepted payment, often in the form of allocations of bank stock at below-market prices. If free banking was not actually as free as commonly perceived, it also was not nearly as unstable. The perception of the free banking era as an era of "wildcat" banking marked by financial instability and, in particular, by widespread significant losses to noteholders also turns out to be wide of the mark. Recent scholarship has demonstrated that free bank failures were not as common and resulting losses to noteholders were not as severe as earlier historians had claimed. In addition, failure rates and loss rates differed significantly across states, suggesting that whatever instability was experienced was not inherent in free banking per se. In particular, widely cited losses to holders of notes issued by free banks in Indiana, Illinois, and Wisconsin appear to have resulted from banks in these states being forced to hold portfolios of risky state bonds that were not well-diversified, were not especially liquid, and too often defaulted. It was, in short, state regulation that caused the high failure rates. During the free banking era private market regulation also matured in several respects. Particularly after the panic of 1837, the public was acutely aware of the possibility that banks would prove unable to redeem their notes. Discounting of bank notes was widespread. Indeed, between 1838 and the Civil War quite a few note brokers began to publish monthly or biweekly periodicals called bank note reporters that listed prevailing discounts on thousands of individual banks. Research based on data from these publications has shown that the notes of new entrants into banking tended to trade at significant discounts. If a bank demonstrated its ability to redeem its notes, over time the discount diminished. The declining discount on a bank's notes implies a lower cost of funds, the present value of which can be considered an intangible asset, the bank's reputation. Banks had a strong incentive to avoid overissuing notes so as not to impair the value of this intangible asset. Throughout the free banking era the effectiveness of this competition for reputation imparted an increased type of market discipline, perhaps because technological change--the telegraph and the railroad--made monitoring of banks more effective and reduced the time required to send a note home for redemption. Between 1838 and 1860 the discounts on notes of new entrants diminished and discounts came to correspond more closely to objective measures of the riskiness of individual banks. Another element of the maturation of private market regulation in banking was the emergence of full-fledged bank clearing houses, beginning with the establishment of the New York Clearing House in 1853. The primary impetus for the development of clearing houses was the increasing importance of checkable deposits as a means of payment. Large merchants were making payments by checks drawn on their deposit accounts as early as the 1780s. But in the 1840s and 1850s the use of checks spread rapidly to shopkeepers, mechanics and professional men. The clearing house reduced the costs of clearing and settling the interbank obligations arising from the collection of checks and banknotes, and thereby made feasible the daily settlement in specie of each bank's multilateral net claim on, or obligation to, the other banks in the clearing house. By itself, such an efficient clearing mechanism constrained the ability of individual banks to expand their lending imprudently. From the very beginning, however, clearing houses introduced other important elements of private, selfregulation. For example, the New York Clearing House's 1854 constitution established capital requirements for admission to the clearing house and required members to submit to periodic exams of the clearing house. If an exam revealed that the bank's capital had become impaired, it could be expelled from the clearing house. One compelling piece of evidence that contemporary observers did not regard free banking as a failure is that the National Banking System, established by an act of Congress in 1863, incorporated key elements of free banking. These included free entry and collateralized bank notes. However, unlike the state laws, the federal law interfered with private market forces by imposing an aggregate limit on note issues, along with a set of geographic allocations of the limit that produced a serious maldistribution of notes. Although the aggregate limit on note issues was repealed in 1875, the collateral requirement for note issues continued to unduly restrict the longer-term growth of the money supply, eventually producing a significant price deflation and, in the 1890s, very poor economic growth. In addition, the restrictions on note issues precluded the accommodation of temporary increases in demands for currency. The inelasticity of the note issue produced strains in financial markets each spring and fall as crops were planted and then brought to market. More seriously, when depositors periodically became nervous about the health of the banks, the demands to convert deposits into well-secured bank notes simply could not be met in the aggregate, and attempts to do so resulted in withdrawals of reserves from the money centers that severely and repeatedly disrupted the money markets. Private markets innovated in ways that tempered the adverse consequences resulting from these flaws in the government regulatory framework. Most notably, the New York Clearing House effectively pooled its members' reserves by issuing clearing house loan certificates and paying them out as substitutes for reserves in interbank settlements, first in the panic of 1857 and in every subsequent panic. By 1873, clearing houses in many other cities were following the same policy. In addition, the clearing houses accepted as settlement media other currency substitutes issued by their members including certified checks and cashier's checks. In effect, the clearing houses were assuming some of the functions of central banks. But a true central bank was perceived through most of the 19th century as an infringement of states' rights. A central bank, in any event, was deemed by many as superfluous given the fully functioning gold standard of the day. It was only with the emergence of periodic credit crises late in the century and especially in 1907, that a central bank gained support. These crises were seen in part as a consequence of the inelastic currency engendered by the National Bank Act. Even with the advent of the Federal Reserve in 1913, monetary policy through the 1920s was largely governed by gold standard rules. Fiscal policy was also restrained. For most of the period prior to the early 1930s, obligations of the U.S. Treasury were payable in gold or silver. This meant the whole outstanding debt of our government was subject to redemption in a medium, the quantity of which could not be altered at the will of the government as it can with today's fiat currency. Hence, debt issuance and budget deficits were constrained by the potential market response to an economy inflated with excess credit, which would have drained the Treasury's gold stock. Indeed, the United States skirted on the edges of bankruptcy in 1895 when our government gold stock shrank ominously and was bailed out by a last minute gold loan, underwritten by a Wall Street syndicate. In the broadest sense, the existence of a gold standard delimited the capability of the banking system to expand imprudently. When the efforts of the Federal Reserve failed to prevent the bank collapses of the 1930s, the Banking Act of 1933 created federal deposit insurance. The subsequent evidence appears persuasive that the combination of a lender of last resort (the Federal Reserve) and federal deposit insurance has contributed significantly to financial stability and has accordingly achieved wide support within the Congress. Inevitably, however, such significant government intervention has not been an unmixed blessing. The federal safety net for banks clearly has diminished the effectiveness of private market regulation and created perverse incentives in the banking system. To cite the most obvious and painful example, without federal deposit insurance, private markets presumably would never have permitted thrift institutions to purchase the portfolios that brought down the industry insurance fund and left future generations of taxpayers responsible for huge losses. To be sure, government regulators and politicians have learned from this experience and taken significant steps to diminish the likelihood of a recurrence. Nonetheless, the safety net undoubtedly still affects decisions by creditors of depository institutions in ways that weaken the effectiveness of private market regulation and leave us all vulnerable to any future failures of government regulation. As the history of American banking demonstrates, private market regulation can be quite effective, provided that government does not get in its way. Indeed, rapidly changing technology is rendering obsolescent much of the old bank examination regime. Bank regulators are perforce being pressed to depend increasingly on ever more complex and sophisticated private market regulation. This is certainly the case for the rapidly expanding bank derivatives markets, and increasingly so for the more traditional loan products. The lessons of early American banking should encourage us in this endeavor. In closing, I should like to emphasize that the rapidly changing technology that is rendering much government bank regulation irrelevant also bids fair to undercut regulatory efforts in a much wider segment of our economy. The reason is that such regulation is inherently conservative. It endeavors to maintain the status quo and the special interests who benefit therefrom. New ideas, new products, new ways of doing things, all, of necessity, raise the riskiness of any organization, riskiness for which regulators have a profound aversion. Yet since the value of all wealth reflects its future productive capabilities, all wealth creation rests on uncertain forecasts, which means every investment is risky. Or put another way, you cannot have wealth creation without risktaking. With technological change clearly accelerating, existing regulatory structures are being bypassed, freeing market forces to enhance wealth creation and economic growth. In finance, regulatory restraints against interstate banking and combinations of investment and commercial banking are being swept away under the pressures of technological change. Much the same is true in transportation and communications. As we move into a new century, the market-stabilizing private regulatory forces should gradually displace many cumbersome, increasingly ineffective government structures. This is a likely outcome since governments, by their nature, cannot adjust sufficiently quickly to a changing environment, which too often veers in unforeseen directions. The current adult generations are having difficulty adjusting to the acceleration of the uncertainties of today's silicon driven environment. Fortunately, our children appear to thrive on it. The future accordingly looks bright.
1997-04-24T00:00:00	Mr. Meyer discusses the economic outlook and the challenges facing monetary policy in the United States (Central Bank Articles and Speeches, 24 Apr 97)	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the Forecasters Club of New York on 24/4/97.	Mr. Meyer discusses the economic outlook and the challenges facing monetary policy in the United States Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the Forecasters Club of New York on 24/4/97. It is a pleasure to be here and discuss the economic outlook and monetary policy with fellow forecasters. I am going to offer some interpretations of the outlook as a context for the recent policy action by the Federal Reserve and explain how I view this action as part of a prudent and systematic strategy for monetary policy. The Forecasters Club of New York is an ideal forum for me to offer this commentary because, in my view, the recent policy action must be understood not in terms of where the economy has been recently, but rather in terms of the change in the forecast, a change in expectations about where the economy likely would be in six or twelve months in the absence of a policy change. Before proceeding, let me emphasize that the views on the economic outlook and monetary policy strategy I present this afternoon are my own. I am not speaking for either the FOMC or the Board of Governors or for any other individual members. If you want to know the views of the FOMC, you will have to do your homework--for example, read the announcement issued at the end of the last FOMC meeting, the Humphrey Hawkins testimony of the Chairman, the speeches and other comments by the full complement of participants in the FOMC, and the minutes of the last meeting when they become available. First, I shall discuss some aspects of the analytical framework or model that underlies my forecast, which in turn underpins my reasoning for the recent policy action. Second, I'll discuss the outlook context of the policy decision. Third, I'll describe the evolution of policy from a period of steady policy and asymmetric directives to the recent preemptive action. Fourth, I'll offer several interpretations of the policy action in relation to what I believe are important aspects of the strategy of monetary policy. Finally, I'll discuss some of the factors that will influence my views of the appropriate course of policy in the months ahead. The Analytical Framework Let me remind you at the outset of the framework I have been using to explain the challenge facing monetary policy in the current environment of healthy growth and high levels of resource utilization. The risk of higher inflation in this environment has two dimensions. First, there is the risk that current utilization rates are already so high that inflation will gradually increase over time. Second, there is the risk that the growth in output will be above trend going forward, implying that utilization rates will rise from their already high level, compounding the risk of higher inflation. Some apparently believe there are no speed limits, and no utilization rate can be so elevated that it threatens higher inflation. The reality is that above-trend growth raises utilization rates and, after some point, excessively high utilization rates result in higher inflation. But it is also true that threshold utilization rates and trend growth can change, that the current threshold levels for both utilization and growth rates are uncertain, that inflation can be affected by factors other than excess demand, and that policy is not infallible. Such uncertainty is a fact of life for both forecasters and policymakers. Just as forecasters do not stop forecasting because the job is difficult, policymakers have to adjust to uncertainty and not be paralyzed by it. The recent Federal Reserve policy action was clearly a preemptive one. This means that it was undertaken not in response to where the economy and inflation were at the time of the policy change, but in response to where the economy and inflation were projected to be in the future, absent a policy change. Such policy action necessarily involves a forecast and such a forecast typically is grounded in some model that relates growth, unemployment, wage change and inflation, among other variables. So let me be specific about the causal structure of the model that underpins my judgment with respect to appropriate monetary policy action. I am a strong and unapologetic proponent of the Phillips Curve and the NAIRU concept. Fundamentally, the NAIRU framework involves two principles. First, the proximate source of an increase in inflation is excess demand in labor and/or product markets. In the labor market, this excess demand gap is often expressed in this model as the difference between the prevailing unemployment rate and NAIRU, the non-accelerating inflation rate of unemployment. Second, once an excess demand gap opens up, inflation increases indefinitely and progressively until the excess demand gap is closed, and then stabilizes at the higher level until cumulative excess supply gaps reverse the process. There is a third principle that I subscribe to, which, though not as fundamental as the first two, also plays a role in my forecast and in my judgment about the appropriate posture of monetary policy today. Utilization rates in the labor market play a special role in the inflation process. That is, inflation is often initially transmitted from labor market excess demand to wage change and then to price change. This third principle may be especially important today because, in my view, there is an important disparity between the balance between supply and demand in the labor and product markets, with at least a hint of excess demand in labor markets, but very little to suggest such imbalance in product markets. It is important to understand that the Phillips Curve is a model of inflation dynamics, not a model that determines the equilibrium inflation rate. For this reason, the Phillips Curve paradigm is not at all inconsistent with the view that inflation is, in the long run, exclusively a monetary phenomenon. Perhaps the easiest way to appreciate this is to recall that the long-run Phillips Curve is widely understood to be vertical. In other words, NAIRU is consistent with any constant rate of inflation, including zero. The Phillips Curve therefore cannot determine inflation in the long run because it is consistent with any constant rate of inflation. What does determine the rate of inflation in the long run? The rate of money growth, of course, though one needs to assume a stable money demand function to get a stable relationship between money growth and inflation. What does the Phillips Curve explain, if not the long-run level of inflation? The answer is that it explains the dynamics of the inflation process, how the economy evolves from one inflation rate to another, for example, in response to an increase in the rate of money growth. The dynamics of changes in inflation operate through excess demand in labor and/or product markets. Thus the Phillips Curve indicates that, if the unemployment rate is maintained at a level below NAIRU, inflation increases over time, progressively and indefinitely. The initial source of an increase in inflation can be anything which produces excess demand in labor and output markets. It could also be a supply shock, but I am ignoring this possibility so I can focus exclusively on the implications of the current strength in aggregate demand. Under an interest rate operating procedure, an increase in aggregate demand which increases output, utilization rates, and, ultimately, inflation will itself generate an increase in the money supply to support the higher nominal income. Money is not pinned down in such a regime, but passively adjusts to changes in nominal income. Despite the sharpness and force of the Phillips Curve/NAIRU model, it can be difficult to implement in practice. Still, this relationship was about the most stable tool in the macroeconomists' tool kit for most of the past 20 years; those who were willing to depend on it were likely to be very successful forecasters of inflation, and the record speaks for itself on this score. Nevertheless, the combination of the 7-year low in the unemployment rate and 30-year low in inflation was a surprise to those using this framework. The challenge is to understand why we have been so fortunate. But, it should also be noted that monetary policy has responded appropriately to this surprise. That is, monetary policy has been careful not to be tied rigidly to a constant estimate of NAIRU. Instead, in my view, monetary policymakers have, in effect, implicitly adjusted their estimate of NAIRU to reflect the incoming data; this might be viewed as following a procedure like the time-varying parameter estimation technique applied by Robert Gordon and others. In the short run, there are many factors, in addition to aggregate demand, that influence inflation - including changes in the minimum wage, shocks to food and oil prices unrelated to the balance between aggregate demand and supply in the U.S., changes in the exchange rate, and exogenous effects on health care costs, etc. Some of these can be and have been effectively incorporated into the Phillips Curve model, but some of these factors have generally been outside the model. One explanation for the better than expected performance of core inflation in relation to the unemployment rate focuses, for example, on a series of favorable supply shocks - including the slowdown in benefit costs and the decline in import prices - that traditionally are not incorporated in estimated Phillips Curves. In addition, even adjusting for the above factors, NAIRU is not a constant, but can and has changed over time. For example, the evidence suggests that changes in the demographic composition of the labor force affect NAIRU and it is also likely that government programs, including unemployment compensation and welfare, also affect NAIRU. Further, the evidence suggests that, even accounting for demographics, government programs, and supply shocks, NAIRU may have edged lower over the last couple of years. The consensus in the profession is that NAIRU may have declined from around 6 percent in the decade ending in the early 1990s to perhaps 51⁄2 percent today, though some believe that the decline is even larger, while others believe that any appearance of decline is due to temporary factors so that NAIRU will ultimately settle back to close to the earlier estimate. Clearly, one of the challenges of monetary policy is to set policy in the context of uncertainty about the precise value of NAIRU. The second element in the analytical framework is the link from output growth to the level of excess demand. The economy has a capacity to grow over time that is limited by the sum of the trend rate of growth in the labor force and the trend rate of growth in labor productivity. While both components can change over time and labor force and productivity growth are subject to both cyclical variation as well as secular shift, the historical record suggests that the trend rate of output growth changes very slowly over time. Currently, the trend rate of labor force growth is near 1 percent per year (based on population growth and leaving, for later, the interpretation of the recent rise in the participation rate) and the trend rate of productivity growth is slightly above 1 percent per year (though there is more than the usual uncertainty about this estimate, in part due to conflicting indications in measures of productivity derived from the product and income sides of the national accounts), resulting in trend output growth in the 2-21⁄2 percent range. A key relationship is that when actual growth in output equals trend growth, utilization rates are constant; and when actual growth exceeds trend growth, utilization rates increase. Now we can put the causal structure of the inflation process together, connecting up growth, unemployment rates, and inflation. Growth above trend raises utilization rates. Rising labor force utilization rates raise wage change relative to productivity growth. An increase in wage change relative to productivity growth raises labor costs and an increase in labor costs results in higher price inflation. Quiz time! Does growth cause inflation? Not exactly. Certainly, higher trend growth does not raise inflation. Indeed, an unexpected increase in trend productivity and hence trend growth in output would likely result in lower inflation for a while; if the rate of money growth were held constant, a permanent increase in productivity growth would result in a permanent decline in inflation. Although above-trend growth in output does not directly cause inflation, to the extent it results in increases in utilization rates, after some point, sustained above-trend growth will result in higher inflation. There are, to be sure, a number of uncertainties in this causal structure that are highly relevant to the current circumstances. First, we have to worry about whether there may have been a change in trend growth, for example, due to a rise in trend productivity growth or a change in the trend in labor force participation. If trend growth has increased, whether because of higher labor force growth or higher productivity growth, then we would observe that rapid growth does not raise utilization rates. Second, we have to worry about whether NAIRU may be declining or, at least, may be lower than currently estimated. If NAIRU is lower than we expect, then the current unemployment rate is less likely to be associated with excess demand in the labor market and therefore poses less risk of higher inflation. Checks and balances are essential here. For example, it is important to confirm that utilization rates are rising before continuing very long to tighten policy to damp presumed above-trend growth. This will prevent a persistent mistake in the face of an unexpected shift in the economy's trend rate of growth. Monetary policy usually avoids this mistake by focusing on utilization rates and not growth. The second check is to confirm that, following a decline in the unemployment rate, wage change is moving higher, consistent with increased excess demand in the labor market. In addition, we have to take into account temporary forces related to, for example, minimum wage, health care costs, and exchange rates. Finally, we have to make allowances for the dynamics of the process, including the tendency for inertia to result in only a very small initial increase in inflation once excess demand has developed and the tendency of the initial rise in wages in excess of productivity to be tempered by a decline in profit margins before leading to higher prices. The Outlook Context Now let me summarize the key features of recent macroeconomic performance. The economy advanced at a 3.1 percent rate over 1996, including a 3.8 percent rate in the fourth quarter. Growth in the first quarter appears to have been at least as strong as the pace in the fourth quarter, and the economy seems to have solid momentum in the current quarter. In short, the economy appears to be growing at an unsustainable above-trend rate. By the way, is the prevailing trend rate of growth both historically low and disappointing? Yes. Would it be desirable, therefore, to raise the trend rate of growth? Yes. Can monetary policy accomplish this worthy task? No. Can the Congress and the Administration, through judicious combination of deficit reduction and saving and investment incentives, raise trend growth (at least for a while)? Yes. Are there opportunities for monetary policy to contribute to steady growth? Yes. First, to the extent that policy can avoid a cyclical rise in inflation, it can avoid the subsequent monetary policy response to limit and then reverse the rise in inflation; the result of avoiding the boom is avoiding the bust. Disciplined monetary policy therefore encourages steady growth, with the emphasis on the steady. Second, to the extent that price stability encourages saving and investment and a more efficient allocation of resources, as is widely believed, a monetary policy that promotes price stability is the one that best encourages steady growth, now with the emphasis on growth. Now back to the economic outlook. The unemployment rate which has fluctuated in a rather narrow band over the last year and a half has recently been inching lower and is now equal to its cyclical and 7-year low. I suspect that the unemployment rate is now below NAIRU, though the steady rise in wage change over the last year suggests that the unemployment rate may have been somewhat below NAIRU for a while. Another aside. Don't I like wage growth? Yes, but only to the extent it is real; that is, only to the extent that it does not yield increases in inflation that in turn prevent the purchasing power of wages from advancing. Shouldn't workers share in the bounty of a healthy economy? Of course. But workers will best share in the bounty when there is sustainable growth and will pay a high price for unsustainable growth in the cyclical instability that would surely follow such excess. Let me add one more complication. It is possible for wages to increase faster than productivity for a while to allow a rebound in real wages, for example, if real wages had earlier in the expansion advanced at a rate less than allowed by trend productivity. In this case, a rebound in real wages could be unwinding a temporary increase in profit margins and could therefore be accommodated without an increase in inflation. Wage change, as I just noted, has been rising. The 12-month increase in average hourly earnings is now 4.1 percent, a percentage point higher than a year ago. Compensation per hour, as measured by the ECI, has to date accelerated more modestly, with the slowing rise in benefit costs tempering the effect of a sharper rise in wage costs. The first quarter ECI bears watching for signs of a further rise in wage change and possibly a bottoming out of the recent slowing in the pace of increase in benefit costs. Core inflation remains at a cyclical and 30-year low, with the 12-month increase in the core CPI at 2.5 percent. Note, however, to correctly measure the change in inflation, a comparison of core inflation over the last couple of years has to be adjusted to account for the methodological revisions to the CPI. To date, BLS revisions have lowered inflation cumulatively by around a quarter point over the past two years. The point of the policy action, of course, is to try to prevent any significant increase in core inflation. Clearly the recent performance has been extraordinary. I have noted previously that it is not only better than virtually anyone had forecast, it is better than historical regularities would have suggested was possible. The explanations for the continuing decline in core inflation, despite an unemployment rate that in earlier periods would have been associated with rising inflation, include some combination of temporary coincidences and longer-lasting structural changes. First, the labor force has been growing about twice as rapidly as a trend rate based on population growth. It is as if demand is calling forth its own supply. Part of the explanation is a rebound from a sharp decline in participation rates over 1995. Part reflects a normal cyclical rise in participation rates, delayed in this expansion. A small part could be the early effects of changes in welfare laws and previous state efforts to trim welfare roles. As a result, the recent strength of output growth has not resulted in much of an increase in resource utilization rates. I do not expect labor force growth to continue at its recent rapid rate, though the underlying trend over the next several years may well be augmented by an upward trend in participation rates. The net result is that output growth must slow from recent levels to prevent further increases in utilization rates. Second, increased job insecurity appears to have moderated the pace of wage change, relative to what we would have expected at current levels of labor force utilization. It is important to note here that the effects on inflation of an increase in worker insecurity may be only temporary. Even with the higher worker insecurity, wages are clearly on a rising trend. Third, a slowing in the rise in benefit costs (primarily via slower increase in health care costs) has moderated the rise in labor compensation associated with wage pressures. As a result, the rise in compensation and hence labor costs has been muted, compared to the faster pace of wage gains. Fourth, declining import prices - directly and indirectly--have restrained price inflation. Some judgment has to be made in any forecast about the persistence of the special forces that have contributed to restrained wage and price change over recent quarters. The least likely to continue to act as a restraining influence, in my judgment, is health care and therefore benefit costs, based on surveys of prospective health care insurance premiums. Given the recent further appreciation of the dollar, import prices may decline further, though the restraining effect on inflation may be less important going forward than it has been over the past year. From an Asymmetric Directive to Preemptive Policy: Why Now? During the period from July of 1996 through February of 1997, monetary policy remained unchanged but operated with an asymmetric directive. Utilization rates were high -high enough to suggest some risk of rising inflation, but wage gains -- while trending higher, remained modest and core inflation remained on a downward trend, perhaps due to declining import prices and the slowing of the rise in health care costs. The anxiety associated with high utilization rates was clearly tempered by the excellent performance of core inflation, resulting in a posture of "watchful waiting." The Federal Reserve remained alert during this period, but on the sidelines. While growth was at times well above my estimate of trend, various factors made it reasonable to expect a slowdown in growth toward trend immediately ahead, suggesting that utilization rates would likely remain within their recent ranges. The asymmetric directive reflected a view that the risks in this environment were asymmetric, that there was a greater risk that inflation would rise in response to the prevailing high utilization rate (and to still higher utilization rates if growth continued above-trend growth) than that the economy would slow to below trend growth. The asymmetric policy posture was, therefore, a reflection of concern that our forecast might be wrong and that if it were wrong it was more likely to underestimate inflation going forward. What was different in March, compared to this earlier period? Not utilization rates. They were still within the narrow range that had prevailed during this period, though admittedly close to the bottom of that range. Not core inflation. If anything, core inflation was lower. No, the difference, from my perspective, was not in the data for utilization rates, wage change, and inflation, but in my forecast of the future path of these variables. The change in the forecast, to be sure, was prompted by incoming data suggesting persistent strength in aggregate demand. Instead of projecting a slowing to trend immediately ahead, it now appeared to me that we were in a period of sustained above-trend growth that would push utilization rates higher and, in particular, would push the unemployment rate below its recent range. A tightening of monetary policy was motivated, from my perspective, not by the prevailing data on unemployment rates, wage change, and inflation, but rather by a forecast of where I expected utilization rates and inflation to be six months and a year from now, if monetary policy remained unchanged. Whereas I supported the earlier asymmetric directive based on concern that my forecast might be wrong, the preemptive policy action was motivated for me by concern that my (new) forecast might be correct! The case for a preemptive approach is that it alone holds the promise of sustaining a durable expansion with continued healthy, balanced growth. The greatest threat to expansions does not come from a spontaneous weakening of demand, from lethargy, but rather from over-exuberance and overheating. Once overheating unleashes an increase in inflation, the attempt to first control and then reverse the higher inflation often results in recession. This gives substance to the well-known worth of "an ounce of prevention." Interpreting the Policy Action as Part of a Strategy for Monetary Policy Let me now interpret the tightening in relation to several descriptions of monetary policy strategy. The first three really are alternative perspectives on a single essential principle of prudent monetary policy, the importance of leaning against the wind by enforcing pro-cyclical movements in short-term interest rates. The fourth reflects one way in which monetary policy might take into account the uncertainty in the outlook. A Taylor Rule perspective I have noted in a number of previous speeches that I view the Taylor Rule as highlighting a couple of important requirements for prudent monetary policy. First, the Taylor Rule links Federal Reserve policy to a long-run inflation target and thus ensures that, in the long run, policy will force the actual inflation rate to converge to the long-run target. The Taylor Rule thus imposes a powerful nominal anchor on monetary policy. Second, the Taylor Rule generally imposes a pro-cyclical pattern on real short-term interest rates, so that monetary policy leans against the cyclical winds and thereby stabilizes the economy, in much the same way that automatic stabilizers in our fiscal institutions, via cyclical swings in government budget deficits, damp business cycles. Nevertheless, the traditional specification of the Taylor Rule does not provide a justification for tightening in March, relative to the earlier decisions to hold policy unchanged. According to the Taylor Rule, the federal funds rate should adjust over time to changes in utilization rates (the gap between actual and potential output or between the unemployment rate and NAIRU) and to changes in inflation. Because utilization rates had not increased (at least had not increased outside the range of the last year) and core inflation was actually lower in March compared with earlier, the Taylor Rule did not dictate a tightening. The Rule did suggest, however, that monetary policy would have had to tighten over time if the forecast of rising utilization rates and higher inflation proved correct. But it did not dictate immediate action. There is however an alternative specification of the Taylor Rule that does motivate an immediate tightening. I call this a forward looking version of the Taylor Rule. The traditional specification is forward looking to a degree in relation to inflation, in that it sets the funds rate in relation to both the utilization rate (an advance warning of future increases in inflation) and to inflation. But the forward-looking specification I have in mind replaces actual inflation and utilization rates in the rule with forecasts of future inflation and utilization rates. This approach to policy reaction functions was pioneered by Steve McNees of the Federal Reserve Bank of Boston in the mid 1980s and there has been a renewed interest in such an approach, in the context of the Taylor Rule, during the last couple of years. Such a forward-looking specification would rationalize and justify an increase in the funds rate in response to the forecast of rising utilization rates in the future. This leaves an interesting question. Does following a Taylor Rule based on an uncertain forecast outperform a Taylor Rule based on actual data? That, of course, depends on the quality of the forecasts. This is an interesting question, one that deserves scrutiny. But it is really the same as the question: Should policy be preemptive or reactive? As a forecaster, I am inclined to believe in the forward-looking approach and therefore in preemptive policy. But I recognize that further work should be done on this subject. An IS-LM perspective on leaning against the wind I would interpret the recent strength in demand, from the perspective of an IS-LM model, as a shift in the IS curve. Such an interpretation of cyclical swings is, of course, in the Keynesian tradition: output is demand determined in the short run (reflecting price stickiness) and swings in output are dominated by autonomous changes in aggregate demand. How should monetary policy respond to cyclical swings in demand? Should monetary policy hold short-term interest rates constant, in effect imposing a horizontal LM curve? In order to do so, it would, in general, have to respond to rightward shifts in the IS curve by adding reserves and facilitating faster money growth, so as to prevent interest rates from rising. This might be appropriate very early in an expansion, when the unemployment rate is high and inflation is declining, but it is not, in my judgment, prudent in the mature stage of an expansion, and it is most surely imprudent once utilization rates have increased toward or beyond their capacity levels. The alternative is to maintain an upward sloping LM curve. In the static model, this is the case when the money supply is fixed; allowing for trend growth and inflation, it would be equivalent to holding money growth constant, assuming a stable money demand function. In this case, a shift in the IS curve would raise interest rates as the IS curve moved along the upward sloping LM curve. This is an example of monetary policy "leaning against the wind." The resulting pro-cyclical movement in interest rates increases the stability of the economy in much the same way as cyclical swings in the federal budget deficit. Some might argue, however, that even if short-term interest rates do not rise, long-term interest rates, equity prices, and the dollar may change in ways that damp the cyclical swing in demand and thereby lessen the necessity of a direct response of monetary policy. This is sometimes referred to as the "gyroscope" theory (the bond market is the economy's gyroscope) and the active part of management of the cycle is in the hands of so-called "bond market vigilantes," some of whom are undoubtedly in the audience this afternoon. When long-term rates rise in response to a cyclical strengthening, it reflects, in large part, the expectation of higher short-term interest rates. Specifically, it reflects expectations about monetary policy. While monetary policy cannot be a slave to the bond market, when the cyclical state of the economy suggests the desirability of a pro-cyclical response in interest rates, the Federal Reserve should pat the bond market on the back and appreciate its help, but not expect the bond market to carry the entire burden. Monetary policy in this case needs to validate the movement in the bond market, rather than resist it. If it does not, surely real long-term interest rates and the dollar will decrease, eroding the market restraint, and in the future markets will be less likely to perform this stabilizing function. Of course, there will be times when the bond market is, in our view, misreading the strength of the economy and hence also misjudging the future course of our policy. In this case, we should ignore the bond market and provide an anchor for long-term interest rates to adjust back toward. Implications of a money growth rule As I have just noted, a pro-cyclical path for short-term interest rates would result from following a money growth rule. For an extended period, money demand has been insufficiently stable to allow the monetary aggregates to play a constructive role in the monetary policy process. More recently, the relationship between M2 and its determinants has stabilized, but the period of a more stable relationship has been relatively brief and has coincided with a relatively stable economy. As a result, there is not yet much inclination to place increased weight on M2 in the policy process. What I am offering here is therefore only a thought experiment. Assume that the money demand function for M2 has stabilized and that we could conduct policy by enforcing a constant rate of M2 growth. Assuming policy maintained a fixed rate of money growth (perhaps the better way to define an unchanged policy), what would be the effect of a cyclical strengthening of the economy (an increase in nominal income growth)? The answer, of course, is that short-term interest rates would rise. This is of course just another way of telling the IS-LM story. What would it take to prevent interest rates from rising? The answer is that an increase in the rate of money growth would be required to accommodate the faster pace of nominal income growth. But would this be prudent? I think not. Policy in an interest rate regime: the importance of flexibility Note that under a money growth strategy, it is possible to operate without a change in policy (no change in money growth) while nevertheless imposing an important degree of stability to the economy through the resulting pro-cyclical movement in interest rates. A constant rate of money supply will not always be optimal, but it will keep you out of a lot of serious trouble you could otherwise get into. The Federal Reserve and virtually all other central banks operate in a policy regime in which we set some short-term interest rate -- in our case, the federal funds rate. For a variety of reasons, this is generally viewed as the best choice of operating strategy. In this type of regime, however, it is more dangerous to be passive and fail to respond to changing economic conditions. The prudent pro-cyclical pattern in interest rates, in particular, must be actively put in place, rather than passively served up as would be the case with a policy of constant money growth. It is important to recognize the importance of moving interest rates in response to changing conditions and the potential for destabilizing policy when policy resists the natural tendency for interest rates to rise during cyclical upswings, especially when the economy is near its potential. Indeed, the major monetary policy mistakes in the past have not originated in overly aggressive movements in interest rates, but in the failure of policy to adjust interest rates in a timely fashion to changes in cyclical developments. Tightening as a maximin solution I noted at the outset the uncertainties in the outlook. As a result, it is possible to make policy mistakes. Another way of interpreting the policy action is as an attempt to avoid the worst possible errors in an uncertain environment. I call this a maximin solution to the policy problem. It involves comparing the relative costs of two potential policy mistakes in the current uncertain environment: tightening when such a move turned out to be inappropriate and failing to tighten when a tightening would have been appropriate. The maximin solution (patterned after the solution to the "prisoners' dilemma") is to select the option that would yield the smaller cost if the policy turned out to be a mistake. This analysis does not, in this case, help one to understand why the policy action was taken in March, rather than earlier. But it does provide a perspective on the role of uncertainty in the setting of monetary policy. If the Fed tightens and it turns out to have been unnecessary, the result would be that utilization rates turn out lower than desired and inflation lower than would otherwise have been the case. In the context of the prevailing 7-year low of the unemployment rate, that translates into a higher but still modest unemployment rate and further progress toward price stability, a central legislative mandate. This may not be the best solution. I would prefer, in the near term, trend growth at full employment with a continuation of the prevailing modest inflation rate. But the alternative outcome just described is not a bad result -- indeed, it would be a preferred result for those who favor a more rapid convergence to price stability. If the Fed fails to tighten when it would have been appropriate, the result would be higher utilization rates and higher inflation than desirable. To the extent that the result is a persistent excess demand gap, inflation will steadily rise over time. This outcome will yield what I call the Taylor Rule's "triple whammy." Once inflation takes off, interest rates will have to be raised first to prevent a decline in real rates, second to erase the increase in output beyond the economy's productive capacity, and third to lower inflation relative to the inflation target. This is an affair that almost always turns out be ugly, and poses a much greater threat to a sustained expansion, in my view, than a premature tightening. What Lies Ahead? I always taught my students that there was an answer that worked remarkably well most of the time to interesting questions in economics: "It depends." And this is the only answer I can offer to this second question of the day. But let me discuss some of the considerations likely to condition my judgment about policy in coming months. I would make a sharp distinction between the action of March 25 and the initial move in February 1994. Before the tightening in February 1994, monetary policy had been in an unprecedentedly stimulative posture into the third year of an expansion -- with the real federal funds rate at zero! This was justified by the unusually slow and erratic nature of the recovery up to this point. However, once the economy moved into a self-sustaining mode, as was the case during 1994, it was clear that the funds rate would quickly move toward its longer-run equilibrium level, meaning at least a 200 basis point increase, and the market was jolted into this realization by the Fed's initial move. In the current environment, entering the seventh year of the expansion, the real federal funds rate is already above its longer-term average. Looking ahead, monetary policy decisions will, as one would expect, depend on how the economy evolves in coming months. I will be focusing, in particular, on whether growth is continuing above trend with utilization rates rising further and whether inflation pressures are mounting at current utilization rates. Conclusion If I have made the setting of monetary policy in an environment characterized by numerous uncertainties appear to be a challenging task, I have accomplished one of my goals. While such uncertainty can affect the timing and aggressiveness of policy action, it is important that uncertainty does not paralyze monetary policy, especially under an interest rate policy regime. It is essential that monetary policy "leans against the wind," and the best way to do so is by enforcing a pro-cyclical pattern in short-term interest rates. This requires that real interest rates rise as long as growth is above-trend and utilization rates are rising. An exception to this regularity is in the early stages of an expansion, when utilization rates are at a cyclical low and inflation may be falling. In addition, as production approaches capacity, it is appropriate that policy become still more preemptive. One way for policy to be more preemptive is to respond to forecasts of rising utilization rates and higher inflation, especially when supported by a recent pattern of strong growth and evidence of continued momentum. One can take an optimistic or pessimistic view of the recent Fed tightening. A pessimistic reading would be that the move was unnecessary and that the economy is going to quickly move from rapid growth into a slump, or at least that the Federal Reserve is constraining the economy from achieving its maximum sustainable rate of growth. An alternative pessimistic assessment is that the policy move was too little, too late, so that the failure to act more swiftly and more aggressively has set the stage for a resurgence in inflation that will threaten the expansion. An optimistic assessment is that the March 25 move was a small, prudent, and preemptive step to lean against the strengthening cyclical forces and will increase the prospects of a continuation of an expansion with healthy but sustainable growth and continued modest inflation. Count me among the optimists.	---[PAGE_BREAK]--- # Mr. Meyer discusses the economic outlook and the challenges facing monetary policy in the United States Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the Forecasters Club of New York on 24/4/97. It is a pleasure to be here and discuss the economic outlook and monetary policy with fellow forecasters. I am going to offer some interpretations of the outlook as a context for the recent policy action by the Federal Reserve and explain how I view this action as part of a prudent and systematic strategy for monetary policy. The Forecasters Club of New York is an ideal forum for me to offer this commentary because, in my view, the recent policy action must be understood not in terms of where the economy has been recently, but rather in terms of the change in the forecast, a change in expectations about where the economy likely would be in six or twelve months in the absence of a policy change. Before proceeding, let me emphasize that the views on the economic outlook and monetary policy strategy I present this afternoon are my own. I am not speaking for either the FOMC or the Board of Governors or for any other individual members. If you want to know the views of the FOMC, you will have to do your homework-for example, read the announcement issued at the end of the last FOMC meeting, the Humphrey Hawkins testimony of the Chairman, the speeches and other comments by the full complement of participants in the FOMC, and the minutes of the last meeting when they become available. First, I shall discuss some aspects of the analytical framework or model that underlies my forecast, which in turn underpins my reasoning for the recent policy action. Second, I'll discuss the outlook context of the policy decision. Third, I'll describe the evolution of policy from a period of steady policy and asymmetric directives to the recent preemptive action. Fourth, I'll offer several interpretations of the policy action in relation to what I believe are important aspects of the strategy of monetary policy. Finally, I'll discuss some of the factors that will influence my views of the appropriate course of policy in the months ahead. ## The Analytical Framework Let me remind you at the outset of the framework I have been using to explain the challenge facing monetary policy in the current environment of healthy growth and high levels of resource utilization. The risk of higher inflation in this environment has two dimensions. First, there is the risk that current utilization rates are already so high that inflation will gradually increase over time. Second, there is the risk that the growth in output will be above trend going forward, implying that utilization rates will rise from their already high level, compounding the risk of higher inflation. Some apparently believe there are no speed limits, and no utilization rate can be so elevated that it threatens higher inflation. The reality is that above-trend growth raises utilization rates and, after some point, excessively high utilization rates result in higher inflation. But it is also true that threshold utilization rates and trend growth can change, that the current threshold levels for both utilization and growth rates are uncertain, that inflation can be affected by factors other than excess demand, and that policy is not infallible. Such uncertainty is a fact of life for both forecasters and policymakers. Just as forecasters do not stop forecasting because the job is difficult, policymakers have to adjust to uncertainty and not be paralyzed by it. ---[PAGE_BREAK]--- The recent Federal Reserve policy action was clearly a preemptive one. This means that it was undertaken not in response to where the economy and inflation were at the time of the policy change, but in response to where the economy and inflation were projected to be in the future, absent a policy change. Such policy action necessarily involves a forecast and such a forecast typically is grounded in some model that relates growth, unemployment, wage change and inflation, among other variables. So let me be specific about the causal structure of the model that underpins my judgment with respect to appropriate monetary policy action. I am a strong and unapologetic proponent of the Phillips Curve and the NAIRU concept. Fundamentally, the NAIRU framework involves two principles. First, the proximate source of an increase in inflation is excess demand in labor and/or product markets. In the labor market, this excess demand gap is often expressed in this model as the difference between the prevailing unemployment rate and NAIRU, the non-accelerating inflation rate of unemployment. Second, once an excess demand gap opens up, inflation increases indefinitely and progressively until the excess demand gap is closed, and then stabilizes at the higher level until cumulative excess supply gaps reverse the process. There is a third principle that I subscribe to, which, though not as fundamental as the first two, also plays a role in my forecast and in my judgment about the appropriate posture of monetary policy today. Utilization rates in the labor market play a special role in the inflation process. That is, inflation is often initially transmitted from labor market excess demand to wage change and then to price change. This third principle may be especially important today because, in my view, there is an important disparity between the balance between supply and demand in the labor and product markets, with at least a hint of excess demand in labor markets, but very little to suggest such imbalance in product markets. It is important to understand that the Phillips Curve is a model of inflation dynamics, not a model that determines the equilibrium inflation rate. For this reason, the Phillips Curve paradigm is not at all inconsistent with the view that inflation is, in the long run, exclusively a monetary phenomenon. Perhaps the easiest way to appreciate this is to recall that the long-run Phillips Curve is widely understood to be vertical. In other words, NAIRU is consistent with any constant rate of inflation, including zero. The Phillips Curve therefore cannot determine inflation in the long run because it is consistent with any constant rate of inflation. What does determine the rate of inflation in the long run? The rate of money growth, of course, though one needs to assume a stable money demand function to get a stable relationship between money growth and inflation. What does the Phillips Curve explain, if not the long-run level of inflation? The answer is that it explains the dynamics of the inflation process, how the economy evolves from one inflation rate to another, for example, in response to an increase in the rate of money growth. The dynamics of changes in inflation operate through excess demand in labor and/or product markets. Thus the Phillips Curve indicates that, if the unemployment rate is maintained at a level below NAIRU, inflation increases over time, progressively and indefinitely. The initial source of an increase in inflation can be anything which produces excess demand in labor and output markets. It could also be a supply shock, but I am ignoring this possibility so I can focus exclusively on the implications of the current strength in aggregate demand. Under an interest rate operating procedure, an increase in aggregate demand which increases output, utilization rates, and, ultimately, inflation will itself generate an increase in the money supply to support the higher nominal income. Money is not pinned down in such a regime, but passively adjusts to changes in nominal income. ---[PAGE_BREAK]--- Despite the sharpness and force of the Phillips Curve/NAIRU model, it can be difficult to implement in practice. Still, this relationship was about the most stable tool in the macroeconomists' tool kit for most of the past 20 years; those who were willing to depend on it were likely to be very successful forecasters of inflation, and the record speaks for itself on this score. Nevertheless, the combination of the 7-year low in the unemployment rate and 30-year low in inflation was a surprise to those using this framework. The challenge is to understand why we have been so fortunate. But, it should also be noted that monetary policy has responded appropriately to this surprise. That is, monetary policy has been careful not to be tied rigidly to a constant estimate of NAIRU. Instead, in my view, monetary policymakers have, in effect, implicitly adjusted their estimate of NAIRU to reflect the incoming data; this might be viewed as following a procedure like the time-varying parameter estimation technique applied by Robert Gordon and others. In the short run, there are many factors, in addition to aggregate demand, that influence inflation - including changes in the minimum wage, shocks to food and oil prices unrelated to the balance between aggregate demand and supply in the U.S., changes in the exchange rate, and exogenous effects on health care costs, etc. Some of these can be and have been effectively incorporated into the Phillips Curve model, but some of these factors have generally been outside the model. One explanation for the better than expected performance of core inflation in relation to the unemployment rate focuses, for example, on a series of favorable supply shocks - including the slowdown in benefit costs and the decline in import prices - that traditionally are not incorporated in estimated Phillips Curves. In addition, even adjusting for the above factors, NAIRU is not a constant, but can and has changed over time. For example, the evidence suggests that changes in the demographic composition of the labor force affect NAIRU and it is also likely that government programs, including unemployment compensation and welfare, also affect NAIRU. Further, the evidence suggests that, even accounting for demographics, government programs, and supply shocks, NAIRU may have edged lower over the last couple of years. The consensus in the profession is that NAIRU may have declined from around 6 percent in the decade ending in the early 1990s to perhaps $51 / 2$ percent today, though some believe that the decline is even larger, while others believe that any appearance of decline is due to temporary factors so that NAIRU will ultimately settle back to close to the earlier estimate. Clearly, one of the challenges of monetary policy is to set policy in the context of uncertainty about the precise value of NAIRU. The second element in the analytical framework is the link from output growth to the level of excess demand. The economy has a capacity to grow over time that is limited by the sum of the trend rate of growth in the labor force and the trend rate of growth in labor productivity. While both components can change over time and labor force and productivity growth are subject to both cyclical variation as well as secular shift, the historical record suggests that the trend rate of output growth changes very slowly over time. Currently, the trend rate of labor force growth is near 1 percent per year (based on population growth and leaving, for later, the interpretation of the recent rise in the participation rate) and the trend rate of productivity growth is slightly above 1 percent per year (though there is more than the usual uncertainty about this estimate, in part due to conflicting indications in measures of productivity derived from the product and income sides of the national accounts), resulting in trend output growth in the $2-21 / 2$ percent range. A key relationship is that when actual growth in output equals trend growth, utilization rates are constant; and when actual growth exceeds trend growth, utilization rates increase. ---[PAGE_BREAK]--- Now we can put the causal structure of the inflation process together, connecting up growth, unemployment rates, and inflation. Growth above trend raises utilization rates. Rising labor force utilization rates raise wage change relative to productivity growth. An increase in wage change relative to productivity growth raises labor costs and an increase in labor costs results in higher price inflation. Quiz time! Does growth cause inflation? Not exactly. Certainly, higher trend growth does not raise inflation. Indeed, an unexpected increase in trend productivity and hence trend growth in output would likely result in lower inflation for a while; if the rate of money growth were held constant, a permanent increase in productivity growth would result in a permanent decline in inflation. Although above-trend growth in output does not directly cause inflation, to the extent it results in increases in utilization rates, after some point, sustained above-trend growth will result in higher inflation. There are, to be sure, a number of uncertainties in this causal structure that are highly relevant to the current circumstances. First, we have to worry about whether there may have been a change in trend growth, for example, due to a rise in trend productivity growth or a change in the trend in labor force participation. If trend growth has increased, whether because of higher labor force growth or higher productivity growth, then we would observe that rapid growth does not raise utilization rates. Second, we have to worry about whether NAIRU may be declining or, at least, may be lower than currently estimated. If NAIRU is lower than we expect, then the current unemployment rate is less likely to be associated with excess demand in the labor market and therefore poses less risk of higher inflation. Checks and balances are essential here. For example, it is important to confirm that utilization rates are rising before continuing very long to tighten policy to damp presumed above-trend growth. This will prevent a persistent mistake in the face of an unexpected shift in the economy's trend rate of growth. Monetary policy usually avoids this mistake by focusing on utilization rates and not growth. The second check is to confirm that, following a decline in the unemployment rate, wage change is moving higher, consistent with increased excess demand in the labor market. In addition, we have to take into account temporary forces related to, for example, minimum wage, health care costs, and exchange rates. Finally, we have to make allowances for the dynamics of the process, including the tendency for inertia to result in only a very small initial increase in inflation once excess demand has developed and the tendency of the initial rise in wages in excess of productivity to be tempered by a decline in profit margins before leading to higher prices. # The Outlook Context Now let me summarize the key features of recent macroeconomic performance. The economy advanced at a 3.1 percent rate over 1996, including a 3.8 percent rate in the fourth quarter. Growth in the first quarter appears to have been at least as strong as the pace in the fourth quarter, and the economy seems to have solid momentum in the current quarter. In short, the economy appears to be growing at an unsustainable above-trend rate. By the way, is the prevailing trend rate of growth both historically low and disappointing? Yes. Would it be desirable, therefore, to raise the trend rate of growth? Yes. Can monetary policy accomplish this worthy task? No. Can the Congress and the Administration, through judicious combination of deficit reduction and saving and investment incentives, raise trend growth (at least for a while)? Yes. Are there opportunities for monetary policy to ---[PAGE_BREAK]--- contribute to steady growth? Yes. First, to the extent that policy can avoid a cyclical rise in inflation, it can avoid the subsequent monetary policy response to limit and then reverse the rise in inflation; the result of avoiding the boom is avoiding the bust. Disciplined monetary policy therefore encourages steady growth, with the emphasis on the steady. Second, to the extent that price stability encourages saving and investment and a more efficient allocation of resources, as is widely believed, a monetary policy that promotes price stability is the one that best encourages steady growth, now with the emphasis on growth. Now back to the economic outlook. The unemployment rate which has fluctuated in a rather narrow band over the last year and a half has recently been inching lower and is now equal to its cyclical and 7-year low. I suspect that the unemployment rate is now below NAIRU, though the steady rise in wage change over the last year suggests that the unemployment rate may have been somewhat below NAIRU for a while. Another aside. Don't I like wage growth? Yes, but only to the extent it is real; that is, only to the extent that it does not yield increases in inflation that in turn prevent the purchasing power of wages from advancing. Shouldn't workers share in the bounty of a healthy economy? Of course. But workers will best share in the bounty when there is sustainable growth and will pay a high price for unsustainable growth in the cyclical instability that would surely follow such excess. Let me add one more complication. It is possible for wages to increase faster than productivity for a while to allow a rebound in real wages, for example, if real wages had earlier in the expansion advanced at a rate less than allowed by trend productivity. In this case, a rebound in real wages could be unwinding a temporary increase in profit margins and could therefore be accommodated without an increase in inflation. Wage change, as I just noted, has been rising. The 12-month increase in average hourly earnings is now 4.1 percent, a percentage point higher than a year ago. Compensation per hour, as measured by the ECI, has to date accelerated more modestly, with the slowing rise in benefit costs tempering the effect of a sharper rise in wage costs. The first quarter ECI bears watching for signs of a further rise in wage change and possibly a bottoming out of the recent slowing in the pace of increase in benefit costs. Core inflation remains at a cyclical and 30-year low, with the 12-month increase in the core CPI at 2.5 percent. Note, however, to correctly measure the change in inflation, a comparison of core inflation over the last couple of years has to be adjusted to account for the methodological revisions to the CPI. To date, BLS revisions have lowered inflation cumulatively by around a quarter point over the past two years. The point of the policy action, of course, is to try to prevent any significant increase in core inflation. Clearly the recent performance has been extraordinary. I have noted previously that it is not only better than virtually anyone had forecast, it is better than historical regularities would have suggested was possible. The explanations for the continuing decline in core inflation, despite an unemployment rate that in earlier periods would have been associated with rising inflation, include some combination of temporary coincidences and longer-lasting structural changes. First, the labor force has been growing about twice as rapidly as a trend rate based on population growth. It is as if demand is calling forth its own supply. Part of the explanation is a rebound from a sharp decline in participation rates over 1995. Part reflects a normal cyclical rise in participation rates, delayed in this expansion. A small part could be the early effects of ---[PAGE_BREAK]--- changes in welfare laws and previous state efforts to trim welfare roles. As a result, the recent strength of output growth has not resulted in much of an increase in resource utilization rates. I do not expect labor force growth to continue at its recent rapid rate, though the underlying trend over the next several years may well be augmented by an upward trend in participation rates. The net result is that output growth must slow from recent levels to prevent further increases in utilization rates. Second, increased job insecurity appears to have moderated the pace of wage change, relative to what we would have expected at current levels of labor force utilization. It is important to note here that the effects on inflation of an increase in worker insecurity may be only temporary. Even with the higher worker insecurity, wages are clearly on a rising trend. Third, a slowing in the rise in benefit costs (primarily via slower increase in health care costs) has moderated the rise in labor compensation associated with wage pressures. As a result, the rise in compensation and hence labor costs has been muted, compared to the faster pace of wage gains. Fourth, declining import prices - directly and indirectly--have restrained price inflation. Some judgment has to be made in any forecast about the persistence of the special forces that have contributed to restrained wage and price change over recent quarters. The least likely to continue to act as a restraining influence, in my judgment, is health care and therefore benefit costs, based on surveys of prospective health care insurance premiums. Given the recent further appreciation of the dollar, import prices may decline further, though the restraining effect on inflation may be less important going forward than it has been over the past year. # From an Asymmetric Directive to Preemptive Policy: Why Now? During the period from July of 1996 through February of 1997, monetary policy remained unchanged but operated with an asymmetric directive. Utilization rates were high -high enough to suggest some risk of rising inflation, but wage gains -- while trending higher, remained modest and core inflation remained on a downward trend, perhaps due to declining import prices and the slowing of the rise in health care costs. The anxiety associated with high utilization rates was clearly tempered by the excellent performance of core inflation, resulting in a posture of "watchful waiting." The Federal Reserve remained alert during this period, but on the sidelines. While growth was at times well above my estimate of trend, various factors made it reasonable to expect a slowdown in growth toward trend immediately ahead, suggesting that utilization rates would likely remain within their recent ranges. The asymmetric directive reflected a view that the risks in this environment were asymmetric, that there was a greater risk that inflation would rise in response to the prevailing high utilization rate (and to still higher utilization rates if growth continued above-trend growth) than that the economy would slow to below trend growth. The asymmetric policy posture was, therefore, a reflection of concern that our forecast might be wrong and that if it were wrong it was more likely to underestimate inflation going forward. What was different in March, compared to this earlier period? Not utilization rates. They were still within the narrow range that had prevailed during this period, though admittedly close to the bottom of that range. Not core inflation. If anything, core inflation was lower. No, the difference, from my perspective, was not in the data for utilization rates, wage change, and inflation, but in my forecast of the future path of these variables. The change in the forecast, to be sure, was prompted by incoming data suggesting persistent strength in aggregate demand. Instead of projecting a slowing to trend immediately ahead, it now appeared to me that we were in a period of sustained above-trend growth that would push utilization rates higher and, in particular, would push the unemployment rate below its recent range. A tightening of ---[PAGE_BREAK]--- monetary policy was motivated, from my perspective, not by the prevailing data on unemployment rates, wage change, and inflation, but rather by a forecast of where I expected utilization rates and inflation to be six months and a year from now, if monetary policy remained unchanged. Whereas I supported the earlier asymmetric directive based on concern that my forecast might be wrong, the preemptive policy action was motivated for me by concern that my (new) forecast might be correct! The case for a preemptive approach is that it alone holds the promise of sustaining a durable expansion with continued healthy, balanced growth. The greatest threat to expansions does not come from a spontaneous weakening of demand, from lethargy, but rather from over-exuberance and overheating. Once overheating unleashes an increase in inflation, the attempt to first control and then reverse the higher inflation often results in recession. This gives substance to the well-known worth of "an ounce of prevention." # Interpreting the Policy Action as Part of a Strategy for Monetary Policy Let me now interpret the tightening in relation to several descriptions of monetary policy strategy. The first three really are alternative perspectives on a single essential principle of prudent monetary policy, the importance of leaning against the wind by enforcing pro-cyclical movements in short-term interest rates. The fourth reflects one way in which monetary policy might take into account the uncertainty in the outlook. ## A Taylor Rule perspective I have noted in a number of previous speeches that I view the Taylor Rule as highlighting a couple of important requirements for prudent monetary policy. First, the Taylor Rule links Federal Reserve policy to a long-run inflation target and thus ensures that, in the long run, policy will force the actual inflation rate to converge to the long-run target. The Taylor Rule thus imposes a powerful nominal anchor on monetary policy. Second, the Taylor Rule generally imposes a pro-cyclical pattern on real short-term interest rates, so that monetary policy leans against the cyclical winds and thereby stabilizes the economy, in much the same way that automatic stabilizers in our fiscal institutions, via cyclical swings in government budget deficits, damp business cycles. Nevertheless, the traditional specification of the Taylor Rule does not provide a justification for tightening in March, relative to the earlier decisions to hold policy unchanged. According to the Taylor Rule, the federal funds rate should adjust over time to changes in utilization rates (the gap between actual and potential output or between the unemployment rate and NAIRU) and to changes in inflation. Because utilization rates had not increased (at least had not increased outside the range of the last year) and core inflation was actually lower in March compared with earlier, the Taylor Rule did not dictate a tightening. The Rule did suggest, however, that monetary policy would have had to tighten over time if the forecast of rising utilization rates and higher inflation proved correct. But it did not dictate immediate action. There is however an alternative specification of the Taylor Rule that does motivate an immediate tightening. I call this a forward looking version of the Taylor Rule. The traditional specification is forward looking to a degree in relation to inflation, in that it sets the funds rate in relation to both the utilization rate (an advance warning of future increases in inflation) and to inflation. But the forward-looking specification I have in mind replaces actual ---[PAGE_BREAK]--- inflation and utilization rates in the rule with forecasts of future inflation and utilization rates. This approach to policy reaction functions was pioneered by Steve McNees of the Federal Reserve Bank of Boston in the mid 1980s and there has been a renewed interest in such an approach, in the context of the Taylor Rule, during the last couple of years. Such a forward-looking specification would rationalize and justify an increase in the funds rate in response to the forecast of rising utilization rates in the future. This leaves an interesting question. Does following a Taylor Rule based on an uncertain forecast outperform a Taylor Rule based on actual data? That, of course, depends on the quality of the forecasts. This is an interesting question, one that deserves scrutiny. But it is really the same as the question: Should policy be preemptive or reactive? As a forecaster, I am inclined to believe in the forward-looking approach and therefore in preemptive policy. But I recognize that further work should be done on this subject. # An IS-LM perspective on leaning against the wind I would interpret the recent strength in demand, from the perspective of an IS-LM model, as a shift in the IS curve. Such an interpretation of cyclical swings is, of course, in the Keynesian tradition: output is demand determined in the short run (reflecting price stickiness) and swings in output are dominated by autonomous changes in aggregate demand. How should monetary policy respond to cyclical swings in demand? Should monetary policy hold short-term interest rates constant, in effect imposing a horizontal LM curve? In order to do so, it would, in general, have to respond to rightward shifts in the IS curve by adding reserves and facilitating faster money growth, so as to prevent interest rates from rising. This might be appropriate very early in an expansion, when the unemployment rate is high and inflation is declining, but it is not, in my judgment, prudent in the mature stage of an expansion, and it is most surely imprudent once utilization rates have increased toward or beyond their capacity levels. The alternative is to maintain an upward sloping LM curve. In the static model, this is the case when the money supply is fixed; allowing for trend growth and inflation, it would be equivalent to holding money growth constant, assuming a stable money demand function. In this case, a shift in the IS curve would raise interest rates as the IS curve moved along the upward sloping LM curve. This is an example of monetary policy "leaning against the wind." The resulting pro-cyclical movement in interest rates increases the stability of the economy in much the same way as cyclical swings in the federal budget deficit. Some might argue, however, that even if short-term interest rates do not rise, long-term interest rates, equity prices, and the dollar may change in ways that damp the cyclical swing in demand and thereby lessen the necessity of a direct response of monetary policy. This is sometimes referred to as the "gyroscope" theory (the bond market is the economy's gyroscope) and the active part of management of the cycle is in the hands of so-called "bond market vigilantes," some of whom are undoubtedly in the audience this afternoon. When long-term rates rise in response to a cyclical strengthening, it reflects, in large part, the expectation of higher short-term interest rates. Specifically, it reflects expectations about monetary policy. While monetary policy cannot be a slave to the bond market, when the cyclical state of the economy suggests the desirability of a pro-cyclical response in interest rates, the Federal Reserve should pat the bond market on the back and appreciate its help, but not expect the bond market to carry the entire burden. Monetary policy in this case needs to validate the movement in the bond market, rather than resist it. If it does not, surely real long-term ---[PAGE_BREAK]--- interest rates and the dollar will decrease, eroding the market restraint, and in the future markets will be less likely to perform this stabilizing function. Of course, there will be times when the bond market is, in our view, misreading the strength of the economy and hence also misjudging the future course of our policy. In this case, we should ignore the bond market and provide an anchor for long-term interest rates to adjust back toward. # Implications of a money growth rule As I have just noted, a pro-cyclical path for short-term interest rates would result from following a money growth rule. For an extended period, money demand has been insufficiently stable to allow the monetary aggregates to play a constructive role in the monetary policy process. More recently, the relationship between M2 and its determinants has stabilized, but the period of a more stable relationship has been relatively brief and has coincided with a relatively stable economy. As a result, there is not yet much inclination to place increased weight on M2 in the policy process. What I am offering here is therefore only a thought experiment. Assume that the money demand function for M2 has stabilized and that we could conduct policy by enforcing a constant rate of M2 growth. Assuming policy maintained a fixed rate of money growth (perhaps the better way to define an unchanged policy), what would be the effect of a cyclical strengthening of the economy (an increase in nominal income growth)? The answer, of course, is that short-term interest rates would rise. This is of course just another way of telling the IS-LM story. What would it take to prevent interest rates from rising? The answer is that an increase in the rate of money growth would be required to accommodate the faster pace of nominal income growth. But would this be prudent? I think not. ## Policy in an interest rate regime: the importance of flexibility Note that under a money growth strategy, it is possible to operate without a change in policy (no change in money growth) while nevertheless imposing an important degree of stability to the economy through the resulting pro-cyclical movement in interest rates. A constant rate of money supply will not always be optimal, but it will keep you out of a lot of serious trouble you could otherwise get into. The Federal Reserve and virtually all other central banks operate in a policy regime in which we set some short-term interest rate -- in our case, the federal funds rate. For a variety of reasons, this is generally viewed as the best choice of operating strategy. In this type of regime, however, it is more dangerous to be passive and fail to respond to changing economic conditions. The prudent pro-cyclical pattern in interest rates, in particular, must be actively put in place, rather than passively served up as would be the case with a policy of constant money growth. It is important to recognize the importance of moving interest rates in response to changing conditions and the potential for destabilizing policy when policy resists the natural tendency for interest rates to rise during cyclical upswings, especially when the economy is near its potential. Indeed, the major monetary policy mistakes in the past have not originated in overly aggressive movements in interest rates, but in the failure of policy to adjust interest rates in a timely fashion to changes in cyclical developments. ---[PAGE_BREAK]--- # Tightening as a maximin solution I noted at the outset the uncertainties in the outlook. As a result, it is possible to make policy mistakes. Another way of interpreting the policy action is as an attempt to avoid the worst possible errors in an uncertain environment. I call this a maximin solution to the policy problem. It involves comparing the relative costs of two potential policy mistakes in the current uncertain environment: tightening when such a move turned out to be inappropriate and failing to tighten when a tightening would have been appropriate. The maximin solution (patterned after the solution to the "prisoners' dilemma") is to select the option that would yield the smaller cost if the policy turned out to be a mistake. This analysis does not, in this case, help one to understand why the policy action was taken in March, rather than earlier. But it does provide a perspective on the role of uncertainty in the setting of monetary policy. If the Fed tightens and it turns out to have been unnecessary, the result would be that utilization rates turn out lower than desired and inflation lower than would otherwise have been the case. In the context of the prevailing 7 -year low of the unemployment rate, that translates into a higher but still modest unemployment rate and further progress toward price stability, a central legislative mandate. This may not be the best solution. I would prefer, in the near term, trend growth at full employment with a continuation of the prevailing modest inflation rate. But the alternative outcome just described is not a bad result -- indeed, it would be a preferred result for those who favor a more rapid convergence to price stability. If the Fed fails to tighten when it would have been appropriate, the result would be higher utilization rates and higher inflation than desirable. To the extent that the result is a persistent excess demand gap, inflation will steadily rise over time. This outcome will yield what I call the Taylor Rule's "triple whammy." Once inflation takes off, interest rates will have to be raised first to prevent a decline in real rates, second to erase the increase in output beyond the economy's productive capacity, and third to lower inflation relative to the inflation target. This is an affair that almost always turns out be ugly, and poses a much greater threat to a sustained expansion, in my view, than a premature tightening. ## What Lies Ahead? I always taught my students that there was an answer that worked remarkably well most of the time to interesting questions in economics: "It depends." And this is the only answer I can offer to this second question of the day. But let me discuss some of the considerations likely to condition my judgment about policy in coming months. I would make a sharp distinction between the action of March 25 and the initial move in February 1994. Before the tightening in February 1994, monetary policy had been in an unprecedentedly stimulative posture into the third year of an expansion -- with the real federal funds rate at zero! This was justified by the unusually slow and erratic nature of the recovery up to this point. However, once the economy moved into a self-sustaining mode, as was the case during 1994, it was clear that the funds rate would quickly move toward its longer-run equilibrium level, meaning at least a 200 basis point increase, and the market was jolted into this realization by the Fed's initial move. In the current environment, entering the seventh year of the expansion, the real federal funds rate is already above its longer-term average. Looking ahead, monetary policy decisions will, as one would expect, depend on how the economy evolves in coming months. I will be focusing, in particular, on whether ---[PAGE_BREAK]--- growth is continuing above trend with utilization rates rising further and whether inflation pressures are mounting at current utilization rates. # Conclusion If I have made the setting of monetary policy in an environment characterized by numerous uncertainties appear to be a challenging task, I have accomplished one of my goals. While such uncertainty can affect the timing and aggressiveness of policy action, it is important that uncertainty does not paralyze monetary policy, especially under an interest rate policy regime. It is essential that monetary policy "leans against the wind," and the best way to do so is by enforcing a pro-cyclical pattern in short-term interest rates. This requires that real interest rates rise as long as growth is above-trend and utilization rates are rising. An exception to this regularity is in the early stages of an expansion, when utilization rates are at a cyclical low and inflation may be falling. In addition, as production approaches capacity, it is appropriate that policy become still more preemptive. One way for policy to be more preemptive is to respond to forecasts of rising utilization rates and higher inflation, especially when supported by a recent pattern of strong growth and evidence of continued momentum. One can take an optimistic or pessimistic view of the recent Fed tightening. A pessimistic reading would be that the move was unnecessary and that the economy is going to quickly move from rapid growth into a slump, or at least that the Federal Reserve is constraining the economy from achieving its maximum sustainable rate of growth. An alternative pessimistic assessment is that the policy move was too little, too late, so that the failure to act more swiftly and more aggressively has set the stage for a resurgence in inflation that will threaten the expansion. An optimistic assessment is that the March 25 move was a small, prudent, and preemptive step to lean against the strengthening cyclical forces and will increase the prospects of a continuation of an expansion with healthy but sustainable growth and continued modest inflation. Count me among the optimists.	Laurence H Meyer	United States	https://www.bis.org/review/r970512a.pdf	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the Forecasters Club of New York on 24/4/97. It is a pleasure to be here and discuss the economic outlook and monetary policy with fellow forecasters. I am going to offer some interpretations of the outlook as a context for the recent policy action by the Federal Reserve and explain how I view this action as part of a prudent and systematic strategy for monetary policy. The Forecasters Club of New York is an ideal forum for me to offer this commentary because, in my view, the recent policy action must be understood not in terms of where the economy has been recently, but rather in terms of the change in the forecast, a change in expectations about where the economy likely would be in six or twelve months in the absence of a policy change. Before proceeding, let me emphasize that the views on the economic outlook and monetary policy strategy I present this afternoon are my own. I am not speaking for either the FOMC or the Board of Governors or for any other individual members. If you want to know the views of the FOMC, you will have to do your homework-for example, read the announcement issued at the end of the last FOMC meeting, the Humphrey Hawkins testimony of the Chairman, the speeches and other comments by the full complement of participants in the FOMC, and the minutes of the last meeting when they become available. First, I shall discuss some aspects of the analytical framework or model that underlies my forecast, which in turn underpins my reasoning for the recent policy action. Second, I'll discuss the outlook context of the policy decision. Third, I'll describe the evolution of policy from a period of steady policy and asymmetric directives to the recent preemptive action. Fourth, I'll offer several interpretations of the policy action in relation to what I believe are important aspects of the strategy of monetary policy. Finally, I'll discuss some of the factors that will influence my views of the appropriate course of policy in the months ahead. Let me remind you at the outset of the framework I have been using to explain the challenge facing monetary policy in the current environment of healthy growth and high levels of resource utilization. The risk of higher inflation in this environment has two dimensions. First, there is the risk that current utilization rates are already so high that inflation will gradually increase over time. Second, there is the risk that the growth in output will be above trend going forward, implying that utilization rates will rise from their already high level, compounding the risk of higher inflation. Some apparently believe there are no speed limits, and no utilization rate can be so elevated that it threatens higher inflation. The reality is that above-trend growth raises utilization rates and, after some point, excessively high utilization rates result in higher inflation. But it is also true that threshold utilization rates and trend growth can change, that the current threshold levels for both utilization and growth rates are uncertain, that inflation can be affected by factors other than excess demand, and that policy is not infallible. Such uncertainty is a fact of life for both forecasters and policymakers. Just as forecasters do not stop forecasting because the job is difficult, policymakers have to adjust to uncertainty and not be paralyzed by it. The recent Federal Reserve policy action was clearly a preemptive one. This means that it was undertaken not in response to where the economy and inflation were at the time of the policy change, but in response to where the economy and inflation were projected to be in the future, absent a policy change. Such policy action necessarily involves a forecast and such a forecast typically is grounded in some model that relates growth, unemployment, wage change and inflation, among other variables. So let me be specific about the causal structure of the model that underpins my judgment with respect to appropriate monetary policy action. I am a strong and unapologetic proponent of the Phillips Curve and the NAIRU concept. Fundamentally, the NAIRU framework involves two principles. First, the proximate source of an increase in inflation is excess demand in labor and/or product markets. In the labor market, this excess demand gap is often expressed in this model as the difference between the prevailing unemployment rate and NAIRU, the non-accelerating inflation rate of unemployment. Second, once an excess demand gap opens up, inflation increases indefinitely and progressively until the excess demand gap is closed, and then stabilizes at the higher level until cumulative excess supply gaps reverse the process. There is a third principle that I subscribe to, which, though not as fundamental as the first two, also plays a role in my forecast and in my judgment about the appropriate posture of monetary policy today. Utilization rates in the labor market play a special role in the inflation process. That is, inflation is often initially transmitted from labor market excess demand to wage change and then to price change. This third principle may be especially important today because, in my view, there is an important disparity between the balance between supply and demand in the labor and product markets, with at least a hint of excess demand in labor markets, but very little to suggest such imbalance in product markets. It is important to understand that the Phillips Curve is a model of inflation dynamics, not a model that determines the equilibrium inflation rate. For this reason, the Phillips Curve paradigm is not at all inconsistent with the view that inflation is, in the long run, exclusively a monetary phenomenon. Perhaps the easiest way to appreciate this is to recall that the long-run Phillips Curve is widely understood to be vertical. In other words, NAIRU is consistent with any constant rate of inflation, including zero. The Phillips Curve therefore cannot determine inflation in the long run because it is consistent with any constant rate of inflation. What does determine the rate of inflation in the long run? The rate of money growth, of course, though one needs to assume a stable money demand function to get a stable relationship between money growth and inflation. What does the Phillips Curve explain, if not the long-run level of inflation? The answer is that it explains the dynamics of the inflation process, how the economy evolves from one inflation rate to another, for example, in response to an increase in the rate of money growth. The dynamics of changes in inflation operate through excess demand in labor and/or product markets. Thus the Phillips Curve indicates that, if the unemployment rate is maintained at a level below NAIRU, inflation increases over time, progressively and indefinitely. The initial source of an increase in inflation can be anything which produces excess demand in labor and output markets. It could also be a supply shock, but I am ignoring this possibility so I can focus exclusively on the implications of the current strength in aggregate demand. Under an interest rate operating procedure, an increase in aggregate demand which increases output, utilization rates, and, ultimately, inflation will itself generate an increase in the money supply to support the higher nominal income. Money is not pinned down in such a regime, but passively adjusts to changes in nominal income. Despite the sharpness and force of the Phillips Curve/NAIRU model, it can be difficult to implement in practice. Still, this relationship was about the most stable tool in the macroeconomists' tool kit for most of the past 20 years; those who were willing to depend on it were likely to be very successful forecasters of inflation, and the record speaks for itself on this score. Nevertheless, the combination of the 7-year low in the unemployment rate and 30-year low in inflation was a surprise to those using this framework. The challenge is to understand why we have been so fortunate. But, it should also be noted that monetary policy has responded appropriately to this surprise. That is, monetary policy has been careful not to be tied rigidly to a constant estimate of NAIRU. Instead, in my view, monetary policymakers have, in effect, implicitly adjusted their estimate of NAIRU to reflect the incoming data; this might be viewed as following a procedure like the time-varying parameter estimation technique applied by Robert Gordon and others. In the short run, there are many factors, in addition to aggregate demand, that influence inflation - including changes in the minimum wage, shocks to food and oil prices unrelated to the balance between aggregate demand and supply in the U.S., changes in the exchange rate, and exogenous effects on health care costs, etc. Some of these can be and have been effectively incorporated into the Phillips Curve model, but some of these factors have generally been outside the model. One explanation for the better than expected performance of core inflation in relation to the unemployment rate focuses, for example, on a series of favorable supply shocks - including the slowdown in benefit costs and the decline in import prices - that traditionally are not incorporated in estimated Phillips Curves. In addition, even adjusting for the above factors, NAIRU is not a constant, but can and has changed over time. For example, the evidence suggests that changes in the demographic composition of the labor force affect NAIRU and it is also likely that government programs, including unemployment compensation and welfare, also affect NAIRU. Further, the evidence suggests that, even accounting for demographics, government programs, and supply shocks, NAIRU may have edged lower over the last couple of years. The consensus in the profession is that NAIRU may have declined from around 6 percent in the decade ending in the early 1990s to perhaps $51 / 2$ percent today, though some believe that the decline is even larger, while others believe that any appearance of decline is due to temporary factors so that NAIRU will ultimately settle back to close to the earlier estimate. Clearly, one of the challenges of monetary policy is to set policy in the context of uncertainty about the precise value of NAIRU. The second element in the analytical framework is the link from output growth to the level of excess demand. The economy has a capacity to grow over time that is limited by the sum of the trend rate of growth in the labor force and the trend rate of growth in labor productivity. While both components can change over time and labor force and productivity growth are subject to both cyclical variation as well as secular shift, the historical record suggests that the trend rate of output growth changes very slowly over time. Currently, the trend rate of labor force growth is near 1 percent per year (based on population growth and leaving, for later, the interpretation of the recent rise in the participation rate) and the trend rate of productivity growth is slightly above 1 percent per year (though there is more than the usual uncertainty about this estimate, in part due to conflicting indications in measures of productivity derived from the product and income sides of the national accounts), resulting in trend output growth in the $2-21 / 2$ percent range. A key relationship is that when actual growth in output equals trend growth, utilization rates are constant; and when actual growth exceeds trend growth, utilization rates increase. Now we can put the causal structure of the inflation process together, connecting up growth, unemployment rates, and inflation. Growth above trend raises utilization rates. Rising labor force utilization rates raise wage change relative to productivity growth. An increase in wage change relative to productivity growth raises labor costs and an increase in labor costs results in higher price inflation. Quiz time! Does growth cause inflation? Not exactly. Certainly, higher trend growth does not raise inflation. Indeed, an unexpected increase in trend productivity and hence trend growth in output would likely result in lower inflation for a while; if the rate of money growth were held constant, a permanent increase in productivity growth would result in a permanent decline in inflation. Although above-trend growth in output does not directly cause inflation, to the extent it results in increases in utilization rates, after some point, sustained above-trend growth will result in higher inflation. There are, to be sure, a number of uncertainties in this causal structure that are highly relevant to the current circumstances. First, we have to worry about whether there may have been a change in trend growth, for example, due to a rise in trend productivity growth or a change in the trend in labor force participation. If trend growth has increased, whether because of higher labor force growth or higher productivity growth, then we would observe that rapid growth does not raise utilization rates. Second, we have to worry about whether NAIRU may be declining or, at least, may be lower than currently estimated. If NAIRU is lower than we expect, then the current unemployment rate is less likely to be associated with excess demand in the labor market and therefore poses less risk of higher inflation. Checks and balances are essential here. For example, it is important to confirm that utilization rates are rising before continuing very long to tighten policy to damp presumed above-trend growth. This will prevent a persistent mistake in the face of an unexpected shift in the economy's trend rate of growth. Monetary policy usually avoids this mistake by focusing on utilization rates and not growth. The second check is to confirm that, following a decline in the unemployment rate, wage change is moving higher, consistent with increased excess demand in the labor market. In addition, we have to take into account temporary forces related to, for example, minimum wage, health care costs, and exchange rates. Finally, we have to make allowances for the dynamics of the process, including the tendency for inertia to result in only a very small initial increase in inflation once excess demand has developed and the tendency of the initial rise in wages in excess of productivity to be tempered by a decline in profit margins before leading to higher prices. Now let me summarize the key features of recent macroeconomic performance. The economy advanced at a 3.1 percent rate over 1996, including a 3.8 percent rate in the fourth quarter. Growth in the first quarter appears to have been at least as strong as the pace in the fourth quarter, and the economy seems to have solid momentum in the current quarter. In short, the economy appears to be growing at an unsustainable above-trend rate. By the way, is the prevailing trend rate of growth both historically low and disappointing? Yes. Would it be desirable, therefore, to raise the trend rate of growth? Yes. Can monetary policy accomplish this worthy task? No. Can the Congress and the Administration, through judicious combination of deficit reduction and saving and investment incentives, raise trend growth (at least for a while)? Yes. Are there opportunities for monetary policy to contribute to steady growth? Yes. First, to the extent that policy can avoid a cyclical rise in inflation, it can avoid the subsequent monetary policy response to limit and then reverse the rise in inflation; the result of avoiding the boom is avoiding the bust. Disciplined monetary policy therefore encourages steady growth, with the emphasis on the steady. Second, to the extent that price stability encourages saving and investment and a more efficient allocation of resources, as is widely believed, a monetary policy that promotes price stability is the one that best encourages steady growth, now with the emphasis on growth. Now back to the economic outlook. The unemployment rate which has fluctuated in a rather narrow band over the last year and a half has recently been inching lower and is now equal to its cyclical and 7-year low. I suspect that the unemployment rate is now below NAIRU, though the steady rise in wage change over the last year suggests that the unemployment rate may have been somewhat below NAIRU for a while. Another aside. Don't I like wage growth? Yes, but only to the extent it is real; that is, only to the extent that it does not yield increases in inflation that in turn prevent the purchasing power of wages from advancing. Shouldn't workers share in the bounty of a healthy economy? Of course. But workers will best share in the bounty when there is sustainable growth and will pay a high price for unsustainable growth in the cyclical instability that would surely follow such excess. Let me add one more complication. It is possible for wages to increase faster than productivity for a while to allow a rebound in real wages, for example, if real wages had earlier in the expansion advanced at a rate less than allowed by trend productivity. In this case, a rebound in real wages could be unwinding a temporary increase in profit margins and could therefore be accommodated without an increase in inflation. Wage change, as I just noted, has been rising. The 12-month increase in average hourly earnings is now 4.1 percent, a percentage point higher than a year ago. Compensation per hour, as measured by the ECI, has to date accelerated more modestly, with the slowing rise in benefit costs tempering the effect of a sharper rise in wage costs. The first quarter ECI bears watching for signs of a further rise in wage change and possibly a bottoming out of the recent slowing in the pace of increase in benefit costs. Core inflation remains at a cyclical and 30-year low, with the 12-month increase in the core CPI at 2.5 percent. Note, however, to correctly measure the change in inflation, a comparison of core inflation over the last couple of years has to be adjusted to account for the methodological revisions to the CPI. To date, BLS revisions have lowered inflation cumulatively by around a quarter point over the past two years. The point of the policy action, of course, is to try to prevent any significant increase in core inflation. Clearly the recent performance has been extraordinary. I have noted previously that it is not only better than virtually anyone had forecast, it is better than historical regularities would have suggested was possible. The explanations for the continuing decline in core inflation, despite an unemployment rate that in earlier periods would have been associated with rising inflation, include some combination of temporary coincidences and longer-lasting structural changes. First, the labor force has been growing about twice as rapidly as a trend rate based on population growth. It is as if demand is calling forth its own supply. Part of the explanation is a rebound from a sharp decline in participation rates over 1995. Part reflects a normal cyclical rise in participation rates, delayed in this expansion. A small part could be the early effects of changes in welfare laws and previous state efforts to trim welfare roles. As a result, the recent strength of output growth has not resulted in much of an increase in resource utilization rates. I do not expect labor force growth to continue at its recent rapid rate, though the underlying trend over the next several years may well be augmented by an upward trend in participation rates. The net result is that output growth must slow from recent levels to prevent further increases in utilization rates. Second, increased job insecurity appears to have moderated the pace of wage change, relative to what we would have expected at current levels of labor force utilization. It is important to note here that the effects on inflation of an increase in worker insecurity may be only temporary. Even with the higher worker insecurity, wages are clearly on a rising trend. Third, a slowing in the rise in benefit costs (primarily via slower increase in health care costs) has moderated the rise in labor compensation associated with wage pressures. As a result, the rise in compensation and hence labor costs has been muted, compared to the faster pace of wage gains. Fourth, declining import prices - directly and indirectly--have restrained price inflation. Some judgment has to be made in any forecast about the persistence of the special forces that have contributed to restrained wage and price change over recent quarters. The least likely to continue to act as a restraining influence, in my judgment, is health care and therefore benefit costs, based on surveys of prospective health care insurance premiums. Given the recent further appreciation of the dollar, import prices may decline further, though the restraining effect on inflation may be less important going forward than it has been over the past year. During the period from July of 1996 through February of 1997, monetary policy remained unchanged but operated with an asymmetric directive. Utilization rates were high -high enough to suggest some risk of rising inflation, but wage gains -- while trending higher, remained modest and core inflation remained on a downward trend, perhaps due to declining import prices and the slowing of the rise in health care costs. The anxiety associated with high utilization rates was clearly tempered by the excellent performance of core inflation, resulting in a posture of "watchful waiting." The Federal Reserve remained alert during this period, but on the sidelines. While growth was at times well above my estimate of trend, various factors made it reasonable to expect a slowdown in growth toward trend immediately ahead, suggesting that utilization rates would likely remain within their recent ranges. The asymmetric directive reflected a view that the risks in this environment were asymmetric, that there was a greater risk that inflation would rise in response to the prevailing high utilization rate (and to still higher utilization rates if growth continued above-trend growth) than that the economy would slow to below trend growth. The asymmetric policy posture was, therefore, a reflection of concern that our forecast might be wrong and that if it were wrong it was more likely to underestimate inflation going forward. What was different in March, compared to this earlier period? Not utilization rates. They were still within the narrow range that had prevailed during this period, though admittedly close to the bottom of that range. Not core inflation. If anything, core inflation was lower. No, the difference, from my perspective, was not in the data for utilization rates, wage change, and inflation, but in my forecast of the future path of these variables. The change in the forecast, to be sure, was prompted by incoming data suggesting persistent strength in aggregate demand. Instead of projecting a slowing to trend immediately ahead, it now appeared to me that we were in a period of sustained above-trend growth that would push utilization rates higher and, in particular, would push the unemployment rate below its recent range. A tightening of monetary policy was motivated, from my perspective, not by the prevailing data on unemployment rates, wage change, and inflation, but rather by a forecast of where I expected utilization rates and inflation to be six months and a year from now, if monetary policy remained unchanged. Whereas I supported the earlier asymmetric directive based on concern that my forecast might be wrong, the preemptive policy action was motivated for me by concern that my (new) forecast might be correct! The case for a preemptive approach is that it alone holds the promise of sustaining a durable expansion with continued healthy, balanced growth. The greatest threat to expansions does not come from a spontaneous weakening of demand, from lethargy, but rather from over-exuberance and overheating. Once overheating unleashes an increase in inflation, the attempt to first control and then reverse the higher inflation often results in recession. This gives substance to the well-known worth of "an ounce of prevention." Let me now interpret the tightening in relation to several descriptions of monetary policy strategy. The first three really are alternative perspectives on a single essential principle of prudent monetary policy, the importance of leaning against the wind by enforcing pro-cyclical movements in short-term interest rates. The fourth reflects one way in which monetary policy might take into account the uncertainty in the outlook. I have noted in a number of previous speeches that I view the Taylor Rule as highlighting a couple of important requirements for prudent monetary policy. First, the Taylor Rule links Federal Reserve policy to a long-run inflation target and thus ensures that, in the long run, policy will force the actual inflation rate to converge to the long-run target. The Taylor Rule thus imposes a powerful nominal anchor on monetary policy. Second, the Taylor Rule generally imposes a pro-cyclical pattern on real short-term interest rates, so that monetary policy leans against the cyclical winds and thereby stabilizes the economy, in much the same way that automatic stabilizers in our fiscal institutions, via cyclical swings in government budget deficits, damp business cycles. Nevertheless, the traditional specification of the Taylor Rule does not provide a justification for tightening in March, relative to the earlier decisions to hold policy unchanged. According to the Taylor Rule, the federal funds rate should adjust over time to changes in utilization rates (the gap between actual and potential output or between the unemployment rate and NAIRU) and to changes in inflation. Because utilization rates had not increased (at least had not increased outside the range of the last year) and core inflation was actually lower in March compared with earlier, the Taylor Rule did not dictate a tightening. The Rule did suggest, however, that monetary policy would have had to tighten over time if the forecast of rising utilization rates and higher inflation proved correct. But it did not dictate immediate action. There is however an alternative specification of the Taylor Rule that does motivate an immediate tightening. I call this a forward looking version of the Taylor Rule. The traditional specification is forward looking to a degree in relation to inflation, in that it sets the funds rate in relation to both the utilization rate (an advance warning of future increases in inflation) and to inflation. But the forward-looking specification I have in mind replaces actual inflation and utilization rates in the rule with forecasts of future inflation and utilization rates. This approach to policy reaction functions was pioneered by Steve McNees of the Federal Reserve Bank of Boston in the mid 1980s and there has been a renewed interest in such an approach, in the context of the Taylor Rule, during the last couple of years. Such a forward-looking specification would rationalize and justify an increase in the funds rate in response to the forecast of rising utilization rates in the future. This leaves an interesting question. Does following a Taylor Rule based on an uncertain forecast outperform a Taylor Rule based on actual data? That, of course, depends on the quality of the forecasts. This is an interesting question, one that deserves scrutiny. But it is really the same as the question: Should policy be preemptive or reactive? As a forecaster, I am inclined to believe in the forward-looking approach and therefore in preemptive policy. But I recognize that further work should be done on this subject. I would interpret the recent strength in demand, from the perspective of an IS-LM model, as a shift in the IS curve. Such an interpretation of cyclical swings is, of course, in the Keynesian tradition: output is demand determined in the short run (reflecting price stickiness) and swings in output are dominated by autonomous changes in aggregate demand. How should monetary policy respond to cyclical swings in demand? Should monetary policy hold short-term interest rates constant, in effect imposing a horizontal LM curve? In order to do so, it would, in general, have to respond to rightward shifts in the IS curve by adding reserves and facilitating faster money growth, so as to prevent interest rates from rising. This might be appropriate very early in an expansion, when the unemployment rate is high and inflation is declining, but it is not, in my judgment, prudent in the mature stage of an expansion, and it is most surely imprudent once utilization rates have increased toward or beyond their capacity levels. The alternative is to maintain an upward sloping LM curve. In the static model, this is the case when the money supply is fixed; allowing for trend growth and inflation, it would be equivalent to holding money growth constant, assuming a stable money demand function. In this case, a shift in the IS curve would raise interest rates as the IS curve moved along the upward sloping LM curve. This is an example of monetary policy "leaning against the wind." The resulting pro-cyclical movement in interest rates increases the stability of the economy in much the same way as cyclical swings in the federal budget deficit. Some might argue, however, that even if short-term interest rates do not rise, long-term interest rates, equity prices, and the dollar may change in ways that damp the cyclical swing in demand and thereby lessen the necessity of a direct response of monetary policy. This is sometimes referred to as the "gyroscope" theory (the bond market is the economy's gyroscope) and the active part of management of the cycle is in the hands of so-called "bond market vigilantes," some of whom are undoubtedly in the audience this afternoon. When long-term rates rise in response to a cyclical strengthening, it reflects, in large part, the expectation of higher short-term interest rates. Specifically, it reflects expectations about monetary policy. While monetary policy cannot be a slave to the bond market, when the cyclical state of the economy suggests the desirability of a pro-cyclical response in interest rates, the Federal Reserve should pat the bond market on the back and appreciate its help, but not expect the bond market to carry the entire burden. Monetary policy in this case needs to validate the movement in the bond market, rather than resist it. If it does not, surely real long-term interest rates and the dollar will decrease, eroding the market restraint, and in the future markets will be less likely to perform this stabilizing function. Of course, there will be times when the bond market is, in our view, misreading the strength of the economy and hence also misjudging the future course of our policy. In this case, we should ignore the bond market and provide an anchor for long-term interest rates to adjust back toward. As I have just noted, a pro-cyclical path for short-term interest rates would result from following a money growth rule. For an extended period, money demand has been insufficiently stable to allow the monetary aggregates to play a constructive role in the monetary policy process. More recently, the relationship between M2 and its determinants has stabilized, but the period of a more stable relationship has been relatively brief and has coincided with a relatively stable economy. As a result, there is not yet much inclination to place increased weight on M2 in the policy process. What I am offering here is therefore only a thought experiment. Assume that the money demand function for M2 has stabilized and that we could conduct policy by enforcing a constant rate of M2 growth. Assuming policy maintained a fixed rate of money growth (perhaps the better way to define an unchanged policy), what would be the effect of a cyclical strengthening of the economy (an increase in nominal income growth)? The answer, of course, is that short-term interest rates would rise. This is of course just another way of telling the IS-LM story. What would it take to prevent interest rates from rising? The answer is that an increase in the rate of money growth would be required to accommodate the faster pace of nominal income growth. But would this be prudent? I think not. Note that under a money growth strategy, it is possible to operate without a change in policy (no change in money growth) while nevertheless imposing an important degree of stability to the economy through the resulting pro-cyclical movement in interest rates. A constant rate of money supply will not always be optimal, but it will keep you out of a lot of serious trouble you could otherwise get into. The Federal Reserve and virtually all other central banks operate in a policy regime in which we set some short-term interest rate -- in our case, the federal funds rate. For a variety of reasons, this is generally viewed as the best choice of operating strategy. In this type of regime, however, it is more dangerous to be passive and fail to respond to changing economic conditions. The prudent pro-cyclical pattern in interest rates, in particular, must be actively put in place, rather than passively served up as would be the case with a policy of constant money growth. It is important to recognize the importance of moving interest rates in response to changing conditions and the potential for destabilizing policy when policy resists the natural tendency for interest rates to rise during cyclical upswings, especially when the economy is near its potential. Indeed, the major monetary policy mistakes in the past have not originated in overly aggressive movements in interest rates, but in the failure of policy to adjust interest rates in a timely fashion to changes in cyclical developments. I noted at the outset the uncertainties in the outlook. As a result, it is possible to make policy mistakes. Another way of interpreting the policy action is as an attempt to avoid the worst possible errors in an uncertain environment. I call this a maximin solution to the policy problem. It involves comparing the relative costs of two potential policy mistakes in the current uncertain environment: tightening when such a move turned out to be inappropriate and failing to tighten when a tightening would have been appropriate. The maximin solution (patterned after the solution to the "prisoners' dilemma") is to select the option that would yield the smaller cost if the policy turned out to be a mistake. This analysis does not, in this case, help one to understand why the policy action was taken in March, rather than earlier. But it does provide a perspective on the role of uncertainty in the setting of monetary policy. If the Fed tightens and it turns out to have been unnecessary, the result would be that utilization rates turn out lower than desired and inflation lower than would otherwise have been the case. In the context of the prevailing 7 -year low of the unemployment rate, that translates into a higher but still modest unemployment rate and further progress toward price stability, a central legislative mandate. This may not be the best solution. I would prefer, in the near term, trend growth at full employment with a continuation of the prevailing modest inflation rate. But the alternative outcome just described is not a bad result -- indeed, it would be a preferred result for those who favor a more rapid convergence to price stability. If the Fed fails to tighten when it would have been appropriate, the result would be higher utilization rates and higher inflation than desirable. To the extent that the result is a persistent excess demand gap, inflation will steadily rise over time. This outcome will yield what I call the Taylor Rule's "triple whammy." Once inflation takes off, interest rates will have to be raised first to prevent a decline in real rates, second to erase the increase in output beyond the economy's productive capacity, and third to lower inflation relative to the inflation target. This is an affair that almost always turns out be ugly, and poses a much greater threat to a sustained expansion, in my view, than a premature tightening. I always taught my students that there was an answer that worked remarkably well most of the time to interesting questions in economics: "It depends." And this is the only answer I can offer to this second question of the day. But let me discuss some of the considerations likely to condition my judgment about policy in coming months. I would make a sharp distinction between the action of March 25 and the initial move in February 1994. Before the tightening in February 1994, monetary policy had been in an unprecedentedly stimulative posture into the third year of an expansion -- with the real federal funds rate at zero! This was justified by the unusually slow and erratic nature of the recovery up to this point. However, once the economy moved into a self-sustaining mode, as was the case during 1994, it was clear that the funds rate would quickly move toward its longer-run equilibrium level, meaning at least a 200 basis point increase, and the market was jolted into this realization by the Fed's initial move. In the current environment, entering the seventh year of the expansion, the real federal funds rate is already above its longer-term average. Looking ahead, monetary policy decisions will, as one would expect, depend on how the economy evolves in coming months. I will be focusing, in particular, on whether growth is continuing above trend with utilization rates rising further and whether inflation pressures are mounting at current utilization rates. If I have made the setting of monetary policy in an environment characterized by numerous uncertainties appear to be a challenging task, I have accomplished one of my goals. While such uncertainty can affect the timing and aggressiveness of policy action, it is important that uncertainty does not paralyze monetary policy, especially under an interest rate policy regime. It is essential that monetary policy "leans against the wind," and the best way to do so is by enforcing a pro-cyclical pattern in short-term interest rates. This requires that real interest rates rise as long as growth is above-trend and utilization rates are rising. An exception to this regularity is in the early stages of an expansion, when utilization rates are at a cyclical low and inflation may be falling. In addition, as production approaches capacity, it is appropriate that policy become still more preemptive. One way for policy to be more preemptive is to respond to forecasts of rising utilization rates and higher inflation, especially when supported by a recent pattern of strong growth and evidence of continued momentum. One can take an optimistic or pessimistic view of the recent Fed tightening. A pessimistic reading would be that the move was unnecessary and that the economy is going to quickly move from rapid growth into a slump, or at least that the Federal Reserve is constraining the economy from achieving its maximum sustainable rate of growth. An alternative pessimistic assessment is that the policy move was too little, too late, so that the failure to act more swiftly and more aggressively has set the stage for a resurgence in inflation that will threaten the expansion. An optimistic assessment is that the March 25 move was a small, prudent, and preemptive step to lean against the strengthening cyclical forces and will increase the prospects of a continuation of an expansion with healthy but sustainable growth and continued modest inflation. Count me among the optimists.
1997-04-29T00:00:00	Mr. Greenspan offers his thoughts on the efforts currently being made relating to supervision and regulation of the financial markets (Central Bank Articles and Speeches, 29 Apr 97)	Remarks by the Chairman of the US Federal Reserve System, Mr. Alan Greenspan, at the Spring Meeting of the Institute of International Finance in Washington on 29/4/97.	Mr. Greenspan offers his thoughts on the efforts currently being made relating to supervision and regulation of the financial markets Remarks by the Chairman of the US Federal Reserve System, Mr. Alan Greenspan, at the Spring Meeting of the Institute of International Finance in Washington on 29/4/97. I will take this occasion to offer some thoughts related to the upcoming G-7 economic summit meeting, which will be held in Denver in less than two months. One theme in recent summit meetings -- starting in Halifax in 1995 and continuing in Lyon last year -- has been the promotion of stability in international financial markets. My purpose today is not to describe all the efforts that have been made in that regard, which relate primarily to supervision and regulation. Rather, I would like to step back a bit and offer a framework for thinking about those efforts. To begin with, we should not lose sight of the fact that government regulation, if not carefully designed, can undermine the effectiveness of private market regulation and can itself be ineffective in protecting the public interest. No market is ever truly unregulated in that the self-interest of participants generates private market regulation. Counterparties thoroughly scrutinize each other, often requiring collateral and special legal protections; self-regulated clearing houses and exchanges set margins and capital requirements to protect the interests of the members. Thus, the real question is not whether a market should be regulated. Rather, it is whether government intervention strengthens or weakens private regulation, and at what cost. At worst, the introduction of government rules may actually weaken the effectiveness of regulation if government regulation is itself ineffective or, more importantly, undermines incentives for private market regulation. Regulation by government unavoidably involves some element of perverse incentives, that is, moral hazard. If private market participants believe that government is protecting their interests, their own efforts to do so will diminish. At the same time, societies have judged that it is not sufficient to rely exclusively on the private sector to ensure the adequacy of the management of risk in our financial systems. There is a perceived need for supervision and regulation by the public sector, as well. As I will point out shortly, this need arises largely to counter the potential moral hazard that arises as a consequence of the development of large safety nets for our financial systems. Many of the benefits banks provide modern societies derive from their willingness to take risks and from their use of a relatively high degree of financial leverage. Through leverage, in the form principally of taking deposits, banks perform a critical role in the financial intermediation process; they provide savers with additional investment choices and borrowers with a greater range of sources of credit, thereby facilitating a more efficient allocation of resources and contributing importantly to greater economic growth. Indeed, it has been the evident value of intermediation and leverage that has shaped the development of our financial systems from the earliest times -- certainly since Renaissance goldsmiths discovered that lending out deposited gold was feasible and profitable. Central bank provision of mechanisms for converting highly illiquid portfolios into liquid ones in extraordinary circumstances -- a key element of our safety nets -- has led to a greater degree of leverage in banking than market forces alone would support. Traditionally these mechanisms involve making discount or Lombard facilities available, so that individual depositories could turn illiquid assets into liquid resources and not exacerbate unsettled market conditions by the forced selling of such assets or the calling of loans. More broadly, open market operations, in situations like that which followed the crash of stock markets around the world in 1987, satisfy increased needs for liquidity for the system as a whole that otherwise could feed cumulative, self-reinforcing contractions across many financial markets. Of course, this same leverage and risk-taking also greatly increase the possibility of bank failures. Without leverage, losses from risk-taking would be absorbed by a bank's owners, virtually eliminating the chance that the bank would be unable to meet its obligations in the case of a "failure." Some failures can be of a bank's own making, resulting, for example, from poor credit judgments. For the most part, these failures are a normal and important part of the market process and provide discipline and information to other participants regarding the level of business risks. However, because of the important roles that banks and other financial intermediaries play in our financial systems, such failures could have large ripple effects that spread throughout business and financial markets at great cost. The presence of the safety net, which inevitably imparts a subsidy to banks, has created a disconnect between risk-taking by banks and banks' cost of capital. It is this disconnect that has made necessary a degree of supervision and regulation that would not be necessary without the existence of the safety net. That is, regulators are compelled to act as a surrogate for market discipline since the market signals that usually accompany excessive risk-taking are substantially muted, and because the prices to banks of government deposit guarantees, or of access to the safety net more generally, do not, and probably cannot, vary sufficiently with risk to mimic market prices. The problems that arise from the retarding of the pressures of market discipline have led us increasingly to accept supervision and regulation that endeavors to simulate the market responses that would occur if there were no safety net, but without giving up its protections. To be sure, we should recognize that if we choose to have the advantages of a safety net and a leveraged system of financial intermediaries, the burden of managing risk in the financial system will not lie with the private sector alone. With leveraging there will always exist a remote possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked. Only a modern central bank, with its unlimited power to create money, can with a high probability thwart such a process before it becomes destructive. Hence, central banks will of necessity be drawn into becoming lenders of last resort. But implicit in the existence of such a role is that there will be some form of allocation between the public and private sectors of the burden of risk of extreme outcomes. Thus, central banks are led to provide what essentially amounts to catastrophic financial insurance coverage. Such a public subsidy should be reserved for only the rarest of disasters. If the owners or managers of private financial institutions were to anticipate being propped up frequently by government support, it would only encourage reckless and irresponsible practices. In theory, the allocation of responsibility for risk-bearing between the private sector and the central bank depends upon an evaluation of the private cost of capital. In order to attract, or at least retain, capital, a private financial institution must earn at minimum the overall economy's rate of return, adjusted for risk. In competitive financial markets, the greater the leverage, the higher the rate of return, before adjustment for risk. If private financial institutions have to absorb all financial risk, then the degree to which they can leverage will be limited, the financial sector smaller, and its contribution to the economy more limited. On the other hand, if central banks effectively insulate private institutions from the largest potential losses, however incurred, increased laxity could threaten a major drain on taxpayers or produce inflationary instability as a consequence of excess money creation. Thus, governments, including central banks, have been given certain responsibilities related to their banking and financial systems that must be balanced. We have the responsibility to prevent major financial market disruptions through development and enforcement of prudent regulatory standards and, if necessary in rare circumstances, through direct intervention in market events. But we also have the responsibility to ensure that private sector institutions have the capacity to take prudent and appropriate risks. Our goal as supervisors should not be to prevent all bank failures, but to maintain sufficient prudential standards so that banking problems that do occur do not become widespread. We try to achieve the proper balance through official regulations, as well as through formal and informal supervisory policies and procedures. The revolution in information and data processing technology has transformed our financial markets and the way our financial institutions conduct their operations. In most respects, these technological advances have enhanced the potential for reducing transactions costs, to the benefit of consumers of financial services, and for managing risks. But in some respects they have increased the potential for more rapid and widespread disruption. The efficiency of global financial markets, engendered by the rapid proliferation of financial products, has the capability of transmitting mistakes at a far faster pace throughout the financial system in ways that were unknown a generation ago, and not even remotely imagined in the 19th century. Financial crises in the early 19th century, for example, particularly those associated with the Napoleonic Wars, were often related to military and other events in faraway places. Communication was still comparatively primitive. An investor's speculative position could be wiped out by a military setback, and he might not even know about it for days or even weeks, which, from the perspective of central banking today, might be considered bliss. Similarly, the collapse of Barings Brothers in 1995 showed how much more rapidly losses can be generated in the current environment relative to a century earlier when Barings Brothers confronted a similar episode. Current technology enables single individuals to initiate massive transactions with very rapid execution. Clearly, not only has the productivity of global finance increased markedly, but so, obviously, has the ability to generate losses at a previously inconceivable rate. These technological forces also have been central to the process of globalization, that is, the growing integration of national economies -- including national financial markets. They are, of course, not the only forces. The gradual removal of barriers to trade, deregulation and reform of financial systems, and simply the enormous creation of wealth have all generated the demand and opportunities for the expansion of investment and business horizons beyond national boundaries. Technological changes have facilitated such an expansion. The growing importance of emerging market economies in international financial markets is one manifestation not just of the impressive growth of those economies but also of increasing global integration. Thus, it is not surprising that the need to promote financial stability, and in particular to enhance prudential supervision, in emerging market economies was identified at the Lyon summit as an important objective. It is important for those economies individually and for all of us collectively. One element of the follow-up to the Lyon summit that is especially fitting in the context of my earlier remarks has been efforts to enhance market transparency, including more - and more meaningful -- public disclosure. Meaningful public disclosures by firms about the nature of their risk exposures and their procedures for managing those risks contribute significantly to the constructive role of market discipline. Not surprisingly, the market itself is probably the most powerful source of pressure for improved disclosures. I might mention one specific accomplishment related to market transparency. Central banks have agreed to establish a system of regular reporting of derivatives activities by the world's major dealers, beginning as of June 1998. The system has been designed to yield aggregate data on global trading activities in a manner that avoids double counting and is sensitive to reporting burden. The aggregate data will be publicly released to enable firms to assess their own activities in relation to the market as a whole. The globalization of international financial markets and of the operations of individual firms clearly calls for international cooperation among supervisors. Correspondingly, supervisory cooperation is an important element of the G-7 summit agenda on financial stability. Much of the recent work has related to the desirability of a more systematic exchange of information among national supervisors, including consideration of what kinds of information need to be exchanged and under what circumstances. The possible need for and possible roles of an "information coordinator" have been central issues in the Joint Forum discussions. The objective of a more systematic exchange of information is easy to support in principle. However, when it comes to implementation, there are questions that need to be addressed. Even more questions arise when one thinks of going beyond the exchange of information to other forms of supervisory coordination, involving a "lead regulator" of some kind that is intended to fill so-called supervisory gaps. What are the supervisory gaps that need to be filled? Each of us could probably point to episodes where problems could have been avoided, or the degree of disruption could have been reduced, if better information had been available sooner to supervisory authorities. Perhaps Barings is one example. It is more difficult to point to episodes when the absence of formal arrangements for coordination of supervisory actions inhibited a response to a problem. Conversely, might arrangements that are too formal, too rigid, or too cumbersome themselves inhibit appropriate responses in emergency situations, each of which is likely to be unique? Another question is whether supervisory authorities have the expertise and resources to provide meaningful oversight and develop accurate assessments of the risk-taking activities of large, diversified, globally active financial institutions. If the answer is no, as might well be the case, should we nevertheless convey to market participants the sense that we are in fact adequately supervising such activities? Wouldn't that reduce the incentives for market participants themselves to provide discipline? Would a statement that all major financial firms, even the most diversified ones, are subject to coordinated supervision suggest a degree of support that effectively extends, to an unwarranted extent, the subsidy associated with national safety nets? Would it generate a degree of moral hazard that could itself be the source of systemic risk? The answers to these questions are not straightforward. However, while many firms should reassess and upgrade their risk management procedures, and supervisors should improve their procedures as well, I do not believe that the need for a radical change in our framework for the supervision of internationally active financial firms has been demonstrated. The paradigm of supervision itself is, of necessity, continuously adjusted to the rapidly changing, technologically driven financial system. In recent years, firms and supervisors alike have sought to harness technological advances to enhance risk management procedures. Much thought has been given to how to make public disclosure more meaningful and to reinforce market discipline. Supervisors around the world, not just in the major industrial countries, have gotten to know each other better and to understand better each others' problems and policies. The legal and institutional infrastructure of financial markets has been significantly improved. Along with good macroeconomic policy -- a topic for another day -- a continuation of this ongoing process of careful and measured progress represents the most constructive strategy for ensuring financial stability.	---[PAGE_BREAK]--- Mr. Greenspan offers his thoughts on the efforts currently being made relating to supervision and regulation of the financial markets Remarks by the Chairman of the US Federal Reserve System, Mr. Alan Greenspan, at the Spring Meeting of the Institute of International Finance in Washington on 29/4/97. I will take this occasion to offer some thoughts related to the upcoming G-7 economic summit meeting, which will be held in Denver in less than two months. One theme in recent summit meetings -- starting in Halifax in 1995 and continuing in Lyon last year -- has been the promotion of stability in international financial markets. My purpose today is not to describe all the efforts that have been made in that regard, which relate primarily to supervision and regulation. Rather, I would like to step back a bit and offer a framework for thinking about those efforts. To begin with, we should not lose sight of the fact that government regulation, if not carefully designed, can undermine the effectiveness of private market regulation and can itself be ineffective in protecting the public interest. No market is ever truly unregulated in that the self-interest of participants generates private market regulation. Counterparties thoroughly scrutinize each other, often requiring collateral and special legal protections; self-regulated clearing houses and exchanges set margins and capital requirements to protect the interests of the members. Thus, the real question is not whether a market should be regulated. Rather, it is whether government intervention strengthens or weakens private regulation, and at what cost. At worst, the introduction of government rules may actually weaken the effectiveness of regulation if government regulation is itself ineffective or, more importantly, undermines incentives for private market regulation. Regulation by government unavoidably involves some element of perverse incentives, that is, moral hazard. If private market participants believe that government is protecting their interests, their own efforts to do so will diminish. At the same time, societies have judged that it is not sufficient to rely exclusively on the private sector to ensure the adequacy of the management of risk in our financial systems. There is a perceived need for supervision and regulation by the public sector, as well. As I will point out shortly, this need arises largely to counter the potential moral hazard that arises as a consequence of the development of large safety nets for our financial systems. Many of the benefits banks provide modern societies derive from their willingness to take risks and from their use of a relatively high degree of financial leverage. Through leverage, in the form principally of taking deposits, banks perform a critical role in the financial intermediation process; they provide savers with additional investment choices and borrowers with a greater range of sources of credit, thereby facilitating a more efficient allocation of resources and contributing importantly to greater economic growth. Indeed, it has been the evident value of intermediation and leverage that has shaped the development of our financial systems from the earliest times -- certainly since Renaissance goldsmiths discovered that lending out deposited gold was feasible and profitable. Central bank provision of mechanisms for converting highly illiquid portfolios into liquid ones in extraordinary circumstances -- a key element of our safety nets -- has led to a greater degree of leverage in banking than market forces alone would support. Traditionally these mechanisms involve making discount or Lombard facilities available, so that individual depositories could turn illiquid assets into liquid resources and not exacerbate unsettled market conditions by the forced selling of such assets or the calling of loans. More broadly, open market operations, in situations like that which followed the crash of stock markets around the world in ---[PAGE_BREAK]--- 1987, satisfy increased needs for liquidity for the system as a whole that otherwise could feed cumulative, self-reinforcing contractions across many financial markets. Of course, this same leverage and risk-taking also greatly increase the possibility of bank failures. Without leverage, losses from risk-taking would be absorbed by a bank's owners, virtually eliminating the chance that the bank would be unable to meet its obligations in the case of a "failure." Some failures can be of a bank's own making, resulting, for example, from poor credit judgments. For the most part, these failures are a normal and important part of the market process and provide discipline and information to other participants regarding the level of business risks. However, because of the important roles that banks and other financial intermediaries play in our financial systems, such failures could have large ripple effects that spread throughout business and financial markets at great cost. The presence of the safety net, which inevitably imparts a subsidy to banks, has created a disconnect between risk-taking by banks and banks' cost of capital. It is this disconnect that has made necessary a degree of supervision and regulation that would not be necessary without the existence of the safety net. That is, regulators are compelled to act as a surrogate for market discipline since the market signals that usually accompany excessive risk-taking are substantially muted, and because the prices to banks of government deposit guarantees, or of access to the safety net more generally, do not, and probably cannot, vary sufficiently with risk to mimic market prices. The problems that arise from the retarding of the pressures of market discipline have led us increasingly to accept supervision and regulation that endeavors to simulate the market responses that would occur if there were no safety net, but without giving up its protections. To be sure, we should recognize that if we choose to have the advantages of a safety net and a leveraged system of financial intermediaries, the burden of managing risk in the financial system will not lie with the private sector alone. With leveraging there will always exist a remote possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked. Only a modern central bank, with its unlimited power to create money, can with a high probability thwart such a process before it becomes destructive. Hence, central banks will of necessity be drawn into becoming lenders of last resort. But implicit in the existence of such a role is that there will be some form of allocation between the public and private sectors of the burden of risk of extreme outcomes. Thus, central banks are led to provide what essentially amounts to catastrophic financial insurance coverage. Such a public subsidy should be reserved for only the rarest of disasters. If the owners or managers of private financial institutions were to anticipate being propped up frequently by government support, it would only encourage reckless and irresponsible practices. In theory, the allocation of responsibility for risk-bearing between the private sector and the central bank depends upon an evaluation of the private cost of capital. In order to attract, or at least retain, capital, a private financial institution must earn at minimum the overall economy's rate of return, adjusted for risk. In competitive financial markets, the greater the leverage, the higher the rate of return, before adjustment for risk. If private financial institutions have to absorb all financial risk, then the degree to which they can leverage will be limited, the financial sector smaller, and its contribution to the economy more limited. On the other hand, if central banks effectively insulate private institutions from the largest potential losses, however incurred, increased laxity could threaten a major drain on taxpayers or produce inflationary instability as a consequence of excess money creation. ---[PAGE_BREAK]--- Thus, governments, including central banks, have been given certain responsibilities related to their banking and financial systems that must be balanced. We have the responsibility to prevent major financial market disruptions through development and enforcement of prudent regulatory standards and, if necessary in rare circumstances, through direct intervention in market events. But we also have the responsibility to ensure that private sector institutions have the capacity to take prudent and appropriate risks. Our goal as supervisors should not be to prevent all bank failures, but to maintain sufficient prudential standards so that banking problems that do occur do not become widespread. We try to achieve the proper balance through official regulations, as well as through formal and informal supervisory policies and procedures. The revolution in information and data processing technology has transformed our financial markets and the way our financial institutions conduct their operations. In most respects, these technological advances have enhanced the potential for reducing transactions costs, to the benefit of consumers of financial services, and for managing risks. But in some respects they have increased the potential for more rapid and widespread disruption. The efficiency of global financial markets, engendered by the rapid proliferation of financial products, has the capability of transmitting mistakes at a far faster pace throughout the financial system in ways that were unknown a generation ago, and not even remotely imagined in the 19th century. Financial crises in the early 19th century, for example, particularly those associated with the Napoleonic Wars, were often related to military and other events in faraway places. Communication was still comparatively primitive. An investor's speculative position could be wiped out by a military setback, and he might not even know about it for days or even weeks, which, from the perspective of central banking today, might be considered bliss. Similarly, the collapse of Barings Brothers in 1995 showed how much more rapidly losses can be generated in the current environment relative to a century earlier when Barings Brothers confronted a similar episode. Current technology enables single individuals to initiate massive transactions with very rapid execution. Clearly, not only has the productivity of global finance increased markedly, but so, obviously, has the ability to generate losses at a previously inconceivable rate. These technological forces also have been central to the process of globalization, that is, the growing integration of national economies -- including national financial markets. They are, of course, not the only forces. The gradual removal of barriers to trade, deregulation and reform of financial systems, and simply the enormous creation of wealth have all generated the demand and opportunities for the expansion of investment and business horizons beyond national boundaries. Technological changes have facilitated such an expansion. The growing importance of emerging market economies in international financial markets is one manifestation not just of the impressive growth of those economies but also of increasing global integration. Thus, it is not surprising that the need to promote financial stability, and in particular to enhance prudential supervision, in emerging market economies was identified at the Lyon summit as an important objective. It is important for those economies individually and for all of us collectively. One element of the follow-up to the Lyon summit that is especially fitting in the context of my earlier remarks has been efforts to enhance market transparency, including more -- and more meaningful -- public disclosure. Meaningful public disclosures by firms about the ---[PAGE_BREAK]--- nature of their risk exposures and their procedures for managing those risks contribute significantly to the constructive role of market discipline. Not surprisingly, the market itself is probably the most powerful source of pressure for improved disclosures. I might mention one specific accomplishment related to market transparency. Central banks have agreed to establish a system of regular reporting of derivatives activities by the world's major dealers, beginning as of June 1998. The system has been designed to yield aggregate data on global trading activities in a manner that avoids double counting and is sensitive to reporting burden. The aggregate data will be publicly released to enable firms to assess their own activities in relation to the market as a whole. The globalization of international financial markets and of the operations of individual firms clearly calls for international cooperation among supervisors. Correspondingly, supervisory cooperation is an important element of the G-7 summit agenda on financial stability. Much of the recent work has related to the desirability of a more systematic exchange of information among national supervisors, including consideration of what kinds of information need to be exchanged and under what circumstances. The possible need for and possible roles of an "information coordinator" have been central issues in the Joint Forum discussions. The objective of a more systematic exchange of information is easy to support in principle. However, when it comes to implementation, there are questions that need to be addressed. Even more questions arise when one thinks of going beyond the exchange of information to other forms of supervisory coordination, involving a "lead regulator" of some kind that is intended to fill so-called supervisory gaps. What are the supervisory gaps that need to be filled? Each of us could probably point to episodes where problems could have been avoided, or the degree of disruption could have been reduced, if better information had been available sooner to supervisory authorities. Perhaps Barings is one example. It is more difficult to point to episodes when the absence of formal arrangements for coordination of supervisory actions inhibited a response to a problem. Conversely, might arrangements that are too formal, too rigid, or too cumbersome themselves inhibit appropriate responses in emergency situations, each of which is likely to be unique? Another question is whether supervisory authorities have the expertise and resources to provide meaningful oversight and develop accurate assessments of the risk-taking activities of large, diversified, globally active financial institutions. If the answer is no, as might well be the case, should we nevertheless convey to market participants the sense that we are in fact adequately supervising such activities? Wouldn't that reduce the incentives for market participants themselves to provide discipline? Would a statement that all major financial firms, even the most diversified ones, are subject to coordinated supervision suggest a degree of support that effectively extends, to an unwarranted extent, the subsidy associated with national safety nets? Would it generate a degree of moral hazard that could itself be the source of systemic risk? The answers to these questions are not straightforward. However, while many firms should reassess and upgrade their risk management procedures, and supervisors should improve their procedures as well, I do not believe that the need for a radical change in our framework for the supervision of internationally active financial firms has been demonstrated. The paradigm of supervision itself is, of necessity, continuously adjusted to the rapidly changing, technologically driven financial system. In recent years, firms and supervisors alike ---[PAGE_BREAK]--- have sought to harness technological advances to enhance risk management procedures. Much thought has been given to how to make public disclosure more meaningful and to reinforce market discipline. Supervisors around the world, not just in the major industrial countries, have gotten to know each other better and to understand better each others' problems and policies. The legal and institutional infrastructure of financial markets has been significantly improved. Along with good macroeconomic policy -- a topic for another day -- a continuation of this ongoing process of careful and measured progress represents the most constructive strategy for ensuring financial stability.	Alan Greenspan	United States	https://www.bis.org/review/r970509e.pdf	Mr. Greenspan offers his thoughts on the efforts currently being made relating to supervision and regulation of the financial markets Remarks by the Chairman of the US Federal Reserve System, Mr. Alan Greenspan, at the Spring Meeting of the Institute of International Finance in Washington on 29/4/97. I will take this occasion to offer some thoughts related to the upcoming G-7 economic summit meeting, which will be held in Denver in less than two months. One theme in recent summit meetings -- starting in Halifax in 1995 and continuing in Lyon last year -- has been the promotion of stability in international financial markets. My purpose today is not to describe all the efforts that have been made in that regard, which relate primarily to supervision and regulation. Rather, I would like to step back a bit and offer a framework for thinking about those efforts. To begin with, we should not lose sight of the fact that government regulation, if not carefully designed, can undermine the effectiveness of private market regulation and can itself be ineffective in protecting the public interest. No market is ever truly unregulated in that the self-interest of participants generates private market regulation. Counterparties thoroughly scrutinize each other, often requiring collateral and special legal protections; self-regulated clearing houses and exchanges set margins and capital requirements to protect the interests of the members. Thus, the real question is not whether a market should be regulated. Rather, it is whether government intervention strengthens or weakens private regulation, and at what cost. At worst, the introduction of government rules may actually weaken the effectiveness of regulation if government regulation is itself ineffective or, more importantly, undermines incentives for private market regulation. Regulation by government unavoidably involves some element of perverse incentives, that is, moral hazard. If private market participants believe that government is protecting their interests, their own efforts to do so will diminish. At the same time, societies have judged that it is not sufficient to rely exclusively on the private sector to ensure the adequacy of the management of risk in our financial systems. There is a perceived need for supervision and regulation by the public sector, as well. As I will point out shortly, this need arises largely to counter the potential moral hazard that arises as a consequence of the development of large safety nets for our financial systems. Many of the benefits banks provide modern societies derive from their willingness to take risks and from their use of a relatively high degree of financial leverage. Through leverage, in the form principally of taking deposits, banks perform a critical role in the financial intermediation process; they provide savers with additional investment choices and borrowers with a greater range of sources of credit, thereby facilitating a more efficient allocation of resources and contributing importantly to greater economic growth. Indeed, it has been the evident value of intermediation and leverage that has shaped the development of our financial systems from the earliest times -- certainly since Renaissance goldsmiths discovered that lending out deposited gold was feasible and profitable. Central bank provision of mechanisms for converting highly illiquid portfolios into liquid ones in extraordinary circumstances -- a key element of our safety nets -- has led to a greater degree of leverage in banking than market forces alone would support. Traditionally these mechanisms involve making discount or Lombard facilities available, so that individual depositories could turn illiquid assets into liquid resources and not exacerbate unsettled market conditions by the forced selling of such assets or the calling of loans. More broadly, open market operations, in situations like that which followed the crash of stock markets around the world in 1987, satisfy increased needs for liquidity for the system as a whole that otherwise could feed cumulative, self-reinforcing contractions across many financial markets. Of course, this same leverage and risk-taking also greatly increase the possibility of bank failures. Without leverage, losses from risk-taking would be absorbed by a bank's owners, virtually eliminating the chance that the bank would be unable to meet its obligations in the case of a "failure." Some failures can be of a bank's own making, resulting, for example, from poor credit judgments. For the most part, these failures are a normal and important part of the market process and provide discipline and information to other participants regarding the level of business risks. However, because of the important roles that banks and other financial intermediaries play in our financial systems, such failures could have large ripple effects that spread throughout business and financial markets at great cost. The presence of the safety net, which inevitably imparts a subsidy to banks, has created a disconnect between risk-taking by banks and banks' cost of capital. It is this disconnect that has made necessary a degree of supervision and regulation that would not be necessary without the existence of the safety net. That is, regulators are compelled to act as a surrogate for market discipline since the market signals that usually accompany excessive risk-taking are substantially muted, and because the prices to banks of government deposit guarantees, or of access to the safety net more generally, do not, and probably cannot, vary sufficiently with risk to mimic market prices. The problems that arise from the retarding of the pressures of market discipline have led us increasingly to accept supervision and regulation that endeavors to simulate the market responses that would occur if there were no safety net, but without giving up its protections. To be sure, we should recognize that if we choose to have the advantages of a safety net and a leveraged system of financial intermediaries, the burden of managing risk in the financial system will not lie with the private sector alone. With leveraging there will always exist a remote possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked. Only a modern central bank, with its unlimited power to create money, can with a high probability thwart such a process before it becomes destructive. Hence, central banks will of necessity be drawn into becoming lenders of last resort. But implicit in the existence of such a role is that there will be some form of allocation between the public and private sectors of the burden of risk of extreme outcomes. Thus, central banks are led to provide what essentially amounts to catastrophic financial insurance coverage. Such a public subsidy should be reserved for only the rarest of disasters. If the owners or managers of private financial institutions were to anticipate being propped up frequently by government support, it would only encourage reckless and irresponsible practices. In theory, the allocation of responsibility for risk-bearing between the private sector and the central bank depends upon an evaluation of the private cost of capital. In order to attract, or at least retain, capital, a private financial institution must earn at minimum the overall economy's rate of return, adjusted for risk. In competitive financial markets, the greater the leverage, the higher the rate of return, before adjustment for risk. If private financial institutions have to absorb all financial risk, then the degree to which they can leverage will be limited, the financial sector smaller, and its contribution to the economy more limited. On the other hand, if central banks effectively insulate private institutions from the largest potential losses, however incurred, increased laxity could threaten a major drain on taxpayers or produce inflationary instability as a consequence of excess money creation. Thus, governments, including central banks, have been given certain responsibilities related to their banking and financial systems that must be balanced. We have the responsibility to prevent major financial market disruptions through development and enforcement of prudent regulatory standards and, if necessary in rare circumstances, through direct intervention in market events. But we also have the responsibility to ensure that private sector institutions have the capacity to take prudent and appropriate risks. Our goal as supervisors should not be to prevent all bank failures, but to maintain sufficient prudential standards so that banking problems that do occur do not become widespread. We try to achieve the proper balance through official regulations, as well as through formal and informal supervisory policies and procedures. The revolution in information and data processing technology has transformed our financial markets and the way our financial institutions conduct their operations. In most respects, these technological advances have enhanced the potential for reducing transactions costs, to the benefit of consumers of financial services, and for managing risks. But in some respects they have increased the potential for more rapid and widespread disruption. The efficiency of global financial markets, engendered by the rapid proliferation of financial products, has the capability of transmitting mistakes at a far faster pace throughout the financial system in ways that were unknown a generation ago, and not even remotely imagined in the 19th century. Financial crises in the early 19th century, for example, particularly those associated with the Napoleonic Wars, were often related to military and other events in faraway places. Communication was still comparatively primitive. An investor's speculative position could be wiped out by a military setback, and he might not even know about it for days or even weeks, which, from the perspective of central banking today, might be considered bliss. Similarly, the collapse of Barings Brothers in 1995 showed how much more rapidly losses can be generated in the current environment relative to a century earlier when Barings Brothers confronted a similar episode. Current technology enables single individuals to initiate massive transactions with very rapid execution. Clearly, not only has the productivity of global finance increased markedly, but so, obviously, has the ability to generate losses at a previously inconceivable rate. These technological forces also have been central to the process of globalization, that is, the growing integration of national economies -- including national financial markets. They are, of course, not the only forces. The gradual removal of barriers to trade, deregulation and reform of financial systems, and simply the enormous creation of wealth have all generated the demand and opportunities for the expansion of investment and business horizons beyond national boundaries. Technological changes have facilitated such an expansion. The growing importance of emerging market economies in international financial markets is one manifestation not just of the impressive growth of those economies but also of increasing global integration. Thus, it is not surprising that the need to promote financial stability, and in particular to enhance prudential supervision, in emerging market economies was identified at the Lyon summit as an important objective. It is important for those economies individually and for all of us collectively. One element of the follow-up to the Lyon summit that is especially fitting in the context of my earlier remarks has been efforts to enhance market transparency, including more -- and more meaningful -- public disclosure. Meaningful public disclosures by firms about the nature of their risk exposures and their procedures for managing those risks contribute significantly to the constructive role of market discipline. Not surprisingly, the market itself is probably the most powerful source of pressure for improved disclosures. I might mention one specific accomplishment related to market transparency. Central banks have agreed to establish a system of regular reporting of derivatives activities by the world's major dealers, beginning as of June 1998. The system has been designed to yield aggregate data on global trading activities in a manner that avoids double counting and is sensitive to reporting burden. The aggregate data will be publicly released to enable firms to assess their own activities in relation to the market as a whole. The globalization of international financial markets and of the operations of individual firms clearly calls for international cooperation among supervisors. Correspondingly, supervisory cooperation is an important element of the G-7 summit agenda on financial stability. Much of the recent work has related to the desirability of a more systematic exchange of information among national supervisors, including consideration of what kinds of information need to be exchanged and under what circumstances. The possible need for and possible roles of an "information coordinator" have been central issues in the Joint Forum discussions. The objective of a more systematic exchange of information is easy to support in principle. However, when it comes to implementation, there are questions that need to be addressed. Even more questions arise when one thinks of going beyond the exchange of information to other forms of supervisory coordination, involving a "lead regulator" of some kind that is intended to fill so-called supervisory gaps. What are the supervisory gaps that need to be filled? Each of us could probably point to episodes where problems could have been avoided, or the degree of disruption could have been reduced, if better information had been available sooner to supervisory authorities. Perhaps Barings is one example. It is more difficult to point to episodes when the absence of formal arrangements for coordination of supervisory actions inhibited a response to a problem. Conversely, might arrangements that are too formal, too rigid, or too cumbersome themselves inhibit appropriate responses in emergency situations, each of which is likely to be unique? Another question is whether supervisory authorities have the expertise and resources to provide meaningful oversight and develop accurate assessments of the risk-taking activities of large, diversified, globally active financial institutions. If the answer is no, as might well be the case, should we nevertheless convey to market participants the sense that we are in fact adequately supervising such activities? Wouldn't that reduce the incentives for market participants themselves to provide discipline? Would a statement that all major financial firms, even the most diversified ones, are subject to coordinated supervision suggest a degree of support that effectively extends, to an unwarranted extent, the subsidy associated with national safety nets? Would it generate a degree of moral hazard that could itself be the source of systemic risk? The answers to these questions are not straightforward. However, while many firms should reassess and upgrade their risk management procedures, and supervisors should improve their procedures as well, I do not believe that the need for a radical change in our framework for the supervision of internationally active financial firms has been demonstrated. The paradigm of supervision itself is, of necessity, continuously adjusted to the rapidly changing, technologically driven financial system. In recent years, firms and supervisors alike have sought to harness technological advances to enhance risk management procedures. Much thought has been given to how to make public disclosure more meaningful and to reinforce market discipline. Supervisors around the world, not just in the major industrial countries, have gotten to know each other better and to understand better each others' problems and policies. The legal and institutional infrastructure of financial markets has been significantly improved. Along with good macroeconomic policy -- a topic for another day -- a continuation of this ongoing process of careful and measured progress represents the most constructive strategy for ensuring financial stability.
1997-05-01T00:00:00	Mr. Greenspan discusses technological change and the design of bank supervisory policies (Central Bank Articles and Speeches, 1 May 97)	Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Conference on Bank Structure and Competition of the Federal Reserve Bank of Chicago on 1/5/97.	Mr. Greenspan discusses technological change and the design of bank supervisory policies Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Conference on Bank Structure and Competition of the Federal Reserve Bank of Chicago on 1/5/97. For more than three decades, this conference has focused our attention on key issues facing banks, their customers, and regulators. Its proceedings have chronicled a remarkable and ongoing transformation of the U.S. financial services industry. At the time of the first gathering in 1963, our financial system was highly segmented, with commercial banks, savings and loans, investment banks, insurance companies, and finance companies providing distinctly separate products. Statutes and regulations greatly restricted competition between banks and nonbanks, and among banks themselves. Today, the marketplace for financial services is intensely competitive, innovative, and global. Banks and nonbanks, domestic and foreign, now compete aggressively across a broad range of on- and off-balance-sheet financial activities. It is noteworthy that, for the most part, this transformation has not been propelled by sweeping legislative reforms. Rather, the primary driving forces have been advances in computing, telecommunications, and theoretical finance that, taken together, have eroded economic and regulatory barriers to competition, de facto. Technology has fundamentally reshaped how financial products are created and how these products are delivered, received, and employed by end-users. In my remarks this morning, I plan to discuss two aspects of this process of technological change. First is the recurring theme of financial products being unbundled into their component parts, including the unbundling of credit, market, and other risks. These developments have worked to enhance the competitiveness and efficiency of the financial system and, at the same time, to provide financial institutions and their customers with better tools for managing risks. A byproduct is that our largest and most complex financial organizations increasingly are measuring and managing risk on a centralized basis. This trend seems irreversible, and in my view provides a compelling reason for maintaining some type of umbrella supervision over banking organizations, especially as we contemplate repeal of GlassSteagall and other restrictions on the activities of banking organizations. The second theme I want to explore is the large element of uncertainty underlying technological progress. Reflecting this uncertainty, it is inherently very difficult to predict the extent to which government policies may distort the private sector's incentives to innovate. This argues for supervisory and regulatory policies that are more "incentive-compatible", in the sense that they are reinforced by market discipline and the profit-maximizing incentives of bank owners and managers. To the extent this can be achieved, and I believe we have taken some innovative steps in this direction, supervisory and regulatory policies will be both less burdensome and more effective. Unbundling of Financial Services The unbundling of financial products is now extensive throughout our financial system. Perhaps the most obvious example is the ever-expanding array of financial derivatives available to help firms manage interest rate risk, other market risks, and, increasingly, credit risks. Derivatives are now used routinely to separate the total risk of more generic products into component parts associated with various risk factors. These components frequently are repackaged into synthetic products having risk profiles that mimic financial instruments in other markets. The synthetic products can then be resold to those investors most willing and able to bear the associated risks. Another far-reaching innovation is the technology of securitization -- a form of derivative -- which has encouraged unbundling of the production processes for many credit services. Securitization permits separate financial institutions to originate, service, fund, and assume the credit or market risks of a portfolio of loans or other assets. Thus, a financial institution may specialize in those activities where it has particular expertise or other comparative advantages. For example, to reduce the costs of originating and securitizing certain types of household loans, the underwriting processes used by some financial institutions rely on highly automated credit-scoring models developed by third-party vendors. These models, in turn, typically are linked to huge databases on borrower characteristics maintained independently by national credit bureaus. Numerous types of assets are now routinely securitized, including residential mortgages, commercial mortgages, auto loans, and credit card loans. In addition, medium- and large-size businesses, including some that are below investment-grade, regularly access the commercial paper market by securitizing their trade accounts or other assets. Recently, securitization and credit-scoring are beginning to be applied to small business lending. These and other developments facilitating the unbundling of financial products have surely improved the efficiency of our financial markets. One benefit is greater economic specialization, as banks and other financial institutions are able to create market niches, for example, in cash management, investment management, or the origination or servicing of certain loans. Moreover, by lowering the costs of hedging and financial arbitrage, derivatives and securitization work to enhance market liquidity and reduce both absolute risk premiums and disparities in risk premiums across financial instruments and geographic regions. Unbundling also has lowered economic barriers to competition, affording households and businesses a greater choice of potential providers for financial products. The ability to unbundle permits potential competitors to target highly specific product- or marketattributes, for which existing providers are earning excessive "rents." Through credit-scoring and direct-mail marketing, for instance, a financial institution can identify and recruit potentially profitable credit card customers over a wide geographic area, without incurring the costs associated with a large branch network. According to our Survey of Consumer Finances, for example, 84 percent of general purpose credit cards held by U.S. households in 1995 were issued by financial institutions from which the card holder received no other financial service. In addition, unbundling has helped erode legal barriers to competition, by enabling one or more attributes of a product to be modified in order to exploit statutory or regulatory "loopholes." A classic example, of course, is the introduction of money market mutual funds, which ultimately forced the removal of Regulation Q interest rate ceilings on deposit accounts. It is important to recognize that these developments would not have been possible without complementary advances in technology across several disciplines. First, innovations in finance theory, such as the principle of financial arbitrage and models for pricing contingent claims, provided a conceptual framework for understanding and modeling financial risks. Second, advances in computer and communications technologies have made these conceptual innovations economically feasible, by lowering the costs associated with information processing and with the transmission of large volumes of data over long distances. Besides promoting competition and improved products and production efficiencies, these same technological advances have spawned a sea-change in the risk management practices of financial institutions. The largest and most sophisticated banking organizations increasingly have centralized their risk management at the parent level -- cutting across legal entities and financial instruments. This new management paradigm is grounded in the same conceptual techniques employed by financial engineers to unbundle the total risk of an individual asset. Such techniques rely on the financial engineer's ability to model the relationship between an individual asset's economic value and a number of separate risk factors. Carrying this process further, the relationship between these risk factors and the value of an overall portfolio can be obtained by summing the relationships for the individual underlying assets. With the processing power of modern computers, it is now possible to estimate the joint probability distribution of many risk factors and, given this distribution, to simulate the probability distributions of losses for large, complex portfolios. Over the past decade or so, the largest banking organizations have invested substantial sums to hire the staff and to create the software, databases, and related management information systems to carry out such computations. Most of you are aware of the application of this technology in VAR, or "value-at-risk", models, which are used to estimate loss distributions for trading portfolios. More recently, many large banking organizations have begun using similar technologies to measure the credit risk in their loan portfolios. In both applications, the measurements of overall portfolio risk are used to determine the prices for loans and other products needed to achieve hurdle rates-of-return on shareholder equity, to assess the adequacy of an organization's overall equity capital, as well as for other management purposes. These efforts to develop more centralized risk management systems are being driven by normal competitive pressures to maximize synergies within financial organizations, such as joint-production and cross-selling opportunities involving multiple subsidiaries. This, in turn, is the logical outcome of the organization's desire to produce and market its products most efficiently and to achieve the highest risk-adjusted returns for shareholders. Such synergies cannot occur if the parent is merely a passive portfolio investor in its subsidiaries. Reflecting this economic reality, virtually all large bank holding companies are now operated and managed as integrated units. The trend toward centralized risk management raises some fundamental policy issues for how we should regulate and supervise large, complex banking organizations. Chief among these, this trend raises serious doubts regarding suggestions that we rely solely on decentralized "functional regulation" as we move to expand further the permissible activities of banking organizations. The traditional view of the functional approach to regulating a banking organization would involve a bank regulator supervising the insured bank, the SEC supervising any broker/dealer subsidiary, a state insurance department supervising any insurance subsidiary, and so on. Each functional regulator would look only at the risk management practices of the regulated entity under its supervision; unregulated subsidiaries, including the parent, would be unsupervised. Before technology advanced to a point where substantial oversight and control of large banking organizations could be consolidated at the parent level, functional regulation conformed with practical limitations on the abilities of managers to coordinate resources, and evaluate risks, for the organizations as a whole. In essence, a decentralized approach to regulation followed from the decentralized financial decisionmaking process of its day. To borrow a concept from architecture: form followed function. In today's world, however, the "form", decentralized regulation, no longer follows the "function", centralized risk management. Almost by definition, the synergies upon which centralized management is predicated imply that neither a subsidiary's economic condition on a going-concern basis nor its exposure to potential risks can be evaluated independently of the condition and management policies of the consolidated organization. Regulation must fit the architecture of what is being regulated. To give one example, it is common for complex banking organizations to manage the relationships with large customers centrally, even though the underlying cash management, credit, or capital markets services provided to the customer may transcend several subsidiaries. Under this framework, the way the organization's internal transfer pricing system allocates costs, revenues, and risks to a specific regulated entity may be somewhat arbitrary, or even misleading. Yet, a functional regulator -- looking only at the entity under its supervision -generally would have insufficient information to validate the reasonableness of these allocations. A purely decentralized regulatory approach would also greatly diminish our ability to evaluate and contain potential systemic disruptions in the financial system, since no regulator would be responsible for monitoring the consolidated banking organization. We should remember that one of the primary motivations of a society having a central bank and a safety net is precisely to limit systemic risk. Partly in recognition of the fact that financial organizations are managed on a consolidated basis, financial markets generally view them as single economic entities. Thus, troubles in the nongovernment-regulated portion of a bank holding company cannot be expected to leave the government-regulated subsidiaries unscathed. In a worst case scenario, problems in one part of an organization could precipitate a run at a healthy affiliate bank and could even generate spillover effects onto nonaffiliated banks. It is worth noting that recent deposit insurance and depositor preference legislation may increase these concerns, by exposing uninsured creditors of banks to a greater risk of loss than in the past. While these new initiatives have the significant benefit of strengthening market discipline, they may also induce some additional systemic risks, even for healthy banks, in periods characterized by heightened levels of economic uncertainty. We don't have much experience, yet, in operating under these new ground rules. For all of these reasons, I believe we must continue to have some type of umbrella supervision for banking organizations, especially for the largest and most complex organizations that pose the greatest systemic risk concerns. In my judgment, therefore, the critical challenge is to develop approaches to implementing umbrella supervision that are effective in limiting systemic risk without distorting economic incentives or being unduly burdensome to banking organizations. Innovation, Uncertainty, and Bank Supervision If history is our guide, market innovations -- with or without supporting legislation -- will continue to stimulate financial modernization. As this process unfolds, we can expect banking organizations to undertake an increasing number of financial activities. Under these circumstances, policymakers face a very difficult tradeoff: namely, balancing the need for financial stability and umbrella supervision, on the one hand, against our desire to avoid extending bank-like regulation and the safety net over these new activities. In addressing this tradeoff, policymakers also have an obligation to consider the potential effects of their policies, unintended as well as intended, on the process of financial innovation. Technological progress has been a critical element in rising living standards. This is not surprising, because the creation and diffusion of innovations have represented voluntary decisions by individuals and firms acting in their own self-interests. Government policies always pose some risk of misdirecting or distorting this process by interfering with normal competitive market mechanisms. This concern is particularly relevant to the financial sector, whose innovations seem to be especially attuned to the risk-return incentives created by the safety net and regulatory policies. Designing government policies that minimize the potentially disruptive effects on private incentives to innovate is complicated by how little we really understand the process of innovation and technological change. Forecasting the direction or pace of technological change has proved to be especially precarious over the generations, even for relatively mature industries. While uncertainty is inherent in any creative process, Nathan Rosenberg of Stanford suggests that even after an innovation's technical feasibility has been clearly established, its ultimate effect on society is often highly unpredictable. He notes at least two sources of this uncertainty. First, the range of applications for a new technology may not be immediately apparent. For instance, Alexander Graham Bell initially viewed the telephone as solely a business instrument -- merely an enhancement of the telegraph -- for use in transmitting very specific messages, such as the terms of a contract. Indeed, he offered to sell his telephone patent to Western Union for only $100,000, but was turned down. Similarly, Guglielmo Marconi initially overlooked the radio's value as a public broadcast medium, instead believing its principal application would be in the transmission of point-to-point messages, such as ship-toship, where communication by wire was infeasible. A second source of technological uncertainty reflects the possibility that an innovation's full potential may be realizable only after extensive improvements, or after complementary innovations in other fields of science. According to Charles Townes, a Nobel Prize winner for his work on the laser, the attorneys for Bell Labs initially refused, in the 1960s, to patent the laser because they believed it had no applications in the field of telecommunications. Only in the 1980s, after extensive improvements in fiber optics technology, did the laser's importance for telecommunications become apparent. It's not hard to find examples of such uncertainties within the financial services industry. The evolution of the OTC derivatives market over the past decade has been nothing less than spectacular. But as the theoretical underpinnings of financial arbitrage were being published by Modigliani and Miller in the late 1950s, few observers could have predicted how their insights would eventually revolutionize global financial markets. This is because, in addition to their insights, at least two complementary innovations had to fall into place. The first was further conceptual advances in contingent claims theory, such as the Black-Scholes option pricing model. The second was several generations of advances in computer and communications technologies that were necessary to make these concepts computationally practicable. Given the high degree of uncertainty inherent in the development of new products and processes, policymakers should be cautious when attempting to anticipate the future path of innovation, or the effects new regulations may have on innovation. There are several aspects to this interaction between government policies and market innovation. First, banking organizations may develop new products or innovations to exploit regulatory "loopholes", or they may decline to develop new products whose likely regulatory treatments are viewed as burdensome or unclear. Another unintended consequence is that a policy action may establish an inappropriate unofficial government standard for how certain activities should be conducted. In contrast to government standards, which can be extremely difficult to change, when the private sector adopts a standard that subsequently becomes outmoded, market forces generally can be expected to remedy the situation. The history of retail electronic payments provides a useful illustration. In the 1970s, when many were heralding the advent of a "cashless society", the Federal Reserve and the Treasury played an important role in developing and promoting what was seen as a key component of this vision -- the automated clearinghouse system. Now, twenty years later, we know that while the ACH has been successful in some areas, it has failed to replace a substantial portion of the daily flow of paper checks in the economy. This experience leads me to conclude that the experimentation with innovative electronic payment methods that we are seeing today in the private sector is likely to have a much better chance of meeting the needs of consumers and businesses than did the government-led initiatives two decades ago. Within the context of banking regulation, concerns about setting a potentially inappropriate regulatory standard were an important factor in the decision by the banking agencies several years ago not to incorporate interest rate risk and asset concentration risk into the formal risk-based capital standards. In the end, we became convinced that the technologies for measuring and managing interest rate risk and concentration risk were evolving so rapidly that any regulatory standard would quickly become outmoded or, worse, inhibit private market innovations. Largely for these reasons, ultimately we chose to address the relationship between these risks and capital adequacy through the supervisory process. I believe that in many cases, policymakers can reduce potential distortions by structuring policies to be more "incentive-compatible" -- that is, by working with, rather than around, the profit-maximizing goals of investors and firm managers. In light of the underlying uncertainties illustrated in my earlier examples, I readily acknowledge this is often easier said than done. Nevertheless, I believe some useful guiding principles can be formulated. The first guiding principle is that, where possible, we should attempt to strengthen market discipline, without compromising financial stability. As financial transactions become increasingly rapid and complex, I believe we have no choice but to harness market forces, as best we can, to reinforce our supervisory objectives. The appeal of market-led discipline lies not only in its cost-effectiveness and flexibility, but also in its limited intrusiveness and its greater adaptability to changing financial environments. Measures to enhance market discipline involve providing private investors the incentives and the means to reward good bank performance and penalize poor performance. Expanded risk management disclosures by financial institutions is a significant step in this direction. In addition, Congress has undertaken important initiatives, including a national depositor preference statute and the least-cost resolution and prompt corrective action provisions of the FDIC Improvement Act. Of course, the value of these initiatives will depend on the credibility of regulators in implementing the legislative mandates consistently over time. A second guiding principle is that, to the extent possible, our regulatory policies should attempt to simulate what would be the private market's response in the absence of the safety net. Such a principle suggests that supervisory and regulatory policies, like market responses, should be capable of evolving over time, along with changes in institutional practices and financial technologies. Almost certainly, such a principle implies that we avoid locking ourselves into formulaic, one-size-fits-all approaches to measuring and affecting bank safety and soundness. For example, as a bank's internal systems for measuring and managing market, credit, and operating risks improve with advances in technology and finance, our supervisory policies should become more tailored to that bank's specific needs and internal management processes. Recently, we have taken several steps that attempt to operationalize this concept, including the introduction of an internal models approach to assessing capital for market risks in large banks' trading accounts. Also, as I am sure most of you are aware, the Board is currently pilot-testing with the New York Clearing House Association an alternative capital allocation procedure for market risk, called the "pre-commitment" approach. The pre-commitment approach would permit capital requirements for market risk to reflect not only the estimates of risk derived from a bank's internal market-risk model, but also other features of the bank's trading risk management system that help limit its overall risk exposure -- such as the effectiveness of its internal controls and other risk-management tools. Conclusions Over the last three decades, the folly of attempting to legislate or regulate against the primal forces of the market is one of the most fundamental lessons learned by banking regulators. If those market forces are driving financial firms toward centralized decisionmaking regarding risk, pricing, and other operational issues, it will be difficult, at best, to implement a decentralized approach to prudential regulation, however attractive its apparent simplicity. Similarly, in the face of continual market-driven innovations in banks' risk measurement and management systems, regulatory approaches based on rigid, one-size-fits-all rules are likely to become quickly outdated, ineffectual, and, worse, potentially counterproductive. Incentive-compatible regulation, flexibly constructed and applied, is the logical alternative to an increasingly complex system of rigid rules and regulations that inevitably have unintended consequences, including possible deleterious effects on the innovation process. While I have discussed some examples of incentive-compatible regulation that appear to be working, we have a very long way to go. For example, banking regulators have yet to reach a consensus on some of the most basic questions associated with prudential supervision -questions such as what is an appropriate conceptual basis for assessing a financial institution's overall risk exposure, how should such risk exposures be measured, and if we use internal management models for such measurements, how can these models be validated? The revolution in risk measurement techniques makes the answers to these questions approachable but not without significant effort on the part of the regulators and the financial industry itself. I am confident that all parties are both willing and able to solve the challenges that confront us. It is clearly in our mutual self-interest to do so. Our success will preserve not only the benefits of the most competitive and innovative financial markets in the world, but also the benefits of financial stability that are critical to our economy.	---[PAGE_BREAK]--- # Mr. Greenspan discusses technological change and the design of bank supervisory policies Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Conference on Bank Structure and Competition of the Federal Reserve Bank of Chicago on 1/5/97. For more than three decades, this conference has focused our attention on key issues facing banks, their customers, and regulators. Its proceedings have chronicled a remarkable and ongoing transformation of the U.S. financial services industry. At the time of the first gathering in 1963, our financial system was highly segmented, with commercial banks, savings and loans, investment banks, insurance companies, and finance companies providing distinctly separate products. Statutes and regulations greatly restricted competition between banks and nonbanks, and among banks themselves. Today, the marketplace for financial services is intensely competitive, innovative, and global. Banks and nonbanks, domestic and foreign, now compete aggressively across a broad range of on- and off-balance-sheet financial activities. It is noteworthy that, for the most part, this transformation has not been propelled by sweeping legislative reforms. Rather, the primary driving forces have been advances in computing, telecommunications, and theoretical finance that, taken together, have eroded economic and regulatory barriers to competition, de facto. Technology has fundamentally reshaped how financial products are created and how these products are delivered, received, and employed by end-users. In my remarks this morning, I plan to discuss two aspects of this process of technological change. First is the recurring theme of financial products being unbundled into their component parts, including the unbundling of credit, market, and other risks. These developments have worked to enhance the competitiveness and efficiency of the financial system and, at the same time, to provide financial institutions and their customers with better tools for managing risks. A byproduct is that our largest and most complex financial organizations increasingly are measuring and managing risk on a centralized basis. This trend seems irreversible, and in my view provides a compelling reason for maintaining some type of umbrella supervision over banking organizations, especially as we contemplate repeal of GlassSteagall and other restrictions on the activities of banking organizations. The second theme I want to explore is the large element of uncertainty underlying technological progress. Reflecting this uncertainty, it is inherently very difficult to predict the extent to which government policies may distort the private sector's incentives to innovate. This argues for supervisory and regulatory policies that are more "incentive-compatible", in the sense that they are reinforced by market discipline and the profit-maximizing incentives of bank owners and managers. To the extent this can be achieved, and I believe we have taken some innovative steps in this direction, supervisory and regulatory policies will be both less burdensome and more effective. ## Unbundling of Financial Services The unbundling of financial products is now extensive throughout our financial system. Perhaps the most obvious example is the ever-expanding array of financial derivatives available to help firms manage interest rate risk, other market risks, and, increasingly, credit risks. Derivatives are now used routinely to separate the total risk of more generic products into component parts associated with various risk factors. These components frequently are repackaged into synthetic products having risk profiles that mimic financial instruments in other ---[PAGE_BREAK]--- markets. The synthetic products can then be resold to those investors most willing and able to bear the associated risks. Another far-reaching innovation is the technology of securitization -- a form of derivative -- which has encouraged unbundling of the production processes for many credit services. Securitization permits separate financial institutions to originate, service, fund, and assume the credit or market risks of a portfolio of loans or other assets. Thus, a financial institution may specialize in those activities where it has particular expertise or other comparative advantages. For example, to reduce the costs of originating and securitizing certain types of household loans, the underwriting processes used by some financial institutions rely on highly automated credit-scoring models developed by third-party vendors. These models, in turn, typically are linked to huge databases on borrower characteristics maintained independently by national credit bureaus. Numerous types of assets are now routinely securitized, including residential mortgages, commercial mortgages, auto loans, and credit card loans. In addition, medium- and large-size businesses, including some that are below investment-grade, regularly access the commercial paper market by securitizing their trade accounts or other assets. Recently, securitization and credit-scoring are beginning to be applied to small business lending. These and other developments facilitating the unbundling of financial products have surely improved the efficiency of our financial markets. One benefit is greater economic specialization, as banks and other financial institutions are able to create market niches, for example, in cash management, investment management, or the origination or servicing of certain loans. Moreover, by lowering the costs of hedging and financial arbitrage, derivatives and securitization work to enhance market liquidity and reduce both absolute risk premiums and disparities in risk premiums across financial instruments and geographic regions. Unbundling also has lowered economic barriers to competition, affording households and businesses a greater choice of potential providers for financial products. The ability to unbundle permits potential competitors to target highly specific product- or marketattributes, for which existing providers are earning excessive "rents." Through credit-scoring and direct-mail marketing, for instance, a financial institution can identify and recruit potentially profitable credit card customers over a wide geographic area, without incurring the costs associated with a large branch network. According to our Survey of Consumer Finances, for example, 84 percent of general purpose credit cards held by U.S. households in 1995 were issued by financial institutions from which the card holder received no other financial service. In addition, unbundling has helped erode legal barriers to competition, by enabling one or more attributes of a product to be modified in order to exploit statutory or regulatory "loopholes." A classic example, of course, is the introduction of money market mutual funds, which ultimately forced the removal of Regulation Q interest rate ceilings on deposit accounts. It is important to recognize that these developments would not have been possible without complementary advances in technology across several disciplines. First, innovations in finance theory, such as the principle of financial arbitrage and models for pricing contingent claims, provided a conceptual framework for understanding and modeling financial risks. Second, advances in computer and communications technologies have made these conceptual innovations economically feasible, by lowering the costs associated with information processing and with the transmission of large volumes of data over long distances. ---[PAGE_BREAK]--- Besides promoting competition and improved products and production efficiencies, these same technological advances have spawned a sea-change in the risk management practices of financial institutions. The largest and most sophisticated banking organizations increasingly have centralized their risk management at the parent level -- cutting across legal entities and financial instruments. This new management paradigm is grounded in the same conceptual techniques employed by financial engineers to unbundle the total risk of an individual asset. Such techniques rely on the financial engineer's ability to model the relationship between an individual asset's economic value and a number of separate risk factors. Carrying this process further, the relationship between these risk factors and the value of an overall portfolio can be obtained by summing the relationships for the individual underlying assets. With the processing power of modern computers, it is now possible to estimate the joint probability distribution of many risk factors and, given this distribution, to simulate the probability distributions of losses for large, complex portfolios. Over the past decade or so, the largest banking organizations have invested substantial sums to hire the staff and to create the software, databases, and related management information systems to carry out such computations. Most of you are aware of the application of this technology in VAR, or "value-at-risk", models, which are used to estimate loss distributions for trading portfolios. More recently, many large banking organizations have begun using similar technologies to measure the credit risk in their loan portfolios. In both applications, the measurements of overall portfolio risk are used to determine the prices for loans and other products needed to achieve hurdle rates-of-return on shareholder equity, to assess the adequacy of an organization's overall equity capital, as well as for other management purposes. These efforts to develop more centralized risk management systems are being driven by normal competitive pressures to maximize synergies within financial organizations, such as joint-production and cross-selling opportunities involving multiple subsidiaries. This, in turn, is the logical outcome of the organization's desire to produce and market its products most efficiently and to achieve the highest risk-adjusted returns for shareholders. Such synergies cannot occur if the parent is merely a passive portfolio investor in its subsidiaries. Reflecting this economic reality, virtually all large bank holding companies are now operated and managed as integrated units. The trend toward centralized risk management raises some fundamental policy issues for how we should regulate and supervise large, complex banking organizations. Chief among these, this trend raises serious doubts regarding suggestions that we rely solely on decentralized "functional regulation" as we move to expand further the permissible activities of banking organizations. The traditional view of the functional approach to regulating a banking organization would involve a bank regulator supervising the insured bank, the SEC supervising any broker/dealer subsidiary, a state insurance department supervising any insurance subsidiary, and so on. Each functional regulator would look only at the risk management practices of the regulated entity under its supervision; unregulated subsidiaries, including the parent, would be unsupervised. Before technology advanced to a point where substantial oversight and control of large banking organizations could be consolidated at the parent level, functional regulation conformed with practical limitations on the abilities of managers to coordinate resources, and evaluate risks, for the organizations as a whole. In essence, a decentralized approach to ---[PAGE_BREAK]--- regulation followed from the decentralized financial decisionmaking process of its day. To borrow a concept from architecture: form followed function. In today's world, however, the "form", decentralized regulation, no longer follows the "function", centralized risk management. Almost by definition, the synergies upon which centralized management is predicated imply that neither a subsidiary's economic condition on a going-concern basis nor its exposure to potential risks can be evaluated independently of the condition and management policies of the consolidated organization. Regulation must fit the architecture of what is being regulated. To give one example, it is common for complex banking organizations to manage the relationships with large customers centrally, even though the underlying cash management, credit, or capital markets services provided to the customer may transcend several subsidiaries. Under this framework, the way the organization's internal transfer pricing system allocates costs, revenues, and risks to a specific regulated entity may be somewhat arbitrary, or even misleading. Yet, a functional regulator -- looking only at the entity under its supervision -generally would have insufficient information to validate the reasonableness of these allocations. A purely decentralized regulatory approach would also greatly diminish our ability to evaluate and contain potential systemic disruptions in the financial system, since no regulator would be responsible for monitoring the consolidated banking organization. We should remember that one of the primary motivations of a society having a central bank and a safety net is precisely to limit systemic risk. Partly in recognition of the fact that financial organizations are managed on a consolidated basis, financial markets generally view them as single economic entities. Thus, troubles in the nongovernment-regulated portion of a bank holding company cannot be expected to leave the government-regulated subsidiaries unscathed. In a worst case scenario, problems in one part of an organization could precipitate a run at a healthy affiliate bank and could even generate spillover effects onto nonaffiliated banks. It is worth noting that recent deposit insurance and depositor preference legislation may increase these concerns, by exposing uninsured creditors of banks to a greater risk of loss than in the past. While these new initiatives have the significant benefit of strengthening market discipline, they may also induce some additional systemic risks, even for healthy banks, in periods characterized by heightened levels of economic uncertainty. We don't have much experience, yet, in operating under these new ground rules. For all of these reasons, I believe we must continue to have some type of umbrella supervision for banking organizations, especially for the largest and most complex organizations that pose the greatest systemic risk concerns. In my judgment, therefore, the critical challenge is to develop approaches to implementing umbrella supervision that are effective in limiting systemic risk without distorting economic incentives or being unduly burdensome to banking organizations. # Innovation, Uncertainty, and Bank Supervision If history is our guide, market innovations -- with or without supporting legislation -- will continue to stimulate financial modernization. As this process unfolds, we can expect banking organizations to undertake an increasing number of financial activities. Under these circumstances, policymakers face a very difficult tradeoff: namely, balancing the need for financial stability and umbrella supervision, on the one hand, against our desire to avoid extending bank-like regulation and the safety net over these new activities. ---[PAGE_BREAK]--- In addressing this tradeoff, policymakers also have an obligation to consider the potential effects of their policies, unintended as well as intended, on the process of financial innovation. Technological progress has been a critical element in rising living standards. This is not surprising, because the creation and diffusion of innovations have represented voluntary decisions by individuals and firms acting in their own self-interests. Government policies always pose some risk of misdirecting or distorting this process by interfering with normal competitive market mechanisms. This concern is particularly relevant to the financial sector, whose innovations seem to be especially attuned to the risk-return incentives created by the safety net and regulatory policies. Designing government policies that minimize the potentially disruptive effects on private incentives to innovate is complicated by how little we really understand the process of innovation and technological change. Forecasting the direction or pace of technological change has proved to be especially precarious over the generations, even for relatively mature industries. While uncertainty is inherent in any creative process, Nathan Rosenberg of Stanford suggests that even after an innovation's technical feasibility has been clearly established, its ultimate effect on society is often highly unpredictable. He notes at least two sources of this uncertainty. First, the range of applications for a new technology may not be immediately apparent. For instance, Alexander Graham Bell initially viewed the telephone as solely a business instrument -- merely an enhancement of the telegraph -- for use in transmitting very specific messages, such as the terms of a contract. Indeed, he offered to sell his telephone patent to Western Union for only $\$ 100,000$, but was turned down. Similarly, Guglielmo Marconi initially overlooked the radio's value as a public broadcast medium, instead believing its principal application would be in the transmission of point-to-point messages, such as ship-toship, where communication by wire was infeasible. A second source of technological uncertainty reflects the possibility that an innovation's full potential may be realizable only after extensive improvements, or after complementary innovations in other fields of science. According to Charles Townes, a Nobel Prize winner for his work on the laser, the attorneys for Bell Labs initially refused, in the 1960s, to patent the laser because they believed it had no applications in the field of telecommunications. Only in the 1980s, after extensive improvements in fiber optics technology, did the laser's importance for telecommunications become apparent. It's not hard to find examples of such uncertainties within the financial services industry. The evolution of the OTC derivatives market over the past decade has been nothing less than spectacular. But as the theoretical underpinnings of financial arbitrage were being published by Modigliani and Miller in the late 1950s, few observers could have predicted how their insights would eventually revolutionize global financial markets. This is because, in addition to their insights, at least two complementary innovations had to fall into place. The first was further conceptual advances in contingent claims theory, such as the Black-Scholes option pricing model. The second was several generations of advances in computer and communications technologies that were necessary to make these concepts computationally practicable. Given the high degree of uncertainty inherent in the development of new products and processes, policymakers should be cautious when attempting to anticipate the future path of innovation, or the effects new regulations may have on innovation. There are several aspects to this interaction between government policies and market innovation. First, banking organizations may develop new products or innovations to exploit regulatory "loopholes", or ---[PAGE_BREAK]--- they may decline to develop new products whose likely regulatory treatments are viewed as burdensome or unclear. Another unintended consequence is that a policy action may establish an inappropriate unofficial government standard for how certain activities should be conducted. In contrast to government standards, which can be extremely difficult to change, when the private sector adopts a standard that subsequently becomes outmoded, market forces generally can be expected to remedy the situation. The history of retail electronic payments provides a useful illustration. In the 1970s, when many were heralding the advent of a "cashless society", the Federal Reserve and the Treasury played an important role in developing and promoting what was seen as a key component of this vision -- the automated clearinghouse system. Now, twenty years later, we know that while the ACH has been successful in some areas, it has failed to replace a substantial portion of the daily flow of paper checks in the economy. This experience leads me to conclude that the experimentation with innovative electronic payment methods that we are seeing today in the private sector is likely to have a much better chance of meeting the needs of consumers and businesses than did the government-led initiatives two decades ago. Within the context of banking regulation, concerns about setting a potentially inappropriate regulatory standard were an important factor in the decision by the banking agencies several years ago not to incorporate interest rate risk and asset concentration risk into the formal risk-based capital standards. In the end, we became convinced that the technologies for measuring and managing interest rate risk and concentration risk were evolving so rapidly that any regulatory standard would quickly become outmoded or, worse, inhibit private market innovations. Largely for these reasons, ultimately we chose to address the relationship between these risks and capital adequacy through the supervisory process. I believe that in many cases, policymakers can reduce potential distortions by structuring policies to be more "incentive-compatible" -- that is, by working with, rather than around, the profit-maximizing goals of investors and firm managers. In light of the underlying uncertainties illustrated in my earlier examples, I readily acknowledge this is often easier said than done. Nevertheless, I believe some useful guiding principles can be formulated. The first guiding principle is that, where possible, we should attempt to strengthen market discipline, without compromising financial stability. As financial transactions become increasingly rapid and complex, I believe we have no choice but to harness market forces, as best we can, to reinforce our supervisory objectives. The appeal of market-led discipline lies not only in its cost-effectiveness and flexibility, but also in its limited intrusiveness and its greater adaptability to changing financial environments. Measures to enhance market discipline involve providing private investors the incentives and the means to reward good bank performance and penalize poor performance. Expanded risk management disclosures by financial institutions is a significant step in this direction. In addition, Congress has undertaken important initiatives, including a national depositor preference statute and the least-cost resolution and prompt corrective action provisions of the FDIC Improvement Act. Of course, the value of these initiatives will depend on the credibility of regulators in implementing the legislative mandates consistently over time. A second guiding principle is that, to the extent possible, our regulatory policies should attempt to simulate what would be the private market's response in the absence of the safety net. Such a principle suggests that supervisory and regulatory policies, like market responses, should be capable of evolving over time, along with changes in institutional practices ---[PAGE_BREAK]--- and financial technologies. Almost certainly, such a principle implies that we avoid locking ourselves into formulaic, one-size-fits-all approaches to measuring and affecting bank safety and soundness. For example, as a bank's internal systems for measuring and managing market, credit, and operating risks improve with advances in technology and finance, our supervisory policies should become more tailored to that bank's specific needs and internal management processes. Recently, we have taken several steps that attempt to operationalize this concept, including the introduction of an internal models approach to assessing capital for market risks in large banks' trading accounts. Also, as I am sure most of you are aware, the Board is currently pilot-testing with the New York Clearing House Association an alternative capital allocation procedure for market risk, called the "pre-commitment" approach. The pre-commitment approach would permit capital requirements for market risk to reflect not only the estimates of risk derived from a bank's internal market-risk model, but also other features of the bank's trading risk management system that help limit its overall risk exposure -- such as the effectiveness of its internal controls and other risk-management tools. # Conclusions Over the last three decades, the folly of attempting to legislate or regulate against the primal forces of the market is one of the most fundamental lessons learned by banking regulators. If those market forces are driving financial firms toward centralized decisionmaking regarding risk, pricing, and other operational issues, it will be difficult, at best, to implement a decentralized approach to prudential regulation, however attractive its apparent simplicity. Similarly, in the face of continual market-driven innovations in banks' risk measurement and management systems, regulatory approaches based on rigid, one-size-fits-all rules are likely to become quickly outdated, ineffectual, and, worse, potentially counterproductive. Incentive-compatible regulation, flexibly constructed and applied, is the logical alternative to an increasingly complex system of rigid rules and regulations that inevitably have unintended consequences, including possible deleterious effects on the innovation process. While I have discussed some examples of incentive-compatible regulation that appear to be working, we have a very long way to go. For example, banking regulators have yet to reach a consensus on some of the most basic questions associated with prudential supervision -questions such as what is an appropriate conceptual basis for assessing a financial institution's overall risk exposure, how should such risk exposures be measured, and if we use internal management models for such measurements, how can these models be validated? The revolution in risk measurement techniques makes the answers to these questions approachable but not without significant effort on the part of the regulators and the financial industry itself. I am confident that all parties are both willing and able to solve the challenges that confront us. It is clearly in our mutual self-interest to do so. Our success will preserve not only the benefits of the most competitive and innovative financial markets in the world, but also the benefits of financial stability that are critical to our economy.	Alan Greenspan	United States	https://www.bis.org/review/r970529b.pdf	supervisory policies Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Conference on Bank Structure and Competition of the Federal Reserve Bank of Chicago on 1/5/97. For more than three decades, this conference has focused our attention on key issues facing banks, their customers, and regulators. Its proceedings have chronicled a remarkable and ongoing transformation of the U.S. financial services industry. At the time of the first gathering in 1963, our financial system was highly segmented, with commercial banks, savings and loans, investment banks, insurance companies, and finance companies providing distinctly separate products. Statutes and regulations greatly restricted competition between banks and nonbanks, and among banks themselves. Today, the marketplace for financial services is intensely competitive, innovative, and global. Banks and nonbanks, domestic and foreign, now compete aggressively across a broad range of on- and off-balance-sheet financial activities. It is noteworthy that, for the most part, this transformation has not been propelled by sweeping legislative reforms. Rather, the primary driving forces have been advances in computing, telecommunications, and theoretical finance that, taken together, have eroded economic and regulatory barriers to competition, de facto. Technology has fundamentally reshaped how financial products are created and how these products are delivered, received, and employed by end-users. In my remarks this morning, I plan to discuss two aspects of this process of technological change. First is the recurring theme of financial products being unbundled into their component parts, including the unbundling of credit, market, and other risks. These developments have worked to enhance the competitiveness and efficiency of the financial system and, at the same time, to provide financial institutions and their customers with better tools for managing risks. A byproduct is that our largest and most complex financial organizations increasingly are measuring and managing risk on a centralized basis. This trend seems irreversible, and in my view provides a compelling reason for maintaining some type of umbrella supervision over banking organizations, especially as we contemplate repeal of GlassSteagall and other restrictions on the activities of banking organizations. The second theme I want to explore is the large element of uncertainty underlying technological progress. Reflecting this uncertainty, it is inherently very difficult to predict the extent to which government policies may distort the private sector's incentives to innovate. This argues for supervisory and regulatory policies that are more "incentive-compatible", in the sense that they are reinforced by market discipline and the profit-maximizing incentives of bank owners and managers. To the extent this can be achieved, and I believe we have taken some innovative steps in this direction, supervisory and regulatory policies will be both less burdensome and more effective. The unbundling of financial products is now extensive throughout our financial system. Perhaps the most obvious example is the ever-expanding array of financial derivatives available to help firms manage interest rate risk, other market risks, and, increasingly, credit risks. Derivatives are now used routinely to separate the total risk of more generic products into component parts associated with various risk factors. These components frequently are repackaged into synthetic products having risk profiles that mimic financial instruments in other markets. The synthetic products can then be resold to those investors most willing and able to bear the associated risks. Another far-reaching innovation is the technology of securitization -- a form of derivative -- which has encouraged unbundling of the production processes for many credit services. Securitization permits separate financial institutions to originate, service, fund, and assume the credit or market risks of a portfolio of loans or other assets. Thus, a financial institution may specialize in those activities where it has particular expertise or other comparative advantages. For example, to reduce the costs of originating and securitizing certain types of household loans, the underwriting processes used by some financial institutions rely on highly automated credit-scoring models developed by third-party vendors. These models, in turn, typically are linked to huge databases on borrower characteristics maintained independently by national credit bureaus. Numerous types of assets are now routinely securitized, including residential mortgages, commercial mortgages, auto loans, and credit card loans. In addition, medium- and large-size businesses, including some that are below investment-grade, regularly access the commercial paper market by securitizing their trade accounts or other assets. Recently, securitization and credit-scoring are beginning to be applied to small business lending. These and other developments facilitating the unbundling of financial products have surely improved the efficiency of our financial markets. One benefit is greater economic specialization, as banks and other financial institutions are able to create market niches, for example, in cash management, investment management, or the origination or servicing of certain loans. Moreover, by lowering the costs of hedging and financial arbitrage, derivatives and securitization work to enhance market liquidity and reduce both absolute risk premiums and disparities in risk premiums across financial instruments and geographic regions. Unbundling also has lowered economic barriers to competition, affording households and businesses a greater choice of potential providers for financial products. The ability to unbundle permits potential competitors to target highly specific product- or marketattributes, for which existing providers are earning excessive "rents." Through credit-scoring and direct-mail marketing, for instance, a financial institution can identify and recruit potentially profitable credit card customers over a wide geographic area, without incurring the costs associated with a large branch network. According to our Survey of Consumer Finances, for example, 84 percent of general purpose credit cards held by U.S. households in 1995 were issued by financial institutions from which the card holder received no other financial service. In addition, unbundling has helped erode legal barriers to competition, by enabling one or more attributes of a product to be modified in order to exploit statutory or regulatory "loopholes." A classic example, of course, is the introduction of money market mutual funds, which ultimately forced the removal of Regulation Q interest rate ceilings on deposit accounts. It is important to recognize that these developments would not have been possible without complementary advances in technology across several disciplines. First, innovations in finance theory, such as the principle of financial arbitrage and models for pricing contingent claims, provided a conceptual framework for understanding and modeling financial risks. Second, advances in computer and communications technologies have made these conceptual innovations economically feasible, by lowering the costs associated with information processing and with the transmission of large volumes of data over long distances. Besides promoting competition and improved products and production efficiencies, these same technological advances have spawned a sea-change in the risk management practices of financial institutions. The largest and most sophisticated banking organizations increasingly have centralized their risk management at the parent level -- cutting across legal entities and financial instruments. This new management paradigm is grounded in the same conceptual techniques employed by financial engineers to unbundle the total risk of an individual asset. Such techniques rely on the financial engineer's ability to model the relationship between an individual asset's economic value and a number of separate risk factors. Carrying this process further, the relationship between these risk factors and the value of an overall portfolio can be obtained by summing the relationships for the individual underlying assets. With the processing power of modern computers, it is now possible to estimate the joint probability distribution of many risk factors and, given this distribution, to simulate the probability distributions of losses for large, complex portfolios. Over the past decade or so, the largest banking organizations have invested substantial sums to hire the staff and to create the software, databases, and related management information systems to carry out such computations. Most of you are aware of the application of this technology in VAR, or "value-at-risk", models, which are used to estimate loss distributions for trading portfolios. More recently, many large banking organizations have begun using similar technologies to measure the credit risk in their loan portfolios. In both applications, the measurements of overall portfolio risk are used to determine the prices for loans and other products needed to achieve hurdle rates-of-return on shareholder equity, to assess the adequacy of an organization's overall equity capital, as well as for other management purposes. These efforts to develop more centralized risk management systems are being driven by normal competitive pressures to maximize synergies within financial organizations, such as joint-production and cross-selling opportunities involving multiple subsidiaries. This, in turn, is the logical outcome of the organization's desire to produce and market its products most efficiently and to achieve the highest risk-adjusted returns for shareholders. Such synergies cannot occur if the parent is merely a passive portfolio investor in its subsidiaries. Reflecting this economic reality, virtually all large bank holding companies are now operated and managed as integrated units. The trend toward centralized risk management raises some fundamental policy issues for how we should regulate and supervise large, complex banking organizations. Chief among these, this trend raises serious doubts regarding suggestions that we rely solely on decentralized "functional regulation" as we move to expand further the permissible activities of banking organizations. The traditional view of the functional approach to regulating a banking organization would involve a bank regulator supervising the insured bank, the SEC supervising any broker/dealer subsidiary, a state insurance department supervising any insurance subsidiary, and so on. Each functional regulator would look only at the risk management practices of the regulated entity under its supervision; unregulated subsidiaries, including the parent, would be unsupervised. Before technology advanced to a point where substantial oversight and control of large banking organizations could be consolidated at the parent level, functional regulation conformed with practical limitations on the abilities of managers to coordinate resources, and evaluate risks, for the organizations as a whole. In essence, a decentralized approach to regulation followed from the decentralized financial decisionmaking process of its day. To borrow a concept from architecture: form followed function. In today's world, however, the "form", decentralized regulation, no longer follows the "function", centralized risk management. Almost by definition, the synergies upon which centralized management is predicated imply that neither a subsidiary's economic condition on a going-concern basis nor its exposure to potential risks can be evaluated independently of the condition and management policies of the consolidated organization. Regulation must fit the architecture of what is being regulated. To give one example, it is common for complex banking organizations to manage the relationships with large customers centrally, even though the underlying cash management, credit, or capital markets services provided to the customer may transcend several subsidiaries. Under this framework, the way the organization's internal transfer pricing system allocates costs, revenues, and risks to a specific regulated entity may be somewhat arbitrary, or even misleading. Yet, a functional regulator -- looking only at the entity under its supervision -generally would have insufficient information to validate the reasonableness of these allocations. A purely decentralized regulatory approach would also greatly diminish our ability to evaluate and contain potential systemic disruptions in the financial system, since no regulator would be responsible for monitoring the consolidated banking organization. We should remember that one of the primary motivations of a society having a central bank and a safety net is precisely to limit systemic risk. Partly in recognition of the fact that financial organizations are managed on a consolidated basis, financial markets generally view them as single economic entities. Thus, troubles in the nongovernment-regulated portion of a bank holding company cannot be expected to leave the government-regulated subsidiaries unscathed. In a worst case scenario, problems in one part of an organization could precipitate a run at a healthy affiliate bank and could even generate spillover effects onto nonaffiliated banks. It is worth noting that recent deposit insurance and depositor preference legislation may increase these concerns, by exposing uninsured creditors of banks to a greater risk of loss than in the past. While these new initiatives have the significant benefit of strengthening market discipline, they may also induce some additional systemic risks, even for healthy banks, in periods characterized by heightened levels of economic uncertainty. We don't have much experience, yet, in operating under these new ground rules. For all of these reasons, I believe we must continue to have some type of umbrella supervision for banking organizations, especially for the largest and most complex organizations that pose the greatest systemic risk concerns. In my judgment, therefore, the critical challenge is to develop approaches to implementing umbrella supervision that are effective in limiting systemic risk without distorting economic incentives or being unduly burdensome to banking organizations. If history is our guide, market innovations -- with or without supporting legislation -- will continue to stimulate financial modernization. As this process unfolds, we can expect banking organizations to undertake an increasing number of financial activities. Under these circumstances, policymakers face a very difficult tradeoff: namely, balancing the need for financial stability and umbrella supervision, on the one hand, against our desire to avoid extending bank-like regulation and the safety net over these new activities. In addressing this tradeoff, policymakers also have an obligation to consider the potential effects of their policies, unintended as well as intended, on the process of financial innovation. Technological progress has been a critical element in rising living standards. This is not surprising, because the creation and diffusion of innovations have represented voluntary decisions by individuals and firms acting in their own self-interests. Government policies always pose some risk of misdirecting or distorting this process by interfering with normal competitive market mechanisms. This concern is particularly relevant to the financial sector, whose innovations seem to be especially attuned to the risk-return incentives created by the safety net and regulatory policies. Designing government policies that minimize the potentially disruptive effects on private incentives to innovate is complicated by how little we really understand the process of innovation and technological change. Forecasting the direction or pace of technological change has proved to be especially precarious over the generations, even for relatively mature industries. While uncertainty is inherent in any creative process, Nathan Rosenberg of Stanford suggests that even after an innovation's technical feasibility has been clearly established, its ultimate effect on society is often highly unpredictable. He notes at least two sources of this uncertainty. First, the range of applications for a new technology may not be immediately apparent. For instance, Alexander Graham Bell initially viewed the telephone as solely a business instrument -- merely an enhancement of the telegraph -- for use in transmitting very specific messages, such as the terms of a contract. Indeed, he offered to sell his telephone patent to Western Union for only $\$ 100,000$, but was turned down. Similarly, Guglielmo Marconi initially overlooked the radio's value as a public broadcast medium, instead believing its principal application would be in the transmission of point-to-point messages, such as ship-toship, where communication by wire was infeasible. A second source of technological uncertainty reflects the possibility that an innovation's full potential may be realizable only after extensive improvements, or after complementary innovations in other fields of science. According to Charles Townes, a Nobel Prize winner for his work on the laser, the attorneys for Bell Labs initially refused, in the 1960s, to patent the laser because they believed it had no applications in the field of telecommunications. Only in the 1980s, after extensive improvements in fiber optics technology, did the laser's importance for telecommunications become apparent. It's not hard to find examples of such uncertainties within the financial services industry. The evolution of the OTC derivatives market over the past decade has been nothing less than spectacular. But as the theoretical underpinnings of financial arbitrage were being published by Modigliani and Miller in the late 1950s, few observers could have predicted how their insights would eventually revolutionize global financial markets. This is because, in addition to their insights, at least two complementary innovations had to fall into place. The first was further conceptual advances in contingent claims theory, such as the Black-Scholes option pricing model. The second was several generations of advances in computer and communications technologies that were necessary to make these concepts computationally practicable. Given the high degree of uncertainty inherent in the development of new products and processes, policymakers should be cautious when attempting to anticipate the future path of innovation, or the effects new regulations may have on innovation. There are several aspects to this interaction between government policies and market innovation. First, banking organizations may develop new products or innovations to exploit regulatory "loopholes", or they may decline to develop new products whose likely regulatory treatments are viewed as burdensome or unclear. Another unintended consequence is that a policy action may establish an inappropriate unofficial government standard for how certain activities should be conducted. In contrast to government standards, which can be extremely difficult to change, when the private sector adopts a standard that subsequently becomes outmoded, market forces generally can be expected to remedy the situation. The history of retail electronic payments provides a useful illustration. In the 1970s, when many were heralding the advent of a "cashless society", the Federal Reserve and the Treasury played an important role in developing and promoting what was seen as a key component of this vision -- the automated clearinghouse system. Now, twenty years later, we know that while the ACH has been successful in some areas, it has failed to replace a substantial portion of the daily flow of paper checks in the economy. This experience leads me to conclude that the experimentation with innovative electronic payment methods that we are seeing today in the private sector is likely to have a much better chance of meeting the needs of consumers and businesses than did the government-led initiatives two decades ago. Within the context of banking regulation, concerns about setting a potentially inappropriate regulatory standard were an important factor in the decision by the banking agencies several years ago not to incorporate interest rate risk and asset concentration risk into the formal risk-based capital standards. In the end, we became convinced that the technologies for measuring and managing interest rate risk and concentration risk were evolving so rapidly that any regulatory standard would quickly become outmoded or, worse, inhibit private market innovations. Largely for these reasons, ultimately we chose to address the relationship between these risks and capital adequacy through the supervisory process. I believe that in many cases, policymakers can reduce potential distortions by structuring policies to be more "incentive-compatible" -- that is, by working with, rather than around, the profit-maximizing goals of investors and firm managers. In light of the underlying uncertainties illustrated in my earlier examples, I readily acknowledge this is often easier said than done. Nevertheless, I believe some useful guiding principles can be formulated. The first guiding principle is that, where possible, we should attempt to strengthen market discipline, without compromising financial stability. As financial transactions become increasingly rapid and complex, I believe we have no choice but to harness market forces, as best we can, to reinforce our supervisory objectives. The appeal of market-led discipline lies not only in its cost-effectiveness and flexibility, but also in its limited intrusiveness and its greater adaptability to changing financial environments. Measures to enhance market discipline involve providing private investors the incentives and the means to reward good bank performance and penalize poor performance. Expanded risk management disclosures by financial institutions is a significant step in this direction. In addition, Congress has undertaken important initiatives, including a national depositor preference statute and the least-cost resolution and prompt corrective action provisions of the FDIC Improvement Act. Of course, the value of these initiatives will depend on the credibility of regulators in implementing the legislative mandates consistently over time. A second guiding principle is that, to the extent possible, our regulatory policies should attempt to simulate what would be the private market's response in the absence of the safety net. Such a principle suggests that supervisory and regulatory policies, like market responses, should be capable of evolving over time, along with changes in institutional practices and financial technologies. Almost certainly, such a principle implies that we avoid locking ourselves into formulaic, one-size-fits-all approaches to measuring and affecting bank safety and soundness. For example, as a bank's internal systems for measuring and managing market, credit, and operating risks improve with advances in technology and finance, our supervisory policies should become more tailored to that bank's specific needs and internal management processes. Recently, we have taken several steps that attempt to operationalize this concept, including the introduction of an internal models approach to assessing capital for market risks in large banks' trading accounts. Also, as I am sure most of you are aware, the Board is currently pilot-testing with the New York Clearing House Association an alternative capital allocation procedure for market risk, called the "pre-commitment" approach. The pre-commitment approach would permit capital requirements for market risk to reflect not only the estimates of risk derived from a bank's internal market-risk model, but also other features of the bank's trading risk management system that help limit its overall risk exposure -- such as the effectiveness of its internal controls and other risk-management tools. Over the last three decades, the folly of attempting to legislate or regulate against the primal forces of the market is one of the most fundamental lessons learned by banking regulators. If those market forces are driving financial firms toward centralized decisionmaking regarding risk, pricing, and other operational issues, it will be difficult, at best, to implement a decentralized approach to prudential regulation, however attractive its apparent simplicity. Similarly, in the face of continual market-driven innovations in banks' risk measurement and management systems, regulatory approaches based on rigid, one-size-fits-all rules are likely to become quickly outdated, ineffectual, and, worse, potentially counterproductive. Incentive-compatible regulation, flexibly constructed and applied, is the logical alternative to an increasingly complex system of rigid rules and regulations that inevitably have unintended consequences, including possible deleterious effects on the innovation process. While I have discussed some examples of incentive-compatible regulation that appear to be working, we have a very long way to go. For example, banking regulators have yet to reach a consensus on some of the most basic questions associated with prudential supervision -questions such as what is an appropriate conceptual basis for assessing a financial institution's overall risk exposure, how should such risk exposures be measured, and if we use internal management models for such measurements, how can these models be validated? The revolution in risk measurement techniques makes the answers to these questions approachable but not without significant effort on the part of the regulators and the financial industry itself. I am confident that all parties are both willing and able to solve the challenges that confront us. It is clearly in our mutual self-interest to do so. Our success will preserve not only the benefits of the most competitive and innovative financial markets in the world, but also the benefits of financial stability that are critical to our economy.
1997-05-03T00:00:00	Mr. Greenspan discusses financial reform and the importance of the State Charter (Central Bank Articles and Speeches, 3 May 97)	Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the annual meeting and Conference of State Bank Supervisors held in San Diego, California on 3/5/97.	Mr. Greenspan discusses financial reform and the importance of the State Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Charter Mr. Alan Greenspan, at the annual meeting and Conference of State Bank Supervisors held in San Diego, California on 3/5/97. I am pleased once again to address this annual meeting of the Conference of State Bank Supervisors. Before I begin, I would like to join his colleagues in wishing Bob Richard well. Over the years, it has been a pleasure to work with him. He will be sorely missed. Today, I shall concentrate my remarks on the current debate in Congress and elsewhere on how best to accomplish financial reform. This subject has been a recurring theme in Federal Reserve comments, speeches, and testimonies during the first part of 1997 and, I suspect, the subject will continue to engage us for some months ahead. My remarks today will reemphasize some of the points made at other venues this year, although I will attempt to place these arguments in the context of the impact of financial reform on the state-chartered banks and on the roles such banks, and their regulators, play in maintaining the overall well-being of our banking system and our economy. To begin, there does appear to be general agreement on the need for financial reform. Permitting various financial businesses to be conducted jointly should provide the benefits of increased services and/or lower prices to financial customers, improved risk reduction, and cost savings for financial firms. More broadly, it should improve the efficiency and stability of the financial system that underlies our economy. These benefits are expected to flow primarily from opportunities for diversification, non-interest cost reduction, and cross-marketing for those banks, investment banks, and insurance companies that find ways to profitably merge their businesses in the wake of legislation permitting expanded powers for banking organizations. But the longer financial reform is delayed, the less important and useful it will be. Put in economist's jargon, the longer the delay the lower the marginal economic benefits produced by reform legislation, and the more we should be concerned instead with possible unintended negative effects that might outweigh those marginal benefits. Let me explain. Financial markets, as we all should know by now, have a way of effectively circumventing uneconomic barriers or bottlenecks created by inefficient legislation or regulation. Today, it has become possible, through the judicious use of derivative instruments, for a financial firm engaged primarily in one kind of financial activity to mimic the risks and returns of any other financial activity. Banking, investment banking, and insurance can no longer be viewed, from a risk-return perspective, as separate and distinct lines of business. To cite just one example, banks are prohibited from underwriting insurance, yet the writing of a put option -- a form of derivative activity engaged in widely by large banks -- is, in economic substance, a form of insurance underwriting. Other derivative markets, including the emerging credit derivative instruments, now permit banks to diversify their credit and market risks as if they had been permitted to merge with investment banks or insurance companies. Thus, some of the long-sought-after economic benefits resulting from the repeal of legislative barriers between and among different "types" of financial firm already have been achieved through the creativity of the marketplace. Nevertheless, by not being able to engage directly in the impermissible activity, a banking company cannot achieve the production or marketing synergies, and therefore the cost reductions, that may flow from joint operations and that may benefit a bank's shareholders as well as its customers. In addition to the actions of the marketplace, banking regulators have acted, within the constraints of statute, to facilitate economic combinations of banking and nonbanking financial activities. Specifically, the Federal Reserve has adopted both liberalization of Section 20 activities and expedited procedures for processing applications under Regulation Y. The OCC, meanwhile, has generated some controversy by liberalizing banks' insurance agency powers as well as procedures generally for establishing operating subsidiaries of national banks that may engage in activities not permitted to the bank. This is not to say that financial reform legislation will have no marginal benefit. Clearly, in addition to the benefit of lowered costs, much remains to be accomplished in the form of improved management efficiency. These benefits, which will accrue both to the banks and the general public, probably can be maximized only within the context of clear legislative authority for combining financial firms of various types. We must be careful, however, in our efforts to achieve the benefits of financial reform, not to violate the tenets of good public policy. In this regard, the Federal Reserve believes that any financial reform should be consistent with four basic objectives: (1) continuing the safety and soundness of the banking system; (2) limiting systemic risk; (3) contributing to macroeconomic stability; and (4) limiting the spread of both the moral hazard and the subsidy implicit in the federal safety net. I have spent a good deal of time of late on the fourth objective. Therefore, today I will concentrate on the first three and how, in particular, financial reform must be careful to preserve the role of the state-chartered bank in meeting our economy's macroeconomic objectives and our concerns regarding systemic risk. The importance of the state-chartered bank Some erroneously dismiss state-chartered banks as representing only the down-scale end of the banking market and, therefore, being not particularly worthy of careful policy consideration. State-chartered banks indeed are smaller on average than national banks, and are disproportionately represented within the very smallest size class. Nevertheless, state-chartered banks account for about a third of our superregionals, not to mention a few state banks that are among the very largest money center institutions. Even the preponderance of small, state-chartered banks, however, play a critical role within our financial system, for several reasons. First, having large numbers of community-sized banks, be they state-chartered or national banks, is a major contribution to the stability of the banking system and the well-being of the macroeconomy. Just as a more highly diversified loan portfolio reduces risk to the individual bank, a more highly diversified banking structure reduces risk to the banking system as a whole. Indeed, our decentralized and diverse banking structure was arguably the key to weathering the financial crisis of the late 1980s. During those dark days, our system was able to absorb more than a thousand U.S. bank failures. And yet here we are, less than a decade later, with loan loss reserves and bank capital at their highest levels in almost a half century, and the insurance fund restored to its maximum coverage ratio -- all without cost to the taxpayer. Of course, the bank failures of the past decade, combined with the current wave of mergers and acquisitions, have served to reduce significantly the total number of banking organizations in the U.S. But the more than 7,000 separate banking companies that remain are more than sufficient to maintain our highly decentralized and flexible banking structure. Large numbers of small banks go hand in hand with a macroeconomy characterized by large numbers of small, entrepreneurial nonfinancial businesses. Smaller banks traditionally have been a major source of capital for small businesses that may not have access to securities markets. In turn, small businesses account for the major portion of new employment and new ideas, thereby playing a major role in fueling economic growth. This connection running between small banks, small business, and the macroeconomy -- indeed the role of banks generally in funding business expansion -- is so important that we must be sensitive to the tradeoff between risk-taking and bank solvency. Risk-taking -- prudent risk-taking to be sure -- is the primary economic function of banking. All wealth is measured by its perceived ability to produce goods and services of value in the future. Since the future is fundamentally unknown, endeavoring to create wealth implies an uncertain expectation of how the future will unfold. That is, creating wealth is risky. Hence banking, to further its primary economic purpose of financing the economy, cannot and should not avoid prudent risk-taking. Bank supervisors, in turn, need to recognize that the optimal bank failure rate is not zero. A zero failure rate over time implies either extraordinary insight by bankers, a notion I readily dismiss, or an undue and unhelpful degree of conservatism in banking practice. In taking on risk, of course, some mistakes will be made, and some banks will fail. Even if a bank is well-managed, it can simply become unlucky. Failure should occur, indeed does occur, as part of the natural process within our competitive economy. It should not be viewed as a flaw in our financial system, and certainly we should not attempt to eliminate it. Only when the failure rate threatens to breach a prudent threshold should we become concerned. Just as large numbers of smaller banks are a key to the robustness of our economy, the state charter is a key to the robustness of our banking structure. The dual banking system has fostered a steady stream of banking innovations that have benefited consumers and bank shareholders alike. For example, the NOW account, as I like to point out, was invented at a state-chartered bank; and the NOW account was the opening shot in the campaign to remove national deposit interest rate controls and allow banks to compete on common ground with nonbank institutions such as money funds. The 1994 interstate branching statute likewise has its origin in the state laws that permitted cross-border banking, beginning with the rewriting of the Maine banking laws. Adjustable rate mortgages are another innovation that began at the state level, and of course, the National Banking Act itself has its origin in the states' "free banking" laws of the nineteenth century. The dual banking system not only fosters and preserves innovation but also constitutes our main protection against overly zealous and rigid federal regulation and supervision. A bank must have a choice of more than one federal regulator, must be permitted to change charters, to protect itself against arbitrary and capricious regulatory behavior. Naturally, some observers are concerned that two or more federal agencies will engage in a "competition in laxity", and we must guard against that; but the greater danger, I believe, is that a single federal regulator would become rigid and insensitive to the needs of the marketplace. Thus, so long as we have a federal guarantee of deposits, Federal Reserve guarantee of intraday payments over Fedwire, and other elements of the safety net -- and, therefore, so long as there is a need for federal regulation of banks -- such regulation should entail a choice of that regulator at the federal level. As you are well aware, the Federal Reserve has long been a strong supporter of the dual banking system in the context of efficient supervision. That is why we, along with the FDIC, have sought examination partnerships with the state banking regulators. Currently, the Fed has cooperative agreements with about three dozen states, calling for either joint examinations or alternate year exams. Overall, our experience with these programs has been quite positive, in part because of the quality of state supervision in the states with the cooperative agreements. Indeed, the evidence suggests that safety and soundness of state banks compare quite favorably with national banks, possibly reflecting the benefits of having both state and federal supervision. For example, during the banking crisis of the late 1980s, when the failure rate by any measure breached the prudent threshold I mentioned earlier, the national bank failure rate was considerably greater than for state banks. While bank failure is determined by more than just the supervision process, these data nevertheless speak well of the quality of the state supervisory process and the ability of the state and federal regulators to function together efficiently. The dual banking system, however, despite its advantages and achievements, is under attack. This attack is neither particularly intentional nor particularly coordinated, but rather consists of the unintended consequences of statutory and regulatory changes aimed at achieving broader policy objectives. I am referring primarily to the consequences of the 1994 interstate branching legislation, coupled with the OCC's recent liberalization of regulatory procedures for operating subsidiaries of national banks. These events may have served to tip the balance in favor of national banks, so to speak, in a manner that weakens banks' ability to switch federal regulators without incurring prohibitive real economic costs. In particular, while most state-chartered banks will continue to operate on an intrastate basis in local markets, regional and nationwide banks may find that state charters are burdensome to the extent that the banks are forced to operate under varying regulatory rules and procedures across multiple states. If that burden were to become excessive, banks with interstate operations -- especially interstate retail operations -- would likely turn to the national charter on grounds of simple expediency. For example, I am struck by the fact that the very largest state-chartered banks among the money center institutions are without significant retail operations or without announced intentions to expand retail banking beyond their home states. The rest of the large state-chartered banks, those with assets over $10 billion, consist mainly of lead banks in multi-bank, multi-state holding companies. It seems likely that some of these institutions will seek to consolidate their interstate retail operations under a national bank charter after interstate branching becomes fully operational, unless countervailing forces emerge. The evident superiority of the national charter is not a foregone conclusion, however. For example, the Federal Reserve this past month approved an application by a superregional banking company to consolidate its retail branches in four states under a single state-chartered bank headquartered in Alabama. The consolidation would become effective on or after June 1, 1997, when the Riegle-Neal Interstate Banking Act becomes operational. Another positive indication of the resiliency of the state charter has been the establishment of the State-Federal Working Group. This cooperative effort involving the states, the CSBS, the Federal Reserve, and the FDIC is contributing importantly to the strengthening of the supervision of state-chartered institutions through a number of initiatives, including the adoption of the State/Federal Protocol. The Protocol and the Nationwide Supervisory Agreement of 1996 spell out the principles and specific actions that would lead to a seamless supervision and examination of interstate, state-chartered banks. Other initiatives of the State-Federal Working Group include greater examination emphasis on bank risk management processes, a more formalized, risk-focused approach to examination, and expanded and more effective use of information technology. It would also be extremely helpful, especially if enacted prior to interstate branching becoming fully operational, if the Congress were to pass the so-called home state rule, which would place state-chartered banks on an equal footing with national banks with regard to permissible activities of branches in a host state. Systemic Risk and the Role of the Federal Reserve By now, we are all acutely aware that the process of "financial reform" is a complex one, with intended and unintended consequences flowing from almost every act of the legislator or regulator. I have focused today on only two aspects of the debate over financial reform, albeit two very important aspects -- the need to maintain our uniquely decentralized banking system, with its reliance on large numbers of relatively small institutions, and the desirability of retaining the dual banking system, with its implicit choice of regulator. Let me conclude by turning to another important facet of the debate over financial reform -- the role of the Federal Reserve in containing systemic risk. It is critical that we guard against diminution of this role as yet another unintended consequence of financial reform. The risk of systemwide disruptions, for better or for worse, is importantly determined by the actions or inactions of our largest, most complex banking organizations. The architects of financial reform, therefore, must necessarily consider how best to supervise risk-taking at these large organizations and, in particular, whether there should be significant umbrella or consolidated supervision of the banking company. In the past, holding company supervision was concentrated at the bank level, not only because the bank tended to constitute the bulk of risk-taking activities but also because the holding company tended to manage the bank separately from the various nonbank activities of the organization. More recently, however, the focus of supervision of holding companies by the Federal Reserve has been modified to reflect changes in management procedures -- holding companies now tend to manage risk on a consolidated basis across all their bank and nonbank subsidiaries. Risk and profitability measurements, including, for example, risk-adjusted return on capital calculations, most often are made by business line rather than on a subsidiary basis. As banks engage in new or expanded nonbanking activity in the wake of financial reform, it is likely that these activities too would be managed on a consolidated basis. For this reason, and because supervisors recognize that scarce examination resources are often most effectively employed by focusing on risk management processes, our determination of an institution's safety and soundness increasingly will be based on an analysis of the decisionmaking and internal control processes for the total organization. Such umbrella supervision need not be in any significant way "intrusive", nor should financial firms be burdened by the extension of bank-like regulation and supervision to their nonbank activities. For some time, the focus of the Fed's inspections of nonbanking activities of bank holding companies has been to assess the strengths of the individual units and their interrelations with one another and with the bank. Emphasis is placed on the adequacy of risk measurement and managements systems, as well as internal control systems, and only if there is a major deficiency in these areas should the inspection of the nonbank activities become at all intrusive. We intend that this philosophy of holding company supervision will not change as banks are granted extended powers. Finally, I should note that some have questioned not only the need for umbrella supervision but also the need for the Fed's involvement in such supervision. It is primarily the responsibility of the Federal Reserve to maintain the stability of our overall financial system, including the interconnections between the domestic financial system and world financial markets. This obligation to protect against systemic disruptions cannot be met solely via open market operations and use of the discount window, as powerful as these tools may be. If the past is any guide, financial crises of the future will be unpredictable and unique in nature. The globalization of financial and real markets means that a foreign crisis can impact on the domestic financial system, and vice versa. Our ability to respond quickly and decisively to any systemic threat depends critically on the experience and expertise of the central bank with regard to the institutional detail of the U.S. and foreign financial systems, including our familiarity with payments and settlement systems. Thus, in order to carry out our systemic obligation, the Federal Reserve must be directly involved in the supervision of banks of all sizes and must, in particular, be able to address the problems of large banking companies if one or more of their activities constitute a threat to the stability of the financial system. Conclusions The concerns I have outlined today demonstrate the necessity that the central bank maintain appropriate supervisory authority and, as I hope I have made clear, this authority is best exercised within the current context of the dual banking system, a system that has served us so well over the generations. Financial reform clearly is needed, but financial reform should not be interpreted to mean regulatory reform for its own sake. I am hopeful that reasoned financial reform, based on sound tenets of public policy, can be achieved in a manner that preserves the best components of the current system while introducing the improvements that are long overdue.	---[PAGE_BREAK]--- # Mr. Greenspan discusses financial reform and the importance of the State Charter Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the annual meeting and Conference of State Bank Supervisors held in San Diego, California on 3/5/97. I am pleased once again to address this annual meeting of the Conference of State Bank Supervisors. Before I begin, I would like to join his colleagues in wishing Bob Richard well. Over the years, it has been a pleasure to work with him. He will be sorely missed. Today, I shall concentrate my remarks on the current debate in Congress and elsewhere on how best to accomplish financial reform. This subject has been a recurring theme in Federal Reserve comments, speeches, and testimonies during the first part of 1997 and, I suspect, the subject will continue to engage us for some months ahead. My remarks today will reemphasize some of the points made at other venues this year, although I will attempt to place these arguments in the context of the impact of financial reform on the state-chartered banks and on the roles such banks, and their regulators, play in maintaining the overall well-being of our banking system and our economy. To begin, there does appear to be general agreement on the need for financial reform. Permitting various financial businesses to be conducted jointly should provide the benefits of increased services and/or lower prices to financial customers, improved risk reduction, and cost savings for financial firms. More broadly, it should improve the efficiency and stability of the financial system that underlies our economy. These benefits are expected to flow primarily from opportunities for diversification, non-interest cost reduction, and cross-marketing for those banks, investment banks, and insurance companies that find ways to profitably merge their businesses in the wake of legislation permitting expanded powers for banking organizations. But the longer financial reform is delayed, the less important and useful it will be. Put in economist's jargon, the longer the delay the lower the marginal economic benefits produced by reform legislation, and the more we should be concerned instead with possible unintended negative effects that might outweigh those marginal benefits. Let me explain. Financial markets, as we all should know by now, have a way of effectively circumventing uneconomic barriers or bottlenecks created by inefficient legislation or regulation. Today, it has become possible, through the judicious use of derivative instruments, for a financial firm engaged primarily in one kind of financial activity to mimic the risks and returns of any other financial activity. Banking, investment banking, and insurance can no longer be viewed, from a risk-return perspective, as separate and distinct lines of business. To cite just one example, banks are prohibited from underwriting insurance, yet the writing of a put option -- a form of derivative activity engaged in widely by large banks -- is, in economic substance, a form of insurance underwriting. Other derivative markets, including the emerging credit derivative instruments, now permit banks to diversify their credit and market risks as if they had been permitted to merge with investment banks or insurance companies. Thus, some of the long-sought-after economic benefits resulting from the repeal of legislative barriers between and among different "types" of financial firm already have been achieved through the creativity of the marketplace. Nevertheless, by not being able to engage directly in the impermissible activity, a banking company cannot achieve the production or marketing synergies, and therefore the cost reductions, that may flow from joint operations and that may benefit a bank's shareholders as well as its customers. In addition to the actions of the marketplace, banking regulators have acted, within the constraints of statute, to facilitate economic combinations of banking and nonbanking financial activities. Specifically, the Federal Reserve has adopted both liberalization of Section 20 activities and expedited procedures for processing applications under Regulation Y. The OCC, meanwhile, has ---[PAGE_BREAK]--- generated some controversy by liberalizing banks' insurance agency powers as well as procedures generally for establishing operating subsidiaries of national banks that may engage in activities not permitted to the bank. This is not to say that financial reform legislation will have no marginal benefit. Clearly, in addition to the benefit of lowered costs, much remains to be accomplished in the form of improved management efficiency. These benefits, which will accrue both to the banks and the general public, probably can be maximized only within the context of clear legislative authority for combining financial firms of various types. We must be careful, however, in our efforts to achieve the benefits of financial reform, not to violate the tenets of good public policy. In this regard, the Federal Reserve believes that any financial reform should be consistent with four basic objectives: (1) continuing the safety and soundness of the banking system; (2) limiting systemic risk; (3) contributing to macroeconomic stability; and (4) limiting the spread of both the moral hazard and the subsidy implicit in the federal safety net. I have spent a good deal of time of late on the fourth objective. Therefore, today I will concentrate on the first three and how, in particular, financial reform must be careful to preserve the role of the state-chartered bank in meeting our economy's macroeconomic objectives and our concerns regarding systemic risk. # The importance of the state-chartered bank Some erroneously dismiss state-chartered banks as representing only the down-scale end of the banking market and, therefore, being not particularly worthy of careful policy consideration. State-chartered banks indeed are smaller on average than national banks, and are disproportionately represented within the very smallest size class. Nevertheless, state-chartered banks account for about a third of our superregionals, not to mention a few state banks that are among the very largest money center institutions. Even the preponderance of small, state-chartered banks, however, play a critical role within our financial system, for several reasons. First, having large numbers of community-sized banks, be they state-chartered or national banks, is a major contribution to the stability of the banking system and the well-being of the macroeconomy. Just as a more highly diversified loan portfolio reduces risk to the individual bank, a more highly diversified banking structure reduces risk to the banking system as a whole. Indeed, our decentralized and diverse banking structure was arguably the key to weathering the financial crisis of the late 1980s. During those dark days, our system was able to absorb more than a thousand U.S. bank failures. And yet here we are, less than a decade later, with loan loss reserves and bank capital at their highest levels in almost a half century, and the insurance fund restored to its maximum coverage ratio -- all without cost to the taxpayer. Of course, the bank failures of the past decade, combined with the current wave of mergers and acquisitions, have served to reduce significantly the total number of banking organizations in the U.S. But the more than 7,000 separate banking companies that remain are more than sufficient to maintain our highly decentralized and flexible banking structure. Large numbers of small banks go hand in hand with a macroeconomy characterized by large numbers of small, entrepreneurial nonfinancial businesses. Smaller banks traditionally have been a major source of capital for small businesses that may not have access to securities markets. In turn, small businesses account for the major portion of new employment and new ideas, thereby playing a major role in fueling economic growth. This connection running between small banks, small business, and the macroeconomy -- indeed the role of banks generally in funding business expansion -- is so important that we must be sensitive to the tradeoff between risk-taking and bank solvency. Risk-taking -- prudent risk-taking to be sure -- is the primary economic function of banking. All wealth is measured by its perceived ability to produce goods and services of value in the future. Since the future is fundamentally ---[PAGE_BREAK]--- unknown, endeavoring to create wealth implies an uncertain expectation of how the future will unfold. That is, creating wealth is risky. Hence banking, to further its primary economic purpose of financing the economy, cannot and should not avoid prudent risk-taking. Bank supervisors, in turn, need to recognize that the optimal bank failure rate is not zero. A zero failure rate over time implies either extraordinary insight by bankers, a notion I readily dismiss, or an undue and unhelpful degree of conservatism in banking practice. In taking on risk, of course, some mistakes will be made, and some banks will fail. Even if a bank is well-managed, it can simply become unlucky. Failure should occur, indeed does occur, as part of the natural process within our competitive economy. It should not be viewed as a flaw in our financial system, and certainly we should not attempt to eliminate it. Only when the failure rate threatens to breach a prudent threshold should we become concerned. Just as large numbers of smaller banks are a key to the robustness of our economy, the state charter is a key to the robustness of our banking structure. The dual banking system has fostered a steady stream of banking innovations that have benefited consumers and bank shareholders alike. For example, the NOW account, as I like to point out, was invented at a state-chartered bank; and the NOW account was the opening shot in the campaign to remove national deposit interest rate controls and allow banks to compete on common ground with nonbank institutions such as money funds. The 1994 interstate branching statute likewise has its origin in the state laws that permitted cross-border banking, beginning with the rewriting of the Maine banking laws. Adjustable rate mortgages are another innovation that began at the state level, and of course, the National Banking Act itself has its origin in the states' "free banking" laws of the nineteenth century. The dual banking system not only fosters and preserves innovation but also constitutes our main protection against overly zealous and rigid federal regulation and supervision. A bank must have a choice of more than one federal regulator, must be permitted to change charters, to protect itself against arbitrary and capricious regulatory behavior. Naturally, some observers are concerned that two or more federal agencies will engage in a "competition in laxity", and we must guard against that; but the greater danger, I believe, is that a single federal regulator would become rigid and insensitive to the needs of the marketplace. Thus, so long as we have a federal guarantee of deposits, Federal Reserve guarantee of intraday payments over Fedwire, and other elements of the safety net -- and, therefore, so long as there is a need for federal regulation of banks -- such regulation should entail a choice of that regulator at the federal level. As you are well aware, the Federal Reserve has long been a strong supporter of the dual banking system in the context of efficient supervision. That is why we, along with the FDIC, have sought examination partnerships with the state banking regulators. Currently, the Fed has cooperative agreements with about three dozen states, calling for either joint examinations or alternate year exams. Overall, our experience with these programs has been quite positive, in part because of the quality of state supervision in the states with the cooperative agreements. Indeed, the evidence suggests that safety and soundness of state banks compare quite favorably with national banks, possibly reflecting the benefits of having both state and federal supervision. For example, during the banking crisis of the late 1980s, when the failure rate by any measure breached the prudent threshold I mentioned earlier, the national bank failure rate was considerably greater than for state banks. While bank failure is determined by more than just the supervision process, these data nevertheless speak well of the quality of the state supervisory process and the ability of the state and federal regulators to function together efficiently. The dual banking system, however, despite its advantages and achievements, is under attack. This attack is neither particularly intentional nor particularly coordinated, but rather consists of the unintended consequences of statutory and regulatory changes aimed at achieving broader policy objectives. I am referring primarily to the consequences of the 1994 interstate branching ---[PAGE_BREAK]--- legislation, coupled with the OCC's recent liberalization of regulatory procedures for operating subsidiaries of national banks. These events may have served to tip the balance in favor of national banks, so to speak, in a manner that weakens banks' ability to switch federal regulators without incurring prohibitive real economic costs. In particular, while most state-chartered banks will continue to operate on an intrastate basis in local markets, regional and nationwide banks may find that state charters are burdensome to the extent that the banks are forced to operate under varying regulatory rules and procedures across multiple states. If that burden were to become excessive, banks with interstate operations -- especially interstate retail operations -- would likely turn to the national charter on grounds of simple expediency. For example, I am struck by the fact that the very largest state-chartered banks among the money center institutions are without significant retail operations or without announced intentions to expand retail banking beyond their home states. The rest of the large state-chartered banks, those with assets over $\$ 10$ billion, consist mainly of lead banks in multi-bank, multi-state holding companies. It seems likely that some of these institutions will seek to consolidate their interstate retail operations under a national bank charter after interstate branching becomes fully operational, unless countervailing forces emerge. The evident superiority of the national charter is not a foregone conclusion, however. For example, the Federal Reserve this past month approved an application by a superregional banking company to consolidate its retail branches in four states under a single state-chartered bank headquartered in Alabama. The consolidation would become effective on or after June 1, 1997, when the Riegle-Neal Interstate Banking Act becomes operational. Another positive indication of the resiliency of the state charter has been the establishment of the State-Federal Working Group. This cooperative effort involving the states, the CSBS, the Federal Reserve, and the FDIC is contributing importantly to the strengthening of the supervision of state-chartered institutions through a number of initiatives, including the adoption of the State/Federal Protocol. The Protocol and the Nationwide Supervisory Agreement of 1996 spell out the principles and specific actions that would lead to a seamless supervision and examination of interstate, state-chartered banks. Other initiatives of the State-Federal Working Group include greater examination emphasis on bank risk management processes, a more formalized, risk-focused approach to examination, and expanded and more effective use of information technology. It would also be extremely helpful, especially if enacted prior to interstate branching becoming fully operational, if the Congress were to pass the so-called home state rule, which would place state-chartered banks on an equal footing with national banks with regard to permissible activities of branches in a host state. # Systemic Risk and the Role of the Federal Reserve By now, we are all acutely aware that the process of "financial reform" is a complex one, with intended and unintended consequences flowing from almost every act of the legislator or regulator. I have focused today on only two aspects of the debate over financial reform, albeit two very important aspects -- the need to maintain our uniquely decentralized banking system, with its reliance on large numbers of relatively small institutions, and the desirability of retaining the dual banking system, with its implicit choice of regulator. Let me conclude by turning to another important facet of the debate over financial reform -- the role of the Federal Reserve in containing systemic risk. It is critical that we guard against diminution of this role as yet another unintended consequence of financial reform. The risk of systemwide disruptions, for better or for worse, is importantly determined by the actions or inactions of our largest, most complex banking organizations. The architects of financial reform, therefore, must necessarily consider how best to supervise risk-taking at these large organizations and, in particular, whether there should be significant umbrella or consolidated supervision of the banking company. ---[PAGE_BREAK]--- In the past, holding company supervision was concentrated at the bank level, not only because the bank tended to constitute the bulk of risk-taking activities but also because the holding company tended to manage the bank separately from the various nonbank activities of the organization. More recently, however, the focus of supervision of holding companies by the Federal Reserve has been modified to reflect changes in management procedures -- holding companies now tend to manage risk on a consolidated basis across all their bank and nonbank subsidiaries. Risk and profitability measurements, including, for example, risk-adjusted return on capital calculations, most often are made by business line rather than on a subsidiary basis. As banks engage in new or expanded nonbanking activity in the wake of financial reform, it is likely that these activities too would be managed on a consolidated basis. For this reason, and because supervisors recognize that scarce examination resources are often most effectively employed by focusing on risk management processes, our determination of an institution's safety and soundness increasingly will be based on an analysis of the decisionmaking and internal control processes for the total organization. Such umbrella supervision need not be in any significant way "intrusive", nor should financial firms be burdened by the extension of bank-like regulation and supervision to their nonbank activities. For some time, the focus of the Fed's inspections of nonbanking activities of bank holding companies has been to assess the strengths of the individual units and their interrelations with one another and with the bank. Emphasis is placed on the adequacy of risk measurement and managements systems, as well as internal control systems, and only if there is a major deficiency in these areas should the inspection of the nonbank activities become at all intrusive. We intend that this philosophy of holding company supervision will not change as banks are granted extended powers. Finally, I should note that some have questioned not only the need for umbrella supervision but also the need for the Fed's involvement in such supervision. It is primarily the responsibility of the Federal Reserve to maintain the stability of our overall financial system, including the interconnections between the domestic financial system and world financial markets. This obligation to protect against systemic disruptions cannot be met solely via open market operations and use of the discount window, as powerful as these tools may be. If the past is any guide, financial crises of the future will be unpredictable and unique in nature. The globalization of financial and real markets means that a foreign crisis can impact on the domestic financial system, and vice versa. Our ability to respond quickly and decisively to any systemic threat depends critically on the experience and expertise of the central bank with regard to the institutional detail of the U.S. and foreign financial systems, including our familiarity with payments and settlement systems. Thus, in order to carry out our systemic obligation, the Federal Reserve must be directly involved in the supervision of banks of all sizes and must, in particular, be able to address the problems of large banking companies if one or more of their activities constitute a threat to the stability of the financial system. # Conclusions The concerns I have outlined today demonstrate the necessity that the central bank maintain appropriate supervisory authority and, as I hope I have made clear, this authority is best exercised within the current context of the dual banking system, a system that has served us so well over the generations. Financial reform clearly is needed, but financial reform should not be interpreted to mean regulatory reform for its own sake. I am hopeful that reasoned financial reform, based on sound tenets of public policy, can be achieved in a manner that preserves the best components of the current system while introducing the improvements that are long overdue.	Alan Greenspan	United States	https://www.bis.org/review/r970514b.pdf	Charter Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the annual meeting and Conference of State Bank Supervisors held in San Diego, California on 3/5/97. I am pleased once again to address this annual meeting of the Conference of State Bank Supervisors. Before I begin, I would like to join his colleagues in wishing Bob Richard well. Over the years, it has been a pleasure to work with him. He will be sorely missed. Today, I shall concentrate my remarks on the current debate in Congress and elsewhere on how best to accomplish financial reform. This subject has been a recurring theme in Federal Reserve comments, speeches, and testimonies during the first part of 1997 and, I suspect, the subject will continue to engage us for some months ahead. My remarks today will reemphasize some of the points made at other venues this year, although I will attempt to place these arguments in the context of the impact of financial reform on the state-chartered banks and on the roles such banks, and their regulators, play in maintaining the overall well-being of our banking system and our economy. To begin, there does appear to be general agreement on the need for financial reform. Permitting various financial businesses to be conducted jointly should provide the benefits of increased services and/or lower prices to financial customers, improved risk reduction, and cost savings for financial firms. More broadly, it should improve the efficiency and stability of the financial system that underlies our economy. These benefits are expected to flow primarily from opportunities for diversification, non-interest cost reduction, and cross-marketing for those banks, investment banks, and insurance companies that find ways to profitably merge their businesses in the wake of legislation permitting expanded powers for banking organizations. But the longer financial reform is delayed, the less important and useful it will be. Put in economist's jargon, the longer the delay the lower the marginal economic benefits produced by reform legislation, and the more we should be concerned instead with possible unintended negative effects that might outweigh those marginal benefits. Let me explain. Financial markets, as we all should know by now, have a way of effectively circumventing uneconomic barriers or bottlenecks created by inefficient legislation or regulation. Today, it has become possible, through the judicious use of derivative instruments, for a financial firm engaged primarily in one kind of financial activity to mimic the risks and returns of any other financial activity. Banking, investment banking, and insurance can no longer be viewed, from a risk-return perspective, as separate and distinct lines of business. To cite just one example, banks are prohibited from underwriting insurance, yet the writing of a put option -- a form of derivative activity engaged in widely by large banks -- is, in economic substance, a form of insurance underwriting. Other derivative markets, including the emerging credit derivative instruments, now permit banks to diversify their credit and market risks as if they had been permitted to merge with investment banks or insurance companies. Thus, some of the long-sought-after economic benefits resulting from the repeal of legislative barriers between and among different "types" of financial firm already have been achieved through the creativity of the marketplace. Nevertheless, by not being able to engage directly in the impermissible activity, a banking company cannot achieve the production or marketing synergies, and therefore the cost reductions, that may flow from joint operations and that may benefit a bank's shareholders as well as its customers. In addition to the actions of the marketplace, banking regulators have acted, within the constraints of statute, to facilitate economic combinations of banking and nonbanking financial activities. Specifically, the Federal Reserve has adopted both liberalization of Section 20 activities and expedited procedures for processing applications under Regulation Y. The OCC, meanwhile, has generated some controversy by liberalizing banks' insurance agency powers as well as procedures generally for establishing operating subsidiaries of national banks that may engage in activities not permitted to the bank. This is not to say that financial reform legislation will have no marginal benefit. Clearly, in addition to the benefit of lowered costs, much remains to be accomplished in the form of improved management efficiency. These benefits, which will accrue both to the banks and the general public, probably can be maximized only within the context of clear legislative authority for combining financial firms of various types. We must be careful, however, in our efforts to achieve the benefits of financial reform, not to violate the tenets of good public policy. In this regard, the Federal Reserve believes that any financial reform should be consistent with four basic objectives: (1) continuing the safety and soundness of the banking system; (2) limiting systemic risk; (3) contributing to macroeconomic stability; and (4) limiting the spread of both the moral hazard and the subsidy implicit in the federal safety net. I have spent a good deal of time of late on the fourth objective. Therefore, today I will concentrate on the first three and how, in particular, financial reform must be careful to preserve the role of the state-chartered bank in meeting our economy's macroeconomic objectives and our concerns regarding systemic risk. Some erroneously dismiss state-chartered banks as representing only the down-scale end of the banking market and, therefore, being not particularly worthy of careful policy consideration. State-chartered banks indeed are smaller on average than national banks, and are disproportionately represented within the very smallest size class. Nevertheless, state-chartered banks account for about a third of our superregionals, not to mention a few state banks that are among the very largest money center institutions. Even the preponderance of small, state-chartered banks, however, play a critical role within our financial system, for several reasons. First, having large numbers of community-sized banks, be they state-chartered or national banks, is a major contribution to the stability of the banking system and the well-being of the macroeconomy. Just as a more highly diversified loan portfolio reduces risk to the individual bank, a more highly diversified banking structure reduces risk to the banking system as a whole. Indeed, our decentralized and diverse banking structure was arguably the key to weathering the financial crisis of the late 1980s. During those dark days, our system was able to absorb more than a thousand U.S. bank failures. And yet here we are, less than a decade later, with loan loss reserves and bank capital at their highest levels in almost a half century, and the insurance fund restored to its maximum coverage ratio -- all without cost to the taxpayer. Of course, the bank failures of the past decade, combined with the current wave of mergers and acquisitions, have served to reduce significantly the total number of banking organizations in the U.S. But the more than 7,000 separate banking companies that remain are more than sufficient to maintain our highly decentralized and flexible banking structure. Large numbers of small banks go hand in hand with a macroeconomy characterized by large numbers of small, entrepreneurial nonfinancial businesses. Smaller banks traditionally have been a major source of capital for small businesses that may not have access to securities markets. In turn, small businesses account for the major portion of new employment and new ideas, thereby playing a major role in fueling economic growth. This connection running between small banks, small business, and the macroeconomy -- indeed the role of banks generally in funding business expansion -- is so important that we must be sensitive to the tradeoff between risk-taking and bank solvency. Risk-taking -- prudent risk-taking to be sure -- is the primary economic function of banking. All wealth is measured by its perceived ability to produce goods and services of value in the future. Since the future is fundamentally unknown, endeavoring to create wealth implies an uncertain expectation of how the future will unfold. That is, creating wealth is risky. Hence banking, to further its primary economic purpose of financing the economy, cannot and should not avoid prudent risk-taking. Bank supervisors, in turn, need to recognize that the optimal bank failure rate is not zero. A zero failure rate over time implies either extraordinary insight by bankers, a notion I readily dismiss, or an undue and unhelpful degree of conservatism in banking practice. In taking on risk, of course, some mistakes will be made, and some banks will fail. Even if a bank is well-managed, it can simply become unlucky. Failure should occur, indeed does occur, as part of the natural process within our competitive economy. It should not be viewed as a flaw in our financial system, and certainly we should not attempt to eliminate it. Only when the failure rate threatens to breach a prudent threshold should we become concerned. Just as large numbers of smaller banks are a key to the robustness of our economy, the state charter is a key to the robustness of our banking structure. The dual banking system has fostered a steady stream of banking innovations that have benefited consumers and bank shareholders alike. For example, the NOW account, as I like to point out, was invented at a state-chartered bank; and the NOW account was the opening shot in the campaign to remove national deposit interest rate controls and allow banks to compete on common ground with nonbank institutions such as money funds. The 1994 interstate branching statute likewise has its origin in the state laws that permitted cross-border banking, beginning with the rewriting of the Maine banking laws. Adjustable rate mortgages are another innovation that began at the state level, and of course, the National Banking Act itself has its origin in the states' "free banking" laws of the nineteenth century. The dual banking system not only fosters and preserves innovation but also constitutes our main protection against overly zealous and rigid federal regulation and supervision. A bank must have a choice of more than one federal regulator, must be permitted to change charters, to protect itself against arbitrary and capricious regulatory behavior. Naturally, some observers are concerned that two or more federal agencies will engage in a "competition in laxity", and we must guard against that; but the greater danger, I believe, is that a single federal regulator would become rigid and insensitive to the needs of the marketplace. Thus, so long as we have a federal guarantee of deposits, Federal Reserve guarantee of intraday payments over Fedwire, and other elements of the safety net -- and, therefore, so long as there is a need for federal regulation of banks -- such regulation should entail a choice of that regulator at the federal level. As you are well aware, the Federal Reserve has long been a strong supporter of the dual banking system in the context of efficient supervision. That is why we, along with the FDIC, have sought examination partnerships with the state banking regulators. Currently, the Fed has cooperative agreements with about three dozen states, calling for either joint examinations or alternate year exams. Overall, our experience with these programs has been quite positive, in part because of the quality of state supervision in the states with the cooperative agreements. Indeed, the evidence suggests that safety and soundness of state banks compare quite favorably with national banks, possibly reflecting the benefits of having both state and federal supervision. For example, during the banking crisis of the late 1980s, when the failure rate by any measure breached the prudent threshold I mentioned earlier, the national bank failure rate was considerably greater than for state banks. While bank failure is determined by more than just the supervision process, these data nevertheless speak well of the quality of the state supervisory process and the ability of the state and federal regulators to function together efficiently. The dual banking system, however, despite its advantages and achievements, is under attack. This attack is neither particularly intentional nor particularly coordinated, but rather consists of the unintended consequences of statutory and regulatory changes aimed at achieving broader policy objectives. I am referring primarily to the consequences of the 1994 interstate branching legislation, coupled with the OCC's recent liberalization of regulatory procedures for operating subsidiaries of national banks. These events may have served to tip the balance in favor of national banks, so to speak, in a manner that weakens banks' ability to switch federal regulators without incurring prohibitive real economic costs. In particular, while most state-chartered banks will continue to operate on an intrastate basis in local markets, regional and nationwide banks may find that state charters are burdensome to the extent that the banks are forced to operate under varying regulatory rules and procedures across multiple states. If that burden were to become excessive, banks with interstate operations -- especially interstate retail operations -- would likely turn to the national charter on grounds of simple expediency. For example, I am struck by the fact that the very largest state-chartered banks among the money center institutions are without significant retail operations or without announced intentions to expand retail banking beyond their home states. The rest of the large state-chartered banks, those with assets over $\$ 10$ billion, consist mainly of lead banks in multi-bank, multi-state holding companies. It seems likely that some of these institutions will seek to consolidate their interstate retail operations under a national bank charter after interstate branching becomes fully operational, unless countervailing forces emerge. The evident superiority of the national charter is not a foregone conclusion, however. For example, the Federal Reserve this past month approved an application by a superregional banking company to consolidate its retail branches in four states under a single state-chartered bank headquartered in Alabama. The consolidation would become effective on or after June 1, 1997, when the Riegle-Neal Interstate Banking Act becomes operational. Another positive indication of the resiliency of the state charter has been the establishment of the State-Federal Working Group. This cooperative effort involving the states, the CSBS, the Federal Reserve, and the FDIC is contributing importantly to the strengthening of the supervision of state-chartered institutions through a number of initiatives, including the adoption of the State/Federal Protocol. The Protocol and the Nationwide Supervisory Agreement of 1996 spell out the principles and specific actions that would lead to a seamless supervision and examination of interstate, state-chartered banks. Other initiatives of the State-Federal Working Group include greater examination emphasis on bank risk management processes, a more formalized, risk-focused approach to examination, and expanded and more effective use of information technology. It would also be extremely helpful, especially if enacted prior to interstate branching becoming fully operational, if the Congress were to pass the so-called home state rule, which would place state-chartered banks on an equal footing with national banks with regard to permissible activities of branches in a host state. By now, we are all acutely aware that the process of "financial reform" is a complex one, with intended and unintended consequences flowing from almost every act of the legislator or regulator. I have focused today on only two aspects of the debate over financial reform, albeit two very important aspects -- the need to maintain our uniquely decentralized banking system, with its reliance on large numbers of relatively small institutions, and the desirability of retaining the dual banking system, with its implicit choice of regulator. Let me conclude by turning to another important facet of the debate over financial reform -- the role of the Federal Reserve in containing systemic risk. It is critical that we guard against diminution of this role as yet another unintended consequence of financial reform. The risk of systemwide disruptions, for better or for worse, is importantly determined by the actions or inactions of our largest, most complex banking organizations. The architects of financial reform, therefore, must necessarily consider how best to supervise risk-taking at these large organizations and, in particular, whether there should be significant umbrella or consolidated supervision of the banking company. In the past, holding company supervision was concentrated at the bank level, not only because the bank tended to constitute the bulk of risk-taking activities but also because the holding company tended to manage the bank separately from the various nonbank activities of the organization. More recently, however, the focus of supervision of holding companies by the Federal Reserve has been modified to reflect changes in management procedures -- holding companies now tend to manage risk on a consolidated basis across all their bank and nonbank subsidiaries. Risk and profitability measurements, including, for example, risk-adjusted return on capital calculations, most often are made by business line rather than on a subsidiary basis. As banks engage in new or expanded nonbanking activity in the wake of financial reform, it is likely that these activities too would be managed on a consolidated basis. For this reason, and because supervisors recognize that scarce examination resources are often most effectively employed by focusing on risk management processes, our determination of an institution's safety and soundness increasingly will be based on an analysis of the decisionmaking and internal control processes for the total organization. Such umbrella supervision need not be in any significant way "intrusive", nor should financial firms be burdened by the extension of bank-like regulation and supervision to their nonbank activities. For some time, the focus of the Fed's inspections of nonbanking activities of bank holding companies has been to assess the strengths of the individual units and their interrelations with one another and with the bank. Emphasis is placed on the adequacy of risk measurement and managements systems, as well as internal control systems, and only if there is a major deficiency in these areas should the inspection of the nonbank activities become at all intrusive. We intend that this philosophy of holding company supervision will not change as banks are granted extended powers. Finally, I should note that some have questioned not only the need for umbrella supervision but also the need for the Fed's involvement in such supervision. It is primarily the responsibility of the Federal Reserve to maintain the stability of our overall financial system, including the interconnections between the domestic financial system and world financial markets. This obligation to protect against systemic disruptions cannot be met solely via open market operations and use of the discount window, as powerful as these tools may be. If the past is any guide, financial crises of the future will be unpredictable and unique in nature. The globalization of financial and real markets means that a foreign crisis can impact on the domestic financial system, and vice versa. Our ability to respond quickly and decisively to any systemic threat depends critically on the experience and expertise of the central bank with regard to the institutional detail of the U.S. and foreign financial systems, including our familiarity with payments and settlement systems. Thus, in order to carry out our systemic obligation, the Federal Reserve must be directly involved in the supervision of banks of all sizes and must, in particular, be able to address the problems of large banking companies if one or more of their activities constitute a threat to the stability of the financial system. The concerns I have outlined today demonstrate the necessity that the central bank maintain appropriate supervisory authority and, as I hope I have made clear, this authority is best exercised within the current context of the dual banking system, a system that has served us so well over the generations. Financial reform clearly is needed, but financial reform should not be interpreted to mean regulatory reform for its own sake. I am hopeful that reasoned financial reform, based on sound tenets of public policy, can be achieved in a manner that preserves the best components of the current system while introducing the improvements that are long overdue.
1997-05-08T00:00:00	Mr. Greenspan reviews current monetary policy in the United States (Central Bank Articles and Speeches, 8 May 97)	Remarks by the Chairman of the US Federal Reserve System, Mr. Alan Greenspan, at the 1997 Haskins Partners Dinner of the Stern School of Business, New York University, New York on 8/5/97.	Mr. Greenspan reviews current monetary policy in the United States Remarks by the Chairman of the US Federal Reserve System, Mr. Alan Greenspan, at the 1997 Haskins Partners Dinner of the Stern School of Business, New York University, New York on 8/5/97. I am pleased to accept this year's Charles Waldo Haskins Award and have the opportunity to address this distinguished audience on current monetary policy. A central bank's raising interest rates is rarely popular. But the Federal Reserve's action on March 25, to tighten the stance of monetary policy, seems to have attracted more than the usual share of attention and criticism. I believe the critics of our action deserve a response. So tonight, I would like to take a few minutes to put this action in the broad context of the Fed's mandate to promote the stable financial environment that will encourage economic growth. The Federal Open Market Committee raised rates as a form of insurance. It was a small prudent step in the face of the increasing possibility that excessive credit creation, spurred by an overly accommodative monetary policy, might undermine the sustained economic expansion. That expansion has been fostered by the maintenance of low inflation. But the persisting -- indeed increasing -- strength of nominal demand for goods and services suggested to us that monetary policy might not be positioned appropriately to avoid a buildup of inflationary pressures and imbalances that would be incompatible with extending the current expansion into 1998, and hopefully beyond. Even if it should appear in retrospect that we could have skirted the dangers of credit excesses without a modest tightening, the effect on the expansion would be small, temporary, and like most insurance, its purchase to protect against possible adverse outcomes would still be eminently sensible. For the Federal Reserve to remain inactive against a possible buildup of insidious inflationary pressures would be to sanction a threat to the job security and standards of living of too many Americans. As I pointed out in testimony before the Congress in March, the type of economy that we are now experiencing, with strong growth and tight labor markets, has the special advantage of drawing hundreds of thousands of people onto employment payrolls, where they can acquire permanent work skills. Under less favorable conditions they would have remained out of the labor force, or among the long-term unemployed. Moreover, the current more-than-six-year expansion has enabled us to accelerate the modernization of our productive facilities. It has long been the goal of monetary policy to foster the maximum sustainable growth in the American economy. I emphasize sustainable because it is clear from our history that surges in growth financed by excessive credit creation are, by their nature, unsustainable, and, unless contained, threaten the underlying stability of our economy. Such stability, in turn, is necessary to nurture the sources of permanent growth. The Federal Reserve, of late, has been criticized as being too focused on subduing nonexistent inflation and, in the process, being willing to suppress economic growth, retard job expansion, and inhibit real wage gains. On the contrary, our actions to tighten money market conditions in 1994, and again in March of this year, were directed at sustaining and fostering growth in economic activity, jobs, and real wages. Our goal has never been to contain inflation as an end in itself. Prices are only signals of how the economy is functioning. If inflation had no effect on economic growth, we would be much less concerned about inflationary pressures. But the evidence is compelling that low inflation is necessary to the most favorable performance of the economy. Inflation, as is generally recognized throughout the world, destroys jobs and undermines productivity gains, the foundation for increases in real wages. Low inflation is being increasingly viewed as a necessary condition for sustained growth. It may be an old cliché, but you cannot have a vibrant growing economy without sound money. History is unequivocal on this. The Federal Reserve has not always been successful at maintaining sound money and sustained growth, and the lessons have been costly. The Federal Reserve's policy actions, the evidence demonstrates, affect the financial markets immediately, but work with a significant lag of several quarters or more on output and employment, and even longer on prices. Too often in the past, policymakers responded late to unfolding economic developments and found they were far behind the curve, so to speak; as a result, their policy actions were creating or accentuating business cycles, rather than sustaining expansion. Those who wish for us, in the current environment, to await clearly visible signs of emerging inflation before acting are recommending we return to a failed regime of monetary policy that cost jobs and living standards. I wish it were otherwise, but there is no alternative to basing policy on what are, unavoidably, uncertain forecasts. As I have indicated to the Congress, we do not base policy on a single best-estimate forecast, but rather on a series of potential outcomes and the possible effects of alternative policies, including judgments of the consequences of taking a policy action that might, in the end, have turned out to be less than optimal. I viewed our small increase in the federal funds rate on March 25 as taken not so much as a consequence of a change in the most probable forecast of moderate growth and low inflation for later this year and next, but rather to address the probability that being wrong had materially increased. In the same sense that it would be folly not to endure the small immediate discomfort of a vaccination against the possibility of getting a serious disease, it would have been folly not to take this small prudent step last March to reduce the probabilities that destabilizing inflation would re-emerge. The risk to the economy from inaction came to outweigh the risk from action. To be sure, 1997 is not 1994 when the Fed was forced to tighten monetary conditions very substantially to avoid accommodating rising inflation. Current financial conditions are much less accommodative than they were in 1994. Yet we must be wary. While there is scant evidence of any imminent resurgence of inflation at the moment, there also appears to be little slack in our capacity to produce. Should the expected slowing in the growth of demand fail to materialize, we would need to address any emerging pressures in product and credit markets. To understand the problems of capacity restraint, I should like to spend a few moments on what we have learned over the years about economic growth and the conditions necessary to foster it. First it is useful to distinguish between two quite different types of economic growth. One is true, sustainable growth, the other is not. True growth reflects the capacity of the economic system to produce goods and services and is based on the growth in productivity and in the labor force. That growth contrasts with the second type, what I would call transitory growth. An economy producing near capacity can expand faster for a short time through excess credit creation. But this is not growth in any meaningful sense of promoting lasting increases in standards of living for our nation. Indeed, it will detract from achieving our long-term goals. Temporary fluctuations in output owing to say, inventory adjustments, but not financed through excess credit, will quickly adjust on their own and need not concern us as much, provided policy is appropriately positioned to foster sustainable growth. When excessive credit fostered by the central bank finances excess demand, history tells us destabilizing inflationary pressures eventually emerge. For a considerable portion of the nineteenth and early twentieth centuries, inflationary credit excesses and prices were contained by a gold standard and balanced budgets. Both, however, were deemed too constraining to the achievement of wider social goals as well as for other reasons, and instead the Federal Reserve was given the mandate of maintaining the appropriate degree of liquidity in the system. Over the long haul, the economy's growth is effectively limited to the expansion of capacity based on productivity and labor force growth. To be sure, it is often difficult to judge whether observed growth is soundly based on productivity or arises from transitory surges in output financed in many cases by excess credit, but this is in part what making monetary policy is all about. In that regard and in the current context, how can we be confident we at the Federal Reserve are not inhibiting the nation reaching its full growth potential? One way is to examine closely the recent economic record. Only two and a half years ago, rising commodity prices, lengthening delivery times, and heavy overtime indicated that our productive facilities were under some strain to meet demand. To be sure, since early 1995, those pressures have eased off. However, given the good pace of economic expansion since then, it would stretch credulity to believe that capacity growth has accelerated at a sufficient pace to produce a large degree of slack at this moment. Capacity utilization in industry is a little below its level through much of 1994, and pressures in product markets have remained tame. However, falling unemployment rates and rising overtime hours -- as well as anecdotal reports -- unambiguously point to growing tightness in labor markets. With tight labor markets and little slack in product markets, we are led to conclude that significant persistent strength in the growth of nominal demand for goods and services, outstripping the likely rate of increase in capacity, will presumably be resisted by higher market interest rates. If, instead, that demand is accommodated for a time by a step up in credit expansion facilitated by monetary policy, increasing pressures on productive resources would sow, as they have in the past, the seeds of even higher interest rates and a consequent subsequent economic retrenchment. This, then, was the context for our recent action. We saw a significant risk that monetary policy was not positioned to promote sustainable economic expansion, and we took a small step to increase the odds that the good performance of the economy can continue. There is another point of view of the current context that merits consideration. It is the notion that, owing largely to technological advance and to freer international trade, the conventional notions of capacity are becoming increasingly outmoded, and that domestic resources can be used much more intensively than in the past without added price pressures. There is, no doubt, a substantial element of truth in these observations, as I have often noted in the past. Computer and telecommunication based technologies are truly revolutionizing the way we produce goods and services. This has imparted a substantially increased degree of flexibility into the workplace, which in conjunction with just-in-time inventory strategies and increased availability of products from around the world, has kept costs in check through increased productivity. Our production system and the notion of capacity are far more flexible than they were ten or twenty years ago. Nonetheless, any inference that our productive capacity is essentially unlimited is clearly unwarranted. As I pointed out earlier, judging from a number of tangible signs of strains on facilities, we were producing near capacity in early 1995, and it is just not credible that an economy as vast and complex as that of the United States could have changed its underlying structure in the short time since then. If we consider the current rate of true, sustainable growth unsatisfactory, are there policies which could augment it? In my view, improving productivity and standards of living necessitates increasing incentives to risk taking. To encourage people to take prudent risks, the potential rewards must be perceived to exceed the possible losses. Maintaining low inflation rates reduces the levels of future uncertainties and, hence, increases the scope of investment opportunities. It is here that the Federal Reserve can most contribute to long-term growth. Other government policies also can affect these perceptions. For example, lower marginal tax rates and capital gains taxes would increase the return to successful investments and, thus, the incentive to initiate them. In addition, coming to grips now with the outsized projected growth in entitlement spending in the early years of the next century could have a profound effect on current expectations of stability. Early actions could bring real long-term interest rates down, also increasing the scope of investment opportunities. And, clearly, removing the federal deficit's drain on private savings would help to finance such private investment. Deregulation, by increasing the flexibility in the deployment of our capital and management resources, can also make a decided contribution to growth. The deregulation of telecommunications, motor and rail transport, utilities, and financial services, to name a few, may have done more to foster America's competitive market efficiencies than we can readily document. Finally, though not a function of government policies, is the continued good pace of productivity growth this late in the business expansion. This cyclical pattern is contrary to our experience and it suggests there may be an undetected delayed bonus from technical and managerial efficiencies coming from the massive advances in computer and telecommunications technology applications over the last two decades. If so, it is important that we nurture it with adequate incentives -- at a minimum, eschew regulations and taxation that reduce most incentives -- for this may well be one source of our low inflation environment. While productivity improvement through capital investment and technological advance is clearly central to the process of economic growth, the pace and quality of labor force expansion is additive to productivity growth in achieving overall gains in GDP. Hence, appropriate upgrading of skills through education and training should go with any menu to expand economic growth. Looking ahead, there are many reasons to be optimistic about the economy's prospects. For a vast nation such as ours at the cutting edge of technology, a large pickup in productivity growth is difficult to envisage. But appropriate incentives advancing that cutting edge can augment growth in a material way. And cumulatively, over time even a modest acceleration in productivity would very significantly improve the standards of living of our children. The twenty-first century will pose many challenges to our ingenuity to develop new and sophisticated ways of creating economic value. But with the competitive benefits of increasingly open markets, I have little doubt we Americans will meet the challenge admirably.	---[PAGE_BREAK]--- # Mr. Greenspan reviews current monetary policy in the United States Remarks by the Chairman of the US Federal Reserve System, Mr. Alan Greenspan, at the 1997 Haskins Partners Dinner of the Stern School of Business, New York University, New York on 8/5/97. I am pleased to accept this year's Charles Waldo Haskins Award and have the opportunity to address this distinguished audience on current monetary policy. A central bank's raising interest rates is rarely popular. But the Federal Reserve's action on March 25, to tighten the stance of monetary policy, seems to have attracted more than the usual share of attention and criticism. I believe the critics of our action deserve a response. So tonight, I would like to take a few minutes to put this action in the broad context of the Fed's mandate to promote the stable financial environment that will encourage economic growth. The Federal Open Market Committee raised rates as a form of insurance. It was a small prudent step in the face of the increasing possibility that excessive credit creation, spurred by an overly accommodative monetary policy, might undermine the sustained economic expansion. That expansion has been fostered by the maintenance of low inflation. But the persisting -- indeed increasing -- strength of nominal demand for goods and services suggested to us that monetary policy might not be positioned appropriately to avoid a buildup of inflationary pressures and imbalances that would be incompatible with extending the current expansion into 1998, and hopefully beyond. Even if it should appear in retrospect that we could have skirted the dangers of credit excesses without a modest tightening, the effect on the expansion would be small, temporary, and like most insurance, its purchase to protect against possible adverse outcomes would still be eminently sensible. For the Federal Reserve to remain inactive against a possible buildup of insidious inflationary pressures would be to sanction a threat to the job security and standards of living of too many Americans. As I pointed out in testimony before the Congress in March, the type of economy that we are now experiencing, with strong growth and tight labor markets, has the special advantage of drawing hundreds of thousands of people onto employment payrolls, where they can acquire permanent work skills. Under less favorable conditions they would have remained out of the labor force, or among the long-term unemployed. Moreover, the current more-than-six-year expansion has enabled us to accelerate the modernization of our productive facilities. It has long been the goal of monetary policy to foster the maximum sustainable growth in the American economy. I emphasize sustainable because it is clear from our history that surges in growth financed by excessive credit creation are, by their nature, unsustainable, and, unless contained, threaten the underlying stability of our economy. Such stability, in turn, is necessary to nurture the sources of permanent growth. The Federal Reserve, of late, has been criticized as being too focused on subduing nonexistent inflation and, in the process, being willing to suppress economic growth, retard job expansion, and inhibit real wage gains. On the contrary, our actions to tighten money market conditions in 1994, and again in March of this year, were directed at sustaining and fostering growth in economic activity, jobs, and real wages. Our goal has never been to contain inflation as an end in itself. Prices are only signals of how the economy is functioning. If inflation had no effect on economic growth, we would be much less concerned about inflationary pressures. ---[PAGE_BREAK]--- But the evidence is compelling that low inflation is necessary to the most favorable performance of the economy. Inflation, as is generally recognized throughout the world, destroys jobs and undermines productivity gains, the foundation for increases in real wages. Low inflation is being increasingly viewed as a necessary condition for sustained growth. It may be an old cliché, but you cannot have a vibrant growing economy without sound money. History is unequivocal on this. The Federal Reserve has not always been successful at maintaining sound money and sustained growth, and the lessons have been costly. The Federal Reserve's policy actions, the evidence demonstrates, affect the financial markets immediately, but work with a significant lag of several quarters or more on output and employment, and even longer on prices. Too often in the past, policymakers responded late to unfolding economic developments and found they were far behind the curve, so to speak; as a result, their policy actions were creating or accentuating business cycles, rather than sustaining expansion. Those who wish for us, in the current environment, to await clearly visible signs of emerging inflation before acting are recommending we return to a failed regime of monetary policy that cost jobs and living standards. I wish it were otherwise, but there is no alternative to basing policy on what are, unavoidably, uncertain forecasts. As I have indicated to the Congress, we do not base policy on a single best-estimate forecast, but rather on a series of potential outcomes and the possible effects of alternative policies, including judgments of the consequences of taking a policy action that might, in the end, have turned out to be less than optimal. I viewed our small increase in the federal funds rate on March 25 as taken not so much as a consequence of a change in the most probable forecast of moderate growth and low inflation for later this year and next, but rather to address the probability that being wrong had materially increased. In the same sense that it would be folly not to endure the small immediate discomfort of a vaccination against the possibility of getting a serious disease, it would have been folly not to take this small prudent step last March to reduce the probabilities that destabilizing inflation would re-emerge. The risk to the economy from inaction came to outweigh the risk from action. To be sure, 1997 is not 1994 when the Fed was forced to tighten monetary conditions very substantially to avoid accommodating rising inflation. Current financial conditions are much less accommodative than they were in 1994. Yet we must be wary. While there is scant evidence of any imminent resurgence of inflation at the moment, there also appears to be little slack in our capacity to produce. Should the expected slowing in the growth of demand fail to materialize, we would need to address any emerging pressures in product and credit markets. To understand the problems of capacity restraint, I should like to spend a few moments on what we have learned over the years about economic growth and the conditions necessary to foster it. First it is useful to distinguish between two quite different types of economic growth. One is true, sustainable growth, the other is not. True growth reflects the capacity of the economic system to produce goods and services and is based on the growth in productivity and in the labor force. ---[PAGE_BREAK]--- That growth contrasts with the second type, what I would call transitory growth. An economy producing near capacity can expand faster for a short time through excess credit creation. But this is not growth in any meaningful sense of promoting lasting increases in standards of living for our nation. Indeed, it will detract from achieving our long-term goals. Temporary fluctuations in output owing to say, inventory adjustments, but not financed through excess credit, will quickly adjust on their own and need not concern us as much, provided policy is appropriately positioned to foster sustainable growth. When excessive credit fostered by the central bank finances excess demand, history tells us destabilizing inflationary pressures eventually emerge. For a considerable portion of the nineteenth and early twentieth centuries, inflationary credit excesses and prices were contained by a gold standard and balanced budgets. Both, however, were deemed too constraining to the achievement of wider social goals as well as for other reasons, and instead the Federal Reserve was given the mandate of maintaining the appropriate degree of liquidity in the system. Over the long haul, the economy's growth is effectively limited to the expansion of capacity based on productivity and labor force growth. To be sure, it is often difficult to judge whether observed growth is soundly based on productivity or arises from transitory surges in output financed in many cases by excess credit, but this is in part what making monetary policy is all about. In that regard and in the current context, how can we be confident we at the Federal Reserve are not inhibiting the nation reaching its full growth potential? One way is to examine closely the recent economic record. Only two and a half years ago, rising commodity prices, lengthening delivery times, and heavy overtime indicated that our productive facilities were under some strain to meet demand. To be sure, since early 1995, those pressures have eased off. However, given the good pace of economic expansion since then, it would stretch credulity to believe that capacity growth has accelerated at a sufficient pace to produce a large degree of slack at this moment. Capacity utilization in industry is a little below its level through much of 1994, and pressures in product markets have remained tame. However, falling unemployment rates and rising overtime hours -- as well as anecdotal reports -- unambiguously point to growing tightness in labor markets. With tight labor markets and little slack in product markets, we are led to conclude that significant persistent strength in the growth of nominal demand for goods and services, outstripping the likely rate of increase in capacity, will presumably be resisted by higher market interest rates. If, instead, that demand is accommodated for a time by a step up in credit expansion facilitated by monetary policy, increasing pressures on productive resources would sow, as they have in the past, the seeds of even higher interest rates and a consequent subsequent economic retrenchment. This, then, was the context for our recent action. We saw a significant risk that monetary policy was not positioned to promote sustainable economic expansion, and we took a small step to increase the odds that the good performance of the economy can continue. There is another point of view of the current context that merits consideration. It is the notion that, owing largely to technological advance and to freer international trade, the conventional notions of capacity are becoming increasingly outmoded, and that domestic resources can be used much more intensively than in the past without added price pressures. ---[PAGE_BREAK]--- There is, no doubt, a substantial element of truth in these observations, as I have often noted in the past. Computer and telecommunication based technologies are truly revolutionizing the way we produce goods and services. This has imparted a substantially increased degree of flexibility into the workplace, which in conjunction with just-in-time inventory strategies and increased availability of products from around the world, has kept costs in check through increased productivity. Our production system and the notion of capacity are far more flexible than they were ten or twenty years ago. Nonetheless, any inference that our productive capacity is essentially unlimited is clearly unwarranted. As I pointed out earlier, judging from a number of tangible signs of strains on facilities, we were producing near capacity in early 1995, and it is just not credible that an economy as vast and complex as that of the United States could have changed its underlying structure in the short time since then. If we consider the current rate of true, sustainable growth unsatisfactory, are there policies which could augment it? In my view, improving productivity and standards of living necessitates increasing incentives to risk taking. To encourage people to take prudent risks, the potential rewards must be perceived to exceed the possible losses. Maintaining low inflation rates reduces the levels of future uncertainties and, hence, increases the scope of investment opportunities. It is here that the Federal Reserve can most contribute to long-term growth. Other government policies also can affect these perceptions. For example, lower marginal tax rates and capital gains taxes would increase the return to successful investments and, thus, the incentive to initiate them. In addition, coming to grips now with the outsized projected growth in entitlement spending in the early years of the next century could have a profound effect on current expectations of stability. Early actions could bring real long-term interest rates down, also increasing the scope of investment opportunities. And, clearly, removing the federal deficit's drain on private savings would help to finance such private investment. Deregulation, by increasing the flexibility in the deployment of our capital and management resources, can also make a decided contribution to growth. The deregulation of telecommunications, motor and rail transport, utilities, and financial services, to name a few, may have done more to foster America's competitive market efficiencies than we can readily document. Finally, though not a function of government policies, is the continued good pace of productivity growth this late in the business expansion. This cyclical pattern is contrary to our experience and it suggests there may be an undetected delayed bonus from technical and managerial efficiencies coming from the massive advances in computer and telecommunications technology applications over the last two decades. If so, it is important that we nurture it with adequate incentives -- at a minimum, eschew regulations and taxation that reduce most incentives -- for this may well be one source of our low inflation environment. While productivity improvement through capital investment and technological advance is clearly central to the process of economic growth, the pace and quality of labor force expansion is additive to productivity growth in achieving overall gains in GDP. Hence, appropriate upgrading of skills through education and training should go with any menu to expand economic growth. ---[PAGE_BREAK]--- Looking ahead, there are many reasons to be optimistic about the economy's prospects. For a vast nation such as ours at the cutting edge of technology, a large pickup in productivity growth is difficult to envisage. But appropriate incentives advancing that cutting edge can augment growth in a material way. And cumulatively, over time even a modest acceleration in productivity would very significantly improve the standards of living of our children. The twenty-first century will pose many challenges to our ingenuity to develop new and sophisticated ways of creating economic value. But with the competitive benefits of increasingly open markets, I have little doubt we Americans will meet the challenge admirably.	Alan Greenspan	United States	https://www.bis.org/review/r970529a.pdf	Remarks by the Chairman of the US Federal Reserve System, Mr. Alan Greenspan, at the 1997 Haskins Partners Dinner of the Stern School of Business, New York University, New York on 8/5/97. I am pleased to accept this year's Charles Waldo Haskins Award and have the opportunity to address this distinguished audience on current monetary policy. A central bank's raising interest rates is rarely popular. But the Federal Reserve's action on March 25, to tighten the stance of monetary policy, seems to have attracted more than the usual share of attention and criticism. I believe the critics of our action deserve a response. So tonight, I would like to take a few minutes to put this action in the broad context of the Fed's mandate to promote the stable financial environment that will encourage economic growth. The Federal Open Market Committee raised rates as a form of insurance. It was a small prudent step in the face of the increasing possibility that excessive credit creation, spurred by an overly accommodative monetary policy, might undermine the sustained economic expansion. That expansion has been fostered by the maintenance of low inflation. But the persisting -- indeed increasing -- strength of nominal demand for goods and services suggested to us that monetary policy might not be positioned appropriately to avoid a buildup of inflationary pressures and imbalances that would be incompatible with extending the current expansion into 1998, and hopefully beyond. Even if it should appear in retrospect that we could have skirted the dangers of credit excesses without a modest tightening, the effect on the expansion would be small, temporary, and like most insurance, its purchase to protect against possible adverse outcomes would still be eminently sensible. For the Federal Reserve to remain inactive against a possible buildup of insidious inflationary pressures would be to sanction a threat to the job security and standards of living of too many Americans. As I pointed out in testimony before the Congress in March, the type of economy that we are now experiencing, with strong growth and tight labor markets, has the special advantage of drawing hundreds of thousands of people onto employment payrolls, where they can acquire permanent work skills. Under less favorable conditions they would have remained out of the labor force, or among the long-term unemployed. Moreover, the current more-than-six-year expansion has enabled us to accelerate the modernization of our productive facilities. It has long been the goal of monetary policy to foster the maximum sustainable growth in the American economy. I emphasize sustainable because it is clear from our history that surges in growth financed by excessive credit creation are, by their nature, unsustainable, and, unless contained, threaten the underlying stability of our economy. Such stability, in turn, is necessary to nurture the sources of permanent growth. The Federal Reserve, of late, has been criticized as being too focused on subduing nonexistent inflation and, in the process, being willing to suppress economic growth, retard job expansion, and inhibit real wage gains. On the contrary, our actions to tighten money market conditions in 1994, and again in March of this year, were directed at sustaining and fostering growth in economic activity, jobs, and real wages. Our goal has never been to contain inflation as an end in itself. Prices are only signals of how the economy is functioning. If inflation had no effect on economic growth, we would be much less concerned about inflationary pressures. But the evidence is compelling that low inflation is necessary to the most favorable performance of the economy. Inflation, as is generally recognized throughout the world, destroys jobs and undermines productivity gains, the foundation for increases in real wages. Low inflation is being increasingly viewed as a necessary condition for sustained growth. It may be an old cliché, but you cannot have a vibrant growing economy without sound money. History is unequivocal on this. The Federal Reserve has not always been successful at maintaining sound money and sustained growth, and the lessons have been costly. The Federal Reserve's policy actions, the evidence demonstrates, affect the financial markets immediately, but work with a significant lag of several quarters or more on output and employment, and even longer on prices. Too often in the past, policymakers responded late to unfolding economic developments and found they were far behind the curve, so to speak; as a result, their policy actions were creating or accentuating business cycles, rather than sustaining expansion. Those who wish for us, in the current environment, to await clearly visible signs of emerging inflation before acting are recommending we return to a failed regime of monetary policy that cost jobs and living standards. I wish it were otherwise, but there is no alternative to basing policy on what are, unavoidably, uncertain forecasts. As I have indicated to the Congress, we do not base policy on a single best-estimate forecast, but rather on a series of potential outcomes and the possible effects of alternative policies, including judgments of the consequences of taking a policy action that might, in the end, have turned out to be less than optimal. I viewed our small increase in the federal funds rate on March 25 as taken not so much as a consequence of a change in the most probable forecast of moderate growth and low inflation for later this year and next, but rather to address the probability that being wrong had materially increased. In the same sense that it would be folly not to endure the small immediate discomfort of a vaccination against the possibility of getting a serious disease, it would have been folly not to take this small prudent step last March to reduce the probabilities that destabilizing inflation would re-emerge. The risk to the economy from inaction came to outweigh the risk from action. To be sure, 1997 is not 1994 when the Fed was forced to tighten monetary conditions very substantially to avoid accommodating rising inflation. Current financial conditions are much less accommodative than they were in 1994. Yet we must be wary. While there is scant evidence of any imminent resurgence of inflation at the moment, there also appears to be little slack in our capacity to produce. Should the expected slowing in the growth of demand fail to materialize, we would need to address any emerging pressures in product and credit markets. To understand the problems of capacity restraint, I should like to spend a few moments on what we have learned over the years about economic growth and the conditions necessary to foster it. First it is useful to distinguish between two quite different types of economic growth. One is true, sustainable growth, the other is not. True growth reflects the capacity of the economic system to produce goods and services and is based on the growth in productivity and in the labor force. That growth contrasts with the second type, what I would call transitory growth. An economy producing near capacity can expand faster for a short time through excess credit creation. But this is not growth in any meaningful sense of promoting lasting increases in standards of living for our nation. Indeed, it will detract from achieving our long-term goals. Temporary fluctuations in output owing to say, inventory adjustments, but not financed through excess credit, will quickly adjust on their own and need not concern us as much, provided policy is appropriately positioned to foster sustainable growth. When excessive credit fostered by the central bank finances excess demand, history tells us destabilizing inflationary pressures eventually emerge. For a considerable portion of the nineteenth and early twentieth centuries, inflationary credit excesses and prices were contained by a gold standard and balanced budgets. Both, however, were deemed too constraining to the achievement of wider social goals as well as for other reasons, and instead the Federal Reserve was given the mandate of maintaining the appropriate degree of liquidity in the system. Over the long haul, the economy's growth is effectively limited to the expansion of capacity based on productivity and labor force growth. To be sure, it is often difficult to judge whether observed growth is soundly based on productivity or arises from transitory surges in output financed in many cases by excess credit, but this is in part what making monetary policy is all about. In that regard and in the current context, how can we be confident we at the Federal Reserve are not inhibiting the nation reaching its full growth potential? One way is to examine closely the recent economic record. Only two and a half years ago, rising commodity prices, lengthening delivery times, and heavy overtime indicated that our productive facilities were under some strain to meet demand. To be sure, since early 1995, those pressures have eased off. However, given the good pace of economic expansion since then, it would stretch credulity to believe that capacity growth has accelerated at a sufficient pace to produce a large degree of slack at this moment. Capacity utilization in industry is a little below its level through much of 1994, and pressures in product markets have remained tame. However, falling unemployment rates and rising overtime hours -- as well as anecdotal reports -- unambiguously point to growing tightness in labor markets. With tight labor markets and little slack in product markets, we are led to conclude that significant persistent strength in the growth of nominal demand for goods and services, outstripping the likely rate of increase in capacity, will presumably be resisted by higher market interest rates. If, instead, that demand is accommodated for a time by a step up in credit expansion facilitated by monetary policy, increasing pressures on productive resources would sow, as they have in the past, the seeds of even higher interest rates and a consequent subsequent economic retrenchment. This, then, was the context for our recent action. We saw a significant risk that monetary policy was not positioned to promote sustainable economic expansion, and we took a small step to increase the odds that the good performance of the economy can continue. There is another point of view of the current context that merits consideration. It is the notion that, owing largely to technological advance and to freer international trade, the conventional notions of capacity are becoming increasingly outmoded, and that domestic resources can be used much more intensively than in the past without added price pressures. There is, no doubt, a substantial element of truth in these observations, as I have often noted in the past. Computer and telecommunication based technologies are truly revolutionizing the way we produce goods and services. This has imparted a substantially increased degree of flexibility into the workplace, which in conjunction with just-in-time inventory strategies and increased availability of products from around the world, has kept costs in check through increased productivity. Our production system and the notion of capacity are far more flexible than they were ten or twenty years ago. Nonetheless, any inference that our productive capacity is essentially unlimited is clearly unwarranted. As I pointed out earlier, judging from a number of tangible signs of strains on facilities, we were producing near capacity in early 1995, and it is just not credible that an economy as vast and complex as that of the United States could have changed its underlying structure in the short time since then. If we consider the current rate of true, sustainable growth unsatisfactory, are there policies which could augment it? In my view, improving productivity and standards of living necessitates increasing incentives to risk taking. To encourage people to take prudent risks, the potential rewards must be perceived to exceed the possible losses. Maintaining low inflation rates reduces the levels of future uncertainties and, hence, increases the scope of investment opportunities. It is here that the Federal Reserve can most contribute to long-term growth. Other government policies also can affect these perceptions. For example, lower marginal tax rates and capital gains taxes would increase the return to successful investments and, thus, the incentive to initiate them. In addition, coming to grips now with the outsized projected growth in entitlement spending in the early years of the next century could have a profound effect on current expectations of stability. Early actions could bring real long-term interest rates down, also increasing the scope of investment opportunities. And, clearly, removing the federal deficit's drain on private savings would help to finance such private investment. Deregulation, by increasing the flexibility in the deployment of our capital and management resources, can also make a decided contribution to growth. The deregulation of telecommunications, motor and rail transport, utilities, and financial services, to name a few, may have done more to foster America's competitive market efficiencies than we can readily document. Finally, though not a function of government policies, is the continued good pace of productivity growth this late in the business expansion. This cyclical pattern is contrary to our experience and it suggests there may be an undetected delayed bonus from technical and managerial efficiencies coming from the massive advances in computer and telecommunications technology applications over the last two decades. If so, it is important that we nurture it with adequate incentives -- at a minimum, eschew regulations and taxation that reduce most incentives -- for this may well be one source of our low inflation environment. While productivity improvement through capital investment and technological advance is clearly central to the process of economic growth, the pace and quality of labor force expansion is additive to productivity growth in achieving overall gains in GDP. Hence, appropriate upgrading of skills through education and training should go with any menu to expand economic growth. Looking ahead, there are many reasons to be optimistic about the economy's prospects. For a vast nation such as ours at the cutting edge of technology, a large pickup in productivity growth is difficult to envisage. But appropriate incentives advancing that cutting edge can augment growth in a material way. And cumulatively, over time even a modest acceleration in productivity would very significantly improve the standards of living of our children. The twenty-first century will pose many challenges to our ingenuity to develop new and sophisticated ways of creating economic value. But with the competitive benefits of increasingly open markets, I have little doubt we Americans will meet the challenge admirably.
1997-05-23T00:00:00	Mr. Meyer looks at the role of US banks in small business finance (Central Bank Articles and Speeches, 23 May 97)	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the Conference on Small Business Finance held at the Leonard N. Stern School of Business, Berkley Center for Entrepreneurial Studies and New York University Salomon Center in New York on 23/5/97.	Mr. Meyer looks at the role of US banks in small business finance Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the Conference on Small Business Finance held at the Leonard N. Stern School of Business, Berkley Center for Entrepreneurial Studies and New York University Salomon Center in New York on 23/5/97. It is a pleasure to be here to meet with you at New York University for this Conference on Small Business Finance. It is clear from the conference program that there is an excellent mix of academics, government representatives, and practitioners here to study how small business is financed. Indeed, I am glad to see so much attention being paid to this important topic. Small business is a vital and energetic part of our economy that plays a key role in the generation of jobs, new ideas, and the encouragement of entrepreneurial activity. Without doubt, a thriving small business sector contributes to the well-being of our nation. Today, I would like to share with you some thoughts about the role of banks in supplying credit to small business. The part played by banks in small business finance is not a new topic for the Federal Reserve. In fact, for many years we have been devoting substantial resources to collecting and analyzing data on small business finance generally, and the credit supplied by banks in particular. We collect data from small businesses on how they obtain financing -- or in some cases fail to obtain financing -- using the National Survey of Small Business Finance and the Survey of Consumer Finances. We also gather information directly on the small business credit extended by individual commercial banks. We have collected information on the contract terms of bank loans to both small and large businesses since 1977 through the Survey of Terms of Bank Lending to Business. Since 1993, the banking agencies have required all commercial banks to report their quantities of loans to businesses by size of loan on the June Call Reports. Lastly, as part of revised Community Reinvestment Act procedures, the banking agencies have just this year begun to collect data on small business loans by local geographic area. When these data become available, they should prove to be a rich source of new information. A number of economists have used the existing data in research that has helped us to better understand the potential effects on the supply of small business credit of public policies regarding bank mergers and acquisitions, financial modernization, and prudential supervision and regulation. For example, some have argued that the consolidation of the banking industry may be reducing the supply of credit to small business, since larger banking institutions tend to devote smaller proportions of their assets to small business lending. Solid economic research applying modern econometric techniques to accurate data is needed to evaluate such claims and to determine the likely effects of policy actions in order to improve future policy decisions. The Importance of the Bank-Small Business Relationship According to our survey information, commercial banks are the single most important source of external credit to small firms. Small businesses rely on banks not just for a reliable supply of credit, but for transactions and deposit services as well. Because of their needs for banking services on both the asset and liability sides of their balance sheets, small businesses typically enter into relationships with nearby banks. The data show, for example, that 85 percent of small businesses use the services of a commercial bank within 30 miles of their firm, and that small businesses typically obtain multiple different services from their local bank. The 30 miles actually overstates the distance that small businesses are willing to travel for most of their basic financial services. For example, the median distances from a small business' offices to the institutions where it obtains deposit, credit, or financial management services are all 5 miles or less. One of the reasons why the banking relationship is so important to small business finance is that banks can efficiently gain valuable information on a small business over the course of their relationship, and then use this information to help make pricing and credit decisions. The financial conditions of small firms are usually rather opaque to investors, and the costs of issuing securities directly to the public are prohibitive for most small firms. Thus, without financial intermediaries like banks it would simply be too costly for most investors to learn the information needed to provide the credit, and too costly for the small firm to issue the credit itself. Banks, performing the classic functions of financial intermediaries, solve these problems by producing information about borrowers and monitoring them over time, by setting loan contract terms to improve borrower incentives, by renegotiating the terms if and when the borrower is in financial difficulty, and by diversifying the risks across many small business credits. Some recent empirical research suggests that this characterization of the bank-small business borrower relationship is accurate. For example, as the relationship matures, banks typically reduce the interest rates charged and often drop the collateral requirements on small business loans. In short, the bank-borrower relationship appears to be an efficient means for overcoming information and cost problems in small firm finance, and for allowing fundamentally creditworthy small firms to finance sound projects that might otherwise go unfunded. One implication of the importance of the bank-small business relationship is that it may impose limits on the migration of small business finance out of the banking sector. Over the last two decades, many large business loans left the banking sector as improvements in information technology, increased use of statistical techniques in applied finance, and the globalization of financial markets have allowed nonbank and foreign bank competitors to gain market share over U.S. banks. For example, over the 1980s and first half of the 1990s, the share of total U.S. nonfarm, nonfinancial corporate debt held by U.S. banks fell by about one-quarter from 19.6 percent to 14.5 percent. Banks compensated somewhat for these on-balance sheet reductions in a variety of ways. Many banks expanded their participation in off-balance sheet back-up lines of credit, standby letters of credit, and the securitization and sale of some large loans. Other adaptations included a shift in focus toward fee-based services and derivatives activities. The types of developments that might similarly reduce bank market share in small business lending are proceeding rather slowly at present, but may accelerate in the future. Improvements in analytical and information technologies such as credit scoring may decrease the cost of lending to small businesses and make it easier for nonbank lenders to enter this market. These developments are already contributing to more competition for small business loans within the banking industry and between bank and nonbank lenders. Similarly, a significant secondary market for securitization of loans to some small businesses may develop in the future. Those small businesses among current bank borrowers whose information problems are the least severe -- that is, those that are the least informationally opaque -- would presumably be the most likely to be funded outside of the banking system. Nevertheless, no matter how many advances there are in information processing and no matter how sophisticated financial markets may become, there will likely remain a significant role for bank-borrower relationship lending to solve the information and other financing problems of small businesses. That is, in the foreseeable future it seems very likely that there will remain many small business borrowers with sufficient problems that only bank information gathering, monitoring, and financing can overcome, although this group of borrowers will almost surely differ somewhat from current relationship borrowers. As technology and markets improve to the point that some relatively transparent small business borrowers can be financed outside the bank, other, more opaque potential borrowers that previously had information and other problems too serious for even a bank loan will enter the bank intermediation process. Put another way, the relationship lending process will fund small business borrowers with increasingly difficult information problems as the technology for resolving these problems improves. In my view, this should only increase the efficiency and the competitiveness of small business finance. For example, the improved ability of banks to lend to more opaque borrowers should provide some increased competition for the venture capitalists and angel financiers that were discussed at the conference yesterday. The value of gathering information through the relationship between banks and small businesses also bodes well for the survival of small community-based banks that tend to specialize in these relationships. Most forecasts of the future of the U.S. banking industry predict that thousands of small banks will survive. I hasten to point out that these are not my personal forecasts. I stick to predicting interest rates, GDP growth, and inflation -- items over which I have more control and inside information -- and I leave the banking forecasts to others! But the forecast of thousands of small banks continuing to operate and do well makes sense to me. They have information advantages, knowhow, and local community orientations that are hard to duplicate in large organizations. The importance of relationship lending to small business also raises prudential concerns about bank risk taking. When a bank fails, the losses to society exceed the book values involved because of the loss of the value of the bank's customer relationships. Even if small business borrowers are able to find financing after their bank fails, it may be at a higher interest rate and with additional collateral requirements until the new bank has had a chance to learn about the borrower's condition and prospects. When many banks fail during a crisis, this can create a credit crunch or significant reduction in the supply of credit to bank-dependent small business borrowers. For example, research on the Great Depression suggests that the loss of bank-borrower relationships in the 1930s may have deepened and prolonged the economic downturn. More recently, it appears that the weak capital positions of many banks in the late 1980s and early 1990s, not to mention the outright failure of over 1,100 banks during this period, contributed importantly to the sharp slowdown in bank commercial lending during the early 1990s. While the ability of small businesses to find alternative sources of funds is considerably greater today than in the 1930s, and will likely be even greater in the future than it was in the early 1990s, such arguments do reinforce the importance of the connection between macroeconomic and bank supervisory policy. Financial Modernization and Bank Small Business Lending In the remainder of my remarks, I will touch on three additional concerns about the potential effects of financial modernization on the supply of bank credit to small business. I will first discuss the effects of increases in market concentration created by bank mergers and acquisitions within a local market; second, the effects of consolidation of the banking industry as a whole; and third, the possible impacts of the increased complexity of financial service firms in which banking and other organizations may provide a multitude of traditional banking and nonbanking services. At the outset, I would emphasize that the overriding public policy concern regarding these issues is not the quantity of small business lending, but rather economic efficiency. If some banks are issuing loans to finance negative net present value projects, then such loans should be discouraged. If consolidation of the banking industry or the increased complexity of financial services firms reduces such lending, then economic efficiency is promoted by freeing up those resources to be invested elsewhere, even though the supply of small business credit to these borrowers is reduced. Similarly, a lack of competition or poor corporate control may currently be keeping some positive net present value loans from being made. If modernization increases the supply of loans to creditworthy small business borrowers to pursue financially sound projects, then economic efficiency is also raised as the supply of credit to these small businesses rises. Antitrust analysis in banking has typically been based on the concentration of bank deposits in local markets like Metropolitan Statistical Areas (MSAs) or non-MSA rural counties. Under the traditional "cluster approach," small business loans and other products are assumed to be competitive on approximately the same basis as bank deposits in local markets. While on-going technological and institutional changes seem likely to erode the usefulness of this assumption over time, evidence continues to generally support this assumption. As I noted earlier, small businesses typically get their loans and other financial services from a local bank. Additional research finds that the concentration of the local banking market is a key determinant of the rates that are charged on small business loans. For example, it is estimated that small business borrowers in the most concentrated markets pay rates about 50 to 150 basis points higher than those in the least concentrated markets. This exceeds estimates of the effects of local market concentration on retail deposit rates of about 50 basis points. Research has also suggested that high local-market deposit concentration may lead to reduced managerial efficiency, as the price cushion provided by market power allows a "quiet life" for managers in which relatively little effort is required to be profitable. Managers in these concentrated markets may choose to work less hard or pursue their own personal interests because the lower rates on deposits and higher rates on small business loans raise profits enough to cover for inefficient or self-serving practices. These findings support the need to maintain competition in local banking markets to deter the exercise of market power in pricing consumer deposits and small business loans, and to ensure that the local banks are under sufficient competitive pressure that they are operated in a reasonably efficient way. When bank mergers and acquisitions involve banks operating in different local markets, the issues raised are typically quite different from those I have just discussed. Since the late 1970s, states have been liberalizing laws that previously restricted mergers and acquisitions between banks in different local markets, including allowing holding company acquisitions across state lines. The U.S. banking industry has responded strongly and has been consolidating at a rapid rate over the last 15 years. Consolidation has picked up even more in the first half of the 1990s -- each year bank mergers have involved about 20 percent of industry assets. This trend is likely to continue or accelerate under the Riegle-Neal Act, which has already allowed increased interstate banking, and which will allow interstate branching into almost all states this summer. Importantly, an increase in local market concentration is not a major issue in most of these mergers and acquisitions, as they are primarily of the market-extension type. As such, these consolidations, and sometimes merely the threat of such actions, may be pro-competitive and reduce the market power of local banks over depositors and small business borrowers in the markets that are invaded. They may also improve the diversification and efficiency of the consolidating institutions. Research generally suggests that most mergers and acquisitions, by improving diversification, allow the consolidating institutions to make more loans and improve their profit efficiency. Mostly as a result of these mergers and acquisitions, the mean size of banking organizations has approximately doubled in real terms in the last 15 years. As I mentioned earlier, a frequently voiced concern about this consolidation is whether the supply of credit to small business may be decreased, since larger banking institutions tend to devote smaller proportions of their assets to small business lending. To illustrate, banks with under $100 million in assets devote about 9 percent of their assets to small business lending on average, whereas banks with over $10 billion in assets invest only about 2 percent of assets in these loans. While such a simplistic analysis may sound appealing on the surface, it is clearly incomplete. It neglects the fundamental nature of mergers and acquisitions as dynamic events that may involve significant changes in the business focus of the consolidating institutions. That is, banks get involved in mergers and acquisitions because they want to do something different, not simply behave like a larger bank. The simplistic comparison of the lending patterns of large and small banks also ignores the reactions of other lenders in the same local markets. Other existing or even new local banks or nonbank lenders might pick up any profitable loans that are no longer supplied by the consolidated banking institutions. These other institutions may also react to M&As with their own dynamic changes in focus that could either increase or decrease their supplies of small business loans. Thus, even if merging institutions reduce their own supplies of small business loans substantially, the total supply of these loans in the local market need not decline. There have been a number of recent studies of these dynamic effects of bank mergers and acquisitions, some of which we heard about this morning. The results suggest that the dynamic effects of mergers and acquisitions are much more complex and heterogenous than would be suggested by the increased sizes of the consolidating institutions alone. For example, mergers of small and medium-sized banks appear to be associated with increases in small business lending by the merging banks, whereas mergers of large banks may be associated with decreases in small business lending by the participants. On average, mergers appear to reduce small business lending by the participants, but this decline appears to be offset in part or in whole by an increase in lending by other banks in the same local market. These other banks may pick up profitable loans that are dropped by merging institutions, or otherwise have dynamic reactions that increase their supplies of small business lending. Moreover, these results do not include the potential for increased lending by nonbank firms. The bottom line is that small business loan markets seem to work quite well. Creditworthy borrowers with financially sound projects seem to receive financing, although they sometimes have to bear the short-term switching costs, such as temporarily higher loan rates and collateral requirements, of changing banks after their institutions merge. On-going technological change in small business lending should only help to improve the efficiency of this process. Again, I would emphasize that it is not the quantity of small business loans supplied that is most important, but rather the economic efficiency with which the market chooses which small businesses receive credit. To the extent that mergers and acquisitions are pro-competitive and improve corporate control and efficiency, the supply of credit to some borrowers with negative net present value projects may be reduced, as it should be. That is, the protection from competition provided by interstate and intrastate barriers may have allowed some firms with market power to be inefficient or make uneconomic loans. Similarly, any improvement in competition and efficiency may increase the supply of credit to borrowers with positive net present value projects that inefficient lenders previously did not fund. In either of these cases, economic efficiency is improved. As promised, the final issue I will discuss is that aspect of the modernization of financial markets in which financial service firms are likely to become more complex, providing more types of financial services within the same organization. At the present time, we do not know if and when the Glass-Steagall Act will be repealed, whether nontraditional activities will be provided by bank subsidiaries or bank holding company affiliates, and in which activities banking organizations will be allowed to engage or choose to engage. However, similar to the arguments regarding consolidation of the banking industry, concern is sometimes expressed that small business borrowers may receive less credit from these larger, more complex financial institutions. There is much less research evidence available regarding the potential effects on small business lending of this type of financial modernization than there is about the consolidation of the banking industry, so my remarks here are substantially more speculative. However, I believe there are several reasons for optimism regarding adequate supplies of services to creditworthy small businesses. First, a limited amount of research suggests that there is little if any effect of the current organizational complexity of U.S. banks on their treatment of small businesses, other things equal. In particular, banking organizations with multiple layers of management, those that operate in multiple states, those with Section 20 securities affiliates, and those with other organizational complexities tend to charge about as much for small business credit as other banks of their same size. Second, the research results for the consolidation of banks alone suggest that if profitable loans are dropped by the newer universal-like banks, other small banks or nonbank firms will be standing by to pick up these loans. Finally, the additional insurance, securities underwriting, or other financial services provided by the new institutions should provide greater opportunities for small businesses to have access to these nontraditional services. I want to leave time for questions, so let me conclude with a few summary comments. It is gratifying to see all of this attention being paid to the financing of small business, which is a vital part of our economy, and the Federal Reserve is working actively to stay abreast of the issues with its data collection and research efforts. Small businesses tend to rely on banks for their credit needs and other financial services, and relationships between banks and small businesses are important and efficient means of distributing these services. While technological and institutional changes are and undoubtedly will in the future affect these relationships, it seems unlikely that the core bank-small business relationship will be replaced. The continued heavy dependence of small businesses on local banks also suggests an on-going need for bank supervisors to be sensitive to antitrust issues when considering mergers and acquisitions of banks in the same local market. In contrast, cross-market mergers rarely raise antitrust concerns; indeed, such mergers can be quite pro-competitive. Finally, while some observers have argued that banking consolidation and other aspects of the modernization of the banking industry and financial markets raise concerns about the supply of credit to small business, the market for small business loans in fact seems to work rather well. If there is a merger or other event that reduces the supply of profitable loans to small businesses, other banks seem to step in and provide this credit, and there is every reason to expect that such responses will continue in the future.	---[PAGE_BREAK]--- Mr. Meyer looks at the role of US banks in small business finance Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the Conference on Small Business Finance held at the Leonard N. Stern School of Business, Berkley Center for Entrepreneurial Studies and New York University Salomon Center in New York on 23/5/97. It is a pleasure to be here to meet with you at New York University for this Conference on Small Business Finance. It is clear from the conference program that there is an excellent mix of academics, government representatives, and practitioners here to study how small business is financed. Indeed, I am glad to see so much attention being paid to this important topic. Small business is a vital and energetic part of our economy that plays a key role in the generation of jobs, new ideas, and the encouragement of entrepreneurial activity. Without doubt, a thriving small business sector contributes to the well-being of our nation. Today, I would like to share with you some thoughts about the role of banks in supplying credit to small business. The part played by banks in small business finance is not a new topic for the Federal Reserve. In fact, for many years we have been devoting substantial resources to collecting and analyzing data on small business finance generally, and the credit supplied by banks in particular. We collect data from small businesses on how they obtain financing -- or in some cases fail to obtain financing -- using the National Survey of Small Business Finance and the Survey of Consumer Finances. We also gather information directly on the small business credit extended by individual commercial banks. We have collected information on the contract terms of bank loans to both small and large businesses since 1977 through the Survey of Terms of Bank Lending to Business. Since 1993, the banking agencies have required all commercial banks to report their quantities of loans to businesses by size of loan on the June Call Reports. Lastly, as part of revised Community Reinvestment Act procedures, the banking agencies have just this year begun to collect data on small business loans by local geographic area. When these data become available, they should prove to be a rich source of new information. A number of economists have used the existing data in research that has helped us to better understand the potential effects on the supply of small business credit of public policies regarding bank mergers and acquisitions, financial modernization, and prudential supervision and regulation. For example, some have argued that the consolidation of the banking industry may be reducing the supply of credit to small business, since larger banking institutions tend to devote smaller proportions of their assets to small business lending. Solid economic research applying modern econometric techniques to accurate data is needed to evaluate such claims and to determine the likely effects of policy actions in order to improve future policy decisions. # The Importance of the Bank-Small Business Relationship According to our survey information, commercial banks are the single most important source of external credit to small firms. Small businesses rely on banks not just for a reliable supply of credit, but for transactions and deposit services as well. Because of their needs for banking services on both the asset and liability sides of their balance sheets, small businesses typically enter into relationships with nearby banks. The data show, for example, that 85 percent of small businesses use the services of a commercial bank within 30 miles of their firm, and that small businesses typically obtain multiple different services from their local bank. The 30 miles actually overstates the distance that small businesses are willing to travel for most of their basic financial services. For example, the median distances from a small business' offices to the ---[PAGE_BREAK]--- institutions where it obtains deposit, credit, or financial management services are all 5 miles or less. One of the reasons why the banking relationship is so important to small business finance is that banks can efficiently gain valuable information on a small business over the course of their relationship, and then use this information to help make pricing and credit decisions. The financial conditions of small firms are usually rather opaque to investors, and the costs of issuing securities directly to the public are prohibitive for most small firms. Thus, without financial intermediaries like banks it would simply be too costly for most investors to learn the information needed to provide the credit, and too costly for the small firm to issue the credit itself. Banks, performing the classic functions of financial intermediaries, solve these problems by producing information about borrowers and monitoring them over time, by setting loan contract terms to improve borrower incentives, by renegotiating the terms if and when the borrower is in financial difficulty, and by diversifying the risks across many small business credits. Some recent empirical research suggests that this characterization of the bank-small business borrower relationship is accurate. For example, as the relationship matures, banks typically reduce the interest rates charged and often drop the collateral requirements on small business loans. In short, the bank-borrower relationship appears to be an efficient means for overcoming information and cost problems in small firm finance, and for allowing fundamentally creditworthy small firms to finance sound projects that might otherwise go unfunded. One implication of the importance of the bank-small business relationship is that it may impose limits on the migration of small business finance out of the banking sector. Over the last two decades, many large business loans left the banking sector as improvements in information technology, increased use of statistical techniques in applied finance, and the globalization of financial markets have allowed nonbank and foreign bank competitors to gain market share over U.S. banks. For example, over the 1980s and first half of the 1990s, the share of total U.S. nonfarm, nonfinancial corporate debt held by U.S. banks fell by about one-quarter from 19.6 percent to 14.5 percent. Banks compensated somewhat for these on-balance sheet reductions in a variety of ways. Many banks expanded their participation in off-balance sheet back-up lines of credit, standby letters of credit, and the securitization and sale of some large loans. Other adaptations included a shift in focus toward fee-based services and derivatives activities. The types of developments that might similarly reduce bank market share in small business lending are proceeding rather slowly at present, but may accelerate in the future. Improvements in analytical and information technologies such as credit scoring may decrease the cost of lending to small businesses and make it easier for nonbank lenders to enter this market. These developments are already contributing to more competition for small business loans within the banking industry and between bank and nonbank lenders. Similarly, a significant secondary market for securitization of loans to some small businesses may develop in the future. Those small businesses among current bank borrowers whose information problems are the least severe -- that is, those that are the least informationally opaque -- would presumably be the most likely to be funded outside of the banking system. Nevertheless, no matter how many advances there are in information processing and no matter how sophisticated financial markets may become, there will likely remain a significant role for bank-borrower relationship lending to solve the information and other ---[PAGE_BREAK]--- financing problems of small businesses. That is, in the foreseeable future it seems very likely that there will remain many small business borrowers with sufficient problems that only bank information gathering, monitoring, and financing can overcome, although this group of borrowers will almost surely differ somewhat from current relationship borrowers. As technology and markets improve to the point that some relatively transparent small business borrowers can be financed outside the bank, other, more opaque potential borrowers that previously had information and other problems too serious for even a bank loan will enter the bank intermediation process. Put another way, the relationship lending process will fund small business borrowers with increasingly difficult information problems as the technology for resolving these problems improves. In my view, this should only increase the efficiency and the competitiveness of small business finance. For example, the improved ability of banks to lend to more opaque borrowers should provide some increased competition for the venture capitalists and angel financiers that were discussed at the conference yesterday. The value of gathering information through the relationship between banks and small businesses also bodes well for the survival of small community-based banks that tend to specialize in these relationships. Most forecasts of the future of the U.S. banking industry predict that thousands of small banks will survive. I hasten to point out that these are not my personal forecasts. I stick to predicting interest rates, GDP growth, and inflation -- items over which I have more control and inside information -- and I leave the banking forecasts to others! But the forecast of thousands of small banks continuing to operate and do well makes sense to me. They have information advantages, knowhow, and local community orientations that are hard to duplicate in large organizations. The importance of relationship lending to small business also raises prudential concerns about bank risk taking. When a bank fails, the losses to society exceed the book values involved because of the loss of the value of the bank's customer relationships. Even if small business borrowers are able to find financing after their bank fails, it may be at a higher interest rate and with additional collateral requirements until the new bank has had a chance to learn about the borrower's condition and prospects. When many banks fail during a crisis, this can create a credit crunch or significant reduction in the supply of credit to bank-dependent small business borrowers. For example, research on the Great Depression suggests that the loss of bank-borrower relationships in the 1930s may have deepened and prolonged the economic downturn. More recently, it appears that the weak capital positions of many banks in the late 1980s and early 1990s, not to mention the outright failure of over 1,100 banks during this period, contributed importantly to the sharp slowdown in bank commercial lending during the early 1990s. While the ability of small businesses to find alternative sources of funds is considerably greater today than in the 1930s, and will likely be even greater in the future than it was in the early 1990s, such arguments do reinforce the importance of the connection between macroeconomic and bank supervisory policy. # Financial Modernization and Bank Small Business Lending In the remainder of my remarks, I will touch on three additional concerns about the potential effects of financial modernization on the supply of bank credit to small business. I will first discuss the effects of increases in market concentration created by bank mergers and acquisitions within a local market; second, the effects of consolidation of the banking industry as a whole; and third, the possible impacts of the increased complexity of financial service firms in which banking and other organizations may provide a multitude of traditional banking and nonbanking services. ---[PAGE_BREAK]--- At the outset, I would emphasize that the overriding public policy concern regarding these issues is not the quantity of small business lending, but rather economic efficiency. If some banks are issuing loans to finance negative net present value projects, then such loans should be discouraged. If consolidation of the banking industry or the increased complexity of financial services firms reduces such lending, then economic efficiency is promoted by freeing up those resources to be invested elsewhere, even though the supply of small business credit to these borrowers is reduced. Similarly, a lack of competition or poor corporate control may currently be keeping some positive net present value loans from being made. If modernization increases the supply of loans to creditworthy small business borrowers to pursue financially sound projects, then economic efficiency is also raised as the supply of credit to these small businesses rises. Antitrust analysis in banking has typically been based on the concentration of bank deposits in local markets like Metropolitan Statistical Areas (MSAs) or non-MSA rural counties. Under the traditional "cluster approach," small business loans and other products are assumed to be competitive on approximately the same basis as bank deposits in local markets. While on-going technological and institutional changes seem likely to erode the usefulness of this assumption over time, evidence continues to generally support this assumption. As I noted earlier, small businesses typically get their loans and other financial services from a local bank. Additional research finds that the concentration of the local banking market is a key determinant of the rates that are charged on small business loans. For example, it is estimated that small business borrowers in the most concentrated markets pay rates about 50 to 150 basis points higher than those in the least concentrated markets. This exceeds estimates of the effects of local market concentration on retail deposit rates of about 50 basis points. Research has also suggested that high local-market deposit concentration may lead to reduced managerial efficiency, as the price cushion provided by market power allows a "quiet life" for managers in which relatively little effort is required to be profitable. Managers in these concentrated markets may choose to work less hard or pursue their own personal interests because the lower rates on deposits and higher rates on small business loans raise profits enough to cover for inefficient or self-serving practices. These findings support the need to maintain competition in local banking markets to deter the exercise of market power in pricing consumer deposits and small business loans, and to ensure that the local banks are under sufficient competitive pressure that they are operated in a reasonably efficient way. When bank mergers and acquisitions involve banks operating in different local markets, the issues raised are typically quite different from those I have just discussed. Since the late 1970s, states have been liberalizing laws that previously restricted mergers and acquisitions between banks in different local markets, including allowing holding company acquisitions across state lines. The U.S. banking industry has responded strongly and has been consolidating at a rapid rate over the last 15 years. Consolidation has picked up even more in the first half of the 1990s -- each year bank mergers have involved about 20 percent of industry assets. This trend is likely to continue or accelerate under the Riegle-Neal Act, which has already allowed increased interstate banking, and which will allow interstate branching into almost all states this summer. Importantly, an increase in local market concentration is not a major issue in most of these mergers and acquisitions, as they are primarily of the market-extension type. As such, these consolidations, and sometimes merely the threat of such actions, may be pro-competitive ---[PAGE_BREAK]--- and reduce the market power of local banks over depositors and small business borrowers in the markets that are invaded. They may also improve the diversification and efficiency of the consolidating institutions. Research generally suggests that most mergers and acquisitions, by improving diversification, allow the consolidating institutions to make more loans and improve their profit efficiency. Mostly as a result of these mergers and acquisitions, the mean size of banking organizations has approximately doubled in real terms in the last 15 years. As I mentioned earlier, a frequently voiced concern about this consolidation is whether the supply of credit to small business may be decreased, since larger banking institutions tend to devote smaller proportions of their assets to small business lending. To illustrate, banks with under $\$ 100$ million in assets devote about 9 percent of their assets to small business lending on average, whereas banks with over $\$ 10$ billion in assets invest only about 2 percent of assets in these loans. While such a simplistic analysis may sound appealing on the surface, it is clearly incomplete. It neglects the fundamental nature of mergers and acquisitions as dynamic events that may involve significant changes in the business focus of the consolidating institutions. That is, banks get involved in mergers and acquisitions because they want to do something different, not simply behave like a larger bank. The simplistic comparison of the lending patterns of large and small banks also ignores the reactions of other lenders in the same local markets. Other existing or even new local banks or nonbank lenders might pick up any profitable loans that are no longer supplied by the consolidated banking institutions. These other institutions may also react to M\&As with their own dynamic changes in focus that could either increase or decrease their supplies of small business loans. Thus, even if merging institutions reduce their own supplies of small business loans substantially, the total supply of these loans in the local market need not decline. There have been a number of recent studies of these dynamic effects of bank mergers and acquisitions, some of which we heard about this morning. The results suggest that the dynamic effects of mergers and acquisitions are much more complex and heterogenous than would be suggested by the increased sizes of the consolidating institutions alone. For example, mergers of small and medium-sized banks appear to be associated with increases in small business lending by the merging banks, whereas mergers of large banks may be associated with decreases in small business lending by the participants. On average, mergers appear to reduce small business lending by the participants, but this decline appears to be offset in part or in whole by an increase in lending by other banks in the same local market. These other banks may pick up profitable loans that are dropped by merging institutions, or otherwise have dynamic reactions that increase their supplies of small business lending. Moreover, these results do not include the potential for increased lending by nonbank firms. The bottom line is that small business loan markets seem to work quite well. Creditworthy borrowers with financially sound projects seem to receive financing, although they sometimes have to bear the short-term switching costs, such as temporarily higher loan rates and collateral requirements, of changing banks after their institutions merge. On-going technological change in small business lending should only help to improve the efficiency of this process. Again, I would emphasize that it is not the quantity of small business loans supplied that is most important, but rather the economic efficiency with which the market chooses which small businesses receive credit. To the extent that mergers and acquisitions are pro-competitive and improve corporate control and efficiency, the supply of credit to some ---[PAGE_BREAK]--- borrowers with negative net present value projects may be reduced, as it should be. That is, the protection from competition provided by interstate and intrastate barriers may have allowed some firms with market power to be inefficient or make uneconomic loans. Similarly, any improvement in competition and efficiency may increase the supply of credit to borrowers with positive net present value projects that inefficient lenders previously did not fund. In either of these cases, economic efficiency is improved. As promised, the final issue I will discuss is that aspect of the modernization of financial markets in which financial service firms are likely to become more complex, providing more types of financial services within the same organization. At the present time, we do not know if and when the Glass-Steagall Act will be repealed, whether nontraditional activities will be provided by bank subsidiaries or bank holding company affiliates, and in which activities banking organizations will be allowed to engage or choose to engage. However, similar to the arguments regarding consolidation of the banking industry, concern is sometimes expressed that small business borrowers may receive less credit from these larger, more complex financial institutions. There is much less research evidence available regarding the potential effects on small business lending of this type of financial modernization than there is about the consolidation of the banking industry, so my remarks here are substantially more speculative. However, I believe there are several reasons for optimism regarding adequate supplies of services to creditworthy small businesses. First, a limited amount of research suggests that there is little if any effect of the current organizational complexity of U.S. banks on their treatment of small businesses, other things equal. In particular, banking organizations with multiple layers of management, those that operate in multiple states, those with Section 20 securities affiliates, and those with other organizational complexities tend to charge about as much for small business credit as other banks of their same size. Second, the research results for the consolidation of banks alone suggest that if profitable loans are dropped by the newer universal-like banks, other small banks or nonbank firms will be standing by to pick up these loans. Finally, the additional insurance, securities underwriting, or other financial services provided by the new institutions should provide greater opportunities for small businesses to have access to these nontraditional services. I want to leave time for questions, so let me conclude with a few summary comments. It is gratifying to see all of this attention being paid to the financing of small business, which is a vital part of our economy, and the Federal Reserve is working actively to stay abreast of the issues with its data collection and research efforts. Small businesses tend to rely on banks for their credit needs and other financial services, and relationships between banks and small businesses are important and efficient means of distributing these services. While technological and institutional changes are and undoubtedly will in the future affect these relationships, it seems unlikely that the core bank-small business relationship will be replaced. The continued heavy dependence of small businesses on local banks also suggests an on-going need for bank supervisors to be sensitive to antitrust issues when considering mergers and acquisitions of banks in the same local market. In contrast, cross-market mergers rarely raise antitrust concerns; indeed, such mergers can be quite pro-competitive. Finally, while some observers have argued that banking consolidation and other aspects of the modernization of the banking industry and financial markets raise concerns about the supply of credit to small business, the market for small business loans in fact seems to work rather well. If there is a merger or other event that reduces the supply of profitable loans to small businesses, other banks seem to step in and provide this credit, and there is every reason to expect that such responses will continue in the future.	Laurence H Meyer	United States	https://www.bis.org/review/r970609a.pdf	Mr. Meyer looks at the role of US banks in small business finance Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the Conference on Small Business Finance held at the Leonard N. Stern School of Business, Berkley Center for Entrepreneurial Studies and New York University Salomon Center in New York on 23/5/97. It is a pleasure to be here to meet with you at New York University for this Conference on Small Business Finance. It is clear from the conference program that there is an excellent mix of academics, government representatives, and practitioners here to study how small business is financed. Indeed, I am glad to see so much attention being paid to this important topic. Small business is a vital and energetic part of our economy that plays a key role in the generation of jobs, new ideas, and the encouragement of entrepreneurial activity. Without doubt, a thriving small business sector contributes to the well-being of our nation. Today, I would like to share with you some thoughts about the role of banks in supplying credit to small business. The part played by banks in small business finance is not a new topic for the Federal Reserve. In fact, for many years we have been devoting substantial resources to collecting and analyzing data on small business finance generally, and the credit supplied by banks in particular. We collect data from small businesses on how they obtain financing -- or in some cases fail to obtain financing -- using the National Survey of Small Business Finance and the Survey of Consumer Finances. We also gather information directly on the small business credit extended by individual commercial banks. We have collected information on the contract terms of bank loans to both small and large businesses since 1977 through the Survey of Terms of Bank Lending to Business. Since 1993, the banking agencies have required all commercial banks to report their quantities of loans to businesses by size of loan on the June Call Reports. Lastly, as part of revised Community Reinvestment Act procedures, the banking agencies have just this year begun to collect data on small business loans by local geographic area. When these data become available, they should prove to be a rich source of new information. A number of economists have used the existing data in research that has helped us to better understand the potential effects on the supply of small business credit of public policies regarding bank mergers and acquisitions, financial modernization, and prudential supervision and regulation. For example, some have argued that the consolidation of the banking industry may be reducing the supply of credit to small business, since larger banking institutions tend to devote smaller proportions of their assets to small business lending. Solid economic research applying modern econometric techniques to accurate data is needed to evaluate such claims and to determine the likely effects of policy actions in order to improve future policy decisions. According to our survey information, commercial banks are the single most important source of external credit to small firms. Small businesses rely on banks not just for a reliable supply of credit, but for transactions and deposit services as well. Because of their needs for banking services on both the asset and liability sides of their balance sheets, small businesses typically enter into relationships with nearby banks. The data show, for example, that 85 percent of small businesses use the services of a commercial bank within 30 miles of their firm, and that small businesses typically obtain multiple different services from their local bank. The 30 miles actually overstates the distance that small businesses are willing to travel for most of their basic financial services. For example, the median distances from a small business' offices to the institutions where it obtains deposit, credit, or financial management services are all 5 miles or less. One of the reasons why the banking relationship is so important to small business finance is that banks can efficiently gain valuable information on a small business over the course of their relationship, and then use this information to help make pricing and credit decisions. The financial conditions of small firms are usually rather opaque to investors, and the costs of issuing securities directly to the public are prohibitive for most small firms. Thus, without financial intermediaries like banks it would simply be too costly for most investors to learn the information needed to provide the credit, and too costly for the small firm to issue the credit itself. Banks, performing the classic functions of financial intermediaries, solve these problems by producing information about borrowers and monitoring them over time, by setting loan contract terms to improve borrower incentives, by renegotiating the terms if and when the borrower is in financial difficulty, and by diversifying the risks across many small business credits. Some recent empirical research suggests that this characterization of the bank-small business borrower relationship is accurate. For example, as the relationship matures, banks typically reduce the interest rates charged and often drop the collateral requirements on small business loans. In short, the bank-borrower relationship appears to be an efficient means for overcoming information and cost problems in small firm finance, and for allowing fundamentally creditworthy small firms to finance sound projects that might otherwise go unfunded. One implication of the importance of the bank-small business relationship is that it may impose limits on the migration of small business finance out of the banking sector. Over the last two decades, many large business loans left the banking sector as improvements in information technology, increased use of statistical techniques in applied finance, and the globalization of financial markets have allowed nonbank and foreign bank competitors to gain market share over U.S. banks. For example, over the 1980s and first half of the 1990s, the share of total U.S. nonfarm, nonfinancial corporate debt held by U.S. banks fell by about one-quarter from 19.6 percent to 14.5 percent. Banks compensated somewhat for these on-balance sheet reductions in a variety of ways. Many banks expanded their participation in off-balance sheet back-up lines of credit, standby letters of credit, and the securitization and sale of some large loans. Other adaptations included a shift in focus toward fee-based services and derivatives activities. The types of developments that might similarly reduce bank market share in small business lending are proceeding rather slowly at present, but may accelerate in the future. Improvements in analytical and information technologies such as credit scoring may decrease the cost of lending to small businesses and make it easier for nonbank lenders to enter this market. These developments are already contributing to more competition for small business loans within the banking industry and between bank and nonbank lenders. Similarly, a significant secondary market for securitization of loans to some small businesses may develop in the future. Those small businesses among current bank borrowers whose information problems are the least severe -- that is, those that are the least informationally opaque -- would presumably be the most likely to be funded outside of the banking system. Nevertheless, no matter how many advances there are in information processing and no matter how sophisticated financial markets may become, there will likely remain a significant role for bank-borrower relationship lending to solve the information and other financing problems of small businesses. That is, in the foreseeable future it seems very likely that there will remain many small business borrowers with sufficient problems that only bank information gathering, monitoring, and financing can overcome, although this group of borrowers will almost surely differ somewhat from current relationship borrowers. As technology and markets improve to the point that some relatively transparent small business borrowers can be financed outside the bank, other, more opaque potential borrowers that previously had information and other problems too serious for even a bank loan will enter the bank intermediation process. Put another way, the relationship lending process will fund small business borrowers with increasingly difficult information problems as the technology for resolving these problems improves. In my view, this should only increase the efficiency and the competitiveness of small business finance. For example, the improved ability of banks to lend to more opaque borrowers should provide some increased competition for the venture capitalists and angel financiers that were discussed at the conference yesterday. The value of gathering information through the relationship between banks and small businesses also bodes well for the survival of small community-based banks that tend to specialize in these relationships. Most forecasts of the future of the U.S. banking industry predict that thousands of small banks will survive. I hasten to point out that these are not my personal forecasts. I stick to predicting interest rates, GDP growth, and inflation -- items over which I have more control and inside information -- and I leave the banking forecasts to others! But the forecast of thousands of small banks continuing to operate and do well makes sense to me. They have information advantages, knowhow, and local community orientations that are hard to duplicate in large organizations. The importance of relationship lending to small business also raises prudential concerns about bank risk taking. When a bank fails, the losses to society exceed the book values involved because of the loss of the value of the bank's customer relationships. Even if small business borrowers are able to find financing after their bank fails, it may be at a higher interest rate and with additional collateral requirements until the new bank has had a chance to learn about the borrower's condition and prospects. When many banks fail during a crisis, this can create a credit crunch or significant reduction in the supply of credit to bank-dependent small business borrowers. For example, research on the Great Depression suggests that the loss of bank-borrower relationships in the 1930s may have deepened and prolonged the economic downturn. More recently, it appears that the weak capital positions of many banks in the late 1980s and early 1990s, not to mention the outright failure of over 1,100 banks during this period, contributed importantly to the sharp slowdown in bank commercial lending during the early 1990s. While the ability of small businesses to find alternative sources of funds is considerably greater today than in the 1930s, and will likely be even greater in the future than it was in the early 1990s, such arguments do reinforce the importance of the connection between macroeconomic and bank supervisory policy. In the remainder of my remarks, I will touch on three additional concerns about the potential effects of financial modernization on the supply of bank credit to small business. I will first discuss the effects of increases in market concentration created by bank mergers and acquisitions within a local market; second, the effects of consolidation of the banking industry as a whole; and third, the possible impacts of the increased complexity of financial service firms in which banking and other organizations may provide a multitude of traditional banking and nonbanking services. At the outset, I would emphasize that the overriding public policy concern regarding these issues is not the quantity of small business lending, but rather economic efficiency. If some banks are issuing loans to finance negative net present value projects, then such loans should be discouraged. If consolidation of the banking industry or the increased complexity of financial services firms reduces such lending, then economic efficiency is promoted by freeing up those resources to be invested elsewhere, even though the supply of small business credit to these borrowers is reduced. Similarly, a lack of competition or poor corporate control may currently be keeping some positive net present value loans from being made. If modernization increases the supply of loans to creditworthy small business borrowers to pursue financially sound projects, then economic efficiency is also raised as the supply of credit to these small businesses rises. Antitrust analysis in banking has typically been based on the concentration of bank deposits in local markets like Metropolitan Statistical Areas (MSAs) or non-MSA rural counties. Under the traditional "cluster approach," small business loans and other products are assumed to be competitive on approximately the same basis as bank deposits in local markets. While on-going technological and institutional changes seem likely to erode the usefulness of this assumption over time, evidence continues to generally support this assumption. As I noted earlier, small businesses typically get their loans and other financial services from a local bank. Additional research finds that the concentration of the local banking market is a key determinant of the rates that are charged on small business loans. For example, it is estimated that small business borrowers in the most concentrated markets pay rates about 50 to 150 basis points higher than those in the least concentrated markets. This exceeds estimates of the effects of local market concentration on retail deposit rates of about 50 basis points. Research has also suggested that high local-market deposit concentration may lead to reduced managerial efficiency, as the price cushion provided by market power allows a "quiet life" for managers in which relatively little effort is required to be profitable. Managers in these concentrated markets may choose to work less hard or pursue their own personal interests because the lower rates on deposits and higher rates on small business loans raise profits enough to cover for inefficient or self-serving practices. These findings support the need to maintain competition in local banking markets to deter the exercise of market power in pricing consumer deposits and small business loans, and to ensure that the local banks are under sufficient competitive pressure that they are operated in a reasonably efficient way. When bank mergers and acquisitions involve banks operating in different local markets, the issues raised are typically quite different from those I have just discussed. Since the late 1970s, states have been liberalizing laws that previously restricted mergers and acquisitions between banks in different local markets, including allowing holding company acquisitions across state lines. The U.S. banking industry has responded strongly and has been consolidating at a rapid rate over the last 15 years. Consolidation has picked up even more in the first half of the 1990s -- each year bank mergers have involved about 20 percent of industry assets. This trend is likely to continue or accelerate under the Riegle-Neal Act, which has already allowed increased interstate banking, and which will allow interstate branching into almost all states this summer. Importantly, an increase in local market concentration is not a major issue in most of these mergers and acquisitions, as they are primarily of the market-extension type. As such, these consolidations, and sometimes merely the threat of such actions, may be pro-competitive and reduce the market power of local banks over depositors and small business borrowers in the markets that are invaded. They may also improve the diversification and efficiency of the consolidating institutions. Research generally suggests that most mergers and acquisitions, by improving diversification, allow the consolidating institutions to make more loans and improve their profit efficiency. Mostly as a result of these mergers and acquisitions, the mean size of banking organizations has approximately doubled in real terms in the last 15 years. As I mentioned earlier, a frequently voiced concern about this consolidation is whether the supply of credit to small business may be decreased, since larger banking institutions tend to devote smaller proportions of their assets to small business lending. To illustrate, banks with under $\$ 100$ million in assets devote about 9 percent of their assets to small business lending on average, whereas banks with over $\$ 10$ billion in assets invest only about 2 percent of assets in these loans. While such a simplistic analysis may sound appealing on the surface, it is clearly incomplete. It neglects the fundamental nature of mergers and acquisitions as dynamic events that may involve significant changes in the business focus of the consolidating institutions. That is, banks get involved in mergers and acquisitions because they want to do something different, not simply behave like a larger bank. The simplistic comparison of the lending patterns of large and small banks also ignores the reactions of other lenders in the same local markets. Other existing or even new local banks or nonbank lenders might pick up any profitable loans that are no longer supplied by the consolidated banking institutions. These other institutions may also react to M\&As with their own dynamic changes in focus that could either increase or decrease their supplies of small business loans. Thus, even if merging institutions reduce their own supplies of small business loans substantially, the total supply of these loans in the local market need not decline. There have been a number of recent studies of these dynamic effects of bank mergers and acquisitions, some of which we heard about this morning. The results suggest that the dynamic effects of mergers and acquisitions are much more complex and heterogenous than would be suggested by the increased sizes of the consolidating institutions alone. For example, mergers of small and medium-sized banks appear to be associated with increases in small business lending by the merging banks, whereas mergers of large banks may be associated with decreases in small business lending by the participants. On average, mergers appear to reduce small business lending by the participants, but this decline appears to be offset in part or in whole by an increase in lending by other banks in the same local market. These other banks may pick up profitable loans that are dropped by merging institutions, or otherwise have dynamic reactions that increase their supplies of small business lending. Moreover, these results do not include the potential for increased lending by nonbank firms. The bottom line is that small business loan markets seem to work quite well. Creditworthy borrowers with financially sound projects seem to receive financing, although they sometimes have to bear the short-term switching costs, such as temporarily higher loan rates and collateral requirements, of changing banks after their institutions merge. On-going technological change in small business lending should only help to improve the efficiency of this process. Again, I would emphasize that it is not the quantity of small business loans supplied that is most important, but rather the economic efficiency with which the market chooses which small businesses receive credit. To the extent that mergers and acquisitions are pro-competitive and improve corporate control and efficiency, the supply of credit to some borrowers with negative net present value projects may be reduced, as it should be. That is, the protection from competition provided by interstate and intrastate barriers may have allowed some firms with market power to be inefficient or make uneconomic loans. Similarly, any improvement in competition and efficiency may increase the supply of credit to borrowers with positive net present value projects that inefficient lenders previously did not fund. In either of these cases, economic efficiency is improved. As promised, the final issue I will discuss is that aspect of the modernization of financial markets in which financial service firms are likely to become more complex, providing more types of financial services within the same organization. At the present time, we do not know if and when the Glass-Steagall Act will be repealed, whether nontraditional activities will be provided by bank subsidiaries or bank holding company affiliates, and in which activities banking organizations will be allowed to engage or choose to engage. However, similar to the arguments regarding consolidation of the banking industry, concern is sometimes expressed that small business borrowers may receive less credit from these larger, more complex financial institutions. There is much less research evidence available regarding the potential effects on small business lending of this type of financial modernization than there is about the consolidation of the banking industry, so my remarks here are substantially more speculative. However, I believe there are several reasons for optimism regarding adequate supplies of services to creditworthy small businesses. First, a limited amount of research suggests that there is little if any effect of the current organizational complexity of U.S. banks on their treatment of small businesses, other things equal. In particular, banking organizations with multiple layers of management, those that operate in multiple states, those with Section 20 securities affiliates, and those with other organizational complexities tend to charge about as much for small business credit as other banks of their same size. Second, the research results for the consolidation of banks alone suggest that if profitable loans are dropped by the newer universal-like banks, other small banks or nonbank firms will be standing by to pick up these loans. Finally, the additional insurance, securities underwriting, or other financial services provided by the new institutions should provide greater opportunities for small businesses to have access to these nontraditional services. I want to leave time for questions, so let me conclude with a few summary comments. It is gratifying to see all of this attention being paid to the financing of small business, which is a vital part of our economy, and the Federal Reserve is working actively to stay abreast of the issues with its data collection and research efforts. Small businesses tend to rely on banks for their credit needs and other financial services, and relationships between banks and small businesses are important and efficient means of distributing these services. While technological and institutional changes are and undoubtedly will in the future affect these relationships, it seems unlikely that the core bank-small business relationship will be replaced. The continued heavy dependence of small businesses on local banks also suggests an on-going need for bank supervisors to be sensitive to antitrust issues when considering mergers and acquisitions of banks in the same local market. In contrast, cross-market mergers rarely raise antitrust concerns; indeed, such mergers can be quite pro-competitive. Finally, while some observers have argued that banking consolidation and other aspects of the modernization of the banking industry and financial markets raise concerns about the supply of credit to small business, the market for small business loans in fact seems to work rather well. If there is a merger or other event that reduces the supply of profitable loans to small businesses, other banks seem to step in and provide this credit, and there is every reason to expect that such responses will continue in the future.
1997-05-30T00:00:00	Mr. McDonough examines recent developments and trends in the foreign exchange markets (Central Bank Articles and Speeches, 30 May 97)	Remarks by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough, before the 39th International Congress of the Association Cambiste International, The Financial Markets Association in Toronto on 30/5/97.	Mr. McDonough examines recent developments and trends in the foreign exchange markets Remarks by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough, before the 39th International Congress of the Association Cambiste International, The Financial Markets Association in Toronto on 30/5/97. I am delighted to be invited to address the 39th International Congress of the Association Cambiste Internationale (ACI) -- The Financial Markets Association. I must confess to a certain affinity for the foreign exchange community, stemming, no doubt, from my commercial banking experience and my time overseeing the foreign exchange desk at the Federal Reserve Bank of New York. I've long believed that, more so than in most other sectors of the finance industry, there is a real community among those engaged in foreign exchange -- a community that relies on close personal ties and contacts. It is this spirit of community that makes events such as these ACI meetings today and tomorrow so enjoyable and important, giving us the opportunity to renew old friendships and build new relationships that will enable us to do our respective jobs that much better. In my remarks to you this morning, I would like to highlight some recent developments in the foreign exchange market and share with you my view, as a central banker, of what has been driving some of the trends we've been observing. We heard a lot of talk in the foreign exchange markets in 1996 about the "end of volatility." As the market performance of the last few weeks has demonstrated, such commentary was a bit exaggerated. However, even with the spike in volatility we've seen in recent weeks, there is no question that we have witnessed a remarkable period of relative stability in foreign exchange rates over the past six quarters or so. What accounts for this relative stability in the foreign exchange markets since late 1995? Economic fundamentals are certainly one factor -- we have had a period of relative price stability in the major world economies, and a general absence of severe market shocks. However, I would argue that what we've been observing is also, in part, a by-product of continuously greater transparency that has characterized the foreign exchange market over the past several years. Moreover, I am convinced that the increased transparency in the foreign exchange markets is beneficial: for the foreign exchange community, for financial markets in general, and for the global economy as a whole. Before explaining what I mean by greater transparency and why I believe it is so beneficial, I would like to take a quick look at the record itself. Is the talk about declining volatility reflected in hard evidence? Yes, it largely is. Thirty-day dollar-mark and dollar-yen historical volatility remained below 10 percent throughout most of 1996 and the first quarter of 1997, and, even with the price action we saw in May, the spike in thirty-day historical volatility we've observed is not particularly dramatic when compared with similar periods in past years. Similarly, implied volatility on dollar-mark and dollar-yen options traded to near record lows in 1996. But, as this month has shown, volatility has not been eliminated. There also have been a number of days in the past year and a half with considerable volatility in the foreign exchange market. And, I have no doubt that we'll have many more of these days -- at times, for example, when markets rapidly adjust to new information or when periods of poor liquidity result in exaggerated price swings. What is clear is that this is a market that is constantly evolving. None of us can say with any certainty whether we're observing the beginning of a trend or an anomalous period that will ultimately be viewed as a brief lull in volatility. However, I don't think many of you would disagree with me when I say that the foreign exchange market over the past six quarters or so has changed significantly from that in 1994 and 1992. For those of you who, like me, were involved in this business in the 1970s and 1980s following the collapse of the Bretton Woods system, the contrast is very dramatic. Given these realities, we must ask ourselves what has changed to alter the way foreign exchange rates fluctuate in the global marketplace? It is obvious that this is not a case of declining volume. The foreign exchange survey most recently published by the Bank for International Settlements in 1996 shows that daily volume in foreign exchange grew by almost 50 percent between 1992 and 1995, and we have no reason to think that anything has changed since then to alter this trend. What has changed, however, is the new, higher level of transparency that has been introduced in recent years into the foreign exchange market. When I speak of transparency, I am actually referring to a combination of several factors. Broadly speaking, I define transparency in this market as the degree to which its participants have equal and simultaneous access to the inputs necessary to price assets and their associated risk accurately. By reducing guesswork and uncertainty, transparency helps to smooth price adjustments and eliminate some of the shocks that can result when market participants discover they have "priced in" assumptions that are inaccurate. In my view, the current move toward greater market transparency is reflected in four broad categories: policy, information, pricing, and risk management. The increased transparency of central bank policy -- which is a product of deliberate steps taken by policymakers -- is an important aspect of the move toward more transparent overall market conditions that we've been observing. Over the past several years, central banks in a number of countries, most notably in Canada, New Zealand, Australia, and the United Kingdom, have become increasingly convinced of the value of making a public commitment to an articulated and transparent policy standard, usually price stability. By setting clear policy objectives, the makers of monetary policy can eliminate much of the guesswork that central bank watchers must engage in to figure out what the central bank will do next. In so doing, they can help anchor inflation expectations over the long term, and thereby foster economic growth by ensuring a stable price environment. Many central banks are also increasingly coming to realize that much of the secrecy and cautious signaling that once characterized monetary policy decisions is, to some extent, counterproductive. In recent years, a number of central banks have taken measures to further open up their policy processes to the public. For example, prior to February 1994, changes in monetary policy in the United States were signaled to the market through open market operations. Since that time, the Federal Reserve has publicly announced changes in policy, typically following each meeting of the Federal Open Market Committee, or FOMC. Some policymakers had been concerned that this shift in procedure for communicating policy decisions might create additional market volatility. In fact, a recent study by some of my colleagues at the Federal Reserve Bank of St. Louis found just the opposite -- that announcing policy changes has not led to increased volatility in the federal funds rate. By making information on monetary policy decisions available quickly and broadly, we at the Federal Reserve have helped level the playing field and, I believe, contributed to smoothing the process by which new information on FOMC policy is incorporated more quickly and efficiently in asset prices. Other central banks have similarly increased transparency in their monetary policy processes. One example is the Bank of England's move to publish the minutes of the monthly policy meetings between the Chancellor and the Bank of England Governor, a practice that is to continue under the new monetary policy council. The Bank of Canada, too, has taken steps to increase the level of transparency in its markets. It now publishes a semiannual monetary policy report and sets an explicit level for its bank rate. National governments also have contributed to greater transparency in monetary policy by increasingly recognizing the value of endowing their central banks with greater independence. Moves of this sort have occurred in several Western European countries and many emerging market economies, especially in Latin America, over the past several years. A second area where recent developments have resulted in improved transparency in the foreign exchange market is information technology. Easy and inexpensive access to a vast array of information has changed the way financial markets absorb new data. Most of us in this room sit in offices or trading rooms with keyboard access to data, analysis, and news that once took huge resources to manage. And, neither bankers nor traders have a monopoly on this capacity -- corporate treasurers and institutional investors can pull up most of the same screens we can. At one time, a presence in a local market and access to early newspapers could provide a trading advantage for a large market maker. Today, news from that market is available electronically worldwide with almost no lag. Information is cheaper and easier to come by than ever before. The result? A global market that reacts quickly and efficiently to new data, and participants who have more time to analyze information because they need to spend less time gathering it. One consequence of this improved transparency in information technology is that information gets reflected in asset prices more quickly and more smoothly than ever before. A closely related development that has also contributed to increased transparency in the foreign exchange market has been the rapid evolution of the price discovery process in the past several years. Electronic brokerage and electronic interbank dealing systems have evolved that have smoothed the dissemination of current pricing and improved market liquidity. Whereas truly competitive pricing was once the province of only the largest market makers, smaller interbank dealers -- and even some foreign exchange end-users -- now also have access to narrow bid-ask spreads. The result so far has been a deeper market and, again, a more level playing field for all market participants, with pricing no longer dominated by a few large players. The final area in which recent innovations have improved market transparency is risk management. While we are far from being able to rest on our laurels, there is no denying the fact that financial institutions, their customers, and their investors have become more sophisticated over the past several years at evaluating, monitoring, and controlling market risk. If market participants better understand the risk of the positions they put on their books, they are more able to react effectively and efficiently when their assumptions are challenged or unwound. Although it is crucial that rapid innovations in trading and risk management practices continue, most of the institutions represented here have already made important progress along these lines in recent years. What needs to be stressed, however, is that it is not enough for a firm to develop - for internal purposes alone -- sophisticated new techniques to assess, price, and manage increasingly refined components of financial risk. If financial markets are to function most efficiently, shareholders, creditors, and counterparties of these firms also must be able to assess the risks when they make their evaluations. In order for them to do this, meaningful information about risks and risk management performance must be available. The Federal Reserve Bank of New York has been actively involved in encouraging an evolution of disclosure practices that will improve the functioning of financial markets. As you may know, Peter Fisher, an executive vice president of the New York Fed, chaired a working group of the Euro-Currency Standing Committee of the G-10 central banks, which published a discussion paper on "Public Disclosure of Market and Credit Risks by Financial Intermediaries" in September 1994. This so-called Fisher report described how trading and financial risk management practices had developed far beyond the public disclosure of financial information, creating a gap between the precision with which a firm's management could assess and adjust the firm's own risk exposures and the information available to outsiders to help them assess the riskiness of that firm's activities. Recognizing that such an asymmetry of available information could cause the misallocation of capital among firms and amplify market disturbances, the Fisher report recommended that all financial intermediaries -- regulated and unregulated -- move in the direction of publicly disclosing periodic quantitative information. The information requested would provide estimates relied upon by the firm's management of: the market risks in the relevant portfolio or portfolios, as well as the firm's actual performance in managing the market risks in these portfolios; and the counterparty credit risks arising from the firm's trading and risk management activities. By and large, these proposed measures for reporting risk have been adopted voluntarily by many major banking institutions around the world, with many others moving in that direction. As such, they have contributed importantly to improved transparency in financial markets. The Federal Reserve Bank of New York has also been deeply involved in efforts to reduce foreign exchange settlement risk -- efforts that should further serve to improve market efficiency and overall financial stability. In October 1994, the New York Fed-sponsored Foreign Exchange Committee issued a major report on "Reducing Foreign Exchange Settlement Risk." The Bank has also been working actively in this area with other central banks through the G-10 central bank Committee on Payment and Settlement Systems, or CPSS, which I have had the pleasure to chair in recent years. Building upon the work of the New York Foreign Exchange Committee, the CPSS published a document in March of last year, often referred to as the Allsopp report, that contains a comprehensive strategy outlining how the public and private sectors can work together to reduce foreign exchange settlement risk. The strategy was endorsed by the G-10 central bank governors and calls for specific action on the part of individual banks and industry groups. A survey conducted by the CPSS last autumn indicates that individual banks are answering the G-10 governors' call for action. Many banks have made a good start in improving their ability to measure, manage, control, and net their bilateral settlement exposures, and they plan to push these efforts even further over the next year. While this is a very encouraging beginning, we can't ignore the fact that more work must be done by individual banks. With this in mind, the CPSS will continue to closely monitor progress over the next year for any signs of slippage. The search by individual banks for efficient ways to reduce their foreign exchange settlement risk has brought about important progress at the industry-group level as well. The Allsopp report noted the efforts of FXNET, S.W.I.F.T, ECHO, Multinet, and the Group of 20 banks to offer various types of risk-reducing services, and these ongoing efforts are very encouraging. Some banks are also exploring the elimination of settlement risk altogether by shifting the market to trades that simply settle the gain or loss associated with exchange rate movements -- called "contracts for difference" -- instead of requiring delivery of the underlying currencies. We are well aware that many market participants are currently debating what constitutes the most efficient multi-currency netting and settlement services. While there will be potential winners and losers, I believe that the market as a whole should ultimately benefit from this rigorous competition. At the same time, settlement risk reduction should not be used to justify the concentration of market power. The G-10 central bank governors have long been on record in favor of fair and open access to services that permit participation by a broad range of institutions, consistent with the prudent management of risk. Such access was formally adopted as a requirement for multilateral netting systems, and I am convinced that the G-10 central banks would apply a similar standard when evaluating the start-up of any major multi-currency settlement service. In sum, the evolution toward more transparent foreign exchange markets that we've observed in the past several years is largely a product of both technological progress in the private sector and conscious policy decisions in the public sector. None of the policy decisions, I should stress, were taken with any explicit or implicit intention of reducing market volatility. On the contrary, the policy community has viewed moves toward increased transparency as desirable ends in and of themselves for a number of reasons. For one, transparency promotes a more level playing field for all market participants. In other words, transparent markets tend not to be dominated by just a few players. Rather, they are open to new entrants, large and small. In such markets, no one group of institutions or type of institution can develop a monopoly on information or competitive pricing. As in most industries, competition in the area of financial services spurs innovation, better service for customers, and a more efficient allocation of resources. Second, transparency in these markets also promotes investment. If money and investment fund managers or corporate CFOs can better understand the risks entailed in various investment alternatives, they are more likely to make the investment decisions best suited to their needs. The result, again, is a more efficient allocation of global capital than would otherwise be possible. To the extent, therefore, that reduced volatility in the foreign exchange market stems from improved transparency, I would view this result as a beneficial by-product -- one that also contributes to the ultimate goal of economic and monetary policy: namely, sustained growth and a stable price environment. The move toward increased transparency in global markets and the accompanying relative decline in foreign exchange market volatility and trading ranges that we have observed in the last year and a half have posed considerable challenges to market makers, spot traders, and brokers, on both an institutional and a personal level. There is an axiom in these markets that volatility is good for market makers. I believe that this is a short-sighted view. On the contrary, I would submit that excessive volatility not only frightens investors, but also potentially undermines growth and, in so doing, benefits none of us. As a result, I cannot help but conclude that stable -- and not volatile -- markets are in the best interests of both central banks and the financial community. Stability in foreign exchange and other financial markets, along with price stability, is vital to the promotion of sustainable economic growth and rising living standards for everyone. Reducing the diversion of resources to deal with uncertainty and volatility allows resources to be directed toward more productive uses and, in so doing, promotes long-term growth by increasing the resource base available to the economy. We have seen in high-inflation economies how the transfer of resources away from productive activities and into financial transactions geared toward dealing with inflation uncertainty can negatively affect growth. We have also seen how a proliferation of tax code dodges can decrease the available resource base. If individuals must spend more time engaging in financial maneuvers because of uncertainty, then more of the economy's productive capacity is transferred to the activity of handling transactions. An expansion of the financial sector that stems from an increasing number of people employed to handle distortions arising from inflation and its attendant uncertainty is growth that diverts resources better employed elsewhere. By contrast, an expansion of the financial sector that stems from growth of productivity is growth that offers benefits to all. The same basic principle applies to the foreign exchange market. Foreign exchange rates are fundamentally determined by market forces and should be free to fluctuate as a vital adjustment mechanism for the global economy. However, excessive volatility, like price instability, can diminish resources otherwise available for productive growth. The economy in which we live and work is a global one, and becomes more so every year. Regions and industries in need of private capital and investors requiring adequate returns benefit when money can move across national boundaries without excessive risk or hedging costs. Foreign exchange markets that are more stable and more transparent ultimately will better allow investors to allocate their capital efficiently, thereby improving global economic growth. Change is difficult in any industry and can put enormous stress on individuals. I'm not ignoring this dynamic. However, I am persuaded that, in the long run, what is good for economic growth is in the best interests of the financial community, and, in turn, benefits the individuals that make up that community. Just as U.S. industries went through enormous stress in the 1970s and 1980s in coping with a new era of expanding international trade and emerged in the 1990s as among the most competitive in the world, so too must global financial institutions adapt and find new ways to add value and share in the larger benefits that transparency and reduced volatility can bring. We central bankers can contribute to this process. While we can do little to limit market volatility directly, we can work toward more transparent markets supported by sound infrastructure, and by these means lay the groundwork for market stability. And, while we're not in the business of determining market rates or the ranges in which rates should trade, what we are trying to do is move increasingly toward improving the transparency of our own operations as an end in and of itself. Our collective efforts, along with developments in information technology and risk management techniques, have already contributed to improved market stability. The growing, and successful, commitment of central banks to the achievement of price stability as their primary goal is another crucial and positive contribution toward market stability. Moreover, where we as central banks see gaps that develop in the global financial system, as we did in the areas of market risk and settlement risk management, we play the role of facilitator to private sector solutions. As central bankers, we tend to view our role in the global financial markets as ensuring that the necessary infrastructure is in place to promote well-functioning markets for all players. Then we step aside and let the markets take care of themselves.	---[PAGE_BREAK]--- # Mr. McDonough examines recent developments and trends in the foreign exchange markets Remarks by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough, before the 39th International Congress of the Association Cambiste International, The Financial Markets Association in Toronto on 30/5/97. I am delighted to be invited to address the 39th International Congress of the Association Cambiste Internationale (ACI) -- The Financial Markets Association. I must confess to a certain affinity for the foreign exchange community, stemming, no doubt, from my commercial banking experience and my time overseeing the foreign exchange desk at the Federal Reserve Bank of New York. I've long believed that, more so than in most other sectors of the finance industry, there is a real community among those engaged in foreign exchange -- a community that relies on close personal ties and contacts. It is this spirit of community that makes events such as these ACI meetings today and tomorrow so enjoyable and important, giving us the opportunity to renew old friendships and build new relationships that will enable us to do our respective jobs that much better. In my remarks to you this morning, I would like to highlight some recent developments in the foreign exchange market and share with you my view, as a central banker, of what has been driving some of the trends we've been observing. We heard a lot of talk in the foreign exchange markets in 1996 about the "end of volatility." As the market performance of the last few weeks has demonstrated, such commentary was a bit exaggerated. However, even with the spike in volatility we've seen in recent weeks, there is no question that we have witnessed a remarkable period of relative stability in foreign exchange rates over the past six quarters or so. What accounts for this relative stability in the foreign exchange markets since late 1995? Economic fundamentals are certainly one factor -- we have had a period of relative price stability in the major world economies, and a general absence of severe market shocks. However, I would argue that what we've been observing is also, in part, a by-product of continuously greater transparency that has characterized the foreign exchange market over the past several years. Moreover, I am convinced that the increased transparency in the foreign exchange markets is beneficial: for the foreign exchange community, for financial markets in general, and for the global economy as a whole. Before explaining what I mean by greater transparency and why I believe it is so beneficial, I would like to take a quick look at the record itself. Is the talk about declining volatility reflected in hard evidence? Yes, it largely is. Thirty-day dollar-mark and dollar-yen historical volatility remained below 10 percent throughout most of 1996 and the first quarter of 1997, and, even with the price action we saw in May, the spike in thirty-day historical volatility we've observed is not particularly dramatic when compared with similar periods in past years. Similarly, implied volatility on dollar-mark and dollar-yen options traded to near record lows in 1996. But, as this month has shown, volatility has not been eliminated. There also have been a number of days in the past year and a half with considerable volatility in the foreign exchange market. And, I have no doubt that we'll have many more of these days -- at times, for example, when markets rapidly adjust to new information or when periods of poor liquidity result in exaggerated price swings. What is clear is that this is a market that is constantly evolving. None of us can say with any certainty whether we're observing the beginning of a trend or an anomalous period ---[PAGE_BREAK]--- that will ultimately be viewed as a brief lull in volatility. However, I don't think many of you would disagree with me when I say that the foreign exchange market over the past six quarters or so has changed significantly from that in 1994 and 1992. For those of you who, like me, were involved in this business in the 1970s and 1980s following the collapse of the Bretton Woods system, the contrast is very dramatic. Given these realities, we must ask ourselves what has changed to alter the way foreign exchange rates fluctuate in the global marketplace? It is obvious that this is not a case of declining volume. The foreign exchange survey most recently published by the Bank for International Settlements in 1996 shows that daily volume in foreign exchange grew by almost 50 percent between 1992 and 1995, and we have no reason to think that anything has changed since then to alter this trend. What has changed, however, is the new, higher level of transparency that has been introduced in recent years into the foreign exchange market. When I speak of transparency, I am actually referring to a combination of several factors. Broadly speaking, I define transparency in this market as the degree to which its participants have equal and simultaneous access to the inputs necessary to price assets and their associated risk accurately. By reducing guesswork and uncertainty, transparency helps to smooth price adjustments and eliminate some of the shocks that can result when market participants discover they have "priced in" assumptions that are inaccurate. In my view, the current move toward greater market transparency is reflected in four broad categories: policy, information, pricing, and risk management. The increased transparency of central bank policy -- which is a product of deliberate steps taken by policymakers -- is an important aspect of the move toward more transparent overall market conditions that we've been observing. Over the past several years, central banks in a number of countries, most notably in Canada, New Zealand, Australia, and the United Kingdom, have become increasingly convinced of the value of making a public commitment to an articulated and transparent policy standard, usually price stability. By setting clear policy objectives, the makers of monetary policy can eliminate much of the guesswork that central bank watchers must engage in to figure out what the central bank will do next. In so doing, they can help anchor inflation expectations over the long term, and thereby foster economic growth by ensuring a stable price environment. Many central banks are also increasingly coming to realize that much of the secrecy and cautious signaling that once characterized monetary policy decisions is, to some extent, counterproductive. In recent years, a number of central banks have taken measures to further open up their policy processes to the public. For example, prior to February 1994, changes in monetary policy in the United States were signaled to the market through open market operations. Since that time, the Federal Reserve has publicly announced changes in policy, typically following each meeting of the Federal Open Market Committee, or FOMC. Some policymakers had been concerned that this shift in procedure for communicating policy decisions might create additional market volatility. In fact, a recent study by some of my colleagues at the Federal Reserve Bank of St. Louis found just the opposite -- that announcing policy changes has not led to increased volatility in the federal funds rate. By making information on monetary policy decisions available quickly and broadly, we at the Federal Reserve have helped level the playing field and, I believe, contributed to smoothing the process by which new information on FOMC policy is incorporated more quickly and efficiently in asset prices. ---[PAGE_BREAK]--- Other central banks have similarly increased transparency in their monetary policy processes. One example is the Bank of England's move to publish the minutes of the monthly policy meetings between the Chancellor and the Bank of England Governor, a practice that is to continue under the new monetary policy council. The Bank of Canada, too, has taken steps to increase the level of transparency in its markets. It now publishes a semiannual monetary policy report and sets an explicit level for its bank rate. National governments also have contributed to greater transparency in monetary policy by increasingly recognizing the value of endowing their central banks with greater independence. Moves of this sort have occurred in several Western European countries and many emerging market economies, especially in Latin America, over the past several years. A second area where recent developments have resulted in improved transparency in the foreign exchange market is information technology. Easy and inexpensive access to a vast array of information has changed the way financial markets absorb new data. Most of us in this room sit in offices or trading rooms with keyboard access to data, analysis, and news that once took huge resources to manage. And, neither bankers nor traders have a monopoly on this capacity -- corporate treasurers and institutional investors can pull up most of the same screens we can. At one time, a presence in a local market and access to early newspapers could provide a trading advantage for a large market maker. Today, news from that market is available electronically worldwide with almost no lag. Information is cheaper and easier to come by than ever before. The result? A global market that reacts quickly and efficiently to new data, and participants who have more time to analyze information because they need to spend less time gathering it. One consequence of this improved transparency in information technology is that information gets reflected in asset prices more quickly and more smoothly than ever before. A closely related development that has also contributed to increased transparency in the foreign exchange market has been the rapid evolution of the price discovery process in the past several years. Electronic brokerage and electronic interbank dealing systems have evolved that have smoothed the dissemination of current pricing and improved market liquidity. Whereas truly competitive pricing was once the province of only the largest market makers, smaller interbank dealers -- and even some foreign exchange end-users -- now also have access to narrow bid-ask spreads. The result so far has been a deeper market and, again, a more level playing field for all market participants, with pricing no longer dominated by a few large players. The final area in which recent innovations have improved market transparency is risk management. While we are far from being able to rest on our laurels, there is no denying the fact that financial institutions, their customers, and their investors have become more sophisticated over the past several years at evaluating, monitoring, and controlling market risk. If market participants better understand the risk of the positions they put on their books, they are more able to react effectively and efficiently when their assumptions are challenged or unwound. Although it is crucial that rapid innovations in trading and risk management practices continue, most of the institutions represented here have already made important progress along these lines in recent years. What needs to be stressed, however, is that it is not enough for a firm to develop - for internal purposes alone -- sophisticated new techniques to assess, price, and manage increasingly refined components of financial risk. If financial markets are to function most efficiently, shareholders, creditors, and counterparties of these firms also must be able to ---[PAGE_BREAK]--- assess the risks when they make their evaluations. In order for them to do this, meaningful information about risks and risk management performance must be available. The Federal Reserve Bank of New York has been actively involved in encouraging an evolution of disclosure practices that will improve the functioning of financial markets. As you may know, Peter Fisher, an executive vice president of the New York Fed, chaired a working group of the Euro-Currency Standing Committee of the G-10 central banks, which published a discussion paper on "Public Disclosure of Market and Credit Risks by Financial Intermediaries" in September 1994. This so-called Fisher report described how trading and financial risk management practices had developed far beyond the public disclosure of financial information, creating a gap between the precision with which a firm's management could assess and adjust the firm's own risk exposures and the information available to outsiders to help them assess the riskiness of that firm's activities. Recognizing that such an asymmetry of available information could cause the misallocation of capital among firms and amplify market disturbances, the Fisher report recommended that all financial intermediaries -- regulated and unregulated -- move in the direction of publicly disclosing periodic quantitative information. The information requested would provide estimates relied upon by the firm's management of: the market risks in the relevant portfolio or portfolios, as well as the firm's actual performance in managing the market risks in these portfolios; and the counterparty credit risks arising from the firm's trading and risk management activities. By and large, these proposed measures for reporting risk have been adopted voluntarily by many major banking institutions around the world, with many others moving in that direction. As such, they have contributed importantly to improved transparency in financial markets. The Federal Reserve Bank of New York has also been deeply involved in efforts to reduce foreign exchange settlement risk -- efforts that should further serve to improve market efficiency and overall financial stability. In October 1994, the New York Fed-sponsored Foreign Exchange Committee issued a major report on "Reducing Foreign Exchange Settlement Risk." The Bank has also been working actively in this area with other central banks through the G-10 central bank Committee on Payment and Settlement Systems, or CPSS, which I have had the pleasure to chair in recent years. Building upon the work of the New York Foreign Exchange Committee, the CPSS published a document in March of last year, often referred to as the Allsopp report, that contains a comprehensive strategy outlining how the public and private sectors can work together to reduce foreign exchange settlement risk. The strategy was endorsed by the G-10 central bank governors and calls for specific action on the part of individual banks and industry groups. A survey conducted by the CPSS last autumn indicates that individual banks are answering the G-10 governors' call for action. Many banks have made a good start in improving their ability to measure, manage, control, and net their bilateral settlement exposures, and they plan to push these efforts even further over the next year. While this is a very encouraging beginning, we can't ignore the fact that more work must be done by individual banks. With this in mind, the CPSS will continue to closely monitor progress over the next year for any signs of slippage. ---[PAGE_BREAK]--- The search by individual banks for efficient ways to reduce their foreign exchange settlement risk has brought about important progress at the industry-group level as well. The Allsopp report noted the efforts of FXNET, S.W.I.F.T, ECHO, Multinet, and the Group of 20 banks to offer various types of risk-reducing services, and these ongoing efforts are very encouraging. Some banks are also exploring the elimination of settlement risk altogether by shifting the market to trades that simply settle the gain or loss associated with exchange rate movements -- called "contracts for difference" -- instead of requiring delivery of the underlying currencies. We are well aware that many market participants are currently debating what constitutes the most efficient multi-currency netting and settlement services. While there will be potential winners and losers, I believe that the market as a whole should ultimately benefit from this rigorous competition. At the same time, settlement risk reduction should not be used to justify the concentration of market power. The G-10 central bank governors have long been on record in favor of fair and open access to services that permit participation by a broad range of institutions, consistent with the prudent management of risk. Such access was formally adopted as a requirement for multilateral netting systems, and I am convinced that the G-10 central banks would apply a similar standard when evaluating the start-up of any major multi-currency settlement service. In sum, the evolution toward more transparent foreign exchange markets that we've observed in the past several years is largely a product of both technological progress in the private sector and conscious policy decisions in the public sector. None of the policy decisions, I should stress, were taken with any explicit or implicit intention of reducing market volatility. On the contrary, the policy community has viewed moves toward increased transparency as desirable ends in and of themselves for a number of reasons. For one, transparency promotes a more level playing field for all market participants. In other words, transparent markets tend not to be dominated by just a few players. Rather, they are open to new entrants, large and small. In such markets, no one group of institutions or type of institution can develop a monopoly on information or competitive pricing. As in most industries, competition in the area of financial services spurs innovation, better service for customers, and a more efficient allocation of resources. Second, transparency in these markets also promotes investment. If money and investment fund managers or corporate CFOs can better understand the risks entailed in various investment alternatives, they are more likely to make the investment decisions best suited to their needs. The result, again, is a more efficient allocation of global capital than would otherwise be possible. To the extent, therefore, that reduced volatility in the foreign exchange market stems from improved transparency, I would view this result as a beneficial by-product -- one that also contributes to the ultimate goal of economic and monetary policy: namely, sustained growth and a stable price environment. The move toward increased transparency in global markets and the accompanying relative decline in foreign exchange market volatility and trading ranges that we have observed in the last year and a half have posed considerable challenges to market makers, spot traders, and brokers, on both an institutional and a personal level. There is an axiom in these markets that volatility is good for market makers. I believe that this is a short-sighted view. On the contrary, I ---[PAGE_BREAK]--- would submit that excessive volatility not only frightens investors, but also potentially undermines growth and, in so doing, benefits none of us. As a result, I cannot help but conclude that stable -- and not volatile -- markets are in the best interests of both central banks and the financial community. Stability in foreign exchange and other financial markets, along with price stability, is vital to the promotion of sustainable economic growth and rising living standards for everyone. Reducing the diversion of resources to deal with uncertainty and volatility allows resources to be directed toward more productive uses and, in so doing, promotes long-term growth by increasing the resource base available to the economy. We have seen in high-inflation economies how the transfer of resources away from productive activities and into financial transactions geared toward dealing with inflation uncertainty can negatively affect growth. We have also seen how a proliferation of tax code dodges can decrease the available resource base. If individuals must spend more time engaging in financial maneuvers because of uncertainty, then more of the economy's productive capacity is transferred to the activity of handling transactions. An expansion of the financial sector that stems from an increasing number of people employed to handle distortions arising from inflation and its attendant uncertainty is growth that diverts resources better employed elsewhere. By contrast, an expansion of the financial sector that stems from growth of productivity is growth that offers benefits to all. The same basic principle applies to the foreign exchange market. Foreign exchange rates are fundamentally determined by market forces and should be free to fluctuate as a vital adjustment mechanism for the global economy. However, excessive volatility, like price instability, can diminish resources otherwise available for productive growth. The economy in which we live and work is a global one, and becomes more so every year. Regions and industries in need of private capital and investors requiring adequate returns benefit when money can move across national boundaries without excessive risk or hedging costs. Foreign exchange markets that are more stable and more transparent ultimately will better allow investors to allocate their capital efficiently, thereby improving global economic growth. Change is difficult in any industry and can put enormous stress on individuals. I'm not ignoring this dynamic. However, I am persuaded that, in the long run, what is good for economic growth is in the best interests of the financial community, and, in turn, benefits the individuals that make up that community. Just as U.S. industries went through enormous stress in the 1970s and 1980s in coping with a new era of expanding international trade and emerged in the 1990s as among the most competitive in the world, so too must global financial institutions adapt and find new ways to add value and share in the larger benefits that transparency and reduced volatility can bring. We central bankers can contribute to this process. While we can do little to limit market volatility directly, we can work toward more transparent markets supported by sound infrastructure, and by these means lay the groundwork for market stability. And, while we're not in the business of determining market rates or the ranges in which rates should trade, what we are trying to do is move increasingly toward improving the transparency of our own operations as an end in and of itself. Our collective efforts, along with developments in information technology and risk management techniques, have already contributed to improved market stability. The growing, and successful, commitment of central banks to the achievement of price stability as ---[PAGE_BREAK]--- their primary goal is another crucial and positive contribution toward market stability. Moreover, where we as central banks see gaps that develop in the global financial system, as we did in the areas of market risk and settlement risk management, we play the role of facilitator to private sector solutions. As central bankers, we tend to view our role in the global financial markets as ensuring that the necessary infrastructure is in place to promote well-functioning markets for all players. Then we step aside and let the markets take care of themselves.	William J McDonough	United States	https://www.bis.org/review/r970617b.pdf	I am delighted to be invited to address the 39th International Congress of the Association Cambiste Internationale (ACI) -- The Financial Markets Association. I must confess to a certain affinity for the foreign exchange community, stemming, no doubt, from my commercial banking experience and my time overseeing the foreign exchange desk at the Federal Reserve Bank of New York. I've long believed that, more so than in most other sectors of the finance industry, there is a real community among those engaged in foreign exchange -- a community that relies on close personal ties and contacts. It is this spirit of community that makes events such as these ACI meetings today and tomorrow so enjoyable and important, giving us the opportunity to renew old friendships and build new relationships that will enable us to do our respective jobs that much better. In my remarks to you this morning, I would like to highlight some recent developments in the foreign exchange market and share with you my view, as a central banker, of what has been driving some of the trends we've been observing. We heard a lot of talk in the foreign exchange markets in 1996 about the "end of volatility." As the market performance of the last few weeks has demonstrated, such commentary was a bit exaggerated. However, even with the spike in volatility we've seen in recent weeks, there is no question that we have witnessed a remarkable period of relative stability in foreign exchange rates over the past six quarters or so. What accounts for this relative stability in the foreign exchange markets since late 1995? Economic fundamentals are certainly one factor -- we have had a period of relative price stability in the major world economies, and a general absence of severe market shocks. However, I would argue that what we've been observing is also, in part, a by-product of continuously greater transparency that has characterized the foreign exchange market over the past several years. Moreover, I am convinced that the increased transparency in the foreign exchange markets is beneficial: for the foreign exchange community, for financial markets in general, and for the global economy as a whole. Before explaining what I mean by greater transparency and why I believe it is so beneficial, I would like to take a quick look at the record itself. Is the talk about declining volatility reflected in hard evidence? Yes, it largely is. Thirty-day dollar-mark and dollar-yen historical volatility remained below 10 percent throughout most of 1996 and the first quarter of 1997, and, even with the price action we saw in May, the spike in thirty-day historical volatility we've observed is not particularly dramatic when compared with similar periods in past years. Similarly, implied volatility on dollar-mark and dollar-yen options traded to near record lows in 1996. But, as this month has shown, volatility has not been eliminated. There also have been a number of days in the past year and a half with considerable volatility in the foreign exchange market. And, I have no doubt that we'll have many more of these days -- at times, for example, when markets rapidly adjust to new information or when periods of poor liquidity result in exaggerated price swings. What is clear is that this is a market that is constantly evolving. None of us can say with any certainty whether we're observing the beginning of a trend or an anomalous period that will ultimately be viewed as a brief lull in volatility. However, I don't think many of you would disagree with me when I say that the foreign exchange market over the past six quarters or so has changed significantly from that in 1994 and 1992. For those of you who, like me, were involved in this business in the 1970s and 1980s following the collapse of the Bretton Woods system, the contrast is very dramatic. Given these realities, we must ask ourselves what has changed to alter the way foreign exchange rates fluctuate in the global marketplace? It is obvious that this is not a case of declining volume. The foreign exchange survey most recently published by the Bank for International Settlements in 1996 shows that daily volume in foreign exchange grew by almost 50 percent between 1992 and 1995, and we have no reason to think that anything has changed since then to alter this trend. What has changed, however, is the new, higher level of transparency that has been introduced in recent years into the foreign exchange market. When I speak of transparency, I am actually referring to a combination of several factors. Broadly speaking, I define transparency in this market as the degree to which its participants have equal and simultaneous access to the inputs necessary to price assets and their associated risk accurately. By reducing guesswork and uncertainty, transparency helps to smooth price adjustments and eliminate some of the shocks that can result when market participants discover they have "priced in" assumptions that are inaccurate. In my view, the current move toward greater market transparency is reflected in four broad categories: policy, information, pricing, and risk management. The increased transparency of central bank policy -- which is a product of deliberate steps taken by policymakers -- is an important aspect of the move toward more transparent overall market conditions that we've been observing. Over the past several years, central banks in a number of countries, most notably in Canada, New Zealand, Australia, and the United Kingdom, have become increasingly convinced of the value of making a public commitment to an articulated and transparent policy standard, usually price stability. By setting clear policy objectives, the makers of monetary policy can eliminate much of the guesswork that central bank watchers must engage in to figure out what the central bank will do next. In so doing, they can help anchor inflation expectations over the long term, and thereby foster economic growth by ensuring a stable price environment. Many central banks are also increasingly coming to realize that much of the secrecy and cautious signaling that once characterized monetary policy decisions is, to some extent, counterproductive. In recent years, a number of central banks have taken measures to further open up their policy processes to the public. For example, prior to February 1994, changes in monetary policy in the United States were signaled to the market through open market operations. Since that time, the Federal Reserve has publicly announced changes in policy, typically following each meeting of the Federal Open Market Committee, or FOMC. Some policymakers had been concerned that this shift in procedure for communicating policy decisions might create additional market volatility. In fact, a recent study by some of my colleagues at the Federal Reserve Bank of St. Louis found just the opposite -- that announcing policy changes has not led to increased volatility in the federal funds rate. By making information on monetary policy decisions available quickly and broadly, we at the Federal Reserve have helped level the playing field and, I believe, contributed to smoothing the process by which new information on FOMC policy is incorporated more quickly and efficiently in asset prices. Other central banks have similarly increased transparency in their monetary policy processes. One example is the Bank of England's move to publish the minutes of the monthly policy meetings between the Chancellor and the Bank of England Governor, a practice that is to continue under the new monetary policy council. The Bank of Canada, too, has taken steps to increase the level of transparency in its markets. It now publishes a semiannual monetary policy report and sets an explicit level for its bank rate. National governments also have contributed to greater transparency in monetary policy by increasingly recognizing the value of endowing their central banks with greater independence. Moves of this sort have occurred in several Western European countries and many emerging market economies, especially in Latin America, over the past several years. A second area where recent developments have resulted in improved transparency in the foreign exchange market is information technology. Easy and inexpensive access to a vast array of information has changed the way financial markets absorb new data. Most of us in this room sit in offices or trading rooms with keyboard access to data, analysis, and news that once took huge resources to manage. And, neither bankers nor traders have a monopoly on this capacity -- corporate treasurers and institutional investors can pull up most of the same screens we can. At one time, a presence in a local market and access to early newspapers could provide a trading advantage for a large market maker. Today, news from that market is available electronically worldwide with almost no lag. Information is cheaper and easier to come by than ever before. The result? A global market that reacts quickly and efficiently to new data, and participants who have more time to analyze information because they need to spend less time gathering it. One consequence of this improved transparency in information technology is that information gets reflected in asset prices more quickly and more smoothly than ever before. A closely related development that has also contributed to increased transparency in the foreign exchange market has been the rapid evolution of the price discovery process in the past several years. Electronic brokerage and electronic interbank dealing systems have evolved that have smoothed the dissemination of current pricing and improved market liquidity. Whereas truly competitive pricing was once the province of only the largest market makers, smaller interbank dealers -- and even some foreign exchange end-users -- now also have access to narrow bid-ask spreads. The result so far has been a deeper market and, again, a more level playing field for all market participants, with pricing no longer dominated by a few large players. The final area in which recent innovations have improved market transparency is risk management. While we are far from being able to rest on our laurels, there is no denying the fact that financial institutions, their customers, and their investors have become more sophisticated over the past several years at evaluating, monitoring, and controlling market risk. If market participants better understand the risk of the positions they put on their books, they are more able to react effectively and efficiently when their assumptions are challenged or unwound. Although it is crucial that rapid innovations in trading and risk management practices continue, most of the institutions represented here have already made important progress along these lines in recent years. What needs to be stressed, however, is that it is not enough for a firm to develop - for internal purposes alone -- sophisticated new techniques to assess, price, and manage increasingly refined components of financial risk. If financial markets are to function most efficiently, shareholders, creditors, and counterparties of these firms also must be able to assess the risks when they make their evaluations. In order for them to do this, meaningful information about risks and risk management performance must be available. The Federal Reserve Bank of New York has been actively involved in encouraging an evolution of disclosure practices that will improve the functioning of financial markets. As you may know, Peter Fisher, an executive vice president of the New York Fed, chaired a working group of the Euro-Currency Standing Committee of the G-10 central banks, which published a discussion paper on "Public Disclosure of Market and Credit Risks by Financial Intermediaries" in September 1994. This so-called Fisher report described how trading and financial risk management practices had developed far beyond the public disclosure of financial information, creating a gap between the precision with which a firm's management could assess and adjust the firm's own risk exposures and the information available to outsiders to help them assess the riskiness of that firm's activities. Recognizing that such an asymmetry of available information could cause the misallocation of capital among firms and amplify market disturbances, the Fisher report recommended that all financial intermediaries -- regulated and unregulated -- move in the direction of publicly disclosing periodic quantitative information. The information requested would provide estimates relied upon by the firm's management of: the market risks in the relevant portfolio or portfolios, as well as the firm's actual performance in managing the market risks in these portfolios; and the counterparty credit risks arising from the firm's trading and risk management activities. By and large, these proposed measures for reporting risk have been adopted voluntarily by many major banking institutions around the world, with many others moving in that direction. As such, they have contributed importantly to improved transparency in financial markets. The Federal Reserve Bank of New York has also been deeply involved in efforts to reduce foreign exchange settlement risk -- efforts that should further serve to improve market efficiency and overall financial stability. In October 1994, the New York Fed-sponsored Foreign Exchange Committee issued a major report on "Reducing Foreign Exchange Settlement Risk." The Bank has also been working actively in this area with other central banks through the G-10 central bank Committee on Payment and Settlement Systems, or CPSS, which I have had the pleasure to chair in recent years. Building upon the work of the New York Foreign Exchange Committee, the CPSS published a document in March of last year, often referred to as the Allsopp report, that contains a comprehensive strategy outlining how the public and private sectors can work together to reduce foreign exchange settlement risk. The strategy was endorsed by the G-10 central bank governors and calls for specific action on the part of individual banks and industry groups. A survey conducted by the CPSS last autumn indicates that individual banks are answering the G-10 governors' call for action. Many banks have made a good start in improving their ability to measure, manage, control, and net their bilateral settlement exposures, and they plan to push these efforts even further over the next year. While this is a very encouraging beginning, we can't ignore the fact that more work must be done by individual banks. With this in mind, the CPSS will continue to closely monitor progress over the next year for any signs of slippage. The search by individual banks for efficient ways to reduce their foreign exchange settlement risk has brought about important progress at the industry-group level as well. The Allsopp report noted the efforts of FXNET, S.W.I.F.T, ECHO, Multinet, and the Group of 20 banks to offer various types of risk-reducing services, and these ongoing efforts are very encouraging. Some banks are also exploring the elimination of settlement risk altogether by shifting the market to trades that simply settle the gain or loss associated with exchange rate movements -- called "contracts for difference" -- instead of requiring delivery of the underlying currencies. We are well aware that many market participants are currently debating what constitutes the most efficient multi-currency netting and settlement services. While there will be potential winners and losers, I believe that the market as a whole should ultimately benefit from this rigorous competition. At the same time, settlement risk reduction should not be used to justify the concentration of market power. The G-10 central bank governors have long been on record in favor of fair and open access to services that permit participation by a broad range of institutions, consistent with the prudent management of risk. Such access was formally adopted as a requirement for multilateral netting systems, and I am convinced that the G-10 central banks would apply a similar standard when evaluating the start-up of any major multi-currency settlement service. In sum, the evolution toward more transparent foreign exchange markets that we've observed in the past several years is largely a product of both technological progress in the private sector and conscious policy decisions in the public sector. None of the policy decisions, I should stress, were taken with any explicit or implicit intention of reducing market volatility. On the contrary, the policy community has viewed moves toward increased transparency as desirable ends in and of themselves for a number of reasons. For one, transparency promotes a more level playing field for all market participants. In other words, transparent markets tend not to be dominated by just a few players. Rather, they are open to new entrants, large and small. In such markets, no one group of institutions or type of institution can develop a monopoly on information or competitive pricing. As in most industries, competition in the area of financial services spurs innovation, better service for customers, and a more efficient allocation of resources. Second, transparency in these markets also promotes investment. If money and investment fund managers or corporate CFOs can better understand the risks entailed in various investment alternatives, they are more likely to make the investment decisions best suited to their needs. The result, again, is a more efficient allocation of global capital than would otherwise be possible. To the extent, therefore, that reduced volatility in the foreign exchange market stems from improved transparency, I would view this result as a beneficial by-product -- one that also contributes to the ultimate goal of economic and monetary policy: namely, sustained growth and a stable price environment. The move toward increased transparency in global markets and the accompanying relative decline in foreign exchange market volatility and trading ranges that we have observed in the last year and a half have posed considerable challenges to market makers, spot traders, and brokers, on both an institutional and a personal level. There is an axiom in these markets that volatility is good for market makers. I believe that this is a short-sighted view. On the contrary, I would submit that excessive volatility not only frightens investors, but also potentially undermines growth and, in so doing, benefits none of us. As a result, I cannot help but conclude that stable -- and not volatile -- markets are in the best interests of both central banks and the financial community. Stability in foreign exchange and other financial markets, along with price stability, is vital to the promotion of sustainable economic growth and rising living standards for everyone. Reducing the diversion of resources to deal with uncertainty and volatility allows resources to be directed toward more productive uses and, in so doing, promotes long-term growth by increasing the resource base available to the economy. We have seen in high-inflation economies how the transfer of resources away from productive activities and into financial transactions geared toward dealing with inflation uncertainty can negatively affect growth. We have also seen how a proliferation of tax code dodges can decrease the available resource base. If individuals must spend more time engaging in financial maneuvers because of uncertainty, then more of the economy's productive capacity is transferred to the activity of handling transactions. An expansion of the financial sector that stems from an increasing number of people employed to handle distortions arising from inflation and its attendant uncertainty is growth that diverts resources better employed elsewhere. By contrast, an expansion of the financial sector that stems from growth of productivity is growth that offers benefits to all. The same basic principle applies to the foreign exchange market. Foreign exchange rates are fundamentally determined by market forces and should be free to fluctuate as a vital adjustment mechanism for the global economy. However, excessive volatility, like price instability, can diminish resources otherwise available for productive growth. The economy in which we live and work is a global one, and becomes more so every year. Regions and industries in need of private capital and investors requiring adequate returns benefit when money can move across national boundaries without excessive risk or hedging costs. Foreign exchange markets that are more stable and more transparent ultimately will better allow investors to allocate their capital efficiently, thereby improving global economic growth. Change is difficult in any industry and can put enormous stress on individuals. I'm not ignoring this dynamic. However, I am persuaded that, in the long run, what is good for economic growth is in the best interests of the financial community, and, in turn, benefits the individuals that make up that community. Just as U.S. industries went through enormous stress in the 1970s and 1980s in coping with a new era of expanding international trade and emerged in the 1990s as among the most competitive in the world, so too must global financial institutions adapt and find new ways to add value and share in the larger benefits that transparency and reduced volatility can bring. We central bankers can contribute to this process. While we can do little to limit market volatility directly, we can work toward more transparent markets supported by sound infrastructure, and by these means lay the groundwork for market stability. And, while we're not in the business of determining market rates or the ranges in which rates should trade, what we are trying to do is move increasingly toward improving the transparency of our own operations as an end in and of itself. Our collective efforts, along with developments in information technology and risk management techniques, have already contributed to improved market stability. The growing, and successful, commitment of central banks to the achievement of price stability as their primary goal is another crucial and positive contribution toward market stability. Moreover, where we as central banks see gaps that develop in the global financial system, as we did in the areas of market risk and settlement risk management, we play the role of facilitator to private sector solutions. As central bankers, we tend to view our role in the global financial markets as ensuring that the necessary infrastructure is in place to promote well-functioning markets for all players. Then we step aside and let the markets take care of themselves.
1997-06-10T00:00:00	Mr. Greenspan examines the process by which former centrally planned economies are embracing free markets (Central Bank Articles and Speeches, 10 Jun 97)	Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Woodrow Wilson Award Dinner of the Woodrow Wilson International Center for Scholars in New York on 10/6/97.	Mr. Greenspan examines the process by which former centrally planned economies are embracing free markets Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Woodrow Wilson Award Dinner of the Woodrow Wilson International Center for Scholars in New York on 10/6/97. On November 9, 1989, the Berlin Wall came down, symbolizing the end of an experiment in economic and social policy that began more than four decades earlier with the division of the states of Western and Central Europe into market economies and those governed by state central planning. At the end of World War II, as Winston Churchill put it, "From Stettin in the Baltic to Trieste in the Adriatic an iron curtain ... descended across the Continent." Aside from the Soviet Union itself, the economies on the Soviet side of the "curtain" had been, in the prewar period, similar to the market-based economies on the western side. Over four decades both types of economies developed with limited interaction across the dividing line. It was as close to a controlled experiment in the viability of economic systems as could ever be implemented. The results, unequivocally in favor of market economies, have had far-reaching consequences. The long-standing debate between the virtues of economies organized around free markets and those governed by centrally planned socialism is essentially at an end. To be sure, there are still a few who still support the old fashioned socialism -- but for the vast majority of professed socialists it is now a highly diluted socialism, an amalgam of social equity and the efficiency of the market, often called market socialism. The verdict on rigid central planning has been rendered, and it is generally appreciated to have been unequivocally negative. Over the last seven years, with the Soviet bloc books now open, we of course have learned much about how communist economics worked, or, more to the point, did not. But the biggest surprise is what the aftermath of the four-decade experiment has been teaching us about how and why our own Western economies and societies function, or, perhaps more exactly, refreshing our own long-dormant memories of the process. Economists have had considerable experience this century in observing how market economies converted to centrally planned ones but until recently have had virtually no exposure in the opposite direction. Ironically, in aiding in the process of implementing the latter, we are being forced to more fully understand the roots of our own system. Much of what we took for granted in our free market system and assumed to be human nature was not nature at all, but culture. The dismantling of the central planning function in an economy does not, as some had supposed, automatically establish a free market entrepreneurial system. There is a vast amount of capitalist culture and infrastructure underpinning market economies that has evolved over generations: laws, conventions, behaviors, and a wide variety of business professions and practices that have no important functions in a centrally planned economy. Centrally planned economic systems, such as that which existed in the Soviet Union, had great difficulty in creating wealth and rising standards of living. In theory, and to a large extent in practice, production and distribution were determined by specific instructions -often in the form of state orders -- coming from the central planning agencies to the various different producing establishments, indicating from whom, and in what quantities, they should receive their raw materials and services, and to whom they should distribute their final outputs. The work force was assumed to be fully employed and wages were somewhat arbitrarily predetermined. Without an effective market clearing mechanism, the consequences of such a paradigm, as one might readily anticipate, were both huge surpluses of goods which, while produced, were not wanted by the populace, and huge shortages of products that consumers desired but were not produced in adequate quantities. The imbalance of demand over supply inevitably required rationing or its equivalent, standing in queues for limited quantities of goods and services. One might think that the planning authorities should have been able to adjust to these distortions. They tried. But they faced insurmountable handicaps in that they did not have access to the immediate signals of price changes that so efficiently clear markets in capitalist economies. Just as important, they did not have the signals of finance to adjust the allocation of physical resources to accommodate the shifting tastes of consumers. In a centrally planned system, banking and finance play a decidedly minor role. Since the production and distribution of goods and services are essentially driven by state orders and rationing, finance is little more than record keeping. While there are pro-forma payment transfers among state-owned enterprises, few if any actions are driven by them. Payment arrears, or even defaults, are largely irrelevant in the sense that they are essentially transactions among enterprises owned by the same entity, that is, the state. Under central planning there are no credit standards, no interest rate risks, no market value changes, that is, none of the key financial signals that determine who gets credit, and who does not, and hence who produces what, and sells to whom, in a market economy. In short, none of the financial infrastructure which converts the changing valuations of consumers into market signals that direct production for profit are available. But it didn't matter in the Soviet-bloc economies. Few decisions in those centrally planned systems were affected by the lack of a developed financial system. That centrally planned economies, as a consequence, were highly inefficient is best illustrated by the fact that energy consumed per unit of output was as much as five to seven times higher in Eastern Europe and the former Soviet Union than in the West. Moreover, the exceptionally large amount of resources devoted to capital investment, without contributing to the productive capacity of these economies, suggests that these resources were largely wasted. Regrettably, until the Berlin Wall was breached and the need to develop market economies out of the rubble of Eastern Europe's central planning regime became apparent, little contemporary thought had been given to the institutional infrastructure required of markets. Nonetheless, in the years immediately following the fall of the Berlin Wall many of the states of the former Soviet bloc did get something akin to a market system in the form of a rapid growth of black markets that replicated some of what seemingly goes on in a market economy. But only in part. Black markets, by definition, are not supported by the rule of law. There are no rights to own and dispose of property protected by the enforcement power of the state. There are no laws of contract or bankruptcy, or judicial review and determination again enforced by the state. The essential infrastructure of a market economy is missing. Black markets offer few of the benefits of legally sanctioned trade. To know that the state will protect one's rights to property will encourage the taking of risks that create wealth and foster growth. Few will risk their capital, however, if there is little assurance that the rewards of risk are secure from the arbitrary actions of government or street mobs. Indeed, today's Russia is striving to rid itself of a substantial black market intertwined with its evolving market economy. Law enforcement in support of private property is uneven in its application. Private security forces, to a large extent, have taken over protection, with results sometimes less than satisfactory. The shift of vast real resources from the defunct Soviet state to private parties, whose claims in many instances are perceived as dubious, has not enhanced public support for the protection of such claims by official authorities. Some, but not all, would argue with the Russian academic who last month told the Washington Post that "The state thinks ... private capital should be defended by those who have it. ...It's a completely conscious policy of the law enforcement authorities to remove themselves from defending private capital." Certainly, if generations of Russians have been brought up on the Marxist notion that private property is "theft," a breakdown of the Soviet central planning infrastructure is not going to automatically alter the perceived moral base of its social system. The right to property in market economies, on the other hand, is morally rooted in its culture. Indeed, the presumption of property ownership and the legality of its transfer must be deeply embedded in the culture of a society for free market economies to function effectively. In the West and especially under British common law and its derivatives, the moral validity of property rights is accepted, or at least acquiesced in, by virtually the whole of the population. Accordingly, a very small proportion of contracts have to be enforced through actions in the courts. Moreover, reflecting a strong commitment to property rights, a surprisingly large number of contracts, especially in financial markets, are initially oral, confirmed only at a later date, and at times after much price movement, by a written document. The differing attitudes and views toward property ownership are passed from generation to generation through family values and education systems. Hence, the process of full transition from the so-called collective rights of socialist economies to the individual property rights of market economies and legal certainties can be expected to be slow. One prominent young Russian reformer of my acquaintance thinks the transition is moving quickly among those under forty years of age, much less so among their elders. Altering what a nation teaches its children is a profoundly difficult task and clearly cannot be accomplished overnight. Changing attitudes toward property and profit is not simple. These attitudes derive from the deepest values of personal worth people hold. Aside from property rights enforced by an impartial judiciary, for a market economy to function effectively, there must also be widespread dissemination of timely financial and other relevant information. This enables market participants to make the type of informed judgments that foster the most efficient allocation of capital -- efficient in the sense that our physical resources are directed at producing those goods and services most valued by consumers. This requires a free press and government data information systems that are perceived to be free of hidden political manipulation. Government censorship in any form renders information suspect. Such information will be disregarded by market participants as virtually useless, requiring individuals to rely on rumor and other dubious sources of information. This leads to misjudgments about the changing patterns of consumer demand and hence significantly eviscerates the market's effectiveness and its role in directing real resources to their optimum uses. Most other rights that we Americans cherish -- protection against extra-legal violence or intimidation by the state, arbitrary confiscation of property without due process, as well as freedom of speech and of the press, and an absence of discrimination -- are all essential to an effective, functioning market system. Indeed a list or bill of rights enforced by an impartial judiciary is, and I hesitate to use the analogy, what substitutes for the central planning function as the guiding mechanism of a free market economy. It is these "rights" that enable the value judgements of millions of consumers to be converted through a legally protected free market into prices of products and financial instruments; and it is, of course, these market prices that substitute for the state orders of the centrally planned economies. We depend on government in a free society to ensure those market "rights." Perhaps of greater importance, those rights can also be viewed as a list of prohibitions delimiting the actions of government. Thus, the more effective the list is in constraining the arbitrary actions of government officials, the less it matters what they do. The tighter the proscription on government officials' discretion, the less arbitrary government power is available to the highest bidder. The democratic process, of course, is needed to ensure that the "list of market rights" has the continued sanction of the people. Since any bill of rights specifies the limits to which government officials can infringe on the rights of individuals, the rational self-interest of the populace is always to protect and broaden individual rights. The self-interest of those officials who have the power to exert discretionary power in areas not specifically delimited by a bill of rights, is, too often, to broaden that scope. Hence, authoritarian societies, even benevolent ones, are biased to restraining the rights of individuals generally and property in particular. Clearly, not all democracies protect the private right of property with the same fervor. Indeed, they vary widely. Nor is it the case that all societies with firmly protected property rights bend invariably to the majority will of the populace on all public issues. Certainly in its earlier years Hong Kong did not have a democratic process but a "list of rights" protected by British common law and Britain's democracy. Singapore, from a similar heritage, does protect property and contract rights, the crucial pillars of market efficiency, but does not have some of the other characteristics of western democracies with which we are familiar. There are those who argue, however, that as this remarkable city-state evolves, increasing wealth will push it toward broader freedoms. To summarize then, the ideal state of affairs for a centrally planned economy is one in which there is continuous production of the same type of goods, of the same quality, of the same design, obediently purchased in repetitive quantities, with cash wages backed as necessary by rationing coupons. Centrally planned economies are frozen in time. They cannot readily accommodate innovation, new ideas, new products, and altered specifications. In sharp contrast, capitalist market economies are driven by what Professor Joseph Schumpeter, a number of decades ago, called "creative destruction." By this he meant newer ways of doing things, newer products, and novel engineering and architectural insights that induce the continuous obsolescence and retirement of factories and equipment and a reshuffling of workers to new and different activities. Market economies in that sense are continuously renewing themselves. Innovation, risk taking, and competition are the driving forces that propel standards of living progressively higher. Thus, the bold, if unintended, experiment in economic and social systems, which began after World War II in Europe, did not come to a full resting place with the fall of the Berlin Wall in 1989. Despite the ebb and flow of governments of differing persuasions, the face of the world economy continues to edge toward free-market-oriented societies. This is especially the case as increasing numbers of transition economies prosper and emerging market economies wedded to free-market paradigms grow impressively. There has been, to be sure, much pain and periodic backtracking among a number of the nations that discarded the mantle of central planning. There will doubtless be more. But the experience of the last half century clearly attests to how far the power of the idea of market freedom can carry.	---[PAGE_BREAK]--- # Mr. Greenspan examines the process by which former centrally planned economies are embracing free markets Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Woodrow Wilson Award Dinner of the Woodrow Wilson International Center for Scholars in New York on 10/6/97. On November 9, 1989, the Berlin Wall came down, symbolizing the end of an experiment in economic and social policy that began more than four decades earlier with the division of the states of Western and Central Europe into market economies and those governed by state central planning. At the end of World War II, as Winston Churchill put it, "From Stettin in the Baltic to Trieste in the Adriatic an iron curtain ... descended across the Continent." Aside from the Soviet Union itself, the economies on the Soviet side of the "curtain" had been, in the prewar period, similar to the market-based economies on the western side. Over four decades both types of economies developed with limited interaction across the dividing line. It was as close to a controlled experiment in the viability of economic systems as could ever be implemented. The results, unequivocally in favor of market economies, have had far-reaching consequences. The long-standing debate between the virtues of economies organized around free markets and those governed by centrally planned socialism is essentially at an end. To be sure, there are still a few who still support the old fashioned socialism -- but for the vast majority of professed socialists it is now a highly diluted socialism, an amalgam of social equity and the efficiency of the market, often called market socialism. The verdict on rigid central planning has been rendered, and it is generally appreciated to have been unequivocally negative. Over the last seven years, with the Soviet bloc books now open, we of course have learned much about how communist economics worked, or, more to the point, did not. But the biggest surprise is what the aftermath of the four-decade experiment has been teaching us about how and why our own Western economies and societies function, or, perhaps more exactly, refreshing our own long-dormant memories of the process. Economists have had considerable experience this century in observing how market economies converted to centrally planned ones but until recently have had virtually no exposure in the opposite direction. Ironically, in aiding in the process of implementing the latter, we are being forced to more fully understand the roots of our own system. Much of what we took for granted in our free market system and assumed to be human nature was not nature at all, but culture. The dismantling of the central planning function in an economy does not, as some had supposed, automatically establish a free market entrepreneurial system. There is a vast amount of capitalist culture and infrastructure underpinning market economies that has evolved over generations: laws, conventions, behaviors, and a wide variety of business professions and practices that have no important functions in a centrally planned economy. Centrally planned economic systems, such as that which existed in the Soviet Union, had great difficulty in creating wealth and rising standards of living. In theory, and to a large extent in practice, production and distribution were determined by specific instructions -often in the form of state orders -- coming from the central planning agencies to the various different producing establishments, indicating from whom, and in what quantities, they should receive their raw materials and services, and to whom they should distribute their final outputs. The work force was assumed to be fully employed and wages were somewhat arbitrarily predetermined. ---[PAGE_BREAK]--- Without an effective market clearing mechanism, the consequences of such a paradigm, as one might readily anticipate, were both huge surpluses of goods which, while produced, were not wanted by the populace, and huge shortages of products that consumers desired but were not produced in adequate quantities. The imbalance of demand over supply inevitably required rationing or its equivalent, standing in queues for limited quantities of goods and services. One might think that the planning authorities should have been able to adjust to these distortions. They tried. But they faced insurmountable handicaps in that they did not have access to the immediate signals of price changes that so efficiently clear markets in capitalist economies. Just as important, they did not have the signals of finance to adjust the allocation of physical resources to accommodate the shifting tastes of consumers. In a centrally planned system, banking and finance play a decidedly minor role. Since the production and distribution of goods and services are essentially driven by state orders and rationing, finance is little more than record keeping. While there are pro-forma payment transfers among state-owned enterprises, few if any actions are driven by them. Payment arrears, or even defaults, are largely irrelevant in the sense that they are essentially transactions among enterprises owned by the same entity, that is, the state. Under central planning there are no credit standards, no interest rate risks, no market value changes, that is, none of the key financial signals that determine who gets credit, and who does not, and hence who produces what, and sells to whom, in a market economy. In short, none of the financial infrastructure which converts the changing valuations of consumers into market signals that direct production for profit are available. But it didn't matter in the Soviet-bloc economies. Few decisions in those centrally planned systems were affected by the lack of a developed financial system. That centrally planned economies, as a consequence, were highly inefficient is best illustrated by the fact that energy consumed per unit of output was as much as five to seven times higher in Eastern Europe and the former Soviet Union than in the West. Moreover, the exceptionally large amount of resources devoted to capital investment, without contributing to the productive capacity of these economies, suggests that these resources were largely wasted. Regrettably, until the Berlin Wall was breached and the need to develop market economies out of the rubble of Eastern Europe's central planning regime became apparent, little contemporary thought had been given to the institutional infrastructure required of markets. Nonetheless, in the years immediately following the fall of the Berlin Wall many of the states of the former Soviet bloc did get something akin to a market system in the form of a rapid growth of black markets that replicated some of what seemingly goes on in a market economy. But only in part. Black markets, by definition, are not supported by the rule of law. There are no rights to own and dispose of property protected by the enforcement power of the state. There are no laws of contract or bankruptcy, or judicial review and determination again enforced by the state. The essential infrastructure of a market economy is missing. Black markets offer few of the benefits of legally sanctioned trade. To know that the state will protect one's rights to property will encourage the taking of risks that create wealth and foster growth. Few will risk their capital, however, if there is little assurance that the rewards of risk are secure from the arbitrary actions of government or street mobs. ---[PAGE_BREAK]--- Indeed, today's Russia is striving to rid itself of a substantial black market intertwined with its evolving market economy. Law enforcement in support of private property is uneven in its application. Private security forces, to a large extent, have taken over protection, with results sometimes less than satisfactory. The shift of vast real resources from the defunct Soviet state to private parties, whose claims in many instances are perceived as dubious, has not enhanced public support for the protection of such claims by official authorities. Some, but not all, would argue with the Russian academic who last month told the Washington Post that "The state thinks ... private capital should be defended by those who have it. ...It's a completely conscious policy of the law enforcement authorities to remove themselves from defending private capital." Certainly, if generations of Russians have been brought up on the Marxist notion that private property is "theft," a breakdown of the Soviet central planning infrastructure is not going to automatically alter the perceived moral base of its social system. The right to property in market economies, on the other hand, is morally rooted in its culture. Indeed, the presumption of property ownership and the legality of its transfer must be deeply embedded in the culture of a society for free market economies to function effectively. In the West and especially under British common law and its derivatives, the moral validity of property rights is accepted, or at least acquiesced in, by virtually the whole of the population. Accordingly, a very small proportion of contracts have to be enforced through actions in the courts. Moreover, reflecting a strong commitment to property rights, a surprisingly large number of contracts, especially in financial markets, are initially oral, confirmed only at a later date, and at times after much price movement, by a written document. The differing attitudes and views toward property ownership are passed from generation to generation through family values and education systems. Hence, the process of full transition from the so-called collective rights of socialist economies to the individual property rights of market economies and legal certainties can be expected to be slow. One prominent young Russian reformer of my acquaintance thinks the transition is moving quickly among those under forty years of age, much less so among their elders. Altering what a nation teaches its children is a profoundly difficult task and clearly cannot be accomplished overnight. Changing attitudes toward property and profit is not simple. These attitudes derive from the deepest values of personal worth people hold. Aside from property rights enforced by an impartial judiciary, for a market economy to function effectively, there must also be widespread dissemination of timely financial and other relevant information. This enables market participants to make the type of informed judgments that foster the most efficient allocation of capital -- efficient in the sense that our physical resources are directed at producing those goods and services most valued by consumers. This requires a free press and government data information systems that are perceived to be free of hidden political manipulation. Government censorship in any form renders information suspect. Such information will be disregarded by market participants as virtually useless, requiring individuals to rely on rumor and other dubious sources of information. This leads to misjudgments about the changing patterns of consumer demand and hence significantly eviscerates the market's effectiveness and its role in directing real resources to their optimum uses. ---[PAGE_BREAK]--- Most other rights that we Americans cherish -- protection against extra-legal violence or intimidation by the state, arbitrary confiscation of property without due process, as well as freedom of speech and of the press, and an absence of discrimination -- are all essential to an effective, functioning market system. Indeed a list or bill of rights enforced by an impartial judiciary is, and I hesitate to use the analogy, what substitutes for the central planning function as the guiding mechanism of a free market economy. It is these "rights" that enable the value judgements of millions of consumers to be converted through a legally protected free market into prices of products and financial instruments; and it is, of course, these market prices that substitute for the state orders of the centrally planned economies. We depend on government in a free society to ensure those market "rights." Perhaps of greater importance, those rights can also be viewed as a list of prohibitions delimiting the actions of government. Thus, the more effective the list is in constraining the arbitrary actions of government officials, the less it matters what they do. The tighter the proscription on government officials' discretion, the less arbitrary government power is available to the highest bidder. The democratic process, of course, is needed to ensure that the "list of market rights" has the continued sanction of the people. Since any bill of rights specifies the limits to which government officials can infringe on the rights of individuals, the rational self-interest of the populace is always to protect and broaden individual rights. The self-interest of those officials who have the power to exert discretionary power in areas not specifically delimited by a bill of rights, is, too often, to broaden that scope. Hence, authoritarian societies, even benevolent ones, are biased to restraining the rights of individuals generally and property in particular. Clearly, not all democracies protect the private right of property with the same fervor. Indeed, they vary widely. Nor is it the case that all societies with firmly protected property rights bend invariably to the majority will of the populace on all public issues. Certainly in its earlier years Hong Kong did not have a democratic process but a "list of rights" protected by British common law and Britain's democracy. Singapore, from a similar heritage, does protect property and contract rights, the crucial pillars of market efficiency, but does not have some of the other characteristics of western democracies with which we are familiar. There are those who argue, however, that as this remarkable city-state evolves, increasing wealth will push it toward broader freedoms. To summarize then, the ideal state of affairs for a centrally planned economy is one in which there is continuous production of the same type of goods, of the same quality, of the same design, obediently purchased in repetitive quantities, with cash wages backed as necessary by rationing coupons. Centrally planned economies are frozen in time. They cannot readily accommodate innovation, new ideas, new products, and altered specifications. In sharp contrast, capitalist market economies are driven by what Professor Joseph Schumpeter, a number of decades ago, called "creative destruction." By this he meant newer ways of doing things, newer products, and novel engineering and architectural insights that induce the continuous obsolescence and retirement of factories and equipment and a reshuffling of workers to new and different activities. Market economies in that sense are continuously renewing themselves. Innovation, risk taking, and competition are the driving forces that propel standards of living progressively higher. ---[PAGE_BREAK]--- Thus, the bold, if unintended, experiment in economic and social systems, which began after World War II in Europe, did not come to a full resting place with the fall of the Berlin Wall in 1989. Despite the ebb and flow of governments of differing persuasions, the face of the world economy continues to edge toward free-market-oriented societies. This is especially the case as increasing numbers of transition economies prosper and emerging market economies wedded to free-market paradigms grow impressively. There has been, to be sure, much pain and periodic backtracking among a number of the nations that discarded the mantle of central planning. There will doubtless be more. But the experience of the last half century clearly attests to how far the power of the idea of market freedom can carry.	Alan Greenspan	United States	https://www.bis.org/review/r970626c.pdf	economies are embracing free markets Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Woodrow Wilson Award Dinner of the Woodrow Wilson International Center for Scholars in New York on 10/6/97. On November 9, 1989, the Berlin Wall came down, symbolizing the end of an experiment in economic and social policy that began more than four decades earlier with the division of the states of Western and Central Europe into market economies and those governed by state central planning. At the end of World War II, as Winston Churchill put it, "From Stettin in the Baltic to Trieste in the Adriatic an iron curtain . descended across the Continent." Aside from the Soviet Union itself, the economies on the Soviet side of the "curtain" had been, in the prewar period, similar to the market-based economies on the western side. Over four decades both types of economies developed with limited interaction across the dividing line. It was as close to a controlled experiment in the viability of economic systems as could ever be implemented. The results, unequivocally in favor of market economies, have had far-reaching consequences. The long-standing debate between the virtues of economies organized around free markets and those governed by centrally planned socialism is essentially at an end. To be sure, there are still a few who still support the old fashioned socialism -- but for the vast majority of professed socialists it is now a highly diluted socialism, an amalgam of social equity and the efficiency of the market, often called market socialism. The verdict on rigid central planning has been rendered, and it is generally appreciated to have been unequivocally negative. Over the last seven years, with the Soviet bloc books now open, we of course have learned much about how communist economics worked, or, more to the point, did not. But the biggest surprise is what the aftermath of the four-decade experiment has been teaching us about how and why our own Western economies and societies function, or, perhaps more exactly, refreshing our own long-dormant memories of the process. Economists have had considerable experience this century in observing how market economies converted to centrally planned ones but until recently have had virtually no exposure in the opposite direction. Ironically, in aiding in the process of implementing the latter, we are being forced to more fully understand the roots of our own system. Much of what we took for granted in our free market system and assumed to be human nature was not nature at all, but culture. The dismantling of the central planning function in an economy does not, as some had supposed, automatically establish a free market entrepreneurial system. There is a vast amount of capitalist culture and infrastructure underpinning market economies that has evolved over generations: laws, conventions, behaviors, and a wide variety of business professions and practices that have no important functions in a centrally planned economy. Centrally planned economic systems, such as that which existed in the Soviet Union, had great difficulty in creating wealth and rising standards of living. In theory, and to a large extent in practice, production and distribution were determined by specific instructions -often in the form of state orders -- coming from the central planning agencies to the various different producing establishments, indicating from whom, and in what quantities, they should receive their raw materials and services, and to whom they should distribute their final outputs. The work force was assumed to be fully employed and wages were somewhat arbitrarily predetermined. Without an effective market clearing mechanism, the consequences of such a paradigm, as one might readily anticipate, were both huge surpluses of goods which, while produced, were not wanted by the populace, and huge shortages of products that consumers desired but were not produced in adequate quantities. The imbalance of demand over supply inevitably required rationing or its equivalent, standing in queues for limited quantities of goods and services. One might think that the planning authorities should have been able to adjust to these distortions. They tried. But they faced insurmountable handicaps in that they did not have access to the immediate signals of price changes that so efficiently clear markets in capitalist economies. Just as important, they did not have the signals of finance to adjust the allocation of physical resources to accommodate the shifting tastes of consumers. In a centrally planned system, banking and finance play a decidedly minor role. Since the production and distribution of goods and services are essentially driven by state orders and rationing, finance is little more than record keeping. While there are pro-forma payment transfers among state-owned enterprises, few if any actions are driven by them. Payment arrears, or even defaults, are largely irrelevant in the sense that they are essentially transactions among enterprises owned by the same entity, that is, the state. Under central planning there are no credit standards, no interest rate risks, no market value changes, that is, none of the key financial signals that determine who gets credit, and who does not, and hence who produces what, and sells to whom, in a market economy. In short, none of the financial infrastructure which converts the changing valuations of consumers into market signals that direct production for profit are available. But it didn't matter in the Soviet-bloc economies. Few decisions in those centrally planned systems were affected by the lack of a developed financial system. That centrally planned economies, as a consequence, were highly inefficient is best illustrated by the fact that energy consumed per unit of output was as much as five to seven times higher in Eastern Europe and the former Soviet Union than in the West. Moreover, the exceptionally large amount of resources devoted to capital investment, without contributing to the productive capacity of these economies, suggests that these resources were largely wasted. Regrettably, until the Berlin Wall was breached and the need to develop market economies out of the rubble of Eastern Europe's central planning regime became apparent, little contemporary thought had been given to the institutional infrastructure required of markets. Nonetheless, in the years immediately following the fall of the Berlin Wall many of the states of the former Soviet bloc did get something akin to a market system in the form of a rapid growth of black markets that replicated some of what seemingly goes on in a market economy. But only in part. Black markets, by definition, are not supported by the rule of law. There are no rights to own and dispose of property protected by the enforcement power of the state. There are no laws of contract or bankruptcy, or judicial review and determination again enforced by the state. The essential infrastructure of a market economy is missing. Black markets offer few of the benefits of legally sanctioned trade. To know that the state will protect one's rights to property will encourage the taking of risks that create wealth and foster growth. Few will risk their capital, however, if there is little assurance that the rewards of risk are secure from the arbitrary actions of government or street mobs. Indeed, today's Russia is striving to rid itself of a substantial black market intertwined with its evolving market economy. Law enforcement in support of private property is uneven in its application. Private security forces, to a large extent, have taken over protection, with results sometimes less than satisfactory. The shift of vast real resources from the defunct Soviet state to private parties, whose claims in many instances are perceived as dubious, has not enhanced public support for the protection of such claims by official authorities. Some, but not all, would argue with the Russian academic who last month told the Washington Post that "The state thinks . private capital should be defended by those who have it. .It's a completely conscious policy of the law enforcement authorities to remove themselves from defending private capital." Certainly, if generations of Russians have been brought up on the Marxist notion that private property is "theft," a breakdown of the Soviet central planning infrastructure is not going to automatically alter the perceived moral base of its social system. The right to property in market economies, on the other hand, is morally rooted in its culture. Indeed, the presumption of property ownership and the legality of its transfer must be deeply embedded in the culture of a society for free market economies to function effectively. In the West and especially under British common law and its derivatives, the moral validity of property rights is accepted, or at least acquiesced in, by virtually the whole of the population. Accordingly, a very small proportion of contracts have to be enforced through actions in the courts. Moreover, reflecting a strong commitment to property rights, a surprisingly large number of contracts, especially in financial markets, are initially oral, confirmed only at a later date, and at times after much price movement, by a written document. The differing attitudes and views toward property ownership are passed from generation to generation through family values and education systems. Hence, the process of full transition from the so-called collective rights of socialist economies to the individual property rights of market economies and legal certainties can be expected to be slow. One prominent young Russian reformer of my acquaintance thinks the transition is moving quickly among those under forty years of age, much less so among their elders. Altering what a nation teaches its children is a profoundly difficult task and clearly cannot be accomplished overnight. Changing attitudes toward property and profit is not simple. These attitudes derive from the deepest values of personal worth people hold. Aside from property rights enforced by an impartial judiciary, for a market economy to function effectively, there must also be widespread dissemination of timely financial and other relevant information. This enables market participants to make the type of informed judgments that foster the most efficient allocation of capital -- efficient in the sense that our physical resources are directed at producing those goods and services most valued by consumers. This requires a free press and government data information systems that are perceived to be free of hidden political manipulation. Government censorship in any form renders information suspect. Such information will be disregarded by market participants as virtually useless, requiring individuals to rely on rumor and other dubious sources of information. This leads to misjudgments about the changing patterns of consumer demand and hence significantly eviscerates the market's effectiveness and its role in directing real resources to their optimum uses. Most other rights that we Americans cherish -- protection against extra-legal violence or intimidation by the state, arbitrary confiscation of property without due process, as well as freedom of speech and of the press, and an absence of discrimination -- are all essential to an effective, functioning market system. Indeed a list or bill of rights enforced by an impartial judiciary is, and I hesitate to use the analogy, what substitutes for the central planning function as the guiding mechanism of a free market economy. It is these "rights" that enable the value judgements of millions of consumers to be converted through a legally protected free market into prices of products and financial instruments; and it is, of course, these market prices that substitute for the state orders of the centrally planned economies. We depend on government in a free society to ensure those market "rights." Perhaps of greater importance, those rights can also be viewed as a list of prohibitions delimiting the actions of government. Thus, the more effective the list is in constraining the arbitrary actions of government officials, the less it matters what they do. The tighter the proscription on government officials' discretion, the less arbitrary government power is available to the highest bidder. The democratic process, of course, is needed to ensure that the "list of market rights" has the continued sanction of the people. Since any bill of rights specifies the limits to which government officials can infringe on the rights of individuals, the rational self-interest of the populace is always to protect and broaden individual rights. The self-interest of those officials who have the power to exert discretionary power in areas not specifically delimited by a bill of rights, is, too often, to broaden that scope. Hence, authoritarian societies, even benevolent ones, are biased to restraining the rights of individuals generally and property in particular. Clearly, not all democracies protect the private right of property with the same fervor. Indeed, they vary widely. Nor is it the case that all societies with firmly protected property rights bend invariably to the majority will of the populace on all public issues. Certainly in its earlier years Hong Kong did not have a democratic process but a "list of rights" protected by British common law and Britain's democracy. Singapore, from a similar heritage, does protect property and contract rights, the crucial pillars of market efficiency, but does not have some of the other characteristics of western democracies with which we are familiar. There are those who argue, however, that as this remarkable city-state evolves, increasing wealth will push it toward broader freedoms. To summarize then, the ideal state of affairs for a centrally planned economy is one in which there is continuous production of the same type of goods, of the same quality, of the same design, obediently purchased in repetitive quantities, with cash wages backed as necessary by rationing coupons. Centrally planned economies are frozen in time. They cannot readily accommodate innovation, new ideas, new products, and altered specifications. In sharp contrast, capitalist market economies are driven by what Professor Joseph Schumpeter, a number of decades ago, called "creative destruction." By this he meant newer ways of doing things, newer products, and novel engineering and architectural insights that induce the continuous obsolescence and retirement of factories and equipment and a reshuffling of workers to new and different activities. Market economies in that sense are continuously renewing themselves. Innovation, risk taking, and competition are the driving forces that propel standards of living progressively higher. Thus, the bold, if unintended, experiment in economic and social systems, which began after World War II in Europe, did not come to a full resting place with the fall of the Berlin Wall in 1989. Despite the ebb and flow of governments of differing persuasions, the face of the world economy continues to edge toward free-market-oriented societies. This is especially the case as increasing numbers of transition economies prosper and emerging market economies wedded to free-market paradigms grow impressively. There has been, to be sure, much pain and periodic backtracking among a number of the nations that discarded the mantle of central planning. There will doubtless be more. But the experience of the last half century clearly attests to how far the power of the idea of market freedom can carry.
1997-06-18T00:00:00	Ms. Phillips discusses the changing financial landscape and umbrella supervision in the United States (Central Bank Articles and Speeches, 18 Jun 97)	Remarks by Governor Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at the Exchequer Club in Washington on 18/6/97.	Ms. Phillips discusses the changing financial landscape and umbrella supervision in the United States Remarks by Governor Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at the Exchequer Club in Washington on 18/6/97. It is a pleasure to be here today at the Exchequer Club. I thank you for the opportunity to discuss the changing financial landscape and offer my own perspectives on what the future might bring. During the next few months, there will be significant debates on various aspects of financial modernization, both within and without the halls of Congress. These debates may well set the stage for how financial service companies will operate as we enter the twentyfirst century. As we can all plainly see, the world is changing across many dimensions, posing new and ever-increasing challenges for both financial services firms and their supervisors. To succeed in this new world, I believe it is important for the industry and supervisors to find common ground for coping with these challenges. By working together to find solutions, we can both accomplish our goals, while retaining the core principles and values that have contributed to the industry's success. So today I would like to discuss briefly the changes underway affecting the financial services industry, as well as the individual and collective responses by the industry and supervisors to those changes. Then lastly, I will offer some thoughts on what the role of an umbrella supervisor might look like in this changing environment for financial services. All of these changes must be considered in the context of possible legislative reform. The Changing World As widely noted, dramatic advances in information and telecommunication technologies have allowed banks to develop new and more customized products and services and deliver them over a broader geographic area with greater efficiency. Such innovations by the banking industry, and by financial markets in general, have increased the sophistication and complexity of bank lending, investing, trading, and funding. They have propelled growth in less traditional or newer banking activities such as investment banking, mutual fund management, insurance and securitization. In the process, the risk profiles of many banking organizations have been altered in fundamental ways, placing greater pressure on management to monitor and manage underlying risks. To meet this challenge, a growing number of institutions are employing modern financial theory for measuring and analyzing the trade-off between risk and returns. The availability of dramatically more powerful computers at ever more affordable prices has allowed institutions to process vast data bases of rates, prices, defaults, and recoveries. As a result, techniques for portfolio management and risk measurement that not long ago were possible only in theory are now becoming integral parts of daily operating practice. By applying these theories and techniques, institutions today are more effectively pricing and hedging risk, allocating capital, evaluating risk-adjusted returns and identifying the optimum mix of financial products or services. I believe these enhanced management practices have contributed importantly to the economic growth and market gains seen in recent years. As competition has intensified, we have seen a growing overlap in the activities and product lines provided by both banks and other financial service providers that has diminished the past distinction between banks and many nonbank firms. That trend has raised public policy questions regarding bank powers and the appropriate organizational structure through which banking organizations should gain new powers. Proposals recently introduced in Congress to address those issues would fundamentally redefine the relationship of banks to other financial services companies and in some instances their relationship to commercial firms as well. Banks have not only expanded their products and activities, but have also expanded their geographic reach, both domestically and globally. Within the United States, banks have expanded nationwide as barriers to interstate banking have been removed. This expansion should continue as banks exercise their new power to branch across state lines. A related domestic trend is the rapid consolidation within and between banking organizations. Although some consolidation is undoubtedly related to the removal of barriers to interstate branching, it is also spurred by improved technology, strong competition in banking markets, and the drive by banks to reduce costs. Internationally, the globalization of banking has accelerated, driven by improved technology and the opening of economies in eastern Europe, Asia, Latin America, and other regions. In particular, U.S. and other international financial institutions are forging a growing presence in lending, trading, and underwriting in these emerging markets. These efforts have created closer links among the world's financial markets and have improved the efficiency and availability of capital. However, market integration has also increased the potential for systemic problems to transcend national borders, as the volume of international financial transactions has grown. Last year, for example, an estimated $1.5 trillion of foreign exchange contracts were settled daily in New York City alone. A default by a major U.S. or foreign participant in that market could disrupt financial markets worldwide. Competitive pressures are intense to reduce the cost of financial services to the public. This is occurring against the need to improve the financial strength and competitiveness of the banking industry from the levels at the beginning of this decade. These factors have, in turn, also placed pressure on the banking agencies to remove unnecessary burdens on the industry without threatening safety and soundness. Regulatory and Supervisory Responses to Change What have been the regulatory and supervisory responses to these changes? Let me first discuss how we addressed the issue of regulatory burden. Although the poor bank profitability of the 1980s and early 1990s was mostly related to industry asset quality problems, regulators and Congress alike recognized that improvements could be made in bank regulations and in supervisory processes to improve credit availability and bank competitiveness without sacrificing safety and soundness. Both legislative and regulatory efforts undertaken in the decade of the 1990's have simplified regulatory reporting requirements, expedited the application process, eliminated duplicate regulatory filings, and have led to more streamlined and uniform banking agency guidelines and regulations. Taken individually, these and other refinements may not appear material, but taken as a whole they have put a meaningful dent in regulatory costs. In fact, the industry on several occasions has reminded us that it is not necessarily any particular individual regulatory requirement that is problematic, but rather, their cumulative effect, much like the straw that broke the camel's back. We have taken that point to heart when considering new guidelines and regulations. Efforts to reduce regulatory burden apply not only to banks, but to holding companies as well. Earlier this year, for example, the Board streamlined Regulation Y and reduced application requirements. These changes recognize that regulatory burden arises not only from the direct operational costs of compliance, but also from the indirect costs of delayed or lost opportunities to enter new activities. To reduce impediments, the Board has decided that the application process should focus on the analysis of the effects of a specific proposal, and should not generally become a vehicle for comprehensively evaluating and addressing supervisory and compliance issues. Rather, the latter can more effectively be addressed in the supervisory process. The Board also recently completed a lengthy review of its policies and procedures for assessing the competitive implications of bank mergers and acquisitions. Modifications have been made to that process to make it more efficient and address the potential benefits of scale economies for small bank mergers. Another improvement in our regulations is the ability of well-capitalized, wellrun companies to apply to acquire banks and nonbanks in a faster more streamlined fashion and to commence nonbanking activities approved by regulation without obtaining prior approval. To allow bank holding companies greater opportunities to innovate, the Board has also indicated that it will be pro-active in approving new activities. Further efforts to provide flexibility and help modernize bank holding company regulations have been directed toward securities firms known as section 20 affiliates. Last year the Board raised the Section 20 ineligible revenue limit on underwriting and dealing in securities from 10 to 25 percent. This appears to be allowing greater flexibility for these operations. The Board has also eliminated certain firewalls between banks and their securities affiliates and for other firewalls has proposed to eliminate or scale back even more, recognizing that other laws, regulations, and improved disclosures provide adequate protections against conflicts of interest. These and other refinements should allow holding companies to move closer toward their goal of operating as a one-stop financial service firm for customers, while operating safely and soundly. The Comptroller of the Currency has also taken steps to widen the breadth of activities undertaken by banking organizations. For example, the expansion of insurance sales activities has opened new opportunities for national banks. Beyond efforts to reduce burden and modernize banking powers, regulators are also redesigning their supervisory practices to address more effectively the changing nature of the industry. These efforts are leading to a more risk-focused approach to supervision. That approach is more responsive to the industry's rapidly evolving activities and risk profiles and places emphasis on the institution's own ongoing system for managing risk, rather than point-intime transaction testing. By focusing resources on the areas of highest risk, and eliminating unnecessary procedures, this approach is not only more effective, but also less intrusive and costly to all parties. I should note, however, that successfully implementing this approach requires that supervisors attract, train, and retain qualified staff while also upgrading training, automation, and other resources. This is a continuing challenge indeed! Regulators are also trying to build on private sector initiatives that promote safety, soundness and systemic stability. For example, at the height of Congressional concern about financial derivatives, the Group of Thirty sponsored a study to identify principles of sound practice for managing risks in derivatives for both dealers and end-users. By providing guidance on this issue, that study served as a catalyst for industry participants to analyze and evaluate their own practices. Subsequent guidance from the Federal Reserve and the Comptroller benefited from the insights provided by the study, while adding a supervisor's perspective. The study's emphasis on education and sound practices spurred greater understanding and acceptance by the industry of supervisory recommendations for sound risk management systems. I think it is safe to say that this cooperative approach between the private sector and regulators resulted in stronger industry practices and better supervisory oversight, not only for derivatives, but also for bank risk management more generally. Together, the industry and agency response helped stave off potentially restrictive legislation. Another example of how supervisors are trying to build on bank management practices is their use of internal value-at-risk models in the calculation of capital requirements for market risk. By relying on internal models already used by the institutions for their trading and risk management activities, regulators can reduce burden while vastly improving the accuracy of the capital calculation. In addition, by embracing internal models for regulatory purposes, supervisors are encouraging organizations to incorporate sophisticated risk models more fully and formally into their risk management systems and to continue to upgrade and improve the models. As these two examples illustrate, supervisors recognize that they do not have all the answers and that rigid regulatory solutions may often do more harm than good. A supervisory approach that promotes continued improvements in private sector practices provides the right incentives to industry and, in the case of banking, also reduces risks to the federal safety net. In these ways, supervisors are placing greater reliance on a bank's own risk management system as the first line of defense for ensuring safety and soundness. We also want to rely more on market discipline as another line of defense. This requires increased, improved disclosure of a bank's activities, risk exposures, and philosophy for managing and controlling risk. We have made significant gains for derivatives and market risks. Hopefully we will see further gains in other areas in the years ahead. While it is important for supervisors to identify risk at individual banks, as the central bank the Federal Reserve must also be watchful for conditions and trends external to the banking system that could place the financial system and the economy at risk. This broader perspective has become especially important with the globalization of banking and integration of markets. That is why the Federal Reserve has worked closely with financial regulators around the world to reduce systemic risk and promote sound banking practices and improved disclosures among both developed and emerging countries. These efforts have led to the advancement by the BIS of core principles of bank supervision for authorities world-wide and, significantly, promotion of consolidated supervision of banking organizations by home country authorities. The issue of consolidated supervision is particularly relevant in revisiting the question of the modernization of the banking system. I will come to that in a moment. Financial Modernization and Umbrella Supervision First I would like to point out that whether legislative agreement is reached or not, market forces will continue the modernization of the financial services industry and will further blur the lines between banks and nonbanks. For example, we can expect mutual funds to refine their offerings to compete with bank checking and savings accounts, albeit without deposit insurance. Banks will undoubtedly make further inroads in mutual fund management and investment banking through internal growth and through acquisitions of securities firms. Investment banks may also supplement their services by making commercial loans and participating in loan syndications. With such things happening, why do we need a legislative solution? The answer is that a well thought out proposal addressing the appropriate structure for the industry would allow for a more rapid and efficient integration of financial services. Moreover, by clearly defining the boundaries and structure of financial conglomerates, a well-considered supervisory program could adequately protect banks without undue intrusion to other parts of the conglomerate. Because financial conglomerates generally operate as integrated entities and manage risks on a global basis across business lines, their true operating structure superimposes a risk management and internal control process that extends across legal-entity-based corporate structures. In this light, supervision by legal entity can create important supervisory gaps that may expose the insured depository institution to unnecessary risk. That is to say, someone should look at the risk management of the organization as an organic whole, rather than as separate pieces that are simply added together. In fact, comprehensive, consolidated supervision by the home country supervisor is a legal requirement for foreign banks operating in the U.S. Some foreign supervisors are now beginning to question the consolidated supervision of U.S. firms operating in their countries. Now, I suspect some nonbank firms may feel apprehension at having an umbrella supervisor evaluate their operations. But let me emphasize that such oversight need not be overly onerous or intrusive. In fact, regulators are probably better prepared than ever before to implement an umbrella supervisory approach as a result of the supervisory techniques and approaches I just discussed. By applying risk-focused supervision, and promoting sound practices, and improved market disclosures, an umbrella supervisor should be able to implement an effective, unintrusive oversight process for conglomerates. Moreover, an umbrella supervisor may be able to provide assurances and information to other regulators and individual supervisors which may minimize their need to extend their reviews beyond the legal supervised entity and into the conglomerate's other operations, creating duplication and burden. I believe that the umbrella supervisor, whether it is the central bank or another agency, should not attempt to duplicate efforts of other regulators. Rather, the umbrella supervisor should evaluate the financial conglomerate from a more comprehensive perspective, bridging the gap between an organization's legal structure and its structure for taking and managing risk. Similarly, the umbrella supervisor need not attempt to extend bank-like safety and soundness regulations to nonbank entities. Those standards were never intended to apply to the nonbank entities of a conglomerate and would insert unnecessary competitive barriers without achieving the desired benefits. How exactly should an umbrella supervisor meet its responsibilities? First by focusing its supervisory efforts on the adequacy of the risk management and internal control process of the parent company and of the group as a whole, and determining how well those systems protect the safety and soundness of affiliated banks. That evaluation could be performed in a manner similar to that of a securities analyst, albeit from a different viewpoint. This assessment might involve analysis of public financial statements, rating agencies and Wall Street analyst reports, internal management reports, internal and external audit reports, meetings with management, and only limited, if any, on-site inspections of nonbank affiliates. Any visits that are made could be limited to testing the adequacy of management and operating systems, to protect the insured depository institution. While various approaches could be taken to address capital adequacy and to avoid the unnecessary or inappropriate use of double leverage, I believe such approaches should be measured against the goal of assuring the safety and soundness of the affiliated banks. And finally, the umbrella supervisor should have appropriate enforcement authority, including the authority to require the sale of the bank in extreme situations. Conclusion It is clear that the financial services industry is changing and that banking powers must also change if banks are to remain competitive. The Board has long supported reforms and strongly urges them today. However, changes such as these carry risks. It is important, therefore, that change be introduced properly through legislative debate and by adopting proper safeguards to ensure that nonbank activities do not unduly expose banks and taxpayers. The Federal Reserve is mindful of regulatory burden and of the need to accommodate change. Nevertheless, we also believe that some type of umbrella supervision will be necessary to protect insured depository institutions and address systemic risk concerns. Whoever plays that role should take a broad perspective in evaluating risks not only to specific depository institutions but also to the payment system and to the broad financial industry as well. Simply put, I believe that in an economy as complicated and integrated as we have in the United States, it is important for the nation's central bank to have a significant role in comprehensive financial institution supervision.	---[PAGE_BREAK]--- # Ms. Phillips discusses the changing financial landscape and umbrella supervision in the United States Remarks by Governor Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at the Exchequer Club in Washington on 18/6/97. It is a pleasure to be here today at the Exchequer Club. I thank you for the opportunity to discuss the changing financial landscape and offer my own perspectives on what the future might bring. During the next few months, there will be significant debates on various aspects of financial modernization, both within and without the halls of Congress. These debates may well set the stage for how financial service companies will operate as we enter the twentyfirst century. As we can all plainly see, the world is changing across many dimensions, posing new and ever-increasing challenges for both financial services firms and their supervisors. To succeed in this new world, I believe it is important for the industry and supervisors to find common ground for coping with these challenges. By working together to find solutions, we can both accomplish our goals, while retaining the core principles and values that have contributed to the industry's success. So today I would like to discuss briefly the changes underway affecting the financial services industry, as well as the individual and collective responses by the industry and supervisors to those changes. Then lastly, I will offer some thoughts on what the role of an umbrella supervisor might look like in this changing environment for financial services. All of these changes must be considered in the context of possible legislative reform. ## The Changing World As widely noted, dramatic advances in information and telecommunication technologies have allowed banks to develop new and more customized products and services and deliver them over a broader geographic area with greater efficiency. Such innovations by the banking industry, and by financial markets in general, have increased the sophistication and complexity of bank lending, investing, trading, and funding. They have propelled growth in less traditional or newer banking activities such as investment banking, mutual fund management, insurance and securitization. In the process, the risk profiles of many banking organizations have been altered in fundamental ways, placing greater pressure on management to monitor and manage underlying risks. To meet this challenge, a growing number of institutions are employing modern financial theory for measuring and analyzing the trade-off between risk and returns. The availability of dramatically more powerful computers at ever more affordable prices has allowed institutions to process vast data bases of rates, prices, defaults, and recoveries. As a result, techniques for portfolio management and risk measurement that not long ago were possible only in theory are now becoming integral parts of daily operating practice. By applying these theories and techniques, institutions today are more effectively pricing and hedging risk, allocating capital, evaluating risk-adjusted returns and identifying the optimum mix of financial products or services. I believe these enhanced management practices have contributed importantly to the economic growth and market gains seen in recent years. As competition has intensified, we have seen a growing overlap in the activities and product lines provided by both banks and other financial service providers that has diminished the past distinction between banks and many nonbank firms. That trend has raised ---[PAGE_BREAK]--- public policy questions regarding bank powers and the appropriate organizational structure through which banking organizations should gain new powers. Proposals recently introduced in Congress to address those issues would fundamentally redefine the relationship of banks to other financial services companies and in some instances their relationship to commercial firms as well. Banks have not only expanded their products and activities, but have also expanded their geographic reach, both domestically and globally. Within the United States, banks have expanded nationwide as barriers to interstate banking have been removed. This expansion should continue as banks exercise their new power to branch across state lines. A related domestic trend is the rapid consolidation within and between banking organizations. Although some consolidation is undoubtedly related to the removal of barriers to interstate branching, it is also spurred by improved technology, strong competition in banking markets, and the drive by banks to reduce costs. Internationally, the globalization of banking has accelerated, driven by improved technology and the opening of economies in eastern Europe, Asia, Latin America, and other regions. In particular, U.S. and other international financial institutions are forging a growing presence in lending, trading, and underwriting in these emerging markets. These efforts have created closer links among the world's financial markets and have improved the efficiency and availability of capital. However, market integration has also increased the potential for systemic problems to transcend national borders, as the volume of international financial transactions has grown. Last year, for example, an estimated $\$ 1.5$ trillion of foreign exchange contracts were settled daily in New York City alone. A default by a major U.S. or foreign participant in that market could disrupt financial markets worldwide. Competitive pressures are intense to reduce the cost of financial services to the public. This is occurring against the need to improve the financial strength and competitiveness of the banking industry from the levels at the beginning of this decade. These factors have, in turn, also placed pressure on the banking agencies to remove unnecessary burdens on the industry without threatening safety and soundness. # Regulatory and Supervisory Responses to Change What have been the regulatory and supervisory responses to these changes? Let me first discuss how we addressed the issue of regulatory burden. Although the poor bank profitability of the 1980s and early 1990s was mostly related to industry asset quality problems, regulators and Congress alike recognized that improvements could be made in bank regulations and in supervisory processes to improve credit availability and bank competitiveness without sacrificing safety and soundness. Both legislative and regulatory efforts undertaken in the decade of the 1990's have simplified regulatory reporting requirements, expedited the application process, eliminated duplicate regulatory filings, and have led to more streamlined and uniform banking agency guidelines and regulations. Taken individually, these and other refinements may not appear material, but taken as a whole they have put a meaningful dent in regulatory costs. In fact, the industry on several occasions has reminded us that it is not necessarily any particular individual regulatory requirement that is problematic, but rather, their cumulative effect, much like the straw that broke the camel's back. We have taken that point to heart when considering new guidelines and regulations. ---[PAGE_BREAK]--- Efforts to reduce regulatory burden apply not only to banks, but to holding companies as well. Earlier this year, for example, the Board streamlined Regulation Y and reduced application requirements. These changes recognize that regulatory burden arises not only from the direct operational costs of compliance, but also from the indirect costs of delayed or lost opportunities to enter new activities. To reduce impediments, the Board has decided that the application process should focus on the analysis of the effects of a specific proposal, and should not generally become a vehicle for comprehensively evaluating and addressing supervisory and compliance issues. Rather, the latter can more effectively be addressed in the supervisory process. The Board also recently completed a lengthy review of its policies and procedures for assessing the competitive implications of bank mergers and acquisitions. Modifications have been made to that process to make it more efficient and address the potential benefits of scale economies for small bank mergers. Another improvement in our regulations is the ability of well-capitalized, wellrun companies to apply to acquire banks and nonbanks in a faster more streamlined fashion and to commence nonbanking activities approved by regulation without obtaining prior approval. To allow bank holding companies greater opportunities to innovate, the Board has also indicated that it will be pro-active in approving new activities. Further efforts to provide flexibility and help modernize bank holding company regulations have been directed toward securities firms known as section 20 affiliates. Last year the Board raised the Section 20 ineligible revenue limit on underwriting and dealing in securities from 10 to 25 percent. This appears to be allowing greater flexibility for these operations. The Board has also eliminated certain firewalls between banks and their securities affiliates and for other firewalls has proposed to eliminate or scale back even more, recognizing that other laws, regulations, and improved disclosures provide adequate protections against conflicts of interest. These and other refinements should allow holding companies to move closer toward their goal of operating as a one-stop financial service firm for customers, while operating safely and soundly. The Comptroller of the Currency has also taken steps to widen the breadth of activities undertaken by banking organizations. For example, the expansion of insurance sales activities has opened new opportunities for national banks. Beyond efforts to reduce burden and modernize banking powers, regulators are also redesigning their supervisory practices to address more effectively the changing nature of the industry. These efforts are leading to a more risk-focused approach to supervision. That approach is more responsive to the industry's rapidly evolving activities and risk profiles and places emphasis on the institution's own ongoing system for managing risk, rather than point-intime transaction testing. By focusing resources on the areas of highest risk, and eliminating unnecessary procedures, this approach is not only more effective, but also less intrusive and costly to all parties. I should note, however, that successfully implementing this approach requires that supervisors attract, train, and retain qualified staff while also upgrading training, automation, and other resources. This is a continuing challenge indeed! Regulators are also trying to build on private sector initiatives that promote safety, soundness and systemic stability. For example, at the height of Congressional concern ---[PAGE_BREAK]--- about financial derivatives, the Group of Thirty sponsored a study to identify principles of sound practice for managing risks in derivatives for both dealers and end-users. By providing guidance on this issue, that study served as a catalyst for industry participants to analyze and evaluate their own practices. Subsequent guidance from the Federal Reserve and the Comptroller benefited from the insights provided by the study, while adding a supervisor's perspective. The study's emphasis on education and sound practices spurred greater understanding and acceptance by the industry of supervisory recommendations for sound risk management systems. I think it is safe to say that this cooperative approach between the private sector and regulators resulted in stronger industry practices and better supervisory oversight, not only for derivatives, but also for bank risk management more generally. Together, the industry and agency response helped stave off potentially restrictive legislation. Another example of how supervisors are trying to build on bank management practices is their use of internal value-at-risk models in the calculation of capital requirements for market risk. By relying on internal models already used by the institutions for their trading and risk management activities, regulators can reduce burden while vastly improving the accuracy of the capital calculation. In addition, by embracing internal models for regulatory purposes, supervisors are encouraging organizations to incorporate sophisticated risk models more fully and formally into their risk management systems and to continue to upgrade and improve the models. As these two examples illustrate, supervisors recognize that they do not have all the answers and that rigid regulatory solutions may often do more harm than good. A supervisory approach that promotes continued improvements in private sector practices provides the right incentives to industry and, in the case of banking, also reduces risks to the federal safety net. In these ways, supervisors are placing greater reliance on a bank's own risk management system as the first line of defense for ensuring safety and soundness. We also want to rely more on market discipline as another line of defense. This requires increased, improved disclosure of a bank's activities, risk exposures, and philosophy for managing and controlling risk. We have made significant gains for derivatives and market risks. Hopefully we will see further gains in other areas in the years ahead. While it is important for supervisors to identify risk at individual banks, as the central bank the Federal Reserve must also be watchful for conditions and trends external to the banking system that could place the financial system and the economy at risk. This broader perspective has become especially important with the globalization of banking and integration of markets. That is why the Federal Reserve has worked closely with financial regulators around the world to reduce systemic risk and promote sound banking practices and improved disclosures among both developed and emerging countries. These efforts have led to the advancement by the BIS of core principles of bank supervision for authorities world-wide and, significantly, promotion of consolidated supervision of banking organizations by home country authorities. The issue of consolidated supervision is particularly relevant in revisiting the question of the modernization of the banking system. I will come to that in a moment. ---[PAGE_BREAK]--- # Financial Modernization and Umbrella Supervision First I would like to point out that whether legislative agreement is reached or not, market forces will continue the modernization of the financial services industry and will further blur the lines between banks and nonbanks. For example, we can expect mutual funds to refine their offerings to compete with bank checking and savings accounts, albeit without deposit insurance. Banks will undoubtedly make further inroads in mutual fund management and investment banking through internal growth and through acquisitions of securities firms. Investment banks may also supplement their services by making commercial loans and participating in loan syndications. With such things happening, why do we need a legislative solution? The answer is that a well thought out proposal addressing the appropriate structure for the industry would allow for a more rapid and efficient integration of financial services. Moreover, by clearly defining the boundaries and structure of financial conglomerates, a well-considered supervisory program could adequately protect banks without undue intrusion to other parts of the conglomerate. Because financial conglomerates generally operate as integrated entities and manage risks on a global basis across business lines, their true operating structure superimposes a risk management and internal control process that extends across legal-entity-based corporate structures. In this light, supervision by legal entity can create important supervisory gaps that may expose the insured depository institution to unnecessary risk. That is to say, someone should look at the risk management of the organization as an organic whole, rather than as separate pieces that are simply added together. In fact, comprehensive, consolidated supervision by the home country supervisor is a legal requirement for foreign banks operating in the U.S. Some foreign supervisors are now beginning to question the consolidated supervision of U.S. firms operating in their countries. Now, I suspect some nonbank firms may feel apprehension at having an umbrella supervisor evaluate their operations. But let me emphasize that such oversight need not be overly onerous or intrusive. In fact, regulators are probably better prepared than ever before to implement an umbrella supervisory approach as a result of the supervisory techniques and approaches I just discussed. By applying risk-focused supervision, and promoting sound practices, and improved market disclosures, an umbrella supervisor should be able to implement an effective, unintrusive oversight process for conglomerates. Moreover, an umbrella supervisor may be able to provide assurances and information to other regulators and individual supervisors which may minimize their need to extend their reviews beyond the legal supervised entity and into the conglomerate's other operations, creating duplication and burden. I believe that the umbrella supervisor, whether it is the central bank or another agency, should not attempt to duplicate efforts of other regulators. Rather, the umbrella supervisor should evaluate the financial conglomerate from a more comprehensive perspective, bridging the gap between an organization's legal structure and its structure for taking and managing risk. Similarly, the umbrella supervisor need not attempt to extend bank-like safety and soundness regulations to nonbank entities. Those standards were never intended to apply to the nonbank entities of a conglomerate and would insert unnecessary competitive barriers without achieving the desired benefits. ---[PAGE_BREAK]--- How exactly should an umbrella supervisor meet its responsibilities? First by focusing its supervisory efforts on the adequacy of the risk management and internal control process of the parent company and of the group as a whole, and determining how well those systems protect the safety and soundness of affiliated banks. That evaluation could be performed in a manner similar to that of a securities analyst, albeit from a different viewpoint. This assessment might involve analysis of public financial statements, rating agencies and Wall Street analyst reports, internal management reports, internal and external audit reports, meetings with management, and only limited, if any, on-site inspections of nonbank affiliates. Any visits that are made could be limited to testing the adequacy of management and operating systems, to protect the insured depository institution. While various approaches could be taken to address capital adequacy and to avoid the unnecessary or inappropriate use of double leverage, I believe such approaches should be measured against the goal of assuring the safety and soundness of the affiliated banks. And finally, the umbrella supervisor should have appropriate enforcement authority, including the authority to require the sale of the bank in extreme situations. # Conclusion It is clear that the financial services industry is changing and that banking powers must also change if banks are to remain competitive. The Board has long supported reforms and strongly urges them today. However, changes such as these carry risks. It is important, therefore, that change be introduced properly through legislative debate and by adopting proper safeguards to ensure that nonbank activities do not unduly expose banks and taxpayers. The Federal Reserve is mindful of regulatory burden and of the need to accommodate change. Nevertheless, we also believe that some type of umbrella supervision will be necessary to protect insured depository institutions and address systemic risk concerns. Whoever plays that role should take a broad perspective in evaluating risks not only to specific depository institutions but also to the payment system and to the broad financial industry as well. Simply put, I believe that in an economy as complicated and integrated as we have in the United States, it is important for the nation's central bank to have a significant role in comprehensive financial institution supervision.	Susan M Phillips	United States	https://www.bis.org/review/r970725b.pdf	supervision in the United States Remarks by Governor Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at the Exchequer Club in Washington on 18/6/97. It is a pleasure to be here today at the Exchequer Club. I thank you for the opportunity to discuss the changing financial landscape and offer my own perspectives on what the future might bring. During the next few months, there will be significant debates on various aspects of financial modernization, both within and without the halls of Congress. These debates may well set the stage for how financial service companies will operate as we enter the twentyfirst century. As we can all plainly see, the world is changing across many dimensions, posing new and ever-increasing challenges for both financial services firms and their supervisors. To succeed in this new world, I believe it is important for the industry and supervisors to find common ground for coping with these challenges. By working together to find solutions, we can both accomplish our goals, while retaining the core principles and values that have contributed to the industry's success. So today I would like to discuss briefly the changes underway affecting the financial services industry, as well as the individual and collective responses by the industry and supervisors to those changes. Then lastly, I will offer some thoughts on what the role of an umbrella supervisor might look like in this changing environment for financial services. All of these changes must be considered in the context of possible legislative reform. As widely noted, dramatic advances in information and telecommunication technologies have allowed banks to develop new and more customized products and services and deliver them over a broader geographic area with greater efficiency. Such innovations by the banking industry, and by financial markets in general, have increased the sophistication and complexity of bank lending, investing, trading, and funding. They have propelled growth in less traditional or newer banking activities such as investment banking, mutual fund management, insurance and securitization. In the process, the risk profiles of many banking organizations have been altered in fundamental ways, placing greater pressure on management to monitor and manage underlying risks. To meet this challenge, a growing number of institutions are employing modern financial theory for measuring and analyzing the trade-off between risk and returns. The availability of dramatically more powerful computers at ever more affordable prices has allowed institutions to process vast data bases of rates, prices, defaults, and recoveries. As a result, techniques for portfolio management and risk measurement that not long ago were possible only in theory are now becoming integral parts of daily operating practice. By applying these theories and techniques, institutions today are more effectively pricing and hedging risk, allocating capital, evaluating risk-adjusted returns and identifying the optimum mix of financial products or services. I believe these enhanced management practices have contributed importantly to the economic growth and market gains seen in recent years. As competition has intensified, we have seen a growing overlap in the activities and product lines provided by both banks and other financial service providers that has diminished the past distinction between banks and many nonbank firms. That trend has raised public policy questions regarding bank powers and the appropriate organizational structure through which banking organizations should gain new powers. Proposals recently introduced in Congress to address those issues would fundamentally redefine the relationship of banks to other financial services companies and in some instances their relationship to commercial firms as well. Banks have not only expanded their products and activities, but have also expanded their geographic reach, both domestically and globally. Within the United States, banks have expanded nationwide as barriers to interstate banking have been removed. This expansion should continue as banks exercise their new power to branch across state lines. A related domestic trend is the rapid consolidation within and between banking organizations. Although some consolidation is undoubtedly related to the removal of barriers to interstate branching, it is also spurred by improved technology, strong competition in banking markets, and the drive by banks to reduce costs. Internationally, the globalization of banking has accelerated, driven by improved technology and the opening of economies in eastern Europe, Asia, Latin America, and other regions. In particular, U.S. and other international financial institutions are forging a growing presence in lending, trading, and underwriting in these emerging markets. These efforts have created closer links among the world's financial markets and have improved the efficiency and availability of capital. However, market integration has also increased the potential for systemic problems to transcend national borders, as the volume of international financial transactions has grown. Last year, for example, an estimated $\$ 1.5$ trillion of foreign exchange contracts were settled daily in New York City alone. A default by a major U.S. or foreign participant in that market could disrupt financial markets worldwide. Competitive pressures are intense to reduce the cost of financial services to the public. This is occurring against the need to improve the financial strength and competitiveness of the banking industry from the levels at the beginning of this decade. These factors have, in turn, also placed pressure on the banking agencies to remove unnecessary burdens on the industry without threatening safety and soundness. What have been the regulatory and supervisory responses to these changes? Let me first discuss how we addressed the issue of regulatory burden. Although the poor bank profitability of the 1980s and early 1990s was mostly related to industry asset quality problems, regulators and Congress alike recognized that improvements could be made in bank regulations and in supervisory processes to improve credit availability and bank competitiveness without sacrificing safety and soundness. Both legislative and regulatory efforts undertaken in the decade of the 1990's have simplified regulatory reporting requirements, expedited the application process, eliminated duplicate regulatory filings, and have led to more streamlined and uniform banking agency guidelines and regulations. Taken individually, these and other refinements may not appear material, but taken as a whole they have put a meaningful dent in regulatory costs. In fact, the industry on several occasions has reminded us that it is not necessarily any particular individual regulatory requirement that is problematic, but rather, their cumulative effect, much like the straw that broke the camel's back. We have taken that point to heart when considering new guidelines and regulations. Efforts to reduce regulatory burden apply not only to banks, but to holding companies as well. Earlier this year, for example, the Board streamlined Regulation Y and reduced application requirements. These changes recognize that regulatory burden arises not only from the direct operational costs of compliance, but also from the indirect costs of delayed or lost opportunities to enter new activities. To reduce impediments, the Board has decided that the application process should focus on the analysis of the effects of a specific proposal, and should not generally become a vehicle for comprehensively evaluating and addressing supervisory and compliance issues. Rather, the latter can more effectively be addressed in the supervisory process. The Board also recently completed a lengthy review of its policies and procedures for assessing the competitive implications of bank mergers and acquisitions. Modifications have been made to that process to make it more efficient and address the potential benefits of scale economies for small bank mergers. Another improvement in our regulations is the ability of well-capitalized, wellrun companies to apply to acquire banks and nonbanks in a faster more streamlined fashion and to commence nonbanking activities approved by regulation without obtaining prior approval. To allow bank holding companies greater opportunities to innovate, the Board has also indicated that it will be pro-active in approving new activities. Further efforts to provide flexibility and help modernize bank holding company regulations have been directed toward securities firms known as section 20 affiliates. Last year the Board raised the Section 20 ineligible revenue limit on underwriting and dealing in securities from 10 to 25 percent. This appears to be allowing greater flexibility for these operations. The Board has also eliminated certain firewalls between banks and their securities affiliates and for other firewalls has proposed to eliminate or scale back even more, recognizing that other laws, regulations, and improved disclosures provide adequate protections against conflicts of interest. These and other refinements should allow holding companies to move closer toward their goal of operating as a one-stop financial service firm for customers, while operating safely and soundly. The Comptroller of the Currency has also taken steps to widen the breadth of activities undertaken by banking organizations. For example, the expansion of insurance sales activities has opened new opportunities for national banks. Beyond efforts to reduce burden and modernize banking powers, regulators are also redesigning their supervisory practices to address more effectively the changing nature of the industry. These efforts are leading to a more risk-focused approach to supervision. That approach is more responsive to the industry's rapidly evolving activities and risk profiles and places emphasis on the institution's own ongoing system for managing risk, rather than point-intime transaction testing. By focusing resources on the areas of highest risk, and eliminating unnecessary procedures, this approach is not only more effective, but also less intrusive and costly to all parties. I should note, however, that successfully implementing this approach requires that supervisors attract, train, and retain qualified staff while also upgrading training, automation, and other resources. This is a continuing challenge indeed! Regulators are also trying to build on private sector initiatives that promote safety, soundness and systemic stability. For example, at the height of Congressional concern about financial derivatives, the Group of Thirty sponsored a study to identify principles of sound practice for managing risks in derivatives for both dealers and end-users. By providing guidance on this issue, that study served as a catalyst for industry participants to analyze and evaluate their own practices. Subsequent guidance from the Federal Reserve and the Comptroller benefited from the insights provided by the study, while adding a supervisor's perspective. The study's emphasis on education and sound practices spurred greater understanding and acceptance by the industry of supervisory recommendations for sound risk management systems. I think it is safe to say that this cooperative approach between the private sector and regulators resulted in stronger industry practices and better supervisory oversight, not only for derivatives, but also for bank risk management more generally. Together, the industry and agency response helped stave off potentially restrictive legislation. Another example of how supervisors are trying to build on bank management practices is their use of internal value-at-risk models in the calculation of capital requirements for market risk. By relying on internal models already used by the institutions for their trading and risk management activities, regulators can reduce burden while vastly improving the accuracy of the capital calculation. In addition, by embracing internal models for regulatory purposes, supervisors are encouraging organizations to incorporate sophisticated risk models more fully and formally into their risk management systems and to continue to upgrade and improve the models. As these two examples illustrate, supervisors recognize that they do not have all the answers and that rigid regulatory solutions may often do more harm than good. A supervisory approach that promotes continued improvements in private sector practices provides the right incentives to industry and, in the case of banking, also reduces risks to the federal safety net. In these ways, supervisors are placing greater reliance on a bank's own risk management system as the first line of defense for ensuring safety and soundness. We also want to rely more on market discipline as another line of defense. This requires increased, improved disclosure of a bank's activities, risk exposures, and philosophy for managing and controlling risk. We have made significant gains for derivatives and market risks. Hopefully we will see further gains in other areas in the years ahead. While it is important for supervisors to identify risk at individual banks, as the central bank the Federal Reserve must also be watchful for conditions and trends external to the banking system that could place the financial system and the economy at risk. This broader perspective has become especially important with the globalization of banking and integration of markets. That is why the Federal Reserve has worked closely with financial regulators around the world to reduce systemic risk and promote sound banking practices and improved disclosures among both developed and emerging countries. These efforts have led to the advancement by the BIS of core principles of bank supervision for authorities world-wide and, significantly, promotion of consolidated supervision of banking organizations by home country authorities. The issue of consolidated supervision is particularly relevant in revisiting the question of the modernization of the banking system. I will come to that in a moment. First I would like to point out that whether legislative agreement is reached or not, market forces will continue the modernization of the financial services industry and will further blur the lines between banks and nonbanks. For example, we can expect mutual funds to refine their offerings to compete with bank checking and savings accounts, albeit without deposit insurance. Banks will undoubtedly make further inroads in mutual fund management and investment banking through internal growth and through acquisitions of securities firms. Investment banks may also supplement their services by making commercial loans and participating in loan syndications. With such things happening, why do we need a legislative solution? The answer is that a well thought out proposal addressing the appropriate structure for the industry would allow for a more rapid and efficient integration of financial services. Moreover, by clearly defining the boundaries and structure of financial conglomerates, a well-considered supervisory program could adequately protect banks without undue intrusion to other parts of the conglomerate. Because financial conglomerates generally operate as integrated entities and manage risks on a global basis across business lines, their true operating structure superimposes a risk management and internal control process that extends across legal-entity-based corporate structures. In this light, supervision by legal entity can create important supervisory gaps that may expose the insured depository institution to unnecessary risk. That is to say, someone should look at the risk management of the organization as an organic whole, rather than as separate pieces that are simply added together. In fact, comprehensive, consolidated supervision by the home country supervisor is a legal requirement for foreign banks operating in the U.S. Some foreign supervisors are now beginning to question the consolidated supervision of U.S. firms operating in their countries. Now, I suspect some nonbank firms may feel apprehension at having an umbrella supervisor evaluate their operations. But let me emphasize that such oversight need not be overly onerous or intrusive. In fact, regulators are probably better prepared than ever before to implement an umbrella supervisory approach as a result of the supervisory techniques and approaches I just discussed. By applying risk-focused supervision, and promoting sound practices, and improved market disclosures, an umbrella supervisor should be able to implement an effective, unintrusive oversight process for conglomerates. Moreover, an umbrella supervisor may be able to provide assurances and information to other regulators and individual supervisors which may minimize their need to extend their reviews beyond the legal supervised entity and into the conglomerate's other operations, creating duplication and burden. I believe that the umbrella supervisor, whether it is the central bank or another agency, should not attempt to duplicate efforts of other regulators. Rather, the umbrella supervisor should evaluate the financial conglomerate from a more comprehensive perspective, bridging the gap between an organization's legal structure and its structure for taking and managing risk. Similarly, the umbrella supervisor need not attempt to extend bank-like safety and soundness regulations to nonbank entities. Those standards were never intended to apply to the nonbank entities of a conglomerate and would insert unnecessary competitive barriers without achieving the desired benefits. How exactly should an umbrella supervisor meet its responsibilities? First by focusing its supervisory efforts on the adequacy of the risk management and internal control process of the parent company and of the group as a whole, and determining how well those systems protect the safety and soundness of affiliated banks. That evaluation could be performed in a manner similar to that of a securities analyst, albeit from a different viewpoint. This assessment might involve analysis of public financial statements, rating agencies and Wall Street analyst reports, internal management reports, internal and external audit reports, meetings with management, and only limited, if any, on-site inspections of nonbank affiliates. Any visits that are made could be limited to testing the adequacy of management and operating systems, to protect the insured depository institution. While various approaches could be taken to address capital adequacy and to avoid the unnecessary or inappropriate use of double leverage, I believe such approaches should be measured against the goal of assuring the safety and soundness of the affiliated banks. And finally, the umbrella supervisor should have appropriate enforcement authority, including the authority to require the sale of the bank in extreme situations. It is clear that the financial services industry is changing and that banking powers must also change if banks are to remain competitive. The Board has long supported reforms and strongly urges them today. However, changes such as these carry risks. It is important, therefore, that change be introduced properly through legislative debate and by adopting proper safeguards to ensure that nonbank activities do not unduly expose banks and taxpayers. The Federal Reserve is mindful of regulatory burden and of the need to accommodate change. Nevertheless, we also believe that some type of umbrella supervision will be necessary to protect insured depository institutions and address systemic risk concerns. Whoever plays that role should take a broad perspective in evaluating risks not only to specific depository institutions but also to the payment system and to the broad financial industry as well. Simply put, I believe that in an economy as complicated and integrated as we have in the United States, it is important for the nation's central bank to have a significant role in comprehensive financial institution supervision.
1997-07-22T00:00:00	Mr. Greenspan presents the views of the Federal Reserve in its semi-annual Humphrey-Hawkins report on monetary policy (Central Bank Articles and Speeches, 22 Jul 97)	Testimony of the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before Congress on 22/7/97.	Mr. Greenspan presents the views of the Federal Reserve in its semi-annual Humphrey-Hawkins report on monetary policy Testimony of the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before Congress on 22/7/97. I am pleased to appear before this Subcommittee to present the Federal Reserve's report on the economic situation and monetary policy. The recent performance of the economy, characterized by strong growth and low inflation, has been exceptional -- and better than most anticipated. During the first quarter of 1997, real gross domestic product expanded at nearly a 6 percent annual rate, after posting a 3 percent increase over 1996. Activity apparently continued to expand in the second quarter, albeit at a more moderate pace. The economy is now in the seventh consecutive year of expansion, making it the third longest post-World War II cyclical upswing to date. Moreover, our Federal Reserve Banks indicate that economic activity is on the rise, and at a relatively high level, in virtually every geographic region and community of the nation. The expansion has been balanced, in that inventories, as well as stocks of business capital and other durable assets, have been kept closely in line with spending, so overhangs have been small and readily corrected. This strong expansion has produced a remarkable increase in work opportunities for Americans. A net of more than thirteen million jobs has been created since the current period of growth began in the spring of 1991. As a consequence, the unemployment rate has fallen to 5 percent -- its lowest level in almost a quarter century. The expansion has enabled many in the working-age population, a large number of whom would have otherwise remained out of the labor force or among the longer-term unemployed, to acquire work experience and improved skills. Our whole economy will benefit from their greater productivity. To be sure, not all segments of our population are fully sharing in the economic improvement. Some Americans still have trouble finding jobs, and for part of our work force real wage stagnation persists. In contrast to the typical postwar business cycle, measured price inflation is lower now than when the expansion began and has shown little tendency to rebound of late, despite high rates of resource utilization. In the business sector, producer prices have fallen in each of the past six months. Consumers also are enjoying low inflation. The consumer price index rose at less than a 2 percent annual rate over the first half of the year, down from a little over 3 percent in 1996. With the economy performing so well for so long, financial markets have been buoyant, as memories of past business and financial cycles fade with time. Soaring prices in the stock market have been fuelled by moderate long-term interest rates and expectations of investors that profit margins and earnings growth will hold steady, or even increase further, in a relatively stable, low-inflation environment. Credit spreads at depository institutions and in the open market have remained extremely narrow by historical standards, suggesting a high degree of confidence among lenders regarding the prospects for credit repayment. The key questions facing financial markets and policy makers are: "What is behind the good performance of the economy?" and "Will it persist?" Without question, the exceptional economic situation reflects some temporary factors that have been restraining inflation rates. In addition, however, important pieces of information, while just suggestive at this point, could be read as indicating basic improvements in the longer-term efficiency of our economy. The Federal Reserve has been aware of this possibility in our monetary policy deliberations and, as always, has operated with a view to supplying adequate liquidity to allow the economy to reach its highest potential on a sustainable basis. Nonetheless, we also recognize that the capacity of our economy to produce goods and services is not without limit. If demand were to outrun supply, inflationary imbalances would eventually develop that would tend to undermine the current expansion and inhibit the long-run growth potential of the economy. Because monetary policy works with a significant lag, policy actions are directed at a future that may not be clearly evident in current experience. This leads to policy judgements that are by their nature calibrated to the relative probabilities of differing outcomes. We moved the federal funds rate higher in March because we perceived the probability of demand outstripping supply to have increased to a point where inaction would have put at risk the solid elements of support that have sustained this expansion and made it so beneficial. In making such judgements in March and in the future, we need to analyze carefully the various forces that may be affecting the balance of supply and demand in the economy, including those that may be responsible for its exceptional recent behavior. The remainder of my testimony will address the various possibilities. Inflation, Output, and Technological Change in the 1990s Many observers, including us, have been puzzled about how an economy, operating at high levels and drawing into employment increasingly less-experienced workers, can still produce subdued and, by some measures even falling, inflation rates. It will, doubtless, be several years before we know with any conviction the full story of the surprisingly benign combination of output and prices that has marked the business expansion of the last six years. Certainly, public policy has played an important role. Administration and Congressional actions to curtail budget deficits have enabled long-term interest rates to move lower, encouraging private efficiency-enhancing capital investment. Deregulation in a number of industries has fostered competition and held down prices. Finally, the pre-emptive actions of the Federal Reserve in 1994 contained a potentially destabilizing surge in demand, short-circuiting a boom-bust business cycle in the making and keeping inflation low to encourage business innovation. But the fuller explanation of the recent extraordinary performance may well lie deeper. In February 1996, I raised before this Committee a hypothesis tying together technological change and cost pressures that could explain what was even then a puzzling quiescence of inflation. The new information received in the last eighteen months remains consistent with those earlier notions; indeed, some additional pieces of the puzzle appear to be falling into place. A surge in capital investment in high tech equipment that began in early 1993 has since strengthened. Purchases of computer and telecommunications equipment have risen at a more than 14 percent annual rate since early 1993 in nominal terms, and at an astonishing rate of nearly 25 percent in real terms, reflecting the fall in the prices of this equipment. Presumably companies have come to perceive a significant increase in profit opportunities from exploiting the improved productivity of these new technologies. It is premature to judge definitively whether these business perceptions are the harbinger of a more general and persistent improvement in productivity. Supporting this possibility, productivity growth, which often suffers as business expansions mature, has not followed that pattern. In addition, profit margins remain high in the face of pickups in compensation growth, suggesting that businesses continue to find new ways to enhance their efficiency. Nonetheless, although the anecdotal evidence is ample and manufacturing productivity has picked up, a change in the underlying trend is not yet reflected in our conventional data for the whole economy. But even if the perceived quicker pace of application of our newer technologies turns out to be mere wheel-spinning rather than true productivity advance, it has brought with it a heightened sense of job insecurity and, as a consequence, subdued wage gains. As I pointed out here last February, polls indicated that despite the significant fall in the unemployment rate, the proportion of workers in larger establishments fearful of being laid off rose from 25 percent in 1991 to 46 percent by 1996. It should not have been surprising then that strike activity in the 1990s has been lower than it has been in decades and that new labor union contracts have been longer and have given greater emphasis to job security. Nor should it have been unexpected that the number of workers voluntarily leaving their jobs to seek other employment has not risen in this period of tight labor markets. To be sure, since last year, surveys have indicated that the proportion of workers fearful of layoff has stabilized and the number of voluntary job leavers has edged up. And, indeed, perhaps as a consequence, wage gains have accelerated some. But increases in the Employment Cost Index still trail behind what previous relationships to tight labor markets would have suggested, and a lingering sense of fear or uncertainty seems still to pervade the job market, though to a somewhat lesser extent. Consumer surveys do indicate greater optimism about the economy. However, it is one thing to believe that the economy, indeed the job market, will do well overall, but quite another to feel secure about one's individual situation, given the accelerated pace of corporate restructuring and the heightened fear of skill obsolescence that has apparently characterized this expansion. Persisting insecurity would help explain why measured personal saving rates have not declined as would have been expected from the huge increase in stock market wealth. We will, however, have a better fix on savings rates after the coming benchmark revisions to the national income and product accounts. The combination in recent years of subdued compensation per hour and solid productivity advances has meant that unit labor costs of non financial corporations have barely moved. Moreover, when you combine unit labor costs with non labor costs -- which account for one-quarter of total costs on a consolidated basis -- total unit costs for the year ended in the first quarter of 1997 rose only about half a percent. Hence, a significant part of the measured price increase over that period was attributable to a rise in profit margins, unusual well into a business expansion. Rising margins are further evidence suggesting that productivity gains have been unexpectedly strong; in these situations, real labor compensation usually catches up only with a lag. While accelerated technological change may well be an important element in unravelling the current economic puzzle, there have been other influences at play as well in restraining price increases at high levels of resource utilization. The strong dollar of the last two years has pared import prices and constrained the pricing behavior of domestic firms facing import competition. Increasing globalization has enabled greater specialization over a wider array of goods and services, in effect allowing comparative advantage to hold down costs and enhance efficiencies. Increased deregulation of telecommunications, motor and rail transport, utilities, and finance doubtless has been a factor restraining prices, as perhaps has the reduced market power of labor unions. Certainly, changes in the health care industry and the pricing of health services have greatly contributed to holding down growth in the cost of benefits, and hence overall labor compensation. Many of these forces are limited or temporary, and their effects can be expected to diminish, at which time cost and price pressures would tend to re-emerge. The effects of an increased rate of technological change might be more persistent, but they too could not permanently hold down inflation if the Federal Reserve allows excess liquidity to flood financial markets. I have noted to you before the likelihood that at some point workers might no longer be willing to restrain wage gains for added security, at which time accelerating unit labor costs could begin to press on profit margins and prices, should monetary policy be too accommodative. When I discuss greater technological change, I am not referring primarily to a particular new invention. Instead, I have in mind the increasingly successful and pervasive application of recent technological advances, especially in telecommunications and computers, to enhance efficiencies in production processes throughout the economy. Many of these technologies have been around for some time. Why might they be having a more pronounced effect now? In an intriguing paper prepared for a conference last year sponsored by the Federal Reserve Bank of Boston, Professor Nathan Rosenberg of Stanford documented how, in the past, it often took a considerable period of time for the necessary synergies to develop between different forms of capital and technologies. One example is the invention of the dynamo in the mid 1800s. Rosenberg's colleague Professor Paul David had noted a number of years ago that it wasn't until the 1920s that critical complementary technologies of the dynamo -- for example, the electric motor as the primary source of mechanical drive in factories, and central generating stations -were developed and in place and that production processes had fully adapted to these inventions. What we may be observing in the current environment is a number of key technologies, some even mature, finally interacting to create significant new opportunities for value creation. For example, the applications for the laser were modest until the later development of fiber optics engendered a revolution in telecommunications. Broad advances in software have enabled us to capitalize on the prodigious gains in hardware capacity. The interaction of both of these has created the Internet. The accelerated synergies of the various technologies may be what have been creating the apparent significant new profit opportunities that presumably lie at the root of the recent boom in high-tech investment. An expected result of the widespread and effective application of information and other technologies would be a significant increase in productivity and reduction in business costs. We do not now know, nor do I suspect can anyone know, whether current developments are part of a once or twice in a century phenomenon that will carry productivity trends nationally and globally to a new higher track, or whether we are merely observing some unusual variations within the context of an otherwise generally conventional business cycle expansion. The recent improvement in productivity could be just transitory, an artifact of a temporary surge in demand and output growth. In view of the slowing in growth in the second quarter and the more moderate expansion widely expected going forward, data for profit margins on domestic operations and productivity from the second quarter on will be especially relevant in assessing whether recent improvements are structural or cyclical. Whatever the trend in productivity and, by extension, overall sustainable economic growth, from the Federal Reserve's point of view, the faster the better. We see our job as fostering the degree of liquidity that will best support the most effective platform for growth to flourish. We believe a non inflationary environment is such a platform because it promotes long-term planning and capital investment and keeps the pressure on businesses to contain costs and enhance efficiency. The Federal Reserve's policy problem is not with growth, but with maintaining an effective platform. To do so, we endeavor to prevent strains from developing in our economic system, which long experience tells us produce bottlenecks, shortages, and inefficiencies. These eventually create more inflation, which undermines economic expansion and limits the longer-term potential of the economy. In gauging the potential for oncoming strains, it is the effective capacity of the economy to produce that is important to us. An economy operating at a high level of utilization and growing 5 percent a year is in little difficulty if capacity is growing at least that fast. But a fully utilized economy growing at 1 percent will eventually get into trouble if capacity is growing less than that. Capacity itself, however, is a complex concept, which requires a separate evaluation of its two components, capital and labor. It appears that capital, that is, plant and equipment, can adapt and expand more expeditiously than in the past to meet demands. Hence, capital capacity is now a considerably less rigid constraint than it once was. In recent years, technology has engendered a significant compression of lead times between order and delivery for production facilities. This has enabled output to respond increasingly faster to an upsurge in demand, thereby decreasing the incidence of strains on capital capacity and shortages so evident in earlier business expansions. Reflecting progressively shorter lead times for capital equipment, unfilled orders to shipment ratios for non-defense capital goods have declined by 30 percent in the last six years. Not only do producers have quicker access to equipment that embodies the most recent advances, but they have been able to adjust their overall capital stock more rapidly to increases in demand. The current lack of material shortages and bottlenecks, despite the high level and recent robust expansion of demand, is striking. The effective capacity of production facilities has increased substantially in recent years in response to strong final demands and the influence of cost reductions possible with the newer technologies. Increased flexibility is particularly evident in the computer, telecommunications, and related industries, a segment of our economy that seems far less subject to physical capacity constraints than many older-line establishments, and one that is assuming greater importance in our overall output. But the shortening of lags has been pervasive even in more mature industries, owing in part to the application of advanced technologies to production methods. At the extreme, if all capital goods could be produced at constant cost and on demand, the size of our nation's capital stock would never pose a restraint on production. We are obviously very far from that nirvana, but it is important to note that we are also far from the situation a half-century ago when our production processes were dominated by equipment such as open hearth steel furnaces, which had very exacting limits on how much they could produce in a fixed time frame and which required huge lead times to expand their capacity. Even so, today's economy as a whole still can face capacity constraints from its facilities. Indeed, just three years ago, bottlenecks in industrial production -- though less extensive than in years past at high levels of measured capacity utilization -- were nonetheless putting significant upward pressures on prices at earlier stages of production. More recently vendor performance has deteriorated somewhat, indicating that flexibility to meet demands still has limits. Although further strides toward greater facilities flexibility have occurred since 1994, this is clearly an evolutionary, not a revolutionary, process. Labor Markets Moreover, technology and management changes have had only a limited effect on the ability of labor supply to respond to changes in demand. To be sure, individual firms have acquired additional flexibility by increased use of outsourcing and temporary workers. In addition, smaller work teams can adapt more readily to variations in order flows. While these techniques put the right workers at the right spots to reduce bottlenecks, they do not increase the aggregate supply of labor. That supply is sensitive to changes in demand, but to a far more limited extent than for facilities. New plants can almost always be built. But labor capacity for an individual country is constrained by the size of the working-age population, which, except for immigration, is basically determined several decades in the past. Of course, capital facilities and labor are not fully separate markets. Within limits, labor and capital are substitutes, and slack in one market can offset tightness in another. For example, additional work shifts can expand output without significant addition to facilities, and similarly more labor-displacing equipment can permit production to be increased with the same level of employment. Yet despite significant increases in capital equipment in recent years, new additions to labor supply have been inadequate to meet the demand for labor. As a consequence, the recent period has been one of significant reduction in labor market slack. Of the more than two million net new hires at an annual rate since early 1994, only about half have come from an expansion in the population aged 16 to 64 who wanted a job, and more than a third of those were net new immigrants. The remaining one million plus per year increase in employment has been pulled from those who had been reported as unemployed (600 thousand annually) and those who wanted, but had not actively sought, a job (more than 400 thousand annually). The latter, of course, are not in the official unemployment count. The key point is that continuously digging ever deeper into the available work age population is not a sustainable trajectory for job creation. The unemployment rate has a downside limit if for no other reason than unemployment, in part, reflects voluntary periods of job search and other frictional unemployment. There is also a limit on how many of the additional 5 million who wanted a job last quarter but were not actively seeking one could be readily absorbed into jobs -- in particular, the large number enrolled in school, and those who may lack the necessary skills or face other barriers to taking jobs. The rise in the average workweek since early 1996 suggests employers are having increasingly greater difficulty fitting the millions who want a job into available job slots. If the pace of job creation continues, the pressures on wages and other costs of hiring increasing numbers of such individuals could escalate more rapidly. To be sure, there remain an additional 34 million in the working-age population (age 16 - 64) who say they do not want a job. Presumably, some of these early retirees, students, or homemakers might be attracted to the job market if it became sufficiently rewarding. However, making it attractive enough could also involve upward pressures in real wages that would trigger renewed price pressures, undermining the expansion. Thus, there would seem to be emerging constraints on potential labor input. Even before we reach the ultimate limit of sustainable labor supply growth, the economy's ability to expand employment at the recent rate should rapidly diminish. The availability of unemployed labor could no longer add to growth, irrespective of the degree of slack in physical facilities at that time. Simply adding new facilities will not increase production unless output per worker improves. Such improvements are possible if worker skills increase, but such gains come slowly through improved education and on-the-job training. They are also possible as capital substitutes for labor, but are limited by the state of technology. More significant advances require technological breakthroughs. At the cutting edge of technology, where America finds itself, major improvements cannot be produced on demand. New ideas that matter are hard won. The Economic Outlook As I noted, the recent performance of the labor markets suggests that the economy was on an unsustainable track. Unless aggregate demand increases more slowly than it has in recent years -- more in line with trends in the supply of labor and productivity -- imbalances will emerge. We do not know, however, at what point pressures would develop -- or indeed whether the economy is already close to that point. Fortunately, the very rapid growth of demand over the winter has eased recently. To an extent this easing seems to reflect some falloff in growth of demand for consumer durables and for inventories to a pace more in line with moderate expansion in income. But some of the recent slower growth could simply be a product of abnormal weather patterns, which contributed to a first-quarter surge in output and weakened the second quarter, in which case the underlying trend could be somewhat higher than suggested by the second-quarter data alone. Certainly, business and consumer confidence remains high and financial conditions are supportive of growth. Particularly notable is the run-up in stock market wealth, the full effects of which apparently have not been reflected in overall demand, but might yet be. Monetary policymakers, balancing these various forces, forecast a continuation of less rapid growth in coming quarters. For 1997 as a whole, the central tendency of their forecasts has real GDP growing 3 to 31⁄4 percent. This would be much more brisk than was anticipated in February, and the upward revision to this estimate largely reflects the unexpectedly strong first quarter. The central tendency of monetary policymakers' projections is that real GDP will expand 2 to 21⁄2 percent in 1998. This pace of expansion is expected to keep the unemployment rate close to its current low level. We are reasonably confident that inflation will be quite modest for 1997 as a whole. The central tendency of the forecasts is that consumer prices will rise only 21⁄4 to 21⁄2 percent this year. This would be a significantly better outcome than the 23⁄4 to 3 percent CPI inflation foreseen in February. Federal Open Market Committee members do see higher rates of inflation next year. The central tendency of the projections is that CPI inflation will be 21⁄2 to 3 percent in 1998 -- a little above the expectation for this year. However, much of this increase is presumed to result from the absence of temporary factors that are holding down inflation this year. In particular, the favorable movements in food and energy prices of 1997 are unlikely to be repeated, and non-oil import prices may not continue to decline. While it is possible that better productivity trends and subdued wage growth will continue to help damp the increases in business costs associated with tight labor markets, this is a situation that the Federal Reserve plans to monitor closely. I have no doubt that the current stance of policy -- characterized by a nominal federal funds rate around 51⁄2 percent -- will need to be changed at some point to foster sustainable growth and low inflation. Adjustments in the policy instrument in response to new information are a necessary and, I should like to emphasize, routine aspect of responsible policy making. For the present, as I indicated, demand growth does appear to have moderated, but whether that moderation will be sufficient to avoid putting additional pressures on resources is an open question. With considerable momentum behind the expansion and labor market utilization rates unusually high, the Federal Reserve must be alert to the possibility that additional action might be called for to forestall excessive credit creation. The Federal Reserve is intent on gearing its policy to facilitate the maximum sustainable growth of the economy, but it is not, as some commentators have suggested, involved in an experiment that deliberately prods the economy to see how far and fast it can grow. The costs of a failed experiment would be much too burdensome for too many of our citizens. Clearly, in considering issues of monetary policy we need to distinguish carefully between sustainable economic growth and unsustainable accelerations of activity. Sustainable growth reflects the increased capacity of the economic system to produce goods and services over the longer run. It is largely the sum of increases in productivity and in the labor force. That growth contrasts with a second type, a more transitory growth. An economy producing near capacity can expand faster for a short time, often through unsustainably low short-term interest rates and excess credit creation. But this is not growth that promotes lasting increases in standards of living and in jobs for our nation. Rather, it is a growth that creates instability and thereby inhibits the achievement of our nation's economic goals. The key question is how monetary policy can best foster the highest rate of sustainable growth and avoid amplifying swings in output, employment, and prices. The historical evidence is unambiguous that excessive creation of credit and liquidity contributes nothing to the long-run growth of our productive potential and much to costly shorter-term fluctuations. Moreover, it promotes inflation, impairing the economy's longer-term potential output. Our objective has never been to contain inflation as an end in itself, but rather as a precondition for the highest possible long-run growth of output and income -- the ultimate goal of macroeconomic policy. In considering possible adjustments of policy to achieve that goal, the issue of lags in the effects of monetary policy is crucial. The evidence clearly demonstrates that monetary policy affects the financial markets immediately but works with significant lags on output, employment, and prices. Thus, as I pointed out earlier, policy needs to be made today on the basis of likely economic conditions in the future. As a consequence, and in the absence of once-reliable monetary guides to policy, there is no alternative to formulating policy using risk-reward trade-offs based on what are, unavoidably, uncertain forecasts. Operating on uncertain forecasts, of course, is not unusual. People do it every day, consciously or subconsciously. A driver might tap the brakes to make sure not to be hit by a truck coming down the street, even if he thinks the chances of such an event are relatively low; the costs of being wrong are simply too high. Similarly, in conducting monetary policy the Federal Reserve needs constantly to look down the road to gauge the future risks to the economy and act accordingly. Growth of Money and Credit The view that the Federal Reserve's best contribution to growth is to foster price stability has informed both our tactical decisions on the stance of monetary policy and our longer-run judgements on appropriate rates of liquidity provision. To be sure, growth rates of monetary and credit aggregates have become less reliable as guides for monetary policy as a result of rapid change in our financial system. As I have reported to you previously, the current uncertainties regarding the behavior of the monetary aggregates have implied that we have been unable to employ them as guides to short-run policy decisions. Accordingly, in recent years we have reported annual ranges for money growth that serve as benchmarks under conditions of price stability and a return to historically stable patterns of velocity. Over the past several years, the monetary aggregates -- M2 in particular -- have shown some signs of re-establishing such stable patterns. The velocity of M2 has fluctuated in a relatively narrow range, and some of its variation within that range has been explained by interest rate movements, in a relationship similar to that established over earlier decades. We find this an encouraging development, and it is possible that at some point the FOMC might elect to put more weight on such monetary quantities in the conduct of policy. But in our view, sufficient evidence has not yet accumulated to support such a judgement. Consequently, we have decided to keep the existing ranges of growth for money and credit for 1997 and carry them over to next year, retaining the interpretation of the money ranges as benchmarks for the achievement of price stability. With nominal income growth strong relative to the rate that would likely prevail under conditions of price stability, the growth of M2 is likely to run in the upper part of its range both this year and next, while M3 could run a little above its cone. Domestic non financial sector debt is likely to remain well within its range, with private debt growth brisk and federal debt growth subdued. Although any tendency for the aggregates to exceed their ranges would not, in the event, necessarily call for an examination of whether a policy adjustment was needed, the Federal Reserve will be closely examining financial market prices and flows in the context of a broad range of economic and price indicators for evidence that the sustainability of the economic expansion may be in jeopardy. Concluding Comment The Federal Reserve recognizes, of course, that monetary policy does not determine the economy's potential. All that it can do is help establish sound money and a stable financial environment in which the inherent vitality of a market economy can flourish and promote the capital investment that in the long run is the basis for vigorous economic growth. Similarly, other government policies also have a major role to play in contributing to economic growth. A continued emphasis on market mechanisms through deregulation will help sharpen incentives to work, save, invest, and innovate. Similarly, a fiscal policy oriented toward limited growth in government expenditures, producing smaller budget deficits and even budget surpluses, would tend to lower real interest rates even further, also promoting capital investment. The recent experience provides striking evidence of the potential for the continuation and extension of monetary, fiscal, and structural policies to enhance our economy's performance in the period ahead.	---[PAGE_BREAK]--- # Mr. Greenspan presents the views of the Federal Reserve in its semi-annual Humphrey-Hawkins report on monetary policy Testimony of the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before Congress on 22/7/97. I am pleased to appear before this Subcommittee to present the Federal Reserve's report on the economic situation and monetary policy. The recent performance of the economy, characterized by strong growth and low inflation, has been exceptional -- and better than most anticipated. During the first quarter of 1997, real gross domestic product expanded at nearly a 6 percent annual rate, after posting a 3 percent increase over 1996. Activity apparently continued to expand in the second quarter, albeit at a more moderate pace. The economy is now in the seventh consecutive year of expansion, making it the third longest post-World War II cyclical upswing to date. Moreover, our Federal Reserve Banks indicate that economic activity is on the rise, and at a relatively high level, in virtually every geographic region and community of the nation. The expansion has been balanced, in that inventories, as well as stocks of business capital and other durable assets, have been kept closely in line with spending, so overhangs have been small and readily corrected. This strong expansion has produced a remarkable increase in work opportunities for Americans. A net of more than thirteen million jobs has been created since the current period of growth began in the spring of 1991. As a consequence, the unemployment rate has fallen to 5 percent -- its lowest level in almost a quarter century. The expansion has enabled many in the working-age population, a large number of whom would have otherwise remained out of the labor force or among the longer-term unemployed, to acquire work experience and improved skills. Our whole economy will benefit from their greater productivity. To be sure, not all segments of our population are fully sharing in the economic improvement. Some Americans still have trouble finding jobs, and for part of our work force real wage stagnation persists. In contrast to the typical postwar business cycle, measured price inflation is lower now than when the expansion began and has shown little tendency to rebound of late, despite high rates of resource utilization. In the business sector, producer prices have fallen in each of the past six months. Consumers also are enjoying low inflation. The consumer price index rose at less than a 2 percent annual rate over the first half of the year, down from a little over 3 percent in 1996. With the economy performing so well for so long, financial markets have been buoyant, as memories of past business and financial cycles fade with time. Soaring prices in the stock market have been fuelled by moderate long-term interest rates and expectations of investors that profit margins and earnings growth will hold steady, or even increase further, in a relatively stable, low-inflation environment. Credit spreads at depository institutions and in the open market have remained extremely narrow by historical standards, suggesting a high degree of confidence among lenders regarding the prospects for credit repayment. The key questions facing financial markets and policy makers are: "What is behind the good performance of the economy?" and "Will it persist?" Without question, the exceptional economic situation reflects some temporary factors that have been restraining inflation rates. In addition, however, important pieces of information, while just suggestive at this point, could be read as indicating basic improvements in the longer-term efficiency of our ---[PAGE_BREAK]--- economy. The Federal Reserve has been aware of this possibility in our monetary policy deliberations and, as always, has operated with a view to supplying adequate liquidity to allow the economy to reach its highest potential on a sustainable basis. Nonetheless, we also recognize that the capacity of our economy to produce goods and services is not without limit. If demand were to outrun supply, inflationary imbalances would eventually develop that would tend to undermine the current expansion and inhibit the long-run growth potential of the economy. Because monetary policy works with a significant lag, policy actions are directed at a future that may not be clearly evident in current experience. This leads to policy judgements that are by their nature calibrated to the relative probabilities of differing outcomes. We moved the federal funds rate higher in March because we perceived the probability of demand outstripping supply to have increased to a point where inaction would have put at risk the solid elements of support that have sustained this expansion and made it so beneficial. In making such judgements in March and in the future, we need to analyze carefully the various forces that may be affecting the balance of supply and demand in the economy, including those that may be responsible for its exceptional recent behavior. The remainder of my testimony will address the various possibilities. # Inflation, Output, and Technological Change in the 1990s Many observers, including us, have been puzzled about how an economy, operating at high levels and drawing into employment increasingly less-experienced workers, can still produce subdued and, by some measures even falling, inflation rates. It will, doubtless, be several years before we know with any conviction the full story of the surprisingly benign combination of output and prices that has marked the business expansion of the last six years. Certainly, public policy has played an important role. Administration and Congressional actions to curtail budget deficits have enabled long-term interest rates to move lower, encouraging private efficiency-enhancing capital investment. Deregulation in a number of industries has fostered competition and held down prices. Finally, the pre-emptive actions of the Federal Reserve in 1994 contained a potentially destabilizing surge in demand, short-circuiting a boom-bust business cycle in the making and keeping inflation low to encourage business innovation. But the fuller explanation of the recent extraordinary performance may well lie deeper. In February 1996, I raised before this Committee a hypothesis tying together technological change and cost pressures that could explain what was even then a puzzling quiescence of inflation. The new information received in the last eighteen months remains consistent with those earlier notions; indeed, some additional pieces of the puzzle appear to be falling into place. A surge in capital investment in high tech equipment that began in early 1993 has since strengthened. Purchases of computer and telecommunications equipment have risen at a more than 14 percent annual rate since early 1993 in nominal terms, and at an astonishing rate of nearly 25 percent in real terms, reflecting the fall in the prices of this equipment. Presumably companies have come to perceive a significant increase in profit opportunities from exploiting the improved productivity of these new technologies. ---[PAGE_BREAK]--- It is premature to judge definitively whether these business perceptions are the harbinger of a more general and persistent improvement in productivity. Supporting this possibility, productivity growth, which often suffers as business expansions mature, has not followed that pattern. In addition, profit margins remain high in the face of pickups in compensation growth, suggesting that businesses continue to find new ways to enhance their efficiency. Nonetheless, although the anecdotal evidence is ample and manufacturing productivity has picked up, a change in the underlying trend is not yet reflected in our conventional data for the whole economy. But even if the perceived quicker pace of application of our newer technologies turns out to be mere wheel-spinning rather than true productivity advance, it has brought with it a heightened sense of job insecurity and, as a consequence, subdued wage gains. As I pointed out here last February, polls indicated that despite the significant fall in the unemployment rate, the proportion of workers in larger establishments fearful of being laid off rose from 25 percent in 1991 to 46 percent by 1996. It should not have been surprising then that strike activity in the 1990s has been lower than it has been in decades and that new labor union contracts have been longer and have given greater emphasis to job security. Nor should it have been unexpected that the number of workers voluntarily leaving their jobs to seek other employment has not risen in this period of tight labor markets. To be sure, since last year, surveys have indicated that the proportion of workers fearful of layoff has stabilized and the number of voluntary job leavers has edged up. And, indeed, perhaps as a consequence, wage gains have accelerated some. But increases in the Employment Cost Index still trail behind what previous relationships to tight labor markets would have suggested, and a lingering sense of fear or uncertainty seems still to pervade the job market, though to a somewhat lesser extent. Consumer surveys do indicate greater optimism about the economy. However, it is one thing to believe that the economy, indeed the job market, will do well overall, but quite another to feel secure about one's individual situation, given the accelerated pace of corporate restructuring and the heightened fear of skill obsolescence that has apparently characterized this expansion. Persisting insecurity would help explain why measured personal saving rates have not declined as would have been expected from the huge increase in stock market wealth. We will, however, have a better fix on savings rates after the coming benchmark revisions to the national income and product accounts. The combination in recent years of subdued compensation per hour and solid productivity advances has meant that unit labor costs of non financial corporations have barely moved. Moreover, when you combine unit labor costs with non labor costs -- which account for one-quarter of total costs on a consolidated basis -- total unit costs for the year ended in the first quarter of 1997 rose only about half a percent. Hence, a significant part of the measured price increase over that period was attributable to a rise in profit margins, unusual well into a business expansion. Rising margins are further evidence suggesting that productivity gains have been unexpectedly strong; in these situations, real labor compensation usually catches up only with a lag. While accelerated technological change may well be an important element in unravelling the current economic puzzle, there have been other influences at play as well in restraining price increases at high levels of resource utilization. The strong dollar of the last two years has pared import prices and constrained the pricing behavior of domestic firms facing import competition. Increasing globalization has enabled greater specialization over a wider ---[PAGE_BREAK]--- array of goods and services, in effect allowing comparative advantage to hold down costs and enhance efficiencies. Increased deregulation of telecommunications, motor and rail transport, utilities, and finance doubtless has been a factor restraining prices, as perhaps has the reduced market power of labor unions. Certainly, changes in the health care industry and the pricing of health services have greatly contributed to holding down growth in the cost of benefits, and hence overall labor compensation. Many of these forces are limited or temporary, and their effects can be expected to diminish, at which time cost and price pressures would tend to re-emerge. The effects of an increased rate of technological change might be more persistent, but they too could not permanently hold down inflation if the Federal Reserve allows excess liquidity to flood financial markets. I have noted to you before the likelihood that at some point workers might no longer be willing to restrain wage gains for added security, at which time accelerating unit labor costs could begin to press on profit margins and prices, should monetary policy be too accommodative. When I discuss greater technological change, I am not referring primarily to a particular new invention. Instead, I have in mind the increasingly successful and pervasive application of recent technological advances, especially in telecommunications and computers, to enhance efficiencies in production processes throughout the economy. Many of these technologies have been around for some time. Why might they be having a more pronounced effect now? In an intriguing paper prepared for a conference last year sponsored by the Federal Reserve Bank of Boston, Professor Nathan Rosenberg of Stanford documented how, in the past, it often took a considerable period of time for the necessary synergies to develop between different forms of capital and technologies. One example is the invention of the dynamo in the mid 1800s. Rosenberg's colleague Professor Paul David had noted a number of years ago that it wasn't until the 1920s that critical complementary technologies of the dynamo -- for example, the electric motor as the primary source of mechanical drive in factories, and central generating stations -were developed and in place and that production processes had fully adapted to these inventions. What we may be observing in the current environment is a number of key technologies, some even mature, finally interacting to create significant new opportunities for value creation. For example, the applications for the laser were modest until the later development of fiber optics engendered a revolution in telecommunications. Broad advances in software have enabled us to capitalize on the prodigious gains in hardware capacity. The interaction of both of these has created the Internet. The accelerated synergies of the various technologies may be what have been creating the apparent significant new profit opportunities that presumably lie at the root of the recent boom in high-tech investment. An expected result of the widespread and effective application of information and other technologies would be a significant increase in productivity and reduction in business costs. We do not now know, nor do I suspect can anyone know, whether current developments are part of a once or twice in a century phenomenon that will carry productivity trends nationally and globally to a new higher track, or whether we are merely observing some unusual variations within the context of an otherwise generally conventional business cycle expansion. The recent improvement in productivity could be just transitory, an artifact of a temporary surge in demand and output growth. In view of the slowing in growth in the second ---[PAGE_BREAK]--- quarter and the more moderate expansion widely expected going forward, data for profit margins on domestic operations and productivity from the second quarter on will be especially relevant in assessing whether recent improvements are structural or cyclical. Whatever the trend in productivity and, by extension, overall sustainable economic growth, from the Federal Reserve's point of view, the faster the better. We see our job as fostering the degree of liquidity that will best support the most effective platform for growth to flourish. We believe a non inflationary environment is such a platform because it promotes long-term planning and capital investment and keeps the pressure on businesses to contain costs and enhance efficiency. The Federal Reserve's policy problem is not with growth, but with maintaining an effective platform. To do so, we endeavor to prevent strains from developing in our economic system, which long experience tells us produce bottlenecks, shortages, and inefficiencies. These eventually create more inflation, which undermines economic expansion and limits the longer-term potential of the economy. In gauging the potential for oncoming strains, it is the effective capacity of the economy to produce that is important to us. An economy operating at a high level of utilization and growing 5 percent a year is in little difficulty if capacity is growing at least that fast. But a fully utilized economy growing at 1 percent will eventually get into trouble if capacity is growing less than that. Capacity itself, however, is a complex concept, which requires a separate evaluation of its two components, capital and labor. It appears that capital, that is, plant and equipment, can adapt and expand more expeditiously than in the past to meet demands. Hence, capital capacity is now a considerably less rigid constraint than it once was. In recent years, technology has engendered a significant compression of lead times between order and delivery for production facilities. This has enabled output to respond increasingly faster to an upsurge in demand, thereby decreasing the incidence of strains on capital capacity and shortages so evident in earlier business expansions. Reflecting progressively shorter lead times for capital equipment, unfilled orders to shipment ratios for non-defense capital goods have declined by 30 percent in the last six years. Not only do producers have quicker access to equipment that embodies the most recent advances, but they have been able to adjust their overall capital stock more rapidly to increases in demand. The current lack of material shortages and bottlenecks, despite the high level and recent robust expansion of demand, is striking. The effective capacity of production facilities has increased substantially in recent years in response to strong final demands and the influence of cost reductions possible with the newer technologies. Increased flexibility is particularly evident in the computer, telecommunications, and related industries, a segment of our economy that seems far less subject to physical capacity constraints than many older-line establishments, and one that is assuming greater importance in our overall output. But the shortening of lags has been pervasive even in more mature industries, owing in part to the application of advanced technologies to production methods. At the extreme, if all capital goods could be produced at constant cost and on demand, the size of our nation's capital stock would never pose a restraint on production. We are ---[PAGE_BREAK]--- obviously very far from that nirvana, but it is important to note that we are also far from the situation a half-century ago when our production processes were dominated by equipment such as open hearth steel furnaces, which had very exacting limits on how much they could produce in a fixed time frame and which required huge lead times to expand their capacity. Even so, today's economy as a whole still can face capacity constraints from its facilities. Indeed, just three years ago, bottlenecks in industrial production -- though less extensive than in years past at high levels of measured capacity utilization -- were nonetheless putting significant upward pressures on prices at earlier stages of production. More recently vendor performance has deteriorated somewhat, indicating that flexibility to meet demands still has limits. Although further strides toward greater facilities flexibility have occurred since 1994, this is clearly an evolutionary, not a revolutionary, process. # Labor Markets Moreover, technology and management changes have had only a limited effect on the ability of labor supply to respond to changes in demand. To be sure, individual firms have acquired additional flexibility by increased use of outsourcing and temporary workers. In addition, smaller work teams can adapt more readily to variations in order flows. While these techniques put the right workers at the right spots to reduce bottlenecks, they do not increase the aggregate supply of labor. That supply is sensitive to changes in demand, but to a far more limited extent than for facilities. New plants can almost always be built. But labor capacity for an individual country is constrained by the size of the working-age population, which, except for immigration, is basically determined several decades in the past. Of course, capital facilities and labor are not fully separate markets. Within limits, labor and capital are substitutes, and slack in one market can offset tightness in another. For example, additional work shifts can expand output without significant addition to facilities, and similarly more labor-displacing equipment can permit production to be increased with the same level of employment. Yet despite significant increases in capital equipment in recent years, new additions to labor supply have been inadequate to meet the demand for labor. As a consequence, the recent period has been one of significant reduction in labor market slack. Of the more than two million net new hires at an annual rate since early 1994, only about half have come from an expansion in the population aged 16 to 64 who wanted a job, and more than a third of those were net new immigrants. The remaining one million plus per year increase in employment has been pulled from those who had been reported as unemployed ( 600 thousand annually) and those who wanted, but had not actively sought, a job (more than 400 thousand annually). The latter, of course, are not in the official unemployment count. The key point is that continuously digging ever deeper into the available work age population is not a sustainable trajectory for job creation. The unemployment rate has a downside limit if for no other reason than unemployment, in part, reflects voluntary periods of job search and other frictional unemployment. There is also a limit on how many of the additional 5 million who wanted a job last quarter but were not actively seeking one could be readily absorbed into jobs -- in particular, the large number enrolled in school, and those who may lack the necessary skills or face other barriers to taking jobs. The rise in the average workweek since early 1996 suggests employers are having increasingly greater difficulty fitting ---[PAGE_BREAK]--- the millions who want a job into available job slots. If the pace of job creation continues, the pressures on wages and other costs of hiring increasing numbers of such individuals could escalate more rapidly. To be sure, there remain an additional 34 million in the working-age population (age 16 - 64) who say they do not want a job. Presumably, some of these early retirees, students, or homemakers might be attracted to the job market if it became sufficiently rewarding. However, making it attractive enough could also involve upward pressures in real wages that would trigger renewed price pressures, undermining the expansion. Thus, there would seem to be emerging constraints on potential labor input. Even before we reach the ultimate limit of sustainable labor supply growth, the economy's ability to expand employment at the recent rate should rapidly diminish. The availability of unemployed labor could no longer add to growth, irrespective of the degree of slack in physical facilities at that time. Simply adding new facilities will not increase production unless output per worker improves. Such improvements are possible if worker skills increase, but such gains come slowly through improved education and on-the-job training. They are also possible as capital substitutes for labor, but are limited by the state of technology. More significant advances require technological breakthroughs. At the cutting edge of technology, where America finds itself, major improvements cannot be produced on demand. New ideas that matter are hard won. # The Economic Outlook As I noted, the recent performance of the labor markets suggests that the economy was on an unsustainable track. Unless aggregate demand increases more slowly than it has in recent years -- more in line with trends in the supply of labor and productivity -- imbalances will emerge. We do not know, however, at what point pressures would develop -- or indeed whether the economy is already close to that point. Fortunately, the very rapid growth of demand over the winter has eased recently. To an extent this easing seems to reflect some falloff in growth of demand for consumer durables and for inventories to a pace more in line with moderate expansion in income. But some of the recent slower growth could simply be a product of abnormal weather patterns, which contributed to a first-quarter surge in output and weakened the second quarter, in which case the underlying trend could be somewhat higher than suggested by the second-quarter data alone. Certainly, business and consumer confidence remains high and financial conditions are supportive of growth. Particularly notable is the run-up in stock market wealth, the full effects of which apparently have not been reflected in overall demand, but might yet be. Monetary policymakers, balancing these various forces, forecast a continuation of less rapid growth in coming quarters. For 1997 as a whole, the central tendency of their forecasts has real GDP growing 3 to $3^{1 / 4}$ percent. This would be much more brisk than was anticipated in February, and the upward revision to this estimate largely reflects the unexpectedly strong first quarter. The central tendency of monetary policymakers' projections is that real GDP will expand 2 to $2^{1 / 2}$ percent in 1998. This pace of expansion is expected to keep the unemployment rate close to its current low level. We are reasonably confident that inflation will be quite modest for 1997 as a whole. The central tendency of the forecasts is that consumer prices will rise only $2^{1 / 4}$ to $2^{1 / 2}$ ---[PAGE_BREAK]--- percent this year. This would be a significantly better outcome than the $23 / 4$ to 3 percent CPI inflation foreseen in February. Federal Open Market Committee members do see higher rates of inflation next year. The central tendency of the projections is that CPI inflation will be $21 / 2$ to 3 percent in 1998 -- a little above the expectation for this year. However, much of this increase is presumed to result from the absence of temporary factors that are holding down inflation this year. In particular, the favorable movements in food and energy prices of 1997 are unlikely to be repeated, and non-oil import prices may not continue to decline. While it is possible that better productivity trends and subdued wage growth will continue to help damp the increases in business costs associated with tight labor markets, this is a situation that the Federal Reserve plans to monitor closely. I have no doubt that the current stance of policy -- characterized by a nominal federal funds rate around $51 / 2$ percent -- will need to be changed at some point to foster sustainable growth and low inflation. Adjustments in the policy instrument in response to new information are a necessary and, I should like to emphasize, routine aspect of responsible policy making. For the present, as I indicated, demand growth does appear to have moderated, but whether that moderation will be sufficient to avoid putting additional pressures on resources is an open question. With considerable momentum behind the expansion and labor market utilization rates unusually high, the Federal Reserve must be alert to the possibility that additional action might be called for to forestall excessive credit creation. The Federal Reserve is intent on gearing its policy to facilitate the maximum sustainable growth of the economy, but it is not, as some commentators have suggested, involved in an experiment that deliberately prods the economy to see how far and fast it can grow. The costs of a failed experiment would be much too burdensome for too many of our citizens. Clearly, in considering issues of monetary policy we need to distinguish carefully between sustainable economic growth and unsustainable accelerations of activity. Sustainable growth reflects the increased capacity of the economic system to produce goods and services over the longer run. It is largely the sum of increases in productivity and in the labor force. That growth contrasts with a second type, a more transitory growth. An economy producing near capacity can expand faster for a short time, often through unsustainably low short-term interest rates and excess credit creation. But this is not growth that promotes lasting increases in standards of living and in jobs for our nation. Rather, it is a growth that creates instability and thereby inhibits the achievement of our nation's economic goals. The key question is how monetary policy can best foster the highest rate of sustainable growth and avoid amplifying swings in output, employment, and prices. The historical evidence is unambiguous that excessive creation of credit and liquidity contributes nothing to the long-run growth of our productive potential and much to costly shorter-term fluctuations. Moreover, it promotes inflation, impairing the economy's longer-term potential output. Our objective has never been to contain inflation as an end in itself, but rather as a precondition for the highest possible long-run growth of output and income -- the ultimate goal of macroeconomic policy. ---[PAGE_BREAK]--- In considering possible adjustments of policy to achieve that goal, the issue of lags in the effects of monetary policy is crucial. The evidence clearly demonstrates that monetary policy affects the financial markets immediately but works with significant lags on output, employment, and prices. Thus, as I pointed out earlier, policy needs to be made today on the basis of likely economic conditions in the future. As a consequence, and in the absence of once-reliable monetary guides to policy, there is no alternative to formulating policy using risk-reward trade-offs based on what are, unavoidably, uncertain forecasts. Operating on uncertain forecasts, of course, is not unusual. People do it every day, consciously or subconsciously. A driver might tap the brakes to make sure not to be hit by a truck coming down the street, even if he thinks the chances of such an event are relatively low; the costs of being wrong are simply too high. Similarly, in conducting monetary policy the Federal Reserve needs constantly to look down the road to gauge the future risks to the economy and act accordingly. # Growth of Money and Credit The view that the Federal Reserve's best contribution to growth is to foster price stability has informed both our tactical decisions on the stance of monetary policy and our longer-run judgements on appropriate rates of liquidity provision. To be sure, growth rates of monetary and credit aggregates have become less reliable as guides for monetary policy as a result of rapid change in our financial system. As I have reported to you previously, the current uncertainties regarding the behavior of the monetary aggregates have implied that we have been unable to employ them as guides to short-run policy decisions. Accordingly, in recent years we have reported annual ranges for money growth that serve as benchmarks under conditions of price stability and a return to historically stable patterns of velocity. Over the past several years, the monetary aggregates -- M2 in particular -- have shown some signs of re-establishing such stable patterns. The velocity of M2 has fluctuated in a relatively narrow range, and some of its variation within that range has been explained by interest rate movements, in a relationship similar to that established over earlier decades. We find this an encouraging development, and it is possible that at some point the FOMC might elect to put more weight on such monetary quantities in the conduct of policy. But in our view, sufficient evidence has not yet accumulated to support such a judgement. Consequently, we have decided to keep the existing ranges of growth for money and credit for 1997 and carry them over to next year, retaining the interpretation of the money ranges as benchmarks for the achievement of price stability. With nominal income growth strong relative to the rate that would likely prevail under conditions of price stability, the growth of M2 is likely to run in the upper part of its range both this year and next, while M3 could run a little above its cone. Domestic non financial sector debt is likely to remain well within its range, with private debt growth brisk and federal debt growth subdued. Although any tendency for the aggregates to exceed their ranges would not, in the event, necessarily call for an examination of whether a policy adjustment was needed, the Federal Reserve will be closely examining financial market prices and flows in the context of a broad range of economic and price indicators for evidence that the sustainability of the economic expansion may be in jeopardy. ---[PAGE_BREAK]--- # Concluding Comment The Federal Reserve recognizes, of course, that monetary policy does not determine the economy's potential. All that it can do is help establish sound money and a stable financial environment in which the inherent vitality of a market economy can flourish and promote the capital investment that in the long run is the basis for vigorous economic growth. Similarly, other government policies also have a major role to play in contributing to economic growth. A continued emphasis on market mechanisms through deregulation will help sharpen incentives to work, save, invest, and innovate. Similarly, a fiscal policy oriented toward limited growth in government expenditures, producing smaller budget deficits and even budget surpluses, would tend to lower real interest rates even further, also promoting capital investment. The recent experience provides striking evidence of the potential for the continuation and extension of monetary, fiscal, and structural policies to enhance our economy's performance in the period ahead.	Alan Greenspan	United States	https://www.bis.org/review/r970731b.pdf	Humphrey-Hawkins report on monetary policy Testimony of the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before Congress on 22/7/97. I am pleased to appear before this Subcommittee to present the Federal Reserve's report on the economic situation and monetary policy. The recent performance of the economy, characterized by strong growth and low inflation, has been exceptional -- and better than most anticipated. During the first quarter of 1997, real gross domestic product expanded at nearly a 6 percent annual rate, after posting a 3 percent increase over 1996. Activity apparently continued to expand in the second quarter, albeit at a more moderate pace. The economy is now in the seventh consecutive year of expansion, making it the third longest post-World War II cyclical upswing to date. Moreover, our Federal Reserve Banks indicate that economic activity is on the rise, and at a relatively high level, in virtually every geographic region and community of the nation. The expansion has been balanced, in that inventories, as well as stocks of business capital and other durable assets, have been kept closely in line with spending, so overhangs have been small and readily corrected. This strong expansion has produced a remarkable increase in work opportunities for Americans. A net of more than thirteen million jobs has been created since the current period of growth began in the spring of 1991. As a consequence, the unemployment rate has fallen to 5 percent -- its lowest level in almost a quarter century. The expansion has enabled many in the working-age population, a large number of whom would have otherwise remained out of the labor force or among the longer-term unemployed, to acquire work experience and improved skills. Our whole economy will benefit from their greater productivity. To be sure, not all segments of our population are fully sharing in the economic improvement. Some Americans still have trouble finding jobs, and for part of our work force real wage stagnation persists. In contrast to the typical postwar business cycle, measured price inflation is lower now than when the expansion began and has shown little tendency to rebound of late, despite high rates of resource utilization. In the business sector, producer prices have fallen in each of the past six months. Consumers also are enjoying low inflation. The consumer price index rose at less than a 2 percent annual rate over the first half of the year, down from a little over 3 percent in 1996. With the economy performing so well for so long, financial markets have been buoyant, as memories of past business and financial cycles fade with time. Soaring prices in the stock market have been fuelled by moderate long-term interest rates and expectations of investors that profit margins and earnings growth will hold steady, or even increase further, in a relatively stable, low-inflation environment. Credit spreads at depository institutions and in the open market have remained extremely narrow by historical standards, suggesting a high degree of confidence among lenders regarding the prospects for credit repayment. The key questions facing financial markets and policy makers are: "What is behind the good performance of the economy?" and "Will it persist?" Without question, the exceptional economic situation reflects some temporary factors that have been restraining inflation rates. In addition, however, important pieces of information, while just suggestive at this point, could be read as indicating basic improvements in the longer-term efficiency of our economy. The Federal Reserve has been aware of this possibility in our monetary policy deliberations and, as always, has operated with a view to supplying adequate liquidity to allow the economy to reach its highest potential on a sustainable basis. Nonetheless, we also recognize that the capacity of our economy to produce goods and services is not without limit. If demand were to outrun supply, inflationary imbalances would eventually develop that would tend to undermine the current expansion and inhibit the long-run growth potential of the economy. Because monetary policy works with a significant lag, policy actions are directed at a future that may not be clearly evident in current experience. This leads to policy judgements that are by their nature calibrated to the relative probabilities of differing outcomes. We moved the federal funds rate higher in March because we perceived the probability of demand outstripping supply to have increased to a point where inaction would have put at risk the solid elements of support that have sustained this expansion and made it so beneficial. In making such judgements in March and in the future, we need to analyze carefully the various forces that may be affecting the balance of supply and demand in the economy, including those that may be responsible for its exceptional recent behavior. The remainder of my testimony will address the various possibilities. Many observers, including us, have been puzzled about how an economy, operating at high levels and drawing into employment increasingly less-experienced workers, can still produce subdued and, by some measures even falling, inflation rates. It will, doubtless, be several years before we know with any conviction the full story of the surprisingly benign combination of output and prices that has marked the business expansion of the last six years. Certainly, public policy has played an important role. Administration and Congressional actions to curtail budget deficits have enabled long-term interest rates to move lower, encouraging private efficiency-enhancing capital investment. Deregulation in a number of industries has fostered competition and held down prices. Finally, the pre-emptive actions of the Federal Reserve in 1994 contained a potentially destabilizing surge in demand, short-circuiting a boom-bust business cycle in the making and keeping inflation low to encourage business innovation. But the fuller explanation of the recent extraordinary performance may well lie deeper. In February 1996, I raised before this Committee a hypothesis tying together technological change and cost pressures that could explain what was even then a puzzling quiescence of inflation. The new information received in the last eighteen months remains consistent with those earlier notions; indeed, some additional pieces of the puzzle appear to be falling into place. A surge in capital investment in high tech equipment that began in early 1993 has since strengthened. Purchases of computer and telecommunications equipment have risen at a more than 14 percent annual rate since early 1993 in nominal terms, and at an astonishing rate of nearly 25 percent in real terms, reflecting the fall in the prices of this equipment. Presumably companies have come to perceive a significant increase in profit opportunities from exploiting the improved productivity of these new technologies. It is premature to judge definitively whether these business perceptions are the harbinger of a more general and persistent improvement in productivity. Supporting this possibility, productivity growth, which often suffers as business expansions mature, has not followed that pattern. In addition, profit margins remain high in the face of pickups in compensation growth, suggesting that businesses continue to find new ways to enhance their efficiency. Nonetheless, although the anecdotal evidence is ample and manufacturing productivity has picked up, a change in the underlying trend is not yet reflected in our conventional data for the whole economy. But even if the perceived quicker pace of application of our newer technologies turns out to be mere wheel-spinning rather than true productivity advance, it has brought with it a heightened sense of job insecurity and, as a consequence, subdued wage gains. As I pointed out here last February, polls indicated that despite the significant fall in the unemployment rate, the proportion of workers in larger establishments fearful of being laid off rose from 25 percent in 1991 to 46 percent by 1996. It should not have been surprising then that strike activity in the 1990s has been lower than it has been in decades and that new labor union contracts have been longer and have given greater emphasis to job security. Nor should it have been unexpected that the number of workers voluntarily leaving their jobs to seek other employment has not risen in this period of tight labor markets. To be sure, since last year, surveys have indicated that the proportion of workers fearful of layoff has stabilized and the number of voluntary job leavers has edged up. And, indeed, perhaps as a consequence, wage gains have accelerated some. But increases in the Employment Cost Index still trail behind what previous relationships to tight labor markets would have suggested, and a lingering sense of fear or uncertainty seems still to pervade the job market, though to a somewhat lesser extent. Consumer surveys do indicate greater optimism about the economy. However, it is one thing to believe that the economy, indeed the job market, will do well overall, but quite another to feel secure about one's individual situation, given the accelerated pace of corporate restructuring and the heightened fear of skill obsolescence that has apparently characterized this expansion. Persisting insecurity would help explain why measured personal saving rates have not declined as would have been expected from the huge increase in stock market wealth. We will, however, have a better fix on savings rates after the coming benchmark revisions to the national income and product accounts. The combination in recent years of subdued compensation per hour and solid productivity advances has meant that unit labor costs of non financial corporations have barely moved. Moreover, when you combine unit labor costs with non labor costs -- which account for one-quarter of total costs on a consolidated basis -- total unit costs for the year ended in the first quarter of 1997 rose only about half a percent. Hence, a significant part of the measured price increase over that period was attributable to a rise in profit margins, unusual well into a business expansion. Rising margins are further evidence suggesting that productivity gains have been unexpectedly strong; in these situations, real labor compensation usually catches up only with a lag. While accelerated technological change may well be an important element in unravelling the current economic puzzle, there have been other influences at play as well in restraining price increases at high levels of resource utilization. The strong dollar of the last two years has pared import prices and constrained the pricing behavior of domestic firms facing import competition. Increasing globalization has enabled greater specialization over a wider array of goods and services, in effect allowing comparative advantage to hold down costs and enhance efficiencies. Increased deregulation of telecommunications, motor and rail transport, utilities, and finance doubtless has been a factor restraining prices, as perhaps has the reduced market power of labor unions. Certainly, changes in the health care industry and the pricing of health services have greatly contributed to holding down growth in the cost of benefits, and hence overall labor compensation. Many of these forces are limited or temporary, and their effects can be expected to diminish, at which time cost and price pressures would tend to re-emerge. The effects of an increased rate of technological change might be more persistent, but they too could not permanently hold down inflation if the Federal Reserve allows excess liquidity to flood financial markets. I have noted to you before the likelihood that at some point workers might no longer be willing to restrain wage gains for added security, at which time accelerating unit labor costs could begin to press on profit margins and prices, should monetary policy be too accommodative. When I discuss greater technological change, I am not referring primarily to a particular new invention. Instead, I have in mind the increasingly successful and pervasive application of recent technological advances, especially in telecommunications and computers, to enhance efficiencies in production processes throughout the economy. Many of these technologies have been around for some time. Why might they be having a more pronounced effect now? In an intriguing paper prepared for a conference last year sponsored by the Federal Reserve Bank of Boston, Professor Nathan Rosenberg of Stanford documented how, in the past, it often took a considerable period of time for the necessary synergies to develop between different forms of capital and technologies. One example is the invention of the dynamo in the mid 1800s. Rosenberg's colleague Professor Paul David had noted a number of years ago that it wasn't until the 1920s that critical complementary technologies of the dynamo -- for example, the electric motor as the primary source of mechanical drive in factories, and central generating stations -were developed and in place and that production processes had fully adapted to these inventions. What we may be observing in the current environment is a number of key technologies, some even mature, finally interacting to create significant new opportunities for value creation. For example, the applications for the laser were modest until the later development of fiber optics engendered a revolution in telecommunications. Broad advances in software have enabled us to capitalize on the prodigious gains in hardware capacity. The interaction of both of these has created the Internet. The accelerated synergies of the various technologies may be what have been creating the apparent significant new profit opportunities that presumably lie at the root of the recent boom in high-tech investment. An expected result of the widespread and effective application of information and other technologies would be a significant increase in productivity and reduction in business costs. We do not now know, nor do I suspect can anyone know, whether current developments are part of a once or twice in a century phenomenon that will carry productivity trends nationally and globally to a new higher track, or whether we are merely observing some unusual variations within the context of an otherwise generally conventional business cycle expansion. The recent improvement in productivity could be just transitory, an artifact of a temporary surge in demand and output growth. In view of the slowing in growth in the second quarter and the more moderate expansion widely expected going forward, data for profit margins on domestic operations and productivity from the second quarter on will be especially relevant in assessing whether recent improvements are structural or cyclical. Whatever the trend in productivity and, by extension, overall sustainable economic growth, from the Federal Reserve's point of view, the faster the better. We see our job as fostering the degree of liquidity that will best support the most effective platform for growth to flourish. We believe a non inflationary environment is such a platform because it promotes long-term planning and capital investment and keeps the pressure on businesses to contain costs and enhance efficiency. The Federal Reserve's policy problem is not with growth, but with maintaining an effective platform. To do so, we endeavor to prevent strains from developing in our economic system, which long experience tells us produce bottlenecks, shortages, and inefficiencies. These eventually create more inflation, which undermines economic expansion and limits the longer-term potential of the economy. In gauging the potential for oncoming strains, it is the effective capacity of the economy to produce that is important to us. An economy operating at a high level of utilization and growing 5 percent a year is in little difficulty if capacity is growing at least that fast. But a fully utilized economy growing at 1 percent will eventually get into trouble if capacity is growing less than that. Capacity itself, however, is a complex concept, which requires a separate evaluation of its two components, capital and labor. It appears that capital, that is, plant and equipment, can adapt and expand more expeditiously than in the past to meet demands. Hence, capital capacity is now a considerably less rigid constraint than it once was. In recent years, technology has engendered a significant compression of lead times between order and delivery for production facilities. This has enabled output to respond increasingly faster to an upsurge in demand, thereby decreasing the incidence of strains on capital capacity and shortages so evident in earlier business expansions. Reflecting progressively shorter lead times for capital equipment, unfilled orders to shipment ratios for non-defense capital goods have declined by 30 percent in the last six years. Not only do producers have quicker access to equipment that embodies the most recent advances, but they have been able to adjust their overall capital stock more rapidly to increases in demand. The current lack of material shortages and bottlenecks, despite the high level and recent robust expansion of demand, is striking. The effective capacity of production facilities has increased substantially in recent years in response to strong final demands and the influence of cost reductions possible with the newer technologies. Increased flexibility is particularly evident in the computer, telecommunications, and related industries, a segment of our economy that seems far less subject to physical capacity constraints than many older-line establishments, and one that is assuming greater importance in our overall output. But the shortening of lags has been pervasive even in more mature industries, owing in part to the application of advanced technologies to production methods. At the extreme, if all capital goods could be produced at constant cost and on demand, the size of our nation's capital stock would never pose a restraint on production. We are obviously very far from that nirvana, but it is important to note that we are also far from the situation a half-century ago when our production processes were dominated by equipment such as open hearth steel furnaces, which had very exacting limits on how much they could produce in a fixed time frame and which required huge lead times to expand their capacity. Even so, today's economy as a whole still can face capacity constraints from its facilities. Indeed, just three years ago, bottlenecks in industrial production -- though less extensive than in years past at high levels of measured capacity utilization -- were nonetheless putting significant upward pressures on prices at earlier stages of production. More recently vendor performance has deteriorated somewhat, indicating that flexibility to meet demands still has limits. Although further strides toward greater facilities flexibility have occurred since 1994, this is clearly an evolutionary, not a revolutionary, process. Moreover, technology and management changes have had only a limited effect on the ability of labor supply to respond to changes in demand. To be sure, individual firms have acquired additional flexibility by increased use of outsourcing and temporary workers. In addition, smaller work teams can adapt more readily to variations in order flows. While these techniques put the right workers at the right spots to reduce bottlenecks, they do not increase the aggregate supply of labor. That supply is sensitive to changes in demand, but to a far more limited extent than for facilities. New plants can almost always be built. But labor capacity for an individual country is constrained by the size of the working-age population, which, except for immigration, is basically determined several decades in the past. Of course, capital facilities and labor are not fully separate markets. Within limits, labor and capital are substitutes, and slack in one market can offset tightness in another. For example, additional work shifts can expand output without significant addition to facilities, and similarly more labor-displacing equipment can permit production to be increased with the same level of employment. Yet despite significant increases in capital equipment in recent years, new additions to labor supply have been inadequate to meet the demand for labor. As a consequence, the recent period has been one of significant reduction in labor market slack. Of the more than two million net new hires at an annual rate since early 1994, only about half have come from an expansion in the population aged 16 to 64 who wanted a job, and more than a third of those were net new immigrants. The remaining one million plus per year increase in employment has been pulled from those who had been reported as unemployed ( 600 thousand annually) and those who wanted, but had not actively sought, a job (more than 400 thousand annually). The latter, of course, are not in the official unemployment count. The key point is that continuously digging ever deeper into the available work age population is not a sustainable trajectory for job creation. The unemployment rate has a downside limit if for no other reason than unemployment, in part, reflects voluntary periods of job search and other frictional unemployment. There is also a limit on how many of the additional 5 million who wanted a job last quarter but were not actively seeking one could be readily absorbed into jobs -- in particular, the large number enrolled in school, and those who may lack the necessary skills or face other barriers to taking jobs. The rise in the average workweek since early 1996 suggests employers are having increasingly greater difficulty fitting the millions who want a job into available job slots. If the pace of job creation continues, the pressures on wages and other costs of hiring increasing numbers of such individuals could escalate more rapidly. To be sure, there remain an additional 34 million in the working-age population (age 16 - 64) who say they do not want a job. Presumably, some of these early retirees, students, or homemakers might be attracted to the job market if it became sufficiently rewarding. However, making it attractive enough could also involve upward pressures in real wages that would trigger renewed price pressures, undermining the expansion. Thus, there would seem to be emerging constraints on potential labor input. Even before we reach the ultimate limit of sustainable labor supply growth, the economy's ability to expand employment at the recent rate should rapidly diminish. The availability of unemployed labor could no longer add to growth, irrespective of the degree of slack in physical facilities at that time. Simply adding new facilities will not increase production unless output per worker improves. Such improvements are possible if worker skills increase, but such gains come slowly through improved education and on-the-job training. They are also possible as capital substitutes for labor, but are limited by the state of technology. More significant advances require technological breakthroughs. At the cutting edge of technology, where America finds itself, major improvements cannot be produced on demand. New ideas that matter are hard won. As I noted, the recent performance of the labor markets suggests that the economy was on an unsustainable track. Unless aggregate demand increases more slowly than it has in recent years -- more in line with trends in the supply of labor and productivity -- imbalances will emerge. We do not know, however, at what point pressures would develop -- or indeed whether the economy is already close to that point. Fortunately, the very rapid growth of demand over the winter has eased recently. To an extent this easing seems to reflect some falloff in growth of demand for consumer durables and for inventories to a pace more in line with moderate expansion in income. But some of the recent slower growth could simply be a product of abnormal weather patterns, which contributed to a first-quarter surge in output and weakened the second quarter, in which case the underlying trend could be somewhat higher than suggested by the second-quarter data alone. Certainly, business and consumer confidence remains high and financial conditions are supportive of growth. Particularly notable is the run-up in stock market wealth, the full effects of which apparently have not been reflected in overall demand, but might yet be. Monetary policymakers, balancing these various forces, forecast a continuation of less rapid growth in coming quarters. For 1997 as a whole, the central tendency of their forecasts has real GDP growing 3 to $3^{1 / 4}$ percent. This would be much more brisk than was anticipated in February, and the upward revision to this estimate largely reflects the unexpectedly strong first quarter. The central tendency of monetary policymakers' projections is that real GDP will expand 2 to $2^{1 / 2}$ percent in 1998. This pace of expansion is expected to keep the unemployment rate close to its current low level. We are reasonably confident that inflation will be quite modest for 1997 as a whole. The central tendency of the forecasts is that consumer prices will rise only $2^{1 / 4}$ to $2^{1 / 2}$ percent this year. This would be a significantly better outcome than the $23 / 4$ to 3 percent CPI inflation foreseen in February. Federal Open Market Committee members do see higher rates of inflation next year. The central tendency of the projections is that CPI inflation will be $21 / 2$ to 3 percent in 1998 -- a little above the expectation for this year. However, much of this increase is presumed to result from the absence of temporary factors that are holding down inflation this year. In particular, the favorable movements in food and energy prices of 1997 are unlikely to be repeated, and non-oil import prices may not continue to decline. While it is possible that better productivity trends and subdued wage growth will continue to help damp the increases in business costs associated with tight labor markets, this is a situation that the Federal Reserve plans to monitor closely. I have no doubt that the current stance of policy -- characterized by a nominal federal funds rate around $51 / 2$ percent -- will need to be changed at some point to foster sustainable growth and low inflation. Adjustments in the policy instrument in response to new information are a necessary and, I should like to emphasize, routine aspect of responsible policy making. For the present, as I indicated, demand growth does appear to have moderated, but whether that moderation will be sufficient to avoid putting additional pressures on resources is an open question. With considerable momentum behind the expansion and labor market utilization rates unusually high, the Federal Reserve must be alert to the possibility that additional action might be called for to forestall excessive credit creation. The Federal Reserve is intent on gearing its policy to facilitate the maximum sustainable growth of the economy, but it is not, as some commentators have suggested, involved in an experiment that deliberately prods the economy to see how far and fast it can grow. The costs of a failed experiment would be much too burdensome for too many of our citizens. Clearly, in considering issues of monetary policy we need to distinguish carefully between sustainable economic growth and unsustainable accelerations of activity. Sustainable growth reflects the increased capacity of the economic system to produce goods and services over the longer run. It is largely the sum of increases in productivity and in the labor force. That growth contrasts with a second type, a more transitory growth. An economy producing near capacity can expand faster for a short time, often through unsustainably low short-term interest rates and excess credit creation. But this is not growth that promotes lasting increases in standards of living and in jobs for our nation. Rather, it is a growth that creates instability and thereby inhibits the achievement of our nation's economic goals. The key question is how monetary policy can best foster the highest rate of sustainable growth and avoid amplifying swings in output, employment, and prices. The historical evidence is unambiguous that excessive creation of credit and liquidity contributes nothing to the long-run growth of our productive potential and much to costly shorter-term fluctuations. Moreover, it promotes inflation, impairing the economy's longer-term potential output. Our objective has never been to contain inflation as an end in itself, but rather as a precondition for the highest possible long-run growth of output and income -- the ultimate goal of macroeconomic policy. In considering possible adjustments of policy to achieve that goal, the issue of lags in the effects of monetary policy is crucial. The evidence clearly demonstrates that monetary policy affects the financial markets immediately but works with significant lags on output, employment, and prices. Thus, as I pointed out earlier, policy needs to be made today on the basis of likely economic conditions in the future. As a consequence, and in the absence of once-reliable monetary guides to policy, there is no alternative to formulating policy using risk-reward trade-offs based on what are, unavoidably, uncertain forecasts. Operating on uncertain forecasts, of course, is not unusual. People do it every day, consciously or subconsciously. A driver might tap the brakes to make sure not to be hit by a truck coming down the street, even if he thinks the chances of such an event are relatively low; the costs of being wrong are simply too high. Similarly, in conducting monetary policy the Federal Reserve needs constantly to look down the road to gauge the future risks to the economy and act accordingly. The view that the Federal Reserve's best contribution to growth is to foster price stability has informed both our tactical decisions on the stance of monetary policy and our longer-run judgements on appropriate rates of liquidity provision. To be sure, growth rates of monetary and credit aggregates have become less reliable as guides for monetary policy as a result of rapid change in our financial system. As I have reported to you previously, the current uncertainties regarding the behavior of the monetary aggregates have implied that we have been unable to employ them as guides to short-run policy decisions. Accordingly, in recent years we have reported annual ranges for money growth that serve as benchmarks under conditions of price stability and a return to historically stable patterns of velocity. Over the past several years, the monetary aggregates -- M2 in particular -- have shown some signs of re-establishing such stable patterns. The velocity of M2 has fluctuated in a relatively narrow range, and some of its variation within that range has been explained by interest rate movements, in a relationship similar to that established over earlier decades. We find this an encouraging development, and it is possible that at some point the FOMC might elect to put more weight on such monetary quantities in the conduct of policy. But in our view, sufficient evidence has not yet accumulated to support such a judgement. Consequently, we have decided to keep the existing ranges of growth for money and credit for 1997 and carry them over to next year, retaining the interpretation of the money ranges as benchmarks for the achievement of price stability. With nominal income growth strong relative to the rate that would likely prevail under conditions of price stability, the growth of M2 is likely to run in the upper part of its range both this year and next, while M3 could run a little above its cone. Domestic non financial sector debt is likely to remain well within its range, with private debt growth brisk and federal debt growth subdued. Although any tendency for the aggregates to exceed their ranges would not, in the event, necessarily call for an examination of whether a policy adjustment was needed, the Federal Reserve will be closely examining financial market prices and flows in the context of a broad range of economic and price indicators for evidence that the sustainability of the economic expansion may be in jeopardy. The Federal Reserve recognizes, of course, that monetary policy does not determine the economy's potential. All that it can do is help establish sound money and a stable financial environment in which the inherent vitality of a market economy can flourish and promote the capital investment that in the long run is the basis for vigorous economic growth. Similarly, other government policies also have a major role to play in contributing to economic growth. A continued emphasis on market mechanisms through deregulation will help sharpen incentives to work, save, invest, and innovate. Similarly, a fiscal policy oriented toward limited growth in government expenditures, producing smaller budget deficits and even budget surpluses, would tend to lower real interest rates even further, also promoting capital investment. The recent experience provides striking evidence of the potential for the continuation and extension of monetary, fiscal, and structural policies to enhance our economy's performance in the period ahead.
1997-07-23T00:00:00	Ms. Rivlin reports on the positive performance of the US economy and the policies needed to sustain growth in the future (Central Bank Articles and Speeches, 23 Jul 97)	Testimony of the Vice Chairman of the Board of Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, before the Committee on Banking and Financial Services of the US House of Representatives on 23/7/97.	Ms. Rivlin reports on the positive perfomance of the US economy and the Testimony of the Vice Chairman of the Board of policies needed to sustain growth in the future Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, before the Committee on Banking and Financial Services of the US House of Representatives on 23/7/97. I would like to begin by expressing my appreciation to the Committee for holding this hearing to solicit a wide range of views on appropriate monetary policy at this extremely favorable moment in our economic history. All too often congressional hearings are called when something bad is happening. In a deteriorating situation, Congress finds it necessary to survey the damage, assess responsibility and call for better policies in the future. At the moment, however, the economy as a whole is functioning amazingly well. Employment is high and rising, unemployment is low, incomes are increasing, profits are high, the Federal budget deficit is plummeting, state and local finances are increasingly strong, and inflation is benign. The overriding economic objective -- shared by all participants in the economy -- is to keep the good news flowing. We all want the economy to grow at its highest sustainable rate, to keep unemployment and inflation low, and above all, to avoid recession as long as possible. Thoughtful people, at the Federal Reserve and elsewhere, have somewhat different views about why the economy is doing so well and how best to keep it going. Your invitation to share those views is timely, constructive and welcome. I would like briefly to discuss three questions: 1. Why is the economy performing so well -- and, in particular, why do we have so little inflation with such low unemployment? 2. Why is it so important, especially right now, to keep the economy growing at its highest sustainable rate and to avoid recession? 3. What policies -- monetary and other economic policies -- are most likely to keep economic performance high and sustained? Why is the economy doing so well? Most economists are frankly surprised that the economy has been able to grow fast enough to push unemployment rates below 5 percent without generating accelerating inflation. Until recently, most students of the economy thought that unemployment rates below 5.5 - 6.0 percent (estimates differed) for an appreciable period would lead to rising labor costs that would be passed on in higher prices and start a self-perpetuating wage-price spiral that would be hard to reverse. True, unemployment had been lower in the 1960s while inflation remained low, but the structure of the economy and the characteristics of the labor force subsequently changed in ways that seemed to make the economy more inflation-prone for given levels of unemployment. The experience of the period since about 1970 appeared to confirm that inflationary pressure emerged at unemployment rates appreciably higher than those of the 1960s. Five years ago, most economists would have thought the Federal Reserve irresponsible and derelict in its duty if it had not used monetary policy to slow an economy operating at such a high level that unemployment remained under 5.5 percent for more than a short time. The inflation might not appear immediately, but it was thought to be inevitable, and allowing it to get up a head of steam before acting was taking a high risk of having to react more strongly, perhaps strongly enough to bring on a recession. Nevertheless, the unemployment rate has been below 5.5 percent for over a year and below 5.0 percent in 1997 while inflation has shown no signs of picking up -- indeed, producer prices have actually been falling. The Federal Reserve, except for a quarter point tightening of the federal funds rate in March (after months of inaction), has left the monetary levers alone. Is the Federal Reserve ignoring risks of future inflation? The answer depends on whether the coexistence of higher growth and lower unemployment with benign inflation is explained by a fundamental improvement in the structure of the economy making it less inflation-prone, or by temporary factors that might return to "normal" and kick-off an inflationary wage-price spiral, or by some combination of the two. The honest answer is: We don't know yet. One surprise has been that such tight labor markets have not resulted in more rapid increases in wages and other labor compensation. Part of the explanation, as Chairman Greenspan noted in his testimony on July 22, may lie in less aggressive behavior on the part of workers. Workers may be more reluctant than previously to bargain for higher compensation or to take drastic action, such as striking or quitting to look for a better job. They may be reluctant because they are insecure in the face of rapidly changing technology, for which they fear they may not have the right skills, because they have recent memories of company "downsizing," or because they are less likely than in previous tight labor markets to be members of a union. These explanations of less aggressive worker behavior are plausible, but likely to be temporary. Workers are not likely to get more insecure as low unemployment continues, and union strength is unlikely to ebb further. Part of the explanation of moderate compensation increases may also lie in more aggressive employer resistance to labor cost increases than in previous cycles. Business owners and managers appear to believe strongly that they are operating in such a competitive environment -whether domestic or international -- that they cannot pass cost increases on to their customers in higher prices because they would lose those customers to competitors overseas or down the street. Low import prices resulting from growing international competition and the strong dollar reinforce this perception. Domestic markets have also become more fiercely competitive as the result of deregulation, lower transportation and communication costs, and more competitive business attitudes. These competitive forces, well known to workers, may give employers a plausible reason -- or at least an excuse -- for strong resistance to wage and benefit demands. The subdued inflation rate itself, moreover, has dampened inflationary expectations. These lower expectations contribute both to diminished compensation demands of workers and stiffer employer resistance to those demands. An important contribution to lower total compensation costs has also come from the slowdown in the rise of health benefit costs associated with the shift to managed care and the general reduction in the rate of health care inflation. It is not yet clear how much of this slowdown is temporary. The other surprise is that prices have shown no reaction to the moderate compensation increases that have occurred. Increased foreign and domestic competitiveness is certainly part of the answer, but the remarkable fact is that this competition has not generally eroded profit margins. Persistent high profits suggest that, on the average, employers have been able to increase productivity enough to absorb larger compensation increases without comparable price increases. Whether they will be able to continue to do so is the crucial unanswered question facing monetary policy makers at the moment. Measured productivity has grown slowly for more than two decades and did not accelerate in this expansion as economists hoped it would. Nevertheless, output per hour seems to have picked up a little recently, which is surprising late in an expansion when productivity increase normally slows. If productivity growth were on the verge of sustained acceleration, a possibility discussed in Chairman Greenspan's testimony, it would greatly increase the chances of higher sustained growth without accelerating inflation. There are reasons to be optimistic, but only time will tell if the optimists are right. Why is sustained growth so important now? It is always desirable to live in an economy that is growing at a healthy rate. The general standard of living rises and average people are normally better off. Not only do private resources grow, giving consumers more and better choices, but public resources also grow, making it easier to solve public problems and improve national and community infrastructure. Healthy growth has to be sustainable, not bought at the price of environmental degradation or inflationary overheating that turns a boom into a bust. Nevertheless, there are at least three reasons why it seems especially important for the United States in the next few years to do everything possible to keep the economy growing at a healthy sustainable rate and avoid recession. Welfare reform Recent legislation requires extremely ambitious state and Federal efforts to reduce dependency and channel large portions of the present and future welfare population into selfsupporting jobs. For these efforts to be even moderately successful will require effective skill training and job placement, adequate child care and, above all, low unemployment rates and plentiful entry level jobs. If economic expansion continues and labor markets remain tight, there is a good chance that many families who would otherwise have depended on welfare can acquire the job skills and experience that can enable them to live more independent and satisfying lives. If the economy slides into recession before welfare recipients have time to establish new skills, work patterns and eligibility for unemployment benefits, welfare reform is almost certain to be a failure, if not an outright disaster. Community development Partnerships for community development are beginning to create new hope for some devastated areas of big cities, smaller towns and rural areas. Partners include business and community groups, financial institutions and governments. With continued economic growth and low unemployment, these efforts could transform many blighted areas into viable communities with decent housing and an economic base. Recession, especially a deep one, would dry up public and private resources and greatly reduce the chances of successful community development. Preparing for more older people Perhaps the biggest challenge to the U.S. economy (indeed to all industrial economies) over the next couple of decades is the prospective rise in the ratio of elderly to working age people. Barring a huge increase in working age immigrants or dramatic increases in the length of working life, the number of retirees will rise much faster than the working population beginning early in the next century. No matter what combination of public and private pensions are used to sort out the claims of retirees to a share of the nation's output, the only way to guarantee a rising standard of living for both retirees and workers is to greatly increase the future productivity of that workforce. A high growth economy over the next decade could generate enough saving and investment to make that increased future workforce productivity feasible. Slower growth and repeated recessions could make the burden of an aging population far heavier and policy choices more contentious. What policies are needed? These three challenges to the American economy simply reinforce the need to keep the economy on the highest sustainable growth track attainable and to keep recessions as shallow and infrequent as possible. The biggest problem for monetary policy at the moment is that no one knows what growth rate is sustainable. It may be true that the structure of the economy has changed in ways that make a higher growth rate sustainable without inflation than we thought possible a few years ago -- or it may not be true. The question turns on whether productivity growth has shifted up out of the doldrums of the last couple of decades. It's possible that it has, but by no means certain. This leaves monetary policymakers with the difficult job of watching all the signs, weighing the risks and making a new judgment call every few weeks. At the moment, there seems to be little risk of the economy slowing down too much in the near term and sliding into recession. Growth has already slowed from its clearly unsustainable pace in the first quarter, but all the current signs point to continued economic expansion for the rest of this year and into the next. The risks seem higher on the other side -- that many of the factors holding down inflationary pressures will prove temporary, that the rebound of productivity necessary for higher sustainable growth will not occur or not prove robust and durable. The Federal Open Market Committee has to weigh the risk of slowing the economy unnecessarily against the risk of waiting too long and having to put the brakes on harder later. Waiting longer may increase the possibility of overheating followed by recession. It's a tough call. I can't promise we will make the right decisions, but I can promise we will try. It is important not to overestimate the role of monetary policy and the Federal Reserve. Monetary policy can help keep the economy from falling off the sustainable growth track in either direction -- either by overheating and generating enough inflation to unbalance the economy and threaten growth or by chugging along too slowly with excessive unemployment. But monetary policy cannot do much to determine how high the sustainable growth rate is. How fast the economy can grow is determined by how rapidly the employed labor force is increasing and how fast the productivity of that workforce is growing. There are only two ways to get more output: either more people work or working people produce more (or both). In the 1960s and 1970s, the American workforce was growing rapidly as the large baby boom generation reached working age and women, especially mothers, moved into the workforce in much larger proportions than previously. But those two trends have run their course. The labor force is likely to grow slowly over the next few years, about 1 percent per year. The main hope for increasing labor force growth, besides encouraging more immigration, is that continued tight labor markets plus increased flexibility in employment hours will gradually begin to reverse the trends to early retirement that has reduced labor force participation among older people. Continued employment opportunities combined with well-designed training programs, especially in computer related skills, could also attract into the labor force people who are not actively looking for work because they don't think they have the skills to get a "good" job -- principally older workers and young people who have dropped out of school. Indeed, the shortage of workers with modern technical skills may be the biggest problem facing the American economy at the moment, as well as its biggest opportunity. As long as labor markets stay tight, investment in skill training is likely to pay off handsomely both for individuals and for companies that can retain the trained workers long enough to benefit from their increased productivity. Public investment in training for workers with low skills -- often unsuccessful when jobs are scarce -- also stands a far better chance in tight labor markets of moving workers into jobs in which they can gain increasing skills, experience and higher wages. Continued low unemployment rates, plus public and private investment in skill training are essential, not only for successful welfare reform, but also for modernizing the skills of the portion of the workforce whose real incomes and opportunities have declined both relatively and absolutely in the last couple of decades. The other key to productivity increase, of course, is continued investment, both public and private, in research and development and the technology and infrastructure needed for continuous modernization of the economy. Stable low inflation tends to foster long-term planning and investment by businesses and households. A high growth economy should generate more of the saving needed to finance the investment. Reducing the public dissaving inherent in running a deficit in the Federal budget also adds to national saving. Near term reform of social security and Medicare in ways that add to national saving, public and private, could make a significant contribution to future productivity increase and hence to raising the future rate of sustainable economic growth. In summary, the objective of economic policy -- monetary policy included -- is to keep the economy on the highest sustainable growth path. No one knows exactly what that rate is right now, or what it can be in the future, but a combination of policies, intelligently pursued, can raise it as far as possible. These policies include: wise monetary policy that helps the economy expand, and keeps labor markets tight, without incurring excessive risk of accelerating inflation; investment in skills by individuals, firms and the public and non-profit sectors; increased saving (public and private) invested in research, technology and infrastructure. The Federal Reserve will do its part, in the face of huge uncertainties, to steer an appropriate monetary policy. Fiscal and other policies, both public and private, are needed to take full advantage of the opportunity we have today to keep the American economy operating at a high level in the future.	---[PAGE_BREAK]--- # Ms. Rivlin reports on the positive perfomance of the US economy and the policies needed to sustain growth in the future Testimony of the Vice Chairman of the Board of Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, before the Committee on Banking and Financial Services of the US House of Representatives on 23/7/97. I would like to begin by expressing my appreciation to the Committee for holding this hearing to solicit a wide range of views on appropriate monetary policy at this extremely favorable moment in our economic history. All too often congressional hearings are called when something bad is happening. In a deteriorating situation, Congress finds it necessary to survey the damage, assess responsibility and call for better policies in the future. At the moment, however, the economy as a whole is functioning amazingly well. Employment is high and rising, unemployment is low, incomes are increasing, profits are high, the Federal budget deficit is plummeting, state and local finances are increasingly strong, and inflation is benign. The overriding economic objective -- shared by all participants in the economy -- is to keep the good news flowing. We all want the economy to grow at its highest sustainable rate, to keep unemployment and inflation low, and above all, to avoid recession as long as possible. Thoughtful people, at the Federal Reserve and elsewhere, have somewhat different views about why the economy is doing so well and how best to keep it going. Your invitation to share those views is timely, constructive and welcome. I would like briefly to discuss three questions: 1. Why is the economy performing so well -- and, in particular, why do we have so little inflation with such low unemployment? 2. Why is it so important, especially right now, to keep the economy growing at its highest sustainable rate and to avoid recession? 3. What policies -- monetary and other economic policies -- are most likely to keep economic performance high and sustained? ## Why is the economy doing so well? Most economists are frankly surprised that the economy has been able to grow fast enough to push unemployment rates below 5 percent without generating accelerating inflation. Until recently, most students of the economy thought that unemployment rates below 5.5 - 6.0 percent (estimates differed) for an appreciable period would lead to rising labor costs that would be passed on in higher prices and start a self-perpetuating wage-price spiral that would be hard to reverse. True, unemployment had been lower in the 1960s while inflation remained low, but the structure of the economy and the characteristics of the labor force subsequently changed in ways that seemed to make the economy more inflation-prone for given levels of unemployment. The experience of the period since about 1970 appeared to confirm that inflationary pressure emerged at unemployment rates appreciably higher than those of the 1960s. Five years ago, most economists would have thought the Federal Reserve irresponsible and derelict in its duty if it had not used monetary policy to slow an economy operating at such a high level that unemployment remained under 5.5 percent for more than a short time. The inflation might not appear immediately, but it was thought to be inevitable, and allowing it to get up a head of steam before acting was taking a high risk of having to react more strongly, perhaps strongly enough to bring on a recession. Nevertheless, the unemployment rate has been below 5.5 percent for over a year and below 5.0 percent in 1997 while inflation has shown no signs of picking up -- indeed, producer prices ---[PAGE_BREAK]--- have actually been falling. The Federal Reserve, except for a quarter point tightening of the federal funds rate in March (after months of inaction), has left the monetary levers alone. Is the Federal Reserve ignoring risks of future inflation? The answer depends on whether the coexistence of higher growth and lower unemployment with benign inflation is explained by a fundamental improvement in the structure of the economy making it less inflation-prone, or by temporary factors that might return to "normal" and kick-off an inflationary wage-price spiral, or by some combination of the two. The honest answer is: We don't know yet. One surprise has been that such tight labor markets have not resulted in more rapid increases in wages and other labor compensation. Part of the explanation, as Chairman Greenspan noted in his testimony on July 22, may lie in less aggressive behavior on the part of workers. Workers may be more reluctant than previously to bargain for higher compensation or to take drastic action, such as striking or quitting to look for a better job. They may be reluctant because they are insecure in the face of rapidly changing technology, for which they fear they may not have the right skills, because they have recent memories of company "downsizing," or because they are less likely than in previous tight labor markets to be members of a union. These explanations of less aggressive worker behavior are plausible, but likely to be temporary. Workers are not likely to get more insecure as low unemployment continues, and union strength is unlikely to ebb further. Part of the explanation of moderate compensation increases may also lie in more aggressive employer resistance to labor cost increases than in previous cycles. Business owners and managers appear to believe strongly that they are operating in such a competitive environment -whether domestic or international -- that they cannot pass cost increases on to their customers in higher prices because they would lose those customers to competitors overseas or down the street. Low import prices resulting from growing international competition and the strong dollar reinforce this perception. Domestic markets have also become more fiercely competitive as the result of deregulation, lower transportation and communication costs, and more competitive business attitudes. These competitive forces, well known to workers, may give employers a plausible reason -- or at least an excuse -- for strong resistance to wage and benefit demands. The subdued inflation rate itself, moreover, has dampened inflationary expectations. These lower expectations contribute both to diminished compensation demands of workers and stiffer employer resistance to those demands. An important contribution to lower total compensation costs has also come from the slowdown in the rise of health benefit costs associated with the shift to managed care and the general reduction in the rate of health care inflation. It is not yet clear how much of this slowdown is temporary. The other surprise is that prices have shown no reaction to the moderate compensation increases that have occurred. Increased foreign and domestic competitiveness is certainly part of the answer, but the remarkable fact is that this competition has not generally eroded profit margins. Persistent high profits suggest that, on the average, employers have been able to increase productivity enough to absorb larger compensation increases without comparable price increases. Whether they will be able to continue to do so is the crucial unanswered question facing monetary policy makers at the moment. Measured productivity has grown slowly for more than two decades and did not accelerate in this expansion as economists hoped it would. Nevertheless, output per hour seems to have picked up a little recently, which is surprising late in an expansion when productivity increase normally slows. If productivity growth were on the verge of sustained acceleration, a possibility discussed in Chairman Greenspan's testimony, it would greatly increase the chances of higher sustained growth without accelerating inflation. There are reasons to be optimistic, but only time will tell if the optimists are right. ---[PAGE_BREAK]--- # Why is sustained growth so important now? It is always desirable to live in an economy that is growing at a healthy rate. The general standard of living rises and average people are normally better off. Not only do private resources grow, giving consumers more and better choices, but public resources also grow, making it easier to solve public problems and improve national and community infrastructure. Healthy growth has to be sustainable, not bought at the price of environmental degradation or inflationary overheating that turns a boom into a bust. Nevertheless, there are at least three reasons why it seems especially important for the United States in the next few years to do everything possible to keep the economy growing at a healthy sustainable rate and avoid recession. ## Welfare reform Recent legislation requires extremely ambitious state and Federal efforts to reduce dependency and channel large portions of the present and future welfare population into selfsupporting jobs. For these efforts to be even moderately successful will require effective skill training and job placement, adequate child care and, above all, low unemployment rates and plentiful entry level jobs. If economic expansion continues and labor markets remain tight, there is a good chance that many families who would otherwise have depended on welfare can acquire the job skills and experience that can enable them to live more independent and satisfying lives. If the economy slides into recession before welfare recipients have time to establish new skills, work patterns and eligibility for unemployment benefits, welfare reform is almost certain to be a failure, if not an outright disaster. ## Community development Partnerships for community development are beginning to create new hope for some devastated areas of big cities, smaller towns and rural areas. Partners include business and community groups, financial institutions and governments. With continued economic growth and low unemployment, these efforts could transform many blighted areas into viable communities with decent housing and an economic base. Recession, especially a deep one, would dry up public and private resources and greatly reduce the chances of successful community development. ## Preparing for more older people Perhaps the biggest challenge to the U.S. economy (indeed to all industrial economies) over the next couple of decades is the prospective rise in the ratio of elderly to working age people. Barring a huge increase in working age immigrants or dramatic increases in the length of working life, the number of retirees will rise much faster than the working population beginning early in the next century. No matter what combination of public and private pensions are used to sort out the claims of retirees to a share of the nation's output, the only way to guarantee a rising standard of living for both retirees and workers is to greatly increase the future productivity of that workforce. A high growth economy over the next decade could generate enough saving and investment to make that increased future workforce productivity feasible. Slower growth and repeated recessions could make the burden of an aging population far heavier and policy choices more contentious. ## What policies are needed? These three challenges to the American economy simply reinforce the need to keep the economy on the highest sustainable growth track attainable and to keep recessions as shallow and infrequent as possible. The biggest problem for monetary policy at the moment is that no one knows what growth rate is sustainable. It may be true that the structure of the economy has changed in ways ---[PAGE_BREAK]--- that make a higher growth rate sustainable without inflation than we thought possible a few years ago -- or it may not be true. The question turns on whether productivity growth has shifted up out of the doldrums of the last couple of decades. It's possible that it has, but by no means certain. This leaves monetary policymakers with the difficult job of watching all the signs, weighing the risks and making a new judgment call every few weeks. At the moment, there seems to be little risk of the economy slowing down too much in the near term and sliding into recession. Growth has already slowed from its clearly unsustainable pace in the first quarter, but all the current signs point to continued economic expansion for the rest of this year and into the next. The risks seem higher on the other side -- that many of the factors holding down inflationary pressures will prove temporary, that the rebound of productivity necessary for higher sustainable growth will not occur or not prove robust and durable. The Federal Open Market Committee has to weigh the risk of slowing the economy unnecessarily against the risk of waiting too long and having to put the brakes on harder later. Waiting longer may increase the possibility of overheating followed by recession. It's a tough call. I can't promise we will make the right decisions, but I can promise we will try. It is important not to overestimate the role of monetary policy and the Federal Reserve. Monetary policy can help keep the economy from falling off the sustainable growth track in either direction -- either by overheating and generating enough inflation to unbalance the economy and threaten growth or by chugging along too slowly with excessive unemployment. But monetary policy cannot do much to determine how high the sustainable growth rate is. How fast the economy can grow is determined by how rapidly the employed labor force is increasing and how fast the productivity of that workforce is growing. There are only two ways to get more output: either more people work or working people produce more (or both). In the 1960s and 1970s, the American workforce was growing rapidly as the large baby boom generation reached working age and women, especially mothers, moved into the workforce in much larger proportions than previously. But those two trends have run their course. The labor force is likely to grow slowly over the next few years, about 1 percent per year. The main hope for increasing labor force growth, besides encouraging more immigration, is that continued tight labor markets plus increased flexibility in employment hours will gradually begin to reverse the trends to early retirement that has reduced labor force participation among older people. Continued employment opportunities combined with well-designed training programs, especially in computer related skills, could also attract into the labor force people who are not actively looking for work because they don't think they have the skills to get a "good" job -- principally older workers and young people who have dropped out of school. Indeed, the shortage of workers with modern technical skills may be the biggest problem facing the American economy at the moment, as well as its biggest opportunity. As long as labor markets stay tight, investment in skill training is likely to pay off handsomely both for individuals and for companies that can retain the trained workers long enough to benefit from their increased productivity. Public investment in training for workers with low skills -- often unsuccessful when jobs are scarce -- also stands a far better chance in tight labor markets of moving workers into jobs in which they can gain increasing skills, experience and higher wages. Continued low unemployment rates, plus public and private investment in skill training are essential, not only for successful welfare reform, but also for modernizing the skills of the portion of the workforce whose real incomes and opportunities have declined both relatively and absolutely in the last couple of decades. The other key to productivity increase, of course, is continued investment, both public and private, in research and development and the technology and infrastructure needed for continuous modernization of the economy. Stable low inflation tends to foster long-term planning and investment by businesses and households. A high growth economy should generate more of the saving needed to ---[PAGE_BREAK]--- finance the investment. Reducing the public dissaving inherent in running a deficit in the Federal budget also adds to national saving. Near term reform of social security and Medicare in ways that add to national saving, public and private, could make a significant contribution to future productivity increase and hence to raising the future rate of sustainable economic growth. In summary, the objective of economic policy -- monetary policy included -- is to keep the economy on the highest sustainable growth path. No one knows exactly what that rate is right now, or what it can be in the future, but a combination of policies, intelligently pursued, can raise it as far as possible. These policies include: wise monetary policy that helps the economy expand, and keeps labor markets tight, without incurring excessive risk of accelerating inflation; investment in skills by individuals, firms and the public and non-profit sectors; increased saving (public and private) invested in research, technology and infrastructure. The Federal Reserve will do its part, in the face of huge uncertainties, to steer an appropriate monetary policy. Fiscal and other policies, both public and private, are needed to take full advantage of the opportunity we have today to keep the American economy operating at a high level in the future.	Alice M Rivlin	United States	https://www.bis.org/review/r970806a.pdf	policies needed to sustain growth in the future Testimony of the Vice Chairman of the Board of Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, before the Committee on Banking and Financial Services of the US House of Representatives on 23/7/97. I would like to begin by expressing my appreciation to the Committee for holding this hearing to solicit a wide range of views on appropriate monetary policy at this extremely favorable moment in our economic history. All too often congressional hearings are called when something bad is happening. In a deteriorating situation, Congress finds it necessary to survey the damage, assess responsibility and call for better policies in the future. At the moment, however, the economy as a whole is functioning amazingly well. Employment is high and rising, unemployment is low, incomes are increasing, profits are high, the Federal budget deficit is plummeting, state and local finances are increasingly strong, and inflation is benign. The overriding economic objective -- shared by all participants in the economy -- is to keep the good news flowing. We all want the economy to grow at its highest sustainable rate, to keep unemployment and inflation low, and above all, to avoid recession as long as possible. Thoughtful people, at the Federal Reserve and elsewhere, have somewhat different views about why the economy is doing so well and how best to keep it going. Your invitation to share those views is timely, constructive and welcome. I would like briefly to discuss three questions: Most economists are frankly surprised that the economy has been able to grow fast enough to push unemployment rates below 5 percent without generating accelerating inflation. Until recently, most students of the economy thought that unemployment rates below 5.5 - 6.0 percent (estimates differed) for an appreciable period would lead to rising labor costs that would be passed on in higher prices and start a self-perpetuating wage-price spiral that would be hard to reverse. True, unemployment had been lower in the 1960s while inflation remained low, but the structure of the economy and the characteristics of the labor force subsequently changed in ways that seemed to make the economy more inflation-prone for given levels of unemployment. The experience of the period since about 1970 appeared to confirm that inflationary pressure emerged at unemployment rates appreciably higher than those of the 1960s. Five years ago, most economists would have thought the Federal Reserve irresponsible and derelict in its duty if it had not used monetary policy to slow an economy operating at such a high level that unemployment remained under 5.5 percent for more than a short time. The inflation might not appear immediately, but it was thought to be inevitable, and allowing it to get up a head of steam before acting was taking a high risk of having to react more strongly, perhaps strongly enough to bring on a recession. Nevertheless, the unemployment rate has been below 5.5 percent for over a year and below 5.0 percent in 1997 while inflation has shown no signs of picking up -- indeed, producer prices have actually been falling. The Federal Reserve, except for a quarter point tightening of the federal funds rate in March (after months of inaction), has left the monetary levers alone. Is the Federal Reserve ignoring risks of future inflation? The answer depends on whether the coexistence of higher growth and lower unemployment with benign inflation is explained by a fundamental improvement in the structure of the economy making it less inflation-prone, or by temporary factors that might return to "normal" and kick-off an inflationary wage-price spiral, or by some combination of the two. The honest answer is: We don't know yet. One surprise has been that such tight labor markets have not resulted in more rapid increases in wages and other labor compensation. Part of the explanation, as Chairman Greenspan noted in his testimony on July 22, may lie in less aggressive behavior on the part of workers. Workers may be more reluctant than previously to bargain for higher compensation or to take drastic action, such as striking or quitting to look for a better job. They may be reluctant because they are insecure in the face of rapidly changing technology, for which they fear they may not have the right skills, because they have recent memories of company "downsizing," or because they are less likely than in previous tight labor markets to be members of a union. These explanations of less aggressive worker behavior are plausible, but likely to be temporary. Workers are not likely to get more insecure as low unemployment continues, and union strength is unlikely to ebb further. Part of the explanation of moderate compensation increases may also lie in more aggressive employer resistance to labor cost increases than in previous cycles. Business owners and managers appear to believe strongly that they are operating in such a competitive environment -whether domestic or international -- that they cannot pass cost increases on to their customers in higher prices because they would lose those customers to competitors overseas or down the street. Low import prices resulting from growing international competition and the strong dollar reinforce this perception. Domestic markets have also become more fiercely competitive as the result of deregulation, lower transportation and communication costs, and more competitive business attitudes. These competitive forces, well known to workers, may give employers a plausible reason -- or at least an excuse -- for strong resistance to wage and benefit demands. The subdued inflation rate itself, moreover, has dampened inflationary expectations. These lower expectations contribute both to diminished compensation demands of workers and stiffer employer resistance to those demands. An important contribution to lower total compensation costs has also come from the slowdown in the rise of health benefit costs associated with the shift to managed care and the general reduction in the rate of health care inflation. It is not yet clear how much of this slowdown is temporary. The other surprise is that prices have shown no reaction to the moderate compensation increases that have occurred. Increased foreign and domestic competitiveness is certainly part of the answer, but the remarkable fact is that this competition has not generally eroded profit margins. Persistent high profits suggest that, on the average, employers have been able to increase productivity enough to absorb larger compensation increases without comparable price increases. Whether they will be able to continue to do so is the crucial unanswered question facing monetary policy makers at the moment. Measured productivity has grown slowly for more than two decades and did not accelerate in this expansion as economists hoped it would. Nevertheless, output per hour seems to have picked up a little recently, which is surprising late in an expansion when productivity increase normally slows. If productivity growth were on the verge of sustained acceleration, a possibility discussed in Chairman Greenspan's testimony, it would greatly increase the chances of higher sustained growth without accelerating inflation. There are reasons to be optimistic, but only time will tell if the optimists are right. It is always desirable to live in an economy that is growing at a healthy rate. The general standard of living rises and average people are normally better off. Not only do private resources grow, giving consumers more and better choices, but public resources also grow, making it easier to solve public problems and improve national and community infrastructure. Healthy growth has to be sustainable, not bought at the price of environmental degradation or inflationary overheating that turns a boom into a bust. Nevertheless, there are at least three reasons why it seems especially important for the United States in the next few years to do everything possible to keep the economy growing at a healthy sustainable rate and avoid recession. Recent legislation requires extremely ambitious state and Federal efforts to reduce dependency and channel large portions of the present and future welfare population into selfsupporting jobs. For these efforts to be even moderately successful will require effective skill training and job placement, adequate child care and, above all, low unemployment rates and plentiful entry level jobs. If economic expansion continues and labor markets remain tight, there is a good chance that many families who would otherwise have depended on welfare can acquire the job skills and experience that can enable them to live more independent and satisfying lives. If the economy slides into recession before welfare recipients have time to establish new skills, work patterns and eligibility for unemployment benefits, welfare reform is almost certain to be a failure, if not an outright disaster. Partnerships for community development are beginning to create new hope for some devastated areas of big cities, smaller towns and rural areas. Partners include business and community groups, financial institutions and governments. With continued economic growth and low unemployment, these efforts could transform many blighted areas into viable communities with decent housing and an economic base. Recession, especially a deep one, would dry up public and private resources and greatly reduce the chances of successful community development. Perhaps the biggest challenge to the U.S. economy (indeed to all industrial economies) over the next couple of decades is the prospective rise in the ratio of elderly to working age people. Barring a huge increase in working age immigrants or dramatic increases in the length of working life, the number of retirees will rise much faster than the working population beginning early in the next century. No matter what combination of public and private pensions are used to sort out the claims of retirees to a share of the nation's output, the only way to guarantee a rising standard of living for both retirees and workers is to greatly increase the future productivity of that workforce. A high growth economy over the next decade could generate enough saving and investment to make that increased future workforce productivity feasible. Slower growth and repeated recessions could make the burden of an aging population far heavier and policy choices more contentious. These three challenges to the American economy simply reinforce the need to keep the economy on the highest sustainable growth track attainable and to keep recessions as shallow and infrequent as possible. The biggest problem for monetary policy at the moment is that no one knows what growth rate is sustainable. It may be true that the structure of the economy has changed in ways that make a higher growth rate sustainable without inflation than we thought possible a few years ago -- or it may not be true. The question turns on whether productivity growth has shifted up out of the doldrums of the last couple of decades. It's possible that it has, but by no means certain. This leaves monetary policymakers with the difficult job of watching all the signs, weighing the risks and making a new judgment call every few weeks. At the moment, there seems to be little risk of the economy slowing down too much in the near term and sliding into recession. Growth has already slowed from its clearly unsustainable pace in the first quarter, but all the current signs point to continued economic expansion for the rest of this year and into the next. The risks seem higher on the other side -- that many of the factors holding down inflationary pressures will prove temporary, that the rebound of productivity necessary for higher sustainable growth will not occur or not prove robust and durable. The Federal Open Market Committee has to weigh the risk of slowing the economy unnecessarily against the risk of waiting too long and having to put the brakes on harder later. Waiting longer may increase the possibility of overheating followed by recession. It's a tough call. I can't promise we will make the right decisions, but I can promise we will try. It is important not to overestimate the role of monetary policy and the Federal Reserve. Monetary policy can help keep the economy from falling off the sustainable growth track in either direction -- either by overheating and generating enough inflation to unbalance the economy and threaten growth or by chugging along too slowly with excessive unemployment. But monetary policy cannot do much to determine how high the sustainable growth rate is. How fast the economy can grow is determined by how rapidly the employed labor force is increasing and how fast the productivity of that workforce is growing. There are only two ways to get more output: either more people work or working people produce more (or both). In the 1960s and 1970s, the American workforce was growing rapidly as the large baby boom generation reached working age and women, especially mothers, moved into the workforce in much larger proportions than previously. But those two trends have run their course. The labor force is likely to grow slowly over the next few years, about 1 percent per year. The main hope for increasing labor force growth, besides encouraging more immigration, is that continued tight labor markets plus increased flexibility in employment hours will gradually begin to reverse the trends to early retirement that has reduced labor force participation among older people. Continued employment opportunities combined with well-designed training programs, especially in computer related skills, could also attract into the labor force people who are not actively looking for work because they don't think they have the skills to get a "good" job -- principally older workers and young people who have dropped out of school. Indeed, the shortage of workers with modern technical skills may be the biggest problem facing the American economy at the moment, as well as its biggest opportunity. As long as labor markets stay tight, investment in skill training is likely to pay off handsomely both for individuals and for companies that can retain the trained workers long enough to benefit from their increased productivity. Public investment in training for workers with low skills -- often unsuccessful when jobs are scarce -- also stands a far better chance in tight labor markets of moving workers into jobs in which they can gain increasing skills, experience and higher wages. Continued low unemployment rates, plus public and private investment in skill training are essential, not only for successful welfare reform, but also for modernizing the skills of the portion of the workforce whose real incomes and opportunities have declined both relatively and absolutely in the last couple of decades. The other key to productivity increase, of course, is continued investment, both public and private, in research and development and the technology and infrastructure needed for continuous modernization of the economy. Stable low inflation tends to foster long-term planning and investment by businesses and households. A high growth economy should generate more of the saving needed to finance the investment. Reducing the public dissaving inherent in running a deficit in the Federal budget also adds to national saving. Near term reform of social security and Medicare in ways that add to national saving, public and private, could make a significant contribution to future productivity increase and hence to raising the future rate of sustainable economic growth. In summary, the objective of economic policy -- monetary policy included -- is to keep the economy on the highest sustainable growth path. No one knows exactly what that rate is right now, or what it can be in the future, but a combination of policies, intelligently pursued, can raise it as far as possible. These policies include: wise monetary policy that helps the economy expand, and keeps labor markets tight, without incurring excessive risk of accelerating inflation; investment in skills by individuals, firms and the public and non-profit sectors; increased saving (public and private) invested in research, technology and infrastructure. The Federal Reserve will do its part, in the face of huge uncertainties, to steer an appropriate monetary policy. Fiscal and other policies, both public and private, are needed to take full advantage of the opportunity we have today to keep the American economy operating at a high level in the future.
1997-07-29T00:00:00	Ms. Rivlin discusses the Federal Reserve's planning process and the efforts being made to improve performance (Central Bank Articles and Speeches, 29 Jul 97)	Testimony of the Vice Chairman of the Board of Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, before the Committee on Banking and Financial Services of the US House of Representatives on 29/7/97.	Ms. Rivlin discusses the Federal Reserve's planning process and the efforts being made to improve performance Testimony of the Vice Chairman of the Board of Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, before the Committee on Banking and Financial Services of the US House of Representatives on 29/7/97. Mr. Chairman and members of the Committee, I am pleased to be here today to discuss the Federal Reserve's planning process and the efforts we are making to measure and improve our performance in the spirit of the Government Performance and Results Act (GPRA). I am personally a long-term proponent of GPRA and worked hard on its implementation when I was at the Office of Management and Budget. While the Federal Reserve does not receive appropriated funds and is not, strictly speaking, covered by the Act, we are eager to participate in the processes and activities set forth in the Act. GPRA fits well with the new efforts the Federal Reserve has undertaken to plan further ahead, use our resources more effectively and to coordinate activities across the whole system more explicitly. The testimony is a brief progress report on those efforts. Planning at the Fed In its briefest form, the Federal Reserve's mission is to "foster the stability, integrity and efficiency of the nation's financial and payment systems so as to promote optimal macroeconomic performance." This mission derives directly from the Federal Reserve Act of 1913, which established the Federal Reserve as the nation's central bank, and has three main elements: To formulate and conduct monetary policy toward the achievement of maximum sustainable long-term growth; price stability fosters that goal. To promote a safe, sound, competitive, and accessible banking system and stable financial markets through supervision and regulation of the nation's banking and financial systems; through its function as the lender of last resort; and through effective implementation of statutes designed to inform and protect the consumer. To foster the integrity, efficiency, and accessibility of US dollar payments and settlement systems, issue a uniform currency, and act as the fiscal agent and depository of the US government. The activities involved in carrying out this broad mission are extremely diverse, ranging from setting short-term interest rates to processing checks and cash, to examining depository institutions. Allocation of the resources the Federal Reserve uses to do its job depends heavily on the state of the economy (both national and international), how well or badly the financial services system is functioning, and what additional tasks (such as implementation of the Community Reinvestment Act and expansion of our oversight of foreign banks operating in the US pursuant to the Foreign Bank Supervision Enhancement Act of 1991) the Congress assigns to us. To carry out this multi-faceted mission, the Congress established a highly decentralized Federal Reserve System with a complex governance structure. Leadership and direction are vested in the Board of Governors, but only about 1,700 staff (out of about 24,900) work for the Board in Washington. The regional Reserve Banks carry out the bulk of operations and have substantial autonomy. As a result, planning and resource allocation at the Federal Reserve have historically been quite decentralized, and major changes have required painstaking consensus building across the Board/Bank structure. The regional structure of the Federal Reserve is one of its great strengths. The twelve regional Federal Banks work closely with the banks in their region and are closely tied into their regional economies. The development of Federal Reserve policy is greatly enriched by the in-depth knowledge that the regional banks have of the industrial, agricultural and financial forces shaping different parts of the economy. The challenge confronting strategic planning at the Federal Reserve is to find a balance between decentralized regional planning, which preserves the strengths of the regional structure, and the need for a more comprehensive national plan aimed at increasing efficiency by rationalizing the allocation of resources across regions and functions. In recent years, major changes have occurred in the allocation of Federal Reserve resources in response to unfolding events. When serious problems developed in the banking industry in the 1980s and in response to increased supervisory responsibility for foreign banking entities, more Federal Reserve resources were channeled into supervision and regulation. Rapidly changing technology, especially telecommunications and automation, has revolutionized Federal Reserve operations and required considerable investment in hardware, software and expertise. Consolidation of the banking industry, evolution of payment systems patterns and technology, growth in derivatives, globalization of financial services, concerns about equal credit opportunity and fair housing issues, efforts to reduce systemic risk in the payments area, and changes in monetary aggregates, have all caused planning and resource adjustments. Rapid technological change has also created opportunities for system-wide efficiencies resulting from consolidation of activities in one or more Reserve Banks. A number of the twelve regional banks have developed specialized activities serving other regions. For example, Federal Reserve Automation Services (FRAS) is headquartered in Richmond, but provides mainframe data processing and data communications services to all parts of the system. This consolidation and specialization has enabled the Reserve Banks to centralize operations of many of their mission critical applications, such as Fedwire, Automated Clearing House (ACH), and accounting. Continued technological advance, as well as further consolidation in the financial services industry, is likely to lead to further specialization among regional Federal Reserve Banks. New Strategic Planning Activities In the face of accelerating change, the Federal Reserve recently recognized the need for a more comprehensive planning framework. In 1995, a System Strategic Planning Coordinating Group was appointed, consisting of Board members, Reserve Bank Presidents and senior managers, representing the full range of the Federal Reserve's activities. This group produced an "umbrella" framework, designed to enable the Board, the Reserve Banks and product and support offices to produce their own more detailed plans and decision documents under the "umbrella." This framework, which is the basis for the document submitted to the House and Senate Banking Committees, sets forth the mission of the Federal Reserve referred to above. It also discusses the "values" of the Federal Reserve, the goals and objectives of the Fed, key assumptions, as well as the external and internal factors that could affect the achievement of those goals and objectives. With the overall framework as a reference point, strategic planning activities are proceeding with new energy at the Reserve Banks, at the Board, and with respect to cross-cutting major functions such as the payments system and bank supervision and regulation. Individual Reserve Banks have reviewed their operations from the ground up and reassessed their structure and effectiveness in carrying out their missions. Some of the Banks have launched fundamental re-engineering efforts that are resulting in substantial changes in management structure and operations. The Federal Reserve Bank of Chicago calls its effort "Fresh Look"; the Federal Reserve Bank of Cleveland is engaged in "Transformation: 2000." Board planning and budgeting At the Board, we have restructured the annual planning and budget process to put more emphasis on planning (and less on detailed line-item budgeting), to lengthen the planning and budgeting horizon, and to involve the Board itself more heavily in setting priorities. To this end, we have established a Budget Committee of the Board (consisting of myself and Governors Phillips and Kelley) assisted by a staff planning group drawn from across the major functions of the Board. We are working with a four-year planning horizon and intend to produce the Board's first biennial budget (1998/1999) to go into effect on January 1, 1998. Our hope is that the new process and structure will give the Board a better understanding of the options it faces with respect to alternative ways of carrying out the Federal Reserve's mission, and a clearer basis for deciding on priorities. Payments System study A major study of the Federal Reserve's role in the Payments System, currently underway, is another example of strategic planning with respect to a major portion of the Federal Reserve's activities, under the general umbrella of the strategic planning framework. Since payments technology and the structure of the financial services industry are changing rapidly, it seemed important to focus both on how the payment system was evolving (and should evolve) and what role the Federal Reserve should play in that evolution. The United States is amazingly dependent on paper checks -- Americans wrote 64 billion checks in 1996 -while most of the industrial world is shifting rapidly to more efficient electronic based payments. The study, directed by a committee of two Governors and two Federal Reserve Bank Presidents, has drawn on analytic resources across the Federal Reserve System and outside. We began by examining the consequences of substantially altering the role of the Federal Reserve in the retail payments system (checks and wire transfer system know as ACH). We analyzed the impact of scenarios ranging from withdrawal of the Federal Reserve from the check and ACH markets to more aggressive leadership by the Federal Reserve in making the payment system more efficient and less dependent on paper. To get maximum input from the participants in the payment system -- banks, clearinghouses, vendors, consumers and others -- in helping us assess alternatives for the future, we held a series of "forums" around the country in May and June. We had enthusiastic and extremely helpful participation from a wide range of institutions. We learned a lot from the process and are now reassessing the alternatives, conducting additional analyses and preparing to present preliminary options to the Board. I look forward to sharing the study with this Committee. The payments area is a good example of the dilemma posed for planners by rapid technological change. While rapidly evolving technology makes focussing on future options imperative, it also makes it extremely important to remain flexible. Laying out a blueprint for the payments system of the next ten or even five years, and rigidly following it, would almost certainly be a mistake. The technology is moving so rapidly that investments made now may well be obsolete in a short time. Performance Measures A major theme of GPRA is the identification of specific measures of performance of projects and programs which can be used to evaluate their effectiveness. As in most organizations, performance measurement at the Federal Reserve is more advanced -- and more feasible -- in some types of activities than in others. In the payment services areas, the Reserve Banks have measured their performance through various financial measures for many years. For example, the Monetary Control Act of 1980 imposes market discipline on the Federal Reserve by requiring it fully to cover its costs of providing services to depository institutions, and compliance with this requirement is monitored closely. Frequently private competitors provide or could provide these services, and our ability to recover our costs, adjusted to include a factor for imputed profits, taxes and cost of capital, help determine whether it is beneficial for the economy that we stay in the business. In addition, the Federal Reserve has traditionally measured unit costs for its financial services and has developed various indices that allow a Reserve Bank to measure its cost performance over time and in comparison to other Reserve Banks. Private sector benchmarks are also being developed. The Federal Reserve also tracks quality measures for many Reserve Bank services. Finally, the Federal Reserve monitors the progress of the Reserve Banks against various strategic objectives. Similarly, in bank supervision, the Federal Reserve has long used a variety of measures of the effectiveness of its examination process, but the measurement challenge has taken on new importance as supervision becomes more automated and more focused on analyzing risk. To meet this challenge, the Federal Reserve is working closely with other regulators to standardize and improve examination techniques, and has established a Steering Committee to oversee implementation of a risk-focused examination program and to design a management information system that will permit the Board to evaluate better the efficient use of examination resources among the Reserve Banks. For instance, supervisory data are used to determine in advance of on-site examinations what factors (CAMELS rating, asset size, location, and loan types) are most predictive as to the resources needed for examinations, and which institutions, particular lending areas or other service lines may require more intensive review. Such programs are low-cost because they use information that we already collect, and are effective and cost-saving because they provide a systematic way to plan and prioritize our time and resources. In other areas, such as the research and statistical analysis on which monetary policy is based, performance measurement is -- and will remain -- far more problematic. The performance of the economy itself is not so hard to measure and right now is highly positive. But it is not clear how much of the economic progress can be attributed to monetary policy, and even less clear how particular monetary policy actions are related to the quality and quantity of research and analysis produced by the Fed's research staff. Conclusion GPRA provides the opportunity for a major improvement in the management and effectiveness of Federal agencies. It provides the impetus for agencies to clarify their missions and objectives, measure their performance better and improve their efficiency and effectiveness. It must, however, avoid the risk of becoming, like some previous efforts to improve government management, largely a paper exercise which produces many numbers and reports but few real results. The Federal Reserve welcomes the opportunity to participate in the GPRA process. We will work hard to fulfill the vision of the framers of the Act and avoid the pitfalls. We will have to respond in ways that are appropriate to the Federal Reserve's diverse missions and decentralized structure. I believe we have made significant progress toward the GPRA-type strategic planning and are on the track to making more in the immediate future.	---[PAGE_BREAK]--- # Ms. Rivlin discusses the Federal Reserve's planning process and the efforts being made to improve performance Testimony of the Vice Chairman of the Board of Governors of the US Federal Reserve System, Ms. Alice M. Rivlin, before the Committee on Banking and Financial Services of the US House of Representatives on 29/7/97. Mr. Chairman and members of the Committee, I am pleased to be here today to discuss the Federal Reserve's planning process and the efforts we are making to measure and improve our performance in the spirit of the Government Performance and Results Act (GPRA). I am personally a long-term proponent of GPRA and worked hard on its implementation when I was at the Office of Management and Budget. While the Federal Reserve does not receive appropriated funds and is not, strictly speaking, covered by the Act, we are eager to participate in the processes and activities set forth in the Act. GPRA fits well with the new efforts the Federal Reserve has undertaken to plan further ahead, use our resources more effectively and to coordinate activities across the whole system more explicitly. The testimony is a brief progress report on those efforts. ## Planning at the Fed In its briefest form, the Federal Reserve's mission is to "foster the stability, integrity and efficiency of the nation's financial and payment systems so as to promote optimal macroeconomic performance." This mission derives directly from the Federal Reserve Act of 1913, which established the Federal Reserve as the nation's central bank, and has three main elements: To formulate and conduct monetary policy toward the achievement of maximum sustainable long-term growth; price stability fosters that goal. To promote a safe, sound, competitive, and accessible banking system and stable financial markets through supervision and regulation of the nation's banking and financial systems; through its function as the lender of last resort; and through effective implementation of statutes designed to inform and protect the consumer. To foster the integrity, efficiency, and accessibility of US dollar payments and settlement systems, issue a uniform currency, and act as the fiscal agent and depository of the US government. The activities involved in carrying out this broad mission are extremely diverse, ranging from setting short-term interest rates to processing checks and cash, to examining depository institutions. Allocation of the resources the Federal Reserve uses to do its job depends heavily on the state of the economy (both national and international), how well or badly the financial services system is functioning, and what additional tasks (such as implementation of the Community Reinvestment Act and expansion of our oversight of foreign banks operating in the US pursuant to the Foreign Bank Supervision Enhancement Act of 1991) the Congress assigns to us. To carry out this multi-faceted mission, the Congress established a highly decentralized Federal Reserve System with a complex governance structure. Leadership and direction are vested in the Board of Governors, but only about 1,700 staff (out of about 24,900) work for the Board in Washington. The regional Reserve Banks carry out the bulk of operations and have substantial autonomy. As a result, planning and resource allocation at the Federal ---[PAGE_BREAK]--- Reserve have historically been quite decentralized, and major changes have required painstaking consensus building across the Board/Bank structure. The regional structure of the Federal Reserve is one of its great strengths. The twelve regional Federal Banks work closely with the banks in their region and are closely tied into their regional economies. The development of Federal Reserve policy is greatly enriched by the in-depth knowledge that the regional banks have of the industrial, agricultural and financial forces shaping different parts of the economy. The challenge confronting strategic planning at the Federal Reserve is to find a balance between decentralized regional planning, which preserves the strengths of the regional structure, and the need for a more comprehensive national plan aimed at increasing efficiency by rationalizing the allocation of resources across regions and functions. In recent years, major changes have occurred in the allocation of Federal Reserve resources in response to unfolding events. When serious problems developed in the banking industry in the 1980s and in response to increased supervisory responsibility for foreign banking entities, more Federal Reserve resources were channeled into supervision and regulation. Rapidly changing technology, especially telecommunications and automation, has revolutionized Federal Reserve operations and required considerable investment in hardware, software and expertise. Consolidation of the banking industry, evolution of payment systems patterns and technology, growth in derivatives, globalization of financial services, concerns about equal credit opportunity and fair housing issues, efforts to reduce systemic risk in the payments area, and changes in monetary aggregates, have all caused planning and resource adjustments. Rapid technological change has also created opportunities for system-wide efficiencies resulting from consolidation of activities in one or more Reserve Banks. A number of the twelve regional banks have developed specialized activities serving other regions. For example, Federal Reserve Automation Services (FRAS) is headquartered in Richmond, but provides mainframe data processing and data communications services to all parts of the system. This consolidation and specialization has enabled the Reserve Banks to centralize operations of many of their mission critical applications, such as Fedwire, Automated Clearing House (ACH), and accounting. Continued technological advance, as well as further consolidation in the financial services industry, is likely to lead to further specialization among regional Federal Reserve Banks. # New Strategic Planning Activities In the face of accelerating change, the Federal Reserve recently recognized the need for a more comprehensive planning framework. In 1995, a System Strategic Planning Coordinating Group was appointed, consisting of Board members, Reserve Bank Presidents and senior managers, representing the full range of the Federal Reserve's activities. This group produced an "umbrella" framework, designed to enable the Board, the Reserve Banks and product and support offices to produce their own more detailed plans and decision documents under the "umbrella." This framework, which is the basis for the document submitted to the House and Senate Banking Committees, sets forth the mission of the Federal Reserve referred to above. It also discusses the "values" of the Federal Reserve, the goals and objectives of the Fed, key assumptions, as well as the external and internal factors that could affect the achievement of those goals and objectives. With the overall framework as a reference point, strategic planning ---[PAGE_BREAK]--- activities are proceeding with new energy at the Reserve Banks, at the Board, and with respect to cross-cutting major functions such as the payments system and bank supervision and regulation. Individual Reserve Banks have reviewed their operations from the ground up and reassessed their structure and effectiveness in carrying out their missions. Some of the Banks have launched fundamental re-engineering efforts that are resulting in substantial changes in management structure and operations. The Federal Reserve Bank of Chicago calls its effort "Fresh Look"; the Federal Reserve Bank of Cleveland is engaged in "Transformation: 2000." # Board planning and budgeting At the Board, we have restructured the annual planning and budget process to put more emphasis on planning (and less on detailed line-item budgeting), to lengthen the planning and budgeting horizon, and to involve the Board itself more heavily in setting priorities. To this end, we have established a Budget Committee of the Board (consisting of myself and Governors Phillips and Kelley) assisted by a staff planning group drawn from across the major functions of the Board. We are working with a four-year planning horizon and intend to produce the Board's first biennial budget (1998/1999) to go into effect on January 1, 1998. Our hope is that the new process and structure will give the Board a better understanding of the options it faces with respect to alternative ways of carrying out the Federal Reserve's mission, and a clearer basis for deciding on priorities. ## Payments System study A major study of the Federal Reserve's role in the Payments System, currently underway, is another example of strategic planning with respect to a major portion of the Federal Reserve's activities, under the general umbrella of the strategic planning framework. Since payments technology and the structure of the financial services industry are changing rapidly, it seemed important to focus both on how the payment system was evolving (and should evolve) and what role the Federal Reserve should play in that evolution. The United States is amazingly dependent on paper checks -- Americans wrote 64 billion checks in 1996 -while most of the industrial world is shifting rapidly to more efficient electronic based payments. The study, directed by a committee of two Governors and two Federal Reserve Bank Presidents, has drawn on analytic resources across the Federal Reserve System and outside. We began by examining the consequences of substantially altering the role of the Federal Reserve in the retail payments system (checks and wire transfer system know as ACH). We analyzed the impact of scenarios ranging from withdrawal of the Federal Reserve from the check and ACH markets to more aggressive leadership by the Federal Reserve in making the payment system more efficient and less dependent on paper. To get maximum input from the participants in the payment system -- banks, clearinghouses, vendors, consumers and others -- in helping us assess alternatives for the future, we held a series of "forums" around the country in May and June. We had enthusiastic and extremely helpful participation from a wide range of institutions. We learned a lot from the process and are now reassessing the alternatives, conducting additional analyses and preparing to present preliminary options to the Board. I look forward to sharing the study with this Committee. ---[PAGE_BREAK]--- The payments area is a good example of the dilemma posed for planners by rapid technological change. While rapidly evolving technology makes focussing on future options imperative, it also makes it extremely important to remain flexible. Laying out a blueprint for the payments system of the next ten or even five years, and rigidly following it, would almost certainly be a mistake. The technology is moving so rapidly that investments made now may well be obsolete in a short time. # Performance Measures A major theme of GPRA is the identification of specific measures of performance of projects and programs which can be used to evaluate their effectiveness. As in most organizations, performance measurement at the Federal Reserve is more advanced -- and more feasible -- in some types of activities than in others. In the payment services areas, the Reserve Banks have measured their performance through various financial measures for many years. For example, the Monetary Control Act of 1980 imposes market discipline on the Federal Reserve by requiring it fully to cover its costs of providing services to depository institutions, and compliance with this requirement is monitored closely. Frequently private competitors provide or could provide these services, and our ability to recover our costs, adjusted to include a factor for imputed profits, taxes and cost of capital, help determine whether it is beneficial for the economy that we stay in the business. In addition, the Federal Reserve has traditionally measured unit costs for its financial services and has developed various indices that allow a Reserve Bank to measure its cost performance over time and in comparison to other Reserve Banks. Private sector benchmarks are also being developed. The Federal Reserve also tracks quality measures for many Reserve Bank services. Finally, the Federal Reserve monitors the progress of the Reserve Banks against various strategic objectives. Similarly, in bank supervision, the Federal Reserve has long used a variety of measures of the effectiveness of its examination process, but the measurement challenge has taken on new importance as supervision becomes more automated and more focused on analyzing risk. To meet this challenge, the Federal Reserve is working closely with other regulators to standardize and improve examination techniques, and has established a Steering Committee to oversee implementation of a risk-focused examination program and to design a management information system that will permit the Board to evaluate better the efficient use of examination resources among the Reserve Banks. For instance, supervisory data are used to determine in advance of on-site examinations what factors (CAMELS rating, asset size, location, and loan types) are most predictive as to the resources needed for examinations, and which institutions, particular lending areas or other service lines may require more intensive review. Such programs are low-cost because they use information that we already collect, and are effective and cost-saving because they provide a systematic way to plan and prioritize our time and resources. In other areas, such as the research and statistical analysis on which monetary policy is based, performance measurement is -- and will remain -- far more problematic. The performance of the economy itself is not so hard to measure and right now is highly positive. But it is not clear how much of the economic progress can be attributed to monetary policy, and even less clear how particular monetary policy actions are related to the quality and quantity of research and analysis produced by the Fed's research staff. ---[PAGE_BREAK]--- # Conclusion GPRA provides the opportunity for a major improvement in the management and effectiveness of Federal agencies. It provides the impetus for agencies to clarify their missions and objectives, measure their performance better and improve their efficiency and effectiveness. It must, however, avoid the risk of becoming, like some previous efforts to improve government management, largely a paper exercise which produces many numbers and reports but few real results. The Federal Reserve welcomes the opportunity to participate in the GPRA process. We will work hard to fulfill the vision of the framers of the Act and avoid the pitfalls. We will have to respond in ways that are appropriate to the Federal Reserve's diverse missions and decentralized structure. I believe we have made significant progress toward the GPRA-type strategic planning and are on the track to making more in the immediate future.	Alice M Rivlin	United States	https://www.bis.org/review/r970806b.pdf	Mr. Chairman and members of the Committee, I am pleased to be here today to discuss the Federal Reserve's planning process and the efforts we are making to measure and improve our performance in the spirit of the Government Performance and Results Act (GPRA). I am personally a long-term proponent of GPRA and worked hard on its implementation when I was at the Office of Management and Budget. While the Federal Reserve does not receive appropriated funds and is not, strictly speaking, covered by the Act, we are eager to participate in the processes and activities set forth in the Act. GPRA fits well with the new efforts the Federal Reserve has undertaken to plan further ahead, use our resources more effectively and to coordinate activities across the whole system more explicitly. The testimony is a brief progress report on those efforts. In its briefest form, the Federal Reserve's mission is to "foster the stability, integrity and efficiency of the nation's financial and payment systems so as to promote optimal macroeconomic performance." This mission derives directly from the Federal Reserve Act of 1913, which established the Federal Reserve as the nation's central bank, and has three main elements: To formulate and conduct monetary policy toward the achievement of maximum sustainable long-term growth; price stability fosters that goal. To promote a safe, sound, competitive, and accessible banking system and stable financial markets through supervision and regulation of the nation's banking and financial systems; through its function as the lender of last resort; and through effective implementation of statutes designed to inform and protect the consumer. To foster the integrity, efficiency, and accessibility of US dollar payments and settlement systems, issue a uniform currency, and act as the fiscal agent and depository of the US government. The activities involved in carrying out this broad mission are extremely diverse, ranging from setting short-term interest rates to processing checks and cash, to examining depository institutions. Allocation of the resources the Federal Reserve uses to do its job depends heavily on the state of the economy (both national and international), how well or badly the financial services system is functioning, and what additional tasks (such as implementation of the Community Reinvestment Act and expansion of our oversight of foreign banks operating in the US pursuant to the Foreign Bank Supervision Enhancement Act of 1991) the Congress assigns to us. To carry out this multi-faceted mission, the Congress established a highly decentralized Federal Reserve System with a complex governance structure. Leadership and direction are vested in the Board of Governors, but only about 1,700 staff (out of about 24,900) work for the Board in Washington. The regional Reserve Banks carry out the bulk of operations and have substantial autonomy. As a result, planning and resource allocation at the Federal Reserve have historically been quite decentralized, and major changes have required painstaking consensus building across the Board/Bank structure. The regional structure of the Federal Reserve is one of its great strengths. The twelve regional Federal Banks work closely with the banks in their region and are closely tied into their regional economies. The development of Federal Reserve policy is greatly enriched by the in-depth knowledge that the regional banks have of the industrial, agricultural and financial forces shaping different parts of the economy. The challenge confronting strategic planning at the Federal Reserve is to find a balance between decentralized regional planning, which preserves the strengths of the regional structure, and the need for a more comprehensive national plan aimed at increasing efficiency by rationalizing the allocation of resources across regions and functions. In recent years, major changes have occurred in the allocation of Federal Reserve resources in response to unfolding events. When serious problems developed in the banking industry in the 1980s and in response to increased supervisory responsibility for foreign banking entities, more Federal Reserve resources were channeled into supervision and regulation. Rapidly changing technology, especially telecommunications and automation, has revolutionized Federal Reserve operations and required considerable investment in hardware, software and expertise. Consolidation of the banking industry, evolution of payment systems patterns and technology, growth in derivatives, globalization of financial services, concerns about equal credit opportunity and fair housing issues, efforts to reduce systemic risk in the payments area, and changes in monetary aggregates, have all caused planning and resource adjustments. Rapid technological change has also created opportunities for system-wide efficiencies resulting from consolidation of activities in one or more Reserve Banks. A number of the twelve regional banks have developed specialized activities serving other regions. For example, Federal Reserve Automation Services (FRAS) is headquartered in Richmond, but provides mainframe data processing and data communications services to all parts of the system. This consolidation and specialization has enabled the Reserve Banks to centralize operations of many of their mission critical applications, such as Fedwire, Automated Clearing House (ACH), and accounting. Continued technological advance, as well as further consolidation in the financial services industry, is likely to lead to further specialization among regional Federal Reserve Banks. In the face of accelerating change, the Federal Reserve recently recognized the need for a more comprehensive planning framework. In 1995, a System Strategic Planning Coordinating Group was appointed, consisting of Board members, Reserve Bank Presidents and senior managers, representing the full range of the Federal Reserve's activities. This group produced an "umbrella" framework, designed to enable the Board, the Reserve Banks and product and support offices to produce their own more detailed plans and decision documents under the "umbrella." This framework, which is the basis for the document submitted to the House and Senate Banking Committees, sets forth the mission of the Federal Reserve referred to above. It also discusses the "values" of the Federal Reserve, the goals and objectives of the Fed, key assumptions, as well as the external and internal factors that could affect the achievement of those goals and objectives. With the overall framework as a reference point, strategic planning activities are proceeding with new energy at the Reserve Banks, at the Board, and with respect to cross-cutting major functions such as the payments system and bank supervision and regulation. Individual Reserve Banks have reviewed their operations from the ground up and reassessed their structure and effectiveness in carrying out their missions. Some of the Banks have launched fundamental re-engineering efforts that are resulting in substantial changes in management structure and operations. The Federal Reserve Bank of Chicago calls its effort "Fresh Look"; the Federal Reserve Bank of Cleveland is engaged in "Transformation: 2000." At the Board, we have restructured the annual planning and budget process to put more emphasis on planning (and less on detailed line-item budgeting), to lengthen the planning and budgeting horizon, and to involve the Board itself more heavily in setting priorities. To this end, we have established a Budget Committee of the Board (consisting of myself and Governors Phillips and Kelley) assisted by a staff planning group drawn from across the major functions of the Board. We are working with a four-year planning horizon and intend to produce the Board's first biennial budget (1998/1999) to go into effect on January 1, 1998. Our hope is that the new process and structure will give the Board a better understanding of the options it faces with respect to alternative ways of carrying out the Federal Reserve's mission, and a clearer basis for deciding on priorities. A major study of the Federal Reserve's role in the Payments System, currently underway, is another example of strategic planning with respect to a major portion of the Federal Reserve's activities, under the general umbrella of the strategic planning framework. Since payments technology and the structure of the financial services industry are changing rapidly, it seemed important to focus both on how the payment system was evolving (and should evolve) and what role the Federal Reserve should play in that evolution. The United States is amazingly dependent on paper checks -- Americans wrote 64 billion checks in 1996 -while most of the industrial world is shifting rapidly to more efficient electronic based payments. The study, directed by a committee of two Governors and two Federal Reserve Bank Presidents, has drawn on analytic resources across the Federal Reserve System and outside. We began by examining the consequences of substantially altering the role of the Federal Reserve in the retail payments system (checks and wire transfer system know as ACH). We analyzed the impact of scenarios ranging from withdrawal of the Federal Reserve from the check and ACH markets to more aggressive leadership by the Federal Reserve in making the payment system more efficient and less dependent on paper. To get maximum input from the participants in the payment system -- banks, clearinghouses, vendors, consumers and others -- in helping us assess alternatives for the future, we held a series of "forums" around the country in May and June. We had enthusiastic and extremely helpful participation from a wide range of institutions. We learned a lot from the process and are now reassessing the alternatives, conducting additional analyses and preparing to present preliminary options to the Board. I look forward to sharing the study with this Committee. The payments area is a good example of the dilemma posed for planners by rapid technological change. While rapidly evolving technology makes focussing on future options imperative, it also makes it extremely important to remain flexible. Laying out a blueprint for the payments system of the next ten or even five years, and rigidly following it, would almost certainly be a mistake. The technology is moving so rapidly that investments made now may well be obsolete in a short time. A major theme of GPRA is the identification of specific measures of performance of projects and programs which can be used to evaluate their effectiveness. As in most organizations, performance measurement at the Federal Reserve is more advanced -- and more feasible -- in some types of activities than in others. In the payment services areas, the Reserve Banks have measured their performance through various financial measures for many years. For example, the Monetary Control Act of 1980 imposes market discipline on the Federal Reserve by requiring it fully to cover its costs of providing services to depository institutions, and compliance with this requirement is monitored closely. Frequently private competitors provide or could provide these services, and our ability to recover our costs, adjusted to include a factor for imputed profits, taxes and cost of capital, help determine whether it is beneficial for the economy that we stay in the business. In addition, the Federal Reserve has traditionally measured unit costs for its financial services and has developed various indices that allow a Reserve Bank to measure its cost performance over time and in comparison to other Reserve Banks. Private sector benchmarks are also being developed. The Federal Reserve also tracks quality measures for many Reserve Bank services. Finally, the Federal Reserve monitors the progress of the Reserve Banks against various strategic objectives. Similarly, in bank supervision, the Federal Reserve has long used a variety of measures of the effectiveness of its examination process, but the measurement challenge has taken on new importance as supervision becomes more automated and more focused on analyzing risk. To meet this challenge, the Federal Reserve is working closely with other regulators to standardize and improve examination techniques, and has established a Steering Committee to oversee implementation of a risk-focused examination program and to design a management information system that will permit the Board to evaluate better the efficient use of examination resources among the Reserve Banks. For instance, supervisory data are used to determine in advance of on-site examinations what factors (CAMELS rating, asset size, location, and loan types) are most predictive as to the resources needed for examinations, and which institutions, particular lending areas or other service lines may require more intensive review. Such programs are low-cost because they use information that we already collect, and are effective and cost-saving because they provide a systematic way to plan and prioritize our time and resources. In other areas, such as the research and statistical analysis on which monetary policy is based, performance measurement is -- and will remain -- far more problematic. The performance of the economy itself is not so hard to measure and right now is highly positive. But it is not clear how much of the economic progress can be attributed to monetary policy, and even less clear how particular monetary policy actions are related to the quality and quantity of research and analysis produced by the Fed's research staff. GPRA provides the opportunity for a major improvement in the management and effectiveness of Federal agencies. It provides the impetus for agencies to clarify their missions and objectives, measure their performance better and improve their efficiency and effectiveness. It must, however, avoid the risk of becoming, like some previous efforts to improve government management, largely a paper exercise which produces many numbers and reports but few real results. The Federal Reserve welcomes the opportunity to participate in the GPRA process. We will work hard to fulfill the vision of the framers of the Act and avoid the pitfalls. We will have to respond in ways that are appropriate to the Federal Reserve's diverse missions and decentralized structure. I believe we have made significant progress toward the GPRA-type strategic planning and are on the track to making more in the immediate future.
1997-09-05T00:00:00	Mr. Greenspan considers the recent history of the Federal Reserve System's policy process (Central Bank Articles and Speeches, 5 Sep 97)	Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the 15th Anniversary Conference of the Center for Economic Policy Research at Stanford University, Stanford, California on 5/9/97.	Mr. Greenspan considers the recent history of the Federal Reserve System's policy process Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the 15th Anniversary Conference of the Center for Economic Policy Research at Stanford University, Stanford, California on 5/9/97. It is a pleasure to be at this conference marking the fifteenth anniversary of the Center for Economic Policy Research. The Center, by encouraging academic research into public policy and bringing that research to the attention of policymakers, is performing a most valuable role in our society. I am particularly pleased that Milton Friedman has taken time to join us. His views have had as much, if not more, impact on the way we think about monetary policy and many other important economic issues as those of any person in the last half of the twentieth century. Federal Reserve policy, over the years, has been subject to criticism, often with justification, from Professor Friedman and others. It has been argued, for example, that policy failed to anticipate the emerging inflation of the 1970s, and by fostering excessive monetary creation, contributed to the inflationary upsurge. Surely, it was maintained, some monetary policy rule, however imperfect, would have delivered far superior performance. Even if true in this case, though, policy rules might not always be preferable. Policy rules, at least in a general way, presume some understanding of how economic forces work. Moreover, in effect, they anticipate that key causal connections observed in the past will remain fixed over time, or evolve only very slowly. Use of a rule presupposes that action x will, with a reasonably high probability, be followed over time by event y. Another premise behind many rule-based policy prescriptions, however, is that our knowledge of the full workings of the system is quite limited, so that attempts to improve on the results of policy rules will, on average, only make matters worse. In this view, ad hoc or discretionary policy can cause uncertainty for private decision makers and be wrong for extended periods if there is no anchor to bring it back into line. In addition, discretionary policy is obviously vulnerable to political pressures; if ad hoc judgments are to be made, why shouldn't those of elected representatives supersede those of unelected officials? The monetary policy of the Federal Reserve has involved varying degrees of rule- and discretionary-based modes of operation over time. Recognizing the potential drawbacks of purely discretionary policy, the Federal Reserve frequently has sought to exploit past patterns and regularities to operate in a systematic way. But we have found that very often historical regularities have been disrupted by unanticipated change, especially in technologies. The evolving patterns mean that the performance of the economy under any rule, were it to be rigorously followed, would deviate from expectations. Accordingly we are constantly evaluating how much we can infer from the past and how relationships might have changed. In an ever changing world, some element of discretion appears to be an unavoidable aspect of policymaking. Such changes mean that we can never construct a completely general model of the economy, invariant through time, on which to base our policy. Still, sensible policy does presuppose a conceptual framework, or implicit model, however incompletely specified, of how the economic system operates. Of necessity, we make judgments based importantly on historical regularities in behavior inferred from data relationships. These perceived regularities can be embodied in formal empirical models, often covering only a portion of the economic system. Generally, the regularities inform our interpretation of "experience" and tell us what to look for to determine whether history is in the process of repeating itself, and if not, why not. From such an examination, along with an assessment of past policy actions, we attempt to judge to what extent our current policies should deviate from our past patterns of behavior. When this Center was founded 15 years ago, the rules versus discretion debate focused on the appropriate policy role of the monetary aggregates, and this discussion was echoed in the Federal Reserve's policy process. In the late 1970s, the Federal Reserve's actions to deal with developing inflationary instabilities were shaped in part by the reality portrayed by Milton Friedman's analysis that ever-rising inflation rate peaks, as well as ever-rising inflation rate troughs, followed on the heels of similar patterns of average money growth. The Federal Reserve, in response to such evaluations, acted aggressively under newly installed Chairman Paul Volcker. A considerable tightening of the average stance of policy -- based on intermediate M1 targets tied to reserve operating objectives -- eventually reversed the surge in inflation. The last fifteen years have been a period of consolidating the gains of the early 1980s and extending them to their logical end -- the achievement of price stability. We are not quite there yet, but we trust it is on the horizon. Although the ultimate goals of policy have remained the same over these past fifteen years, the techniques used in formulating and implementing policy have changed considerably as a consequence of vast changes in technology and regulation. Focusing on M1, and following operating procedures that imparted a considerable degree of automaticity to short-term interest rate movements, was extraordinarily useful in the early Volcker years. But after nationwide NOW accounts were introduced, the demand for M1 in the judgment of the Federal Open Market Committee became too interest-sensitive for that aggregate to be useful in implementing policy. Because the velocity of such an aggregate varies substantially in response to small changes in interest rates, target ranges for M1 growth in its judgment no longer were reliable guides for outcomes in nominal spending and inflation. In response to an unanticipated movement in spending and hence the quantity of money demanded, a small variation in interest rates would be sufficient to bring money back to path but not to correct the deviation in spending. As a consequence, by late 1982, M1 was de-emphasized and policy decisions per force became more discretionary. However, in recognition of the longer-run relationship of prices and M2, especially its stable long-term velocity, this broader aggregate was accorded more weight, along with a variety of other indicators, in setting our policy stance. As an indicator, M2 served us well for a number of years. But by the early 1990s, its usefulness was undercut by the increased attractiveness and availability of alternative outlets for saving, such as bond and stock mutual funds, and by mounting financial difficulties for depositories and depositors that led to a restructuring of business and household balance sheets. The apparent result was a significant rise in the velocity of M2, which was especially unusual given continuing declines in short-term market interest rates. By 1993, this extraordinary velocity behavior had become so pronounced that the Federal Reserve was forced to begin disregarding the signals M2 was sending, at least for the time being. Data since mid-1994 do seem to show the re-emergence of a relationship of M2 with nominal income and short-term interest rates similar to that experienced during the three decades of the 1960s through the 1980s. As I indicated to the Congress recently, however, the period of predictable velocity is too brief to justify restoring M2 to its role of earlier years, though clearly persistent outsized changes would get our attention. Increasingly since 1982 we have been setting the funds rate directly in response to a wide variety of factors and forecasts. We recognize that, in fixing the short-term rate, we lose much of the information on the balance of money supply and demand that changing market rates afford, but for the moment we see no alternative. In the current state of our knowledge, money demand has become too difficult to predict. Although our operating target is a nominal short-term rate, we view its linkages to spending and prices as indirect and complex. For one, arguably, it is real, not nominal, rates that are more relevant to spending. For another, spending, prices and other economic variables respond to a whole host of financial variables. Hence, in judging the stance of policy we routinely look at the financial impulses coming from foreign exchange, bond, and equity markets, along with supply conditions in credit markets generally, including at financial intermediaries. Nonetheless, we recognize that inflation is fundamentally a monetary phenomenon, and ultimately determined by the growth of the stock of money, not by nominal or real interest rates. In current circumstances, however, determining which financial data should be aggregated to provide an appropriate empirical proxy for the money stock that tracks income and spending represents a severe challenge for monetary analysts. The absence of a monetary aggregate anchor, however, has not left policy completely adrift. From a longer-term perspective we have been guided by a firm commitment to contain any forces that would undermine economic expansion and efficiency by raising inflation, and we have kept our focus firmly on the ultimate goal of achieving price stability. Within that framework we have attempted not only to lean against the potential for an overheating economy, but also to cushion shortfalls in economic growth. And, recognizing the lags in the effects of policy, we have tried to move in anticipation of such disequilibria developing. But this is a very general framework and does not present clear guidance for day-to-day policy decisions. Thus, as the historic relationship between measured money supply and spending deteriorated, policymaking, seeing no alternative, turned more eclectic and discretionary. Nonetheless, we try to develop as best we can a stable conceptual framework, so policy actions are as regular and predictable as possible -- that is, governed by systematic behavior but open to evidence of structural macroeconomic changes that require policy to adapt. The application of such an approach is illustrated by a number of disparate events we have confronted since 1982 that were in some important respects outside our previous experience. In the early and mid-1980s, the FOMC faced most notably the sharp swings in fiscal policy, the unprecedented rise and fall of the dollar, and the associated shifts in international trade and capital flows. But I will concentrate on several events of the last decade where I personally participated in forming the judgments used in policy implementation. One such event was the stock market crash of October 1987 shortly after I arrived. Unlike many uncertain situations that have confronted monetary policy, there was little question that the appropriate central bank action was to ease policy significantly. We knew we would soon have to sop up the excess liquidity that we added to the system, but the timing and, I believe, the magnitude of our actions were among our easier decisions. Our concerns at that time reflected questions about how the financial markets and the economy would respond to the shock of a decline of more than one-fifth in stock prices in one day, and whether monetary policy alone could stabilize the system. By the early spring of 1988 it was evident that the economy had stabilized and we needed to begin reversing the easy stance of policy. Another development that confronted policy was the commercial property price bust of the late 1980s and early 1990s. Since a large volume of bank and thrift loans was tied to the real estate market and backed by real estate collateral, the fall in property prices impaired the capital of a large number of depositories. These institutions reacted by curtailing new lending -the unprecedented "credit crunch" of 1990 and 1991. Not unexpectedly, our policy response was to move toward significant ease. Our primary concern was the state of the credit markets and the economy, but we could also see that these broader issues were linked inextricably to the state of depository institutions' balance sheets and profitability. A satisfactory recovery from the recession of that period, in our judgment, required the active participation of a viable banking system. The extraordinary circumstances dictated a highly unusual path for monetary policy. The stance of policy eased substantially even after the economy began to recover from the 1990-91 recession, and a stimulative policy was deliberately maintained well into the early expansion period. By mid-1993, however, property prices stabilized and the credit crunch gradually began to dissipate. It was clear as the year moved toward a close that monetary policy, characterized by a real federal funds rate of virtually zero, was now far too easy in light of the strengthening economy on the horizon. Financial and economic conditions were returning to more traditional relationships, and policy had to shift from a situation-specific formulation to one based more closely on previous historical patterns. Although it was difficult at that time to discern any overt inflationary signals, the balance of risks, in our judgment, clearly dictated pre-emptive action. The 1994 to 1995 period was most instructive. It appears we were successful in moving pre-emptively to throttle down an impending unstable boom, which almost surely would have resulted in the current expansion coming to an earlier halt. Because this was the first change in the stance of policy after a prolonged period of unusual ease, we took special care to spell out our analysis and expectations for policy in an unusually explicit way to inform the markets well before we began to tighten. In addition, we began for the first time to issue explanatory statements as changes in the stance of policy were implemented. Even so, the idea of tightening to head off inflation before it was visible in the data was not universally applauded or perhaps understood. Financial markets reacted unusually strongly to our 1994 policy actions, often ratcheting up their expectations for further rate increases when we actually tightened, resulting in very large increases in longer-term interest rates. At the time, these reactions seemed to reflect the extent to which investment strategies had been counting on a persistence of low interest rates. This was a classic case in which we had to be careful not to allow market expectations of Federal Reserve actions to be major elements of policy determination. We are always concerned about assuming that short-term movements in market prices are reflections of changes in underlying supply and demand conditions when we may be observing nothing more than fluctuating expectations about our own policy actions. Most recently, the economy has demonstrated a remarkable confluence of robust growth, high resource utilization, and damped inflation. Once again we have been faced with analyzing and reacting to a situation in which incoming data have not readily conformed to historical experience. Specifically, the persistence of rising profit margins in the face of stable or falling inflation raises the question of what is happening to productivity. If data on profits and prices are even approximately accurate, total consolidated corporate unit costs have, of necessity, been materially contained. With labor costs constituting three-fourths of costs, unless growth in compensation per hour is falling, which seems most unlikely from other information, it is difficult to avoid the conclusion that output per hour has to be rising at a pace significantly in excess of the officially published annual growth rate of nonfarm productivity of one percent over recent quarters. The degree to which these data may be understated is underlined by backing out from the total what appears to be a reasonably accurate, or at least consistent, measure of productivity of corporate businesses. The level of nonfarm noncorporate productivity implied by this exercise has been falling continuously since 1973 despite reasonable earnings margins for proprietorships and partnerships. Presumably this reflects the significant upward bias in our measurement of service prices, which dominate our noncorporate sector. Nonetheless, the still open question is whether productivity growth is in the process of picking up. For it is the answer to this question that is material to the current debate between those who argue that the economy is entering a "new era" of greatly enhanced sustainable growth and unusually high levels of resource utilization, and those who do not. A central bank, while needing to be open to evidence of structural economic change, also needs to be cautious. Supplying excess liquidity to support growth that turns out to have been ephemeral would undermine the very good economic performance we have enjoyed. We raised the federal funds rate in March to help protect against this latter possibility, and with labor resources currently stretched tight, we need to remain on alert. Whatever its successes, the current monetary policy regime is far from ideal. Each episode has had to be treated as unique or nearly so. It may have been the best we could do at the moment. But we continuously examine alternatives that might better anchor policy, so that it becomes less subject to the abilities of the Federal Open Market Committee to analyze developments and make predictions. Gold was such an anchor or rule, prior to World War I, but it was first compromised and eventually abandoned because it restrained the type of discretionary monetary and fiscal policies that modern democracies appear to value. A fixed, or even adaptive, rule on the expansion of the monetary base would anchor the system, but it is hard to envision acceptance for that approach because it also limits economic policy discretion. Moreover, flows of U.S. currency abroad, which are variable and difficult to estimate, and bank reserves avoidance are subverting any relationship that might have existed between growth in the monetary base and U.S. economic performance. Another type of rule using readings on output and prices to help guide monetary policy, such as John Taylor's, has attracted widening interest in recent years in the financial markets, the academic community, and at central banks. Taylor-type rules or reaction functions have a number of attractive features. They assume that central banks can appropriately pay attention simultaneously to developments in both output and inflation, provided their reactions occur in the context of a longer-run goal of price stability and that they recognize that activity is limited by the economy's sustainable potential. As Taylor himself has pointed out, these types of formulations are at best "guideposts" to help central banks, not inflexible rules that eliminate discretion. One reason is that their formulation depends on the values of certain key variables -- most crucially the equilibrium real federal funds rate and the production potential of the economy. In practice these have been obtained by observation of past macroeconomic behavior -- either through informal inspection of the data, or more formally as embedded in models. In that sense, like all rules, as I noted earlier, they embody a forecast that the future will be like the past. Unfortunately, however, history is not an infallible guide to the future, and the levels of these two variables are currently under active debate. The mechanics of monetary policy that I have been addressing are merely means to an end. What are we endeavoring to achieve, and why? The goal of macroeconomic policy should be maximum sustainable growth over the long term, and evidence has continued to accumulate around the world that price stability is a necessary condition for the achievement of that goal. Beyond this very general statement, however, lie difficult issues of concept and measurement for policymakers and academicians to keep us occupied for the next fifteen years and more. Inflation impairs economic efficiency in part because people have difficulty separating movements in relative prices from movements in the general price level. But what prices matter? Certainly prices of goods and services now being produced -- our basic measure of inflation -- matter. But what about prices of claims on future goods and services, like equities, real estate or other earning assets? Is stability in the average level of these prices essential to the stability of the economy? Recent Japanese economic history only underlines the difficulty and importance of this question. The prices of final goods and services were stable in Japan in the mid-to-late 1980s, but soaring asset prices distorted resource allocation and ultimately undermined the performance of the macroeconomy. In the United States, evaluating the effects on the economy of shifts in balance sheets and variations in asset prices has been an integral part of the development of monetary policy. In recent years, for example, we have expended considerable effort to understand the implications of changes in household balance sheets in the form of high and rising consumer debt burdens and increases in market wealth from the run-up in the stock market. And the equity market itself has been the subject of analysis as we attempt to assess the implications for financial and economic stability of the extraordinary rise in equity prices -- a rise based apparently on continuing upward revisions in estimates of our corporations' already robust long-term earning prospects. But, unless they are moving together, prices of assets and of goods and services cannot both be an objective of a particular monetary policy, which, after all, has one effective instrument -- the short-term interest rate. We have chosen product prices as our primary focus on the grounds that stability in the average level of these prices is likely to be consistent with financial stability as well as maximum sustainable growth. History, however, is somewhat ambiguous on the issue of whether central banks can safely ignore asset markets, except as they affect product prices. Over the coming decades, moreover, what constitutes product price and, hence, price stability will itself become harder to measure. When industrial product was the centerpiece of the economy during the first two-thirds of this century, our overall price indexes served us well. Pricing a pound of electrolytic copper presented few definitional problems. The price of a ton of cold rolled steel sheet, or a linear yard of cotton broad woven fabrics, could be reasonably compared over a period of years. I have already noted the problems in defining price and output and, hence, in measuring productivity over the past twenty years. The simple notion of price has turned decidedly complex. What is the price of a unit of software or of a medical procedure? How does one evaluate the price change of a cataract operation over a ten-year period when the nature of the procedure and its impact on the patient has been altered so radically? The pace of change and the shifting to harder-to-measure types of output are more likely to quicken than to slow down. Indeed, how will we measure inflation in the future when our data -- using current techniques -could become increasingly less adequate to trace price trends over time? However, so long as individuals make contractual arrangements for future payments valued in dollars and other currencies, there must be a presumption on the part of those involved in the transaction about the future purchasing power of money. No matter how complex individual products become, there will always be some general sense of the purchasing power of money both across time and across goods and services. Hence, we must assume that embodied in all products is some unit of output, and hence of price, that is recognizable to producers and consumers and upon which they will base their decisions. The emergence of inflation-indexed bonds does not solve the problem of pinning down an economically meaningful measure of the general price level. While there is, of course, an inflation expectation premium embodied in all nominal interest rates, it is fundamentally unobservable. Returns on indexed bonds are tied to forecasts of specific published price indexes, which may or may not reflect the market's judgment of the future purchasing power of money. To the extent they do not, of course, the implicit real interest rate is biased in the opposite direction. Doubtless, we will develop new techniques of measurement to unearth those true prices as the years go on. It is crucial that we do, for inflation can destabilize an economy even if faulty price indexes fail to reveal it. It should be evident from my remarks that ample challenges will continue to face monetary policy. I have concentrated on how we have tried to identify and analyze new developments, and endeavored to use that analysis to fashion and balance policy responses. I have also tried to highlight the questions about how to specify and measure the ultimate goals of policy. Nonetheless, all of us could easily add to the list. In dealing with these issues, policy can only benefit from focused and relevant academic research. I look forward to learning about and utilizing the contributions made under the sponsorship of the Center for Economic Policy Research over the years to come.	---[PAGE_BREAK]--- # Mr. Greenspan considers the recent history of the Federal Reserve System's policy process Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the 15th Anniversary Conference of the Center for Economic Policy Research at Stanford University, Stanford, California on 5/9/97. It is a pleasure to be at this conference marking the fifteenth anniversary of the Center for Economic Policy Research. The Center, by encouraging academic research into public policy and bringing that research to the attention of policymakers, is performing a most valuable role in our society. I am particularly pleased that Milton Friedman has taken time to join us. His views have had as much, if not more, impact on the way we think about monetary policy and many other important economic issues as those of any person in the last half of the twentieth century. Federal Reserve policy, over the years, has been subject to criticism, often with justification, from Professor Friedman and others. It has been argued, for example, that policy failed to anticipate the emerging inflation of the 1970s, and by fostering excessive monetary creation, contributed to the inflationary upsurge. Surely, it was maintained, some monetary policy rule, however imperfect, would have delivered far superior performance. Even if true in this case, though, policy rules might not always be preferable. Policy rules, at least in a general way, presume some understanding of how economic forces work. Moreover, in effect, they anticipate that key causal connections observed in the past will remain fixed over time, or evolve only very slowly. Use of a rule presupposes that action x will, with a reasonably high probability, be followed over time by event y . Another premise behind many rule-based policy prescriptions, however, is that our knowledge of the full workings of the system is quite limited, so that attempts to improve on the results of policy rules will, on average, only make matters worse. In this view, ad hoc or discretionary policy can cause uncertainty for private decision makers and be wrong for extended periods if there is no anchor to bring it back into line. In addition, discretionary policy is obviously vulnerable to political pressures; if ad hoc judgments are to be made, why shouldn't those of elected representatives supersede those of unelected officials? The monetary policy of the Federal Reserve has involved varying degrees of rule- and discretionary-based modes of operation over time. Recognizing the potential drawbacks of purely discretionary policy, the Federal Reserve frequently has sought to exploit past patterns and regularities to operate in a systematic way. But we have found that very often historical regularities have been disrupted by unanticipated change, especially in technologies. The evolving patterns mean that the performance of the economy under any rule, were it to be rigorously followed, would deviate from expectations. Accordingly we are constantly evaluating how much we can infer from the past and how relationships might have changed. In an ever changing world, some element of discretion appears to be an unavoidable aspect of policymaking. Such changes mean that we can never construct a completely general model of the economy, invariant through time, on which to base our policy. Still, sensible policy does presuppose a conceptual framework, or implicit model, however incompletely specified, of how the economic system operates. Of necessity, we make judgments based importantly on historical ---[PAGE_BREAK]--- regularities in behavior inferred from data relationships. These perceived regularities can be embodied in formal empirical models, often covering only a portion of the economic system. Generally, the regularities inform our interpretation of "experience" and tell us what to look for to determine whether history is in the process of repeating itself, and if not, why not. From such an examination, along with an assessment of past policy actions, we attempt to judge to what extent our current policies should deviate from our past patterns of behavior. When this Center was founded 15 years ago, the rules versus discretion debate focused on the appropriate policy role of the monetary aggregates, and this discussion was echoed in the Federal Reserve's policy process. In the late 1970s, the Federal Reserve's actions to deal with developing inflationary instabilities were shaped in part by the reality portrayed by Milton Friedman's analysis that ever-rising inflation rate peaks, as well as ever-rising inflation rate troughs, followed on the heels of similar patterns of average money growth. The Federal Reserve, in response to such evaluations, acted aggressively under newly installed Chairman Paul Volcker. A considerable tightening of the average stance of policy -- based on intermediate M1 targets tied to reserve operating objectives -- eventually reversed the surge in inflation. The last fifteen years have been a period of consolidating the gains of the early 1980s and extending them to their logical end -- the achievement of price stability. We are not quite there yet, but we trust it is on the horizon. Although the ultimate goals of policy have remained the same over these past fifteen years, the techniques used in formulating and implementing policy have changed considerably as a consequence of vast changes in technology and regulation. Focusing on M1, and following operating procedures that imparted a considerable degree of automaticity to short-term interest rate movements, was extraordinarily useful in the early Volcker years. But after nationwide NOW accounts were introduced, the demand for M1 in the judgment of the Federal Open Market Committee became too interest-sensitive for that aggregate to be useful in implementing policy. Because the velocity of such an aggregate varies substantially in response to small changes in interest rates, target ranges for M1 growth in its judgment no longer were reliable guides for outcomes in nominal spending and inflation. In response to an unanticipated movement in spending and hence the quantity of money demanded, a small variation in interest rates would be sufficient to bring money back to path but not to correct the deviation in spending. As a consequence, by late 1982, M1 was de-emphasized and policy decisions per force became more discretionary. However, in recognition of the longer-run relationship of prices and M2, especially its stable long-term velocity, this broader aggregate was accorded more weight, along with a variety of other indicators, in setting our policy stance. As an indicator, M2 served us well for a number of years. But by the early 1990s, its usefulness was undercut by the increased attractiveness and availability of alternative outlets for saving, such as bond and stock mutual funds, and by mounting financial difficulties for depositories and depositors that led to a restructuring of business and household balance sheets. The apparent result was a significant rise in the velocity of M2, which was especially unusual given continuing declines in short-term market interest rates. By 1993, this extraordinary velocity behavior had become so pronounced that the Federal Reserve was forced to begin disregarding the signals M2 was sending, at least for the time being. ---[PAGE_BREAK]--- Data since mid-1994 do seem to show the re-emergence of a relationship of M2 with nominal income and short-term interest rates similar to that experienced during the three decades of the 1960s through the 1980s. As I indicated to the Congress recently, however, the period of predictable velocity is too brief to justify restoring M2 to its role of earlier years, though clearly persistent outsized changes would get our attention. Increasingly since 1982 we have been setting the funds rate directly in response to a wide variety of factors and forecasts. We recognize that, in fixing the short-term rate, we lose much of the information on the balance of money supply and demand that changing market rates afford, but for the moment we see no alternative. In the current state of our knowledge, money demand has become too difficult to predict. Although our operating target is a nominal short-term rate, we view its linkages to spending and prices as indirect and complex. For one, arguably, it is real, not nominal, rates that are more relevant to spending. For another, spending, prices and other economic variables respond to a whole host of financial variables. Hence, in judging the stance of policy we routinely look at the financial impulses coming from foreign exchange, bond, and equity markets, along with supply conditions in credit markets generally, including at financial intermediaries. Nonetheless, we recognize that inflation is fundamentally a monetary phenomenon, and ultimately determined by the growth of the stock of money, not by nominal or real interest rates. In current circumstances, however, determining which financial data should be aggregated to provide an appropriate empirical proxy for the money stock that tracks income and spending represents a severe challenge for monetary analysts. The absence of a monetary aggregate anchor, however, has not left policy completely adrift. From a longer-term perspective we have been guided by a firm commitment to contain any forces that would undermine economic expansion and efficiency by raising inflation, and we have kept our focus firmly on the ultimate goal of achieving price stability. Within that framework we have attempted not only to lean against the potential for an overheating economy, but also to cushion shortfalls in economic growth. And, recognizing the lags in the effects of policy, we have tried to move in anticipation of such disequilibria developing. But this is a very general framework and does not present clear guidance for day-to-day policy decisions. Thus, as the historic relationship between measured money supply and spending deteriorated, policymaking, seeing no alternative, turned more eclectic and discretionary. Nonetheless, we try to develop as best we can a stable conceptual framework, so policy actions are as regular and predictable as possible -- that is, governed by systematic behavior but open to evidence of structural macroeconomic changes that require policy to adapt. The application of such an approach is illustrated by a number of disparate events we have confronted since 1982 that were in some important respects outside our previous experience. In the early and mid-1980s, the FOMC faced most notably the sharp swings in fiscal policy, the unprecedented rise and fall of the dollar, and the associated shifts in international trade and capital flows. But I will concentrate on several events of the last decade where I personally participated in forming the judgments used in policy implementation. ---[PAGE_BREAK]--- One such event was the stock market crash of October 1987 shortly after I arrived. Unlike many uncertain situations that have confronted monetary policy, there was little question that the appropriate central bank action was to ease policy significantly. We knew we would soon have to sop up the excess liquidity that we added to the system, but the timing and, I believe, the magnitude of our actions were among our easier decisions. Our concerns at that time reflected questions about how the financial markets and the economy would respond to the shock of a decline of more than one-fifth in stock prices in one day, and whether monetary policy alone could stabilize the system. By the early spring of 1988 it was evident that the economy had stabilized and we needed to begin reversing the easy stance of policy. Another development that confronted policy was the commercial property price bust of the late 1980s and early 1990s. Since a large volume of bank and thrift loans was tied to the real estate market and backed by real estate collateral, the fall in property prices impaired the capital of a large number of depositories. These institutions reacted by curtailing new lending -the unprecedented "credit crunch" of 1990 and 1991. Not unexpectedly, our policy response was to move toward significant ease. Our primary concern was the state of the credit markets and the economy, but we could also see that these broader issues were linked inextricably to the state of depository institutions' balance sheets and profitability. A satisfactory recovery from the recession of that period, in our judgment, required the active participation of a viable banking system. The extraordinary circumstances dictated a highly unusual path for monetary policy. The stance of policy eased substantially even after the economy began to recover from the 1990-91 recession, and a stimulative policy was deliberately maintained well into the early expansion period. By mid-1993, however, property prices stabilized and the credit crunch gradually began to dissipate. It was clear as the year moved toward a close that monetary policy, characterized by a real federal funds rate of virtually zero, was now far too easy in light of the strengthening economy on the horizon. Financial and economic conditions were returning to more traditional relationships, and policy had to shift from a situation-specific formulation to one based more closely on previous historical patterns. Although it was difficult at that time to discern any overt inflationary signals, the balance of risks, in our judgment, clearly dictated pre-emptive action. The 1994 to 1995 period was most instructive. It appears we were successful in moving pre-emptively to throttle down an impending unstable boom, which almost surely would have resulted in the current expansion coming to an earlier halt. Because this was the first change in the stance of policy after a prolonged period of unusual ease, we took special care to spell out our analysis and expectations for policy in an unusually explicit way to inform the markets well before we began to tighten. In addition, we began for the first time to issue explanatory statements as changes in the stance of policy were implemented. Even so, the idea of tightening to head off inflation before it was visible in the data was not universally applauded or perhaps understood. Financial markets reacted unusually strongly to our 1994 policy actions, often ratcheting up their expectations for further rate increases when we actually tightened, resulting in very large increases in longer-term interest rates. At the time, these reactions seemed to reflect the extent to which investment strategies had been counting on a persistence of low interest rates. This was a classic case in which we had to be careful not to allow market expectations of Federal Reserve actions to be major elements of policy determination. We are always concerned about assuming that short-term movements in market prices are reflections of changes in ---[PAGE_BREAK]--- underlying supply and demand conditions when we may be observing nothing more than fluctuating expectations about our own policy actions. Most recently, the economy has demonstrated a remarkable confluence of robust growth, high resource utilization, and damped inflation. Once again we have been faced with analyzing and reacting to a situation in which incoming data have not readily conformed to historical experience. Specifically, the persistence of rising profit margins in the face of stable or falling inflation raises the question of what is happening to productivity. If data on profits and prices are even approximately accurate, total consolidated corporate unit costs have, of necessity, been materially contained. With labor costs constituting three-fourths of costs, unless growth in compensation per hour is falling, which seems most unlikely from other information, it is difficult to avoid the conclusion that output per hour has to be rising at a pace significantly in excess of the officially published annual growth rate of nonfarm productivity of one percent over recent quarters. The degree to which these data may be understated is underlined by backing out from the total what appears to be a reasonably accurate, or at least consistent, measure of productivity of corporate businesses. The level of nonfarm noncorporate productivity implied by this exercise has been falling continuously since 1973 despite reasonable earnings margins for proprietorships and partnerships. Presumably this reflects the significant upward bias in our measurement of service prices, which dominate our noncorporate sector. Nonetheless, the still open question is whether productivity growth is in the process of picking up. For it is the answer to this question that is material to the current debate between those who argue that the economy is entering a "new era" of greatly enhanced sustainable growth and unusually high levels of resource utilization, and those who do not. A central bank, while needing to be open to evidence of structural economic change, also needs to be cautious. Supplying excess liquidity to support growth that turns out to have been ephemeral would undermine the very good economic performance we have enjoyed. We raised the federal funds rate in March to help protect against this latter possibility, and with labor resources currently stretched tight, we need to remain on alert. Whatever its successes, the current monetary policy regime is far from ideal. Each episode has had to be treated as unique or nearly so. It may have been the best we could do at the moment. But we continuously examine alternatives that might better anchor policy, so that it becomes less subject to the abilities of the Federal Open Market Committee to analyze developments and make predictions. Gold was such an anchor or rule, prior to World War I, but it was first compromised and eventually abandoned because it restrained the type of discretionary monetary and fiscal policies that modern democracies appear to value. A fixed, or even adaptive, rule on the expansion of the monetary base would anchor the system, but it is hard to envision acceptance for that approach because it also limits economic policy discretion. Moreover, flows of U.S. currency abroad, which are variable and difficult to estimate, and bank reserves avoidance are subverting any relationship that might have existed between growth in the monetary base and U.S. economic performance. ---[PAGE_BREAK]--- Another type of rule using readings on output and prices to help guide monetary policy, such as John Taylor's, has attracted widening interest in recent years in the financial markets, the academic community, and at central banks. Taylor-type rules or reaction functions have a number of attractive features. They assume that central banks can appropriately pay attention simultaneously to developments in both output and inflation, provided their reactions occur in the context of a longer-run goal of price stability and that they recognize that activity is limited by the economy's sustainable potential. As Taylor himself has pointed out, these types of formulations are at best "guideposts" to help central banks, not inflexible rules that eliminate discretion. One reason is that their formulation depends on the values of certain key variables -- most crucially the equilibrium real federal funds rate and the production potential of the economy. In practice these have been obtained by observation of past macroeconomic behavior -- either through informal inspection of the data, or more formally as embedded in models. In that sense, like all rules, as I noted earlier, they embody a forecast that the future will be like the past. Unfortunately, however, history is not an infallible guide to the future, and the levels of these two variables are currently under active debate. The mechanics of monetary policy that I have been addressing are merely means to an end. What are we endeavoring to achieve, and why? The goal of macroeconomic policy should be maximum sustainable growth over the long term, and evidence has continued to accumulate around the world that price stability is a necessary condition for the achievement of that goal. Beyond this very general statement, however, lie difficult issues of concept and measurement for policymakers and academicians to keep us occupied for the next fifteen years and more. Inflation impairs economic efficiency in part because people have difficulty separating movements in relative prices from movements in the general price level. But what prices matter? Certainly prices of goods and services now being produced -- our basic measure of inflation -- matter. But what about prices of claims on future goods and services, like equities, real estate or other earning assets? Is stability in the average level of these prices essential to the stability of the economy? Recent Japanese economic history only underlines the difficulty and importance of this question. The prices of final goods and services were stable in Japan in the mid-to-late 1980s, but soaring asset prices distorted resource allocation and ultimately undermined the performance of the macroeconomy. In the United States, evaluating the effects on the economy of shifts in balance sheets and variations in asset prices has been an integral part of the development of monetary policy. In recent years, for example, we have expended considerable effort to understand the implications of changes in household balance sheets in the form of high and rising consumer debt burdens and increases in market wealth from the run-up in the stock market. And the equity market itself has been the subject of analysis as we attempt to assess the implications for financial and economic stability of the extraordinary rise in equity prices -- a rise based apparently on continuing upward revisions in estimates of our corporations' already robust long-term earning prospects. But, unless they are moving together, prices of assets and of goods and services cannot both be an objective of a particular monetary policy, which, after all, has one effective instrument -- the short-term interest rate. We have chosen product prices as our ---[PAGE_BREAK]--- primary focus on the grounds that stability in the average level of these prices is likely to be consistent with financial stability as well as maximum sustainable growth. History, however, is somewhat ambiguous on the issue of whether central banks can safely ignore asset markets, except as they affect product prices. Over the coming decades, moreover, what constitutes product price and, hence, price stability will itself become harder to measure. When industrial product was the centerpiece of the economy during the first two-thirds of this century, our overall price indexes served us well. Pricing a pound of electrolytic copper presented few definitional problems. The price of a ton of cold rolled steel sheet, or a linear yard of cotton broad woven fabrics, could be reasonably compared over a period of years. I have already noted the problems in defining price and output and, hence, in measuring productivity over the past twenty years. The simple notion of price has turned decidedly complex. What is the price of a unit of software or of a medical procedure? How does one evaluate the price change of a cataract operation over a ten-year period when the nature of the procedure and its impact on the patient has been altered so radically? The pace of change and the shifting to harder-to-measure types of output are more likely to quicken than to slow down. Indeed, how will we measure inflation in the future when our data -- using current techniques -could become increasingly less adequate to trace price trends over time? However, so long as individuals make contractual arrangements for future payments valued in dollars and other currencies, there must be a presumption on the part of those involved in the transaction about the future purchasing power of money. No matter how complex individual products become, there will always be some general sense of the purchasing power of money both across time and across goods and services. Hence, we must assume that embodied in all products is some unit of output, and hence of price, that is recognizable to producers and consumers and upon which they will base their decisions. The emergence of inflation-indexed bonds does not solve the problem of pinning down an economically meaningful measure of the general price level. While there is, of course, an inflation expectation premium embodied in all nominal interest rates, it is fundamentally unobservable. Returns on indexed bonds are tied to forecasts of specific published price indexes, which may or may not reflect the market's judgment of the future purchasing power of money. To the extent they do not, of course, the implicit real interest rate is biased in the opposite direction. Doubtless, we will develop new techniques of measurement to unearth those true prices as the years go on. It is crucial that we do, for inflation can destabilize an economy even if faulty price indexes fail to reveal it. It should be evident from my remarks that ample challenges will continue to face monetary policy. I have concentrated on how we have tried to identify and analyze new developments, and endeavored to use that analysis to fashion and balance policy responses. I have also tried to highlight the questions about how to specify and measure the ultimate goals of policy. Nonetheless, all of us could easily add to the list. In dealing with these issues, policy can only benefit from focused and relevant academic research. I look forward to learning about and utilizing the contributions made under the sponsorship of the Center for Economic Policy Research over the years to come.	Alan Greenspan	United States	https://www.bis.org/review/r970912b.pdf	policy process Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the 15th Anniversary Conference of the Center for Economic Policy Research at Stanford University, Stanford, California on 5/9/97. It is a pleasure to be at this conference marking the fifteenth anniversary of the Center for Economic Policy Research. The Center, by encouraging academic research into public policy and bringing that research to the attention of policymakers, is performing a most valuable role in our society. I am particularly pleased that Milton Friedman has taken time to join us. His views have had as much, if not more, impact on the way we think about monetary policy and many other important economic issues as those of any person in the last half of the twentieth century. Federal Reserve policy, over the years, has been subject to criticism, often with justification, from Professor Friedman and others. It has been argued, for example, that policy failed to anticipate the emerging inflation of the 1970s, and by fostering excessive monetary creation, contributed to the inflationary upsurge. Surely, it was maintained, some monetary policy rule, however imperfect, would have delivered far superior performance. Even if true in this case, though, policy rules might not always be preferable. Policy rules, at least in a general way, presume some understanding of how economic forces work. Moreover, in effect, they anticipate that key causal connections observed in the past will remain fixed over time, or evolve only very slowly. Use of a rule presupposes that action x will, with a reasonably high probability, be followed over time by event y . Another premise behind many rule-based policy prescriptions, however, is that our knowledge of the full workings of the system is quite limited, so that attempts to improve on the results of policy rules will, on average, only make matters worse. In this view, ad hoc or discretionary policy can cause uncertainty for private decision makers and be wrong for extended periods if there is no anchor to bring it back into line. In addition, discretionary policy is obviously vulnerable to political pressures; if ad hoc judgments are to be made, why shouldn't those of elected representatives supersede those of unelected officials? The monetary policy of the Federal Reserve has involved varying degrees of rule- and discretionary-based modes of operation over time. Recognizing the potential drawbacks of purely discretionary policy, the Federal Reserve frequently has sought to exploit past patterns and regularities to operate in a systematic way. But we have found that very often historical regularities have been disrupted by unanticipated change, especially in technologies. The evolving patterns mean that the performance of the economy under any rule, were it to be rigorously followed, would deviate from expectations. Accordingly we are constantly evaluating how much we can infer from the past and how relationships might have changed. In an ever changing world, some element of discretion appears to be an unavoidable aspect of policymaking. Such changes mean that we can never construct a completely general model of the economy, invariant through time, on which to base our policy. Still, sensible policy does presuppose a conceptual framework, or implicit model, however incompletely specified, of how the economic system operates. Of necessity, we make judgments based importantly on historical regularities in behavior inferred from data relationships. These perceived regularities can be embodied in formal empirical models, often covering only a portion of the economic system. Generally, the regularities inform our interpretation of "experience" and tell us what to look for to determine whether history is in the process of repeating itself, and if not, why not. From such an examination, along with an assessment of past policy actions, we attempt to judge to what extent our current policies should deviate from our past patterns of behavior. When this Center was founded 15 years ago, the rules versus discretion debate focused on the appropriate policy role of the monetary aggregates, and this discussion was echoed in the Federal Reserve's policy process. In the late 1970s, the Federal Reserve's actions to deal with developing inflationary instabilities were shaped in part by the reality portrayed by Milton Friedman's analysis that ever-rising inflation rate peaks, as well as ever-rising inflation rate troughs, followed on the heels of similar patterns of average money growth. The Federal Reserve, in response to such evaluations, acted aggressively under newly installed Chairman Paul Volcker. A considerable tightening of the average stance of policy -- based on intermediate M1 targets tied to reserve operating objectives -- eventually reversed the surge in inflation. The last fifteen years have been a period of consolidating the gains of the early 1980s and extending them to their logical end -- the achievement of price stability. We are not quite there yet, but we trust it is on the horizon. Although the ultimate goals of policy have remained the same over these past fifteen years, the techniques used in formulating and implementing policy have changed considerably as a consequence of vast changes in technology and regulation. Focusing on M1, and following operating procedures that imparted a considerable degree of automaticity to short-term interest rate movements, was extraordinarily useful in the early Volcker years. But after nationwide NOW accounts were introduced, the demand for M1 in the judgment of the Federal Open Market Committee became too interest-sensitive for that aggregate to be useful in implementing policy. Because the velocity of such an aggregate varies substantially in response to small changes in interest rates, target ranges for M1 growth in its judgment no longer were reliable guides for outcomes in nominal spending and inflation. In response to an unanticipated movement in spending and hence the quantity of money demanded, a small variation in interest rates would be sufficient to bring money back to path but not to correct the deviation in spending. As a consequence, by late 1982, M1 was de-emphasized and policy decisions per force became more discretionary. However, in recognition of the longer-run relationship of prices and M2, especially its stable long-term velocity, this broader aggregate was accorded more weight, along with a variety of other indicators, in setting our policy stance. As an indicator, M2 served us well for a number of years. But by the early 1990s, its usefulness was undercut by the increased attractiveness and availability of alternative outlets for saving, such as bond and stock mutual funds, and by mounting financial difficulties for depositories and depositors that led to a restructuring of business and household balance sheets. The apparent result was a significant rise in the velocity of M2, which was especially unusual given continuing declines in short-term market interest rates. By 1993, this extraordinary velocity behavior had become so pronounced that the Federal Reserve was forced to begin disregarding the signals M2 was sending, at least for the time being. Data since mid-1994 do seem to show the re-emergence of a relationship of M2 with nominal income and short-term interest rates similar to that experienced during the three decades of the 1960s through the 1980s. As I indicated to the Congress recently, however, the period of predictable velocity is too brief to justify restoring M2 to its role of earlier years, though clearly persistent outsized changes would get our attention. Increasingly since 1982 we have been setting the funds rate directly in response to a wide variety of factors and forecasts. We recognize that, in fixing the short-term rate, we lose much of the information on the balance of money supply and demand that changing market rates afford, but for the moment we see no alternative. In the current state of our knowledge, money demand has become too difficult to predict. Although our operating target is a nominal short-term rate, we view its linkages to spending and prices as indirect and complex. For one, arguably, it is real, not nominal, rates that are more relevant to spending. For another, spending, prices and other economic variables respond to a whole host of financial variables. Hence, in judging the stance of policy we routinely look at the financial impulses coming from foreign exchange, bond, and equity markets, along with supply conditions in credit markets generally, including at financial intermediaries. Nonetheless, we recognize that inflation is fundamentally a monetary phenomenon, and ultimately determined by the growth of the stock of money, not by nominal or real interest rates. In current circumstances, however, determining which financial data should be aggregated to provide an appropriate empirical proxy for the money stock that tracks income and spending represents a severe challenge for monetary analysts. The absence of a monetary aggregate anchor, however, has not left policy completely adrift. From a longer-term perspective we have been guided by a firm commitment to contain any forces that would undermine economic expansion and efficiency by raising inflation, and we have kept our focus firmly on the ultimate goal of achieving price stability. Within that framework we have attempted not only to lean against the potential for an overheating economy, but also to cushion shortfalls in economic growth. And, recognizing the lags in the effects of policy, we have tried to move in anticipation of such disequilibria developing. But this is a very general framework and does not present clear guidance for day-to-day policy decisions. Thus, as the historic relationship between measured money supply and spending deteriorated, policymaking, seeing no alternative, turned more eclectic and discretionary. Nonetheless, we try to develop as best we can a stable conceptual framework, so policy actions are as regular and predictable as possible -- that is, governed by systematic behavior but open to evidence of structural macroeconomic changes that require policy to adapt. The application of such an approach is illustrated by a number of disparate events we have confronted since 1982 that were in some important respects outside our previous experience. In the early and mid-1980s, the FOMC faced most notably the sharp swings in fiscal policy, the unprecedented rise and fall of the dollar, and the associated shifts in international trade and capital flows. But I will concentrate on several events of the last decade where I personally participated in forming the judgments used in policy implementation. One such event was the stock market crash of October 1987 shortly after I arrived. Unlike many uncertain situations that have confronted monetary policy, there was little question that the appropriate central bank action was to ease policy significantly. We knew we would soon have to sop up the excess liquidity that we added to the system, but the timing and, I believe, the magnitude of our actions were among our easier decisions. Our concerns at that time reflected questions about how the financial markets and the economy would respond to the shock of a decline of more than one-fifth in stock prices in one day, and whether monetary policy alone could stabilize the system. By the early spring of 1988 it was evident that the economy had stabilized and we needed to begin reversing the easy stance of policy. Another development that confronted policy was the commercial property price bust of the late 1980s and early 1990s. Since a large volume of bank and thrift loans was tied to the real estate market and backed by real estate collateral, the fall in property prices impaired the capital of a large number of depositories. These institutions reacted by curtailing new lending -the unprecedented "credit crunch" of 1990 and 1991. Not unexpectedly, our policy response was to move toward significant ease. Our primary concern was the state of the credit markets and the economy, but we could also see that these broader issues were linked inextricably to the state of depository institutions' balance sheets and profitability. A satisfactory recovery from the recession of that period, in our judgment, required the active participation of a viable banking system. The extraordinary circumstances dictated a highly unusual path for monetary policy. The stance of policy eased substantially even after the economy began to recover from the 1990-91 recession, and a stimulative policy was deliberately maintained well into the early expansion period. By mid-1993, however, property prices stabilized and the credit crunch gradually began to dissipate. It was clear as the year moved toward a close that monetary policy, characterized by a real federal funds rate of virtually zero, was now far too easy in light of the strengthening economy on the horizon. Financial and economic conditions were returning to more traditional relationships, and policy had to shift from a situation-specific formulation to one based more closely on previous historical patterns. Although it was difficult at that time to discern any overt inflationary signals, the balance of risks, in our judgment, clearly dictated pre-emptive action. The 1994 to 1995 period was most instructive. It appears we were successful in moving pre-emptively to throttle down an impending unstable boom, which almost surely would have resulted in the current expansion coming to an earlier halt. Because this was the first change in the stance of policy after a prolonged period of unusual ease, we took special care to spell out our analysis and expectations for policy in an unusually explicit way to inform the markets well before we began to tighten. In addition, we began for the first time to issue explanatory statements as changes in the stance of policy were implemented. Even so, the idea of tightening to head off inflation before it was visible in the data was not universally applauded or perhaps understood. Financial markets reacted unusually strongly to our 1994 policy actions, often ratcheting up their expectations for further rate increases when we actually tightened, resulting in very large increases in longer-term interest rates. At the time, these reactions seemed to reflect the extent to which investment strategies had been counting on a persistence of low interest rates. This was a classic case in which we had to be careful not to allow market expectations of Federal Reserve actions to be major elements of policy determination. We are always concerned about assuming that short-term movements in market prices are reflections of changes in underlying supply and demand conditions when we may be observing nothing more than fluctuating expectations about our own policy actions. Most recently, the economy has demonstrated a remarkable confluence of robust growth, high resource utilization, and damped inflation. Once again we have been faced with analyzing and reacting to a situation in which incoming data have not readily conformed to historical experience. Specifically, the persistence of rising profit margins in the face of stable or falling inflation raises the question of what is happening to productivity. If data on profits and prices are even approximately accurate, total consolidated corporate unit costs have, of necessity, been materially contained. With labor costs constituting three-fourths of costs, unless growth in compensation per hour is falling, which seems most unlikely from other information, it is difficult to avoid the conclusion that output per hour has to be rising at a pace significantly in excess of the officially published annual growth rate of nonfarm productivity of one percent over recent quarters. The degree to which these data may be understated is underlined by backing out from the total what appears to be a reasonably accurate, or at least consistent, measure of productivity of corporate businesses. The level of nonfarm noncorporate productivity implied by this exercise has been falling continuously since 1973 despite reasonable earnings margins for proprietorships and partnerships. Presumably this reflects the significant upward bias in our measurement of service prices, which dominate our noncorporate sector. Nonetheless, the still open question is whether productivity growth is in the process of picking up. For it is the answer to this question that is material to the current debate between those who argue that the economy is entering a "new era" of greatly enhanced sustainable growth and unusually high levels of resource utilization, and those who do not. A central bank, while needing to be open to evidence of structural economic change, also needs to be cautious. Supplying excess liquidity to support growth that turns out to have been ephemeral would undermine the very good economic performance we have enjoyed. We raised the federal funds rate in March to help protect against this latter possibility, and with labor resources currently stretched tight, we need to remain on alert. Whatever its successes, the current monetary policy regime is far from ideal. Each episode has had to be treated as unique or nearly so. It may have been the best we could do at the moment. But we continuously examine alternatives that might better anchor policy, so that it becomes less subject to the abilities of the Federal Open Market Committee to analyze developments and make predictions. Gold was such an anchor or rule, prior to World War I, but it was first compromised and eventually abandoned because it restrained the type of discretionary monetary and fiscal policies that modern democracies appear to value. A fixed, or even adaptive, rule on the expansion of the monetary base would anchor the system, but it is hard to envision acceptance for that approach because it also limits economic policy discretion. Moreover, flows of U.S. currency abroad, which are variable and difficult to estimate, and bank reserves avoidance are subverting any relationship that might have existed between growth in the monetary base and U.S. economic performance. Another type of rule using readings on output and prices to help guide monetary policy, such as John Taylor's, has attracted widening interest in recent years in the financial markets, the academic community, and at central banks. Taylor-type rules or reaction functions have a number of attractive features. They assume that central banks can appropriately pay attention simultaneously to developments in both output and inflation, provided their reactions occur in the context of a longer-run goal of price stability and that they recognize that activity is limited by the economy's sustainable potential. As Taylor himself has pointed out, these types of formulations are at best "guideposts" to help central banks, not inflexible rules that eliminate discretion. One reason is that their formulation depends on the values of certain key variables -- most crucially the equilibrium real federal funds rate and the production potential of the economy. In practice these have been obtained by observation of past macroeconomic behavior -- either through informal inspection of the data, or more formally as embedded in models. In that sense, like all rules, as I noted earlier, they embody a forecast that the future will be like the past. Unfortunately, however, history is not an infallible guide to the future, and the levels of these two variables are currently under active debate. The mechanics of monetary policy that I have been addressing are merely means to an end. What are we endeavoring to achieve, and why? The goal of macroeconomic policy should be maximum sustainable growth over the long term, and evidence has continued to accumulate around the world that price stability is a necessary condition for the achievement of that goal. Beyond this very general statement, however, lie difficult issues of concept and measurement for policymakers and academicians to keep us occupied for the next fifteen years and more. Inflation impairs economic efficiency in part because people have difficulty separating movements in relative prices from movements in the general price level. But what prices matter? Certainly prices of goods and services now being produced -- our basic measure of inflation -- matter. But what about prices of claims on future goods and services, like equities, real estate or other earning assets? Is stability in the average level of these prices essential to the stability of the economy? Recent Japanese economic history only underlines the difficulty and importance of this question. The prices of final goods and services were stable in Japan in the mid-to-late 1980s, but soaring asset prices distorted resource allocation and ultimately undermined the performance of the macroeconomy. In the United States, evaluating the effects on the economy of shifts in balance sheets and variations in asset prices has been an integral part of the development of monetary policy. In recent years, for example, we have expended considerable effort to understand the implications of changes in household balance sheets in the form of high and rising consumer debt burdens and increases in market wealth from the run-up in the stock market. And the equity market itself has been the subject of analysis as we attempt to assess the implications for financial and economic stability of the extraordinary rise in equity prices -- a rise based apparently on continuing upward revisions in estimates of our corporations' already robust long-term earning prospects. But, unless they are moving together, prices of assets and of goods and services cannot both be an objective of a particular monetary policy, which, after all, has one effective instrument -- the short-term interest rate. We have chosen product prices as our primary focus on the grounds that stability in the average level of these prices is likely to be consistent with financial stability as well as maximum sustainable growth. History, however, is somewhat ambiguous on the issue of whether central banks can safely ignore asset markets, except as they affect product prices. Over the coming decades, moreover, what constitutes product price and, hence, price stability will itself become harder to measure. When industrial product was the centerpiece of the economy during the first two-thirds of this century, our overall price indexes served us well. Pricing a pound of electrolytic copper presented few definitional problems. The price of a ton of cold rolled steel sheet, or a linear yard of cotton broad woven fabrics, could be reasonably compared over a period of years. I have already noted the problems in defining price and output and, hence, in measuring productivity over the past twenty years. The simple notion of price has turned decidedly complex. What is the price of a unit of software or of a medical procedure? How does one evaluate the price change of a cataract operation over a ten-year period when the nature of the procedure and its impact on the patient has been altered so radically? The pace of change and the shifting to harder-to-measure types of output are more likely to quicken than to slow down. Indeed, how will we measure inflation in the future when our data -- using current techniques -could become increasingly less adequate to trace price trends over time? However, so long as individuals make contractual arrangements for future payments valued in dollars and other currencies, there must be a presumption on the part of those involved in the transaction about the future purchasing power of money. No matter how complex individual products become, there will always be some general sense of the purchasing power of money both across time and across goods and services. Hence, we must assume that embodied in all products is some unit of output, and hence of price, that is recognizable to producers and consumers and upon which they will base their decisions. The emergence of inflation-indexed bonds does not solve the problem of pinning down an economically meaningful measure of the general price level. While there is, of course, an inflation expectation premium embodied in all nominal interest rates, it is fundamentally unobservable. Returns on indexed bonds are tied to forecasts of specific published price indexes, which may or may not reflect the market's judgment of the future purchasing power of money. To the extent they do not, of course, the implicit real interest rate is biased in the opposite direction. Doubtless, we will develop new techniques of measurement to unearth those true prices as the years go on. It is crucial that we do, for inflation can destabilize an economy even if faulty price indexes fail to reveal it. It should be evident from my remarks that ample challenges will continue to face monetary policy. I have concentrated on how we have tried to identify and analyze new developments, and endeavored to use that analysis to fashion and balance policy responses. I have also tried to highlight the questions about how to specify and measure the ultimate goals of policy. Nonetheless, all of us could easily add to the list. In dealing with these issues, policy can only benefit from focused and relevant academic research. I look forward to learning about and utilizing the contributions made under the sponsorship of the Center for Economic Policy Research over the years to come.
1997-09-12T00:00:00	Mr. Meyer discusses the connection between policy makers and market participants in the United States (Central Bank Articles and Speeches, 12 Sep 97)	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the Fixed Income Summit of PSA, The Bond Market Trade Association held in Washington, D.C. on 12/9/97.	Mr. Meyer discusses the connection between policy makers and market participants in the United States Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the Fixed Income Summit of PSA, The Bond Market Trade Association held in Washington, D.C. on 12/9/97. Monetary Policy and the Bond Market: Complements or Substitutes? It is a pleasure to speak this afternoon at the Fixed Income Summit. To some analysts, a meeting of the heads of the top fifty government securities dealers would represent a concentration of influence over the U.S. economy that perhaps even surpasses that of the meeting I will attend on September 30. Indeed, some have argued that the activities of traders and investors in the bond market have become a major stabilizing force in the economy, even to the point of making the FOMC redundant. This premise suggests an interesting theme for my address this afternoon -- the connection, or maybe more appropriately the symbiosis, between policy makers and market participants. The Importance of Market Mechanisms The Federal Reserve has been most successful over the years when it has relied on market mechanisms to carry out its policy intent. Regulation Q, in its fixing of ceilings on deposit rates, distorted incentives and led to sudden and large swings in the pattern of intermediation. Selective credit controls, in retrospect, were a blunt instrument that was too unpredictable and extreme to use effectively. And the Board of Governors has found that reserve requirements, which represent a tax on depositories because our reserves do not bear interest, are best held steady at the lowest level consistent with the efficient implementation of policy. Instead, the Federal Reserve controls its balance sheet to influence a rate quoted by market participants any time that the reserve market is open -- the overnight federal funds rate. In truth, as you all know, movements in that rate have little direct significance, except to reserve managers and those relatively few others concerned with the overnight cost of funds. But how that rate gets transmitted along the term structure to yields on longer maturity instruments has broad significance that ultimately affects everyone in the economy. And that is where market participants come in. Policymakers' influence is focused on the current short rate. It is the job of traders and investors to read our intentions from the public record, form their own judgments as to the course of economic activity and inflation that are based on, in addition to monetary policy, current and prospective fiscal policies and demand and supply shocks, and translate all that into action as expressed in the prices of a bewildering array of debt, equity, and derivative instruments. Varieties of Errors While the market activities of traders and investors can importantly reinforce and strengthen the actions taken by the FOMC in the pursuit of its broad macroeconomic objectives, they cannot replace the FOMC. Sometimes, believe it or not, they turn out to complicate, rather than advance, the cause of monetary policy. Before I turn to the good the market does in complementing policy action, let me start by deflating the notion that an omniscient bond market always gets it right so as to render the FOMC redundant. Because many of the instruments in which you deal have long maturities, the judgments that have to be made to price them by necessity stretch well into the future. The scope for error can be large and the consequences costly. I think it is useful to separate the grounds for mistakes into two groups: market participants could be wrong about the economy, or wrong about policymakers' objectives. Two examples can make this distinction clearer. For one, we know, after the fact, that most analysts misjudged the full extent to which unusual restraint on credit was exerting a drag on spending from around 1989 to 1993. Essentially, both households and firms recoiled from the explosion of debt in the 1980s. They were burdened by high interest service and took steps to bring their balance sheets into a more sustainable configuration. Lenders, too, had their own imbalances, brought on importantly by the real estate bust. Among them, banks drew back from extending loans to a wide variety of borrowers, including businesses. In this environment, spreads of private over public rates widened in the market, and borrowers and lenders who went to depositories were confronted with far less favorable terms than they had grown accustomed to. While Chairman Greenspan and his fellow policymakers identified the credit crunch in a fairly timely fashion, it took some time to appreciate the full force of its power. By my reading, in the aggregate, market participants were slower on the uptake. Thus, the policy easings of 1991 and 1992 were greeted with some skepticism as market participants apparently interpreted those actions as reflecting a lessened concern about inflation on the part of the Federal Reserve, rather than the appropriate response to a softening in aggregate demand. The effect of those mis-assessments was to produce a stunning steepening of the yield curve. The spread between long and short-term rates is often viewed as one of the most reliable cyclical indicators and a widening as a measure of the increased stimulus of monetary policy. But I viewed the widening in this episode as evidence of the reduced effectiveness of monetary policy in an environment where actions by bond-market participants were preventing long-term interest rates from adjusting in response to the policy-induced decline in short-term rates. At its peak in mid-1992, the long-term Treasury bond yielded 475 basis points over the three-month bill rate, about three times the average for the prior three decades. True, as the full dimension of the effects of the credit crunch became apparent, yields fell from those heights. But in the interim, monetary policy's intentions were blunted by the market's misreading of the economy. This probably prolonged the need for ease and further accentuated the required easing of the federal funds rate. As another example, I have spent enough of my career projecting near-term economic trends to be familiar with a forecaster's favorite friend -- momentum. But momentum can easily be misjudged. It is easy to fall into the trap of presuming that what an economic actor did last is what that actor will do next. Thus, market prices tend to extrapolate that changes in monetary policy cluster in the same direction. This is a rule that works often enough, but, as a look back to 1994 and 1995 reminds us, not always. By mid-1994, the FOMC had substantially raised its intended federal funds rate, but market prices seemed to say that enough was not enough. The tightenings in May and August of that year, for example, were greeted by a roughly parallel shift up in money market futures rates, implying that the actions had not gotten the Federal Reserve any closer to the goal line -- instead, the goal line had been pushed back. And the Fed indeed did continue to tighten through early 1995. But by late 1994 and early 1995, the term structure spreads in financial markets remained very wide, implying an expectation of still significant further tightening. As a result, the restraint associated with the policy action was amplified. In retrospect, a tighter focus on fundamentals -- that policy was acting in a preemptive fashion to contain inflation, rather than an extrapolation of the sequence of recent policy actions -- would have helped to cap the rise in longer-term yields. The Benefits of Market Mechanisms While I have been speaking about all manner of misjudgments, I actually do have an economist's inherent confidence in market mechanisms. Market participants do, on average, get it right and are rewarded accordingly, to the benefit of economic efficiency. Indeed, the pattern of those rewards sharpens skills in trading and forecasting, ensuring that these benefits will continue to accrue. For that reason, policymakers are well advised to heed the message from markets that are expressed in prices. What I find most intriguing is the notion that markets can carry some, and, in the extreme view, all of the load for monetary policymakers. To push it to an extreme, it's as if the actions of the Federal Open Market Committee, of which I am a member, can be anticipated, augmented, and, perhaps, even replaced, by meetings of the Private Open Market Committee, of which you are members. There are two main advantages of these meetings of the Private Open Market Committee. First, members meet twenty-four hours a day, every business day of the year, so that the POMC can respond to every scrap of information on the economy, whether it be an official data release, a statement by an official, or a rumor about the future course of policy. Second, every participant can express the strength of his or her belief in a particular view by the amount of capital committed to the trade. Because of the inclusiveness of the market, a broad assortment of views about the workings of the economy can be reflected in prices. While the design of the FOMC fosters a similar diversity of views, virtually nonstop market trading allows prices to move before official policymakers can react. Of course, the FOMC delegates authority to the Chairman and, in this age of instantaneous communication, conference calls are always possible. But, practically, with a fixed calendar of FOMC meetings, a desire on our part for a systematic review of the situation to help our deliberations, and some inertia in decision making, markets will almost always be better positioned to react more quickly to news than the Federal Reserve. This speedy response, when right, puts in place stimulus or restraint sooner, perhaps lessening the need for us, ultimately, to move our policy instrument as much. In general, the more forward looking the bond market is with respect to future policy action, the shorter will be the lag from policy action to intended economic effect. In the absence of such a forward-looking response of long-term rates, short-term interest rates may have to move by more to achieve the same near-term impact on long-term interest rates and economic activity. Indeed, in those circumstances, the Federal Reserve would have to weigh carefully the effects on long rates of both the current and lagged levels of short rates so as to avoid the potential for an overshooting of short-term interest rates that would have adverse consequences for the economy. However, if long-term rates move swiftly in response to correctly anticipated policy, the required rise in short-term rates will be smaller and there will be less risk of overshooting. Thus, for the same reasons the Federal Reserve attempts to be pre-emptive in its monetary policy decisions, we would welcome pre-emptive pricing by market participants. But we must recognize that what markets are pricing is anticipated Federal Reserve action. If the prices are right, we will act to validate them. If the prices are wrong - built on the base of an incorrect view of the economy or Federal Reserve intentions -- we will prove them wrong and provide an anchor for the market to adjust to. It is also important to appreciate that the anticipatory contribution of the markets cannot be sustained unless the FOMC ratifies well-timed moves of the market. If the FOMC were to fail to do so, it would disconfirm the expectations on which the market move was based, making it less likely in the future that the market would play a constructive anticipatory role. Therefore, while forward-looking markets may change what we policy makers need to do, they will never eliminate the need for the FOMC to respond to changing economic developments. Some Lessons for Markets and Policymakers I hope that the important question that this discussion has been pointing to is obvious by now: How can we -- the Federal and the Private Open Market Committees -- operate to deliver the greatest good for the American economy while you respect your obligation to stakeholders to maximize their return? I think that there are two parts to the answer: We should work at arm's length but with full information. By arm's length, I mean that the information markets provide works best as an independent check on monetary policy decisions. If the FOMC were to tie mechanically our actions to market prices, then we would be placed in the sorry position of validating whatever whim that currently struck investors' fancy. If you were to take our reading of the economy as if from a sacred text, the unique sources of information and skills that you have refined would go untapped. It is far better that we should treat each other warily so as to keep each other sharp. By full information, I mean that the Federal Reserve should do its best to read signals from markets and to communicate to markets its policy intentions. The Domestic and Foreign Open Market Desks of the Federal Reserve Bank of New York are virtually in constant communication with market participants and routinely distill that information for their policy-making principals. My fellow governors and I routinely receive from our staff a translation of the term structure of Treasury yields into implied forward rates, volatility inferred from options prices, and paths for expected monetary policy action consistent with futures prices. Of late, the information we receive has included inferences drawn from quotes on the Treasury's inflation protected securities. In principle, such information should be helpful in interpreting all manner of economic behavior, including the pricing of financial instruments and wage setting. As yet, I must admit that, in the eight months since the first issue, the volume of trade and the apparent lack of interest in related contracts on the futures market has been somewhat disappointing. The Treasury's strong commitment to this product, reflected in the range of maturities that have and will be sold and the volume of securities sold, should do much to foster this market, as will the growing realization by market participants that indexed debt will represent an increasing share of the nation's debt obligations. But even after we have reliable quotes on a more complete indexed term structure, considerable analysis must still be done before we can cull readings of inflation expectations and inflation risk from market prices. As you well appreciate, the spread of the yield on a nominal instrument over its inflation-protected counterpart includes compensation for expected inflation, inflation uncertainty, and differential risk characteristics. Until we have a long enough history to be more certain of the relative contributions of each, we must watch, wait, and learn. Communication must flow two ways. Over the past few years, I am pleased to say, the FOMC has significantly enhanced the information it provides to the public. That list includes announcing actions -- and the reasons underlying them -- within the day that the decisions are made and providing complete transcripts of meetings with a five year lag. We continue to release a comprehensive record of policy discussions six to eight weeks after each meeting. We now report the daily size of reserve operations within minutes of their completion, and we have lifted the last veil covering the inner sanctum of policy: Rather than speaking in tongues about "slight" or "somewhat" changes in reserve pressures, the FOMC now announces the intended federal funds rate when it is changed. In one respect, the distance covered in that change was not all that great, in that for most of this decade, the Federal Reserve has been rather explicit in signaling through its choice of open market operations whenever the FOMC elected to alter its intended rate. But compared to the borrowed reserves operating period of the latter half of the previous decade, the change has been dramatic. Rather than rely on Fed watchers employed by primary dealers to read the tea leaves of our daily interventions, we inform everyone, openly, and take responsibility for the level of short-term interest rates. By my reading, this is one circumstance in which virtue has proved more than its own reward. Over the past 31⁄2 years, a financial innovation -- sweeps from retail deposits -- has complicated reserve operations. On average, depositories that have adopted sweeps have been able to reduce their effective reserve requirements by 80 to 90 percent. When aggregated over the entire banking system, the scale is staggering. By year-end, transactions deposits will probably have been reduced by nearly $1⁄4 trillion as the result of the cumulative effect of retail sweeps, which is big even by Washington standards. Going by a simple rule of thumb, required reserves will be lower by about one-tenth that total. This innovation has made the technical job of implementing monetary policy from day to day more difficult. Simply, reserve requirements are no longer necessarily the binding determinant of reserve demand for many banks. When reserve requirements are in excess of clearing balances, volatile movements in clearing balances will have a small effect on the reserves market. However, when desired clearing balances dictate short-run movements in the demand for reserves, the reserve market, and therefore the federal funds rate, may become a bit more volatile late in the trading day. However, to the credit of my colleagues charged with determining daily open market operations and of market participants who have adjusted operations to the new environment, that volatility has been quite muted. Still, if markets had only daily open market operations to discern the FOMC's intentions, the scope for misimpressions in this environment would be large. Because you can read press releases to learn our policy stance rather than the pattern of reserve additions or drains, there is much less chance for confusion. For pricing any instrument beyond overnight, market participants apparently find the intended federal funds rate to be more informative than the noisy effective federal funds rate. Nonetheless, it would be helpful to prevent a further increase in the volatility of the effective federal funds rate that might result from a further sweep-induced decline in required reserves. And a means is available to the Congress today to accomplish that end: The Federal Reserve should be permitted to pay interest on reserves. As it stands now, depositories resort to complicated means to evade our reserve requirements -- such as retail sweeps -because our reserves are sterile and to do less would put them at a competitive disadvantage in a market where profit margins are paper thin. By paying interest on reserves, the incentive to engage in sweeps would be sharply reduced and the practice would likely diminish over time, if not end entirely. As a result, bankers could devote their attention to more productive pursuits, and reserve markets would be easier to read. Conclusion I can assure you that I view financial markets as a national resource. To be sure, they do not light the way to proper policy making as perfectly as true believers may assert. But there is information to be gotten, and it has been my experience that policy makers do try to extract it. For our part, we will try to preserve those benefits. For your part, the Private Open Market Committee does public good -- even if it is the by-product of the pursuit of personal profits -- when it views policy making with a skeptical eye. After all, it is only the best of friends who have the courage to point out the most sensitive of faults.	---[PAGE_BREAK]--- # Mr. Meyer discusses the connection between policy makers and market participants in the United States Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the Fixed Income Summit of PSA, The Bond Market Trade Association held in Washington, D.C. on 12/9/97. ## Monetary Policy and the Bond Market: Complements or Substitutes? It is a pleasure to speak this afternoon at the Fixed Income Summit. To some analysts, a meeting of the heads of the top fifty government securities dealers would represent a concentration of influence over the U.S. economy that perhaps even surpasses that of the meeting I will attend on September 30. Indeed, some have argued that the activities of traders and investors in the bond market have become a major stabilizing force in the economy, even to the point of making the FOMC redundant. This premise suggests an interesting theme for my address this afternoon -- the connection, or maybe more appropriately the symbiosis, between policy makers and market participants. ## The Importance of Market Mechanisms The Federal Reserve has been most successful over the years when it has relied on market mechanisms to carry out its policy intent. Regulation Q, in its fixing of ceilings on deposit rates, distorted incentives and led to sudden and large swings in the pattern of intermediation. Selective credit controls, in retrospect, were a blunt instrument that was too unpredictable and extreme to use effectively. And the Board of Governors has found that reserve requirements, which represent a tax on depositories because our reserves do not bear interest, are best held steady at the lowest level consistent with the efficient implementation of policy. Instead, the Federal Reserve controls its balance sheet to influence a rate quoted by market participants any time that the reserve market is open -- the overnight federal funds rate. In truth, as you all know, movements in that rate have little direct significance, except to reserve managers and those relatively few others concerned with the overnight cost of funds. But how that rate gets transmitted along the term structure to yields on longer maturity instruments has broad significance that ultimately affects everyone in the economy. And that is where market participants come in. Policymakers' influence is focused on the current short rate. It is the job of traders and investors to read our intentions from the public record, form their own judgments as to the course of economic activity and inflation that are based on, in addition to monetary policy, current and prospective fiscal policies and demand and supply shocks, and translate all that into action as expressed in the prices of a bewildering array of debt, equity, and derivative instruments. ## Varieties of Errors While the market activities of traders and investors can importantly reinforce and strengthen the actions taken by the FOMC in the pursuit of its broad macroeconomic objectives, they cannot replace the FOMC. Sometimes, believe it or not, they turn out to complicate, rather than advance, the cause of monetary policy. Before I turn to the good the market does in complementing policy action, let me start by deflating the notion that an omniscient bond market always gets it right so as to render the FOMC redundant. Because many of the instruments in which you deal have long maturities, the judgments that have to be made to price them by necessity stretch well into the future. The scope for error can be large and the consequences costly. I think it is useful to separate the grounds for ---[PAGE_BREAK]--- mistakes into two groups: market participants could be wrong about the economy, or wrong about policymakers' objectives. Two examples can make this distinction clearer. For one, we know, after the fact, that most analysts misjudged the full extent to which unusual restraint on credit was exerting a drag on spending from around 1989 to 1993. Essentially, both households and firms recoiled from the explosion of debt in the 1980s. They were burdened by high interest service and took steps to bring their balance sheets into a more sustainable configuration. Lenders, too, had their own imbalances, brought on importantly by the real estate bust. Among them, banks drew back from extending loans to a wide variety of borrowers, including businesses. In this environment, spreads of private over public rates widened in the market, and borrowers and lenders who went to depositories were confronted with far less favorable terms than they had grown accustomed to. While Chairman Greenspan and his fellow policymakers identified the credit crunch in a fairly timely fashion, it took some time to appreciate the full force of its power. By my reading, in the aggregate, market participants were slower on the uptake. Thus, the policy easings of 1991 and 1992 were greeted with some skepticism as market participants apparently interpreted those actions as reflecting a lessened concern about inflation on the part of the Federal Reserve, rather than the appropriate response to a softening in aggregate demand. The effect of those mis-assessments was to produce a stunning steepening of the yield curve. The spread between long and short-term rates is often viewed as one of the most reliable cyclical indicators and a widening as a measure of the increased stimulus of monetary policy. But I viewed the widening in this episode as evidence of the reduced effectiveness of monetary policy in an environment where actions by bond-market participants were preventing long-term interest rates from adjusting in response to the policy-induced decline in short-term rates. At its peak in mid-1992, the long-term Treasury bond yielded 475 basis points over the three-month bill rate, about three times the average for the prior three decades. True, as the full dimension of the effects of the credit crunch became apparent, yields fell from those heights. But in the interim, monetary policy's intentions were blunted by the market's misreading of the economy. This probably prolonged the need for ease and further accentuated the required easing of the federal funds rate. As another example, I have spent enough of my career projecting near-term economic trends to be familiar with a forecaster's favorite friend -- momentum. But momentum can easily be misjudged. It is easy to fall into the trap of presuming that what an economic actor did last is what that actor will do next. Thus, market prices tend to extrapolate that changes in monetary policy cluster in the same direction. This is a rule that works often enough, but, as a look back to 1994 and 1995 reminds us, not always. By mid-1994, the FOMC had substantially raised its intended federal funds rate, but market prices seemed to say that enough was not enough. The tightenings in May and August of that year, for example, were greeted by a roughly parallel shift up in money market futures rates, implying that the actions had not gotten the Federal Reserve any closer to the goal line -- instead, the goal line had been pushed back. And the Fed indeed did continue to tighten through early 1995. But by late 1994 and early 1995, the term structure spreads in financial markets remained very wide, implying an expectation of still significant further tightening. As a result, the restraint associated with the policy action was amplified. In retrospect, a tighter focus on fundamentals -- that policy was acting in a preemptive fashion to contain inflation, rather than an extrapolation of the sequence of recent policy actions -- would have helped to cap the rise in longer-term yields. ---[PAGE_BREAK]--- # The Benefits of Market Mechanisms While I have been speaking about all manner of misjudgments, I actually do have an economist's inherent confidence in market mechanisms. Market participants do, on average, get it right and are rewarded accordingly, to the benefit of economic efficiency. Indeed, the pattern of those rewards sharpens skills in trading and forecasting, ensuring that these benefits will continue to accrue. For that reason, policymakers are well advised to heed the message from markets that are expressed in prices. What I find most intriguing is the notion that markets can carry some, and, in the extreme view, all of the load for monetary policymakers. To push it to an extreme, it's as if the actions of the Federal Open Market Committee, of which I am a member, can be anticipated, augmented, and, perhaps, even replaced, by meetings of the Private Open Market Committee, of which you are members. There are two main advantages of these meetings of the Private Open Market Committee. First, members meet twenty-four hours a day, every business day of the year, so that the POMC can respond to every scrap of information on the economy, whether it be an official data release, a statement by an official, or a rumor about the future course of policy. Second, every participant can express the strength of his or her belief in a particular view by the amount of capital committed to the trade. Because of the inclusiveness of the market, a broad assortment of views about the workings of the economy can be reflected in prices. While the design of the FOMC fosters a similar diversity of views, virtually nonstop market trading allows prices to move before official policymakers can react. Of course, the FOMC delegates authority to the Chairman and, in this age of instantaneous communication, conference calls are always possible. But, practically, with a fixed calendar of FOMC meetings, a desire on our part for a systematic review of the situation to help our deliberations, and some inertia in decision making, markets will almost always be better positioned to react more quickly to news than the Federal Reserve. This speedy response, when right, puts in place stimulus or restraint sooner, perhaps lessening the need for us, ultimately, to move our policy instrument as much. In general, the more forward looking the bond market is with respect to future policy action, the shorter will be the lag from policy action to intended economic effect. In the absence of such a forward-looking response of long-term rates, short-term interest rates may have to move by more to achieve the same near-term impact on long-term interest rates and economic activity. Indeed, in those circumstances, the Federal Reserve would have to weigh carefully the effects on long rates of both the current and lagged levels of short rates so as to avoid the potential for an overshooting of short-term interest rates that would have adverse consequences for the economy. However, if long-term rates move swiftly in response to correctly anticipated policy, the required rise in short-term rates will be smaller and there will be less risk of overshooting. Thus, for the same reasons the Federal Reserve attempts to be pre-emptive in its monetary policy decisions, we would welcome pre-emptive pricing by market participants. But we must recognize that what markets are pricing is anticipated Federal Reserve action. If the prices are right, we will act to validate them. If the prices are wrong - built on the base of an incorrect view of the economy or Federal Reserve intentions -- we will prove them wrong and provide an anchor for the market to adjust to. It is also important to appreciate that the anticipatory contribution of the markets cannot be sustained unless the FOMC ratifies ---[PAGE_BREAK]--- well-timed moves of the market. If the FOMC were to fail to do so, it would disconfirm the expectations on which the market move was based, making it less likely in the future that the market would play a constructive anticipatory role. Therefore, while forward-looking markets may change what we policy makers need to do, they will never eliminate the need for the FOMC to respond to changing economic developments. # Some Lessons for Markets and Policymakers I hope that the important question that this discussion has been pointing to is obvious by now: How can we -- the Federal and the Private Open Market Committees -- operate to deliver the greatest good for the American economy while you respect your obligation to stakeholders to maximize their return? I think that there are two parts to the answer: We should work at arm's length but with full information. By arm's length, I mean that the information markets provide works best as an independent check on monetary policy decisions. If the FOMC were to tie mechanically our actions to market prices, then we would be placed in the sorry position of validating whatever whim that currently struck investors' fancy. If you were to take our reading of the economy as if from a sacred text, the unique sources of information and skills that you have refined would go untapped. It is far better that we should treat each other warily so as to keep each other sharp. By full information, I mean that the Federal Reserve should do its best to read signals from markets and to communicate to markets its policy intentions. The Domestic and Foreign Open Market Desks of the Federal Reserve Bank of New York are virtually in constant communication with market participants and routinely distill that information for their policy-making principals. My fellow governors and I routinely receive from our staff a translation of the term structure of Treasury yields into implied forward rates, volatility inferred from options prices, and paths for expected monetary policy action consistent with futures prices. Of late, the information we receive has included inferences drawn from quotes on the Treasury's inflation protected securities. In principle, such information should be helpful in interpreting all manner of economic behavior, including the pricing of financial instruments and wage setting. As yet, I must admit that, in the eight months since the first issue, the volume of trade and the apparent lack of interest in related contracts on the futures market has been somewhat disappointing. The Treasury's strong commitment to this product, reflected in the range of maturities that have and will be sold and the volume of securities sold, should do much to foster this market, as will the growing realization by market participants that indexed debt will represent an increasing share of the nation's debt obligations. But even after we have reliable quotes on a more complete indexed term structure, considerable analysis must still be done before we can cull readings of inflation expectations and inflation risk from market prices. As you well appreciate, the spread of the yield on a nominal instrument over its inflation-protected counterpart includes compensation for expected inflation, inflation uncertainty, and differential risk characteristics. Until we have a long enough history to be more certain of the relative contributions of each, we must watch, wait, and learn. Communication must flow two ways. Over the past few years, I am pleased to say, the FOMC has significantly enhanced the information it provides to the public. That list includes announcing actions -- and the reasons underlying them -- within the day that the decisions are made and providing complete transcripts of meetings with a five year lag. We continue to release a comprehensive record of policy discussions six to eight weeks after each ---[PAGE_BREAK]--- meeting. We now report the daily size of reserve operations within minutes of their completion, and we have lifted the last veil covering the inner sanctum of policy: Rather than speaking in tongues about "slight" or "somewhat" changes in reserve pressures, the FOMC now announces the intended federal funds rate when it is changed. In one respect, the distance covered in that change was not all that great, in that for most of this decade, the Federal Reserve has been rather explicit in signaling through its choice of open market operations whenever the FOMC elected to alter its intended rate. But compared to the borrowed reserves operating period of the latter half of the previous decade, the change has been dramatic. Rather than rely on Fed watchers employed by primary dealers to read the tea leaves of our daily interventions, we inform everyone, openly, and take responsibility for the level of short-term interest rates. By my reading, this is one circumstance in which virtue has proved more than its own reward. Over the past $3^{1 / 2}$ years, a financial innovation -- sweeps from retail deposits -- has complicated reserve operations. On average, depositories that have adopted sweeps have been able to reduce their effective reserve requirements by 80 to 90 percent. When aggregated over the entire banking system, the scale is staggering. By year-end, transactions deposits will probably have been reduced by nearly $\$ 1 / 4$ trillion as the result of the cumulative effect of retail sweeps, which is big even by Washington standards. Going by a simple rule of thumb, required reserves will be lower by about one-tenth that total. This innovation has made the technical job of implementing monetary policy from day to day more difficult. Simply, reserve requirements are no longer necessarily the binding determinant of reserve demand for many banks. When reserve requirements are in excess of clearing balances, volatile movements in clearing balances will have a small effect on the reserves market. However, when desired clearing balances dictate short-run movements in the demand for reserves, the reserve market, and therefore the federal funds rate, may become a bit more volatile late in the trading day. However, to the credit of my colleagues charged with determining daily open market operations and of market participants who have adjusted operations to the new environment, that volatility has been quite muted. Still, if markets had only daily open market operations to discern the FOMC's intentions, the scope for misimpressions in this environment would be large. Because you can read press releases to learn our policy stance rather than the pattern of reserve additions or drains, there is much less chance for confusion. For pricing any instrument beyond overnight, market participants apparently find the intended federal funds rate to be more informative than the noisy effective federal funds rate. Nonetheless, it would be helpful to prevent a further increase in the volatility of the effective federal funds rate that might result from a further sweep-induced decline in required reserves. And a means is available to the Congress today to accomplish that end: The Federal Reserve should be permitted to pay interest on reserves. As it stands now, depositories resort to complicated means to evade our reserve requirements -- such as retail sweeps -because our reserves are sterile and to do less would put them at a competitive disadvantage in a market where profit margins are paper thin. By paying interest on reserves, the incentive to engage in sweeps would be sharply reduced and the practice would likely diminish over time, if not end entirely. As a result, bankers could devote their attention to more productive pursuits, and reserve markets would be easier to read. # Conclusion I can assure you that I view financial markets as a national resource. To be sure, they do not light the way to proper policy making as perfectly as true believers may assert. But there is information to be gotten, and it has been my experience that policy makers do try to ---[PAGE_BREAK]--- extract it. For our part, we will try to preserve those benefits. For your part, the Private Open Market Committee does public good -- even if it is the by-product of the pursuit of personal profits -- when it views policy making with a skeptical eye. After all, it is only the best of friends who have the courage to point out the most sensitive of faults.	Laurence H Meyer	United States	https://www.bis.org/review/r970925a.pdf	participants in the United States Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the Fixed Income Summit of PSA, The Bond Market Trade Association held in Washington, D.C. on 12/9/97. It is a pleasure to speak this afternoon at the Fixed Income Summit. To some analysts, a meeting of the heads of the top fifty government securities dealers would represent a concentration of influence over the U.S. economy that perhaps even surpasses that of the meeting I will attend on September 30. Indeed, some have argued that the activities of traders and investors in the bond market have become a major stabilizing force in the economy, even to the point of making the FOMC redundant. This premise suggests an interesting theme for my address this afternoon -- the connection, or maybe more appropriately the symbiosis, between policy makers and market participants. The Federal Reserve has been most successful over the years when it has relied on market mechanisms to carry out its policy intent. Regulation Q, in its fixing of ceilings on deposit rates, distorted incentives and led to sudden and large swings in the pattern of intermediation. Selective credit controls, in retrospect, were a blunt instrument that was too unpredictable and extreme to use effectively. And the Board of Governors has found that reserve requirements, which represent a tax on depositories because our reserves do not bear interest, are best held steady at the lowest level consistent with the efficient implementation of policy. Instead, the Federal Reserve controls its balance sheet to influence a rate quoted by market participants any time that the reserve market is open -- the overnight federal funds rate. In truth, as you all know, movements in that rate have little direct significance, except to reserve managers and those relatively few others concerned with the overnight cost of funds. But how that rate gets transmitted along the term structure to yields on longer maturity instruments has broad significance that ultimately affects everyone in the economy. And that is where market participants come in. Policymakers' influence is focused on the current short rate. It is the job of traders and investors to read our intentions from the public record, form their own judgments as to the course of economic activity and inflation that are based on, in addition to monetary policy, current and prospective fiscal policies and demand and supply shocks, and translate all that into action as expressed in the prices of a bewildering array of debt, equity, and derivative instruments. While the market activities of traders and investors can importantly reinforce and strengthen the actions taken by the FOMC in the pursuit of its broad macroeconomic objectives, they cannot replace the FOMC. Sometimes, believe it or not, they turn out to complicate, rather than advance, the cause of monetary policy. Before I turn to the good the market does in complementing policy action, let me start by deflating the notion that an omniscient bond market always gets it right so as to render the FOMC redundant. Because many of the instruments in which you deal have long maturities, the judgments that have to be made to price them by necessity stretch well into the future. The scope for error can be large and the consequences costly. I think it is useful to separate the grounds for mistakes into two groups: market participants could be wrong about the economy, or wrong about policymakers' objectives. Two examples can make this distinction clearer. For one, we know, after the fact, that most analysts misjudged the full extent to which unusual restraint on credit was exerting a drag on spending from around 1989 to 1993. Essentially, both households and firms recoiled from the explosion of debt in the 1980s. They were burdened by high interest service and took steps to bring their balance sheets into a more sustainable configuration. Lenders, too, had their own imbalances, brought on importantly by the real estate bust. Among them, banks drew back from extending loans to a wide variety of borrowers, including businesses. In this environment, spreads of private over public rates widened in the market, and borrowers and lenders who went to depositories were confronted with far less favorable terms than they had grown accustomed to. While Chairman Greenspan and his fellow policymakers identified the credit crunch in a fairly timely fashion, it took some time to appreciate the full force of its power. By my reading, in the aggregate, market participants were slower on the uptake. Thus, the policy easings of 1991 and 1992 were greeted with some skepticism as market participants apparently interpreted those actions as reflecting a lessened concern about inflation on the part of the Federal Reserve, rather than the appropriate response to a softening in aggregate demand. The effect of those mis-assessments was to produce a stunning steepening of the yield curve. The spread between long and short-term rates is often viewed as one of the most reliable cyclical indicators and a widening as a measure of the increased stimulus of monetary policy. But I viewed the widening in this episode as evidence of the reduced effectiveness of monetary policy in an environment where actions by bond-market participants were preventing long-term interest rates from adjusting in response to the policy-induced decline in short-term rates. At its peak in mid-1992, the long-term Treasury bond yielded 475 basis points over the three-month bill rate, about three times the average for the prior three decades. True, as the full dimension of the effects of the credit crunch became apparent, yields fell from those heights. But in the interim, monetary policy's intentions were blunted by the market's misreading of the economy. This probably prolonged the need for ease and further accentuated the required easing of the federal funds rate. As another example, I have spent enough of my career projecting near-term economic trends to be familiar with a forecaster's favorite friend -- momentum. But momentum can easily be misjudged. It is easy to fall into the trap of presuming that what an economic actor did last is what that actor will do next. Thus, market prices tend to extrapolate that changes in monetary policy cluster in the same direction. This is a rule that works often enough, but, as a look back to 1994 and 1995 reminds us, not always. By mid-1994, the FOMC had substantially raised its intended federal funds rate, but market prices seemed to say that enough was not enough. The tightenings in May and August of that year, for example, were greeted by a roughly parallel shift up in money market futures rates, implying that the actions had not gotten the Federal Reserve any closer to the goal line -- instead, the goal line had been pushed back. And the Fed indeed did continue to tighten through early 1995. But by late 1994 and early 1995, the term structure spreads in financial markets remained very wide, implying an expectation of still significant further tightening. As a result, the restraint associated with the policy action was amplified. In retrospect, a tighter focus on fundamentals -- that policy was acting in a preemptive fashion to contain inflation, rather than an extrapolation of the sequence of recent policy actions -- would have helped to cap the rise in longer-term yields. While I have been speaking about all manner of misjudgments, I actually do have an economist's inherent confidence in market mechanisms. Market participants do, on average, get it right and are rewarded accordingly, to the benefit of economic efficiency. Indeed, the pattern of those rewards sharpens skills in trading and forecasting, ensuring that these benefits will continue to accrue. For that reason, policymakers are well advised to heed the message from markets that are expressed in prices. What I find most intriguing is the notion that markets can carry some, and, in the extreme view, all of the load for monetary policymakers. To push it to an extreme, it's as if the actions of the Federal Open Market Committee, of which I am a member, can be anticipated, augmented, and, perhaps, even replaced, by meetings of the Private Open Market Committee, of which you are members. There are two main advantages of these meetings of the Private Open Market Committee. First, members meet twenty-four hours a day, every business day of the year, so that the POMC can respond to every scrap of information on the economy, whether it be an official data release, a statement by an official, or a rumor about the future course of policy. Second, every participant can express the strength of his or her belief in a particular view by the amount of capital committed to the trade. Because of the inclusiveness of the market, a broad assortment of views about the workings of the economy can be reflected in prices. While the design of the FOMC fosters a similar diversity of views, virtually nonstop market trading allows prices to move before official policymakers can react. Of course, the FOMC delegates authority to the Chairman and, in this age of instantaneous communication, conference calls are always possible. But, practically, with a fixed calendar of FOMC meetings, a desire on our part for a systematic review of the situation to help our deliberations, and some inertia in decision making, markets will almost always be better positioned to react more quickly to news than the Federal Reserve. This speedy response, when right, puts in place stimulus or restraint sooner, perhaps lessening the need for us, ultimately, to move our policy instrument as much. In general, the more forward looking the bond market is with respect to future policy action, the shorter will be the lag from policy action to intended economic effect. In the absence of such a forward-looking response of long-term rates, short-term interest rates may have to move by more to achieve the same near-term impact on long-term interest rates and economic activity. Indeed, in those circumstances, the Federal Reserve would have to weigh carefully the effects on long rates of both the current and lagged levels of short rates so as to avoid the potential for an overshooting of short-term interest rates that would have adverse consequences for the economy. However, if long-term rates move swiftly in response to correctly anticipated policy, the required rise in short-term rates will be smaller and there will be less risk of overshooting. Thus, for the same reasons the Federal Reserve attempts to be pre-emptive in its monetary policy decisions, we would welcome pre-emptive pricing by market participants. But we must recognize that what markets are pricing is anticipated Federal Reserve action. If the prices are right, we will act to validate them. If the prices are wrong - built on the base of an incorrect view of the economy or Federal Reserve intentions -- we will prove them wrong and provide an anchor for the market to adjust to. It is also important to appreciate that the anticipatory contribution of the markets cannot be sustained unless the FOMC ratifies well-timed moves of the market. If the FOMC were to fail to do so, it would disconfirm the expectations on which the market move was based, making it less likely in the future that the market would play a constructive anticipatory role. Therefore, while forward-looking markets may change what we policy makers need to do, they will never eliminate the need for the FOMC to respond to changing economic developments. I hope that the important question that this discussion has been pointing to is obvious by now: How can we -- the Federal and the Private Open Market Committees -- operate to deliver the greatest good for the American economy while you respect your obligation to stakeholders to maximize their return? I think that there are two parts to the answer: We should work at arm's length but with full information. By arm's length, I mean that the information markets provide works best as an independent check on monetary policy decisions. If the FOMC were to tie mechanically our actions to market prices, then we would be placed in the sorry position of validating whatever whim that currently struck investors' fancy. If you were to take our reading of the economy as if from a sacred text, the unique sources of information and skills that you have refined would go untapped. It is far better that we should treat each other warily so as to keep each other sharp. By full information, I mean that the Federal Reserve should do its best to read signals from markets and to communicate to markets its policy intentions. The Domestic and Foreign Open Market Desks of the Federal Reserve Bank of New York are virtually in constant communication with market participants and routinely distill that information for their policy-making principals. My fellow governors and I routinely receive from our staff a translation of the term structure of Treasury yields into implied forward rates, volatility inferred from options prices, and paths for expected monetary policy action consistent with futures prices. Of late, the information we receive has included inferences drawn from quotes on the Treasury's inflation protected securities. In principle, such information should be helpful in interpreting all manner of economic behavior, including the pricing of financial instruments and wage setting. As yet, I must admit that, in the eight months since the first issue, the volume of trade and the apparent lack of interest in related contracts on the futures market has been somewhat disappointing. The Treasury's strong commitment to this product, reflected in the range of maturities that have and will be sold and the volume of securities sold, should do much to foster this market, as will the growing realization by market participants that indexed debt will represent an increasing share of the nation's debt obligations. But even after we have reliable quotes on a more complete indexed term structure, considerable analysis must still be done before we can cull readings of inflation expectations and inflation risk from market prices. As you well appreciate, the spread of the yield on a nominal instrument over its inflation-protected counterpart includes compensation for expected inflation, inflation uncertainty, and differential risk characteristics. Until we have a long enough history to be more certain of the relative contributions of each, we must watch, wait, and learn. Communication must flow two ways. Over the past few years, I am pleased to say, the FOMC has significantly enhanced the information it provides to the public. That list includes announcing actions -- and the reasons underlying them -- within the day that the decisions are made and providing complete transcripts of meetings with a five year lag. We continue to release a comprehensive record of policy discussions six to eight weeks after each meeting. We now report the daily size of reserve operations within minutes of their completion, and we have lifted the last veil covering the inner sanctum of policy: Rather than speaking in tongues about "slight" or "somewhat" changes in reserve pressures, the FOMC now announces the intended federal funds rate when it is changed. In one respect, the distance covered in that change was not all that great, in that for most of this decade, the Federal Reserve has been rather explicit in signaling through its choice of open market operations whenever the FOMC elected to alter its intended rate. But compared to the borrowed reserves operating period of the latter half of the previous decade, the change has been dramatic. Rather than rely on Fed watchers employed by primary dealers to read the tea leaves of our daily interventions, we inform everyone, openly, and take responsibility for the level of short-term interest rates. By my reading, this is one circumstance in which virtue has proved more than its own reward. Over the past $3^{1 / 2}$ years, a financial innovation -- sweeps from retail deposits -- has complicated reserve operations. On average, depositories that have adopted sweeps have been able to reduce their effective reserve requirements by 80 to 90 percent. When aggregated over the entire banking system, the scale is staggering. By year-end, transactions deposits will probably have been reduced by nearly $\$ 1 / 4$ trillion as the result of the cumulative effect of retail sweeps, which is big even by Washington standards. Going by a simple rule of thumb, required reserves will be lower by about one-tenth that total. This innovation has made the technical job of implementing monetary policy from day to day more difficult. Simply, reserve requirements are no longer necessarily the binding determinant of reserve demand for many banks. When reserve requirements are in excess of clearing balances, volatile movements in clearing balances will have a small effect on the reserves market. However, when desired clearing balances dictate short-run movements in the demand for reserves, the reserve market, and therefore the federal funds rate, may become a bit more volatile late in the trading day. However, to the credit of my colleagues charged with determining daily open market operations and of market participants who have adjusted operations to the new environment, that volatility has been quite muted. Still, if markets had only daily open market operations to discern the FOMC's intentions, the scope for misimpressions in this environment would be large. Because you can read press releases to learn our policy stance rather than the pattern of reserve additions or drains, there is much less chance for confusion. For pricing any instrument beyond overnight, market participants apparently find the intended federal funds rate to be more informative than the noisy effective federal funds rate. Nonetheless, it would be helpful to prevent a further increase in the volatility of the effective federal funds rate that might result from a further sweep-induced decline in required reserves. And a means is available to the Congress today to accomplish that end: The Federal Reserve should be permitted to pay interest on reserves. As it stands now, depositories resort to complicated means to evade our reserve requirements -- such as retail sweeps -because our reserves are sterile and to do less would put them at a competitive disadvantage in a market where profit margins are paper thin. By paying interest on reserves, the incentive to engage in sweeps would be sharply reduced and the practice would likely diminish over time, if not end entirely. As a result, bankers could devote their attention to more productive pursuits, and reserve markets would be easier to read. I can assure you that I view financial markets as a national resource. To be sure, they do not light the way to proper policy making as perfectly as true believers may assert. But there is information to be gotten, and it has been my experience that policy makers do try to extract it. For our part, we will try to preserve those benefits. For your part, the Private Open Market Committee does public good -- even if it is the by-product of the pursuit of personal profits -- when it views policy making with a skeptical eye. After all, it is only the best of friends who have the courage to point out the most sensitive of faults.
1997-09-12T00:00:00	Mr. Greenspan comments on the importance of technological development and the value of education for economic growth in the United States (Central Bank Articles and Speeches, 12 Sep 97)	Remarks by the Chairman of the US Federal Reserve System, Mr. Alan Greenspan, at the Building Dedication Ceremonies at the Kenan-Flagler Business School, University of North Carolina on 12/9/97.	Mr. Greenspan comments on the importance of technological development and the value of education for economic growth in the United States Remarks by the Chairman of the US Federal Reserve System, Mr. Alan Greenspan, at the Building Dedication Ceremonies at the Kenan-Flagler Business School, University of North Carolina on 12/9/97. I welcome the opportunity to join Dean Fulton, President Broad, President Emeritus Spangler, Chancellor Hooker, Hugh McColl, and the many other distinguished guests on the podium today. It isn't every day that we have the opportunity to dedicate a new building devoted to the research and training that our young people need for conducting business in a global setting. This new facility -- the McColl Bulding -- has been equipped with state-of-the-art information technology that will enhance the ability of the faculty and students of Kenan-Flagler to prepare for an exciting future in our global economy. The University has made this important commitment at a time when our businesses and workers are confronting a dynamic set of forces that will influence our nation's ability to compete worldwide in the years ahead. One of the most central of these forces is the rapid acceleration of computer and telecommunications technologies, which can be reasonably expected to appreciably raise our standard of living in the twenty-first century. In the short run, however, the fallout from rapidly changing technology is an environment in which the stock of plant and equipment with which most managers and workers interact is turning over increasingly rapidly, rendering a perception that human skills are becoming obsolete at a rate perhaps unprecedented in American history. I shall endeavor to place this most unusual phenomenon in the context of the broader changes in our economy and, hopefully, explain why the value of education, especially to enhance advanced skills, is so vital to the future growth of our economy. Wealth has always been created, virtually by definition, when individuals use their growing knowledge to interact with an expanding capital stock to produce goods and services of value. Assisted by the whole array of market prices, entrepreneurs seek to identify the types of products and services that individuals will value, especially the added value placed on products and services that customers find better tailored to their particular needs, delivered in shorter time frames, or improved in quality. This striving to unbundle the particular characteristics of goods and services in order to maximize their value to each individual inevitably results in the shift toward value created through the exploitation of ideas and concepts, rather than simply the utilization of physical resources and manual labor. Indeed, over the past century, by far the smallest part of the growth in America's real gross domestic product reflects increased physical product measured in bulk or weight. Most of our gains have been the result of new insights into how to rearrange physical reality to achieve ever-higher standards of living. We have dramatically reduced the physical bulk of our radios, for example, by substituting transistors for vacuum tubes. New architectural, engineering, and materials technologies have enabled the construction of buildings with the same space, but far less physical material, than was required 50 or 100 years ago. Most recently, mobile phones have been significantly downsized as they have been improved. The increasing importance of new insights has, of course, raised the value of information creation and transfer in boosting standards of living. Thus, it should be no surprise that new computer and telecommunications products have been accorded particularly high value by consumers and business and, hence, why companies that successfully innovate in this field exhibit particularly high stock market values. Breakthroughs in all areas of technology are continually adding to the growing list of almost wholly conceptual elements in our economic output. These developments are affecting how we produce output and are demanding greater specialized knowledge. The use, for example, of computer-assisted design instruments, machine tools, and inventory control systems has given our former, more rigid factory assembly lines greater flexibility. Businesses now can more quickly customize their production to changes in market conditions; design cycles are shorter, quality control has been improved, and costs are lower. Offices are now routinely outfitted with high-speed information-processing technology. The accelerated pace of technological advance has also interacted with the rapid rise in financial innovation, with the result that business services and financial transactions now are transmitted almost instantaneously across global networks. Financial instruments have become increasingly diverse, the products more customized, and the markets more intensely competitive. Our nation's financial institutions, in turn, are endeavoring to find more effective and efficient ways to deliver their services. In this environment, America's prospects for economic growth will greatly depend on our capacity to develop and to apply new technology -- a quest that inevitably will entail some risk-taking. One lesson we have clearly learned is that we never can predict with any precision which particular technology or synergies of technologies will add significantly to our knowledge and ability to gain from that knowledge. Moreover, America's ability to remain in the forefront of new ideas and products has become ever more difficult because of the rapid international diffusion of technology. Nonetheless, to date, we have not fallen behind in converting scientific and technological breakthroughs into viable commercial products. But, to be fully effective in realizing the gains from technological advance will require a considerable amount of human investment on the part of managers and workers who have to implement new processes and who must be prepared to adapt, over their lifetimes, to the ongoing change that innovations bring. Clearly our educational institutions will continue to play an important role in preparing workers. While we all are concerned about the performance of American elementary and secondary schools compared with those in other developed countries, there is little question about the quality of our university system, which for decades has attracted growing numbers of students from abroad. However, the notion that formal degree programs at any level can be crafted to fully support the requirements of one's lifework is being challenged. A great deal of innovation and development has been occurring in the business sector where firms are striving to stay on the cutting edge, in an environment where products and knowledge rapidly become obsolete. Education, as a result, is increasingly becoming a lifelong activity; businesses are now looking for employees who are prepared to continue learning, and workers and managers in many kinds of pursuits had better look forward to persistent hard work acquiring and maintaining the skills needed to cope with a dynamically evolving economy. The recognition that more productive workers and learning go hand-in-hand is becoming ever more visible in both schools and in the workplace. Linkages between business and education should be encouraged at all levels of our education system. Your business school is an excellent example of how our educational institutions are building bridges to the private sector that will have payoffs in how well graduates are prepared to meet the challenges of an increasingly knowledge-based global economy. The growth of high-tech industry here in the Research Triangle, as well as in Silicon Valley and Boston -- all areas rich in educational and research institutions -- is no accident. In the private sector, a number of major corporations have invested in their own internal training centers -- so-called corporate universities. Some labor unions have done the same. More broadly, recent surveys by the Bureau of Labor Statistics indicate that the provision of formal education on the job has risen markedly in recent years. By 1995, 70 percent of workers in establishments with 50 or more employees had received some formal training during the twelve months preceding the survey. The incidence of training was relatively high across age groups and educational attainment. Most often this training was conducted in-house by company personnel, but larger firms also relied importantly on educational institutions. At the same time, we must be alert to the need to improve the skills and earning power of those who appear to be falling behind. In the long run, better child-rearing and better basic education at the elementary and secondary school level are essential to providing the foundation for a lifetime of learning. But in the shorter run, we must also develop strategies to overcome the education deficiencies of all too many of our young people, and to renew the skills of workers who have not kept up with the changing demands of the workplace. The advent of the twenty-first century will certainly not bring an end to the challenges we are facing in a rapidly changing world. Americans will surely adjust to a frenetic pace of change, as we have in the past, but we must recognize that adjustment is not automatic. All shifts in the structure of the economy naturally create frictions and human stress, at least temporarily. As those frictions dissipate, however, I have no doubt that the economy will emerge healthier. And, if we are able to boost our investment in people, ideas, and processes as well as machines, the economy can operate more effectively as it adapts to change. This holds the potential to create an even greater payoff of a broadly based rise in living standards over the longer run. Your new Kenan-Flagler facility will enhance this University's ability to meet the challenge.	---[PAGE_BREAK]--- # Mr. Greenspan comments on the importance of technological development and the value of education for economic growth in the United States Remarks by the Chairman of the US Federal Reserve System, Mr. Alan Greenspan, at the Building Dedication Ceremonies at the Kenan-Flagler Business School, University of North Carolina on 12/9/97. I welcome the opportunity to join Dean Fulton, President Broad, President Emeritus Spangler, Chancellor Hooker, Hugh McColl, and the many other distinguished guests on the podium today. It isn't every day that we have the opportunity to dedicate a new building devoted to the research and training that our young people need for conducting business in a global setting. This new facility -- the McColl Bulding -- has been equipped with state-of-the-art information technology that will enhance the ability of the faculty and students of Kenan-Flagler to prepare for an exciting future in our global economy. The University has made this important commitment at a time when our businesses and workers are confronting a dynamic set of forces that will influence our nation's ability to compete worldwide in the years ahead. One of the most central of these forces is the rapid acceleration of computer and telecommunications technologies, which can be reasonably expected to appreciably raise our standard of living in the twenty-first century. In the short run, however, the fallout from rapidly changing technology is an environment in which the stock of plant and equipment with which most managers and workers interact is turning over increasingly rapidly, rendering a perception that human skills are becoming obsolete at a rate perhaps unprecedented in American history. I shall endeavor to place this most unusual phenomenon in the context of the broader changes in our economy and, hopefully, explain why the value of education, especially to enhance advanced skills, is so vital to the future growth of our economy. Wealth has always been created, virtually by definition, when individuals use their growing knowledge to interact with an expanding capital stock to produce goods and services of value. Assisted by the whole array of market prices, entrepreneurs seek to identify the types of products and services that individuals will value, especially the added value placed on products and services that customers find better tailored to their particular needs, delivered in shorter time frames, or improved in quality. This striving to unbundle the particular characteristics of goods and services in order to maximize their value to each individual inevitably results in the shift toward value created through the exploitation of ideas and concepts, rather than simply the utilization of physical resources and manual labor. Indeed, over the past century, by far the smallest part of the growth in America's real gross domestic product reflects increased physical product measured in bulk or weight. Most of our gains have been the result of new insights into how to rearrange physical reality to achieve ever-higher standards of living. We have dramatically reduced the physical bulk of our radios, for example, by substituting transistors for vacuum tubes. New architectural, engineering, and materials technologies have enabled the construction of buildings with the same space, but far less physical material, than was required 50 or 100 years ago. Most recently, mobile phones have been significantly downsized as they have been improved. The increasing importance of new insights has, of course, raised the value of information creation and transfer in boosting standards of living. Thus, it should be no surprise that new computer and telecommunications products have been accorded particularly high value by consumers and business and, hence, why companies that successfully innovate in this field exhibit particularly high stock market values. ---[PAGE_BREAK]--- Breakthroughs in all areas of technology are continually adding to the growing list of almost wholly conceptual elements in our economic output. These developments are affecting how we produce output and are demanding greater specialized knowledge. The use, for example, of computer-assisted design instruments, machine tools, and inventory control systems has given our former, more rigid factory assembly lines greater flexibility. Businesses now can more quickly customize their production to changes in market conditions; design cycles are shorter, quality control has been improved, and costs are lower. Offices are now routinely outfitted with high-speed information-processing technology. The accelerated pace of technological advance has also interacted with the rapid rise in financial innovation, with the result that business services and financial transactions now are transmitted almost instantaneously across global networks. Financial instruments have become increasingly diverse, the products more customized, and the markets more intensely competitive. Our nation's financial institutions, in turn, are endeavoring to find more effective and efficient ways to deliver their services. In this environment, America's prospects for economic growth will greatly depend on our capacity to develop and to apply new technology -- a quest that inevitably will entail some risk-taking. One lesson we have clearly learned is that we never can predict with any precision which particular technology or synergies of technologies will add significantly to our knowledge and ability to gain from that knowledge. Moreover, America's ability to remain in the forefront of new ideas and products has become ever more difficult because of the rapid international diffusion of technology. Nonetheless, to date, we have not fallen behind in converting scientific and technological breakthroughs into viable commercial products. But, to be fully effective in realizing the gains from technological advance will require a considerable amount of human investment on the part of managers and workers who have to implement new processes and who must be prepared to adapt, over their lifetimes, to the ongoing change that innovations bring. Clearly our educational institutions will continue to play an important role in preparing workers. While we all are concerned about the performance of American elementary and secondary schools compared with those in other developed countries, there is little question about the quality of our university system, which for decades has attracted growing numbers of students from abroad. However, the notion that formal degree programs at any level can be crafted to fully support the requirements of one's lifework is being challenged. A great deal of innovation and development has been occurring in the business sector where firms are striving to stay on the cutting edge, in an environment where products and knowledge rapidly become obsolete. Education, as a result, is increasingly becoming a lifelong activity; businesses are now looking for employees who are prepared to continue learning, and workers and managers in many kinds of pursuits had better look forward to persistent hard work acquiring and maintaining the skills needed to cope with a dynamically evolving economy. The recognition that more productive workers and learning go hand-in-hand is becoming ever more visible in both schools and in the workplace. Linkages between business and education should be encouraged at all levels of our education system. Your business school is an excellent example of how our educational institutions are building bridges to the private sector that will have payoffs in how well graduates are prepared to meet the challenges of an ---[PAGE_BREAK]--- increasingly knowledge-based global economy. The growth of high-tech industry here in the Research Triangle, as well as in Silicon Valley and Boston -- all areas rich in educational and research institutions -- is no accident. In the private sector, a number of major corporations have invested in their own internal training centers -- so-called corporate universities. Some labor unions have done the same. More broadly, recent surveys by the Bureau of Labor Statistics indicate that the provision of formal education on the job has risen markedly in recent years. By 1995, 70 percent of workers in establishments with 50 or more employees had received some formal training during the twelve months preceding the survey. The incidence of training was relatively high across age groups and educational attainment. Most often this training was conducted in-house by company personnel, but larger firms also relied importantly on educational institutions. At the same time, we must be alert to the need to improve the skills and earning power of those who appear to be falling behind. In the long run, better child-rearing and better basic education at the elementary and secondary school level are essential to providing the foundation for a lifetime of learning. But in the shorter run, we must also develop strategies to overcome the education deficiencies of all too many of our young people, and to renew the skills of workers who have not kept up with the changing demands of the workplace. The advent of the twenty-first century will certainly not bring an end to the challenges we are facing in a rapidly changing world. Americans will surely adjust to a frenetic pace of change, as we have in the past, but we must recognize that adjustment is not automatic. All shifts in the structure of the economy naturally create frictions and human stress, at least temporarily. As those frictions dissipate, however, I have no doubt that the economy will emerge healthier. And, if we are able to boost our investment in people, ideas, and processes as well as machines, the economy can operate more effectively as it adapts to change. This holds the potential to create an even greater payoff of a broadly based rise in living standards over the longer run. Your new Kenan-Flagler facility will enhance this University's ability to meet the challenge.	Alan Greenspan	United States	https://www.bis.org/review/r970925b.pdf	Remarks by the Chairman of the US Federal Reserve System, Mr. Alan Greenspan, at the Building Dedication Ceremonies at the Kenan-Flagler Business School, University of North Carolina on 12/9/97. I welcome the opportunity to join Dean Fulton, President Broad, President Emeritus Spangler, Chancellor Hooker, Hugh McColl, and the many other distinguished guests on the podium today. It isn't every day that we have the opportunity to dedicate a new building devoted to the research and training that our young people need for conducting business in a global setting. This new facility -- the McColl Bulding -- has been equipped with state-of-the-art information technology that will enhance the ability of the faculty and students of Kenan-Flagler to prepare for an exciting future in our global economy. The University has made this important commitment at a time when our businesses and workers are confronting a dynamic set of forces that will influence our nation's ability to compete worldwide in the years ahead. One of the most central of these forces is the rapid acceleration of computer and telecommunications technologies, which can be reasonably expected to appreciably raise our standard of living in the twenty-first century. In the short run, however, the fallout from rapidly changing technology is an environment in which the stock of plant and equipment with which most managers and workers interact is turning over increasingly rapidly, rendering a perception that human skills are becoming obsolete at a rate perhaps unprecedented in American history. I shall endeavor to place this most unusual phenomenon in the context of the broader changes in our economy and, hopefully, explain why the value of education, especially to enhance advanced skills, is so vital to the future growth of our economy. Wealth has always been created, virtually by definition, when individuals use their growing knowledge to interact with an expanding capital stock to produce goods and services of value. Assisted by the whole array of market prices, entrepreneurs seek to identify the types of products and services that individuals will value, especially the added value placed on products and services that customers find better tailored to their particular needs, delivered in shorter time frames, or improved in quality. This striving to unbundle the particular characteristics of goods and services in order to maximize their value to each individual inevitably results in the shift toward value created through the exploitation of ideas and concepts, rather than simply the utilization of physical resources and manual labor. Indeed, over the past century, by far the smallest part of the growth in America's real gross domestic product reflects increased physical product measured in bulk or weight. Most of our gains have been the result of new insights into how to rearrange physical reality to achieve ever-higher standards of living. We have dramatically reduced the physical bulk of our radios, for example, by substituting transistors for vacuum tubes. New architectural, engineering, and materials technologies have enabled the construction of buildings with the same space, but far less physical material, than was required 50 or 100 years ago. Most recently, mobile phones have been significantly downsized as they have been improved. The increasing importance of new insights has, of course, raised the value of information creation and transfer in boosting standards of living. Thus, it should be no surprise that new computer and telecommunications products have been accorded particularly high value by consumers and business and, hence, why companies that successfully innovate in this field exhibit particularly high stock market values. Breakthroughs in all areas of technology are continually adding to the growing list of almost wholly conceptual elements in our economic output. These developments are affecting how we produce output and are demanding greater specialized knowledge. The use, for example, of computer-assisted design instruments, machine tools, and inventory control systems has given our former, more rigid factory assembly lines greater flexibility. Businesses now can more quickly customize their production to changes in market conditions; design cycles are shorter, quality control has been improved, and costs are lower. Offices are now routinely outfitted with high-speed information-processing technology. The accelerated pace of technological advance has also interacted with the rapid rise in financial innovation, with the result that business services and financial transactions now are transmitted almost instantaneously across global networks. Financial instruments have become increasingly diverse, the products more customized, and the markets more intensely competitive. Our nation's financial institutions, in turn, are endeavoring to find more effective and efficient ways to deliver their services. In this environment, America's prospects for economic growth will greatly depend on our capacity to develop and to apply new technology -- a quest that inevitably will entail some risk-taking. One lesson we have clearly learned is that we never can predict with any precision which particular technology or synergies of technologies will add significantly to our knowledge and ability to gain from that knowledge. Moreover, America's ability to remain in the forefront of new ideas and products has become ever more difficult because of the rapid international diffusion of technology. Nonetheless, to date, we have not fallen behind in converting scientific and technological breakthroughs into viable commercial products. But, to be fully effective in realizing the gains from technological advance will require a considerable amount of human investment on the part of managers and workers who have to implement new processes and who must be prepared to adapt, over their lifetimes, to the ongoing change that innovations bring. Clearly our educational institutions will continue to play an important role in preparing workers. While we all are concerned about the performance of American elementary and secondary schools compared with those in other developed countries, there is little question about the quality of our university system, which for decades has attracted growing numbers of students from abroad. However, the notion that formal degree programs at any level can be crafted to fully support the requirements of one's lifework is being challenged. A great deal of innovation and development has been occurring in the business sector where firms are striving to stay on the cutting edge, in an environment where products and knowledge rapidly become obsolete. Education, as a result, is increasingly becoming a lifelong activity; businesses are now looking for employees who are prepared to continue learning, and workers and managers in many kinds of pursuits had better look forward to persistent hard work acquiring and maintaining the skills needed to cope with a dynamically evolving economy. The recognition that more productive workers and learning go hand-in-hand is becoming ever more visible in both schools and in the workplace. Linkages between business and education should be encouraged at all levels of our education system. Your business school is an excellent example of how our educational institutions are building bridges to the private sector that will have payoffs in how well graduates are prepared to meet the challenges of an increasingly knowledge-based global economy. The growth of high-tech industry here in the Research Triangle, as well as in Silicon Valley and Boston -- all areas rich in educational and research institutions -- is no accident. In the private sector, a number of major corporations have invested in their own internal training centers -- so-called corporate universities. Some labor unions have done the same. More broadly, recent surveys by the Bureau of Labor Statistics indicate that the provision of formal education on the job has risen markedly in recent years. By 1995, 70 percent of workers in establishments with 50 or more employees had received some formal training during the twelve months preceding the survey. The incidence of training was relatively high across age groups and educational attainment. Most often this training was conducted in-house by company personnel, but larger firms also relied importantly on educational institutions. At the same time, we must be alert to the need to improve the skills and earning power of those who appear to be falling behind. In the long run, better child-rearing and better basic education at the elementary and secondary school level are essential to providing the foundation for a lifetime of learning. But in the shorter run, we must also develop strategies to overcome the education deficiencies of all too many of our young people, and to renew the skills of workers who have not kept up with the changing demands of the workplace. The advent of the twenty-first century will certainly not bring an end to the challenges we are facing in a rapidly changing world. Americans will surely adjust to a frenetic pace of change, as we have in the past, but we must recognize that adjustment is not automatic. All shifts in the structure of the economy naturally create frictions and human stress, at least temporarily. As those frictions dissipate, however, I have no doubt that the economy will emerge healthier. And, if we are able to boost our investment in people, ideas, and processes as well as machines, the economy can operate more effectively as it adapts to change. This holds the potential to create an even greater payoff of a broadly based rise in living standards over the longer run. Your new Kenan-Flagler facility will enhance this University's ability to meet the challenge.
1997-09-17T00:00:00	Mr. Meyer considers the economic outlook and challenges facing monetary policy (Central Bank Articles and Speeches, 17 Sep 97)	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the 1998 Global Economic and Investment Outlook Conference, Carnegie Mellon University, Pittsburgh, Pennsylvania on 17/9/97.	Mr. Meyer considers the economic outlook and challenges facing monetary policy Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the 1998 Global Economic and Investment Outlook Conference, Carnegie Mellon University, Pittsburgh, Pennsylvania on 17/9/97. Recent economic performance has been hailed on Wall Street as "paradise found" and the "best of times." And, on Main Street, there is ample survey evidence suggesting that consumers are feeling very upbeat about the prospects for the economy. I call the remarkable combination of healthy growth, low unemployment, low inflation, a soaring stock market, and declining federal budget deficit the "good news" economy. But there are challenges even in the "good news" economy and I want to focus on three of them this afternoon. The first challenge is to avoid complacency and appreciate the policy challenges that remain. The second is to explain how we have been able to achieve such favorable performance, given that it is better than almost anyone predicted and better than historical regularities suggested was even possible. And the third challenge is to assess the risks in the current environment and determine how monetary policy should be positioned to keep the good news coming. Two themes will become evident as I address these challenges. First, there are limits -limits on what policy can accomplish and limits on what the economy can achieve. Second, in assessing the current environment and its implications for monetary policy, uncertainties require us to balance historical regularities and newer possibilities. Expansions, to an important degree, have common properties, what I shall refer to as regularities. Both forecasters and policymakers rely on these. Forecasters make predictions about future developments based on regularities. The same regularities allow policymakers to act pre-emptively -changing policy today in anticipation of developments tomorrow. Yet each expansion has its own signature that reflects the specific set of transitory influences and longer-lasting structural changes in play at the time. The current episode features the following players. Cyclical regularities clearly in evidence include accelerator effects, changing tolerances for risk, and cyclical swings in the unemployment rate and in profits. Two other regularities that I especially want to focus on today are the Phillips Curve and the trend growth in output. The latter regularities define limits - limits to the sustainable level of output, at any moment, and, once that level of capacity is reached, to the growth of output over time. If these limits are exceeded, as typically happens during a cyclical expansion, the economy eventually overheats, inflation increases, and the expansion is undermined as policy is forced to rein in demand. Transitory influences, clearly among the stars of the current episode, feature a coincidence of favorable supply shocks that have restrained inflation. Finally, structural adjustments, in this episode, hint at a decline in NAIRU and/or an increase in trend growth. The central question in interpreting the recent experience is whether the old limits on economic performance are no longer binding, having been replaced by new possibilities, or are just being temporarily overruled by transitory influences. Before moving to the substance of my talk, let me remind you that my remarks on the outlook and monetary policy, today and always, are my views. I do not speak for the FOMC. Near-Term prospects in the Good News Economy Before addressing the challenges and developing these themes, let me briefly review the surprisingly favorable features of recent economic performance and comment on the near-term outlook. For this audience, I can summarize recent performance in a single sentence. We have been recently blessed with relatively strong cyclical growth, the lowest unemployment rate in 24 years, the lowest - 2 - inflation in 31 years, an impressive investment boom, soaring equity prices and a 5-year decline in the federal budget deficit that may take the deficit to below 1⁄2% of GDP in fiscal 1997. But this conference is about the next chapter in this story. And the key in the near term may be crosscurrents that appear likely to both moderate output growth and keep inflation relatively well contained. In the case of output growth, the crosscurrents are the continued strength in demand and the expected slowing in inventory investment. In the second quarter, the economy slowed to an upward revised 3.6% rate, from a 4.9% rate in the first quarter, a much more modest slowing than originally reported and widely anticipated during the quarter. This, by the way, has been a recurring pattern in the expansion -- every time I thought the economy had or was about to slow to trend, it has surprised with its continued strength. The fundamentals continue to look very positive. In particular, households as a group are wealthy and optimistic, businesses are profitable and confronted with dramatic technological opportunities, and financial conditions remain supportive. There appear to be few imbalances that are a threat to continued expansion. As a result, demand is expected to remain strong in the second half of the year, paced by a rebound in consumer spending and complemented by continued strength in business fixed investment. Forecasters know, however, that the composition or mix of output in one quarter -specifically the mix between final demand and inventory investment -- often provides an important hint of what is to come. While I interpret the strength of inventory investment in the first half -- including the upward revised rate of about $78 billion in the second quarter -- as largely voluntary, principally reflecting a response to the strength in past and prospective sales, the flow rate of accumulation in the second quarter is almost certainly unsustainable. That is, stocks may be in equilibrium, but the flow rate will have to slow to keep them there. The resulting slowdown in inventory investment is likely, therefore, to be a significant drag on production in the second half of this year, offsetting, at least in part, the expected rebound in final demand. On the inflation side, there are also important crosscurrents at work. I have been concerned about two considerations that suggest that inflation may well rise over time: the possibility that the economy is operating today beyond its sustainable capacity and the likelihood that the transitory factors that have, on balance, been restraining inflation will diminish in importance over time. However, three other influences that, in my view, have gradually become more significant considerations, are likely to moderate the tendency for inflation to rise in the near term. First, lower-than-expected overall and core inflation and continued modest pace of wage change over this year will encourage more restrained increases in wages and prices over the coming year. Lower inflation leads to lower inflation expectations, reinforcing the prospect for low inflation ahead. In this case, inertia is our friend and the result is a virtuous wage-price spiral, at least for a while. Second, some of the transitory factors, especially the appreciation of the dollar and resulting decline in import prices, appear to have longer legs and are likely to contribute more toward restraint on inflation in coming quarters than earlier appeared likely. Third, the upward adjustment to profits in the July NIPA revisions suggests there is more of a profit cushion that could delay the pass-through of higher compensation to price increases. While these crosscurrents suggest moderation in both output growth and inflation, crosscurrents don't necessarily balance. With respect to output growth, the crosscurrents do point toward slower growth in the second half compared to the first half, but is important whether the slower growth turns out to be near trend, holding utilization rates constant, or above trend, pushing utilization rates still higher. At the very least, the slowdown in inventory investment is likely to be accommodated with minimal disturbance to the continued expansion. But there is a risk that growth will continue to be above trend, pushing utilization rates up, from already high levels. - 3 - With respect to inflation, the netting of the crosscurrents suggests a modest increase in inflation in 1998, albeit from a steadily downward-revised and very low rate in 1997. I will pay very close attention to the source of any rebound in inflation, specifically the degree to which it reflects simply the dissipation of some of the favorable supply shocks that have contributed to the very low inflation this year and the degree to which it reflects the more persistent effect of high utilization rates. As a result, I will be focusing more on core than overall inflation rates and paying particularly close attention to labor costs, given that labor markets appear tighter than product markets and therefore more likely to be the source of any increase in inflation pressures. Still, any increase in inflation would begin from a lower base and may be more modest than previously appeared likely. The bottom line is that past performance, in several important dimensions, has been extraordinary and that prospects look favorable for continued expansion and relatively low inflation. Still, monetary policy must be alert to the potential of a developing upward trend in inflation in an economy that may already be operating beyond its sustainable capacity and possibly still growing at an above-trend rate. And, as always, there are challenges, even in the good news economy. Limits on What Monetary Policy Can Do The first challenge is to avoid becoming complacent. Even as there are good reasons for celebrating recent economic performance, there are good reasons for avoiding complacency. Specifically, there are dimensions of economic performance which are less stellar, such as the slow average growth rate in GDP in the 1990s, a continuation of the effects of the productivity slowdown that began in the early 1970s. There are, in addition, obvious longer-run problems that deserve to be confronted today, such as those related to the aging of the population and resulting pressures on entitlement programs. And there remain lingering social strains associated with a gradual increase in income inequality, interacting with the low average growth rate in productivity to produce a long period of relatively stagnant real income for the median income family. This less rosy perspective on the current state of the economy was suggested by several members of Congress during the recent oversight hearings on monetary policy. I think the point is an important one and I agree that we should not let the recent favorable performance of inflation, unemployment and equity prices distract our attention from the importance of confronting a slow average rate of increase in living standards and lingering social problems that both reflect and are exacerbated by a widening in income inequality. However, other than through its pursuit of its legislative mandates of price stability and maximum sustainable employment, monetary policy cannot make a major contribution to the resolution of these problems. Monetary policy, in particular cannot remedy increases in income inequality, raise the trend rate of increase in living standards, or combat inadequate opportunities for upward mobility out of poverty. It is, as always, important that we carry out our traditional responsibilities well, accommodating the maximum sustainable growth and achieving the maximum sustainable level of employment. But we cannot do more. Regularities The second challenge is to explain why performance has been so favorable, at least in terms of inflation and unemployment. Before exploring explanations of the puzzle, I want to focus on common features of cyclical expansions. In doing so, I will focus on cyclical expansions that have not been dominated by dramatic external shocks, such as the two episodes that were marked by steeply rising world oil prices -- first in the early 1970s and again in the late 1970s and early 1980s. While even these expansions share many of the patterns I emphasize later, their endings are dominated by the effects of the powerful supply shocks and policy responses to the shocks. Expansions, by definition, begin with considerable economic slack, inherited from the previous recession. The economy typically makes a rapid transition from declining output (the definition of recession) to above-trend growth. In a loose way, trend growth refers to the growth in the economy's productive capacity. When growth is above trend, production is expanding faster than the economy's - 4 - productive capacity and, as a result, resource utilization rates rise. Rising capacity utilization rates and falling unemployment rates are thus a typical feature of an expansion period. The natural dynamic of an expansion is for above-trend growth to continue until demand overtakes capacity, despite the best efforts of policy to avoid cyclical excesses. The end of the story is particularly important. Expansions do not die of old age or lethargy, a spontaneous weakening of aggregate demand, but rather of an accumulation of imbalances, specifically with demand outstripping the limits of sustainable level of input utilization and growth of output. The resulting rise in inflation becomes a threat to the continued expansion. Preventive medicine is therefore the best course of treatment. In this story, NAIRU sets a limit to how far the economy can expand before overheating sets in and inflation rises, and the Phillips Curve traces out an important part of the dynamics of inflation, how fast it responds to excess demand. Of course, the Phillips Curve framework has always been much easier to describe than to implement, given uncertainties about the estimates of NAIRU, given the fact that empirical regularities between inflation and unemployment always left much of the variation in inflation unexplained, and given the importance of supply shocks with significant, though transitory, effects on the inflation-unemployment nexus. Nevertheless, the regularity in the cyclical sensitivity of inflation, as embedded in the Phillips Curve, has proved to be an important guide to both forecasters and monetary policymakers in the past. Transitory Influences The consensus estimates of NAIRU as this expansion began -- about 6% -- did not prepare us for the recent surprisingly favorable performance. It is possible that the Phillips Curve and NAIRU is simply the wrong analytical framework, but I doubt it and am not aware of another model of inflation dynamics that is ready to take its place. So my response is to update my estimate of NAIRU and add other explanations consistent with this framework, but not to abandon this concept. One possible explanation is that one or more transitory factors, for the moment, are yielding a more favorable than usual outcome. A coincidence of favorable supply shocks is clearly, in my judgment, an important part of the answer to the puzzle. I won't talk at length about these factors, as I have done so in previous talks. I would just note that these favorable supply shocks include an appreciation of the dollar and consequent decline in import prices; a slowing in the rate of increase in benefit costs, concentrated in a slowdown in costs for health care insurance; a faster rate of decline in computer prices than earlier, reflecting the quicker pace of innovation; and more recently, a decline in oil prices and a slower rate of increase in food prices. A Cyclical Anomaly Let me include in my list of explanations for the current favorable economic performance an intriguing cyclical anomaly. One regularity of past expansions has been the close relationship between two widely used measures of resource utilization -- the capacity utilization and unemployment rates. They have traditionally moved together over a cycle and tended to mirror one another. In this case, it did not matter which one was used as a proxy for excess demand; and the unemployment rate could be used interchangeably as a measure of labor market demand pressures and overall economy-wide demand pressures. In the current episode, however, these two measures are sending different signals. The unemployment rate is flashing a warning of a very tight labor market. The capacity utilization rate, in contrast, suggests a reasonably balanced configuration of production and capacity in the product market, at least in the manufacturing sector. Why has this divergence developed and what are its implications for the relationship between inflation and unemployment? The divergence mirrors one of the other defining features of this expansion -- the boom in business fixed investment. The result is a high level of net investment, a more rapid rate of increase in the capital stock and hence in industrial capacity. - 5 - The resulting absence of excess demand in the product market is, in my view, an important factor explaining the frequently reported absence of pricing leverage by firms. Nothing gives a firm pricing leverage like excess demand. In addition, the resulting inability of firms to pass on higher costs in higher prices likely has altered the way firms operate in the labor market, making them more reluctant to bid aggressively for workers, contributing to a slower rate of increase in wages than we would otherwise have expected at prevailing labor utilization rates. It is possible that the gap that has opened between the unemployment and capacity utilization rates may be a factor that has, in effect, lowered NAIRU in this expansion. This explanation has potential, but there is no historical precedent and it is, therefore, difficult to judge its importance. Possibilities The most intriguing explanations for the recent favorable performance are structural changes, which may have relaxed the capacity constraints that are the core of the cyclical regularities story, or made these constraints more flexible than in the past, or tempered the ability and/or willingness of firms to respond to excess demand by raising wages and prices. I refer to these collectively as "possibilities," as they suggest an optimistic period of improved economic performance, contrasting with both the pessimism of the previously perceived limits in the cyclical regularities story or the grudging "for the moment" concession of explanations relying on transitory influences. There are two possibilities that have been widely discussed: that the economy can now sustain a lower unemployment rate without rising inflation (i.e., that NAIRU has declined) and that, once capacity has been reached, the economy is now capable of faster growth, compared to the estimates of trend growth reported earlier. A lot of the discussion about this episode focuses on sorting out the relative importance of the two possibilities -specifically, whether the recent favorable performance is due more to labor market structural change, as reflected in a lower NAIRU, or to product market structural change, as reflected in a higher rate of growth in productivity. Has there been a decline in NAIRU? Time varying parameter estimates of the Phillips Curve and the more casual eye both suggest a decline in NAIRU. Robert Gordon's work, for example, suggests a decline in NAIRU, from 6% in the decade prior to 1994, to about 51⁄2% by the end of 1995, with NAIRU stabilizing at this level since that time. One possible explanation for the more moderate rate of increase in compensation per hour than would have been expected from historical experience is an increase in worker insecurity as a consequence of the rapid pace of technological change and/or the rapid pace of restructuring and downsizing. As a result, workers may have been willing to trade off some real wages for increased security, resulting in a more modest increase in compensation per hour than otherwise would have been expected. The result is a slower rate of increase in compensation at any given level of unemployment, equivalent to a decline in NAIRU. Another possible explanation is the divergence between the unemployment and capacity utilization rates in this expansion that I discussed earlier. Although a decline in NAIRU is a story of relaxed limits, the worker insecurity explanation is not itself an optimistic story. Some workers, to be sure, gain, by opportunities for employment that otherwise would have been denied. But a broader group of workers suffer a slower increase in living standards, relative to what otherwise would have been "possible." Has there been an increase in trend productivity? Another possibility is that the trend rate of increase in productivity -- and hence the economy's sustainable rate of growth in GDP -- has recently increased. There is some confusion in many discussions of productivity growth about the implications of measurement bias. It is widely accepted that there is a downward bias in measured - 6 - productivity growth, the mirror image of the upward bias in measured inflation. But it is also widely accepted that a similar bias has been present over the entire postwar period. The measurement issue is relevant to explaining the inflation-unemployment experience in the current episode only if the bias has recently become more serious. An increase in measurement bias could be under way, perhaps related to an acceleration in technical change, but it will be a long time before we are able to establish this with a reasonable degree of certainty. Note also that if the measurement bias has increased, this would imply that both actual and potential output growth are higher than reported, with no obvious implication for the gap between actual and potential output, and hence for inflation pressures. Sources of higher productivity growth, all of which should show up in measured productivity, include a return on years of corporate restructuring and the increase in capital per worker associated with the current investment boom, much of which is linked to technological change, specifically the information revolution. There are a couple of reasons why this is an attractive explanation. No other explanation has the ability to explain as many features of the current experience as an increase in trend productivity. Technological change, according to this view, has resulted in new profit opportunities which in turn have resulted in an investment boom (heavily concentrated in high technology equipment), increased corporate earnings, and a soaring stock market. In addition, this explanation is consistent with many anecdotes from businesses about efficiency gains as new technology is put into place. There are, however, some problems with this story as the principal explanation for the favorable inflation performance. First, a productivity explanation would resonate better if the puzzle were why higher wage change was not being passed on in higher prices. But the greater puzzle is the slow pace of increase in compensation per hour at prevailing unemployment rates. This is more clearly the case after the downward revision in compensation in the July NIPA revisions, bringing that measure of compensation per hour more in line with the Employment Cost Index. Given the rate of increase in compensation, an unchanged trend growth in productivity of 1.1%, for example, seems quite consistent with recent price performance. Although not without some serious shortcomings, the published productivity data provide little encouragement to the view that there has been a significant improvement in underlying productivity growth. The growth in measured productivity over this expansion has, in fact, been disappointing. Over 1994 and 1995, in particular, measured productivity was nearly flat. Although it has accelerated over the last two years, this is consistent with another cyclical regularity, the tendency for productivity to accelerate with economic activity. And the rate of growth over the last year, even with the sharp upward revision in the second quarter, is 1.2%, just above the 1.1% average rate of increase over the period from the early 1970s up to the beginning of this expansion. Still, there are other pieces of data and interpretations of the published data that provide some support to a more optimistic assessment. For example, the acceleration in productivity to a 1.2% rate over the last year, at a time when the unemployment rate was dropping to a level that would suggest less productive workers were being drawn on, leaves open the possibility that the productivity trend has quickened. Perhaps the strongest case for an increase in the productivity trend comes from the higher rate of growth over the past two years if productivity is measured from the income side of the national accounts. Balancing regularities and possibilities In my testimony at the Congressional oversight hearings, I presented a range of estimates for NAIRU and trend growth from the CBO, Council of Economic Advisers, DRI, Macroeconomic Advisers and Professor Robert Gordon. The range for NAIRU was 5.4% to 5.9% and for trend growth, 2.1%-2.3%. Since my testimony, both DRI and Macroeconomic Advisers have revised down their estimates of NAIRU-DRI from 5.8% to 5.6% and Macroeconomic Advisers from 5.8% to 5.4%. The range of estimates is now therefore more tightly concentrated around 51⁄2%. I presented these estimates in - 7 - my testimony to emphasize the continuing importance the profession attaches to NAIRU, the central tendency of current NAIRU estimates, and the absence of significant upward adjustments to estimates of trend growth. In short, some updating in the regularities may be appropriate, especially in the case of NAIRU, but continued attention to their message of limits remains critical for disciplined policy. We should remain open minded and alert to the possibility of structural change, but cautious about reaching the conclusion that the regularities that have been so important in the past no longer set limits that policy must respect. The challenge for monetary policy Some day we shall look back on this episode with historical perspective and perhaps -and only perhaps -- have a better ability to sort out what contributed to the favorable outcome and the extent to which the prevailing coexistence of low unemployment and stable low inflation proved permanent or transitory. Monetary policy, however, is made in real time. The appropriate stance of monetary policy should reflect both the increased uncertainty surrounding the failure of historical regularities to predict the better-than-expected outcome in terms of inflation and unemployment and the best judgement about regularities as we update our estimates of NAIRU and trend growth in response to current data. At one extreme, the uncertainty about the source of the recent performance might be viewed as so great that the best course for monetary policy is a reactive posture, waiting for clear signs that inflation is rising and only tightening in response to such evidence. I agree that the current uncertainty encourages caution, but not to the point of paralysis. A prudent approach would continue to lean against the cyclical winds by adjusting policy in response to persistent increases in utilization rates as well as in response to changes in underlying inflation. Summing Up We should always have problems like today's, struggling to explain unexpectedly good performance. And it is important to keep in perspective any questions about how tight labor markets might be or whether near-term growth might remain above trend. The economy is very healthy and the prospects continue to be bright. But as we celebrate the exceptional present, we should not forget the lessons of the past. There are limits. They may not be the old limits that disciplined policy in the past. But even if the limits are new, they must be respected. Overheating is a natural product of expansions that overtax these limits. Recessions typically follow overheating. Good policy must therefore balance regularities and possibilities.	---[PAGE_BREAK]--- # Mr. Meyer considers the economic outlook and challenges facing monetary policy Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the 1998 Global Economic and Investment Outlook Conference, Carnegie Mellon University, Pittsburgh, Pennsylvania on 17/9/97. Recent economic performance has been hailed on Wall Street as "paradise found" and the "best of times." And, on Main Street, there is ample survey evidence suggesting that consumers are feeling very upbeat about the prospects for the economy. I call the remarkable combination of healthy growth, low unemployment, low inflation, a soaring stock market, and declining federal budget deficit the "good news" economy. But there are challenges even in the "good news" economy and I want to focus on three of them this afternoon. The first challenge is to avoid complacency and appreciate the policy challenges that remain. The second is to explain how we have been able to achieve such favorable performance, given that it is better than almost anyone predicted and better than historical regularities suggested was even possible. And the third challenge is to assess the risks in the current environment and determine how monetary policy should be positioned to keep the good news coming. Two themes will become evident as I address these challenges. First, there are limits -limits on what policy can accomplish and limits on what the economy can achieve. Second, in assessing the current environment and its implications for monetary policy, uncertainties require us to balance historical regularities and newer possibilities. Expansions, to an important degree, have common properties, what I shall refer to as regularities. Both forecasters and policymakers rely on these. Forecasters make predictions about future developments based on regularities. The same regularities allow policymakers to act pre-emptively -changing policy today in anticipation of developments tomorrow. Yet each expansion has its own signature that reflects the specific set of transitory influences and longer-lasting structural changes in play at the time. The current episode features the following players. Cyclical regularities clearly in evidence include accelerator effects, changing tolerances for risk, and cyclical swings in the unemployment rate and in profits. Two other regularities that I especially want to focus on today are the Phillips Curve and the trend growth in output. The latter regularities define limits - limits to the sustainable level of output, at any moment, and, once that level of capacity is reached, to the growth of output over time. If these limits are exceeded, as typically happens during a cyclical expansion, the economy eventually overheats, inflation increases, and the expansion is undermined as policy is forced to rein in demand. Transitory influences, clearly among the stars of the current episode, feature a coincidence of favorable supply shocks that have restrained inflation. Finally, structural adjustments, in this episode, hint at a decline in NAIRU and/or an increase in trend growth. The central question in interpreting the recent experience is whether the old limits on economic performance are no longer binding, having been replaced by new possibilities, or are just being temporarily overruled by transitory influences. Before moving to the substance of my talk, let me remind you that my remarks on the outlook and monetary policy, today and always, are my views. I do not speak for the FOMC. ## Near-Term prospects in the Good News Economy Before addressing the challenges and developing these themes, let me briefly review the surprisingly favorable features of recent economic performance and comment on the near-term outlook. For this audience, I can summarize recent performance in a single sentence. We have been recently blessed with relatively strong cyclical growth, the lowest unemployment rate in 24 years, the lowest ---[PAGE_BREAK]--- inflation in 31 years, an impressive investment boom, soaring equity prices and a 5-year decline in the federal budget deficit that may take the deficit to below $1 / 2 \%$ of GDP in fiscal 1997. But this conference is about the next chapter in this story. And the key in the near term may be crosscurrents that appear likely to both moderate output growth and keep inflation relatively well contained. In the case of output growth, the crosscurrents are the continued strength in demand and the expected slowing in inventory investment. In the second quarter, the economy slowed to an upward revised $3.6 \%$ rate, from a $4.9 \%$ rate in the first quarter, a much more modest slowing than originally reported and widely anticipated during the quarter. This, by the way, has been a recurring pattern in the expansion -- every time I thought the economy had or was about to slow to trend, it has surprised with its continued strength. The fundamentals continue to look very positive. In particular, households as a group are wealthy and optimistic, businesses are profitable and confronted with dramatic technological opportunities, and financial conditions remain supportive. There appear to be few imbalances that are a threat to continued expansion. As a result, demand is expected to remain strong in the second half of the year, paced by a rebound in consumer spending and complemented by continued strength in business fixed investment. Forecasters know, however, that the composition or mix of output in one quarter -specifically the mix between final demand and inventory investment -- often provides an important hint of what is to come. While I interpret the strength of inventory investment in the first half -- including the upward revised rate of about $\$ 78$ billion in the second quarter -- as largely voluntary, principally reflecting a response to the strength in past and prospective sales, the flow rate of accumulation in the second quarter is almost certainly unsustainable. That is, stocks may be in equilibrium, but the flow rate will have to slow to keep them there. The resulting slowdown in inventory investment is likely, therefore, to be a significant drag on production in the second half of this year, offsetting, at least in part, the expected rebound in final demand. On the inflation side, there are also important crosscurrents at work. I have been concerned about two considerations that suggest that inflation may well rise over time: the possibility that the economy is operating today beyond its sustainable capacity and the likelihood that the transitory factors that have, on balance, been restraining inflation will diminish in importance over time. However, three other influences that, in my view, have gradually become more significant considerations, are likely to moderate the tendency for inflation to rise in the near term. First, lower-than-expected overall and core inflation and continued modest pace of wage change over this year will encourage more restrained increases in wages and prices over the coming year. Lower inflation leads to lower inflation expectations, reinforcing the prospect for low inflation ahead. In this case, inertia is our friend and the result is a virtuous wage-price spiral, at least for a while. Second, some of the transitory factors, especially the appreciation of the dollar and resulting decline in import prices, appear to have longer legs and are likely to contribute more toward restraint on inflation in coming quarters than earlier appeared likely. Third, the upward adjustment to profits in the July NIPA revisions suggests there is more of a profit cushion that could delay the pass-through of higher compensation to price increases. While these crosscurrents suggest moderation in both output growth and inflation, crosscurrents don't necessarily balance. With respect to output growth, the crosscurrents do point toward slower growth in the second half compared to the first half, but is important whether the slower growth turns out to be near trend, holding utilization rates constant, or above trend, pushing utilization rates still higher. At the very least, the slowdown in inventory investment is likely to be accommodated with minimal disturbance to the continued expansion. But there is a risk that growth will continue to be above trend, pushing utilization rates up, from already high levels. ---[PAGE_BREAK]--- With respect to inflation, the netting of the crosscurrents suggests a modest increase in inflation in 1998, albeit from a steadily downward-revised and very low rate in 1997. I will pay very close attention to the source of any rebound in inflation, specifically the degree to which it reflects simply the dissipation of some of the favorable supply shocks that have contributed to the very low inflation this year and the degree to which it reflects the more persistent effect of high utilization rates. As a result, I will be focusing more on core than overall inflation rates and paying particularly close attention to labor costs, given that labor markets appear tighter than product markets and therefore more likely to be the source of any increase in inflation pressures. Still, any increase in inflation would begin from a lower base and may be more modest than previously appeared likely. The bottom line is that past performance, in several important dimensions, has been extraordinary and that prospects look favorable for continued expansion and relatively low inflation. Still, monetary policy must be alert to the potential of a developing upward trend in inflation in an economy that may already be operating beyond its sustainable capacity and possibly still growing at an above-trend rate. And, as always, there are challenges, even in the good news economy. # Limits on What Monetary Policy Can Do The first challenge is to avoid becoming complacent. Even as there are good reasons for celebrating recent economic performance, there are good reasons for avoiding complacency. Specifically, there are dimensions of economic performance which are less stellar, such as the slow average growth rate in GDP in the 1990s, a continuation of the effects of the productivity slowdown that began in the early 1970s. There are, in addition, obvious longer-run problems that deserve to be confronted today, such as those related to the aging of the population and resulting pressures on entitlement programs. And there remain lingering social strains associated with a gradual increase in income inequality, interacting with the low average growth rate in productivity to produce a long period of relatively stagnant real income for the median income family. This less rosy perspective on the current state of the economy was suggested by several members of Congress during the recent oversight hearings on monetary policy. I think the point is an important one and I agree that we should not let the recent favorable performance of inflation, unemployment and equity prices distract our attention from the importance of confronting a slow average rate of increase in living standards and lingering social problems that both reflect and are exacerbated by a widening in income inequality. However, other than through its pursuit of its legislative mandates of price stability and maximum sustainable employment, monetary policy cannot make a major contribution to the resolution of these problems. Monetary policy, in particular cannot remedy increases in income inequality, raise the trend rate of increase in living standards, or combat inadequate opportunities for upward mobility out of poverty. It is, as always, important that we carry out our traditional responsibilities well, accommodating the maximum sustainable growth and achieving the maximum sustainable level of employment. But we cannot do more. ## Regularities The second challenge is to explain why performance has been so favorable, at least in terms of inflation and unemployment. Before exploring explanations of the puzzle, I want to focus on common features of cyclical expansions. In doing so, I will focus on cyclical expansions that have not been dominated by dramatic external shocks, such as the two episodes that were marked by steeply rising world oil prices -- first in the early 1970s and again in the late 1970s and early 1980s. While even these expansions share many of the patterns I emphasize later, their endings are dominated by the effects of the powerful supply shocks and policy responses to the shocks. Expansions, by definition, begin with considerable economic slack, inherited from the previous recession. The economy typically makes a rapid transition from declining output (the definition of recession) to above-trend growth. In a loose way, trend growth refers to the growth in the economy's productive capacity. When growth is above trend, production is expanding faster than the economy's ---[PAGE_BREAK]--- productive capacity and, as a result, resource utilization rates rise. Rising capacity utilization rates and falling unemployment rates are thus a typical feature of an expansion period. The natural dynamic of an expansion is for above-trend growth to continue until demand overtakes capacity, despite the best efforts of policy to avoid cyclical excesses. The end of the story is particularly important. Expansions do not die of old age or lethargy, a spontaneous weakening of aggregate demand, but rather of an accumulation of imbalances, specifically with demand outstripping the limits of sustainable level of input utilization and growth of output. The resulting rise in inflation becomes a threat to the continued expansion. Preventive medicine is therefore the best course of treatment. In this story, NAIRU sets a limit to how far the economy can expand before overheating sets in and inflation rises, and the Phillips Curve traces out an important part of the dynamics of inflation, how fast it responds to excess demand. Of course, the Phillips Curve framework has always been much easier to describe than to implement, given uncertainties about the estimates of NAIRU, given the fact that empirical regularities between inflation and unemployment always left much of the variation in inflation unexplained, and given the importance of supply shocks with significant, though transitory, effects on the inflation-unemployment nexus. Nevertheless, the regularity in the cyclical sensitivity of inflation, as embedded in the Phillips Curve, has proved to be an important guide to both forecasters and monetary policymakers in the past. # Transitory Influences The consensus estimates of NAIRU as this expansion began -- about $6 \%$-- did not prepare us for the recent surprisingly favorable performance. It is possible that the Phillips Curve and NAIRU is simply the wrong analytical framework, but I doubt it and am not aware of another model of inflation dynamics that is ready to take its place. So my response is to update my estimate of NAIRU and add other explanations consistent with this framework, but not to abandon this concept. One possible explanation is that one or more transitory factors, for the moment, are yielding a more favorable than usual outcome. A coincidence of favorable supply shocks is clearly, in my judgment, an important part of the answer to the puzzle. I won't talk at length about these factors, as I have done so in previous talks. I would just note that these favorable supply shocks include an appreciation of the dollar and consequent decline in import prices; a slowing in the rate of increase in benefit costs, concentrated in a slowdown in costs for health care insurance; a faster rate of decline in computer prices than earlier, reflecting the quicker pace of innovation; and more recently, a decline in oil prices and a slower rate of increase in food prices. ## A Cyclical Anomaly Let me include in my list of explanations for the current favorable economic performance an intriguing cyclical anomaly. One regularity of past expansions has been the close relationship between two widely used measures of resource utilization -- the capacity utilization and unemployment rates. They have traditionally moved together over a cycle and tended to mirror one another. In this case, it did not matter which one was used as a proxy for excess demand; and the unemployment rate could be used interchangeably as a measure of labor market demand pressures and overall economy-wide demand pressures. In the current episode, however, these two measures are sending different signals. The unemployment rate is flashing a warning of a very tight labor market. The capacity utilization rate, in contrast, suggests a reasonably balanced configuration of production and capacity in the product market, at least in the manufacturing sector. Why has this divergence developed and what are its implications for the relationship between inflation and unemployment? The divergence mirrors one of the other defining features of this expansion -- the boom in business fixed investment. The result is a high level of net investment, a more rapid rate of increase in the capital stock and hence in industrial capacity. ---[PAGE_BREAK]--- The resulting absence of excess demand in the product market is, in my view, an important factor explaining the frequently reported absence of pricing leverage by firms. Nothing gives a firm pricing leverage like excess demand. In addition, the resulting inability of firms to pass on higher costs in higher prices likely has altered the way firms operate in the labor market, making them more reluctant to bid aggressively for workers, contributing to a slower rate of increase in wages than we would otherwise have expected at prevailing labor utilization rates. It is possible that the gap that has opened between the unemployment and capacity utilization rates may be a factor that has, in effect, lowered NAIRU in this expansion. This explanation has potential, but there is no historical precedent and it is, therefore, difficult to judge its importance. # Possibilities The most intriguing explanations for the recent favorable performance are structural changes, which may have relaxed the capacity constraints that are the core of the cyclical regularities story, or made these constraints more flexible than in the past, or tempered the ability and/or willingness of firms to respond to excess demand by raising wages and prices. I refer to these collectively as "possibilities," as they suggest an optimistic period of improved economic performance, contrasting with both the pessimism of the previously perceived limits in the cyclical regularities story or the grudging "for the moment" concession of explanations relying on transitory influences. There are two possibilities that have been widely discussed: that the economy can now sustain a lower unemployment rate without rising inflation (i.e., that NAIRU has declined) and that, once capacity has been reached, the economy is now capable of faster growth, compared to the estimates of trend growth reported earlier. A lot of the discussion about this episode focuses on sorting out the relative importance of the two possibilities -specifically, whether the recent favorable performance is due more to labor market structural change, as reflected in a lower NAIRU, or to product market structural change, as reflected in a higher rate of growth in productivity. ## Has there been a decline in NAIRU? Time varying parameter estimates of the Phillips Curve and the more casual eye both suggest a decline in NAIRU. Robert Gordon's work, for example, suggests a decline in NAIRU, from $6 \%$ in the decade prior to 1994, to about $51 / 2 \%$ by the end of 1995, with NAIRU stabilizing at this level since that time. One possible explanation for the more moderate rate of increase in compensation per hour than would have been expected from historical experience is an increase in worker insecurity as a consequence of the rapid pace of technological change and/or the rapid pace of restructuring and downsizing. As a result, workers may have been willing to trade off some real wages for increased security, resulting in a more modest increase in compensation per hour than otherwise would have been expected. The result is a slower rate of increase in compensation at any given level of unemployment, equivalent to a decline in NAIRU. Another possible explanation is the divergence between the unemployment and capacity utilization rates in this expansion that I discussed earlier. Although a decline in NAIRU is a story of relaxed limits, the worker insecurity explanation is not itself an optimistic story. Some workers, to be sure, gain, by opportunities for employment that otherwise would have been denied. But a broader group of workers suffer a slower increase in living standards, relative to what otherwise would have been "possible." ## Has there been an increase in trend productivity? Another possibility is that the trend rate of increase in productivity -- and hence the economy's sustainable rate of growth in GDP -- has recently increased. There is some confusion in many discussions of productivity growth about the implications of measurement bias. It is widely accepted that there is a downward bias in measured ---[PAGE_BREAK]--- productivity growth, the mirror image of the upward bias in measured inflation. But it is also widely accepted that a similar bias has been present over the entire postwar period. The measurement issue is relevant to explaining the inflation-unemployment experience in the current episode only if the bias has recently become more serious. An increase in measurement bias could be under way, perhaps related to an acceleration in technical change, but it will be a long time before we are able to establish this with a reasonable degree of certainty. Note also that if the measurement bias has increased, this would imply that both actual and potential output growth are higher than reported, with no obvious implication for the gap between actual and potential output, and hence for inflation pressures. Sources of higher productivity growth, all of which should show up in measured productivity, include a return on years of corporate restructuring and the increase in capital per worker associated with the current investment boom, much of which is linked to technological change, specifically the information revolution. There are a couple of reasons why this is an attractive explanation. No other explanation has the ability to explain as many features of the current experience as an increase in trend productivity. Technological change, according to this view, has resulted in new profit opportunities which in turn have resulted in an investment boom (heavily concentrated in high technology equipment), increased corporate earnings, and a soaring stock market. In addition, this explanation is consistent with many anecdotes from businesses about efficiency gains as new technology is put into place. There are, however, some problems with this story as the principal explanation for the favorable inflation performance. First, a productivity explanation would resonate better if the puzzle were why higher wage change was not being passed on in higher prices. But the greater puzzle is the slow pace of increase in compensation per hour at prevailing unemployment rates. This is more clearly the case after the downward revision in compensation in the July NIPA revisions, bringing that measure of compensation per hour more in line with the Employment Cost Index. Given the rate of increase in compensation, an unchanged trend growth in productivity of $1.1 \%$, for example, seems quite consistent with recent price performance. Although not without some serious shortcomings, the published productivity data provide little encouragement to the view that there has been a significant improvement in underlying productivity growth. The growth in measured productivity over this expansion has, in fact, been disappointing. Over 1994 and 1995, in particular, measured productivity was nearly flat. Although it has accelerated over the last two years, this is consistent with another cyclical regularity, the tendency for productivity to accelerate with economic activity. And the rate of growth over the last year, even with the sharp upward revision in the second quarter, is $1.2 \%$, just above the $1.1 \%$ average rate of increase over the period from the early 1970s up to the beginning of this expansion. Still, there are other pieces of data and interpretations of the published data that provide some support to a more optimistic assessment. For example, the acceleration in productivity to a $1.2 \%$ rate over the last year, at a time when the unemployment rate was dropping to a level that would suggest less productive workers were being drawn on, leaves open the possibility that the productivity trend has quickened. Perhaps the strongest case for an increase in the productivity trend comes from the higher rate of growth over the past two years if productivity is measured from the income side of the national accounts. # Balancing regularities and possibilities In my testimony at the Congressional oversight hearings, I presented a range of estimates for NAIRU and trend growth from the CBO, Council of Economic Advisers, DRI, Macroeconomic Advisers and Professor Robert Gordon. The range for NAIRU was $5.4 \%$ to $5.9 \%$ and for trend growth, $2.1 \%-2.3 \%$. Since my testimony, both DRI and Macroeconomic Advisers have revised down their estimates of NAIRU-DRI from $5.8 \%$ to $5.6 \%$ and Macroeconomic Advisers from $5.8 \%$ to $5.4 \%$. The range of estimates is now therefore more tightly concentrated around $5 \frac{1}{2} \%$. I presented these estimates in ---[PAGE_BREAK]--- my testimony to emphasize the continuing importance the profession attaches to NAIRU, the central tendency of current NAIRU estimates, and the absence of significant upward adjustments to estimates of trend growth. In short, some updating in the regularities may be appropriate, especially in the case of NAIRU, but continued attention to their message of limits remains critical for disciplined policy. We should remain open minded and alert to the possibility of structural change, but cautious about reaching the conclusion that the regularities that have been so important in the past no longer set limits that policy must respect. # The challenge for monetary policy Some day we shall look back on this episode with historical perspective and perhaps -and only perhaps -- have a better ability to sort out what contributed to the favorable outcome and the extent to which the prevailing coexistence of low unemployment and stable low inflation proved permanent or transitory. Monetary policy, however, is made in real time. The appropriate stance of monetary policy should reflect both the increased uncertainty surrounding the failure of historical regularities to predict the better-than-expected outcome in terms of inflation and unemployment and the best judgement about regularities as we update our estimates of NAIRU and trend growth in response to current data. At one extreme, the uncertainty about the source of the recent performance might be viewed as so great that the best course for monetary policy is a reactive posture, waiting for clear signs that inflation is rising and only tightening in response to such evidence. I agree that the current uncertainty encourages caution, but not to the point of paralysis. A prudent approach would continue to lean against the cyclical winds by adjusting policy in response to persistent increases in utilization rates as well as in response to changes in underlying inflation. ## Summing Up We should always have problems like today's, struggling to explain unexpectedly good performance. And it is important to keep in perspective any questions about how tight labor markets might be or whether near-term growth might remain above trend. The economy is very healthy and the prospects continue to be bright. But as we celebrate the exceptional present, we should not forget the lessons of the past. There are limits. They may not be the old limits that disciplined policy in the past. But even if the limits are new, they must be respected. Overheating is a natural product of expansions that overtax these limits. Recessions typically follow overheating. Good policy must therefore balance regularities and possibilities.	Laurence H Meyer	United States	https://www.bis.org/review/r970925e.pdf	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the 1998 Global Economic and Investment Outlook Conference, Carnegie Mellon University, Pittsburgh, Pennsylvania on 17/9/97. Recent economic performance has been hailed on Wall Street as "paradise found" and the "best of times." And, on Main Street, there is ample survey evidence suggesting that consumers are feeling very upbeat about the prospects for the economy. I call the remarkable combination of healthy growth, low unemployment, low inflation, a soaring stock market, and declining federal budget deficit the "good news" economy. But there are challenges even in the "good news" economy and I want to focus on three of them this afternoon. The first challenge is to avoid complacency and appreciate the policy challenges that remain. The second is to explain how we have been able to achieve such favorable performance, given that it is better than almost anyone predicted and better than historical regularities suggested was even possible. And the third challenge is to assess the risks in the current environment and determine how monetary policy should be positioned to keep the good news coming. Two themes will become evident as I address these challenges. First, there are limits -limits on what policy can accomplish and limits on what the economy can achieve. Second, in assessing the current environment and its implications for monetary policy, uncertainties require us to balance historical regularities and newer possibilities. Expansions, to an important degree, have common properties, what I shall refer to as regularities. Both forecasters and policymakers rely on these. Forecasters make predictions about future developments based on regularities. The same regularities allow policymakers to act pre-emptively -changing policy today in anticipation of developments tomorrow. Yet each expansion has its own signature that reflects the specific set of transitory influences and longer-lasting structural changes in play at the time. The current episode features the following players. Cyclical regularities clearly in evidence include accelerator effects, changing tolerances for risk, and cyclical swings in the unemployment rate and in profits. Two other regularities that I especially want to focus on today are the Phillips Curve and the trend growth in output. The latter regularities define limits - limits to the sustainable level of output, at any moment, and, once that level of capacity is reached, to the growth of output over time. If these limits are exceeded, as typically happens during a cyclical expansion, the economy eventually overheats, inflation increases, and the expansion is undermined as policy is forced to rein in demand. Transitory influences, clearly among the stars of the current episode, feature a coincidence of favorable supply shocks that have restrained inflation. Finally, structural adjustments, in this episode, hint at a decline in NAIRU and/or an increase in trend growth. The central question in interpreting the recent experience is whether the old limits on economic performance are no longer binding, having been replaced by new possibilities, or are just being temporarily overruled by transitory influences. Before moving to the substance of my talk, let me remind you that my remarks on the outlook and monetary policy, today and always, are my views. I do not speak for the FOMC. Before addressing the challenges and developing these themes, let me briefly review the surprisingly favorable features of recent economic performance and comment on the near-term outlook. For this audience, I can summarize recent performance in a single sentence. We have been recently blessed with relatively strong cyclical growth, the lowest unemployment rate in 24 years, the lowest inflation in 31 years, an impressive investment boom, soaring equity prices and a 5-year decline in the federal budget deficit that may take the deficit to below $1 / 2 \%$ of GDP in fiscal 1997. But this conference is about the next chapter in this story. And the key in the near term may be crosscurrents that appear likely to both moderate output growth and keep inflation relatively well contained. In the case of output growth, the crosscurrents are the continued strength in demand and the expected slowing in inventory investment. In the second quarter, the economy slowed to an upward revised $3.6 \%$ rate, from a $4.9 \%$ rate in the first quarter, a much more modest slowing than originally reported and widely anticipated during the quarter. This, by the way, has been a recurring pattern in the expansion -- every time I thought the economy had or was about to slow to trend, it has surprised with its continued strength. The fundamentals continue to look very positive. In particular, households as a group are wealthy and optimistic, businesses are profitable and confronted with dramatic technological opportunities, and financial conditions remain supportive. There appear to be few imbalances that are a threat to continued expansion. As a result, demand is expected to remain strong in the second half of the year, paced by a rebound in consumer spending and complemented by continued strength in business fixed investment. Forecasters know, however, that the composition or mix of output in one quarter -specifically the mix between final demand and inventory investment -- often provides an important hint of what is to come. While I interpret the strength of inventory investment in the first half -- including the upward revised rate of about $\$ 78$ billion in the second quarter -- as largely voluntary, principally reflecting a response to the strength in past and prospective sales, the flow rate of accumulation in the second quarter is almost certainly unsustainable. That is, stocks may be in equilibrium, but the flow rate will have to slow to keep them there. The resulting slowdown in inventory investment is likely, therefore, to be a significant drag on production in the second half of this year, offsetting, at least in part, the expected rebound in final demand. On the inflation side, there are also important crosscurrents at work. I have been concerned about two considerations that suggest that inflation may well rise over time: the possibility that the economy is operating today beyond its sustainable capacity and the likelihood that the transitory factors that have, on balance, been restraining inflation will diminish in importance over time. However, three other influences that, in my view, have gradually become more significant considerations, are likely to moderate the tendency for inflation to rise in the near term. First, lower-than-expected overall and core inflation and continued modest pace of wage change over this year will encourage more restrained increases in wages and prices over the coming year. Lower inflation leads to lower inflation expectations, reinforcing the prospect for low inflation ahead. In this case, inertia is our friend and the result is a virtuous wage-price spiral, at least for a while. Second, some of the transitory factors, especially the appreciation of the dollar and resulting decline in import prices, appear to have longer legs and are likely to contribute more toward restraint on inflation in coming quarters than earlier appeared likely. Third, the upward adjustment to profits in the July NIPA revisions suggests there is more of a profit cushion that could delay the pass-through of higher compensation to price increases. While these crosscurrents suggest moderation in both output growth and inflation, crosscurrents don't necessarily balance. With respect to output growth, the crosscurrents do point toward slower growth in the second half compared to the first half, but is important whether the slower growth turns out to be near trend, holding utilization rates constant, or above trend, pushing utilization rates still higher. At the very least, the slowdown in inventory investment is likely to be accommodated with minimal disturbance to the continued expansion. But there is a risk that growth will continue to be above trend, pushing utilization rates up, from already high levels. With respect to inflation, the netting of the crosscurrents suggests a modest increase in inflation in 1998, albeit from a steadily downward-revised and very low rate in 1997. I will pay very close attention to the source of any rebound in inflation, specifically the degree to which it reflects simply the dissipation of some of the favorable supply shocks that have contributed to the very low inflation this year and the degree to which it reflects the more persistent effect of high utilization rates. As a result, I will be focusing more on core than overall inflation rates and paying particularly close attention to labor costs, given that labor markets appear tighter than product markets and therefore more likely to be the source of any increase in inflation pressures. Still, any increase in inflation would begin from a lower base and may be more modest than previously appeared likely. The bottom line is that past performance, in several important dimensions, has been extraordinary and that prospects look favorable for continued expansion and relatively low inflation. Still, monetary policy must be alert to the potential of a developing upward trend in inflation in an economy that may already be operating beyond its sustainable capacity and possibly still growing at an above-trend rate. And, as always, there are challenges, even in the good news economy. The first challenge is to avoid becoming complacent. Even as there are good reasons for celebrating recent economic performance, there are good reasons for avoiding complacency. Specifically, there are dimensions of economic performance which are less stellar, such as the slow average growth rate in GDP in the 1990s, a continuation of the effects of the productivity slowdown that began in the early 1970s. There are, in addition, obvious longer-run problems that deserve to be confronted today, such as those related to the aging of the population and resulting pressures on entitlement programs. And there remain lingering social strains associated with a gradual increase in income inequality, interacting with the low average growth rate in productivity to produce a long period of relatively stagnant real income for the median income family. This less rosy perspective on the current state of the economy was suggested by several members of Congress during the recent oversight hearings on monetary policy. I think the point is an important one and I agree that we should not let the recent favorable performance of inflation, unemployment and equity prices distract our attention from the importance of confronting a slow average rate of increase in living standards and lingering social problems that both reflect and are exacerbated by a widening in income inequality. However, other than through its pursuit of its legislative mandates of price stability and maximum sustainable employment, monetary policy cannot make a major contribution to the resolution of these problems. Monetary policy, in particular cannot remedy increases in income inequality, raise the trend rate of increase in living standards, or combat inadequate opportunities for upward mobility out of poverty. It is, as always, important that we carry out our traditional responsibilities well, accommodating the maximum sustainable growth and achieving the maximum sustainable level of employment. But we cannot do more. The second challenge is to explain why performance has been so favorable, at least in terms of inflation and unemployment. Before exploring explanations of the puzzle, I want to focus on common features of cyclical expansions. In doing so, I will focus on cyclical expansions that have not been dominated by dramatic external shocks, such as the two episodes that were marked by steeply rising world oil prices -- first in the early 1970s and again in the late 1970s and early 1980s. While even these expansions share many of the patterns I emphasize later, their endings are dominated by the effects of the powerful supply shocks and policy responses to the shocks. Expansions, by definition, begin with considerable economic slack, inherited from the previous recession. The economy typically makes a rapid transition from declining output (the definition of recession) to above-trend growth. In a loose way, trend growth refers to the growth in the economy's productive capacity. When growth is above trend, production is expanding faster than the economy's productive capacity and, as a result, resource utilization rates rise. Rising capacity utilization rates and falling unemployment rates are thus a typical feature of an expansion period. The natural dynamic of an expansion is for above-trend growth to continue until demand overtakes capacity, despite the best efforts of policy to avoid cyclical excesses. The end of the story is particularly important. Expansions do not die of old age or lethargy, a spontaneous weakening of aggregate demand, but rather of an accumulation of imbalances, specifically with demand outstripping the limits of sustainable level of input utilization and growth of output. The resulting rise in inflation becomes a threat to the continued expansion. Preventive medicine is therefore the best course of treatment. In this story, NAIRU sets a limit to how far the economy can expand before overheating sets in and inflation rises, and the Phillips Curve traces out an important part of the dynamics of inflation, how fast it responds to excess demand. Of course, the Phillips Curve framework has always been much easier to describe than to implement, given uncertainties about the estimates of NAIRU, given the fact that empirical regularities between inflation and unemployment always left much of the variation in inflation unexplained, and given the importance of supply shocks with significant, though transitory, effects on the inflation-unemployment nexus. Nevertheless, the regularity in the cyclical sensitivity of inflation, as embedded in the Phillips Curve, has proved to be an important guide to both forecasters and monetary policymakers in the past. The consensus estimates of NAIRU as this expansion began -- about $6 \%$-- did not prepare us for the recent surprisingly favorable performance. It is possible that the Phillips Curve and NAIRU is simply the wrong analytical framework, but I doubt it and am not aware of another model of inflation dynamics that is ready to take its place. So my response is to update my estimate of NAIRU and add other explanations consistent with this framework, but not to abandon this concept. One possible explanation is that one or more transitory factors, for the moment, are yielding a more favorable than usual outcome. A coincidence of favorable supply shocks is clearly, in my judgment, an important part of the answer to the puzzle. I won't talk at length about these factors, as I have done so in previous talks. I would just note that these favorable supply shocks include an appreciation of the dollar and consequent decline in import prices; a slowing in the rate of increase in benefit costs, concentrated in a slowdown in costs for health care insurance; a faster rate of decline in computer prices than earlier, reflecting the quicker pace of innovation; and more recently, a decline in oil prices and a slower rate of increase in food prices. Let me include in my list of explanations for the current favorable economic performance an intriguing cyclical anomaly. One regularity of past expansions has been the close relationship between two widely used measures of resource utilization -- the capacity utilization and unemployment rates. They have traditionally moved together over a cycle and tended to mirror one another. In this case, it did not matter which one was used as a proxy for excess demand; and the unemployment rate could be used interchangeably as a measure of labor market demand pressures and overall economy-wide demand pressures. In the current episode, however, these two measures are sending different signals. The unemployment rate is flashing a warning of a very tight labor market. The capacity utilization rate, in contrast, suggests a reasonably balanced configuration of production and capacity in the product market, at least in the manufacturing sector. Why has this divergence developed and what are its implications for the relationship between inflation and unemployment? The divergence mirrors one of the other defining features of this expansion -- the boom in business fixed investment. The result is a high level of net investment, a more rapid rate of increase in the capital stock and hence in industrial capacity. The resulting absence of excess demand in the product market is, in my view, an important factor explaining the frequently reported absence of pricing leverage by firms. Nothing gives a firm pricing leverage like excess demand. In addition, the resulting inability of firms to pass on higher costs in higher prices likely has altered the way firms operate in the labor market, making them more reluctant to bid aggressively for workers, contributing to a slower rate of increase in wages than we would otherwise have expected at prevailing labor utilization rates. It is possible that the gap that has opened between the unemployment and capacity utilization rates may be a factor that has, in effect, lowered NAIRU in this expansion. This explanation has potential, but there is no historical precedent and it is, therefore, difficult to judge its importance. The most intriguing explanations for the recent favorable performance are structural changes, which may have relaxed the capacity constraints that are the core of the cyclical regularities story, or made these constraints more flexible than in the past, or tempered the ability and/or willingness of firms to respond to excess demand by raising wages and prices. I refer to these collectively as "possibilities," as they suggest an optimistic period of improved economic performance, contrasting with both the pessimism of the previously perceived limits in the cyclical regularities story or the grudging "for the moment" concession of explanations relying on transitory influences. There are two possibilities that have been widely discussed: that the economy can now sustain a lower unemployment rate without rising inflation (i.e., that NAIRU has declined) and that, once capacity has been reached, the economy is now capable of faster growth, compared to the estimates of trend growth reported earlier. A lot of the discussion about this episode focuses on sorting out the relative importance of the two possibilities -specifically, whether the recent favorable performance is due more to labor market structural change, as reflected in a lower NAIRU, or to product market structural change, as reflected in a higher rate of growth in productivity. Time varying parameter estimates of the Phillips Curve and the more casual eye both suggest a decline in NAIRU. Robert Gordon's work, for example, suggests a decline in NAIRU, from $6 \%$ in the decade prior to 1994, to about $51 / 2 \%$ by the end of 1995, with NAIRU stabilizing at this level since that time. One possible explanation for the more moderate rate of increase in compensation per hour than would have been expected from historical experience is an increase in worker insecurity as a consequence of the rapid pace of technological change and/or the rapid pace of restructuring and downsizing. As a result, workers may have been willing to trade off some real wages for increased security, resulting in a more modest increase in compensation per hour than otherwise would have been expected. The result is a slower rate of increase in compensation at any given level of unemployment, equivalent to a decline in NAIRU. Another possible explanation is the divergence between the unemployment and capacity utilization rates in this expansion that I discussed earlier. Although a decline in NAIRU is a story of relaxed limits, the worker insecurity explanation is not itself an optimistic story. Some workers, to be sure, gain, by opportunities for employment that otherwise would have been denied. But a broader group of workers suffer a slower increase in living standards, relative to what otherwise would have been "possible." Another possibility is that the trend rate of increase in productivity -- and hence the economy's sustainable rate of growth in GDP -- has recently increased. There is some confusion in many discussions of productivity growth about the implications of measurement bias. It is widely accepted that there is a downward bias in measured productivity growth, the mirror image of the upward bias in measured inflation. But it is also widely accepted that a similar bias has been present over the entire postwar period. The measurement issue is relevant to explaining the inflation-unemployment experience in the current episode only if the bias has recently become more serious. An increase in measurement bias could be under way, perhaps related to an acceleration in technical change, but it will be a long time before we are able to establish this with a reasonable degree of certainty. Note also that if the measurement bias has increased, this would imply that both actual and potential output growth are higher than reported, with no obvious implication for the gap between actual and potential output, and hence for inflation pressures. Sources of higher productivity growth, all of which should show up in measured productivity, include a return on years of corporate restructuring and the increase in capital per worker associated with the current investment boom, much of which is linked to technological change, specifically the information revolution. There are a couple of reasons why this is an attractive explanation. No other explanation has the ability to explain as many features of the current experience as an increase in trend productivity. Technological change, according to this view, has resulted in new profit opportunities which in turn have resulted in an investment boom (heavily concentrated in high technology equipment), increased corporate earnings, and a soaring stock market. In addition, this explanation is consistent with many anecdotes from businesses about efficiency gains as new technology is put into place. There are, however, some problems with this story as the principal explanation for the favorable inflation performance. First, a productivity explanation would resonate better if the puzzle were why higher wage change was not being passed on in higher prices. But the greater puzzle is the slow pace of increase in compensation per hour at prevailing unemployment rates. This is more clearly the case after the downward revision in compensation in the July NIPA revisions, bringing that measure of compensation per hour more in line with the Employment Cost Index. Given the rate of increase in compensation, an unchanged trend growth in productivity of $1.1 \%$, for example, seems quite consistent with recent price performance. Although not without some serious shortcomings, the published productivity data provide little encouragement to the view that there has been a significant improvement in underlying productivity growth. The growth in measured productivity over this expansion has, in fact, been disappointing. Over 1994 and 1995, in particular, measured productivity was nearly flat. Although it has accelerated over the last two years, this is consistent with another cyclical regularity, the tendency for productivity to accelerate with economic activity. And the rate of growth over the last year, even with the sharp upward revision in the second quarter, is $1.2 \%$, just above the $1.1 \%$ average rate of increase over the period from the early 1970s up to the beginning of this expansion. Still, there are other pieces of data and interpretations of the published data that provide some support to a more optimistic assessment. For example, the acceleration in productivity to a $1.2 \%$ rate over the last year, at a time when the unemployment rate was dropping to a level that would suggest less productive workers were being drawn on, leaves open the possibility that the productivity trend has quickened. Perhaps the strongest case for an increase in the productivity trend comes from the higher rate of growth over the past two years if productivity is measured from the income side of the national accounts. In my testimony at the Congressional oversight hearings, I presented a range of estimates for NAIRU and trend growth from the CBO, Council of Economic Advisers, DRI, Macroeconomic Advisers and Professor Robert Gordon. The range for NAIRU was $5.4 \%$ to $5.9 \%$ and for trend growth, $2.1 \%-2.3 \%$. Since my testimony, both DRI and Macroeconomic Advisers have revised down their estimates of NAIRU-DRI from $5.8 \%$ to $5.6 \%$ and Macroeconomic Advisers from $5.8 \%$ to $5.4 \%$. The range of estimates is now therefore more tightly concentrated around $5 \frac{1}{2} \%$. I presented these estimates in my testimony to emphasize the continuing importance the profession attaches to NAIRU, the central tendency of current NAIRU estimates, and the absence of significant upward adjustments to estimates of trend growth. In short, some updating in the regularities may be appropriate, especially in the case of NAIRU, but continued attention to their message of limits remains critical for disciplined policy. We should remain open minded and alert to the possibility of structural change, but cautious about reaching the conclusion that the regularities that have been so important in the past no longer set limits that policy must respect. Some day we shall look back on this episode with historical perspective and perhaps -and only perhaps -- have a better ability to sort out what contributed to the favorable outcome and the extent to which the prevailing coexistence of low unemployment and stable low inflation proved permanent or transitory. Monetary policy, however, is made in real time. The appropriate stance of monetary policy should reflect both the increased uncertainty surrounding the failure of historical regularities to predict the better-than-expected outcome in terms of inflation and unemployment and the best judgement about regularities as we update our estimates of NAIRU and trend growth in response to current data. At one extreme, the uncertainty about the source of the recent performance might be viewed as so great that the best course for monetary policy is a reactive posture, waiting for clear signs that inflation is rising and only tightening in response to such evidence. I agree that the current uncertainty encourages caution, but not to the point of paralysis. A prudent approach would continue to lean against the cyclical winds by adjusting policy in response to persistent increases in utilization rates as well as in response to changes in underlying inflation. We should always have problems like today's, struggling to explain unexpectedly good performance. And it is important to keep in perspective any questions about how tight labor markets might be or whether near-term growth might remain above trend. The economy is very healthy and the prospects continue to be bright. But as we celebrate the exceptional present, we should not forget the lessons of the past. There are limits. They may not be the old limits that disciplined policy in the past. But even if the limits are new, they must be respected. Overheating is a natural product of expansions that overtax these limits. Recessions typically follow overheating. Good policy must therefore balance regularities and possibilities.
1997-09-21T00:00:00	Mr. McDonough considers the challenge presented by the Year 2000 problem (Central Bank Articles and Speeches, 21 Sep 97)	Remarks by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough before the Annual Membership Meeting of the Institute of International Finance in Hong Kong on 21/9/97.	Mr. McDonough considers the challenge presented by the Year 2000 problem Remarks by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough before the Annual Membership Meeting of the Institute of International Finance in Hong Kong on 21/9/97. I am pleased to be able to share my thoughts with you today on an issue that is sure to challenge every one of our organizations for the next several years -- the Year 2000 and how the century date change poses a very significant risk for financial markets. As I look at the membership of the Institute of International Finance gathered here in Hong Kong, I cannot help but be impressed as to how truly global financial markets have become. Realizing that this meeting is being hosted here in Hong Kong, with the People's Republic of China as the host country, further underscores how rapidly the world is changing and how interdependent we are. As a central banker, I worry a lot about events that could disrupt financial markets. Many of the events that I worry about are hypothetical. In those cases, a large part of my job is to convince others that the hypothetical event in question is sufficiently possible that it is in the industry's best interest to work together to try to avoid the event and related problems. Today, I am sure that I do not have to convince you about the inevitability of the approaching century date change. It is a certainty. What remains for me to do is to help put the dimension of the Year 2000 issue in perspective and suggest some of the actions that are necessary now if we are to avoid potentially serious problems down the road. As recently as the early 1990s, few banks and other financial institutions paid much attention to the Year 2000 problems. After all, using two digits in programs to represent the year made sense for decades. Many institutions didn't recognize the problem at all; others speculated that changes in technology would somehow appear and solve the problem. Now, however, delays have come back to haunt those institutions that acted passively, or not at all, in marshalling the resources needed to manage the problem. Financial institutions depend on the proper sequencing of events and calculations based on dates, but the logic built into applications to sequence events and perform calculations will not work properly when we hit 2000. As a result, Year 2000 issues pervade every business area of all financial and non-financial institutions. As if that were not enough, the problem is not just limited to the business lines and the applications upon which businesses rely. Operating systems and the equipment on which business applications run also are reliant on microchip-embedded logic affected by two-digit year representations. Unlike business applications where the dates usually are visible, potential problems in operating systems and equipment usually are invisible or embedded in programs. That means that banks and other institutions must rely on vendors, rather than their in-house technical staff, to identify and fix the problems. Similarly, mechanical devices used in security systems, elevators, and heating and cooling equipment controlled by microchips can be affected and may even cease to run. Making sure that all of our business applications work together properly will be a formidable challenge, both internally and across the financial services industries. For a variety of business and economic reasons, different approaches to correcting Year 2000 problems will be taken by different organizations. Even within organizations, corrective approaches may well vary for different business applications. Because the changes necessary to fix applications to make them Year 2000-compliant will be completed at different times, testing and re-testing will be needed to assure that information flows properly. Continual testing, however, will consume a very significant amount of resources, usually drawn from business line areas. Consultants estimate that testing alone will absorb as much as 70 percent of Year 2000 project resources at some institutions. The Year 2000 issue stretches well beyond the doors of financial services companies. Your customers and counterparties also must cope. How well they handle this complex and costly technical challenge could affect their business prospects and even their viability. Consequently, over the next couple of years, underwriting standards should specially consider how customers are addressing the issue, and credit officers should monitor the progress of customers who rely on technology on a regular basis. In my Bank's and the Basle Supervisors' work with the industry to meet the Year 2000 challenge, a number of issues have arisen that are worth calling to your attention. Probably the most significant issue is the relationship that banks have with third-party vendors and service providers. Not infrequently, we have found that banks have assumed either that vendors will make their products and services Year 2000-compliant, or have sought only general assurances from the vendors, which have been accepted at face value. Either approach puts a bank at significant risk. In addition, we uncovered instances when products represented by vendors as compliant simply were not. More significantly, we found that even if a vendor has made appropriate modifications and tested a product, there can be no guarantee that it will work properly in a bank's unique operating environment or in concert with related applications. It is now quite clear that every product must be tested and certified as compliant by the user, and testing must be repeated upon the release of new compliant applications, environmental software, and hardware. Remote operations and foreign activities pose special challenges for Year 2000 programs. Efforts to develop or use off-the-shelf applications or to put in place a general plan of action can fail to take into account activities that are unique to a particular business or location. Making certain that inventories are complete for complex organizational structures and geographically dispersed banks is proving to be a very difficult task. Obtaining and retaining the staff resources capable of dealing with Year 2000 issues will be another increasingly difficult problem. There is a limited pool of skilled technical staff to make needed changes, and demands on this pool are growing as the time draws closer. In the short run, the ability to add to this pool significantly through training is limited. Qualified outside consultants already are heavily committed and will become even more scarce over time. Obtaining equipment on which to conduct tests also often requires significant lead time. All of this suggests that controlling the cost of Year 2000 projects will be a problem for many institutions as resource prices are bid up. Already, we have seen many institutions increase their Year 2000 budgets several times, and by significant amounts, as they develop their detailed plans. Security also is likely to be of increasing concern as we move forward. As time pressures mount, there is a risk that shortcuts will be taken. The checking of credentials for new staff or outside contractors or consultants may be rushed and less rigorous. Date-dependent security applications may be turned off to facilitate testing. In an industry like ours, with so much interconnectivity, any compromise of security simply cannot be tolerated. Every financial institution needs its own comprehensive project plan to address the Year 2000 problem. In the United States, bank supervisors have suggested an approach that includes a number of phases. A technical paper prepared by the Basle Committee on Banking Supervision and released by the G-10 Governors on September 8th discusses a very similar approach. In both cases, the basic approach includes the following components: • setting the Year 2000 project as a strategic objective to be managed at the highest level; • making sure that staff at all levels recognize the importance of the project as a business issue, not just a technical one; • identifying all applications, operating systems and equipment affected by the Year 2000 problem, and developing appropriate plans and schedules that can be monitored at the highest level within the organization; • determining what needs to be done and making the necessary changes; • testing each system to be sure that it works, not only as an independent application, but in concert with related systems within the institution, and with those of correspondents and customers; and, lastly, • putting Year 2000-compliant applications into production. The Basle Supervisors' paper does a good job of laying out the full scope of the challenge, and I commend it to your attention. The paper should serve as a strong wake-up call. There still is time to address the problem, but now there is urgency in making the difficult choices. In the mere two years that are left, the challenge will be to minimize business and systemic impacts as much as possible. By now, all major financial institutions should have identified what needs to be done and be in, or near, the final stages of developing detailed plans. Work on changing all applications identified as high business priorities also should be well under way. In the United States, most large institutions plan to have their major applications available for external testing around the middle of 1998, with an expectation that testing with other major institutions would largely be completed by year-end 1998. This schedule allows all of 1999 for end-to-end testing on an industry-wide basis. But even with two years to spare, it is safe to say that no organization will be able to cope successfully with the Year 2000 challenge unless both its management and staff realistically measure its scope and commit to its solution. Bluntly stated, if your own management and staff, or your correspondents and customers, take any of the following positions, your organization may be at risk: -- the Year 2000 is not an issue for our organization. • Denial It is. • -- our organization can handle the Year No resource problems 2000 with its existing resources and within current information technology budgets. Very unlikely. • -- our outside vendors and service Vendors will address the issue providers won't let us down. Trust is not a substitute for testing. • Covered by contract -- our lawyers have determined that we are appropriately protected by our legal agreements. The lawyers may get rich, but will you be in business? • Testing is not a problem -- our organization has good testing and acceptance procedures and we test all the time. Previous internal testing standards probably won't do the job this time. • -- our Obtaining adequate resources will not be an issue organization has a great technical staff and we can always hire additional resources if it becomes necessary. Good luck. As a bank supervisor, the Federal Reserve Bank of New York will do whatever it can to encourage banks to set up and adhere to programs that deal with Year 2000 problems. Our examiners will focus on how well individual banks are doing and will highlight for senior management and directors those instances when progress may be lagging. This oversight will include not only U.S. banks, but also the U.S. branches and agencies of foreign banks. However, the motivation and determination to cope with the Year 2000 problem must come from within banking organizations rather than from supervisory oversight. Getting the Year 2000 issue right is critical for every organization. Failure to get it right will affect the integrity of the payments system and the performance of the domestic, and maybe even the global, economy. The Federal Reserve is working hard to make certain that our systems will be ready and fully tested. And I am pleased by the high level of central bank coordination on this issue, as the recent release of the Basle Supervisors' technical paper demonstrates. All of us need to make sure we are paying sufficient attention and applying appropriate resources to the Year 2000 issue. Only in that way will we be able to insure that the millennium changeover is an occasion for joy and optimism.	---[PAGE_BREAK]--- Mr. McDonough considers the challenge presented by the Year 2000 problem Remarks by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough before the Annual Membership Meeting of the Institute of International Finance in Hong Kong on 21/9/97. I am pleased to be able to share my thoughts with you today on an issue that is sure to challenge every one of our organizations for the next several years -- the Year 2000 and how the century date change poses a very significant risk for financial markets. As I look at the membership of the Institute of International Finance gathered here in Hong Kong, I cannot help but be impressed as to how truly global financial markets have become. Realizing that this meeting is being hosted here in Hong Kong, with the People's Republic of China as the host country, further underscores how rapidly the world is changing and how interdependent we are. As a central banker, I worry a lot about events that could disrupt financial markets. Many of the events that I worry about are hypothetical. In those cases, a large part of my job is to convince others that the hypothetical event in question is sufficiently possible that it is in the industry's best interest to work together to try to avoid the event and related problems. Today, I am sure that I do not have to convince you about the inevitability of the approaching century date change. It is a certainty. What remains for me to do is to help put the dimension of the Year 2000 issue in perspective and suggest some of the actions that are necessary now if we are to avoid potentially serious problems down the road. As recently as the early 1990s, few banks and other financial institutions paid much attention to the Year 2000 problems. After all, using two digits in programs to represent the year made sense for decades. Many institutions didn't recognize the problem at all; others speculated that changes in technology would somehow appear and solve the problem. Now, however, delays have come back to haunt those institutions that acted passively, or not at all, in marshalling the resources needed to manage the problem. Financial institutions depend on the proper sequencing of events and calculations based on dates, but the logic built into applications to sequence events and perform calculations will not work properly when we hit 2000. As a result, Year 2000 issues pervade every business area of all financial and non-financial institutions. As if that were not enough, the problem is not just limited to the business lines and the applications upon which businesses rely. Operating systems and the equipment on which business applications run also are reliant on microchip-embedded logic affected by two-digit year representations. Unlike business applications where the dates usually are visible, potential problems in operating systems and equipment usually are invisible or embedded in programs. That means that banks and other institutions must rely on vendors, rather than their in-house technical staff, to identify and fix the problems. Similarly, mechanical devices used in security systems, elevators, and heating and cooling equipment controlled by microchips can be affected and may even cease to run. Making sure that all of our business applications work together properly will be a formidable challenge, both internally and across the financial services industries. For a variety of business and economic reasons, different approaches to correcting Year 2000 problems will be taken by different organizations. Even within organizations, corrective approaches may well ---[PAGE_BREAK]--- vary for different business applications. Because the changes necessary to fix applications to make them Year 2000-compliant will be completed at different times, testing and re-testing will be needed to assure that information flows properly. Continual testing, however, will consume a very significant amount of resources, usually drawn from business line areas. Consultants estimate that testing alone will absorb as much as 70 percent of Year 2000 project resources at some institutions. The Year 2000 issue stretches well beyond the doors of financial services companies. Your customers and counterparties also must cope. How well they handle this complex and costly technical challenge could affect their business prospects and even their viability. Consequently, over the next couple of years, underwriting standards should specially consider how customers are addressing the issue, and credit officers should monitor the progress of customers who rely on technology on a regular basis. In my Bank's and the Basle Supervisors' work with the industry to meet the Year 2000 challenge, a number of issues have arisen that are worth calling to your attention. Probably the most significant issue is the relationship that banks have with third-party vendors and service providers. Not infrequently, we have found that banks have assumed either that vendors will make their products and services Year 2000-compliant, or have sought only general assurances from the vendors, which have been accepted at face value. Either approach puts a bank at significant risk. In addition, we uncovered instances when products represented by vendors as compliant simply were not. More significantly, we found that even if a vendor has made appropriate modifications and tested a product, there can be no guarantee that it will work properly in a bank's unique operating environment or in concert with related applications. It is now quite clear that every product must be tested and certified as compliant by the user, and testing must be repeated upon the release of new compliant applications, environmental software, and hardware. Remote operations and foreign activities pose special challenges for Year 2000 programs. Efforts to develop or use off-the-shelf applications or to put in place a general plan of action can fail to take into account activities that are unique to a particular business or location. Making certain that inventories are complete for complex organizational structures and geographically dispersed banks is proving to be a very difficult task. Obtaining and retaining the staff resources capable of dealing with Year 2000 issues will be another increasingly difficult problem. There is a limited pool of skilled technical staff to make needed changes, and demands on this pool are growing as the time draws closer. In the short run, the ability to add to this pool significantly through training is limited. Qualified outside consultants already are heavily committed and will become even more scarce over time. Obtaining equipment on which to conduct tests also often requires significant lead time. All of this suggests that controlling the cost of Year 2000 projects will be a problem for many institutions as resource prices are bid up. Already, we have seen many institutions increase their Year 2000 budgets several times, and by significant amounts, as they develop their detailed plans. Security also is likely to be of increasing concern as we move forward. As time pressures mount, there is a risk that shortcuts will be taken. The checking of credentials for new staff or outside contractors or consultants may be rushed and less rigorous. Date-dependent security applications may be turned off to facilitate testing. In an industry like ours, with so much interconnectivity, any compromise of security simply cannot be tolerated. ---[PAGE_BREAK]--- Every financial institution needs its own comprehensive project plan to address the Year 2000 problem. In the United States, bank supervisors have suggested an approach that includes a number of phases. A technical paper prepared by the Basle Committee on Banking Supervision and released by the G-10 Governors on September 8th discusses a very similar approach. In both cases, the basic approach includes the following components: - setting the Year 2000 project as a strategic objective to be managed at the highest level; - making sure that staff at all levels recognize the importance of the project as a business issue, not just a technical one; - identifying all applications, operating systems and equipment affected by the Year 2000 problem, and developing appropriate plans and schedules that can be monitored at the highest level within the organization; - determining what needs to be done and making the necessary changes; - testing each system to be sure that it works, not only as an independent application, but in concert with related systems within the institution, and with those of correspondents and customers; and, lastly, - putting Year 2000-compliant applications into production. The Basle Supervisors' paper does a good job of laying out the full scope of the challenge, and I commend it to your attention. The paper should serve as a strong wake-up call. There still is time to address the problem, but now there is urgency in making the difficult choices. In the mere two years that are left, the challenge will be to minimize business and systemic impacts as much as possible. By now, all major financial institutions should have identified what needs to be done and be in, or near, the final stages of developing detailed plans. Work on changing all applications identified as high business priorities also should be well under way. In the United States, most large institutions plan to have their major applications available for external testing around the middle of 1998, with an expectation that testing with other major institutions would largely be completed by year-end 1998. This schedule allows all of 1999 for end-to-end testing on an industry-wide basis. But even with two years to spare, it is safe to say that no organization will be able to cope successfully with the Year 2000 challenge unless both its management and staff realistically measure its scope and commit to its solution. Bluntly stated, if your own management and staff, or your correspondents and customers, take any of the following positions, your organization may be at risk: - Denial -- the Year 2000 is not an issue for our organization. It is. - No resource problems -- our organization can handle the Year 2000 with its existing resources and within current information technology budgets. Very unlikely. ---[PAGE_BREAK]--- - Vendors will address the issue -- our outside vendors and service providers won't let us down. Trust is not a substitute for testing. - Covered by contract -- our lawyers have determined that we are appropriately protected by our legal agreements. The lawyers may get rich, but will you be in business? - Testing is not a problem -- our organization has good testing and acceptance procedures and we test all the time. Previous internal testing standards probably won't do the job this time. - Obtaining adequate resources will not be an issue -- our organization has a great technical staff and we can always hire additional resources if it becomes necessary. Good luck. As a bank supervisor, the Federal Reserve Bank of New York will do whatever it can to encourage banks to set up and adhere to programs that deal with Year 2000 problems. Our examiners will focus on how well individual banks are doing and will highlight for senior management and directors those instances when progress may be lagging. This oversight will include not only U.S. banks, but also the U.S. branches and agencies of foreign banks. However, the motivation and determination to cope with the Year 2000 problem must come from within banking organizations rather than from supervisory oversight. Getting the Year 2000 issue right is critical for every organization. Failure to get it right will affect the integrity of the payments system and the performance of the domestic, and maybe even the global, economy. The Federal Reserve is working hard to make certain that our systems will be ready and fully tested. And I am pleased by the high level of central bank coordination on this issue, as the recent release of the Basle Supervisors' technical paper demonstrates. All of us need to make sure we are paying sufficient attention and applying appropriate resources to the Year 2000 issue. Only in that way will we be able to insure that the millennium changeover is an occasion for joy and optimism.	William J McDonough	United States	https://www.bis.org/review/r971001c.pdf	Mr. McDonough considers the challenge presented by the Year 2000 problem Remarks by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough before the Annual Membership Meeting of the Institute of International Finance in Hong Kong on 21/9/97. I am pleased to be able to share my thoughts with you today on an issue that is sure to challenge every one of our organizations for the next several years -- the Year 2000 and how the century date change poses a very significant risk for financial markets. As I look at the membership of the Institute of International Finance gathered here in Hong Kong, I cannot help but be impressed as to how truly global financial markets have become. Realizing that this meeting is being hosted here in Hong Kong, with the People's Republic of China as the host country, further underscores how rapidly the world is changing and how interdependent we are. As a central banker, I worry a lot about events that could disrupt financial markets. Many of the events that I worry about are hypothetical. In those cases, a large part of my job is to convince others that the hypothetical event in question is sufficiently possible that it is in the industry's best interest to work together to try to avoid the event and related problems. Today, I am sure that I do not have to convince you about the inevitability of the approaching century date change. It is a certainty. What remains for me to do is to help put the dimension of the Year 2000 issue in perspective and suggest some of the actions that are necessary now if we are to avoid potentially serious problems down the road. As recently as the early 1990s, few banks and other financial institutions paid much attention to the Year 2000 problems. After all, using two digits in programs to represent the year made sense for decades. Many institutions didn't recognize the problem at all; others speculated that changes in technology would somehow appear and solve the problem. Now, however, delays have come back to haunt those institutions that acted passively, or not at all, in marshalling the resources needed to manage the problem. Financial institutions depend on the proper sequencing of events and calculations based on dates, but the logic built into applications to sequence events and perform calculations will not work properly when we hit 2000. As a result, Year 2000 issues pervade every business area of all financial and non-financial institutions. As if that were not enough, the problem is not just limited to the business lines and the applications upon which businesses rely. Operating systems and the equipment on which business applications run also are reliant on microchip-embedded logic affected by two-digit year representations. Unlike business applications where the dates usually are visible, potential problems in operating systems and equipment usually are invisible or embedded in programs. That means that banks and other institutions must rely on vendors, rather than their in-house technical staff, to identify and fix the problems. Similarly, mechanical devices used in security systems, elevators, and heating and cooling equipment controlled by microchips can be affected and may even cease to run. Making sure that all of our business applications work together properly will be a formidable challenge, both internally and across the financial services industries. For a variety of business and economic reasons, different approaches to correcting Year 2000 problems will be taken by different organizations. Even within organizations, corrective approaches may well vary for different business applications. Because the changes necessary to fix applications to make them Year 2000-compliant will be completed at different times, testing and re-testing will be needed to assure that information flows properly. Continual testing, however, will consume a very significant amount of resources, usually drawn from business line areas. Consultants estimate that testing alone will absorb as much as 70 percent of Year 2000 project resources at some institutions. The Year 2000 issue stretches well beyond the doors of financial services companies. Your customers and counterparties also must cope. How well they handle this complex and costly technical challenge could affect their business prospects and even their viability. Consequently, over the next couple of years, underwriting standards should specially consider how customers are addressing the issue, and credit officers should monitor the progress of customers who rely on technology on a regular basis. In my Bank's and the Basle Supervisors' work with the industry to meet the Year 2000 challenge, a number of issues have arisen that are worth calling to your attention. Probably the most significant issue is the relationship that banks have with third-party vendors and service providers. Not infrequently, we have found that banks have assumed either that vendors will make their products and services Year 2000-compliant, or have sought only general assurances from the vendors, which have been accepted at face value. Either approach puts a bank at significant risk. In addition, we uncovered instances when products represented by vendors as compliant simply were not. More significantly, we found that even if a vendor has made appropriate modifications and tested a product, there can be no guarantee that it will work properly in a bank's unique operating environment or in concert with related applications. It is now quite clear that every product must be tested and certified as compliant by the user, and testing must be repeated upon the release of new compliant applications, environmental software, and hardware. Remote operations and foreign activities pose special challenges for Year 2000 programs. Efforts to develop or use off-the-shelf applications or to put in place a general plan of action can fail to take into account activities that are unique to a particular business or location. Making certain that inventories are complete for complex organizational structures and geographically dispersed banks is proving to be a very difficult task. Obtaining and retaining the staff resources capable of dealing with Year 2000 issues will be another increasingly difficult problem. There is a limited pool of skilled technical staff to make needed changes, and demands on this pool are growing as the time draws closer. In the short run, the ability to add to this pool significantly through training is limited. Qualified outside consultants already are heavily committed and will become even more scarce over time. Obtaining equipment on which to conduct tests also often requires significant lead time. All of this suggests that controlling the cost of Year 2000 projects will be a problem for many institutions as resource prices are bid up. Already, we have seen many institutions increase their Year 2000 budgets several times, and by significant amounts, as they develop their detailed plans. Security also is likely to be of increasing concern as we move forward. As time pressures mount, there is a risk that shortcuts will be taken. The checking of credentials for new staff or outside contractors or consultants may be rushed and less rigorous. Date-dependent security applications may be turned off to facilitate testing. In an industry like ours, with so much interconnectivity, any compromise of security simply cannot be tolerated. Every financial institution needs its own comprehensive project plan to address the Year 2000 problem. In the United States, bank supervisors have suggested an approach that includes a number of phases. A technical paper prepared by the Basle Committee on Banking Supervision and released by the G-10 Governors on September 8th discusses a very similar approach. In both cases, the basic approach includes the following components: setting the Year 2000 project as a strategic objective to be managed at the highest level;. making sure that staff at all levels recognize the importance of the project as a business issue, not just a technical one;. identifying all applications, operating systems and equipment affected by the Year 2000 problem, and developing appropriate plans and schedules that can be monitored at the highest level within the organization;. determining what needs to be done and making the necessary changes;. testing each system to be sure that it works, not only as an independent application, but in concert with related systems within the institution, and with those of correspondents and customers; and, lastly,. putting Year 2000-compliant applications into production. The Basle Supervisors' paper does a good job of laying out the full scope of the challenge, and I commend it to your attention. The paper should serve as a strong wake-up call. There still is time to address the problem, but now there is urgency in making the difficult choices. In the mere two years that are left, the challenge will be to minimize business and systemic impacts as much as possible. By now, all major financial institutions should have identified what needs to be done and be in, or near, the final stages of developing detailed plans. Work on changing all applications identified as high business priorities also should be well under way. In the United States, most large institutions plan to have their major applications available for external testing around the middle of 1998, with an expectation that testing with other major institutions would largely be completed by year-end 1998. This schedule allows all of 1999 for end-to-end testing on an industry-wide basis. But even with two years to spare, it is safe to say that no organization will be able to cope successfully with the Year 2000 challenge unless both its management and staff realistically measure its scope and commit to its solution. Bluntly stated, if your own management and staff, or your correspondents and customers, take any of the following positions, your organization may be at risk: Denial -- the Year 2000 is not an issue for our organization. It is. No resource problems -- our organization can handle the Year 2000 with its existing resources and within current information technology budgets. Very unlikely. Vendors will address the issue -- our outside vendors and service providers won't let us down. Trust is not a substitute for testing. Covered by contract -- our lawyers have determined that we are appropriately protected by our legal agreements. The lawyers may get rich, but will you be in business? Testing is not a problem -- our organization has good testing and acceptance procedures and we test all the time. Previous internal testing standards probably won't do the job this time. Obtaining adequate resources will not be an issue -- our organization has a great technical staff and we can always hire additional resources if it becomes necessary. Good luck. As a bank supervisor, the Federal Reserve Bank of New York will do whatever it can to encourage banks to set up and adhere to programs that deal with Year 2000 problems. Our examiners will focus on how well individual banks are doing and will highlight for senior management and directors those instances when progress may be lagging. This oversight will include not only U.S. banks, but also the U.S. branches and agencies of foreign banks. However, the motivation and determination to cope with the Year 2000 problem must come from within banking organizations rather than from supervisory oversight. Getting the Year 2000 issue right is critical for every organization. Failure to get it right will affect the integrity of the payments system and the performance of the domestic, and maybe even the global, economy. The Federal Reserve is working hard to make certain that our systems will be ready and fully tested. And I am pleased by the high level of central bank coordination on this issue, as the recent release of the Basle Supervisors' technical paper demonstrates. All of us need to make sure we are paying sufficient attention and applying appropriate resources to the Year 2000 issue. Only in that way will we be able to insure that the millennium changeover is an occasion for joy and optimism.
1997-09-23T00:00:00	Mr. Kelley looks at the role of the Federal Reserve in the Payments System (Central Bank Articles and Speeches, 23 Sep 97)	Remarks by Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Bank Administration Institute's Symposium on Payments System Strategy, Washington, D.C. 23/9/97.	Mr. Kelley looks at the role of the Federal Reserve in the Payments System Remarks by Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Bank Administration Institute's Symposium on Payments System Strategy, Washington, D.C. 23/9/97. It is a pleasure to be here today to discuss the Federal Reserve's role in the evolving U.S. payments system, a role which is now under careful review. A great deal is going on in the payments industry and, of course, the Federal Reserve is squarely in the middle of the action. You are, too, and we all need to work together to shape the future of our payments systems to ensure that they are as strong as possible. Understanding where we have been and where we are today is an essential foundation for addressing where we wish to go in the future. Accordingly, I will briefly review the history of the role of the Federal Reserve in the payments system, share with you in some detail our ongoing review of that role, and outline some possible directions for the future. All individuals, businesses, and government entities in this country rely upon the smooth functioning of the payments system to purchase goods, pay for services, receive payments, and make investments. Today, all of us can be confident that the payments we initiate will be satisfactorily completed. Tomorrow, technology and regulatory changes will alter the face of the payments system. Interstate banking, which spread nearly nationwide this past June, consolidation in the banking industry, legislation that mandates that most government payments be made electronically by 1999, the opportunities provided by the Internet, and other technological developments, will also contribute to the continued evolution of payment options, payment choices, and payment needs. We, at the Federal Reserve, have been studying what our role in that evolution should be and how best to ensure that all users of payment services will continue to have confidence that their payments will be completed reliably and efficiently and that all banks will have access to payment services on a fair and equitable basis. Before I address the Federal Reserve's future role in the payments system, I would like to review how and why the Federal Reserve came to play its current role. In the 50 years following the Civil War, a series of severe financial crises swept the country, disrupting and undermining the national economy. During the financial panic of 1907 cash payments were largely suspended throughout the country because many banks and clearinghouses refused to clear checks drawn on certain other banks. Otherwise solvent banks failed. The 1907 crisis and the lessons of failing to ensure a stable national economy were still fresh in the minds of Congress when they created the Federal Reserve System. Thus, when Congress passed the Federal Reserve Act in 1913, it directed the Federal Reserve to provide an elastic currency -- that is, a supply of currency in the quantities demanded by the public -- and gave it the authority to establish a nationwide check collection system. In 1917, Congress amended the Federal Reserve Act to prohibit banks from charging the Federal Reserve Banks presentment fees. These Congressional actions launched the Federal Reserve as an active participant in the payments system. Initially, the Reserve Banks fulfilled their role by providing check collection services and permitting member banks to issue transfer drafts to make payments anywhere in the country, which were paid in immediately available funds by any Reserve Bank. Gradually, as needs were identified and as technologies developed, the Reserve Banks added new payments services, beginning with the Fedwire funds transfer system in 1918, the book-entry securities service in 1968, and, finally, the automated clearing house (ACH) in the early 1970s. For much of the time, the Reserve Banks provided payment services to member banks without charge other than required reserves, and non-member banks had access to these services only through member banks. Everything changed in 1980, when Congress enacted the Monetary Control Act (MCA). A primary purpose of the MCA was to promote an efficient payments system by encouraging competition between the Federal Reserve and private-sector providers of payment services. The Act requires the Federal Reserve Banks to charge fees for their payment services, which must, over the long run, be set to recover all direct and indirect costs of providing the services. In addition, the MCA requires the Federal Reserve Banks to recover imputed costs, such as taxes and the cost of capital, and imputed profits that would have been earned if the services were provided by a private firm. Importantly, the MCA also extended reserve requirements to nonmember banks and granted all banks equal access to the Fed's payment services. Congress further expanded the role of the Federal Reserve in the payments system in 1987 when it enacted the Expedited Funds Availability Act (EFAA). For the first time, this act gave the Fed the authority to regulate check payments that were not processed by the Federal Reserve Banks. Thus, the EFAA significantly broadened the System's ability to ensure that the nation's check collection system is efficient and accessible. It also limited the time that a bank may hold funds before making them available to customers for withdrawal and directed the Federal Reserve to improve the process used to return unpaid checks to banks of first deposit. Thus, Congress has directed the Federal Reserve to ensure that the payments system in this country is efficient and effective, that it supports the economic needs of its citizens, and that it is available to all banks so that they can provide for the payment needs of their customers -- the end users of the payments system. To achieve these goals, Congress cast the Federal Reserve in the often difficult position of providing payment services, thereby competing with some of the institutions it regulates, and regulating the payments system in which it is an active participant. We are very mindful of these sometimes conflicting responsibilities and take great pains to ensure that each responsibility is addressed fairly and equitably. As service providers, the Federal Reserve Banks strive to operate in an efficient and cost-effective way. The Reserve Banks continually upgrade their computer and telecommunications systems so that increasing proportions of funds, book-entry, and ACH transactions can be processed without human intervention and, therefore, more accurately, rapidly, and cost effectively. Striving to serve their customers, the Reserve Banks offer a variety of products to meet the differing business requirements of large, mid-sized, and small institutions with widely divergent processing capabilities. For example, banks may obtain payment services from the Federal Reserve Banks using personal computers connected via switched, dial-in communications links or they may connect their mainframe computers to those in the Federal Reserve via dedicated high-speed telecommunications lines. Similarly, banks -- typically the larger ones -- may select check deposit products that require little sorting by the Reserve Banks, and they pay relatively low fees. Smaller banks may deposit checks in ways that meet their relatively greater sorting needs, thereby incurring higher fees, and many banks use a mix of these products. Importantly, because the Reserve Banks must compete for customers, they must provide services that meet or exceed the quality of other providers and must ensure that internal operations are efficient. As a regulator, the Federal Reserve has taken steps to improve the efficiency and effectiveness of the payments system, often with the full awareness that it was moving contrary to its own narrow competitive interests as a service provider. The Expedited Funds Availability Act of 1987, which was implemented through Regulation CC, included provisions designed to speed the processing of dishonored checks. In developing procedures to implement those provisions, the Federal Reserve, working with the banking industry, created a means to process returned checks on high speed equipment, which shortened return times by reducing the number of banks that might handle dishonored checks. More recently, in 1994, the Board modified Regulation CC to implement the same-day settlement rule, which broadened banks' ability to present checks to collecting banks directly and receive same-day funds in settlement. Direct presentments reduced the role of intermediaries, including the Reserve Banks, but it improved the efficiency of the payments system. As expected, the volume of checks collected through Reserve Banks has declined. This summarizes the history of our involvement in payments to date, and the situation on the surface looks quite stable. Why, then, is the Federal Reserve undertaking a fundamental review of its role? There are several reasons. First, as I have noted, the banking industry is in the midst of significant change. These changes are primarily evolutionary -- driven by advances in technology, by industry consolidation, and by regulations that now permit interstate branch banking. They do, however, provide the opportunity for revolutionary responses that may, with time, dramatically alter the face of the payments system. We need to understand and help to beneficially shape these forces. Second, from time to time, and certainly in a period of change such as this one, it is appropriate for any organization to reassess its mission and how it fulfills that mission. As you know, the United States remains far more dependent on paper checks for making payments than any other industrialized country, even though electronic transactions appear to be more efficient and less costly. As you also know, the Federal Reserve is the only institution that presents checks to all depository institutions nationwide. We suspect that industry consolidation and electronic technology may change the impact of our nationwide reach, but exactly how and when that might happen, and what would be appropriate responses, are not clear. Careful self-scrutiny is clearly timely. Finally, there are significant differences of opinion in the industry, and our society more generally, as to the appropriate payments role of the Federal Reserve. As a public service entity, the Federal Reserve should address these concerns. In light of all this, in October 1996, Chairman Greenspan asked me to serve on a committee that is led by Vice Chair Rivlin to examine the Federal Reserve's role in the payments system. The committee has been at work all year, and we expect to complete our task shortly. Let me now outline what we have done, how we have gone about it, and where it is leading us. To begin the study, the committee reviewed the general environment in which payments services are offered. The committee analyzed the economic factors influencing the supply of and demand for wholesale services -- that is, for the large-value and securities transfers that support the interbank market -- and retail services, primarily small dollar payments. We studied current trends in the financial services industry, including the development of new and emerging payment services, and our role in those markets. And, we examined how the Federal Reserve's participation in the payments system affects our ability to implement monetary policy decisions and to regulate and supervise banks. Based on its internal review, the committee decided to focus its study on the Federal Reserve Banks' retail payment services -- check and ACH. The committee excluded the wholesale systems because (1) these systems are efficient and effective now, (2) they are an important vehicle for controlling systemic risk, requiring very close monitoring, (3) they are an integral part in implementing monetary policy decisions, (4) they play an important role in providing everyday liquidity to financial markets, and (5) they provide certainty to payments system participants in times of financial stress. It is worth noting that most central banks in major economies, like the Federal Reserve, provide large-value funds transfer services to banks and many also provide some form of securities settlement and safekeeping services. This is not to imply that we are complacently satisfied with all aspects of our country's wholesale payment arrangements, but rather that we do not feel that a review of the Federal Reserve's role in them is needed at this time. The committee felt that it was critically important to this study that we draw on the insights and expertise of the banking industry and other payments system participants. We wanted to understand fully the dynamics of the payments system and the changes that the industry envisions over the next five to ten years, as well as the reasoning behind the varying views about the Federal Reserve's payments activities. Thus, the committee developed a series of hypothetical scenarios for Federal Reserve participation in the retail payments system that we discussed with industry representatives in a series of forums that were conducted last May and June. Some of you may have attended one of those forums. In total, we held ten national and fifty-two regional forums. Attendees represented a diverse group of payments system participants, including representatives from large and small banks, private payments system providers, corporations, trade associations, academicians, consultants, and emerging payments system service providers. In total, over 500 representatives from 473 organizations participated. To obtain the thoughts of these payments system participants, the Committee developed five hypothetical scenarios for the Federal Reserve's future role in the check and ACH payment services. These scenarios were not developed specifically as policy options but rather were intended solely to stimulate discussion. Because many of you are familiar with these scenarios, I will review them only briefly. In two scenarios the Federal Reserve would withdraw from participation in the check and ACH markets and in the remaining three scenarios, the Federal Reserve would continue to provide those services. In the first withdrawal scenario, the Federal Reserve would announce its intention to liquidate its check and ACH services, although we would take steps to provide for a smooth transition for our customers. In the second, the Federal Reserve envisioned selling its check and ACH services to a private-sector entity that would retain no privileged ties to the Federal Reserve. The three scenarios under which the Federal Reserve would continue to provide retail payment services to banks varied considerably. These scenarios envisioned future roles in which the Federal Reserve would (1) merely ensure that all banks had access to our existing check and ACH services, which many saw as a de facto exit strategy, (2) use our operational presence to stimulate development of more cost-effective and efficient payment methods, or (3) take aggressive steps to expedite the movement to an electronic-based retail payments system. To stimulate discussion about each scenario and its effect on the provision of retail payments, several key questions were introduced. For example, we asked what would happen to the prices and availability of retail payments in times of relative economic stability and in times of financial stress, such as in the Texas banking crisis. Another question asked was what participants thought would be the best way to transform our largely paper-based system to a more electronic one. What have we heard? As you would guess, there are various perspectives on the fundamental question of the appropriate role for the Federal Reserve in the payments system. Some believe that it is inappropriate for the Federal Reserve to provide payment services and that the private sector could provide essentially the same services at a lower cost and perhaps greater efficiency. Many others believe that, by providing payment services, the Federal Reserve ensures that all payments system participants will be able to access competitively priced payment services. While some believe that it is inappropriate for the Federal Reserve to regulate the industry in which it competes, others believe that by providing payment services, the Federal Reserve gains operational experience that makes it a better regulator. More specifically, participants had differing views on various aspects of these issues and the consequences of each scenario. Many were concerned that, if the Federal Reserve withdrew from these services, it would result in short-term service disruptions with few long-term benefits. Many indicated that prices for retail services would rise, and smaller banks and remotely located banks were concerned that they would have difficulty obtaining check and ACH services. Concern was expressed that without an operational presence, the Federal Reserve would have to regulate the retail payments system more extensively to ensure that all banks had access to the services. While not unanimous, there was strong support from institutions of all sizes for continued Federal Reserve provision of retail payment services. Some stated that because check payments would continue to dominate the U.S. payments system for the foreseeable future, the Federal Reserve should maintain its check services while consumers adapt to the use of electronic payments mechanisms. Others indicated that by establishing a more aggressive operational presence in the check and ACH services, the Federal Reserve could undertake initiatives to promote efficiency in general, and to encourage the use of electronics to collect checks in particular. Some indicated that private-sector service providers would prefer to invest in developing new markets and devising new technologies rather than in expanding their capacity to collect paper checks. They also indicated that they face significant resource demands to address other operational issues, such as the federal government's initiative to deliver almost all payments electronically by 1999 and preparation for the year 2000. No matter what their view about the Federal Reserve's continued presence in the retail payments market, virtually all participants believed that the Federal Reserve could play an important role in educating consumers about the benefits of electronic payments. While the committee has not reached detailed final conclusions, it is clear that the Federal Reserve can best ensure the safety and effectiveness of the nation's payments system by continuing to provide its existing retail payment services for checks and ACH, and we will so recommend. We agree with a recurring theme at the forums that there would likely be significant disruptions in the payments system if the Federal Reserve withdrew, with little net societal benefit. Currently, the banking industry is trying to grapple with a variety of technological issues, an effort that is requiring a great deal of resources. Banks are adopting the latest technological innovations to provide their customers with new and improved services and preparing to be century date change compliant. By continuing to provide payment services, the Federal Reserve would enable banks and service providers to continue to focus on these future oriented efforts. This would be far more productive, for example, than attempting to restructure an efficient, but dated, paper-based check collection system. But, as yet, the Committee has not decided on its specific recommendations for Federal Reserve involvement in retail payment services. Many issues identified and needing resolution are still "open." They include considering whether the Federal Reserve should assume a very aggressive operational and regulatory posture to convert all payments to electronics and whether we should launch an intensive public education campaign to inform consumers of the benefits of electronic transactions. We are also considering suggestions that we establish a regulatory regime that encourages electronic payments and discourages paper, that the Federal Reserve take the lead in establishing standards for electronic payments, and that we work toward a revised legal structure more suitable to an electronic environment. Operationally, the Federal Reserve might offer banks new products that take advantage of the latest technology and assist in their efforts to make their customers more comfortable with electronics. Also the Federal Reserve could conceivably open its secure communications to banks that want to offer their own electronic products. To summarize, wholesale payments are being made, at least for now, in a relatively settled regime. But, as we have been discussing, there is great activity in the retail arena. Indeed, many growing and innovative retail payments, such as credit card, debit card, smart card, and Internet payments, do not flow through the Federal Reserve at all, although some do settle using Federal Reserve services. All payments methods will continue to evolve, and the Federal Reserve's role will also evolve as we will continue to work to fulfill our mandate to foster a reliable, efficient, and accessible system. As we assess the options to achieve these goals, we pledge to carefully consider the industry's views concerning future Federal Reserve participation in the payments system and to work in close collaboration with the private sector every step of the way. _____________________________	---[PAGE_BREAK]--- # Mr. Kelley looks at the role of the Federal Reserve in the Payments System Remarks by Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Bank Administration Institute's Symposium on Payments System Strategy, Washington, D.C. 23/9/97. It is a pleasure to be here today to discuss the Federal Reserve's role in the evolving U.S. payments system, a role which is now under careful review. A great deal is going on in the payments industry and, of course, the Federal Reserve is squarely in the middle of the action. You are, too, and we all need to work together to shape the future of our payments systems to ensure that they are as strong as possible. Understanding where we have been and where we are today is an essential foundation for addressing where we wish to go in the future. Accordingly, I will briefly review the history of the role of the Federal Reserve in the payments system, share with you in some detail our ongoing review of that role, and outline some possible directions for the future. All individuals, businesses, and government entities in this country rely upon the smooth functioning of the payments system to purchase goods, pay for services, receive payments, and make investments. Today, all of us can be confident that the payments we initiate will be satisfactorily completed. Tomorrow, technology and regulatory changes will alter the face of the payments system. Interstate banking, which spread nearly nationwide this past June, consolidation in the banking industry, legislation that mandates that most government payments be made electronically by 1999, the opportunities provided by the Internet, and other technological developments, will also contribute to the continued evolution of payment options, payment choices, and payment needs. We, at the Federal Reserve, have been studying what our role in that evolution should be and how best to ensure that all users of payment services will continue to have confidence that their payments will be completed reliably and efficiently and that all banks will have access to payment services on a fair and equitable basis. Before I address the Federal Reserve's future role in the payments system, I would like to review how and why the Federal Reserve came to play its current role. In the 50 years following the Civil War, a series of severe financial crises swept the country, disrupting and undermining the national economy. During the financial panic of 1907 cash payments were largely suspended throughout the country because many banks and clearinghouses refused to clear checks drawn on certain other banks. Otherwise solvent banks failed. The 1907 crisis and the lessons of failing to ensure a stable national economy were still fresh in the minds of Congress when they created the Federal Reserve System. Thus, when Congress passed the Federal Reserve Act in 1913, it directed the Federal Reserve to provide an elastic currency -- that is, a supply of currency in the quantities demanded by the public -- and gave it the authority to establish a nationwide check collection system. In 1917, Congress amended the Federal Reserve Act to prohibit banks from charging the Federal Reserve Banks presentment fees. These Congressional actions launched the Federal Reserve as an active participant in the payments system. Initially, the Reserve Banks fulfilled their role by providing check collection services and permitting member banks to issue transfer drafts to make payments anywhere in the country, which were paid in immediately available funds by any Reserve Bank. Gradually, as needs were identified and as technologies developed, the Reserve Banks added new payments services, beginning with the Fedwire funds transfer system in 1918, the ---[PAGE_BREAK]--- book-entry securities service in 1968, and, finally, the automated clearing house (ACH) in the early 1970s. For much of the time, the Reserve Banks provided payment services to member banks without charge other than required reserves, and non-member banks had access to these services only through member banks. Everything changed in 1980, when Congress enacted the Monetary Control Act (MCA). A primary purpose of the MCA was to promote an efficient payments system by encouraging competition between the Federal Reserve and private-sector providers of payment services. The Act requires the Federal Reserve Banks to charge fees for their payment services, which must, over the long run, be set to recover all direct and indirect costs of providing the services. In addition, the MCA requires the Federal Reserve Banks to recover imputed costs, such as taxes and the cost of capital, and imputed profits that would have been earned if the services were provided by a private firm. Importantly, the MCA also extended reserve requirements to nonmember banks and granted all banks equal access to the Fed's payment services. Congress further expanded the role of the Federal Reserve in the payments system in 1987 when it enacted the Expedited Funds Availability Act (EFAA). For the first time, this act gave the Fed the authority to regulate check payments that were not processed by the Federal Reserve Banks. Thus, the EFAA significantly broadened the System's ability to ensure that the nation's check collection system is efficient and accessible. It also limited the time that a bank may hold funds before making them available to customers for withdrawal and directed the Federal Reserve to improve the process used to return unpaid checks to banks of first deposit. Thus, Congress has directed the Federal Reserve to ensure that the payments system in this country is efficient and effective, that it supports the economic needs of its citizens, and that it is available to all banks so that they can provide for the payment needs of their customers -- the end users of the payments system. To achieve these goals, Congress cast the Federal Reserve in the often difficult position of providing payment services, thereby competing with some of the institutions it regulates, and regulating the payments system in which it is an active participant. We are very mindful of these sometimes conflicting responsibilities and take great pains to ensure that each responsibility is addressed fairly and equitably. As service providers, the Federal Reserve Banks strive to operate in an efficient and cost-effective way. The Reserve Banks continually upgrade their computer and telecommunications systems so that increasing proportions of funds, book-entry, and ACH transactions can be processed without human intervention and, therefore, more accurately, rapidly, and cost effectively. Striving to serve their customers, the Reserve Banks offer a variety of products to meet the differing business requirements of large, mid-sized, and small institutions with widely divergent processing capabilities. For example, banks may obtain payment services from the Federal Reserve Banks using personal computers connected via switched, dial-in communications links or they may connect their mainframe computers to those in the Federal Reserve via dedicated high-speed telecommunications lines. Similarly, banks -- typically the larger ones -- may select check deposit products that require little sorting by the Reserve Banks, and they pay relatively low fees. Smaller banks may deposit checks in ways that meet their relatively greater sorting needs, thereby incurring higher fees, and many banks use a mix of these products. Importantly, because the Reserve Banks must compete for customers, they must ---[PAGE_BREAK]--- provide services that meet or exceed the quality of other providers and must ensure that internal operations are efficient. As a regulator, the Federal Reserve has taken steps to improve the efficiency and effectiveness of the payments system, often with the full awareness that it was moving contrary to its own narrow competitive interests as a service provider. The Expedited Funds Availability Act of 1987, which was implemented through Regulation CC, included provisions designed to speed the processing of dishonored checks. In developing procedures to implement those provisions, the Federal Reserve, working with the banking industry, created a means to process returned checks on high speed equipment, which shortened return times by reducing the number of banks that might handle dishonored checks. More recently, in 1994, the Board modified Regulation CC to implement the same-day settlement rule, which broadened banks' ability to present checks to collecting banks directly and receive same-day funds in settlement. Direct presentments reduced the role of intermediaries, including the Reserve Banks, but it improved the efficiency of the payments system. As expected, the volume of checks collected through Reserve Banks has declined. This summarizes the history of our involvement in payments to date, and the situation on the surface looks quite stable. Why, then, is the Federal Reserve undertaking a fundamental review of its role? There are several reasons. First, as I have noted, the banking industry is in the midst of significant change. These changes are primarily evolutionary -- driven by advances in technology, by industry consolidation, and by regulations that now permit interstate branch banking. They do, however, provide the opportunity for revolutionary responses that may, with time, dramatically alter the face of the payments system. We need to understand and help to beneficially shape these forces. Second, from time to time, and certainly in a period of change such as this one, it is appropriate for any organization to reassess its mission and how it fulfills that mission. As you know, the United States remains far more dependent on paper checks for making payments than any other industrialized country, even though electronic transactions appear to be more efficient and less costly. As you also know, the Federal Reserve is the only institution that presents checks to all depository institutions nationwide. We suspect that industry consolidation and electronic technology may change the impact of our nationwide reach, but exactly how and when that might happen, and what would be appropriate responses, are not clear. Careful self-scrutiny is clearly timely. Finally, there are significant differences of opinion in the industry, and our society more generally, as to the appropriate payments role of the Federal Reserve. As a public service entity, the Federal Reserve should address these concerns. In light of all this, in October 1996, Chairman Greenspan asked me to serve on a committee that is led by Vice Chair Rivlin to examine the Federal Reserve's role in the payments system. The committee has been at work all year, and we expect to complete our task shortly. Let me now outline what we have done, how we have gone about it, and where it is leading us. To begin the study, the committee reviewed the general environment in which payments services are offered. The committee analyzed the economic factors influencing the supply of and demand for wholesale services -- that is, for the large-value and securities transfers that support the interbank market -- and retail services, primarily small dollar ---[PAGE_BREAK]--- payments. We studied current trends in the financial services industry, including the development of new and emerging payment services, and our role in those markets. And, we examined how the Federal Reserve's participation in the payments system affects our ability to implement monetary policy decisions and to regulate and supervise banks. Based on its internal review, the committee decided to focus its study on the Federal Reserve Banks' retail payment services -- check and ACH. The committee excluded the wholesale systems because (1) these systems are efficient and effective now, (2) they are an important vehicle for controlling systemic risk, requiring very close monitoring, (3) they are an integral part in implementing monetary policy decisions, (4) they play an important role in providing everyday liquidity to financial markets, and (5) they provide certainty to payments system participants in times of financial stress. It is worth noting that most central banks in major economies, like the Federal Reserve, provide large-value funds transfer services to banks and many also provide some form of securities settlement and safekeeping services. This is not to imply that we are complacently satisfied with all aspects of our country's wholesale payment arrangements, but rather that we do not feel that a review of the Federal Reserve's role in them is needed at this time. The committee felt that it was critically important to this study that we draw on the insights and expertise of the banking industry and other payments system participants. We wanted to understand fully the dynamics of the payments system and the changes that the industry envisions over the next five to ten years, as well as the reasoning behind the varying views about the Federal Reserve's payments activities. Thus, the committee developed a series of hypothetical scenarios for Federal Reserve participation in the retail payments system that we discussed with industry representatives in a series of forums that were conducted last May and June. Some of you may have attended one of those forums. In total, we held ten national and fifty-two regional forums. Attendees represented a diverse group of payments system participants, including representatives from large and small banks, private payments system providers, corporations, trade associations, academicians, consultants, and emerging payments system service providers. In total, over 500 representatives from 473 organizations participated. To obtain the thoughts of these payments system participants, the Committee developed five hypothetical scenarios for the Federal Reserve's future role in the check and ACH payment services. These scenarios were not developed specifically as policy options but rather were intended solely to stimulate discussion. Because many of you are familiar with these scenarios, I will review them only briefly. In two scenarios the Federal Reserve would withdraw from participation in the check and ACH markets and in the remaining three scenarios, the Federal Reserve would continue to provide those services. In the first withdrawal scenario, the Federal Reserve would announce its intention to liquidate its check and ACH services, although we would take steps to provide for a smooth transition for our customers. In the second, the Federal Reserve envisioned selling its check and ACH services to a private-sector entity that would retain no privileged ties to the Federal Reserve. The three scenarios under which the Federal Reserve would continue to provide retail payment services to banks varied considerably. These scenarios envisioned future roles in which the Federal Reserve would (1) merely ensure that all banks had access to our existing check and ACH services, which many saw as a de facto exit strategy, (2) use our operational ---[PAGE_BREAK]--- presence to stimulate development of more cost-effective and efficient payment methods, or (3) take aggressive steps to expedite the movement to an electronic-based retail payments system. To stimulate discussion about each scenario and its effect on the provision of retail payments, several key questions were introduced. For example, we asked what would happen to the prices and availability of retail payments in times of relative economic stability and in times of financial stress, such as in the Texas banking crisis. Another question asked was what participants thought would be the best way to transform our largely paper-based system to a more electronic one. What have we heard? As you would guess, there are various perspectives on the fundamental question of the appropriate role for the Federal Reserve in the payments system. Some believe that it is inappropriate for the Federal Reserve to provide payment services and that the private sector could provide essentially the same services at a lower cost and perhaps greater efficiency. Many others believe that, by providing payment services, the Federal Reserve ensures that all payments system participants will be able to access competitively priced payment services. While some believe that it is inappropriate for the Federal Reserve to regulate the industry in which it competes, others believe that by providing payment services, the Federal Reserve gains operational experience that makes it a better regulator. More specifically, participants had differing views on various aspects of these issues and the consequences of each scenario. Many were concerned that, if the Federal Reserve withdrew from these services, it would result in short-term service disruptions with few long-term benefits. Many indicated that prices for retail services would rise, and smaller banks and remotely located banks were concerned that they would have difficulty obtaining check and ACH services. Concern was expressed that without an operational presence, the Federal Reserve would have to regulate the retail payments system more extensively to ensure that all banks had access to the services. While not unanimous, there was strong support from institutions of all sizes for continued Federal Reserve provision of retail payment services. Some stated that because check payments would continue to dominate the U.S. payments system for the foreseeable future, the Federal Reserve should maintain its check services while consumers adapt to the use of electronic payments mechanisms. Others indicated that by establishing a more aggressive operational presence in the check and ACH services, the Federal Reserve could undertake initiatives to promote efficiency in general, and to encourage the use of electronics to collect checks in particular. Some indicated that private-sector service providers would prefer to invest in developing new markets and devising new technologies rather than in expanding their capacity to collect paper checks. They also indicated that they face significant resource demands to address other operational issues, such as the federal government's initiative to deliver almost all payments electronically by 1999 and preparation for the year 2000. No matter what their view about the Federal Reserve's continued presence in the retail payments market, virtually all participants believed that the Federal Reserve could play an important role in educating consumers about the benefits of electronic payments. While the committee has not reached detailed final conclusions, it is clear that the Federal Reserve can best ensure the safety and effectiveness of the nation's payments system by continuing to provide its existing retail payment services for checks and ACH , and we will so ---[PAGE_BREAK]--- recommend. We agree with a recurring theme at the forums that there would likely be significant disruptions in the payments system if the Federal Reserve withdrew, with little net societal benefit. Currently, the banking industry is trying to grapple with a variety of technological issues, an effort that is requiring a great deal of resources. Banks are adopting the latest technological innovations to provide their customers with new and improved services and preparing to be century date change compliant. By continuing to provide payment services, the Federal Reserve would enable banks and service providers to continue to focus on these future oriented efforts. This would be far more productive, for example, than attempting to restructure an efficient, but dated, paper-based check collection system. But, as yet, the Committee has not decided on its specific recommendations for Federal Reserve involvement in retail payment services. Many issues identified and needing resolution are still "open." They include considering whether the Federal Reserve should assume a very aggressive operational and regulatory posture to convert all payments to electronics and whether we should launch an intensive public education campaign to inform consumers of the benefits of electronic transactions. We are also considering suggestions that we establish a regulatory regime that encourages electronic payments and discourages paper, that the Federal Reserve take the lead in establishing standards for electronic payments, and that we work toward a revised legal structure more suitable to an electronic environment. Operationally, the Federal Reserve might offer banks new products that take advantage of the latest technology and assist in their efforts to make their customers more comfortable with electronics. Also the Federal Reserve could conceivably open its secure communications to banks that want to offer their own electronic products. To summarize, wholesale payments are being made, at least for now, in a relatively settled regime. But, as we have been discussing, there is great activity in the retail arena. Indeed, many growing and innovative retail payments, such as credit card, debit card, smart card, and Internet payments, do not flow through the Federal Reserve at all, although some do settle using Federal Reserve services. All payments methods will continue to evolve, and the Federal Reserve's role will also evolve as we will continue to work to fulfill our mandate to foster a reliable, efficient, and accessible system. As we assess the options to achieve these goals, we pledge to carefully consider the industry's views concerning future Federal Reserve participation in the payments system and to work in close collaboration with the private sector every step of the way.	Edward W Kelley, Jr	United States	https://www.bis.org/review/r971001e.pdf	Remarks by Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Bank Administration Institute's Symposium on Payments System Strategy, Washington, D.C. 23/9/97. It is a pleasure to be here today to discuss the Federal Reserve's role in the evolving U.S. payments system, a role which is now under careful review. A great deal is going on in the payments industry and, of course, the Federal Reserve is squarely in the middle of the action. You are, too, and we all need to work together to shape the future of our payments systems to ensure that they are as strong as possible. Understanding where we have been and where we are today is an essential foundation for addressing where we wish to go in the future. Accordingly, I will briefly review the history of the role of the Federal Reserve in the payments system, share with you in some detail our ongoing review of that role, and outline some possible directions for the future. All individuals, businesses, and government entities in this country rely upon the smooth functioning of the payments system to purchase goods, pay for services, receive payments, and make investments. Today, all of us can be confident that the payments we initiate will be satisfactorily completed. Tomorrow, technology and regulatory changes will alter the face of the payments system. Interstate banking, which spread nearly nationwide this past June, consolidation in the banking industry, legislation that mandates that most government payments be made electronically by 1999, the opportunities provided by the Internet, and other technological developments, will also contribute to the continued evolution of payment options, payment choices, and payment needs. We, at the Federal Reserve, have been studying what our role in that evolution should be and how best to ensure that all users of payment services will continue to have confidence that their payments will be completed reliably and efficiently and that all banks will have access to payment services on a fair and equitable basis. Before I address the Federal Reserve's future role in the payments system, I would like to review how and why the Federal Reserve came to play its current role. In the 50 years following the Civil War, a series of severe financial crises swept the country, disrupting and undermining the national economy. During the financial panic of 1907 cash payments were largely suspended throughout the country because many banks and clearinghouses refused to clear checks drawn on certain other banks. Otherwise solvent banks failed. The 1907 crisis and the lessons of failing to ensure a stable national economy were still fresh in the minds of Congress when they created the Federal Reserve System. Thus, when Congress passed the Federal Reserve Act in 1913, it directed the Federal Reserve to provide an elastic currency -- that is, a supply of currency in the quantities demanded by the public -- and gave it the authority to establish a nationwide check collection system. In 1917, Congress amended the Federal Reserve Act to prohibit banks from charging the Federal Reserve Banks presentment fees. These Congressional actions launched the Federal Reserve as an active participant in the payments system. Initially, the Reserve Banks fulfilled their role by providing check collection services and permitting member banks to issue transfer drafts to make payments anywhere in the country, which were paid in immediately available funds by any Reserve Bank. Gradually, as needs were identified and as technologies developed, the Reserve Banks added new payments services, beginning with the Fedwire funds transfer system in 1918, the book-entry securities service in 1968, and, finally, the automated clearing house (ACH) in the early 1970s. For much of the time, the Reserve Banks provided payment services to member banks without charge other than required reserves, and non-member banks had access to these services only through member banks. Everything changed in 1980, when Congress enacted the Monetary Control Act (MCA). A primary purpose of the MCA was to promote an efficient payments system by encouraging competition between the Federal Reserve and private-sector providers of payment services. The Act requires the Federal Reserve Banks to charge fees for their payment services, which must, over the long run, be set to recover all direct and indirect costs of providing the services. In addition, the MCA requires the Federal Reserve Banks to recover imputed costs, such as taxes and the cost of capital, and imputed profits that would have been earned if the services were provided by a private firm. Importantly, the MCA also extended reserve requirements to nonmember banks and granted all banks equal access to the Fed's payment services. Congress further expanded the role of the Federal Reserve in the payments system in 1987 when it enacted the Expedited Funds Availability Act (EFAA). For the first time, this act gave the Fed the authority to regulate check payments that were not processed by the Federal Reserve Banks. Thus, the EFAA significantly broadened the System's ability to ensure that the nation's check collection system is efficient and accessible. It also limited the time that a bank may hold funds before making them available to customers for withdrawal and directed the Federal Reserve to improve the process used to return unpaid checks to banks of first deposit. Thus, Congress has directed the Federal Reserve to ensure that the payments system in this country is efficient and effective, that it supports the economic needs of its citizens, and that it is available to all banks so that they can provide for the payment needs of their customers -- the end users of the payments system. To achieve these goals, Congress cast the Federal Reserve in the often difficult position of providing payment services, thereby competing with some of the institutions it regulates, and regulating the payments system in which it is an active participant. We are very mindful of these sometimes conflicting responsibilities and take great pains to ensure that each responsibility is addressed fairly and equitably. As service providers, the Federal Reserve Banks strive to operate in an efficient and cost-effective way. The Reserve Banks continually upgrade their computer and telecommunications systems so that increasing proportions of funds, book-entry, and ACH transactions can be processed without human intervention and, therefore, more accurately, rapidly, and cost effectively. Striving to serve their customers, the Reserve Banks offer a variety of products to meet the differing business requirements of large, mid-sized, and small institutions with widely divergent processing capabilities. For example, banks may obtain payment services from the Federal Reserve Banks using personal computers connected via switched, dial-in communications links or they may connect their mainframe computers to those in the Federal Reserve via dedicated high-speed telecommunications lines. Similarly, banks -- typically the larger ones -- may select check deposit products that require little sorting by the Reserve Banks, and they pay relatively low fees. Smaller banks may deposit checks in ways that meet their relatively greater sorting needs, thereby incurring higher fees, and many banks use a mix of these products. Importantly, because the Reserve Banks must compete for customers, they must provide services that meet or exceed the quality of other providers and must ensure that internal operations are efficient. As a regulator, the Federal Reserve has taken steps to improve the efficiency and effectiveness of the payments system, often with the full awareness that it was moving contrary to its own narrow competitive interests as a service provider. The Expedited Funds Availability Act of 1987, which was implemented through Regulation CC, included provisions designed to speed the processing of dishonored checks. In developing procedures to implement those provisions, the Federal Reserve, working with the banking industry, created a means to process returned checks on high speed equipment, which shortened return times by reducing the number of banks that might handle dishonored checks. More recently, in 1994, the Board modified Regulation CC to implement the same-day settlement rule, which broadened banks' ability to present checks to collecting banks directly and receive same-day funds in settlement. Direct presentments reduced the role of intermediaries, including the Reserve Banks, but it improved the efficiency of the payments system. As expected, the volume of checks collected through Reserve Banks has declined. This summarizes the history of our involvement in payments to date, and the situation on the surface looks quite stable. Why, then, is the Federal Reserve undertaking a fundamental review of its role? There are several reasons. First, as I have noted, the banking industry is in the midst of significant change. These changes are primarily evolutionary -- driven by advances in technology, by industry consolidation, and by regulations that now permit interstate branch banking. They do, however, provide the opportunity for revolutionary responses that may, with time, dramatically alter the face of the payments system. We need to understand and help to beneficially shape these forces. Second, from time to time, and certainly in a period of change such as this one, it is appropriate for any organization to reassess its mission and how it fulfills that mission. As you know, the United States remains far more dependent on paper checks for making payments than any other industrialized country, even though electronic transactions appear to be more efficient and less costly. As you also know, the Federal Reserve is the only institution that presents checks to all depository institutions nationwide. We suspect that industry consolidation and electronic technology may change the impact of our nationwide reach, but exactly how and when that might happen, and what would be appropriate responses, are not clear. Careful self-scrutiny is clearly timely. Finally, there are significant differences of opinion in the industry, and our society more generally, as to the appropriate payments role of the Federal Reserve. As a public service entity, the Federal Reserve should address these concerns. In light of all this, in October 1996, Chairman Greenspan asked me to serve on a committee that is led by Vice Chair Rivlin to examine the Federal Reserve's role in the payments system. The committee has been at work all year, and we expect to complete our task shortly. Let me now outline what we have done, how we have gone about it, and where it is leading us. To begin the study, the committee reviewed the general environment in which payments services are offered. The committee analyzed the economic factors influencing the supply of and demand for wholesale services -- that is, for the large-value and securities transfers that support the interbank market -- and retail services, primarily small dollar payments. We studied current trends in the financial services industry, including the development of new and emerging payment services, and our role in those markets. And, we examined how the Federal Reserve's participation in the payments system affects our ability to implement monetary policy decisions and to regulate and supervise banks. Based on its internal review, the committee decided to focus its study on the Federal Reserve Banks' retail payment services -- check and ACH. The committee excluded the wholesale systems because (1) these systems are efficient and effective now, (2) they are an important vehicle for controlling systemic risk, requiring very close monitoring, (3) they are an integral part in implementing monetary policy decisions, (4) they play an important role in providing everyday liquidity to financial markets, and (5) they provide certainty to payments system participants in times of financial stress. It is worth noting that most central banks in major economies, like the Federal Reserve, provide large-value funds transfer services to banks and many also provide some form of securities settlement and safekeeping services. This is not to imply that we are complacently satisfied with all aspects of our country's wholesale payment arrangements, but rather that we do not feel that a review of the Federal Reserve's role in them is needed at this time. The committee felt that it was critically important to this study that we draw on the insights and expertise of the banking industry and other payments system participants. We wanted to understand fully the dynamics of the payments system and the changes that the industry envisions over the next five to ten years, as well as the reasoning behind the varying views about the Federal Reserve's payments activities. Thus, the committee developed a series of hypothetical scenarios for Federal Reserve participation in the retail payments system that we discussed with industry representatives in a series of forums that were conducted last May and June. Some of you may have attended one of those forums. In total, we held ten national and fifty-two regional forums. Attendees represented a diverse group of payments system participants, including representatives from large and small banks, private payments system providers, corporations, trade associations, academicians, consultants, and emerging payments system service providers. In total, over 500 representatives from 473 organizations participated. To obtain the thoughts of these payments system participants, the Committee developed five hypothetical scenarios for the Federal Reserve's future role in the check and ACH payment services. These scenarios were not developed specifically as policy options but rather were intended solely to stimulate discussion. Because many of you are familiar with these scenarios, I will review them only briefly. In two scenarios the Federal Reserve would withdraw from participation in the check and ACH markets and in the remaining three scenarios, the Federal Reserve would continue to provide those services. In the first withdrawal scenario, the Federal Reserve would announce its intention to liquidate its check and ACH services, although we would take steps to provide for a smooth transition for our customers. In the second, the Federal Reserve envisioned selling its check and ACH services to a private-sector entity that would retain no privileged ties to the Federal Reserve. The three scenarios under which the Federal Reserve would continue to provide retail payment services to banks varied considerably. These scenarios envisioned future roles in which the Federal Reserve would (1) merely ensure that all banks had access to our existing check and ACH services, which many saw as a de facto exit strategy, (2) use our operational presence to stimulate development of more cost-effective and efficient payment methods, or (3) take aggressive steps to expedite the movement to an electronic-based retail payments system. To stimulate discussion about each scenario and its effect on the provision of retail payments, several key questions were introduced. For example, we asked what would happen to the prices and availability of retail payments in times of relative economic stability and in times of financial stress, such as in the Texas banking crisis. Another question asked was what participants thought would be the best way to transform our largely paper-based system to a more electronic one. What have we heard? As you would guess, there are various perspectives on the fundamental question of the appropriate role for the Federal Reserve in the payments system. Some believe that it is inappropriate for the Federal Reserve to provide payment services and that the private sector could provide essentially the same services at a lower cost and perhaps greater efficiency. Many others believe that, by providing payment services, the Federal Reserve ensures that all payments system participants will be able to access competitively priced payment services. While some believe that it is inappropriate for the Federal Reserve to regulate the industry in which it competes, others believe that by providing payment services, the Federal Reserve gains operational experience that makes it a better regulator. More specifically, participants had differing views on various aspects of these issues and the consequences of each scenario. Many were concerned that, if the Federal Reserve withdrew from these services, it would result in short-term service disruptions with few long-term benefits. Many indicated that prices for retail services would rise, and smaller banks and remotely located banks were concerned that they would have difficulty obtaining check and ACH services. Concern was expressed that without an operational presence, the Federal Reserve would have to regulate the retail payments system more extensively to ensure that all banks had access to the services. While not unanimous, there was strong support from institutions of all sizes for continued Federal Reserve provision of retail payment services. Some stated that because check payments would continue to dominate the U.S. payments system for the foreseeable future, the Federal Reserve should maintain its check services while consumers adapt to the use of electronic payments mechanisms. Others indicated that by establishing a more aggressive operational presence in the check and ACH services, the Federal Reserve could undertake initiatives to promote efficiency in general, and to encourage the use of electronics to collect checks in particular. Some indicated that private-sector service providers would prefer to invest in developing new markets and devising new technologies rather than in expanding their capacity to collect paper checks. They also indicated that they face significant resource demands to address other operational issues, such as the federal government's initiative to deliver almost all payments electronically by 1999 and preparation for the year 2000. No matter what their view about the Federal Reserve's continued presence in the retail payments market, virtually all participants believed that the Federal Reserve could play an important role in educating consumers about the benefits of electronic payments. While the committee has not reached detailed final conclusions, it is clear that the Federal Reserve can best ensure the safety and effectiveness of the nation's payments system by continuing to provide its existing retail payment services for checks and ACH , and we will so recommend. We agree with a recurring theme at the forums that there would likely be significant disruptions in the payments system if the Federal Reserve withdrew, with little net societal benefit. Currently, the banking industry is trying to grapple with a variety of technological issues, an effort that is requiring a great deal of resources. Banks are adopting the latest technological innovations to provide their customers with new and improved services and preparing to be century date change compliant. By continuing to provide payment services, the Federal Reserve would enable banks and service providers to continue to focus on these future oriented efforts. This would be far more productive, for example, than attempting to restructure an efficient, but dated, paper-based check collection system. But, as yet, the Committee has not decided on its specific recommendations for Federal Reserve involvement in retail payment services. Many issues identified and needing resolution are still "open." They include considering whether the Federal Reserve should assume a very aggressive operational and regulatory posture to convert all payments to electronics and whether we should launch an intensive public education campaign to inform consumers of the benefits of electronic transactions. We are also considering suggestions that we establish a regulatory regime that encourages electronic payments and discourages paper, that the Federal Reserve take the lead in establishing standards for electronic payments, and that we work toward a revised legal structure more suitable to an electronic environment. Operationally, the Federal Reserve might offer banks new products that take advantage of the latest technology and assist in their efforts to make their customers more comfortable with electronics. Also the Federal Reserve could conceivably open its secure communications to banks that want to offer their own electronic products. To summarize, wholesale payments are being made, at least for now, in a relatively settled regime. But, as we have been discussing, there is great activity in the retail arena. Indeed, many growing and innovative retail payments, such as credit card, debit card, smart card, and Internet payments, do not flow through the Federal Reserve at all, although some do settle using Federal Reserve services. All payments methods will continue to evolve, and the Federal Reserve's role will also evolve as we will continue to work to fulfill our mandate to foster a reliable, efficient, and accessible system. As we assess the options to achieve these goals, we pledge to carefully consider the industry's views concerning future Federal Reserve participation in the payments system and to work in close collaboration with the private sector every step of the way.
1997-09-30T22:00:00	Ms. Phillips discusses derivatives and risk management in the context of banking supervision	Remarks by Governor Susan M. Phillips, a member of the Board of Governors of the U.S. Federal Reserve System at the Derivatives	Ms. Phillips discusses derivatives and risk management in the context of banking supervision Remarks by Governor Susan M. Phillips, a member of the Board of Governors of the U.S. Federal Reserve System at the Derivatives & Risk Management Symposium of the Fordham University School of Law, New York, on 19/9/97. Thank you for inviting me to speak in this symposium on derivatives and risk management, sponsored by the Institute on Law and Financial Services. These two topics have attracted wide attention among the public, market participants, and government over the past several years, and will probably continue to do so for many years. Clearly, financial engineering and improvements in risk management have helped the financial industry offer products to their clients to better control various business risks. At the same time, financial institutions also benefit from these innovations in that they can better manage the risks associated with increasingly complex financial instruments and the growing volume of financial transactions. As you know, risk management is a process for identifying, measuring, reporting, and controlling risks. While the term has been recently popularized in the financial press, the root concepts of risk management are not new to the financial industry. Indeed, by taking risk, or acting as an intermediary in transferring risk, the financial industry fulfils a role that has been and continues to be vital for economic growth. It is fair to say, however, that the process of risk management is becoming increasingly quantitative. Turning to derivatives, this is also not a recent innovation. Derivative markets, such as those for futures contracts, have existed for decades, indeed even centuries for some kinds of price risks. The trends in financial engineering that we have been seeing in recent years are really the fruits of technological progress: Reduced costs of product innovation and increased feasibility of applying financial theories that require intensive computational power. Along with the technological progress that has made it possible, financial engineering has profoundly changed the structure of many leading banks. These processes continue to reverberate throughout the industry. Banks engineer new products to shift business risks to others that had been borne routinely in the past. The reverse side of the coin is that market participants can assume risks through alternatives to the traditional lending and investing avenues. For example, credit derivatives, which are in a nascent stage of development, may someday lead to banks being able to trade credit risk associated with commercial bank loans as easily as they can alter the risk profile of their bond portfolios. Prior to these innovations, institutions could be generally compartmentalized into market segments that did not directly compete with one another. Government regulation mirrored and reinforced this segmentation. With financial innovation came new levels of competition, which then caused pressure for government to change the rules of play. As a result, the legal strictures preventing banks from engaging in certain businesses are being loosened. Banks are increasingly in direct competition with securities firms and insurance companies. New technology and financial innovation have clearly affected the way in which many firms manage their business. They have also put stress on many aspects of traditional legal, regulatory, and accounting frameworks. Over the past decade bank supervisors have learned some important lessons in this regard. These lessons propel our efforts to adapt supervisory and regulatory regimes to better accommodate the changes under way in the financial services sector -- to move to a new supervisory paradigm. Today, I would like to briefly summarize some of these lessons, illustrate how they are shaping the evolution of bank supervision, and some thoughts of how they may affect international supervision, as well. Lessons Learned by Bank Supervisors Perhaps the most basic lesson we have learned from our experience in supervising trading and derivatives activities is that the underlying risk of a financial instrument is more important than what an instrument is called. Although two instruments that differ in name only may have entirely different treatment under existing (and outmoded) legal and regulatory frameworks, the market, credit, liquidity, operational, and reputational risks embodied in them can be identical. To be sure, financial engineering can create derivative instruments that combine risks in complex ways. But, upon analysis, traditional cash instruments that appear simple may have greater risk than the complex instruments that are labelled "derivative." Indeed, placing financial instruments in pigeonholes without regard to their true risks and economic functions can create disincentives for prudent risk management -- often with unfortunate results. The structured note phenomenon of 1993 and 1994 is an important example. Many institutions shunned "derivatives" in favor of these seemingly low-risk securities issued by federal agencies, only to find out later that these instruments had significant price volatility from embedded options. The reaction of many was to label structured notes as derivatives as well, rather than understanding that it was the underlying risk characteristics that had been poorly managed. In its supervisory role, the Federal Reserve is increasingly emphasizing the need for managing the risks of banking and de-emphasizing a focus on specific instruments. For example, in 1993 we issued examiner guidance on trading and dealer activities. This guidance covered a large spectrum of financial instruments, including derivatives. The risk management principles under examination applied whether or not the institution used derivatives. We addressed structured notes in similar fashion in 1995 with guidance on the risk management of bank investment and end-user activities. More recently, the Federal Reserve issued examiner guidance on the risks relating to banks' management of secondary credit market activities, including securitization activities, the extension of various types of off-balance-sheet credit enhancements, and the use of credit derivatives. The guidance stresses the importance of internal capital allocation schemes and risk management systems that accurately reflect the economic substance of transactions. A second lesson that has been reinforced over the past several years is that risk must be measured and managed comprehensively. That is, the focus should be on the dynamics of the portfolio rather than on specific instruments, which can ignore the interplay among various instruments. Although portfolio theory is widely appreciated by bankers and regulators, putting its principles into practice in banking has not been easy. Past banking crises have, in part, reflected a failure by some institutions to recognize and limit concentrations of risk within their portfolios. However, technology and financial innovation are enabling banks to put theories and conceptual techniques into practice to manage the market and credit risks involved in trading, investment, and lending activities. Most dealer banks now routinely employ value-at-risk (VaR) measures to manage the market risks of their trading portfolios and significant strides are being made in the quantitative measurement and management of credit risk. The move to a portfolio-based approach to managing risk has influenced bank supervisory efforts in several other ways. All three of the U.S. banking agencies now take a more risk-focused approach to supervision. This is simply allocating more supervisory resources to a bank's activities that pose greater risk. For example, bank examiners no longer exhaustively review all of a bank's activities. Instead, the examination approach is now to identify and review the sources of risk within a bank's various lines of business. The need to measure risk on a portfolio basis has also begun to be reflected more explicitly in our capital guidelines and our reporting requirements. Beginning next year, internationally active banks meeting certain criteria for risk management will calculate the amount of capital necessary to support the market risk of their trading activities using their own internal VaR measures. This approach allows banks to make use of empirical correlations among risk factors when computing the VaR. A third lesson that our experience with derivatives and other financial innovations has driven home is the critical importance of firms' internal processes for controlling risk. This, of course, is the most obvious lesson from several spectacular losses that the press has put under the rubric of "derivatives debacles." Supervisors, both here and abroad, are focusing more on reviewing the adequacy of internal controls and management processes, such as enforced risk limits. These are the key to gaining maximum benefit from financial innovation, while at the same time avoiding missteps. The final lesson that I will highlight is the need for supervisory and regulatory polices that are more "incentive-compatible" in the sense that they • foster sound risk management within the institution rather than narrow adherence to rules and regulations; • minimize burden by using internal risk measurement systems; and • are reinforced by market forces and the performance incentives of bank owners and managers. Too often financial engineering is targeted at regulatory arbitrage -- that is, exploiting loopholes in narrowly focused regulatory policies that are based on old, traditional instruments or business lines. Also, potential new products may not be introduced because their regulatory treatment is viewed as too burdensome or uncertain. This situation demonstrates all too clearly the differing reaction times of public and private entities. Regulatory policies and standards often take a long time to change whereas, in the private sector, market forces can quickly remedy outmoded standards. The resulting distortions of resources that arise when supervisory standards are slow to change is an unfortunate, albeit predictable, outcome. Policymakers can reduce this potential for distortion by structuring policies to be more "incentive-compatible." This involves harnessing market forces and market discipline to achieve supervisory objectives. Increasingly, supervisors are trying to avoid locking themselves into formulaic, one-size-fits-all approaches to supervision and regulation. The use of internal VaR models for calculating capital charges for trading activities is an important step in this direction. Risk-focused supervision emphasizing sound practices and internal controls is another. A significant effort that could increase supervisory reliance on market discipline in the future is the Federal Reserve's so-called "pre-commitment" approach to determining capital for market risk. It seeks to provide banks with stronger regulatory and market incentives to improve all aspects of market risk management. This approach is currently being studied and tested by a group of U.S. banks organized by the New York Clearing House. What will be the eventual outcome of incorporating the lessons learned into banking supervision? I see two themes in the evolution in the supervision of financial institutions: First is providing strong regulatory incentives for banks to exercise • prudence in taking and managing risk, and to develop ever better systems and processes for risk management. I believe the best evidence of this thinking is illustrated by the recent moves to align regulatory capital requirements for market risk with individual institutions' systems for allocating economic capital based on their own internal models. Supervisory oversight then concentrates on the performance of each institution's risk management process rather than devising a regulatory capital scheme that may not fit every institution, and inevitably have loopholes or inconsistencies that can be exploited. • Second, greater reliance will be placed -- particularly for nonbank business lines -- on the discipline the market can exert on individual participants. The latter element to our supervisory approach depends on market participants acting in their own self interest when dealing with counterparties. That involves understanding the risks of engaging in business and properly pricing transactions. Reliable financial information is an essential ingredient to efficient market discipline. Such information would clearly convey the risk profile of the institution it represents. In its absence, markets are more susceptible to distortions caused by rumors, misinformation, or failures to disclose. Many believe the dearth of information on risk profiles reflects the market's reliance on the federal safety net. Such information would be available if participants were not, to a large extent, indemnified from loss. It is this desire to see market discipline taking a greater role in regulating the affairs of banking organizations and others that has motivated the Federal Reserve Board to voice its opinions about accounting standards that are being developed by the Financial Accounting Standards Board (FASB). As in regulation, an important consideration to setting accounting standards should be the benefits of a particular standard outweighing its cost. The Federal Reserve's opinion is that the accounting for derivatives (and other financial instruments for that matter) should be consistent with the approach to risk management the firm takes in its business. This consistency can yield cost savings by reducing the need for two sets of books: one for financial reporting and another that supports internal management decisions. Moreover, it avoids the possibility of regulatory reports diverging from financial reporting, thereby helping to ensure that supervisory information and capital requirements appropriately reflect the institution's economic risks. Globalization of these Lessons and Future Prospects The challenges of supervision in a rapidly changing financial and technological environment are compounded by global integration of the marketplace. To the extent that regulation in one country is deemed too restrictive, firms can avoid it by simply booking business in another country. The ease with which firms can circumvent national borders and regulatory jurisdictions is a challenge of one dimension. If circumvention results in unsafe or unsound banking practices, it is a problem of another dimension. The problem may end up back in the United States after all. It is for these reasons that the Federal Reserve and the other U.S. banking agencies have been advocating that international agreements on banking supervision have a risk focus. For example, the Basle Committee on Supervision (under the Bank for International Settlements) recently agreed to embrace a portfolio-based, risk-sensitive approach to setting capital requirements for market risk. Instead, supervisors will be building upon the processes banks use to measure trading risks. This should substantially reduce regulatory burden and make standards more compatible with industry practice. In addition, the Basle Committee has agreed to common frameworks for gaining information on the derivatives activities of supervised institutions. A major task before us is to work with emerging-market countries to strengthen and unify banking supervision. Greater consistency should reduce the risk of systemic problems arising from a financial disruption in any particular market. While most of these efforts have focused on market risk, I think it is fair to point out that the major exposure for most banks is credit risk. Looking to the future, will the risk-based capital approach for credit risk ever evolve into an internal models approach? The answer is probably yes; however, with credit-risk modeling in such an early stage of development, it is premature to predict just when credit modeling and the supporting data will develop to the point that they can be relied upon as effective management tools. I am, however, encouraged by progress in modeling credit risk. The risk-based capital accord has worked well in the past and remains useful today. It was an excellent vehicle for bringing about a convergence in bank capital standards worldwide. But it does illustrate the problems of a standardized scheme. For example, banks have an incentive to securitize low-risk assets to avoid regulatory capital charges that unregulated competitors need not meet. Alternatively, market participants can get a false sense of security about a bank's condition if the risk-based capital ratios understate the true risks of the bank's portfolios. Recognizing these shortcomings, we regulators need to continually review and revise our standards, as we have proposed in connection with certain securitizations of assets. Conclusion Some of you in the audience may be surprised that my remarks on derivatives end with a discussion of risk-based capital. This, to me, illustrates the unexpected effects of financial innovation. A decade ago, few would have predicted that techniques for controlling trading risks might point the way for measuring risks in lending and allocating capital -- but that's the very nature of innovation. Those who identify new ways to apply lessons learned in one area to other activities are the ones most likely to succeed. Taking risk is unavoidable in banking, indeed bankers must do so to survive. The key is to identify, manage, and control the risks that are inherent in the business. The intelligent use of derivatives is one way to accomplish that. One should focus not on derivatives in and of themselves, but on their role and effect on a bank's overall portfolio.	---[PAGE_BREAK]--- # Ms. Phillips discusses derivatives and risk management in the context of banking supervision Remarks by Governor Susan M. Phillips, a member of the Board of Governors of the U.S. Federal Reserve System at the Derivatives \& Risk Management Symposium of the Fordham University School of Law, New York, on 19/9/97. Thank you for inviting me to speak in this symposium on derivatives and risk management, sponsored by the Institute on Law and Financial Services. These two topics have attracted wide attention among the public, market participants, and government over the past several years, and will probably continue to do so for many years. Clearly, financial engineering and improvements in risk management have helped the financial industry offer products to their clients to better control various business risks. At the same time, financial institutions also benefit from these innovations in that they can better manage the risks associated with increasingly complex financial instruments and the growing volume of financial transactions. As you know, risk management is a process for identifying, measuring, reporting, and controlling risks. While the term has been recently popularized in the financial press, the root concepts of risk management are not new to the financial industry. Indeed, by taking risk, or acting as an intermediary in transferring risk, the financial industry fulfils a role that has been and continues to be vital for economic growth. It is fair to say, however, that the process of risk management is becoming increasingly quantitative. Turning to derivatives, this is also not a recent innovation. Derivative markets, such as those for futures contracts, have existed for decades, indeed even centuries for some kinds of price risks. The trends in financial engineering that we have been seeing in recent years are really the fruits of technological progress: Reduced costs of product innovation and increased feasibility of applying financial theories that require intensive computational power. Along with the technological progress that has made it possible, financial engineering has profoundly changed the structure of many leading banks. These processes continue to reverberate throughout the industry. Banks engineer new products to shift business risks to others that had been borne routinely in the past. The reverse side of the coin is that market participants can assume risks through alternatives to the traditional lending and investing avenues. For example, credit derivatives, which are in a nascent stage of development, may someday lead to banks being able to trade credit risk associated with commercial bank loans as easily as they can alter the risk profile of their bond portfolios. Prior to these innovations, institutions could be generally compartmentalized into market segments that did not directly compete with one another. Government regulation mirrored and reinforced this segmentation. With financial innovation came new levels of competition, which then caused pressure for government to change the rules of play. As a result, the legal strictures preventing banks from engaging in certain businesses are being loosened. Banks are increasingly in direct competition with securities firms and insurance companies. New technology and financial innovation have clearly affected the way in which many firms manage their business. They have also put stress on many aspects of traditional legal, regulatory, and accounting frameworks. Over the past decade bank supervisors have learned some important lessons in this regard. These lessons propel our efforts to adapt supervisory and regulatory regimes to better accommodate the changes under way in the financial services sector -- to move to a new supervisory paradigm. Today, I would like to ---[PAGE_BREAK]--- briefly summarize some of these lessons, illustrate how they are shaping the evolution of bank supervision, and some thoughts of how they may affect international supervision, as well. # Lessons Learned by Bank Supervisors Perhaps the most basic lesson we have learned from our experience in supervising trading and derivatives activities is that the underlying risk of a financial instrument is more important than what an instrument is called. Although two instruments that differ in name only may have entirely different treatment under existing (and outmoded) legal and regulatory frameworks, the market, credit, liquidity, operational, and reputational risks embodied in them can be identical. To be sure, financial engineering can create derivative instruments that combine risks in complex ways. But, upon analysis, traditional cash instruments that appear simple may have greater risk than the complex instruments that are labelled "derivative." Indeed, placing financial instruments in pigeonholes without regard to their true risks and economic functions can create disincentives for prudent risk management -- often with unfortunate results. The structured note phenomenon of 1993 and 1994 is an important example. Many institutions shunned "derivatives" in favor of these seemingly low-risk securities issued by federal agencies, only to find out later that these instruments had significant price volatility from embedded options. The reaction of many was to label structured notes as derivatives as well, rather than understanding that it was the underlying risk characteristics that had been poorly managed. In its supervisory role, the Federal Reserve is increasingly emphasizing the need for managing the risks of banking and de-emphasizing a focus on specific instruments. For example, in 1993 we issued examiner guidance on trading and dealer activities. This guidance covered a large spectrum of financial instruments, including derivatives. The risk management principles under examination applied whether or not the institution used derivatives. We addressed structured notes in similar fashion in 1995 with guidance on the risk management of bank investment and end-user activities. More recently, the Federal Reserve issued examiner guidance on the risks relating to banks' management of secondary credit market activities, including securitization activities, the extension of various types of off-balance-sheet credit enhancements, and the use of credit derivatives. The guidance stresses the importance of internal capital allocation schemes and risk management systems that accurately reflect the economic substance of transactions. A second lesson that has been reinforced over the past several years is that risk must be measured and managed comprehensively. That is, the focus should be on the dynamics of the portfolio rather than on specific instruments, which can ignore the interplay among various instruments. Although portfolio theory is widely appreciated by bankers and regulators, putting its principles into practice in banking has not been easy. Past banking crises have, in part, reflected a failure by some institutions to recognize and limit concentrations of risk within their portfolios. However, technology and financial innovation are enabling banks to put theories and conceptual techniques into practice to manage the market and credit risks involved in trading, investment, and lending activities. Most dealer banks now routinely employ value-at-risk (VaR) measures to manage the market risks of their trading portfolios and significant strides are being made in the quantitative measurement and management of credit risk. The move to a portfolio-based approach to managing risk has influenced bank supervisory efforts in several other ways. All three of the U.S. banking agencies now take a more risk-focused approach to supervision. This is simply allocating more supervisory resources to a bank's activities that pose greater risk. For example, bank examiners no longer exhaustively ---[PAGE_BREAK]--- review all of a bank's activities. Instead, the examination approach is now to identify and review the sources of risk within a bank's various lines of business. The need to measure risk on a portfolio basis has also begun to be reflected more explicitly in our capital guidelines and our reporting requirements. Beginning next year, internationally active banks meeting certain criteria for risk management will calculate the amount of capital necessary to support the market risk of their trading activities using their own internal VaR measures. This approach allows banks to make use of empirical correlations among risk factors when computing the VaR. A third lesson that our experience with derivatives and other financial innovations has driven home is the critical importance of firms' internal processes for controlling risk. This, of course, is the most obvious lesson from several spectacular losses that the press has put under the rubric of "derivatives debacles." Supervisors, both here and abroad, are focusing more on reviewing the adequacy of internal controls and management processes, such as enforced risk limits. These are the key to gaining maximum benefit from financial innovation, while at the same time avoiding missteps. The final lesson that I will highlight is the need for supervisory and regulatory polices that are more "incentive-compatible" in the sense that they - foster sound risk management within the institution rather than narrow adherence to rules and regulations; - minimize burden by using internal risk measurement systems; and - are reinforced by market forces and the performance incentives of bank owners and managers. Too often financial engineering is targeted at regulatory arbitrage -- that is, exploiting loopholes in narrowly focused regulatory policies that are based on old, traditional instruments or business lines. Also, potential new products may not be introduced because their regulatory treatment is viewed as too burdensome or uncertain. This situation demonstrates all too clearly the differing reaction times of public and private entities. Regulatory policies and standards often take a long time to change whereas, in the private sector, market forces can quickly remedy outmoded standards. The resulting distortions of resources that arise when supervisory standards are slow to change is an unfortunate, albeit predictable, outcome. Policymakers can reduce this potential for distortion by structuring policies to be more "incentive-compatible." This involves harnessing market forces and market discipline to achieve supervisory objectives. Increasingly, supervisors are trying to avoid locking themselves into formulaic, one-size-fits-all approaches to supervision and regulation. The use of internal VaR models for calculating capital charges for trading activities is an important step in this direction. Risk-focused supervision emphasizing sound practices and internal controls is another. A significant effort that could increase supervisory reliance on market discipline in the future is the Federal Reserve's so-called "pre-commitment" approach to determining capital for market risk. It seeks to provide banks with stronger regulatory and market incentives to improve all aspects of market risk management. This approach is currently being studied and tested by a group of U.S. banks organized by the New York Clearing House. ---[PAGE_BREAK]--- What will be the eventual outcome of incorporating the lessons learned into banking supervision? I see two themes in the evolution in the supervision of financial institutions: - First is providing strong regulatory incentives for banks to exercise prudence in taking and managing risk, and to develop ever better systems and processes for risk management. I believe the best evidence of this thinking is illustrated by the recent moves to align regulatory capital requirements for market risk with individual institutions' systems for allocating economic capital based on their own internal models. Supervisory oversight then concentrates on the performance of each institution's risk management process rather than devising a regulatory capital scheme that may not fit every institution, and inevitably have loopholes or inconsistencies that can be exploited. - Second, greater reliance will be placed -- particularly for nonbank business lines -- on the discipline the market can exert on individual participants. The latter element to our supervisory approach depends on market participants acting in their own self interest when dealing with counterparties. That involves understanding the risks of engaging in business and properly pricing transactions. Reliable financial information is an essential ingredient to efficient market discipline. Such information would clearly convey the risk profile of the institution it represents. In its absence, markets are more susceptible to distortions caused by rumors, misinformation, or failures to disclose. Many believe the dearth of information on risk profiles reflects the market's reliance on the federal safety net. Such information would be available if participants were not, to a large extent, indemnified from loss. It is this desire to see market discipline taking a greater role in regulating the affairs of banking organizations and others that has motivated the Federal Reserve Board to voice its opinions about accounting standards that are being developed by the Financial Accounting Standards Board (FASB). As in regulation, an important consideration to setting accounting standards should be the benefits of a particular standard outweighing its cost. The Federal Reserve's opinion is that the accounting for derivatives (and other financial instruments for that matter) should be consistent with the approach to risk management the firm takes in its business. This consistency can yield cost savings by reducing the need for two sets of books: one for financial reporting and another that supports internal management decisions. Moreover, it avoids the possibility of regulatory reports diverging from financial reporting, thereby helping to ensure that supervisory information and capital requirements appropriately reflect the institution's economic risks. # Globalization of these Lessons and Future Prospects The challenges of supervision in a rapidly changing financial and technological environment are compounded by global integration of the marketplace. To the extent that regulation in one country is deemed too restrictive, firms can avoid it by simply booking business in another country. The ease with which firms can circumvent national borders and regulatory jurisdictions is a challenge of one dimension. If circumvention results in unsafe or unsound banking practices, it is a problem of another dimension. The problem may end up back ---[PAGE_BREAK]--- in the United States after all. It is for these reasons that the Federal Reserve and the other U.S. banking agencies have been advocating that international agreements on banking supervision have a risk focus. For example, the Basle Committee on Supervision (under the Bank for International Settlements) recently agreed to embrace a portfolio-based, risk-sensitive approach to setting capital requirements for market risk. Instead, supervisors will be building upon the processes banks use to measure trading risks. This should substantially reduce regulatory burden and make standards more compatible with industry practice. In addition, the Basle Committee has agreed to common frameworks for gaining information on the derivatives activities of supervised institutions. A major task before us is to work with emerging-market countries to strengthen and unify banking supervision. Greater consistency should reduce the risk of systemic problems arising from a financial disruption in any particular market. While most of these efforts have focused on market risk, I think it is fair to point out that the major exposure for most banks is credit risk. Looking to the future, will the risk-based capital approach for credit risk ever evolve into an internal models approach? The answer is probably yes; however, with credit-risk modeling in such an early stage of development, it is premature to predict just when credit modeling and the supporting data will develop to the point that they can be relied upon as effective management tools. I am, however, encouraged by progress in modeling credit risk. The risk-based capital accord has worked well in the past and remains useful today. It was an excellent vehicle for bringing about a convergence in bank capital standards worldwide. But it does illustrate the problems of a standardized scheme. For example, banks have an incentive to securitize low-risk assets to avoid regulatory capital charges that unregulated competitors need not meet. Alternatively, market participants can get a false sense of security about a bank's condition if the risk-based capital ratios understate the true risks of the bank's portfolios. Recognizing these shortcomings, we regulators need to continually review and revise our standards, as we have proposed in connection with certain securitizations of assets. # Conclusion Some of you in the audience may be surprised that my remarks on derivatives end with a discussion of risk-based capital. This, to me, illustrates the unexpected effects of financial innovation. A decade ago, few would have predicted that techniques for controlling trading risks might point the way for measuring risks in lending and allocating capital -- but that's the very nature of innovation. Those who identify new ways to apply lessons learned in one area to other activities are the ones most likely to succeed. Taking risk is unavoidable in banking, indeed bankers must do so to survive. The key is to identify, manage, and control the risks that are inherent in the business. The intelligent use of derivatives is one way to accomplish that. One should focus not on derivatives in and of themselves, but on their role and effect on a bank's overall portfolio.	Susan M Phillips	United States	https://www.bis.org/review/r971001d.pdf	Thank you for inviting me to speak in this symposium on derivatives and risk management, sponsored by the Institute on Law and Financial Services. These two topics have attracted wide attention among the public, market participants, and government over the past several years, and will probably continue to do so for many years. Clearly, financial engineering and improvements in risk management have helped the financial industry offer products to their clients to better control various business risks. At the same time, financial institutions also benefit from these innovations in that they can better manage the risks associated with increasingly complex financial instruments and the growing volume of financial transactions. As you know, risk management is a process for identifying, measuring, reporting, and controlling risks. While the term has been recently popularized in the financial press, the root concepts of risk management are not new to the financial industry. Indeed, by taking risk, or acting as an intermediary in transferring risk, the financial industry fulfils a role that has been and continues to be vital for economic growth. It is fair to say, however, that the process of risk management is becoming increasingly quantitative. Turning to derivatives, this is also not a recent innovation. Derivative markets, such as those for futures contracts, have existed for decades, indeed even centuries for some kinds of price risks. The trends in financial engineering that we have been seeing in recent years are really the fruits of technological progress: Reduced costs of product innovation and increased feasibility of applying financial theories that require intensive computational power. Along with the technological progress that has made it possible, financial engineering has profoundly changed the structure of many leading banks. These processes continue to reverberate throughout the industry. Banks engineer new products to shift business risks to others that had been borne routinely in the past. The reverse side of the coin is that market participants can assume risks through alternatives to the traditional lending and investing avenues. For example, credit derivatives, which are in a nascent stage of development, may someday lead to banks being able to trade credit risk associated with commercial bank loans as easily as they can alter the risk profile of their bond portfolios. Prior to these innovations, institutions could be generally compartmentalized into market segments that did not directly compete with one another. Government regulation mirrored and reinforced this segmentation. With financial innovation came new levels of competition, which then caused pressure for government to change the rules of play. As a result, the legal strictures preventing banks from engaging in certain businesses are being loosened. Banks are increasingly in direct competition with securities firms and insurance companies. New technology and financial innovation have clearly affected the way in which many firms manage their business. They have also put stress on many aspects of traditional legal, regulatory, and accounting frameworks. Over the past decade bank supervisors have learned some important lessons in this regard. These lessons propel our efforts to adapt supervisory and regulatory regimes to better accommodate the changes under way in the financial services sector -- to move to a new supervisory paradigm. Today, I would like to briefly summarize some of these lessons, illustrate how they are shaping the evolution of bank supervision, and some thoughts of how they may affect international supervision, as well. Perhaps the most basic lesson we have learned from our experience in supervising trading and derivatives activities is that the underlying risk of a financial instrument is more important than what an instrument is called. Although two instruments that differ in name only may have entirely different treatment under existing (and outmoded) legal and regulatory frameworks, the market, credit, liquidity, operational, and reputational risks embodied in them can be identical. To be sure, financial engineering can create derivative instruments that combine risks in complex ways. But, upon analysis, traditional cash instruments that appear simple may have greater risk than the complex instruments that are labelled "derivative." Indeed, placing financial instruments in pigeonholes without regard to their true risks and economic functions can create disincentives for prudent risk management -- often with unfortunate results. The structured note phenomenon of 1993 and 1994 is an important example. Many institutions shunned "derivatives" in favor of these seemingly low-risk securities issued by federal agencies, only to find out later that these instruments had significant price volatility from embedded options. The reaction of many was to label structured notes as derivatives as well, rather than understanding that it was the underlying risk characteristics that had been poorly managed. In its supervisory role, the Federal Reserve is increasingly emphasizing the need for managing the risks of banking and de-emphasizing a focus on specific instruments. For example, in 1993 we issued examiner guidance on trading and dealer activities. This guidance covered a large spectrum of financial instruments, including derivatives. The risk management principles under examination applied whether or not the institution used derivatives. We addressed structured notes in similar fashion in 1995 with guidance on the risk management of bank investment and end-user activities. More recently, the Federal Reserve issued examiner guidance on the risks relating to banks' management of secondary credit market activities, including securitization activities, the extension of various types of off-balance-sheet credit enhancements, and the use of credit derivatives. The guidance stresses the importance of internal capital allocation schemes and risk management systems that accurately reflect the economic substance of transactions. A second lesson that has been reinforced over the past several years is that risk must be measured and managed comprehensively. That is, the focus should be on the dynamics of the portfolio rather than on specific instruments, which can ignore the interplay among various instruments. Although portfolio theory is widely appreciated by bankers and regulators, putting its principles into practice in banking has not been easy. Past banking crises have, in part, reflected a failure by some institutions to recognize and limit concentrations of risk within their portfolios. However, technology and financial innovation are enabling banks to put theories and conceptual techniques into practice to manage the market and credit risks involved in trading, investment, and lending activities. Most dealer banks now routinely employ value-at-risk (VaR) measures to manage the market risks of their trading portfolios and significant strides are being made in the quantitative measurement and management of credit risk. The move to a portfolio-based approach to managing risk has influenced bank supervisory efforts in several other ways. All three of the U.S. banking agencies now take a more risk-focused approach to supervision. This is simply allocating more supervisory resources to a bank's activities that pose greater risk. For example, bank examiners no longer exhaustively review all of a bank's activities. Instead, the examination approach is now to identify and review the sources of risk within a bank's various lines of business. The need to measure risk on a portfolio basis has also begun to be reflected more explicitly in our capital guidelines and our reporting requirements. Beginning next year, internationally active banks meeting certain criteria for risk management will calculate the amount of capital necessary to support the market risk of their trading activities using their own internal VaR measures. This approach allows banks to make use of empirical correlations among risk factors when computing the VaR. A third lesson that our experience with derivatives and other financial innovations has driven home is the critical importance of firms' internal processes for controlling risk. This, of course, is the most obvious lesson from several spectacular losses that the press has put under the rubric of "derivatives debacles." Supervisors, both here and abroad, are focusing more on reviewing the adequacy of internal controls and management processes, such as enforced risk limits. These are the key to gaining maximum benefit from financial innovation, while at the same time avoiding missteps. The final lesson that I will highlight is the need for supervisory and regulatory polices that are more "incentive-compatible" in the sense that they foster sound risk management within the institution rather than narrow adherence to rules and regulations;. minimize burden by using internal risk measurement systems; and. are reinforced by market forces and the performance incentives of bank owners and managers. Too often financial engineering is targeted at regulatory arbitrage -- that is, exploiting loopholes in narrowly focused regulatory policies that are based on old, traditional instruments or business lines. Also, potential new products may not be introduced because their regulatory treatment is viewed as too burdensome or uncertain. This situation demonstrates all too clearly the differing reaction times of public and private entities. Regulatory policies and standards often take a long time to change whereas, in the private sector, market forces can quickly remedy outmoded standards. The resulting distortions of resources that arise when supervisory standards are slow to change is an unfortunate, albeit predictable, outcome. Policymakers can reduce this potential for distortion by structuring policies to be more "incentive-compatible." This involves harnessing market forces and market discipline to achieve supervisory objectives. Increasingly, supervisors are trying to avoid locking themselves into formulaic, one-size-fits-all approaches to supervision and regulation. The use of internal VaR models for calculating capital charges for trading activities is an important step in this direction. Risk-focused supervision emphasizing sound practices and internal controls is another. A significant effort that could increase supervisory reliance on market discipline in the future is the Federal Reserve's so-called "pre-commitment" approach to determining capital for market risk. It seeks to provide banks with stronger regulatory and market incentives to improve all aspects of market risk management. This approach is currently being studied and tested by a group of U.S. banks organized by the New York Clearing House. What will be the eventual outcome of incorporating the lessons learned into banking supervision? I see two themes in the evolution in the supervision of financial institutions: First is providing strong regulatory incentives for banks to exercise prudence in taking and managing risk, and to develop ever better systems and processes for risk management. I believe the best evidence of this thinking is illustrated by the recent moves to align regulatory capital requirements for market risk with individual institutions' systems for allocating economic capital based on their own internal models. Supervisory oversight then concentrates on the performance of each institution's risk management process rather than devising a regulatory capital scheme that may not fit every institution, and inevitably have loopholes or inconsistencies that can be exploited. Second, greater reliance will be placed -- particularly for nonbank business lines -- on the discipline the market can exert on individual participants. The latter element to our supervisory approach depends on market participants acting in their own self interest when dealing with counterparties. That involves understanding the risks of engaging in business and properly pricing transactions. Reliable financial information is an essential ingredient to efficient market discipline. Such information would clearly convey the risk profile of the institution it represents. In its absence, markets are more susceptible to distortions caused by rumors, misinformation, or failures to disclose. Many believe the dearth of information on risk profiles reflects the market's reliance on the federal safety net. Such information would be available if participants were not, to a large extent, indemnified from loss. It is this desire to see market discipline taking a greater role in regulating the affairs of banking organizations and others that has motivated the Federal Reserve Board to voice its opinions about accounting standards that are being developed by the Financial Accounting Standards Board (FASB). As in regulation, an important consideration to setting accounting standards should be the benefits of a particular standard outweighing its cost. The Federal Reserve's opinion is that the accounting for derivatives (and other financial instruments for that matter) should be consistent with the approach to risk management the firm takes in its business. This consistency can yield cost savings by reducing the need for two sets of books: one for financial reporting and another that supports internal management decisions. Moreover, it avoids the possibility of regulatory reports diverging from financial reporting, thereby helping to ensure that supervisory information and capital requirements appropriately reflect the institution's economic risks. The challenges of supervision in a rapidly changing financial and technological environment are compounded by global integration of the marketplace. To the extent that regulation in one country is deemed too restrictive, firms can avoid it by simply booking business in another country. The ease with which firms can circumvent national borders and regulatory jurisdictions is a challenge of one dimension. If circumvention results in unsafe or unsound banking practices, it is a problem of another dimension. The problem may end up back in the United States after all. It is for these reasons that the Federal Reserve and the other U.S. banking agencies have been advocating that international agreements on banking supervision have a risk focus. For example, the Basle Committee on Supervision (under the Bank for International Settlements) recently agreed to embrace a portfolio-based, risk-sensitive approach to setting capital requirements for market risk. Instead, supervisors will be building upon the processes banks use to measure trading risks. This should substantially reduce regulatory burden and make standards more compatible with industry practice. In addition, the Basle Committee has agreed to common frameworks for gaining information on the derivatives activities of supervised institutions. A major task before us is to work with emerging-market countries to strengthen and unify banking supervision. Greater consistency should reduce the risk of systemic problems arising from a financial disruption in any particular market. While most of these efforts have focused on market risk, I think it is fair to point out that the major exposure for most banks is credit risk. Looking to the future, will the risk-based capital approach for credit risk ever evolve into an internal models approach? The answer is probably yes; however, with credit-risk modeling in such an early stage of development, it is premature to predict just when credit modeling and the supporting data will develop to the point that they can be relied upon as effective management tools. I am, however, encouraged by progress in modeling credit risk. The risk-based capital accord has worked well in the past and remains useful today. It was an excellent vehicle for bringing about a convergence in bank capital standards worldwide. But it does illustrate the problems of a standardized scheme. For example, banks have an incentive to securitize low-risk assets to avoid regulatory capital charges that unregulated competitors need not meet. Alternatively, market participants can get a false sense of security about a bank's condition if the risk-based capital ratios understate the true risks of the bank's portfolios. Recognizing these shortcomings, we regulators need to continually review and revise our standards, as we have proposed in connection with certain securitizations of assets. Some of you in the audience may be surprised that my remarks on derivatives end with a discussion of risk-based capital. This, to me, illustrates the unexpected effects of financial innovation. A decade ago, few would have predicted that techniques for controlling trading risks might point the way for measuring risks in lending and allocating capital -- but that's the very nature of innovation. Those who identify new ways to apply lessons learned in one area to other activities are the ones most likely to succeed. Taking risk is unavoidable in banking, indeed bankers must do so to survive. The key is to identify, manage, and control the risks that are inherent in the business. The intelligent use of derivatives is one way to accomplish that. One should focus not on derivatives in and of themselves, but on their role and effect on a bank's overall portfolio.
1997-10-01T00:00:00	Ms. Phillips discusses the Federal Reserve Board's views on proposed accounting standards for derivatives and risk management activities (Central Bank Articles and Speeches, 1 Oct 97)	Testimony of Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, before the Subcommittee on Capital Markets, Securities and Government Sponsored Enterprises of the Committee on Banking and Financial Services, U.S. House of Representatives, on 1/10/97.	Ms. Phillips discusses the Federal Reserve Board's views on proposed Testimony of Ms. Susan accounting standards for derivatives and risk management activities M. Phillips, a member of the Board of Governors of the US Federal Reserve System, before the Subcommittee on Capital Markets, Securities and Government Sponsored Enterprises of the Committee on Banking and Financial Services, U.S. House of Representatives, on 1/10/97. I welcome this opportunity to discuss the Federal Reserve Board's views on proposed accounting standards for derivatives and risk management activities issued by the Financial Accounting Standards Board (FASB). In approaching this complex matter, it should be acknowledged up front that most responsible observers and market participants share an interest in improved accounting standards and disclosure of information that is useful and relevant to the broad range of users of financial statements. Thus, the desirability of meaningful disclosure is not the issue. All would agree, I think, that enhanced financial disclosure and market transparency can lead to more efficient financial markets, more accurate pricing of risks, and more effective market discipline. With respect to financial disclosures, the interests of most firm managers, investors, and other market participants are essentially the same. Market participants can benefit from enhanced disclosure by being in a better position to understand the financial condition of their counterparties and competitors. Investors have an obvious interest in being able to make meaningful assessments of a firm's performance, underlying trends, and income-producing potential. Sound, well-managed firms can benefit if better disclosure enables them to obtain funds at risk premiums that accurately reflect their lower risk profiles. Inadequate financial disclosures, on the other hand, could penalize well-managed firms if market participants are unable to assess their fundamental financial strength. While most market participants favor sound accounting standards and meaningful disclosure, a key question is how to ensure that accounting practices and techniques reflect, and are consistent with, how a business is run, that is, its overall business strategy. Indeed, accounting methodology should measure the results of a business purpose or strategy, and not be an end in itself. For example, in the case of a company that actively trades financial instruments or other products to profit from short-term price movements, such as a securities firm, reporting trading positions at fair values appropriately measures the success or failure of that business strategy, and market participants expect this reporting treatment. However, for many other types of businesses, such as a manufacturer or a lender that funds loans with liabilities of equal maturity, market value accounting in the primary financial statements may not accurately reflect business strategies or appropriately measure the firm's underlying performance and condition. In these cases, although information about fair value can be useful in supplemental disclosures, it is questionable whether there is widespread demand for market value accounting to become the basis for the preparation of the primary financial statements. Although the needs of financial statement users may vary, a critical function of financial statements is to reflect in a meaningful way underlying trends in the financial performance and condition of the firm. The application of market value accounting to business strategies where it is not appropriate, and particularly when applied on a piecemeal basis, may lead to increased volatility or fluctuation in reported results and actually obscure underlying trends or developments affecting a firm's condition and performance. Requiring companies to adopt market value accounting where it is not consistent with their business strategies can cause them to incur significant costs to provide information that may not reflect in a meaningful way their underlying circumstances or trends in their performance. Moreover, from the standpoint of financial statement analysts and other users, having to make adjustments to remove the effects of this accounting volatility from income statements and balance sheets -- volatility that is not consistent with firm's risk positions -- can also impose significant costs without offsetting benefits. These problems can be minimized by placing market values in meaningful supplemental disclosures rather than by forcing their use in the primary financial statements. Such an approach would give analysts the information they need, without imposing the broader costs of having to reverse or back out the effects of artificial volatility from the primary financial statements. Of course, financial statements and supplemental disclosures must be accurate and not misrepresent a firm's financial circumstances -- a problem that can be minimized when financial reports are subject to thorough review by management and external auditors. Federal Reserve's Experience The Federal Reserve Board has a long-standing interest in the quality of financial reporting. This arises from our role as the nation's central bank, and as the supervisor of bank holding companies, state member banks, and the U.S. operations of foreign banking organizations (FBOs). The Federal Reserve and other bank supervisors are responsible for assessing the safety and soundness of the institutions they regulate. In this regard, the Federal Reserve relies on off-site monitoring, on-site supervision, capital and other regulatory requirements, and policies that encourage sound risk management practices. We believe that market discipline -- supported by appropriate accounting standards and public disclosure -- complement these supervisory efforts by fostering healthy financial institutions and efficient capital markets. In the course of supervising financial institutions, the Federal Reserve has developed considerable familiarity with financial instruments, both derivative and non-derivative, that are characterized by a wide range of complexity and risk. We have learned that in supervising trading and derivatives activities it is the underlying characteristics of a financial instrument -- and how it contributes to the overall risk profile of the firm -- that are important, not the instrument's name. Two instruments that differ in name only may have entirely different treatment under existing legal and accounting frameworks, even though the economic risks (including market, credit, liquidity, operational, and reputational risks) they embody are identical. Financial engineering can certainly create derivative instruments that combine risks in complex ways. But the same engineers can create cash instruments that appear simple and traditional, but may have greater risk than many instruments labeled "derivative." Indeed, placing financial instruments in regulatory or accounting pigeonholes without regard to their true risks and economic functions can create disincentives for prudent risk management. The Federal Reserve is increasingly emphasizing the need for institutions to manage the aggregate or portfolio risks of banking and de-emphasizing a focus on specific instruments. Risk should be measured and managed comprehensively. That is, an institution should manage the dynamics of its portfolio rather than manage specific instruments. A focus on individual transactions can ignore the interaction of the specified instrument with other instruments. Although portfolio theory is widely appreciated by bankers and regulators, putting its principles into practice in banking has not been easy. For example, past banking crises have, in part, reflected a failure by some institutions to recognize and limit concentrations of risk within their portfolios. The Federal Reserve is increasingly recognizing the need for supervisory and regulatory policies to be more "incentive-compatible," in that they encourage sound risk management within an institution. Furthermore, supervisory and regulatory policies are placing increasing emphasis on minimizing burden by using internal risk measurement systems, and by reinforcing supervisory objectives through market forces. We believe that market discipline -- supported by appropriate accounting standards and public disclosure -- complements our supervisory efforts by fostering strong financial institutions and efficient capital markets. We believe this approach is more constructive than rote adherence to rules and regulations that may not be consistent with the firm's own risk management systems. Consistent with these policies, the Federal Reserve and other banking supervisors have explored regulatory approaches that encourage more use of market-value-based measures in risk management approaches. For example, beginning next year, internationally active banks meeting certain criteria for risk management will calculate the amount of capital necessary to support the market risk of their trading activities using their own internal value-at-risk (VaR) measures. A significant effort that could increase supervisory reliance on market discipline in the future is the Federal Reserve's so-called "pre-commitment" approach to determining capital for market risk. It seeks to provide banks with stronger regulatory and market incentives to improve all aspects of market risk management. Other initiatives have improved the focus of our supervision policies and examination practices on institutions' risk profiles and risk management activities in ways that emphasize sound practices and strong internal controls. Moreover, the Federal Reserve has called for improved U.S. accounting and disclosure standards and has had a key role in sponsoring major international initiatives to encourage improved disclosures by the largest banks and securities firms of their trading and derivatives activities. For example, our 1995 and 1996 analyses of the derivatives disclosure by the top ten U.S. dealer banks were used as models for the joint reports by the Basle Committee on Banking Supervision and the International Organization of Securities Commissions, which covered a sample of the largest banks and securities firms in the G-10 countries. These studies revealed major differences in disclosure among the participating countries and highlighted the greater level of disclosure by U.S. dealer banks. In addition, a representative of the Federal Reserve chaired an international working group of the Euro-currency Standing Committee that recommended in 1994 improvements to disclosure by financial intermediaries of the credit and market risks of their trading activities. The Federal Reserve and the other federal banking agencies also developed improvements in derivatives disclosure standards for regulatory reports that are similar to disclosure requirements issued at the same time by FASB in Statement No. 119, "Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments." Specific Issues Raised by the Derivatives Proposal We share several objectives with the FASB for improving financial reporting. For example, we both support the fundamental objectives of promoting clear and understandable financial reports that increase the transparency of companies' activities. We also share the view that accounting and disclosure standards which faithfully represent financial condition and performance can improve investor and counterparty decisions, thus improving market discipline on banking organizations and other companies. Further, we also agree that current accounting and disclosure standards for derivatives -- as well as for other financial instruments -- should be improved. We recognize the difficult task that FASB has in developing a standard that is acceptable to its many constituents. In this regard, we understand that FASB has considered and rejected a number of approaches to hedge accounting for derivatives because particular problems were identified with each approach. We also believe that the approach of reporting all financial instruments at fair value in the primary set of financial instruments, while having some theoretical appeal at least for some types of firms, is not an appropriate solution in the near term. In this regard, fair value estimation techniques are not yet sufficiently robust for exclusive reliance in financial statements. For example, difficult valuation issues arise for highly illiquid instruments for which fair value is based on models rather than observed prices, core deposits with varying durations, and the liabilities of a firm whose credit quality has weakened. Furthermore, fair value estimates can be highly subjective, and little guidance is available for measuring fair values in the financial statements. Another difficult issue relates to whether fair value is the most relevant measurement for commercial banks and other firms that are in the business of holding illiquid loans and other assets for the long term. The success or failure of such a strategy is not measured by evaluating such loans on the basis of a price that indicates value in the context of immediate delivery. In this regard, an appropriate value for many bank loans and off-balance-sheet commitments -- the one that reflect the nature of a bank's business -- is the original acquisition price adjusted for the expectation of performance at maturity. Given the many difficulties of FASB's task, it is not surprising that their proposal raises a number of complex issues. For example, the proposal is likely to lead to increased volatility in income and stockholders equity by companies that manage risk with derivatives. This volatility could be artificial due to the piecemeal approach of marking certain risk positions to fair value, but not all positions contributing to the risk. As a result, there could be accounting volatility that bears little relation to an institution's overall risk position. Supervisors and analysts will have to strip out the artificially created volatility to assess the true performance of the firm. On the other hand, companies that do not manage their risks, or manage their risks solely through cash instruments that are not covered by the standard, would not reflect similar volatility. A simple example might illustrate this concern. Assume a company's activities consist solely of lending long term at fixed rates and funding these loans with variable-rate deposits. I think we can all agree that this company has a significant exposure to interest rate risk. If the company does not manage its risk with derivatives, it would not be affected by the derivatives accounting proposal and would not report any volatility from fair value changes in its financial statements. If, however, the company has a strategy to use derivatives to reduce its interest rate risk and move it closer to a match-funded position, the company may report greater volatility in income and stockholders' equity -- a result not consistent with its reduced risk exposure. For example, if the company specified under the framework set forth in the FASB proposal that the derivatives are "cash flow" hedges of variable rate liabilities, the company would have volatility in equity or earnings based on the specifically linked effectiveness tests set forth by the proposal. Thus, the firm in using derivatives reduces its economic volatility, yet increases its accounting volatility. More important, by taking a transaction level approach to hedging, the proposal would not describe well the efforts of more sophisticated market participants to hedge their risks on a comprehensive, portfolio basis. Thus, these firms would effectively be required to keep different sets of books, and their financial reporting may not be consistent with the derivatives' intended use. This leads me to conclude that the proposal could discourage or constrain prudent risk management practices that rely on derivatives. Furthermore, it may not improve transparency of financial information. The proposal also introduces into the financial statements an untested method for reporting loans, deposits, and other assets and liabilities being hedged. These assets and liabilities would be valued at a "hybrid" historical cost and fair value amount on the balance sheet when they are hedged with derivatives that are designated as fair value hedges. For example, generally, the historical cost values of these assets and liabilities would be adjusted for changes in fair value related to the risk being hedged. However, certain other changes in fair value would not be recognized (such as those that arise from other risks, that are the results of an ineffective hedge, or that do not offset a gain or loss on the hedging instrument). These hybrid amounts could differ significantly from -- and potentially exceed -- fair values. They may also be difficult to verify by auditors and examiners, thus reducing the reliability of amounts reported in the financial statements. The proposed approach is complex, which may increase related developmental systems costs. In this regard, the proposal may cause significant systems changes for institutions that hedge with derivatives. At the same time institutions are making these systems changes, they need to upgrade their systems to address Year 2000 issues. The cost of systems changes arising from the derivatives proposal should be evaluated along with other costs and benefits arising from the proposal. This is particularly important since the derivatives proposal is intended by the FASB to be an interim treatment, and its long-term goal is to measure all financial instruments at fair value. Indeed, the FASB already has under way a project that is evaluating issues related to that goal.	---[PAGE_BREAK]--- # Ms. Phillips discusses the Federal Reserve Board's views on proposed accounting standards for derivatives and risk management activities Testimony of Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, before the Subcommittee on Capital Markets, Securities and Government Sponsored Enterprises of the Committee on Banking and Financial Services, U.S. House of Representatives, on 1/10/97. I welcome this opportunity to discuss the Federal Reserve Board's views on proposed accounting standards for derivatives and risk management activities issued by the Financial Accounting Standards Board (FASB). In approaching this complex matter, it should be acknowledged up front that most responsible observers and market participants share an interest in improved accounting standards and disclosure of information that is useful and relevant to the broad range of users of financial statements. Thus, the desirability of meaningful disclosure is not the issue. All would agree, I think, that enhanced financial disclosure and market transparency can lead to more efficient financial markets, more accurate pricing of risks, and more effective market discipline. With respect to financial disclosures, the interests of most firm managers, investors, and other market participants are essentially the same. Market participants can benefit from enhanced disclosure by being in a better position to understand the financial condition of their counterparties and competitors. Investors have an obvious interest in being able to make meaningful assessments of a firm's performance, underlying trends, and income-producing potential. Sound, well-managed firms can benefit if better disclosure enables them to obtain funds at risk premiums that accurately reflect their lower risk profiles. Inadequate financial disclosures, on the other hand, could penalize well-managed firms if market participants are unable to assess their fundamental financial strength. While most market participants favor sound accounting standards and meaningful disclosure, a key question is how to ensure that accounting practices and techniques reflect, and are consistent with, how a business is run, that is, its overall business strategy. Indeed, accounting methodology should measure the results of a business purpose or strategy, and not be an end in itself. For example, in the case of a company that actively trades financial instruments or other products to profit from short-term price movements, such as a securities firm, reporting trading positions at fair values appropriately measures the success or failure of that business strategy, and market participants expect this reporting treatment. However, for many other types of businesses, such as a manufacturer or a lender that funds loans with liabilities of equal maturity, market value accounting in the primary financial statements may not accurately reflect business strategies or appropriately measure the firm's underlying performance and condition. In these cases, although information about fair value can be useful in supplemental disclosures, it is questionable whether there is widespread demand for market value accounting to become the basis for the preparation of the primary financial statements. Although the needs of financial statement users may vary, a critical function of financial statements is to reflect in a meaningful way underlying trends in the financial performance and condition of the firm. The application of market value accounting to business strategies where it is not appropriate, and particularly when applied on a piecemeal basis, may lead to increased volatility or fluctuation in reported results and actually obscure underlying trends or developments affecting a firm's condition and performance. Requiring companies to adopt market value accounting where it is not consistent with their business strategies can cause them to incur significant costs to provide information that may not reflect in a meaningful way their underlying circumstances or trends in their performance. Moreover, from the standpoint of financial statement analysts and other users, having to make adjustments to remove the effects of this accounting volatility from income statements and balance sheets -- volatility that is not consistent with firm's risk positions -- can also impose significant costs without offsetting benefits. ---[PAGE_BREAK]--- These problems can be minimized by placing market values in meaningful supplemental disclosures rather than by forcing their use in the primary financial statements. Such an approach would give analysts the information they need, without imposing the broader costs of having to reverse or back out the effects of artificial volatility from the primary financial statements. Of course, financial statements and supplemental disclosures must be accurate and not misrepresent a firm's financial circumstances -- a problem that can be minimized when financial reports are subject to thorough review by management and external auditors. # Federal Reserve's Experience The Federal Reserve Board has a long-standing interest in the quality of financial reporting. This arises from our role as the nation's central bank, and as the supervisor of bank holding companies, state member banks, and the U.S. operations of foreign banking organizations (FBOs). The Federal Reserve and other bank supervisors are responsible for assessing the safety and soundness of the institutions they regulate. In this regard, the Federal Reserve relies on off-site monitoring, on-site supervision, capital and other regulatory requirements, and policies that encourage sound risk management practices. We believe that market discipline -- supported by appropriate accounting standards and public disclosure -- complement these supervisory efforts by fostering healthy financial institutions and efficient capital markets. In the course of supervising financial institutions, the Federal Reserve has developed considerable familiarity with financial instruments, both derivative and non-derivative, that are characterized by a wide range of complexity and risk. We have learned that in supervising trading and derivatives activities it is the underlying characteristics of a financial instrument -- and how it contributes to the overall risk profile of the firm -- that are important, not the instrument's name. Two instruments that differ in name only may have entirely different treatment under existing legal and accounting frameworks, even though the economic risks (including market, credit, liquidity, operational, and reputational risks) they embody are identical. Financial engineering can certainly create derivative instruments that combine risks in complex ways. But the same engineers can create cash instruments that appear simple and traditional, but may have greater risk than many instruments labeled "derivative." Indeed, placing financial instruments in regulatory or accounting pigeonholes without regard to their true risks and economic functions can create disincentives for prudent risk management. The Federal Reserve is increasingly emphasizing the need for institutions to manage the aggregate or portfolio risks of banking and de-emphasizing a focus on specific instruments. Risk should be measured and managed comprehensively. That is, an institution should manage the dynamics of its portfolio rather than manage specific instruments. A focus on individual transactions can ignore the interaction of the specified instrument with other instruments. Although portfolio theory is widely appreciated by bankers and regulators, putting its principles into practice in banking has not been easy. For example, past banking crises have, in part, reflected a failure by some institutions to recognize and limit concentrations of risk within their portfolios. The Federal Reserve is increasingly recognizing the need for supervisory and regulatory policies to be more "incentive-compatible," in that they encourage sound risk management within an institution. Furthermore, supervisory and regulatory policies are placing increasing emphasis on minimizing burden by using internal risk measurement systems, and by reinforcing supervisory objectives through market forces. We believe that market discipline -- supported by appropriate accounting standards and public disclosure -- complements our supervisory efforts by fostering strong financial institutions and efficient capital markets. We believe this approach is more constructive than rote adherence to rules and regulations that may not be consistent with the firm's own risk management systems. ---[PAGE_BREAK]--- Consistent with these policies, the Federal Reserve and other banking supervisors have explored regulatory approaches that encourage more use of market-value-based measures in risk management approaches. For example, beginning next year, internationally active banks meeting certain criteria for risk management will calculate the amount of capital necessary to support the market risk of their trading activities using their own internal value-at-risk (VaR) measures. A significant effort that could increase supervisory reliance on market discipline in the future is the Federal Reserve's so-called "pre-commitment" approach to determining capital for market risk. It seeks to provide banks with stronger regulatory and market incentives to improve all aspects of market risk management. Other initiatives have improved the focus of our supervision policies and examination practices on institutions' risk profiles and risk management activities in ways that emphasize sound practices and strong internal controls. Moreover, the Federal Reserve has called for improved U.S. accounting and disclosure standards and has had a key role in sponsoring major international initiatives to encourage improved disclosures by the largest banks and securities firms of their trading and derivatives activities. For example, our 1995 and 1996 analyses of the derivatives disclosure by the top ten U.S. dealer banks were used as models for the joint reports by the Basle Committee on Banking Supervision and the International Organization of Securities Commissions, which covered a sample of the largest banks and securities firms in the G-10 countries. These studies revealed major differences in disclosure among the participating countries and highlighted the greater level of disclosure by U.S. dealer banks. In addition, a representative of the Federal Reserve chaired an international working group of the Euro-currency Standing Committee that recommended in 1994 improvements to disclosure by financial intermediaries of the credit and market risks of their trading activities. The Federal Reserve and the other federal banking agencies also developed improvements in derivatives disclosure standards for regulatory reports that are similar to disclosure requirements issued at the same time by FASB in Statement No. 119, "Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments." # Specific Issues Raised by the Derivatives Proposal We share several objectives with the FASB for improving financial reporting. For example, we both support the fundamental objectives of promoting clear and understandable financial reports that increase the transparency of companies' activities. We also share the view that accounting and disclosure standards which faithfully represent financial condition and performance can improve investor and counterparty decisions, thus improving market discipline on banking organizations and other companies. Further, we also agree that current accounting and disclosure standards for derivatives -- as well as for other financial instruments -- should be improved. We recognize the difficult task that FASB has in developing a standard that is acceptable to its many constituents. In this regard, we understand that FASB has considered and rejected a number of approaches to hedge accounting for derivatives because particular problems were identified with each approach. We also believe that the approach of reporting all financial instruments at fair value in the primary set of financial instruments, while having some theoretical appeal at least for some types of firms, is not an appropriate solution in the near term. In this regard, fair value estimation techniques are not yet sufficiently robust for exclusive reliance in financial statements. For example, difficult valuation issues arise for highly illiquid instruments for which fair value is based on models rather than observed prices, core deposits with varying durations, and the liabilities of a firm whose credit quality has weakened. Furthermore, fair value estimates can be highly subjective, and little guidance is available for measuring fair values in the financial statements. Another difficult issue relates to whether fair value is the most relevant measurement for commercial banks and other firms that are in the business of holding illiquid loans and other assets for the long term. The success or failure of such a strategy is not measured by evaluating such loans on the basis ---[PAGE_BREAK]--- of a price that indicates value in the context of immediate delivery. In this regard, an appropriate value for many bank loans and off-balance-sheet commitments -- the one that reflect the nature of a bank's business -- is the original acquisition price adjusted for the expectation of performance at maturity. Given the many difficulties of FASB's task, it is not surprising that their proposal raises a number of complex issues. For example, the proposal is likely to lead to increased volatility in income and stockholders equity by companies that manage risk with derivatives. This volatility could be artificial due to the piecemeal approach of marking certain risk positions to fair value, but not all positions contributing to the risk. As a result, there could be accounting volatility that bears little relation to an institution's overall risk position. Supervisors and analysts will have to strip out the artificially created volatility to assess the true performance of the firm. On the other hand, companies that do not manage their risks, or manage their risks solely through cash instruments that are not covered by the standard, would not reflect similar volatility. A simple example might illustrate this concern. Assume a company's activities consist solely of lending long term at fixed rates and funding these loans with variable-rate deposits. I think we can all agree that this company has a significant exposure to interest rate risk. If the company does not manage its risk with derivatives, it would not be affected by the derivatives accounting proposal and would not report any volatility from fair value changes in its financial statements. If, however, the company has a strategy to use derivatives to reduce its interest rate risk and move it closer to a match-funded position, the company may report greater volatility in income and stockholders' equity -- a result not consistent with its reduced risk exposure. For example, if the company specified under the framework set forth in the FASB proposal that the derivatives are "cash flow" hedges of variable rate liabilities, the company would have volatility in equity or earnings based on the specifically linked effectiveness tests set forth by the proposal. Thus, the firm in using derivatives reduces its economic volatility, yet increases its accounting volatility. More important, by taking a transaction level approach to hedging, the proposal would not describe well the efforts of more sophisticated market participants to hedge their risks on a comprehensive, portfolio basis. Thus, these firms would effectively be required to keep different sets of books, and their financial reporting may not be consistent with the derivatives' intended use. This leads me to conclude that the proposal could discourage or constrain prudent risk management practices that rely on derivatives. Furthermore, it may not improve transparency of financial information. The proposal also introduces into the financial statements an untested method for reporting loans, deposits, and other assets and liabilities being hedged. These assets and liabilities would be valued at a "hybrid" historical cost and fair value amount on the balance sheet when they are hedged with derivatives that are designated as fair value hedges. For example, generally, the historical cost values of these assets and liabilities would be adjusted for changes in fair value related to the risk being hedged. However, certain other changes in fair value would not be recognized (such as those that arise from other risks, that are the results of an ineffective hedge, or that do not offset a gain or loss on the hedging instrument). These hybrid amounts could differ significantly from -- and potentially exceed -- fair values. They may also be difficult to verify by auditors and examiners, thus reducing the reliability of amounts reported in the financial statements. The proposed approach is complex, which may increase related developmental systems costs. In this regard, the proposal may cause significant systems changes for institutions that hedge with derivatives. At the same time institutions are making these systems changes, they need to upgrade their systems to address Year 2000 issues. The cost of systems changes arising from the derivatives proposal should be evaluated along with other costs and benefits arising from the proposal. This is particularly important since the derivatives proposal is intended by the FASB to be ---[PAGE_BREAK]--- an interim treatment, and its long-term goal is to measure all financial instruments at fair value. Indeed, the FASB already has under way a project that is evaluating issues related to that goal.	Susan M Phillips	United States	https://www.bis.org/review/r971007b.pdf	accounting standards for derivatives and risk management activities Testimony of Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, before the Subcommittee on Capital Markets, Securities and Government Sponsored Enterprises of the Committee on Banking and Financial Services, U.S. House of Representatives, on 1/10/97. I welcome this opportunity to discuss the Federal Reserve Board's views on proposed accounting standards for derivatives and risk management activities issued by the Financial Accounting Standards Board (FASB). In approaching this complex matter, it should be acknowledged up front that most responsible observers and market participants share an interest in improved accounting standards and disclosure of information that is useful and relevant to the broad range of users of financial statements. Thus, the desirability of meaningful disclosure is not the issue. All would agree, I think, that enhanced financial disclosure and market transparency can lead to more efficient financial markets, more accurate pricing of risks, and more effective market discipline. With respect to financial disclosures, the interests of most firm managers, investors, and other market participants are essentially the same. Market participants can benefit from enhanced disclosure by being in a better position to understand the financial condition of their counterparties and competitors. Investors have an obvious interest in being able to make meaningful assessments of a firm's performance, underlying trends, and income-producing potential. Sound, well-managed firms can benefit if better disclosure enables them to obtain funds at risk premiums that accurately reflect their lower risk profiles. Inadequate financial disclosures, on the other hand, could penalize well-managed firms if market participants are unable to assess their fundamental financial strength. While most market participants favor sound accounting standards and meaningful disclosure, a key question is how to ensure that accounting practices and techniques reflect, and are consistent with, how a business is run, that is, its overall business strategy. Indeed, accounting methodology should measure the results of a business purpose or strategy, and not be an end in itself. For example, in the case of a company that actively trades financial instruments or other products to profit from short-term price movements, such as a securities firm, reporting trading positions at fair values appropriately measures the success or failure of that business strategy, and market participants expect this reporting treatment. However, for many other types of businesses, such as a manufacturer or a lender that funds loans with liabilities of equal maturity, market value accounting in the primary financial statements may not accurately reflect business strategies or appropriately measure the firm's underlying performance and condition. In these cases, although information about fair value can be useful in supplemental disclosures, it is questionable whether there is widespread demand for market value accounting to become the basis for the preparation of the primary financial statements. Although the needs of financial statement users may vary, a critical function of financial statements is to reflect in a meaningful way underlying trends in the financial performance and condition of the firm. The application of market value accounting to business strategies where it is not appropriate, and particularly when applied on a piecemeal basis, may lead to increased volatility or fluctuation in reported results and actually obscure underlying trends or developments affecting a firm's condition and performance. Requiring companies to adopt market value accounting where it is not consistent with their business strategies can cause them to incur significant costs to provide information that may not reflect in a meaningful way their underlying circumstances or trends in their performance. Moreover, from the standpoint of financial statement analysts and other users, having to make adjustments to remove the effects of this accounting volatility from income statements and balance sheets -- volatility that is not consistent with firm's risk positions -- can also impose significant costs without offsetting benefits. These problems can be minimized by placing market values in meaningful supplemental disclosures rather than by forcing their use in the primary financial statements. Such an approach would give analysts the information they need, without imposing the broader costs of having to reverse or back out the effects of artificial volatility from the primary financial statements. Of course, financial statements and supplemental disclosures must be accurate and not misrepresent a firm's financial circumstances -- a problem that can be minimized when financial reports are subject to thorough review by management and external auditors. The Federal Reserve Board has a long-standing interest in the quality of financial reporting. This arises from our role as the nation's central bank, and as the supervisor of bank holding companies, state member banks, and the U.S. operations of foreign banking organizations (FBOs). The Federal Reserve and other bank supervisors are responsible for assessing the safety and soundness of the institutions they regulate. In this regard, the Federal Reserve relies on off-site monitoring, on-site supervision, capital and other regulatory requirements, and policies that encourage sound risk management practices. We believe that market discipline -- supported by appropriate accounting standards and public disclosure -- complement these supervisory efforts by fostering healthy financial institutions and efficient capital markets. In the course of supervising financial institutions, the Federal Reserve has developed considerable familiarity with financial instruments, both derivative and non-derivative, that are characterized by a wide range of complexity and risk. We have learned that in supervising trading and derivatives activities it is the underlying characteristics of a financial instrument -- and how it contributes to the overall risk profile of the firm -- that are important, not the instrument's name. Two instruments that differ in name only may have entirely different treatment under existing legal and accounting frameworks, even though the economic risks (including market, credit, liquidity, operational, and reputational risks) they embody are identical. Financial engineering can certainly create derivative instruments that combine risks in complex ways. But the same engineers can create cash instruments that appear simple and traditional, but may have greater risk than many instruments labeled "derivative." Indeed, placing financial instruments in regulatory or accounting pigeonholes without regard to their true risks and economic functions can create disincentives for prudent risk management. The Federal Reserve is increasingly emphasizing the need for institutions to manage the aggregate or portfolio risks of banking and de-emphasizing a focus on specific instruments. Risk should be measured and managed comprehensively. That is, an institution should manage the dynamics of its portfolio rather than manage specific instruments. A focus on individual transactions can ignore the interaction of the specified instrument with other instruments. Although portfolio theory is widely appreciated by bankers and regulators, putting its principles into practice in banking has not been easy. For example, past banking crises have, in part, reflected a failure by some institutions to recognize and limit concentrations of risk within their portfolios. The Federal Reserve is increasingly recognizing the need for supervisory and regulatory policies to be more "incentive-compatible," in that they encourage sound risk management within an institution. Furthermore, supervisory and regulatory policies are placing increasing emphasis on minimizing burden by using internal risk measurement systems, and by reinforcing supervisory objectives through market forces. We believe that market discipline -- supported by appropriate accounting standards and public disclosure -- complements our supervisory efforts by fostering strong financial institutions and efficient capital markets. We believe this approach is more constructive than rote adherence to rules and regulations that may not be consistent with the firm's own risk management systems. Consistent with these policies, the Federal Reserve and other banking supervisors have explored regulatory approaches that encourage more use of market-value-based measures in risk management approaches. For example, beginning next year, internationally active banks meeting certain criteria for risk management will calculate the amount of capital necessary to support the market risk of their trading activities using their own internal value-at-risk (VaR) measures. A significant effort that could increase supervisory reliance on market discipline in the future is the Federal Reserve's so-called "pre-commitment" approach to determining capital for market risk. It seeks to provide banks with stronger regulatory and market incentives to improve all aspects of market risk management. Other initiatives have improved the focus of our supervision policies and examination practices on institutions' risk profiles and risk management activities in ways that emphasize sound practices and strong internal controls. Moreover, the Federal Reserve has called for improved U.S. accounting and disclosure standards and has had a key role in sponsoring major international initiatives to encourage improved disclosures by the largest banks and securities firms of their trading and derivatives activities. For example, our 1995 and 1996 analyses of the derivatives disclosure by the top ten U.S. dealer banks were used as models for the joint reports by the Basle Committee on Banking Supervision and the International Organization of Securities Commissions, which covered a sample of the largest banks and securities firms in the G-10 countries. These studies revealed major differences in disclosure among the participating countries and highlighted the greater level of disclosure by U.S. dealer banks. In addition, a representative of the Federal Reserve chaired an international working group of the Euro-currency Standing Committee that recommended in 1994 improvements to disclosure by financial intermediaries of the credit and market risks of their trading activities. The Federal Reserve and the other federal banking agencies also developed improvements in derivatives disclosure standards for regulatory reports that are similar to disclosure requirements issued at the same time by FASB in Statement No. 119, "Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments." We share several objectives with the FASB for improving financial reporting. For example, we both support the fundamental objectives of promoting clear and understandable financial reports that increase the transparency of companies' activities. We also share the view that accounting and disclosure standards which faithfully represent financial condition and performance can improve investor and counterparty decisions, thus improving market discipline on banking organizations and other companies. Further, we also agree that current accounting and disclosure standards for derivatives -- as well as for other financial instruments -- should be improved. We recognize the difficult task that FASB has in developing a standard that is acceptable to its many constituents. In this regard, we understand that FASB has considered and rejected a number of approaches to hedge accounting for derivatives because particular problems were identified with each approach. We also believe that the approach of reporting all financial instruments at fair value in the primary set of financial instruments, while having some theoretical appeal at least for some types of firms, is not an appropriate solution in the near term. In this regard, fair value estimation techniques are not yet sufficiently robust for exclusive reliance in financial statements. For example, difficult valuation issues arise for highly illiquid instruments for which fair value is based on models rather than observed prices, core deposits with varying durations, and the liabilities of a firm whose credit quality has weakened. Furthermore, fair value estimates can be highly subjective, and little guidance is available for measuring fair values in the financial statements. Another difficult issue relates to whether fair value is the most relevant measurement for commercial banks and other firms that are in the business of holding illiquid loans and other assets for the long term. The success or failure of such a strategy is not measured by evaluating such loans on the basis of a price that indicates value in the context of immediate delivery. In this regard, an appropriate value for many bank loans and off-balance-sheet commitments -- the one that reflect the nature of a bank's business -- is the original acquisition price adjusted for the expectation of performance at maturity. Given the many difficulties of FASB's task, it is not surprising that their proposal raises a number of complex issues. For example, the proposal is likely to lead to increased volatility in income and stockholders equity by companies that manage risk with derivatives. This volatility could be artificial due to the piecemeal approach of marking certain risk positions to fair value, but not all positions contributing to the risk. As a result, there could be accounting volatility that bears little relation to an institution's overall risk position. Supervisors and analysts will have to strip out the artificially created volatility to assess the true performance of the firm. On the other hand, companies that do not manage their risks, or manage their risks solely through cash instruments that are not covered by the standard, would not reflect similar volatility. A simple example might illustrate this concern. Assume a company's activities consist solely of lending long term at fixed rates and funding these loans with variable-rate deposits. I think we can all agree that this company has a significant exposure to interest rate risk. If the company does not manage its risk with derivatives, it would not be affected by the derivatives accounting proposal and would not report any volatility from fair value changes in its financial statements. If, however, the company has a strategy to use derivatives to reduce its interest rate risk and move it closer to a match-funded position, the company may report greater volatility in income and stockholders' equity -- a result not consistent with its reduced risk exposure. For example, if the company specified under the framework set forth in the FASB proposal that the derivatives are "cash flow" hedges of variable rate liabilities, the company would have volatility in equity or earnings based on the specifically linked effectiveness tests set forth by the proposal. Thus, the firm in using derivatives reduces its economic volatility, yet increases its accounting volatility. More important, by taking a transaction level approach to hedging, the proposal would not describe well the efforts of more sophisticated market participants to hedge their risks on a comprehensive, portfolio basis. Thus, these firms would effectively be required to keep different sets of books, and their financial reporting may not be consistent with the derivatives' intended use. This leads me to conclude that the proposal could discourage or constrain prudent risk management practices that rely on derivatives. Furthermore, it may not improve transparency of financial information. The proposal also introduces into the financial statements an untested method for reporting loans, deposits, and other assets and liabilities being hedged. These assets and liabilities would be valued at a "hybrid" historical cost and fair value amount on the balance sheet when they are hedged with derivatives that are designated as fair value hedges. For example, generally, the historical cost values of these assets and liabilities would be adjusted for changes in fair value related to the risk being hedged. However, certain other changes in fair value would not be recognized (such as those that arise from other risks, that are the results of an ineffective hedge, or that do not offset a gain or loss on the hedging instrument). These hybrid amounts could differ significantly from -- and potentially exceed -- fair values. They may also be difficult to verify by auditors and examiners, thus reducing the reliability of amounts reported in the financial statements. The proposed approach is complex, which may increase related developmental systems costs. In this regard, the proposal may cause significant systems changes for institutions that hedge with derivatives. At the same time institutions are making these systems changes, they need to upgrade their systems to address Year 2000 issues. The cost of systems changes arising from the derivatives proposal should be evaluated along with other costs and benefits arising from the proposal. This is particularly important since the derivatives proposal is intended by the FASB to be an interim treatment, and its long-term goal is to measure all financial instruments at fair value. Indeed, the FASB already has under way a project that is evaluating issues related to that goal.
1997-10-05T00:00:00	Mr. Greenspan considers some of the effects of technological change (Central Bank Articles and Speeches, 5 Oct 97)	Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Annual Convention of the American Bankers Association in Boston, on 5/10/97.	Mr. Greenspan considers some of the effects of technological change Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Annual Convention of the American Bankers Association in Boston, on 5/10/97. It is always with mixed feelings of pleasure and trepidation that I accept an invitation to speak at the American Bankers Association annual convention. I still have a disconcerted remembrance of my acceptance of your first invitation, which had been scheduled for October 20, 1987. That speech had to be scratched at the last minute as the result of a certain adversity in stock price adjustments the day before. Experience suggests, however, that history does not repeat with a fixed periodicity and, besides, I have crossed my fingers. The theme of your convention this year is timely. It is exactly when rapid innovation and institutional and technological change are taking place that market participants should take time to contemplate the opportunities and the risks, what to retain and what to change. Only then can the banking industry create the most value-added for customers, employees, and society, and as a consequence, for shareholders. As in recent years, the future role of banks and other providers of financial services will surely be significantly affected by the same basic forces that have shaped the real and financial economy world-wide: relentless technological change. This morning, I would like to describe some of the effects of technological change in both the financial and nonfinancial sectors and discuss a few of their more important implications. I will begin with the real economy. Technological Change and the Real Economy The most important single characteristic of the changes in U.S. technology in recent years is the ever expanding conceptualization of our Gross Domestic Product. We are witnessing the substitution of ideas for physical matter in the creation of economic value -- a shift from hardware to software, as it were. The roots of increasing conceptualization of output lie deep in human history, but the pace of such substitution probably picked up in the early stages of the industrial revolution, when science and machines created new leverage for human energy and ideas. Nonetheless, even as recently as the middle of this century, the symbols of American economic strength were our outputs of such physical products as steel, motor vehicles, and heavy machinery -- items for which sizable proportions of production costs reflected the exploitation of raw materials and the sheer manual labor required to manipulate them. However, today's views of economic leadership focus increasingly on downsized, smaller, less palpable evidence of weight and bulk, requiring more technologically sophisticated labor input. Examples of this trend permeate our daily lives. Radios used to be activated by large vacuum tubes; today we have elegantly designed pocked-sized transistors to perform the same function -- but with the higher quality of sound and greater reliability that consumers now expect. Thin fiber optic cable has replaced huge tonnages of copper wire. Owing to advances in metallurgy, engineering, and architectural design, we now can construct buildings that enclose as much or more space with fewer materials. A number of commentators, particularly Professor Paul David of Stanford University, have suggested that, despite the benefits we have seen this decade, it may be that the truly significant increases in living standards resulting from the introduction of computers and communications equipment still lie ahead. If true, this would not be unusual. Past innovations, such as the introduction of the dynamo or the invention of the gasoline-powered motor, required considerable infrastructure investment before their full potential could be realized. Electricity, when it substituted for steam power late last century, was initially applied to production processes suited to steam. Gravity was used to move goods vertically in the steam environment, and that could not immediately change with the advent of electric power. It was only when horizontal factories, newly designed for optimal use of electric power, began to dominate our industrial system many years after electricity's initial introduction, that national productivity clearly accelerated. Similarly, it was only when modern highways and gasoline service stations became extensive that the lower cost of motor vehicle transportation became evident. Technological Change and the Financial Economy It is surely not news to a group of bankers that the same forces that have been reshaping the real economy have also been transforming the financial services industry. Once again, perhaps the most profound development has been the rapid growth of computer and telecommunications technology. The advent of such technology has lowered the costs, reduced the risks, and broadened the scope of financial services, making it increasingly possible for borrowers and lenders to transact directly, and for a wide variety of financial products to be tailored for very specific purposes. As a result, competitive pressures in the financial services industry are probably greater than ever before. As is true in the real economy, it is difficult to overestimate the importance of education and ongoing training to the advancement of technology and product innovation in the financial sector. I doubt that I need to tell any of you about the importance of education and training for employees. But the same is almost surely true for your customers. Surveys repeatedly indicate that users of electronic banking products are typically very well educated. For example, data from the Federal Reserve Board's Survey of Consumer Finances suggest that a higher level of education significantly increases the chances that a household consumer will use an electronic banking product. Indeed, this survey indicates that, in late 1995, the median user of an electronic source of information for savings or borrowing decisions had a college degree -- a level of education currently achieved by less than one-third of American households. Technological innovation and more sophisticated users have accelerated the second major trend -- financial globalization -- which has been reshaping our financial system, not to mention the real economy, for at least three decades. Both developments have expanded cross-border asset holding, trading, and credit flows and, in response, both securities firms and U.S. and foreign banks have increased their cross-border operations. Once again, a critical result has been greatly increased competition both at home and abroad. A third development reshaping financial markets -- deregulation -- has been as much a reaction to technological change and globalization as an independent factor. Moreover, the continuing evolution of markets suggests that it will be literally impossible to maintain some of the remaining rules and regulations established for previous economic environments. While the ultimate public policy goals of economic growth and stability will remain unchanged, market forces will continue to make it impossible to sustain outdated restrictions, as we have recently seen with respect to interstate banking and branching. In such an environment, I share your frustration with the pace of legislative reform and revision to statutorily mandated regulations. Nonetheless, we should not lose sight of the remarkable degree of re-codification of law and regulation to make banking rules more consistent with market realities that has occurred in recent years. Deposit and other interest rate ceilings have been eliminated, geographical restrictions have been virtually removed, many banking organizations can do a fairly broadly based securities underwriting and dealing business, many can do insurance sales, and those with the resources and skill are authorized to virtually match foreign bank competition abroad. Moreover, it seems clear that there is recognition by the Congress that the basic financial framework has to be adjusted further. The process, as you know, is not easy when the results of regulatory relief create both a new competitive landscape and new supervisory and stability challenges. Change will, I believe, ultimately occur because the pressures unleashed by technology, globalization, and deregulation have inexorably eroded the traditional institutional differences among financial firms. Examples abound. Securities firms have for some time offered checking-like accounts linked to mutual funds, and their affiliates routinely extend significant credit directly to business. On the bank side, the economics of a typical bank loan syndication do not differ essentially from the economics of a best-efforts securities underwriting. Indeed, investment banks are themselves becoming increasingly important in the syndicated loan market. With regard to derivatives instruments, the expertise required to manage prudently the writing of over-the-counter derivatives, a business dominated by banks, is similar to that required for using exchange-traded futures and options, instruments used extensively by both commercial and investment banks. The writing of a put option by a bank is economically indistinguishable from the issuance of an insurance policy. The list could go on. It is sufficient to say that a strong case can be made that the evolution of financial technology alone has changed forever our ability to place commercial banking, investment banking, insurance underwriting, and insurance sales into neat separate boxes. Nonetheless, not all financial institutions would prosper as, nor desire to be, financial supermarkets. Many specialized providers of financial services are successful today and will be so in the future because of their advantages in specific areas. Moreover, especially at commercial banks, the demand for traditional services by smaller businesses and by households is likely to continue for some time. And the information revolution, while it has deprived banks of some of the traditional lending business with their best customers, has also benefitted banks by making it less costly for them to assess the credit and other risks of customers they previously would have shunned. Thus, it seems most likely that banks of all types will continue to engage in a substantial amount of traditional banking, delivered, of course, by ever improving technology. Community banks, in particular, are likely to provide loans and payments services via traditional on-balance sheet banking. Indeed, smaller banks have repeatedly demonstrated their ability to survive and prosper in the face of major technological and structural change by providing traditional banking services to their customers. The evidence is clear that well-managed smaller banks can and will exist side by side with larger banks, often maintaining or increasing local market share. Technological change has facilitated this process by providing smaller banks with low-cost access to new products and services. In short, the record shows that well-managed smaller banks have nothing to fear from technology, globalization, or deregulation. For all size entities, however, technological change is blurring not only traditional distinctions between the banking, securities, and insurance business, but is also having a profound effect on historical separations between financial and nonfinancial businesses. Most of us are aware of software companies interested in the financial services business, but some financial firms, leveraging off their own internal skills, are also seeking to produce software for third parties. Shipping companies' tracking software lends itself to payment services. Manufacturers have financed their customers' purchases for a long time, but now increasingly are using the resultant financial skills to finance noncustomers. Moreover, many nonbank financial institutions are now profitably engaged in nonfinancial activities. Current facts and expected future trends, in short, are creating market pressures to permit the common ownership of financial and nonfinancial firms. In my judgement, it is quite likely that in future years it will be close to impossible to distinguish where one type of activity ends and another begins. Nonetheless, it seems wise to move with caution in addressing the removal of the current legal barriers between commerce and banking, since the unrestricted association of banking and commerce would be a profound and surely irreversible structural change in the American economy. Were we fully confident of how emerging technologies would affect the evolution of our economic and financial structure, we could presumably develop today the regulations which would foster that evolution. But we are not, and history suggests we cannot, be confident of how our real and financial economies will evolve. If we act too quickly, we run the risk of locking in a set of inappropriate rules that could adversely alter the development of market structures. Our ability to foresee accurately the future implications of technologies and market developments in banking, as in other industries, has not been particularly impressive. As Professor Nathan Rosenberg of Stanford University has pointed out, ". . . mistaken forecasts of future structure litter our financial landscape." Indeed, Professor Rosenberg suggests that even after an innovation's technical feasibility has been clearly established, its ultimate effect on society is often highly unpredictable. He notes at least two sources of this uncertainty. First, the range of applications for a new technology may not be immediately apparent. For instance, Alexander Graham Bell initially viewed the telephone as solely a business instrument -- merely an enhancement of the telegraph -- for use in transmitting very specific messages, such as the terms of a contract. Indeed, he offered to sell his telephone patent to Western Union for only $100,000, but was turned down. Similarly, Marconi initially overlooked the radio's value as a public broadcast medium, instead believing its principal application would be in the transmission of point-to-point messages, such as ship-to-ship, where communication by wire was infeasible. A second source of technological uncertainty reflects the possibility that an innovation's full potential may be realized only after extensive improvements, or after complementary innovations in other fields of science. According to Charles Townes, a Nobel Prize winner for his work on the laser, the attorneys for Bell Labs initially refused, in the late 1960s, to patent the laser because they believed it had no applications in the field of telecommunications. Only in the 1980s, after extensive improvements in fiber optics technology, did the laser's importance for telecommunications become apparent. It's not hard to find examples of such uncertainties within the financial services industry. The evolution of the over-the-counter derivatives market over the past decade has been nothing less than spectacular. But as the theoretical underpinnings of financial arbitrage were being published in the academic journals in the late 1950s, few observers could have predicted how the scholars' insights would eventually revolutionize global financial markets. Not only were additional theoretical and empirical research necessary, but, in addition, several generations of advances in computer and communications technologies were necessary to make these concepts computationally practicable. All these examples, and more, suggest, that if we dramatically change the rules now about banking and commerce, with what is great uncertainty about future synergies between finance and nonfinance, we may well end up doing more harm than good. And, as with all rule changes by government, we are likely to find it impossible to correct our errors promptly, if at all. Modifications of such a fundamental structural rule as the separation of banking and commerce accordingly should proceed at a deliberate pace in order to test the response of markets and technological innovations to the altered rules in the years ahead. The need for caution and humility with respect to our ability to predict the future is highly relevant for how banking supervision should evolve. As I proposed to this audience last year, regulators are beginning to understand that the supervision of a financial institution is, of necessity, a continually evolving process reflecting the continually changing financial landscape. Increasingly, supervisory techniques and requirements try to harness both the new technologies and market incentives to improve oversight while reducing regulatory burden, burdens that are becoming progressively obsolescent and counterproductive. Concerns about setting a potentially inappropriate regulatory standard were an important factor in the decision by the banking agencies several years ago not to incorporate interest rate risk and asset concentration risk into the formal risk-based capital standards. In the end, we became convinced that the technologies for measuring and managing interest rate risk and concentration risk were evolving so rapidly that any regulatory standard would quickly become outmoded or, worse, inhibit private market innovations. Largely for these reasons, ultimately we chose to address the relationship between these risks and capital adequacy through the supervisory process rather than through the writing of regulations. Conclusion In conclusion, it is clear that both the real and the financial economies have been, and will continue to be, changed dramatically by the forces of technological progress. Banks will be under constant challenge to harness these forces to meet the ever-shifting competition. In such an environment, many existing rules and regulations will, if not modified, increasingly bind those banks seeking to respond, let alone innovate. Thus, there is a profound need for legislators and banking supervisors also to adapt to the changing realities. But do keep in mind that the government has an obligation to limit systemic risk exposure, and centuries of experience teach us the critical role that financial stability plays in the stability of the real economy. Bankers also have an obligation to their shareholders and creditors to measure and manage risk appropriately. In short, the regulators and the industry both want the same things -- financial innovation, creative change, responsible risk-taking, and growth. The market forces at work will get us there, perhaps not as rapidly as some banks may desire, but get there we will.	---[PAGE_BREAK]--- # Mr. Greenspan considers some of the effects of technological change Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Annual Convention of the American Bankers Association in Boston, on $5 / 10 / 97$. It is always with mixed feelings of pleasure and trepidation that I accept an invitation to speak at the American Bankers Association annual convention. I still have a disconcerted remembrance of my acceptance of your first invitation, which had been scheduled for October 20, 1987. That speech had to be scratched at the last minute as the result of a certain adversity in stock price adjustments the day before. Experience suggests, however, that history does not repeat with a fixed periodicity and, besides, I have crossed my fingers. The theme of your convention this year is timely. It is exactly when rapid innovation and institutional and technological change are taking place that market participants should take time to contemplate the opportunities and the risks, what to retain and what to change. Only then can the banking industry create the most value-added for customers, employees, and society, and as a consequence, for shareholders. As in recent years, the future role of banks and other providers of financial services will surely be significantly affected by the same basic forces that have shaped the real and financial economy world-wide: relentless technological change. This morning, I would like to describe some of the effects of technological change in both the financial and nonfinancial sectors and discuss a few of their more important implications. I will begin with the real economy. ## Technological Change and the Real Economy The most important single characteristic of the changes in U.S. technology in recent years is the ever expanding conceptualization of our Gross Domestic Product. We are witnessing the substitution of ideas for physical matter in the creation of economic value -- a shift from hardware to software, as it were. The roots of increasing conceptualization of output lie deep in human history, but the pace of such substitution probably picked up in the early stages of the industrial revolution, when science and machines created new leverage for human energy and ideas. Nonetheless, even as recently as the middle of this century, the symbols of American economic strength were our outputs of such physical products as steel, motor vehicles, and heavy machinery -- items for which sizable proportions of production costs reflected the exploitation of raw materials and the sheer manual labor required to manipulate them. However, today's views of economic leadership focus increasingly on downsized, smaller, less palpable evidence of weight and bulk, requiring more technologically sophisticated labor input. Examples of this trend permeate our daily lives. Radios used to be activated by large vacuum tubes; today we have elegantly designed pocked-sized transistors to perform the same function -- but with the higher quality of sound and greater reliability that consumers now expect. Thin fiber optic cable has replaced huge tonnages of copper wire. Owing to advances in metallurgy, engineering, and architectural design, we now can construct buildings that enclose as much or more space with fewer materials. A number of commentators, particularly Professor Paul David of Stanford University, have suggested that, despite the benefits we have seen this decade, it may be that the truly significant increases in living standards resulting from the introduction of computers and ---[PAGE_BREAK]--- communications equipment still lie ahead. If true, this would not be unusual. Past innovations, such as the introduction of the dynamo or the invention of the gasoline-powered motor, required considerable infrastructure investment before their full potential could be realized. Electricity, when it substituted for steam power late last century, was initially applied to production processes suited to steam. Gravity was used to move goods vertically in the steam environment, and that could not immediately change with the advent of electric power. It was only when horizontal factories, newly designed for optimal use of electric power, began to dominate our industrial system many years after electricity's initial introduction, that national productivity clearly accelerated. Similarly, it was only when modern highways and gasoline service stations became extensive that the lower cost of motor vehicle transportation became evident. # Technological Change and the Financial Economy It is surely not news to a group of bankers that the same forces that have been reshaping the real economy have also been transforming the financial services industry. Once again, perhaps the most profound development has been the rapid growth of computer and telecommunications technology. The advent of such technology has lowered the costs, reduced the risks, and broadened the scope of financial services, making it increasingly possible for borrowers and lenders to transact directly, and for a wide variety of financial products to be tailored for very specific purposes. As a result, competitive pressures in the financial services industry are probably greater than ever before. As is true in the real economy, it is difficult to overestimate the importance of education and ongoing training to the advancement of technology and product innovation in the financial sector. I doubt that I need to tell any of you about the importance of education and training for employees. But the same is almost surely true for your customers. Surveys repeatedly indicate that users of electronic banking products are typically very well educated. For example, data from the Federal Reserve Board's Survey of Consumer Finances suggest that a higher level of education significantly increases the chances that a household consumer will use an electronic banking product. Indeed, this survey indicates that, in late 1995, the median user of an electronic source of information for savings or borrowing decisions had a college degree -- a level of education currently achieved by less than one-third of American households. Technological innovation and more sophisticated users have accelerated the second major trend -- financial globalization -- which has been reshaping our financial system, not to mention the real economy, for at least three decades. Both developments have expanded cross-border asset holding, trading, and credit flows and, in response, both securities firms and U.S. and foreign banks have increased their cross-border operations. Once again, a critical result has been greatly increased competition both at home and abroad. A third development reshaping financial markets -- deregulation -- has been as much a reaction to technological change and globalization as an independent factor. Moreover, the continuing evolution of markets suggests that it will be literally impossible to maintain some of the remaining rules and regulations established for previous economic environments. While the ultimate public policy goals of economic growth and stability will remain unchanged, market forces will continue to make it impossible to sustain outdated restrictions, as we have recently seen with respect to interstate banking and branching. ---[PAGE_BREAK]--- In such an environment, I share your frustration with the pace of legislative reform and revision to statutorily mandated regulations. Nonetheless, we should not lose sight of the remarkable degree of re-codification of law and regulation to make banking rules more consistent with market realities that has occurred in recent years. Deposit and other interest rate ceilings have been eliminated, geographical restrictions have been virtually removed, many banking organizations can do a fairly broadly based securities underwriting and dealing business, many can do insurance sales, and those with the resources and skill are authorized to virtually match foreign bank competition abroad. Moreover, it seems clear that there is recognition by the Congress that the basic financial framework has to be adjusted further. The process, as you know, is not easy when the results of regulatory relief create both a new competitive landscape and new supervisory and stability challenges. Change will, I believe, ultimately occur because the pressures unleashed by technology, globalization, and deregulation have inexorably eroded the traditional institutional differences among financial firms. Examples abound. Securities firms have for some time offered checking-like accounts linked to mutual funds, and their affiliates routinely extend significant credit directly to business. On the bank side, the economics of a typical bank loan syndication do not differ essentially from the economics of a best-efforts securities underwriting. Indeed, investment banks are themselves becoming increasingly important in the syndicated loan market. With regard to derivatives instruments, the expertise required to manage prudently the writing of over-the-counter derivatives, a business dominated by banks, is similar to that required for using exchange-traded futures and options, instruments used extensively by both commercial and investment banks. The writing of a put option by a bank is economically indistinguishable from the issuance of an insurance policy. The list could go on. It is sufficient to say that a strong case can be made that the evolution of financial technology alone has changed forever our ability to place commercial banking, investment banking, insurance underwriting, and insurance sales into neat separate boxes. Nonetheless, not all financial institutions would prosper as, nor desire to be, financial supermarkets. Many specialized providers of financial services are successful today and will be so in the future because of their advantages in specific areas. Moreover, especially at commercial banks, the demand for traditional services by smaller businesses and by households is likely to continue for some time. And the information revolution, while it has deprived banks of some of the traditional lending business with their best customers, has also benefitted banks by making it less costly for them to assess the credit and other risks of customers they previously would have shunned. Thus, it seems most likely that banks of all types will continue to engage in a substantial amount of traditional banking, delivered, of course, by ever improving technology. Community banks, in particular, are likely to provide loans and payments services via traditional on-balance sheet banking. Indeed, smaller banks have repeatedly demonstrated their ability to survive and prosper in the face of major technological and structural change by providing traditional banking services to their customers. The evidence is clear that well-managed smaller banks can and will exist side by side with larger banks, often maintaining or increasing local market share. Technological change has facilitated this process by providing smaller banks with low-cost access to new products and services. In short, the record shows that well-managed smaller banks have nothing to fear from technology, globalization, or deregulation. For all size entities, however, technological change is blurring not only traditional distinctions between the banking, securities, and insurance business, but is also having a ---[PAGE_BREAK]--- profound effect on historical separations between financial and nonfinancial businesses. Most of us are aware of software companies interested in the financial services business, but some financial firms, leveraging off their own internal skills, are also seeking to produce software for third parties. Shipping companies' tracking software lends itself to payment services. Manufacturers have financed their customers' purchases for a long time, but now increasingly are using the resultant financial skills to finance noncustomers. Moreover, many nonbank financial institutions are now profitably engaged in nonfinancial activities. Current facts and expected future trends, in short, are creating market pressures to permit the common ownership of financial and nonfinancial firms. In my judgement, it is quite likely that in future years it will be close to impossible to distinguish where one type of activity ends and another begins. Nonetheless, it seems wise to move with caution in addressing the removal of the current legal barriers between commerce and banking, since the unrestricted association of banking and commerce would be a profound and surely irreversible structural change in the American economy. Were we fully confident of how emerging technologies would affect the evolution of our economic and financial structure, we could presumably develop today the regulations which would foster that evolution. But we are not, and history suggests we cannot, be confident of how our real and financial economies will evolve. If we act too quickly, we run the risk of locking in a set of inappropriate rules that could adversely alter the development of market structures. Our ability to foresee accurately the future implications of technologies and market developments in banking, as in other industries, has not been particularly impressive. As Professor Nathan Rosenberg of Stanford University has pointed out, ". . . mistaken forecasts of future structure litter our financial landscape." Indeed, Professor Rosenberg suggests that even after an innovation's technical feasibility has been clearly established, its ultimate effect on society is often highly unpredictable. He notes at least two sources of this uncertainty. First, the range of applications for a new technology may not be immediately apparent. For instance, Alexander Graham Bell initially viewed the telephone as solely a business instrument -- merely an enhancement of the telegraph -- for use in transmitting very specific messages, such as the terms of a contract. Indeed, he offered to sell his telephone patent to Western Union for only $\$ 100,000$, but was turned down. Similarly, Marconi initially overlooked the radio's value as a public broadcast medium, instead believing its principal application would be in the transmission of point-to-point messages, such as ship-to-ship, where communication by wire was infeasible. A second source of technological uncertainty reflects the possibility that an innovation's full potential may be realized only after extensive improvements, or after complementary innovations in other fields of science. According to Charles Townes, a Nobel Prize winner for his work on the laser, the attorneys for Bell Labs initially refused, in the late 1960s, to patent the laser because they believed it had no applications in the field of telecommunications. Only in the 1980s, after extensive improvements in fiber optics technology, did the laser's importance for telecommunications become apparent. It's not hard to find examples of such uncertainties within the financial services industry. The evolution of the over-the-counter derivatives market over the past decade has been nothing less than spectacular. But as the theoretical underpinnings of financial arbitrage were being published in the academic journals in the late 1950s, few observers could have predicted how the scholars' insights would eventually revolutionize global financial markets. Not only were additional theoretical and empirical research necessary, but, in addition, several generations ---[PAGE_BREAK]--- of advances in computer and communications technologies were necessary to make these concepts computationally practicable. All these examples, and more, suggest, that if we dramatically change the rules now about banking and commerce, with what is great uncertainty about future synergies between finance and nonfinance, we may well end up doing more harm than good. And, as with all rule changes by government, we are likely to find it impossible to correct our errors promptly, if at all. Modifications of such a fundamental structural rule as the separation of banking and commerce accordingly should proceed at a deliberate pace in order to test the response of markets and technological innovations to the altered rules in the years ahead. The need for caution and humility with respect to our ability to predict the future is highly relevant for how banking supervision should evolve. As I proposed to this audience last year, regulators are beginning to understand that the supervision of a financial institution is, of necessity, a continually evolving process reflecting the continually changing financial landscape. Increasingly, supervisory techniques and requirements try to harness both the new technologies and market incentives to improve oversight while reducing regulatory burden, burdens that are becoming progressively obsolescent and counterproductive. Concerns about setting a potentially inappropriate regulatory standard were an important factor in the decision by the banking agencies several years ago not to incorporate interest rate risk and asset concentration risk into the formal risk-based capital standards. In the end, we became convinced that the technologies for measuring and managing interest rate risk and concentration risk were evolving so rapidly that any regulatory standard would quickly become outmoded or, worse, inhibit private market innovations. Largely for these reasons, ultimately we chose to address the relationship between these risks and capital adequacy through the supervisory process rather than through the writing of regulations. # Conclusion In conclusion, it is clear that both the real and the financial economies have been, and will continue to be, changed dramatically by the forces of technological progress. Banks will be under constant challenge to harness these forces to meet the ever-shifting competition. In such an environment, many existing rules and regulations will, if not modified, increasingly bind those banks seeking to respond, let alone innovate. Thus, there is a profound need for legislators and banking supervisors also to adapt to the changing realities. But do keep in mind that the government has an obligation to limit systemic risk exposure, and centuries of experience teach us the critical role that financial stability plays in the stability of the real economy. Bankers also have an obligation to their shareholders and creditors to measure and manage risk appropriately. In short, the regulators and the industry both want the same things -- financial innovation, creative change, responsible risk-taking, and growth. The market forces at work will get us there, perhaps not as rapidly as some banks may desire, but get there we will.	Alan Greenspan	United States	https://www.bis.org/review/r971010b.pdf	Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Annual Convention of the American Bankers Association in Boston, on $5 / 10 / 97$. It is always with mixed feelings of pleasure and trepidation that I accept an invitation to speak at the American Bankers Association annual convention. I still have a disconcerted remembrance of my acceptance of your first invitation, which had been scheduled for October 20, 1987. That speech had to be scratched at the last minute as the result of a certain adversity in stock price adjustments the day before. Experience suggests, however, that history does not repeat with a fixed periodicity and, besides, I have crossed my fingers. The theme of your convention this year is timely. It is exactly when rapid innovation and institutional and technological change are taking place that market participants should take time to contemplate the opportunities and the risks, what to retain and what to change. Only then can the banking industry create the most value-added for customers, employees, and society, and as a consequence, for shareholders. As in recent years, the future role of banks and other providers of financial services will surely be significantly affected by the same basic forces that have shaped the real and financial economy world-wide: relentless technological change. This morning, I would like to describe some of the effects of technological change in both the financial and nonfinancial sectors and discuss a few of their more important implications. I will begin with the real economy. The most important single characteristic of the changes in U.S. technology in recent years is the ever expanding conceptualization of our Gross Domestic Product. We are witnessing the substitution of ideas for physical matter in the creation of economic value -- a shift from hardware to software, as it were. The roots of increasing conceptualization of output lie deep in human history, but the pace of such substitution probably picked up in the early stages of the industrial revolution, when science and machines created new leverage for human energy and ideas. Nonetheless, even as recently as the middle of this century, the symbols of American economic strength were our outputs of such physical products as steel, motor vehicles, and heavy machinery -- items for which sizable proportions of production costs reflected the exploitation of raw materials and the sheer manual labor required to manipulate them. However, today's views of economic leadership focus increasingly on downsized, smaller, less palpable evidence of weight and bulk, requiring more technologically sophisticated labor input. Examples of this trend permeate our daily lives. Radios used to be activated by large vacuum tubes; today we have elegantly designed pocked-sized transistors to perform the same function -- but with the higher quality of sound and greater reliability that consumers now expect. Thin fiber optic cable has replaced huge tonnages of copper wire. Owing to advances in metallurgy, engineering, and architectural design, we now can construct buildings that enclose as much or more space with fewer materials. A number of commentators, particularly Professor Paul David of Stanford University, have suggested that, despite the benefits we have seen this decade, it may be that the truly significant increases in living standards resulting from the introduction of computers and communications equipment still lie ahead. If true, this would not be unusual. Past innovations, such as the introduction of the dynamo or the invention of the gasoline-powered motor, required considerable infrastructure investment before their full potential could be realized. Electricity, when it substituted for steam power late last century, was initially applied to production processes suited to steam. Gravity was used to move goods vertically in the steam environment, and that could not immediately change with the advent of electric power. It was only when horizontal factories, newly designed for optimal use of electric power, began to dominate our industrial system many years after electricity's initial introduction, that national productivity clearly accelerated. Similarly, it was only when modern highways and gasoline service stations became extensive that the lower cost of motor vehicle transportation became evident. It is surely not news to a group of bankers that the same forces that have been reshaping the real economy have also been transforming the financial services industry. Once again, perhaps the most profound development has been the rapid growth of computer and telecommunications technology. The advent of such technology has lowered the costs, reduced the risks, and broadened the scope of financial services, making it increasingly possible for borrowers and lenders to transact directly, and for a wide variety of financial products to be tailored for very specific purposes. As a result, competitive pressures in the financial services industry are probably greater than ever before. As is true in the real economy, it is difficult to overestimate the importance of education and ongoing training to the advancement of technology and product innovation in the financial sector. I doubt that I need to tell any of you about the importance of education and training for employees. But the same is almost surely true for your customers. Surveys repeatedly indicate that users of electronic banking products are typically very well educated. For example, data from the Federal Reserve Board's Survey of Consumer Finances suggest that a higher level of education significantly increases the chances that a household consumer will use an electronic banking product. Indeed, this survey indicates that, in late 1995, the median user of an electronic source of information for savings or borrowing decisions had a college degree -- a level of education currently achieved by less than one-third of American households. Technological innovation and more sophisticated users have accelerated the second major trend -- financial globalization -- which has been reshaping our financial system, not to mention the real economy, for at least three decades. Both developments have expanded cross-border asset holding, trading, and credit flows and, in response, both securities firms and U.S. and foreign banks have increased their cross-border operations. Once again, a critical result has been greatly increased competition both at home and abroad. A third development reshaping financial markets -- deregulation -- has been as much a reaction to technological change and globalization as an independent factor. Moreover, the continuing evolution of markets suggests that it will be literally impossible to maintain some of the remaining rules and regulations established for previous economic environments. While the ultimate public policy goals of economic growth and stability will remain unchanged, market forces will continue to make it impossible to sustain outdated restrictions, as we have recently seen with respect to interstate banking and branching. In such an environment, I share your frustration with the pace of legislative reform and revision to statutorily mandated regulations. Nonetheless, we should not lose sight of the remarkable degree of re-codification of law and regulation to make banking rules more consistent with market realities that has occurred in recent years. Deposit and other interest rate ceilings have been eliminated, geographical restrictions have been virtually removed, many banking organizations can do a fairly broadly based securities underwriting and dealing business, many can do insurance sales, and those with the resources and skill are authorized to virtually match foreign bank competition abroad. Moreover, it seems clear that there is recognition by the Congress that the basic financial framework has to be adjusted further. The process, as you know, is not easy when the results of regulatory relief create both a new competitive landscape and new supervisory and stability challenges. Change will, I believe, ultimately occur because the pressures unleashed by technology, globalization, and deregulation have inexorably eroded the traditional institutional differences among financial firms. Examples abound. Securities firms have for some time offered checking-like accounts linked to mutual funds, and their affiliates routinely extend significant credit directly to business. On the bank side, the economics of a typical bank loan syndication do not differ essentially from the economics of a best-efforts securities underwriting. Indeed, investment banks are themselves becoming increasingly important in the syndicated loan market. With regard to derivatives instruments, the expertise required to manage prudently the writing of over-the-counter derivatives, a business dominated by banks, is similar to that required for using exchange-traded futures and options, instruments used extensively by both commercial and investment banks. The writing of a put option by a bank is economically indistinguishable from the issuance of an insurance policy. The list could go on. It is sufficient to say that a strong case can be made that the evolution of financial technology alone has changed forever our ability to place commercial banking, investment banking, insurance underwriting, and insurance sales into neat separate boxes. Nonetheless, not all financial institutions would prosper as, nor desire to be, financial supermarkets. Many specialized providers of financial services are successful today and will be so in the future because of their advantages in specific areas. Moreover, especially at commercial banks, the demand for traditional services by smaller businesses and by households is likely to continue for some time. And the information revolution, while it has deprived banks of some of the traditional lending business with their best customers, has also benefitted banks by making it less costly for them to assess the credit and other risks of customers they previously would have shunned. Thus, it seems most likely that banks of all types will continue to engage in a substantial amount of traditional banking, delivered, of course, by ever improving technology. Community banks, in particular, are likely to provide loans and payments services via traditional on-balance sheet banking. Indeed, smaller banks have repeatedly demonstrated their ability to survive and prosper in the face of major technological and structural change by providing traditional banking services to their customers. The evidence is clear that well-managed smaller banks can and will exist side by side with larger banks, often maintaining or increasing local market share. Technological change has facilitated this process by providing smaller banks with low-cost access to new products and services. In short, the record shows that well-managed smaller banks have nothing to fear from technology, globalization, or deregulation. For all size entities, however, technological change is blurring not only traditional distinctions between the banking, securities, and insurance business, but is also having a profound effect on historical separations between financial and nonfinancial businesses. Most of us are aware of software companies interested in the financial services business, but some financial firms, leveraging off their own internal skills, are also seeking to produce software for third parties. Shipping companies' tracking software lends itself to payment services. Manufacturers have financed their customers' purchases for a long time, but now increasingly are using the resultant financial skills to finance noncustomers. Moreover, many nonbank financial institutions are now profitably engaged in nonfinancial activities. Current facts and expected future trends, in short, are creating market pressures to permit the common ownership of financial and nonfinancial firms. In my judgement, it is quite likely that in future years it will be close to impossible to distinguish where one type of activity ends and another begins. Nonetheless, it seems wise to move with caution in addressing the removal of the current legal barriers between commerce and banking, since the unrestricted association of banking and commerce would be a profound and surely irreversible structural change in the American economy. Were we fully confident of how emerging technologies would affect the evolution of our economic and financial structure, we could presumably develop today the regulations which would foster that evolution. But we are not, and history suggests we cannot, be confident of how our real and financial economies will evolve. If we act too quickly, we run the risk of locking in a set of inappropriate rules that could adversely alter the development of market structures. Our ability to foresee accurately the future implications of technologies and market developments in banking, as in other industries, has not been particularly impressive. As Professor Nathan Rosenberg of Stanford University has pointed out, ". . . mistaken forecasts of future structure litter our financial landscape." Indeed, Professor Rosenberg suggests that even after an innovation's technical feasibility has been clearly established, its ultimate effect on society is often highly unpredictable. He notes at least two sources of this uncertainty. First, the range of applications for a new technology may not be immediately apparent. For instance, Alexander Graham Bell initially viewed the telephone as solely a business instrument -- merely an enhancement of the telegraph -- for use in transmitting very specific messages, such as the terms of a contract. Indeed, he offered to sell his telephone patent to Western Union for only $\$ 100,000$, but was turned down. Similarly, Marconi initially overlooked the radio's value as a public broadcast medium, instead believing its principal application would be in the transmission of point-to-point messages, such as ship-to-ship, where communication by wire was infeasible. A second source of technological uncertainty reflects the possibility that an innovation's full potential may be realized only after extensive improvements, or after complementary innovations in other fields of science. According to Charles Townes, a Nobel Prize winner for his work on the laser, the attorneys for Bell Labs initially refused, in the late 1960s, to patent the laser because they believed it had no applications in the field of telecommunications. Only in the 1980s, after extensive improvements in fiber optics technology, did the laser's importance for telecommunications become apparent. It's not hard to find examples of such uncertainties within the financial services industry. The evolution of the over-the-counter derivatives market over the past decade has been nothing less than spectacular. But as the theoretical underpinnings of financial arbitrage were being published in the academic journals in the late 1950s, few observers could have predicted how the scholars' insights would eventually revolutionize global financial markets. Not only were additional theoretical and empirical research necessary, but, in addition, several generations of advances in computer and communications technologies were necessary to make these concepts computationally practicable. All these examples, and more, suggest, that if we dramatically change the rules now about banking and commerce, with what is great uncertainty about future synergies between finance and nonfinance, we may well end up doing more harm than good. And, as with all rule changes by government, we are likely to find it impossible to correct our errors promptly, if at all. Modifications of such a fundamental structural rule as the separation of banking and commerce accordingly should proceed at a deliberate pace in order to test the response of markets and technological innovations to the altered rules in the years ahead. The need for caution and humility with respect to our ability to predict the future is highly relevant for how banking supervision should evolve. As I proposed to this audience last year, regulators are beginning to understand that the supervision of a financial institution is, of necessity, a continually evolving process reflecting the continually changing financial landscape. Increasingly, supervisory techniques and requirements try to harness both the new technologies and market incentives to improve oversight while reducing regulatory burden, burdens that are becoming progressively obsolescent and counterproductive. Concerns about setting a potentially inappropriate regulatory standard were an important factor in the decision by the banking agencies several years ago not to incorporate interest rate risk and asset concentration risk into the formal risk-based capital standards. In the end, we became convinced that the technologies for measuring and managing interest rate risk and concentration risk were evolving so rapidly that any regulatory standard would quickly become outmoded or, worse, inhibit private market innovations. Largely for these reasons, ultimately we chose to address the relationship between these risks and capital adequacy through the supervisory process rather than through the writing of regulations. In conclusion, it is clear that both the real and the financial economies have been, and will continue to be, changed dramatically by the forces of technological progress. Banks will be under constant challenge to harness these forces to meet the ever-shifting competition. In such an environment, many existing rules and regulations will, if not modified, increasingly bind those banks seeking to respond, let alone innovate. Thus, there is a profound need for legislators and banking supervisors also to adapt to the changing realities. But do keep in mind that the government has an obligation to limit systemic risk exposure, and centuries of experience teach us the critical role that financial stability plays in the stability of the real economy. Bankers also have an obligation to their shareholders and creditors to measure and manage risk appropriately. In short, the regulators and the industry both want the same things -- financial innovation, creative change, responsible risk-taking, and growth. The market forces at work will get us there, perhaps not as rapidly as some banks may desire, but get there we will.
1997-10-08T00:00:00	Mr. Greenspan's testimony before the US House of Representatives Committee on the Budget (Central Bank Articles and Speeches, 8 Oct 97)	Testimony by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, in Washington on 8/10/97.	Mr. Greenspan's testimony before the US House of Representatives Committee Testimony by the Chairman of the Board of Governors of the US Federal Reserve on the Budget System, Mr. Alan Greenspan, in Washington on 8/10/97. After decades of budgetary imprudence, there has been a growing recognition of our fiscal problems in recent years and an increased willingness of Presidents and Congresses to address them. The capping of discretionary programs and the first steps to deal with entitlement programs are encouraging, as, unquestionably, is the slower pace at which we are creating new entitlement programs. But it is important to place this improvement in the context of the decades-long deterioration in our fiscal position; we have stopped the erosion for now, but we have made only a downpayment on the longer-range problem confronting us. Moreover, much of the fiscal improvement of recent years is less the result of a return to the prudent attitudes and actions of earlier generations, than the emergence of benevolent forces largely external to the fiscal process. The end of the Cold War has yielded a substantial peace dividend, and the best economic performance in decades has augmented tax revenues far beyond expectations while restraining countercyclically sensitive outlays. The payout of the peace dividend is coming to an end. Defense outlays have fallen from 6.2 percent of GDP in 1985 to 3.4 percent this year. Further cuts may be difficult to achieve, for even if we are fortunate enough to enjoy a relatively tranquil world, spending will tend to be buoyed by the need to replace technologically obsolescent equipment, as well as by the usual political pressures. The long-term outlook for the American economy presents us with, perhaps, even greater uncertainties. There can be little doubt that the American economy in the last several years has performed far better than the history of business expansions would have led us to expect. Labor markets have tightened considerably without inflation emerging as it has in the past. Encouraged by these results, financial markets seem to have priced in an optimistic outlook, characterized by a significant reduction in risk and an increasingly benevolent inflation process. For example, in equity markets, continual upward revisions of longer-term corporate earnings expectations have driven price-earnings ratios to levels not often observed at this stage of an economic expansion. Contributing to the expected increases in profits is a perceived marked increase in the prospective rate of return on new business ventures. This is evidenced by the sharp increase in capital investment since early 1993, especially in hi-tech equipment, which has persisted and even accelerated in recent quarters. Underlying this apparent bulge in expected profitability and rates of return, as I suggested in my July Humphrey-Hawkins testimony, may be a maturing of major technologies in recent years. The synergies of lasers and fiber optics have spurred large increases in communications investments. The continued extraordinary spread of computer-related applications, as costs of manipulating data and other information fall, has also been a major factor in increased investment outlays. The combination of advancing telecommunications and computer technologies have induced large investment outlays to support the Internet and utilize it to realize efficiencies in purchasing, production, and marketing. This dramatic change in technology, as I pointed out in earlier testimony, has markedly shortened the lead times in bringing new production facilities on line to meet increased demand, and has accordingly significantly reduced longer-term bottlenecks and materials shortages, phenomena often leading to inflation in the past. Indeed, this faster response of facility capacity, coupled with dramatic declines in transportation costs owing to a downsizing of products, has led to speculation that we are operating with a new "paradigm," where price pressures need rarely ever arise because low-cost capacity, both here and abroad, can be brought on sufficiently rapidly when demand accelerates. Before we go too far in this direction, however, we need to recall that it was just three years ago that we were confronted with bottlenecks in the industrial sector. Though less extensive than in years past at similarly high levels of capacity utilization, they were nonetheless putting visible upward pressures on prices at early stages of the production chain. Further strides toward greater flexibility of facilities have occurred since 1994, but this is clearly an evolutionary, not a revolutionary, process. At least for the foreseeable future, it will still take time to bring many types of new facilities into the production process, and productive capacity will still impose limits on meeting large unexpected increases in demand in a short period. More relevant, by far, however, is that technology and management changes have had only a limited effect on the ability of labor supply to respond to changes in demand. To be sure, individual firms have acquired additional flexibility through increased use of outsourcing and temporary workers. In addition, smaller work teams may be able to adapt more readily to variations in order flows. While these techniques put the right workers at the right spots to reduce bottlenecks, they do not increase the aggregate supply of labor. That supply is sensitive to changes in demand, but to a far more limited extent than facilities. New plants can almost always be built. But labor capacity for an individual country is constrained by the size of the working-age population, which, except for immigration, is basically determined several decades in the past. Its lead time reflects biology, not technology. Of course, the demand for capital facilities and labor are not entirely independent. Within limits, labor and capital are substitutes, and slack in one market can offset tightness in another. For example, additional work shifts often can expand output without significant addition to facilities. Similarly, more labor-saving equipment can permit production to be increased with the same level of employment, an outcome that we would observe as increased labor productivity. As I will be discussing in a moment, we are seeing some favorable signs in this regard, but they are only suggestive, and the potential for increased productivity to enhance the effective supply of labor is limited. The fact is, that despite large additions to the capital stock in recent years, the supply of labor has kept pace with the demand for goods and services and the labor to produce them only by reducing the margin of slack in labor markets. Of the more than two million net new hires at an annual rate from early 1994 through the third quarter of this year, little more than half came from an expansion in the population aged 16 to 64 who wanted a job, and more than a third of those were net new immigrants. The remaining one million per year increase in employment was pulled from those who had been reported as unemployed (nearly 700 thousand annually) and those who wanted, but had not actively sought, a job (more than 300 thousand annually). The latter, of course, are not in the official unemployment count. The key point is that continuously digging ever deeper into the available working-age population is not a sustainable trajectory for job creation. The unemployment rate has a downside limit, if for no other reason than unemployment, in part, reflects voluntary periods of job search and other frictional unemployment, and includes people whose skills are not well adapted to work today and would be very costly to employ. In addition, there is a limit on how many of the millions who wanted a job but were not actively seeking one could be readily absorbed into jobs -- in particular, the large number whose availability is limited by their enrollment in school, and those who may lack the necessary skills or may face other barriers to taking jobs. The number of people saying they would like a job, but have not been engaged in active job search, declined dramatically in 1996. But, despite increasingly favorable labor markets, few more of these 5 million individuals have been added to payrolls in 1997. This group of potential workers, on balance, is at its lowest level relative to the working-age population since at least 1970. As a source of new workers we may have reached about as far as is feasible into this group of the population. Presumably, some of the early retirees, students, or homemakers who do not now profess to want to work could be lured to the job market. Rewards sufficient to make jobs attractive, however, could conceivably also engender upward pressures on labor costs that would trigger renewed price pressures, undermining the expansion. Thus, there would seem to be emerging constraints on potential labor input. If the recent 2 million plus annual pace of job creation were to continue, the pressures on wages and other costs of hiring large numbers of such individuals could escalate more rapidly. To be sure, job growth slowed significantly in August and September, but it did not slow enough to close, from the demand side alone, the gap of the demand for labor over the supply from increases in the working-age population. Thus, the performance of the labor markets this year suggests that the economy has been on an unsustainable track. That the marked rate of absorption of potential workers since 1994 has not induced a more dramatic increase in employee compensation per hour and price inflation has come as a major surprise to most analysts. The strengthened exchange value of the dollar, which has helped contain price increases, is certainly one factor in explaining business reluctance to grant wage increases. Another explanation I have offered in the past is that the acceleration in technology and capital investment, in part by engendering important changes in the types of facilities with which people work on a day-by-day basis, has also induced a discernible increase in fear of job skill obsolescence and, hence, an increasing willingness to seek job security in lieu of wage gains. Certainly, the dramatic rise in recent years of on-the-job training and a substantial increase in people returning to school -- especially those aged twenty-five to thirty-four, mainly at the college level -- suggests significant concerns about skills. But the force of insecurity may be fading. Public opinion polls, which recorded a marked increase in fear of job loss from 1991 to 1995, a period of tightening labor markets, now indicate a partial reversal of that uptrend. To be sure, there is still little evidence of wage acceleration. To believe, however, that wage pressures will not intensify as the group of people who are not working, but who would like to, rapidly diminishes, strains credibility. The law of supply and demand has not been repealed. If labor demand continues to outpace sustainable increases in supply, the question is surely when, not whether, labor costs will escalate more rapidly. Of course, a fall-off in the current pace of demand for goods and services could close the gap and avoid the emergence of inflationary pressures. So could a sharp improvement in productivity growth, which would reduce the pace of new hiring required to produce a given rate of growth of real output. Productivity growth in manufacturing, as best we can measure it, apparently did pick up some in the third quarter and the broader measures of productivity growth have exhibited a modest quickening this year. Certainly, the persistence, even acceleration, of commitments to invest in new facilities suggests that the actual profitability of recent past investments, and by extension increased productivity, has already been achieved to some degree rather than being merely prospective. However, to reduce the recent two million plus annual rate of job gains to the one million rate consistent with long-term population growth would require, all else equal, a full percentage point increase in the rate of productivity growth. While not inconceivable, such a rapid change is rare in the annals of business history, especially for a mature industrial society of our breadth and scope. Clearly, impressive new technologies have imparted a sense of change in which previous economic relationships are seen as being less reliable now. Improvements in productivity are possible if worker skills increase, but gains come slowly through experience, education, and on-the-job training. They are also possible as capital substitutes for labor, but that is limited by the state of current technology. Very significant advances in productivity require technological breakthroughs that alter fundamentally the efficiency with which we use our labor and capital resources. But at the cutting edge of technology, where America finds itself, major improvements cannot be produced on demand. New ideas that matter are hard won. Short of a marked slowing in the demand for goods and services and, hence, labor -- or a degree of acceleration of productivity growth that appears unlikely -- the imbalance between the growth in labor demand and the expansion of potential labor supply of recent years must eventually erode the current state of inflation quiescence and, with it, the solid growth of real activity. In this context, the economic outlook sketched out for the United States by both the Office of Management and Budget and the Congressional Budget Office is realistic, even in some sense conservative. But you should recognize the range of possible long-term outcomes, both significantly better or worse, has risen markedly in the last year. An acceleration of productivity growth, should it materialize, would put the economy on a higher trend growth path than they have projected. The development of inflationary pressures, on the other hand, would doubtless create an environment of slower growth in real output than that projected by OMB or CBO. A re-emergence of inflation is, without question, the greatest threat to sustaining what has been a balanced economic expansion virtually without parallel in recent decades. In this regard, we at the Federal Reserve recognize that how we handle monetary policy will be a significant factor influencing the path of economic growth and, hence, fiscal outcomes. Given the wider range of possible outcomes that we face for long-term economic growth, the corresponding ranges of possible budget outcomes over the next five to ten years also has widened appreciably. In addition to the uncertainties associated with economic outcomes, questions may be raised about other assumptions behind both projected receipts and outlays. With regard to the former, it is difficult to believe that our much higher-than-expected income tax receipts of late are unrelated to the huge increase in capital gains, which since 1995 have totaled the equivalent of one-third of national income. Aside from the question of whether stock prices will rise or fall, it clearly would be unrealistic to look for a continuation of stock market gains of anything like the magnitude of those recorded in the past couple of years. On the outlay side, the recently enacted budget agreement relies importantly on significant, but as-yet-unspecified, restraints on discretionary spending to be made in the years 2001, 2002, and thereafter. Supporters of each program expect the restraints to fall elsewhere. Inevitably, the eventual publication of the detail will expose deep political divisions, which could make the realization of the budget projections less likely. In addition, while the budget agreement included significant cuts in Medicare spending, past experience has shown us how difficult Medicare is to control, raising the possibility that savings will never be realized. More generally, I wonder whether there is enough funding slack to accommodate contingencies, or the inevitable new, but as yet unidentified, spending programs. Budget forecasts are understandably subject to fairly large errors. Seemingly small changes in receipts and outlays are magnified in the budget deficit. For example, during the 1990s, the average absolute error in the projections of February for receipts and outlays in the fiscal years starting the subsequent October has been greater than four percent. A four percent error in both outlays and receipts in opposite directions amounts to more than $125 billion annually. Indeed, the uncertainty of budget forecasts is no better illustrated than by an admittedly extreme case. During the last two and a half years the projection of the fiscal balance, excluding new initiatives, for the year 2002 has changed by about $250 billion. While all this fortunately has been in the direction of smaller deficits, the degree of uncertainty suggests that the error could just as easily be on the other side. With this high level of uncertainty in projecting budget totals and associated deficits, the Congress needs to evaluate the consequences to long-term economic growth of errors in fiscal policy. A base issue in such an evaluation is whether we are better off to be targeting a large deficit, balance, or a chronic surplus in our unified budget. There is nothing special about budget balance per se, except that it is far superior to deficits. I have always emphasized the value of a budgetary surplus in increasing national savings, especially when American private domestic savings is low, as it is today. Higher national savings lead in the long run to higher investment and living standards. They also foster low inflation. Low inflation itself may be responsible, in part, for higher productivity growth and larger gains in standards of living. If economic growth and rising living standards, fostered by investment and price stability, are our goal, fiscal policy in my judgment will need to be biased toward surpluses in the years immediately ahead. This is especially so given the inexorable demographic trends that threaten huge increases in outlays beyond 2010. We should view the recent budget agreement, even if receipts and outlays evolve as expected, as only an important downpayment on the larger steps we need to take to solve the harder problem -- putting our entitlement programs on a sound financial footing for the 21st century. Moreover, targeted surpluses could hopefully help to offset the inbuilt political bias in favor of budget deficits. I have been in too many budget meetings in the last three decades not to have learned that the ideal fiscal initiative from a political perspective is one that creates visible benefits for one group of constituents without a perceived cost to anybody else, a form of political single-entry bookkeeping. To be sure, in recent years we have been showing some real restraint in our approach to fiscal policy. Yet, despite terminating a number of programs, the ratio of federal nondefense, noninterest, spending to GDP still stands at nearly 14 percent, double what it was in the 1950s. This may be one reason why inflation premiums, embodied in long-term interest rates, still are significant. There is, thus, doubtless a lot of catching up to do. The current initiatives toward welfare, social security, and Medicare reform are clearly steps in the right direction, but far more is required. Let us not squander years of efforts to balance the budget and the benefits of ideal economic conditions by failing to address our long-term imbalances. A critical imbalance is the one faced by social security. Its fund's reported imbalance stems primarily from the fact that, until very recently, the payments into the social security trust accounts by the average employee, plus employer contributions and interest earned, were inadequate, at retirement, to fund the total of retirement benefits. This has started to change. Under the most recent revisions to the law, and presumably conservative economic and demographic assumptions, today's younger workers will be paying social security taxes over their working years that appear sufficient to fund their benefits during retirement. However, the huge liability for current retirees, as well as for much of the work force closer to retirement, leaves the system, as a whole, badly underfunded. The official unfunded liability for the Old Age, Survivors and Disability funds, which takes into account expected future tax payments and benefits out to the year 2070, has reached a staggering $3 trillion. This issue of funding underscores the critical elements in the forthcoming debate on social security reform, because it focusses on the core of any retirement system, private or public. Simply put, enough must be set aside over a lifetime of work to fund the excess of consumption over claims on production a retiree may enjoy. At the most rudimentary level, one could envision households saving by actually storing goods purchased during their working years for consumption during retirement. Even better, the resources that would have otherwise gone into the stored goods could be diverted to the production of new capital assets, which would, cumulatively, over a working lifetime, produce an even greater quantity of goods and services to be consumed in retirement. In the latter case, we would be getting more output per worker, our traditional measure of productivity, and a factor that is central in all calculations of long-term social security trust fund financing. Hence, the bottom line in all retirement programs is physical resource availability. The finance of any system is merely to facilitate the underlying system of allocating real resources that fund retirement consumption of goods and services. Unless social security savings are increased by higher taxes (with negative consequences for growth) or lowered benefits, domestic savings must be augmented by greater private saving or surpluses in the rest of the government budget to help ensure that there is enough savings to finance adequate productive capacity down the road to meet the consumption needs of both retirees and active workers. The basic premise of our current largely pay-as-you-go social security system is that future productivity growth will be sufficient to supply promised retirement benefits for current workers. However, even supposing some acceleration in long-term productivity growth from recent experience, at existing rates of domestic saving and capital investment this is becoming increasingly dubious. Accordingly, short of a far more general reform of the system, there are a number of initiatives, at a minimum, that should be addressed. As I argued at length in the Social Security Commission deliberations of 1983, with only marginal effect, some delaying of the age of eligibility for retirement benefits will become increasingly pressing. For example, adjusting the full-benefits retirement age to keep pace with increases in life expectancy in a way that would keep the ratio of retirement years to expected life span approximately constant would help to significantly narrow the funding gap. Such an initiative will become easier to implement as fewer and fewer of our older citizens retire from physically arduous work. Hopefully, other modifications to social security, such as improved cost of living indexing, will be instituted. There are a number of thoughtful reform initiatives that, through the process of privatization, could increase domestic saving rates. These are clearly worthy of intensive evaluation. Perhaps the strongest argument for privatization is that replacing the current underfunded system with a fully funded one could boost domestic saving. But, we must remember it is because privatization plans might increase savings that makes them potentially valuable, not their particular form of financing. As I have argued elsewhere, unless national savings is increased, shifting social security trust funds to private securities, while increasing government retirement system income, will lower retirement incomes in the private sector to an offsetting degree. This would not be an improvement to our overall retirement system. The types of changes that will be required to restore fiscal balance to our social security accounts, in the broader scheme of things, are significant but manageable. More important, most entail changes that are less unsettling if they are enacted soon, even if their effects are significantly delayed, rather than waiting five or ten years or longer for legislation. Minimizing the potential disruptions associated with the inevitable changes to social security is made all the more essential because of the pressing financial problems in the Medicare system, social security's companion program for retirees. Medicare as you are well aware is in an even more precarious position than social security. The financing of Medicare faces some of the same problems associated with demographics and productivity as social security but faces different, and currently greater, pressures owing to the behavior of medical costs and utilization rates. Reform of the Medicare system will require more immediate and potentially more dramatic changes than those necessary to reform social security. We owe it to those who will retire after the turn of the century to be given sufficient advance notice to make what alterations in retirement planning may be required. The longer we wait to make what are surely inevitable adjustments, the more difficult they will become. If we procrastinate too long, the adjustments could be truly wrenching. Our senior citizens, both current and future, deserve better.	---[PAGE_BREAK]--- # Mr. Greenspan's testimony before the US House of Representatives Committee on the Budget Testimony by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, in Washington on 8/10/97. After decades of budgetary imprudence, there has been a growing recognition of our fiscal problems in recent years and an increased willingness of Presidents and Congresses to address them. The capping of discretionary programs and the first steps to deal with entitlement programs are encouraging, as, unquestionably, is the slower pace at which we are creating new entitlement programs. But it is important to place this improvement in the context of the decades-long deterioration in our fiscal position; we have stopped the erosion for now, but we have made only a downpayment on the longer-range problem confronting us. Moreover, much of the fiscal improvement of recent years is less the result of a return to the prudent attitudes and actions of earlier generations, than the emergence of benevolent forces largely external to the fiscal process. The end of the Cold War has yielded a substantial peace dividend, and the best economic performance in decades has augmented tax revenues far beyond expectations while restraining countercyclically sensitive outlays. The payout of the peace dividend is coming to an end. Defense outlays have fallen from 6.2 percent of GDP in 1985 to 3.4 percent this year. Further cuts may be difficult to achieve, for even if we are fortunate enough to enjoy a relatively tranquil world, spending will tend to be buoyed by the need to replace technologically obsolescent equipment, as well as by the usual political pressures. The long-term outlook for the American economy presents us with, perhaps, even greater uncertainties. There can be little doubt that the American economy in the last several years has performed far better than the history of business expansions would have led us to expect. Labor markets have tightened considerably without inflation emerging as it has in the past. Encouraged by these results, financial markets seem to have priced in an optimistic outlook, characterized by a significant reduction in risk and an increasingly benevolent inflation process. For example, in equity markets, continual upward revisions of longer-term corporate earnings expectations have driven price-earnings ratios to levels not often observed at this stage of an economic expansion. Contributing to the expected increases in profits is a perceived marked increase in the prospective rate of return on new business ventures. This is evidenced by the sharp increase in capital investment since early 1993, especially in hi-tech equipment, which has persisted and even accelerated in recent quarters. Underlying this apparent bulge in expected profitability and rates of return, as I suggested in my July Humphrey-Hawkins testimony, may be a maturing of major technologies in recent years. The synergies of lasers and fiber optics have spurred large increases in communications investments. The continued extraordinary spread of computer-related applications, as costs of manipulating data and other information fall, has also been a major factor in increased investment outlays. The combination of advancing telecommunications and computer technologies have induced large investment outlays to support the Internet and utilize it to realize efficiencies in purchasing, production, and marketing. This dramatic change in technology, as I pointed out in earlier testimony, has markedly shortened the lead times in bringing new production facilities on line to meet increased ---[PAGE_BREAK]--- demand, and has accordingly significantly reduced longer-term bottlenecks and materials shortages, phenomena often leading to inflation in the past. Indeed, this faster response of facility capacity, coupled with dramatic declines in transportation costs owing to a downsizing of products, has led to speculation that we are operating with a new "paradigm," where price pressures need rarely ever arise because low-cost capacity, both here and abroad, can be brought on sufficiently rapidly when demand accelerates. Before we go too far in this direction, however, we need to recall that it was just three years ago that we were confronted with bottlenecks in the industrial sector. Though less extensive than in years past at similarly high levels of capacity utilization, they were nonetheless putting visible upward pressures on prices at early stages of the production chain. Further strides toward greater flexibility of facilities have occurred since 1994, but this is clearly an evolutionary, not a revolutionary, process. At least for the foreseeable future, it will still take time to bring many types of new facilities into the production process, and productive capacity will still impose limits on meeting large unexpected increases in demand in a short period. More relevant, by far, however, is that technology and management changes have had only a limited effect on the ability of labor supply to respond to changes in demand. To be sure, individual firms have acquired additional flexibility through increased use of outsourcing and temporary workers. In addition, smaller work teams may be able to adapt more readily to variations in order flows. While these techniques put the right workers at the right spots to reduce bottlenecks, they do not increase the aggregate supply of labor. That supply is sensitive to changes in demand, but to a far more limited extent than facilities. New plants can almost always be built. But labor capacity for an individual country is constrained by the size of the working-age population, which, except for immigration, is basically determined several decades in the past. Its lead time reflects biology, not technology. Of course, the demand for capital facilities and labor are not entirely independent. Within limits, labor and capital are substitutes, and slack in one market can offset tightness in another. For example, additional work shifts often can expand output without significant addition to facilities. Similarly, more labor-saving equipment can permit production to be increased with the same level of employment, an outcome that we would observe as increased labor productivity. As I will be discussing in a moment, we are seeing some favorable signs in this regard, but they are only suggestive, and the potential for increased productivity to enhance the effective supply of labor is limited. The fact is, that despite large additions to the capital stock in recent years, the supply of labor has kept pace with the demand for goods and services and the labor to produce them only by reducing the margin of slack in labor markets. Of the more than two million net new hires at an annual rate from early 1994 through the third quarter of this year, little more than half came from an expansion in the population aged 16 to 64 who wanted a job, and more than a third of those were net new immigrants. The remaining one million per year increase in employment was pulled from those who had been reported as unemployed (nearly 700 thousand annually) and those who wanted, but had not actively sought, a job (more than 300 thousand annually). The latter, of course, are not in the official unemployment count. The key point is that continuously digging ever deeper into the available working-age population is not a sustainable trajectory for job creation. The unemployment rate has a downside limit, if for no other reason than unemployment, in part, reflects voluntary periods of job search and other frictional unemployment, and includes people whose skills are not well adapted to work today and would be very costly to employ. ---[PAGE_BREAK]--- In addition, there is a limit on how many of the millions who wanted a job but were not actively seeking one could be readily absorbed into jobs -- in particular, the large number whose availability is limited by their enrollment in school, and those who may lack the necessary skills or may face other barriers to taking jobs. The number of people saying they would like a job, but have not been engaged in active job search, declined dramatically in 1996. But, despite increasingly favorable labor markets, few more of these 5 million individuals have been added to payrolls in 1997. This group of potential workers, on balance, is at its lowest level relative to the working-age population since at least 1970. As a source of new workers we may have reached about as far as is feasible into this group of the population. Presumably, some of the early retirees, students, or homemakers who do not now profess to want to work could be lured to the job market. Rewards sufficient to make jobs attractive, however, could conceivably also engender upward pressures on labor costs that would trigger renewed price pressures, undermining the expansion. Thus, there would seem to be emerging constraints on potential labor input. If the recent 2 million plus annual pace of job creation were to continue, the pressures on wages and other costs of hiring large numbers of such individuals could escalate more rapidly. To be sure, job growth slowed significantly in August and September, but it did not slow enough to close, from the demand side alone, the gap of the demand for labor over the supply from increases in the working-age population. Thus, the performance of the labor markets this year suggests that the economy has been on an unsustainable track. That the marked rate of absorption of potential workers since 1994 has not induced a more dramatic increase in employee compensation per hour and price inflation has come as a major surprise to most analysts. The strengthened exchange value of the dollar, which has helped contain price increases, is certainly one factor in explaining business reluctance to grant wage increases. Another explanation I have offered in the past is that the acceleration in technology and capital investment, in part by engendering important changes in the types of facilities with which people work on a day-by-day basis, has also induced a discernible increase in fear of job skill obsolescence and, hence, an increasing willingness to seek job security in lieu of wage gains. Certainly, the dramatic rise in recent years of on-the-job training and a substantial increase in people returning to school -- especially those aged twenty-five to thirty-four, mainly at the college level -- suggests significant concerns about skills. But the force of insecurity may be fading. Public opinion polls, which recorded a marked increase in fear of job loss from 1991 to 1995, a period of tightening labor markets, now indicate a partial reversal of that uptrend. To be sure, there is still little evidence of wage acceleration. To believe, however, that wage pressures will not intensify as the group of people who are not working, but who would like to, rapidly diminishes, strains credibility. The law of supply and demand has not been repealed. If labor demand continues to outpace sustainable increases in supply, the question is surely when, not whether, labor costs will escalate more rapidly. Of course, a fall-off in the current pace of demand for goods and services could close the gap and avoid the emergence of inflationary pressures. So could a sharp improvement in productivity growth, which would reduce the pace of new hiring required to produce a given rate of growth of real output. ---[PAGE_BREAK]--- Productivity growth in manufacturing, as best we can measure it, apparently did pick up some in the third quarter and the broader measures of productivity growth have exhibited a modest quickening this year. Certainly, the persistence, even acceleration, of commitments to invest in new facilities suggests that the actual profitability of recent past investments, and by extension increased productivity, has already been achieved to some degree rather than being merely prospective. However, to reduce the recent two million plus annual rate of job gains to the one million rate consistent with long-term population growth would require, all else equal, a full percentage point increase in the rate of productivity growth. While not inconceivable, such a rapid change is rare in the annals of business history, especially for a mature industrial society of our breadth and scope. Clearly, impressive new technologies have imparted a sense of change in which previous economic relationships are seen as being less reliable now. Improvements in productivity are possible if worker skills increase, but gains come slowly through experience, education, and on-the-job training. They are also possible as capital substitutes for labor, but that is limited by the state of current technology. Very significant advances in productivity require technological breakthroughs that alter fundamentally the efficiency with which we use our labor and capital resources. But at the cutting edge of technology, where America finds itself, major improvements cannot be produced on demand. New ideas that matter are hard won. Short of a marked slowing in the demand for goods and services and, hence, labor -- or a degree of acceleration of productivity growth that appears unlikely -- the imbalance between the growth in labor demand and the expansion of potential labor supply of recent years must eventually erode the current state of inflation quiescence and, with it, the solid growth of real activity. In this context, the economic outlook sketched out for the United States by both the Office of Management and Budget and the Congressional Budget Office is realistic, even in some sense conservative. But you should recognize the range of possible long-term outcomes, both significantly better or worse, has risen markedly in the last year. An acceleration of productivity growth, should it materialize, would put the economy on a higher trend growth path than they have projected. The development of inflationary pressures, on the other hand, would doubtless create an environment of slower growth in real output than that projected by OMB or CBO. A re-emergence of inflation is, without question, the greatest threat to sustaining what has been a balanced economic expansion virtually without parallel in recent decades. In this regard, we at the Federal Reserve recognize that how we handle monetary policy will be a significant factor influencing the path of economic growth and, hence, fiscal outcomes. Given the wider range of possible outcomes that we face for long-term economic growth, the corresponding ranges of possible budget outcomes over the next five to ten years also has widened appreciably. In addition to the uncertainties associated with economic outcomes, questions may be raised about other assumptions behind both projected receipts and outlays. With regard to the former, it is difficult to believe that our much higher-than-expected income tax receipts of late are unrelated to the huge increase in capital gains, which since 1995 have totaled the equivalent of one-third of national income. Aside from the question of whether stock prices will rise or fall, it clearly would be unrealistic to look for a continuation of stock market gains of anything like the magnitude of those recorded in the past couple of years. On the outlay side, the recently enacted budget agreement relies importantly on significant, but as-yet-unspecified, restraints on discretionary spending to be made in the years 2001, ---[PAGE_BREAK]--- 2002, and thereafter. Supporters of each program expect the restraints to fall elsewhere. Inevitably, the eventual publication of the detail will expose deep political divisions, which could make the realization of the budget projections less likely. In addition, while the budget agreement included significant cuts in Medicare spending, past experience has shown us how difficult Medicare is to control, raising the possibility that savings will never be realized. More generally, I wonder whether there is enough funding slack to accommodate contingencies, or the inevitable new, but as yet unidentified, spending programs. Budget forecasts are understandably subject to fairly large errors. Seemingly small changes in receipts and outlays are magnified in the budget deficit. For example, during the 1990s, the average absolute error in the projections of February for receipts and outlays in the fiscal years starting the subsequent October has been greater than four percent. A four percent error in both outlays and receipts in opposite directions amounts to more than $\$ 125$ billion annually. Indeed, the uncertainty of budget forecasts is no better illustrated than by an admittedly extreme case. During the last two and a half years the projection of the fiscal balance, excluding new initiatives, for the year 2002 has changed by about $\$ 250$ billion. While all this fortunately has been in the direction of smaller deficits, the degree of uncertainty suggests that the error could just as easily be on the other side. With this high level of uncertainty in projecting budget totals and associated deficits, the Congress needs to evaluate the consequences to long-term economic growth of errors in fiscal policy. A base issue in such an evaluation is whether we are better off to be targeting a large deficit, balance, or a chronic surplus in our unified budget. There is nothing special about budget balance per se, except that it is far superior to deficits. I have always emphasized the value of a budgetary surplus in increasing national savings, especially when American private domestic savings is low, as it is today. Higher national savings lead in the long run to higher investment and living standards. They also foster low inflation. Low inflation itself may be responsible, in part, for higher productivity growth and larger gains in standards of living. If economic growth and rising living standards, fostered by investment and price stability, are our goal, fiscal policy in my judgment will need to be biased toward surpluses in the years immediately ahead. This is especially so given the inexorable demographic trends that threaten huge increases in outlays beyond 2010. We should view the recent budget agreement, even if receipts and outlays evolve as expected, as only an important downpayment on the larger steps we need to take to solve the harder problem -- putting our entitlement programs on a sound financial footing for the 21 st century. Moreover, targeted surpluses could hopefully help to offset the inbuilt political bias in favor of budget deficits. I have been in too many budget meetings in the last three decades not to have learned that the ideal fiscal initiative from a political perspective is one that creates visible benefits for one group of constituents without a perceived cost to anybody else, a form of political single-entry bookkeeping. To be sure, in recent years we have been showing some real restraint in our approach to fiscal policy. Yet, despite terminating a number of programs, the ratio of federal nondefense, noninterest, spending to GDP still stands at nearly 14 percent, double what it was in the 1950s. This may be one reason why inflation premiums, embodied in long-term interest rates, still are significant. There is, thus, doubtless a lot of catching up to do. The current initiatives toward welfare, social security, and Medicare reform are clearly steps in the right direction, but far more is required. Let us not squander years of efforts to ---[PAGE_BREAK]--- balance the budget and the benefits of ideal economic conditions by failing to address our long-term imbalances. A critical imbalance is the one faced by social security. Its fund's reported imbalance stems primarily from the fact that, until very recently, the payments into the social security trust accounts by the average employee, plus employer contributions and interest earned, were inadequate, at retirement, to fund the total of retirement benefits. This has started to change. Under the most recent revisions to the law, and presumably conservative economic and demographic assumptions, today's younger workers will be paying social security taxes over their working years that appear sufficient to fund their benefits during retirement. However, the huge liability for current retirees, as well as for much of the work force closer to retirement, leaves the system, as a whole, badly underfunded. The official unfunded liability for the Old Age, Survivors and Disability funds, which takes into account expected future tax payments and benefits out to the year 2070, has reached a staggering $\$ 3$ trillion. This issue of funding underscores the critical elements in the forthcoming debate on social security reform, because it focusses on the core of any retirement system, private or public. Simply put, enough must be set aside over a lifetime of work to fund the excess of consumption over claims on production a retiree may enjoy. At the most rudimentary level, one could envision households saving by actually storing goods purchased during their working years for consumption during retirement. Even better, the resources that would have otherwise gone into the stored goods could be diverted to the production of new capital assets, which would, cumulatively, over a working lifetime, produce an even greater quantity of goods and services to be consumed in retirement. In the latter case, we would be getting more output per worker, our traditional measure of productivity, and a factor that is central in all calculations of long-term social security trust fund financing. Hence, the bottom line in all retirement programs is physical resource availability. The finance of any system is merely to facilitate the underlying system of allocating real resources that fund retirement consumption of goods and services. Unless social security savings are increased by higher taxes (with negative consequences for growth) or lowered benefits, domestic savings must be augmented by greater private saving or surpluses in the rest of the government budget to help ensure that there is enough savings to finance adequate productive capacity down the road to meet the consumption needs of both retirees and active workers. The basic premise of our current largely pay-as-you-go social security system is that future productivity growth will be sufficient to supply promised retirement benefits for current workers. However, even supposing some acceleration in long-term productivity growth from recent experience, at existing rates of domestic saving and capital investment this is becoming increasingly dubious. Accordingly, short of a far more general reform of the system, there are a number of initiatives, at a minimum, that should be addressed. As I argued at length in the Social Security Commission deliberations of 1983, with only marginal effect, some delaying of the age of eligibility for retirement benefits will become increasingly pressing. For example, adjusting the full-benefits retirement age to keep pace with increases in life expectancy in a way that would keep the ratio of retirement years to expected life span approximately constant would help to significantly narrow the funding gap. Such an initiative will become easier to implement as fewer and fewer of our older citizens retire from physically arduous work. Hopefully, other modifications to social security, such as improved cost of living indexing, will be instituted. There are a number of thoughtful reform initiatives that, through the process of privatization, could increase domestic saving rates. These are clearly worthy of intensive evaluation. Perhaps the strongest argument for privatization is that replacing the current underfunded system with ---[PAGE_BREAK]--- a fully funded one could boost domestic saving. But, we must remember it is because privatization plans might increase savings that makes them potentially valuable, not their particular form of financing. As I have argued elsewhere, unless national savings is increased, shifting social security trust funds to private securities, while increasing government retirement system income, will lower retirement incomes in the private sector to an offsetting degree. This would not be an improvement to our overall retirement system. The types of changes that will be required to restore fiscal balance to our social security accounts, in the broader scheme of things, are significant but manageable. More important, most entail changes that are less unsettling if they are enacted soon, even if their effects are significantly delayed, rather than waiting five or ten years or longer for legislation. Minimizing the potential disruptions associated with the inevitable changes to social security is made all the more essential because of the pressing financial problems in the Medicare system, social security's companion program for retirees. Medicare as you are well aware is in an even more precarious position than social security. The financing of Medicare faces some of the same problems associated with demographics and productivity as social security but faces different, and currently greater, pressures owing to the behavior of medical costs and utilization rates. Reform of the Medicare system will require more immediate and potentially more dramatic changes than those necessary to reform social security. We owe it to those who will retire after the turn of the century to be given sufficient advance notice to make what alterations in retirement planning may be required. The longer we wait to make what are surely inevitable adjustments, the more difficult they will become. If we procrastinate too long, the adjustments could be truly wrenching. Our senior citizens, both current and future, deserve better.	Alan Greenspan	United States	https://www.bis.org/review/r971010d.pdf	After decades of budgetary imprudence, there has been a growing recognition of our fiscal problems in recent years and an increased willingness of Presidents and Congresses to address them. The capping of discretionary programs and the first steps to deal with entitlement programs are encouraging, as, unquestionably, is the slower pace at which we are creating new entitlement programs. But it is important to place this improvement in the context of the decades-long deterioration in our fiscal position; we have stopped the erosion for now, but we have made only a downpayment on the longer-range problem confronting us. Moreover, much of the fiscal improvement of recent years is less the result of a return to the prudent attitudes and actions of earlier generations, than the emergence of benevolent forces largely external to the fiscal process. The end of the Cold War has yielded a substantial peace dividend, and the best economic performance in decades has augmented tax revenues far beyond expectations while restraining countercyclically sensitive outlays. The payout of the peace dividend is coming to an end. Defense outlays have fallen from 6.2 percent of GDP in 1985 to 3.4 percent this year. Further cuts may be difficult to achieve, for even if we are fortunate enough to enjoy a relatively tranquil world, spending will tend to be buoyed by the need to replace technologically obsolescent equipment, as well as by the usual political pressures. The long-term outlook for the American economy presents us with, perhaps, even greater uncertainties. There can be little doubt that the American economy in the last several years has performed far better than the history of business expansions would have led us to expect. Labor markets have tightened considerably without inflation emerging as it has in the past. Encouraged by these results, financial markets seem to have priced in an optimistic outlook, characterized by a significant reduction in risk and an increasingly benevolent inflation process. For example, in equity markets, continual upward revisions of longer-term corporate earnings expectations have driven price-earnings ratios to levels not often observed at this stage of an economic expansion. Contributing to the expected increases in profits is a perceived marked increase in the prospective rate of return on new business ventures. This is evidenced by the sharp increase in capital investment since early 1993, especially in hi-tech equipment, which has persisted and even accelerated in recent quarters. Underlying this apparent bulge in expected profitability and rates of return, as I suggested in my July Humphrey-Hawkins testimony, may be a maturing of major technologies in recent years. The synergies of lasers and fiber optics have spurred large increases in communications investments. The continued extraordinary spread of computer-related applications, as costs of manipulating data and other information fall, has also been a major factor in increased investment outlays. The combination of advancing telecommunications and computer technologies have induced large investment outlays to support the Internet and utilize it to realize efficiencies in purchasing, production, and marketing. This dramatic change in technology, as I pointed out in earlier testimony, has markedly shortened the lead times in bringing new production facilities on line to meet increased demand, and has accordingly significantly reduced longer-term bottlenecks and materials shortages, phenomena often leading to inflation in the past. Indeed, this faster response of facility capacity, coupled with dramatic declines in transportation costs owing to a downsizing of products, has led to speculation that we are operating with a new "paradigm," where price pressures need rarely ever arise because low-cost capacity, both here and abroad, can be brought on sufficiently rapidly when demand accelerates. Before we go too far in this direction, however, we need to recall that it was just three years ago that we were confronted with bottlenecks in the industrial sector. Though less extensive than in years past at similarly high levels of capacity utilization, they were nonetheless putting visible upward pressures on prices at early stages of the production chain. Further strides toward greater flexibility of facilities have occurred since 1994, but this is clearly an evolutionary, not a revolutionary, process. At least for the foreseeable future, it will still take time to bring many types of new facilities into the production process, and productive capacity will still impose limits on meeting large unexpected increases in demand in a short period. More relevant, by far, however, is that technology and management changes have had only a limited effect on the ability of labor supply to respond to changes in demand. To be sure, individual firms have acquired additional flexibility through increased use of outsourcing and temporary workers. In addition, smaller work teams may be able to adapt more readily to variations in order flows. While these techniques put the right workers at the right spots to reduce bottlenecks, they do not increase the aggregate supply of labor. That supply is sensitive to changes in demand, but to a far more limited extent than facilities. New plants can almost always be built. But labor capacity for an individual country is constrained by the size of the working-age population, which, except for immigration, is basically determined several decades in the past. Its lead time reflects biology, not technology. Of course, the demand for capital facilities and labor are not entirely independent. Within limits, labor and capital are substitutes, and slack in one market can offset tightness in another. For example, additional work shifts often can expand output without significant addition to facilities. Similarly, more labor-saving equipment can permit production to be increased with the same level of employment, an outcome that we would observe as increased labor productivity. As I will be discussing in a moment, we are seeing some favorable signs in this regard, but they are only suggestive, and the potential for increased productivity to enhance the effective supply of labor is limited. The fact is, that despite large additions to the capital stock in recent years, the supply of labor has kept pace with the demand for goods and services and the labor to produce them only by reducing the margin of slack in labor markets. Of the more than two million net new hires at an annual rate from early 1994 through the third quarter of this year, little more than half came from an expansion in the population aged 16 to 64 who wanted a job, and more than a third of those were net new immigrants. The remaining one million per year increase in employment was pulled from those who had been reported as unemployed (nearly 700 thousand annually) and those who wanted, but had not actively sought, a job (more than 300 thousand annually). The latter, of course, are not in the official unemployment count. The key point is that continuously digging ever deeper into the available working-age population is not a sustainable trajectory for job creation. The unemployment rate has a downside limit, if for no other reason than unemployment, in part, reflects voluntary periods of job search and other frictional unemployment, and includes people whose skills are not well adapted to work today and would be very costly to employ. In addition, there is a limit on how many of the millions who wanted a job but were not actively seeking one could be readily absorbed into jobs -- in particular, the large number whose availability is limited by their enrollment in school, and those who may lack the necessary skills or may face other barriers to taking jobs. The number of people saying they would like a job, but have not been engaged in active job search, declined dramatically in 1996. But, despite increasingly favorable labor markets, few more of these 5 million individuals have been added to payrolls in 1997. This group of potential workers, on balance, is at its lowest level relative to the working-age population since at least 1970. As a source of new workers we may have reached about as far as is feasible into this group of the population. Presumably, some of the early retirees, students, or homemakers who do not now profess to want to work could be lured to the job market. Rewards sufficient to make jobs attractive, however, could conceivably also engender upward pressures on labor costs that would trigger renewed price pressures, undermining the expansion. Thus, there would seem to be emerging constraints on potential labor input. If the recent 2 million plus annual pace of job creation were to continue, the pressures on wages and other costs of hiring large numbers of such individuals could escalate more rapidly. To be sure, job growth slowed significantly in August and September, but it did not slow enough to close, from the demand side alone, the gap of the demand for labor over the supply from increases in the working-age population. Thus, the performance of the labor markets this year suggests that the economy has been on an unsustainable track. That the marked rate of absorption of potential workers since 1994 has not induced a more dramatic increase in employee compensation per hour and price inflation has come as a major surprise to most analysts. The strengthened exchange value of the dollar, which has helped contain price increases, is certainly one factor in explaining business reluctance to grant wage increases. Another explanation I have offered in the past is that the acceleration in technology and capital investment, in part by engendering important changes in the types of facilities with which people work on a day-by-day basis, has also induced a discernible increase in fear of job skill obsolescence and, hence, an increasing willingness to seek job security in lieu of wage gains. Certainly, the dramatic rise in recent years of on-the-job training and a substantial increase in people returning to school -- especially those aged twenty-five to thirty-four, mainly at the college level -- suggests significant concerns about skills. But the force of insecurity may be fading. Public opinion polls, which recorded a marked increase in fear of job loss from 1991 to 1995, a period of tightening labor markets, now indicate a partial reversal of that uptrend. To be sure, there is still little evidence of wage acceleration. To believe, however, that wage pressures will not intensify as the group of people who are not working, but who would like to, rapidly diminishes, strains credibility. The law of supply and demand has not been repealed. If labor demand continues to outpace sustainable increases in supply, the question is surely when, not whether, labor costs will escalate more rapidly. Of course, a fall-off in the current pace of demand for goods and services could close the gap and avoid the emergence of inflationary pressures. So could a sharp improvement in productivity growth, which would reduce the pace of new hiring required to produce a given rate of growth of real output. Productivity growth in manufacturing, as best we can measure it, apparently did pick up some in the third quarter and the broader measures of productivity growth have exhibited a modest quickening this year. Certainly, the persistence, even acceleration, of commitments to invest in new facilities suggests that the actual profitability of recent past investments, and by extension increased productivity, has already been achieved to some degree rather than being merely prospective. However, to reduce the recent two million plus annual rate of job gains to the one million rate consistent with long-term population growth would require, all else equal, a full percentage point increase in the rate of productivity growth. While not inconceivable, such a rapid change is rare in the annals of business history, especially for a mature industrial society of our breadth and scope. Clearly, impressive new technologies have imparted a sense of change in which previous economic relationships are seen as being less reliable now. Improvements in productivity are possible if worker skills increase, but gains come slowly through experience, education, and on-the-job training. They are also possible as capital substitutes for labor, but that is limited by the state of current technology. Very significant advances in productivity require technological breakthroughs that alter fundamentally the efficiency with which we use our labor and capital resources. But at the cutting edge of technology, where America finds itself, major improvements cannot be produced on demand. New ideas that matter are hard won. Short of a marked slowing in the demand for goods and services and, hence, labor -- or a degree of acceleration of productivity growth that appears unlikely -- the imbalance between the growth in labor demand and the expansion of potential labor supply of recent years must eventually erode the current state of inflation quiescence and, with it, the solid growth of real activity. In this context, the economic outlook sketched out for the United States by both the Office of Management and Budget and the Congressional Budget Office is realistic, even in some sense conservative. But you should recognize the range of possible long-term outcomes, both significantly better or worse, has risen markedly in the last year. An acceleration of productivity growth, should it materialize, would put the economy on a higher trend growth path than they have projected. The development of inflationary pressures, on the other hand, would doubtless create an environment of slower growth in real output than that projected by OMB or CBO. A re-emergence of inflation is, without question, the greatest threat to sustaining what has been a balanced economic expansion virtually without parallel in recent decades. In this regard, we at the Federal Reserve recognize that how we handle monetary policy will be a significant factor influencing the path of economic growth and, hence, fiscal outcomes. Given the wider range of possible outcomes that we face for long-term economic growth, the corresponding ranges of possible budget outcomes over the next five to ten years also has widened appreciably. In addition to the uncertainties associated with economic outcomes, questions may be raised about other assumptions behind both projected receipts and outlays. With regard to the former, it is difficult to believe that our much higher-than-expected income tax receipts of late are unrelated to the huge increase in capital gains, which since 1995 have totaled the equivalent of one-third of national income. Aside from the question of whether stock prices will rise or fall, it clearly would be unrealistic to look for a continuation of stock market gains of anything like the magnitude of those recorded in the past couple of years. On the outlay side, the recently enacted budget agreement relies importantly on significant, but as-yet-unspecified, restraints on discretionary spending to be made in the years 2001, 2002, and thereafter. Supporters of each program expect the restraints to fall elsewhere. Inevitably, the eventual publication of the detail will expose deep political divisions, which could make the realization of the budget projections less likely. In addition, while the budget agreement included significant cuts in Medicare spending, past experience has shown us how difficult Medicare is to control, raising the possibility that savings will never be realized. More generally, I wonder whether there is enough funding slack to accommodate contingencies, or the inevitable new, but as yet unidentified, spending programs. Budget forecasts are understandably subject to fairly large errors. Seemingly small changes in receipts and outlays are magnified in the budget deficit. For example, during the 1990s, the average absolute error in the projections of February for receipts and outlays in the fiscal years starting the subsequent October has been greater than four percent. A four percent error in both outlays and receipts in opposite directions amounts to more than $\$ 125$ billion annually. Indeed, the uncertainty of budget forecasts is no better illustrated than by an admittedly extreme case. During the last two and a half years the projection of the fiscal balance, excluding new initiatives, for the year 2002 has changed by about $\$ 250$ billion. While all this fortunately has been in the direction of smaller deficits, the degree of uncertainty suggests that the error could just as easily be on the other side. With this high level of uncertainty in projecting budget totals and associated deficits, the Congress needs to evaluate the consequences to long-term economic growth of errors in fiscal policy. A base issue in such an evaluation is whether we are better off to be targeting a large deficit, balance, or a chronic surplus in our unified budget. There is nothing special about budget balance per se, except that it is far superior to deficits. I have always emphasized the value of a budgetary surplus in increasing national savings, especially when American private domestic savings is low, as it is today. Higher national savings lead in the long run to higher investment and living standards. They also foster low inflation. Low inflation itself may be responsible, in part, for higher productivity growth and larger gains in standards of living. If economic growth and rising living standards, fostered by investment and price stability, are our goal, fiscal policy in my judgment will need to be biased toward surpluses in the years immediately ahead. This is especially so given the inexorable demographic trends that threaten huge increases in outlays beyond 2010. We should view the recent budget agreement, even if receipts and outlays evolve as expected, as only an important downpayment on the larger steps we need to take to solve the harder problem -- putting our entitlement programs on a sound financial footing for the 21 st century. Moreover, targeted surpluses could hopefully help to offset the inbuilt political bias in favor of budget deficits. I have been in too many budget meetings in the last three decades not to have learned that the ideal fiscal initiative from a political perspective is one that creates visible benefits for one group of constituents without a perceived cost to anybody else, a form of political single-entry bookkeeping. To be sure, in recent years we have been showing some real restraint in our approach to fiscal policy. Yet, despite terminating a number of programs, the ratio of federal nondefense, noninterest, spending to GDP still stands at nearly 14 percent, double what it was in the 1950s. This may be one reason why inflation premiums, embodied in long-term interest rates, still are significant. There is, thus, doubtless a lot of catching up to do. The current initiatives toward welfare, social security, and Medicare reform are clearly steps in the right direction, but far more is required. Let us not squander years of efforts to balance the budget and the benefits of ideal economic conditions by failing to address our long-term imbalances. A critical imbalance is the one faced by social security. Its fund's reported imbalance stems primarily from the fact that, until very recently, the payments into the social security trust accounts by the average employee, plus employer contributions and interest earned, were inadequate, at retirement, to fund the total of retirement benefits. This has started to change. Under the most recent revisions to the law, and presumably conservative economic and demographic assumptions, today's younger workers will be paying social security taxes over their working years that appear sufficient to fund their benefits during retirement. However, the huge liability for current retirees, as well as for much of the work force closer to retirement, leaves the system, as a whole, badly underfunded. The official unfunded liability for the Old Age, Survivors and Disability funds, which takes into account expected future tax payments and benefits out to the year 2070, has reached a staggering $\$ 3$ trillion. This issue of funding underscores the critical elements in the forthcoming debate on social security reform, because it focusses on the core of any retirement system, private or public. Simply put, enough must be set aside over a lifetime of work to fund the excess of consumption over claims on production a retiree may enjoy. At the most rudimentary level, one could envision households saving by actually storing goods purchased during their working years for consumption during retirement. Even better, the resources that would have otherwise gone into the stored goods could be diverted to the production of new capital assets, which would, cumulatively, over a working lifetime, produce an even greater quantity of goods and services to be consumed in retirement. In the latter case, we would be getting more output per worker, our traditional measure of productivity, and a factor that is central in all calculations of long-term social security trust fund financing. Hence, the bottom line in all retirement programs is physical resource availability. The finance of any system is merely to facilitate the underlying system of allocating real resources that fund retirement consumption of goods and services. Unless social security savings are increased by higher taxes (with negative consequences for growth) or lowered benefits, domestic savings must be augmented by greater private saving or surpluses in the rest of the government budget to help ensure that there is enough savings to finance adequate productive capacity down the road to meet the consumption needs of both retirees and active workers. The basic premise of our current largely pay-as-you-go social security system is that future productivity growth will be sufficient to supply promised retirement benefits for current workers. However, even supposing some acceleration in long-term productivity growth from recent experience, at existing rates of domestic saving and capital investment this is becoming increasingly dubious. Accordingly, short of a far more general reform of the system, there are a number of initiatives, at a minimum, that should be addressed. As I argued at length in the Social Security Commission deliberations of 1983, with only marginal effect, some delaying of the age of eligibility for retirement benefits will become increasingly pressing. For example, adjusting the full-benefits retirement age to keep pace with increases in life expectancy in a way that would keep the ratio of retirement years to expected life span approximately constant would help to significantly narrow the funding gap. Such an initiative will become easier to implement as fewer and fewer of our older citizens retire from physically arduous work. Hopefully, other modifications to social security, such as improved cost of living indexing, will be instituted. There are a number of thoughtful reform initiatives that, through the process of privatization, could increase domestic saving rates. These are clearly worthy of intensive evaluation. Perhaps the strongest argument for privatization is that replacing the current underfunded system with a fully funded one could boost domestic saving. But, we must remember it is because privatization plans might increase savings that makes them potentially valuable, not their particular form of financing. As I have argued elsewhere, unless national savings is increased, shifting social security trust funds to private securities, while increasing government retirement system income, will lower retirement incomes in the private sector to an offsetting degree. This would not be an improvement to our overall retirement system. The types of changes that will be required to restore fiscal balance to our social security accounts, in the broader scheme of things, are significant but manageable. More important, most entail changes that are less unsettling if they are enacted soon, even if their effects are significantly delayed, rather than waiting five or ten years or longer for legislation. Minimizing the potential disruptions associated with the inevitable changes to social security is made all the more essential because of the pressing financial problems in the Medicare system, social security's companion program for retirees. Medicare as you are well aware is in an even more precarious position than social security. The financing of Medicare faces some of the same problems associated with demographics and productivity as social security but faces different, and currently greater, pressures owing to the behavior of medical costs and utilization rates. Reform of the Medicare system will require more immediate and potentially more dramatic changes than those necessary to reform social security. We owe it to those who will retire after the turn of the century to be given sufficient advance notice to make what alterations in retirement planning may be required. The longer we wait to make what are surely inevitable adjustments, the more difficult they will become. If we procrastinate too long, the adjustments could be truly wrenching. Our senior citizens, both current and future, deserve better.
1997-10-08T00:00:00	Ms. Phillips' testimony before the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Banking and Financial Services of the U.S. House of Representatives (Central Bank Articles and Speeches, 8 Oct 97)	Testimony of a member of the Board of Governors of the US Federal Reserve System, Ms. Susan M. Phillips in Washington, on 8/10/97.	Ms. Phillips' testimony before the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Banking and Financial Services of the U.S. House of Testimony of a member of the Board of Governors of the US Federal Reserve Representatives System, Ms. Susan M. Phillips in Washington, on 8/10/97. Madam Chairwoman and members of the Subcommittee, I am pleased to be here today to discuss the Federal Reserve's efforts in recent years to strengthen its supervisory processes and also to share with you the Board's views about what challenges lie ahead, both for the banking system and the supervisory process. As you know, the U.S. economy and its banking system have enjoyed half a decade of improving strength in which U.S. banks have become better capitalized and more profitable than they have been in generations. Moreover, in the past 13 months not a single insured bank has failed, and the Bank Insurance Fund is now capitalized at a level requiring most banks to pay only nominal fees for their insurance. While we can take comfort and, to some degree, satisfaction in these events, experience has demonstrated that at times like these -- if we are not vigilant -- risks can occur that set the stage for future problems. As I begin my remarks, I would like to point out that no system of supervision or regulation can provide total assurance that banking problems will not occur or that banks will not fail. Nor should it. Our goal as regulators is to identify weak banking practices early so that small or emerging problems can be addressed before they become large and costly -- either to the insurance fund or the financial system as a whole. We believe that progress made in recent years to focus our examinations on the areas of highest risk at banking organizations places us in a better position to identify problems early, control systemic risk, and maintain financial stability. That goal and the need to adapt the supervisory process to the potentially rapidly changing conditions in banking and financial markets underlies our decision to pursue a more risk-focused supervisory approach. We are well underway in implementing this new supervisory framework, and initial indications about that process from both the Federal Reserve's supervisory staff and the banking industry, itself, have been favorable. The risk-focused approach reflects our supervisory response to the effects that technology and financial innovation have had on the pace of change in banking organizations, the nature of U.S. and world financial markets, and the techniques employed for managing and controlling risk. As banking practices and markets continue to evolve, our emphasis on risk-focused supervision will be even more necessary in the years to come. The Federal Reserve's Oversight Role As the primary federal supervisor of U.S. bank holding companies, state member banks, and most U.S. offices of foreign banks, the Federal Reserve has sought to apply effective supervision and contain excessive risks to the federal safety net, while also ensuring that banks adequately serve their communities and accommodate economic growth. As the nation's central bank, the Federal Reserve brings a different, important perspective to the supervisory process through its attention to the broad and long-term consequences of supervisory actions on the financial system and the economy. Significantly, the practical, hands-on involvement which the Federal Reserve gains through its supervisory function supports and complements our other central bank responsibilities, including fostering a safe and efficient payment system and ensuring the stability of the financial system. Past studies of bank failures have cited a number of contributing factors including, but certainly not limited to, inadequate supervisory staffing and antiquated examination procedures. Over the years, as it has supervised and regulated banking organizations, the Federal Reserve has emphasized periodic, on-site examinations that entail substantive loan portfolio reviews and significant transaction testing to identify emerging problems. In that connection, the Federal Reserve has sought to maintain a sufficient number and quality of supervisory personnel to conduct examinations with appropriate frequency and depth. That approach appears to have provided us with some consistent success. As conditions within the industry have substantially improved, the Board has been mindful of the cost of conducting its supervisory activities and has worked to contain those costs in the face of increased responsibilities. Throughout this period we have recognized the need to maintain stability in our work force, and have sought to avoid excessive build-ups or periods of disruptive retrenchment. That approach has enabled us to maintain what we believe has been an adequate and consistent level of oversight of banking organizations under our supervision during both good times and bad. Developments Driving Change During the past decade, the U.S. banking system has experienced a great deal of turmoil, stress, and change. Ten years ago, many of the country's largest banks announced huge loan loss provisions, beginning the process of reducing the industry's overhang of doubtful developing country loans. At the same time, many of these institutions and smaller regional banks were struggling with oil and agriculture sector difficulties or accumulating commercial real estate problems. These and other difficulties took a heavy toll. By the end of the 1980s, more than 200 banks were failing annually, and there were more than 1,000 other problem banks. This experience provided important lessons and forced supervisors and bankers, alike, to reconsider the way they approached their jobs. For their part, bankers recognized the need to build their capital and reserves, strengthen their internal controls, and improve practices for identifying, underwriting and managing risk. Supervisors were also reminded of the need to remain vigilant and of the high costs that bank failures can bring, not only to the insurance fund but to local communities as well. The FDIC Improvement Act of 1991 emphasized that point, requiring frequent examinations and prompt regulatory actions when serious problems emerge. Beyond these largely domestic, institutional events, banks and businesses throughout the world were dealing in the 1980s and 1990s with new technologies that were leading to a multitude of new and increasingly complex financial products that changed the nature of banking and financial markets. These technologies have brought many benefits that facilitate more efficient markets and, in turn, greater international trade and economic growth. They may also, however, have raised macro-stability concerns by concentrating the growing volume and complexity of certain activities within a small number of truly global institutions. It is essential that these largest firms adequately manage the related risks of these activities and that they remain adequately supervised. For it is these institutions that have the potential to disrupt worldwide payment systems and contribute most to systemic risk. In addition to the formal supervisory oversight exerted by regulators, concerns may be eased somewhat by the strong counterparty discipline being brought to bear world wide on banks and other financial institutions dealing in these new products. The scrutiny among counterparties in the global market place has contributed to improvements in capital positions and in overall risk management practices. In many ways, U.S. banks have been in the vanguard in applying technological advances to their products, distribution systems, and management processes, with such applications and innovations as ATMs, home banking, securitizations and credit derivatives. Such efforts, combined with greater attention to pricing their services and measuring their risks, have had material effects on the increased strength and profitability that our banks have seen. Within the United States, our banking system has also experienced a dramatic consolidation in the number of banking institutions, with the number of independent commercial banking organizations declining from 12,400 in 1980 to 7,400 in June of this year.1 That structural change has also contributed to industry earnings by providing banks with greater opportunities to reduce costs. The challenge going forward for many of these institutions may be in managing the growth and the continuing process of industry consolidation. This challenge may be greatest as banking organizations expand, particularly through acquisitions, into more diverse or nontraditional banking activities. That growth into a wider array of activities is especially important if banks are to meet the wide-ranging needs of their business and household customers while competing effectively with other regulated and unregulated firms. However, the managerial implications of rapid growth and growth into new activities should not be overlooked, either by the institutions or their supervisors. Supervisory Challenges Ahead There is also no shortage of tasks facing the Federal Reserve as a bank supervisor, despite the virtually unprecedented strong condition of the U.S. banking system today. We, too, must deal with the evolving financial markets and advances in technology. At the same time, we must ensure that our own supervisory practices, tools, and standards take advantage of technological improvements and financial techniques so that our oversight is not only effective, but also as unobtrusive and appropriate as possible. These tasks are wide ranging, extending from our own re-engineering of the supervisory process to the way supervisors approach issues such as measuring capital adequacy and how we seek convergence on bank supervisory standards worldwide. Risk-focused examinations Constructing a sound supervisory process while minimizing regulatory burden has been a long-standing and on-going effort at the Federal Reserve and an objective we have sought to advance with our emphasis on risk-focused examinations. Particularly in the past decade, we have found that the increased range of products and the greater depth and liquidity of financial markets permit banking organizations to change their risk profiles more rapidly than ever before. That possibility requires that we strike an appropriate balance between evaluating the condition of an institution at a point in time and evaluating the soundness of the bank's processes for managing risk. Recognition of the need for that balance is at the heart of the risk-focused examination approach. The risk-focused approach, by definition, entails a more formal risk assessment planning phase that identifies those areas and activities that warrant the most extensive review. This pre-planning process is supported by technology, for example, to download certain information about a bank's loan portfolio to our own computer systems and target areas of the portfolio for review. Once on-site, examiners analyze the bank's loans and other assets to ascertain the organization's current condition, and also to evaluate its internal control process and its own ability to identify and resolve problems. As a result, the Federal Reserve is placing greater reliance than before on a bank's internal auditors and on the accuracy and adequacy of its information systems. The review of the information flow extends from top to bottom, and with the expectation that bank senior management and boards of directors are actively involved in monitoring the bank's activities and providing sufficient guidance regarding risk assumption. 1 "Independent commercial banking organizations" is defined as the sum of all bank holding companies and independent banks. Multi-bank holding companies are, therefore, considered as a single organization. As in the past, performance of substantive checks on the reliability of a bank's controls remains today a cornerstone of the examination process, albeit in a more automated and advanced form. For example, automated loan sampling is performed for the purpose of generating statistically valid conclusions about the accuracy of a bank's internal loan review process. To the extent we can validate the integrity of a bank's internal controls more efficiently, we can place more confidence in them at an earlier stage and can also take greater comfort that management is getting an accurate indication of the bank's condition. Toward that end, Board staff is working to refine loan-sampling procedures that should further boost examiner productivity and accomplish other supervisory goals. Moreover, as examiners are able to complete loan reviews more quickly, they will have more time to review other high-priority aspects of the institution's operations. A significant benefit of the risk-focused approach is its emphasis on ensuring that the bank's internal oversight processes are sound and that communication between the bank and senior examiners is ongoing between examinations. That approach is generally supported by institutions we supervise and provides a more comprehensive oversight process that complements our annual or 18-month examinations. Such an approach strengthens our ability to respond promptly if conditions deteriorate. Another benefit of the risk-focused approach has been a greater amount of planning, analysis, and information gathering at Reserve Banks prior to the on-site portion of the examination. Far from reducing our hands-on knowledge of the institution, this approach has ensured that when we are on-site, we are reviewing and analyzing the right areas, talking to the right people and making better use of our time and that of the bank's management and employees. In addition to improving productivity, it has also reduced our travel costs and improved employee morale. Examination staff at the Reserve Banks indicate that this process may be reducing on-site examination time by 15-30 percent in many cases and overall examination time of Federal Reserve personnel by perhaps 10 percent. While those results are tentative, partial, and unscientific, they are certainly encouraging in terms of resource implications. Complementing the risk-focused approach to supervision are enhancements to the tools we use to grade a bank's condition and management. Since 1995, we have asked Federal Reserve examiners to provide a specific supervisory rating for a bank's risk management process. More recently, the CAMEL rating system, too, has been revised by the banking agencies to place more emphasis on the adequacy of a bank's risk management practices and was expanded to include a specific "S" rating for an institution's sensitivity to market risk. As you may know, the Federal Reserve has also, for some time, used a rating scheme that focuses heavily on managerial procedures and controls in its oversight of U.S. branches and agencies of foreign banks. How effective is the risk-focused process? Since economic and industry conditions have been generally favorable for the past several years, there has not been a sufficiently stressful economic downturn to test fully bank risk management systems or supervisory practices. The market volatility beginning in 1994 did, however, provide some tests for the risk management systems of the larger banks with active trading desks. Nevertheless, there are many indications that bank and supervisory practices are materially better than they were in the 1980s and early 1990s. For example, the risk-focused approach is helping to identify certain deficiencies before they show up in a bank's financial condition. These are evidenced by instances where ratings for the quality of bank management are lower than those for capital, asset quality, or earnings. Because managerial weaknesses eventually show up in a bank's financial condition, it is important to identify and resolve those weaknesses early. In that regard, the risk-focused approach endeavors to prevent problems from developing to the point that they cause unnecessary losses that impair the institution's capital and require resolution under the Prompt Corrective Action mandate. One example of how the risk-focused approach is helping to identify and address deficiencies is our supervisory experience with the U.S. branches of foreign banks. Subsequent to the enactment of the Foreign Bank Supervision Enhancement Act of 1991, which gave the Federal Reserve greater supervisory authority over foreign branches, our examinations uncovered a number of entities with internal control and audit weaknesses. This result was not completely unexpected, as these foreign banking organizations were not previously subject to the same level of oversight as our domestic organizations. Recognizing the seriousness of these weaknesses and their potential for causing problems in the future, the Federal Reserve has taken a number of steps to ensure that practices are materially upgraded at foreign branches and that any weaknesses continue to be uncovered. In addition to identifying and addressing internal control and audit weaknesses through examinations and supervisory follow-up, these efforts include ensuring that the foreign bank provides the necessary managerial support to its U.S. branches, including adequate systems of controls and audit. To place even more emphasis on internal controls and audit systems, the foreign branch rating system was revised in 1994. Furthermore, in 1996 additional steps were taken to ensure that internal control weaknesses are corrected and will not cause financial harm by adopting requirements for audit procedures in situations where significant control weaknesses are detected. These efforts to detect problems at their early stages and resolve them appear to be having positive effects. After peaking in 1993, there has been a steady decline in the number of U.S. branches and agencies with an overall examination rating of fair or lower and a rating of fair or lower in an examination component substantively affected by internal control and audit weaknesses. We believe that our continued efforts in this area will lead to further improvements in the internal control and audit practices of foreign banking organizations Implementing the risk-focused approach has not been an easy task. It has required a significant revision of our broad and specialized training programs, including expansion of capital markets, information technology, and global trading activities, as well as courses devoted exclusively to internal controls. These education programs will, of course, need to be continually updated as industry activities and conditions evolve. With the greater discretion provided to examiners to focus on areas of highest risk, ensuring the consistency and quality of examinations has increased in importance. Fortunately, new training courses and improved examination platforms, tools, and programs that guide examiners through the appropriate selection of examination procedures will help. In addition, our ability to evaluate more thoroughly the quality of an examination has improved with the greater depth of analysis provided in supporting examination materials such as the written risk assessments and analysis of exam findings. Those materials are allowing us to perform comparative reviews of examinations across institutions of similar size, risk profile and complexity, to ensure quality and consistency. So far we have been able to evaluate the effectiveness of our examination programs by identifying whether problems are identified early and resolved in a timely fashion, by evaluating whether examination reports and findings provide clear feedback to management and identify areas of highest risk, and by monitoring the extent to which our examinations are complying with statutory mandates for the frequency of examinations. Based on those criteria, I believe our examination program has been generally successful. Application of technology to supervisory process The Federal Reserve has also done much to increase its own use of technology in an effort to improve examiner productivity, enhance analyses, and reduce burden on banks. Much of this effort has been conducted on an inter-agency basis, particularly in cooperation with the FDIC and state banking departments with whom we share supervision of state-chartered banks. Specific results include the development of a personal computer, lap-top workstation that provides examiners with a decision tree framework to assist them through the necessary procedures. The workstation also helps them document their work and prepare exam reports more efficiently. In addition, a software program has also been developed for receiving and analyzing loan portfolio data transmitted electronically from financial institutions. This process not only saves time but also improves the examiner's understanding of the risks presented by individual portfolios. The Federal Reserve is also developing an electronic examination tool for large domestic and foreign banking organizations that enhances our ability to share examination analysis and findings and other pertinent supervisory information among our Reserve Banks and with other supervisory authorities. This platform should substantively improve our ability to provide comprehensive oversight to those firms that are most prominent in the payment system and global financial markets. In addition to examination tools, the Federal Reserve has for many years maintained a comprehensive source of banking structure, financial, and examination data in its National Information Center. By year-end, we will have completed significant enhancements to the tools that provide examiners and analysts at the federal and state banking agencies with access to those data. The Year 2000 One of the clearest reminders that managing technology is a challenge of its own is the need for banks to resolve the "Year 2000" problem. U.S. banks appear to be taking this matter seriously and are generally well underway toward identifying their individual needs and developing action plans. The Federal Reserve and the other federal bank supervisors are reviewing the relevant efforts of every insured depository institution in order to determine whether adequate progress on this issue is being made. This process should be complete by the middle of next year so that any detected deficiencies may be addressed in time. Meeting the demands of this review and ensuring proper remedies both before and after the year 2000 will be a significant and costly task to both the industry and the banking agencies. However, even within the context of banking, the scope of the Year 2000 problem extends far beyond U.S. banks to foreign banks, bank borrowers, depositors, vendors, and other counterparties. Through the Bank for International Settlements and other international forums, the Federal Reserve and other U.S. banking agencies have emphasized the need for all institutions to recognize this issue and to address it actively. Importantly, century date compliance is gaining more attention internationally, and the Basle Supervisors Committee is taking steps to address this matter. Banks and others need to address year 2000 system alterations, not only because of the potential effects on overall markets, but also as a threat to individual firm viability. At a minimum, banks should be concerned about their ability to provide uninterrupted service to their customers into the next millennium. If nothing else, it is simply good business. Efforts to Accommodate Industry Growth and Innovation Another goal of the Federal Reserve's supervisory approach is to remove unnecessary barriers that might hinder the industry's ability to grow, innovate, and remain competitive. Recently, the Board refined its application process to ensure that well-run, well capitalized banking organizations may apply to acquire banks and nonbanks in a more streamlined fashion and commence certain types of new activities without prior approval. The Board also significantly revised various rules for section 20 companies and scaled back or removed many redundant firewalls. While these refinements require some changes to the supervisory process, we firmly believe that removing barriers to these lower risk activities is essential to maintaining the industry's health and competitiveness and its ability to serve its customers and the community. Supervising nationwide and international institutions The consolidation and transformation of the U.S. banking system resulting from evolving market, statutory, and regulatory changes are also requiring the Federal Reserve to adapt to new conditions. As previously noted, we are working closely with the FDIC and state banking agencies to deal with the challenges presented by interstate banking and branching to ensure that the dual banking system remains viable in future years. To address that goal, the FDIC, the Federal Reserve, and the state banking departments began on October 1 a common risk-focused process for the examination of state-chartered community banks. Another initiative has been the State/Federal Supervisory Protocol, which commits the various banking agencies to work toward a "seamless" and minimally burdensome oversight process. In short, it sets forth a process in which state banking supervisors will accept the supervisory reports of other agencies for banks operating in their states through branches, but headquartered elsewhere. The fact that the plan has been accepted by all involved parties is encouraging. We now need to ensure that it is implemented as intended, as banks make use of their broader branching powers. Similar coordination efforts are necessary and underway in an international context. Through the Bank for International Settlements, for example, the Federal Reserve and the other U.S. banking agencies participate with supervisors from other G-10 countries to develop not only prudential capital and other regulatory standards, but also to promote sound practices over a broad range of banking issues. In this regard, the Basle Committee on Banking Supervision, with the approval of the central bank Governors of the G-10 countries, recently issued three documents: one dealing with the management of interest rate risk by banks, one dealing with the Year 2000 problems, and another identifying 25 "core principles" of effective supervision that is directed at bank supervisors worldwide. The Basle Committee is also working to improve international risk disclosure practices of banks, and has created the new market risk capital standard that is based on banks' internal value-at-risk models. That standard goes into effect in January of next year. Beyond the work of the Basle Committee and the banking agencies, we are also meeting with the SEC and international securities and insurance regulators to identify common issues, and to bring about greater convergence in our respective regulatory frameworks. That effort also has links to the Committee's efforts and should prove helpful in strengthening the oversight and regulation of financial institutions throughout the world that provide a broad range of financial products. Successful groundwork from this effort could also have implications for moving forward domestically in an era of financial reform. Guidance as well as supervisory and regulatory standards such as these -- whether developed in a domestic or international context -- are soon incorporated into examination procedures and help examiners in their reviews of many of the more complex activities of global banking organizations. These global institutions are perhaps the most challenging to supervise. Since it is not feasible for supervisors to review all locations of a global banking organization, emphasis is placed on the integrity of risk management and internal control systems, coordination with international supervisors, strong capital standards, and improved disclosures. Staffing the Supervisory Process A final supervisory challenge relates to the Federal Reserve's need to continue attracting, training, and retaining expert staff. Retaining sufficient numbers of individuals with the expertise to evaluate fully the risks in a rapidly changing banking industry is a major priority for the Federal Reserve and figures prominently in the bank supervision function's strategic plan. Particularly challenging is attracting and retaining specialists in the areas of capital markets and information technology where we have experienced increased turnover. We will continue efforts to attract and retain both specialists and generalists who are qualified to address issues as the industry evolves. As I have outlined in my testimony, the Federal Reserve's supervisory strategy is to maintain staff who can adequately evaluate the general soundness of banking activities by placing strong emphasis on the bank's management processes, systems, and controls. I believe such an approach will serve us well as the industry continues to evolve either by expanding the scope of its activities or through broader structural changes from financial modernization legislation. Nevertheless, developing the supervisory techniques, and attracting and training the personnel to do the job will pose a continuing challenge in the years ahead. Conclusion The history of banking and of bank supervision shows a long and rather close relationship between the health of the banking system and the economy, a connection reflecting the role of banks in the credit intermediation process. We can expect that relationship to continue and for bank earnings and asset quality to fluctuate as economic conditions change. As supervisors, we must prepare for such developments. In many ways, however, the banking and financial system have changed dramatically in the past decade both in terms of structure and diversity of activities. Risk management practices have also advanced, helped by technological and financial innovations. I believe that both bank supervisors and the banking industry have learned important lessons from the experience of the past ten years specifically about the need to actively monitor, manage and control risks. Nevertheless, conditions can always change, and the risk-focused approach will be continually challenged to anticipate and avoid new kinds of problems. We must recognize that a risk-focused approach to supervision is a developing process and however successful it may be, there will again be bank failures. Indeed, having no bank failures may suggest inadequate risk-taking by banks and less economic growth. Through our supervisory process, the Federal Reserve seeks to maintain the proper balance -- permitting banks maximum freedom, while still protecting the safety net and maintaining financial stability. Devoting adequate attention to banking practices and conditions and responding promptly as events unfold is the key. We intend to do that now and in the years ahead.	---[PAGE_BREAK]--- # Ms. Phillips' testimony before the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Banking and Financial Services of the U.S. House of Representatives Testimony of a member of the Board of Governors of the US Federal Reserve System, Ms. Susan M. Phillips in Washington, on 8/10/97. Madam Chairwoman and members of the Subcommittee, I am pleased to be here today to discuss the Federal Reserve's efforts in recent years to strengthen its supervisory processes and also to share with you the Board's views about what challenges lie ahead, both for the banking system and the supervisory process. As you know, the U.S. economy and its banking system have enjoyed half a decade of improving strength in which U.S. banks have become better capitalized and more profitable than they have been in generations. Moreover, in the past 13 months not a single insured bank has failed, and the Bank Insurance Fund is now capitalized at a level requiring most banks to pay only nominal fees for their insurance. While we can take comfort and, to some degree, satisfaction in these events, experience has demonstrated that at times like these -- if we are not vigilant -- risks can occur that set the stage for future problems. As I begin my remarks, I would like to point out that no system of supervision or regulation can provide total assurance that banking problems will not occur or that banks will not fail. Nor should it. Our goal as regulators is to identify weak banking practices early so that small or emerging problems can be addressed before they become large and costly -- either to the insurance fund or the financial system as a whole. We believe that progress made in recent years to focus our examinations on the areas of highest risk at banking organizations places us in a better position to identify problems early, control systemic risk, and maintain financial stability. That goal and the need to adapt the supervisory process to the potentially rapidly changing conditions in banking and financial markets underlies our decision to pursue a more risk-focused supervisory approach. We are well underway in implementing this new supervisory framework, and initial indications about that process from both the Federal Reserve's supervisory staff and the banking industry, itself, have been favorable. The risk-focused approach reflects our supervisory response to the effects that technology and financial innovation have had on the pace of change in banking organizations, the nature of U.S. and world financial markets, and the techniques employed for managing and controlling risk. As banking practices and markets continue to evolve, our emphasis on risk-focused supervision will be even more necessary in the years to come. ## The Federal Reserve's Oversight Role As the primary federal supervisor of U.S. bank holding companies, state member banks, and most U.S. offices of foreign banks, the Federal Reserve has sought to apply effective supervision and contain excessive risks to the federal safety net, while also ensuring that banks adequately serve their communities and accommodate economic growth. As the nation's central bank, the Federal Reserve brings a different, important perspective to the supervisory process through its attention to the broad and long-term consequences of supervisory actions on the financial system and the economy. Significantly, the practical, hands-on involvement which the Federal Reserve gains through its supervisory function supports and complements our other central bank responsibilities, including fostering a safe and efficient payment system and ensuring the stability of the financial system. Past studies of bank failures have cited a number of contributing factors including, but certainly not limited to, inadequate supervisory staffing and antiquated examination procedures. Over the years, as it has supervised and regulated banking organizations, the Federal Reserve has emphasized periodic, on-site examinations that entail substantive loan portfolio reviews and significant transaction testing to identify emerging problems. In that connection, the Federal Reserve has sought to maintain a sufficient number and quality of supervisory personnel to conduct ---[PAGE_BREAK]--- examinations with appropriate frequency and depth. That approach appears to have provided us with some consistent success. As conditions within the industry have substantially improved, the Board has been mindful of the cost of conducting its supervisory activities and has worked to contain those costs in the face of increased responsibilities. Throughout this period we have recognized the need to maintain stability in our work force, and have sought to avoid excessive build-ups or periods of disruptive retrenchment. That approach has enabled us to maintain what we believe has been an adequate and consistent level of oversight of banking organizations under our supervision during both good times and bad. # Developments Driving Change During the past decade, the U.S. banking system has experienced a great deal of turmoil, stress, and change. Ten years ago, many of the country's largest banks announced huge loan loss provisions, beginning the process of reducing the industry's overhang of doubtful developing country loans. At the same time, many of these institutions and smaller regional banks were struggling with oil and agriculture sector difficulties or accumulating commercial real estate problems. These and other difficulties took a heavy toll. By the end of the 1980s, more than 200 banks were failing annually, and there were more than 1,000 other problem banks. This experience provided important lessons and forced supervisors and bankers, alike, to reconsider the way they approached their jobs. For their part, bankers recognized the need to build their capital and reserves, strengthen their internal controls, and improve practices for identifying, underwriting and managing risk. Supervisors were also reminded of the need to remain vigilant and of the high costs that bank failures can bring, not only to the insurance fund but to local communities as well. The FDIC Improvement Act of 1991 emphasized that point, requiring frequent examinations and prompt regulatory actions when serious problems emerge. Beyond these largely domestic, institutional events, banks and businesses throughout the world were dealing in the 1980s and 1990s with new technologies that were leading to a multitude of new and increasingly complex financial products that changed the nature of banking and financial markets. These technologies have brought many benefits that facilitate more efficient markets and, in turn, greater international trade and economic growth. They may also, however, have raised macro-stability concerns by concentrating the growing volume and complexity of certain activities within a small number of truly global institutions. It is essential that these largest firms adequately manage the related risks of these activities and that they remain adequately supervised. For it is these institutions that have the potential to disrupt worldwide payment systems and contribute most to systemic risk. In addition to the formal supervisory oversight exerted by regulators, concerns may be eased somewhat by the strong counterparty discipline being brought to bear world wide on banks and other financial institutions dealing in these new products. The scrutiny among counterparties in the global market place has contributed to improvements in capital positions and in overall risk management practices. In many ways, U.S. banks have been in the vanguard in applying technological advances to their products, distribution systems, and management processes, with such applications and innovations as ATMs, home banking, securitizations and credit derivatives. Such efforts, combined with greater attention to pricing their services and measuring their risks, have had material effects on the increased strength and profitability that our banks have seen. Within the United States, our banking system has also experienced a dramatic consolidation in the number of banking institutions, with the number of independent commercial ---[PAGE_BREAK]--- banking organizations declining from 12,400 in 1980 to 7,400 in June of this year. ${ }^{1}$ That structural change has also contributed to industry earnings by providing banks with greater opportunities to reduce costs. The challenge going forward for many of these institutions may be in managing the growth and the continuing process of industry consolidation. This challenge may be greatest as banking organizations expand, particularly through acquisitions, into more diverse or nontraditional banking activities. That growth into a wider array of activities is especially important if banks are to meet the wide-ranging needs of their business and household customers while competing effectively with other regulated and unregulated firms. However, the managerial implications of rapid growth and growth into new activities should not be overlooked, either by the institutions or their supervisors. # Supervisory Challenges Ahead There is also no shortage of tasks facing the Federal Reserve as a bank supervisor, despite the virtually unprecedented strong condition of the U.S. banking system today. We, too, must deal with the evolving financial markets and advances in technology. At the same time, we must ensure that our own supervisory practices, tools, and standards take advantage of technological improvements and financial techniques so that our oversight is not only effective, but also as unobtrusive and appropriate as possible. These tasks are wide ranging, extending from our own re-engineering of the supervisory process to the way supervisors approach issues such as measuring capital adequacy and how we seek convergence on bank supervisory standards worldwide. ## Risk-focused examinations Constructing a sound supervisory process while minimizing regulatory burden has been a long-standing and on-going effort at the Federal Reserve and an objective we have sought to advance with our emphasis on risk-focused examinations. Particularly in the past decade, we have found that the increased range of products and the greater depth and liquidity of financial markets permit banking organizations to change their risk profiles more rapidly than ever before. That possibility requires that we strike an appropriate balance between evaluating the condition of an institution at a point in time and evaluating the soundness of the bank's processes for managing risk. Recognition of the need for that balance is at the heart of the risk-focused examination approach. The risk-focused approach, by definition, entails a more formal risk assessment planning phase that identifies those areas and activities that warrant the most extensive review. This pre-planning process is supported by technology, for example, to download certain information about a bank's loan portfolio to our own computer systems and target areas of the portfolio for review. Once on-site, examiners analyze the bank's loans and other assets to ascertain the organization's current condition, and also to evaluate its internal control process and its own ability to identify and resolve problems. As a result, the Federal Reserve is placing greater reliance than before on a bank's internal auditors and on the accuracy and adequacy of its information systems. The review of the information flow extends from top to bottom, and with the expectation that bank senior management and boards of directors are actively involved in monitoring the bank's activities and providing sufficient guidance regarding risk assumption. [^0] [^0]: 1 "Independent commercial banking organizations" is defined as the sum of all bank holding companies and independent banks. Multi-bank holding companies are, therefore, considered as a single organization. ---[PAGE_BREAK]--- As in the past, performance of substantive checks on the reliability of a bank's controls remains today a cornerstone of the examination process, albeit in a more automated and advanced form. For example, automated loan sampling is performed for the purpose of generating statistically valid conclusions about the accuracy of a bank's internal loan review process. To the extent we can validate the integrity of a bank's internal controls more efficiently, we can place more confidence in them at an earlier stage and can also take greater comfort that management is getting an accurate indication of the bank's condition. Toward that end, Board staff is working to refine loan-sampling procedures that should further boost examiner productivity and accomplish other supervisory goals. Moreover, as examiners are able to complete loan reviews more quickly, they will have more time to review other high-priority aspects of the institution's operations. A significant benefit of the risk-focused approach is its emphasis on ensuring that the bank's internal oversight processes are sound and that communication between the bank and senior examiners is ongoing between examinations. That approach is generally supported by institutions we supervise and provides a more comprehensive oversight process that complements our annual or 18 -month examinations. Such an approach strengthens our ability to respond promptly if conditions deteriorate. Another benefit of the risk-focused approach has been a greater amount of planning, analysis, and information gathering at Reserve Banks prior to the on-site portion of the examination. Far from reducing our hands-on knowledge of the institution, this approach has ensured that when we are on-site, we are reviewing and analyzing the right areas, talking to the right people and making better use of our time and that of the bank's management and employees. In addition to improving productivity, it has also reduced our travel costs and improved employee morale. Examination staff at the Reserve Banks indicate that this process may be reducing on-site examination time by 15-30 percent in many cases and overall examination time of Federal Reserve personnel by perhaps 10 percent. While those results are tentative, partial, and unscientific, they are certainly encouraging in terms of resource implications. Complementing the risk-focused approach to supervision are enhancements to the tools we use to grade a bank's condition and management. Since 1995, we have asked Federal Reserve examiners to provide a specific supervisory rating for a bank's risk management process. More recently, the CAMEL rating system, too, has been revised by the banking agencies to place more emphasis on the adequacy of a bank's risk management practices and was expanded to include a specific "S" rating for an institution's sensitivity to market risk. As you may know, the Federal Reserve has also, for some time, used a rating scheme that focuses heavily on managerial procedures and controls in its oversight of U.S. branches and agencies of foreign banks. How effective is the risk-focused process? Since economic and industry conditions have been generally favorable for the past several years, there has not been a sufficiently stressful economic downturn to test fully bank risk management systems or supervisory practices. The market volatility beginning in 1994 did, however, provide some tests for the risk management systems of the larger banks with active trading desks. Nevertheless, there are many indications that bank and supervisory practices are materially better than they were in the 1980s and early 1990s. For example, the risk-focused approach is helping to identify certain deficiencies before they show up in a bank's financial condition. These are evidenced by instances where ratings for the quality of bank management are lower than those for capital, asset quality, or earnings. Because managerial weaknesses eventually show up in a bank's financial condition, it is important to identify and resolve those weaknesses early. In that regard, the risk-focused approach endeavors to prevent problems from developing to the point that they cause unnecessary losses that impair the institution's capital and require resolution under the Prompt Corrective Action mandate. ---[PAGE_BREAK]--- One example of how the risk-focused approach is helping to identify and address deficiencies is our supervisory experience with the U.S. branches of foreign banks. Subsequent to the enactment of the Foreign Bank Supervision Enhancement Act of 1991, which gave the Federal Reserve greater supervisory authority over foreign branches, our examinations uncovered a number of entities with internal control and audit weaknesses. This result was not completely unexpected, as these foreign banking organizations were not previously subject to the same level of oversight as our domestic organizations. Recognizing the seriousness of these weaknesses and their potential for causing problems in the future, the Federal Reserve has taken a number of steps to ensure that practices are materially upgraded at foreign branches and that any weaknesses continue to be uncovered. In addition to identifying and addressing internal control and audit weaknesses through examinations and supervisory follow-up, these efforts include ensuring that the foreign bank provides the necessary managerial support to its U.S. branches, including adequate systems of controls and audit. To place even more emphasis on internal controls and audit systems, the foreign branch rating system was revised in 1994. Furthermore, in 1996 additional steps were taken to ensure that internal control weaknesses are corrected and will not cause financial harm by adopting requirements for audit procedures in situations where significant control weaknesses are detected. These efforts to detect problems at their early stages and resolve them appear to be having positive effects. After peaking in 1993, there has been a steady decline in the number of U.S. branches and agencies with an overall examination rating of fair or lower and a rating of fair or lower in an examination component substantively affected by internal control and audit weaknesses. We believe that our continued efforts in this area will lead to further improvements in the internal control and audit practices of foreign banking organizations Implementing the risk-focused approach has not been an easy task. It has required a significant revision of our broad and specialized training programs, including expansion of capital markets, information technology, and global trading activities, as well as courses devoted exclusively to internal controls. These education programs will, of course, need to be continually updated as industry activities and conditions evolve. With the greater discretion provided to examiners to focus on areas of highest risk, ensuring the consistency and quality of examinations has increased in importance. Fortunately, new training courses and improved examination platforms, tools, and programs that guide examiners through the appropriate selection of examination procedures will help. In addition, our ability to evaluate more thoroughly the quality of an examination has improved with the greater depth of analysis provided in supporting examination materials such as the written risk assessments and analysis of exam findings. Those materials are allowing us to perform comparative reviews of examinations across institutions of similar size, risk profile and complexity, to ensure quality and consistency. So far we have been able to evaluate the effectiveness of our examination programs by identifying whether problems are identified early and resolved in a timely fashion, by evaluating whether examination reports and findings provide clear feedback to management and identify areas of highest risk, and by monitoring the extent to which our examinations are complying with statutory mandates for the frequency of examinations. Based on those criteria, I believe our examination program has been generally successful. Application of technology to supervisory process ---[PAGE_BREAK]--- The Federal Reserve has also done much to increase its own use of technology in an effort to improve examiner productivity, enhance analyses, and reduce burden on banks. Much of this effort has been conducted on an inter-agency basis, particularly in cooperation with the FDIC and state banking departments with whom we share supervision of state-chartered banks. Specific results include the development of a personal computer, lap-top workstation that provides examiners with a decision tree framework to assist them through the necessary procedures. The workstation also helps them document their work and prepare exam reports more efficiently. In addition, a software program has also been developed for receiving and analyzing loan portfolio data transmitted electronically from financial institutions. This process not only saves time but also improves the examiner's understanding of the risks presented by individual portfolios. The Federal Reserve is also developing an electronic examination tool for large domestic and foreign banking organizations that enhances our ability to share examination analysis and findings and other pertinent supervisory information among our Reserve Banks and with other supervisory authorities. This platform should substantively improve our ability to provide comprehensive oversight to those firms that are most prominent in the payment system and global financial markets. In addition to examination tools, the Federal Reserve has for many years maintained a comprehensive source of banking structure, financial, and examination data in its National Information Center. By year-end, we will have completed significant enhancements to the tools that provide examiners and analysts at the federal and state banking agencies with access to those data. # The Year 2000 One of the clearest reminders that managing technology is a challenge of its own is the need for banks to resolve the "Year 2000" problem. U.S. banks appear to be taking this matter seriously and are generally well underway toward identifying their individual needs and developing action plans. The Federal Reserve and the other federal bank supervisors are reviewing the relevant efforts of every insured depository institution in order to determine whether adequate progress on this issue is being made. This process should be complete by the middle of next year so that any detected deficiencies may be addressed in time. Meeting the demands of this review and ensuring proper remedies both before and after the year 2000 will be a significant and costly task to both the industry and the banking agencies. However, even within the context of banking, the scope of the Year 2000 problem extends far beyond U.S. banks to foreign banks, bank borrowers, depositors, vendors, and other counterparties. Through the Bank for International Settlements and other international forums, the Federal Reserve and other U.S. banking agencies have emphasized the need for all institutions to recognize this issue and to address it actively. Importantly, century date compliance is gaining more attention internationally, and the Basle Supervisors Committee is taking steps to address this matter. Banks and others need to address year 2000 system alterations, not only because of the potential effects on overall markets, but also as a threat to individual firm viability. At a minimum, banks should be concerned about their ability to provide uninterrupted service to their customers into the next millennium. If nothing else, it is simply good business. ## Efforts to Accommodate Industry Growth and Innovation Another goal of the Federal Reserve's supervisory approach is to remove unnecessary barriers that might hinder the industry's ability to grow, innovate, and remain competitive. Recently, the Board refined its application process to ensure that well-run, well capitalized banking organizations may apply to acquire banks and nonbanks in a more streamlined fashion and ---[PAGE_BREAK]--- commence certain types of new activities without prior approval. The Board also significantly revised various rules for section 20 companies and scaled back or removed many redundant firewalls. While these refinements require some changes to the supervisory process, we firmly believe that removing barriers to these lower risk activities is essential to maintaining the industry's health and competitiveness and its ability to serve its customers and the community. # Supervising nationwide and international institutions The consolidation and transformation of the U.S. banking system resulting from evolving market, statutory, and regulatory changes are also requiring the Federal Reserve to adapt to new conditions. As previously noted, we are working closely with the FDIC and state banking agencies to deal with the challenges presented by interstate banking and branching to ensure that the dual banking system remains viable in future years. To address that goal, the FDIC, the Federal Reserve, and the state banking departments began on October 1 a common risk-focused process for the examination of state-chartered community banks. Another initiative has been the State/Federal Supervisory Protocol, which commits the various banking agencies to work toward a "seamless" and minimally burdensome oversight process. In short, it sets forth a process in which state banking supervisors will accept the supervisory reports of other agencies for banks operating in their states through branches, but headquartered elsewhere. The fact that the plan has been accepted by all involved parties is encouraging. We now need to ensure that it is implemented as intended, as banks make use of their broader branching powers. Similar coordination efforts are necessary and underway in an international context. Through the Bank for International Settlements, for example, the Federal Reserve and the other U.S. banking agencies participate with supervisors from other G-10 countries to develop not only prudential capital and other regulatory standards, but also to promote sound practices over a broad range of banking issues. In this regard, the Basle Committee on Banking Supervision, with the approval of the central bank Governors of the G-10 countries, recently issued three documents: one dealing with the management of interest rate risk by banks, one dealing with the Year 2000 problems, and another identifying 25 "core principles" of effective supervision that is directed at bank supervisors worldwide. The Basle Committee is also working to improve international risk disclosure practices of banks, and has created the new market risk capital standard that is based on banks' internal value-at-risk models. That standard goes into effect in January of next year. Beyond the work of the Basle Committee and the banking agencies, we are also meeting with the SEC and international securities and insurance regulators to identify common issues, and to bring about greater convergence in our respective regulatory frameworks. That effort also has links to the Committee's efforts and should prove helpful in strengthening the oversight and regulation of financial institutions throughout the world that provide a broad range of financial products. Successful groundwork from this effort could also have implications for moving forward domestically in an era of financial reform. Guidance as well as supervisory and regulatory standards such as these -- whether developed in a domestic or international context -- are soon incorporated into examination procedures and help examiners in their reviews of many of the more complex activities of global banking organizations. These global institutions are perhaps the most challenging to supervise. Since it is not feasible for supervisors to review all locations of a global banking organization, emphasis is placed on the integrity of risk management and internal control systems, coordination with international supervisors, strong capital standards, and improved disclosures. ---[PAGE_BREAK]--- # Staffing the Supervisory Process A final supervisory challenge relates to the Federal Reserve's need to continue attracting, training, and retaining expert staff. Retaining sufficient numbers of individuals with the expertise to evaluate fully the risks in a rapidly changing banking industry is a major priority for the Federal Reserve and figures prominently in the bank supervision function's strategic plan. Particularly challenging is attracting and retaining specialists in the areas of capital markets and information technology where we have experienced increased turnover. We will continue efforts to attract and retain both specialists and generalists who are qualified to address issues as the industry evolves. As I have outlined in my testimony, the Federal Reserve's supervisory strategy is to maintain staff who can adequately evaluate the general soundness of banking activities by placing strong emphasis on the bank's management processes, systems, and controls. I believe such an approach will serve us well as the industry continues to evolve either by expanding the scope of its activities or through broader structural changes from financial modernization legislation. Nevertheless, developing the supervisory techniques, and attracting and training the personnel to do the job will pose a continuing challenge in the years ahead. ## Conclusion The history of banking and of bank supervision shows a long and rather close relationship between the health of the banking system and the economy, a connection reflecting the role of banks in the credit intermediation process. We can expect that relationship to continue and for bank earnings and asset quality to fluctuate as economic conditions change. As supervisors, we must prepare for such developments. In many ways, however, the banking and financial system have changed dramatically in the past decade both in terms of structure and diversity of activities. Risk management practices have also advanced, helped by technological and financial innovations. I believe that both bank supervisors and the banking industry have learned important lessons from the experience of the past ten years specifically about the need to actively monitor, manage and control risks. Nevertheless, conditions can always change, and the risk-focused approach will be continually challenged to anticipate and avoid new kinds of problems. We must recognize that a risk-focused approach to supervision is a developing process and however successful it may be, there will again be bank failures. Indeed, having no bank failures may suggest inadequate risk-taking by banks and less economic growth. Through our supervisory process, the Federal Reserve seeks to maintain the proper balance -- permitting banks maximum freedom, while still protecting the safety net and maintaining financial stability. Devoting adequate attention to banking practices and conditions and responding promptly as events unfold is the key. We intend to do that now and in the years ahead.	Susan M Phillips	United States	https://www.bis.org/review/r971010c.pdf	Madam Chairwoman and members of the Subcommittee, I am pleased to be here today to discuss the Federal Reserve's efforts in recent years to strengthen its supervisory processes and also to share with you the Board's views about what challenges lie ahead, both for the banking system and the supervisory process. As you know, the U.S. economy and its banking system have enjoyed half a decade of improving strength in which U.S. banks have become better capitalized and more profitable than they have been in generations. Moreover, in the past 13 months not a single insured bank has failed, and the Bank Insurance Fund is now capitalized at a level requiring most banks to pay only nominal fees for their insurance. While we can take comfort and, to some degree, satisfaction in these events, experience has demonstrated that at times like these -- if we are not vigilant -- risks can occur that set the stage for future problems. As I begin my remarks, I would like to point out that no system of supervision or regulation can provide total assurance that banking problems will not occur or that banks will not fail. Nor should it. Our goal as regulators is to identify weak banking practices early so that small or emerging problems can be addressed before they become large and costly -- either to the insurance fund or the financial system as a whole. We believe that progress made in recent years to focus our examinations on the areas of highest risk at banking organizations places us in a better position to identify problems early, control systemic risk, and maintain financial stability. That goal and the need to adapt the supervisory process to the potentially rapidly changing conditions in banking and financial markets underlies our decision to pursue a more risk-focused supervisory approach. We are well underway in implementing this new supervisory framework, and initial indications about that process from both the Federal Reserve's supervisory staff and the banking industry, itself, have been favorable. The risk-focused approach reflects our supervisory response to the effects that technology and financial innovation have had on the pace of change in banking organizations, the nature of U.S. and world financial markets, and the techniques employed for managing and controlling risk. As banking practices and markets continue to evolve, our emphasis on risk-focused supervision will be even more necessary in the years to come. As the primary federal supervisor of U.S. bank holding companies, state member banks, and most U.S. offices of foreign banks, the Federal Reserve has sought to apply effective supervision and contain excessive risks to the federal safety net, while also ensuring that banks adequately serve their communities and accommodate economic growth. As the nation's central bank, the Federal Reserve brings a different, important perspective to the supervisory process through its attention to the broad and long-term consequences of supervisory actions on the financial system and the economy. Significantly, the practical, hands-on involvement which the Federal Reserve gains through its supervisory function supports and complements our other central bank responsibilities, including fostering a safe and efficient payment system and ensuring the stability of the financial system. Past studies of bank failures have cited a number of contributing factors including, but certainly not limited to, inadequate supervisory staffing and antiquated examination procedures. Over the years, as it has supervised and regulated banking organizations, the Federal Reserve has emphasized periodic, on-site examinations that entail substantive loan portfolio reviews and significant transaction testing to identify emerging problems. In that connection, the Federal Reserve has sought to maintain a sufficient number and quality of supervisory personnel to conduct examinations with appropriate frequency and depth. That approach appears to have provided us with some consistent success. As conditions within the industry have substantially improved, the Board has been mindful of the cost of conducting its supervisory activities and has worked to contain those costs in the face of increased responsibilities. Throughout this period we have recognized the need to maintain stability in our work force, and have sought to avoid excessive build-ups or periods of disruptive retrenchment. That approach has enabled us to maintain what we believe has been an adequate and consistent level of oversight of banking organizations under our supervision during both good times and bad. During the past decade, the U.S. banking system has experienced a great deal of turmoil, stress, and change. Ten years ago, many of the country's largest banks announced huge loan loss provisions, beginning the process of reducing the industry's overhang of doubtful developing country loans. At the same time, many of these institutions and smaller regional banks were struggling with oil and agriculture sector difficulties or accumulating commercial real estate problems. These and other difficulties took a heavy toll. By the end of the 1980s, more than 200 banks were failing annually, and there were more than 1,000 other problem banks. This experience provided important lessons and forced supervisors and bankers, alike, to reconsider the way they approached their jobs. For their part, bankers recognized the need to build their capital and reserves, strengthen their internal controls, and improve practices for identifying, underwriting and managing risk. Supervisors were also reminded of the need to remain vigilant and of the high costs that bank failures can bring, not only to the insurance fund but to local communities as well. The FDIC Improvement Act of 1991 emphasized that point, requiring frequent examinations and prompt regulatory actions when serious problems emerge. Beyond these largely domestic, institutional events, banks and businesses throughout the world were dealing in the 1980s and 1990s with new technologies that were leading to a multitude of new and increasingly complex financial products that changed the nature of banking and financial markets. These technologies have brought many benefits that facilitate more efficient markets and, in turn, greater international trade and economic growth. They may also, however, have raised macro-stability concerns by concentrating the growing volume and complexity of certain activities within a small number of truly global institutions. It is essential that these largest firms adequately manage the related risks of these activities and that they remain adequately supervised. For it is these institutions that have the potential to disrupt worldwide payment systems and contribute most to systemic risk. In addition to the formal supervisory oversight exerted by regulators, concerns may be eased somewhat by the strong counterparty discipline being brought to bear world wide on banks and other financial institutions dealing in these new products. The scrutiny among counterparties in the global market place has contributed to improvements in capital positions and in overall risk management practices. In many ways, U.S. banks have been in the vanguard in applying technological advances to their products, distribution systems, and management processes, with such applications and innovations as ATMs, home banking, securitizations and credit derivatives. Such efforts, combined with greater attention to pricing their services and measuring their risks, have had material effects on the increased strength and profitability that our banks have seen. Within the United States, our banking system has also experienced a dramatic consolidation in the number of banking institutions, with the number of independent commercial banking organizations declining from 12,400 in 1980 to 7,400 in June of this year. That structural change has also contributed to industry earnings by providing banks with greater opportunities to reduce costs. The challenge going forward for many of these institutions may be in managing the growth and the continuing process of industry consolidation. This challenge may be greatest as banking organizations expand, particularly through acquisitions, into more diverse or nontraditional banking activities. That growth into a wider array of activities is especially important if banks are to meet the wide-ranging needs of their business and household customers while competing effectively with other regulated and unregulated firms. However, the managerial implications of rapid growth and growth into new activities should not be overlooked, either by the institutions or their supervisors. There is also no shortage of tasks facing the Federal Reserve as a bank supervisor, despite the virtually unprecedented strong condition of the U.S. banking system today. We, too, must deal with the evolving financial markets and advances in technology. At the same time, we must ensure that our own supervisory practices, tools, and standards take advantage of technological improvements and financial techniques so that our oversight is not only effective, but also as unobtrusive and appropriate as possible. These tasks are wide ranging, extending from our own re-engineering of the supervisory process to the way supervisors approach issues such as measuring capital adequacy and how we seek convergence on bank supervisory standards worldwide. Constructing a sound supervisory process while minimizing regulatory burden has been a long-standing and on-going effort at the Federal Reserve and an objective we have sought to advance with our emphasis on risk-focused examinations. Particularly in the past decade, we have found that the increased range of products and the greater depth and liquidity of financial markets permit banking organizations to change their risk profiles more rapidly than ever before. That possibility requires that we strike an appropriate balance between evaluating the condition of an institution at a point in time and evaluating the soundness of the bank's processes for managing risk. Recognition of the need for that balance is at the heart of the risk-focused examination approach. The risk-focused approach, by definition, entails a more formal risk assessment planning phase that identifies those areas and activities that warrant the most extensive review. This pre-planning process is supported by technology, for example, to download certain information about a bank's loan portfolio to our own computer systems and target areas of the portfolio for review. Once on-site, examiners analyze the bank's loans and other assets to ascertain the organization's current condition, and also to evaluate its internal control process and its own ability to identify and resolve problems. As a result, the Federal Reserve is placing greater reliance than before on a bank's internal auditors and on the accuracy and adequacy of its information systems. The review of the information flow extends from top to bottom, and with the expectation that bank senior management and boards of directors are actively involved in monitoring the bank's activities and providing sufficient guidance regarding risk assumption. As in the past, performance of substantive checks on the reliability of a bank's controls remains today a cornerstone of the examination process, albeit in a more automated and advanced form. For example, automated loan sampling is performed for the purpose of generating statistically valid conclusions about the accuracy of a bank's internal loan review process. To the extent we can validate the integrity of a bank's internal controls more efficiently, we can place more confidence in them at an earlier stage and can also take greater comfort that management is getting an accurate indication of the bank's condition. Toward that end, Board staff is working to refine loan-sampling procedures that should further boost examiner productivity and accomplish other supervisory goals. Moreover, as examiners are able to complete loan reviews more quickly, they will have more time to review other high-priority aspects of the institution's operations. A significant benefit of the risk-focused approach is its emphasis on ensuring that the bank's internal oversight processes are sound and that communication between the bank and senior examiners is ongoing between examinations. That approach is generally supported by institutions we supervise and provides a more comprehensive oversight process that complements our annual or 18 -month examinations. Such an approach strengthens our ability to respond promptly if conditions deteriorate. Another benefit of the risk-focused approach has been a greater amount of planning, analysis, and information gathering at Reserve Banks prior to the on-site portion of the examination. Far from reducing our hands-on knowledge of the institution, this approach has ensured that when we are on-site, we are reviewing and analyzing the right areas, talking to the right people and making better use of our time and that of the bank's management and employees. In addition to improving productivity, it has also reduced our travel costs and improved employee morale. Examination staff at the Reserve Banks indicate that this process may be reducing on-site examination time by 15-30 percent in many cases and overall examination time of Federal Reserve personnel by perhaps 10 percent. While those results are tentative, partial, and unscientific, they are certainly encouraging in terms of resource implications. Complementing the risk-focused approach to supervision are enhancements to the tools we use to grade a bank's condition and management. Since 1995, we have asked Federal Reserve examiners to provide a specific supervisory rating for a bank's risk management process. More recently, the CAMEL rating system, too, has been revised by the banking agencies to place more emphasis on the adequacy of a bank's risk management practices and was expanded to include a specific "S" rating for an institution's sensitivity to market risk. As you may know, the Federal Reserve has also, for some time, used a rating scheme that focuses heavily on managerial procedures and controls in its oversight of U.S. branches and agencies of foreign banks. How effective is the risk-focused process? Since economic and industry conditions have been generally favorable for the past several years, there has not been a sufficiently stressful economic downturn to test fully bank risk management systems or supervisory practices. The market volatility beginning in 1994 did, however, provide some tests for the risk management systems of the larger banks with active trading desks. Nevertheless, there are many indications that bank and supervisory practices are materially better than they were in the 1980s and early 1990s. For example, the risk-focused approach is helping to identify certain deficiencies before they show up in a bank's financial condition. These are evidenced by instances where ratings for the quality of bank management are lower than those for capital, asset quality, or earnings. Because managerial weaknesses eventually show up in a bank's financial condition, it is important to identify and resolve those weaknesses early. In that regard, the risk-focused approach endeavors to prevent problems from developing to the point that they cause unnecessary losses that impair the institution's capital and require resolution under the Prompt Corrective Action mandate. One example of how the risk-focused approach is helping to identify and address deficiencies is our supervisory experience with the U.S. branches of foreign banks. Subsequent to the enactment of the Foreign Bank Supervision Enhancement Act of 1991, which gave the Federal Reserve greater supervisory authority over foreign branches, our examinations uncovered a number of entities with internal control and audit weaknesses. This result was not completely unexpected, as these foreign banking organizations were not previously subject to the same level of oversight as our domestic organizations. Recognizing the seriousness of these weaknesses and their potential for causing problems in the future, the Federal Reserve has taken a number of steps to ensure that practices are materially upgraded at foreign branches and that any weaknesses continue to be uncovered. In addition to identifying and addressing internal control and audit weaknesses through examinations and supervisory follow-up, these efforts include ensuring that the foreign bank provides the necessary managerial support to its U.S. branches, including adequate systems of controls and audit. To place even more emphasis on internal controls and audit systems, the foreign branch rating system was revised in 1994. Furthermore, in 1996 additional steps were taken to ensure that internal control weaknesses are corrected and will not cause financial harm by adopting requirements for audit procedures in situations where significant control weaknesses are detected. These efforts to detect problems at their early stages and resolve them appear to be having positive effects. After peaking in 1993, there has been a steady decline in the number of U.S. branches and agencies with an overall examination rating of fair or lower and a rating of fair or lower in an examination component substantively affected by internal control and audit weaknesses. We believe that our continued efforts in this area will lead to further improvements in the internal control and audit practices of foreign banking organizations Implementing the risk-focused approach has not been an easy task. It has required a significant revision of our broad and specialized training programs, including expansion of capital markets, information technology, and global trading activities, as well as courses devoted exclusively to internal controls. These education programs will, of course, need to be continually updated as industry activities and conditions evolve. With the greater discretion provided to examiners to focus on areas of highest risk, ensuring the consistency and quality of examinations has increased in importance. Fortunately, new training courses and improved examination platforms, tools, and programs that guide examiners through the appropriate selection of examination procedures will help. In addition, our ability to evaluate more thoroughly the quality of an examination has improved with the greater depth of analysis provided in supporting examination materials such as the written risk assessments and analysis of exam findings. Those materials are allowing us to perform comparative reviews of examinations across institutions of similar size, risk profile and complexity, to ensure quality and consistency. So far we have been able to evaluate the effectiveness of our examination programs by identifying whether problems are identified early and resolved in a timely fashion, by evaluating whether examination reports and findings provide clear feedback to management and identify areas of highest risk, and by monitoring the extent to which our examinations are complying with statutory mandates for the frequency of examinations. Based on those criteria, I believe our examination program has been generally successful. Application of technology to supervisory process The Federal Reserve has also done much to increase its own use of technology in an effort to improve examiner productivity, enhance analyses, and reduce burden on banks. Much of this effort has been conducted on an inter-agency basis, particularly in cooperation with the FDIC and state banking departments with whom we share supervision of state-chartered banks. Specific results include the development of a personal computer, lap-top workstation that provides examiners with a decision tree framework to assist them through the necessary procedures. The workstation also helps them document their work and prepare exam reports more efficiently. In addition, a software program has also been developed for receiving and analyzing loan portfolio data transmitted electronically from financial institutions. This process not only saves time but also improves the examiner's understanding of the risks presented by individual portfolios. The Federal Reserve is also developing an electronic examination tool for large domestic and foreign banking organizations that enhances our ability to share examination analysis and findings and other pertinent supervisory information among our Reserve Banks and with other supervisory authorities. This platform should substantively improve our ability to provide comprehensive oversight to those firms that are most prominent in the payment system and global financial markets. In addition to examination tools, the Federal Reserve has for many years maintained a comprehensive source of banking structure, financial, and examination data in its National Information Center. By year-end, we will have completed significant enhancements to the tools that provide examiners and analysts at the federal and state banking agencies with access to those data. One of the clearest reminders that managing technology is a challenge of its own is the need for banks to resolve the "Year 2000" problem. U.S. banks appear to be taking this matter seriously and are generally well underway toward identifying their individual needs and developing action plans. The Federal Reserve and the other federal bank supervisors are reviewing the relevant efforts of every insured depository institution in order to determine whether adequate progress on this issue is being made. This process should be complete by the middle of next year so that any detected deficiencies may be addressed in time. Meeting the demands of this review and ensuring proper remedies both before and after the year 2000 will be a significant and costly task to both the industry and the banking agencies. However, even within the context of banking, the scope of the Year 2000 problem extends far beyond U.S. banks to foreign banks, bank borrowers, depositors, vendors, and other counterparties. Through the Bank for International Settlements and other international forums, the Federal Reserve and other U.S. banking agencies have emphasized the need for all institutions to recognize this issue and to address it actively. Importantly, century date compliance is gaining more attention internationally, and the Basle Supervisors Committee is taking steps to address this matter. Banks and others need to address year 2000 system alterations, not only because of the potential effects on overall markets, but also as a threat to individual firm viability. At a minimum, banks should be concerned about their ability to provide uninterrupted service to their customers into the next millennium. If nothing else, it is simply good business. Another goal of the Federal Reserve's supervisory approach is to remove unnecessary barriers that might hinder the industry's ability to grow, innovate, and remain competitive. Recently, the Board refined its application process to ensure that well-run, well capitalized banking organizations may apply to acquire banks and nonbanks in a more streamlined fashion and commence certain types of new activities without prior approval. The Board also significantly revised various rules for section 20 companies and scaled back or removed many redundant firewalls. While these refinements require some changes to the supervisory process, we firmly believe that removing barriers to these lower risk activities is essential to maintaining the industry's health and competitiveness and its ability to serve its customers and the community. The consolidation and transformation of the U.S. banking system resulting from evolving market, statutory, and regulatory changes are also requiring the Federal Reserve to adapt to new conditions. As previously noted, we are working closely with the FDIC and state banking agencies to deal with the challenges presented by interstate banking and branching to ensure that the dual banking system remains viable in future years. To address that goal, the FDIC, the Federal Reserve, and the state banking departments began on October 1 a common risk-focused process for the examination of state-chartered community banks. Another initiative has been the State/Federal Supervisory Protocol, which commits the various banking agencies to work toward a "seamless" and minimally burdensome oversight process. In short, it sets forth a process in which state banking supervisors will accept the supervisory reports of other agencies for banks operating in their states through branches, but headquartered elsewhere. The fact that the plan has been accepted by all involved parties is encouraging. We now need to ensure that it is implemented as intended, as banks make use of their broader branching powers. Similar coordination efforts are necessary and underway in an international context. Through the Bank for International Settlements, for example, the Federal Reserve and the other U.S. banking agencies participate with supervisors from other G-10 countries to develop not only prudential capital and other regulatory standards, but also to promote sound practices over a broad range of banking issues. In this regard, the Basle Committee on Banking Supervision, with the approval of the central bank Governors of the G-10 countries, recently issued three documents: one dealing with the management of interest rate risk by banks, one dealing with the Year 2000 problems, and another identifying 25 "core principles" of effective supervision that is directed at bank supervisors worldwide. The Basle Committee is also working to improve international risk disclosure practices of banks, and has created the new market risk capital standard that is based on banks' internal value-at-risk models. That standard goes into effect in January of next year. Beyond the work of the Basle Committee and the banking agencies, we are also meeting with the SEC and international securities and insurance regulators to identify common issues, and to bring about greater convergence in our respective regulatory frameworks. That effort also has links to the Committee's efforts and should prove helpful in strengthening the oversight and regulation of financial institutions throughout the world that provide a broad range of financial products. Successful groundwork from this effort could also have implications for moving forward domestically in an era of financial reform. Guidance as well as supervisory and regulatory standards such as these -- whether developed in a domestic or international context -- are soon incorporated into examination procedures and help examiners in their reviews of many of the more complex activities of global banking organizations. These global institutions are perhaps the most challenging to supervise. Since it is not feasible for supervisors to review all locations of a global banking organization, emphasis is placed on the integrity of risk management and internal control systems, coordination with international supervisors, strong capital standards, and improved disclosures. A final supervisory challenge relates to the Federal Reserve's need to continue attracting, training, and retaining expert staff. Retaining sufficient numbers of individuals with the expertise to evaluate fully the risks in a rapidly changing banking industry is a major priority for the Federal Reserve and figures prominently in the bank supervision function's strategic plan. Particularly challenging is attracting and retaining specialists in the areas of capital markets and information technology where we have experienced increased turnover. We will continue efforts to attract and retain both specialists and generalists who are qualified to address issues as the industry evolves. As I have outlined in my testimony, the Federal Reserve's supervisory strategy is to maintain staff who can adequately evaluate the general soundness of banking activities by placing strong emphasis on the bank's management processes, systems, and controls. I believe such an approach will serve us well as the industry continues to evolve either by expanding the scope of its activities or through broader structural changes from financial modernization legislation. Nevertheless, developing the supervisory techniques, and attracting and training the personnel to do the job will pose a continuing challenge in the years ahead. The history of banking and of bank supervision shows a long and rather close relationship between the health of the banking system and the economy, a connection reflecting the role of banks in the credit intermediation process. We can expect that relationship to continue and for bank earnings and asset quality to fluctuate as economic conditions change. As supervisors, we must prepare for such developments. In many ways, however, the banking and financial system have changed dramatically in the past decade both in terms of structure and diversity of activities. Risk management practices have also advanced, helped by technological and financial innovations. I believe that both bank supervisors and the banking industry have learned important lessons from the experience of the past ten years specifically about the need to actively monitor, manage and control risks. Nevertheless, conditions can always change, and the risk-focused approach will be continually challenged to anticipate and avoid new kinds of problems. We must recognize that a risk-focused approach to supervision is a developing process and however successful it may be, there will again be bank failures. Indeed, having no bank failures may suggest inadequate risk-taking by banks and less economic growth. Through our supervisory process, the Federal Reserve seeks to maintain the proper balance -- permitting banks maximum freedom, while still protecting the safety net and maintaining financial stability. Devoting adequate attention to banking practices and conditions and responding promptly as events unfold is the key. We intend to do that now and in the years ahead.
1997-10-14T00:00:00	Mr. Greenspan inaugurates a series of economic seminars (Central Bank Articles and Speeches, 14 Oct 97)	Remarks by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the University of Connecticut, Storrs, Connecticut on 14/10/97.	Mr. Greenspan inaugurates a series of economic seminars Remarks by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the University of Connecticut, Storrs, Connecticut on 14/10/97. I welcome the opportunity to inaugurate your economic seminar series because I believe that the education community has a crucial role to play in the current era of rapid economic change. Our businesses and workers are confronting a dynamic set of forces that will influence our nation's ability to compete worldwide in the years ahead. Our success in preparing workers and managers to harness those forces will be an important element in the outcome. One of the most central dynamic forces is the accelerated expansion of computer and telecommunications technologies, which can be reasonably expected to appreciably raise our standard of living in the twenty-first century. In the short run, however, fast-paced technological change creates an environment in which the stock of plant and equipment with which most managers and workers interact is turning over more rapidly, creating a perception that human skills are becoming obsolete at a rate perhaps unprecedented in American history. I shall endeavor to place this most unusual phenomenon in the context of the broader changes in our economy and, I hope, to explain why education, especially to enhance advanced skills, is so vital to the future growth of our economy. Wealth has always been created, virtually by definition, when individuals use their growing knowledge to interact with an expanding capital stock to produce goods and services of value. Assisted by the whole array of market prices, entrepreneurs seek to identify the types of products and services that individuals will value. More specifically, they seek the added value that customers place on products and services tailored to their particular needs, delivered in shorter time frames, or improved in quality. A century ago, much, if not most, of our effort was expended in producing food, clothing, and shelter. Only when crop yields increased, steam power was developed, and textile fabrication became more efficient were available work hours freed for the production and consumption of more discretionary goods and services. We manufactured cars and refrigerators and learned how to produce them with ever less human effort. As those products found their way into most homes, human effort moved on to the creation of values that were less constrained by limits of physical bulk, such as smaller, transistor-based electronics, and beyond to a wide variety of impalpable services -- medical care, education, entertainment, and travel, to name just a few. The demand for a virtually infinite array of impalpable values is, to a first approximation, insatiable. Understandably, today's efforts to create new values for consumers concentrates on these impalpables, which offer the highest potential value-added relative to costs in physical resources and human effort. Unbundling the particular characteristics of each good or service facilitates maximizing its value to each individual. Some individuals place more value on, and are willing to pay more for, style y rather than style x, whereas others prefer x. Producing both x and y enhances overall consumer well-being. Fifty years ago, only x was feasible. This striving to expand the options for satisfying the particular needs of individuals inevitably results in a shift toward value created through the exploitation of ideas and concepts -- or, more generally, information -- from the more straightforward utilization of physical resources and manual labor. Thus, it should come as no surprise that, over the past century, by far the largest part of the growth in America's real gross domestic product is the result of new insights and, more broadly, new information about how to rearrange physical reality to achieve ever-higher standards of living. The amount of physical input into our real GDP, measured in bulk or weight, has contributed only modestly to economic growth since the turn of the century. We have, for example, dramatically reduced the physical bulk of our radios, by substituting transistors for vacuum tubes. Thin fiber optic cable has replaced huge tonnages of copper wire. New architectural, engineering, and materials technologies have enabled the construction of buildings enclosing the same amount of space, but with far less physical material than was required, say, 50 or 100 years ago. Most recently, mobile phones have become significantly downsized as they have been improved. As it became technologically possible to differentiate output to meet the increasingly calibrated choices that consumers now regularly make, the value of information creation and its transfer was expanded. Hence, it is understandable that our advanced computer and telecommunications products have been accorded particularly high value and, thus, why computer and telecommunications companies that successfully innovate in this field exhibit particularly elevated stock market values. Breakthroughs in all areas of technology are continually adding to the growing list of almost wholly conceptual elements in our economic output. These developments are affecting how we produce output and are demanding greater specialized knowledge. We could expect the widespread and effective application of information and other technologies to significantly increase productivity and reduce business costs. Certainly, we can already see dramatic improvements in quality control that have sharply reduced costly product rejects and lost time, while computer and satellite technology has markedly improved the efficiencies of moving goods through even more sophisticated, just-in-time, inventory systems. With computer-assisted design, experiments can be evaluated in a virtual reality setting, where mistakes can be readily corrected without the misuse of time and materials. And new technologies have had extensive applications in the services sector -- for example, in health services, where improvements in both diagnosis and treatment have been singularly impressive; in airline efficiency and safety; and in secretarial services now dominated by word processing, faxes, and voice and electronic mail. The accelerated pace of technological advance has also interacted with the rapid rise in financial innovation, with the result that business services and financial transactions now are transmitted almost instantaneously across global networks. Financial instruments have become increasingly diverse, products more customized, and markets more intensely competitive. The scope and size of our financial sector has grown rapidly because of its ability to facilitate the financing of products and services that are themselves valued highly in the marketplace. Our nation's financial institutions, as a consequence, are endeavoring to find more effective and efficient ways to deliver their services. In this environment, America's prospects for economic growth will depend greatly on our capacity to develop and to apply new technology. Unfortunately, we have found that we never can predict with any precision which particular technology or synergies of technologies will add significantly to our knowledge and our ability to gain from that knowledge. For instance, Alexander Graham Bell initially viewed the telephone solely as a business instrument -- merely an enhancement of the telegraph for use in transmitting very specific messages. Indeed, he offered to sell his telephone patent to Western Union for only $100,000, but he was turned down. Similarly, Marconi, at first, overlooked the radio's value as a public broadcast medium, instead believing its principal application would be in the transmission of point-to-point messages, such as ship-to-ship, where communication by wire was infeasible. Moreover, we must recognize that an innovation's full potential may be realized only after extensive improvements or after complementary innovations in other fields of science. According to Charles Townes, a Nobel Prize winner for his work on the laser, the attorneys for Bell Labs initially, in the late 1960s, refused to patent the laser because they believed it had no applications in the field of telecommunications. Only in the 1980s, after extensive improvements in fiber optics technology, did the laser's importance for telecommunications become apparent. America's continued success in garnering the benefits of technological advance will depend on the ability of our businesses to deal with risk and uncertainty. Moreover, our ability to remain in the forefront of new ideas and products will be ever more difficult because of the rapid international diffusion of technology. Nonetheless, to date, we have not fallen behind in converting scientific and technological breakthroughs into viable commercial products. Even if the most recent, tentative indications that productivity growth may be speeding up were to turn out to be less than we had hoped, it is possible that the big increases in efficiency growing out of the introduction of computers and communications systems may still lie ahead. Past innovations, such as the advent of electricity or the invention of the gasoline-powered motor, required the development of considerable infrastructure before their full potential could be realized. Electricity, when it substituted for steam power late last century, was applied to production processes that had been developed for steam. For example, gravity was used to move goods vertically in the steam environment, and that setup did not initially change with the advent of electric power. Only much later -- when horizontal factories, newly designed for optimal use of electric power, began to dominate our industrial system -- did productivity clearly accelerate. Similarly, only when highways and gasoline service stations became extensive was the lower cost of motor vehicle transportation achieved. In addition, full effectiveness in realizing the gains from technological advance will require a considerable amount of human investment on the part of managers and workers who have to implement new processes and who must be prepared to adapt, over their lifetimes, to the ongoing change that innovations bring. The growth of the conceptual component of output has brought with it accelerating demands for workers who are equipped not simply with technical know-how, but with the ability to create, analyze, and transform information and to interact effectively with others. A popular term for the type of human capital that firms are today employing to a greater degree is "functional literacy,"1 which perhaps sounds deceptively simple when one considers the complex of attributes necessary to transform information into economic value. Indeed, the debate about whether the introduction of technology would upgrade or "deskill" the workforce is as old as Adam Smith. Certainly, one can point to some very routine types of jobs, such as those for telephone operators, that have lower skill requirements in today's world of automated communications systems than when more labor-intensive manual phone systems were in place. But, on the whole, the evidence suggests that across a wide range of industries, employers have upgraded their skill mix2. Importantly, these changes represent not simply a shift in the occupational mix, but, to a larger degree, an upgrading of skill requirements of individual jobs for which the range and complexity of tasks and the scope for problem-solving and decision-making has expanded. This process appears to have occurred more rapidly in those businesses with greater computer utilization3. However, this is not to argue that growing use of technology alone can explain the accelerated demand for more skilled workers. A 1994 survey of employers conducted by the Census Bureau for the National Center on the Educational Quality of the Workforce found that rising skill requirements also are more common in firms that have introduced more flexible production systems, adopted team management practices, or reduced the layers of management in the organization. More generally, at the root of both the rise in the demand for workers who embody greater human capital and the increasing application of technology is the realization by businesses that remaining competitive in today's world requires unprecedented flexibility to adapt to change. Traditionally, broader human capital skills have been associated with higher education, and, accordingly, the demand for college-trained workers has been increasing rapidly. The result is that, over the past 15 years, a wide gap has opened up between the earnings of college graduates and those of workers who stopped their formal schooling with a high-school diploma or less. But the dispersion of pay outcomes has also increased within groups of workers with the same levels of education, which suggests that broader cognitive skills and conceptual abilities have become increasingly important on a wide scale, and that basic credentials, by themselves, are not enough to ensure success in the workplace. Clearly our educational institutions will continue to play an important role in preparing workers to meet these demands. And, responding to the strong signals that the returns to formal education have been rising, the supply of college-trained labor has been increasing. School enrollment rates among traditional college-age young people, which were little changed in the 1970s, have moved up sharply since then. At the same time, enrollment rates have picked up noticeably among individuals aged 25 and over. Presumably, many of these older students are striving to keep pace with the new demands evolving in the job market. Indeed, an important aspect of the changing nature of jobs appears to be that an increasing number of workers are facing the likelihood that they will need retooling during their careers. The notion that formal degree programs at any level can be crafted to fully support the requirements of one's lifework is being challenged. As a result, education is increasingly becoming a lifelong activity; businesses are now looking for employees who are prepared to continue learning, and workers and managers in many kinds of pursuits have begun to recognize that maintaining their human capital will require persistent hard work and flexibility. Economists have long argued that more than half of the market human capital produced in a worker's lifetime is produced on the job4. Several decades ago, much of that on-the-job training was acquired through work experience; today we are seeing greater emphasis on the value of formal education and training programs for workers. Developing human capital is perceived by many corporations as adding to shareholder value. If idea creation is increasingly the factor that engenders value-added, then training and education are crucial to the growth of company value-added and profitability. In the private sector, a number of major corporations have invested in their own internal training centers -- so-called corporate universities. Some labor unions have done the same. More broadly, recent surveys by the Bureau of Labor Statistics and by the Department of Education indicate that the provision of education on the job has risen markedly in recent years. In 1995, the BLS report showed that 70 percent of workers in establishments with 50 or more employees received some formal training during the twelve months preceding the survey. Most often this training was conducted in house by company personnel, but larger firms also relied to a great extent on educational institutions. The information collected by the Department of Education indicated that the percentage of employed individuals who took courses specifically to improve their current job skills rose between 1991 and 1995; by 1995, four of every ten full-time workers aged 35 to 54 had sought to upgrade their skills. The survey shows that growing proportions of workers with a high-school education or less and of those in production and craft jobs sought additional training; however, college graduates and those in professional occupations still reported the highest incidence of additional coursework -- almost 50 percent. Thus, learning does seem to beget perhaps both a capacity as well as a desire for more learning. This finding should underscore the need to begin the learning process as early as possible. In the long run, better child-rearing and better basic education at the elementary and secondary school levels are essential to providing the foundation for a lifetime of learning. At the same time, we must be alert to the need to improve the skills and earning power of those who appear to be falling behind. We must also develop strategies to overcome the education deficiencies of all too many of our young people and to renew the skills of workers who have not kept up with the changing demands of the workplace. The recognition that more productive workers and learning go hand-in-hand is becoming ever more visible in schools and in the workplace. Expanded linkages between business and education should be encouraged at all levels of our education system. Building bridges between our educational institutions and the private business sector should have payoffs in how well graduates are prepared to meet the challenges of an increasingly knowledge-based global economy. Indeed, a recent study argues that we need not rely on colleges and universities to teach "the new basic skills" to prepare workers for jobs in a knowledge-based economy; that foundation could be built in high schools if only more high schools were to ensure that graduates left with not only essential basic reading and computational skills, but also with training in how to solve semi-structured problems, how to make oral presentations, and how to work in diverse groups5. Those researchers argue for a better connection between secondary school curricula and business needs -- "vocational education" in a very broad sense rather than the traditional narrow one. While many debate how to make our elementary and secondary schools more effective in preparing students -- particularly compared with those in other developed countries -- there is little question about the quality of our university system, which for decades has attracted growing numbers of students from abroad. The payoff to advanced training remains high, and even with higher rates of enrollment, the supply of college-trained labor does not appear likely to outstrip the growing demands of a rapidly changing economy. The linkages between the private sector and our colleges and universities have a long tradition, and many schools are endeavoring to extend those connections. Your university's plans for the Connecticut Information Technology Institute embodies this reality. You and your partners in the business community clearly appreciate the mutual benefits that will accrue as technologically advanced learning is grounded in real-world curricula -- beginning with students and continuing for workers seeking to renew their skills. The advent of the twenty-first century will certainly bring new challenges and new possibilities for our businesses, our workers, and our educational system. We cannot know the precise directions in which technological change will take us. As in the past, our economic institutions and our workforce will strive to adjust, but we must recognize that adjustment is not automatic. All shifts in the structure of the economy naturally create frictions and human stress, at least temporarily. However, if we are able to boost our investment in people, ideas, and processes as well as in machines, the economy can readily adapt to change, and support ever-rising standards of living.	---[PAGE_BREAK]--- Mr. Greenspan inaugurates a series of economic seminars Remarks by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the University of Connecticut, Storrs, Connecticut on 14/10/97. I welcome the opportunity to inaugurate your economic seminar series because I believe that the education community has a crucial role to play in the current era of rapid economic change. Our businesses and workers are confronting a dynamic set of forces that will influence our nation's ability to compete worldwide in the years ahead. Our success in preparing workers and managers to harness those forces will be an important element in the outcome. One of the most central dynamic forces is the accelerated expansion of computer and telecommunications technologies, which can be reasonably expected to appreciably raise our standard of living in the twenty-first century. In the short run, however, fast-paced technological change creates an environment in which the stock of plant and equipment with which most managers and workers interact is turning over more rapidly, creating a perception that human skills are becoming obsolete at a rate perhaps unprecedented in American history. I shall endeavor to place this most unusual phenomenon in the context of the broader changes in our economy and, I hope, to explain why education, especially to enhance advanced skills, is so vital to the future growth of our economy. Wealth has always been created, virtually by definition, when individuals use their growing knowledge to interact with an expanding capital stock to produce goods and services of value. Assisted by the whole array of market prices, entrepreneurs seek to identify the types of products and services that individuals will value. More specifically, they seek the added value that customers place on products and services tailored to their particular needs, delivered in shorter time frames, or improved in quality. A century ago, much, if not most, of our effort was expended in producing food, clothing, and shelter. Only when crop yields increased, steam power was developed, and textile fabrication became more efficient were available work hours freed for the production and consumption of more discretionary goods and services. We manufactured cars and refrigerators and learned how to produce them with ever less human effort. As those products found their way into most homes, human effort moved on to the creation of values that were less constrained by limits of physical bulk, such as smaller, transistor-based electronics, and beyond to a wide variety of impalpable services -- medical care, education, entertainment, and travel, to name just a few. The demand for a virtually infinite array of impalpable values is, to a first approximation, insatiable. Understandably, today's efforts to create new values for consumers concentrates on these impalpables, which offer the highest potential value-added relative to costs in physical resources and human effort. Unbundling the particular characteristics of each good or service facilitates maximizing its value to each individual. Some individuals place more value on, and are willing to pay more for, style y rather than style x , whereas others prefer x . Producing both x and y enhances overall consumer well-being. Fifty years ago, only x was feasible. This striving to expand the options for satisfying the particular needs of individuals inevitably results in a shift toward value created through the exploitation of ideas and concepts -- or, more generally, information -- from the more straightforward utilization of physical resources and manual labor. ---[PAGE_BREAK]--- Thus, it should come as no surprise that, over the past century, by far the largest part of the growth in America's real gross domestic product is the result of new insights and, more broadly, new information about how to rearrange physical reality to achieve ever-higher standards of living. The amount of physical input into our real GDP, measured in bulk or weight, has contributed only modestly to economic growth since the turn of the century. We have, for example, dramatically reduced the physical bulk of our radios, by substituting transistors for vacuum tubes. Thin fiber optic cable has replaced huge tonnages of copper wire. New architectural, engineering, and materials technologies have enabled the construction of buildings enclosing the same amount of space, but with far less physical material than was required, say, 50 or 100 years ago. Most recently, mobile phones have become significantly downsized as they have been improved. As it became technologically possible to differentiate output to meet the increasingly calibrated choices that consumers now regularly make, the value of information creation and its transfer was expanded. Hence, it is understandable that our advanced computer and telecommunications products have been accorded particularly high value and, thus, why computer and telecommunications companies that successfully innovate in this field exhibit particularly elevated stock market values. Breakthroughs in all areas of technology are continually adding to the growing list of almost wholly conceptual elements in our economic output. These developments are affecting how we produce output and are demanding greater specialized knowledge. We could expect the widespread and effective application of information and other technologies to significantly increase productivity and reduce business costs. Certainly, we can already see dramatic improvements in quality control that have sharply reduced costly product rejects and lost time, while computer and satellite technology has markedly improved the efficiencies of moving goods through even more sophisticated, just-in-time, inventory systems. With computer-assisted design, experiments can be evaluated in a virtual reality setting, where mistakes can be readily corrected without the misuse of time and materials. And new technologies have had extensive applications in the services sector -- for example, in health services, where improvements in both diagnosis and treatment have been singularly impressive; in airline efficiency and safety; and in secretarial services now dominated by word processing, faxes, and voice and electronic mail. The accelerated pace of technological advance has also interacted with the rapid rise in financial innovation, with the result that business services and financial transactions now are transmitted almost instantaneously across global networks. Financial instruments have become increasingly diverse, products more customized, and markets more intensely competitive. The scope and size of our financial sector has grown rapidly because of its ability to facilitate the financing of products and services that are themselves valued highly in the marketplace. Our nation's financial institutions, as a consequence, are endeavoring to find more effective and efficient ways to deliver their services. In this environment, America's prospects for economic growth will depend greatly on our capacity to develop and to apply new technology. Unfortunately, we have found that we never can predict with any precision which particular technology or synergies of technologies will add significantly to our knowledge and our ability to gain from that knowledge. For instance, Alexander Graham Bell initially viewed the telephone solely as a business instrument -- merely an enhancement of the telegraph for use in transmitting very specific messages. Indeed, he offered to sell his telephone patent to Western Union for only ---[PAGE_BREAK]--- $\$ 100,000$, but he was turned down. Similarly, Marconi, at first, overlooked the radio's value as a public broadcast medium, instead believing its principal application would be in the transmission of point-to-point messages, such as ship-to-ship, where communication by wire was infeasible. Moreover, we must recognize that an innovation's full potential may be realized only after extensive improvements or after complementary innovations in other fields of science. According to Charles Townes, a Nobel Prize winner for his work on the laser, the attorneys for Bell Labs initially, in the late 1960s, refused to patent the laser because they believed it had no applications in the field of telecommunications. Only in the 1980s, after extensive improvements in fiber optics technology, did the laser's importance for telecommunications become apparent. America's continued success in garnering the benefits of technological advance will depend on the ability of our businesses to deal with risk and uncertainty. Moreover, our ability to remain in the forefront of new ideas and products will be ever more difficult because of the rapid international diffusion of technology. Nonetheless, to date, we have not fallen behind in converting scientific and technological breakthroughs into viable commercial products. Even if the most recent, tentative indications that productivity growth may be speeding up were to turn out to be less than we had hoped, it is possible that the big increases in efficiency growing out of the introduction of computers and communications systems may still lie ahead. Past innovations, such as the advent of electricity or the invention of the gasoline-powered motor, required the development of considerable infrastructure before their full potential could be realized. Electricity, when it substituted for steam power late last century, was applied to production processes that had been developed for steam. For example, gravity was used to move goods vertically in the steam environment, and that setup did not initially change with the advent of electric power. Only much later -- when horizontal factories, newly designed for optimal use of electric power, began to dominate our industrial system -- did productivity clearly accelerate. Similarly, only when highways and gasoline service stations became extensive was the lower cost of motor vehicle transportation achieved. In addition, full effectiveness in realizing the gains from technological advance will require a considerable amount of human investment on the part of managers and workers who have to implement new processes and who must be prepared to adapt, over their lifetimes, to the ongoing change that innovations bring. The growth of the conceptual component of output has brought with it accelerating demands for workers who are equipped not simply with technical know-how, but with the ability to create, analyze, and transform information and to interact effectively with others. A popular term for the type of human capital that firms are today employing to a greater degree is "functional literacy," ${ }^{1}$ which perhaps sounds deceptively simple when one considers the complex of attributes necessary to transform information into economic value. Indeed, the debate about whether the introduction of technology would upgrade or "deskill" the workforce is as old as Adam Smith. Certainly, one can point to some very routine [^0] [^0]: ${ }^{1}$ Frederic L. Pryor and David Schaffer, "Wages and the University Educated: A Paradox Resolved," Monthly Labor Review (July 1997), pp. 3-14. ---[PAGE_BREAK]--- types of jobs, such as those for telephone operators, that have lower skill requirements in today's world of automated communications systems than when more labor-intensive manual phone systems were in place. But, on the whole, the evidence suggests that across a wide range of industries, employers have upgraded their skill mix ${ }^{2}$. Importantly, these changes represent not simply a shift in the occupational mix, but, to a larger degree, an upgrading of skill requirements of individual jobs for which the range and complexity of tasks and the scope for problem-solving and decision-making has expanded. This process appears to have occurred more rapidly in those businesses with greater computer utilization ${ }^{3}$. However, this is not to argue that growing use of technology alone can explain the accelerated demand for more skilled workers. A 1994 survey of employers conducted by the Census Bureau for the National Center on the Educational Quality of the Workforce found that rising skill requirements also are more common in firms that have introduced more flexible production systems, adopted team management practices, or reduced the layers of management in the organization. More generally, at the root of both the rise in the demand for workers who embody greater human capital and the increasing application of technology is the realization by businesses that remaining competitive in today's world requires unprecedented flexibility to adapt to change. Traditionally, broader human capital skills have been associated with higher education, and, accordingly, the demand for college-trained workers has been increasing rapidly. The result is that, over the past 15 years, a wide gap has opened up between the earnings of college graduates and those of workers who stopped their formal schooling with a high-school diploma or less. But the dispersion of pay outcomes has also increased within groups of workers with the same levels of education, which suggests that broader cognitive skills and conceptual abilities have become increasingly important on a wide scale, and that basic credentials, by themselves, are not enough to ensure success in the workplace. Clearly our educational institutions will continue to play an important role in preparing workers to meet these demands. And, responding to the strong signals that the returns to formal education have been rising, the supply of college-trained labor has been increasing. School enrollment rates among traditional college-age young people, which were little changed in the 1970s, have moved up sharply since then. At the same time, enrollment rates have picked up noticeably among individuals aged 25 and over. Presumably, many of these older students are striving to keep pace with the new demands evolving in the job market. Indeed, an important aspect of the changing nature of jobs appears to be that an increasing number of workers are facing the likelihood that they will need retooling during their careers. The notion that formal degree programs at any level can be crafted to fully support the requirements of one's lifework is being challenged. As a result, education is increasingly becoming a lifelong activity; businesses are now looking for employees who are prepared to continue learning, and workers and managers in many kinds of pursuits have begun to recognize that maintaining their human capital will require persistent hard work and flexibility. [^0] [^0]: ${ }^{2}$ Peter Cappelli, "Are Skilling Requirements Rising? Evidence from Production and Clerical Jobs," Industrial and Labor Relations Review (April 1993), pp. 515-530; and "Technology and Skill Requirements: Implications for Establishment Wage Structures," New England Economic Review, Special Issue on Earnings and Inequality (May/June, 1996), pp. 139-154. ${ }^{3}$ David H. Autor, Lawrence F. Katz, and Alan B. Krueger, "Computing Inequality: Have Computers Changed the Labor Market," National Bureau of Economic Research Working Paper 5956 (March 1997). ---[PAGE_BREAK]--- Economists have long argued that more than half of the market human capital produced in a worker's lifetime is produced on the job ${ }^{4}$. Several decades ago, much of that on-the-job training was acquired through work experience; today we are seeing greater emphasis on the value of formal education and training programs for workers. Developing human capital is perceived by many corporations as adding to shareholder value. If idea creation is increasingly the factor that engenders value-added, then training and education are crucial to the growth of company value-added and profitability. In the private sector, a number of major corporations have invested in their own internal training centers -- so-called corporate universities. Some labor unions have done the same. More broadly, recent surveys by the Bureau of Labor Statistics and by the Department of Education indicate that the provision of education on the job has risen markedly in recent years. In 1995, the BLS report showed that 70 percent of workers in establishments with 50 or more employees received some formal training during the twelve months preceding the survey. Most often this training was conducted in house by company personnel, but larger firms also relied to a great extent on educational institutions. The information collected by the Department of Education indicated that the percentage of employed individuals who took courses specifically to improve their current job skills rose between 1991 and 1995; by 1995, four of every ten full-time workers aged 35 to 54 had sought to upgrade their skills. The survey shows that growing proportions of workers with a high-school education or less and of those in production and craft jobs sought additional training; however, college graduates and those in professional occupations still reported the highest incidence of additional coursework -- almost 50 percent. Thus, learning does seem to beget perhaps both a capacity as well as a desire for more learning. This finding should underscore the need to begin the learning process as early as possible. In the long run, better child-rearing and better basic education at the elementary and secondary school levels are essential to providing the foundation for a lifetime of learning. At the same time, we must be alert to the need to improve the skills and earning power of those who appear to be falling behind. We must also develop strategies to overcome the education deficiencies of all too many of our young people and to renew the skills of workers who have not kept up with the changing demands of the workplace. The recognition that more productive workers and learning go hand-in-hand is becoming ever more visible in schools and in the workplace. Expanded linkages between business and education should be encouraged at all levels of our education system. Building bridges between our educational institutions and the private business sector should have payoffs in how well graduates are prepared to meet the challenges of an increasingly knowledge-based global economy. Indeed, a recent study argues that we need not rely on colleges and universities to teach "the new basic skills" to prepare workers for jobs in a knowledge-based economy; that foundation could be built in high schools if only more high schools were to ensure that graduates left with not only essential basic reading and computational skills, but also with training in how to solve semi-structured problems, how to make oral presentations, and how to work in diverse groups ${ }^{5}$. Those researchers argue for a better connection between secondary school curricula and business needs -- "vocational education" in a very broad sense rather than the traditional narrow one. [^0] [^0]: ${ }^{4}$ Jacob Mincer, "On the Job Training: Costs, Returns, and Some Implications," Journal of Political Economy, vol. 70, Supplement (October 1962), pp. 50-79; and James Heckman, Lance Lochner, and Christopher Taber, "Estimating and Evaluating Human Capital Policies in a General Equilibrium Environment" (Working Paper, University of Chicago, 1997). ${ }^{5}$ Richard J. Murnane and Frank Levy, Teaching the New Basic Skills: Principles for Educating Children to Thrive in a Changing Economy (The Free Press, 1997). ---[PAGE_BREAK]--- While many debate how to make our elementary and secondary schools more effective in preparing students -- particularly compared with those in other developed countries -- there is little question about the quality of our university system, which for decades has attracted growing numbers of students from abroad. The payoff to advanced training remains high, and even with higher rates of enrollment, the supply of college-trained labor does not appear likely to outstrip the growing demands of a rapidly changing economy. The linkages between the private sector and our colleges and universities have a long tradition, and many schools are endeavoring to extend those connections. Your university's plans for the Connecticut Information Technology Institute embodies this reality. You and your partners in the business community clearly appreciate the mutual benefits that will accrue as technologically advanced learning is grounded in real-world curricula -- beginning with students and continuing for workers seeking to renew their skills. The advent of the twenty-first century will certainly bring new challenges and new possibilities for our businesses, our workers, and our educational system. We cannot know the precise directions in which technological change will take us. As in the past, our economic institutions and our workforce will strive to adjust, but we must recognize that adjustment is not automatic. All shifts in the structure of the economy naturally create frictions and human stress, at least temporarily. However, if we are able to boost our investment in people, ideas, and processes as well as in machines, the economy can readily adapt to change, and support ever-rising standards of living.	Alan Greenspan	United States	https://www.bis.org/review/r971021d.pdf	Mr. Greenspan inaugurates a series of economic seminars Remarks by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the University of Connecticut, Storrs, Connecticut on 14/10/97. I welcome the opportunity to inaugurate your economic seminar series because I believe that the education community has a crucial role to play in the current era of rapid economic change. Our businesses and workers are confronting a dynamic set of forces that will influence our nation's ability to compete worldwide in the years ahead. Our success in preparing workers and managers to harness those forces will be an important element in the outcome. One of the most central dynamic forces is the accelerated expansion of computer and telecommunications technologies, which can be reasonably expected to appreciably raise our standard of living in the twenty-first century. In the short run, however, fast-paced technological change creates an environment in which the stock of plant and equipment with which most managers and workers interact is turning over more rapidly, creating a perception that human skills are becoming obsolete at a rate perhaps unprecedented in American history. I shall endeavor to place this most unusual phenomenon in the context of the broader changes in our economy and, I hope, to explain why education, especially to enhance advanced skills, is so vital to the future growth of our economy. Wealth has always been created, virtually by definition, when individuals use their growing knowledge to interact with an expanding capital stock to produce goods and services of value. Assisted by the whole array of market prices, entrepreneurs seek to identify the types of products and services that individuals will value. More specifically, they seek the added value that customers place on products and services tailored to their particular needs, delivered in shorter time frames, or improved in quality. A century ago, much, if not most, of our effort was expended in producing food, clothing, and shelter. Only when crop yields increased, steam power was developed, and textile fabrication became more efficient were available work hours freed for the production and consumption of more discretionary goods and services. We manufactured cars and refrigerators and learned how to produce them with ever less human effort. As those products found their way into most homes, human effort moved on to the creation of values that were less constrained by limits of physical bulk, such as smaller, transistor-based electronics, and beyond to a wide variety of impalpable services -- medical care, education, entertainment, and travel, to name just a few. The demand for a virtually infinite array of impalpable values is, to a first approximation, insatiable. Understandably, today's efforts to create new values for consumers concentrates on these impalpables, which offer the highest potential value-added relative to costs in physical resources and human effort. Unbundling the particular characteristics of each good or service facilitates maximizing its value to each individual. Some individuals place more value on, and are willing to pay more for, style y rather than style x , whereas others prefer x . Producing both x and y enhances overall consumer well-being. Fifty years ago, only x was feasible. This striving to expand the options for satisfying the particular needs of individuals inevitably results in a shift toward value created through the exploitation of ideas and concepts -- or, more generally, information -- from the more straightforward utilization of physical resources and manual labor. Thus, it should come as no surprise that, over the past century, by far the largest part of the growth in America's real gross domestic product is the result of new insights and, more broadly, new information about how to rearrange physical reality to achieve ever-higher standards of living. The amount of physical input into our real GDP, measured in bulk or weight, has contributed only modestly to economic growth since the turn of the century. We have, for example, dramatically reduced the physical bulk of our radios, by substituting transistors for vacuum tubes. Thin fiber optic cable has replaced huge tonnages of copper wire. New architectural, engineering, and materials technologies have enabled the construction of buildings enclosing the same amount of space, but with far less physical material than was required, say, 50 or 100 years ago. Most recently, mobile phones have become significantly downsized as they have been improved. As it became technologically possible to differentiate output to meet the increasingly calibrated choices that consumers now regularly make, the value of information creation and its transfer was expanded. Hence, it is understandable that our advanced computer and telecommunications products have been accorded particularly high value and, thus, why computer and telecommunications companies that successfully innovate in this field exhibit particularly elevated stock market values. Breakthroughs in all areas of technology are continually adding to the growing list of almost wholly conceptual elements in our economic output. These developments are affecting how we produce output and are demanding greater specialized knowledge. We could expect the widespread and effective application of information and other technologies to significantly increase productivity and reduce business costs. Certainly, we can already see dramatic improvements in quality control that have sharply reduced costly product rejects and lost time, while computer and satellite technology has markedly improved the efficiencies of moving goods through even more sophisticated, just-in-time, inventory systems. With computer-assisted design, experiments can be evaluated in a virtual reality setting, where mistakes can be readily corrected without the misuse of time and materials. And new technologies have had extensive applications in the services sector -- for example, in health services, where improvements in both diagnosis and treatment have been singularly impressive; in airline efficiency and safety; and in secretarial services now dominated by word processing, faxes, and voice and electronic mail. The accelerated pace of technological advance has also interacted with the rapid rise in financial innovation, with the result that business services and financial transactions now are transmitted almost instantaneously across global networks. Financial instruments have become increasingly diverse, products more customized, and markets more intensely competitive. The scope and size of our financial sector has grown rapidly because of its ability to facilitate the financing of products and services that are themselves valued highly in the marketplace. Our nation's financial institutions, as a consequence, are endeavoring to find more effective and efficient ways to deliver their services. In this environment, America's prospects for economic growth will depend greatly on our capacity to develop and to apply new technology. Unfortunately, we have found that we never can predict with any precision which particular technology or synergies of technologies will add significantly to our knowledge and our ability to gain from that knowledge. For instance, Alexander Graham Bell initially viewed the telephone solely as a business instrument -- merely an enhancement of the telegraph for use in transmitting very specific messages. Indeed, he offered to sell his telephone patent to Western Union for only $\$ 100,000$, but he was turned down. Similarly, Marconi, at first, overlooked the radio's value as a public broadcast medium, instead believing its principal application would be in the transmission of point-to-point messages, such as ship-to-ship, where communication by wire was infeasible. Moreover, we must recognize that an innovation's full potential may be realized only after extensive improvements or after complementary innovations in other fields of science. According to Charles Townes, a Nobel Prize winner for his work on the laser, the attorneys for Bell Labs initially, in the late 1960s, refused to patent the laser because they believed it had no applications in the field of telecommunications. Only in the 1980s, after extensive improvements in fiber optics technology, did the laser's importance for telecommunications become apparent. America's continued success in garnering the benefits of technological advance will depend on the ability of our businesses to deal with risk and uncertainty. Moreover, our ability to remain in the forefront of new ideas and products will be ever more difficult because of the rapid international diffusion of technology. Nonetheless, to date, we have not fallen behind in converting scientific and technological breakthroughs into viable commercial products. Even if the most recent, tentative indications that productivity growth may be speeding up were to turn out to be less than we had hoped, it is possible that the big increases in efficiency growing out of the introduction of computers and communications systems may still lie ahead. Past innovations, such as the advent of electricity or the invention of the gasoline-powered motor, required the development of considerable infrastructure before their full potential could be realized. Electricity, when it substituted for steam power late last century, was applied to production processes that had been developed for steam. For example, gravity was used to move goods vertically in the steam environment, and that setup did not initially change with the advent of electric power. Only much later -- when horizontal factories, newly designed for optimal use of electric power, began to dominate our industrial system -- did productivity clearly accelerate. Similarly, only when highways and gasoline service stations became extensive was the lower cost of motor vehicle transportation achieved. In addition, full effectiveness in realizing the gains from technological advance will require a considerable amount of human investment on the part of managers and workers who have to implement new processes and who must be prepared to adapt, over their lifetimes, to the ongoing change that innovations bring. The growth of the conceptual component of output has brought with it accelerating demands for workers who are equipped not simply with technical know-how, but with the ability to create, analyze, and transform information and to interact effectively with others. A popular term for the type of human capital that firms are today employing to a greater degree is "functional literacy," which perhaps sounds deceptively simple when one considers the complex of attributes necessary to transform information into economic value. Indeed, the debate about whether the introduction of technology would upgrade or "deskill" the workforce is as old as Adam Smith. Certainly, one can point to some very routine types of jobs, such as those for telephone operators, that have lower skill requirements in today's world of automated communications systems than when more labor-intensive manual phone systems were in place. But, on the whole, the evidence suggests that across a wide range of industries, employers have upgraded their skill mix . Importantly, these changes represent not simply a shift in the occupational mix, but, to a larger degree, an upgrading of skill requirements of individual jobs for which the range and complexity of tasks and the scope for problem-solving and decision-making has expanded. This process appears to have occurred more rapidly in those businesses with greater computer utilization . However, this is not to argue that growing use of technology alone can explain the accelerated demand for more skilled workers. A 1994 survey of employers conducted by the Census Bureau for the National Center on the Educational Quality of the Workforce found that rising skill requirements also are more common in firms that have introduced more flexible production systems, adopted team management practices, or reduced the layers of management in the organization. More generally, at the root of both the rise in the demand for workers who embody greater human capital and the increasing application of technology is the realization by businesses that remaining competitive in today's world requires unprecedented flexibility to adapt to change. Traditionally, broader human capital skills have been associated with higher education, and, accordingly, the demand for college-trained workers has been increasing rapidly. The result is that, over the past 15 years, a wide gap has opened up between the earnings of college graduates and those of workers who stopped their formal schooling with a high-school diploma or less. But the dispersion of pay outcomes has also increased within groups of workers with the same levels of education, which suggests that broader cognitive skills and conceptual abilities have become increasingly important on a wide scale, and that basic credentials, by themselves, are not enough to ensure success in the workplace. Clearly our educational institutions will continue to play an important role in preparing workers to meet these demands. And, responding to the strong signals that the returns to formal education have been rising, the supply of college-trained labor has been increasing. School enrollment rates among traditional college-age young people, which were little changed in the 1970s, have moved up sharply since then. At the same time, enrollment rates have picked up noticeably among individuals aged 25 and over. Presumably, many of these older students are striving to keep pace with the new demands evolving in the job market. Indeed, an important aspect of the changing nature of jobs appears to be that an increasing number of workers are facing the likelihood that they will need retooling during their careers. The notion that formal degree programs at any level can be crafted to fully support the requirements of one's lifework is being challenged. As a result, education is increasingly becoming a lifelong activity; businesses are now looking for employees who are prepared to continue learning, and workers and managers in many kinds of pursuits have begun to recognize that maintaining their human capital will require persistent hard work and flexibility. Economists have long argued that more than half of the market human capital produced in a worker's lifetime is produced on the job . Several decades ago, much of that on-the-job training was acquired through work experience; today we are seeing greater emphasis on the value of formal education and training programs for workers. Developing human capital is perceived by many corporations as adding to shareholder value. If idea creation is increasingly the factor that engenders value-added, then training and education are crucial to the growth of company value-added and profitability. In the private sector, a number of major corporations have invested in their own internal training centers -- so-called corporate universities. Some labor unions have done the same. More broadly, recent surveys by the Bureau of Labor Statistics and by the Department of Education indicate that the provision of education on the job has risen markedly in recent years. In 1995, the BLS report showed that 70 percent of workers in establishments with 50 or more employees received some formal training during the twelve months preceding the survey. Most often this training was conducted in house by company personnel, but larger firms also relied to a great extent on educational institutions. The information collected by the Department of Education indicated that the percentage of employed individuals who took courses specifically to improve their current job skills rose between 1991 and 1995; by 1995, four of every ten full-time workers aged 35 to 54 had sought to upgrade their skills. The survey shows that growing proportions of workers with a high-school education or less and of those in production and craft jobs sought additional training; however, college graduates and those in professional occupations still reported the highest incidence of additional coursework -- almost 50 percent. Thus, learning does seem to beget perhaps both a capacity as well as a desire for more learning. This finding should underscore the need to begin the learning process as early as possible. In the long run, better child-rearing and better basic education at the elementary and secondary school levels are essential to providing the foundation for a lifetime of learning. At the same time, we must be alert to the need to improve the skills and earning power of those who appear to be falling behind. We must also develop strategies to overcome the education deficiencies of all too many of our young people and to renew the skills of workers who have not kept up with the changing demands of the workplace. The recognition that more productive workers and learning go hand-in-hand is becoming ever more visible in schools and in the workplace. Expanded linkages between business and education should be encouraged at all levels of our education system. Building bridges between our educational institutions and the private business sector should have payoffs in how well graduates are prepared to meet the challenges of an increasingly knowledge-based global economy. Indeed, a recent study argues that we need not rely on colleges and universities to teach "the new basic skills" to prepare workers for jobs in a knowledge-based economy; that foundation could be built in high schools if only more high schools were to ensure that graduates left with not only essential basic reading and computational skills, but also with training in how to solve semi-structured problems, how to make oral presentations, and how to work in diverse groups . Those researchers argue for a better connection between secondary school curricula and business needs -- "vocational education" in a very broad sense rather than the traditional narrow one. While many debate how to make our elementary and secondary schools more effective in preparing students -- particularly compared with those in other developed countries -- there is little question about the quality of our university system, which for decades has attracted growing numbers of students from abroad. The payoff to advanced training remains high, and even with higher rates of enrollment, the supply of college-trained labor does not appear likely to outstrip the growing demands of a rapidly changing economy. The linkages between the private sector and our colleges and universities have a long tradition, and many schools are endeavoring to extend those connections. Your university's plans for the Connecticut Information Technology Institute embodies this reality. You and your partners in the business community clearly appreciate the mutual benefits that will accrue as technologically advanced learning is grounded in real-world curricula -- beginning with students and continuing for workers seeking to renew their skills. The advent of the twenty-first century will certainly bring new challenges and new possibilities for our businesses, our workers, and our educational system. We cannot know the precise directions in which technological change will take us. As in the past, our economic institutions and our workforce will strive to adjust, but we must recognize that adjustment is not automatic. All shifts in the structure of the economy naturally create frictions and human stress, at least temporarily. However, if we are able to boost our investment in people, ideas, and processes as well as in machines, the economy can readily adapt to change, and support ever-rising standards of living.
1997-10-14T00:00:00	Mr. Meyer focuses on the effect of globalization on the conduct of US monetary policy (Central Bank Articles and Speeches, 14 Oct 97)	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the Institute for Global Management and Research, School of Business and Public Management, The George Washington University, Washington, D.C., on 14/10/97.	Mr. Meyer focuses on the effect of globalization on the conduct of US monetary policy Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the Institute for Global Management and Research, School of Business and Public Management, The George Washington University, Washington, D.C., on 14/10/97. World trade has increased much faster than world output over the last 30 years and international capital flows have expanded at a still more rapid pace. As a result, forecasting and modeling the national economic developments and the conduct of domestic policy has increasingly required more careful attention to the global context. My focus is on how globalization has affected the conduct of U.S. monetary policy. I begin by documenting the trend toward increased openness of the U.S. economy. With that background in place, I turn to the implications of increased openness for the conduct of U.S. monetary policy. The views I present here about the conduct of monetary policy are my own. They should not be interpreted as official policy positions of the Board of Governors or the FOMC. Some of the questions that I address along the way are: Does an open economy introduce either new objectives or new instruments for monetary policy? How does an open economy affect the monetary policy transmission mechanism? Does the rapid growth in cross-border capital flows limit or even eliminate the ability of domestic monetary policy to affect domestic interest rates? How does U.S. monetary policy affect economic conditions in other countries? How does globalization affect the cyclical properties of the U.S. economy, the inflation process, and longer-term trends in the economy? My conclusion is that, while the increasing openness has resulted in some important changes to how the U.S. economy operates, it has not fundamentally altered the determination of output and inflation, introduced new objectives of monetary policy, or offered new instruments to pursue those objectives. Nevertheless, it has importantly affected the monetary policy transmission mechanism and increasingly subjected the domestic economy to the effects of changes in economic conditions abroad. Documenting the trend toward increased openness of the U.S. economy The increased openness has two dimensions -- expanded trade in goods and services and expanded cross-border capital flows. A related indicator of openness is the volume of foreign exchange transactions, since both goods and financial asset transactions typically are preceded by currency conversions. U.S. trade in goods and services has increased about twice as fast as the growth in U.S. GDP over the last 31⁄2 decades. This reflects the effect of both trade liberalization and technological advance, as well as the rapid growth of emerging markets recently. Trade liberalization -- including both a series of multi-lateral efforts through GATT and regional efforts such as NAFTA -- has involved both reduction in tariffs and the elimination of many non-tariff barriers to trade. Technological gains have reduced transportation costs and improved the flow of information about goods around the world. A measure of the openness of the U.S. economy in terms of trade in goods and services is the ratio of the sum of U.S. imports and exports to U.S. GDP. This ratio has almost tripled over the last 31⁄2 decades, from 9% in 1960 to 24% in 1996. Even more striking is the expansion of international capital flows. Financial liberalization, deregulation, and technology, including the information revolution, have contributed to the globalization of asset markets. A measure of the net result of cross-border capital flows, the combined U.S. holdings of foreign securities and foreign holdings of U.S. securities, has increased more than tenfold just from 1980 to 1996. Foreigners now hold 33% of U.S. government securities, 17% of U.S. corporate bonds, and 7% of U.S. corporate stocks. U.S. holdings of foreign securities have also increased. Foreign stocks now make up about 10% of U.S. residents' equity holdings and foreign bonds make up about 4% of U.S. bond holdings. While the increase in cross-border capital flows is impressive, it is nevertheless clear that "home bias," the concentration of domestic wealth in domestic assets, still exists. Another indicator of the increased openness of the U.S. and other economies is the volume of foreign exchange transactions, since these transactions are often the first step in effecting both foreign trade and cross-border capital flows. The daily volume of foreign exchange transactions surveyed in major financial centers doubled over the period from 1989 to 1995 to about $1.2 trillion, and more than four-fifths of these transactions involve dollars. The daily volume of foreign exchange transactions, however, is an imperfect measure of openness of the U.S. economy, because many transactions among other countries involve dollars. Monetary policy in a global economy: responding to external shocks One implication of a global economy is that external shocks, those arising from outside the country, become an additional source of disturbance to the U.S. economy and therefore an additional challenge to which monetary policy must respond. I will consider three types of external shocks: demand, supply, and exchange rate shocks. An example of a demand shock would be an unexpected change in the overall level of economic activity abroad, which would affect the demand for U.S. exports. For example, in the early 1970s, the latter 1970s, and late 1980s, global expansions and the resulting sharp increase in world commodity prices and demand for U.S. exports contributed to the mounting inflationary pressures and overheating in the United States. In the three episodes just noted, commodity price booms were exacerbated by a run-up in oil prices resulting from the disruption of supplies from the Middle East. In the mid-1980s, oil prices plummeted, contributing to a transitory decline in inflation and easing of monetary conditions. Such changes in world oil prices are an example of a supply shock, a change in the price of goods unrelated to the balance between supply and demand in the domestic market. Energy and food prices, in particular, are subject to volatile swings, due to political decisions, weather, or other developments unrelated to overall domestic economic conditions. The United States is vulnerable to oil price shocks both because we have a very high consumption of oil and because we import about 50% of crude petroleum. The rise in oil prices not only has a sharp effect on overall prices in the United States, but, given the relatively inelastic demand for energy, results in an increase in real imports and hence a decline in aggregate demand for domestic output. Even much smaller shocks have had clearly visible effects on the U.S. economy, including the $5 dollar a barrel increase over 1996 and the $5 decline over 1997. Exchange rates move in response to both domestic and foreign economic developments and at times appear to move for reasons not clearly linked to economic fundamentals. The movements that are tied to changes in domestic economic fundamentals are part of the process of income and price determination in open economies, and I will have something to say about this below. But movements related to developments abroad or movements not clearly tied to economic fundamentals are another source of shock to national economies. This is especially important because the empirical linkages between exchange rates and fundamentals are weak, or not as well understood as we might like, so that movements in exchange rates often appear to be exaggerated relative to or seemingly unrelated to changes in fundamentals. Do cross-border capital flows reduce the effectiveness of monetary policy? One of the dimensions of increased openness is the rapid increase in the volume of cross-border capital flows. If foreign and domestic securities are perfect substitutes, the liberalization of cross-border financial transactions could, in principle, result in a single world financial market. This might appear to imply that the interest rate at which citizens and governments of a nation could borrow and lend would then be set on world markets, with little or at least limited influence by national policymakers. A small country, for example, would have no ability to influence world interest rates in this case. A very large country, such as the U.S., would retain some influence, but the influence would be diminished relative to the closed-economy case and would result from its ability to affect the world interest rate. If a country's exchange rate is pegged to the currency of another country (or countries), then its interest rates will move closely in line with those in the country or group of countries to which it is pegged. But for countries with flexible exchange rates, domestic interest rates can move quite independently of interest rates abroad. However, if countries care about the level of their exchange rates, which have implications for aggregate demand and inflation, and adjust monetary policy accordingly, interest rates will, to a degree, move in common across countries. Greater integration of global capital markets does in fact mean that expected returns for holding different assets, with appropriate compensation for differences in risk, should increasingly converge. However, as long as exchange rates can adjust, this does not imply that interest rates across countries must move together. Instead, it is movements in exchange rates which insure convergence of holding period yields across the countries. Before turning to the connection between interest rates and exchange rates, let me note that the evidence does not confirm an increase in correlations in interest rate movements across world asset markets, at least in the 1990s compared to the 1980s. It is true that the levels of long-term interest rates in major industrial countries have tended to converge since the early 1980s. But this is largely accounted for by a convergence of inflation rates. On the other hand, there is little evidence to suggest that correlations between changes in long-term interest rates across these countries have increased over this period. These correlations are a little higher in the 1980s and 1990s than they were in the 1970s, but again have shown no tendency to increase since the early 1980s. At any rate, the correlations between U.S. interest rates and those of major industrial countries suggest that there remains ample room for real interest rates to move differently across the world financial markets and implies that domestic monetary policies remain important tools of macroeconomic policy, at least in countries with flexible exchange rates. While the correlations among changes in interest rates have not increased, changes in interest rates between the U.S. and major industrial counties are correlated. Correlations tend to be about 0.5. This leaves open the question of causality and source of the correlations. It does not mean that higher U.S. interest rates directly raise foreign interest rates by this amount. First, some of the co-movement could reflect synchronous business cycles. Second, some of the co-movement could reflect the spillover effects of a cycle in one country on aggregate demand and hence interest rates in the other countries. In addition, some of the correlation may reflect the effect of the response of monetary policy to exchange rate developments. Perhaps reflecting the latter influence, the correlation between interest rates in the United States and Canada is higher, about 0.8, while that between the United States and Europe is lower, about 0.4. The transmission mechanism in a open economy While cross-border capital flows do not interfere with the ability of U.S. monetary policy to influence the broad spectrum of interest rates in the United States, they do quickly transmit pressures from changes in U.S. interest rates to the exchange rate and thereby broaden the channels through which monetary policy affects aggregate demand. In the closed economy setting, the transmission mechanism runs from increases in the federal funds rate, the short-term interest rate targeted by monetary policy, first to longer-term interest rates and equity prices and then to aggregate demand. Several components of aggregate demand depend importantly on interest rates, particularly longer-term interest rates (specifically, business fixed investment, housing, spending on consumer durables); consumer spending also depends on the net wealth of households and is therefore affected by equity prices. Under floating exchange rates, net exports become another interest-sensitive component of aggregate demand. Higher U.S. (real) interest rates, relative to foreign rates, raise the demand for dollar-denominated assets, and bring about an appreciation of the dollar which, in turn, stimulates imports and restrains exports. Net exports as a result become inversely related to U.S. interest rates. Evidence suggests that the response of net exports to interest rates (via exchange rates) has become larger over time. The open economy version of the monetary policy transmission mechanism involves three steps: from U.S. interest rates to nominal exchange rates; from nominal exchange rates to the absolute and relative prices of imports and exports; and from the prices of imports and exports to the real volumes of imports and exports and domestic prices. From U.S. interest rates to the exchange rate We begin with the link between interest rates in the U.S. and exchange rates. A policy-initiated increase in U.S. short-term rates would, as noted above, generally result in higher U.S. long-term interest rates. At initial levels of foreign interest rates and equity prices, the movement in U.S. rates would make dollar-denominated assets more attractive compared to foreign currency-denominated assets, resulting in shifts in asset demands and either incipient or actual cross-border capital inflows to the U.S. and outflows from foreign economies. These shifts result in an appreciation of the dollar. Indeed, the single most important determinant of short-term movements in exchange rates is the change in real interest rate differentials across countries. A 1% point increase in U.S. long-term (10-year) interest rates, with unchanged foreign rates, will typically induce a 10% increase in the U.S. trade-weighted exchange rate. After the initial jump in the dollar, there will be an expectation of a decline in the dollar by about 1% each year for the next 10 years. The result of the rise in the dollar and the expectations of gradual reversal is what is referred to as international interest rate parity. The holding period yields of U.S. and foreign assets, each denominated in their home currency, are thereby equated, eliminating the incentive for further changes in asset demands or capital flows. That is, the higher interest rate yield on U.S. assets (measured in dollars) is just offset by the expected depreciation in the value of the asset, measured in the foreign currency. This is the mechanism by which holding period yields are equated across countries via international capital flows. By the end of the 10-year period, according to this framework, both interest rates and exchange rate would have returned to their original levels. Evidence suggests that the response of the exchange rate to changes in U.S. interest rates (relative to foreign rates) has increased over time. This likely reflects the removal of capital controls by many major industrial countries during the 1970s and early 1980s that in turn contributed the sharp rise in international capital flows documented above. So, increased integration of financial markets across countries appears to have had a more important effect in raising the responsiveness of exchange rates to interest rate developments than in directly connecting interest rates across countries. From the exchange rate to the relative prices of imports and exports The next step in the transmission mechanism is the pass-through of the exchange rate to the dollar prices of imports and the foreign currency price of U.S. exports. The evidence suggests that the pass-through is much more complete for U.S. exports than for imports, but there is no evidence that these pass-throughs have changed over time. An appreciation of the dollar will be gradually partially passed through over time to the price of imports, lowering their price relative to U.S. produced goods. The corresponding depreciation in other countries' currencies will result in a gradual increase in the foreign currency price of U.S. exports, compared to the prices of foreign produced goods. The result is movements in relative prices that encourage imports and discourage exports. From relative prices to real import and export volumes The final step in the process is from the relative price of imports and exports to the volumes of real imports and exports. This depends on the elasticity of the demands for imports and exports with respect to their relative prices and the size of trade flows relative to GDP. The elasticities of imports and exports with respect to their respective relative prices are estimated to be about unity, and there is no evidence of a shift in this elasticity over the past several decades. A one percentage point increase in the real exchange rate would increase real imports by one percentage point over a three-year period and decrease real exports by a similar percentage. The absolute effect on aggregate demand also depends on initial levels of imports and exports. As import and export volumes have been increasing rapidly, the absolute effect of exchange rate changes on aggregate demand and the contribution of the exchange rate channel to the monetary transmission mechanism has been growing over time. Trends in interest sensitivity If the magnitude of other channels in the transmission mechanism remained unchanged, the growing importance of imports and exports and the increase in the responsiveness of exchange rates to interest rate differentials would have raised the overall responsiveness of aggregate demand to interest rates. However, it appears that the interest sensitivity of residential construction has moderated over time, beginning with the repeal of Regulation Q, and continuing with innovations in housing finance, including adjustable rate mortgages, the broadening of the sources of mortgage lending, and the development of securitization and secondary markets for mortgages. The net result is that the interest responsiveness of aggregate demand appears to have remained reasonably stable over time, although the sectoral distribution of the overall effect of interest rates has shifted toward net exports and away from housing. The response of net exports to changes in U.S. interest rates, via exchange rates, contributes about one-third of the total interest sensitivity of U.S. aggregate demand over both a one-year and three-year interval. It is therefore a very important part of the monetary policy transmission mechanism. How does U.S. monetary policy affect other countries? Just as developments abroad affect the U.S. economy, changes in U.S. economic conditions impact on foreign economies, although the effects are not necessarily symmetric. Because of the large relative size of the U.S. economy, changes in U.S. economic conditions have relatively larger effects on foreign economies, compared to the effect of changing conditions in any one country abroad on the U.S. economy. A change in U.S. monetary policy affects foreign economies in three ways -- via exchange rates, interest rates, and income in the United States. The effects depend critically on the nature of the foreign exchange regime in the foreign country. If the foreign country's currency is pegged to the dollar, for example, there will, of course, be no exchange rate effect vis-à-vis the United States. An increase in U.S. interest rates, however, would put downward pressure on the foreign currency and require the country to raise domestic interest rates to maintain the fixed exchange rate. Therefore, foreign interest rates are very likely to have to rise with U.S. rates in this case. The restraining effect of the rise in foreign interest rates will be reinforced by the effect of the deceleration in U.S. demand for foreign goods induced by the slowdown in U.S. income. As a result, a tightening of monetary policy is likely to have an unambiguously restrictive impact on those countries whose exchange rates are pegged to the dollar. For countries with floating exchange rates, on the other hand, the exchange rate and income effects of rising U.S. interest rates are likely to be offsetting. The appreciation of the dollar, of course, implies a depreciation in other countries' exchange rates; the depreciation will stimulate foreign aggregate demand by raising net exports. Offsetting this will be the effect of the decline in U.S. income on the demand for foreign countries' exports. The net effect, for countries with floating exchange rates, is likely to be small. That is, floating exchange rates tend to insulate a country from monetary shocks abroad. Other effects of globalization on the U.S. economy The increased openness of the U.S. economy has also focused attention on the possible effects of globalization on the macroeconomic performance of the U.S. economy, beyond the effects on the transmission of monetary policy that I have already addressed. I want to focus my attention in this section on the implications of globalization for wage-price dynamics because this has a direct bearing on the conduct of monetary policy. Some have argued that increased global competition has made the United States (and presumably other countries) less inflation prone, so that the U.S. economy can operate at a higher degree of resource utilization without the threat of rising inflation. It is useful to distinguish three ways in which global developments might recently be contributing to restraining inflation in the United States. First, the significant appreciation of the dollar over the last two years has clearly had an important restraining effect on U.S. inflation, both via the direct effect on the prices of imported goods and on the pricing power of domestic firms producing import-competing goods. Second, the absence of synchronous expansions among the major industrial countries -- specifically the much weaker expansions in continental Europe and the still weaker condition of the Japanese economy -- has prevented the pressures on worldwide commodity markets that often accompany U.S. expansions and has perhaps also encouraged greater price competitiveness than would otherwise have been the case. Third, increased international competitive pressures, associated with growing openness of the U.S. economy, might be restraining inflation. But I wonder whether we would be talking about the contribution of globalization to U.S. inflation performance if the dollar had been stable for the last several years and the expansions in Europe and Japan were as robust as in the U.S. I doubt it. Are there additional objectives for monetary policy in a global environment? An interesting question is whether the increased openness of the U.S. and other economies suggests new objectives for domestic monetary policies. It is certainly true that increased globalization has encouraged a proliferation of information-sharing exercises around the world and some increased attention to the coordination of policies across countries. I will comment on this briefly below. Let's start with objectives appropriate in the closed economy context. Congress has set dual objectives for monetary policy in the Federal Reserve Act: price stability and full employment. These objectives relate directly to the performance of the domestic economy and they are also objectives that monetary policy has the ability to pursue in the closed economy setting. The first question is whether the open economy environment reduces the ability of domestic monetary policy to achieve these objectives. I have argued that globalization has not reduced the ability of countries with flexible exchange rates to carry out independent monetary policies and therefore pursue domestic objectives. On the other hand, countries that fix exchange rates do give up much of the independence in their domestic monetary policies. The second issue is whether the open economy setting introduces new objectives, beyond those that motivate policy in the closed economy context. Three possibilities come to mind: the current account and/or trade balance, the exchange rate (or pattern in exchange rates around the world), and economic performance abroad. Even thinking of the external measures as domestic objectives raises questions. With respect to the current account, we should begin by separating cyclical and structural movements. Cyclical movements in net exports contribute the economy's built-in stability and are therefore quite desirable. Changes in the structural current account balance may contribute to or interfere with broader domestic objectives, depending on circumstances. The fundamental source of a structural current account deficit is domestic spending in excess of domestic production. Is this good or bad? The answer is: it depends. An excess of spending over production used to finance business fixed investment could have a payoff in terms of higher future output large enough to service the increased international indebtedness and still leave the country better off. An increase in the current account deficit as a result of increased private or public consumption would, in contrast, require lower future consumption as some of future production would have to be used to service the higher level of foreign debt. In addition, there is an issue of sustainability. International indebtedness can become so large in relation to current production, depending in part on the relationship between the real interest rate on foreign debt and the economy's trend rate of growth, that the current account deficit could increase explosively. If the current account is an objective, durable changes in the structural deficit can only be achieved by fiscal policy. A cut in the structural federal budget deficit for example would increase national saving, lower real interest rates, lead to a depreciation of the dollar, boost net exports, and lower the current account deficit. It is even more difficult to talk about the exchange rate as an objective. The exchange rate is, after all, basically a relative price. We might say that we prefer that an exchange rate that reflect fundamentals. But other than that the exchange rate is a symptom, rather than an outcome. If the current account deficit is wide because of a high dollar, the appropriate question is why is the dollar so high. If the answer is because the federal budget structural deficit is high and has raised real interest rates in the U.S., the offender is not the exchange rate, but the federal budget deficit. If the problem with exchange rates is fundamentals, then it is the fundamentals that need to be changed. Monetary policy can, via its effect on interest rates, influence exchange rates in the short run. But, for monetary policy to target exchange rates, it must give reduced weight to its domestic objectives. When fundamentals are the issue, it is the mix of monetary and fiscal policies that must answer the call. Stabilization policy, for example, calls for a level of aggregate demand consistent with full employment. That level of aggregate demand can be produced by a variety of combinations of monetary and fiscal policies, varying from a very tight fiscal and loose monetary policy to a tight monetary and loose fiscal policy. The difference among these options is interest rates. If fiscal policy, for example, moves to a higher deficit, monetary policy will have to offset the effect on aggregate demand by tightening. The result is higher interest rate, a higher dollar, and ultimately a wider current account deficit. If this outcome is viewed as undesirable, the way to unwind it is by lowering the deficit, accompanied by more accommodative monetary policy. It takes two to do this tango! But I always view fiscal policy as having the first move. Monetary policy's job is to follow the lead of fiscal, so that the resulting mix is appropriate to the requirements of stabilization policy. I am occasionally asked whether I worry about the effect on other countries of changes in U.S. monetary policy. While I do keep in mind the potential international repercussions of U.S. monetary policy actions, I believe that the best way for the U.S. to contribute to the health of the world economy is to pursue prudent domestic policy and achieve maximum sustainable employment and price stability and accommodate the maximum sustainable growth in the U.S. economy. Are there new policy instruments in a global economy? Another question about the conduct of monetary policy in an open economy is whether the open economy offers monetary policy a new instrument that it did not have in the closed economy world. In a closed economy context, monetary policy has a single instrument: open market operations, used to target a short-term interest rate. The obvious candidate for an additional instrument in the open economy case is the exchange rate. I have already argued that monetary policy cannot be used to target the exchange rate. The issue here is whether there are opportunities to exercise direct control of the exchange rate. The obvious option is intervention. Intervention refers to a government buying or selling foreign currency in order to influence the exchange rate. One can identify two reasons for intervening. The first is to calm disorderly markets. That is, an increase in volatility in the foreign exchange market might be damped by intervention. However, most intervention is about affecting the level of the exchange rate, not its volatility, though the rhetoric of disorderly markets often is employed to justify the action. Actions to affect the level can be intended to prevent a further decline (or increase) or to encourage a change in the level. With a daily volume of $1.2 trillion in the foreign exchange markets, and underlying stocks of financial assets that are substantially larger, there is ground for skepticism that intervention, which seldom ranges into the billions of dollars in daily volume, can have more than a marginal and transitory effect. Still, there are examples of modest "successes," especially when intervention is coordinated across countries and well timed. The major opportunity for intervention to succeed is when the exchange rate has diverged to a significant degree from fundamentals and the intervention induces a reconsideration of the market or a refocus of the market on fundamentals. The management of foreign exchange interventions varies around the world. In the United States, this management is shared by the Federal Reserve System and the Treasury Department. In principle, intervention can be initiated by either party, although when the Treasury opts to intervene it is the Federal Reserve Bank of New York that actually does the buying or selling of foreign currency, albeit from an account held in the name of Treasury and at the direction of Treasury. Similarly, when the FOMC makes a decision to intervene, it directs the Federal Reserve Bank of New York to do so, from the account in the name of the Federal Reserve System. The traditional practice is that U.S. intervention exercises are carried out jointly, half from the Federal Reserve's account and half from the Treasury's account. However, in principle, either party could intervene on its own. International information exchange, policy coordination, and crisis management Given the growing interdependence of national economies and macroeconomic policies, the coordination of (or more accurately, mutual consultation about) these policies has taken on increased importance. The Federal Reserve takes part in many international forums to exchange information on economic developments and discuss global economic issues. Examples include the 10 meetings each year among G-10 central bank Governors, under the auspices of the BIS; the twice a year meetings of the Economic Policy Committee of the OECD, meetings of the G-7, IMF, and regional meetings, such as APEC and Governors of the Central Banks of the American Continent. In addition to discussions about the performance of the various economies and global macroeconomic issues, there are also ongoing discussions about international crisis management and a growing interest in global standards for risk management in financial institutions and for cooperation in sharing information about the performance and risk profiles of internationally active financial conglomerates.	---[PAGE_BREAK]--- # Mr. Meyer focuses on the effect of globalization on the conduct of US monetary policy Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the Institute for Global Management and Research, School of Business and Public Management, The George Washington University, Washington, D.C., on 14/10/97. World trade has increased much faster than world output over the last 30 years and international capital flows have expanded at a still more rapid pace. As a result, forecasting and modeling the national economic developments and the conduct of domestic policy has increasingly required more careful attention to the global context. My focus is on how globalization has affected the conduct of U.S. monetary policy. I begin by documenting the trend toward increased openness of the U.S. economy. With that background in place, I turn to the implications of increased openness for the conduct of U.S. monetary policy. The views I present here about the conduct of monetary policy are my own. They should not be interpreted as official policy positions of the Board of Governors or the FOMC. Some of the questions that I address along the way are: Does an open economy introduce either new objectives or new instruments for monetary policy? How does an open economy affect the monetary policy transmission mechanism? Does the rapid growth in cross-border capital flows limit or even eliminate the ability of domestic monetary policy to affect domestic interest rates? How does U.S. monetary policy affect economic conditions in other countries? How does globalization affect the cyclical properties of the U.S. economy, the inflation process, and longer-term trends in the economy? My conclusion is that, while the increasing openness has resulted in some important changes to how the U.S. economy operates, it has not fundamentally altered the determination of output and inflation, introduced new objectives of monetary policy, or offered new instruments to pursue those objectives. Nevertheless, it has importantly affected the monetary policy transmission mechanism and increasingly subjected the domestic economy to the effects of changes in economic conditions abroad. Documenting the trend toward increased openness of the U.S. economy The increased openness has two dimensions -- expanded trade in goods and services and expanded cross-border capital flows. A related indicator of openness is the volume of foreign exchange transactions, since both goods and financial asset transactions typically are preceded by currency conversions. U.S. trade in goods and services has increased about twice as fast as the growth in U.S. GDP over the last $31 / 2$ decades. This reflects the effect of both trade liberalization and technological advance, as well as the rapid growth of emerging markets recently. Trade liberalization -- including both a series of multi-lateral efforts through GATT and regional efforts such as NAFTA -- has involved both reduction in tariffs and the elimination of many non-tariff barriers to trade. Technological gains have reduced transportation costs and improved the flow of information about goods around the world. A measure of the openness of the U.S. economy in terms of trade in goods and services is the ratio of the sum of U.S. imports and exports to U.S. GDP. This ratio has almost tripled over the last $31 / 2$ decades, from $9 \%$ in 1960 to $24 \%$ in 1996. ---[PAGE_BREAK]--- Even more striking is the expansion of international capital flows. Financial liberalization, deregulation, and technology, including the information revolution, have contributed to the globalization of asset markets. A measure of the net result of cross-border capital flows, the combined U.S. holdings of foreign securities and foreign holdings of U.S. securities, has increased more than tenfold just from 1980 to 1996. Foreigners now hold 33\% of U.S. government securities, $17 \%$ of U.S. corporate bonds, and $7 \%$ of U.S. corporate stocks. U.S. holdings of foreign securities have also increased. Foreign stocks now make up about $10 \%$ of U.S. residents' equity holdings and foreign bonds make up about $4 \%$ of U.S. bond holdings. While the increase in cross-border capital flows is impressive, it is nevertheless clear that "home bias," the concentration of domestic wealth in domestic assets, still exists. Another indicator of the increased openness of the U.S. and other economies is the volume of foreign exchange transactions, since these transactions are often the first step in effecting both foreign trade and cross-border capital flows. The daily volume of foreign exchange transactions surveyed in major financial centers doubled over the period from 1989 to 1995 to about $\$ 1.2$ trillion, and more than four-fifths of these transactions involve dollars. The daily volume of foreign exchange transactions, however, is an imperfect measure of openness of the U.S. economy, because many transactions among other countries involve dollars. # Monetary policy in a global economy: responding to external shocks One implication of a global economy is that external shocks, those arising from outside the country, become an additional source of disturbance to the U.S. economy and therefore an additional challenge to which monetary policy must respond. I will consider three types of external shocks: demand, supply, and exchange rate shocks. An example of a demand shock would be an unexpected change in the overall level of economic activity abroad, which would affect the demand for U.S. exports. For example, in the early 1970s, the latter 1970s, and late 1980s, global expansions and the resulting sharp increase in world commodity prices and demand for U.S. exports contributed to the mounting inflationary pressures and overheating in the United States. In the three episodes just noted, commodity price booms were exacerbated by a run-up in oil prices resulting from the disruption of supplies from the Middle East. In the mid-1980s, oil prices plummeted, contributing to a transitory decline in inflation and easing of monetary conditions. Such changes in world oil prices are an example of a supply shock, a change in the price of goods unrelated to the balance between supply and demand in the domestic market. Energy and food prices, in particular, are subject to volatile swings, due to political decisions, weather, or other developments unrelated to overall domestic economic conditions. The United States is vulnerable to oil price shocks both because we have a very high consumption of oil and because we import about $50 \%$ of crude petroleum. The rise in oil prices not only has a sharp effect on overall prices in the United States, but, given the relatively inelastic demand for energy, results in an increase in real imports and hence a decline in aggregate demand for domestic output. Even much smaller shocks have had clearly visible effects on the U.S. economy, including the $\$ 5$ dollar a barrel increase over 1996 and the $\$ 5$ decline over 1997. Exchange rates move in response to both domestic and foreign economic developments and at times appear to move for reasons not clearly linked to economic fundamentals. The movements that are tied to changes in domestic economic fundamentals are ---[PAGE_BREAK]--- part of the process of income and price determination in open economies, and I will have something to say about this below. But movements related to developments abroad or movements not clearly tied to economic fundamentals are another source of shock to national economies. This is especially important because the empirical linkages between exchange rates and fundamentals are weak, or not as well understood as we might like, so that movements in exchange rates often appear to be exaggerated relative to or seemingly unrelated to changes in fundamentals. # Do cross-border capital flows reduce the effectiveness of monetary policy? One of the dimensions of increased openness is the rapid increase in the volume of cross-border capital flows. If foreign and domestic securities are perfect substitutes, the liberalization of cross-border financial transactions could, in principle, result in a single world financial market. This might appear to imply that the interest rate at which citizens and governments of a nation could borrow and lend would then be set on world markets, with little or at least limited influence by national policymakers. A small country, for example, would have no ability to influence world interest rates in this case. A very large country, such as the U.S., would retain some influence, but the influence would be diminished relative to the closed-economy case and would result from its ability to affect the world interest rate. If a country's exchange rate is pegged to the currency of another country (or countries), then its interest rates will move closely in line with those in the country or group of countries to which it is pegged. But for countries with flexible exchange rates, domestic interest rates can move quite independently of interest rates abroad. However, if countries care about the level of their exchange rates, which have implications for aggregate demand and inflation, and adjust monetary policy accordingly, interest rates will, to a degree, move in common across countries. Greater integration of global capital markets does in fact mean that expected returns for holding different assets, with appropriate compensation for differences in risk, should increasingly converge. However, as long as exchange rates can adjust, this does not imply that interest rates across countries must move together. Instead, it is movements in exchange rates which insure convergence of holding period yields across the countries. Before turning to the connection between interest rates and exchange rates, let me note that the evidence does not confirm an increase in correlations in interest rate movements across world asset markets, at least in the 1990s compared to the 1980s. It is true that the levels of long-term interest rates in major industrial countries have tended to converge since the early 1980s. But this is largely accounted for by a convergence of inflation rates. On the other hand, there is little evidence to suggest that correlations between changes in long-term interest rates across these countries have increased over this period. These correlations are a little higher in the 1980s and 1990s than they were in the 1970s, but again have shown no tendency to increase since the early 1980s. At any rate, the correlations between U.S. interest rates and those of major industrial countries suggest that there remains ample room for real interest rates to move differently across the world financial markets and implies that domestic monetary policies remain important tools of macroeconomic policy, at least in countries with flexible exchange rates. While the correlations among changes in interest rates have not increased, changes in interest rates between the U.S. and major industrial counties are correlated. Correlations tend to be about 0.5 . This leaves open the question of causality and source of the ---[PAGE_BREAK]--- correlations. It does not mean that higher U.S. interest rates directly raise foreign interest rates by this amount. First, some of the co-movement could reflect synchronous business cycles. Second, some of the co-movement could reflect the spillover effects of a cycle in one country on aggregate demand and hence interest rates in the other countries. In addition, some of the correlation may reflect the effect of the response of monetary policy to exchange rate developments. Perhaps reflecting the latter influence, the correlation between interest rates in the United States and Canada is higher, about 0.8 , while that between the United States and Europe is lower, about 0.4 . # The transmission mechanism in a open economy While cross-border capital flows do not interfere with the ability of U.S. monetary policy to influence the broad spectrum of interest rates in the United States, they do quickly transmit pressures from changes in U.S. interest rates to the exchange rate and thereby broaden the channels through which monetary policy affects aggregate demand. In the closed economy setting, the transmission mechanism runs from increases in the federal funds rate, the short-term interest rate targeted by monetary policy, first to longer-term interest rates and equity prices and then to aggregate demand. Several components of aggregate demand depend importantly on interest rates, particularly longer-term interest rates (specifically, business fixed investment, housing, spending on consumer durables); consumer spending also depends on the net wealth of households and is therefore affected by equity prices. Under floating exchange rates, net exports become another interest-sensitive component of aggregate demand. Higher U.S. (real) interest rates, relative to foreign rates, raise the demand for dollar-denominated assets, and bring about an appreciation of the dollar which, in turn, stimulates imports and restrains exports. Net exports as a result become inversely related to U.S. interest rates. Evidence suggests that the response of net exports to interest rates (via exchange rates) has become larger over time. The open economy version of the monetary policy transmission mechanism involves three steps: from U.S. interest rates to nominal exchange rates; from nominal exchange rates to the absolute and relative prices of imports and exports; and from the prices of imports and exports to the real volumes of imports and exports and domestic prices. ## From U.S. interest rates to the exchange rate We begin with the link between interest rates in the U.S. and exchange rates. A policy-initiated increase in U.S. short-term rates would, as noted above, generally result in higher U.S. long-term interest rates. At initial levels of foreign interest rates and equity prices, the movement in U.S. rates would make dollar-denominated assets more attractive compared to foreign currency-denominated assets, resulting in shifts in asset demands and either incipient or actual cross-border capital inflows to the U.S. and outflows from foreign economies. These shifts result in an appreciation of the dollar. Indeed, the single most important determinant of short-term movements in exchange rates is the change in real interest rate differentials across countries. A $1 \%$ point increase in U.S. long-term (10-year) interest rates, with unchanged foreign rates, will typically induce a $10 \%$ increase in the U.S. trade-weighted exchange rate. After the initial jump in the dollar, there will be an expectation of a decline in the dollar by about $1 \%$ each year for the next 10 years. The result of the rise in the dollar and the expectations of gradual reversal is what is ---[PAGE_BREAK]--- referred to as international interest rate parity. The holding period yields of U.S. and foreign assets, each denominated in their home currency, are thereby equated, eliminating the incentive for further changes in asset demands or capital flows. That is, the higher interest rate yield on U.S. assets (measured in dollars) is just offset by the expected depreciation in the value of the asset, measured in the foreign currency. This is the mechanism by which holding period yields are equated across countries via international capital flows. By the end of the 10-year period, according to this framework, both interest rates and exchange rate would have returned to their original levels. Evidence suggests that the response of the exchange rate to changes in U.S. interest rates (relative to foreign rates) has increased over time. This likely reflects the removal of capital controls by many major industrial countries during the 1970s and early 1980s that in turn contributed the sharp rise in international capital flows documented above. So, increased integration of financial markets across countries appears to have had a more important effect in raising the responsiveness of exchange rates to interest rate developments than in directly connecting interest rates across countries. From the exchange rate to the relative prices of imports and exports The next step in the transmission mechanism is the pass-through of the exchange rate to the dollar prices of imports and the foreign currency price of U.S. exports. The evidence suggests that the pass-through is much more complete for U.S. exports than for imports, but there is no evidence that these pass-throughs have changed over time. An appreciation of the dollar will be gradually partially passed through over time to the price of imports, lowering their price relative to U.S. produced goods. The corresponding depreciation in other countries' currencies will result in a gradual increase in the foreign currency price of U.S. exports, compared to the prices of foreign produced goods. The result is movements in relative prices that encourage imports and discourage exports. From relative prices to real import and export volumes The final step in the process is from the relative price of imports and exports to the volumes of real imports and exports. This depends on the elasticity of the demands for imports and exports with respect to their relative prices and the size of trade flows relative to GDP. The elasticities of imports and exports with respect to their respective relative prices are estimated to be about unity, and there is no evidence of a shift in this elasticity over the past several decades. A one percentage point increase in the real exchange rate would increase real imports by one percentage point over a three-year period and decrease real exports by a similar percentage. The absolute effect on aggregate demand also depends on initial levels of imports and exports. As import and export volumes have been increasing rapidly, the absolute effect of exchange rate changes on aggregate demand and the contribution of the exchange rate channel to the monetary transmission mechanism has been growing over time. # Trends in interest sensitivity If the magnitude of other channels in the transmission mechanism remained unchanged, the growing importance of imports and exports and the increase in the responsiveness of exchange rates to interest rate differentials would have raised the overall responsiveness of aggregate demand to interest rates. However, it appears that the interest sensitivity of residential construction has moderated over time, beginning with the repeal of Regulation Q , and continuing with innovations in housing finance, including adjustable rate ---[PAGE_BREAK]--- mortgages, the broadening of the sources of mortgage lending, and the development of securitization and secondary markets for mortgages. The net result is that the interest responsiveness of aggregate demand appears to have remained reasonably stable over time, although the sectoral distribution of the overall effect of interest rates has shifted toward net exports and away from housing. The response of net exports to changes in U.S. interest rates, via exchange rates, contributes about one-third of the total interest sensitivity of U.S. aggregate demand over both a one-year and three-year interval. It is therefore a very important part of the monetary policy transmission mechanism. # How does U.S. monetary policy affect other countries? Just as developments abroad affect the U.S. economy, changes in U.S. economic conditions impact on foreign economies, although the effects are not necessarily symmetric. Because of the large relative size of the U.S. economy, changes in U.S. economic conditions have relatively larger effects on foreign economies, compared to the effect of changing conditions in any one country abroad on the U.S. economy. A change in U.S. monetary policy affects foreign economies in three ways -- via exchange rates, interest rates, and income in the United States. The effects depend critically on the nature of the foreign exchange regime in the foreign country. If the foreign country's currency is pegged to the dollar, for example, there will, of course, be no exchange rate effect vis-à-vis the United States. An increase in U.S. interest rates, however, would put downward pressure on the foreign currency and require the country to raise domestic interest rates to maintain the fixed exchange rate. Therefore, foreign interest rates are very likely to have to rise with U.S. rates in this case. The restraining effect of the rise in foreign interest rates will be reinforced by the effect of the deceleration in U.S. demand for foreign goods induced by the slowdown in U.S. income. As a result, a tightening of monetary policy is likely to have an unambiguously restrictive impact on those countries whose exchange rates are pegged to the dollar. For countries with floating exchange rates, on the other hand, the exchange rate and income effects of rising U.S. interest rates are likely to be offsetting. The appreciation of the dollar, of course, implies a depreciation in other countries' exchange rates; the depreciation will stimulate foreign aggregate demand by raising net exports. Offsetting this will be the effect of the decline in U.S. income on the demand for foreign countries' exports. The net effect, for countries with floating exchange rates, is likely to be small. That is, floating exchange rates tend to insulate a country from monetary shocks abroad. Other effects of globalization on the U.S. economy The increased openness of the U.S. economy has also focused attention on the possible effects of globalization on the macroeconomic performance of the U.S. economy, beyond the effects on the transmission of monetary policy that I have already addressed. I want to focus my attention in this section on the implications of globalization for wage-price dynamics because this has a direct bearing on the conduct of monetary policy. Some have argued that increased global competition has made the United States (and presumably other countries) less inflation prone, so that the U.S. economy can operate at a higher degree of resource utilization without the threat of rising inflation. ---[PAGE_BREAK]--- It is useful to distinguish three ways in which global developments might recently be contributing to restraining inflation in the United States. First, the significant appreciation of the dollar over the last two years has clearly had an important restraining effect on U.S. inflation, both via the direct effect on the prices of imported goods and on the pricing power of domestic firms producing import-competing goods. Second, the absence of synchronous expansions among the major industrial countries -- specifically the much weaker expansions in continental Europe and the still weaker condition of the Japanese economy -- has prevented the pressures on worldwide commodity markets that often accompany U.S. expansions and has perhaps also encouraged greater price competitiveness than would otherwise have been the case. Third, increased international competitive pressures, associated with growing openness of the U.S. economy, might be restraining inflation. But I wonder whether we would be talking about the contribution of globalization to U.S. inflation performance if the dollar had been stable for the last several years and the expansions in Europe and Japan were as robust as in the U.S. I doubt it. # Are there additional objectives for monetary policy in a global environment? An interesting question is whether the increased openness of the U.S. and other economies suggests new objectives for domestic monetary policies. It is certainly true that increased globalization has encouraged a proliferation of information-sharing exercises around the world and some increased attention to the coordination of policies across countries. I will comment on this briefly below. Let's start with objectives appropriate in the closed economy context. Congress has set dual objectives for monetary policy in the Federal Reserve Act: price stability and full employment. These objectives relate directly to the performance of the domestic economy and they are also objectives that monetary policy has the ability to pursue in the closed economy setting. The first question is whether the open economy environment reduces the ability of domestic monetary policy to achieve these objectives. I have argued that globalization has not reduced the ability of countries with flexible exchange rates to carry out independent monetary policies and therefore pursue domestic objectives. On the other hand, countries that fix exchange rates do give up much of the independence in their domestic monetary policies. The second issue is whether the open economy setting introduces new objectives, beyond those that motivate policy in the closed economy context. Three possibilities come to mind: the current account and/or trade balance, the exchange rate (or pattern in exchange rates around the world), and economic performance abroad. Even thinking of the external measures as domestic objectives raises questions. With respect to the current account, we should begin by separating cyclical and structural movements. Cyclical movements in net exports contribute the economy's built-in stability and are therefore quite desirable. Changes in the structural current account balance may contribute to or interfere with broader domestic objectives, depending on circumstances. The fundamental source of a structural current account deficit is domestic spending in excess of domestic production. Is this good or bad? The answer is: it depends. An excess of spending over production used to finance business fixed investment could have a payoff in terms of higher future output large enough to service the increased international indebtedness and still leave the country better off. An increase in the current account deficit as a result of increased private or public consumption would, in contrast, require lower future consumption as some of future ---[PAGE_BREAK]--- production would have to be used to service the higher level of foreign debt. In addition, there is an issue of sustainability. International indebtedness can become so large in relation to current production, depending in part on the relationship between the real interest rate on foreign debt and the economy's trend rate of growth, that the current account deficit could increase explosively. If the current account is an objective, durable changes in the structural deficit can only be achieved by fiscal policy. A cut in the structural federal budget deficit for example would increase national saving, lower real interest rates, lead to a depreciation of the dollar, boost net exports, and lower the current account deficit. It is even more difficult to talk about the exchange rate as an objective. The exchange rate is, after all, basically a relative price. We might say that we prefer that an exchange rate that reflect fundamentals. But other than that the exchange rate is a symptom, rather than an outcome. If the current account deficit is wide because of a high dollar, the appropriate question is why is the dollar so high. If the answer is because the federal budget structural deficit is high and has raised real interest rates in the U.S., the offender is not the exchange rate, but the federal budget deficit. If the problem with exchange rates is fundamentals, then it is the fundamentals that need to be changed. Monetary policy can, via its effect on interest rates, influence exchange rates in the short run. But, for monetary policy to target exchange rates, it must give reduced weight to its domestic objectives. When fundamentals are the issue, it is the mix of monetary and fiscal policies that must answer the call. Stabilization policy, for example, calls for a level of aggregate demand consistent with full employment. That level of aggregate demand can be produced by a variety of combinations of monetary and fiscal policies, varying from a very tight fiscal and loose monetary policy to a tight monetary and loose fiscal policy. The difference among these options is interest rates. If fiscal policy, for example, moves to a higher deficit, monetary policy will have to offset the effect on aggregate demand by tightening. The result is higher interest rate, a higher dollar, and ultimately a wider current account deficit. If this outcome is viewed as undesirable, the way to unwind it is by lowering the deficit, accompanied by more accommodative monetary policy. It takes two to do this tango! But I always view fiscal policy as having the first move. Monetary policy's job is to follow the lead of fiscal, so that the resulting mix is appropriate to the requirements of stabilization policy. I am occasionally asked whether I worry about the effect on other countries of changes in U.S. monetary policy. While I do keep in mind the potential international repercussions of U.S. monetary policy actions, I believe that the best way for the U.S. to contribute to the health of the world economy is to pursue prudent domestic policy and achieve maximum sustainable employment and price stability and accommodate the maximum sustainable growth in the U.S. economy. # Are there new policy instruments in a global economy? Another question about the conduct of monetary policy in an open economy is whether the open economy offers monetary policy a new instrument that it did not have in the closed economy world. In a closed economy context, monetary policy has a single instrument: open market operations, used to target a short-term interest rate. ---[PAGE_BREAK]--- The obvious candidate for an additional instrument in the open economy case is the exchange rate. I have already argued that monetary policy cannot be used to target the exchange rate. The issue here is whether there are opportunities to exercise direct control of the exchange rate. The obvious option is intervention. Intervention refers to a government buying or selling foreign currency in order to influence the exchange rate. One can identify two reasons for intervening. The first is to calm disorderly markets. That is, an increase in volatility in the foreign exchange market might be damped by intervention. However, most intervention is about affecting the level of the exchange rate, not its volatility, though the rhetoric of disorderly markets often is employed to justify the action. Actions to affect the level can be intended to prevent a further decline (or increase) or to encourage a change in the level. With a daily volume of $\$ 1.2$ trillion in the foreign exchange markets, and underlying stocks of financial assets that are substantially larger, there is ground for skepticism that intervention, which seldom ranges into the billions of dollars in daily volume, can have more than a marginal and transitory effect. Still, there are examples of modest "successes," especially when intervention is coordinated across countries and well timed. The major opportunity for intervention to succeed is when the exchange rate has diverged to a significant degree from fundamentals and the intervention induces a reconsideration of the market or a refocus of the market on fundamentals. The management of foreign exchange interventions varies around the world. In the United States, this management is shared by the Federal Reserve System and the Treasury Department. In principle, intervention can be initiated by either party, although when the Treasury opts to intervene it is the Federal Reserve Bank of New York that actually does the buying or selling of foreign currency, albeit from an account held in the name of Treasury and at the direction of Treasury. Similarly, when the FOMC makes a decision to intervene, it directs the Federal Reserve Bank of New York to do so, from the account in the name of the Federal Reserve System. The traditional practice is that U.S. intervention exercises are carried out jointly, half from the Federal Reserve's account and half from the Treasury's account. However, in principle, either party could intervene on its own. International information exchange, policy coordination, and crisis management Given the growing interdependence of national economies and macroeconomic policies, the coordination of (or more accurately, mutual consultation about) these policies has taken on increased importance. The Federal Reserve takes part in many international forums to exchange information on economic developments and discuss global economic issues. Examples include the 10 meetings each year among G-10 central bank Governors, under the auspices of the BIS; the twice a year meetings of the Economic Policy Committee of the OECD, meetings of the G-7, IMF, and regional meetings, such as APEC and Governors of the Central Banks of the American Continent. In addition to discussions about the performance of the various economies and global macroeconomic issues, there are also ongoing discussions about international crisis management and a growing interest in global standards for risk management in financial institutions and for cooperation in sharing information about the performance and risk profiles of internationally active financial conglomerates.	Laurence H Meyer	United States	https://www.bis.org/review/r971021c.pdf	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the Institute for Global Management and Research, School of Business and Public Management, The George Washington University, Washington, D.C., on 14/10/97. World trade has increased much faster than world output over the last 30 years and international capital flows have expanded at a still more rapid pace. As a result, forecasting and modeling the national economic developments and the conduct of domestic policy has increasingly required more careful attention to the global context. My focus is on how globalization has affected the conduct of U.S. monetary policy. I begin by documenting the trend toward increased openness of the U.S. economy. With that background in place, I turn to the implications of increased openness for the conduct of U.S. monetary policy. The views I present here about the conduct of monetary policy are my own. They should not be interpreted as official policy positions of the Board of Governors or the FOMC. Some of the questions that I address along the way are: Does an open economy introduce either new objectives or new instruments for monetary policy? How does an open economy affect the monetary policy transmission mechanism? Does the rapid growth in cross-border capital flows limit or even eliminate the ability of domestic monetary policy to affect domestic interest rates? How does U.S. monetary policy affect economic conditions in other countries? How does globalization affect the cyclical properties of the U.S. economy, the inflation process, and longer-term trends in the economy? My conclusion is that, while the increasing openness has resulted in some important changes to how the U.S. economy operates, it has not fundamentally altered the determination of output and inflation, introduced new objectives of monetary policy, or offered new instruments to pursue those objectives. Nevertheless, it has importantly affected the monetary policy transmission mechanism and increasingly subjected the domestic economy to the effects of changes in economic conditions abroad. Documenting the trend toward increased openness of the U.S. economy The increased openness has two dimensions -- expanded trade in goods and services and expanded cross-border capital flows. A related indicator of openness is the volume of foreign exchange transactions, since both goods and financial asset transactions typically are preceded by currency conversions. U.S. trade in goods and services has increased about twice as fast as the growth in U.S. GDP over the last $31 / 2$ decades. This reflects the effect of both trade liberalization and technological advance, as well as the rapid growth of emerging markets recently. Trade liberalization -- including both a series of multi-lateral efforts through GATT and regional efforts such as NAFTA -- has involved both reduction in tariffs and the elimination of many non-tariff barriers to trade. Technological gains have reduced transportation costs and improved the flow of information about goods around the world. A measure of the openness of the U.S. economy in terms of trade in goods and services is the ratio of the sum of U.S. imports and exports to U.S. GDP. This ratio has almost tripled over the last $31 / 2$ decades, from $9 \%$ in 1960 to $24 \%$ in 1996. Even more striking is the expansion of international capital flows. Financial liberalization, deregulation, and technology, including the information revolution, have contributed to the globalization of asset markets. A measure of the net result of cross-border capital flows, the combined U.S. holdings of foreign securities and foreign holdings of U.S. securities, has increased more than tenfold just from 1980 to 1996. Foreigners now hold 33\% of U.S. government securities, $17 \%$ of U.S. corporate bonds, and $7 \%$ of U.S. corporate stocks. U.S. holdings of foreign securities have also increased. Foreign stocks now make up about $10 \%$ of U.S. residents' equity holdings and foreign bonds make up about $4 \%$ of U.S. bond holdings. While the increase in cross-border capital flows is impressive, it is nevertheless clear that "home bias," the concentration of domestic wealth in domestic assets, still exists. Another indicator of the increased openness of the U.S. and other economies is the volume of foreign exchange transactions, since these transactions are often the first step in effecting both foreign trade and cross-border capital flows. The daily volume of foreign exchange transactions surveyed in major financial centers doubled over the period from 1989 to 1995 to about $\$ 1.2$ trillion, and more than four-fifths of these transactions involve dollars. The daily volume of foreign exchange transactions, however, is an imperfect measure of openness of the U.S. economy, because many transactions among other countries involve dollars. One implication of a global economy is that external shocks, those arising from outside the country, become an additional source of disturbance to the U.S. economy and therefore an additional challenge to which monetary policy must respond. I will consider three types of external shocks: demand, supply, and exchange rate shocks. An example of a demand shock would be an unexpected change in the overall level of economic activity abroad, which would affect the demand for U.S. exports. For example, in the early 1970s, the latter 1970s, and late 1980s, global expansions and the resulting sharp increase in world commodity prices and demand for U.S. exports contributed to the mounting inflationary pressures and overheating in the United States. In the three episodes just noted, commodity price booms were exacerbated by a run-up in oil prices resulting from the disruption of supplies from the Middle East. In the mid-1980s, oil prices plummeted, contributing to a transitory decline in inflation and easing of monetary conditions. Such changes in world oil prices are an example of a supply shock, a change in the price of goods unrelated to the balance between supply and demand in the domestic market. Energy and food prices, in particular, are subject to volatile swings, due to political decisions, weather, or other developments unrelated to overall domestic economic conditions. The United States is vulnerable to oil price shocks both because we have a very high consumption of oil and because we import about $50 \%$ of crude petroleum. The rise in oil prices not only has a sharp effect on overall prices in the United States, but, given the relatively inelastic demand for energy, results in an increase in real imports and hence a decline in aggregate demand for domestic output. Even much smaller shocks have had clearly visible effects on the U.S. economy, including the $\$ 5$ dollar a barrel increase over 1996 and the $\$ 5$ decline over 1997. Exchange rates move in response to both domestic and foreign economic developments and at times appear to move for reasons not clearly linked to economic fundamentals. The movements that are tied to changes in domestic economic fundamentals are part of the process of income and price determination in open economies, and I will have something to say about this below. But movements related to developments abroad or movements not clearly tied to economic fundamentals are another source of shock to national economies. This is especially important because the empirical linkages between exchange rates and fundamentals are weak, or not as well understood as we might like, so that movements in exchange rates often appear to be exaggerated relative to or seemingly unrelated to changes in fundamentals. One of the dimensions of increased openness is the rapid increase in the volume of cross-border capital flows. If foreign and domestic securities are perfect substitutes, the liberalization of cross-border financial transactions could, in principle, result in a single world financial market. This might appear to imply that the interest rate at which citizens and governments of a nation could borrow and lend would then be set on world markets, with little or at least limited influence by national policymakers. A small country, for example, would have no ability to influence world interest rates in this case. A very large country, such as the U.S., would retain some influence, but the influence would be diminished relative to the closed-economy case and would result from its ability to affect the world interest rate. If a country's exchange rate is pegged to the currency of another country (or countries), then its interest rates will move closely in line with those in the country or group of countries to which it is pegged. But for countries with flexible exchange rates, domestic interest rates can move quite independently of interest rates abroad. However, if countries care about the level of their exchange rates, which have implications for aggregate demand and inflation, and adjust monetary policy accordingly, interest rates will, to a degree, move in common across countries. Greater integration of global capital markets does in fact mean that expected returns for holding different assets, with appropriate compensation for differences in risk, should increasingly converge. However, as long as exchange rates can adjust, this does not imply that interest rates across countries must move together. Instead, it is movements in exchange rates which insure convergence of holding period yields across the countries. Before turning to the connection between interest rates and exchange rates, let me note that the evidence does not confirm an increase in correlations in interest rate movements across world asset markets, at least in the 1990s compared to the 1980s. It is true that the levels of long-term interest rates in major industrial countries have tended to converge since the early 1980s. But this is largely accounted for by a convergence of inflation rates. On the other hand, there is little evidence to suggest that correlations between changes in long-term interest rates across these countries have increased over this period. These correlations are a little higher in the 1980s and 1990s than they were in the 1970s, but again have shown no tendency to increase since the early 1980s. At any rate, the correlations between U.S. interest rates and those of major industrial countries suggest that there remains ample room for real interest rates to move differently across the world financial markets and implies that domestic monetary policies remain important tools of macroeconomic policy, at least in countries with flexible exchange rates. While the correlations among changes in interest rates have not increased, changes in interest rates between the U.S. and major industrial counties are correlated. Correlations tend to be about 0.5 . This leaves open the question of causality and source of the correlations. It does not mean that higher U.S. interest rates directly raise foreign interest rates by this amount. First, some of the co-movement could reflect synchronous business cycles. Second, some of the co-movement could reflect the spillover effects of a cycle in one country on aggregate demand and hence interest rates in the other countries. In addition, some of the correlation may reflect the effect of the response of monetary policy to exchange rate developments. Perhaps reflecting the latter influence, the correlation between interest rates in the United States and Canada is higher, about 0.8 , while that between the United States and Europe is lower, about 0.4 . While cross-border capital flows do not interfere with the ability of U.S. monetary policy to influence the broad spectrum of interest rates in the United States, they do quickly transmit pressures from changes in U.S. interest rates to the exchange rate and thereby broaden the channels through which monetary policy affects aggregate demand. In the closed economy setting, the transmission mechanism runs from increases in the federal funds rate, the short-term interest rate targeted by monetary policy, first to longer-term interest rates and equity prices and then to aggregate demand. Several components of aggregate demand depend importantly on interest rates, particularly longer-term interest rates (specifically, business fixed investment, housing, spending on consumer durables); consumer spending also depends on the net wealth of households and is therefore affected by equity prices. Under floating exchange rates, net exports become another interest-sensitive component of aggregate demand. Higher U.S. (real) interest rates, relative to foreign rates, raise the demand for dollar-denominated assets, and bring about an appreciation of the dollar which, in turn, stimulates imports and restrains exports. Net exports as a result become inversely related to U.S. interest rates. Evidence suggests that the response of net exports to interest rates (via exchange rates) has become larger over time. The open economy version of the monetary policy transmission mechanism involves three steps: from U.S. interest rates to nominal exchange rates; from nominal exchange rates to the absolute and relative prices of imports and exports; and from the prices of imports and exports to the real volumes of imports and exports and domestic prices. We begin with the link between interest rates in the U.S. and exchange rates. A policy-initiated increase in U.S. short-term rates would, as noted above, generally result in higher U.S. long-term interest rates. At initial levels of foreign interest rates and equity prices, the movement in U.S. rates would make dollar-denominated assets more attractive compared to foreign currency-denominated assets, resulting in shifts in asset demands and either incipient or actual cross-border capital inflows to the U.S. and outflows from foreign economies. These shifts result in an appreciation of the dollar. Indeed, the single most important determinant of short-term movements in exchange rates is the change in real interest rate differentials across countries. A $1 \%$ point increase in U.S. long-term (10-year) interest rates, with unchanged foreign rates, will typically induce a $10 \%$ increase in the U.S. trade-weighted exchange rate. After the initial jump in the dollar, there will be an expectation of a decline in the dollar by about $1 \%$ each year for the next 10 years. The result of the rise in the dollar and the expectations of gradual reversal is what is referred to as international interest rate parity. The holding period yields of U.S. and foreign assets, each denominated in their home currency, are thereby equated, eliminating the incentive for further changes in asset demands or capital flows. That is, the higher interest rate yield on U.S. assets (measured in dollars) is just offset by the expected depreciation in the value of the asset, measured in the foreign currency. This is the mechanism by which holding period yields are equated across countries via international capital flows. By the end of the 10-year period, according to this framework, both interest rates and exchange rate would have returned to their original levels. Evidence suggests that the response of the exchange rate to changes in U.S. interest rates (relative to foreign rates) has increased over time. This likely reflects the removal of capital controls by many major industrial countries during the 1970s and early 1980s that in turn contributed the sharp rise in international capital flows documented above. So, increased integration of financial markets across countries appears to have had a more important effect in raising the responsiveness of exchange rates to interest rate developments than in directly connecting interest rates across countries. From the exchange rate to the relative prices of imports and exports The next step in the transmission mechanism is the pass-through of the exchange rate to the dollar prices of imports and the foreign currency price of U.S. exports. The evidence suggests that the pass-through is much more complete for U.S. exports than for imports, but there is no evidence that these pass-throughs have changed over time. An appreciation of the dollar will be gradually partially passed through over time to the price of imports, lowering their price relative to U.S. produced goods. The corresponding depreciation in other countries' currencies will result in a gradual increase in the foreign currency price of U.S. exports, compared to the prices of foreign produced goods. The result is movements in relative prices that encourage imports and discourage exports. From relative prices to real import and export volumes The final step in the process is from the relative price of imports and exports to the volumes of real imports and exports. This depends on the elasticity of the demands for imports and exports with respect to their relative prices and the size of trade flows relative to GDP. The elasticities of imports and exports with respect to their respective relative prices are estimated to be about unity, and there is no evidence of a shift in this elasticity over the past several decades. A one percentage point increase in the real exchange rate would increase real imports by one percentage point over a three-year period and decrease real exports by a similar percentage. The absolute effect on aggregate demand also depends on initial levels of imports and exports. As import and export volumes have been increasing rapidly, the absolute effect of exchange rate changes on aggregate demand and the contribution of the exchange rate channel to the monetary transmission mechanism has been growing over time. If the magnitude of other channels in the transmission mechanism remained unchanged, the growing importance of imports and exports and the increase in the responsiveness of exchange rates to interest rate differentials would have raised the overall responsiveness of aggregate demand to interest rates. However, it appears that the interest sensitivity of residential construction has moderated over time, beginning with the repeal of Regulation Q , and continuing with innovations in housing finance, including adjustable rate mortgages, the broadening of the sources of mortgage lending, and the development of securitization and secondary markets for mortgages. The net result is that the interest responsiveness of aggregate demand appears to have remained reasonably stable over time, although the sectoral distribution of the overall effect of interest rates has shifted toward net exports and away from housing. The response of net exports to changes in U.S. interest rates, via exchange rates, contributes about one-third of the total interest sensitivity of U.S. aggregate demand over both a one-year and three-year interval. It is therefore a very important part of the monetary policy transmission mechanism. Just as developments abroad affect the U.S. economy, changes in U.S. economic conditions impact on foreign economies, although the effects are not necessarily symmetric. Because of the large relative size of the U.S. economy, changes in U.S. economic conditions have relatively larger effects on foreign economies, compared to the effect of changing conditions in any one country abroad on the U.S. economy. A change in U.S. monetary policy affects foreign economies in three ways -- via exchange rates, interest rates, and income in the United States. The effects depend critically on the nature of the foreign exchange regime in the foreign country. If the foreign country's currency is pegged to the dollar, for example, there will, of course, be no exchange rate effect vis-à-vis the United States. An increase in U.S. interest rates, however, would put downward pressure on the foreign currency and require the country to raise domestic interest rates to maintain the fixed exchange rate. Therefore, foreign interest rates are very likely to have to rise with U.S. rates in this case. The restraining effect of the rise in foreign interest rates will be reinforced by the effect of the deceleration in U.S. demand for foreign goods induced by the slowdown in U.S. income. As a result, a tightening of monetary policy is likely to have an unambiguously restrictive impact on those countries whose exchange rates are pegged to the dollar. For countries with floating exchange rates, on the other hand, the exchange rate and income effects of rising U.S. interest rates are likely to be offsetting. The appreciation of the dollar, of course, implies a depreciation in other countries' exchange rates; the depreciation will stimulate foreign aggregate demand by raising net exports. Offsetting this will be the effect of the decline in U.S. income on the demand for foreign countries' exports. The net effect, for countries with floating exchange rates, is likely to be small. That is, floating exchange rates tend to insulate a country from monetary shocks abroad. Other effects of globalization on the U.S. economy The increased openness of the U.S. economy has also focused attention on the possible effects of globalization on the macroeconomic performance of the U.S. economy, beyond the effects on the transmission of monetary policy that I have already addressed. I want to focus my attention in this section on the implications of globalization for wage-price dynamics because this has a direct bearing on the conduct of monetary policy. Some have argued that increased global competition has made the United States (and presumably other countries) less inflation prone, so that the U.S. economy can operate at a higher degree of resource utilization without the threat of rising inflation. It is useful to distinguish three ways in which global developments might recently be contributing to restraining inflation in the United States. First, the significant appreciation of the dollar over the last two years has clearly had an important restraining effect on U.S. inflation, both via the direct effect on the prices of imported goods and on the pricing power of domestic firms producing import-competing goods. Second, the absence of synchronous expansions among the major industrial countries -- specifically the much weaker expansions in continental Europe and the still weaker condition of the Japanese economy -- has prevented the pressures on worldwide commodity markets that often accompany U.S. expansions and has perhaps also encouraged greater price competitiveness than would otherwise have been the case. Third, increased international competitive pressures, associated with growing openness of the U.S. economy, might be restraining inflation. But I wonder whether we would be talking about the contribution of globalization to U.S. inflation performance if the dollar had been stable for the last several years and the expansions in Europe and Japan were as robust as in the U.S. I doubt it. An interesting question is whether the increased openness of the U.S. and other economies suggests new objectives for domestic monetary policies. It is certainly true that increased globalization has encouraged a proliferation of information-sharing exercises around the world and some increased attention to the coordination of policies across countries. I will comment on this briefly below. Let's start with objectives appropriate in the closed economy context. Congress has set dual objectives for monetary policy in the Federal Reserve Act: price stability and full employment. These objectives relate directly to the performance of the domestic economy and they are also objectives that monetary policy has the ability to pursue in the closed economy setting. The first question is whether the open economy environment reduces the ability of domestic monetary policy to achieve these objectives. I have argued that globalization has not reduced the ability of countries with flexible exchange rates to carry out independent monetary policies and therefore pursue domestic objectives. On the other hand, countries that fix exchange rates do give up much of the independence in their domestic monetary policies. The second issue is whether the open economy setting introduces new objectives, beyond those that motivate policy in the closed economy context. Three possibilities come to mind: the current account and/or trade balance, the exchange rate (or pattern in exchange rates around the world), and economic performance abroad. Even thinking of the external measures as domestic objectives raises questions. With respect to the current account, we should begin by separating cyclical and structural movements. Cyclical movements in net exports contribute the economy's built-in stability and are therefore quite desirable. Changes in the structural current account balance may contribute to or interfere with broader domestic objectives, depending on circumstances. The fundamental source of a structural current account deficit is domestic spending in excess of domestic production. Is this good or bad? The answer is: it depends. An excess of spending over production used to finance business fixed investment could have a payoff in terms of higher future output large enough to service the increased international indebtedness and still leave the country better off. An increase in the current account deficit as a result of increased private or public consumption would, in contrast, require lower future consumption as some of future production would have to be used to service the higher level of foreign debt. In addition, there is an issue of sustainability. International indebtedness can become so large in relation to current production, depending in part on the relationship between the real interest rate on foreign debt and the economy's trend rate of growth, that the current account deficit could increase explosively. If the current account is an objective, durable changes in the structural deficit can only be achieved by fiscal policy. A cut in the structural federal budget deficit for example would increase national saving, lower real interest rates, lead to a depreciation of the dollar, boost net exports, and lower the current account deficit. It is even more difficult to talk about the exchange rate as an objective. The exchange rate is, after all, basically a relative price. We might say that we prefer that an exchange rate that reflect fundamentals. But other than that the exchange rate is a symptom, rather than an outcome. If the current account deficit is wide because of a high dollar, the appropriate question is why is the dollar so high. If the answer is because the federal budget structural deficit is high and has raised real interest rates in the U.S., the offender is not the exchange rate, but the federal budget deficit. If the problem with exchange rates is fundamentals, then it is the fundamentals that need to be changed. Monetary policy can, via its effect on interest rates, influence exchange rates in the short run. But, for monetary policy to target exchange rates, it must give reduced weight to its domestic objectives. When fundamentals are the issue, it is the mix of monetary and fiscal policies that must answer the call. Stabilization policy, for example, calls for a level of aggregate demand consistent with full employment. That level of aggregate demand can be produced by a variety of combinations of monetary and fiscal policies, varying from a very tight fiscal and loose monetary policy to a tight monetary and loose fiscal policy. The difference among these options is interest rates. If fiscal policy, for example, moves to a higher deficit, monetary policy will have to offset the effect on aggregate demand by tightening. The result is higher interest rate, a higher dollar, and ultimately a wider current account deficit. If this outcome is viewed as undesirable, the way to unwind it is by lowering the deficit, accompanied by more accommodative monetary policy. It takes two to do this tango! But I always view fiscal policy as having the first move. Monetary policy's job is to follow the lead of fiscal, so that the resulting mix is appropriate to the requirements of stabilization policy. I am occasionally asked whether I worry about the effect on other countries of changes in U.S. monetary policy. While I do keep in mind the potential international repercussions of U.S. monetary policy actions, I believe that the best way for the U.S. to contribute to the health of the world economy is to pursue prudent domestic policy and achieve maximum sustainable employment and price stability and accommodate the maximum sustainable growth in the U.S. economy. Another question about the conduct of monetary policy in an open economy is whether the open economy offers monetary policy a new instrument that it did not have in the closed economy world. In a closed economy context, monetary policy has a single instrument: open market operations, used to target a short-term interest rate. The obvious candidate for an additional instrument in the open economy case is the exchange rate. I have already argued that monetary policy cannot be used to target the exchange rate. The issue here is whether there are opportunities to exercise direct control of the exchange rate. The obvious option is intervention. Intervention refers to a government buying or selling foreign currency in order to influence the exchange rate. One can identify two reasons for intervening. The first is to calm disorderly markets. That is, an increase in volatility in the foreign exchange market might be damped by intervention. However, most intervention is about affecting the level of the exchange rate, not its volatility, though the rhetoric of disorderly markets often is employed to justify the action. Actions to affect the level can be intended to prevent a further decline (or increase) or to encourage a change in the level. With a daily volume of $\$ 1.2$ trillion in the foreign exchange markets, and underlying stocks of financial assets that are substantially larger, there is ground for skepticism that intervention, which seldom ranges into the billions of dollars in daily volume, can have more than a marginal and transitory effect. Still, there are examples of modest "successes," especially when intervention is coordinated across countries and well timed. The major opportunity for intervention to succeed is when the exchange rate has diverged to a significant degree from fundamentals and the intervention induces a reconsideration of the market or a refocus of the market on fundamentals. The management of foreign exchange interventions varies around the world. In the United States, this management is shared by the Federal Reserve System and the Treasury Department. In principle, intervention can be initiated by either party, although when the Treasury opts to intervene it is the Federal Reserve Bank of New York that actually does the buying or selling of foreign currency, albeit from an account held in the name of Treasury and at the direction of Treasury. Similarly, when the FOMC makes a decision to intervene, it directs the Federal Reserve Bank of New York to do so, from the account in the name of the Federal Reserve System. The traditional practice is that U.S. intervention exercises are carried out jointly, half from the Federal Reserve's account and half from the Treasury's account. However, in principle, either party could intervene on its own. International information exchange, policy coordination, and crisis management Given the growing interdependence of national economies and macroeconomic policies, the coordination of (or more accurately, mutual consultation about) these policies has taken on increased importance. The Federal Reserve takes part in many international forums to exchange information on economic developments and discuss global economic issues. Examples include the 10 meetings each year among G-10 central bank Governors, under the auspices of the BIS; the twice a year meetings of the Economic Policy Committee of the OECD, meetings of the G-7, IMF, and regional meetings, such as APEC and Governors of the Central Banks of the American Continent. In addition to discussions about the performance of the various economies and global macroeconomic issues, there are also ongoing discussions about international crisis management and a growing interest in global standards for risk management in financial institutions and for cooperation in sharing information about the performance and risk profiles of internationally active financial conglomerates.
1997-10-14T00:00:00	Mr. Greenspan considers the globalization of finance (Central Bank Articles and Speeches, 14 Oct 97)	Remarks by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the 15th Annual Monetary Conference of the Cato Institute, Washington, D.C., on 14/10/97.	Remarks by the Chairman Mr. Greenspan considers the globalization of finance of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the 15th Annual Monetary Conference of the Cato Institute, Washington, D.C., on 14/10/97. Globalization of Finance As a result of very rapid increases in telecommunications and computer-based technologies and products, a dramatic expansion in cross-border financial flows and within countries has emerged. The pace has become truly remarkable. These technology-based developments have so expanded the breadth and depth of markets that governments, even reluctant ones, increasingly have felt they have had little alternative but to deregulate and free up internal credit and financial markets. In recent years global economic integration has accelerated on a multitude of fronts. While trade liberalization, which has been ongoing for a longer period, has continued, more dramatic changes have occurred in the financial sphere. World financial markets undoubtedly are far more efficient today than ever before. Changes in communications and information technology, and the new instruments and risk-management techniques they have made possible, enable an ever wider range of financial and non-financial firms today to manage their financial risks more effectively. As a consequence, they can now concentrate on managing the economic risks associated with their primary businesses. The solid profitability of new financial products in the face of their huge proliferation attests to the increasing effectiveness of financial markets in facilitating the flow of trade and direct investment, which are so patently contributing to ever higher standards of living around the world. Complex financial instruments -- derivative instruments, in one form or another -- are being developed to take advantage of the gains in communications and information technology. Such instruments would not have flourished as they have without the technological advances of the past several decades. They could not be priced properly, the markets they involve could not be arbitraged properly, and the risks they give rise to could not be managed at all, to say nothing of properly, without high-powered data processing and communications capabilities. Still, for central bankers with responsibilities for financial market stability, the new technologies and new instruments have presented new challenges. Some argue that market dynamics have been altered in ways that increase the likelihood of significant market disruptions. Whatever the merits of this argument, there is a clear sense that the new technologies, and the financial instruments and techniques they have made possible, have strengthened interdependencies between markets and market participants, both within and across national boundaries. As a result, a disturbance in one market segment or one country is likely to be transmitted far more rapidly throughout the world economy than was evident in previous eras. In earlier generations information moved slowly, constrained by the primitive state of communications. Financial crises in the early nineteenth century, for example, particularly those associated with the Napoleonic Wars, were often related to military and other events in faraway places. An investor's speculative position could be wiped out by a military setback, and he might not even know about it for days or even weeks, which, from the perspective of central banking today, might be considered bliss. As the nineteenth century unfolded, communications speeded up. By the turn of the century events moved more rapidly, but their speed was at most a crawl by the standard of today's financial markets. The environment now facing the world's central banks -- and, of course, private participants in financial markets as well -- is characterized by instant communication. This morning I should like to take a few minutes to trace the roots of this extraordinary expansion of global finance, endeavor to assess its benefits and risks, and suggest some avenues that can usefully be explored in order to contain some of its potentially adverse consequences. A global financial system, of course, is not an end in itself. It is the institutional structure that has been developed over the centuries to facilitate the production of goods and services. Accordingly, we can better understand the evolution of today's burgeoning global financial markets by parsing the extraordinary changes that have emerged, in the past century or more, in what we conventionally call the real side of economies: the production of goods and services. The same technological forces currently driving finance were first evident in the production process and have had a profound effect on what we produce, how we produce it, and how it is financed. Technological change or, more generally, ideas have significantly altered the nature of output so that it has become increasingly conceptual and less physical. A much smaller proportion of the measured real gross domestic product constitutes physical bulk today than in past generations. The increasing substitution of concepts for physical effort in the creation of economic value also has affected how we produce that economic output; computer-assisted design systems, machine tools, and inventory control systems provide examples. Offices are now routinely outfitted with high-speed information-processing technology. Because the accretion of knowledge is, with rare exceptions, irreversible, this trend almost surely will continue into the twenty-first century and beyond. Value creation at the turn of the twenty-first century will surely involve the transmission of information and ideas, generally over complex telecommunication networks. This will create considerably greater flexibility of where services are produced and where employees do their work. The transmission of ideas, or more broadly information, places it where it can be employed in maximum value creation. A century earlier, transportation of goods to their most value-creating locations served the same purpose for an economy whose value creation still rested heavily on physical, bulky output. Not unexpectedly, as goods and services have moved across borders, the necessity to finance them has increased dramatically. But what is particularly startling is how large the expansion in cross-border finance has become, relative to the trade it finances. To be sure, much cross-border finance supports investment portfolios, doubtless some largely speculative. But at bottom, even they are part of the support systems for efficient international movement of goods and services. The rapid expansion in cross-border banking and finance should not be surprising given the extent to which low-cost information processing and communications technology have improved the ability of customers in one part of the world to avail themselves of borrowing, depositing, or risk-management opportunities offered anywhere in the world on a real-time basis. These developments enhance the process whereby an excess of saving over investment in one country finds an appropriate outlet in another. In short, they facilitate the drive to equate risk-adjusted rates of return on investments worldwide. They thereby improve the worldwide allocation of scarce capital and, in the process, engender a huge increase in risk dispersion and hedging opportunities. But there is still evidence of less than full arbitrage of risk-adjusted rates of return on a worldwide basis. This suggests the potential for a far larger world financial system than currently exists. If we can resist protectionist pressures in our societies in the financial arena as well as in the interchange of goods and services, we can look forward to the benefits of the international division of labor on a much larger scale in the 21st century. What we don't know for sure, but strongly suspect, is that the accelerating expansion of global finance may be indispensable to the continued rapid growth in world trade in goods and services. It is becoming increasingly evident that many layers of financial intermediation will be required if we are to capture the full benefits of our advances in finance. Certainly, the emergence of a highly liquid foreign exchange market has facilitated basic forex transactions, and the availability of more complex hedging strategies enables producers and investors to achieve their desired risk positions. This owes largely to the ability of modern financial products to unbundle complex risks in ways that enable each counterparty to choose the combination of risks necessary to advance its business strategy, and to eschew those that do not. This process enhances cross-border trade in goods and services, facilitates cross-border portfolio investment strategies, enhances the lower-cost financing of real capital formation on a worldwide basis and, hence, leads to an expansion of international trade and rising standards of living. But achieving those benefits surely will require the maintenance of a stable macroeconomic environment. An environment conducive to stable product prices and to maintaining sustainable economic growth has become a prime responsibility of governments and, of course, central banks. It was not always thus. In the last comparable period of open international trade a century ago the gold standard prevailed. The roles of central banks, where they existed (remember the United States did not have one), were then quite different from today. International stabilization was implemented by more or less automatic gold flows from those financial markets where conditions were lax, to those where liquidity was in short supply. To some, myself included, the system appears to have worked rather well. To others, the gold standard was perceived as too rigid or unstable, and in any event the inability to finance discretionary policy, both monetary and fiscal, led first to a further compromise of the gold standard system after World War I, and by the 1930s it had been essentially abandoned. The fiat money systems that emerged have given considerable power and responsibility to central banks to manage the sovereign credit of nations. Under a gold standard, money creation was at the limit tied to changes in gold reserves. The discretionary range of monetary policy was relatively narrow. Today's central banks have the capability of creating or destroying unlimited supplies of money and credit. Clearly, how well we take our responsibilities in this modern world has profound implications for participants in financial markets. We provide the backdrop against which individual market participants make their decisions. As a consequence, it is incumbent upon us to endeavor to produce the same non-inflationary environment as existed a century ago, if we seek maximum sustainable growth. In this regard, doubtless, the most important development that has occurred in recent years has been the shift from an environment of inflationary expectations built into both business planning and financial contracts toward an environment of lower inflation. It is important that that progress continue and that we maintain a credible long-run commitment to price stability. While there can be little doubt that the extraordinary changes in global finance on balance have been beneficial in facilitating significant improvements in economic structures and living standards throughout the world, they also have the potential for some negative consequences. In fact, while the speed of transmission of positive economic events has been an important plus for the world economy in recent years, it is becoming increasingly obvious, as evidenced by recent events in Thailand and its neighbors and several years ago in Mexico, that significant macroeconomic policy mistakes also reverberate around the world at a prodigious pace. In any event, technological progress is not reversible. We must learn to live with it. In the context of rapid changes affecting financial markets, disruptions are inevitable. The turmoil in the European Exchange Rate mechanism in 1992, the plunge in the exchange value of the Mexican peso at the end of 1994 and early 1995, and the recent sharp exchange rate adjustments in a number of Asian economies have shown how the new world of financial trading can punish policy misalignments, actual or perceived, with amazing alacrity. This is new. Even as recently as 15 or 20 years ago, the size of the international financial system was a fraction of what it is today. Contagion effects were more limited, and, thus, breakdowns carried fewer negative consequences. In both new and old environments, the economic consequences of disruptions are minimized if they are not further compounded by financial instability associated with underlying inflation trends. The recent financial turmoil in some Asian financial markets, and similar events elsewhere previously, confirm that in a world of increasing capital mobility there is a premium on governments maintaining sound macroeconomic policies and allowing exchange rates to provide appropriate signals for the broader pricing structure of the economy. These countries became vulnerable as markets became increasingly aware of a buildup of excesses, including overvalued exchange rates, bulging current account deficits, and sharp increases in asset values. In many cases, these were the consequence of poor investment judgements in seeking to employ huge increases in portfolios for investment. In some cases, these excesses were fed by unsound real estate and other lending activity by various financial institutions in these countries, which, in turn, undermined the soundness of these countries' financial systems. As a consequence, these countries lost the confidence of both domestic and international investors, with resulting disturbances in their financial markets. The resort to capital controls to deal with financial market disturbances of the sort a number of emerging economies have experienced would be a step backwards from the trend toward financial market liberalization, and in the end would not be effective. The maintenance of financial stability in an environment of global capital markets, therefore, calls for greater attention by governments to the soundness of public policy. Governments are beginning to recognize that the release of timely and accurate economic and financial data is a critical element to the maintenance of financial stability. We do not know what the appropriate amount of disclosure is, but it is pretty clear from the Mexican experience in 1994 and the recent Thai experience that the level of disclosure was too little. More comprehensive public information on the financial condition of a country, including current data on commitments by governments to buy or sell currencies in the future and on non-performing loans of a country's financial institutions, would allow investors -- both domestic and international -- to make more rational investment decisions. Such disclosure would help to avoid sudden and sharp reversals in the investment positions of investors once they become aware of the true status of a country's and a banking system's financial health. More timely and more comprehensive disclosure of financial data also would help sensitize the principal economic policymakers of a country to the potential emerging threats to its financial stability. Thus, as international financial markets continue to expand, central banks have twin objectives: achieving macroeconomic stability and a safe and sound financial system that can take advantage of stability while exploiting the inevitable new technological advances. The changing dynamics of modern global financial systems also require that central banks address the inevitable increase of systemic risk. It is probably fair to say that the very efficiency of global financial markets, engendered by the rapid proliferation of financial products, also has the capability of transmitting mistakes at a far faster pace throughout the financial system in ways that were unknown a generation ago, and not even remotely imagined in the nineteenth century. Today's technology enables single individuals to initiate massive transactions with very rapid execution. Clearly, not only has the productivity of global finance increased markedly, but so, obviously, has the ability to generate losses at a previously inconceivable rate. Moreover, increasing global financial efficiency, by creating the mechanisms for mistakes to ricochet throughout the global financial system, has patently increased the potential for systemic risk. Why not then, one might ask, bar or contain the expansion of global finance by capital controls, transaction taxes, or other market inhibiting initiatives? Why not return to the less hectic and seemingly less threatening markets of, say, the 1950s? Endeavoring to thwart technological advance and new knowledge and innovation through the erection of barriers to the spread of knowledge would, as history amply demonstrates, have large, often adverse, unintended consequences. Suppressed markets in one location would be rapidly displaced by others outside the reach of government controls and taxes. Of greater importance, risk taking, so indispensable to the creation of wealth, would undoubtedly be curbed, to the detriment of rising living standards. We cannot turn back the clock on technology -- and we should not try to do so. Rather, we should recognize that, if it is technology that has imparted the current stress to markets, technology can be employed to contain it. Enhancements to financial institutions' internal risk-management systems arguably constitute the most effective countermeasure to the increased potential instability of the global financial system. Improving the efficiency of the world's payment systems is clearly another. The availability of new technology and new derivative financial instruments clearly has facilitated new, more rigorous approaches to the conceptualization, measurement, and management of risk for such systems. There are, however, limitations to the statistical models used in such systems owing to the necessity of overly simplifying assumptions. Hence, human judgements, based on analytically looser but far more realistic evaluations of what the future may hold, are of critical importance in risk management. Although a sophisticated understanding of statistical modeling techniques is important to risk management, an intimate knowledge of the markets in which an institution trades and of the customers it serves is turning out to be far more important. In these and other ways, we must assure that our rapidly changing global financial system retains the capacity to contain market shocks. This is a never-ending process that requires never-ending vigilance.	---[PAGE_BREAK]--- Mr. Greenspan considers the globalization of finance Remarks by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the 15th Annual Monetary Conference of the Cato Institute, Washington, D.C., on 14/10/97. # Globalization of Finance As a result of very rapid increases in telecommunications and computer-based technologies and products, a dramatic expansion in cross-border financial flows and within countries has emerged. The pace has become truly remarkable. These technology-based developments have so expanded the breadth and depth of markets that governments, even reluctant ones, increasingly have felt they have had little alternative but to deregulate and free up internal credit and financial markets. In recent years global economic integration has accelerated on a multitude of fronts. While trade liberalization, which has been ongoing for a longer period, has continued, more dramatic changes have occurred in the financial sphere. World financial markets undoubtedly are far more efficient today than ever before. Changes in communications and information technology, and the new instruments and risk-management techniques they have made possible, enable an ever wider range of financial and non-financial firms today to manage their financial risks more effectively. As a consequence, they can now concentrate on managing the economic risks associated with their primary businesses. The solid profitability of new financial products in the face of their huge proliferation attests to the increasing effectiveness of financial markets in facilitating the flow of trade and direct investment, which are so patently contributing to ever higher standards of living around the world. Complex financial instruments -- derivative instruments, in one form or another -- are being developed to take advantage of the gains in communications and information technology. Such instruments would not have flourished as they have without the technological advances of the past several decades. They could not be priced properly, the markets they involve could not be arbitraged properly, and the risks they give rise to could not be managed at all, to say nothing of properly, without high-powered data processing and communications capabilities. Still, for central bankers with responsibilities for financial market stability, the new technologies and new instruments have presented new challenges. Some argue that market dynamics have been altered in ways that increase the likelihood of significant market disruptions. Whatever the merits of this argument, there is a clear sense that the new technologies, and the financial instruments and techniques they have made possible, have strengthened interdependencies between markets and market participants, both within and across national boundaries. As a result, a disturbance in one market segment or one country is likely to be transmitted far more rapidly throughout the world economy than was evident in previous eras. In earlier generations information moved slowly, constrained by the primitive state of communications. Financial crises in the early nineteenth century, for example, particularly those associated with the Napoleonic Wars, were often related to military and other events in faraway places. An investor's speculative position could be wiped out by a military setback, and he might not even know about it for days or even weeks, which, from the perspective of central banking today, might be considered bliss. As the nineteenth century unfolded, communications speeded up. By the turn of the century events moved more rapidly, but their speed was at most a crawl by the standard of today's financial markets. The environment now facing the world's central banks -- and, of course, private participants in financial markets as well -- is characterized by instant communication. ---[PAGE_BREAK]--- This morning I should like to take a few minutes to trace the roots of this extraordinary expansion of global finance, endeavor to assess its benefits and risks, and suggest some avenues that can usefully be explored in order to contain some of its potentially adverse consequences. A global financial system, of course, is not an end in itself. It is the institutional structure that has been developed over the centuries to facilitate the production of goods and services. Accordingly, we can better understand the evolution of today's burgeoning global financial markets by parsing the extraordinary changes that have emerged, in the past century or more, in what we conventionally call the real side of economies: the production of goods and services. The same technological forces currently driving finance were first evident in the production process and have had a profound effect on what we produce, how we produce it, and how it is financed. Technological change or, more generally, ideas have significantly altered the nature of output so that it has become increasingly conceptual and less physical. A much smaller proportion of the measured real gross domestic product constitutes physical bulk today than in past generations. The increasing substitution of concepts for physical effort in the creation of economic value also has affected how we produce that economic output; computer-assisted design systems, machine tools, and inventory control systems provide examples. Offices are now routinely outfitted with high-speed information-processing technology. Because the accretion of knowledge is, with rare exceptions, irreversible, this trend almost surely will continue into the twenty-first century and beyond. Value creation at the turn of the twenty-first century will surely involve the transmission of information and ideas, generally over complex telecommunication networks. This will create considerably greater flexibility of where services are produced and where employees do their work. The transmission of ideas, or more broadly information, places it where it can be employed in maximum value creation. A century earlier, transportation of goods to their most value-creating locations served the same purpose for an economy whose value creation still rested heavily on physical, bulky output. Not unexpectedly, as goods and services have moved across borders, the necessity to finance them has increased dramatically. But what is particularly startling is how large the expansion in cross-border finance has become, relative to the trade it finances. To be sure, much cross-border finance supports investment portfolios, doubtless some largely speculative. But at bottom, even they are part of the support systems for efficient international movement of goods and services. The rapid expansion in cross-border banking and finance should not be surprising given the extent to which low-cost information processing and communications technology have improved the ability of customers in one part of the world to avail themselves of borrowing, depositing, or risk-management opportunities offered anywhere in the world on a real-time basis. These developments enhance the process whereby an excess of saving over investment in one country finds an appropriate outlet in another. In short, they facilitate the drive to equate risk-adjusted rates of return on investments worldwide. They thereby improve the worldwide allocation of scarce capital and, in the process, engender a huge increase in risk dispersion and hedging opportunities. But there is still evidence of less than full arbitrage of risk-adjusted rates of return on a worldwide basis. This suggests the potential for a far larger world financial system than currently exists. If we can resist protectionist pressures in our societies in the financial arena as well as in the ---[PAGE_BREAK]--- interchange of goods and services, we can look forward to the benefits of the international division of labor on a much larger scale in the 21 st century. What we don't know for sure, but strongly suspect, is that the accelerating expansion of global finance may be indispensable to the continued rapid growth in world trade in goods and services. It is becoming increasingly evident that many layers of financial intermediation will be required if we are to capture the full benefits of our advances in finance. Certainly, the emergence of a highly liquid foreign exchange market has facilitated basic forex transactions, and the availability of more complex hedging strategies enables producers and investors to achieve their desired risk positions. This owes largely to the ability of modern financial products to unbundle complex risks in ways that enable each counterparty to choose the combination of risks necessary to advance its business strategy, and to eschew those that do not. This process enhances cross-border trade in goods and services, facilitates cross-border portfolio investment strategies, enhances the lower-cost financing of real capital formation on a worldwide basis and, hence, leads to an expansion of international trade and rising standards of living. But achieving those benefits surely will require the maintenance of a stable macroeconomic environment. An environment conducive to stable product prices and to maintaining sustainable economic growth has become a prime responsibility of governments and, of course, central banks. It was not always thus. In the last comparable period of open international trade a century ago the gold standard prevailed. The roles of central banks, where they existed (remember the United States did not have one), were then quite different from today. International stabilization was implemented by more or less automatic gold flows from those financial markets where conditions were lax, to those where liquidity was in short supply. To some, myself included, the system appears to have worked rather well. To others, the gold standard was perceived as too rigid or unstable, and in any event the inability to finance discretionary policy, both monetary and fiscal, led first to a further compromise of the gold standard system after World War I, and by the 1930s it had been essentially abandoned. The fiat money systems that emerged have given considerable power and responsibility to central banks to manage the sovereign credit of nations. Under a gold standard, money creation was at the limit tied to changes in gold reserves. The discretionary range of monetary policy was relatively narrow. Today's central banks have the capability of creating or destroying unlimited supplies of money and credit. Clearly, how well we take our responsibilities in this modern world has profound implications for participants in financial markets. We provide the backdrop against which individual market participants make their decisions. As a consequence, it is incumbent upon us to endeavor to produce the same non-inflationary environment as existed a century ago, if we seek maximum sustainable growth. In this regard, doubtless, the most important development that has occurred in recent years has been the shift from an environment of inflationary expectations built into both business planning and financial contracts toward an environment of lower inflation. It is important that that progress continue and that we maintain a credible long-run commitment to price stability. While there can be little doubt that the extraordinary changes in global finance on balance have been beneficial in facilitating significant improvements in economic structures and living standards throughout the world, they also have the potential for some negative consequences. In fact, while the speed of transmission of positive economic events has been an important plus for the world economy in recent years, it is becoming increasingly obvious, as evidenced by recent events in Thailand and its neighbors and several years ago in Mexico, that significant macroeconomic policy mistakes also reverberate around the world at a prodigious pace. In any event, technological progress is not reversible. We must learn to live with it. ---[PAGE_BREAK]--- In the context of rapid changes affecting financial markets, disruptions are inevitable. The turmoil in the European Exchange Rate mechanism in 1992, the plunge in the exchange value of the Mexican peso at the end of 1994 and early 1995, and the recent sharp exchange rate adjustments in a number of Asian economies have shown how the new world of financial trading can punish policy misalignments, actual or perceived, with amazing alacrity. This is new. Even as recently as 15 or 20 years ago, the size of the international financial system was a fraction of what it is today. Contagion effects were more limited, and, thus, breakdowns carried fewer negative consequences. In both new and old environments, the economic consequences of disruptions are minimized if they are not further compounded by financial instability associated with underlying inflation trends. The recent financial turmoil in some Asian financial markets, and similar events elsewhere previously, confirm that in a world of increasing capital mobility there is a premium on governments maintaining sound macroeconomic policies and allowing exchange rates to provide appropriate signals for the broader pricing structure of the economy. These countries became vulnerable as markets became increasingly aware of a buildup of excesses, including overvalued exchange rates, bulging current account deficits, and sharp increases in asset values. In many cases, these were the consequence of poor investment judgements in seeking to employ huge increases in portfolios for investment. In some cases, these excesses were fed by unsound real estate and other lending activity by various financial institutions in these countries, which, in turn, undermined the soundness of these countries' financial systems. As a consequence, these countries lost the confidence of both domestic and international investors, with resulting disturbances in their financial markets. The resort to capital controls to deal with financial market disturbances of the sort a number of emerging economies have experienced would be a step backwards from the trend toward financial market liberalization, and in the end would not be effective. The maintenance of financial stability in an environment of global capital markets, therefore, calls for greater attention by governments to the soundness of public policy. Governments are beginning to recognize that the release of timely and accurate economic and financial data is a critical element to the maintenance of financial stability. We do not know what the appropriate amount of disclosure is, but it is pretty clear from the Mexican experience in 1994 and the recent Thai experience that the level of disclosure was too little. More comprehensive public information on the financial condition of a country, including current data on commitments by governments to buy or sell currencies in the future and on non-performing loans of a country's financial institutions, would allow investors -- both domestic and international -- to make more rational investment decisions. Such disclosure would help to avoid sudden and sharp reversals in the investment positions of investors once they become aware of the true status of a country's and a banking system's financial health. More timely and more comprehensive disclosure of financial data also would help sensitize the principal economic policymakers of a country to the potential emerging threats to its financial stability. Thus, as international financial markets continue to expand, central banks have twin objectives: achieving macroeconomic stability and a safe and sound financial system that can take advantage of stability while exploiting the inevitable new technological advances. The changing dynamics of modern global financial systems also require that central banks address the inevitable increase of systemic risk. It is probably fair to say that the very efficiency of global financial markets, engendered by the rapid proliferation of financial products, also has the capability of transmitting mistakes at a far faster pace throughout the financial system in ways that were unknown a generation ago, and not even remotely imagined in the nineteenth century. ---[PAGE_BREAK]--- Today's technology enables single individuals to initiate massive transactions with very rapid execution. Clearly, not only has the productivity of global finance increased markedly, but so, obviously, has the ability to generate losses at a previously inconceivable rate. Moreover, increasing global financial efficiency, by creating the mechanisms for mistakes to ricochet throughout the global financial system, has patently increased the potential for systemic risk. Why not then, one might ask, bar or contain the expansion of global finance by capital controls, transaction taxes, or other market inhibiting initiatives? Why not return to the less hectic and seemingly less threatening markets of, say, the 1950s? Endeavoring to thwart technological advance and new knowledge and innovation through the erection of barriers to the spread of knowledge would, as history amply demonstrates, have large, often adverse, unintended consequences. Suppressed markets in one location would be rapidly displaced by others outside the reach of government controls and taxes. Of greater importance, risk taking, so indispensable to the creation of wealth, would undoubtedly be curbed, to the detriment of rising living standards. We cannot turn back the clock on technology -- and we should not try to do so. Rather, we should recognize that, if it is technology that has imparted the current stress to markets, technology can be employed to contain it. Enhancements to financial institutions' internal risk-management systems arguably constitute the most effective countermeasure to the increased potential instability of the global financial system. Improving the efficiency of the world's payment systems is clearly another. The availability of new technology and new derivative financial instruments clearly has facilitated new, more rigorous approaches to the conceptualization, measurement, and management of risk for such systems. There are, however, limitations to the statistical models used in such systems owing to the necessity of overly simplifying assumptions. Hence, human judgements, based on analytically looser but far more realistic evaluations of what the future may hold, are of critical importance in risk management. Although a sophisticated understanding of statistical modeling techniques is important to risk management, an intimate knowledge of the markets in which an institution trades and of the customers it serves is turning out to be far more important. In these and other ways, we must assure that our rapidly changing global financial system retains the capacity to contain market shocks. This is a never-ending process that requires never-ending vigilance.	Alan Greenspan	United States	https://www.bis.org/review/r971021b.pdf	Mr. Greenspan considers the globalization of finance Remarks by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the 15th Annual Monetary Conference of the Cato Institute, Washington, D.C., on 14/10/97. As a result of very rapid increases in telecommunications and computer-based technologies and products, a dramatic expansion in cross-border financial flows and within countries has emerged. The pace has become truly remarkable. These technology-based developments have so expanded the breadth and depth of markets that governments, even reluctant ones, increasingly have felt they have had little alternative but to deregulate and free up internal credit and financial markets. In recent years global economic integration has accelerated on a multitude of fronts. While trade liberalization, which has been ongoing for a longer period, has continued, more dramatic changes have occurred in the financial sphere. World financial markets undoubtedly are far more efficient today than ever before. Changes in communications and information technology, and the new instruments and risk-management techniques they have made possible, enable an ever wider range of financial and non-financial firms today to manage their financial risks more effectively. As a consequence, they can now concentrate on managing the economic risks associated with their primary businesses. The solid profitability of new financial products in the face of their huge proliferation attests to the increasing effectiveness of financial markets in facilitating the flow of trade and direct investment, which are so patently contributing to ever higher standards of living around the world. Complex financial instruments -- derivative instruments, in one form or another -- are being developed to take advantage of the gains in communications and information technology. Such instruments would not have flourished as they have without the technological advances of the past several decades. They could not be priced properly, the markets they involve could not be arbitraged properly, and the risks they give rise to could not be managed at all, to say nothing of properly, without high-powered data processing and communications capabilities. Still, for central bankers with responsibilities for financial market stability, the new technologies and new instruments have presented new challenges. Some argue that market dynamics have been altered in ways that increase the likelihood of significant market disruptions. Whatever the merits of this argument, there is a clear sense that the new technologies, and the financial instruments and techniques they have made possible, have strengthened interdependencies between markets and market participants, both within and across national boundaries. As a result, a disturbance in one market segment or one country is likely to be transmitted far more rapidly throughout the world economy than was evident in previous eras. In earlier generations information moved slowly, constrained by the primitive state of communications. Financial crises in the early nineteenth century, for example, particularly those associated with the Napoleonic Wars, were often related to military and other events in faraway places. An investor's speculative position could be wiped out by a military setback, and he might not even know about it for days or even weeks, which, from the perspective of central banking today, might be considered bliss. As the nineteenth century unfolded, communications speeded up. By the turn of the century events moved more rapidly, but their speed was at most a crawl by the standard of today's financial markets. The environment now facing the world's central banks -- and, of course, private participants in financial markets as well -- is characterized by instant communication. This morning I should like to take a few minutes to trace the roots of this extraordinary expansion of global finance, endeavor to assess its benefits and risks, and suggest some avenues that can usefully be explored in order to contain some of its potentially adverse consequences. A global financial system, of course, is not an end in itself. It is the institutional structure that has been developed over the centuries to facilitate the production of goods and services. Accordingly, we can better understand the evolution of today's burgeoning global financial markets by parsing the extraordinary changes that have emerged, in the past century or more, in what we conventionally call the real side of economies: the production of goods and services. The same technological forces currently driving finance were first evident in the production process and have had a profound effect on what we produce, how we produce it, and how it is financed. Technological change or, more generally, ideas have significantly altered the nature of output so that it has become increasingly conceptual and less physical. A much smaller proportion of the measured real gross domestic product constitutes physical bulk today than in past generations. The increasing substitution of concepts for physical effort in the creation of economic value also has affected how we produce that economic output; computer-assisted design systems, machine tools, and inventory control systems provide examples. Offices are now routinely outfitted with high-speed information-processing technology. Because the accretion of knowledge is, with rare exceptions, irreversible, this trend almost surely will continue into the twenty-first century and beyond. Value creation at the turn of the twenty-first century will surely involve the transmission of information and ideas, generally over complex telecommunication networks. This will create considerably greater flexibility of where services are produced and where employees do their work. The transmission of ideas, or more broadly information, places it where it can be employed in maximum value creation. A century earlier, transportation of goods to their most value-creating locations served the same purpose for an economy whose value creation still rested heavily on physical, bulky output. Not unexpectedly, as goods and services have moved across borders, the necessity to finance them has increased dramatically. But what is particularly startling is how large the expansion in cross-border finance has become, relative to the trade it finances. To be sure, much cross-border finance supports investment portfolios, doubtless some largely speculative. But at bottom, even they are part of the support systems for efficient international movement of goods and services. The rapid expansion in cross-border banking and finance should not be surprising given the extent to which low-cost information processing and communications technology have improved the ability of customers in one part of the world to avail themselves of borrowing, depositing, or risk-management opportunities offered anywhere in the world on a real-time basis. These developments enhance the process whereby an excess of saving over investment in one country finds an appropriate outlet in another. In short, they facilitate the drive to equate risk-adjusted rates of return on investments worldwide. They thereby improve the worldwide allocation of scarce capital and, in the process, engender a huge increase in risk dispersion and hedging opportunities. But there is still evidence of less than full arbitrage of risk-adjusted rates of return on a worldwide basis. This suggests the potential for a far larger world financial system than currently exists. If we can resist protectionist pressures in our societies in the financial arena as well as in the interchange of goods and services, we can look forward to the benefits of the international division of labor on a much larger scale in the 21 st century. What we don't know for sure, but strongly suspect, is that the accelerating expansion of global finance may be indispensable to the continued rapid growth in world trade in goods and services. It is becoming increasingly evident that many layers of financial intermediation will be required if we are to capture the full benefits of our advances in finance. Certainly, the emergence of a highly liquid foreign exchange market has facilitated basic forex transactions, and the availability of more complex hedging strategies enables producers and investors to achieve their desired risk positions. This owes largely to the ability of modern financial products to unbundle complex risks in ways that enable each counterparty to choose the combination of risks necessary to advance its business strategy, and to eschew those that do not. This process enhances cross-border trade in goods and services, facilitates cross-border portfolio investment strategies, enhances the lower-cost financing of real capital formation on a worldwide basis and, hence, leads to an expansion of international trade and rising standards of living. But achieving those benefits surely will require the maintenance of a stable macroeconomic environment. An environment conducive to stable product prices and to maintaining sustainable economic growth has become a prime responsibility of governments and, of course, central banks. It was not always thus. In the last comparable period of open international trade a century ago the gold standard prevailed. The roles of central banks, where they existed (remember the United States did not have one), were then quite different from today. International stabilization was implemented by more or less automatic gold flows from those financial markets where conditions were lax, to those where liquidity was in short supply. To some, myself included, the system appears to have worked rather well. To others, the gold standard was perceived as too rigid or unstable, and in any event the inability to finance discretionary policy, both monetary and fiscal, led first to a further compromise of the gold standard system after World War I, and by the 1930s it had been essentially abandoned. The fiat money systems that emerged have given considerable power and responsibility to central banks to manage the sovereign credit of nations. Under a gold standard, money creation was at the limit tied to changes in gold reserves. The discretionary range of monetary policy was relatively narrow. Today's central banks have the capability of creating or destroying unlimited supplies of money and credit. Clearly, how well we take our responsibilities in this modern world has profound implications for participants in financial markets. We provide the backdrop against which individual market participants make their decisions. As a consequence, it is incumbent upon us to endeavor to produce the same non-inflationary environment as existed a century ago, if we seek maximum sustainable growth. In this regard, doubtless, the most important development that has occurred in recent years has been the shift from an environment of inflationary expectations built into both business planning and financial contracts toward an environment of lower inflation. It is important that that progress continue and that we maintain a credible long-run commitment to price stability. While there can be little doubt that the extraordinary changes in global finance on balance have been beneficial in facilitating significant improvements in economic structures and living standards throughout the world, they also have the potential for some negative consequences. In fact, while the speed of transmission of positive economic events has been an important plus for the world economy in recent years, it is becoming increasingly obvious, as evidenced by recent events in Thailand and its neighbors and several years ago in Mexico, that significant macroeconomic policy mistakes also reverberate around the world at a prodigious pace. In any event, technological progress is not reversible. We must learn to live with it. In the context of rapid changes affecting financial markets, disruptions are inevitable. The turmoil in the European Exchange Rate mechanism in 1992, the plunge in the exchange value of the Mexican peso at the end of 1994 and early 1995, and the recent sharp exchange rate adjustments in a number of Asian economies have shown how the new world of financial trading can punish policy misalignments, actual or perceived, with amazing alacrity. This is new. Even as recently as 15 or 20 years ago, the size of the international financial system was a fraction of what it is today. Contagion effects were more limited, and, thus, breakdowns carried fewer negative consequences. In both new and old environments, the economic consequences of disruptions are minimized if they are not further compounded by financial instability associated with underlying inflation trends. The recent financial turmoil in some Asian financial markets, and similar events elsewhere previously, confirm that in a world of increasing capital mobility there is a premium on governments maintaining sound macroeconomic policies and allowing exchange rates to provide appropriate signals for the broader pricing structure of the economy. These countries became vulnerable as markets became increasingly aware of a buildup of excesses, including overvalued exchange rates, bulging current account deficits, and sharp increases in asset values. In many cases, these were the consequence of poor investment judgements in seeking to employ huge increases in portfolios for investment. In some cases, these excesses were fed by unsound real estate and other lending activity by various financial institutions in these countries, which, in turn, undermined the soundness of these countries' financial systems. As a consequence, these countries lost the confidence of both domestic and international investors, with resulting disturbances in their financial markets. The resort to capital controls to deal with financial market disturbances of the sort a number of emerging economies have experienced would be a step backwards from the trend toward financial market liberalization, and in the end would not be effective. The maintenance of financial stability in an environment of global capital markets, therefore, calls for greater attention by governments to the soundness of public policy. Governments are beginning to recognize that the release of timely and accurate economic and financial data is a critical element to the maintenance of financial stability. We do not know what the appropriate amount of disclosure is, but it is pretty clear from the Mexican experience in 1994 and the recent Thai experience that the level of disclosure was too little. More comprehensive public information on the financial condition of a country, including current data on commitments by governments to buy or sell currencies in the future and on non-performing loans of a country's financial institutions, would allow investors -- both domestic and international -- to make more rational investment decisions. Such disclosure would help to avoid sudden and sharp reversals in the investment positions of investors once they become aware of the true status of a country's and a banking system's financial health. More timely and more comprehensive disclosure of financial data also would help sensitize the principal economic policymakers of a country to the potential emerging threats to its financial stability. Thus, as international financial markets continue to expand, central banks have twin objectives: achieving macroeconomic stability and a safe and sound financial system that can take advantage of stability while exploiting the inevitable new technological advances. The changing dynamics of modern global financial systems also require that central banks address the inevitable increase of systemic risk. It is probably fair to say that the very efficiency of global financial markets, engendered by the rapid proliferation of financial products, also has the capability of transmitting mistakes at a far faster pace throughout the financial system in ways that were unknown a generation ago, and not even remotely imagined in the nineteenth century. Today's technology enables single individuals to initiate massive transactions with very rapid execution. Clearly, not only has the productivity of global finance increased markedly, but so, obviously, has the ability to generate losses at a previously inconceivable rate. Moreover, increasing global financial efficiency, by creating the mechanisms for mistakes to ricochet throughout the global financial system, has patently increased the potential for systemic risk. Why not then, one might ask, bar or contain the expansion of global finance by capital controls, transaction taxes, or other market inhibiting initiatives? Why not return to the less hectic and seemingly less threatening markets of, say, the 1950s? Endeavoring to thwart technological advance and new knowledge and innovation through the erection of barriers to the spread of knowledge would, as history amply demonstrates, have large, often adverse, unintended consequences. Suppressed markets in one location would be rapidly displaced by others outside the reach of government controls and taxes. Of greater importance, risk taking, so indispensable to the creation of wealth, would undoubtedly be curbed, to the detriment of rising living standards. We cannot turn back the clock on technology -- and we should not try to do so. Rather, we should recognize that, if it is technology that has imparted the current stress to markets, technology can be employed to contain it. Enhancements to financial institutions' internal risk-management systems arguably constitute the most effective countermeasure to the increased potential instability of the global financial system. Improving the efficiency of the world's payment systems is clearly another. The availability of new technology and new derivative financial instruments clearly has facilitated new, more rigorous approaches to the conceptualization, measurement, and management of risk for such systems. There are, however, limitations to the statistical models used in such systems owing to the necessity of overly simplifying assumptions. Hence, human judgements, based on analytically looser but far more realistic evaluations of what the future may hold, are of critical importance in risk management. Although a sophisticated understanding of statistical modeling techniques is important to risk management, an intimate knowledge of the markets in which an institution trades and of the customers it serves is turning out to be far more important. In these and other ways, we must assure that our rapidly changing global financial system retains the capacity to contain market shocks. This is a never-ending process that requires never-ending vigilance.
1997-10-15T00:00:00	Ms. Phillips reassesses the stock market crash of 1987 in the context of subsequent market and regulatory changes (Central Bank Articles and Speeches, 15 Oct 97)	Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at Bentley College, Waltham, Massachusetts on 15/10/97.	Ms. Phillips reassesses the stock market crash of 1987 in the context of subsequent market and regulatory changes Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at Bentley College, Waltham, Massachusetts on 15/10/97. Black Monday: 10 Years Later Thank you for inviting me to participate in this program sponsored by the Financial Women's Association. We are drawing very close to the tenth anniversary of the stock market crash. It is useful to reassess that event in the context of subsequent market and regulatory changes. The crash was one of those (fortunately rare) events that serve as a watershed for our discussion of markets and public policies. Considerations of regulatory approaches now almost always use the crash as a reference point. Panels such as this one provide a vehicle for evaluating not only what we have learned from the event but also the various actions taken following the crash. But it is also appropriate to look forward. Changes in financial markets and the risk management capability of firms have been significant in the intervening years. The crash may no longer be as useful a reference point for judging events and evaluating public policy responses. I suppose everyone can remember what they were doing on the day of the crash. I had the good fortune to have left the CFTC prior to the crash. Thus, I got to watch events unfold from the cornfields of Iowa. Later, however, I participated in several post-crash evaluations. Even now, at the Federal Reserve Board, the crash periodically comes up in supervisory discussions about bank risk. (Regrettably, the crash is now part of a pantheon of financial market "problems" that include Barings, Daiwa, Metallgesellschaft, Orange County, and Sumitomo.) The Legacy of the Crash The legacy of the crash is both tangible and intangible. An impressive number of studies of the crash were done. The more noteworthy ones take up about three linear feet on my bookshelf, a very tangible reminder. More seriously, the studies done after the crash were wide-ranging and examined events through the eyes of many different market participants, many different regulators, and a host of academicians. They identified weaknesses in trading and clearing systems that have resulted in tangible changes to those systems. These changes have been very positive. Exchanges have greatly expanded their ability to handle surges in volume, for example. The capitalization of market makers has been bolstered as well. Numerous changes also have been implemented in clearing systems. Doubts that emerged about the soundness of clearing systems were some of the most frightening aspects of the crash. The changes to clearing systems have received far less attention than those to trading systems, but their long-term consequences likely are more profound. Such critical parts of the "plumbing" as the agreements between the futures clearing houses and the settlement banks have been clarified and put on a much sounder footing. In addition, many clearing organizations have established back-up liquidity facilities that will enable them to make payments to clearing members in a timely fashion even if a clearing member has defaulted. In both our evaluation of trading mechanisms and our evaluation of clearing systems, an important intangible outcome of the crash is that we now have a better understanding of the way these systems work. During ordinary trading days, market participants rarely if ever question counterparties' ability and willingness to perform on obligations. In the months following the crash, policy makers and market participants began to examine those payment conventions more closely. The bulk of the changes to risk management systems that flowed from the crash related to efforts to clarify or make more rigorous the responsibilities and obligations of market participants that previously had been left ambiguous or were part of the lore of "normal" market practice. - 2 - Another very important intangible legacy of the crash is our better understanding of the need for cooperation and coordination among commodity, securities, and banking market authorities. The crash vividly illustrated the extent to which markets are intertwined and the extent to which large financial firms have lines of business that cut across many markets. The forums for coordination are almost too numerous to mention, not least of which is the President's Working Group on Financial Markets. The Working Group comprises the heads of the Treasury, SEC, CFTC, and Federal Reserve, and in addition, other banking supervisory agencies, the National Economic Council, and the Council of Economic Advisers participate. Prospect Looking forward, we are better positioned today to absorb market shocks than we were prior to the 1987 crash. We undoubtedly, however, will have many different problems in future periods of volatility. Responses to events such as the 1987 crash tend to be crisis-specific. One of our challenges is to make public policy responsive to changing market conditions rather than let it be driven solely by the most recent crisis. The circuit breakers put in place after the crash offer an interesting example of this phenomenon. Circuit breakers are trading halts coordinated across the equity and equity derivatives markets. They were first suggested by the Brady Task Force, and they are one of the more notable recommendations of that report. As stated in the report, the purpose of this (and the other recommendations) was "[t]o help prevent a repetition of the events of mid-October and to provide an effective and coordinated response in the face of market disorder." Circuit breakers are widely cited today as one of the successes of the crash post-mortems. But I, for one, question this evaluation. Circuit breakers have never actually been triggered, in contrast to some of the so-called "speed bumps" which affect particular trading strategies and are now tripped routinely. (In contrast to circuit breakers, which are coordinated across the equity and derivative markets, speed bumps are trading restrictions that have been put in place by individual market places.) If circuit breakers have never been used to halt trading, it follows that we have never had the experience of trying to re-start trading either. To an economist such as myself, some of the scariest times during the market crash were those in which trading was not occurring. Our tendency to worry more about stopping trading than re-starting it is mystifying. (I realize that there has been some discussion about the rules for the resumption of trading but the overwhelming attention has been on the halt.) Recent re-assessments of circuit breakers have focused on increasing the magnitude of price declines necessary to trigger coordinated trading halts. If we are going to continue having circuit breakers, I am supportive of this action and feel that a periodic evaluation of circuit breakers is valuable to ensure that trading halts only occur during very unusual market conditions. Nonetheless, I think that we also should broadly re-evaluate circuit breakers in light of current market conditions. Are circuit breakers fulfilling the goal articulated by the Brady Task Force of providing an effective and coordinated response in the face of market disorder? Do circuit breakers continue to be the best public policy response to market volatility? Many features of financial markets have changed over the last ten years, not least of which is the continuing growth in international activity. Circuit breakers are much more difficult to impose when trading activity can move to markets that do not participate in the trading halt. As I noted earlier, one of my main concerns is the restarting of trading following a halt. If liquidity has moved to over-the-counter markets or foreign venues, how does one get that liquidity back in the domestic, exchange-traded market when the trading halt ends? What kinds of problems might domestic specialists and market makers have in restarting if the market has moved away from them during the halt? Recent changes to shorten the duration of the circuit breakers likely would ameliorate these concerns somewhat, but the worry remains. - 3 - Another important change in the financial landscape in the years since the crash has been a greater focus on risk management by both market participants and supervisors. Developments of new instruments, both on and off exchanges, and of new methods for evaluating risk, have given market participants powerful new tools to allow them to absorb market shocks. Similarly, risk management tools have been enhanced at clearing organizations. Regulators must respond to these new tools. To fully utilize their benefits, regulators will need to approach regulation and supervision in different ways. A good example is to be found in the approach by banking supervisors to developing a capital requirement for market risk. After initial fits and starts, the Basle Supervisors' Committee embraced the concept of using banks' internal models as a basis for a capital requirement for market risk. The Federal Reserve has taken this process of employing new approaches to regulation a step further with its pre-commitment proposal. Pre-commitment allows banks to commit to the maximum loss they will experience over the next quarter in their trading portfolio; this commitment becomes their capital requirement. The proposal gives banks incentives to establish the commitment in a prudent fashion through fines and disclosures if it is violated. Economists in the audience will recognize this proposal as an application of an incentive-compatible approach to regulation. I suspect that there are far more areas in our regulatory structure in which incentive-compatible approaches could be implemented. Self-regulatory organizations also may find such an approach beneficial, particularly in this era in which SROs are being asked to assume more and more regulatory responsibilities. Incentive-compatible regulation essentially tries to harness the self-interest of market participants to achieve broader public policy goals. By using such an approach, our overall goal is to make individual market participants more resilient and better able to withstand shocks. This, after all, is the most basic (and probably the most effective) protection for firms faced with events such as the 1987 crash. At a macroeconomic level, public policies also should ensure that markets and the economy itself can withstand shocks. While the 1987 crash did not have significant, real economic effects, this is not always the case with stock market crashes. Such episodes are generally accompanied by dramatic increases in uncertainty and increased demands for liquidity and safety. Some of these demands for liquidity may, in turn, reflect the fear that the crisis will spread more broadly to the economy. In 1987, a key role played by the Federal Reserve was to demonstrate a determination to meet liquidity demands, and thereby to reassure market participants that problems would not spread beyond the financial system. Problems were contained in this instance, but policy makers cannot be complacent. In the lessons to be learned from the crash, we should not lose sight of the potential for financial crises to have real effects and of the on-going need for public policies to be directed toward mitigating these effects.	---[PAGE_BREAK]--- # Ms. Phillips reassesses the stock market crash of 1987 in the context of subsequent market and regulatory changes Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at Bentley College, Waltham, Massachusetts on 15/10/97. ## Black Monday: 10 Years Later Thank you for inviting me to participate in this program sponsored by the Financial Women's Association. We are drawing very close to the tenth anniversary of the stock market crash. It is useful to reassess that event in the context of subsequent market and regulatory changes. The crash was one of those (fortunately rare) events that serve as a watershed for our discussion of markets and public policies. Considerations of regulatory approaches now almost always use the crash as a reference point. Panels such as this one provide a vehicle for evaluating not only what we have learned from the event but also the various actions taken following the crash. But it is also appropriate to look forward. Changes in financial markets and the risk management capability of firms have been significant in the intervening years. The crash may no longer be as useful a reference point for judging events and evaluating public policy responses. I suppose everyone can remember what they were doing on the day of the crash. I had the good fortune to have left the CFTC prior to the crash. Thus, I got to watch events unfold from the cornfields of Iowa. Later, however, I participated in several post-crash evaluations. Even now, at the Federal Reserve Board, the crash periodically comes up in supervisory discussions about bank risk. (Regrettably, the crash is now part of a pantheon of financial market "problems" that include Barings, Daiwa, Metallgesellschaft, Orange County, and Sumitomo.) ## The Legacy of the Crash The legacy of the crash is both tangible and intangible. An impressive number of studies of the crash were done. The more noteworthy ones take up about three linear feet on my bookshelf, a very tangible reminder. More seriously, the studies done after the crash were wide-ranging and examined events through the eyes of many different market participants, many different regulators, and a host of academicians. They identified weaknesses in trading and clearing systems that have resulted in tangible changes to those systems. These changes have been very positive. Exchanges have greatly expanded their ability to handle surges in volume, for example. The capitalization of market makers has been bolstered as well. Numerous changes also have been implemented in clearing systems. Doubts that emerged about the soundness of clearing systems were some of the most frightening aspects of the crash. The changes to clearing systems have received far less attention than those to trading systems, but their long-term consequences likely are more profound. Such critical parts of the "plumbing" as the agreements between the futures clearing houses and the settlement banks have been clarified and put on a much sounder footing. In addition, many clearing organizations have established back-up liquidity facilities that will enable them to make payments to clearing members in a timely fashion even if a clearing member has defaulted. In both our evaluation of trading mechanisms and our evaluation of clearing systems, an important intangible outcome of the crash is that we now have a better understanding of the way these systems work. During ordinary trading days, market participants rarely if ever question counterparties' ability and willingness to perform on obligations. In the months following the crash, policy makers and market participants began to examine those payment conventions more closely. The bulk of the changes to risk management systems that flowed from the crash related to efforts to clarify or make more rigorous the responsibilities and obligations of market participants that previously had been left ambiguous or were part of the lore of "normal" market practice. ---[PAGE_BREAK]--- Another very important intangible legacy of the crash is our better understanding of the need for cooperation and coordination among commodity, securities, and banking market authorities. The crash vividly illustrated the extent to which markets are intertwined and the extent to which large financial firms have lines of business that cut across many markets. The forums for coordination are almost too numerous to mention, not least of which is the President's Working Group on Financial Markets. The Working Group comprises the heads of the Treasury, SEC, CFTC, and Federal Reserve, and in addition, other banking supervisory agencies, the National Economic Council, and the Council of Economic Advisers participate. # Prospect Looking forward, we are better positioned today to absorb market shocks than we were prior to the 1987 crash. We undoubtedly, however, will have many different problems in future periods of volatility. Responses to events such as the 1987 crash tend to be crisis-specific. One of our challenges is to make public policy responsive to changing market conditions rather than let it be driven solely by the most recent crisis. The circuit breakers put in place after the crash offer an interesting example of this phenomenon. Circuit breakers are trading halts coordinated across the equity and equity derivatives markets. They were first suggested by the Brady Task Force, and they are one of the more notable recommendations of that report. As stated in the report, the purpose of this (and the other recommendations) was " $[t]$ o help prevent a repetition of the events of mid-October and to provide an effective and coordinated response in the face of market disorder." Circuit breakers are widely cited today as one of the successes of the crash post-mortems. But I, for one, question this evaluation. Circuit breakers have never actually been triggered, in contrast to some of the so-called "speed bumps" which affect particular trading strategies and are now tripped routinely. (In contrast to circuit breakers, which are coordinated across the equity and derivative markets, speed bumps are trading restrictions that have been put in place by individual market places.) If circuit breakers have never been used to halt trading, it follows that we have never had the experience of trying to re-start trading either. To an economist such as myself, some of the scariest times during the market crash were those in which trading was not occurring. Our tendency to worry more about stopping trading than re-starting it is mystifying. (I realize that there has been some discussion about the rules for the resumption of trading but the overwhelming attention has been on the halt.) Recent re-assessments of circuit breakers have focused on increasing the magnitude of price declines necessary to trigger coordinated trading halts. If we are going to continue having circuit breakers, I am supportive of this action and feel that a periodic evaluation of circuit breakers is valuable to ensure that trading halts only occur during very unusual market conditions. Nonetheless, I think that we also should broadly re-evaluate circuit breakers in light of current market conditions. Are circuit breakers fulfilling the goal articulated by the Brady Task Force of providing an effective and coordinated response in the face of market disorder? Do circuit breakers continue to be the best public policy response to market volatility? Many features of financial markets have changed over the last ten years, not least of which is the continuing growth in international activity. Circuit breakers are much more difficult to impose when trading activity can move to markets that do not participate in the trading halt. As I noted earlier, one of my main concerns is the restarting of trading following a halt. If liquidity has moved to over-the-counter markets or foreign venues, how does one get that liquidity back in the domestic, exchange-traded market when the trading halt ends? What kinds of problems might domestic specialists and market makers have in restarting if the market has moved away from them during the halt? Recent changes to shorten the duration of the circuit breakers likely would ameliorate these concerns somewhat, but the worry remains. ---[PAGE_BREAK]--- Another important change in the financial landscape in the years since the crash has been a greater focus on risk management by both market participants and supervisors. Developments of new instruments, both on and off exchanges, and of new methods for evaluating risk, have given market participants powerful new tools to allow them to absorb market shocks. Similarly, risk management tools have been enhanced at clearing organizations. Regulators must respond to these new tools. To fully utilize their benefits, regulators will need to approach regulation and supervision in different ways. A good example is to be found in the approach by banking supervisors to developing a capital requirement for market risk. After initial fits and starts, the Basle Supervisors' Committee embraced the concept of using banks' internal models as a basis for a capital requirement for market risk. The Federal Reserve has taken this process of employing new approaches to regulation a step further with its pre-commitment proposal. Pre-commitment allows banks to commit to the maximum loss they will experience over the next quarter in their trading portfolio; this commitment becomes their capital requirement. The proposal gives banks incentives to establish the commitment in a prudent fashion through fines and disclosures if it is violated. Economists in the audience will recognize this proposal as an application of an incentive-compatible approach to regulation. I suspect that there are far more areas in our regulatory structure in which incentive-compatible approaches could be implemented. Self-regulatory organizations also may find such an approach beneficial, particularly in this era in which SROs are being asked to assume more and more regulatory responsibilities. Incentive-compatible regulation essentially tries to harness the self-interest of market participants to achieve broader public policy goals. By using such an approach, our overall goal is to make individual market participants more resilient and better able to withstand shocks. This, after all, is the most basic (and probably the most effective) protection for firms faced with events such as the 1987 crash. At a macroeconomic level, public policies also should ensure that markets and the economy itself can withstand shocks. While the 1987 crash did not have significant, real economic effects, this is not always the case with stock market crashes. Such episodes are generally accompanied by dramatic increases in uncertainty and increased demands for liquidity and safety. Some of these demands for liquidity may, in turn, reflect the fear that the crisis will spread more broadly to the economy. In 1987, a key role played by the Federal Reserve was to demonstrate a determination to meet liquidity demands, and thereby to reassure market participants that problems would not spread beyond the financial system. Problems were contained in this instance, but policy makers cannot be complacent. In the lessons to be learned from the crash, we should not lose sight of the potential for financial crises to have real effects and of the on-going need for public policies to be directed toward mitigating these effects.	Susan M Phillips	United States	https://www.bis.org/review/r971030c.pdf	market and regulatory changes Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at Bentley College, Waltham, Massachusetts on 15/10/97. Thank you for inviting me to participate in this program sponsored by the Financial Women's Association. We are drawing very close to the tenth anniversary of the stock market crash. It is useful to reassess that event in the context of subsequent market and regulatory changes. The crash was one of those (fortunately rare) events that serve as a watershed for our discussion of markets and public policies. Considerations of regulatory approaches now almost always use the crash as a reference point. Panels such as this one provide a vehicle for evaluating not only what we have learned from the event but also the various actions taken following the crash. But it is also appropriate to look forward. Changes in financial markets and the risk management capability of firms have been significant in the intervening years. The crash may no longer be as useful a reference point for judging events and evaluating public policy responses. I suppose everyone can remember what they were doing on the day of the crash. I had the good fortune to have left the CFTC prior to the crash. Thus, I got to watch events unfold from the cornfields of Iowa. Later, however, I participated in several post-crash evaluations. Even now, at the Federal Reserve Board, the crash periodically comes up in supervisory discussions about bank risk. (Regrettably, the crash is now part of a pantheon of financial market "problems" that include Barings, Daiwa, Metallgesellschaft, Orange County, and Sumitomo.) The legacy of the crash is both tangible and intangible. An impressive number of studies of the crash were done. The more noteworthy ones take up about three linear feet on my bookshelf, a very tangible reminder. More seriously, the studies done after the crash were wide-ranging and examined events through the eyes of many different market participants, many different regulators, and a host of academicians. They identified weaknesses in trading and clearing systems that have resulted in tangible changes to those systems. These changes have been very positive. Exchanges have greatly expanded their ability to handle surges in volume, for example. The capitalization of market makers has been bolstered as well. Numerous changes also have been implemented in clearing systems. Doubts that emerged about the soundness of clearing systems were some of the most frightening aspects of the crash. The changes to clearing systems have received far less attention than those to trading systems, but their long-term consequences likely are more profound. Such critical parts of the "plumbing" as the agreements between the futures clearing houses and the settlement banks have been clarified and put on a much sounder footing. In addition, many clearing organizations have established back-up liquidity facilities that will enable them to make payments to clearing members in a timely fashion even if a clearing member has defaulted. In both our evaluation of trading mechanisms and our evaluation of clearing systems, an important intangible outcome of the crash is that we now have a better understanding of the way these systems work. During ordinary trading days, market participants rarely if ever question counterparties' ability and willingness to perform on obligations. In the months following the crash, policy makers and market participants began to examine those payment conventions more closely. The bulk of the changes to risk management systems that flowed from the crash related to efforts to clarify or make more rigorous the responsibilities and obligations of market participants that previously had been left ambiguous or were part of the lore of "normal" market practice. Another very important intangible legacy of the crash is our better understanding of the need for cooperation and coordination among commodity, securities, and banking market authorities. The crash vividly illustrated the extent to which markets are intertwined and the extent to which large financial firms have lines of business that cut across many markets. The forums for coordination are almost too numerous to mention, not least of which is the President's Working Group on Financial Markets. The Working Group comprises the heads of the Treasury, SEC, CFTC, and Federal Reserve, and in addition, other banking supervisory agencies, the National Economic Council, and the Council of Economic Advisers participate. Looking forward, we are better positioned today to absorb market shocks than we were prior to the 1987 crash. We undoubtedly, however, will have many different problems in future periods of volatility. Responses to events such as the 1987 crash tend to be crisis-specific. One of our challenges is to make public policy responsive to changing market conditions rather than let it be driven solely by the most recent crisis. The circuit breakers put in place after the crash offer an interesting example of this phenomenon. Circuit breakers are trading halts coordinated across the equity and equity derivatives markets. They were first suggested by the Brady Task Force, and they are one of the more notable recommendations of that report. As stated in the report, the purpose of this (and the other recommendations) was " $$ o help prevent a repetition of the events of mid-October and to provide an effective and coordinated response in the face of market disorder." Circuit breakers are widely cited today as one of the successes of the crash post-mortems. But I, for one, question this evaluation. Circuit breakers have never actually been triggered, in contrast to some of the so-called "speed bumps" which affect particular trading strategies and are now tripped routinely. (In contrast to circuit breakers, which are coordinated across the equity and derivative markets, speed bumps are trading restrictions that have been put in place by individual market places.) If circuit breakers have never been used to halt trading, it follows that we have never had the experience of trying to re-start trading either. To an economist such as myself, some of the scariest times during the market crash were those in which trading was not occurring. Our tendency to worry more about stopping trading than re-starting it is mystifying. (I realize that there has been some discussion about the rules for the resumption of trading but the overwhelming attention has been on the halt.) Recent re-assessments of circuit breakers have focused on increasing the magnitude of price declines necessary to trigger coordinated trading halts. If we are going to continue having circuit breakers, I am supportive of this action and feel that a periodic evaluation of circuit breakers is valuable to ensure that trading halts only occur during very unusual market conditions. Nonetheless, I think that we also should broadly re-evaluate circuit breakers in light of current market conditions. Are circuit breakers fulfilling the goal articulated by the Brady Task Force of providing an effective and coordinated response in the face of market disorder? Do circuit breakers continue to be the best public policy response to market volatility? Many features of financial markets have changed over the last ten years, not least of which is the continuing growth in international activity. Circuit breakers are much more difficult to impose when trading activity can move to markets that do not participate in the trading halt. As I noted earlier, one of my main concerns is the restarting of trading following a halt. If liquidity has moved to over-the-counter markets or foreign venues, how does one get that liquidity back in the domestic, exchange-traded market when the trading halt ends? What kinds of problems might domestic specialists and market makers have in restarting if the market has moved away from them during the halt? Recent changes to shorten the duration of the circuit breakers likely would ameliorate these concerns somewhat, but the worry remains. Another important change in the financial landscape in the years since the crash has been a greater focus on risk management by both market participants and supervisors. Developments of new instruments, both on and off exchanges, and of new methods for evaluating risk, have given market participants powerful new tools to allow them to absorb market shocks. Similarly, risk management tools have been enhanced at clearing organizations. Regulators must respond to these new tools. To fully utilize their benefits, regulators will need to approach regulation and supervision in different ways. A good example is to be found in the approach by banking supervisors to developing a capital requirement for market risk. After initial fits and starts, the Basle Supervisors' Committee embraced the concept of using banks' internal models as a basis for a capital requirement for market risk. The Federal Reserve has taken this process of employing new approaches to regulation a step further with its pre-commitment proposal. Pre-commitment allows banks to commit to the maximum loss they will experience over the next quarter in their trading portfolio; this commitment becomes their capital requirement. The proposal gives banks incentives to establish the commitment in a prudent fashion through fines and disclosures if it is violated. Economists in the audience will recognize this proposal as an application of an incentive-compatible approach to regulation. I suspect that there are far more areas in our regulatory structure in which incentive-compatible approaches could be implemented. Self-regulatory organizations also may find such an approach beneficial, particularly in this era in which SROs are being asked to assume more and more regulatory responsibilities. Incentive-compatible regulation essentially tries to harness the self-interest of market participants to achieve broader public policy goals. By using such an approach, our overall goal is to make individual market participants more resilient and better able to withstand shocks. This, after all, is the most basic (and probably the most effective) protection for firms faced with events such as the 1987 crash. At a macroeconomic level, public policies also should ensure that markets and the economy itself can withstand shocks. While the 1987 crash did not have significant, real economic effects, this is not always the case with stock market crashes. Such episodes are generally accompanied by dramatic increases in uncertainty and increased demands for liquidity and safety. Some of these demands for liquidity may, in turn, reflect the fear that the crisis will spread more broadly to the economy. In 1987, a key role played by the Federal Reserve was to demonstrate a determination to meet liquidity demands, and thereby to reassure market participants that problems would not spread beyond the financial system. Problems were contained in this instance, but policy makers cannot be complacent. In the lessons to be learned from the crash, we should not lose sight of the potential for financial crises to have real effects and of the on-going need for public policies to be directed toward mitigating these effects.
1997-10-29T00:00:00	Mr. Greenspan's testimony before the Joint Economic Committee of the US Congress (Central Bank Articles and Speeches, 29 Oct 97)	Testimony by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Joint Economic Committee of the US Congress in Washington DC on 29/10/97.	Mr. Greenspan's testimony before the Joint Economic Committee of the US Congress Testimony by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Joint Economic Committee of the US Congress in Washington DC on 29/10/97. We meet against the background of considerable turbulence in world financial markets, and I shall address the bulk of my remarks to those circumstances. We need to assess these developments against the backdrop of a continuing impressive performance of the American economy in recent months. Growth appears to have remained robust and inflation low, and even falling, despite an ever tightening labor market. Our economy has enjoyed a lengthy period of good economic growth, linked, not coincidentally, to damped inflation. The Federal Reserve is dedicated to contributing as best it can to prolonging this performance, and we will be watching economic and financial market developments closely and evaluating their implications. Even after the sharp rebound around the world in the past twenty-four hours, declines in stock markets in the United States and elsewhere have left investors less wealthy than they were a week ago and businesses facing higher equity cost of capital. Yet, provided the decline in financial markets does not cumulate, it is quite conceivable that a few years hence we will look back at this episode, as we now look back at the 1987 crash, as a salutary event in terms of its implications for the macroeconomy. The 1987 crash occurred at a time when the American economy was operating with a significant degree of inflationary excess that the fall in market values arguably neutralized. Today's economy, as I have been suggesting of late, has been drawing down unused labor resources at an unsustainable pace, spurred, in part, by a substantial wealth effect on demand. The market's net retrenchment of recent days will tend to damp that impetus, a development that should help to prolong our six-and-a-half-year business expansion. As I have testified previously, much of the stock price gain since early 1995 seems to have reflected upward revisions of long-term earnings expectations, which were implying a continuing indefinite rise in profit margins from already high levels. I suspect we are experiencing some scaling back of the projected gains in foreign affiliate earnings, and investors probably also are revisiting expectations of domestic earnings growth. Still, the foundation for good business performance remains solid. Indeed, data on our national economy in recent months are beginning to support the notion that productivity growth, the basis for increases in earnings, is beginning to pick up. I also suspect earnings expectations and equity prices in the United States were primed to adjust. The currency crises in Southeast Asia and the declines in equity prices there and elsewhere do have some direct effects on U.S. corporate earnings, but not enough to explain the recent behavior of our financial markets. If it was not developments in Southeast Asia, something else would have been the proximate cause for a re-evaluation. While productivity growth does appear to have picked up in the last six months, as I have pointed out in the past, it likely is overly optimistic to assume that the dimension of any acceleration in productivity will be great enough and persistent enough to close, by itself, the gap between an excess of long-term demand for labor and its supply. It will take some time to judge the extent of a lasting improvement. Regrettably, over the last year the argument for the so-called new paradigm has slowly shifted from the not unreasonable notion that productivity is in the process of accelerating, to a less than credible view, often implied rather than stated, that we need no longer be concerned about the risk that inflation can rise again. The Federal Reserve cannot afford to take such a complacent view of our price prospects. There is much that is encouraging in the recent performance of the American economy, but, as I have often mentioned before, fundamental change comes slowly and we need to evaluate the prospective balance of supply and demand for various productive resources in deciding policy. - 2 - Recent developments in equity markets have highlighted growing interactions among national financial markets. The underlying technology-based structure of the international financial system has enabled us to improve materially the efficiency of the flows of capital and payment systems. That improvement, however, has also enhanced the ability of the financial system to transmit problems in one part of the globe to another quite rapidly. The recent turmoil is a case in point. I believe there is much to be learned from the recent experience in Asia that can be applied to better the workings of the international financial system and its support of international trade that has done so much to enhance living standards worldwide. While each of the Asian economies differs in many important respects, the sources of their spectacular growth in recent years, in some cases decades, and the problems that have recently emerged are relevant to a greater or lesser extent to nearly all of them. Following the early post-World War II period, policies generally fostering low levels of inflation and openness of their economies coupled with high savings and investment rates contributed to a sustained period of rapid growth, in some cases starting in 1960s and 1970s. By the 1980s most economies in the region were expanding vigorously. Foreign net capital inflows grew, but until recent years were relatively modest. The World Bank estimates that net inflows of long-term debt, foreign direct investment, and equity purchases to the Asia Pacific region were only about $25 billion in 1990, but exploded to more than $110 billion by 1996. A major impetus behind this rapid expansion was the global stock market boom of the 1990s. As that boom progressed, investors in many industrial countries found themselves more heavily concentrated in the recently higher valued securities of companies in the developed world, whose rates of return, in many instances, had fallen to levels perceived as uncompetitive with the earnings potential in emerging economies, especially in Asia. The resultant diversification induced a sharp increase in capital flows into those economies. To a large extent, they came from investors in the United States and Western Europe. A substantial amount came from Japan, as well, owing more to a search for higher yields than to rising stock prices and capital gains in that country. The rising yen through mid-1995 also encouraged a substantial increase in direct investment inflows from Japan. In retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at modest risk. I suspect that it was inevitable in those conditions of low inflation, rapid growth and ample liquidity that much investment moved into the real estate sector, with an emphasis by both the public and private sectors on conspicuous construction projects. This is an experience, of course, not unknown in the United States on occasion. These real estate assets, in turn, ended up as collateral for a significant proportion of the assets of domestic financial systems. In many instances, those financial systems were less than robust, beset with problems of lax lending standards, weak supervisory regimes, and inadequate capital. Moreover, in most cases, the currencies of these economies were closely tied to the U.S. dollar, and the dollar's substantial recovery since mid-1995, especially relative to the yen, made their exports less competitive. In addition, in some cases, the glut of semiconductors in 1996 suppressed export growth, exerting further pressures on highly leveraged businesses. However, overall GDP growth rates generally edged off only slightly, and imports, fostered by rising real exchange rates, continued to expand, contributing to what became unsustainable current account deficits in a number of these economies. Moreover, with exchange rates seeming to be solidly tied to the dollar, and with dollar and yen interest rates lower than domestic currency rates, a significant part of the enlarged capital inflows, into these economies, in particular short-term flows, was denominated by the ultimate borrowers in foreign currencies. This put additional pressure on companies to earn foreign exchange through exports. - 3 - The pressures on fixed exchange rate regimes mounted as foreign investors slowed the pace of new capital inflows, and domestic businesses sought increasingly to convert domestic currencies into foreign currencies, or, equivalently, slowed the conversion of export earnings into domestic currencies. The shifts in perceived future investment risks led to sharp declines in stock markets across Asia, often on top of earlier declines or lackluster performances. To date, the direct impact of these developments on the American economy has been modest, but it can be expected not to be negligible. U.S. exports to Thailand, the Philippines, Indonesia, and Malaysia (the four countries initially affected) were about four percent of total U.S. exports in 1996. However, an additional 12 percent went to Hong Kong, Korea, Singapore and Taiwan (economies that have been affected more recently). Thus, depending on the extent of the inevitable slowdown in growth in this area of the world, the growth of our exports will tend to be muted. Our direct foreign investment in, and foreign affiliate earnings reported from, the economies in this region as a whole have been a smaller share of the respective totals than their share of our exports. The share is, nonetheless, large enough to expect some drop-off in those earnings in the period ahead. In addition, there may be indirect effects on the U.S. real economy from countries such as Japan that compete even more extensively with the economies in the Asian region. Particularly troublesome over the past several months has been the so-called contagion effect of weakness in one economy spreading to others as investors perceive, rightly or wrongly, similar vulnerabilities. Even economies, such as Hong Kong, with formidable stocks of international reserves, balanced external accounts and relatively robust financial systems, have experienced severe pressures in recent days. One can debate whether the recent turbulence in Latin American asset values reflect contagion effects from Asia, the influence of developments in U.S. financial markets, or home-grown causes. Whatever the answer, and the answer may be all of the above, this phenomenon illustrates the interdependencies in today's world economy and financial system. Perhaps it was inevitable that the impressive and rapid growth experienced by the economies in the Asian region would run into a temporary slowdown or pause. But there is no reason that above-average growth in countries that are still in a position to gain from catching up with the prevailing technology cannot persist for a very long time. Nevertheless, rapidly developing, free-market economies periodically can be expected to run into difficulties because investment mistakes are inevitable in any dynamic economy. Private capital flows may temporarily turn adverse. In these circumstances, companies should be allowed to default, private investors should take their losses, and government policies should be directed toward laying the macroeconomic and structural foundations for renewed expansion; new growth opportunities must be allowed to emerge. Similarly, in providing any international financial assistance, we need to be mindful of the desirability of minimizing the impression that international authorities stand ready to guarantee the liabilities of failed domestic businesses. To do otherwise could lead to distorted investments and could ultimately unbalance the world financial system. The recent experience in Asia underscores the importance of financially sound domestic banking and other associated financial institutions. While the current turmoil has significant interaction with the international financial system, the recent crises would arguably have been better contained if long-maturity property loans had not accentuated the usual mismatch between maturities of assets and liabilities of domestic financial systems that were far from robust to begin with. Our unlamented savings and loan crises come to mind. These are trying days for economic policymakers in Asia. They must fend off domestic pressures that seek disengagement from the world trading and financial system. The authorities in these countries are working hard, in some cases with substantial assistance from the IMF, and the World Bank, and the Asian Development Bank, to stabilize their financial systems and economies. The financial disturbances that have afflicted a number of currencies in Asia do not at this point, as I indicated earlier, threaten prosperity in this country, but we need to work closely with their leaders and the international financial community to assure that their situations stabilize. It is in the - 4 - interest of the United States and other nations around the world to encourage appropriate policy adjustments, and where required, provide temporary financial assistance.	---[PAGE_BREAK]--- Mr. Greenspan's testimony before the Joint Economic Committee of the US Congress Testimony by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Joint Economic Committee of the US Congress in Washington DC on 29/10/97. We meet against the background of considerable turbulence in world financial markets, and I shall address the bulk of my remarks to those circumstances. We need to assess these developments against the backdrop of a continuing impressive performance of the American economy in recent months. Growth appears to have remained robust and inflation low, and even falling, despite an ever tightening labor market. Our economy has enjoyed a lengthy period of good economic growth, linked, not coincidentally, to damped inflation. The Federal Reserve is dedicated to contributing as best it can to prolonging this performance, and we will be watching economic and financial market developments closely and evaluating their implications. Even after the sharp rebound around the world in the past twenty-four hours, declines in stock markets in the United States and elsewhere have left investors less wealthy than they were a week ago and businesses facing higher equity cost of capital. Yet, provided the decline in financial markets does not cumulate, it is quite conceivable that a few years hence we will look back at this episode, as we now look back at the 1987 crash, as a salutary event in terms of its implications for the macroeconomy. The 1987 crash occurred at a time when the American economy was operating with a significant degree of inflationary excess that the fall in market values arguably neutralized. Today's economy, as I have been suggesting of late, has been drawing down unused labor resources at an unsustainable pace, spurred, in part, by a substantial wealth effect on demand. The market's net retrenchment of recent days will tend to damp that impetus, a development that should help to prolong our six-and-a-half-year business expansion. As I have testified previously, much of the stock price gain since early 1995 seems to have reflected upward revisions of long-term earnings expectations, which were implying a continuing indefinite rise in profit margins from already high levels. I suspect we are experiencing some scaling back of the projected gains in foreign affiliate earnings, and investors probably also are revisiting expectations of domestic earnings growth. Still, the foundation for good business performance remains solid. Indeed, data on our national economy in recent months are beginning to support the notion that productivity growth, the basis for increases in earnings, is beginning to pick up. I also suspect earnings expectations and equity prices in the United States were primed to adjust. The currency crises in Southeast Asia and the declines in equity prices there and elsewhere do have some direct effects on U.S. corporate earnings, but not enough to explain the recent behavior of our financial markets. If it was not developments in Southeast Asia, something else would have been the proximate cause for a re-evaluation. While productivity growth does appear to have picked up in the last six months, as I have pointed out in the past, it likely is overly optimistic to assume that the dimension of any acceleration in productivity will be great enough and persistent enough to close, by itself, the gap between an excess of long-term demand for labor and its supply. It will take some time to judge the extent of a lasting improvement. Regrettably, over the last year the argument for the so-called new paradigm has slowly shifted from the not unreasonable notion that productivity is in the process of accelerating, to a less than credible view, often implied rather than stated, that we need no longer be concerned about the risk that inflation can rise again. The Federal Reserve cannot afford to take such a complacent view of our price prospects. There is much that is encouraging in the recent performance of the American economy, but, as I have often mentioned before, fundamental change comes slowly and we need to evaluate the prospective balance of supply and demand for various productive resources in deciding policy. ---[PAGE_BREAK]--- Recent developments in equity markets have highlighted growing interactions among national financial markets. The underlying technology-based structure of the international financial system has enabled us to improve materially the efficiency of the flows of capital and payment systems. That improvement, however, has also enhanced the ability of the financial system to transmit problems in one part of the globe to another quite rapidly. The recent turmoil is a case in point. I believe there is much to be learned from the recent experience in Asia that can be applied to better the workings of the international financial system and its support of international trade that has done so much to enhance living standards worldwide. While each of the Asian economies differs in many important respects, the sources of their spectacular growth in recent years, in some cases decades, and the problems that have recently emerged are relevant to a greater or lesser extent to nearly all of them. Following the early post-World War II period, policies generally fostering low levels of inflation and openness of their economies coupled with high savings and investment rates contributed to a sustained period of rapid growth, in some cases starting in 1960s and 1970s. By the 1980s most economies in the region were expanding vigorously. Foreign net capital inflows grew, but until recent years were relatively modest. The World Bank estimates that net inflows of long-term debt, foreign direct investment, and equity purchases to the Asia Pacific region were only about $\$ 25$ billion in 1990, but exploded to more than $\$ 110$ billion by 1996. A major impetus behind this rapid expansion was the global stock market boom of the 1990s. As that boom progressed, investors in many industrial countries found themselves more heavily concentrated in the recently higher valued securities of companies in the developed world, whose rates of return, in many instances, had fallen to levels perceived as uncompetitive with the earnings potential in emerging economies, especially in Asia. The resultant diversification induced a sharp increase in capital flows into those economies. To a large extent, they came from investors in the United States and Western Europe. A substantial amount came from Japan, as well, owing more to a search for higher yields than to rising stock prices and capital gains in that country. The rising yen through mid-1995 also encouraged a substantial increase in direct investment inflows from Japan. In retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at modest risk. I suspect that it was inevitable in those conditions of low inflation, rapid growth and ample liquidity that much investment moved into the real estate sector, with an emphasis by both the public and private sectors on conspicuous construction projects. This is an experience, of course, not unknown in the United States on occasion. These real estate assets, in turn, ended up as collateral for a significant proportion of the assets of domestic financial systems. In many instances, those financial systems were less than robust, beset with problems of lax lending standards, weak supervisory regimes, and inadequate capital. Moreover, in most cases, the currencies of these economies were closely tied to the U.S. dollar, and the dollar's substantial recovery since mid-1995, especially relative to the yen, made their exports less competitive. In addition, in some cases, the glut of semiconductors in 1996 suppressed export growth, exerting further pressures on highly leveraged businesses. However, overall GDP growth rates generally edged off only slightly, and imports, fostered by rising real exchange rates, continued to expand, contributing to what became unsustainable current account deficits in a number of these economies. Moreover, with exchange rates seeming to be solidly tied to the dollar, and with dollar and yen interest rates lower than domestic currency rates, a significant part of the enlarged capital inflows, into these economies, in particular short-term flows, was denominated by the ultimate borrowers in foreign currencies. This put additional pressure on companies to earn foreign exchange through exports. ---[PAGE_BREAK]--- The pressures on fixed exchange rate regimes mounted as foreign investors slowed the pace of new capital inflows, and domestic businesses sought increasingly to convert domestic currencies into foreign currencies, or, equivalently, slowed the conversion of export earnings into domestic currencies. The shifts in perceived future investment risks led to sharp declines in stock markets across Asia, often on top of earlier declines or lackluster performances. To date, the direct impact of these developments on the American economy has been modest, but it can be expected not to be negligible. U.S. exports to Thailand, the Philippines, Indonesia, and Malaysia (the four countries initially affected) were about four percent of total U.S. exports in 1996. However, an additional 12 percent went to Hong Kong, Korea, Singapore and Taiwan (economies that have been affected more recently). Thus, depending on the extent of the inevitable slowdown in growth in this area of the world, the growth of our exports will tend to be muted. Our direct foreign investment in, and foreign affiliate earnings reported from, the economies in this region as a whole have been a smaller share of the respective totals than their share of our exports. The share is, nonetheless, large enough to expect some drop-off in those earnings in the period ahead. In addition, there may be indirect effects on the U.S. real economy from countries such as Japan that compete even more extensively with the economies in the Asian region. Particularly troublesome over the past several months has been the so-called contagion effect of weakness in one economy spreading to others as investors perceive, rightly or wrongly, similar vulnerabilities. Even economies, such as Hong Kong, with formidable stocks of international reserves, balanced external accounts and relatively robust financial systems, have experienced severe pressures in recent days. One can debate whether the recent turbulence in Latin American asset values reflect contagion effects from Asia, the influence of developments in U.S. financial markets, or home-grown causes. Whatever the answer, and the answer may be all of the above, this phenomenon illustrates the interdependencies in today's world economy and financial system. Perhaps it was inevitable that the impressive and rapid growth experienced by the economies in the Asian region would run into a temporary slowdown or pause. But there is no reason that above-average growth in countries that are still in a position to gain from catching up with the prevailing technology cannot persist for a very long time. Nevertheless, rapidly developing, free-market economies periodically can be expected to run into difficulties because investment mistakes are inevitable in any dynamic economy. Private capital flows may temporarily turn adverse. In these circumstances, companies should be allowed to default, private investors should take their losses, and government policies should be directed toward laying the macroeconomic and structural foundations for renewed expansion; new growth opportunities must be allowed to emerge. Similarly, in providing any international financial assistance, we need to be mindful of the desirability of minimizing the impression that international authorities stand ready to guarantee the liabilities of failed domestic businesses. To do otherwise could lead to distorted investments and could ultimately unbalance the world financial system. The recent experience in Asia underscores the importance of financially sound domestic banking and other associated financial institutions. While the current turmoil has significant interaction with the international financial system, the recent crises would arguably have been better contained if long-maturity property loans had not accentuated the usual mismatch between maturities of assets and liabilities of domestic financial systems that were far from robust to begin with. Our unlamented savings and loan crises come to mind. These are trying days for economic policymakers in Asia. They must fend off domestic pressures that seek disengagement from the world trading and financial system. The authorities in these countries are working hard, in some cases with substantial assistance from the IMF, and the World Bank, and the Asian Development Bank, to stabilize their financial systems and economies. The financial disturbances that have afflicted a number of currencies in Asia do not at this point, as I indicated earlier, threaten prosperity in this country, but we need to work closely with their leaders and the international financial community to assure that their situations stabilize. It is in the ---[PAGE_BREAK]--- interest of the United States and other nations around the world to encourage appropriate policy adjustments, and where required, provide temporary financial assistance.	Alan Greenspan	United States	https://www.bis.org/review/r971104b.pdf	Mr. Greenspan's testimony before the Joint Economic Committee of the US Congress Testimony by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Joint Economic Committee of the US Congress in Washington DC on 29/10/97. We meet against the background of considerable turbulence in world financial markets, and I shall address the bulk of my remarks to those circumstances. We need to assess these developments against the backdrop of a continuing impressive performance of the American economy in recent months. Growth appears to have remained robust and inflation low, and even falling, despite an ever tightening labor market. Our economy has enjoyed a lengthy period of good economic growth, linked, not coincidentally, to damped inflation. The Federal Reserve is dedicated to contributing as best it can to prolonging this performance, and we will be watching economic and financial market developments closely and evaluating their implications. Even after the sharp rebound around the world in the past twenty-four hours, declines in stock markets in the United States and elsewhere have left investors less wealthy than they were a week ago and businesses facing higher equity cost of capital. Yet, provided the decline in financial markets does not cumulate, it is quite conceivable that a few years hence we will look back at this episode, as we now look back at the 1987 crash, as a salutary event in terms of its implications for the macroeconomy. The 1987 crash occurred at a time when the American economy was operating with a significant degree of inflationary excess that the fall in market values arguably neutralized. Today's economy, as I have been suggesting of late, has been drawing down unused labor resources at an unsustainable pace, spurred, in part, by a substantial wealth effect on demand. The market's net retrenchment of recent days will tend to damp that impetus, a development that should help to prolong our six-and-a-half-year business expansion. As I have testified previously, much of the stock price gain since early 1995 seems to have reflected upward revisions of long-term earnings expectations, which were implying a continuing indefinite rise in profit margins from already high levels. I suspect we are experiencing some scaling back of the projected gains in foreign affiliate earnings, and investors probably also are revisiting expectations of domestic earnings growth. Still, the foundation for good business performance remains solid. Indeed, data on our national economy in recent months are beginning to support the notion that productivity growth, the basis for increases in earnings, is beginning to pick up. I also suspect earnings expectations and equity prices in the United States were primed to adjust. The currency crises in Southeast Asia and the declines in equity prices there and elsewhere do have some direct effects on U.S. corporate earnings, but not enough to explain the recent behavior of our financial markets. If it was not developments in Southeast Asia, something else would have been the proximate cause for a re-evaluation. While productivity growth does appear to have picked up in the last six months, as I have pointed out in the past, it likely is overly optimistic to assume that the dimension of any acceleration in productivity will be great enough and persistent enough to close, by itself, the gap between an excess of long-term demand for labor and its supply. It will take some time to judge the extent of a lasting improvement. Regrettably, over the last year the argument for the so-called new paradigm has slowly shifted from the not unreasonable notion that productivity is in the process of accelerating, to a less than credible view, often implied rather than stated, that we need no longer be concerned about the risk that inflation can rise again. The Federal Reserve cannot afford to take such a complacent view of our price prospects. There is much that is encouraging in the recent performance of the American economy, but, as I have often mentioned before, fundamental change comes slowly and we need to evaluate the prospective balance of supply and demand for various productive resources in deciding policy. Recent developments in equity markets have highlighted growing interactions among national financial markets. The underlying technology-based structure of the international financial system has enabled us to improve materially the efficiency of the flows of capital and payment systems. That improvement, however, has also enhanced the ability of the financial system to transmit problems in one part of the globe to another quite rapidly. The recent turmoil is a case in point. I believe there is much to be learned from the recent experience in Asia that can be applied to better the workings of the international financial system and its support of international trade that has done so much to enhance living standards worldwide. While each of the Asian economies differs in many important respects, the sources of their spectacular growth in recent years, in some cases decades, and the problems that have recently emerged are relevant to a greater or lesser extent to nearly all of them. Following the early post-World War II period, policies generally fostering low levels of inflation and openness of their economies coupled with high savings and investment rates contributed to a sustained period of rapid growth, in some cases starting in 1960s and 1970s. By the 1980s most economies in the region were expanding vigorously. Foreign net capital inflows grew, but until recent years were relatively modest. The World Bank estimates that net inflows of long-term debt, foreign direct investment, and equity purchases to the Asia Pacific region were only about $\$ 25$ billion in 1990, but exploded to more than $\$ 110$ billion by 1996. A major impetus behind this rapid expansion was the global stock market boom of the 1990s. As that boom progressed, investors in many industrial countries found themselves more heavily concentrated in the recently higher valued securities of companies in the developed world, whose rates of return, in many instances, had fallen to levels perceived as uncompetitive with the earnings potential in emerging economies, especially in Asia. The resultant diversification induced a sharp increase in capital flows into those economies. To a large extent, they came from investors in the United States and Western Europe. A substantial amount came from Japan, as well, owing more to a search for higher yields than to rising stock prices and capital gains in that country. The rising yen through mid-1995 also encouraged a substantial increase in direct investment inflows from Japan. In retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at modest risk. I suspect that it was inevitable in those conditions of low inflation, rapid growth and ample liquidity that much investment moved into the real estate sector, with an emphasis by both the public and private sectors on conspicuous construction projects. This is an experience, of course, not unknown in the United States on occasion. These real estate assets, in turn, ended up as collateral for a significant proportion of the assets of domestic financial systems. In many instances, those financial systems were less than robust, beset with problems of lax lending standards, weak supervisory regimes, and inadequate capital. Moreover, in most cases, the currencies of these economies were closely tied to the U.S. dollar, and the dollar's substantial recovery since mid-1995, especially relative to the yen, made their exports less competitive. In addition, in some cases, the glut of semiconductors in 1996 suppressed export growth, exerting further pressures on highly leveraged businesses. However, overall GDP growth rates generally edged off only slightly, and imports, fostered by rising real exchange rates, continued to expand, contributing to what became unsustainable current account deficits in a number of these economies. Moreover, with exchange rates seeming to be solidly tied to the dollar, and with dollar and yen interest rates lower than domestic currency rates, a significant part of the enlarged capital inflows, into these economies, in particular short-term flows, was denominated by the ultimate borrowers in foreign currencies. This put additional pressure on companies to earn foreign exchange through exports. The pressures on fixed exchange rate regimes mounted as foreign investors slowed the pace of new capital inflows, and domestic businesses sought increasingly to convert domestic currencies into foreign currencies, or, equivalently, slowed the conversion of export earnings into domestic currencies. The shifts in perceived future investment risks led to sharp declines in stock markets across Asia, often on top of earlier declines or lackluster performances. To date, the direct impact of these developments on the American economy has been modest, but it can be expected not to be negligible. U.S. exports to Thailand, the Philippines, Indonesia, and Malaysia (the four countries initially affected) were about four percent of total U.S. exports in 1996. However, an additional 12 percent went to Hong Kong, Korea, Singapore and Taiwan (economies that have been affected more recently). Thus, depending on the extent of the inevitable slowdown in growth in this area of the world, the growth of our exports will tend to be muted. Our direct foreign investment in, and foreign affiliate earnings reported from, the economies in this region as a whole have been a smaller share of the respective totals than their share of our exports. The share is, nonetheless, large enough to expect some drop-off in those earnings in the period ahead. In addition, there may be indirect effects on the U.S. real economy from countries such as Japan that compete even more extensively with the economies in the Asian region. Particularly troublesome over the past several months has been the so-called contagion effect of weakness in one economy spreading to others as investors perceive, rightly or wrongly, similar vulnerabilities. Even economies, such as Hong Kong, with formidable stocks of international reserves, balanced external accounts and relatively robust financial systems, have experienced severe pressures in recent days. One can debate whether the recent turbulence in Latin American asset values reflect contagion effects from Asia, the influence of developments in U.S. financial markets, or home-grown causes. Whatever the answer, and the answer may be all of the above, this phenomenon illustrates the interdependencies in today's world economy and financial system. Perhaps it was inevitable that the impressive and rapid growth experienced by the economies in the Asian region would run into a temporary slowdown or pause. But there is no reason that above-average growth in countries that are still in a position to gain from catching up with the prevailing technology cannot persist for a very long time. Nevertheless, rapidly developing, free-market economies periodically can be expected to run into difficulties because investment mistakes are inevitable in any dynamic economy. Private capital flows may temporarily turn adverse. In these circumstances, companies should be allowed to default, private investors should take their losses, and government policies should be directed toward laying the macroeconomic and structural foundations for renewed expansion; new growth opportunities must be allowed to emerge. Similarly, in providing any international financial assistance, we need to be mindful of the desirability of minimizing the impression that international authorities stand ready to guarantee the liabilities of failed domestic businesses. To do otherwise could lead to distorted investments and could ultimately unbalance the world financial system. The recent experience in Asia underscores the importance of financially sound domestic banking and other associated financial institutions. While the current turmoil has significant interaction with the international financial system, the recent crises would arguably have been better contained if long-maturity property loans had not accentuated the usual mismatch between maturities of assets and liabilities of domestic financial systems that were far from robust to begin with. Our unlamented savings and loan crises come to mind. These are trying days for economic policymakers in Asia. They must fend off domestic pressures that seek disengagement from the world trading and financial system. The authorities in these countries are working hard, in some cases with substantial assistance from the IMF, and the World Bank, and the Asian Development Bank, to stabilize their financial systems and economies. The financial disturbances that have afflicted a number of currencies in Asia do not at this point, as I indicated earlier, threaten prosperity in this country, but we need to work closely with their leaders and the international financial community to assure that their situations stabilize. It is in the interest of the United States and other nations around the world to encourage appropriate policy adjustments, and where required, provide temporary financial assistance.
1997-10-30T00:00:00	Ms. Phillips discusses trends and challenges in Federal Reserve bank supervision (Central Bank Articles and Speeches, 30 Oct 97)	Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at Houston Baptist University, Houston, Texas on 30/10/97.	Ms. Phillips discusses trends and challenges in Federal Reserve bank supervision Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at Houston Baptist University, Houston, Texas on 30/10/97. Trends and Challenges in Federal Reserve Bank Supervision I am pleased to be here today to talk with you about some of the important, fundamental changes taking place within the U.S. banking system and the effects those changes are having on the Federal Reserve's supervisory process. As you know, the U.S. economy and banking system have enjoyed more than half a decade of improving strength and prosperity in which U.S. banks have become better capitalized and more profitable than they have been in generations. Moreover, in the past 13 months not a single insured bank has failed, and the Bank Insurance Fund is now capitalized at a level requiring most banks to pay only nominal fees for their insurance. While this situation is a vast improvement over conditions in earlier years, experience has demonstrated that at times like these -- if we are not vigilant -- risks can occur that set the stage for future problems. That's what makes supervising banks so interesting and such a challenge. When the economy and the banking industry are in difficulty, supervisors must identify and address immediate problems in an effort to protect the U.S. taxpayer and the federal safety net. When conditions are good, as they are today, supervisors have the opportunity to review their oversight process and promote sound practices for managing banking risks in an effort to avert or mitigate future problems. This and keeping up with the pace of financial innovation and industry change that has occurred in the past 5 to 10 years has been a challenge, indeed. As I begin my remarks, I would like to point out that no system of supervision or regulation can provide total assurance that banking problems will not occur or that banks will not fail. Nor should it. Any process that prevents all banking problems would be extremely invasive to banking organizations and would likely inhibit economic growth. As financial intermediaries, banks must take risks if they and their communities are to grow. As risk-takers, some banks will necessarily incur losses, and some will eventually fail. The objective is to contain the costs of risk-taking, both to individual institutions and to the safety net, more generally. Therefore, our goal as regulators is to help identify weak banking practices so that small or emerging problems can be addressed before they become large and costly. To do that in today's markets, and in an environment in which technology and financial innovation can lead to rapid change, the Federal Reserve is pursuing a more risk-focused supervisory approach. We are well underway toward implementing this new supervisory framework, and initial indications about it -- from both examiners and bankers -- have been favorable. This risk-focused approach to supervision is seen as a necessary response to a variety of factors: the growing complexity and pace of change within the industry, the increasingly global nature of U.S. and world financial markets, and the methods available today for managing and controlling risk. As banking practices and markets continue to evolve, I believe this emphasis on risk-focused supervision will be even more necessary in the years to come. What is "Risk-Focused" Supervision? With that introduction, let me clarify what I mean by risk-focused supervision. How does it differ from the way supervisors have traditionally done their job? What does it mean to the banking system? What is it? In short, risk-focused supervision simply means that in conducting bank examinations and other supervisory activities, we will seek to direct our attention and resources to the areas that we perceive pose the greatest risk to banks. In many respects, that would seem rather obvious and hardly earth shaking, and in many ways it is, indeed, nothing new. The Federal Reserve and the other banking agencies have long sought to identify exceptions and to prioritize examination activities. In the past, though, the business of bank supervision has focused on validating bank balance sheets, particularly the value of loan portfolios, which have been historically the principal source of problems for banks. Much of the prior emphasis was on determining the condition of a bank at a point in time. In the process, we would go through the balance sheet, assuring ourselves that a bank's assets and liabilities were essentially as stated and that its reserves and net worth were real. As part of the process, there was a review of sound management practices, internal controls, and strong internal audit activities, but that review was not the initial or primary focus. In earlier times that approach was adequate, since bank balance sheets were generally slow to change. Banks held their loans to maturity; they acquired deposits locally and at a pace similar to local economic growth; their product lines were stable; and management turnover, itself, was typically low. By tracking the quality of loans and other assets, examiners could generally detect deterioration and other business problems through their periodic on-site examinations. If done often enough, those examinations typically gave authorities sufficient time to take action and to either close or sell a bank before the losses became significant to the deposit insurance fund. Developments Driving Change During the past decade, though, the U.S. banking system experienced a great deal of turmoil, stress, and change. Ten years ago, many of the country's largest banks announced huge loan loss provisions, beginning the process of reducing the industry's overhang of doubtful developing country loans. At the same time, many of these institutions and smaller regional banks were struggling with energy and agricultural sector difficulties or accumulating commercial real estate problems. I am sure that many of you here today can easily recall those times, and that these and other difficulties took a heavy toll -- if not in your own banks, in those of your competitors. By the end of the 1980s, more than 200 banks were failing annually, and there were more than 1,000 banks on the FDIC problem list. This experience provided important lessons and forced supervisors and bankers, alike, to reconsider the way they approached their jobs. For their part, bankers recognized the need to rebuild their capital and reserves, strengthen their internal controls, diversify their risks, and improve their practices for identifying, underwriting, and managing risk. Supervisors were also reminded of the need to remain vigilant and of the high costs that bank failures can bring, not only to the insurance fund but to local communities as well. The FDIC Improvement Act of 1991 emphasized that point, requiring frequent examinations and prompt regulatory actions when serious problems emerge. Beyond these mostly domestic events, banks and businesses throughout the world were dealing in the 1980s and 1990s with new technologies that were leading to a multitude of new and increasingly complex financial products that changed the nature of banking and financial markets. These technologies have brought about an endless variety of derivative instruments, increased securitization, ATMs, and a broader range of banking products. By lowering information costs, they have also led to dramatic improvements in risk management and have expanded the marketing and service capabilities of banks and their competitors. In large part, these changes and innovations are unequivocally good for society and have produced more efficient markets and, in turn, greater international trade and economic growth. They have also, however, greatly increased the complexity of banking and bank supervision. In both cases, these developments have spurred the demand for highly trained and qualified personnel. Within the United States, our banking system has also experienced a dramatic consolidation in the number of banking institutions, due not only to technology and financial innovation, but also to legislative changes allowing interstate banking. The number of independent commercial banking organizations has declined 40 percent since 1980 to 7,400 in June of this year. While possibly stressful to many bankers and bank customers, this dramatic structural change has also contributed to industry earnings by providing banks with greater opportunities to reduce costs. A challenge now for many institutions may be to manage their growth and the continuing process of industry consolidation. This challenge may be greatest as banking organizations expand into more diverse or nontraditional banking activities, particularly through acquisitions. Growth into a wider array of activities is especially important if banks are to meet the wide-ranging needs of their business and household customers, while competing effectively with other regulated and unregulated firms. As you know, the Congress has been wrestling with the issue of banking powers for years and -- with the exception of interstate branching -- has yet to make much progress. The Federal Reserve has long believed that legislation is needed and that the industry can best move forward if this issue is resolved by lawmakers, rather than by regulators in a piecemeal fashion. Nevertheless, with or without legislation, we must all deal with changing markets and with the opportunities and pressures they present. Utilizing existing legislative authority, regulators have been able to approve new banking products that were not available a decade ago, as financial markets and products have evolved. However, whether future expansion comes through new laws or merely through new interpretations of current laws and regulations, it is important that the banking industry use its powers wisely and that its performance remain sound. Supervisory Challenges Ahead In supervising this "industry-in-transition", the Federal Reserve has no shortage of tasks, despite the virtually unprecedented strong condition of the U.S. banking system today. We, too, must deal with the evolving financial markets and advances in technology. At the same time, we must ensure that our own supervisory practices, tools, and standards take advantage of improving technology and financial techniques so that our oversight is not only effective, but also as unobtrusive and as appropriate as possible. These tasks are wide ranging, extending from our own re-engineering of the supervisory process to the way supervisors approach such issues as measuring capital adequacy and international convergence of supervisory standards. Constructing a sound supervisory process while minimizing regulatory burden has been a long-standing and on-going effort at the Federal Reserve and an objective we have sought to advance with our emphasis on risk-focused examinations. Particularly in the past decade, the development of new financial products and the greater depth and liquidity of financial markets have enabled banking organizations to change their risk profiles more rapidly than ever before. That possibility requires that we strike an appropriate balance between evaluating the condition of an institution at a point in time and evaluating the soundness of the bank's on-going process for managing risk. The risk-focused approach, by definition, entails a more formal planning phase that identifies those areas and activities at risk that warrant the most extensive review. This pre-planning process is supported by technology, for example, to download certain information about a bank's loan portfolio to our own computer systems and then, through off-site analysis, target areas of the portfolio for review. This revised process should be less disruptive to the daily activities of banks than earlier examination procedures and has the further advantage of reducing our own travel costs and improving examiner morale. Once on-site, examiners analyze the bank's loans and other assets to ascertain the organization's current condition, and also to evaluate its internal control process and its own ability to identify and resolve problems. As a result, the Federal Reserve is placing greater reliance than before on a bank's internal auditors and on the accuracy and adequacy of bank information systems. The review of a bank's information flow extends from top to bottom, and with the expectation that bank senior management and boards of directors are actively involved in monitoring the bank's activities and providing sufficient guidance regarding their appetite for risk. As in the past, performance of substantive checks on the reliability of a bank's controls remains an important element of the examination process, albeit in a more automated and advanced form. For example, we are pursuing ways to make greater use of loan sampling in order to generate statistically valid conclusions about the accuracy of a bank's internal loan review process. To the extent we can validate the integrity of a bank's internal controls more efficiently, we can place more confidence in them at an earlier stage and can also take greater comfort that management is providing itself with an accurate indication of the bank's condition. Moreover, as examiners are able to complete loan reviews more quickly, they will have more time to review other high priority aspects of the institution's operations. A significant benefit of the risk-focused approach is its emphasis on ensuring that the bank's internal oversight processes are sound and that communication between the bank and Federal Reserve examiners occurs between examinations. That approach is generally supported by institutions we supervise and provides a more comprehensive oversight process that complements our annual or 18-month examination cycle. It also strengthens our ability to respond promptly if conditions deteriorate. Importantly, the Federal Reserve's examination staff indicates that this risk-focused process may be reducing on-site examination time by 15-30 percent in many cases and overall examination time of Reserve Bank personnel by perhaps 10 percent. While those results are tentative, partial, and unscientific, they are certainly encouraging in terms of resource implications. Complementing the risk-focused approach to supervision are enhancements to the tools we use to grade a bank's condition and management. Since 1995, we have asked our examiners to provide a specific supervisory rating for a bank's risk management process. This Fed initiative preceded, but is quite consistent with, the more recent interagency decision to add an "S" to the end of the CAMEL rating. That "S", as you know, addresses sensitivity to market risk and reflects in large part a bank's ability to manage that risk. Any managers in the audience who are with U.S. offices of foreign banks may appreciate that these rating changes simply highlight the importance of risk management that the Federal Reserve has for some time emphasized in its review of foreign banks. How effective is the risk-focused process? Since economic and industry conditions have been so favorable in recent years, there has not been a sufficiently stressful economic downturn to provide a robust test. The market volatility beginning in 1994 offered some insights about supervisory judgements of the risk management systems of large trading banks, but there have been few other indications. Even the rise to record levels of delinquencies and defaults on credit card debt may reflect factors other than the ability of supervisors to ensure that management has all the important bases covered. The real test, of course, would come with a major economic downturn. Even then, though, it will be hard to know what might have occurred had our oversight procedures not changed. Nevertheless, there are indications that both banking and supervisory practices are materially better now than they were in the 1980s and early 1990s. Because of technology and lower computer and communications costs, information is much more readily available than in earlier decades, and sound management practices are more widespread. Risk measurement and portfolio management techniques that were largely theoretical when some of us were in college are now fully operational in many banks. Moreover, the costly experience with bank and thrift failures in the early 1990s has not been forgotten. As a result, most bankers and business managers today have a greater appreciation, I believe, for the value of risk management and internal controls. To that point, we are finding, with increased frequency, that banks are designing personnel compensation systems to provide managers with greater incentives to control risk. Implementing a risk-focused supervisory approach has not been an easy task. It has required significant revisions to our broad and specialized training programs, including expansion of capital markets, risk assessment information technology, and global trading activities as well as courses devoted exclusively to internal controls. These education programs will, of course, need to be continually updated as industry activities and conditions evolve. With the greater discretion examiners now have to focus their efforts on areas of highest risk, it has also become more important that we ensure the consistency and overall quality of our examinations. To address that point, we have developed automated examination tools, based on a decision-tree framework, that will help guide examiners through the procedures most relevant to individual banks, given their specific circumstances and risk profiles. Moreover, both domestically and abroad, the Federal Reserve is working with other bank supervisors and with the banking industry to develop sound practices for management for a variety of bank activities. Initiatives in recent years include guidance on disclosure and on managing interest rate risk and derivative activities. Such efforts, and the growing worldwide recognition of the value of market forces, should lead to clearer expectations of supervisors, greater reliance on market discipline, and less intrusive regulation. In that connection, the Federal Reserve in recent years has worked closely with the FDIC and with state banking departments to coordinate our examination procedures and supervisory practices. A prime example of these efforts is the adoption last year of the State and Federal Protocol, through which we all seek to achieve a relatively seamless supervisory process for banks operating across state lines. We are also working together on a variety of automation efforts, some of which I have referred to already. The Year 2000 Under the category of "problems we don't need", I find it difficult to talk with bankers these days without raising the "Year 2000" problem. Fortunately, most U.S. banks appear to be taking this matter seriously and are generally well underway toward identifying their individual needs and developing action plans. Nevertheless, the Federal Reserve and the other federal banking agencies are actively reviewing the efforts of banks to address this vital issue. Some banks, particularly large ones, have stated, themselves, that if an institution is not already well underway toward resolving this problem, then it is already too late. I hope that all of you are giving this matter adequate attention, and are taking the steps necessary to ensure that changes are being made within your banks, and also by your vendors and customers. A critical aspect of the year 2000 problem is that we are all so inter-linked. Not only are we exposed to our own internal computer problems, but also to those with whom we do business. This matter has far-reaching implications for banks, covering not only operating risk, but also credit risk, liquidity risk, reputational risk, and others if material problems emerge. This is yet another illustration of the many challenges faced by bankers today. Conclusion In conclusion, the history of banking and of bank supervision shows a long and rather close relationship between the health of the banking system and the economy, a connection that reflects the role of banks in the credit intermediation process. We can expect that relationship to continue and for bank earnings and asset quality to fluctuate as economic conditions change. In many ways, however, the banking and financial system has changed dramatically in the past decade both in terms of its structure and the diversity of its activities. Risk management practices have also advanced, helped by technological and financial innovations. I believe that both bank supervisors and the banking industry have learned important lessons from the experience of the past ten years, specifically about the need to actively monitor, manage, and control risks. Through its supervisory process, the Federal Reserve seeks to maintain a proper balance: permitting banks maximum freedom, while still protecting the safety net and maintaining financial stability. Maintaining responsible banking and responsible bank supervision is the key. We must all work to identify risks and to ensure they are adequately monitored and controlled. That result will lead to better banking practices, to more stable earnings and asset quality for the industry, and to less regulatory and legislative risk. These are goals we all share.	---[PAGE_BREAK]--- # Ms. Phillips discusses trends and challenges in Federal Reserve bank supervision Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at Houston Baptist University, Houston, Texas on 30/10/97. ## Trends and Challenges in Federal Reserve Bank Supervision I am pleased to be here today to talk with you about some of the important, fundamental changes taking place within the U.S. banking system and the effects those changes are having on the Federal Reserve's supervisory process. As you know, the U.S. economy and banking system have enjoyed more than half a decade of improving strength and prosperity in which U.S. banks have become better capitalized and more profitable than they have been in generations. Moreover, in the past 13 months not a single insured bank has failed, and the Bank Insurance Fund is now capitalized at a level requiring most banks to pay only nominal fees for their insurance. While this situation is a vast improvement over conditions in earlier years, experience has demonstrated that at times like these -- if we are not vigilant -- risks can occur that set the stage for future problems. That's what makes supervising banks so interesting and such a challenge. When the economy and the banking industry are in difficulty, supervisors must identify and address immediate problems in an effort to protect the U.S. taxpayer and the federal safety net. When conditions are good, as they are today, supervisors have the opportunity to review their oversight process and promote sound practices for managing banking risks in an effort to avert or mitigate future problems. This and keeping up with the pace of financial innovation and industry change that has occurred in the past 5 to 10 years has been a challenge, indeed. As I begin my remarks, I would like to point out that no system of supervision or regulation can provide total assurance that banking problems will not occur or that banks will not fail. Nor should it. Any process that prevents all banking problems would be extremely invasive to banking organizations and would likely inhibit economic growth. As financial intermediaries, banks must take risks if they and their communities are to grow. As risk-takers, some banks will necessarily incur losses, and some will eventually fail. The objective is to contain the costs of risk-taking, both to individual institutions and to the safety net, more generally. Therefore, our goal as regulators is to help identify weak banking practices so that small or emerging problems can be addressed before they become large and costly. To do that in today's markets, and in an environment in which technology and financial innovation can lead to rapid change, the Federal Reserve is pursuing a more risk-focused supervisory approach. We are well underway toward implementing this new supervisory framework, and initial indications about it -- from both examiners and bankers -- have been favorable. This risk-focused approach to supervision is seen as a necessary response to a variety of factors: the growing complexity and pace of change within the industry, the increasingly global nature of U.S. and world financial markets, and the methods available today for managing and controlling risk. As banking practices and markets continue to evolve, I believe this emphasis on risk-focused supervision will be even more necessary in the years to come. ## What is "Risk-Focused" Supervision? With that introduction, let me clarify what I mean by risk-focused supervision. How does it differ from the way supervisors have traditionally done their job? What does it mean to the ---[PAGE_BREAK]--- banking system? What is it? In short, risk-focused supervision simply means that in conducting bank examinations and other supervisory activities, we will seek to direct our attention and resources to the areas that we perceive pose the greatest risk to banks. In many respects, that would seem rather obvious and hardly earth shaking, and in many ways it is, indeed, nothing new. The Federal Reserve and the other banking agencies have long sought to identify exceptions and to prioritize examination activities. In the past, though, the business of bank supervision has focused on validating bank balance sheets, particularly the value of loan portfolios, which have been historically the principal source of problems for banks. Much of the prior emphasis was on determining the condition of a bank at a point in time. In the process, we would go through the balance sheet, assuring ourselves that a bank's assets and liabilities were essentially as stated and that its reserves and net worth were real. As part of the process, there was a review of sound management practices, internal controls, and strong internal audit activities, but that review was not the initial or primary focus. In earlier times that approach was adequate, since bank balance sheets were generally slow to change. Banks held their loans to maturity; they acquired deposits locally and at a pace similar to local economic growth; their product lines were stable; and management turnover, itself, was typically low. By tracking the quality of loans and other assets, examiners could generally detect deterioration and other business problems through their periodic on-site examinations. If done often enough, those examinations typically gave authorities sufficient time to take action and to either close or sell a bank before the losses became significant to the deposit insurance fund. # Developments Driving Change During the past decade, though, the U.S. banking system experienced a great deal of turmoil, stress, and change. Ten years ago, many of the country's largest banks announced huge loan loss provisions, beginning the process of reducing the industry's overhang of doubtful developing country loans. At the same time, many of these institutions and smaller regional banks were struggling with energy and agricultural sector difficulties or accumulating commercial real estate problems. I am sure that many of you here today can easily recall those times, and that these and other difficulties took a heavy toll -- if not in your own banks, in those of your competitors. By the end of the 1980s, more than 200 banks were failing annually, and there were more than 1,000 banks on the FDIC problem list. This experience provided important lessons and forced supervisors and bankers, alike, to reconsider the way they approached their jobs. For their part, bankers recognized the need to rebuild their capital and reserves, strengthen their internal controls, diversify their risks, and improve their practices for identifying, underwriting, and managing risk. Supervisors were also reminded of the need to remain vigilant and of the high costs that bank failures can bring, not only to the insurance fund but to local communities as well. The FDIC Improvement Act of 1991 emphasized that point, requiring frequent examinations and prompt regulatory actions when serious problems emerge. Beyond these mostly domestic events, banks and businesses throughout the world were dealing in the 1980s and 1990s with new technologies that were leading to a multitude of new and increasingly complex financial products that changed the nature of banking and financial markets. These technologies have brought about an endless variety of derivative instruments, increased securitization, ATMs, and a broader range of banking products. By lowering information costs, they have also led to dramatic improvements in risk management and have expanded the marketing and service capabilities of banks and their competitors. In large part, these changes and innovations are unequivocally good for society and have produced more efficient markets and, in turn, greater international trade and economic growth. ---[PAGE_BREAK]--- They have also, however, greatly increased the complexity of banking and bank supervision. In both cases, these developments have spurred the demand for highly trained and qualified personnel. Within the United States, our banking system has also experienced a dramatic consolidation in the number of banking institutions, due not only to technology and financial innovation, but also to legislative changes allowing interstate banking. The number of independent commercial banking organizations has declined 40 percent since 1980 to 7,400 in June of this year. While possibly stressful to many bankers and bank customers, this dramatic structural change has also contributed to industry earnings by providing banks with greater opportunities to reduce costs. A challenge now for many institutions may be to manage their growth and the continuing process of industry consolidation. This challenge may be greatest as banking organizations expand into more diverse or nontraditional banking activities, particularly through acquisitions. Growth into a wider array of activities is especially important if banks are to meet the wide-ranging needs of their business and household customers, while competing effectively with other regulated and unregulated firms. As you know, the Congress has been wrestling with the issue of banking powers for years and -- with the exception of interstate branching -- has yet to make much progress. The Federal Reserve has long believed that legislation is needed and that the industry can best move forward if this issue is resolved by lawmakers, rather than by regulators in a piecemeal fashion. Nevertheless, with or without legislation, we must all deal with changing markets and with the opportunities and pressures they present. Utilizing existing legislative authority, regulators have been able to approve new banking products that were not available a decade ago, as financial markets and products have evolved. However, whether future expansion comes through new laws or merely through new interpretations of current laws and regulations, it is important that the banking industry use its powers wisely and that its performance remain sound. # Supervisory Challenges Ahead In supervising this "industry-in-transition", the Federal Reserve has no shortage of tasks, despite the virtually unprecedented strong condition of the U.S. banking system today. We, too, must deal with the evolving financial markets and advances in technology. At the same time, we must ensure that our own supervisory practices, tools, and standards take advantage of improving technology and financial techniques so that our oversight is not only effective, but also as unobtrusive and as appropriate as possible. These tasks are wide ranging, extending from our own re-engineering of the supervisory process to the way supervisors approach such issues as measuring capital adequacy and international convergence of supervisory standards. Constructing a sound supervisory process while minimizing regulatory burden has been a long-standing and on-going effort at the Federal Reserve and an objective we have sought to advance with our emphasis on risk-focused examinations. Particularly in the past decade, the development of new financial products and the greater depth and liquidity of financial markets have enabled banking organizations to change their risk profiles more rapidly than ever before. That possibility requires that we strike an appropriate balance between evaluating the condition of an institution at a point in time and evaluating the soundness of the bank's on-going process for managing risk. The risk-focused approach, by definition, entails a more formal planning phase that identifies those areas and activities at risk that warrant the most extensive review. This pre-planning process is supported by technology, for example, to download certain information about a bank's ---[PAGE_BREAK]--- loan portfolio to our own computer systems and then, through off-site analysis, target areas of the portfolio for review. This revised process should be less disruptive to the daily activities of banks than earlier examination procedures and has the further advantage of reducing our own travel costs and improving examiner morale. Once on-site, examiners analyze the bank's loans and other assets to ascertain the organization's current condition, and also to evaluate its internal control process and its own ability to identify and resolve problems. As a result, the Federal Reserve is placing greater reliance than before on a bank's internal auditors and on the accuracy and adequacy of bank information systems. The review of a bank's information flow extends from top to bottom, and with the expectation that bank senior management and boards of directors are actively involved in monitoring the bank's activities and providing sufficient guidance regarding their appetite for risk. As in the past, performance of substantive checks on the reliability of a bank's controls remains an important element of the examination process, albeit in a more automated and advanced form. For example, we are pursuing ways to make greater use of loan sampling in order to generate statistically valid conclusions about the accuracy of a bank's internal loan review process. To the extent we can validate the integrity of a bank's internal controls more efficiently, we can place more confidence in them at an earlier stage and can also take greater comfort that management is providing itself with an accurate indication of the bank's condition. Moreover, as examiners are able to complete loan reviews more quickly, they will have more time to review other high priority aspects of the institution's operations. A significant benefit of the risk-focused approach is its emphasis on ensuring that the bank's internal oversight processes are sound and that communication between the bank and Federal Reserve examiners occurs between examinations. That approach is generally supported by institutions we supervise and provides a more comprehensive oversight process that complements our annual or 18 -month examination cycle. It also strengthens our ability to respond promptly if conditions deteriorate. Importantly, the Federal Reserve's examination staff indicates that this risk-focused process may be reducing on-site examination time by 15-30 percent in many cases and overall examination time of Reserve Bank personnel by perhaps 10 percent. While those results are tentative, partial, and unscientific, they are certainly encouraging in terms of resource implications. Complementing the risk-focused approach to supervision are enhancements to the tools we use to grade a bank's condition and management. Since 1995, we have asked our examiners to provide a specific supervisory rating for a bank's risk management process. This Fed initiative preceded, but is quite consistent with, the more recent interagency decision to add an "S" to the end of the CAMEL rating. That "S", as you know, addresses sensitivity to market risk and reflects in large part a bank's ability to manage that risk. Any managers in the audience who are with U.S. offices of foreign banks may appreciate that these rating changes simply highlight the importance of risk management that the Federal Reserve has for some time emphasized in its review of foreign banks. # How effective is the risk-focused process? Since economic and industry conditions have been so favorable in recent years, there has not been a sufficiently stressful economic downturn to provide a robust test. The market volatility beginning in 1994 offered some insights about supervisory judgements of the risk management systems of large trading banks, but there have been few other indications. Even the rise to record levels of delinquencies and defaults on credit card debt may reflect factors other than the ability of supervisors to ensure that management has all the important bases covered. The real test, of course, ---[PAGE_BREAK]--- would come with a major economic downturn. Even then, though, it will be hard to know what might have occurred had our oversight procedures not changed. Nevertheless, there are indications that both banking and supervisory practices are materially better now than they were in the 1980s and early 1990s. Because of technology and lower computer and communications costs, information is much more readily available than in earlier decades, and sound management practices are more widespread. Risk measurement and portfolio management techniques that were largely theoretical when some of us were in college are now fully operational in many banks. Moreover, the costly experience with bank and thrift failures in the early 1990s has not been forgotten. As a result, most bankers and business managers today have a greater appreciation, I believe, for the value of risk management and internal controls. To that point, we are finding, with increased frequency, that banks are designing personnel compensation systems to provide managers with greater incentives to control risk. Implementing a risk-focused supervisory approach has not been an easy task. It has required significant revisions to our broad and specialized training programs, including expansion of capital markets, risk assessment information technology, and global trading activities as well as courses devoted exclusively to internal controls. These education programs will, of course, need to be continually updated as industry activities and conditions evolve. With the greater discretion examiners now have to focus their efforts on areas of highest risk, it has also become more important that we ensure the consistency and overall quality of our examinations. To address that point, we have developed automated examination tools, based on a decision-tree framework, that will help guide examiners through the procedures most relevant to individual banks, given their specific circumstances and risk profiles. Moreover, both domestically and abroad, the Federal Reserve is working with other bank supervisors and with the banking industry to develop sound practices for management for a variety of bank activities. Initiatives in recent years include guidance on disclosure and on managing interest rate risk and derivative activities. Such efforts, and the growing worldwide recognition of the value of market forces, should lead to clearer expectations of supervisors, greater reliance on market discipline, and less intrusive regulation. In that connection, the Federal Reserve in recent years has worked closely with the FDIC and with state banking departments to coordinate our examination procedures and supervisory practices. A prime example of these efforts is the adoption last year of the State and Federal Protocol, through which we all seek to achieve a relatively seamless supervisory process for banks operating across state lines. We are also working together on a variety of automation efforts, some of which I have referred to already. # The Year 2000 Under the category of "problems we don't need", I find it difficult to talk with bankers these days without raising the "Year 2000" problem. Fortunately, most U.S. banks appear to be taking this matter seriously and are generally well underway toward identifying their individual needs and developing action plans. Nevertheless, the Federal Reserve and the other federal banking agencies are actively reviewing the efforts of banks to address this vital issue. Some banks, particularly large ones, have stated, themselves, that if an institution is not already well underway toward resolving this problem, then it is already too late. I hope that all of you are giving this matter adequate attention, and are taking the steps necessary to ensure that changes are being made within your banks, and also by your vendors and customers. ---[PAGE_BREAK]--- A critical aspect of the year 2000 problem is that we are all so inter-linked. Not only are we exposed to our own internal computer problems, but also to those with whom we do business. This matter has far-reaching implications for banks, covering not only operating risk, but also credit risk, liquidity risk, reputational risk, and others if material problems emerge. This is yet another illustration of the many challenges faced by bankers today. # Conclusion In conclusion, the history of banking and of bank supervision shows a long and rather close relationship between the health of the banking system and the economy, a connection that reflects the role of banks in the credit intermediation process. We can expect that relationship to continue and for bank earnings and asset quality to fluctuate as economic conditions change. In many ways, however, the banking and financial system has changed dramatically in the past decade both in terms of its structure and the diversity of its activities. Risk management practices have also advanced, helped by technological and financial innovations. I believe that both bank supervisors and the banking industry have learned important lessons from the experience of the past ten years, specifically about the need to actively monitor, manage, and control risks. Through its supervisory process, the Federal Reserve seeks to maintain a proper balance: permitting banks maximum freedom, while still protecting the safety net and maintaining financial stability. Maintaining responsible banking and responsible bank supervision is the key. We must all work to identify risks and to ensure they are adequately monitored and controlled. That result will lead to better banking practices, to more stable earnings and asset quality for the industry, and to less regulatory and legislative risk. These are goals we all share.	Susan M Phillips	United States	https://www.bis.org/review/r971119b.pdf	Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at Houston Baptist University, Houston, Texas on 30/10/97. I am pleased to be here today to talk with you about some of the important, fundamental changes taking place within the U.S. banking system and the effects those changes are having on the Federal Reserve's supervisory process. As you know, the U.S. economy and banking system have enjoyed more than half a decade of improving strength and prosperity in which U.S. banks have become better capitalized and more profitable than they have been in generations. Moreover, in the past 13 months not a single insured bank has failed, and the Bank Insurance Fund is now capitalized at a level requiring most banks to pay only nominal fees for their insurance. While this situation is a vast improvement over conditions in earlier years, experience has demonstrated that at times like these -- if we are not vigilant -- risks can occur that set the stage for future problems. That's what makes supervising banks so interesting and such a challenge. When the economy and the banking industry are in difficulty, supervisors must identify and address immediate problems in an effort to protect the U.S. taxpayer and the federal safety net. When conditions are good, as they are today, supervisors have the opportunity to review their oversight process and promote sound practices for managing banking risks in an effort to avert or mitigate future problems. This and keeping up with the pace of financial innovation and industry change that has occurred in the past 5 to 10 years has been a challenge, indeed. As I begin my remarks, I would like to point out that no system of supervision or regulation can provide total assurance that banking problems will not occur or that banks will not fail. Nor should it. Any process that prevents all banking problems would be extremely invasive to banking organizations and would likely inhibit economic growth. As financial intermediaries, banks must take risks if they and their communities are to grow. As risk-takers, some banks will necessarily incur losses, and some will eventually fail. The objective is to contain the costs of risk-taking, both to individual institutions and to the safety net, more generally. Therefore, our goal as regulators is to help identify weak banking practices so that small or emerging problems can be addressed before they become large and costly. To do that in today's markets, and in an environment in which technology and financial innovation can lead to rapid change, the Federal Reserve is pursuing a more risk-focused supervisory approach. We are well underway toward implementing this new supervisory framework, and initial indications about it -- from both examiners and bankers -- have been favorable. This risk-focused approach to supervision is seen as a necessary response to a variety of factors: the growing complexity and pace of change within the industry, the increasingly global nature of U.S. and world financial markets, and the methods available today for managing and controlling risk. As banking practices and markets continue to evolve, I believe this emphasis on risk-focused supervision will be even more necessary in the years to come. With that introduction, let me clarify what I mean by risk-focused supervision. How does it differ from the way supervisors have traditionally done their job? What does it mean to the banking system? What is it? In short, risk-focused supervision simply means that in conducting bank examinations and other supervisory activities, we will seek to direct our attention and resources to the areas that we perceive pose the greatest risk to banks. In many respects, that would seem rather obvious and hardly earth shaking, and in many ways it is, indeed, nothing new. The Federal Reserve and the other banking agencies have long sought to identify exceptions and to prioritize examination activities. In the past, though, the business of bank supervision has focused on validating bank balance sheets, particularly the value of loan portfolios, which have been historically the principal source of problems for banks. Much of the prior emphasis was on determining the condition of a bank at a point in time. In the process, we would go through the balance sheet, assuring ourselves that a bank's assets and liabilities were essentially as stated and that its reserves and net worth were real. As part of the process, there was a review of sound management practices, internal controls, and strong internal audit activities, but that review was not the initial or primary focus. In earlier times that approach was adequate, since bank balance sheets were generally slow to change. Banks held their loans to maturity; they acquired deposits locally and at a pace similar to local economic growth; their product lines were stable; and management turnover, itself, was typically low. By tracking the quality of loans and other assets, examiners could generally detect deterioration and other business problems through their periodic on-site examinations. If done often enough, those examinations typically gave authorities sufficient time to take action and to either close or sell a bank before the losses became significant to the deposit insurance fund. During the past decade, though, the U.S. banking system experienced a great deal of turmoil, stress, and change. Ten years ago, many of the country's largest banks announced huge loan loss provisions, beginning the process of reducing the industry's overhang of doubtful developing country loans. At the same time, many of these institutions and smaller regional banks were struggling with energy and agricultural sector difficulties or accumulating commercial real estate problems. I am sure that many of you here today can easily recall those times, and that these and other difficulties took a heavy toll -- if not in your own banks, in those of your competitors. By the end of the 1980s, more than 200 banks were failing annually, and there were more than 1,000 banks on the FDIC problem list. This experience provided important lessons and forced supervisors and bankers, alike, to reconsider the way they approached their jobs. For their part, bankers recognized the need to rebuild their capital and reserves, strengthen their internal controls, diversify their risks, and improve their practices for identifying, underwriting, and managing risk. Supervisors were also reminded of the need to remain vigilant and of the high costs that bank failures can bring, not only to the insurance fund but to local communities as well. The FDIC Improvement Act of 1991 emphasized that point, requiring frequent examinations and prompt regulatory actions when serious problems emerge. Beyond these mostly domestic events, banks and businesses throughout the world were dealing in the 1980s and 1990s with new technologies that were leading to a multitude of new and increasingly complex financial products that changed the nature of banking and financial markets. These technologies have brought about an endless variety of derivative instruments, increased securitization, ATMs, and a broader range of banking products. By lowering information costs, they have also led to dramatic improvements in risk management and have expanded the marketing and service capabilities of banks and their competitors. In large part, these changes and innovations are unequivocally good for society and have produced more efficient markets and, in turn, greater international trade and economic growth. They have also, however, greatly increased the complexity of banking and bank supervision. In both cases, these developments have spurred the demand for highly trained and qualified personnel. Within the United States, our banking system has also experienced a dramatic consolidation in the number of banking institutions, due not only to technology and financial innovation, but also to legislative changes allowing interstate banking. The number of independent commercial banking organizations has declined 40 percent since 1980 to 7,400 in June of this year. While possibly stressful to many bankers and bank customers, this dramatic structural change has also contributed to industry earnings by providing banks with greater opportunities to reduce costs. A challenge now for many institutions may be to manage their growth and the continuing process of industry consolidation. This challenge may be greatest as banking organizations expand into more diverse or nontraditional banking activities, particularly through acquisitions. Growth into a wider array of activities is especially important if banks are to meet the wide-ranging needs of their business and household customers, while competing effectively with other regulated and unregulated firms. As you know, the Congress has been wrestling with the issue of banking powers for years and -- with the exception of interstate branching -- has yet to make much progress. The Federal Reserve has long believed that legislation is needed and that the industry can best move forward if this issue is resolved by lawmakers, rather than by regulators in a piecemeal fashion. Nevertheless, with or without legislation, we must all deal with changing markets and with the opportunities and pressures they present. Utilizing existing legislative authority, regulators have been able to approve new banking products that were not available a decade ago, as financial markets and products have evolved. However, whether future expansion comes through new laws or merely through new interpretations of current laws and regulations, it is important that the banking industry use its powers wisely and that its performance remain sound. In supervising this "industry-in-transition", the Federal Reserve has no shortage of tasks, despite the virtually unprecedented strong condition of the U.S. banking system today. We, too, must deal with the evolving financial markets and advances in technology. At the same time, we must ensure that our own supervisory practices, tools, and standards take advantage of improving technology and financial techniques so that our oversight is not only effective, but also as unobtrusive and as appropriate as possible. These tasks are wide ranging, extending from our own re-engineering of the supervisory process to the way supervisors approach such issues as measuring capital adequacy and international convergence of supervisory standards. Constructing a sound supervisory process while minimizing regulatory burden has been a long-standing and on-going effort at the Federal Reserve and an objective we have sought to advance with our emphasis on risk-focused examinations. Particularly in the past decade, the development of new financial products and the greater depth and liquidity of financial markets have enabled banking organizations to change their risk profiles more rapidly than ever before. That possibility requires that we strike an appropriate balance between evaluating the condition of an institution at a point in time and evaluating the soundness of the bank's on-going process for managing risk. The risk-focused approach, by definition, entails a more formal planning phase that identifies those areas and activities at risk that warrant the most extensive review. This pre-planning process is supported by technology, for example, to download certain information about a bank's loan portfolio to our own computer systems and then, through off-site analysis, target areas of the portfolio for review. This revised process should be less disruptive to the daily activities of banks than earlier examination procedures and has the further advantage of reducing our own travel costs and improving examiner morale. Once on-site, examiners analyze the bank's loans and other assets to ascertain the organization's current condition, and also to evaluate its internal control process and its own ability to identify and resolve problems. As a result, the Federal Reserve is placing greater reliance than before on a bank's internal auditors and on the accuracy and adequacy of bank information systems. The review of a bank's information flow extends from top to bottom, and with the expectation that bank senior management and boards of directors are actively involved in monitoring the bank's activities and providing sufficient guidance regarding their appetite for risk. As in the past, performance of substantive checks on the reliability of a bank's controls remains an important element of the examination process, albeit in a more automated and advanced form. For example, we are pursuing ways to make greater use of loan sampling in order to generate statistically valid conclusions about the accuracy of a bank's internal loan review process. To the extent we can validate the integrity of a bank's internal controls more efficiently, we can place more confidence in them at an earlier stage and can also take greater comfort that management is providing itself with an accurate indication of the bank's condition. Moreover, as examiners are able to complete loan reviews more quickly, they will have more time to review other high priority aspects of the institution's operations. A significant benefit of the risk-focused approach is its emphasis on ensuring that the bank's internal oversight processes are sound and that communication between the bank and Federal Reserve examiners occurs between examinations. That approach is generally supported by institutions we supervise and provides a more comprehensive oversight process that complements our annual or 18 -month examination cycle. It also strengthens our ability to respond promptly if conditions deteriorate. Importantly, the Federal Reserve's examination staff indicates that this risk-focused process may be reducing on-site examination time by 15-30 percent in many cases and overall examination time of Reserve Bank personnel by perhaps 10 percent. While those results are tentative, partial, and unscientific, they are certainly encouraging in terms of resource implications. Complementing the risk-focused approach to supervision are enhancements to the tools we use to grade a bank's condition and management. Since 1995, we have asked our examiners to provide a specific supervisory rating for a bank's risk management process. This Fed initiative preceded, but is quite consistent with, the more recent interagency decision to add an "S" to the end of the CAMEL rating. That "S", as you know, addresses sensitivity to market risk and reflects in large part a bank's ability to manage that risk. Any managers in the audience who are with U.S. offices of foreign banks may appreciate that these rating changes simply highlight the importance of risk management that the Federal Reserve has for some time emphasized in its review of foreign banks. Since economic and industry conditions have been so favorable in recent years, there has not been a sufficiently stressful economic downturn to provide a robust test. The market volatility beginning in 1994 offered some insights about supervisory judgements of the risk management systems of large trading banks, but there have been few other indications. Even the rise to record levels of delinquencies and defaults on credit card debt may reflect factors other than the ability of supervisors to ensure that management has all the important bases covered. The real test, of course, would come with a major economic downturn. Even then, though, it will be hard to know what might have occurred had our oversight procedures not changed. Nevertheless, there are indications that both banking and supervisory practices are materially better now than they were in the 1980s and early 1990s. Because of technology and lower computer and communications costs, information is much more readily available than in earlier decades, and sound management practices are more widespread. Risk measurement and portfolio management techniques that were largely theoretical when some of us were in college are now fully operational in many banks. Moreover, the costly experience with bank and thrift failures in the early 1990s has not been forgotten. As a result, most bankers and business managers today have a greater appreciation, I believe, for the value of risk management and internal controls. To that point, we are finding, with increased frequency, that banks are designing personnel compensation systems to provide managers with greater incentives to control risk. Implementing a risk-focused supervisory approach has not been an easy task. It has required significant revisions to our broad and specialized training programs, including expansion of capital markets, risk assessment information technology, and global trading activities as well as courses devoted exclusively to internal controls. These education programs will, of course, need to be continually updated as industry activities and conditions evolve. With the greater discretion examiners now have to focus their efforts on areas of highest risk, it has also become more important that we ensure the consistency and overall quality of our examinations. To address that point, we have developed automated examination tools, based on a decision-tree framework, that will help guide examiners through the procedures most relevant to individual banks, given their specific circumstances and risk profiles. Moreover, both domestically and abroad, the Federal Reserve is working with other bank supervisors and with the banking industry to develop sound practices for management for a variety of bank activities. Initiatives in recent years include guidance on disclosure and on managing interest rate risk and derivative activities. Such efforts, and the growing worldwide recognition of the value of market forces, should lead to clearer expectations of supervisors, greater reliance on market discipline, and less intrusive regulation. In that connection, the Federal Reserve in recent years has worked closely with the FDIC and with state banking departments to coordinate our examination procedures and supervisory practices. A prime example of these efforts is the adoption last year of the State and Federal Protocol, through which we all seek to achieve a relatively seamless supervisory process for banks operating across state lines. We are also working together on a variety of automation efforts, some of which I have referred to already. Under the category of "problems we don't need", I find it difficult to talk with bankers these days without raising the "Year 2000" problem. Fortunately, most U.S. banks appear to be taking this matter seriously and are generally well underway toward identifying their individual needs and developing action plans. Nevertheless, the Federal Reserve and the other federal banking agencies are actively reviewing the efforts of banks to address this vital issue. Some banks, particularly large ones, have stated, themselves, that if an institution is not already well underway toward resolving this problem, then it is already too late. I hope that all of you are giving this matter adequate attention, and are taking the steps necessary to ensure that changes are being made within your banks, and also by your vendors and customers. A critical aspect of the year 2000 problem is that we are all so inter-linked. Not only are we exposed to our own internal computer problems, but also to those with whom we do business. This matter has far-reaching implications for banks, covering not only operating risk, but also credit risk, liquidity risk, reputational risk, and others if material problems emerge. This is yet another illustration of the many challenges faced by bankers today. In conclusion, the history of banking and of bank supervision shows a long and rather close relationship between the health of the banking system and the economy, a connection that reflects the role of banks in the credit intermediation process. We can expect that relationship to continue and for bank earnings and asset quality to fluctuate as economic conditions change. In many ways, however, the banking and financial system has changed dramatically in the past decade both in terms of its structure and the diversity of its activities. Risk management practices have also advanced, helped by technological and financial innovations. I believe that both bank supervisors and the banking industry have learned important lessons from the experience of the past ten years, specifically about the need to actively monitor, manage, and control risks. Through its supervisory process, the Federal Reserve seeks to maintain a proper balance: permitting banks maximum freedom, while still protecting the safety net and maintaining financial stability. Maintaining responsible banking and responsible bank supervision is the key. We must all work to identify risks and to ensure they are adequately monitored and controlled. That result will lead to better banking practices, to more stable earnings and asset quality for the industry, and to less regulatory and legislative risk. These are goals we all share.
1997-11-04T00:00:00	Remarks by Ms. Phillips at the Asset/Liability and Treasury Management Conference of the Bank Administration Institute (Central Bank Articles and Speeches, 4 Nov 97)	Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at the Asset/Liability and Treasury Management Conference of the Bank Administration Institute, Chicago, on 4/11/97.	Remarks by Ms. Phillips at the Asset/Liability and Treasury Management Conference of the Bank Administration Institute Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at the Asset/Liability and Treasury Management Conference of the Bank Administration Institute, Chicago, on 4/11/97. It is a pleasure to be here to discuss the Federal Reserve's perspective on risk management. As you know, advances in the methods and techniques in this area are having wide-ranging effects on the corporate decision making process in all types of business. The effects on banking institutions have been especially profound. Clearly, financial engineering and improvements in risk management have helped banks to expand product lines, offer more efficient services, and control the risks of ever more complex financial instruments and the growing volume of financial transactions. For some institutions, the application of new risk management techniques to specific areas is leading the way to a broader, firm-wide risk consciousness that is completely, and appropriately, transforming the entire corporate culture. This is particularly important since the very essence of banking and financial intermediation is the acceptance and management of risk. Adopting a "risk-focused" corporate culture from the highest levels of senior management down through business line personnel represents the ultimate product quality assurance program for individual customers and the financial system more generally. From the Federal Reserve's perspective, effective risk management at financial institutions plays a critical role in helping to achieve our central bank responsibilities of: 1. promoting an efficient and effective financial system that adequately finances economic growth, and 2. ensuring that financial institutions do not become a source of systemic risk, or pose a threat to the payment system or burden taxpayers with losses arising from the federal safety net. Advances in risk management clearly help reduce potential systemic disruptions. The Federal Reserve, along with other supervisors both here and abroad, has focused increasing resources on encouraging developments in this area. Indeed, just as financial engineering and advances in risk management are changing the operating methods and business cultures of financial institutions, they are also transforming both the operations and the corporate culture of bank supervisors. While ultimate goals and objectives remain the same, over the past several years, supervisors have been moving to more "incentive-compatible" approaches to 1) foster sound risk management within the institution rather than compliance with narrow rules and regulations, 2) minimize burden through the use of new examination approaches and internal risk measurement systems, and 3) reinforce market discipline. Fostering Sound Risk Management Key to almost all of these initiatives has been an increasing effort by supervisors to avoid locking themselves into formulaic, one-size-fits-all approaches to supervision and regulation. Too often financial engineering has been targeted at regulatory arbitrage -- that is, the exploitation of loopholes in narrow regulatory policies are based on old traditional instruments, activities or business lines. Supervisors are increasingly recognizing that the underlying risk characteristics of a financial instrument, activity or business line are of primary importance and not what they are called or officially labelled. To be sure, financial engineering can create derivative instruments which can combine component risks (including market, credit, liquidity, operational and reputational risks) in complex ways. But seemingly simple traditional cash instruments can actually have higher risk profiles than many instruments that are formally labelled "derivatives." In fact, the categorization of financial instruments and activities without regard to their underlying risk and economic functions can actually handicap sound management. - 2 - Thus, Federal Reserve and other supervisors have increasingly issued supervisory guidance that emphasizes managing the risks involved in bank activities and de-emphasizes the supervisory focus on specific instruments or traditional products. Most recently, the FFIEC published for industry comment a new policy statement that would eliminate the 1992 interagency policy that instituted the FFIEC high risk test. The older policy statement placed significant constraints on a depository institution's holding of certain "high-risk" mortgage securities that met specific market risk sensitivity tests. The new policy would replace the high risk test with broader guidance on sound practices for managing all investment and end-user activities. In essence, the new statement would allow an institution to hold any bank-eligible instrument as an investment as long as the institution had an adequate risk management process commensurate with the scope, complexity, and sophistication of its investment and end-user holdings. The old FFIEC high-risk tests offer an excellent case study of the potential pitfalls of narrow formulaic supervision in an age of dynamic financial engineering. By requiring a pre-purchase price sensitivity analysis, the high risk test successfully helped institutions better understand the interest rate risk of certain mortgage securities. It effectively constrained many smaller financial institutions from acquiring certain types of securities that subsequently created large losses for other investors. However, while protecting some institutions, the tests may also have distorted the investment decision making process at other depository institutions. Concerns about burden and heightened examiner review of all types of mortgage securities may have led institutions to blindly eliminate them as potential investments -- regardless of the merits of their risk/return profiles. Also, by focusing only on certain products, the test provided incentives for institutions to acquire other types of securities with embedded options that required no testing. Such instruments were thought to have a supervisory "stamp of approval", but in fact often had risk characteristics similar to or greater than those designated as "high risk". Assuming positive industry comments, the FFIEC hopes to implement the proposed new policy in early 1998. The comment period extends through November 17, and I encourage all of you to comment. I might mention that the new policy will apply to all investment and end-user derivatives activities. It illustrates that supervisors are increasingly emphasizing risk management on a portfolio rather than an instrument-specific basis. Although this is arguably the first principle of finance and is widely appreciated by bankers and regulators, putting this principle into practice in banking has not been easy. Past banking crises have, in part, reflected a failure to recognize or to prudently limit concentrations of risk. However, technology and financial innovation are now enabling financial theories and conceptual techniques that have been around for decades to be put into practice to manage market, credit and liquidity risks. Moreover, these risks are increasingly being managed across activities and in some cases on a global basis. This move to a broad portfolio or "macro" approach to managing risk has influenced bank supervisory efforts in several ways. All three of the U.S. banking agencies now take a more "risk-focused" approach to bank supervision. Bank exams are no longer exhaustive reviews of all of a bank's specific activities. Instead, they now take a more targeted approach to identifying and reviewing the sources of risk within a bank's "portfolio" of activities. Exam resources are now targeted at evaluating the soundness of a bank's processes for managing risks and our supervisory tools have been enhanced in this direction. Increased Use of Internal Measurement and Management Systems In addition, supervisors increasingly are relying on internal risk management systems, including increasingly sophisticated risk measurement systems used by banks to manage their businesses. - 3 - The objectives here are two-fold -- to help improve the effectiveness of our examinations and to reduce the burden on banking organizations. Examinations now involve significant off-site, pre-planning, analysis and fact finding. Then the on-site examination activities include spot checks to determine the reliability of the bank's internal risk management system. To the extent examiners gain confidence in the bank's risk management process, they will place greater emphasis on the findings of the bank's internal auditors at an earlier stage in the examination process and focus resources in other areas. An area of bank risk management systems that has been particularly useful to supervisors is risk measurement. No better example exists than the banking agencies' adoption of a risk assessment approach for evaluating capital adequacy for interest rate risk. Early on in that rulemaking process, supervisors recognized that a number of banking institutions had internal models for measuring interest rate risk that were much more sophisticated than any possible standardized regulatory model. However, at the same time, supervisors were acutely aware that many other institutions had limited capabilities in this area and that many banks may have been hesitant to develop more sophisticated internal measurement systems prior to the determination of a supervisory approach. Accordingly, in 1993, supervisors proposed to use the results of internal models for evaluating the quantitative level of interest rate risk exposure at individual institutions. While the rulemaking process was ultimately longer than desired, it did demonstrate the clear intent of supervisors to encourage and provide incentives for improvements in risk management and to take full advantage of such advances when possible. I think most banks would agree that the discovery process and comment periods supervisors convened from 1993 through 1995, and the ensuing dialogue, spurred significant industry development and refinement of interest rate risk models. A similar process evolved in developing the international capital standard for market risk in the trading activities of internationally active banks. Beginning next January, banks that meet certain qualitative and quantitative standards for risk management will calculate market risk capital charges for their trading activities on the basis of their own internal Value at Risk (VaR) measures. Here again, supervisors recognized early developments in the quantitative measurement of market risks, encouraged industry progress, and sought to build on the VaR concept when developing a supervisory approach. During the discovery and rulemaking process the supervisory attention paid to VaR techniques led to more robust modelling and has helped spread the use of VaR techniques worldwide. Moving forward, perhaps such supervisory/private sector synergies can be gained in other areas of risk management, as well. The quantification of credit risks, by far the most important risk in banking, may be a candidate. At present, some institutions are making significant strides on a number of fronts to better quantify and manage credit risk. In addition to major developments in credit scoring and the use of artificial intelligence in underwriting various types of consumer loans, a few banks are beginning to use historical data to estimate probability loss distributions for the credit risk of different quality commercial loans. In some banks, credit risk-adjusted returns to capital are being used to construct a portfolio management framework for credit risk. This, in turn, is providing a proving ground for a risk-adjusted pricing of loans as well as a myriad of new instruments such as credit derivatives. While industry efforts to quantify credit risks are still in the early stages of evolution, recent progress holds promise for reducing both institutional and systemic risks. Indeed, these efforts might eventually lead to new supervisory regimes for addressing credit risk. Better methods of quantifying credit risk have significant potential for reducing the time examiners spend in on-site examinations. Moreover, advances in credit risk measurement may ultimately allow supervisors to design regulatory capital standards around internal models. We recognize the inadequacy of the existing risk-based capital regime where such assets as loans are all treated as having the same risk. We are actively encouraging the development of more quantitative approaches to credit risk management. However, better regulatory tools are not yet available. While supervisors can prod - 4 - developments in risk management, ultimately it will be up to the industry to find other ways to better measure and manage credit risk. Strengthening Market Discipline Harnessing market forces to reinforce supervisory objectives is another important goal in the changing culture of supervisors. Reliable financial information and adequate disclosure of risk exposures is an essential ingredient to achieving this goal. Market participants can benefit from enhanced disclosure by being in a better position to understand the financial condition of counterparties and competitors. Investors have an obvious interest in being able to make meaningful assessments of a firm's performance, underlying trends, and income-producing potential. Sound, well-managed firms can benefit if better disclosure enables them to obtain funds at risk premiums that accurately reflect lower risk profiles. Inadequate financial disclosures, on the other hand, could penalize well-managed firms if market participants are unable to assess fundamental financial strength. It is this desire to see market discipline play a greater role in influencing banking activities that has prompted the Federal Reserve Board to join the debate about the derivative accounting standards that are being developed by the Financial Accounting Standards Board (FASB). Everyone agrees that a critical function of financial statements is to reflect in a meaningful way underlying trends in the financial performance and condition of the firm as well as the economic substance of its activities. However, the Board believes that the application of market value accounting to business strategies where not appropriate, and particularly when applied on a piecemeal basis, or when market prices are not readily available, may lead to increased volatility or fluctuation in reported results. Such accounting practices may actually obscure underlying trends or developments affecting a firm's condition and performance. Requiring companies to adopt market value accounting where it is not consistent with business strategies can cause them to incur significant costs to provide information that may not realistically reflect way underlying circumstances or trends in performance. Moreover, from the standpoint of financial statement analysts and other users, having to make adjustments to remove the effects of meaningless accounting volatility from income statements and balance sheets can also impose significant costs without offsetting benefits. The Board believes that these problems can be minimized by having large firms with active trading portfolios place market values in supplemental disclosures rather than by forcing their use in the primary financial statements. Such an approach would give analysts the information they need, without imposing costs on an unnecessarily wide range of firms and without imposing the broader costs of having to reverse or "back out" the distorting effects of the proposed accounting standard. Emerging Challenges to Risk Management Without a doubt, banking institutions have made significant progress in implementing new techniques and methods in risk management. To date, most work in this area has centered around the "science" of risk management -- that is, the quantitative measurement of risk. However, quantitative measurement is only one element of the overall process of financial risk management. Other elements such as board and senior management oversight, internal controls, and the role of internal and external audits are just as important. Given the pace of technological and financial innovation, inadequate internal controls can expose an institution to significant risk. Indeed, inadequate management oversight, combined with a lack of internal controls, has been the primary cause of the losses experienced by several high profile major international banking organizations. In some cases basic time-honored internal controls such as segmentation of duties and independent risk assessment had been ignored. In others, internal management processes have failed to keep pace with technological development, financial innovation, and global expansion. It is these "low tech" areas that pose continued challenges to risk management. - 5 - Some institutions are beginning to address these challenges in their attempts to identify, monitor and control the operating risks of various business lines. Indeed, operating risk is quickly emerging as the next frontier of risk management. While no clear standardized definition of operating risk has yet emerged, several progressive institutions are expending significant resources to address the operating risks inherent in particular business lines. For some, this involves conducting extensive risk assessments throughout business and product lines to identify both the types of processing, information, and personnel risks that exist and the potential measures that can be taken to mitigate them. Others are buttressing these assessments with attempts actually to quantify and charge internal capital for operating risk exposures. Supervisors can also be expected to more closely monitor banks' efforts to identify and manage operating risks. One very important operating risk that all banking institutions face is the challenge of addressing the Year 2000 issue. U.S. banks appear to be taking this matter seriously and are generally well underway toward identifying individual needs and developing action plans. The Federal Reserve and the other federal bank supervisors are reviewing the relevant efforts of every insured depository institution in order to determine whether adequate progress on this issue is being made. Meeting the demands of this review and ensuring proper remedies both before and after the Year 2000 will be a significant and costly task to both the industry and the banking agencies. However, even within the context of banking, the scope of the Year 2000 problem extends far beyond U.S. banks to foreign banks, bank borrowers, depositors, vendors, and other counterparties. Banks and others need to address Year 2000 system alterations, not only because of the potential effects on overall markets, but also as a threat to individual firm viability. At a minimum, banks should be concerned about their ability to provide uninterrupted service to their customers into the next millennium. If nothing else, it is simply good business. Summary In summary, advances in computerization and communications have created a paradigm shift for financial markets, the financial services industry, and the management of financial risks. In response, supervisors are also moving to a new, more "incentive-compatible" regime of greater reliance on banks' own risk measures and internal controls. This transformation may be slow and will be challenging for all. Supervisors can encourage innovation, but the private sector must do much of the development work. As always, a transition to an improved framework will work best with cooperative, open dialogue between the financial industry and its regulators, so that compatible and efficient answers are found. In today's markets, institutions and financial systems are linked as never before, and such connections are likely to grow in the years ahead. How effectively institutions manage their risks and allocate their capital will have substantial consequences for economic growth. We have seen significant progress in measuring market risk, and the groundwork is being laid for future gains in measuring credit risk, but those are only two risks. Operating risks such as fraud, human misjudgments, and the failure of information systems, processing operations and basic internal controls must be addressed comprehensively. At this point, we can take satisfaction in the risk management strides we have made. But I am confident that opportunities for even greater progress lie ahead.	---[PAGE_BREAK]--- Remarks by Ms. Phillips at the Asset/Liability and Treasury Management Conference of the Bank Administration Institute Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at the Asset/Liability and Treasury Management Conference of the Bank Administration Institute, Chicago, on 4/11/97. It is a pleasure to be here to discuss the Federal Reserve's perspective on risk management. As you know, advances in the methods and techniques in this area are having wide-ranging effects on the corporate decision making process in all types of business. The effects on banking institutions have been especially profound. Clearly, financial engineering and improvements in risk management have helped banks to expand product lines, offer more efficient services, and control the risks of ever more complex financial instruments and the growing volume of financial transactions. For some institutions, the application of new risk management techniques to specific areas is leading the way to a broader, firm-wide risk consciousness that is completely, and appropriately, transforming the entire corporate culture. This is particularly important since the very essence of banking and financial intermediation is the acceptance and management of risk. Adopting a "risk-focused" corporate culture from the highest levels of senior management down through business line personnel represents the ultimate product quality assurance program for individual customers and the financial system more generally. From the Federal Reserve's perspective, effective risk management at financial institutions plays a critical role in helping to achieve our central bank responsibilities of: 1. promoting an efficient and effective financial system that adequately finances economic growth, and 2. ensuring that financial institutions do not become a source of systemic risk, or pose a threat to the payment system or burden taxpayers with losses arising from the federal safety net. Advances in risk management clearly help reduce potential systemic disruptions. The Federal Reserve, along with other supervisors both here and abroad, has focused increasing resources on encouraging developments in this area. Indeed, just as financial engineering and advances in risk management are changing the operating methods and business cultures of financial institutions, they are also transforming both the operations and the corporate culture of bank supervisors. While ultimate goals and objectives remain the same, over the past several years, supervisors have been moving to more "incentive-compatible" approaches to 1) foster sound risk management within the institution rather than compliance with narrow rules and regulations, 2) minimize burden through the use of new examination approaches and internal risk measurement systems, and 3) reinforce market discipline. # Fostering Sound Risk Management Key to almost all of these initiatives has been an increasing effort by supervisors to avoid locking themselves into formulaic, one-size-fits-all approaches to supervision and regulation. Too often financial engineering has been targeted at regulatory arbitrage -- that is, the exploitation of loopholes in narrow regulatory policies are based on old traditional instruments, activities or business lines. Supervisors are increasingly recognizing that the underlying risk characteristics of a financial instrument, activity or business line are of primary importance and not what they are called or officially labelled. To be sure, financial engineering can create derivative instruments which can combine component risks (including market, credit, liquidity, operational and reputational risks) in complex ways. But seemingly simple traditional cash instruments can actually have higher risk profiles than many instruments that are formally labelled "derivatives." In fact, the categorization of financial instruments and activities without regard to their underlying risk and economic functions can actually handicap sound management. ---[PAGE_BREAK]--- Thus, Federal Reserve and other supervisors have increasingly issued supervisory guidance that emphasizes managing the risks involved in bank activities and de-emphasizes the supervisory focus on specific instruments or traditional products. Most recently, the FFIEC published for industry comment a new policy statement that would eliminate the 1992 interagency policy that instituted the FFIEC high risk test. The older policy statement placed significant constraints on a depository institution's holding of certain "high-risk" mortgage securities that met specific market risk sensitivity tests. The new policy would replace the high risk test with broader guidance on sound practices for managing all investment and end-user activities. In essence, the new statement would allow an institution to hold any bank-eligible instrument as an investment as long as the institution had an adequate risk management process commensurate with the scope, complexity, and sophistication of its investment and end-user holdings. The old FFIEC high-risk tests offer an excellent case study of the potential pitfalls of narrow formulaic supervision in an age of dynamic financial engineering. By requiring a pre-purchase price sensitivity analysis, the high risk test successfully helped institutions better understand the interest rate risk of certain mortgage securities. It effectively constrained many smaller financial institutions from acquiring certain types of securities that subsequently created large losses for other investors. However, while protecting some institutions, the tests may also have distorted the investment decision making process at other depository institutions. Concerns about burden and heightened examiner review of all types of mortgage securities may have led institutions to blindly eliminate them as potential investments -- regardless of the merits of their risk/return profiles. Also, by focusing only on certain products, the test provided incentives for institutions to acquire other types of securities with embedded options that required no testing. Such instruments were thought to have a supervisory "stamp of approval", but in fact often had risk characteristics similar to or greater than those designated as "high risk". Assuming positive industry comments, the FFIEC hopes to implement the proposed new policy in early 1998. The comment period extends through November 17, and I encourage all of you to comment. I might mention that the new policy will apply to all investment and end-user derivatives activities. It illustrates that supervisors are increasingly emphasizing risk management on a portfolio rather than an instrument-specific basis. Although this is arguably the first principle of finance and is widely appreciated by bankers and regulators, putting this principle into practice in banking has not been easy. Past banking crises have, in part, reflected a failure to recognize or to prudently limit concentrations of risk. However, technology and financial innovation are now enabling financial theories and conceptual techniques that have been around for decades to be put into practice to manage market, credit and liquidity risks. Moreover, these risks are increasingly being managed across activities and in some cases on a global basis. This move to a broad portfolio or "macro" approach to managing risk has influenced bank supervisory efforts in several ways. All three of the U.S. banking agencies now take a more "risk-focused" approach to bank supervision. Bank exams are no longer exhaustive reviews of all of a bank's specific activities. Instead, they now take a more targeted approach to identifying and reviewing the sources of risk within a bank's "portfolio" of activities. Exam resources are now targeted at evaluating the soundness of a bank's processes for managing risks and our supervisory tools have been enhanced in this direction. # Increased Use of Internal Measurement and Management Systems In addition, supervisors increasingly are relying on internal risk management systems, including increasingly sophisticated risk measurement systems used by banks to manage their businesses. ---[PAGE_BREAK]--- The objectives here are two-fold -- to help improve the effectiveness of our examinations and to reduce the burden on banking organizations. Examinations now involve significant off-site, pre-planning, analysis and fact finding. Then the on-site examination activities include spot checks to determine the reliability of the bank's internal risk management system. To the extent examiners gain confidence in the bank's risk management process, they will place greater emphasis on the findings of the bank's internal auditors at an earlier stage in the examination process and focus resources in other areas. An area of bank risk management systems that has been particularly useful to supervisors is risk measurement. No better example exists than the banking agencies' adoption of a risk assessment approach for evaluating capital adequacy for interest rate risk. Early on in that rulemaking process, supervisors recognized that a number of banking institutions had internal models for measuring interest rate risk that were much more sophisticated than any possible standardized regulatory model. However, at the same time, supervisors were acutely aware that many other institutions had limited capabilities in this area and that many banks may have been hesitant to develop more sophisticated internal measurement systems prior to the determination of a supervisory approach. Accordingly, in 1993, supervisors proposed to use the results of internal models for evaluating the quantitative level of interest rate risk exposure at individual institutions. While the rulemaking process was ultimately longer than desired, it did demonstrate the clear intent of supervisors to encourage and provide incentives for improvements in risk management and to take full advantage of such advances when possible. I think most banks would agree that the discovery process and comment periods supervisors convened from 1993 through 1995, and the ensuing dialogue, spurred significant industry development and refinement of interest rate risk models. A similar process evolved in developing the international capital standard for market risk in the trading activities of internationally active banks. Beginning next January, banks that meet certain qualitative and quantitative standards for risk management will calculate market risk capital charges for their trading activities on the basis of their own internal Value at Risk (VaR) measures. Here again, supervisors recognized early developments in the quantitative measurement of market risks, encouraged industry progress, and sought to build on the VaR concept when developing a supervisory approach. During the discovery and rulemaking process the supervisory attention paid to VaR techniques led to more robust modelling and has helped spread the use of VaR techniques worldwide. Moving forward, perhaps such supervisory/private sector synergies can be gained in other areas of risk management, as well. The quantification of credit risks, by far the most important risk in banking, may be a candidate. At present, some institutions are making significant strides on a number of fronts to better quantify and manage credit risk. In addition to major developments in credit scoring and the use of artificial intelligence in underwriting various types of consumer loans, a few banks are beginning to use historical data to estimate probability loss distributions for the credit risk of different quality commercial loans. In some banks, credit risk-adjusted returns to capital are being used to construct a portfolio management framework for credit risk. This, in turn, is providing a proving ground for a risk-adjusted pricing of loans as well as a myriad of new instruments such as credit derivatives. While industry efforts to quantify credit risks are still in the early stages of evolution, recent progress holds promise for reducing both institutional and systemic risks. Indeed, these efforts might eventually lead to new supervisory regimes for addressing credit risk. Better methods of quantifying credit risk have significant potential for reducing the time examiners spend in on-site examinations. Moreover, advances in credit risk measurement may ultimately allow supervisors to design regulatory capital standards around internal models. We recognize the inadequacy of the existing risk-based capital regime where such assets as loans are all treated as having the same risk. We are actively encouraging the development of more quantitative approaches to credit risk management. However, better regulatory tools are not yet available. While supervisors can prod ---[PAGE_BREAK]--- developments in risk management, ultimately it will be up to the industry to find other ways to better measure and manage credit risk. # Strengthening Market Discipline Harnessing market forces to reinforce supervisory objectives is another important goal in the changing culture of supervisors. Reliable financial information and adequate disclosure of risk exposures is an essential ingredient to achieving this goal. Market participants can benefit from enhanced disclosure by being in a better position to understand the financial condition of counterparties and competitors. Investors have an obvious interest in being able to make meaningful assessments of a firm's performance, underlying trends, and income-producing potential. Sound, well-managed firms can benefit if better disclosure enables them to obtain funds at risk premiums that accurately reflect lower risk profiles. Inadequate financial disclosures, on the other hand, could penalize well-managed firms if market participants are unable to assess fundamental financial strength. It is this desire to see market discipline play a greater role in influencing banking activities that has prompted the Federal Reserve Board to join the debate about the derivative accounting standards that are being developed by the Financial Accounting Standards Board (FASB). Everyone agrees that a critical function of financial statements is to reflect in a meaningful way underlying trends in the financial performance and condition of the firm as well as the economic substance of its activities. However, the Board believes that the application of market value accounting to business strategies where not appropriate, and particularly when applied on a piecemeal basis, or when market prices are not readily available, may lead to increased volatility or fluctuation in reported results. Such accounting practices may actually obscure underlying trends or developments affecting a firm's condition and performance. Requiring companies to adopt market value accounting where it is not consistent with business strategies can cause them to incur significant costs to provide information that may not realistically reflect way underlying circumstances or trends in performance. Moreover, from the standpoint of financial statement analysts and other users, having to make adjustments to remove the effects of meaningless accounting volatility from income statements and balance sheets can also impose significant costs without offsetting benefits. The Board believes that these problems can be minimized by having large firms with active trading portfolios place market values in supplemental disclosures rather than by forcing their use in the primary financial statements. Such an approach would give analysts the information they need, without imposing costs on an unnecessarily wide range of firms and without imposing the broader costs of having to reverse or "back out" the distorting effects of the proposed accounting standard. ## Emerging Challenges to Risk Management Without a doubt, banking institutions have made significant progress in implementing new techniques and methods in risk management. To date, most work in this area has centered around the "science" of risk management -- that is, the quantitative measurement of risk. However, quantitative measurement is only one element of the overall process of financial risk management. Other elements such as board and senior management oversight, internal controls, and the role of internal and external audits are just as important. Given the pace of technological and financial innovation, inadequate internal controls can expose an institution to significant risk. Indeed, inadequate management oversight, combined with a lack of internal controls, has been the primary cause of the losses experienced by several high profile major international banking organizations. In some cases basic time-honored internal controls such as segmentation of duties and independent risk assessment had been ignored. In others, internal management processes have failed to keep pace with technological development, financial innovation, and global expansion. It is these "low tech" areas that pose continued challenges to risk management. ---[PAGE_BREAK]--- Some institutions are beginning to address these challenges in their attempts to identify, monitor and control the operating risks of various business lines. Indeed, operating risk is quickly emerging as the next frontier of risk management. While no clear standardized definition of operating risk has yet emerged, several progressive institutions are expending significant resources to address the operating risks inherent in particular business lines. For some, this involves conducting extensive risk assessments throughout business and product lines to identify both the types of processing, information, and personnel risks that exist and the potential measures that can be taken to mitigate them. Others are buttressing these assessments with attempts actually to quantify and charge internal capital for operating risk exposures. Supervisors can also be expected to more closely monitor banks' efforts to identify and manage operating risks. One very important operating risk that all banking institutions face is the challenge of addressing the Year 2000 issue. U.S. banks appear to be taking this matter seriously and are generally well underway toward identifying individual needs and developing action plans. The Federal Reserve and the other federal bank supervisors are reviewing the relevant efforts of every insured depository institution in order to determine whether adequate progress on this issue is being made. Meeting the demands of this review and ensuring proper remedies both before and after the Year 2000 will be a significant and costly task to both the industry and the banking agencies. However, even within the context of banking, the scope of the Year 2000 problem extends far beyond U.S. banks to foreign banks, bank borrowers, depositors, vendors, and other counterparties. Banks and others need to address Year 2000 system alterations, not only because of the potential effects on overall markets, but also as a threat to individual firm viability. At a minimum, banks should be concerned about their ability to provide uninterrupted service to their customers into the next millennium. If nothing else, it is simply good business. # Summary In summary, advances in computerization and communications have created a paradigm shift for financial markets, the financial services industry, and the management of financial risks. In response, supervisors are also moving to a new, more "incentive-compatible" regime of greater reliance on banks' own risk measures and internal controls. This transformation may be slow and will be challenging for all. Supervisors can encourage innovation, but the private sector must do much of the development work. As always, a transition to an improved framework will work best with cooperative, open dialogue between the financial industry and its regulators, so that compatible and efficient answers are found. In today's markets, institutions and financial systems are linked as never before, and such connections are likely to grow in the years ahead. How effectively institutions manage their risks and allocate their capital will have substantial consequences for economic growth. We have seen significant progress in measuring market risk, and the groundwork is being laid for future gains in measuring credit risk, but those are only two risks. Operating risks such as fraud, human misjudgments, and the failure of information systems, processing operations and basic internal controls must be addressed comprehensively. At this point, we can take satisfaction in the risk management strides we have made. But I am confident that opportunities for even greater progress lie ahead.	Susan M Phillips	United States	https://www.bis.org/review/r971119c.pdf	Remarks by Ms. Phillips at the Asset/Liability and Treasury Management Conference of the Bank Administration Institute Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, at the Asset/Liability and Treasury Management Conference of the Bank Administration Institute, Chicago, on 4/11/97. It is a pleasure to be here to discuss the Federal Reserve's perspective on risk management. As you know, advances in the methods and techniques in this area are having wide-ranging effects on the corporate decision making process in all types of business. The effects on banking institutions have been especially profound. Clearly, financial engineering and improvements in risk management have helped banks to expand product lines, offer more efficient services, and control the risks of ever more complex financial instruments and the growing volume of financial transactions. For some institutions, the application of new risk management techniques to specific areas is leading the way to a broader, firm-wide risk consciousness that is completely, and appropriately, transforming the entire corporate culture. This is particularly important since the very essence of banking and financial intermediation is the acceptance and management of risk. Adopting a "risk-focused" corporate culture from the highest levels of senior management down through business line personnel represents the ultimate product quality assurance program for individual customers and the financial system more generally. From the Federal Reserve's perspective, effective risk management at financial institutions plays a critical role in helping to achieve our central bank responsibilities of: 1. promoting an efficient and effective financial system that adequately finances economic growth, and 2. ensuring that financial institutions do not become a source of systemic risk, or pose a threat to the payment system or burden taxpayers with losses arising from the federal safety net. Advances in risk management clearly help reduce potential systemic disruptions. The Federal Reserve, along with other supervisors both here and abroad, has focused increasing resources on encouraging developments in this area. Indeed, just as financial engineering and advances in risk management are changing the operating methods and business cultures of financial institutions, they are also transforming both the operations and the corporate culture of bank supervisors. While ultimate goals and objectives remain the same, over the past several years, supervisors have been moving to more "incentive-compatible" approaches to 1) foster sound risk management within the institution rather than compliance with narrow rules and regulations, 2) minimize burden through the use of new examination approaches and internal risk measurement systems, and 3) reinforce market discipline. Key to almost all of these initiatives has been an increasing effort by supervisors to avoid locking themselves into formulaic, one-size-fits-all approaches to supervision and regulation. Too often financial engineering has been targeted at regulatory arbitrage -- that is, the exploitation of loopholes in narrow regulatory policies are based on old traditional instruments, activities or business lines. Supervisors are increasingly recognizing that the underlying risk characteristics of a financial instrument, activity or business line are of primary importance and not what they are called or officially labelled. To be sure, financial engineering can create derivative instruments which can combine component risks (including market, credit, liquidity, operational and reputational risks) in complex ways. But seemingly simple traditional cash instruments can actually have higher risk profiles than many instruments that are formally labelled "derivatives." In fact, the categorization of financial instruments and activities without regard to their underlying risk and economic functions can actually handicap sound management. Thus, Federal Reserve and other supervisors have increasingly issued supervisory guidance that emphasizes managing the risks involved in bank activities and de-emphasizes the supervisory focus on specific instruments or traditional products. Most recently, the FFIEC published for industry comment a new policy statement that would eliminate the 1992 interagency policy that instituted the FFIEC high risk test. The older policy statement placed significant constraints on a depository institution's holding of certain "high-risk" mortgage securities that met specific market risk sensitivity tests. The new policy would replace the high risk test with broader guidance on sound practices for managing all investment and end-user activities. In essence, the new statement would allow an institution to hold any bank-eligible instrument as an investment as long as the institution had an adequate risk management process commensurate with the scope, complexity, and sophistication of its investment and end-user holdings. The old FFIEC high-risk tests offer an excellent case study of the potential pitfalls of narrow formulaic supervision in an age of dynamic financial engineering. By requiring a pre-purchase price sensitivity analysis, the high risk test successfully helped institutions better understand the interest rate risk of certain mortgage securities. It effectively constrained many smaller financial institutions from acquiring certain types of securities that subsequently created large losses for other investors. However, while protecting some institutions, the tests may also have distorted the investment decision making process at other depository institutions. Concerns about burden and heightened examiner review of all types of mortgage securities may have led institutions to blindly eliminate them as potential investments -- regardless of the merits of their risk/return profiles. Also, by focusing only on certain products, the test provided incentives for institutions to acquire other types of securities with embedded options that required no testing. Such instruments were thought to have a supervisory "stamp of approval", but in fact often had risk characteristics similar to or greater than those designated as "high risk". Assuming positive industry comments, the FFIEC hopes to implement the proposed new policy in early 1998. The comment period extends through November 17, and I encourage all of you to comment. I might mention that the new policy will apply to all investment and end-user derivatives activities. It illustrates that supervisors are increasingly emphasizing risk management on a portfolio rather than an instrument-specific basis. Although this is arguably the first principle of finance and is widely appreciated by bankers and regulators, putting this principle into practice in banking has not been easy. Past banking crises have, in part, reflected a failure to recognize or to prudently limit concentrations of risk. However, technology and financial innovation are now enabling financial theories and conceptual techniques that have been around for decades to be put into practice to manage market, credit and liquidity risks. Moreover, these risks are increasingly being managed across activities and in some cases on a global basis. This move to a broad portfolio or "macro" approach to managing risk has influenced bank supervisory efforts in several ways. All three of the U.S. banking agencies now take a more "risk-focused" approach to bank supervision. Bank exams are no longer exhaustive reviews of all of a bank's specific activities. Instead, they now take a more targeted approach to identifying and reviewing the sources of risk within a bank's "portfolio" of activities. Exam resources are now targeted at evaluating the soundness of a bank's processes for managing risks and our supervisory tools have been enhanced in this direction. In addition, supervisors increasingly are relying on internal risk management systems, including increasingly sophisticated risk measurement systems used by banks to manage their businesses. The objectives here are two-fold -- to help improve the effectiveness of our examinations and to reduce the burden on banking organizations. Examinations now involve significant off-site, pre-planning, analysis and fact finding. Then the on-site examination activities include spot checks to determine the reliability of the bank's internal risk management system. To the extent examiners gain confidence in the bank's risk management process, they will place greater emphasis on the findings of the bank's internal auditors at an earlier stage in the examination process and focus resources in other areas. An area of bank risk management systems that has been particularly useful to supervisors is risk measurement. No better example exists than the banking agencies' adoption of a risk assessment approach for evaluating capital adequacy for interest rate risk. Early on in that rulemaking process, supervisors recognized that a number of banking institutions had internal models for measuring interest rate risk that were much more sophisticated than any possible standardized regulatory model. However, at the same time, supervisors were acutely aware that many other institutions had limited capabilities in this area and that many banks may have been hesitant to develop more sophisticated internal measurement systems prior to the determination of a supervisory approach. Accordingly, in 1993, supervisors proposed to use the results of internal models for evaluating the quantitative level of interest rate risk exposure at individual institutions. While the rulemaking process was ultimately longer than desired, it did demonstrate the clear intent of supervisors to encourage and provide incentives for improvements in risk management and to take full advantage of such advances when possible. I think most banks would agree that the discovery process and comment periods supervisors convened from 1993 through 1995, and the ensuing dialogue, spurred significant industry development and refinement of interest rate risk models. A similar process evolved in developing the international capital standard for market risk in the trading activities of internationally active banks. Beginning next January, banks that meet certain qualitative and quantitative standards for risk management will calculate market risk capital charges for their trading activities on the basis of their own internal Value at Risk (VaR) measures. Here again, supervisors recognized early developments in the quantitative measurement of market risks, encouraged industry progress, and sought to build on the VaR concept when developing a supervisory approach. During the discovery and rulemaking process the supervisory attention paid to VaR techniques led to more robust modelling and has helped spread the use of VaR techniques worldwide. Moving forward, perhaps such supervisory/private sector synergies can be gained in other areas of risk management, as well. The quantification of credit risks, by far the most important risk in banking, may be a candidate. At present, some institutions are making significant strides on a number of fronts to better quantify and manage credit risk. In addition to major developments in credit scoring and the use of artificial intelligence in underwriting various types of consumer loans, a few banks are beginning to use historical data to estimate probability loss distributions for the credit risk of different quality commercial loans. In some banks, credit risk-adjusted returns to capital are being used to construct a portfolio management framework for credit risk. This, in turn, is providing a proving ground for a risk-adjusted pricing of loans as well as a myriad of new instruments such as credit derivatives. While industry efforts to quantify credit risks are still in the early stages of evolution, recent progress holds promise for reducing both institutional and systemic risks. Indeed, these efforts might eventually lead to new supervisory regimes for addressing credit risk. Better methods of quantifying credit risk have significant potential for reducing the time examiners spend in on-site examinations. Moreover, advances in credit risk measurement may ultimately allow supervisors to design regulatory capital standards around internal models. We recognize the inadequacy of the existing risk-based capital regime where such assets as loans are all treated as having the same risk. We are actively encouraging the development of more quantitative approaches to credit risk management. However, better regulatory tools are not yet available. While supervisors can prod developments in risk management, ultimately it will be up to the industry to find other ways to better measure and manage credit risk. Harnessing market forces to reinforce supervisory objectives is another important goal in the changing culture of supervisors. Reliable financial information and adequate disclosure of risk exposures is an essential ingredient to achieving this goal. Market participants can benefit from enhanced disclosure by being in a better position to understand the financial condition of counterparties and competitors. Investors have an obvious interest in being able to make meaningful assessments of a firm's performance, underlying trends, and income-producing potential. Sound, well-managed firms can benefit if better disclosure enables them to obtain funds at risk premiums that accurately reflect lower risk profiles. Inadequate financial disclosures, on the other hand, could penalize well-managed firms if market participants are unable to assess fundamental financial strength. It is this desire to see market discipline play a greater role in influencing banking activities that has prompted the Federal Reserve Board to join the debate about the derivative accounting standards that are being developed by the Financial Accounting Standards Board (FASB). Everyone agrees that a critical function of financial statements is to reflect in a meaningful way underlying trends in the financial performance and condition of the firm as well as the economic substance of its activities. However, the Board believes that the application of market value accounting to business strategies where not appropriate, and particularly when applied on a piecemeal basis, or when market prices are not readily available, may lead to increased volatility or fluctuation in reported results. Such accounting practices may actually obscure underlying trends or developments affecting a firm's condition and performance. Requiring companies to adopt market value accounting where it is not consistent with business strategies can cause them to incur significant costs to provide information that may not realistically reflect way underlying circumstances or trends in performance. Moreover, from the standpoint of financial statement analysts and other users, having to make adjustments to remove the effects of meaningless accounting volatility from income statements and balance sheets can also impose significant costs without offsetting benefits. The Board believes that these problems can be minimized by having large firms with active trading portfolios place market values in supplemental disclosures rather than by forcing their use in the primary financial statements. Such an approach would give analysts the information they need, without imposing costs on an unnecessarily wide range of firms and without imposing the broader costs of having to reverse or "back out" the distorting effects of the proposed accounting standard. Without a doubt, banking institutions have made significant progress in implementing new techniques and methods in risk management. To date, most work in this area has centered around the "science" of risk management -- that is, the quantitative measurement of risk. However, quantitative measurement is only one element of the overall process of financial risk management. Other elements such as board and senior management oversight, internal controls, and the role of internal and external audits are just as important. Given the pace of technological and financial innovation, inadequate internal controls can expose an institution to significant risk. Indeed, inadequate management oversight, combined with a lack of internal controls, has been the primary cause of the losses experienced by several high profile major international banking organizations. In some cases basic time-honored internal controls such as segmentation of duties and independent risk assessment had been ignored. In others, internal management processes have failed to keep pace with technological development, financial innovation, and global expansion. It is these "low tech" areas that pose continued challenges to risk management. Some institutions are beginning to address these challenges in their attempts to identify, monitor and control the operating risks of various business lines. Indeed, operating risk is quickly emerging as the next frontier of risk management. While no clear standardized definition of operating risk has yet emerged, several progressive institutions are expending significant resources to address the operating risks inherent in particular business lines. For some, this involves conducting extensive risk assessments throughout business and product lines to identify both the types of processing, information, and personnel risks that exist and the potential measures that can be taken to mitigate them. Others are buttressing these assessments with attempts actually to quantify and charge internal capital for operating risk exposures. Supervisors can also be expected to more closely monitor banks' efforts to identify and manage operating risks. One very important operating risk that all banking institutions face is the challenge of addressing the Year 2000 issue. U.S. banks appear to be taking this matter seriously and are generally well underway toward identifying individual needs and developing action plans. The Federal Reserve and the other federal bank supervisors are reviewing the relevant efforts of every insured depository institution in order to determine whether adequate progress on this issue is being made. Meeting the demands of this review and ensuring proper remedies both before and after the Year 2000 will be a significant and costly task to both the industry and the banking agencies. However, even within the context of banking, the scope of the Year 2000 problem extends far beyond U.S. banks to foreign banks, bank borrowers, depositors, vendors, and other counterparties. Banks and others need to address Year 2000 system alterations, not only because of the potential effects on overall markets, but also as a threat to individual firm viability. At a minimum, banks should be concerned about their ability to provide uninterrupted service to their customers into the next millennium. If nothing else, it is simply good business. In summary, advances in computerization and communications have created a paradigm shift for financial markets, the financial services industry, and the management of financial risks. In response, supervisors are also moving to a new, more "incentive-compatible" regime of greater reliance on banks' own risk measures and internal controls. This transformation may be slow and will be challenging for all. Supervisors can encourage innovation, but the private sector must do much of the development work. As always, a transition to an improved framework will work best with cooperative, open dialogue between the financial industry and its regulators, so that compatible and efficient answers are found. In today's markets, institutions and financial systems are linked as never before, and such connections are likely to grow in the years ahead. How effectively institutions manage their risks and allocate their capital will have substantial consequences for economic growth. We have seen significant progress in measuring market risk, and the groundwork is being laid for future gains in measuring credit risk, but those are only two risks. Operating risks such as fraud, human misjudgments, and the failure of information systems, processing operations and basic internal controls must be addressed comprehensively. At this point, we can take satisfaction in the risk management strides we have made. But I am confident that opportunities for even greater progress lie ahead.
1997-11-04T00:00:00	Mr. Kelley's testimony to the US House of Representatives Committee on Banking and Financial Services (Central Bank Articles and Speeches, 4 Nov 97)	Testimony by Mr. Edward W. Kelley Jr., a member of the Board of Governors of the US Federal Reserve System, before the Committee on Banking and Financial Services of the US House of Representatives, in Washington DC, on 4/11/97.	Mr. Kelley's testimony to the US House of Representatives Committee on Testimony by Mr. Edward W. Kelley Jr., a member of the Board Banking and Financial Services of Governors of the US Federal Reserve System, before the Committee on Banking and Financial Services of the US House of Representatives, in Washington DC, on 4/11/97. I am pleased to appear before the Committee today to discuss the Federal Reserve's efforts to address the Year 2000 computer systems issue. The Federal Reserve System has developed and is executing a comprehensive plan to ensure its own Year 2000 readiness and the bank supervision function is well along in a cooperative, interagency effort, to promote timely remediation and testing by the banking industry. This afternoon I will focus on actions being taken by the Federal Reserve System to address our internal systems, coordination with the industry, and contingency planning. Background The Federal Reserve operates several payments applications that process and settle payments and securities transactions between depository institutions in the United States. Three of these applications are the Fedwire funds transfer, Fedwire securities transfer, and Automated Clearing House (ACH) applications. The first two applications are large-value payments mechanisms for U.S. dollar interbank funds transfers and U.S. government securities transfers. Users of the applications are primarily depository institutions and government agencies. The Fedwire funds transfer system is a real-time credit transfer system used primarily for payments related to interbank funds transfers such as Fed funds transactions, interbank settlement transactions, and "third-party" payments between the customers of depository institutions. Funds transferred over Fedwire are immediately final; they cannot be revoked after they have been accepted and processed by the Federal Reserve. About 10,000 depository institutions use the Fedwire funds transfer system to transfer each year approximately 86 million payments valued at over $280 trillion. The current average total daily value of Fedwire funds transfers is approximately $1.1 trillion. The Fedwire securities transfer system supports the safekeeping, clearing, and settlement of U.S. government securities in both the primary and secondary markets. It provides custody of U.S. government securities in book-entry form, as well as the transfer of securities ownership among market participants. On the custody side, the system calculates and credits interest and principal payments to the holders of securities, reconciles outstanding securities balances with issuers, and performs other record keeping and collateral safekeeping functions. On the transfer side, the system delivers book-entry securities against a simultaneous payment, called delivery-versus-payment, thus reducing the settlement risks of market participants. About 8,000 depository institutions use the Fedwire securities transfer service to transfer each year approximately 13 million securities valued at over $160 trillion. The average total daily value of Fedwire securities transfers is about $650 billion. The ACH is an electronic payment service that supports both credit and debit transactions and is used by approximately 14,000 financial institutions, 400,000 companies, and an estimated 50 million consumers. Typical credit transactions include direct deposit of payroll and corporate payments to suppliers. Typical debit transactions include the collection of mortgage and loan payments and corporate cash concentration transactions. The ACH processes transactions in batches one or two days before they are scheduled to settle. ACH transactions are settled through depository institutions' accounts at the Federal Reserve Banks. Approximately 4 billion ACH transactions were processed in 1996 with a total value of approximately $12 trillion. About 3.3 billion of these payments were commercial transactions; 625 million payments were originated by the Federal government. The Reserve Banks' critical applications, such as Fedwire funds and securities transfer, ACH, and supporting accounting systems, run on mainframe computer systems operated by Federal Reserve Automation Services (FRAS), the internal organizational unit that processes applications on behalf of the Federal Reserve Banks and operates the Federal Reserve's national network. These critical applications are "centralized", that is, one copy of the application is used by all twelve Reserve Banks. In addition to centralized applications on the mainframe, the Federal Reserve Banks operate a range of applications in a distributed computing environment, supporting business functions such as cash distribution, banking supervision and regulation, research, public information, and human resources. The Reserve Banks also operate check processing systems that provide check services to depository institutions and the U.S. government. A national communications network, called FEDNET, supports the exchange of information among the Reserve Banks, FRAS, and external organizations. The scope of the Federal Reserve's Year 2000 activities includes all of these processing environments and the supporting telecommunications network. Year 2000 Readiness It is crucial that the Federal Reserve provide reliable services to the nation's banking system and financial markets. The Federal Reserve is giving the Year 2000 its highest priority, commensurate with our goal of maintaining the stability of the nation's financial markets and payments systems, preserving public confidence, and supporting reliable government operations. We are taking a comprehensive approach to our preparedness which includes assessments of readiness, remediation, and testing. The Federal Reserve has completed application assessments and internal test plans, and we are currently renovating and testing software. We are also updating proven plans and techniques used during other times of operational stress in order to be prepared to address potential century date change difficulties. All Federal Reserve computer program changes, as well as system and user-acceptance testing, are scheduled to be completed by year-end 1998. Further, critical financial services systems that interface with the depository institutions will be Year 2000-ready by mid-1998. This schedule will permit approximately 18 months for customer testing, to which we are dedicating considerable support resources. A large cadre of top personnel in the Federal Reserve System have been assigned to this task. Our staff is putting in many extra hours to prepare for testing with customers, planning for business continuity in the event of any unanticipated problems with internal systems, and enhancing our ability to respond to possible Year 2000-related operating failures of depository institutions. Assuring compliance internally is requiring review of approximately 90 million lines of computer code. While there are challenges and a great deal of work before us, I can report that we expect to be fully prepared for the century date change. The Federal Reserve recognized the potential problem with two-digit date fields more than five years ago when we began consolidating our mainframe data processing operations. Our new centralized mission-critical applications, such as Fedwire funds transfer, Fedwire securities transfer, and ACH, were designed from inception with Year 2000 compliance in mind. The mainframe consolidation effort also necessitated extensive application standardization, which required us to complete a comprehensive inventory of our mainframe applications, a necessary first step to effective remediation. Like our counterparts in the private sector, the Federal Reserve System still faces substantial challenges in achieving Year 2000 readiness. These challenges include managing a highly complex project involving multiple interfaces with others, ensuring the readiness of vendor components, ensuring the readiness of applications, thorough testing, and establishing contingency plans. We are also faced with labor market pressures that call for creative measures to retain staff who are critical to the success of our Year 2000 activities. CDC Project Management According to industry experts, up to one-quarter of an organization's Year 2000 compliance efforts are devoted to project management. Managing preparations for the century date change is particularly resource-intensive given the number of automated systems to be addressed, systems interrelationships and interdependencies, interfaces with external data sources and customers, and testing requirements. In addition, Year 2000 preparations must address many computerized environmental and facilities management systems such as power, heating and cooling, voice communications, elevators, and vaults. Our Year 2000 project is being closely coordinated among the Reserve Banks, the Board of Governors, numerous vendors and service providers, approximately 13,000 customers, and government agencies. In 1995, a Federal Reserve System-wide project was initiated, referred to as the Century Date Change (CDC) project, to coordinate the efforts of the Reserve Banks, FRAS, and the Board of Governors. Our project team is taking a three-part approach to achieve its objectives, focusing on planning, readiness, communication, and monitoring. Our planning began with a careful inventory of all applications and establishment of schedules and support mechanisms to ensure that readiness objectives are met. The readiness process involves performing risk assessments, modifying automated systems, and testing both internally and with depository institutions, service providers, and government agencies. We are stressing effective, consistent, and timely communication, both internal and external, to promote awareness and commitment at all levels of our own organization and the financial services industry, more generally. Some of our most senior executives are leading the project, and the Board and senior Bank management are now receiving formal, detailed status reports at least every 60 days. Any significant compliance issues will be reported to the Board immediately. The Reserve Banks' internal audit departments and the Board's oversight staff are also closely monitoring progress. A significant challenge in meeting our Year 2000 readiness objectives is our reliance on commercial hardware and software products and services. Much of our information processing and communications infrastructure is comprised of hardware and software products from third-party vendors. Additionally, the Federal Reserve utilizes commercial application software products and services for certain administrative functions and other operations. As a result, we must coordinate with numerous vendors and manufacturers to ensure that all of our hardware, software, and services are Year 2000-ready. In many cases, compliance will require upgrading, or even replacing, equipment and software. We have a complete inventory of vendor components used in our mainframe and distributed computing environments, and vendor coordination and system change are progressing well. These preparations also include careful attention to the Year 2000 readiness of telecommunications providers. Testing As we continue to assess our systems for Year 2000 readiness, we are well along in preparing a special central environment for testing our payment system applications. We are establishing isolated mainframe data processing environments to be used for internal testing of all system components as well as for testing with depository institutions and other government agencies. These environments will enable testing for high-risk dates, such as the rollover to the year 2000 and leap year processing. Testing will be conducted through a combination of future-dating our computer systems to verify the readiness of our infrastructure, and testing critical future dates within interfaces to other institutions. Our test environments will be configured to provide flexible and nearly continuous access by customers. Network communications components are also being tested and certified in a special test lab environment at FRAS. The testing effort for Year 2000 readiness within the Federal Reserve will be extensive and complex. Industry experts estimate that testing for readiness will consume more than half of total Year 2000 project resources. To leverage existing resources and processes, we are modelling our Year 2000 testing on proven testing methods and processes. Our customers are already familiar with these processes and the testing environment. We shared our testing strategy with depository institutions in October of this year, and we are currently developing a coordinated test schedule. As I noted earlier, the Reserve Banks are targeting June 1998 to commence testing with their depository institution customers, which allows an 18-month time period for depository institutions to test their systems with the Federal Reserve. All of these activities require that we retain highly skilled staff critical to the success of the project. As I mentioned earlier, we have placed the highest priority on our CDC project, and, as such, have allocated many of the best managers and technical staff in the Federal Reserve System to work on the project. The information technology industry is already experiencing market pressures due to the increased demand for technical talent. As the millennium draws closer, the global market requirements for qualified personnel will intensify even further. We are responding as necessary to these market-induced pressures by implementing programs to retain staff members in critical, high-demand positions. Our focus at the Board goes beyond the immediate need to prepare our systems and ensure reliable operation of the payments infrastructure. We are also working hard to address the supervisory issues raised by Year 2000 and are developing contingency plans which I will discuss later. Bank Supervision As a bank supervisor, the Federal Reserve has worked closely with the other supervisory agencies that are part of the Federal Financial Institutions Examination Council (FFIEC) to alert the industry to our concerns and to monitor Year 2000 preparations of the institutions we supervise so that we can identify early and address problems that arise. Comptroller of the Currency Ludwig is testifying today as Chairman of the FFIEC to describe the interagency Year 2000 supervisory initiatives of all of the five member agencies (Federal Reserve, OCC, FDIC, OTS and NCUA), so I will limit my comments on the Federal Reserve's supervisory efforts. In May of this year, the Federal Reserve and the other regulatory agencies developed a uniform Year 2000 assessment questionnaire to collect information on a national basis. Based on the responses and other information, we believe the banking industry's awareness level improved substantially during 1997 and is reflected in the intensified project management, planning, budgeting, and renovation efforts that have been initiated. Generally speaking, the nation's largest banking organizations have done much to address the issues and have devoted significant financial and human resources to preparing for the century date change. Many larger banks are already renovating their operating systems and have commenced testing of their critical applications. Large organizations seem generally capable of renovating their critical operating systems by year-end 1998, and will have their testing well underway by then. Smaller banks, including the U.S. offices of foreign banks and those dependent on a third party to provide their computer services, are generally aware of the issues and are working on the problem; however, their progress is less measurable and is being carefully monitored. We are directing significant attention to ensure that these banks intensify their efforts to prepare for the Year 2000. Major third-party service providers and software vendors serving the banking industry are acutely aware of the issue and are working diligently to address it. Most of these suppliers consider their Year 2000 capability to be a business survival issue, as it is of critical importance to their ability to remain competitive in an aggressive industry. By mid-year 1998 we will have conducted a thorough Year 2000 preparedness examination of every bank, U.S. branch and agency of a foreign bank, and service provider that we supervise. Our examination program includes a review of each organization's Year 2000 project management plans in order to evaluate their sufficiency, to ensure the direct involvement of senior management and the board of directors, and to monitor their progress against the plan. As we proceed through the examination process, we are identifying any institutions that require intensified supervisory attention and establishing our priorities for subsequent examinations. International Awareness With regard to the international aspects of the Year 2000 issue, U.S. offices of foreign banks pose a unique set of challenges. We are concerned about the possibility that some offices may not have an adequate appreciation of the magnitude and ramifications of the problem, and may not as yet have committed the resources necessary to address the issues effectively. This is a particular concern for foreign bank offices that are dependent on their foreign parent bank for information processing systems. In addition, we are increasingly concerned that the foreign branches of U.S. banks may be adversely affected if counterparties in foreign markets are not ready for the Year 2000. Therefore, we are working through the Bank for International Settlements' (BIS) Committee on Banking Supervision, composed of many of the international supervisory agencies responsible for the foreign banks that operate in the United States. Through formal and informal discussions, the distribution of several interagency statements and advisories, and the Federal Reserve's Year 2000 video (see below) to the BIS supervisors committee, we have sought to elevate foreign bank supervisors' awareness of the risks posed by the century date change. The G-10 governors issued an advisory in September that included a paper by the bank supervisors committee on the Year 2000 challenge to banks and bank supervisors around the world to ensure a higher level of awareness and activity on their part. The BIS supervisors committee has developed a survey sent to about 40 countries to collect better information on the state of readiness of banks in those countries and the extent of the efforts of the bank supervisors to address the issues locally and internationally. The surveys will be evaluated and the findings distributed early next year. Also on the international front, William McDonough, President of the Federal Reserve Bank of New York, in a keynote address to the annual meeting of the Institute of International Finance in Hong Kong, emphasized the importance of planning for the century date change on an international basis and the significant risk to financial markets posed by the Year 2000. We also participated in the BIS meeting sponsored by the Committee on Payments and Settlement Systems and the Group of Computer Experts for G-10 and major non-G-10 central banks in September which provided a forum to share views on and approaches to dealing with Year 2000 issues, and we have been active in various private sector forums. The majority of foreign central banks are confident that payment and settlement applications under their management will be Year 2000-ready. Like the Federal Reserve, however, the operation of foreign central bank payment systems is dependent on compliant products from hardware and software suppliers and the readiness of telecommunication service providers. The approach of foreign central banks toward raising bank industry awareness varies widely. Information garnered from this meeting and similar meetings planned for the future will assist the BIS Committee on Payment and Settlement Systems, as well as the Federal Reserve, in understanding the state of preparedness of payment systems on a global level. Public Awareness We are mindful that extensive communication with the industry and the public is crucial to the success of century date change efforts. Our public awareness program concentrates on communications with the financial services industry related to our testing efforts and our overall concerns about the industry's readiness. We continue to advise our bank customers of the Federal Reserve's plans and time frames for making our software Year 2000-ready. We have inaugurated a Year 2000 industry newsletter and have just published our first bulletin addressing specific technical issues. We would be glad to provide you with copies of our recent newsletter and the bulletin. We have also established an Internet Web site to provide depository institutions with information regarding the Federal Reserve System's CDC project. This site can be accessed at the following Internet address: http://www.frbsf.org/fiservices/cdc. On behalf of the FFIEC, the Federal Reserve has developed a Year 2000 information distribution system, including an Internet Web site and a toll free Fax Back service (888-882-0982). The Web site provides easy access to policy statements, guidance to examiners, and paths to other Year 2000 Web sites available from numerous other sources. The FFIEC Year 2000 Web site can be accessed at the following Internet address: http://www.ffiec.gov/y2k. The Federal Reserve has also produced a ten-minute video entitled "Year 2000 Executive Awareness" intended for viewing by a bank's board of directors and senior management. The video presents a summary of the Year 2000 five-phase project management plan outlined in the interagency policy statement. In my introductory remarks on the video, I note that senior bank officials should be directly involved in managing the Year 2000 project to ensure that it is given the appropriate level of attention and sufficient resources to address the issue on a timely basis. The video can be ordered through the Board's Web site. Contingency Planning While we will continue our public outreach efforts, our main focus is preparedness. Because smooth and uninterrupted financial flows are obviously of utmost importance, our main focus is on our readiness and the avoidance of problems. But we know from experience that upon occasion, things can go wrong. Given our unique role as the nation's central bank, the Federal Reserve has always stressed contingency planning -- for both systemic risks as well as operational failures. In this regard, we regularly conduct exhaustive business resumption tests of our major payment systems that include depository institutions. Moreover, as a result of our experience in responding to problems arising from such diverse events as earthquakes, fires, storms, and power outages, as well as liquidity problems in institutions, we expect to be appropriately positioned to deal with similar problems in the financial sector that might arise as a result of CDC. However, CDC presents many unique situations. For example, in the software application arena, the normal contingency of falling back to a prior release of the software is not a viable option. We are, of course, developing specific CDC contingency plans to address various operational scenarios, and our contingency planning includes preparation to address unanticipated problems when we bring our systems into production as Year 2000 begins. Key technical staff will be ready to respond quickly to problems with our computer and network systems. We are establishing procedures with our primary vendors to ensure direct communication and appropriate recourse should their products fail at Federal Reserve installations during Year 2000 date processing. Our existing business resumption plans will be updated to address date-related difficulties that may face the financial industry. We already have arrangements in place to assist financial institutions in the event they are unable to access their own systems. For example, we are able to provide financial institutions with access to Federal Reserve computer terminals on a limited basis for the processing of critical funds transfers. This contingency arrangement has proven highly effective when used from time to time by depository institutions experiencing major hardware/software outages or that have had their operations disrupted due to natural disasters such as the Los Angeles earthquake, hurricane Hugo in the Carolinas, and hurricane Andrew in south Florida. In these cases we worked closely with financial institutions to ensure that adequate supplies of cash were available to the community, and we arranged for our operations to function virtually without interruptions for 24 hours a day during the crisis period. We feel the experience gained from such crises will prove very helpful in the event of similar problems triggered by the century date change. We are formulating responses for augmenting certain functions, such as computer help desk services and off-line funds transfers, to respond to short-term needs for these services. Beyond reliance on a sound plan and effective execution of the plan, the Federal Reserve provides several different payment services, such as Fedwire, ACH, check, and cash; therefore, the banking industry is not totally dependent upon any single system for executing payments. Alternatives are available in the event of a disruption in a segment of the electronic payment system. We recognize that despite their best efforts, some depository institutions may experience operating difficulties, either as a result of their own computer problems or those of their customers, counterparties, or others. These problems could be manifested in a number of ways and would not necessarily involve funding shortfalls. Nevertheless, the Federal Reserve is always prepared to provide information to depository institutions on the balances in their accounts with us throughout the day, so that they can identify shortfalls and seek funding in the market. The Federal Reserve will be prepared to lend in appropriate circumstances and with adequate collateral to depository institutions when market sources of funding are not reasonably available. The terms and conditions of such lending may depend upon the circumstances giving rise to the liquidity shortfall. Our preparations for possible liquidity difficulties also extend to the foreign bank branches and agencies in the U.S. that may be adversely affected directly by their own computer systems or through difficulties caused by the linkage and dependence on their parent bank. Such circumstances would necessitate coordination with the home country supervisor. Moreover, consistent with current policy, foreign central banks will be expected to provide liquidity support to any of their banking organizations that experience a funding shortfall. Closing Remarks As I indicated at the outset, the Federal Reserve views its Year 2000 preparations with great seriousness. As such, we have placed a high priority on the remediation of date problems in our systems and the development of action plans that will ensure business continuity for the critical financial systems we operate. While we have made significant progress and are on schedule in validating our internal systems and preparing for testing with depository institutions and others using Federal Reserve services, we must work to ensure that our efforts remain on schedule and that problems are addressed in a timely fashion. In particular, we will be paying special attention to the testing needs of depository institutions and the financial industry and are prepared to adjust our support for them as required by experience. We believe that we are well-positioned to meet our objectives and will remain vigilant throughout the process. As a bank supervisor, the Federal Reserve will continue to address the industry's preparedness, monitor progress, and target for special supervisory attention those organizations that are most in need of assistance. Lastly, we will continue to participate in international forums with the expectation that these efforts will help foster an international awareness of Year 2000 issues and provide for the sharing of experiences, ideas, and best practices.	---[PAGE_BREAK]--- # Mr. Kelley's testimony to the US House of Representatives Committee on Banking and Financial Services Testimony by Mr. Edward W. Kelley Jr., a member of the Board of Governors of the US Federal Reserve System, before the Committee on Banking and Financial Services of the US House of Representatives, in Washington DC, on 4/11/97. I am pleased to appear before the Committee today to discuss the Federal Reserve's efforts to address the Year 2000 computer systems issue. The Federal Reserve System has developed and is executing a comprehensive plan to ensure its own Year 2000 readiness and the bank supervision function is well along in a cooperative, interagency effort, to promote timely remediation and testing by the banking industry. This afternoon I will focus on actions being taken by the Federal Reserve System to address our internal systems, coordination with the industry, and contingency planning. ## Background The Federal Reserve operates several payments applications that process and settle payments and securities transactions between depository institutions in the United States. Three of these applications are the Fedwire funds transfer, Fedwire securities transfer, and Automated Clearing House (ACH) applications. The first two applications are large-value payments mechanisms for U.S. dollar interbank funds transfers and U.S. government securities transfers. Users of the applications are primarily depository institutions and government agencies. The Fedwire funds transfer system is a real-time credit transfer system used primarily for payments related to interbank funds transfers such as Fed funds transactions, interbank settlement transactions, and "third-party" payments between the customers of depository institutions. Funds transferred over Fedwire are immediately final; they cannot be revoked after they have been accepted and processed by the Federal Reserve. About 10,000 depository institutions use the Fedwire funds transfer system to transfer each year approximately 86 million payments valued at over $\$ 280$ trillion. The current average total daily value of Fedwire funds transfers is approximately $\$ 1.1$ trillion. The Fedwire securities transfer system supports the safekeeping, clearing, and settlement of U.S. government securities in both the primary and secondary markets. It provides custody of U.S. government securities in book-entry form, as well as the transfer of securities ownership among market participants. On the custody side, the system calculates and credits interest and principal payments to the holders of securities, reconciles outstanding securities balances with issuers, and performs other record keeping and collateral safekeeping functions. On the transfer side, the system delivers book-entry securities against a simultaneous payment, called delivery-versus-payment, thus reducing the settlement risks of market participants. About 8,000 depository institutions use the Fedwire securities transfer service to transfer each year approximately 13 million securities valued at over $\$ 160$ trillion. The average total daily value of Fedwire securities transfers is about $\$ 650$ billion. The ACH is an electronic payment service that supports both credit and debit transactions and is used by approximately 14,000 financial institutions, 400,000 companies, and an estimated 50 million consumers. Typical credit transactions include direct deposit of payroll and corporate payments to suppliers. Typical debit transactions include the collection of mortgage and loan payments and corporate cash concentration transactions. The ACH processes transactions in batches one or two days before they are scheduled to settle. ACH transactions are settled through depository institutions' accounts at the Federal Reserve Banks. Approximately 4 billion ACH transactions were processed in 1996 with a total value of approximately $\$ 12$ trillion. About 3.3 billion of these payments were commercial transactions; 625 million payments were originated by the Federal government. ---[PAGE_BREAK]--- The Reserve Banks' critical applications, such as Fedwire funds and securities transfer, ACH , and supporting accounting systems, run on mainframe computer systems operated by Federal Reserve Automation Services (FRAS), the internal organizational unit that processes applications on behalf of the Federal Reserve Banks and operates the Federal Reserve's national network. These critical applications are "centralized", that is, one copy of the application is used by all twelve Reserve Banks. In addition to centralized applications on the mainframe, the Federal Reserve Banks operate a range of applications in a distributed computing environment, supporting business functions such as cash distribution, banking supervision and regulation, research, public information, and human resources. The Reserve Banks also operate check processing systems that provide check services to depository institutions and the U.S. government. A national communications network, called FEDNET, supports the exchange of information among the Reserve Banks, FRAS, and external organizations. The scope of the Federal Reserve's Year 2000 activities includes all of these processing environments and the supporting telecommunications network. # Year 2000 Readiness It is crucial that the Federal Reserve provide reliable services to the nation's banking system and financial markets. The Federal Reserve is giving the Year 2000 its highest priority, commensurate with our goal of maintaining the stability of the nation's financial markets and payments systems, preserving public confidence, and supporting reliable government operations. We are taking a comprehensive approach to our preparedness which includes assessments of readiness, remediation, and testing. The Federal Reserve has completed application assessments and internal test plans, and we are currently renovating and testing software. We are also updating proven plans and techniques used during other times of operational stress in order to be prepared to address potential century date change difficulties. All Federal Reserve computer program changes, as well as system and user-acceptance testing, are scheduled to be completed by year-end 1998. Further, critical financial services systems that interface with the depository institutions will be Year 2000-ready by mid-1998. This schedule will permit approximately 18 months for customer testing, to which we are dedicating considerable support resources. A large cadre of top personnel in the Federal Reserve System have been assigned to this task. Our staff is putting in many extra hours to prepare for testing with customers, planning for business continuity in the event of any unanticipated problems with internal systems, and enhancing our ability to respond to possible Year 2000-related operating failures of depository institutions. Assuring compliance internally is requiring review of approximately 90 million lines of computer code. While there are challenges and a great deal of work before us, I can report that we expect to be fully prepared for the century date change. The Federal Reserve recognized the potential problem with two-digit date fields more than five years ago when we began consolidating our mainframe data processing operations. Our new centralized mission-critical applications, such as Fedwire funds transfer, Fedwire securities transfer, and ACH , were designed from inception with Year 2000 compliance in mind. The mainframe consolidation effort also necessitated extensive application standardization, which required us to complete a comprehensive inventory of our mainframe applications, a necessary first step to effective remediation. Like our counterparts in the private sector, the Federal Reserve System still faces substantial challenges in achieving Year 2000 readiness. These challenges include managing a highly complex project involving multiple interfaces with others, ensuring the readiness of vendor components, ensuring the readiness of applications, thorough testing, and establishing contingency plans. We are also faced with labor market pressures that call for creative measures to retain staff who are critical to the success of our Year 2000 activities. ---[PAGE_BREAK]--- # CDC Project Management According to industry experts, up to one-quarter of an organization's Year 2000 compliance efforts are devoted to project management. Managing preparations for the century date change is particularly resource-intensive given the number of automated systems to be addressed, systems interrelationships and interdependencies, interfaces with external data sources and customers, and testing requirements. In addition, Year 2000 preparations must address many computerized environmental and facilities management systems such as power, heating and cooling, voice communications, elevators, and vaults. Our Year 2000 project is being closely coordinated among the Reserve Banks, the Board of Governors, numerous vendors and service providers, approximately 13,000 customers, and government agencies. In 1995, a Federal Reserve System-wide project was initiated, referred to as the Century Date Change (CDC) project, to coordinate the efforts of the Reserve Banks, FRAS, and the Board of Governors. Our project team is taking a three-part approach to achieve its objectives, focusing on planning, readiness, communication, and monitoring. Our planning began with a careful inventory of all applications and establishment of schedules and support mechanisms to ensure that readiness objectives are met. The readiness process involves performing risk assessments, modifying automated systems, and testing both internally and with depository institutions, service providers, and government agencies. We are stressing effective, consistent, and timely communication, both internal and external, to promote awareness and commitment at all levels of our own organization and the financial services industry, more generally. Some of our most senior executives are leading the project, and the Board and senior Bank management are now receiving formal, detailed status reports at least every 60 days. Any significant compliance issues will be reported to the Board immediately. The Reserve Banks' internal audit departments and the Board's oversight staff are also closely monitoring progress. A significant challenge in meeting our Year 2000 readiness objectives is our reliance on commercial hardware and software products and services. Much of our information processing and communications infrastructure is comprised of hardware and software products from third-party vendors. Additionally, the Federal Reserve utilizes commercial application software products and services for certain administrative functions and other operations. As a result, we must coordinate with numerous vendors and manufacturers to ensure that all of our hardware, software, and services are Year 2000-ready. In many cases, compliance will require upgrading, or even replacing, equipment and software. We have a complete inventory of vendor components used in our mainframe and distributed computing environments, and vendor coordination and system change are progressing well. These preparations also include careful attention to the Year 2000 readiness of telecommunications providers. ## Testing As we continue to assess our systems for Year 2000 readiness, we are well along in preparing a special central environment for testing our payment system applications. We are establishing isolated mainframe data processing environments to be used for internal testing of all system components as well as for testing with depository institutions and other government agencies. These environments will enable testing for high-risk dates, such as the rollover to the year 2000 and leap year processing. Testing will be conducted through a combination of future-dating our computer systems to verify the readiness of our infrastructure, and testing critical future dates within interfaces to other institutions. Our test environments will be configured to provide flexible and nearly continuous access by customers. Network communications components are also being tested and certified in a special test lab environment at FRAS. ---[PAGE_BREAK]--- The testing effort for Year 2000 readiness within the Federal Reserve will be extensive and complex. Industry experts estimate that testing for readiness will consume more than half of total Year 2000 project resources. To leverage existing resources and processes, we are modelling our Year 2000 testing on proven testing methods and processes. Our customers are already familiar with these processes and the testing environment. We shared our testing strategy with depository institutions in October of this year, and we are currently developing a coordinated test schedule. As I noted earlier, the Reserve Banks are targeting June 1998 to commence testing with their depository institution customers, which allows an 18 -month time period for depository institutions to test their systems with the Federal Reserve. All of these activities require that we retain highly skilled staff critical to the success of the project. As I mentioned earlier, we have placed the highest priority on our CDC project, and, as such, have allocated many of the best managers and technical staff in the Federal Reserve System to work on the project. The information technology industry is already experiencing market pressures due to the increased demand for technical talent. As the millennium draws closer, the global market requirements for qualified personnel will intensify even further. We are responding as necessary to these market-induced pressures by implementing programs to retain staff members in critical, high-demand positions. Our focus at the Board goes beyond the immediate need to prepare our systems and ensure reliable operation of the payments infrastructure. We are also working hard to address the supervisory issues raised by Year 2000 and are developing contingency plans which I will discuss later. # Bank Supervision As a bank supervisor, the Federal Reserve has worked closely with the other supervisory agencies that are part of the Federal Financial Institutions Examination Council (FFIEC) to alert the industry to our concerns and to monitor Year 2000 preparations of the institutions we supervise so that we can identify early and address problems that arise. Comptroller of the Currency Ludwig is testifying today as Chairman of the FFIEC to describe the interagency Year 2000 supervisory initiatives of all of the five member agencies (Federal Reserve, OCC, FDIC, OTS and NCUA), so I will limit my comments on the Federal Reserve's supervisory efforts. In May of this year, the Federal Reserve and the other regulatory agencies developed a uniform Year 2000 assessment questionnaire to collect information on a national basis. Based on the responses and other information, we believe the banking industry's awareness level improved substantially during 1997 and is reflected in the intensified project management, planning, budgeting, and renovation efforts that have been initiated. Generally speaking, the nation's largest banking organizations have done much to address the issues and have devoted significant financial and human resources to preparing for the century date change. Many larger banks are already renovating their operating systems and have commenced testing of their critical applications. Large organizations seem generally capable of renovating their critical operating systems by year-end 1998, and will have their testing well underway by then. Smaller banks, including the U.S. offices of foreign banks and those dependent on a third party to provide their computer services, are generally aware of the issues and are working on the problem; however, their progress is less measurable and is being carefully monitored. We are directing significant attention to ensure that these banks intensify their efforts to prepare for the Year 2000 . ---[PAGE_BREAK]--- Major third-party service providers and software vendors serving the banking industry are acutely aware of the issue and are working diligently to address it. Most of these suppliers consider their Year 2000 capability to be a business survival issue, as it is of critical importance to their ability to remain competitive in an aggressive industry. By mid-year 1998 we will have conducted a thorough Year 2000 preparedness examination of every bank, U.S. branch and agency of a foreign bank, and service provider that we supervise. Our examination program includes a review of each organization's Year 2000 project management plans in order to evaluate their sufficiency, to ensure the direct involvement of senior management and the board of directors, and to monitor their progress against the plan. As we proceed through the examination process, we are identifying any institutions that require intensified supervisory attention and establishing our priorities for subsequent examinations. # International Awareness With regard to the international aspects of the Year 2000 issue, U.S. offices of foreign banks pose a unique set of challenges. We are concerned about the possibility that some offices may not have an adequate appreciation of the magnitude and ramifications of the problem, and may not as yet have committed the resources necessary to address the issues effectively. This is a particular concern for foreign bank offices that are dependent on their foreign parent bank for information processing systems. In addition, we are increasingly concerned that the foreign branches of U.S. banks may be adversely affected if counterparties in foreign markets are not ready for the Year 2000. Therefore, we are working through the Bank for International Settlements’ (BIS) Committee on Banking Supervision, composed of many of the international supervisory agencies responsible for the foreign banks that operate in the United States. Through formal and informal discussions, the distribution of several interagency statements and advisories, and the Federal Reserve's Year 2000 video (see below) to the BIS supervisors committee, we have sought to elevate foreign bank supervisors' awareness of the risks posed by the century date change. The G-10 governors issued an advisory in September that included a paper by the bank supervisors committee on the Year 2000 challenge to banks and bank supervisors around the world to ensure a higher level of awareness and activity on their part. The BIS supervisors committee has developed a survey sent to about 40 countries to collect better information on the state of readiness of banks in those countries and the extent of the efforts of the bank supervisors to address the issues locally and internationally. The surveys will be evaluated and the findings distributed early next year. Also on the international front, William McDonough, President of the Federal Reserve Bank of New York, in a keynote address to the annual meeting of the Institute of International Finance in Hong Kong, emphasized the importance of planning for the century date change on an international basis and the significant risk to financial markets posed by the Year 2000. We also participated in the BIS meeting sponsored by the Committee on Payments and Settlement Systems and the Group of Computer Experts for G-10 and major non-G-10 central banks in September which provided a forum to share views on and approaches to dealing with Year 2000 issues, and we have been active in various private sector forums. The majority of foreign central banks are confident that payment and settlement applications under their management will be Year 2000-ready. Like the Federal Reserve, however, the operation of foreign central bank payment systems is dependent on compliant products from hardware and software suppliers and the readiness of telecommunication service providers. The approach of foreign central banks toward raising bank industry awareness varies widely. Information garnered from this meeting and similar meetings planned for the future will assist the BIS Committee on Payment and Settlement Systems, as well as the Federal Reserve, in understanding the state of preparedness of payment systems on a global level. ---[PAGE_BREAK]--- # Public Awareness We are mindful that extensive communication with the industry and the public is crucial to the success of century date change efforts. Our public awareness program concentrates on communications with the financial services industry related to our testing efforts and our overall concerns about the industry's readiness. We continue to advise our bank customers of the Federal Reserve's plans and time frames for making our software Year 2000-ready. We have inaugurated a Year 2000 industry newsletter and have just published our first bulletin addressing specific technical issues. We would be glad to provide you with copies of our recent newsletter and the bulletin. We have also established an Internet Web site to provide depository institutions with information regarding the Federal Reserve System's CDC project. This site can be accessed at the following Internet address: http://www.frbsf.org/fiservices/cdc. On behalf of the FFIEC, the Federal Reserve has developed a Year 2000 information distribution system, including an Internet Web site and a toll free Fax Back service (888-882-0982). The Web site provides easy access to policy statements, guidance to examiners, and paths to other Year 2000 Web sites available from numerous other sources. The FFIEC Year 2000 Web site can be accessed at the following Internet address: http://www.ffiec.gov/y2k. The Federal Reserve has also produced a ten-minute video entitled "Year 2000 Executive Awareness" intended for viewing by a bank's board of directors and senior management. The video presents a summary of the Year 2000 five-phase project management plan outlined in the interagency policy statement. In my introductory remarks on the video, I note that senior bank officials should be directly involved in managing the Year 2000 project to ensure that it is given the appropriate level of attention and sufficient resources to address the issue on a timely basis. The video can be ordered through the Board's Web site. ## Contingency Planning While we will continue our public outreach efforts, our main focus is preparedness. Because smooth and uninterrupted financial flows are obviously of utmost importance, our main focus is on our readiness and the avoidance of problems. But we know from experience that upon occasion, things can go wrong. Given our unique role as the nation's central bank, the Federal Reserve has always stressed contingency planning -- for both systemic risks as well as operational failures. In this regard, we regularly conduct exhaustive business resumption tests of our major payment systems that include depository institutions. Moreover, as a result of our experience in responding to problems arising from such diverse events as earthquakes, fires, storms, and power outages, as well as liquidity problems in institutions, we expect to be appropriately positioned to deal with similar problems in the financial sector that might arise as a result of CDC. However, CDC presents many unique situations. For example, in the software application arena, the normal contingency of falling back to a prior release of the software is not a viable option. We are, of course, developing specific CDC contingency plans to address various operational scenarios, and our contingency planning includes preparation to address unanticipated problems when we bring our systems into production as Year 2000 begins. Key technical staff will be ready to respond quickly to problems with our computer and network systems. We are establishing procedures with our primary vendors to ensure direct communication and appropriate recourse should their products fail at Federal Reserve installations during Year 2000 date processing. Our existing business resumption plans will be updated to address date-related difficulties that may face the financial industry. We already have arrangements in place to assist financial institutions in the event they are unable to access their own systems. For example, we are able to provide financial institutions with ---[PAGE_BREAK]--- access to Federal Reserve computer terminals on a limited basis for the processing of critical funds transfers. This contingency arrangement has proven highly effective when used from time to time by depository institutions experiencing major hardware/software outages or that have had their operations disrupted due to natural disasters such as the Los Angeles earthquake, hurricane Hugo in the Carolinas, and hurricane Andrew in south Florida. In these cases we worked closely with financial institutions to ensure that adequate supplies of cash were available to the community, and we arranged for our operations to function virtually without interruptions for 24 hours a day during the crisis period. We feel the experience gained from such crises will prove very helpful in the event of similar problems triggered by the century date change. We are formulating responses for augmenting certain functions, such as computer help desk services and off-line funds transfers, to respond to short-term needs for these services. Beyond reliance on a sound plan and effective execution of the plan, the Federal Reserve provides several different payment services, such as Fedwire, ACH, check, and cash; therefore, the banking industry is not totally dependent upon any single system for executing payments. Alternatives are available in the event of a disruption in a segment of the electronic payment system. We recognize that despite their best efforts, some depository institutions may experience operating difficulties, either as a result of their own computer problems or those of their customers, counterparties, or others. These problems could be manifested in a number of ways and would not necessarily involve funding shortfalls. Nevertheless, the Federal Reserve is always prepared to provide information to depository institutions on the balances in their accounts with us throughout the day, so that they can identify shortfalls and seek funding in the market. The Federal Reserve will be prepared to lend in appropriate circumstances and with adequate collateral to depository institutions when market sources of funding are not reasonably available. The terms and conditions of such lending may depend upon the circumstances giving rise to the liquidity shortfall. Our preparations for possible liquidity difficulties also extend to the foreign bank branches and agencies in the U.S. that may be adversely affected directly by their own computer systems or through difficulties caused by the linkage and dependence on their parent bank. Such circumstances would necessitate coordination with the home country supervisor. Moreover, consistent with current policy, foreign central banks will be expected to provide liquidity support to any of their banking organizations that experience a funding shortfall. # Closing Remarks As I indicated at the outset, the Federal Reserve views its Year 2000 preparations with great seriousness. As such, we have placed a high priority on the remediation of date problems in our systems and the development of action plans that will ensure business continuity for the critical financial systems we operate. While we have made significant progress and are on schedule in validating our internal systems and preparing for testing with depository institutions and others using Federal Reserve services, we must work to ensure that our efforts remain on schedule and that problems are addressed in a timely fashion. In particular, we will be paying special attention to the testing needs of depository institutions and the financial industry and are prepared to adjust our support for them as required by experience. We believe that we are well-positioned to meet our objectives and will remain vigilant throughout the process. As a bank supervisor, the Federal Reserve will continue to address the industry's preparedness, monitor progress, and target for special supervisory attention those organizations that are most in need of assistance. Lastly, we will continue to participate in international forums with the expectation that these efforts will help foster an international awareness of Year 2000 issues and provide for the sharing of experiences, ideas, and best practices.	Edward W Kelley, Jr	United States	https://www.bis.org/review/r971119a.pdf	I am pleased to appear before the Committee today to discuss the Federal Reserve's efforts to address the Year 2000 computer systems issue. The Federal Reserve System has developed and is executing a comprehensive plan to ensure its own Year 2000 readiness and the bank supervision function is well along in a cooperative, interagency effort, to promote timely remediation and testing by the banking industry. This afternoon I will focus on actions being taken by the Federal Reserve System to address our internal systems, coordination with the industry, and contingency planning. The Federal Reserve operates several payments applications that process and settle payments and securities transactions between depository institutions in the United States. Three of these applications are the Fedwire funds transfer, Fedwire securities transfer, and Automated Clearing House (ACH) applications. The first two applications are large-value payments mechanisms for U.S. dollar interbank funds transfers and U.S. government securities transfers. Users of the applications are primarily depository institutions and government agencies. The Fedwire funds transfer system is a real-time credit transfer system used primarily for payments related to interbank funds transfers such as Fed funds transactions, interbank settlement transactions, and "third-party" payments between the customers of depository institutions. Funds transferred over Fedwire are immediately final; they cannot be revoked after they have been accepted and processed by the Federal Reserve. About 10,000 depository institutions use the Fedwire funds transfer system to transfer each year approximately 86 million payments valued at over $\$ 280$ trillion. The current average total daily value of Fedwire funds transfers is approximately $\$ 1.1$ trillion. The Fedwire securities transfer system supports the safekeeping, clearing, and settlement of U.S. government securities in both the primary and secondary markets. It provides custody of U.S. government securities in book-entry form, as well as the transfer of securities ownership among market participants. On the custody side, the system calculates and credits interest and principal payments to the holders of securities, reconciles outstanding securities balances with issuers, and performs other record keeping and collateral safekeeping functions. On the transfer side, the system delivers book-entry securities against a simultaneous payment, called delivery-versus-payment, thus reducing the settlement risks of market participants. About 8,000 depository institutions use the Fedwire securities transfer service to transfer each year approximately 13 million securities valued at over $\$ 160$ trillion. The average total daily value of Fedwire securities transfers is about $\$ 650$ billion. The ACH is an electronic payment service that supports both credit and debit transactions and is used by approximately 14,000 financial institutions, 400,000 companies, and an estimated 50 million consumers. Typical credit transactions include direct deposit of payroll and corporate payments to suppliers. Typical debit transactions include the collection of mortgage and loan payments and corporate cash concentration transactions. The ACH processes transactions in batches one or two days before they are scheduled to settle. ACH transactions are settled through depository institutions' accounts at the Federal Reserve Banks. Approximately 4 billion ACH transactions were processed in 1996 with a total value of approximately $\$ 12$ trillion. About 3.3 billion of these payments were commercial transactions; 625 million payments were originated by the Federal government. The Reserve Banks' critical applications, such as Fedwire funds and securities transfer, ACH , and supporting accounting systems, run on mainframe computer systems operated by Federal Reserve Automation Services (FRAS), the internal organizational unit that processes applications on behalf of the Federal Reserve Banks and operates the Federal Reserve's national network. These critical applications are "centralized", that is, one copy of the application is used by all twelve Reserve Banks. In addition to centralized applications on the mainframe, the Federal Reserve Banks operate a range of applications in a distributed computing environment, supporting business functions such as cash distribution, banking supervision and regulation, research, public information, and human resources. The Reserve Banks also operate check processing systems that provide check services to depository institutions and the U.S. government. A national communications network, called FEDNET, supports the exchange of information among the Reserve Banks, FRAS, and external organizations. The scope of the Federal Reserve's Year 2000 activities includes all of these processing environments and the supporting telecommunications network. It is crucial that the Federal Reserve provide reliable services to the nation's banking system and financial markets. The Federal Reserve is giving the Year 2000 its highest priority, commensurate with our goal of maintaining the stability of the nation's financial markets and payments systems, preserving public confidence, and supporting reliable government operations. We are taking a comprehensive approach to our preparedness which includes assessments of readiness, remediation, and testing. The Federal Reserve has completed application assessments and internal test plans, and we are currently renovating and testing software. We are also updating proven plans and techniques used during other times of operational stress in order to be prepared to address potential century date change difficulties. All Federal Reserve computer program changes, as well as system and user-acceptance testing, are scheduled to be completed by year-end 1998. Further, critical financial services systems that interface with the depository institutions will be Year 2000-ready by mid-1998. This schedule will permit approximately 18 months for customer testing, to which we are dedicating considerable support resources. A large cadre of top personnel in the Federal Reserve System have been assigned to this task. Our staff is putting in many extra hours to prepare for testing with customers, planning for business continuity in the event of any unanticipated problems with internal systems, and enhancing our ability to respond to possible Year 2000-related operating failures of depository institutions. Assuring compliance internally is requiring review of approximately 90 million lines of computer code. While there are challenges and a great deal of work before us, I can report that we expect to be fully prepared for the century date change. The Federal Reserve recognized the potential problem with two-digit date fields more than five years ago when we began consolidating our mainframe data processing operations. Our new centralized mission-critical applications, such as Fedwire funds transfer, Fedwire securities transfer, and ACH , were designed from inception with Year 2000 compliance in mind. The mainframe consolidation effort also necessitated extensive application standardization, which required us to complete a comprehensive inventory of our mainframe applications, a necessary first step to effective remediation. Like our counterparts in the private sector, the Federal Reserve System still faces substantial challenges in achieving Year 2000 readiness. These challenges include managing a highly complex project involving multiple interfaces with others, ensuring the readiness of vendor components, ensuring the readiness of applications, thorough testing, and establishing contingency plans. We are also faced with labor market pressures that call for creative measures to retain staff who are critical to the success of our Year 2000 activities. According to industry experts, up to one-quarter of an organization's Year 2000 compliance efforts are devoted to project management. Managing preparations for the century date change is particularly resource-intensive given the number of automated systems to be addressed, systems interrelationships and interdependencies, interfaces with external data sources and customers, and testing requirements. In addition, Year 2000 preparations must address many computerized environmental and facilities management systems such as power, heating and cooling, voice communications, elevators, and vaults. Our Year 2000 project is being closely coordinated among the Reserve Banks, the Board of Governors, numerous vendors and service providers, approximately 13,000 customers, and government agencies. In 1995, a Federal Reserve System-wide project was initiated, referred to as the Century Date Change (CDC) project, to coordinate the efforts of the Reserve Banks, FRAS, and the Board of Governors. Our project team is taking a three-part approach to achieve its objectives, focusing on planning, readiness, communication, and monitoring. Our planning began with a careful inventory of all applications and establishment of schedules and support mechanisms to ensure that readiness objectives are met. The readiness process involves performing risk assessments, modifying automated systems, and testing both internally and with depository institutions, service providers, and government agencies. We are stressing effective, consistent, and timely communication, both internal and external, to promote awareness and commitment at all levels of our own organization and the financial services industry, more generally. Some of our most senior executives are leading the project, and the Board and senior Bank management are now receiving formal, detailed status reports at least every 60 days. Any significant compliance issues will be reported to the Board immediately. The Reserve Banks' internal audit departments and the Board's oversight staff are also closely monitoring progress. A significant challenge in meeting our Year 2000 readiness objectives is our reliance on commercial hardware and software products and services. Much of our information processing and communications infrastructure is comprised of hardware and software products from third-party vendors. Additionally, the Federal Reserve utilizes commercial application software products and services for certain administrative functions and other operations. As a result, we must coordinate with numerous vendors and manufacturers to ensure that all of our hardware, software, and services are Year 2000-ready. In many cases, compliance will require upgrading, or even replacing, equipment and software. We have a complete inventory of vendor components used in our mainframe and distributed computing environments, and vendor coordination and system change are progressing well. These preparations also include careful attention to the Year 2000 readiness of telecommunications providers. As we continue to assess our systems for Year 2000 readiness, we are well along in preparing a special central environment for testing our payment system applications. We are establishing isolated mainframe data processing environments to be used for internal testing of all system components as well as for testing with depository institutions and other government agencies. These environments will enable testing for high-risk dates, such as the rollover to the year 2000 and leap year processing. Testing will be conducted through a combination of future-dating our computer systems to verify the readiness of our infrastructure, and testing critical future dates within interfaces to other institutions. Our test environments will be configured to provide flexible and nearly continuous access by customers. Network communications components are also being tested and certified in a special test lab environment at FRAS. The testing effort for Year 2000 readiness within the Federal Reserve will be extensive and complex. Industry experts estimate that testing for readiness will consume more than half of total Year 2000 project resources. To leverage existing resources and processes, we are modelling our Year 2000 testing on proven testing methods and processes. Our customers are already familiar with these processes and the testing environment. We shared our testing strategy with depository institutions in October of this year, and we are currently developing a coordinated test schedule. As I noted earlier, the Reserve Banks are targeting June 1998 to commence testing with their depository institution customers, which allows an 18 -month time period for depository institutions to test their systems with the Federal Reserve. All of these activities require that we retain highly skilled staff critical to the success of the project. As I mentioned earlier, we have placed the highest priority on our CDC project, and, as such, have allocated many of the best managers and technical staff in the Federal Reserve System to work on the project. The information technology industry is already experiencing market pressures due to the increased demand for technical talent. As the millennium draws closer, the global market requirements for qualified personnel will intensify even further. We are responding as necessary to these market-induced pressures by implementing programs to retain staff members in critical, high-demand positions. Our focus at the Board goes beyond the immediate need to prepare our systems and ensure reliable operation of the payments infrastructure. We are also working hard to address the supervisory issues raised by Year 2000 and are developing contingency plans which I will discuss later. As a bank supervisor, the Federal Reserve has worked closely with the other supervisory agencies that are part of the Federal Financial Institutions Examination Council (FFIEC) to alert the industry to our concerns and to monitor Year 2000 preparations of the institutions we supervise so that we can identify early and address problems that arise. Comptroller of the Currency Ludwig is testifying today as Chairman of the FFIEC to describe the interagency Year 2000 supervisory initiatives of all of the five member agencies (Federal Reserve, OCC, FDIC, OTS and NCUA), so I will limit my comments on the Federal Reserve's supervisory efforts. In May of this year, the Federal Reserve and the other regulatory agencies developed a uniform Year 2000 assessment questionnaire to collect information on a national basis. Based on the responses and other information, we believe the banking industry's awareness level improved substantially during 1997 and is reflected in the intensified project management, planning, budgeting, and renovation efforts that have been initiated. Generally speaking, the nation's largest banking organizations have done much to address the issues and have devoted significant financial and human resources to preparing for the century date change. Many larger banks are already renovating their operating systems and have commenced testing of their critical applications. Large organizations seem generally capable of renovating their critical operating systems by year-end 1998, and will have their testing well underway by then. Smaller banks, including the U.S. offices of foreign banks and those dependent on a third party to provide their computer services, are generally aware of the issues and are working on the problem; however, their progress is less measurable and is being carefully monitored. We are directing significant attention to ensure that these banks intensify their efforts to prepare for the Year 2000 . Major third-party service providers and software vendors serving the banking industry are acutely aware of the issue and are working diligently to address it. Most of these suppliers consider their Year 2000 capability to be a business survival issue, as it is of critical importance to their ability to remain competitive in an aggressive industry. By mid-year 1998 we will have conducted a thorough Year 2000 preparedness examination of every bank, U.S. branch and agency of a foreign bank, and service provider that we supervise. Our examination program includes a review of each organization's Year 2000 project management plans in order to evaluate their sufficiency, to ensure the direct involvement of senior management and the board of directors, and to monitor their progress against the plan. As we proceed through the examination process, we are identifying any institutions that require intensified supervisory attention and establishing our priorities for subsequent examinations. With regard to the international aspects of the Year 2000 issue, U.S. offices of foreign banks pose a unique set of challenges. We are concerned about the possibility that some offices may not have an adequate appreciation of the magnitude and ramifications of the problem, and may not as yet have committed the resources necessary to address the issues effectively. This is a particular concern for foreign bank offices that are dependent on their foreign parent bank for information processing systems. In addition, we are increasingly concerned that the foreign branches of U.S. banks may be adversely affected if counterparties in foreign markets are not ready for the Year 2000. Therefore, we are working through the Bank for International Settlements’ (BIS) Committee on Banking Supervision, composed of many of the international supervisory agencies responsible for the foreign banks that operate in the United States. Through formal and informal discussions, the distribution of several interagency statements and advisories, and the Federal Reserve's Year 2000 video (see below) to the BIS supervisors committee, we have sought to elevate foreign bank supervisors' awareness of the risks posed by the century date change. The G-10 governors issued an advisory in September that included a paper by the bank supervisors committee on the Year 2000 challenge to banks and bank supervisors around the world to ensure a higher level of awareness and activity on their part. The BIS supervisors committee has developed a survey sent to about 40 countries to collect better information on the state of readiness of banks in those countries and the extent of the efforts of the bank supervisors to address the issues locally and internationally. The surveys will be evaluated and the findings distributed early next year. Also on the international front, William McDonough, President of the Federal Reserve Bank of New York, in a keynote address to the annual meeting of the Institute of International Finance in Hong Kong, emphasized the importance of planning for the century date change on an international basis and the significant risk to financial markets posed by the Year 2000. We also participated in the BIS meeting sponsored by the Committee on Payments and Settlement Systems and the Group of Computer Experts for G-10 and major non-G-10 central banks in September which provided a forum to share views on and approaches to dealing with Year 2000 issues, and we have been active in various private sector forums. The majority of foreign central banks are confident that payment and settlement applications under their management will be Year 2000-ready. Like the Federal Reserve, however, the operation of foreign central bank payment systems is dependent on compliant products from hardware and software suppliers and the readiness of telecommunication service providers. The approach of foreign central banks toward raising bank industry awareness varies widely. Information garnered from this meeting and similar meetings planned for the future will assist the BIS Committee on Payment and Settlement Systems, as well as the Federal Reserve, in understanding the state of preparedness of payment systems on a global level. We are mindful that extensive communication with the industry and the public is crucial to the success of century date change efforts. Our public awareness program concentrates on communications with the financial services industry related to our testing efforts and our overall concerns about the industry's readiness. We continue to advise our bank customers of the Federal Reserve's plans and time frames for making our software Year 2000-ready. We have inaugurated a Year 2000 industry newsletter and have just published our first bulletin addressing specific technical issues. We would be glad to provide you with copies of our recent newsletter and the bulletin. We have also established an Internet Web site to provide depository institutions with information regarding the Federal Reserve System's CDC project. This site can be accessed at the following Internet address: http://www.frbsf.org/fiservices/cdc. On behalf of the FFIEC, the Federal Reserve has developed a Year 2000 information distribution system, including an Internet Web site and a toll free Fax Back service (888-882-0982). The Web site provides easy access to policy statements, guidance to examiners, and paths to other Year 2000 Web sites available from numerous other sources. The FFIEC Year 2000 Web site can be accessed at the following Internet address: http://www.ffiec.gov/y2k. The Federal Reserve has also produced a ten-minute video entitled "Year 2000 Executive Awareness" intended for viewing by a bank's board of directors and senior management. The video presents a summary of the Year 2000 five-phase project management plan outlined in the interagency policy statement. In my introductory remarks on the video, I note that senior bank officials should be directly involved in managing the Year 2000 project to ensure that it is given the appropriate level of attention and sufficient resources to address the issue on a timely basis. The video can be ordered through the Board's Web site. While we will continue our public outreach efforts, our main focus is preparedness. Because smooth and uninterrupted financial flows are obviously of utmost importance, our main focus is on our readiness and the avoidance of problems. But we know from experience that upon occasion, things can go wrong. Given our unique role as the nation's central bank, the Federal Reserve has always stressed contingency planning -- for both systemic risks as well as operational failures. In this regard, we regularly conduct exhaustive business resumption tests of our major payment systems that include depository institutions. Moreover, as a result of our experience in responding to problems arising from such diverse events as earthquakes, fires, storms, and power outages, as well as liquidity problems in institutions, we expect to be appropriately positioned to deal with similar problems in the financial sector that might arise as a result of CDC. However, CDC presents many unique situations. For example, in the software application arena, the normal contingency of falling back to a prior release of the software is not a viable option. We are, of course, developing specific CDC contingency plans to address various operational scenarios, and our contingency planning includes preparation to address unanticipated problems when we bring our systems into production as Year 2000 begins. Key technical staff will be ready to respond quickly to problems with our computer and network systems. We are establishing procedures with our primary vendors to ensure direct communication and appropriate recourse should their products fail at Federal Reserve installations during Year 2000 date processing. Our existing business resumption plans will be updated to address date-related difficulties that may face the financial industry. We already have arrangements in place to assist financial institutions in the event they are unable to access their own systems. For example, we are able to provide financial institutions with access to Federal Reserve computer terminals on a limited basis for the processing of critical funds transfers. This contingency arrangement has proven highly effective when used from time to time by depository institutions experiencing major hardware/software outages or that have had their operations disrupted due to natural disasters such as the Los Angeles earthquake, hurricane Hugo in the Carolinas, and hurricane Andrew in south Florida. In these cases we worked closely with financial institutions to ensure that adequate supplies of cash were available to the community, and we arranged for our operations to function virtually without interruptions for 24 hours a day during the crisis period. We feel the experience gained from such crises will prove very helpful in the event of similar problems triggered by the century date change. We are formulating responses for augmenting certain functions, such as computer help desk services and off-line funds transfers, to respond to short-term needs for these services. Beyond reliance on a sound plan and effective execution of the plan, the Federal Reserve provides several different payment services, such as Fedwire, ACH, check, and cash; therefore, the banking industry is not totally dependent upon any single system for executing payments. Alternatives are available in the event of a disruption in a segment of the electronic payment system. We recognize that despite their best efforts, some depository institutions may experience operating difficulties, either as a result of their own computer problems or those of their customers, counterparties, or others. These problems could be manifested in a number of ways and would not necessarily involve funding shortfalls. Nevertheless, the Federal Reserve is always prepared to provide information to depository institutions on the balances in their accounts with us throughout the day, so that they can identify shortfalls and seek funding in the market. The Federal Reserve will be prepared to lend in appropriate circumstances and with adequate collateral to depository institutions when market sources of funding are not reasonably available. The terms and conditions of such lending may depend upon the circumstances giving rise to the liquidity shortfall. Our preparations for possible liquidity difficulties also extend to the foreign bank branches and agencies in the U.S. that may be adversely affected directly by their own computer systems or through difficulties caused by the linkage and dependence on their parent bank. Such circumstances would necessitate coordination with the home country supervisor. Moreover, consistent with current policy, foreign central banks will be expected to provide liquidity support to any of their banking organizations that experience a funding shortfall. As I indicated at the outset, the Federal Reserve views its Year 2000 preparations with great seriousness. As such, we have placed a high priority on the remediation of date problems in our systems and the development of action plans that will ensure business continuity for the critical financial systems we operate. While we have made significant progress and are on schedule in validating our internal systems and preparing for testing with depository institutions and others using Federal Reserve services, we must work to ensure that our efforts remain on schedule and that problems are addressed in a timely fashion. In particular, we will be paying special attention to the testing needs of depository institutions and the financial industry and are prepared to adjust our support for them as required by experience. We believe that we are well-positioned to meet our objectives and will remain vigilant throughout the process. As a bank supervisor, the Federal Reserve will continue to address the industry's preparedness, monitor progress, and target for special supervisory attention those organizations that are most in need of assistance. Lastly, we will continue to participate in international forums with the expectation that these efforts will help foster an international awareness of Year 2000 issues and provide for the sharing of experiences, ideas, and best practices.
1997-11-07T00:00:00	Mr. Greenspan's remarks at the Center for Financial Studies in Frankfurt (Central Bank Articles and Speeches, 7 Nov 97)	Remarks by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the Center for Financial Studies in Frankfurt-am-Main, on 7/11/97.	Mr. Greenspan's remarks at the Center for Financial Studies in Frankfurt Remarks by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the Center for Financial Studies in Frankfurt-am-Main, on 7/11/97. The remarkable progress that has been made by virtually all of the major industrial countries in achieving low rates of inflation in recent years has brought into sharper focus the issue of price measurement. As we move closer to price stability, the necessity of measuring prices accurately has become an especial challenge. Biases of a few tenths in annual inflation rates do not matter when inflation is high. They do matter when, as now, a debate has emerged over whether our economies are moving toward price deflation. In today's advanced economies, allocative decisions are primarily made not by governments but by markets, and the central guide to the efficient allocation of resources in a market economy is prices. Prices are the signals through which tastes and technology affect the decisions of consumers and producers, directing resources toward their highest valued use. Of course, this signaling process would work with or without government statistical agencies that measure individual and aggregate price levels, and in this sense, price measurement probably is not fundamental for the overall efficiency of the market economy. Indeed, vibrant market economies existed long before government agencies were established to measure prices. Nonetheless, in a modern monetary economy, accurate price measurement is of considerable importance, increasingly so for central banks whose mandate is to maintain financial stability. Accurate price measures are necessary for understanding economic developments, not only involving inflation but also involving real output and productivity. If the general price level is estimated to be rising more rapidly than is in fact the case, then we are simultaneously understating growth in real output and productivity. Real incomes and living standards are rising faster than our published data suggest. Under these circumstances, policymakers must be cognizant of the shortcomings of our published price indexes to avoid misguided actions that will provoke unintended consequences. Clearly, central bankers need to be conscious of the problems of price measurement as we gauge policies designed to promote price stability and maximum sustainable economic growth. Moreover, many economic transactions, both private and public, are explicitly tied to movements in some published price index, most commonly a consumer price index; and some transactions that are not explicitly tied to a published price index may nevertheless take such an index into account less formally. If the price index is not accurately measuring what the participants in such transactions believe it is measuring, then economic transactions will be skewed. The measured price indexes have played an especially prominent role in Germany, both in terms of public perceptions of inflation performance and as a guide for policymakers. The Bundesbank's long-standing commitment to price stability and the public's support for that commitment derive at least to some extent from Germany's experiences with hyperinflation earlier this century. Given this experience with the devastation that such inflation can bring to the economy and to people's lives, it comes as no surprise that your public and your policymakers give such careful scrutiny to the available measures of inflation. Germany has a reputation for special vigilance in guarding the stability of the price level and has achieved an admirable record of success in maintaining low inflation over the postwar period. From the standpoint of monetary policy, this very success makes accurate price measurement all the more important. When measured inflation is high, we can be confident that the proper direction of monetary policy is to bring inflation lower. But when measured inflation is low, the proper direction of monetary policy, as I indicated, could depend crucially on the accuracy of those measurements. The importance of accurate price measurement was particularly apparent during unification, when it became necessary to gauge productivity in East and West Germany on a comparable basis. Initial estimates of East German productivity relative to that of the West were considerably higher than later, more accurate estimates showed to be the case. These differences, we are told, owed largely to - 2 - the difficulties in adjusting the prices of East German products to take into account that they were, on average, of lower quality than the equivalent items produced in the West. In thinking about the problems of price measurement, a distinction must be made between the measurement of individual prices, on the one hand, and the aggregation of those prices into indexes of the overall price level, on the other. The notion of what we mean by a general price level -- or more relevantly, its change -- is never unambiguously defined. Moreover, in practice, aggregation can be complicated because standard price indexes frequently assume that individuals and businesses purchase the same basket of goods and services over time -- whereas, in fact, people substitute some goods for others when relative prices change and as new goods are introduced. How one aggregates individual prices, of course, depends on the purpose of the measure. Still, the problems of aggregation are well understood by economists, and workable solutions are within reach. Many countries have made progress in utilizing aggregation formulas that do take into account product substitutions, and further progress in this area seems likely in the years ahead. It is the measurement of individual prices, not the aggregation of those prices, that is so difficult conceptually. At first glance, observing and measuring prices might not appear especially daunting. After all, prices are at the center of virtually all economic transactions. But, in fact, the problem is extraordinarily complex. To be sure, the nominal value -- in dollars or Deutsche Marks, for example -- of most transactions is unambiguously exact and, at least in principle, is amenable to highly accurate estimation by our statistical agencies. But dividing that nominal value change into components representing changes in real quantity versus price requires that one define a unit of output that is to remain constant over time. Defining such a constant-quality unit of output is the central conceptual difficulty in price measurement. Such a definition may be clear for unalloyed aluminium ingot of 99.7 percent purity for the vast proportion of transactions; consequently, its price can be compared over time with a degree of precision adequate for virtually all producers and consumers of aluminium ingot. Similarly, the prices of a ton of cold rolled steel sheet, or of a linear meter of cotton broad woven fabric, can be reasonably compared over a period of years. But when the characteristics of products and services are changing rapidly, defining the unit of output, and thereby adjusting an item's price for improvements in quality, can be exceptionally difficult. These problems are becoming pervasive in modern economies as service prices, which are generally more difficult to measure, become more prominent in aggregate price measures. One does not have to look to the most advanced technology to recognize the difficulties that are faced. To take just a few examples, automobile tires, refrigerators, winter jackets, and tennis rackets have all changed in ways that make them surprisingly hard to compare to their counterparts of twenty or thirty years ago. The continual introduction of new goods and services onto the markets creates special challenges for price measurement. In some cases, a new good may best be viewed as an improved version of an old good. But, in many cases, new products may deliver services that simply were not available before. When personal computers were first introduced, the benefits they brought households in terms of word processing services, financial calculations, organizational assistance, and the like, were truly unique. The introduction of heart bypass operations literally prolonged many lives by decades. And, further in the past, think of the revolutionary changes that automobile ownership, or jet travel, brought to people's lives. In theory, economists understand how to value such innovations; in practice, it is an enormous challenge to construct such an estimate with any precision. The area of medical care, where technology is changing in ways that make techniques of only a decade ago seem archaic, provides some particularly striking illustrations of the difficulties involved in measuring quality-adjusted prices. Cures and preventive treatments have become available for previously untreatable diseases. Medical advances have led to new treatments that are more effective and that have increased the speed and comfort of recovery. In an area with such rapid technological change, what is the appropriate unit of output? Is it a procedure, a treatment, or a cure? How does one - 3 - value the benefit to the patient when a condition that once required a complicated operation and a lengthy stay in the hospital now can be easily treated on an outpatient basis? Although there is considerable uncertainty, the pace of change and the shift toward output that is difficult to measure are more likely to quicken than to slow down. How, then, will we measure inflation in the future if our measurement techniques become increasingly obsolete? We must keep in mind that, difficult as the problem seems, consistently measured prices do exist in principle. Embodied in all products is some unit of output, and hence of price, that is recognizable to those who buy and sell the product if not to the outside observer. A company that pays a sum of money for computer software knows what it is buying, and at least has an idea about its value relative to software it has purchased in the past, and relative to other possible uses for that sum of money in the present. Furthermore, so long as people continue to exchange nominal interest rate debt instruments and contract for future payments in terms of dollars or other currencies, there must be a presumption about the future purchasing power of money no matter how complex individual products become. Market participants do have a sense of the aggregate price level and how they expect it to change over time, and these views must be embedded in the value of financial assets. The emergence of inflation-indexed bonds, while providing us with useful information, does not solve the problem of ascertaining an economically meaningful measure of the general price level. By necessity, the total return on indexed bonds must be tied to forecasts of specific published price indexes, which may or may not reflect the market's judgement of the future purchasing power of money. To the extent they do not, of course, the implicit real interest rate is biased in the opposite direction. Moreover, we are, as yet, unable to separate compensation for inflation risk from compensation for expected inflation. Eventually, financial markets may develop the instruments and associated analytical techniques for unearthing these implicit changes in the price level with some precision. In those circumstances, then -- at least for purposes of monetary policy -- these measures could obviate the more traditional approaches to aggregate price measurement now employed. They may help us understand, for example, whether markets perceive the true change in aggregate prices to reflect fixed or variable weight indexes of the components or whether arithmetic or logarithmic weighting of the components is more appropriate. But, for the foreseeable future, we shall have to rely on our statistical agencies to produce the price data necessary to assess economic performance and to make economic policy. In that regard, assuming further advances in economic science and provided that our statistical agencies receive adequate resources, procedures should continue to improve. To be sure, progress will not be easy for estimating the value of quality improvements is a painstaking process. It must be done methodically, item by item. But progress can be made. One improvement that has been made in recent years is a better ability to capture quality differences by pricing the underlying characteristics of complex products. With an increasingly wide range of product variants available to the public, product characteristics are now bundled together in an enormous variety of combinations. A "personal computer" is, in actuality, an amalgamation of computing speed, memory, networking capability, graphics capability, and so on. Computer manufacturers are moving toward build-to-order systems, in which any combination of these specifications and peripheral equipment is available to each individual buyer. Other examples abound. Advancements in computer-assisted design have reduced the costs of producing multiple varieties of small machine tools. The variety of commercial aircraft is much larger now than it was twenty years ago. And in services, witness the plethora of products now available from financial institutions, which have allowed a more complete disentangling and exchange of economic risks across participants around the world. Although hard data are scarce, there can be little doubt that products are tailor-made for the buyer to a larger extent than ever. Gone are the days when Henry Ford could say he would sell a car of any color "so long as it's black". - 4 - In such an environment, when product characteristics are bundled together in so many different combinations, defining the unit of output means unbundling these characteristics and pricing each of them separately. The so-called hedonic technique is designed to do precisely that. This technique associates changes in a product's price with changes in product characteristics. It therefore allows a quality comparison when new products with improved characteristics are introduced. Not surprisingly, one area in which this approach has been especially useful is in computer technology. In the United States, prior to the mid-1980s, computer prices simply were held constant in the national accounts. Now, with the introduction of hedonic techniques, the accounts show computer prices declining at double-digit rates, surely a more accurate estimate of the true quality-adjusted price change. The few other countries that have introduced these techniques -- France being the most recent -- show computer prices declining much more rapidly than in the majority of countries that have not yet done so. But hedonics are by no means a panacea. First of all, this technique obviously will be of no use in valuing the quality of an entirely new product that has fundamentally different characteristics from its predecessors. The benefits of cellular telephones, and the value they provide in terms of making calls from any location, cannot be measured from an examination of the attributes of standard telephones. In addition, the measured characteristics may only be proxies for the overall performance that consumers ultimately value. In the case of computers, the buyer ultimately cares about the quality of services that computer will provide -- word processing capabilities, database services, high-speed calculations, and so on. But, in many cases, the number of message instructions per second and the other easily measured characteristics may not be a wholly adequate proxy for the computer services that the buyer values. In these circumstances, the right approach, ultimately, may be to move toward directly pricing the services we obtain from our computers -- that is, word processing services, database management services, and so on -- rather than pricing separately the hardware and software. The issues surrounding the appropriate measurement of computer prices also illustrate some of the difficulties of valuing goods and services when there are significant interactions among users of the products. New generations of computers sometimes require software that is incompatible with previous generations, and some users who have no need for the improved computing power nevertheless may feel compelled to purchase the new technology because they need to remain compatible with the bulk of users who are at the frontier. Even if our techniques allow us to accurately measure consumers' valuation of the increased speed and power of the new generation of computer, we may miss the negative influence on some consumers of this incompatibility. Therefore, even in the case of personal computers, where we have made such great strides in measuring quality changes, I suspect that important phenomena still may not be adequately captured by our published price indexes. Despite the advances in price measurement that have been made over the years, there remains considerable room for improvement. In the United States, a group of experts empanelled by the Senate Finance Committee -- the Boskin commission -- concluded that the consumer price index has overstated changes in the cost of living by roughly one percentage point per annum in recent years. About half of this bias owed to inadequate adjustment for quality improvement and the introduction of new goods, and about half reflected the manner in which the individual prices were aggregated. Researchers at the Federal Reserve and elsewhere have come up with similar figures. Although the estimates of bias owing to inadequate adjustment for quality improvements surely are the most uncertain aspect of this calculation, the preponderance of evidence is that, on average, such a bias in quality adjustment does exist. The Boskin commission, along with most other estimates of bias in the U.S. CPI, have taken a micro-statistical approach, estimating separately the magnitude of each category of potential bias. Recent work by staff economists at the Federal Reserve Board has added corroborating evidence of price mis-measurement, using a macroeconomic approach that is essentially independent of the - 5 - micro-statistical exercises. Specifically, employing disaggregated data from the national income and product accounts, this research finds that the measured growth of real output and productivity in the service sector is implausibly weak, given that the return to owners of businesses in that sector apparently has been well-maintained. Indeed, the published data indicate that the level of output per hour in a number of service-producing industries has been falling for more than two decades. It is simply not credible that firms in these industries have been becoming less and less efficient for more than twenty years. Much more reasonable is the view that prices have been mis-measured and that the true quality-adjusted prices have been rising more slowly than the published price indexes. Properly measured, output and productivity trends in these service industries might be considerably stronger than suggested by the published data. Assuming, for example, no change in productivity for these industries would imply a price bias consistent with the Boskin commission findings. Of course, the United States is not the only country that faces challenges in constructing an accurate measure of inflation. Other countries -- Germany among them -- confront similar issues. In a recent survey of consumer price indexes in its member countries, the OECD found that most countries felt that measurement bias was smaller in magnitude in their own countries than in the United States. Certainly regarding quality adjustment, however, I doubt that this is generally the case. Many countries' responses were prepared by the countries' statistical agencies, which tend to take a somewhat more sanguine view of the adequacy of the existing price statistics than do outside economists. But, in any case, the OECD survey did indicate that many countries reported that measurement bias was a concern and that most countries do not adequately adjust their statistics for quality improvements. Indeed, as I noted previously, most European countries still have yet to adopt the most up-to-date techniques for measuring computer prices in their national accounts. As the OECD survey recognized, the challenges presented by rapid technological advances have affected all of us -- not just the United States. Thus, potential sources of measurement bias should be seriously examined in all countries. Indeed, issues of price measurement may be especially important for the European countries entering into monetary union. For a region with a single monetary policy, a single, consistently estimated measure of inflation is necessary to gauge the region's economic performance. Toward that end, as you know, Eurostat publishes harmonized indexes of consumer prices that are constructed using a common basket of goods and services for each EU member state and using similar statistical methodology. These measures should go a long way toward providing a conceptually sound basis for judging convergence of EU member states in the selection of countries to participate in monetary union. Subsequent to monetary union, harmonized consumer prices can be used as the best available measure of inflation in the Euro area. However, as it now stands, the harmonized measures do not contain a broad coverage of consumer services. Most notably, the costs of owner-occupied housing -- a sizable share of consumer expenditures -- are excluded from the harmonized indexes. In the United States, for example, the CPI calculated on this harmonized basis would have increased three or four tenths of a percentage point more slowly than the published CPI, on average, over the past few years, largely because prices of owner-occupied housing have been rising more rapidly than the other components. Arguably, the published index, with broader coverage, is more relevant to assessing inflation trends in the United States than would be the harmonized index. As long as relative prices can and do diverge across countries, the harmonized indexes need to contain as broad a range of items as is practical. As monetary union proceeds, then, it would be to the advantage of monetary authorities in the Euro area to have a consistent measure of inflation defined over a broad basket of goods and services that is measured according to established statistical methods. Most useful would be for the member countries to continue the harmonization process until the national statistical agencies are truly working on a consistent basis. Indeed, measuring prices consistently across countries could be an important step toward making price measurement more accurate everywhere, if harmonization results in each country's best practices being adopted throughout the monetary union. Moreover, different prices of the same tradable good across the community might signal inefficiencies of distribution which were not evident from other sources. - 6 - Harmonization of CPIs in Europe is just one of many examples demonstrating why price measurement techniques cannot be static. With innovation constantly leading to new products, greater variety, and higher quality, the statistical agencies must work ever harder just to stay in place. A government official in the United States once compared a nation's statistical system to a tailor, measuring the economy much as a tailor measures a person for a suit of clothes -- with the difference that, unlike the tailor, the person we are measuring is running while we try to measure him. The only way the system can succeed, he said, is to be just as fast and twice as agile. That is the challenge that lies ahead, and it is, indeed, a large one. There are, however, reasons for optimism. The information revolution, which lies behind so much of the rapid technological change that makes prices difficult to measure, may also play an important role in helping our statistical agencies acquire the necessary speed and agility to better capture the changes taking place in our economies. For example, computers might some day allow our statistical agencies to tap into a great many economic transactions on a nearly real-time basis. Utilizing data from store checkout scanners, which the United States is now investigating, may be an important first step in that direction. But the possibilities offered by information technology for the improvement of price measurement may turn out to be much broader in scope. Just as it is difficult to predict the ways in which technology will change our consumption over time, so is it difficult to predict how economic and statistical science will make creative use of the improved technology. Such advances must be taken to ensure that our economic statistics remain adequate to support the public policy decisions that must be made. If the challenge for our statistical agencies is not to lose in their race against technology, the challenge for policymakers is to make our best judgements about the limitations of the existing statistics, as we design policies to promote the economic well-being of our nations.	---[PAGE_BREAK]--- # Mr. Greenspan's remarks at the Center for Financial Studies in Frankfurt Remarks by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the Center for Financial Studies in Frankfurt-am-Main, on 7/11/97. The remarkable progress that has been made by virtually all of the major industrial countries in achieving low rates of inflation in recent years has brought into sharper focus the issue of price measurement. As we move closer to price stability, the necessity of measuring prices accurately has become an especial challenge. Biases of a few tenths in annual inflation rates do not matter when inflation is high. They do matter when, as now, a debate has emerged over whether our economies are moving toward price deflation. In today's advanced economies, allocative decisions are primarily made not by governments but by markets, and the central guide to the efficient allocation of resources in a market economy is prices. Prices are the signals through which tastes and technology affect the decisions of consumers and producers, directing resources toward their highest valued use. Of course, this signaling process would work with or without government statistical agencies that measure individual and aggregate price levels, and in this sense, price measurement probably is not fundamental for the overall efficiency of the market economy. Indeed, vibrant market economies existed long before government agencies were established to measure prices. Nonetheless, in a modern monetary economy, accurate price measurement is of considerable importance, increasingly so for central banks whose mandate is to maintain financial stability. Accurate price measures are necessary for understanding economic developments, not only involving inflation but also involving real output and productivity. If the general price level is estimated to be rising more rapidly than is in fact the case, then we are simultaneously understating growth in real output and productivity. Real incomes and living standards are rising faster than our published data suggest. Under these circumstances, policymakers must be cognizant of the shortcomings of our published price indexes to avoid misguided actions that will provoke unintended consequences. Clearly, central bankers need to be conscious of the problems of price measurement as we gauge policies designed to promote price stability and maximum sustainable economic growth. Moreover, many economic transactions, both private and public, are explicitly tied to movements in some published price index, most commonly a consumer price index; and some transactions that are not explicitly tied to a published price index may nevertheless take such an index into account less formally. If the price index is not accurately measuring what the participants in such transactions believe it is measuring, then economic transactions will be skewed. The measured price indexes have played an especially prominent role in Germany, both in terms of public perceptions of inflation performance and as a guide for policymakers. The Bundesbank's long-standing commitment to price stability and the public's support for that commitment derive at least to some extent from Germany's experiences with hyperinflation earlier this century. Given this experience with the devastation that such inflation can bring to the economy and to people's lives, it comes as no surprise that your public and your policymakers give such careful scrutiny to the available measures of inflation. Germany has a reputation for special vigilance in guarding the stability of the price level and has achieved an admirable record of success in maintaining low inflation over the postwar period. From the standpoint of monetary policy, this very success makes accurate price measurement all the more important. When measured inflation is high, we can be confident that the proper direction of monetary policy is to bring inflation lower. But when measured inflation is low, the proper direction of monetary policy, as I indicated, could depend crucially on the accuracy of those measurements. The importance of accurate price measurement was particularly apparent during unification, when it became necessary to gauge productivity in East and West Germany on a comparable basis. Initial estimates of East German productivity relative to that of the West were considerably higher than later, more accurate estimates showed to be the case. These differences, we are told, owed largely to ---[PAGE_BREAK]--- the difficulties in adjusting the prices of East German products to take into account that they were, on average, of lower quality than the equivalent items produced in the West. In thinking about the problems of price measurement, a distinction must be made between the measurement of individual prices, on the one hand, and the aggregation of those prices into indexes of the overall price level, on the other. The notion of what we mean by a general price level -- or more relevantly, its change -- is never unambiguously defined. Moreover, in practice, aggregation can be complicated because standard price indexes frequently assume that individuals and businesses purchase the same basket of goods and services over time -- whereas, in fact, people substitute some goods for others when relative prices change and as new goods are introduced. How one aggregates individual prices, of course, depends on the purpose of the measure. Still, the problems of aggregation are well understood by economists, and workable solutions are within reach. Many countries have made progress in utilizing aggregation formulas that do take into account product substitutions, and further progress in this area seems likely in the years ahead. It is the measurement of individual prices, not the aggregation of those prices, that is so difficult conceptually. At first glance, observing and measuring prices might not appear especially daunting. After all, prices are at the center of virtually all economic transactions. But, in fact, the problem is extraordinarily complex. To be sure, the nominal value -- in dollars or Deutsche Marks, for example -- of most transactions is unambiguously exact and, at least in principle, is amenable to highly accurate estimation by our statistical agencies. But dividing that nominal value change into components representing changes in real quantity versus price requires that one define a unit of output that is to remain constant over time. Defining such a constant-quality unit of output is the central conceptual difficulty in price measurement. Such a definition may be clear for unalloyed aluminium ingot of 99.7 percent purity for the vast proportion of transactions; consequently, its price can be compared over time with a degree of precision adequate for virtually all producers and consumers of aluminium ingot. Similarly, the prices of a ton of cold rolled steel sheet, or of a linear meter of cotton broad woven fabric, can be reasonably compared over a period of years. But when the characteristics of products and services are changing rapidly, defining the unit of output, and thereby adjusting an item's price for improvements in quality, can be exceptionally difficult. These problems are becoming pervasive in modern economies as service prices, which are generally more difficult to measure, become more prominent in aggregate price measures. One does not have to look to the most advanced technology to recognize the difficulties that are faced. To take just a few examples, automobile tires, refrigerators, winter jackets, and tennis rackets have all changed in ways that make them surprisingly hard to compare to their counterparts of twenty or thirty years ago. The continual introduction of new goods and services onto the markets creates special challenges for price measurement. In some cases, a new good may best be viewed as an improved version of an old good. But, in many cases, new products may deliver services that simply were not available before. When personal computers were first introduced, the benefits they brought households in terms of word processing services, financial calculations, organizational assistance, and the like, were truly unique. The introduction of heart bypass operations literally prolonged many lives by decades. And, further in the past, think of the revolutionary changes that automobile ownership, or jet travel, brought to people's lives. In theory, economists understand how to value such innovations; in practice, it is an enormous challenge to construct such an estimate with any precision. The area of medical care, where technology is changing in ways that make techniques of only a decade ago seem archaic, provides some particularly striking illustrations of the difficulties involved in measuring quality-adjusted prices. Cures and preventive treatments have become available for previously untreatable diseases. Medical advances have led to new treatments that are more effective and that have increased the speed and comfort of recovery. In an area with such rapid technological change, what is the appropriate unit of output? Is it a procedure, a treatment, or a cure? How does one ---[PAGE_BREAK]--- value the benefit to the patient when a condition that once required a complicated operation and a lengthy stay in the hospital now can be easily treated on an outpatient basis? Although there is considerable uncertainty, the pace of change and the shift toward output that is difficult to measure are more likely to quicken than to slow down. How, then, will we measure inflation in the future if our measurement techniques become increasingly obsolete? We must keep in mind that, difficult as the problem seems, consistently measured prices do exist in principle. Embodied in all products is some unit of output, and hence of price, that is recognizable to those who buy and sell the product if not to the outside observer. A company that pays a sum of money for computer software knows what it is buying, and at least has an idea about its value relative to software it has purchased in the past, and relative to other possible uses for that sum of money in the present. Furthermore, so long as people continue to exchange nominal interest rate debt instruments and contract for future payments in terms of dollars or other currencies, there must be a presumption about the future purchasing power of money no matter how complex individual products become. Market participants do have a sense of the aggregate price level and how they expect it to change over time, and these views must be embedded in the value of financial assets. The emergence of inflation-indexed bonds, while providing us with useful information, does not solve the problem of ascertaining an economically meaningful measure of the general price level. By necessity, the total return on indexed bonds must be tied to forecasts of specific published price indexes, which may or may not reflect the market's judgement of the future purchasing power of money. To the extent they do not, of course, the implicit real interest rate is biased in the opposite direction. Moreover, we are, as yet, unable to separate compensation for inflation risk from compensation for expected inflation. Eventually, financial markets may develop the instruments and associated analytical techniques for unearthing these implicit changes in the price level with some precision. In those circumstances, then -- at least for purposes of monetary policy -- these measures could obviate the more traditional approaches to aggregate price measurement now employed. They may help us understand, for example, whether markets perceive the true change in aggregate prices to reflect fixed or variable weight indexes of the components or whether arithmetic or logarithmic weighting of the components is more appropriate. But, for the foreseeable future, we shall have to rely on our statistical agencies to produce the price data necessary to assess economic performance and to make economic policy. In that regard, assuming further advances in economic science and provided that our statistical agencies receive adequate resources, procedures should continue to improve. To be sure, progress will not be easy for estimating the value of quality improvements is a painstaking process. It must be done methodically, item by item. But progress can be made. One improvement that has been made in recent years is a better ability to capture quality differences by pricing the underlying characteristics of complex products. With an increasingly wide range of product variants available to the public, product characteristics are now bundled together in an enormous variety of combinations. A "personal computer" is, in actuality, an amalgamation of computing speed, memory, networking capability, graphics capability, and so on. Computer manufacturers are moving toward build-to-order systems, in which any combination of these specifications and peripheral equipment is available to each individual buyer. Other examples abound. Advancements in computer-assisted design have reduced the costs of producing multiple varieties of small machine tools. The variety of commercial aircraft is much larger now than it was twenty years ago. And in services, witness the plethora of products now available from financial institutions, which have allowed a more complete disentangling and exchange of economic risks across participants around the world. Although hard data are scarce, there can be little doubt that products are tailor-made for the buyer to a larger extent than ever. Gone are the days when Henry Ford could say he would sell a car of any color "so long as it's black". ---[PAGE_BREAK]--- In such an environment, when product characteristics are bundled together in so many different combinations, defining the unit of output means unbundling these characteristics and pricing each of them separately. The so-called hedonic technique is designed to do precisely that. This technique associates changes in a product's price with changes in product characteristics. It therefore allows a quality comparison when new products with improved characteristics are introduced. Not surprisingly, one area in which this approach has been especially useful is in computer technology. In the United States, prior to the mid-1980s, computer prices simply were held constant in the national accounts. Now, with the introduction of hedonic techniques, the accounts show computer prices declining at double-digit rates, surely a more accurate estimate of the true quality-adjusted price change. The few other countries that have introduced these techniques -- France being the most recent -- show computer prices declining much more rapidly than in the majority of countries that have not yet done so. But hedonics are by no means a panacea. First of all, this technique obviously will be of no use in valuing the quality of an entirely new product that has fundamentally different characteristics from its predecessors. The benefits of cellular telephones, and the value they provide in terms of making calls from any location, cannot be measured from an examination of the attributes of standard telephones. In addition, the measured characteristics may only be proxies for the overall performance that consumers ultimately value. In the case of computers, the buyer ultimately cares about the quality of services that computer will provide -- word processing capabilities, database services, high-speed calculations, and so on. But, in many cases, the number of message instructions per second and the other easily measured characteristics may not be a wholly adequate proxy for the computer services that the buyer values. In these circumstances, the right approach, ultimately, may be to move toward directly pricing the services we obtain from our computers -- that is, word processing services, database management services, and so on -- rather than pricing separately the hardware and software. The issues surrounding the appropriate measurement of computer prices also illustrate some of the difficulties of valuing goods and services when there are significant interactions among users of the products. New generations of computers sometimes require software that is incompatible with previous generations, and some users who have no need for the improved computing power nevertheless may feel compelled to purchase the new technology because they need to remain compatible with the bulk of users who are at the frontier. Even if our techniques allow us to accurately measure consumers' valuation of the increased speed and power of the new generation of computer, we may miss the negative influence on some consumers of this incompatibility. Therefore, even in the case of personal computers, where we have made such great strides in measuring quality changes, I suspect that important phenomena still may not be adequately captured by our published price indexes. Despite the advances in price measurement that have been made over the years, there remains considerable room for improvement. In the United States, a group of experts empanelled by the Senate Finance Committee -- the Boskin commission -- concluded that the consumer price index has overstated changes in the cost of living by roughly one percentage point per annum in recent years. About half of this bias owed to inadequate adjustment for quality improvement and the introduction of new goods, and about half reflected the manner in which the individual prices were aggregated. Researchers at the Federal Reserve and elsewhere have come up with similar figures. Although the estimates of bias owing to inadequate adjustment for quality improvements surely are the most uncertain aspect of this calculation, the preponderance of evidence is that, on average, such a bias in quality adjustment does exist. The Boskin commission, along with most other estimates of bias in the U.S. CPI, have taken a micro-statistical approach, estimating separately the magnitude of each category of potential bias. Recent work by staff economists at the Federal Reserve Board has added corroborating evidence of price mis-measurement, using a macroeconomic approach that is essentially independent of the ---[PAGE_BREAK]--- micro-statistical exercises. Specifically, employing disaggregated data from the national income and product accounts, this research finds that the measured growth of real output and productivity in the service sector is implausibly weak, given that the return to owners of businesses in that sector apparently has been well-maintained. Indeed, the published data indicate that the level of output per hour in a number of service-producing industries has been falling for more than two decades. It is simply not credible that firms in these industries have been becoming less and less efficient for more than twenty years. Much more reasonable is the view that prices have been mis-measured and that the true quality-adjusted prices have been rising more slowly than the published price indexes. Properly measured, output and productivity trends in these service industries might be considerably stronger than suggested by the published data. Assuming, for example, no change in productivity for these industries would imply a price bias consistent with the Boskin commission findings. Of course, the United States is not the only country that faces challenges in constructing an accurate measure of inflation. Other countries -- Germany among them -- confront similar issues. In a recent survey of consumer price indexes in its member countries, the OECD found that most countries felt that measurement bias was smaller in magnitude in their own countries than in the United States. Certainly regarding quality adjustment, however, I doubt that this is generally the case. Many countries' responses were prepared by the countries' statistical agencies, which tend to take a somewhat more sanguine view of the adequacy of the existing price statistics than do outside economists. But, in any case, the OECD survey did indicate that many countries reported that measurement bias was a concern and that most countries do not adequately adjust their statistics for quality improvements. Indeed, as I noted previously, most European countries still have yet to adopt the most up-to-date techniques for measuring computer prices in their national accounts. As the OECD survey recognized, the challenges presented by rapid technological advances have affected all of us -- not just the United States. Thus, potential sources of measurement bias should be seriously examined in all countries. Indeed, issues of price measurement may be especially important for the European countries entering into monetary union. For a region with a single monetary policy, a single, consistently estimated measure of inflation is necessary to gauge the region's economic performance. Toward that end, as you know, Eurostat publishes harmonized indexes of consumer prices that are constructed using a common basket of goods and services for each EU member state and using similar statistical methodology. These measures should go a long way toward providing a conceptually sound basis for judging convergence of EU member states in the selection of countries to participate in monetary union. Subsequent to monetary union, harmonized consumer prices can be used as the best available measure of inflation in the Euro area. However, as it now stands, the harmonized measures do not contain a broad coverage of consumer services. Most notably, the costs of owner-occupied housing -- a sizable share of consumer expenditures -- are excluded from the harmonized indexes. In the United States, for example, the CPI calculated on this harmonized basis would have increased three or four tenths of a percentage point more slowly than the published CPI, on average, over the past few years, largely because prices of owner-occupied housing have been rising more rapidly than the other components. Arguably, the published index, with broader coverage, is more relevant to assessing inflation trends in the United States than would be the harmonized index. As long as relative prices can and do diverge across countries, the harmonized indexes need to contain as broad a range of items as is practical. As monetary union proceeds, then, it would be to the advantage of monetary authorities in the Euro area to have a consistent measure of inflation defined over a broad basket of goods and services that is measured according to established statistical methods. Most useful would be for the member countries to continue the harmonization process until the national statistical agencies are truly working on a consistent basis. Indeed, measuring prices consistently across countries could be an important step toward making price measurement more accurate everywhere, if harmonization results in each country's best practices being adopted throughout the monetary union. Moreover, different prices of the same tradable good across the community might signal inefficiencies of distribution which were not evident from other sources. ---[PAGE_BREAK]--- Harmonization of CPIs in Europe is just one of many examples demonstrating why price measurement techniques cannot be static. With innovation constantly leading to new products, greater variety, and higher quality, the statistical agencies must work ever harder just to stay in place. A government official in the United States once compared a nation's statistical system to a tailor, measuring the economy much as a tailor measures a person for a suit of clothes -- with the difference that, unlike the tailor, the person we are measuring is running while we try to measure him. The only way the system can succeed, he said, is to be just as fast and twice as agile. That is the challenge that lies ahead, and it is, indeed, a large one. There are, however, reasons for optimism. The information revolution, which lies behind so much of the rapid technological change that makes prices difficult to measure, may also play an important role in helping our statistical agencies acquire the necessary speed and agility to better capture the changes taking place in our economies. For example, computers might some day allow our statistical agencies to tap into a great many economic transactions on a nearly real-time basis. Utilizing data from store checkout scanners, which the United States is now investigating, may be an important first step in that direction. But the possibilities offered by information technology for the improvement of price measurement may turn out to be much broader in scope. Just as it is difficult to predict the ways in which technology will change our consumption over time, so is it difficult to predict how economic and statistical science will make creative use of the improved technology. Such advances must be taken to ensure that our economic statistics remain adequate to support the public policy decisions that must be made. If the challenge for our statistical agencies is not to lose in their race against technology, the challenge for policymakers is to make our best judgements about the limitations of the existing statistics, as we design policies to promote the economic well-being of our nations.	Alan Greenspan	United States	https://www.bis.org/review/r971121c.pdf	Remarks by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the Center for Financial Studies in Frankfurt-am-Main, on 7/11/97. The remarkable progress that has been made by virtually all of the major industrial countries in achieving low rates of inflation in recent years has brought into sharper focus the issue of price measurement. As we move closer to price stability, the necessity of measuring prices accurately has become an especial challenge. Biases of a few tenths in annual inflation rates do not matter when inflation is high. They do matter when, as now, a debate has emerged over whether our economies are moving toward price deflation. In today's advanced economies, allocative decisions are primarily made not by governments but by markets, and the central guide to the efficient allocation of resources in a market economy is prices. Prices are the signals through which tastes and technology affect the decisions of consumers and producers, directing resources toward their highest valued use. Of course, this signaling process would work with or without government statistical agencies that measure individual and aggregate price levels, and in this sense, price measurement probably is not fundamental for the overall efficiency of the market economy. Indeed, vibrant market economies existed long before government agencies were established to measure prices. Nonetheless, in a modern monetary economy, accurate price measurement is of considerable importance, increasingly so for central banks whose mandate is to maintain financial stability. Accurate price measures are necessary for understanding economic developments, not only involving inflation but also involving real output and productivity. If the general price level is estimated to be rising more rapidly than is in fact the case, then we are simultaneously understating growth in real output and productivity. Real incomes and living standards are rising faster than our published data suggest. Under these circumstances, policymakers must be cognizant of the shortcomings of our published price indexes to avoid misguided actions that will provoke unintended consequences. Clearly, central bankers need to be conscious of the problems of price measurement as we gauge policies designed to promote price stability and maximum sustainable economic growth. Moreover, many economic transactions, both private and public, are explicitly tied to movements in some published price index, most commonly a consumer price index; and some transactions that are not explicitly tied to a published price index may nevertheless take such an index into account less formally. If the price index is not accurately measuring what the participants in such transactions believe it is measuring, then economic transactions will be skewed. The measured price indexes have played an especially prominent role in Germany, both in terms of public perceptions of inflation performance and as a guide for policymakers. The Bundesbank's long-standing commitment to price stability and the public's support for that commitment derive at least to some extent from Germany's experiences with hyperinflation earlier this century. Given this experience with the devastation that such inflation can bring to the economy and to people's lives, it comes as no surprise that your public and your policymakers give such careful scrutiny to the available measures of inflation. Germany has a reputation for special vigilance in guarding the stability of the price level and has achieved an admirable record of success in maintaining low inflation over the postwar period. From the standpoint of monetary policy, this very success makes accurate price measurement all the more important. When measured inflation is high, we can be confident that the proper direction of monetary policy is to bring inflation lower. But when measured inflation is low, the proper direction of monetary policy, as I indicated, could depend crucially on the accuracy of those measurements. The importance of accurate price measurement was particularly apparent during unification, when it became necessary to gauge productivity in East and West Germany on a comparable basis. Initial estimates of East German productivity relative to that of the West were considerably higher than later, more accurate estimates showed to be the case. These differences, we are told, owed largely to the difficulties in adjusting the prices of East German products to take into account that they were, on average, of lower quality than the equivalent items produced in the West. In thinking about the problems of price measurement, a distinction must be made between the measurement of individual prices, on the one hand, and the aggregation of those prices into indexes of the overall price level, on the other. The notion of what we mean by a general price level -- or more relevantly, its change -- is never unambiguously defined. Moreover, in practice, aggregation can be complicated because standard price indexes frequently assume that individuals and businesses purchase the same basket of goods and services over time -- whereas, in fact, people substitute some goods for others when relative prices change and as new goods are introduced. How one aggregates individual prices, of course, depends on the purpose of the measure. Still, the problems of aggregation are well understood by economists, and workable solutions are within reach. Many countries have made progress in utilizing aggregation formulas that do take into account product substitutions, and further progress in this area seems likely in the years ahead. It is the measurement of individual prices, not the aggregation of those prices, that is so difficult conceptually. At first glance, observing and measuring prices might not appear especially daunting. After all, prices are at the center of virtually all economic transactions. But, in fact, the problem is extraordinarily complex. To be sure, the nominal value -- in dollars or Deutsche Marks, for example -- of most transactions is unambiguously exact and, at least in principle, is amenable to highly accurate estimation by our statistical agencies. But dividing that nominal value change into components representing changes in real quantity versus price requires that one define a unit of output that is to remain constant over time. Defining such a constant-quality unit of output is the central conceptual difficulty in price measurement. Such a definition may be clear for unalloyed aluminium ingot of 99.7 percent purity for the vast proportion of transactions; consequently, its price can be compared over time with a degree of precision adequate for virtually all producers and consumers of aluminium ingot. Similarly, the prices of a ton of cold rolled steel sheet, or of a linear meter of cotton broad woven fabric, can be reasonably compared over a period of years. But when the characteristics of products and services are changing rapidly, defining the unit of output, and thereby adjusting an item's price for improvements in quality, can be exceptionally difficult. These problems are becoming pervasive in modern economies as service prices, which are generally more difficult to measure, become more prominent in aggregate price measures. One does not have to look to the most advanced technology to recognize the difficulties that are faced. To take just a few examples, automobile tires, refrigerators, winter jackets, and tennis rackets have all changed in ways that make them surprisingly hard to compare to their counterparts of twenty or thirty years ago. The continual introduction of new goods and services onto the markets creates special challenges for price measurement. In some cases, a new good may best be viewed as an improved version of an old good. But, in many cases, new products may deliver services that simply were not available before. When personal computers were first introduced, the benefits they brought households in terms of word processing services, financial calculations, organizational assistance, and the like, were truly unique. The introduction of heart bypass operations literally prolonged many lives by decades. And, further in the past, think of the revolutionary changes that automobile ownership, or jet travel, brought to people's lives. In theory, economists understand how to value such innovations; in practice, it is an enormous challenge to construct such an estimate with any precision. The area of medical care, where technology is changing in ways that make techniques of only a decade ago seem archaic, provides some particularly striking illustrations of the difficulties involved in measuring quality-adjusted prices. Cures and preventive treatments have become available for previously untreatable diseases. Medical advances have led to new treatments that are more effective and that have increased the speed and comfort of recovery. In an area with such rapid technological change, what is the appropriate unit of output? Is it a procedure, a treatment, or a cure? How does one value the benefit to the patient when a condition that once required a complicated operation and a lengthy stay in the hospital now can be easily treated on an outpatient basis? Although there is considerable uncertainty, the pace of change and the shift toward output that is difficult to measure are more likely to quicken than to slow down. How, then, will we measure inflation in the future if our measurement techniques become increasingly obsolete? We must keep in mind that, difficult as the problem seems, consistently measured prices do exist in principle. Embodied in all products is some unit of output, and hence of price, that is recognizable to those who buy and sell the product if not to the outside observer. A company that pays a sum of money for computer software knows what it is buying, and at least has an idea about its value relative to software it has purchased in the past, and relative to other possible uses for that sum of money in the present. Furthermore, so long as people continue to exchange nominal interest rate debt instruments and contract for future payments in terms of dollars or other currencies, there must be a presumption about the future purchasing power of money no matter how complex individual products become. Market participants do have a sense of the aggregate price level and how they expect it to change over time, and these views must be embedded in the value of financial assets. The emergence of inflation-indexed bonds, while providing us with useful information, does not solve the problem of ascertaining an economically meaningful measure of the general price level. By necessity, the total return on indexed bonds must be tied to forecasts of specific published price indexes, which may or may not reflect the market's judgement of the future purchasing power of money. To the extent they do not, of course, the implicit real interest rate is biased in the opposite direction. Moreover, we are, as yet, unable to separate compensation for inflation risk from compensation for expected inflation. Eventually, financial markets may develop the instruments and associated analytical techniques for unearthing these implicit changes in the price level with some precision. In those circumstances, then -- at least for purposes of monetary policy -- these measures could obviate the more traditional approaches to aggregate price measurement now employed. They may help us understand, for example, whether markets perceive the true change in aggregate prices to reflect fixed or variable weight indexes of the components or whether arithmetic or logarithmic weighting of the components is more appropriate. But, for the foreseeable future, we shall have to rely on our statistical agencies to produce the price data necessary to assess economic performance and to make economic policy. In that regard, assuming further advances in economic science and provided that our statistical agencies receive adequate resources, procedures should continue to improve. To be sure, progress will not be easy for estimating the value of quality improvements is a painstaking process. It must be done methodically, item by item. But progress can be made. One improvement that has been made in recent years is a better ability to capture quality differences by pricing the underlying characteristics of complex products. With an increasingly wide range of product variants available to the public, product characteristics are now bundled together in an enormous variety of combinations. A "personal computer" is, in actuality, an amalgamation of computing speed, memory, networking capability, graphics capability, and so on. Computer manufacturers are moving toward build-to-order systems, in which any combination of these specifications and peripheral equipment is available to each individual buyer. Other examples abound. Advancements in computer-assisted design have reduced the costs of producing multiple varieties of small machine tools. The variety of commercial aircraft is much larger now than it was twenty years ago. And in services, witness the plethora of products now available from financial institutions, which have allowed a more complete disentangling and exchange of economic risks across participants around the world. Although hard data are scarce, there can be little doubt that products are tailor-made for the buyer to a larger extent than ever. Gone are the days when Henry Ford could say he would sell a car of any color "so long as it's black". In such an environment, when product characteristics are bundled together in so many different combinations, defining the unit of output means unbundling these characteristics and pricing each of them separately. The so-called hedonic technique is designed to do precisely that. This technique associates changes in a product's price with changes in product characteristics. It therefore allows a quality comparison when new products with improved characteristics are introduced. Not surprisingly, one area in which this approach has been especially useful is in computer technology. In the United States, prior to the mid-1980s, computer prices simply were held constant in the national accounts. Now, with the introduction of hedonic techniques, the accounts show computer prices declining at double-digit rates, surely a more accurate estimate of the true quality-adjusted price change. The few other countries that have introduced these techniques -- France being the most recent -- show computer prices declining much more rapidly than in the majority of countries that have not yet done so. But hedonics are by no means a panacea. First of all, this technique obviously will be of no use in valuing the quality of an entirely new product that has fundamentally different characteristics from its predecessors. The benefits of cellular telephones, and the value they provide in terms of making calls from any location, cannot be measured from an examination of the attributes of standard telephones. In addition, the measured characteristics may only be proxies for the overall performance that consumers ultimately value. In the case of computers, the buyer ultimately cares about the quality of services that computer will provide -- word processing capabilities, database services, high-speed calculations, and so on. But, in many cases, the number of message instructions per second and the other easily measured characteristics may not be a wholly adequate proxy for the computer services that the buyer values. In these circumstances, the right approach, ultimately, may be to move toward directly pricing the services we obtain from our computers -- that is, word processing services, database management services, and so on -- rather than pricing separately the hardware and software. The issues surrounding the appropriate measurement of computer prices also illustrate some of the difficulties of valuing goods and services when there are significant interactions among users of the products. New generations of computers sometimes require software that is incompatible with previous generations, and some users who have no need for the improved computing power nevertheless may feel compelled to purchase the new technology because they need to remain compatible with the bulk of users who are at the frontier. Even if our techniques allow us to accurately measure consumers' valuation of the increased speed and power of the new generation of computer, we may miss the negative influence on some consumers of this incompatibility. Therefore, even in the case of personal computers, where we have made such great strides in measuring quality changes, I suspect that important phenomena still may not be adequately captured by our published price indexes. Despite the advances in price measurement that have been made over the years, there remains considerable room for improvement. In the United States, a group of experts empanelled by the Senate Finance Committee -- the Boskin commission -- concluded that the consumer price index has overstated changes in the cost of living by roughly one percentage point per annum in recent years. About half of this bias owed to inadequate adjustment for quality improvement and the introduction of new goods, and about half reflected the manner in which the individual prices were aggregated. Researchers at the Federal Reserve and elsewhere have come up with similar figures. Although the estimates of bias owing to inadequate adjustment for quality improvements surely are the most uncertain aspect of this calculation, the preponderance of evidence is that, on average, such a bias in quality adjustment does exist. The Boskin commission, along with most other estimates of bias in the U.S. CPI, have taken a micro-statistical approach, estimating separately the magnitude of each category of potential bias. Recent work by staff economists at the Federal Reserve Board has added corroborating evidence of price mis-measurement, using a macroeconomic approach that is essentially independent of the micro-statistical exercises. Specifically, employing disaggregated data from the national income and product accounts, this research finds that the measured growth of real output and productivity in the service sector is implausibly weak, given that the return to owners of businesses in that sector apparently has been well-maintained. Indeed, the published data indicate that the level of output per hour in a number of service-producing industries has been falling for more than two decades. It is simply not credible that firms in these industries have been becoming less and less efficient for more than twenty years. Much more reasonable is the view that prices have been mis-measured and that the true quality-adjusted prices have been rising more slowly than the published price indexes. Properly measured, output and productivity trends in these service industries might be considerably stronger than suggested by the published data. Assuming, for example, no change in productivity for these industries would imply a price bias consistent with the Boskin commission findings. Of course, the United States is not the only country that faces challenges in constructing an accurate measure of inflation. Other countries -- Germany among them -- confront similar issues. In a recent survey of consumer price indexes in its member countries, the OECD found that most countries felt that measurement bias was smaller in magnitude in their own countries than in the United States. Certainly regarding quality adjustment, however, I doubt that this is generally the case. Many countries' responses were prepared by the countries' statistical agencies, which tend to take a somewhat more sanguine view of the adequacy of the existing price statistics than do outside economists. But, in any case, the OECD survey did indicate that many countries reported that measurement bias was a concern and that most countries do not adequately adjust their statistics for quality improvements. Indeed, as I noted previously, most European countries still have yet to adopt the most up-to-date techniques for measuring computer prices in their national accounts. As the OECD survey recognized, the challenges presented by rapid technological advances have affected all of us -- not just the United States. Thus, potential sources of measurement bias should be seriously examined in all countries. Indeed, issues of price measurement may be especially important for the European countries entering into monetary union. For a region with a single monetary policy, a single, consistently estimated measure of inflation is necessary to gauge the region's economic performance. Toward that end, as you know, Eurostat publishes harmonized indexes of consumer prices that are constructed using a common basket of goods and services for each EU member state and using similar statistical methodology. These measures should go a long way toward providing a conceptually sound basis for judging convergence of EU member states in the selection of countries to participate in monetary union. Subsequent to monetary union, harmonized consumer prices can be used as the best available measure of inflation in the Euro area. However, as it now stands, the harmonized measures do not contain a broad coverage of consumer services. Most notably, the costs of owner-occupied housing -- a sizable share of consumer expenditures -- are excluded from the harmonized indexes. In the United States, for example, the CPI calculated on this harmonized basis would have increased three or four tenths of a percentage point more slowly than the published CPI, on average, over the past few years, largely because prices of owner-occupied housing have been rising more rapidly than the other components. Arguably, the published index, with broader coverage, is more relevant to assessing inflation trends in the United States than would be the harmonized index. As long as relative prices can and do diverge across countries, the harmonized indexes need to contain as broad a range of items as is practical. As monetary union proceeds, then, it would be to the advantage of monetary authorities in the Euro area to have a consistent measure of inflation defined over a broad basket of goods and services that is measured according to established statistical methods. Most useful would be for the member countries to continue the harmonization process until the national statistical agencies are truly working on a consistent basis. Indeed, measuring prices consistently across countries could be an important step toward making price measurement more accurate everywhere, if harmonization results in each country's best practices being adopted throughout the monetary union. Moreover, different prices of the same tradable good across the community might signal inefficiencies of distribution which were not evident from other sources. Harmonization of CPIs in Europe is just one of many examples demonstrating why price measurement techniques cannot be static. With innovation constantly leading to new products, greater variety, and higher quality, the statistical agencies must work ever harder just to stay in place. A government official in the United States once compared a nation's statistical system to a tailor, measuring the economy much as a tailor measures a person for a suit of clothes -- with the difference that, unlike the tailor, the person we are measuring is running while we try to measure him. The only way the system can succeed, he said, is to be just as fast and twice as agile. That is the challenge that lies ahead, and it is, indeed, a large one. There are, however, reasons for optimism. The information revolution, which lies behind so much of the rapid technological change that makes prices difficult to measure, may also play an important role in helping our statistical agencies acquire the necessary speed and agility to better capture the changes taking place in our economies. For example, computers might some day allow our statistical agencies to tap into a great many economic transactions on a nearly real-time basis. Utilizing data from store checkout scanners, which the United States is now investigating, may be an important first step in that direction. But the possibilities offered by information technology for the improvement of price measurement may turn out to be much broader in scope. Just as it is difficult to predict the ways in which technology will change our consumption over time, so is it difficult to predict how economic and statistical science will make creative use of the improved technology. Such advances must be taken to ensure that our economic statistics remain adequate to support the public policy decisions that must be made. If the challenge for our statistical agencies is not to lose in their race against technology, the challenge for policymakers is to make our best judgements about the limitations of the existing statistics, as we design policies to promote the economic well-being of our nations.
1997-11-13T00:00:00	Mr. Greenspan's testimony before the House of Representatives' Committee on Banking and Financial Services (Central Bank Articles and Speeches, 13 Nov 97)	Testimony of the Chairman of the Governing Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on Banking and Financial Services of the US House of Representatives in Washington DC, on 13/11/97.	Mr. Greenspan's testimony before the House of Respresentatives' Commmittee on Banking and Financial Services Testimony of the Chairman of the Governing Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on Banking and Financial Services of the US House of Representatives in Washington DC, on 13/11/97. Recent developments in world finance have highlighted growing interactions among national financial markets. The underlying technology-based structure of the international financial system has enabled us to improve materially the efficiency of the flows of capital and payment systems. That improvement, however, has also enhanced the ability of the financial system to transmit problems in one part of the globe to another quite rapidly. Doubtless, there is much to be learned from the recent experience in Asia that can be applied to better the workings of the international financial system and its support of international trade that has done so much to enhance living standards worldwide. While each of the Asian economies differs in many important respects, the sources of their spectacular growth in recent years, in some cases decades, and the problems that have emerged are relevant to a greater or lesser extent to nearly all of them. Following the early post-World War II period, policies generally fostering low levels of inflation and openness of their economies coupled with high savings and investment rates contributed to a sustained period of rapid growth, in some cases starting in 1960s and 1970s. By the 1980s most economies in the region were expanding vigorously. Foreign net capital inflows grew, but until recent years were relatively modest. The World Bank estimates that net inflows of long-term debt, foreign direct investment, and equity purchases to the Asia Pacific region were only about $25 billion in 1990, but exploded to more than $110 billion by 1996. A major impetus behind this rapid expansion was the global stock market boom of the 1990s. As that boom progressed, investors in many industrial countries found themselves more heavily concentrated in the recently higher valued securities of companies in the developed world, whose rates of return, in many instances, had fallen to levels perceived as uncompetitive with the earnings potential in emerging economies, especially in Asia. The resultant diversification induced a sharp increase in capital flows into those economies. To a large extent, they came from investors in the United States and Western Europe. A substantial amount came from Japan, as well, owing more to a search for higher yields than to rising stock prices and capital gains in that country. The rising yen through mid-1995 also encouraged a substantial increase in direct investment inflows from Japan. In retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at modest risk. I suspect that it was inevitable in those conditions of low inflation, rapid growth, and ample liquidity that much investment moved into the real estate sector, with an emphasis by both the public and private sectors on conspicuous construction projects. This is an experience, of course, not unknown in the United States on occasion. These real estate assets, in turn, ended up as collateral for a significant proportion of the assets of domestic financial systems. In many instances, those financial systems were less than robust, beset with problems of lax lending standards, weak supervisory regimes, and inadequate capital. Moreover, in most cases, the currencies of these economies were closely tied to the U.S. dollar, and the dollar's substantial recovery since mid-1995, especially relative to the yen, made their exports less competitive. In addition, in some cases, the glut of semiconductors in 1996 suppressed export growth, exerting further pressures on highly leveraged businesses. However, overall GDP growth rates generally edged off only slightly, and imports, fostered by rising real exchange rates, continued to expand, contributing to what became unsustainable current account deficits in a number of these economies. Moreover, with exchange rates seeming to be solidly tied to the dollar, and with dollar and yen interest rates lower than domestic currency rates, a significant part of the enlarged capital inflows into these economies, in particular short-term flows, was - 2 - denominated by the ultimate borrowers in foreign currencies. This put additional pressure on companies to earn foreign exchange through exports. The pressures on fixed exchange rate regimes mounted as foreign investors slowed the pace of new capital inflows, and domestic businesses sought increasingly to convert domestic currencies into foreign currencies, or, equivalently, slowed the conversion of export earnings into domestic currencies. The shifts in perceived future investment risks led to sharp declines in stock markets across Asia, often on top of earlier declines or lackluster performances. To date, the direct impact of these developments on the American economy has been modest, but it can be expected not to be negligible. U.S. exports to Thailand, the Philippines, Indonesia, and Malaysia (the four countries initially affected) were about 4 percent of total U.S. exports in 1996. However, an additional 12 percent went to Hong Kong, Korea, Singapore and Taiwan (economies that have been affected more recently). Thus, depending on the extent of the inevitable slowdown in growth in this area of the world, the growth of our exports will tend to be muted. Our direct foreign investment in, and foreign affiliate earnings reported from, the economies in this region as a whole have been a smaller share of the respective totals than their share of our exports. The share is, nonetheless, large enough to expect some drop-off in those earnings in the period ahead. In addition, there will be indirect effects on the U.S. real economy from countries such as Japan that compete even more extensively with the economies in the Asian region. Particularly troublesome over the past several months has been the so-called contagion effect of weakness in one economy spreading to others as investors perceive, rightly or wrongly, similar vulnerabilities. Even economies, such as Hong Kong, with formidable stocks of international reserves, balanced external accounts, and relatively robust financial systems, have experienced severe pressures. One can debate whether the turbulence in Latin American asset values reflects contagion effects from Asia, the influence of developments in U.S. financial markets, or home-grown causes. Whatever the answer, and the answer may be all of the above, this phenomenon illustrates the interdependencies in today's world economy and financial system. Perhaps it was inevitable that the impressive and rapid growth experienced by the economies in the Asian region would run into a temporary slowdown or pause. But there is no reason that above-average growth in countries that are still in a position to gain from catching up with the prevailing technology cannot persist for a very long time. Nevertheless, rapidly developing, free-market economies periodically can be expected to run into difficulties because investment mistakes are inevitable in any dynamic economy. Private capital flows may temporarily turn adverse. In these circumstances, companies should be allowed to default, private investors should take their losses, and government policies should be directed toward laying the macroeconomic and structural foundations for renewed expansion; new growth opportunities must be allowed to emerge. Similarly, in providing any international financial assistance, we need to be mindful of the desirability of minimizing the impression that international authorities stand ready to guarantee the external liabilities of sovereign governments or failed domestic businesses. To do otherwise could lead to distorted investments and could ultimately unbalance the world financial system. The recent experience in Asia underscores the importance of financially sound domestic banking and other associated financial institutions. While the current turmoil has significant interaction with the international financial system, the recent crises would arguably have been better contained if long-maturity property loans had not accentuated the usual mismatch between maturities of assets and liabilities of domestic financial systems that were far from robust to begin with. Our unlamented savings and loan crises come to mind. These are trying days for economic policymakers in Asia. They must fend off domestic pressures that seek disengagement from the world trading and financial system. The authorities in these countries are working hard, in some cases with substantial assistance from the IMF, the World Bank, and the Asian Development Bank, to stabilize their financial systems and economies. - 3 - The financial disturbances that have afflicted a number of currencies in Asia do not at this point, as I indicated earlier, threaten prosperity in this country, but we need to work closely with their leaders and the international financial community to assure that their situations stabilize. It is in the interest of the United States and other nations around the world to encourage appropriate policy adjustments, and where required, provide temporary financial assistance.	---[PAGE_BREAK]--- # Mr. Greenspan's testimony before the House of Representatives' Commmittee on Banking and Financial Services Testimony of the Chairman of the Governing Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on Banking and Financial Services of the US House of Representatives in Washington DC, on 13/11/97. Recent developments in world finance have highlighted growing interactions among national financial markets. The underlying technology-based structure of the international financial system has enabled us to improve materially the efficiency of the flows of capital and payment systems. That improvement, however, has also enhanced the ability of the financial system to transmit problems in one part of the globe to another quite rapidly. Doubtless, there is much to be learned from the recent experience in Asia that can be applied to better the workings of the international financial system and its support of international trade that has done so much to enhance living standards worldwide. While each of the Asian economies differs in many important respects, the sources of their spectacular growth in recent years, in some cases decades, and the problems that have emerged are relevant to a greater or lesser extent to nearly all of them. Following the early post-World War II period, policies generally fostering low levels of inflation and openness of their economies coupled with high savings and investment rates contributed to a sustained period of rapid growth, in some cases starting in 1960s and 1970s. By the 1980s most economies in the region were expanding vigorously. Foreign net capital inflows grew, but until recent years were relatively modest. The World Bank estimates that net inflows of long-term debt, foreign direct investment, and equity purchases to the Asia Pacific region were only about $\$ 25$ billion in 1990, but exploded to more than $\$ 110$ billion by 1996. A major impetus behind this rapid expansion was the global stock market boom of the 1990s. As that boom progressed, investors in many industrial countries found themselves more heavily concentrated in the recently higher valued securities of companies in the developed world, whose rates of return, in many instances, had fallen to levels perceived as uncompetitive with the earnings potential in emerging economies, especially in Asia. The resultant diversification induced a sharp increase in capital flows into those economies. To a large extent, they came from investors in the United States and Western Europe. A substantial amount came from Japan, as well, owing more to a search for higher yields than to rising stock prices and capital gains in that country. The rising yen through mid-1995 also encouraged a substantial increase in direct investment inflows from Japan. In retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at modest risk. I suspect that it was inevitable in those conditions of low inflation, rapid growth, and ample liquidity that much investment moved into the real estate sector, with an emphasis by both the public and private sectors on conspicuous construction projects. This is an experience, of course, not unknown in the United States on occasion. These real estate assets, in turn, ended up as collateral for a significant proportion of the assets of domestic financial systems. In many instances, those financial systems were less than robust, beset with problems of lax lending standards, weak supervisory regimes, and inadequate capital. Moreover, in most cases, the currencies of these economies were closely tied to the U.S. dollar, and the dollar's substantial recovery since mid-1995, especially relative to the yen, made their exports less competitive. In addition, in some cases, the glut of semiconductors in 1996 suppressed export growth, exerting further pressures on highly leveraged businesses. However, overall GDP growth rates generally edged off only slightly, and imports, fostered by rising real exchange rates, continued to expand, contributing to what became unsustainable current account deficits in a number of these economies. Moreover, with exchange rates seeming to be solidly tied to the dollar, and with dollar and yen interest rates lower than domestic currency rates, a significant part of the enlarged capital inflows into these economies, in particular short-term flows, was ---[PAGE_BREAK]--- denominated by the ultimate borrowers in foreign currencies. This put additional pressure on companies to earn foreign exchange through exports. The pressures on fixed exchange rate regimes mounted as foreign investors slowed the pace of new capital inflows, and domestic businesses sought increasingly to convert domestic currencies into foreign currencies, or, equivalently, slowed the conversion of export earnings into domestic currencies. The shifts in perceived future investment risks led to sharp declines in stock markets across Asia, often on top of earlier declines or lackluster performances. To date, the direct impact of these developments on the American economy has been modest, but it can be expected not to be negligible. U.S. exports to Thailand, the Philippines, Indonesia, and Malaysia (the four countries initially affected) were about 4 percent of total U.S. exports in 1996. However, an additional 12 percent went to Hong Kong, Korea, Singapore and Taiwan (economies that have been affected more recently). Thus, depending on the extent of the inevitable slowdown in growth in this area of the world, the growth of our exports will tend to be muted. Our direct foreign investment in, and foreign affiliate earnings reported from, the economies in this region as a whole have been a smaller share of the respective totals than their share of our exports. The share is, nonetheless, large enough to expect some drop-off in those earnings in the period ahead. In addition, there will be indirect effects on the U.S. real economy from countries such as Japan that compete even more extensively with the economies in the Asian region. Particularly troublesome over the past several months has been the so-called contagion effect of weakness in one economy spreading to others as investors perceive, rightly or wrongly, similar vulnerabilities. Even economies, such as Hong Kong, with formidable stocks of international reserves, balanced external accounts, and relatively robust financial systems, have experienced severe pressures. One can debate whether the turbulence in Latin American asset values reflects contagion effects from Asia, the influence of developments in U.S. financial markets, or home-grown causes. Whatever the answer, and the answer may be all of the above, this phenomenon illustrates the interdependencies in today's world economy and financial system. Perhaps it was inevitable that the impressive and rapid growth experienced by the economies in the Asian region would run into a temporary slowdown or pause. But there is no reason that above-average growth in countries that are still in a position to gain from catching up with the prevailing technology cannot persist for a very long time. Nevertheless, rapidly developing, free-market economies periodically can be expected to run into difficulties because investment mistakes are inevitable in any dynamic economy. Private capital flows may temporarily turn adverse. In these circumstances, companies should be allowed to default, private investors should take their losses, and government policies should be directed toward laying the macroeconomic and structural foundations for renewed expansion; new growth opportunities must be allowed to emerge. Similarly, in providing any international financial assistance, we need to be mindful of the desirability of minimizing the impression that international authorities stand ready to guarantee the external liabilities of sovereign governments or failed domestic businesses. To do otherwise could lead to distorted investments and could ultimately unbalance the world financial system. The recent experience in Asia underscores the importance of financially sound domestic banking and other associated financial institutions. While the current turmoil has significant interaction with the international financial system, the recent crises would arguably have been better contained if long-maturity property loans had not accentuated the usual mismatch between maturities of assets and liabilities of domestic financial systems that were far from robust to begin with. Our unlamented savings and loan crises come to mind. These are trying days for economic policymakers in Asia. They must fend off domestic pressures that seek disengagement from the world trading and financial system. The authorities in these countries are working hard, in some cases with substantial assistance from the IMF, the World Bank, and the Asian Development Bank, to stabilize their financial systems and economies. ---[PAGE_BREAK]--- The financial disturbances that have afflicted a number of currencies in Asia do not at this point, as I indicated earlier, threaten prosperity in this country, but we need to work closely with their leaders and the international financial community to assure that their situations stabilize. It is in the interest of the United States and other nations around the world to encourage appropriate policy adjustments, and where required, provide temporary financial assistance.	Alan Greenspan	United States	https://www.bis.org/review/r971119d.pdf	Recent developments in world finance have highlighted growing interactions among national financial markets. The underlying technology-based structure of the international financial system has enabled us to improve materially the efficiency of the flows of capital and payment systems. That improvement, however, has also enhanced the ability of the financial system to transmit problems in one part of the globe to another quite rapidly. Doubtless, there is much to be learned from the recent experience in Asia that can be applied to better the workings of the international financial system and its support of international trade that has done so much to enhance living standards worldwide. While each of the Asian economies differs in many important respects, the sources of their spectacular growth in recent years, in some cases decades, and the problems that have emerged are relevant to a greater or lesser extent to nearly all of them. Following the early post-World War II period, policies generally fostering low levels of inflation and openness of their economies coupled with high savings and investment rates contributed to a sustained period of rapid growth, in some cases starting in 1960s and 1970s. By the 1980s most economies in the region were expanding vigorously. Foreign net capital inflows grew, but until recent years were relatively modest. The World Bank estimates that net inflows of long-term debt, foreign direct investment, and equity purchases to the Asia Pacific region were only about $\$ 25$ billion in 1990, but exploded to more than $\$ 110$ billion by 1996. A major impetus behind this rapid expansion was the global stock market boom of the 1990s. As that boom progressed, investors in many industrial countries found themselves more heavily concentrated in the recently higher valued securities of companies in the developed world, whose rates of return, in many instances, had fallen to levels perceived as uncompetitive with the earnings potential in emerging economies, especially in Asia. The resultant diversification induced a sharp increase in capital flows into those economies. To a large extent, they came from investors in the United States and Western Europe. A substantial amount came from Japan, as well, owing more to a search for higher yields than to rising stock prices and capital gains in that country. The rising yen through mid-1995 also encouraged a substantial increase in direct investment inflows from Japan. In retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at modest risk. I suspect that it was inevitable in those conditions of low inflation, rapid growth, and ample liquidity that much investment moved into the real estate sector, with an emphasis by both the public and private sectors on conspicuous construction projects. This is an experience, of course, not unknown in the United States on occasion. These real estate assets, in turn, ended up as collateral for a significant proportion of the assets of domestic financial systems. In many instances, those financial systems were less than robust, beset with problems of lax lending standards, weak supervisory regimes, and inadequate capital. Moreover, in most cases, the currencies of these economies were closely tied to the U.S. dollar, and the dollar's substantial recovery since mid-1995, especially relative to the yen, made their exports less competitive. In addition, in some cases, the glut of semiconductors in 1996 suppressed export growth, exerting further pressures on highly leveraged businesses. However, overall GDP growth rates generally edged off only slightly, and imports, fostered by rising real exchange rates, continued to expand, contributing to what became unsustainable current account deficits in a number of these economies. Moreover, with exchange rates seeming to be solidly tied to the dollar, and with dollar and yen interest rates lower than domestic currency rates, a significant part of the enlarged capital inflows into these economies, in particular short-term flows, was denominated by the ultimate borrowers in foreign currencies. This put additional pressure on companies to earn foreign exchange through exports. The pressures on fixed exchange rate regimes mounted as foreign investors slowed the pace of new capital inflows, and domestic businesses sought increasingly to convert domestic currencies into foreign currencies, or, equivalently, slowed the conversion of export earnings into domestic currencies. The shifts in perceived future investment risks led to sharp declines in stock markets across Asia, often on top of earlier declines or lackluster performances. To date, the direct impact of these developments on the American economy has been modest, but it can be expected not to be negligible. U.S. exports to Thailand, the Philippines, Indonesia, and Malaysia (the four countries initially affected) were about 4 percent of total U.S. exports in 1996. However, an additional 12 percent went to Hong Kong, Korea, Singapore and Taiwan (economies that have been affected more recently). Thus, depending on the extent of the inevitable slowdown in growth in this area of the world, the growth of our exports will tend to be muted. Our direct foreign investment in, and foreign affiliate earnings reported from, the economies in this region as a whole have been a smaller share of the respective totals than their share of our exports. The share is, nonetheless, large enough to expect some drop-off in those earnings in the period ahead. In addition, there will be indirect effects on the U.S. real economy from countries such as Japan that compete even more extensively with the economies in the Asian region. Particularly troublesome over the past several months has been the so-called contagion effect of weakness in one economy spreading to others as investors perceive, rightly or wrongly, similar vulnerabilities. Even economies, such as Hong Kong, with formidable stocks of international reserves, balanced external accounts, and relatively robust financial systems, have experienced severe pressures. One can debate whether the turbulence in Latin American asset values reflects contagion effects from Asia, the influence of developments in U.S. financial markets, or home-grown causes. Whatever the answer, and the answer may be all of the above, this phenomenon illustrates the interdependencies in today's world economy and financial system. Perhaps it was inevitable that the impressive and rapid growth experienced by the economies in the Asian region would run into a temporary slowdown or pause. But there is no reason that above-average growth in countries that are still in a position to gain from catching up with the prevailing technology cannot persist for a very long time. Nevertheless, rapidly developing, free-market economies periodically can be expected to run into difficulties because investment mistakes are inevitable in any dynamic economy. Private capital flows may temporarily turn adverse. In these circumstances, companies should be allowed to default, private investors should take their losses, and government policies should be directed toward laying the macroeconomic and structural foundations for renewed expansion; new growth opportunities must be allowed to emerge. Similarly, in providing any international financial assistance, we need to be mindful of the desirability of minimizing the impression that international authorities stand ready to guarantee the external liabilities of sovereign governments or failed domestic businesses. To do otherwise could lead to distorted investments and could ultimately unbalance the world financial system. The recent experience in Asia underscores the importance of financially sound domestic banking and other associated financial institutions. While the current turmoil has significant interaction with the international financial system, the recent crises would arguably have been better contained if long-maturity property loans had not accentuated the usual mismatch between maturities of assets and liabilities of domestic financial systems that were far from robust to begin with. Our unlamented savings and loan crises come to mind. These are trying days for economic policymakers in Asia. They must fend off domestic pressures that seek disengagement from the world trading and financial system. The authorities in these countries are working hard, in some cases with substantial assistance from the IMF, the World Bank, and the Asian Development Bank, to stabilize their financial systems and economies. The financial disturbances that have afflicted a number of currencies in Asia do not at this point, as I indicated earlier, threaten prosperity in this country, but we need to work closely with their leaders and the international financial community to assure that their situations stabilize. It is in the interest of the United States and other nations around the world to encourage appropriate policy adjustments, and where required, provide temporary financial assistance.
1997-11-17T00:00:00	Mr. McDonough gives a US perspective on Economic and Monetary Union in Europe (Central Bank Articles and Speeches, 17 Nov 97)	Remarks by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough, before the Association of German Mortgage Banks in Frankfurt, on 17/11/97.	Mr. McDonough gives a US perspective on Economic and Monetary Union in Remarks by the President of the Federal Reserve Bank of New York, Mr. William Europe J. McDonough, before the Association of German Mortgage Banks in Frankfurt, on 17/11/97. I am honored to be invited by the German Mortgage Banks to be the keynote speaker tonight at the Association's annual Pfandbrief Forum. It is a great pleasure to be here in Frankfurt among so many distinguished representatives of the German banking and financial community and members of the Bundesbank Council. In my remarks to you this evening, I would like to offer a few thoughts on the implications of Economic and Monetary Union in Europe from my perspective as President of the Federal Reserve Bank of New York. Many in the United States today are following developments in Europe's move toward monetary union with considerable interest. I am certainly among them. There can be no doubt about the magnitude and economic importance of the historic event that will take place on January 1, 1999, when the currencies of up to 15 member countries of the European Union are scheduled to be unified. It is a goal toward which Europe has been working ever since the Treaty of Rome was signed in 1957 creating the European Economic Community. While some might claim that this historic development will have little impact on the U.S. economy, nothing could be further from the truth. The United States will be directly affected in several important ways by the start of Economic and Monetary Union in Europe, or EMU. I would like to review some of the main channels through which EMU is likely to affect American business and policymaking over the next several years. Further, I think it may be useful to highlight some of the important similarities and differences between the currency union that exists in the United States today and the currency union that you are in the process of creating in Europe. The most obvious implication of the start of EMU for the United States -- as well as for the world community -- is the coming into existence of a new currency, the euro, which is intended to function as a major international currency alongside the U.S. dollar. I should make clear at the outset that it would be a mistake to think that the United States looks at this prospect with concern, as if the introduction of the euro could somehow compromise the ability of the United States to continue to conduct trade and financial transactions with the rest of the world. As you well know, the dollar is currently used in roughly 50 percent of world trade transactions and in at least one side of 80 percent of world financial transactions. The introduction of another major international currency will neither harm the depth and liquidity of the dollar market nor hinder the ability of the United States to conduct its external transactions smoothly. On the contrary, to the extent that the birth of the euro fosters deeper trade and financial markets globally and a more efficient international monetary system, all countries stand to benefit, particularly an active participant such as the United States. Let me be more specific. In my view, for the United States and the international monetary system, the implication of a growing international role for the euro over the foreseeable future will be most significant with respect to financial rather than trade transactions. It is quite true that the euro may quickly become the currency of choice in the invoicing of trade between companies in the European Union and their foreign counterparts. Companies in regions with strong links to the European Union, such as those in eastern and central Europe, North Africa, and the CFA French franc zone, may also choose to invoice trade in euros. More generally, the euro may well expand its importance in world trade beyond the relative trade weight of the European Union countries, following a path similar to that taken by the U.S. dollar and -- before that -- by the pound sterling. Nevertheless, I would argue that the economic effects of these potential changes in invoicing practices are likely to be limited. Why do I say this? First, to a large extent, the re-denomination of a significant share of world trade into euros will mainly represent a shift in invoicing practices from the use of former European currencies to euros. Moreover, third-country effects are unlikely to be major, because the European currencies as a whole are already somewhat over-represented in their share of world trade transactions relative to their countries' weights in world trade -- not as much so as the dollar, but certainly more so than the yen. Finally, changes in trade invoicing practices have a direct economic impact only on the two parties involved in the transaction, and these effects are limited to determining who ultimately bears the exchange rate risk. In fact, because of the wide variety of risk-hedging instruments that are available to traders exposed to exchange rate fluctuations, the impact of exchange rate risk on trade patterns is likely to be secondary. This conjecture is confirmed by a substantial amount of empirical research. In short, the economic impact of the euro in international trade transactions is likely to be limited. The same cannot be said of the euro's potential role in international financial transactions. Partly because of their sheer magnitude -- some estimates place the volume of international capital transactions at more than 40 times the volume of international trade transactions -- growth in the use of the euro as the currency of choice in global capital markets will have much more significant repercussions for the United States than will increasing use of the euro in global product markets. To a large extent, these repercussions reflect the well-known gains that stem from increasing returns in the use of a currency as a store of value. As the market for a currency becomes more liquid, the costs of carrying wealth denominated in that currency fall, raising investors' preferences for denominating their portfolios in that currency. These increased preferences in turn lead to a further deepening and broadening of the market for that currency, costs of holdings are reduced further, and the process continues. As in trade transactions, the dollar is the predominant means of exchange in international financial transactions. Its predominance is especially apparent with respect to large issues of international bonds -- a clear reflection of the low cost of covering exchange rate and interest rate risk for long-term dollar instruments. I would suggest, however, that the current role of the dollar should not be taken for granted. Once the euro comes into existence, the simple conversion of the EMU countries' outstanding securities into euros will contribute to the immediate creation of a major securities market. This development alone will create a critical mass for a market in euro-denominated securities. It will give the market depth and liquidity, and, in so doing, bring down the costs of conducting transactions, issuing loans, and trading securities below those currently seen for European national currencies -- possibly to levels comparable to those for dollars. The development of such a virtuous cycle could well feed upon itself and lead to the continuous growth of the market for euros. In this context, I would like to suggest that the experience the United States has had with a large, unified capital market may point to ways in which a unified European capital market may evolve after the advent of EMU. If the U.S. experience is of any relevance, we may expect to see a decreasing use of bank loans in favor of a growing use of securities in Europe after 1999. Repo markets would also likely grow, potentially along the lines we have seen in the United States, where institutional investors such as mutual funds and pension funds, state and local governments, and insurance companies have become the largest providers of capital under repo arrangements -- in contrast with Europe's experience, where these types of investors tend to hold bank deposits. A growing role for repurchase arrangements is already apparent in Europe, and this growth may be expected to accelerate once the European central bank starts to operate in this market, accepting -- and fostering -- the use of a wide range of government paper as collateral. It is useful to keep in mind that the move to a single-currency, highly securitized European capital market cannot be expected to be completely painless. Clearly, since banks are the main intermediaries of cross-border transactions, the banking sector will bear the brunt of the costs associated with the changeover to a common currency. For example, it will suffer losses from reduced foreign exchange trading and transfer revenues. It will also have to pay for the retooling of information management and delivery systems, as well as face increased uncertainties in its core deposits. At the same time, however, the larger single market will create new opportunities for banks, particularly in the areas of investment banking and the cross-border sale of deposits, mutual funds, and other savings products. On balance, it seems fair to conclude that the commercial position and earnings of many European banks are likely to come under pressure. This may accelerate the ongoing restructuring of Europe's banking industry, a process that has been confined, to date, primarily to developments within each country. More broadly, there can be no doubt that the implications of the growth of a more efficient and cost-effective market for euro-denominated capital would extend well beyond Europe. The availability of a new, low-cost channel for portfolio investment, for example, could help reverse the traditional reluctance of households and many institutional investors worldwide to invest internationally -- a reluctance that has long puzzled academics and policymakers. Moreover, a well-developed market for euro-denominated capital would encourage institutional investors from the United States and elsewhere to acquire diversified European portfolios offered in a single currency. In fact, this development could be accelerated if member governments chose to deepen the euro market by increasing the available range of bond maturities, which in some countries is somewhat limited at the short and long ends. In addition, capital might also flow in the opposite direction, as non-European firms and governments tap the euro-denominated capital market as an efficient source of funds, in the same way as European businesses and governments have chosen to borrow dollars in recent decades. While the potential benefits of a more integrated European capital market in the long run are apparent, a number of observers have suggested that the economics of EMU -- as well as its plain mechanics -- may have unwelcome consequences for the dollar and world trade. More specifically, some have argued, EMU may cause a short-run glut of dollars in the international capital markets, leading the dollar to depreciate and the euro to appreciate, with resulting undesirable effects on trade flows. The reason there could be a dollar glut, these observers maintain, is that EMU would eliminate the need for intra-European intervention, reduce the importance of exchange rate management, and allow national central banks to pool reserves for external intervention, thus generally reducing the European central banks' need for dollar reserves. Moreover, if the euro were to become an attractive reserve currency for non-European central banks, the dollar glut could become even more severe. While some decline in the reserve role of the dollar is certainly plausible over time with the creation of EMU, I believe that the risk of a dramatic shift in official dollar reserve holdings both in and outside Europe in the wake of EMU has been exaggerated in terms of both its potential scope and effects. I would suggest that it will take some time before the objectives and operating procedures of the European central bank become clearly understood by market participants. Although low inflation will be the ultimate objective of the new European central bank, markets will have to understand precisely how that objective will be pursued: What price aggregate will be the focus of monetary policy? How will intermediate instruments such as monetary aggregates be used to achieve the ultimate objective? What channels will the central bank choose to signal and implement changes in its policy stance? As these longer-term questions are addressed, the policy importance of the external value of the euro, particularly the euro/dollar exchange rate, will certainly be watched carefully. Both market participants and foreign central banks are likely to focus on the euro exchange rate as a high-frequency and widely available -- if somewhat noisy -- indicator of the current and likely future stance of European monetary policy. Given its need to instil confidence in the markets and to ensure the stability of the euro exchange rate, the European central bank is likely to want to be perceived as ready and able to operate effectively in the dollar market, for which substantial dollar reserves may be required. In the short term, the response of non-European central banks to the introduction of the euro is also likely to be cautious. Ultimately, the desired euro holdings of these central banks will largely depend on the decisions they make about their exchange rate regime. A number of countries -- including the central European countries that have applied for membership in the European Union and other countries in Africa -- may decide to peg their currency to the euro. Yet these countries may well wait for the newly-formed European central bank to establish its policy record and clarify its operating procedures before they commit their currencies to a euro peg. Indeed, history suggests that a currency's role as an international reserve, means of exchange, and store of value is slowly gained and slowly lost -- as the examples of the dollar and pound sterling illustrate. The dollar, in particular, may have seemed on the way to losing much of its international prominence after the demise of the Bretton Woods system in 1973. After declining as a share of international reserves and a means for international transactions from 1974 to the mid-1980s, however, the dollar's relative use has not changed significantly during the past decade. Indeed, as the U.S. economy has grown more efficient and internationally competitive in the past ten years, the dollar has retained its strong role in the international monetary system. In short, it seems safe to assume that significant changes in the international role of the dollar and the functioning of the international monetary system would occur only gradually, and surely in a manner that could be easily coped with, given the turnover in capital markets we observe today. But should a different international monetary system ultimately emerge in which other currencies, such as the euro, play an increasingly important role alongside the dollar, there would be benefits for the United States as well. Such a development would, for example, impose greater market-led discipline on the United States and, in the process, help us address our chronic low-savings problem. There is another indirect -- although potentially more important -- way in which EMU may affect U.S. business and policymaking. This implication of EMU has to do with the contribution a currency union is likely to make to increasing the efficiency and flexibility of the economies that join it. At least since the publication of the "One Market, One Money" study by the European Commission in 1990, observers and analysts of EMU have paid significant attention to the decline in transaction costs that can be achieved by unifying up to 15 different currencies, and to the resulting gains in efficiency for Europe's economies. The experience of the United States is useful in this respect. The fact that 50 states in the United States share a common currency -- and have done so for over 130 years -- provides the critical foundation for an integrated and efficient capital market that extends from Maine to California and on to Alaska and Hawaii. In this market, capital flows smoothly from high-saving to high-investment areas, as required by changing business conditions, without any thought of exchange rate risk. A common U.S. currency, it is important to note, has many advantages beyond simply reducing transaction costs. It also simplifies choices for households and corporate management, enhances the efficiency with which financial institutions and the payments system function, and promotes competition across the whole productive spectrum. While a common currency in Europe can be expected to lead to similar efficiency gains, the economies of the United States and Europe differ in several important dimensions, so that a common currency is likely to work in substantially different ways in the two regions. The ways in which Europe and the United States differ most have to do with the degree of integration of their labor markets and their fiscal systems. The United States enjoys a very mobile labor force -- across sectors and states -which allows job losses arising during sector-specific or state-specific recessions to be rapidly absorbed where jobs are growing faster. This contributes to aggregate unemployment being kept reasonably in check. This willingness of American workers to move themselves and their family is a cultural characteristic of our people, no doubt based in the history of the United States as a nation of immigrants. To complement its high degree of labor mobility, the United States also has in place a federal fiscal system that allows the federal government to channel large transfers from fast-growing regions to slow-growing regions. Progressive income taxation, a high elasticity of corporate tax profits to changes in income, and an integrated federal budget are the main components of this system. In contrast to the United States, Europe is characterized by a more segmented labor market and very limited integration of its national fiscal systems. Both these characteristics limit the ability not only of Europe's private sector to shift resources in response to regional recessions, but also of Europe's public sector to compensate for this rigidity. This lack of flexibility is widely acknowledged to be one of the root causes of the high unemployment rates that Europe has experienced during the last decade. But, we may well ask, does it necessarily follow that because of the greater rigidity of its labor markets and the lack of a federal fiscal system, Europe cannot accommodate a common currency and instead needs to rely on periodic exchange rate adjustments as surrogates for productive flexibility? I do not think so. While less flexible labor markets and the absence of a federal fiscal system will certainly pose constant challenges for the management of a common European currency, a fluctuating exchange rate need not be the optimal way to respond to these shortcomings. The argument that Europe -- even a core component of Europe -- can ill afford to renounce exchange rate flexibility rests crucially on the view that Europe is significantly more heterogeneous than the United States and, therefore, more vulnerable to country-specific shocks that can best be corrected by exchange rate changes. I do not support this view. Rather, I believe that in many respects differences among the European economies have been over-emphasized in the public debate. It is possible to suggest, for example, that the economies of some European countries have more in common today than do those of some individual states in the United States, such as New York and Michigan or California and Idaho. Moreover, as a result of the convergence of economic policy objectives, the economic cycles among many European countries have become more synchronized over the last ten years, a trend that is likely to be reinforced by monetary unification. Furthermore, when shocks are mainly at the industry level -- for instance, when a recession hits the automobile or steel industry in Germany and France -- the German and French economies would hardly benefit from an exchange rate change. Such a change, in this case, simply would not affect the appropriate relative prices. By contrast, American policymakers might have found it helpful to devalue the dollar in Texas when oil prices collapsed in the mid-1980s or the dollar in New England at the end of the defense-led growth of the late 1980s. These options, however, simply were not available. In retrospect, it was the discipline fostered by the absence of the opportunity to alter regional exchange rates that forced our firms, local governments, and workers to reorganize, become more efficient, and grow in what are now some of the most productive areas of the United States. Similarly, if national labor markets in Europe become more flexible and efficient in the presence of a common currency and firms learn to count only on their own resources -- with no help from an occasional exchange rate adjustment -- European capital and labor markets may themselves become more integrated. And if greater integration of labor markets can only proceed slowly -- given persistent and unavoidable cultural and language differences -- this need not be the case for financial markets, where the disappearance of exchange rate risk will cause capital to move in response to interest rate differentials of only a very few percentage points. In this context, I would like to make clear that I do not view as ideal the U.S. model where the burden of recessions tends to fall heavily on the shoulders of workers, who may be obliged to move across regions and industries in response to the business cycle. How to deal with the reality of the business cycle is an area where Europe -- with its tradition of social safety nets -- and the United States -- with its tradition of flexible work arrangements -- can perhaps learn something from each other. To date, neither of us seems yet to have found the optimal way to cope with the unavoidable reality of the business cycle to enable us to avoid both high unemployment rates and too skewed a distribution of income. My last general observation about the implications of EMU for the United States has to do with the dramatic changes in macroeconomic policies that will accompany the creation of monetary union in Europe. Naturally, the main change will concern monetary policy, and it is in this area that the similarities between Europe and the United States will ultimately be the greatest. The first similarity is that, with EMU, the formulation of monetary policy in both Europe and the United States will be highly centralized and the European central bank will enjoy, as the Federal Reserve does, a considerable degree of independence. These institutional features will reduce the scope for national governments to bend monetary policy to the needs of their country's business cycle and will help keep the focus of the European central bank on the objective of price stability. The second similarity we may expect to see between Europe and the United States is that, with EMU, external considerations -- such as the trade balance or the value of the exchange rate -- will over time impinge less and less on the conduct of monetary policy, as now is the case in the United States. Once monetary union is in place for all 15 countries, the openness of Europe's unified economy -- as measured, for example, by the share of exports in relation to GDP -- is likely to be quite similar to that of the U.S. economy, on the order of 10 percent. While the conduct of monetary policy in Europe may increasingly resemble that in the United States, the conduct of fiscal policy will continue to differ significantly in the two regions, largely reflecting the different paths Europe and the United States have taken to monetary unification. In the United States, political union came well ahead of a common monetary policy. The Federal Reserve was not created until 1913, when political unification had been long in place. The situation is, of course, quite different in Europe, where EMU member countries plan to retain substantial political and fiscal independence. Despite this independence, EMU may well foster fiscal coordination among the member countries. This may happen in part because the EMU countries have chosen to subscribe to a set of common guidelines on the magnitude of their fiscal deficits, and in part because these countries will compete for a common pool of savings in an integrated capital market. The prospect of market-based discipline on the fiscal policies pursued by the EMU countries is not so different from the situation faced by individual states and municipalities in the United States. The need for these entities to tap a common capital market to finance their deficits places their actions under a stricter market test than they would face if they could rely mainly on captive local savings. The municipal bond market in the United States is today a very active and competitive market, where yield differences on public debt reflect investors' perceptions of default risk, and inefficient state and local administrations are quickly penalized for fiscal profligacy. Similar markets are likely to evolve in Europe after 1999. In fact, the major rating agencies are already planning for European issues of government debt following the creation of EMU. By all accounts, the agencies expect these ratings to mirror those currently assigned to countries' foreign currency debt, with fiscal factors driving rating changes once EMU is well under way. As I hope I have made clear in my remarks this evening, we in the United States, as elsewhere, have been observing the progress toward monetary unification in Europe with great interest. In the process, I think we have learned to appreciate the complexity of this enormous undertaking. One conclusion I have drawn from my observations over the years is that many of the reforms Europe is pursuing on its path to monetary unification -- including fiscal stabilization, tax harmonization, welfare and labor market reform, trade liberalization, and capital market integration -are goals that are worth pursuing in their own right and for which EMU provides a consistent frame of reference. Continued progress toward furthering these broad-based goals is in the interest not only of Europe but also of the United States. There can be no question that the United States has benefited greatly in the past two decades from Europe's deepening integration. Europe has provided a steady opening of markets for American products and served as a source of an increasingly efficient supply of goods to U.S. households and firms. Europe's growing participation in international capital markets, which a successful EMU and a strong euro are intended to further, has also encouraged an increasing flow of savings between Europe and the United States in response to changing macroeconomic conditions in our two regions. We in the United States have much at stake in Europe's and EMU's future and we stand ready to work with you and support you in the furtherance of your historic efforts.	---[PAGE_BREAK]--- # Mr. McDonough gives a US perspective on Economic and Monetary Union in Europe Remarks by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough, before the Association of German Mortgage Banks in Frankfurt, on 17/11/97. I am honored to be invited by the German Mortgage Banks to be the keynote speaker tonight at the Association's annual Pfandbrief Forum. It is a great pleasure to be here in Frankfurt among so many distinguished representatives of the German banking and financial community and members of the Bundesbank Council. In my remarks to you this evening, I would like to offer a few thoughts on the implications of Economic and Monetary Union in Europe from my perspective as President of the Federal Reserve Bank of New York. Many in the United States today are following developments in Europe's move toward monetary union with considerable interest. I am certainly among them. There can be no doubt about the magnitude and economic importance of the historic event that will take place on January 1, 1999, when the currencies of up to 15 member countries of the European Union are scheduled to be unified. It is a goal toward which Europe has been working ever since the Treaty of Rome was signed in 1957 creating the European Economic Community. While some might claim that this historic development will have little impact on the U.S. economy, nothing could be further from the truth. The United States will be directly affected in several important ways by the start of Economic and Monetary Union in Europe, or EMU. I would like to review some of the main channels through which EMU is likely to affect American business and policymaking over the next several years. Further, I think it may be useful to highlight some of the important similarities and differences between the currency union that exists in the United States today and the currency union that you are in the process of creating in Europe. The most obvious implication of the start of EMU for the United States -- as well as for the world community -- is the coming into existence of a new currency, the euro, which is intended to function as a major international currency alongside the U.S. dollar. I should make clear at the outset that it would be a mistake to think that the United States looks at this prospect with concern, as if the introduction of the euro could somehow compromise the ability of the United States to continue to conduct trade and financial transactions with the rest of the world. As you well know, the dollar is currently used in roughly 50 percent of world trade transactions and in at least one side of 80 percent of world financial transactions. The introduction of another major international currency will neither harm the depth and liquidity of the dollar market nor hinder the ability of the United States to conduct its external transactions smoothly. On the contrary, to the extent that the birth of the euro fosters deeper trade and financial markets globally and a more efficient international monetary system, all countries stand to benefit, particularly an active participant such as the United States. Let me be more specific. In my view, for the United States and the international monetary system, the implication of a growing international role for the euro over the foreseeable future will be most significant with respect to financial rather than trade transactions. It is quite true that the euro may quickly become the currency of choice in the invoicing of trade between companies in the European Union and their foreign counterparts. Companies in regions with strong links to the European Union, such as those in eastern and central Europe, North Africa, and the CFA French franc zone, may also choose to invoice trade in euros. ---[PAGE_BREAK]--- More generally, the euro may well expand its importance in world trade beyond the relative trade weight of the European Union countries, following a path similar to that taken by the U.S. dollar and -- before that -- by the pound sterling. Nevertheless, I would argue that the economic effects of these potential changes in invoicing practices are likely to be limited. Why do I say this? First, to a large extent, the re-denomination of a significant share of world trade into euros will mainly represent a shift in invoicing practices from the use of former European currencies to euros. Moreover, third-country effects are unlikely to be major, because the European currencies as a whole are already somewhat over-represented in their share of world trade transactions relative to their countries' weights in world trade -- not as much so as the dollar, but certainly more so than the yen. Finally, changes in trade invoicing practices have a direct economic impact only on the two parties involved in the transaction, and these effects are limited to determining who ultimately bears the exchange rate risk. In fact, because of the wide variety of risk-hedging instruments that are available to traders exposed to exchange rate fluctuations, the impact of exchange rate risk on trade patterns is likely to be secondary. This conjecture is confirmed by a substantial amount of empirical research. In short, the economic impact of the euro in international trade transactions is likely to be limited. The same cannot be said of the euro's potential role in international financial transactions. Partly because of their sheer magnitude -- some estimates place the volume of international capital transactions at more than 40 times the volume of international trade transactions -- growth in the use of the euro as the currency of choice in global capital markets will have much more significant repercussions for the United States than will increasing use of the euro in global product markets. To a large extent, these repercussions reflect the well-known gains that stem from increasing returns in the use of a currency as a store of value. As the market for a currency becomes more liquid, the costs of carrying wealth denominated in that currency fall, raising investors' preferences for denominating their portfolios in that currency. These increased preferences in turn lead to a further deepening and broadening of the market for that currency, costs of holdings are reduced further, and the process continues. As in trade transactions, the dollar is the predominant means of exchange in international financial transactions. Its predominance is especially apparent with respect to large issues of international bonds -- a clear reflection of the low cost of covering exchange rate and interest rate risk for long-term dollar instruments. I would suggest, however, that the current role of the dollar should not be taken for granted. Once the euro comes into existence, the simple conversion of the EMU countries' outstanding securities into euros will contribute to the immediate creation of a major securities market. This development alone will create a critical mass for a market in euro-denominated securities. It will give the market depth and liquidity, and, in so doing, bring down the costs of conducting transactions, issuing loans, and trading securities below those currently seen for European national currencies -- possibly to levels comparable to those for dollars. The development of such a virtuous cycle could well feed upon itself and lead to the continuous growth of the market for euros. In this context, I would like to suggest that the experience the United States has had with a large, unified capital market may point to ways in which a unified European capital market ---[PAGE_BREAK]--- may evolve after the advent of EMU. If the U.S. experience is of any relevance, we may expect to see a decreasing use of bank loans in favor of a growing use of securities in Europe after 1999. Repo markets would also likely grow, potentially along the lines we have seen in the United States, where institutional investors such as mutual funds and pension funds, state and local governments, and insurance companies have become the largest providers of capital under repo arrangements -- in contrast with Europe's experience, where these types of investors tend to hold bank deposits. A growing role for repurchase arrangements is already apparent in Europe, and this growth may be expected to accelerate once the European central bank starts to operate in this market, accepting -- and fostering -- the use of a wide range of government paper as collateral. It is useful to keep in mind that the move to a single-currency, highly securitized European capital market cannot be expected to be completely painless. Clearly, since banks are the main intermediaries of cross-border transactions, the banking sector will bear the brunt of the costs associated with the changeover to a common currency. For example, it will suffer losses from reduced foreign exchange trading and transfer revenues. It will also have to pay for the retooling of information management and delivery systems, as well as face increased uncertainties in its core deposits. At the same time, however, the larger single market will create new opportunities for banks, particularly in the areas of investment banking and the cross-border sale of deposits, mutual funds, and other savings products. On balance, it seems fair to conclude that the commercial position and earnings of many European banks are likely to come under pressure. This may accelerate the ongoing restructuring of Europe's banking industry, a process that has been confined, to date, primarily to developments within each country. More broadly, there can be no doubt that the implications of the growth of a more efficient and cost-effective market for euro-denominated capital would extend well beyond Europe. The availability of a new, low-cost channel for portfolio investment, for example, could help reverse the traditional reluctance of households and many institutional investors worldwide to invest internationally -- a reluctance that has long puzzled academics and policymakers. Moreover, a well-developed market for euro-denominated capital would encourage institutional investors from the United States and elsewhere to acquire diversified European portfolios offered in a single currency. In fact, this development could be accelerated if member governments chose to deepen the euro market by increasing the available range of bond maturities, which in some countries is somewhat limited at the short and long ends. In addition, capital might also flow in the opposite direction, as non-European firms and governments tap the euro-denominated capital market as an efficient source of funds, in the same way as European businesses and governments have chosen to borrow dollars in recent decades. While the potential benefits of a more integrated European capital market in the long run are apparent, a number of observers have suggested that the economics of EMU -- as well as its plain mechanics -- may have unwelcome consequences for the dollar and world trade. More specifically, some have argued, EMU may cause a short-run glut of dollars in the international capital markets, leading the dollar to depreciate and the euro to appreciate, with resulting undesirable effects on trade flows. The reason there could be a dollar glut, these observers maintain, is that EMU would eliminate the need for intra-European intervention, reduce the importance of exchange rate management, and allow national central banks to pool reserves for external intervention, thus generally reducing the European central banks' need for dollar reserves. Moreover, if the euro were ---[PAGE_BREAK]--- to become an attractive reserve currency for non-European central banks, the dollar glut could become even more severe. While some decline in the reserve role of the dollar is certainly plausible over time with the creation of EMU, I believe that the risk of a dramatic shift in official dollar reserve holdings both in and outside Europe in the wake of EMU has been exaggerated in terms of both its potential scope and effects. I would suggest that it will take some time before the objectives and operating procedures of the European central bank become clearly understood by market participants. Although low inflation will be the ultimate objective of the new European central bank, markets will have to understand precisely how that objective will be pursued: What price aggregate will be the focus of monetary policy? How will intermediate instruments such as monetary aggregates be used to achieve the ultimate objective? What channels will the central bank choose to signal and implement changes in its policy stance? As these longer-term questions are addressed, the policy importance of the external value of the euro, particularly the euro/dollar exchange rate, will certainly be watched carefully. Both market participants and foreign central banks are likely to focus on the euro exchange rate as a high-frequency and widely available -- if somewhat noisy -- indicator of the current and likely future stance of European monetary policy. Given its need to instil confidence in the markets and to ensure the stability of the euro exchange rate, the European central bank is likely to want to be perceived as ready and able to operate effectively in the dollar market, for which substantial dollar reserves may be required. In the short term, the response of non-European central banks to the introduction of the euro is also likely to be cautious. Ultimately, the desired euro holdings of these central banks will largely depend on the decisions they make about their exchange rate regime. A number of countries -- including the central European countries that have applied for membership in the European Union and other countries in Africa -- may decide to peg their currency to the euro. Yet these countries may well wait for the newly-formed European central bank to establish its policy record and clarify its operating procedures before they commit their currencies to a euro peg. Indeed, history suggests that a currency's role as an international reserve, means of exchange, and store of value is slowly gained and slowly lost -- as the examples of the dollar and pound sterling illustrate. The dollar, in particular, may have seemed on the way to losing much of its international prominence after the demise of the Bretton Woods system in 1973. After declining as a share of international reserves and a means for international transactions from 1974 to the mid-1980s, however, the dollar's relative use has not changed significantly during the past decade. Indeed, as the U.S. economy has grown more efficient and internationally competitive in the past ten years, the dollar has retained its strong role in the international monetary system. In short, it seems safe to assume that significant changes in the international role of the dollar and the functioning of the international monetary system would occur only gradually, and surely in a manner that could be easily coped with, given the turnover in capital markets we observe today. But should a different international monetary system ultimately emerge in which other currencies, such as the euro, play an increasingly important role alongside the dollar, there would be benefits for the United States as well. Such a development would, for example, impose greater market-led discipline on the United States and, in the process, help us address our chronic low-savings problem. There is another indirect -- although potentially more important -- way in which EMU may affect U.S. business and policymaking. This implication of EMU has to do with the contribution ---[PAGE_BREAK]--- a currency union is likely to make to increasing the efficiency and flexibility of the economies that join it. At least since the publication of the "One Market, One Money" study by the European Commission in 1990, observers and analysts of EMU have paid significant attention to the decline in transaction costs that can be achieved by unifying up to 15 different currencies, and to the resulting gains in efficiency for Europe's economies. The experience of the United States is useful in this respect. The fact that 50 states in the United States share a common currency -- and have done so for over 130 years -- provides the critical foundation for an integrated and efficient capital market that extends from Maine to California and on to Alaska and Hawaii. In this market, capital flows smoothly from high-saving to high-investment areas, as required by changing business conditions, without any thought of exchange rate risk. A common U.S. currency, it is important to note, has many advantages beyond simply reducing transaction costs. It also simplifies choices for households and corporate management, enhances the efficiency with which financial institutions and the payments system function, and promotes competition across the whole productive spectrum. While a common currency in Europe can be expected to lead to similar efficiency gains, the economies of the United States and Europe differ in several important dimensions, so that a common currency is likely to work in substantially different ways in the two regions. The ways in which Europe and the United States differ most have to do with the degree of integration of their labor markets and their fiscal systems. The United States enjoys a very mobile labor force -- across sectors and states -which allows job losses arising during sector-specific or state-specific recessions to be rapidly absorbed where jobs are growing faster. This contributes to aggregate unemployment being kept reasonably in check. This willingness of American workers to move themselves and their family is a cultural characteristic of our people, no doubt based in the history of the United States as a nation of immigrants. To complement its high degree of labor mobility, the United States also has in place a federal fiscal system that allows the federal government to channel large transfers from fast-growing regions to slow-growing regions. Progressive income taxation, a high elasticity of corporate tax profits to changes in income, and an integrated federal budget are the main components of this system. In contrast to the United States, Europe is characterized by a more segmented labor market and very limited integration of its national fiscal systems. Both these characteristics limit the ability not only of Europe's private sector to shift resources in response to regional recessions, but also of Europe's public sector to compensate for this rigidity. This lack of flexibility is widely acknowledged to be one of the root causes of the high unemployment rates that Europe has experienced during the last decade. But, we may well ask, does it necessarily follow that because of the greater rigidity of its labor markets and the lack of a federal fiscal system, Europe cannot accommodate a common currency and instead needs to rely on periodic exchange rate adjustments as surrogates for productive flexibility? I do not think so. While less flexible labor markets and the absence of a federal fiscal system will certainly pose constant challenges for the management of a common European currency, a fluctuating exchange rate need not be the optimal way to respond to these shortcomings. The argument that Europe -- even a core component of Europe -- can ill afford to renounce exchange rate flexibility rests crucially on the view that Europe is significantly more ---[PAGE_BREAK]--- heterogeneous than the United States and, therefore, more vulnerable to country-specific shocks that can best be corrected by exchange rate changes. I do not support this view. Rather, I believe that in many respects differences among the European economies have been over-emphasized in the public debate. It is possible to suggest, for example, that the economies of some European countries have more in common today than do those of some individual states in the United States, such as New York and Michigan or California and Idaho. Moreover, as a result of the convergence of economic policy objectives, the economic cycles among many European countries have become more synchronized over the last ten years, a trend that is likely to be reinforced by monetary unification. Furthermore, when shocks are mainly at the industry level -- for instance, when a recession hits the automobile or steel industry in Germany and France -- the German and French economies would hardly benefit from an exchange rate change. Such a change, in this case, simply would not affect the appropriate relative prices. By contrast, American policymakers might have found it helpful to devalue the dollar in Texas when oil prices collapsed in the mid-1980s or the dollar in New England at the end of the defense-led growth of the late 1980s. These options, however, simply were not available. In retrospect, it was the discipline fostered by the absence of the opportunity to alter regional exchange rates that forced our firms, local governments, and workers to reorganize, become more efficient, and grow in what are now some of the most productive areas of the United States. Similarly, if national labor markets in Europe become more flexible and efficient in the presence of a common currency and firms learn to count only on their own resources -- with no help from an occasional exchange rate adjustment -- European capital and labor markets may themselves become more integrated. And if greater integration of labor markets can only proceed slowly -- given persistent and unavoidable cultural and language differences -- this need not be the case for financial markets, where the disappearance of exchange rate risk will cause capital to move in response to interest rate differentials of only a very few percentage points. In this context, I would like to make clear that I do not view as ideal the U.S. model where the burden of recessions tends to fall heavily on the shoulders of workers, who may be obliged to move across regions and industries in response to the business cycle. How to deal with the reality of the business cycle is an area where Europe -- with its tradition of social safety nets -- and the United States -- with its tradition of flexible work arrangements -- can perhaps learn something from each other. To date, neither of us seems yet to have found the optimal way to cope with the unavoidable reality of the business cycle to enable us to avoid both high unemployment rates and too skewed a distribution of income. My last general observation about the implications of EMU for the United States has to do with the dramatic changes in macroeconomic policies that will accompany the creation of monetary union in Europe. Naturally, the main change will concern monetary policy, and it is in this area that the similarities between Europe and the United States will ultimately be the greatest. The first similarity is that, with EMU, the formulation of monetary policy in both Europe and the United States will be highly centralized and the European central bank will enjoy, as the Federal Reserve does, a considerable degree of independence. These institutional features will reduce the scope for national governments to bend monetary policy to the needs of their country's business cycle and will help keep the focus of the European central bank on the objective of price stability. The second similarity we may expect to see between Europe and the United States is that, with EMU, external considerations -- such as the trade balance or the value of the exchange ---[PAGE_BREAK]--- rate -- will over time impinge less and less on the conduct of monetary policy, as now is the case in the United States. Once monetary union is in place for all 15 countries, the openness of Europe's unified economy -- as measured, for example, by the share of exports in relation to GDP -- is likely to be quite similar to that of the U.S. economy, on the order of 10 percent. While the conduct of monetary policy in Europe may increasingly resemble that in the United States, the conduct of fiscal policy will continue to differ significantly in the two regions, largely reflecting the different paths Europe and the United States have taken to monetary unification. In the United States, political union came well ahead of a common monetary policy. The Federal Reserve was not created until 1913, when political unification had been long in place. The situation is, of course, quite different in Europe, where EMU member countries plan to retain substantial political and fiscal independence. Despite this independence, EMU may well foster fiscal coordination among the member countries. This may happen in part because the EMU countries have chosen to subscribe to a set of common guidelines on the magnitude of their fiscal deficits, and in part because these countries will compete for a common pool of savings in an integrated capital market. The prospect of market-based discipline on the fiscal policies pursued by the EMU countries is not so different from the situation faced by individual states and municipalities in the United States. The need for these entities to tap a common capital market to finance their deficits places their actions under a stricter market test than they would face if they could rely mainly on captive local savings. The municipal bond market in the United States is today a very active and competitive market, where yield differences on public debt reflect investors' perceptions of default risk, and inefficient state and local administrations are quickly penalized for fiscal profligacy. Similar markets are likely to evolve in Europe after 1999. In fact, the major rating agencies are already planning for European issues of government debt following the creation of EMU. By all accounts, the agencies expect these ratings to mirror those currently assigned to countries' foreign currency debt, with fiscal factors driving rating changes once EMU is well under way. As I hope I have made clear in my remarks this evening, we in the United States, as elsewhere, have been observing the progress toward monetary unification in Europe with great interest. In the process, I think we have learned to appreciate the complexity of this enormous undertaking. One conclusion I have drawn from my observations over the years is that many of the reforms Europe is pursuing on its path to monetary unification -- including fiscal stabilization, tax harmonization, welfare and labor market reform, trade liberalization, and capital market integration -are goals that are worth pursuing in their own right and for which EMU provides a consistent frame of reference. Continued progress toward furthering these broad-based goals is in the interest not only of Europe but also of the United States. There can be no question that the United States has benefited greatly in the past two decades from Europe's deepening integration. Europe has provided a steady opening of markets for American products and served as a source of an increasingly efficient supply of goods to U.S. households and firms. Europe's growing participation in international capital markets, which a successful EMU and a strong euro are intended to further, has also encouraged an increasing flow of savings between Europe and the United States in response to changing macroeconomic conditions in our two regions. We in the United States have much at stake in Europe's and EMU's future and we stand ready to work with you and support you in the furtherance of your historic efforts.	William J McDonough	United States	https://www.bis.org/review/r971202b.pdf	Europe Remarks by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough, before the Association of German Mortgage Banks in Frankfurt, on 17/11/97. I am honored to be invited by the German Mortgage Banks to be the keynote speaker tonight at the Association's annual Pfandbrief Forum. It is a great pleasure to be here in Frankfurt among so many distinguished representatives of the German banking and financial community and members of the Bundesbank Council. In my remarks to you this evening, I would like to offer a few thoughts on the implications of Economic and Monetary Union in Europe from my perspective as President of the Federal Reserve Bank of New York. Many in the United States today are following developments in Europe's move toward monetary union with considerable interest. I am certainly among them. There can be no doubt about the magnitude and economic importance of the historic event that will take place on January 1, 1999, when the currencies of up to 15 member countries of the European Union are scheduled to be unified. It is a goal toward which Europe has been working ever since the Treaty of Rome was signed in 1957 creating the European Economic Community. While some might claim that this historic development will have little impact on the U.S. economy, nothing could be further from the truth. The United States will be directly affected in several important ways by the start of Economic and Monetary Union in Europe, or EMU. I would like to review some of the main channels through which EMU is likely to affect American business and policymaking over the next several years. Further, I think it may be useful to highlight some of the important similarities and differences between the currency union that exists in the United States today and the currency union that you are in the process of creating in Europe. The most obvious implication of the start of EMU for the United States -- as well as for the world community -- is the coming into existence of a new currency, the euro, which is intended to function as a major international currency alongside the U.S. dollar. I should make clear at the outset that it would be a mistake to think that the United States looks at this prospect with concern, as if the introduction of the euro could somehow compromise the ability of the United States to continue to conduct trade and financial transactions with the rest of the world. As you well know, the dollar is currently used in roughly 50 percent of world trade transactions and in at least one side of 80 percent of world financial transactions. The introduction of another major international currency will neither harm the depth and liquidity of the dollar market nor hinder the ability of the United States to conduct its external transactions smoothly. On the contrary, to the extent that the birth of the euro fosters deeper trade and financial markets globally and a more efficient international monetary system, all countries stand to benefit, particularly an active participant such as the United States. Let me be more specific. In my view, for the United States and the international monetary system, the implication of a growing international role for the euro over the foreseeable future will be most significant with respect to financial rather than trade transactions. It is quite true that the euro may quickly become the currency of choice in the invoicing of trade between companies in the European Union and their foreign counterparts. Companies in regions with strong links to the European Union, such as those in eastern and central Europe, North Africa, and the CFA French franc zone, may also choose to invoice trade in euros. More generally, the euro may well expand its importance in world trade beyond the relative trade weight of the European Union countries, following a path similar to that taken by the U.S. dollar and -- before that -- by the pound sterling. Nevertheless, I would argue that the economic effects of these potential changes in invoicing practices are likely to be limited. Why do I say this? First, to a large extent, the re-denomination of a significant share of world trade into euros will mainly represent a shift in invoicing practices from the use of former European currencies to euros. Moreover, third-country effects are unlikely to be major, because the European currencies as a whole are already somewhat over-represented in their share of world trade transactions relative to their countries' weights in world trade -- not as much so as the dollar, but certainly more so than the yen. Finally, changes in trade invoicing practices have a direct economic impact only on the two parties involved in the transaction, and these effects are limited to determining who ultimately bears the exchange rate risk. In fact, because of the wide variety of risk-hedging instruments that are available to traders exposed to exchange rate fluctuations, the impact of exchange rate risk on trade patterns is likely to be secondary. This conjecture is confirmed by a substantial amount of empirical research. In short, the economic impact of the euro in international trade transactions is likely to be limited. The same cannot be said of the euro's potential role in international financial transactions. Partly because of their sheer magnitude -- some estimates place the volume of international capital transactions at more than 40 times the volume of international trade transactions -- growth in the use of the euro as the currency of choice in global capital markets will have much more significant repercussions for the United States than will increasing use of the euro in global product markets. To a large extent, these repercussions reflect the well-known gains that stem from increasing returns in the use of a currency as a store of value. As the market for a currency becomes more liquid, the costs of carrying wealth denominated in that currency fall, raising investors' preferences for denominating their portfolios in that currency. These increased preferences in turn lead to a further deepening and broadening of the market for that currency, costs of holdings are reduced further, and the process continues. As in trade transactions, the dollar is the predominant means of exchange in international financial transactions. Its predominance is especially apparent with respect to large issues of international bonds -- a clear reflection of the low cost of covering exchange rate and interest rate risk for long-term dollar instruments. I would suggest, however, that the current role of the dollar should not be taken for granted. Once the euro comes into existence, the simple conversion of the EMU countries' outstanding securities into euros will contribute to the immediate creation of a major securities market. This development alone will create a critical mass for a market in euro-denominated securities. It will give the market depth and liquidity, and, in so doing, bring down the costs of conducting transactions, issuing loans, and trading securities below those currently seen for European national currencies -- possibly to levels comparable to those for dollars. The development of such a virtuous cycle could well feed upon itself and lead to the continuous growth of the market for euros. In this context, I would like to suggest that the experience the United States has had with a large, unified capital market may point to ways in which a unified European capital market may evolve after the advent of EMU. If the U.S. experience is of any relevance, we may expect to see a decreasing use of bank loans in favor of a growing use of securities in Europe after 1999. Repo markets would also likely grow, potentially along the lines we have seen in the United States, where institutional investors such as mutual funds and pension funds, state and local governments, and insurance companies have become the largest providers of capital under repo arrangements -- in contrast with Europe's experience, where these types of investors tend to hold bank deposits. A growing role for repurchase arrangements is already apparent in Europe, and this growth may be expected to accelerate once the European central bank starts to operate in this market, accepting -- and fostering -- the use of a wide range of government paper as collateral. It is useful to keep in mind that the move to a single-currency, highly securitized European capital market cannot be expected to be completely painless. Clearly, since banks are the main intermediaries of cross-border transactions, the banking sector will bear the brunt of the costs associated with the changeover to a common currency. For example, it will suffer losses from reduced foreign exchange trading and transfer revenues. It will also have to pay for the retooling of information management and delivery systems, as well as face increased uncertainties in its core deposits. At the same time, however, the larger single market will create new opportunities for banks, particularly in the areas of investment banking and the cross-border sale of deposits, mutual funds, and other savings products. On balance, it seems fair to conclude that the commercial position and earnings of many European banks are likely to come under pressure. This may accelerate the ongoing restructuring of Europe's banking industry, a process that has been confined, to date, primarily to developments within each country. More broadly, there can be no doubt that the implications of the growth of a more efficient and cost-effective market for euro-denominated capital would extend well beyond Europe. The availability of a new, low-cost channel for portfolio investment, for example, could help reverse the traditional reluctance of households and many institutional investors worldwide to invest internationally -- a reluctance that has long puzzled academics and policymakers. Moreover, a well-developed market for euro-denominated capital would encourage institutional investors from the United States and elsewhere to acquire diversified European portfolios offered in a single currency. In fact, this development could be accelerated if member governments chose to deepen the euro market by increasing the available range of bond maturities, which in some countries is somewhat limited at the short and long ends. In addition, capital might also flow in the opposite direction, as non-European firms and governments tap the euro-denominated capital market as an efficient source of funds, in the same way as European businesses and governments have chosen to borrow dollars in recent decades. While the potential benefits of a more integrated European capital market in the long run are apparent, a number of observers have suggested that the economics of EMU -- as well as its plain mechanics -- may have unwelcome consequences for the dollar and world trade. More specifically, some have argued, EMU may cause a short-run glut of dollars in the international capital markets, leading the dollar to depreciate and the euro to appreciate, with resulting undesirable effects on trade flows. The reason there could be a dollar glut, these observers maintain, is that EMU would eliminate the need for intra-European intervention, reduce the importance of exchange rate management, and allow national central banks to pool reserves for external intervention, thus generally reducing the European central banks' need for dollar reserves. Moreover, if the euro were to become an attractive reserve currency for non-European central banks, the dollar glut could become even more severe. While some decline in the reserve role of the dollar is certainly plausible over time with the creation of EMU, I believe that the risk of a dramatic shift in official dollar reserve holdings both in and outside Europe in the wake of EMU has been exaggerated in terms of both its potential scope and effects. I would suggest that it will take some time before the objectives and operating procedures of the European central bank become clearly understood by market participants. Although low inflation will be the ultimate objective of the new European central bank, markets will have to understand precisely how that objective will be pursued: What price aggregate will be the focus of monetary policy? How will intermediate instruments such as monetary aggregates be used to achieve the ultimate objective? What channels will the central bank choose to signal and implement changes in its policy stance? As these longer-term questions are addressed, the policy importance of the external value of the euro, particularly the euro/dollar exchange rate, will certainly be watched carefully. Both market participants and foreign central banks are likely to focus on the euro exchange rate as a high-frequency and widely available -- if somewhat noisy -- indicator of the current and likely future stance of European monetary policy. Given its need to instil confidence in the markets and to ensure the stability of the euro exchange rate, the European central bank is likely to want to be perceived as ready and able to operate effectively in the dollar market, for which substantial dollar reserves may be required. In the short term, the response of non-European central banks to the introduction of the euro is also likely to be cautious. Ultimately, the desired euro holdings of these central banks will largely depend on the decisions they make about their exchange rate regime. A number of countries -- including the central European countries that have applied for membership in the European Union and other countries in Africa -- may decide to peg their currency to the euro. Yet these countries may well wait for the newly-formed European central bank to establish its policy record and clarify its operating procedures before they commit their currencies to a euro peg. Indeed, history suggests that a currency's role as an international reserve, means of exchange, and store of value is slowly gained and slowly lost -- as the examples of the dollar and pound sterling illustrate. The dollar, in particular, may have seemed on the way to losing much of its international prominence after the demise of the Bretton Woods system in 1973. After declining as a share of international reserves and a means for international transactions from 1974 to the mid-1980s, however, the dollar's relative use has not changed significantly during the past decade. Indeed, as the U.S. economy has grown more efficient and internationally competitive in the past ten years, the dollar has retained its strong role in the international monetary system. In short, it seems safe to assume that significant changes in the international role of the dollar and the functioning of the international monetary system would occur only gradually, and surely in a manner that could be easily coped with, given the turnover in capital markets we observe today. But should a different international monetary system ultimately emerge in which other currencies, such as the euro, play an increasingly important role alongside the dollar, there would be benefits for the United States as well. Such a development would, for example, impose greater market-led discipline on the United States and, in the process, help us address our chronic low-savings problem. There is another indirect -- although potentially more important -- way in which EMU may affect U.S. business and policymaking. This implication of EMU has to do with the contribution a currency union is likely to make to increasing the efficiency and flexibility of the economies that join it. At least since the publication of the "One Market, One Money" study by the European Commission in 1990, observers and analysts of EMU have paid significant attention to the decline in transaction costs that can be achieved by unifying up to 15 different currencies, and to the resulting gains in efficiency for Europe's economies. The experience of the United States is useful in this respect. The fact that 50 states in the United States share a common currency -- and have done so for over 130 years -- provides the critical foundation for an integrated and efficient capital market that extends from Maine to California and on to Alaska and Hawaii. In this market, capital flows smoothly from high-saving to high-investment areas, as required by changing business conditions, without any thought of exchange rate risk. A common U.S. currency, it is important to note, has many advantages beyond simply reducing transaction costs. It also simplifies choices for households and corporate management, enhances the efficiency with which financial institutions and the payments system function, and promotes competition across the whole productive spectrum. While a common currency in Europe can be expected to lead to similar efficiency gains, the economies of the United States and Europe differ in several important dimensions, so that a common currency is likely to work in substantially different ways in the two regions. The ways in which Europe and the United States differ most have to do with the degree of integration of their labor markets and their fiscal systems. The United States enjoys a very mobile labor force -- across sectors and states -which allows job losses arising during sector-specific or state-specific recessions to be rapidly absorbed where jobs are growing faster. This contributes to aggregate unemployment being kept reasonably in check. This willingness of American workers to move themselves and their family is a cultural characteristic of our people, no doubt based in the history of the United States as a nation of immigrants. To complement its high degree of labor mobility, the United States also has in place a federal fiscal system that allows the federal government to channel large transfers from fast-growing regions to slow-growing regions. Progressive income taxation, a high elasticity of corporate tax profits to changes in income, and an integrated federal budget are the main components of this system. In contrast to the United States, Europe is characterized by a more segmented labor market and very limited integration of its national fiscal systems. Both these characteristics limit the ability not only of Europe's private sector to shift resources in response to regional recessions, but also of Europe's public sector to compensate for this rigidity. This lack of flexibility is widely acknowledged to be one of the root causes of the high unemployment rates that Europe has experienced during the last decade. But, we may well ask, does it necessarily follow that because of the greater rigidity of its labor markets and the lack of a federal fiscal system, Europe cannot accommodate a common currency and instead needs to rely on periodic exchange rate adjustments as surrogates for productive flexibility? I do not think so. While less flexible labor markets and the absence of a federal fiscal system will certainly pose constant challenges for the management of a common European currency, a fluctuating exchange rate need not be the optimal way to respond to these shortcomings. The argument that Europe -- even a core component of Europe -- can ill afford to renounce exchange rate flexibility rests crucially on the view that Europe is significantly more heterogeneous than the United States and, therefore, more vulnerable to country-specific shocks that can best be corrected by exchange rate changes. I do not support this view. Rather, I believe that in many respects differences among the European economies have been over-emphasized in the public debate. It is possible to suggest, for example, that the economies of some European countries have more in common today than do those of some individual states in the United States, such as New York and Michigan or California and Idaho. Moreover, as a result of the convergence of economic policy objectives, the economic cycles among many European countries have become more synchronized over the last ten years, a trend that is likely to be reinforced by monetary unification. Furthermore, when shocks are mainly at the industry level -- for instance, when a recession hits the automobile or steel industry in Germany and France -- the German and French economies would hardly benefit from an exchange rate change. Such a change, in this case, simply would not affect the appropriate relative prices. By contrast, American policymakers might have found it helpful to devalue the dollar in Texas when oil prices collapsed in the mid-1980s or the dollar in New England at the end of the defense-led growth of the late 1980s. These options, however, simply were not available. In retrospect, it was the discipline fostered by the absence of the opportunity to alter regional exchange rates that forced our firms, local governments, and workers to reorganize, become more efficient, and grow in what are now some of the most productive areas of the United States. Similarly, if national labor markets in Europe become more flexible and efficient in the presence of a common currency and firms learn to count only on their own resources -- with no help from an occasional exchange rate adjustment -- European capital and labor markets may themselves become more integrated. And if greater integration of labor markets can only proceed slowly -- given persistent and unavoidable cultural and language differences -- this need not be the case for financial markets, where the disappearance of exchange rate risk will cause capital to move in response to interest rate differentials of only a very few percentage points. In this context, I would like to make clear that I do not view as ideal the U.S. model where the burden of recessions tends to fall heavily on the shoulders of workers, who may be obliged to move across regions and industries in response to the business cycle. How to deal with the reality of the business cycle is an area where Europe -- with its tradition of social safety nets -- and the United States -- with its tradition of flexible work arrangements -- can perhaps learn something from each other. To date, neither of us seems yet to have found the optimal way to cope with the unavoidable reality of the business cycle to enable us to avoid both high unemployment rates and too skewed a distribution of income. My last general observation about the implications of EMU for the United States has to do with the dramatic changes in macroeconomic policies that will accompany the creation of monetary union in Europe. Naturally, the main change will concern monetary policy, and it is in this area that the similarities between Europe and the United States will ultimately be the greatest. The first similarity is that, with EMU, the formulation of monetary policy in both Europe and the United States will be highly centralized and the European central bank will enjoy, as the Federal Reserve does, a considerable degree of independence. These institutional features will reduce the scope for national governments to bend monetary policy to the needs of their country's business cycle and will help keep the focus of the European central bank on the objective of price stability. The second similarity we may expect to see between Europe and the United States is that, with EMU, external considerations -- such as the trade balance or the value of the exchange rate -- will over time impinge less and less on the conduct of monetary policy, as now is the case in the United States. Once monetary union is in place for all 15 countries, the openness of Europe's unified economy -- as measured, for example, by the share of exports in relation to GDP -- is likely to be quite similar to that of the U.S. economy, on the order of 10 percent. While the conduct of monetary policy in Europe may increasingly resemble that in the United States, the conduct of fiscal policy will continue to differ significantly in the two regions, largely reflecting the different paths Europe and the United States have taken to monetary unification. In the United States, political union came well ahead of a common monetary policy. The Federal Reserve was not created until 1913, when political unification had been long in place. The situation is, of course, quite different in Europe, where EMU member countries plan to retain substantial political and fiscal independence. Despite this independence, EMU may well foster fiscal coordination among the member countries. This may happen in part because the EMU countries have chosen to subscribe to a set of common guidelines on the magnitude of their fiscal deficits, and in part because these countries will compete for a common pool of savings in an integrated capital market. The prospect of market-based discipline on the fiscal policies pursued by the EMU countries is not so different from the situation faced by individual states and municipalities in the United States. The need for these entities to tap a common capital market to finance their deficits places their actions under a stricter market test than they would face if they could rely mainly on captive local savings. The municipal bond market in the United States is today a very active and competitive market, where yield differences on public debt reflect investors' perceptions of default risk, and inefficient state and local administrations are quickly penalized for fiscal profligacy. Similar markets are likely to evolve in Europe after 1999. In fact, the major rating agencies are already planning for European issues of government debt following the creation of EMU. By all accounts, the agencies expect these ratings to mirror those currently assigned to countries' foreign currency debt, with fiscal factors driving rating changes once EMU is well under way. As I hope I have made clear in my remarks this evening, we in the United States, as elsewhere, have been observing the progress toward monetary unification in Europe with great interest. In the process, I think we have learned to appreciate the complexity of this enormous undertaking. One conclusion I have drawn from my observations over the years is that many of the reforms Europe is pursuing on its path to monetary unification -- including fiscal stabilization, tax harmonization, welfare and labor market reform, trade liberalization, and capital market integration -are goals that are worth pursuing in their own right and for which EMU provides a consistent frame of reference. Continued progress toward furthering these broad-based goals is in the interest not only of Europe but also of the United States. There can be no question that the United States has benefited greatly in the past two decades from Europe's deepening integration. Europe has provided a steady opening of markets for American products and served as a source of an increasingly efficient supply of goods to U.S. households and firms. Europe's growing participation in international capital markets, which a successful EMU and a strong euro are intended to further, has also encouraged an increasing flow of savings between Europe and the United States in response to changing macroeconomic conditions in our two regions. We in the United States have much at stake in Europe's and EMU's future and we stand ready to work with you and support you in the furtherance of your historic efforts.
1997-12-02T00:00:00	Mr. Greenspan's remarks to the Economic Club of New York (Central Bank Articles and Speeches, 2 Dec 97)	Remarks by the Chairman of the Board of the U S Federal Reserve System, Mr. Alan Greenspan, at the Economic Club of New York in New York City, on 02/12/97.	Mr. Greenspan's remarks to the Economic Club of New York Remarks by the Chairman of the Board of the U S Federal Reserve System, Mr. Alan Greenspan, at the Economic Club of New York in New York City, on 02/12/97. Dramatic advances in the global financial system have enabled us to materially improve the efficiency of the flows of capital and payments. Those advances, however, have also enhanced the ability of the system to rapidly transmit problems in one part of the globe to another. The events of recent weeks have underscored this latter process. The lessons we are learning from these experiences hopefully can be applied to better the workings of the international financial system, a system that has done so much to foster gains in living standards worldwide. The current crisis is likely to accelerate the dismantling in many Asian countries of the remnants of a system with large elements of government-directed investment, in which finance played a key role in carrying out the state's objectives. Such a system inevitably has led to the investment excesses and errors to which all similar endeavors seem prone. Government-directed production, financed with directed bank loans, cannot readily adjust to the continuously changing patterns of market demand for domestically consumed goods or exports. Gluts and shortages are inevitable. The accelerated opening up in recent years of product and financial markets worldwide offers enormous benefits to all nations over the long run. However, it has also exposed more quickly and harshly the underlying rigidities of economic systems in which governments -- or governments working with large industrial groups -- exercise substantial influence over resource allocation. Such systems can produce vigorous growth for a time when the gap between indigenous applied technologies and world standards is large, such as in the Soviet Union in the 1960s and 1970s and Southeast Asia in the 1980s and 1990s. But as the gap narrows, the ability of these systems to handle their increasingly sophisticated economies declines markedly. In western developed economies, in contrast, market forces have been allowed much freer rein to dictate production schedules. Rapid responses by businesses to changes in free-market prices have muted much of the tendency for unsold goods to back up, or unmet needs to produce shortages. Recent improvements in technology have significantly compressed business response times and enhanced the effectiveness of the market mechanism. Most Asian policymakers, while justly proud of the enormous success of their economies in recent decades, nonetheless have been moving of late toward these more open and flexible economies. Belatedly perhaps, they have perceived the problems to which their systems are prone and recognized the unforgiving nature of the new global market forces. Doubtless, the current crises will hasten that trend. While the adjustments may be difficult for a time, these crises will pass. Stronger individual economies and a more robust and efficient international economic and financial system will surely emerge in their wake. While each of the Asian economies is unique in many important respects, the sources of their spectacular growth in recent years, in some cases decades, and the problems that have emerged are relevant to a greater or lesser extent to nearly all of them. Following the early post-World War II period, policies generally fostering low levels of inflation and high rates of savings and investment -- including investment in human capital through education -- contributed to a sustained period of rapid growth. In some cases this started in the 1960s and 1970s, but by the 1980s most economies in the region were expanding vigorously. Foreign net capital inflows grew, but until recently were relatively modest. The World Bank estimates that net inflows of long-term debt, foreign direct investment, and equity purchases to the Asia-Pacific region were only about $25 billion in 1990, but exploded to more than $110 billion by 1996; less comprehensive data suggest that inflows rose to a still higher rate earlier this year. Sustained, spectacular growth in Asian economies fostered expectations of high returns with moderate risk. Moreover the global stock market boom of the 1990s provided the impetus to seek these perceived high returns. As that boom progressed, investors in many industrial countries found themselves more heavily concentrated in the recently higher valued securities of companies in the developed world, whose rates of return, in many instances, had reached levels perceived as uncompetitive with the earnings potential in emerging economies, especially in Asia. The resultant diversification induced a sharp increase in capital flows into those economies. To a large extent, they came from investors in the United States and western Europe. A substantial amount came from Japan, as well, owing more to a search for higher yields than to rising stock prices and capital gains in that country. The rising yen through mid-1995 also encouraged a substantial increase in direct investment outflows from Japan. In retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at reasonable risk. It may have been inevitable in those conditions of rapid growth, ample liquidity, and an absence of sufficient profitable alternatives, that much investment moved into the real estate sector, with an emphasis by both the public and private sectors on conspicuous construction projects that had little economic rationale. These real estate assets, in turn, ended up as collateral for a significant proportion of the assets of domestic financial systems. In many instances, those financial systems were already less than robust, beset with problems of poor lending standards, weak supervisory regimes, and inadequate capital. At the same time, rising business leverage added to financial fragility. Businesses were borrowing to maintain high rates of return on equity and weak financial systems were poorly disciplining this process. In addition, explicit government guarantees of debt or, more often, the presumption of such guarantees by the investment community, encouraged insufficient vigilance by lenders and hence greater leverage. But high debt burdens allow little tolerance for rising interest rates or slowdowns in economic growth, as recent events have demonstrated. Moreover, the rapidly growing foreign-currency-denominated debt, in part the result of pegged exchange rates to the dollar, put pressure on companies to earn foreign exchange. But earning it became increasingly difficult. The substantial rise in the value of the dollar since mid-1995, especially relative to the yen, made exports of the Southeast Asian economies less competitive. In addition, in some cases, the glut of semiconductors in 1996 and the accelerated drop in their prices suppressed export earnings growth, exerting further pressures on highly leveraged businesses. In time, the pressures on what had become fixed-exchange-rate regimes mounted as investors, confronted with ever fewer profitable prospects, slowed the pace of new capital inflows. Fearing devaluation, many domestic Asian businesses sought increasingly to convert domestic currencies into foreign currencies, or, equivalently, slowed the conversion of export earnings into domestic currencies. To counter pressures on exchange rates, countries raised interest rates. For fixed-exchange-rate, highly leveraged economies, it was only a matter of time before slower growth and higher interest rates led to difficulties for borrowers, especially those with fixed obligations. Particularly troublesome over the past several months has been the so-called contagion effect of weakness in one economy spreading to others as investors perceive, rightly or wrongly, similar vulnerabilities. This is an age-old phenomenon. When investors are unsettled by uncertainties and fears, they withdraw commitments on a broad front; the finer distinctions between countries and currencies are lost. There is a flight to safe-haven investments, many of which are in developed nations. Perhaps, given the circumstances, it was inevitable that the impressive and rapid growth experienced by the economies in the Asian region would encounter a temporary slowdown or pause. I say temporary because there is no reason that above-average growth in countries that are still in a position to gain from catching up with the prevailing technology cannot persist for a very long time, provided their markets are opened to the full force of competition. Nonetheless, free-market, even partially free-market, economies do periodically run into difficulties because investment mistakes invariably occur. And, as I noted earlier, many of these mistakes arose from government-directed or influenced investments. When this happens, private capital flows may temporarily turn adverse. In these circumstances, individual companies should be allowed to default, private investors should take their losses, and government policies should be directed toward laying the macroeconomic and structural foundations for renewed expansion. New growth opportunities must be allowed to emerge. Although the economies of the troubled Asian countries were usually characterized by a combination of current account deficits, large net foreign currency exposures, and constraints on exchange rate fluctuations, one cannot generalize that these are always signs of impending difficulties. Large current account deficits, per se, are not dangerous if they result from direct investment inflows that are not subject to rapid withdrawal and that generate an increase in income sufficient to compensate the investors. Foreign currency exposures need not be a problem if positions are properly managed and the risks are recognized. Fixed exchange rates, also, are not necessarily a problem. Indeed, if they can be sustained, they yield extensive benefits in lower risk and lower costs for all international transactions. But a small open economy can maintain an exchange rate fixed to a hard currency only under certain conditions. Both Austria and the Netherlands, for example, have been able to lock their currencies against the Deutsche Mark because their economies are tightly linked through trade with Germany, they mirror the Bundesbank's monetary policies, and they are perceived to engage in prudent fiscal policies. Were it not for issues of national identity and seignorage, they could just as readily embrace the DM as their domestic currency without any economic disruption. Other economies, such as Argentina and Hong Kong, have fixed their exchange rates essentially through currency boards. Changes in dollar reserves directly affect the monetary base of those economies. But when exchange rates are fixed, with or without currency boards, should monetary and fiscal policies diverge significantly from those of the larger economy, the currency lock of the smaller economy would be difficult to hold irrespective of the size of reserves. Large reserves can delay adjustment. They cannot prevent it if policies are inconsistent, or prices in the smaller country are inflexible. A well-functioning international financial system will seek out anomalies in policy alignments and exchange rates and set them right. In such a system, the exploitation of above-normal profit opportunities, that is, arbitrage, will force prices to change until expected returns have been equalized. To policymakers in the country whose currency is not appropriately aligned, capital outflows are too often seen as attacks by marauding currency speculators. There have no doubt been some such attempts on occasion. But speculators rarely succeed in dislodging an exchange rate that is firmly rooted in compatible policies and cost structures. More often, speculation forces currencies through arbitrage into a closer alignment with underlying market values to the benefit of the international economic and financial system as a whole. We used to describe capital flight as "hot money". But we soon recognized that it was not the money that was "hot", but the place it was running from. The prodigious expansion of cross-border financial transactions in recent years has tightened and refined the arbitrage process significantly. But, to repeat, the inestimable advantages that it brings to trade and standards of living also carry a price. The inevitable investment mistakes and governmental policy failures are more rapidly transmitted to other markets by this process than was the case say twenty, or even ten, years ago. Moreover, there is little evidence to suggest that the rate of increase of financial transactions will slow materially in the years immediately ahead. Technology will continue to reduce the costs of finding and exploiting perceived differences in risk-adjusted rates of return around the world, helping to direct capital even more to its most efficient use. Already, covered rates of return on actively traded interest-rate instruments have been equalized among many industrial countries. But the broader merging of world savings and investment markets, clearly, has not been achieved, largely because investors are fearful of investing in countries they do not understand to the extent that they do their own, or are uninformed of the opportunities. One measure of this so-called home bias in world investments is the degree that portfolios remain substantially local. Foreign investments, on average, represent less than 10 percent of U.S. portfolios, for example. The percentage of Japanese portfolios is only slightly higher, and 15 percent of German portfolios is in foreign assets. The partial exception is Great Britain, where, with a longer history of global financial involvement, one-third of portfolios is invested in foreign assets. Home bias in investments is considerably less than it was ten years ago, but we are still far from full globalization. Unless government restrictions inhibit the expansion of ever more sophisticated financial products that enable savers in one part of the world to reduce risk by investing in another, the bias will continue to diminish and the size of the international financial system will continue to expand at a significant pace. It is this overall diversification, and hence lowering of risk, that an effective international financial system offers. It facilitates the ever more efficient functioning of the global economic system and, hence, is a major contributor to rising standards of living worldwide. Nonetheless, there are those who ask whether the price of so sophisticated a financial system is too high. Would it not be better to slow it down a bit, and perhaps achieve a system somewhat more forgiving of mistakes, even recognizing that such a slowing may entail some shortfall in long-term economic growth? Even if we could implement such a tradeoff, with only minor disruption, should we try? For centuries groups in our societies have railed against, and endeavored on occasion to destroy, new inventions. Fortunately for us the Luddites and their ilk failed, and recent generations have enjoyed the fruits of those technologies. Moreover such a slowdown may not even be possible -- at least without major disruption and cost. Newer technologies, especially advanced telecommunications, make it exceptionally difficult for open markets, with associated opportunities, to be suppressed. Price and capital controls, which might have been feasible a half century ago, would be very difficult to implement in today's more technologically advanced environment. Tinkering at the edges of our system in order to produce a less frenetic pace of change would be easily circumvented. Arguably, it would take massive government controls to substantially slow the advance toward greater efficiency of our systems. This would surely produce a far more negative impact on economic growth than would be acceptable to even the most ardent advocates of reining in the rapid expansion of our international financial system. If, as I suspect, it turns out after due deliberation and analysis, that slowing the pace of financial modernization is not in fact seen as a feasible alternative, what policy alternatives confront the international financial community to contain the periodic disruptions that are bound to occur in any free market economy? A financial system, like all structures, is as strong as its weakest link. As the international financial system has become even more complex, the particular areas of weakness to be addressed have changed. At the risk of oversimplification, let's examine some of the key links of our current infrastructure. Today, the organized exchanges and over-the-counter markets of industrial countries can handle massive volumes of transactions. Even in emerging countries exchanges are developing and expanding. In contrast, during the world-wide stock market crash of October 1987, the transactions systems were under severe stress and, indeed, some broke down, incapable of handling the enlarged volumes. At that time, the Hong Kong stock exchange could not open for several days. The New York Stock Exchange was straining badly under the near 400 million daily share volume of late October 1987, with long reporting delays creating uncertainties that, doubtless, exaggerated the price declines. Those weaker links have since been strengthened by large infrastructure investments. Almost 1.2 billion shares traded on the NYSE on October 28 of this year, three times the 1987 volumes with no evident problems or delays. Our equity, debt, and foreign exchange trading systems, and their peripheral futures and options markets have functioned well under stress recently. These systems are not weak links in the developed economies, nor, for the most part are they in other economies. Neither is the payment system, that complex network, which transfers funds and securities in huge and growing volumes domestically and internationally, rapidly and efficiently. The private and public sectors across the globe have endeavored diligently for years to expand the capacity of the system to meet the increasing demands put upon it. And they have initiated and strengthened procedures for reducing risk in settling transactions, and diminishing uncertainties. That they have generally succeeded is evident from the smoothness with which huge volumes of funds produced under recent stressed market conditions were transferred and settled with finality, through various netting and clearing arrangements. Banks are another matter. These are highly leveraged institutions, financed in part by interbank credits and, hence, prone to crises of confidence that can quickly spread. In most developed nations banking systems appear reasonably solid. Japan has been somewhat of an exception, but there have been some positive signs there, as well. Banks have been recognizing losses, and the government seems finally to be appropriately addressing their problems. In a large number of emerging nations, as I indicated previously, banks are in poor shape. Lax lending has created a high incidence of non-performing loans, supported by inadequate capital, leaving banks vulnerable to declines in collateral values and non-performance by borrowers. How can such deficient institutions be elevated to a level that would allow their economies to function effectively in our increasingly sophisticated international financial system? Certainly, improved cost and risk management and elimination of poor lending practices are a good place to start. But these cannot be accomplished overnight. Loan officers with experience judging credit and market risks are in very short supply in emerging economies. Training will require time. The same difficulties confront bank supervision and regulation. Important efforts in this area have been underway for several years through the auspices of the Bank for International Settlements, the International Monetary Fund, and the World Bank. But again, it will take time to develop adequate systems and trained personnel. Moreover, robust banking and financial systems require firmly enforced laws of contract, and transparent, market-oriented systems of corporate reporting and governance. The current crisis in Asia is, to a much greater extent than many previous crises, one of private, not public, debts, at least de jure. Arguably, the absence of efficient and transparent work-out arrangements for troubled private borrowers makes the problems more difficult to deal with. Efficient bankruptcy arrangements reduce disruptions to economic activity that often arise when losses have to be imposed on creditors. Many developing countries do not have good work-out arrangements for troubled debtors, and, as a result, governments in these countries often feel compelled to bail them out rather than accept the consequences of defaults. The most troublesome aspect of many banking systems of emerging countries, to expand on the issue I raised earlier, is the widespread prevalence of loans driven by "industrial policy" imperatives rather than market forces. What is wrong with policy -- that is, politically-driven -- loans? Potentially nothing if they were made to firms to finance expansions that just happened to coincide with a rise in consumer or business or overseas demand for their newly-produced products. In these circumstances, the loan proceeds would have been profitably employed and the loan repaid at maturity with interest. Unfortunately, this is often not the case. Policy loans, in too many instances, foster misuse of resources, unprofitable expansions, losses, and eventually loan defaults. In many cases, of course, these loans regrettably end up being guaranteed by governments. If denominated in local currency, they can be financed with the printing press -- though with consequent risk of inflation. Too often, however, they are foreign-currency denominated, where governments face greater constraints on access to credit. Restructuring of financial systems, while indispensable, cannot be implemented quickly. Yes, the potential risks to the banking systems of many Asian countries and the potential contagion effects for their neighbors, and other trading partners, should have been spotted earlier and addressed. But flaws, seen clearly in retrospect, are never so evident at the time. Moreover, there is significant bias in political systems of all varieties to substitute hope (read, wishful thinking) for possibly difficult pre-emptive policy moves, both with respect to financial systems and economic policy. There is often denial and delay in instituting proper adjustments. Recent propensities to obscure the need for change have been evidenced by unreported declines in reserves, issuance by the government of equivalents to foreign currency obligations, or unreported large new forward short positions against foreign currencies. It is very difficult for political leaders to incur what they perceive as large, immediate political costs to contain problems they see as only prospective. Reality eventually replaces hope, and the cost of the delay is a more abrupt and disruptive adjustment than would have been required if action had been more pre-emptive. Increased transparency for businesses and governments is a key ingredient in fostering more discipline on private transactors and on government policymakers. Increased transparency can counter political bias in part by exposing for all to see the risks of current policies to stability as they develop. Under such conditions, failure to act would also be perceived as having political costs. We should strongly stress to the newer members of the international financial system -- the emerging economies -- that they should accelerate the restructuring of their financial systems in their own interests. But having delayed timely restructuring, many now find themselves with major shortfalls in bank liquidity and equity capital that put their systems at severe risk of collapse before any full restructuring is feasible. The IMF, the World Bank, and their major shareholders, the developed countries, may wish to facilitate adjustment through temporary loans to governments and the encouragement of private equity infusions to these banking systems. Since any severe breakdown can have contagion effects on a world-wide basis, it is in our interest to do so. These loans must be judged in their entirety. They transform short-term obligations into medium-term loans, but they do so contingent on the country using the time to reform financial systems as well as adopt sound economic policies. Such conditionality accelerates the adjustments in financial systems needed to lay the foundation for resumption of robust, sustainable, growth, while cushioning to some degree the economic effects of the immediate crisis. Assistance without further reform of financial systems and economic policies would be worse than useless since it would foster expectations of being perpetually bailed out. That, in turn, could induce perverse behavior on the part of emerging nations' governments and of private sector investors in emerging nations. Believing that the international financial community will support these economies, in part by backstopping the obligations they incur, induces investors to commit more than they would otherwise. This has tended in the past to push the expansion of investment beyond prudence -- given the limit of profitable opportunities. As the international financial system becomes ever larger and more efficient, the size of the financial response -- whether to help banks or to add to foreign currency reserves -- may have to be correspondingly larger per unit of crisis, if I may put it that way -unless we alter our approach. While it is precarious to generalize from one observation, it is likely that the Mexican financial crisis of the 1980s was broader than in 1994-95, but the size of the assistance program, to set things right, was much larger in the latter than in the former case. The reason appears to be that the increased efficiency of the financial system created a larger negative spillover, which had to be contained. Among other developments, the marked shift from bank credits in the earlier crisis, to a more securitized, anonymous, set of liabilities made workouts far more complex. It is, hence, all the more essential that the weaker links in our international financial system, the banking systems of the emerging nations, be strengthened. Preventive programs should be accelerated sufficiently far in advance of the next crisis to effectively thwart or contain it. Moreover, it is incumbent on governmental policymakers to insure that unstable economic environments do not induce or exacerbate international financial disruptions. But governments and international financial institutions should be brought on the scene only rarely. To do otherwise risks the perverse incentives I spoke of earlier. Markets should be allowed to work. Recent events in Asia have sharpened our understanding of the complexity of today's international capital flows and, presumably, of similar episodes that may emerge in the future. The rapid integration of national financial systems has fostered the growth of trade and standards of living worldwide. It has also forced a review of the soundness and viability of our burgeoning financial systems. We should welcome such pressures even as they impose challenges to all of us. The end result is very worthwhile having.	---[PAGE_BREAK]--- Mr. Greenspan's remarks to the Economic Club of New York Remarks by the Chairman of the Board of the U S Federal Reserve System, Mr. Alan Greenspan, at the Economic Club of New York in New York City, on 02/12/97. Dramatic advances in the global financial system have enabled us to materially improve the efficiency of the flows of capital and payments. Those advances, however, have also enhanced the ability of the system to rapidly transmit problems in one part of the globe to another. The events of recent weeks have underscored this latter process. The lessons we are learning from these experiences hopefully can be applied to better the workings of the international financial system, a system that has done so much to foster gains in living standards worldwide. The current crisis is likely to accelerate the dismantling in many Asian countries of the remnants of a system with large elements of government-directed investment, in which finance played a key role in carrying out the state's objectives. Such a system inevitably has led to the investment excesses and errors to which all similar endeavors seem prone. Government-directed production, financed with directed bank loans, cannot readily adjust to the continuously changing patterns of market demand for domestically consumed goods or exports. Gluts and shortages are inevitable. The accelerated opening up in recent years of product and financial markets worldwide offers enormous benefits to all nations over the long run. However, it has also exposed more quickly and harshly the underlying rigidities of economic systems in which governments -- or governments working with large industrial groups -- exercise substantial influence over resource allocation. Such systems can produce vigorous growth for a time when the gap between indigenous applied technologies and world standards is large, such as in the Soviet Union in the 1960s and 1970s and Southeast Asia in the 1980s and 1990s. But as the gap narrows, the ability of these systems to handle their increasingly sophisticated economies declines markedly. In western developed economies, in contrast, market forces have been allowed much freer rein to dictate production schedules. Rapid responses by businesses to changes in free-market prices have muted much of the tendency for unsold goods to back up, or unmet needs to produce shortages. Recent improvements in technology have significantly compressed business response times and enhanced the effectiveness of the market mechanism. Most Asian policymakers, while justly proud of the enormous success of their economies in recent decades, nonetheless have been moving of late toward these more open and flexible economies. Belatedly perhaps, they have perceived the problems to which their systems are prone and recognized the unforgiving nature of the new global market forces. Doubtless, the current crises will hasten that trend. While the adjustments may be difficult for a time, these crises will pass. Stronger individual economies and a more robust and efficient international economic and financial system will surely emerge in their wake. While each of the Asian economies is unique in many important respects, the sources of their spectacular growth in recent years, in some cases decades, and the problems that have emerged are relevant to a greater or lesser extent to nearly all of them. Following the early post-World War II period, policies generally fostering low levels of inflation and high rates of savings and investment -- including investment in human capital through education -- contributed to a sustained period of rapid growth. In some cases this ---[PAGE_BREAK]--- started in the 1960s and 1970s, but by the 1980s most economies in the region were expanding vigorously. Foreign net capital inflows grew, but until recently were relatively modest. The World Bank estimates that net inflows of long-term debt, foreign direct investment, and equity purchases to the Asia-Pacific region were only about $\$ 25$ billion in 1990, but exploded to more than $\$ 110$ billion by 1996; less comprehensive data suggest that inflows rose to a still higher rate earlier this year. Sustained, spectacular growth in Asian economies fostered expectations of high returns with moderate risk. Moreover the global stock market boom of the 1990s provided the impetus to seek these perceived high returns. As that boom progressed, investors in many industrial countries found themselves more heavily concentrated in the recently higher valued securities of companies in the developed world, whose rates of return, in many instances, had reached levels perceived as uncompetitive with the earnings potential in emerging economies, especially in Asia. The resultant diversification induced a sharp increase in capital flows into those economies. To a large extent, they came from investors in the United States and western Europe. A substantial amount came from Japan, as well, owing more to a search for higher yields than to rising stock prices and capital gains in that country. The rising yen through mid-1995 also encouraged a substantial increase in direct investment outflows from Japan. In retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at reasonable risk. It may have been inevitable in those conditions of rapid growth, ample liquidity, and an absence of sufficient profitable alternatives, that much investment moved into the real estate sector, with an emphasis by both the public and private sectors on conspicuous construction projects that had little economic rationale. These real estate assets, in turn, ended up as collateral for a significant proportion of the assets of domestic financial systems. In many instances, those financial systems were already less than robust, beset with problems of poor lending standards, weak supervisory regimes, and inadequate capital. At the same time, rising business leverage added to financial fragility. Businesses were borrowing to maintain high rates of return on equity and weak financial systems were poorly disciplining this process. In addition, explicit government guarantees of debt or, more often, the presumption of such guarantees by the investment community, encouraged insufficient vigilance by lenders and hence greater leverage. But high debt burdens allow little tolerance for rising interest rates or slowdowns in economic growth, as recent events have demonstrated. Moreover, the rapidly growing foreign-currency-denominated debt, in part the result of pegged exchange rates to the dollar, put pressure on companies to earn foreign exchange. But earning it became increasingly difficult. The substantial rise in the value of the dollar since mid-1995, especially relative to the yen, made exports of the Southeast Asian economies less competitive. In addition, in some cases, the glut of semiconductors in 1996 and the accelerated drop in their prices suppressed export earnings growth, exerting further pressures on highly leveraged businesses. In time, the pressures on what had become fixed-exchange-rate regimes mounted as investors, confronted with ever fewer profitable prospects, slowed the pace of new capital inflows. Fearing devaluation, many domestic Asian businesses sought increasingly to convert domestic currencies into foreign currencies, or, equivalently, slowed the conversion of export earnings into domestic currencies. To counter pressures on exchange rates, countries raised interest rates. For fixed-exchange-rate, highly leveraged economies, it was only a matter of time ---[PAGE_BREAK]--- before slower growth and higher interest rates led to difficulties for borrowers, especially those with fixed obligations. Particularly troublesome over the past several months has been the so-called contagion effect of weakness in one economy spreading to others as investors perceive, rightly or wrongly, similar vulnerabilities. This is an age-old phenomenon. When investors are unsettled by uncertainties and fears, they withdraw commitments on a broad front; the finer distinctions between countries and currencies are lost. There is a flight to safe-haven investments, many of which are in developed nations. Perhaps, given the circumstances, it was inevitable that the impressive and rapid growth experienced by the economies in the Asian region would encounter a temporary slowdown or pause. I say temporary because there is no reason that above-average growth in countries that are still in a position to gain from catching up with the prevailing technology cannot persist for a very long time, provided their markets are opened to the full force of competition. Nonetheless, free-market, even partially free-market, economies do periodically run into difficulties because investment mistakes invariably occur. And, as I noted earlier, many of these mistakes arose from government-directed or influenced investments. When this happens, private capital flows may temporarily turn adverse. In these circumstances, individual companies should be allowed to default, private investors should take their losses, and government policies should be directed toward laying the macroeconomic and structural foundations for renewed expansion. New growth opportunities must be allowed to emerge. Although the economies of the troubled Asian countries were usually characterized by a combination of current account deficits, large net foreign currency exposures, and constraints on exchange rate fluctuations, one cannot generalize that these are always signs of impending difficulties. Large current account deficits, per se, are not dangerous if they result from direct investment inflows that are not subject to rapid withdrawal and that generate an increase in income sufficient to compensate the investors. Foreign currency exposures need not be a problem if positions are properly managed and the risks are recognized. Fixed exchange rates, also, are not necessarily a problem. Indeed, if they can be sustained, they yield extensive benefits in lower risk and lower costs for all international transactions. But a small open economy can maintain an exchange rate fixed to a hard currency only under certain conditions. Both Austria and the Netherlands, for example, have been able to lock their currencies against the Deutsche Mark because their economies are tightly linked through trade with Germany, they mirror the Bundesbank's monetary policies, and they are perceived to engage in prudent fiscal policies. Were it not for issues of national identity and seignorage, they could just as readily embrace the DM as their domestic currency without any economic disruption. Other economies, such as Argentina and Hong Kong, have fixed their exchange rates essentially through currency boards. Changes in dollar reserves directly affect the monetary base of those economies. But when exchange rates are fixed, with or without currency boards, should monetary and fiscal policies diverge significantly from those of the larger economy, the currency lock of the smaller economy would be difficult to hold irrespective of the size of reserves. Large reserves can delay adjustment. They cannot prevent it if policies are inconsistent, or prices in the smaller country are inflexible. A well-functioning international financial system will seek out anomalies in policy alignments and exchange rates and set them right. In such a system, the exploitation of ---[PAGE_BREAK]--- above-normal profit opportunities, that is, arbitrage, will force prices to change until expected returns have been equalized. To policymakers in the country whose currency is not appropriately aligned, capital outflows are too often seen as attacks by marauding currency speculators. There have no doubt been some such attempts on occasion. But speculators rarely succeed in dislodging an exchange rate that is firmly rooted in compatible policies and cost structures. More often, speculation forces currencies through arbitrage into a closer alignment with underlying market values to the benefit of the international economic and financial system as a whole. We used to describe capital flight as "hot money". But we soon recognized that it was not the money that was "hot", but the place it was running from. The prodigious expansion of cross-border financial transactions in recent years has tightened and refined the arbitrage process significantly. But, to repeat, the inestimable advantages that it brings to trade and standards of living also carry a price. The inevitable investment mistakes and governmental policy failures are more rapidly transmitted to other markets by this process than was the case say twenty, or even ten, years ago. Moreover, there is little evidence to suggest that the rate of increase of financial transactions will slow materially in the years immediately ahead. Technology will continue to reduce the costs of finding and exploiting perceived differences in risk-adjusted rates of return around the world, helping to direct capital even more to its most efficient use. Already, covered rates of return on actively traded interest-rate instruments have been equalized among many industrial countries. But the broader merging of world savings and investment markets, clearly, has not been achieved, largely because investors are fearful of investing in countries they do not understand to the extent that they do their own, or are uninformed of the opportunities. One measure of this so-called home bias in world investments is the degree that portfolios remain substantially local. Foreign investments, on average, represent less than 10 percent of U.S. portfolios, for example. The percentage of Japanese portfolios is only slightly higher, and 15 percent of German portfolios is in foreign assets. The partial exception is Great Britain, where, with a longer history of global financial involvement, one-third of portfolios is invested in foreign assets. Home bias in investments is considerably less than it was ten years ago, but we are still far from full globalization. Unless government restrictions inhibit the expansion of ever more sophisticated financial products that enable savers in one part of the world to reduce risk by investing in another, the bias will continue to diminish and the size of the international financial system will continue to expand at a significant pace. It is this overall diversification, and hence lowering of risk, that an effective international financial system offers. It facilitates the ever more efficient functioning of the global economic system and, hence, is a major contributor to rising standards of living worldwide. Nonetheless, there are those who ask whether the price of so sophisticated a financial system is too high. Would it not be better to slow it down a bit, and perhaps achieve a system somewhat more forgiving of mistakes, even recognizing that such a slowing may entail some shortfall in long-term economic growth? Even if we could implement such a tradeoff, with only minor disruption, should we try? For centuries groups in our societies have railed against, and endeavored on occasion to ---[PAGE_BREAK]--- destroy, new inventions. Fortunately for us the Luddites and their ilk failed, and recent generations have enjoyed the fruits of those technologies. Moreover such a slowdown may not even be possible -- at least without major disruption and cost. Newer technologies, especially advanced telecommunications, make it exceptionally difficult for open markets, with associated opportunities, to be suppressed. Price and capital controls, which might have been feasible a half century ago, would be very difficult to implement in today's more technologically advanced environment. Tinkering at the edges of our system in order to produce a less frenetic pace of change would be easily circumvented. Arguably, it would take massive government controls to substantially slow the advance toward greater efficiency of our systems. This would surely produce a far more negative impact on economic growth than would be acceptable to even the most ardent advocates of reining in the rapid expansion of our international financial system. If, as I suspect, it turns out after due deliberation and analysis, that slowing the pace of financial modernization is not in fact seen as a feasible alternative, what policy alternatives confront the international financial community to contain the periodic disruptions that are bound to occur in any free market economy? A financial system, like all structures, is as strong as its weakest link. As the international financial system has become even more complex, the particular areas of weakness to be addressed have changed. At the risk of oversimplification, let's examine some of the key links of our current infrastructure. Today, the organized exchanges and over-the-counter markets of industrial countries can handle massive volumes of transactions. Even in emerging countries exchanges are developing and expanding. In contrast, during the world-wide stock market crash of October 1987, the transactions systems were under severe stress and, indeed, some broke down, incapable of handling the enlarged volumes. At that time, the Hong Kong stock exchange could not open for several days. The New York Stock Exchange was straining badly under the near 400 million daily share volume of late October 1987, with long reporting delays creating uncertainties that, doubtless, exaggerated the price declines. Those weaker links have since been strengthened by large infrastructure investments. Almost 1.2 billion shares traded on the NYSE on October 28 of this year, three times the 1987 volumes with no evident problems or delays. Our equity, debt, and foreign exchange trading systems, and their peripheral futures and options markets have functioned well under stress recently. These systems are not weak links in the developed economies, nor, for the most part are they in other economies. Neither is the payment system, that complex network, which transfers funds and securities in huge and growing volumes domestically and internationally, rapidly and efficiently. The private and public sectors across the globe have endeavored diligently for years to expand the capacity of the system to meet the increasing demands put upon it. And they have initiated and strengthened procedures for reducing risk in settling transactions, and diminishing uncertainties. That they have generally succeeded is evident from the smoothness with which huge volumes of funds produced under recent stressed market conditions were transferred and settled with finality, through various netting and clearing arrangements. Banks are another matter. These are highly leveraged institutions, financed in part by interbank credits and, hence, prone to crises of confidence that can quickly spread. In most developed nations banking systems appear reasonably solid. Japan has been somewhat of an ---[PAGE_BREAK]--- exception, but there have been some positive signs there, as well. Banks have been recognizing losses, and the government seems finally to be appropriately addressing their problems. In a large number of emerging nations, as I indicated previously, banks are in poor shape. Lax lending has created a high incidence of non-performing loans, supported by inadequate capital, leaving banks vulnerable to declines in collateral values and non-performance by borrowers. How can such deficient institutions be elevated to a level that would allow their economies to function effectively in our increasingly sophisticated international financial system? Certainly, improved cost and risk management and elimination of poor lending practices are a good place to start. But these cannot be accomplished overnight. Loan officers with experience judging credit and market risks are in very short supply in emerging economies. Training will require time. The same difficulties confront bank supervision and regulation. Important efforts in this area have been underway for several years through the auspices of the Bank for International Settlements, the International Monetary Fund, and the World Bank. But again, it will take time to develop adequate systems and trained personnel. Moreover, robust banking and financial systems require firmly enforced laws of contract, and transparent, market-oriented systems of corporate reporting and governance. The current crisis in Asia is, to a much greater extent than many previous crises, one of private, not public, debts, at least de jure. Arguably, the absence of efficient and transparent work-out arrangements for troubled private borrowers makes the problems more difficult to deal with. Efficient bankruptcy arrangements reduce disruptions to economic activity that often arise when losses have to be imposed on creditors. Many developing countries do not have good work-out arrangements for troubled debtors, and, as a result, governments in these countries often feel compelled to bail them out rather than accept the consequences of defaults. The most troublesome aspect of many banking systems of emerging countries, to expand on the issue I raised earlier, is the widespread prevalence of loans driven by "industrial policy" imperatives rather than market forces. What is wrong with policy -- that is, politically-driven -- loans? Potentially nothing if they were made to firms to finance expansions that just happened to coincide with a rise in consumer or business or overseas demand for their newly-produced products. In these circumstances, the loan proceeds would have been profitably employed and the loan repaid at maturity with interest. Unfortunately, this is often not the case. Policy loans, in too many instances, foster misuse of resources, unprofitable expansions, losses, and eventually loan defaults. In many cases, of course, these loans regrettably end up being guaranteed by governments. If denominated in local currency, they can be financed with the printing press -- though with consequent risk of inflation. Too often, however, they are foreign-currency denominated, where governments face greater constraints on access to credit. Restructuring of financial systems, while indispensable, cannot be implemented quickly. Yes, the potential risks to the banking systems of many Asian countries and the potential contagion effects for their neighbors, and other trading partners, should have been spotted earlier and addressed. But flaws, seen clearly in retrospect, are never so evident at the time. Moreover, there is significant bias in political systems of all varieties to substitute hope (read, wishful thinking) for possibly difficult pre-emptive policy moves, both with respect to financial systems and economic policy. There is often denial and delay in instituting proper adjustments. Recent propensities to obscure the need for change have been evidenced by ---[PAGE_BREAK]--- unreported declines in reserves, issuance by the government of equivalents to foreign currency obligations, or unreported large new forward short positions against foreign currencies. It is very difficult for political leaders to incur what they perceive as large, immediate political costs to contain problems they see as only prospective. Reality eventually replaces hope, and the cost of the delay is a more abrupt and disruptive adjustment than would have been required if action had been more pre-emptive. Increased transparency for businesses and governments is a key ingredient in fostering more discipline on private transactors and on government policymakers. Increased transparency can counter political bias in part by exposing for all to see the risks of current policies to stability as they develop. Under such conditions, failure to act would also be perceived as having political costs. We should strongly stress to the newer members of the international financial system -- the emerging economies -- that they should accelerate the restructuring of their financial systems in their own interests. But having delayed timely restructuring, many now find themselves with major shortfalls in bank liquidity and equity capital that put their systems at severe risk of collapse before any full restructuring is feasible. The IMF, the World Bank, and their major shareholders, the developed countries, may wish to facilitate adjustment through temporary loans to governments and the encouragement of private equity infusions to these banking systems. Since any severe breakdown can have contagion effects on a world-wide basis, it is in our interest to do so. These loans must be judged in their entirety. They transform short-term obligations into medium-term loans, but they do so contingent on the country using the time to reform financial systems as well as adopt sound economic policies. Such conditionality accelerates the adjustments in financial systems needed to lay the foundation for resumption of robust, sustainable, growth, while cushioning to some degree the economic effects of the immediate crisis. Assistance without further reform of financial systems and economic policies would be worse than useless since it would foster expectations of being perpetually bailed out. That, in turn, could induce perverse behavior on the part of emerging nations' governments and of private sector investors in emerging nations. Believing that the international financial community will support these economies, in part by backstopping the obligations they incur, induces investors to commit more than they would otherwise. This has tended in the past to push the expansion of investment beyond prudence -- given the limit of profitable opportunities. As the international financial system becomes ever larger and more efficient, the size of the financial response -- whether to help banks or to add to foreign currency reserves -- may have to be correspondingly larger per unit of crisis, if I may put it that way -unless we alter our approach. While it is precarious to generalize from one observation, it is likely that the Mexican financial crisis of the 1980s was broader than in 1994-95, but the size of the assistance program, to set things right, was much larger in the latter than in the former case. The reason appears to be that the increased efficiency of the financial system created a larger negative spillover, which had to be contained. Among other developments, the marked shift from bank credits in the earlier crisis, to a more securitized, anonymous, set of liabilities made workouts far more complex. It is, hence, all the more essential that the weaker links in our international financial system, the banking systems of the emerging nations, be strengthened. Preventive programs should be accelerated sufficiently far in advance of the next crisis to effectively thwart or contain it. ---[PAGE_BREAK]--- Moreover, it is incumbent on governmental policymakers to insure that unstable economic environments do not induce or exacerbate international financial disruptions. But governments and international financial institutions should be brought on the scene only rarely. To do otherwise risks the perverse incentives I spoke of earlier. Markets should be allowed to work. Recent events in Asia have sharpened our understanding of the complexity of today's international capital flows and, presumably, of similar episodes that may emerge in the future. The rapid integration of national financial systems has fostered the growth of trade and standards of living worldwide. It has also forced a review of the soundness and viability of our burgeoning financial systems. We should welcome such pressures even as they impose challenges to all of us. The end result is very worthwhile having.	Alan Greenspan	United States	https://www.bis.org/review/r971208d.pdf	Mr. Greenspan's remarks to the Economic Club of New York Remarks by the Chairman of the Board of the U S Federal Reserve System, Mr. Alan Greenspan, at the Economic Club of New York in New York City, on 02/12/97. Dramatic advances in the global financial system have enabled us to materially improve the efficiency of the flows of capital and payments. Those advances, however, have also enhanced the ability of the system to rapidly transmit problems in one part of the globe to another. The events of recent weeks have underscored this latter process. The lessons we are learning from these experiences hopefully can be applied to better the workings of the international financial system, a system that has done so much to foster gains in living standards worldwide. The current crisis is likely to accelerate the dismantling in many Asian countries of the remnants of a system with large elements of government-directed investment, in which finance played a key role in carrying out the state's objectives. Such a system inevitably has led to the investment excesses and errors to which all similar endeavors seem prone. Government-directed production, financed with directed bank loans, cannot readily adjust to the continuously changing patterns of market demand for domestically consumed goods or exports. Gluts and shortages are inevitable. The accelerated opening up in recent years of product and financial markets worldwide offers enormous benefits to all nations over the long run. However, it has also exposed more quickly and harshly the underlying rigidities of economic systems in which governments -- or governments working with large industrial groups -- exercise substantial influence over resource allocation. Such systems can produce vigorous growth for a time when the gap between indigenous applied technologies and world standards is large, such as in the Soviet Union in the 1960s and 1970s and Southeast Asia in the 1980s and 1990s. But as the gap narrows, the ability of these systems to handle their increasingly sophisticated economies declines markedly. In western developed economies, in contrast, market forces have been allowed much freer rein to dictate production schedules. Rapid responses by businesses to changes in free-market prices have muted much of the tendency for unsold goods to back up, or unmet needs to produce shortages. Recent improvements in technology have significantly compressed business response times and enhanced the effectiveness of the market mechanism. Most Asian policymakers, while justly proud of the enormous success of their economies in recent decades, nonetheless have been moving of late toward these more open and flexible economies. Belatedly perhaps, they have perceived the problems to which their systems are prone and recognized the unforgiving nature of the new global market forces. Doubtless, the current crises will hasten that trend. While the adjustments may be difficult for a time, these crises will pass. Stronger individual economies and a more robust and efficient international economic and financial system will surely emerge in their wake. While each of the Asian economies is unique in many important respects, the sources of their spectacular growth in recent years, in some cases decades, and the problems that have emerged are relevant to a greater or lesser extent to nearly all of them. Following the early post-World War II period, policies generally fostering low levels of inflation and high rates of savings and investment -- including investment in human capital through education -- contributed to a sustained period of rapid growth. In some cases this started in the 1960s and 1970s, but by the 1980s most economies in the region were expanding vigorously. Foreign net capital inflows grew, but until recently were relatively modest. The World Bank estimates that net inflows of long-term debt, foreign direct investment, and equity purchases to the Asia-Pacific region were only about $\$ 25$ billion in 1990, but exploded to more than $\$ 110$ billion by 1996; less comprehensive data suggest that inflows rose to a still higher rate earlier this year. Sustained, spectacular growth in Asian economies fostered expectations of high returns with moderate risk. Moreover the global stock market boom of the 1990s provided the impetus to seek these perceived high returns. As that boom progressed, investors in many industrial countries found themselves more heavily concentrated in the recently higher valued securities of companies in the developed world, whose rates of return, in many instances, had reached levels perceived as uncompetitive with the earnings potential in emerging economies, especially in Asia. The resultant diversification induced a sharp increase in capital flows into those economies. To a large extent, they came from investors in the United States and western Europe. A substantial amount came from Japan, as well, owing more to a search for higher yields than to rising stock prices and capital gains in that country. The rising yen through mid-1995 also encouraged a substantial increase in direct investment outflows from Japan. In retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at reasonable risk. It may have been inevitable in those conditions of rapid growth, ample liquidity, and an absence of sufficient profitable alternatives, that much investment moved into the real estate sector, with an emphasis by both the public and private sectors on conspicuous construction projects that had little economic rationale. These real estate assets, in turn, ended up as collateral for a significant proportion of the assets of domestic financial systems. In many instances, those financial systems were already less than robust, beset with problems of poor lending standards, weak supervisory regimes, and inadequate capital. At the same time, rising business leverage added to financial fragility. Businesses were borrowing to maintain high rates of return on equity and weak financial systems were poorly disciplining this process. In addition, explicit government guarantees of debt or, more often, the presumption of such guarantees by the investment community, encouraged insufficient vigilance by lenders and hence greater leverage. But high debt burdens allow little tolerance for rising interest rates or slowdowns in economic growth, as recent events have demonstrated. Moreover, the rapidly growing foreign-currency-denominated debt, in part the result of pegged exchange rates to the dollar, put pressure on companies to earn foreign exchange. But earning it became increasingly difficult. The substantial rise in the value of the dollar since mid-1995, especially relative to the yen, made exports of the Southeast Asian economies less competitive. In addition, in some cases, the glut of semiconductors in 1996 and the accelerated drop in their prices suppressed export earnings growth, exerting further pressures on highly leveraged businesses. In time, the pressures on what had become fixed-exchange-rate regimes mounted as investors, confronted with ever fewer profitable prospects, slowed the pace of new capital inflows. Fearing devaluation, many domestic Asian businesses sought increasingly to convert domestic currencies into foreign currencies, or, equivalently, slowed the conversion of export earnings into domestic currencies. To counter pressures on exchange rates, countries raised interest rates. For fixed-exchange-rate, highly leveraged economies, it was only a matter of time before slower growth and higher interest rates led to difficulties for borrowers, especially those with fixed obligations. Particularly troublesome over the past several months has been the so-called contagion effect of weakness in one economy spreading to others as investors perceive, rightly or wrongly, similar vulnerabilities. This is an age-old phenomenon. When investors are unsettled by uncertainties and fears, they withdraw commitments on a broad front; the finer distinctions between countries and currencies are lost. There is a flight to safe-haven investments, many of which are in developed nations. Perhaps, given the circumstances, it was inevitable that the impressive and rapid growth experienced by the economies in the Asian region would encounter a temporary slowdown or pause. I say temporary because there is no reason that above-average growth in countries that are still in a position to gain from catching up with the prevailing technology cannot persist for a very long time, provided their markets are opened to the full force of competition. Nonetheless, free-market, even partially free-market, economies do periodically run into difficulties because investment mistakes invariably occur. And, as I noted earlier, many of these mistakes arose from government-directed or influenced investments. When this happens, private capital flows may temporarily turn adverse. In these circumstances, individual companies should be allowed to default, private investors should take their losses, and government policies should be directed toward laying the macroeconomic and structural foundations for renewed expansion. New growth opportunities must be allowed to emerge. Although the economies of the troubled Asian countries were usually characterized by a combination of current account deficits, large net foreign currency exposures, and constraints on exchange rate fluctuations, one cannot generalize that these are always signs of impending difficulties. Large current account deficits, per se, are not dangerous if they result from direct investment inflows that are not subject to rapid withdrawal and that generate an increase in income sufficient to compensate the investors. Foreign currency exposures need not be a problem if positions are properly managed and the risks are recognized. Fixed exchange rates, also, are not necessarily a problem. Indeed, if they can be sustained, they yield extensive benefits in lower risk and lower costs for all international transactions. But a small open economy can maintain an exchange rate fixed to a hard currency only under certain conditions. Both Austria and the Netherlands, for example, have been able to lock their currencies against the Deutsche Mark because their economies are tightly linked through trade with Germany, they mirror the Bundesbank's monetary policies, and they are perceived to engage in prudent fiscal policies. Were it not for issues of national identity and seignorage, they could just as readily embrace the DM as their domestic currency without any economic disruption. Other economies, such as Argentina and Hong Kong, have fixed their exchange rates essentially through currency boards. Changes in dollar reserves directly affect the monetary base of those economies. But when exchange rates are fixed, with or without currency boards, should monetary and fiscal policies diverge significantly from those of the larger economy, the currency lock of the smaller economy would be difficult to hold irrespective of the size of reserves. Large reserves can delay adjustment. They cannot prevent it if policies are inconsistent, or prices in the smaller country are inflexible. A well-functioning international financial system will seek out anomalies in policy alignments and exchange rates and set them right. In such a system, the exploitation of above-normal profit opportunities, that is, arbitrage, will force prices to change until expected returns have been equalized. To policymakers in the country whose currency is not appropriately aligned, capital outflows are too often seen as attacks by marauding currency speculators. There have no doubt been some such attempts on occasion. But speculators rarely succeed in dislodging an exchange rate that is firmly rooted in compatible policies and cost structures. More often, speculation forces currencies through arbitrage into a closer alignment with underlying market values to the benefit of the international economic and financial system as a whole. We used to describe capital flight as "hot money". But we soon recognized that it was not the money that was "hot", but the place it was running from. The prodigious expansion of cross-border financial transactions in recent years has tightened and refined the arbitrage process significantly. But, to repeat, the inestimable advantages that it brings to trade and standards of living also carry a price. The inevitable investment mistakes and governmental policy failures are more rapidly transmitted to other markets by this process than was the case say twenty, or even ten, years ago. Moreover, there is little evidence to suggest that the rate of increase of financial transactions will slow materially in the years immediately ahead. Technology will continue to reduce the costs of finding and exploiting perceived differences in risk-adjusted rates of return around the world, helping to direct capital even more to its most efficient use. Already, covered rates of return on actively traded interest-rate instruments have been equalized among many industrial countries. But the broader merging of world savings and investment markets, clearly, has not been achieved, largely because investors are fearful of investing in countries they do not understand to the extent that they do their own, or are uninformed of the opportunities. One measure of this so-called home bias in world investments is the degree that portfolios remain substantially local. Foreign investments, on average, represent less than 10 percent of U.S. portfolios, for example. The percentage of Japanese portfolios is only slightly higher, and 15 percent of German portfolios is in foreign assets. The partial exception is Great Britain, where, with a longer history of global financial involvement, one-third of portfolios is invested in foreign assets. Home bias in investments is considerably less than it was ten years ago, but we are still far from full globalization. Unless government restrictions inhibit the expansion of ever more sophisticated financial products that enable savers in one part of the world to reduce risk by investing in another, the bias will continue to diminish and the size of the international financial system will continue to expand at a significant pace. It is this overall diversification, and hence lowering of risk, that an effective international financial system offers. It facilitates the ever more efficient functioning of the global economic system and, hence, is a major contributor to rising standards of living worldwide. Nonetheless, there are those who ask whether the price of so sophisticated a financial system is too high. Would it not be better to slow it down a bit, and perhaps achieve a system somewhat more forgiving of mistakes, even recognizing that such a slowing may entail some shortfall in long-term economic growth? Even if we could implement such a tradeoff, with only minor disruption, should we try? For centuries groups in our societies have railed against, and endeavored on occasion to destroy, new inventions. Fortunately for us the Luddites and their ilk failed, and recent generations have enjoyed the fruits of those technologies. Moreover such a slowdown may not even be possible -- at least without major disruption and cost. Newer technologies, especially advanced telecommunications, make it exceptionally difficult for open markets, with associated opportunities, to be suppressed. Price and capital controls, which might have been feasible a half century ago, would be very difficult to implement in today's more technologically advanced environment. Tinkering at the edges of our system in order to produce a less frenetic pace of change would be easily circumvented. Arguably, it would take massive government controls to substantially slow the advance toward greater efficiency of our systems. This would surely produce a far more negative impact on economic growth than would be acceptable to even the most ardent advocates of reining in the rapid expansion of our international financial system. If, as I suspect, it turns out after due deliberation and analysis, that slowing the pace of financial modernization is not in fact seen as a feasible alternative, what policy alternatives confront the international financial community to contain the periodic disruptions that are bound to occur in any free market economy? A financial system, like all structures, is as strong as its weakest link. As the international financial system has become even more complex, the particular areas of weakness to be addressed have changed. At the risk of oversimplification, let's examine some of the key links of our current infrastructure. Today, the organized exchanges and over-the-counter markets of industrial countries can handle massive volumes of transactions. Even in emerging countries exchanges are developing and expanding. In contrast, during the world-wide stock market crash of October 1987, the transactions systems were under severe stress and, indeed, some broke down, incapable of handling the enlarged volumes. At that time, the Hong Kong stock exchange could not open for several days. The New York Stock Exchange was straining badly under the near 400 million daily share volume of late October 1987, with long reporting delays creating uncertainties that, doubtless, exaggerated the price declines. Those weaker links have since been strengthened by large infrastructure investments. Almost 1.2 billion shares traded on the NYSE on October 28 of this year, three times the 1987 volumes with no evident problems or delays. Our equity, debt, and foreign exchange trading systems, and their peripheral futures and options markets have functioned well under stress recently. These systems are not weak links in the developed economies, nor, for the most part are they in other economies. Neither is the payment system, that complex network, which transfers funds and securities in huge and growing volumes domestically and internationally, rapidly and efficiently. The private and public sectors across the globe have endeavored diligently for years to expand the capacity of the system to meet the increasing demands put upon it. And they have initiated and strengthened procedures for reducing risk in settling transactions, and diminishing uncertainties. That they have generally succeeded is evident from the smoothness with which huge volumes of funds produced under recent stressed market conditions were transferred and settled with finality, through various netting and clearing arrangements. Banks are another matter. These are highly leveraged institutions, financed in part by interbank credits and, hence, prone to crises of confidence that can quickly spread. In most developed nations banking systems appear reasonably solid. Japan has been somewhat of an exception, but there have been some positive signs there, as well. Banks have been recognizing losses, and the government seems finally to be appropriately addressing their problems. In a large number of emerging nations, as I indicated previously, banks are in poor shape. Lax lending has created a high incidence of non-performing loans, supported by inadequate capital, leaving banks vulnerable to declines in collateral values and non-performance by borrowers. How can such deficient institutions be elevated to a level that would allow their economies to function effectively in our increasingly sophisticated international financial system? Certainly, improved cost and risk management and elimination of poor lending practices are a good place to start. But these cannot be accomplished overnight. Loan officers with experience judging credit and market risks are in very short supply in emerging economies. Training will require time. The same difficulties confront bank supervision and regulation. Important efforts in this area have been underway for several years through the auspices of the Bank for International Settlements, the International Monetary Fund, and the World Bank. But again, it will take time to develop adequate systems and trained personnel. Moreover, robust banking and financial systems require firmly enforced laws of contract, and transparent, market-oriented systems of corporate reporting and governance. The current crisis in Asia is, to a much greater extent than many previous crises, one of private, not public, debts, at least de jure. Arguably, the absence of efficient and transparent work-out arrangements for troubled private borrowers makes the problems more difficult to deal with. Efficient bankruptcy arrangements reduce disruptions to economic activity that often arise when losses have to be imposed on creditors. Many developing countries do not have good work-out arrangements for troubled debtors, and, as a result, governments in these countries often feel compelled to bail them out rather than accept the consequences of defaults. The most troublesome aspect of many banking systems of emerging countries, to expand on the issue I raised earlier, is the widespread prevalence of loans driven by "industrial policy" imperatives rather than market forces. What is wrong with policy -- that is, politically-driven -- loans? Potentially nothing if they were made to firms to finance expansions that just happened to coincide with a rise in consumer or business or overseas demand for their newly-produced products. In these circumstances, the loan proceeds would have been profitably employed and the loan repaid at maturity with interest. Unfortunately, this is often not the case. Policy loans, in too many instances, foster misuse of resources, unprofitable expansions, losses, and eventually loan defaults. In many cases, of course, these loans regrettably end up being guaranteed by governments. If denominated in local currency, they can be financed with the printing press -- though with consequent risk of inflation. Too often, however, they are foreign-currency denominated, where governments face greater constraints on access to credit. Restructuring of financial systems, while indispensable, cannot be implemented quickly. Yes, the potential risks to the banking systems of many Asian countries and the potential contagion effects for their neighbors, and other trading partners, should have been spotted earlier and addressed. But flaws, seen clearly in retrospect, are never so evident at the time. Moreover, there is significant bias in political systems of all varieties to substitute hope (read, wishful thinking) for possibly difficult pre-emptive policy moves, both with respect to financial systems and economic policy. There is often denial and delay in instituting proper adjustments. Recent propensities to obscure the need for change have been evidenced by unreported declines in reserves, issuance by the government of equivalents to foreign currency obligations, or unreported large new forward short positions against foreign currencies. It is very difficult for political leaders to incur what they perceive as large, immediate political costs to contain problems they see as only prospective. Reality eventually replaces hope, and the cost of the delay is a more abrupt and disruptive adjustment than would have been required if action had been more pre-emptive. Increased transparency for businesses and governments is a key ingredient in fostering more discipline on private transactors and on government policymakers. Increased transparency can counter political bias in part by exposing for all to see the risks of current policies to stability as they develop. Under such conditions, failure to act would also be perceived as having political costs. We should strongly stress to the newer members of the international financial system -- the emerging economies -- that they should accelerate the restructuring of their financial systems in their own interests. But having delayed timely restructuring, many now find themselves with major shortfalls in bank liquidity and equity capital that put their systems at severe risk of collapse before any full restructuring is feasible. The IMF, the World Bank, and their major shareholders, the developed countries, may wish to facilitate adjustment through temporary loans to governments and the encouragement of private equity infusions to these banking systems. Since any severe breakdown can have contagion effects on a world-wide basis, it is in our interest to do so. These loans must be judged in their entirety. They transform short-term obligations into medium-term loans, but they do so contingent on the country using the time to reform financial systems as well as adopt sound economic policies. Such conditionality accelerates the adjustments in financial systems needed to lay the foundation for resumption of robust, sustainable, growth, while cushioning to some degree the economic effects of the immediate crisis. Assistance without further reform of financial systems and economic policies would be worse than useless since it would foster expectations of being perpetually bailed out. That, in turn, could induce perverse behavior on the part of emerging nations' governments and of private sector investors in emerging nations. Believing that the international financial community will support these economies, in part by backstopping the obligations they incur, induces investors to commit more than they would otherwise. This has tended in the past to push the expansion of investment beyond prudence -- given the limit of profitable opportunities. As the international financial system becomes ever larger and more efficient, the size of the financial response -- whether to help banks or to add to foreign currency reserves -- may have to be correspondingly larger per unit of crisis, if I may put it that way -unless we alter our approach. While it is precarious to generalize from one observation, it is likely that the Mexican financial crisis of the 1980s was broader than in 1994-95, but the size of the assistance program, to set things right, was much larger in the latter than in the former case. The reason appears to be that the increased efficiency of the financial system created a larger negative spillover, which had to be contained. Among other developments, the marked shift from bank credits in the earlier crisis, to a more securitized, anonymous, set of liabilities made workouts far more complex. It is, hence, all the more essential that the weaker links in our international financial system, the banking systems of the emerging nations, be strengthened. Preventive programs should be accelerated sufficiently far in advance of the next crisis to effectively thwart or contain it. Moreover, it is incumbent on governmental policymakers to insure that unstable economic environments do not induce or exacerbate international financial disruptions. But governments and international financial institutions should be brought on the scene only rarely. To do otherwise risks the perverse incentives I spoke of earlier. Markets should be allowed to work. Recent events in Asia have sharpened our understanding of the complexity of today's international capital flows and, presumably, of similar episodes that may emerge in the future. The rapid integration of national financial systems has fostered the growth of trade and standards of living worldwide. It has also forced a review of the soundness and viability of our burgeoning financial systems. We should welcome such pressures even as they impose challenges to all of us. The end result is very worthwhile having.
1997-12-15T00:00:00	Mr. Kelley discusses the 'Millennium Bug' from a public sector perspective (Central Bank Articles and Speeches, 15 Dec 97)	Remarks by Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Professional Banker's Association, Washington, D.C. on 15/12/97.	Mr. Kelley discusses the "Millennium Bug" from a public sector perspective Remarks by Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Professional Banker's Association, Washington, D.C. on 15/12/97. I am pleased to appear before the Professional Banker's Association to discuss the Millennium Bug from a public sector perspective. The Millennium Bug, or Year 2000 problem, has the potential to seriously disrupt the infrastructure of computer systems and telecommunications that the world community depends upon for the free flow of funds and payments and hence, virtually all of everyday commerce. The Year 2000 problem is a business continuity issue that requires a coordinated effort by public and private business and information technology management. Although the problem itself is not technically difficult, ensuring that information systems are Year 2000 compliant is a management challenge of enormous scale and complexity. While this matter will impact every organization everywhere, my talk today will focus specifically on the key areas of public sector finance and banking. The global nature of today's financial services industry relies upon the interconnection of computer systems world-wide. My purpose today is to identify the serious nature of the problem and the urgent need for immediate action by the government of every nation. As it will impact every country with which you interact, I believe that you of the Professional Banker's Association are in a unique position to be a catalyst for promoting attention to the Year 2000, stimulating action, and promulgating best practices in developing nations. This afternoon, after sketching out the critical nature of the problem, I will focus on plans and actions being taken by the Federal Reserve System to address the Millennium Bug in its own internal operation, as a case study of what an organization like ours must do. Then on to our efforts within the U.S. financial services industry and the international financial community, and finally a few words on how you can help. The Millennium Bug What is this problem all about? Most computer operating systems and applications in use today register dates as two digits. Consequently, such computer systems, software programs, or embedded chip devices can not distinguish the year 2000 from 1900, when both dates are registered as "00". When the clock rolls over the next millennium, computations based on two digit dates will produce errors. Those relatively few systems using four digit date fields will have different problems, but they will have problems, nonetheless. While the situation can be stated simply, its scope is vast and fixing it is enormously time consuming. As this audience knows, banking systems and financial services rely heavily on computer systems to manage and deliver services electronically. With the linkage of payment systems globally, a failure of any linked system could have waterfall effects to other systems and a disastrous result to the world economy. The scope of the Millennium Bug extends far beyond financial services and beyond the traditional notion of large mainframe processing systems. Computer systems that control telecommunications, electric utilities, transportation services, and a host of other critical infrastructure systems are vulnerable. The Gartner Group estimates 50 million embedded-system devices worldwide will exhibit Year 2000 problems. Embedded chips are used to control elevators, environmental systems, navigational devices, household appliances, safes and vaults, and on and on. The pervasive reliance on computer systems is not constrained to large industrialized countries; developing countries are also vulnerable, particularly those with older computer systems and software. I think that some "what ifs" cited by the Computer Information Centre in the UK brings a practical perspective of the effect of what could happen in our everyday life as the millennium arrives. • The computers in financial services organizations, etc. cannot deliver payments to counter parties, or receive funds from them. Gridlock ensues. There's a collapse in financial markets because of the bad news coming from companies about their inability to trade normally. • The power fails, and it is mid-winter in the Northern hemisphere and mid-summer in the Southern hemisphere. The power company's production is controlled by innumerable computer chips, which were installed many years ago and no one knows what they do, how they work, nor dare they touch them, because the whole of the plant might come irreparably to a standstill. More personal possibilities: • The telephone system fails -- and you're unable to notify anyone of your pyramiding problems. • Your medical center's computer has problems and cannot trace the medicines your elderly mother has been prescribed in the past nor the conditions she has had. A doctor prescribes the wrong medicine and she becomes very ill. • You try to draw money from an ATM and it refuses, even though you know you have money in your account. Your bank's computer thinks it is January 1, 1900 -- and you weren't a customer then! As I said, fixing the Year 2000 bug is not technically difficult but it is an enormous task that will be frightfully costly. After all, one needs only to find and repair all date instances in programs. But when you consider the number of lines of code in computer programs in the aggregate, however, the scale of this task is monumental. Consider these estimates: • The Gartner Group believes that there are about 180 billion lines of COBOL code alone in the U.S. • British Telecommunications estimates it will need 1,000 staff at peak to check and correct some 300 million lines of computer code. The Federal Reserve is faced with checking some 90 million lines, and some very large financial institutions have many more than that. Clearly, solving the Year 2000 problem requires skilled staff and is time consuming. Because of so many unknowns, however, it is difficult to accurately estimate the amount of resources that will ultimately be required. Killen & Associates estimates that $280 billion will be spent worldwide between 1997 and 2002. Other responsible estimates run to over twice that. Federal Reserve Readiness Efforts Let me now turn to the approach toward Year 2000 compliance that we have taken at the Federal Reserve, as it may be a useful case study of the scope and scale of what a substantial public agency faces. Doubtless there are larger entities that will confront larger tasks internally, but there are probably not very many with more substantial external relationships requiring attention. For example: The Federal Reserve operates several payments applications that process and settle payments and securities transactions between depository institutions in the United States. Three of these applications, Fedwire funds transfer, Fedwire securities transfer, and Automated Clearing House (ACH) are the most critical payment systems. About 10,000 depository institutions use the Fedwire funds transfer system to transfer each year approximately 86 million payments valued at over $280 trillion. About 8,000 depository institutions use the Fedwire securities transfer service to transfer each year approximately 13 million securities valued at over $160 trillion. The average total daily values of Fedwire funds and securities transfers are about $1.1 trillion and $650 billion respectively. The ACH is an electronic payment service that is used by approximately 14,000 financial institutions, 400,000 companies, and an estimated 50 million consumers. Approximately 4 billion ACH transactions were processed in 1996 with a total value of approximately $12 trillion. About 3.3 billion of these payments were commercial transactions and the remainder were originated by the Federal government. The scope of the Federal Reserve's Year 2000 activities includes remediation and testing of all components of these processing environments, the supporting telecommunications network, and all of the many systems supporting the operations of this complex organization. That is just for payment systems; bank supervision and monetary policy management pose challenges of similar magnitude. I believe that we have developed a successful program to ensure Year 2000 readiness that is based on industry best practices. This program is receiving the highest level of executive support that emphasizes awareness and commitment throughout our organization. To date, we have completed application assessments, developed internal test plans, and we are currently renovating software. All Federal Reserve computer program changes are scheduled to be completed by year-end 1998, with the financial services systems that interface externally with the industry completed by mid-1998. This schedule will permit approximately 18 months for customer testing, to which we are dedicating considerable support resources. Challenges ahead include managing a highly complex project involving multiple interfaces with others, ensuring the readiness of vendor components, ensuring the readiness of applications, thorough testing, extensive communications, and establishing contingency plans. We are also faced with labor market pressures that call for creative measures to retain staff who are critical to the success of our activities. And the entire project is being closely coordinated among the twelve Reserve Banks, the Board of Governors, numerous vendors and service providers, approximately 13,000 customers, and numerous other government agencies. Federal Reserve Bank Supervision As a bank supervisor, the Federal Reserve has worked closely with the other U.S. supervisory agencies that are part of the Federal Financial Institutions Examination Council (FFIEC) to alert the industry to our concerns and to monitor Year 2000 preparations of the institutions we supervise, so that we can identify and address problems that arise as early as possible. By mid-year 1998 we expect to complete a thorough compliance preparedness examination of every bank, U.S. branch and agency of a foreign bank, and service provider that we supervise. Our examination program includes a review of each organization's Year 2000 project management plans in order to evaluate their sufficiency, to ensure the direct involvement of senior management and the board of directors, and to monitor their progress against the plan. When facing the most serious supervisory cases of lack of preparedness for the Year 2000, the Federal Reserve will use its enforcement authority as necessary to require corrective action. Recently, the Federal Reserve issued the first cease and desist order against a bank holding company for failing to provide its subsidiary banks with reliable information systems services and for not addressing the needs resulting from the approach of the century date change. Federal Reserve Contingency Planning While our main focus is on our Year 2000 readiness and the avoidance of problems, we know from experience that on occasion things can go wrong. Given our unique role as the nation's central bank, the Federal Reserve has always stressed contingency planning -- for both systemic risks as well as operational failures. As a result of our experience in responding to problems arising from such diverse events as natural disasters and power outages, as well as liquidity problems in institutions, we expect to be well positioned to deal with Year 2000 problems that might arise. We are mindful, however, that Year 2000 failures may present many unique situations and we are developing specific contingency plans to address various operational scenarios. Our existing business resumption plans will be updated to address date-related difficulties, and key technical staff will be ready to respond quickly to problems with our computer and network systems. We recognize that despite their best efforts, some depository institutions may experience operating difficulties, either as a result of their own computer problems or those of their customers, counter parties, or others. The Federal Reserve is prepared to provide information to depository institutions on the balances in their accounts with us throughout the day, so that they can identify shortfalls and seek funding in the market. And, of course, the Federal Reserve will be prepared to lend in appropriate circumstances. Federal Reserve Efforts to Promote Public Awareness We believe that extensive communication with the industry and the public is crucial to the success of century date change efforts. Our public awareness program concentrates on communications with the financial services industry related to our testing efforts and our overall concerns about the industry's readiness. We have inaugurated a Year 2000 industry newsletter to advise our bank customers of our plans and time frames for making our software Year 2000 ready. We have also established an Internet Web site to provide depository institutions with information regarding the Federal Reserve System's CDC project. This site can be accessed at the following Internet address: http://www.frbsf.org/fiservices/cdc. On behalf of the FFIEC, the Federal Reserve has developed a Year 2000 information distribution system, including an Internet Web site and a toll free Fax Back service (888-882-0982). The Web site provides easy access to policy statements, guidance to examiners, and paths to other Year 2000 Web sites available from numerous other sources. It can be accessed at the following Internet address: http://www.ffiec.gov/y2k. We have also produced a ten-minute video entitled "Year 2000 Executive Awareness", intended for viewing by a bank's board of directors and senior management, which presents a summary of the Year 2000 five-phase project management plan outlined in the interagency policy statement. The video can be ordered through the Board's Web site. International Awareness Early in 1996, the Federal Reserve began to have concerns about international progress on the Year 2000. Informal discussions within the Bank for International Settlements (BIS) Committee on Banking Supervision indicated that the Year 2000 was not then a priority in many countries. That has now changed. We are working intensively through the Committee, which is composed of many international supervisory agencies. Through formal and informal discussions, the distribution of several interagency statements, advisories, and the Federal Reserve's Year 2000 video, we have sought to elevate bank supervisors' awareness of the risks posed by the century date change. The G-10 central bank governors issued an advisory in September, that included a paper by the bank supervisors committee on the Year 2000 challenge, to ensure a higher level of awareness and activity among leading bankers. If you have not seen it, I commend it to your attention. Federal Reserve speakers have been featured in a number of Year 2000 conferences and are looking for others wherever they can be found or promoted. We also participated in a BIS meeting for G-10 and major non-G-10 central banks in September which provided a forum to share views on, and approaches to, dealing with Year 2000 issues. The majority of those present seemed confident that payment and settlement applications under their management would be ready, but the approach of many central banks toward raising industry awareness in their countries varies widely, and little is known about preparations in smaller emerging nations. These efforts within the BIS have confirmed what we had been hearing anecdotally from U.S. financial institutions and from the U.S. branches and agencies of foreign banks. Reportedly, many foreign banks continue to be less focused on the Year 2000 than prudence might suggest. Many organizations appear to be underestimating how important and difficult effective preparation is to a successful Year 2000 effort. To broaden the base of global supervisory awareness of the issue, the Basle Supervisors are working with securities and insurance authorities to sponsor additional activities, and I understand that final arrangements are now being made to hold a large meeting for financial supervisors from around the world in early April to further focus on this topic. Additionally, the banking supervisors are working to see that third-party vendors and service providers rise to the issue. Our supervisory agencies sponsored a conference for vendors in November and the New York Reserve Bank is sponsoring two half-day conferences on managing vendor relationships in early January. In areas such as telecommunications, where the financial industry is highly dependent on companies supervised by other regulators, we have also initiated contact with the FCC to help assure that federal supervisors are coordinated in their approaches. How can the Professional Bankers Association Help? You can help. Time is of the essence. As you can see, much is being done, but we fear that on a worldwide comprehensive basis we are far behind where we should be, and the days are inexorably going by. The problem is global and must be solved worldwide, or all will suffer. I believe the membership of the PBA is in a unique position to raise the awareness of developing countries to this looming problem. Your intervention might take many forms, and your assistance in stimulating action within your constituency can help bridge the readiness gap we believe now exists in international Year 2000 preparedness efforts. Each member of the PBA can help to help raise the visibility of the problem, publicize its critical nature, and ensure that a compliance commitment originates from the most senior executive level within all of the organizations you monitor. Your own senior executives could communicate the priority placed on this issue to all constituents through public policy statements such as that issued by the G-10 governors of the BIS. As the Fed case demonstrates, your awareness program should emphasize that this is not just a technical matter, but rather a comprehensive business continuity problem that requires the joint cooperation of government and industry sectors. Your organizations have access to the highest levels of government within your constituent countries that can enable you to effectively elevate concern about the danger this problem poses to the safety and soundness of each country's financial system. The PBA could also work closely with the financial community within developing countries to assist in identifying Year 2000 risks, prioritizing resources, and assessing the application and system inventories of your constituents. You can identify common third-party applications and systems and assist in coordinating efforts among these product suppliers and developing countries. The PBA can promote collaborative efforts among developing nations, and sponsor conferences and workshops on Year 2000. You can act as a clearinghouse for information and share "best practices" that could provide a valuable jump-start to those countries still behind the curve. Finally, Year 2000 assessment must also evaluate the level of financial resources available to developing countries to successfully complete a readiness program, and funding to constituents for Year 2000 initiatives should receive a high priority. Closing Remarks As I indicated at the outset, the Federal Reserve views Year 2000 preparations with great seriousness. We have placed a high priority on the remediation of date problems and the development of action plans that will ensure business continuity for the critical financial systems we operate. While we have made significant progress, and are on schedule in validating our internal systems and preparing for testing with depository institutions and others using Federal Reserve services, we must ensure that our efforts remain on schedule and that problems are addressed in a timely fashion. Much remains to be done. We intend to be as prepared as is humanly possible, and believe that most U.S. banking institutions will be, as well. So will the central and private banks of various other countries. But we would be greatly comforted if this were the outlook for every nation, and for every industry. At this time, that is not the prospect. Let me close by urgently requesting your concern and assistance.	---[PAGE_BREAK]--- # Mr. Kelley discusses the "Millennium Bug" from a public sector perspective Remarks by Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Professional Banker's Association, Washington, D.C. on 15/12/97. I am pleased to appear before the Professional Banker's Association to discuss the Millennium Bug from a public sector perspective. The Millennium Bug, or Year 2000 problem, has the potential to seriously disrupt the infrastructure of computer systems and telecommunications that the world community depends upon for the free flow of funds and payments and hence, virtually all of everyday commerce. The Year 2000 problem is a business continuity issue that requires a coordinated effort by public and private business and information technology management. Although the problem itself is not technically difficult, ensuring that information systems are Year 2000 compliant is a management challenge of enormous scale and complexity. While this matter will impact every organization everywhere, my talk today will focus specifically on the key areas of public sector finance and banking. The global nature of today's financial services industry relies upon the interconnection of computer systems world-wide. My purpose today is to identify the serious nature of the problem and the urgent need for immediate action by the government of every nation. As it will impact every country with which you interact, I believe that you of the Professional Banker's Association are in a unique position to be a catalyst for promoting attention to the Year 2000, stimulating action, and promulgating best practices in developing nations. This afternoon, after sketching out the critical nature of the problem, I will focus on plans and actions being taken by the Federal Reserve System to address the Millennium Bug in its own internal operation, as a case study of what an organization like ours must do. Then on to our efforts within the U.S. financial services industry and the international financial community, and finally a few words on how you can help. ## The Millennium Bug What is this problem all about? Most computer operating systems and applications in use today register dates as two digits. Consequently, such computer systems, software programs, or embedded chip devices can not distinguish the year 2000 from 1900, when both dates are registered as " 00 ". When the clock rolls over the next millennium, computations based on two digit dates will produce errors. Those relatively few systems using four digit date fields will have different problems, but they will have problems, nonetheless. While the situation can be stated simply, its scope is vast and fixing it is enormously time consuming. As this audience knows, banking systems and financial services rely heavily on computer systems to manage and deliver services electronically. With the linkage of payment systems globally, a failure of any linked system could have waterfall effects to other systems and a disastrous result to the world economy. The scope of the Millennium Bug extends far beyond financial services and beyond the traditional notion of large mainframe processing systems. Computer systems that control telecommunications, electric utilities, transportation services, and a host of other critical infrastructure systems are vulnerable. The Gartner Group estimates 50 million embedded-system devices worldwide will exhibit Year 2000 problems. Embedded chips are used to control elevators, environmental systems, navigational devices, household appliances, safes and vaults, and on and on. The pervasive reliance on computer systems is not constrained to large industrialized countries; developing countries are also vulnerable, particularly those with older computer systems and software. ---[PAGE_BREAK]--- I think that some "what ifs" cited by the Computer Information Centre in the UK brings a practical perspective of the effect of what could happen in our everyday life as the millennium arrives. - $\quad$ The computers in financial services organizations, etc. cannot deliver payments to counter parties, or receive funds from them. Gridlock ensues. There's a collapse in financial markets because of the bad news coming from companies about their inability to trade normally. - $\quad$ The power fails, and it is mid-winter in the Northern hemisphere and mid-summer in the Southern hemisphere. The power company's production is controlled by innumerable computer chips, which were installed many years ago and no one knows what they do, how they work, nor dare they touch them, because the whole of the plant might come irreparably to a standstill. More personal possibilities: - $\quad$ The telephone system fails -- and you're unable to notify anyone of your pyramiding problems. - $\quad$ Your medical center's computer has problems and cannot trace the medicines your elderly mother has been prescribed in the past nor the conditions she has had. A doctor prescribes the wrong medicine and she becomes very ill. - $\quad$ You try to draw money from an ATM and it refuses, even though you know you have money in your account. Your bank's computer thinks it is January 1, 1900 -- and you weren't a customer then! As I said, fixing the Year 2000 bug is not technically difficult but it is an enormous task that will be frightfully costly. After all, one needs only to find and repair all date instances in programs. But when you consider the number of lines of code in computer programs in the aggregate, however, the scale of this task is monumental. Consider these estimates: - $\quad$ The Gartner Group believes that there are about 180 billion lines of COBOL code alone in the U.S. - $\quad$ British Telecommunications estimates it will need 1,000 staff at peak to check and correct some 300 million lines of computer code. The Federal Reserve is faced with checking some 90 million lines, and some very large financial institutions have many more than that. Clearly, solving the Year 2000 problem requires skilled staff and is time consuming. Because of so many unknowns, however, it is difficult to accurately estimate the amount of resources that will ultimately be required. Killen \& Associates estimates that \$280 billion will be spent worldwide between 1997 and 2002. Other responsible estimates run to over twice that. # Federal Reserve Readiness Efforts Let me now turn to the approach toward Year 2000 compliance that we have taken at the Federal Reserve, as it may be a useful case study of the scope and scale of what a ---[PAGE_BREAK]--- substantial public agency faces. Doubtless there are larger entities that will confront larger tasks internally, but there are probably not very many with more substantial external relationships requiring attention. For example: The Federal Reserve operates several payments applications that process and settle payments and securities transactions between depository institutions in the United States. Three of these applications, Fedwire funds transfer, Fedwire securities transfer, and Automated Clearing House (ACH) are the most critical payment systems. About 10,000 depository institutions use the Fedwire funds transfer system to transfer each year approximately 86 million payments valued at over $\$ 280$ trillion. About 8,000 depository institutions use the Fedwire securities transfer service to transfer each year approximately 13 million securities valued at over $\$ 160$ trillion. The average total daily values of Fedwire funds and securities transfers are about $\$ 1.1$ trillion and $\$ 650$ billion respectively. The ACH is an electronic payment service that is used by approximately 14,000 financial institutions, 400,000 companies, and an estimated 50 million consumers. Approximately 4 billion ACH transactions were processed in 1996 with a total value of approximately $\$ 12$ trillion. About 3.3 billion of these payments were commercial transactions and the remainder were originated by the Federal government. The scope of the Federal Reserve's Year 2000 activities includes remediation and testing of all components of these processing environments, the supporting telecommunications network, and all of the many systems supporting the operations of this complex organization. That is just for payment systems; bank supervision and monetary policy management pose challenges of similar magnitude. I believe that we have developed a successful program to ensure Year 2000 readiness that is based on industry best practices. This program is receiving the highest level of executive support that emphasizes awareness and commitment throughout our organization. To date, we have completed application assessments, developed internal test plans, and we are currently renovating software. All Federal Reserve computer program changes are scheduled to be completed by year-end 1998, with the financial services systems that interface externally with the industry completed by mid-1998. This schedule will permit approximately 18 months for customer testing, to which we are dedicating considerable support resources. Challenges ahead include managing a highly complex project involving multiple interfaces with others, ensuring the readiness of vendor components, ensuring the readiness of applications, thorough testing, extensive communications, and establishing contingency plans. We are also faced with labor market pressures that call for creative measures to retain staff who are critical to the success of our activities. And the entire project is being closely coordinated among the twelve Reserve Banks, the Board of Governors, numerous vendors and service providers, approximately 13,000 customers, and numerous other government agencies. # Federal Reserve Bank Supervision As a bank supervisor, the Federal Reserve has worked closely with the other U.S. supervisory agencies that are part of the Federal Financial Institutions Examination Council (FFIEC) to alert the industry to our concerns and to monitor Year 2000 preparations of the institutions we supervise, so that we can identify and address problems that arise as early as possible. By mid-year 1998 we expect to complete a thorough compliance preparedness examination of every bank, U.S. branch and agency of a foreign bank, and service provider that we supervise. Our examination program includes a review of each organization's Year 2000 ---[PAGE_BREAK]--- project management plans in order to evaluate their sufficiency, to ensure the direct involvement of senior management and the board of directors, and to monitor their progress against the plan. When facing the most serious supervisory cases of lack of preparedness for the Year 2000, the Federal Reserve will use its enforcement authority as necessary to require corrective action. Recently, the Federal Reserve issued the first cease and desist order against a bank holding company for failing to provide its subsidiary banks with reliable information systems services and for not addressing the needs resulting from the approach of the century date change. # Federal Reserve Contingency Planning While our main focus is on our Year 2000 readiness and the avoidance of problems, we know from experience that on occasion things can go wrong. Given our unique role as the nation's central bank, the Federal Reserve has always stressed contingency planning -- for both systemic risks as well as operational failures. As a result of our experience in responding to problems arising from such diverse events as natural disasters and power outages, as well as liquidity problems in institutions, we expect to be well positioned to deal with Year 2000 problems that might arise. We are mindful, however, that Year 2000 failures may present many unique situations and we are developing specific contingency plans to address various operational scenarios. Our existing business resumption plans will be updated to address date-related difficulties, and key technical staff will be ready to respond quickly to problems with our computer and network systems. We recognize that despite their best efforts, some depository institutions may experience operating difficulties, either as a result of their own computer problems or those of their customers, counter parties, or others. The Federal Reserve is prepared to provide information to depository institutions on the balances in their accounts with us throughout the day, so that they can identify shortfalls and seek funding in the market. And, of course, the Federal Reserve will be prepared to lend in appropriate circumstances. ## Federal Reserve Efforts to Promote Public Awareness We believe that extensive communication with the industry and the public is crucial to the success of century date change efforts. Our public awareness program concentrates on communications with the financial services industry related to our testing efforts and our overall concerns about the industry's readiness. We have inaugurated a Year 2000 industry newsletter to advise our bank customers of our plans and time frames for making our software Year 2000 ready. We have also established an Internet Web site to provide depository institutions with information regarding the Federal Reserve System's CDC project. This site can be accessed at the following Internet address: http://www.frbsf.org/fiservices/cdc. On behalf of the FFIEC, the Federal Reserve has developed a Year 2000 information distribution system, including an Internet Web site and a toll free Fax Back service (888-882-0982). The Web site provides easy access to policy statements, guidance to examiners, and paths to other Year 2000 Web sites available from numerous other sources. It can be accessed at the following Internet address: http://www.ffiec.gov/y2k. ---[PAGE_BREAK]--- We have also produced a ten-minute video entitled "Year 2000 Executive Awareness", intended for viewing by a bank's board of directors and senior management, which presents a summary of the Year 2000 five-phase project management plan outlined in the interagency policy statement. The video can be ordered through the Board's Web site. # International Awareness Early in 1996, the Federal Reserve began to have concerns about international progress on the Year 2000. Informal discussions within the Bank for International Settlements (BIS) Committee on Banking Supervision indicated that the Year 2000 was not then a priority in many countries. That has now changed. We are working intensively through the Committee, which is composed of many international supervisory agencies. Through formal and informal discussions, the distribution of several interagency statements, advisories, and the Federal Reserve's Year 2000 video, we have sought to elevate bank supervisors' awareness of the risks posed by the century date change. The G-10 central bank governors issued an advisory in September, that included a paper by the bank supervisors committee on the Year 2000 challenge, to ensure a higher level of awareness and activity among leading bankers. If you have not seen it, I commend it to your attention. Federal Reserve speakers have been featured in a number of Year 2000 conferences and are looking for others wherever they can be found or promoted. We also participated in a BIS meeting for G-10 and major non-G-10 central banks in September which provided a forum to share views on, and approaches to, dealing with Year 2000 issues. The majority of those present seemed confident that payment and settlement applications under their management would be ready, but the approach of many central banks toward raising industry awareness in their countries varies widely, and little is known about preparations in smaller emerging nations. These efforts within the BIS have confirmed what we had been hearing anecdotally from U.S. financial institutions and from the U.S. branches and agencies of foreign banks. Reportedly, many foreign banks continue to be less focused on the Year 2000 than prudence might suggest. Many organizations appear to be underestimating how important and difficult effective preparation is to a successful Year 2000 effort. To broaden the base of global supervisory awareness of the issue, the Basle Supervisors are working with securities and insurance authorities to sponsor additional activities, and I understand that final arrangements are now being made to hold a large meeting for financial supervisors from around the world in early April to further focus on this topic. Additionally, the banking supervisors are working to see that third-party vendors and service providers rise to the issue. Our supervisory agencies sponsored a conference for vendors in November and the New York Reserve Bank is sponsoring two half-day conferences on managing vendor relationships in early January. In areas such as telecommunications, where the financial industry is highly dependent on companies supervised by other regulators, we have also initiated contact with the FCC to help assure that federal supervisors are coordinated in their approaches. ---[PAGE_BREAK]--- # How can the Professional Bankers Association Help? You can help. Time is of the essence. As you can see, much is being done, but we fear that on a worldwide comprehensive basis we are far behind where we should be, and the days are inexorably going by. The problem is global and must be solved worldwide, or all will suffer. I believe the membership of the PBA is in a unique position to raise the awareness of developing countries to this looming problem. Your intervention might take many forms, and your assistance in stimulating action within your constituency can help bridge the readiness gap we believe now exists in international Year 2000 preparedness efforts. Each member of the PBA can help to help raise the visibility of the problem, publicize its critical nature, and ensure that a compliance commitment originates from the most senior executive level within all of the organizations you monitor. Your own senior executives could communicate the priority placed on this issue to all constituents through public policy statements such as that issued by the G-10 governors of the BIS. As the Fed case demonstrates, your awareness program should emphasize that this is not just a technical matter, but rather a comprehensive business continuity problem that requires the joint cooperation of government and industry sectors. Your organizations have access to the highest levels of government within your constituent countries that can enable you to effectively elevate concern about the danger this problem poses to the safety and soundness of each country's financial system. The PBA could also work closely with the financial community within developing countries to assist in identifying Year 2000 risks, prioritizing resources, and assessing the application and system inventories of your constituents. You can identify common third-party applications and systems and assist in coordinating efforts among these product suppliers and developing countries. The PBA can promote collaborative efforts among developing nations, and sponsor conferences and workshops on Year 2000. You can act as a clearinghouse for information and share "best practices" that could provide a valuable jump-start to those countries still behind the curve. Finally, Year 2000 assessment must also evaluate the level of financial resources available to developing countries to successfully complete a readiness program, and funding to constituents for Year 2000 initiatives should receive a high priority. ## Closing Remarks As I indicated at the outset, the Federal Reserve views Year 2000 preparations with great seriousness. We have placed a high priority on the remediation of date problems and the development of action plans that will ensure business continuity for the critical financial systems we operate. While we have made significant progress, and are on schedule in validating our internal systems and preparing for testing with depository institutions and others using Federal Reserve services, we must ensure that our efforts remain on schedule and that problems are addressed in a timely fashion. Much remains to be done. We intend to be as prepared as is humanly possible, and believe that most U.S. banking institutions will be, as well. So will the central and private banks of various other countries. But we would be greatly comforted if this were the outlook for every nation, and for every industry. At this time, that is not the prospect. Let me close by urgently requesting your concern and assistance.	Edward W Kelley, Jr	United States	https://www.bis.org/review/r980102e.pdf	Remarks by Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Professional Banker's Association, Washington, D.C. on 15/12/97. I am pleased to appear before the Professional Banker's Association to discuss the Millennium Bug from a public sector perspective. The Millennium Bug, or Year 2000 problem, has the potential to seriously disrupt the infrastructure of computer systems and telecommunications that the world community depends upon for the free flow of funds and payments and hence, virtually all of everyday commerce. The Year 2000 problem is a business continuity issue that requires a coordinated effort by public and private business and information technology management. Although the problem itself is not technically difficult, ensuring that information systems are Year 2000 compliant is a management challenge of enormous scale and complexity. While this matter will impact every organization everywhere, my talk today will focus specifically on the key areas of public sector finance and banking. The global nature of today's financial services industry relies upon the interconnection of computer systems world-wide. My purpose today is to identify the serious nature of the problem and the urgent need for immediate action by the government of every nation. As it will impact every country with which you interact, I believe that you of the Professional Banker's Association are in a unique position to be a catalyst for promoting attention to the Year 2000, stimulating action, and promulgating best practices in developing nations. This afternoon, after sketching out the critical nature of the problem, I will focus on plans and actions being taken by the Federal Reserve System to address the Millennium Bug in its own internal operation, as a case study of what an organization like ours must do. Then on to our efforts within the U.S. financial services industry and the international financial community, and finally a few words on how you can help. What is this problem all about? Most computer operating systems and applications in use today register dates as two digits. Consequently, such computer systems, software programs, or embedded chip devices can not distinguish the year 2000 from 1900, when both dates are registered as " 00 ". When the clock rolls over the next millennium, computations based on two digit dates will produce errors. Those relatively few systems using four digit date fields will have different problems, but they will have problems, nonetheless. While the situation can be stated simply, its scope is vast and fixing it is enormously time consuming. As this audience knows, banking systems and financial services rely heavily on computer systems to manage and deliver services electronically. With the linkage of payment systems globally, a failure of any linked system could have waterfall effects to other systems and a disastrous result to the world economy. The scope of the Millennium Bug extends far beyond financial services and beyond the traditional notion of large mainframe processing systems. Computer systems that control telecommunications, electric utilities, transportation services, and a host of other critical infrastructure systems are vulnerable. The Gartner Group estimates 50 million embedded-system devices worldwide will exhibit Year 2000 problems. Embedded chips are used to control elevators, environmental systems, navigational devices, household appliances, safes and vaults, and on and on. The pervasive reliance on computer systems is not constrained to large industrialized countries; developing countries are also vulnerable, particularly those with older computer systems and software. I think that some "what ifs" cited by the Computer Information Centre in the UK brings a practical perspective of the effect of what could happen in our everyday life as the millennium arrives. More personal possibilities: As I said, fixing the Year 2000 bug is not technically difficult but it is an enormous task that will be frightfully costly. After all, one needs only to find and repair all date instances in programs. But when you consider the number of lines of code in computer programs in the aggregate, however, the scale of this task is monumental. Consider these estimates: Clearly, solving the Year 2000 problem requires skilled staff and is time consuming. Because of so many unknowns, however, it is difficult to accurately estimate the amount of resources that will ultimately be required. Killen \& Associates estimates that \$280 billion will be spent worldwide between 1997 and 2002. Other responsible estimates run to over twice that. Let me now turn to the approach toward Year 2000 compliance that we have taken at the Federal Reserve, as it may be a useful case study of the scope and scale of what a substantial public agency faces. Doubtless there are larger entities that will confront larger tasks internally, but there are probably not very many with more substantial external relationships requiring attention. For example: The Federal Reserve operates several payments applications that process and settle payments and securities transactions between depository institutions in the United States. Three of these applications, Fedwire funds transfer, Fedwire securities transfer, and Automated Clearing House (ACH) are the most critical payment systems. About 10,000 depository institutions use the Fedwire funds transfer system to transfer each year approximately 86 million payments valued at over $\$ 280$ trillion. About 8,000 depository institutions use the Fedwire securities transfer service to transfer each year approximately 13 million securities valued at over $\$ 160$ trillion. The average total daily values of Fedwire funds and securities transfers are about $\$ 1.1$ trillion and $\$ 650$ billion respectively. The ACH is an electronic payment service that is used by approximately 14,000 financial institutions, 400,000 companies, and an estimated 50 million consumers. Approximately 4 billion ACH transactions were processed in 1996 with a total value of approximately $\$ 12$ trillion. About 3.3 billion of these payments were commercial transactions and the remainder were originated by the Federal government. The scope of the Federal Reserve's Year 2000 activities includes remediation and testing of all components of these processing environments, the supporting telecommunications network, and all of the many systems supporting the operations of this complex organization. That is just for payment systems; bank supervision and monetary policy management pose challenges of similar magnitude. I believe that we have developed a successful program to ensure Year 2000 readiness that is based on industry best practices. This program is receiving the highest level of executive support that emphasizes awareness and commitment throughout our organization. To date, we have completed application assessments, developed internal test plans, and we are currently renovating software. All Federal Reserve computer program changes are scheduled to be completed by year-end 1998, with the financial services systems that interface externally with the industry completed by mid-1998. This schedule will permit approximately 18 months for customer testing, to which we are dedicating considerable support resources. Challenges ahead include managing a highly complex project involving multiple interfaces with others, ensuring the readiness of vendor components, ensuring the readiness of applications, thorough testing, extensive communications, and establishing contingency plans. We are also faced with labor market pressures that call for creative measures to retain staff who are critical to the success of our activities. And the entire project is being closely coordinated among the twelve Reserve Banks, the Board of Governors, numerous vendors and service providers, approximately 13,000 customers, and numerous other government agencies. As a bank supervisor, the Federal Reserve has worked closely with the other U.S. supervisory agencies that are part of the Federal Financial Institutions Examination Council (FFIEC) to alert the industry to our concerns and to monitor Year 2000 preparations of the institutions we supervise, so that we can identify and address problems that arise as early as possible. By mid-year 1998 we expect to complete a thorough compliance preparedness examination of every bank, U.S. branch and agency of a foreign bank, and service provider that we supervise. Our examination program includes a review of each organization's Year 2000 project management plans in order to evaluate their sufficiency, to ensure the direct involvement of senior management and the board of directors, and to monitor their progress against the plan. When facing the most serious supervisory cases of lack of preparedness for the Year 2000, the Federal Reserve will use its enforcement authority as necessary to require corrective action. Recently, the Federal Reserve issued the first cease and desist order against a bank holding company for failing to provide its subsidiary banks with reliable information systems services and for not addressing the needs resulting from the approach of the century date change. While our main focus is on our Year 2000 readiness and the avoidance of problems, we know from experience that on occasion things can go wrong. Given our unique role as the nation's central bank, the Federal Reserve has always stressed contingency planning -- for both systemic risks as well as operational failures. As a result of our experience in responding to problems arising from such diverse events as natural disasters and power outages, as well as liquidity problems in institutions, we expect to be well positioned to deal with Year 2000 problems that might arise. We are mindful, however, that Year 2000 failures may present many unique situations and we are developing specific contingency plans to address various operational scenarios. Our existing business resumption plans will be updated to address date-related difficulties, and key technical staff will be ready to respond quickly to problems with our computer and network systems. We recognize that despite their best efforts, some depository institutions may experience operating difficulties, either as a result of their own computer problems or those of their customers, counter parties, or others. The Federal Reserve is prepared to provide information to depository institutions on the balances in their accounts with us throughout the day, so that they can identify shortfalls and seek funding in the market. And, of course, the Federal Reserve will be prepared to lend in appropriate circumstances. We believe that extensive communication with the industry and the public is crucial to the success of century date change efforts. Our public awareness program concentrates on communications with the financial services industry related to our testing efforts and our overall concerns about the industry's readiness. We have inaugurated a Year 2000 industry newsletter to advise our bank customers of our plans and time frames for making our software Year 2000 ready. We have also established an Internet Web site to provide depository institutions with information regarding the Federal Reserve System's CDC project. This site can be accessed at the following Internet address: http://www.frbsf.org/fiservices/cdc. On behalf of the FFIEC, the Federal Reserve has developed a Year 2000 information distribution system, including an Internet Web site and a toll free Fax Back service (888-882-0982). The Web site provides easy access to policy statements, guidance to examiners, and paths to other Year 2000 Web sites available from numerous other sources. It can be accessed at the following Internet address: http://www.ffiec.gov/y2k. We have also produced a ten-minute video entitled "Year 2000 Executive Awareness", intended for viewing by a bank's board of directors and senior management, which presents a summary of the Year 2000 five-phase project management plan outlined in the interagency policy statement. The video can be ordered through the Board's Web site. Early in 1996, the Federal Reserve began to have concerns about international progress on the Year 2000. Informal discussions within the Bank for International Settlements (BIS) Committee on Banking Supervision indicated that the Year 2000 was not then a priority in many countries. That has now changed. We are working intensively through the Committee, which is composed of many international supervisory agencies. Through formal and informal discussions, the distribution of several interagency statements, advisories, and the Federal Reserve's Year 2000 video, we have sought to elevate bank supervisors' awareness of the risks posed by the century date change. The G-10 central bank governors issued an advisory in September, that included a paper by the bank supervisors committee on the Year 2000 challenge, to ensure a higher level of awareness and activity among leading bankers. If you have not seen it, I commend it to your attention. Federal Reserve speakers have been featured in a number of Year 2000 conferences and are looking for others wherever they can be found or promoted. We also participated in a BIS meeting for G-10 and major non-G-10 central banks in September which provided a forum to share views on, and approaches to, dealing with Year 2000 issues. The majority of those present seemed confident that payment and settlement applications under their management would be ready, but the approach of many central banks toward raising industry awareness in their countries varies widely, and little is known about preparations in smaller emerging nations. These efforts within the BIS have confirmed what we had been hearing anecdotally from U.S. financial institutions and from the U.S. branches and agencies of foreign banks. Reportedly, many foreign banks continue to be less focused on the Year 2000 than prudence might suggest. Many organizations appear to be underestimating how important and difficult effective preparation is to a successful Year 2000 effort. To broaden the base of global supervisory awareness of the issue, the Basle Supervisors are working with securities and insurance authorities to sponsor additional activities, and I understand that final arrangements are now being made to hold a large meeting for financial supervisors from around the world in early April to further focus on this topic. Additionally, the banking supervisors are working to see that third-party vendors and service providers rise to the issue. Our supervisory agencies sponsored a conference for vendors in November and the New York Reserve Bank is sponsoring two half-day conferences on managing vendor relationships in early January. In areas such as telecommunications, where the financial industry is highly dependent on companies supervised by other regulators, we have also initiated contact with the FCC to help assure that federal supervisors are coordinated in their approaches. You can help. Time is of the essence. As you can see, much is being done, but we fear that on a worldwide comprehensive basis we are far behind where we should be, and the days are inexorably going by. The problem is global and must be solved worldwide, or all will suffer. I believe the membership of the PBA is in a unique position to raise the awareness of developing countries to this looming problem. Your intervention might take many forms, and your assistance in stimulating action within your constituency can help bridge the readiness gap we believe now exists in international Year 2000 preparedness efforts. Each member of the PBA can help to help raise the visibility of the problem, publicize its critical nature, and ensure that a compliance commitment originates from the most senior executive level within all of the organizations you monitor. Your own senior executives could communicate the priority placed on this issue to all constituents through public policy statements such as that issued by the G-10 governors of the BIS. As the Fed case demonstrates, your awareness program should emphasize that this is not just a technical matter, but rather a comprehensive business continuity problem that requires the joint cooperation of government and industry sectors. Your organizations have access to the highest levels of government within your constituent countries that can enable you to effectively elevate concern about the danger this problem poses to the safety and soundness of each country's financial system. The PBA could also work closely with the financial community within developing countries to assist in identifying Year 2000 risks, prioritizing resources, and assessing the application and system inventories of your constituents. You can identify common third-party applications and systems and assist in coordinating efforts among these product suppliers and developing countries. The PBA can promote collaborative efforts among developing nations, and sponsor conferences and workshops on Year 2000. You can act as a clearinghouse for information and share "best practices" that could provide a valuable jump-start to those countries still behind the curve. Finally, Year 2000 assessment must also evaluate the level of financial resources available to developing countries to successfully complete a readiness program, and funding to constituents for Year 2000 initiatives should receive a high priority. As I indicated at the outset, the Federal Reserve views Year 2000 preparations with great seriousness. We have placed a high priority on the remediation of date problems and the development of action plans that will ensure business continuity for the critical financial systems we operate. While we have made significant progress, and are on schedule in validating our internal systems and preparing for testing with depository institutions and others using Federal Reserve services, we must ensure that our efforts remain on schedule and that problems are addressed in a timely fashion. Much remains to be done. We intend to be as prepared as is humanly possible, and believe that most U.S. banking institutions will be, as well. So will the central and private banks of various other countries. But we would be greatly comforted if this were the outlook for every nation, and for every industry. At this time, that is not the prospect. Let me close by urgently requesting your concern and assistance.
1998-01-03T00:00:00	Mr. Greenspan's remarks to the American Economic Association and the American Finance Association (Central Bank Articles and Speeches, 3 Jan 98)	Remarks by Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the Annual Meeting of the American Economic Association and the American Finance Association held in Chicago on 3/1/98.	Mr. Greenspan's remarks to the American Economic Association and the American Finance Association Remarks by Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the Annual Meeting of the American Economic Association and the American Finance Association held in Chicago on 3/1/98. Problems of Price Measurement For most of the past twenty years, the challenges confronting monetary policymakers centered on addressing the question of how inflation could be brought down with as little economic disruption as possible. Given the progress that has been made in reducing inflation, and the very solid economic performance that this low-inflation environment has helped to promote, a new set of issues is now emerging on the policy agenda. Of mounting importance is a deeper understanding of the economic characteristics of sustained price stability. We central bankers need also to better judge how to assess our performance in achieving and maintaining that objective in light of the uncertainties surrounding the accuracy of our measured price indexes. In today's advanced economies, allocative decisions are primarily made by markets. Prices of goods and services set in those markets are central guides to the efficient allocation of resources in a market economy, along with interest rates and equity values. Prices are the signals through which tastes and technology affect the decisions of consumers and producers, directing resources toward their highest valued use. Of course, this signaling process, which involves individual prices, would work with or without government statistical agencies that measure aggregate price levels, and in this sense, price measurement probably is not fundamental for the overall efficiency of the market economy. Indeed, vibrant market economies existed long before government agencies were established to measure prices. Nonetheless, in a modern monetary economy, accurate measurement of aggregate price levels is of considerable importance, increasingly so for central banks whose mandate is to maintain financial stability. Accurate price measures are necessary for understanding economic developments, not only involving inflation, but also involving real output and productivity. If the general price level is estimated to be rising more rapidly than is in fact the case, then we are simultaneously understating growth in real GDP and productivity, and real incomes and living standards are rising faster than our published data suggest. Under these circumstances, policymakers must be cognizant of the shortcomings of our published price indexes to avoid actions based on inaccurate premises that will provoke undesired consequences. Clearly, central bankers need to be conscious of the problems of price measurement as we gauge policies designed to promote price stability and maximum sustainable economic growth. Moreover, many economic transactions, both private and public, are explicitly tied to movements in some published price index, most commonly a consumer price index; and some transactions that are not explicitly tied to a published price index may, nevertheless, take such an index into account less formally. If the price index is not accurately measuring what the participants in such transactions believe it is measuring, then economic transactions will lead to sub-optimal outcomes. The remarkable progress that has been made by virtually all of the major industrial countries in achieving low rates of inflation in recent years has brought the issue of price measurement into especially sharp focus. For most purposes, biases of a few tenths in annual inflation rates do not matter when inflation is high. They do matter when, as now, inflation has become so low that policymakers need to consider at what point effective price stability has been reached. Indeed, some observers have begun to question whether deflation is now a possibility, and to assess the potential difficulties such a development might pose for the economy. Even if deflation is not considered a significant near-term risk for the economy, the increasing discussion of it could be clearer in defining the circumstance. Regrettably, the term deflation is being used to describe several different states that are not necessarily depicting similar economic conditions. One use of the term refers to an ongoing fall in the prices of existing assets. Asset prices are inherently volatile, in part because expected returns from real assets can vary for a wide variety of reasons, some of which may be only tangentially related to the state of the economy and monetary policy. Nonetheless, a drop in the prices of existing assets can feed back onto real economic activity, not only by changing incentives to consume and invest, but also by impairing the health of financial intermediaries -- as we experienced in the early 1990s and many Asian countries are learning now. But historically, it has been very rapid asset price declines -- in equity and real estate, especially -- that have held the potential to be a virulently negative force in the economy. I emphasize rapid declines because, in most circumstances, slowly deflating asset prices probably can be absorbed without the marked economic disruptions that frequently accompany sharp corrections. The severe economic contraction of the early 1930s, and the associated persistent declines in product prices, could probably not have occurred apart from the steep asset price deflation that started in 1929. While asset price deflation can occur for a number of reasons, a persistent deflation in the prices of currently produced goods and services -- just like a persistent increase in these prices -- necessarily is, at its root, a monetary phenomenon. Just as changes in monetary conditions that involve a flight from money to goods cause inflation, the onset of deflation involves a flight from goods to money. Both rapid or variable inflation and deflation can lead to a state of fear and uncertainty that is associated with significant increases in risk premiums and corresponding shortfalls in economic activity. Even a moderate rate of inflation can hamper economic performance, as I have emphasized many times before; and although we do not have any recent experience, moderate rates of deflation would most probably lead to similar problems. Deflation, like inflation, would distort resource allocation and interfere with the economy's ability to reach its full potential. It would have these effects by making long-term planning difficult, obscuring the true movements of relative prices, and interacting adversely with institutions like the tax system that function on the basis on nominal values. But deflation can be detrimental for reasons that go beyond those that are also associated with inflation. Nominal interest rates are bounded at zero, hence deflation raises the possibility of potentially significant increases in real interest rates. Some also argue that resistance to nominal wage cuts will impart an upward bias to real wages as price stability approaches or outright deflation occurs, leaving the economy with a potentially higher level of unemployment in equilibrium. A deflation that took place in an environment of rapid productivity growth, however, might be largely immune from some of these special problems. For example, in the high-tech sector of our economy today, we observe falling prices together with rapid investment and high profitability. Although real interest rates may be quite high in terms of this sector's declining product prices, rapid productivity growth has ensured that real rates of return are higher still, and investment in this sector has been robust. In practice, firms' decisions depend on an evaluation of their nominal return on investment relative to their nominal cost of capital. In this sense, the choice of a specific, sometimes arbitrary, definition of real output and hence of price by government statisticians is essentially a descriptive issue, and not one that directly affects firms' investment decisions. This is an illustration of where even individual price measurement probably is not always of direct and fundamental importance for private sector behavior. If such high-tech, high-productivity-growth firms produce an increasing share of output in the decades ahead, then, one could readily imagine the economy experiencing an overall product price deflation in which the problems associated with a zero constraint on nominal interest rates or nominal wage changes would seldom be binding. Nevertheless, even if we could ensure significantly more rapid productivity growth than we have seen recently, there are valid reasons for wishing to avoid ongoing declines in the general price level. If increases in both inflation and deflation raise risk premiums and retard growth, it follows that risk premiums are lowest at price stability. Furthermore, price stability, by reducing variation in uncertainty about the future, should also reduce variations in asset values. But how are we to know when our objective of price stability has been achieved? In price measurement, a distinction must be made between the measurement of individual prices, on the one hand, and the aggregation of those prices into indexes of the overall price level on the other. The notion of what we mean by a general price level -- or more relevantly, its change -- is never unambiguously defined. Issues of appropriate weighting in the aggregation process will presumably always bedevil us. But it is the measurement of individual prices, not their aggregation, that pose the most difficult conceptual issues. At first glance, observing and measuring prices might not appear especially daunting. But, in fact, the problem is deceptively complex. To be sure, the dollar value of most transactions is unambiguously exact, and, at least in principle, is amenable to highly accurate estimation by our statistical agencies. But dividing that nominal value change into components representing changes in real quantity versus price requires that one define a unit of output that is to remain constant in all transactions over time. Defining such a constant-quality unit of output, of course, is the central conceptual difficulty in price measurement. Such a definition may be clear for unalloyed aluminum ingot of 99.7 percent or greater purity in wide use. Consequently, its price can be compared over time with a degree of precision adequate for virtually all producers and consumers of aluminum ingot. Similarly, the prices of a ton of cold rolled steel sheet, or of a linear yard of cotton broad woven fabric, can be reasonably compared over a period of years. But when the characteristics of products and services are changing rapidly, defining the unit of output, and thereby adjusting an item's price for improvements in quality, can be exceptionally difficult. These problems are becoming pervasive in modern economies as high tech and service prices, which are generally more difficult to measure, become ever more prominent in aggregate price measures. One does not have to look only to the most advanced technology to recognize the difficulties that are faced. To take just a few examples, automobile tires, refrigerators, winter jackets, and tennis rackets have all changed in ways that make them surprisingly hard to compare to their counterparts of twenty or thirty years ago. The continual introduction of new goods and services onto the markets creates special challenges for price measurement. In some cases, a new good may best be viewed as an improved version of an old good. But, in many cases, new products may deliver services that simply were not available before. When personal computers were first introduced, the benefits they brought households in terms of word processing services, financial calculations, organizational assistance, and the like, were truly unique. And, further in the past, think of the revolutionary changes that automobile ownership, or jet travel, brought to people's lives. In theory, economists understand how to value such innovations; in practice, it is an enormous challenge to construct such an estimate with any precision. The area of medical care, where technology is changing in ways that make techniques of only a decade ago seem archaic, provides some particularly striking illustrations of the difficulties involved in measuring quality-adjusted prices. Cures and preventive treatments have become available for previously untreatable diseases. Medical advances have led to new treatments that are more effective and that have increased the speed and comfort of recovery. In an area with such rapid technological change, what is the appropriate unit of output? Is it a procedure, a treatment, or a cure? How does one value the benefit to the patient when a condition that once required a complicated operation and a lengthy stay in the hospital now can be easily treated on an outpatient basis? Although we may not be able to discern its details, the pace of change and the shift toward output that is difficult to measure are more likely to quicken than to slow down. How, then, will we measure inflation in the future if our measurement techniques become increasingly obsolete? We must keep in mind that, difficult as the problem seems, consistently measured prices do exist in principle. Embodied in all products is some unit of output, and hence of price, that is recognizable to those who buy and sell the product if not to the outside observer. A company that pays a sum of money for computer software knows what it is buying, and at least has an idea about its value relative to software it has purchased in the past, and relative to other possible uses for that sum of money in the present. Furthermore, so long as people continue to exchange nominal interest rate debt instruments and contract for future payments in terms of dollars or other currencies, there must be a presumption about the future purchasing power of money no matter how complex individual products become. Market participants do have a sense of the aggregate price level and how they expect it to change over time, and these views must be embedded in the value of financial assets. The emergence of inflation-indexed bonds, while providing us with useful information, does not solve the problem of ascertaining an economically meaningful measure of the general price level. By necessity, the total return on indexed bonds must be tied to forecasts of specific published price indexes, which may or may not reflect the market's judgment of the future purchasing power of money. To the extent they do not, of course, the implicit real interest rate is biased in the opposite direction. Moreover, we are, as yet, unable to separate compensation for inflation risk from compensation for expected inflation. Eventually, financial markets may develop the instruments and associated analytical techniques for unearthing these implicit changes in the general price level with some precision. In those circumstances, then -- at least for purposes of monetary policy -- these measures could obviate the more traditional approaches to aggregate price measurement now employed. They may help us understand, for example, whether markets perceive the true change in aggregate prices to reflect fixed or variable weight indexes of the components, or whether arithmetic or logarithmic weighting of the components is more appropriate. But, for the foreseeable future, we shall have to rely on our statistical agencies to produce the price data necessary to assess economic performance and to make economic policy. In that regard, assuming further advances in economic science and provided that our statistical agencies receive adequate resources, procedures should continue to improve. To be sure, progress will not be easy, for estimating the value of quality improvements is a painstaking process. It must be done methodically, item by item. But progress can be made. In recent years, we have developed an improved ability to capture quality differences by pricing the underlying characteristics of complex products. With an increasingly wide range of product variants available to the public, product characteristics are now bundled together in an enormous variety of combinations. A "personal computer" is, in actuality, an amalgamation of computing speed, memory, networking capability, graphics capability, and so on. Computer manufacturers are moving toward build-to-order systems, in which any combination of these specifications and peripheral equipment is available to each individual buyer. Other examples abound. Advancements in computer-assisted design have reduced the costs of producing multiple varieties of small machine tools. And in services, witness the plethora of products now available from financial institutions, which have allowed a more complete disentangling and exchange of economic risks across participants around the world. Although hard data are scarce, there can be little doubt that products are tailor-made for the buyer to a larger extent than ever. Gone are the days when Henry Ford could say he would sell a car of any color "so long as it's black". In such an environment, when product characteristics are bundled together in so many different combinations, defining the unit of output means unbundling these characteristics, and pricing each of them separately. The so-called hedonic technique is designed to do precisely that. This technique associates changes in a product's price with changes in product characteristics. It therefore allows a quality comparison when new products with improved characteristics are introduced. This approach has been especially useful in the pricing of computers. But hedonics are by no means a panacea. First of all, this technique obviously will be of no use in valuing the quality of an entirely new product that has fundamentally different characteristics from its predecessors. The benefits of cellular telephones, and the value they provide in terms of making calls from any location, cannot be measured from an examination of the attributes of standard telephones. In addition, the measured characteristics may only be proxies for the overall performance that consumers ultimately value. In the case of computers, the buyer ultimately cares about the quality of services that computer will provide -- word processing capabilities, database services, high-speed calculations, and so on. But, in many cases, the number of message instructions per second and the other easily measured characteristics may not be a wholly adequate proxy for the computer services that the individual buyer values. In these circumstances, the right approach, ultimately, may be to move toward directly pricing the services we obtain from our computers -- that is, word processing services, database management services, and so on -- rather than pricing separately the hardware and software. The issues surrounding the appropriate measurement of computer prices also illustrate some of the difficulties of valuing goods and services when there are significant interactions among users of the products. New generations of computers sometimes require software that is incompatible with previous generations, and some users who have no need for the improved computing power nevertheless may feel compelled to purchase the new technology because they need to remain compatible with the bulk of users who are at the frontier. Even if our techniques allow us to accurately measure consumers' valuation of the increased speed and power of the new generation of computer, we may miss the negative influence on some consumers of this incompatibility. Therefore, even in the case of personal computers, where we have made such great strides in measuring quality changes, I suspect that important phenomena still may not be adequately captured by our published price indexes. Despite the advances in price measurement that have been made over the years, there remains considerable room for improvement. As you know, a group of experts empaneled by the Senate Finance Committee -- the Boskin commission -- concluded that the consumer price index has overstated changes in the cost of living by roughly one percentage point per annum in recent years. About half of this bias owed to inadequate adjustment for quality improvement and the introduction of new goods, and about half reflected the manner in which the individual prices were aggregated. Researchers at the Federal Reserve and elsewhere have come up with similar figures. Although the estimates of bias owing to inadequate adjustment for quality improvements surely are the most uncertain aspect of this calculation, the preponderance of evidence is that, on average, such a bias in quality adjustment does exist. The Boskin commission and most others estimating bias in the CPI have taken a microstatistical approach, estimating separately the magnitude of each category of potential bias. Recent work by staff economists at the Federal Reserve Board has added corroborating evidence of price mismeasurement, using a macroeconomic approach that is essentially independent of the microstatistical exercises. Specifically, employing disaggregated data from the national income and product accounts, this research finds that the measured growth of real output and productivity in the service sector is implausibly weak, given that the return to owners of businesses in that sector apparently has been well-maintained. Indeed, the published data indicate that the level of output per hour in a number of service-producing industries has been falling for more than two decades. It is simply not credible that firms in these industries have been becoming less and less efficient for more than twenty years. Much more reasonable is the view that prices have been mismeasured, and that the true quality-adjusted prices have been rising more slowly than the published price indexes. Properly measured, output and productivity trends in these service industries are doubtless considerably stronger than suggested by the published data. Assuming, for example, no change in the productivity levels for these industries in recent years would imply a price bias consistent with the Boskin commission findings. A Commerce Department official once compared a nation's statistical system to a tailor, measuring the economy much as a tailor measures a person for a suit of clothes -- with the difference that, unlike the tailor, the person we are measuring is running while we try to measure him. The only way the system can succeed, he said, is to be just as fast and twice as agile. That is the challenge that lies ahead, and it is, indeed, a large one. There are, however, reasons for optimism. The information revolution, which lies behind so much of the rapid technological change that makes prices difficult to measure, will surely play an important role in helping our statistical agencies acquire the necessary speed and agility to better capture the changes taking place in our economies. Computers, for example, might some day allow our statistical agencies to tap into a great many economic transactions on a nearly real-time basis. Utilizing data from store checkout scanners, which the BLS is now investigating, may be an important first step in that direction. But the possibilities offered by information technology for the improvement of price measurement may turn out to be much broader in scope. Just as it is difficult to predict the ways in which technology will change our consumption over time, so is it difficult to predict how economic and statistical science will make creative use of the improved technology. Such advances must be taken to ensure that our economic statistics remain adequate to support the public policy decisions that must be made. If the challenge for our statistical agencies is not to lose in their race against technology, the challenge for policymakers is to make our best judgments about the limitations of the existing statistics, as we design policies to promote the economic well-being of our nations. In confronting those challenges, both government statisticians and policymakers would benefit from additional research by you, the economics profession, into the increasingly complex conceptual and empirical issues involved with accurately measuring price and quantity.	---[PAGE_BREAK]--- # Mr. Greenspan's remarks to the American Economic Association and the American Finance Association Remarks by Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the Annual Meeting of the American Economic Association and the American Finance Association held in Chicago on 3/1/98. ## Problems of Price Measurement For most of the past twenty years, the challenges confronting monetary policymakers centered on addressing the question of how inflation could be brought down with as little economic disruption as possible. Given the progress that has been made in reducing inflation, and the very solid economic performance that this low-inflation environment has helped to promote, a new set of issues is now emerging on the policy agenda. Of mounting importance is a deeper understanding of the economic characteristics of sustained price stability. We central bankers need also to better judge how to assess our performance in achieving and maintaining that objective in light of the uncertainties surrounding the accuracy of our measured price indexes. In today's advanced economies, allocative decisions are primarily made by markets. Prices of goods and services set in those markets are central guides to the efficient allocation of resources in a market economy, along with interest rates and equity values. Prices are the signals through which tastes and technology affect the decisions of consumers and producers, directing resources toward their highest valued use. Of course, this signaling process, which involves individual prices, would work with or without government statistical agencies that measure aggregate price levels, and in this sense, price measurement probably is not fundamental for the overall efficiency of the market economy. Indeed, vibrant market economies existed long before government agencies were established to measure prices. Nonetheless, in a modern monetary economy, accurate measurement of aggregate price levels is of considerable importance, increasingly so for central banks whose mandate is to maintain financial stability. Accurate price measures are necessary for understanding economic developments, not only involving inflation, but also involving real output and productivity. If the general price level is estimated to be rising more rapidly than is in fact the case, then we are simultaneously understating growth in real GDP and productivity, and real incomes and living standards are rising faster than our published data suggest. Under these circumstances, policymakers must be cognizant of the shortcomings of our published price indexes to avoid actions based on inaccurate premises that will provoke undesired consequences. Clearly, central bankers need to be conscious of the problems of price measurement as we gauge policies designed to promote price stability and maximum sustainable economic growth. Moreover, many economic transactions, both private and public, are explicitly tied to movements in some published price index, most commonly a consumer price index; and some transactions that are not explicitly tied to a published price index may, nevertheless, take such an index into account less formally. If the price index is not accurately measuring what the participants in such transactions believe it is measuring, then economic transactions will lead to sub-optimal outcomes. The remarkable progress that has been made by virtually all of the major industrial countries in achieving low rates of inflation in recent years has brought the issue of price measurement into especially sharp focus. For most purposes, biases of a few tenths in annual inflation rates do not matter when inflation is high. They do matter when, as now, inflation has become so low that policymakers need to consider at what point effective price ---[PAGE_BREAK]--- stability has been reached. Indeed, some observers have begun to question whether deflation is now a possibility, and to assess the potential difficulties such a development might pose for the economy. Even if deflation is not considered a significant near-term risk for the economy, the increasing discussion of it could be clearer in defining the circumstance. Regrettably, the term deflation is being used to describe several different states that are not necessarily depicting similar economic conditions. One use of the term refers to an ongoing fall in the prices of existing assets. Asset prices are inherently volatile, in part because expected returns from real assets can vary for a wide variety of reasons, some of which may be only tangentially related to the state of the economy and monetary policy. Nonetheless, a drop in the prices of existing assets can feed back onto real economic activity, not only by changing incentives to consume and invest, but also by impairing the health of financial intermediaries -- as we experienced in the early 1990s and many Asian countries are learning now. But historically, it has been very rapid asset price declines -- in equity and real estate, especially -- that have held the potential to be a virulently negative force in the economy. I emphasize rapid declines because, in most circumstances, slowly deflating asset prices probably can be absorbed without the marked economic disruptions that frequently accompany sharp corrections. The severe economic contraction of the early 1930s, and the associated persistent declines in product prices, could probably not have occurred apart from the steep asset price deflation that started in 1929. While asset price deflation can occur for a number of reasons, a persistent deflation in the prices of currently produced goods and services -- just like a persistent increase in these prices -- necessarily is, at its root, a monetary phenomenon. Just as changes in monetary conditions that involve a flight from money to goods cause inflation, the onset of deflation involves a flight from goods to money. Both rapid or variable inflation and deflation can lead to a state of fear and uncertainty that is associated with significant increases in risk premiums and corresponding shortfalls in economic activity. Even a moderate rate of inflation can hamper economic performance, as I have emphasized many times before; and although we do not have any recent experience, moderate rates of deflation would most probably lead to similar problems. Deflation, like inflation, would distort resource allocation and interfere with the economy's ability to reach its full potential. It would have these effects by making long-term planning difficult, obscuring the true movements of relative prices, and interacting adversely with institutions like the tax system that function on the basis on nominal values. But deflation can be detrimental for reasons that go beyond those that are also associated with inflation. Nominal interest rates are bounded at zero, hence deflation raises the possibility of potentially significant increases in real interest rates. Some also argue that resistance to nominal wage cuts will impart an upward bias to real wages as price stability approaches or outright deflation occurs, leaving the economy with a potentially higher level of unemployment in equilibrium. A deflation that took place in an environment of rapid productivity growth, however, might be largely immune from some of these special problems. For example, in the high-tech sector of our economy today, we observe falling prices together with rapid investment and high profitability. Although real interest rates may be quite high in terms of this sector's declining product prices, rapid productivity growth has ensured that real rates of return are higher still, and investment in this sector has been robust. In practice, firms' decisions depend on an evaluation of their nominal return on investment relative to their nominal cost of capital. In ---[PAGE_BREAK]--- this sense, the choice of a specific, sometimes arbitrary, definition of real output and hence of price by government statisticians is essentially a descriptive issue, and not one that directly affects firms' investment decisions. This is an illustration of where even individual price measurement probably is not always of direct and fundamental importance for private sector behavior. If such high-tech, high-productivity-growth firms produce an increasing share of output in the decades ahead, then, one could readily imagine the economy experiencing an overall product price deflation in which the problems associated with a zero constraint on nominal interest rates or nominal wage changes would seldom be binding. Nevertheless, even if we could ensure significantly more rapid productivity growth than we have seen recently, there are valid reasons for wishing to avoid ongoing declines in the general price level. If increases in both inflation and deflation raise risk premiums and retard growth, it follows that risk premiums are lowest at price stability. Furthermore, price stability, by reducing variation in uncertainty about the future, should also reduce variations in asset values. But how are we to know when our objective of price stability has been achieved? In price measurement, a distinction must be made between the measurement of individual prices, on the one hand, and the aggregation of those prices into indexes of the overall price level on the other. The notion of what we mean by a general price level -- or more relevantly, its change -- is never unambiguously defined. Issues of appropriate weighting in the aggregation process will presumably always bedevil us. But it is the measurement of individual prices, not their aggregation, that pose the most difficult conceptual issues. At first glance, observing and measuring prices might not appear especially daunting. But, in fact, the problem is deceptively complex. To be sure, the dollar value of most transactions is unambiguously exact, and, at least in principle, is amenable to highly accurate estimation by our statistical agencies. But dividing that nominal value change into components representing changes in real quantity versus price requires that one define a unit of output that is to remain constant in all transactions over time. Defining such a constant-quality unit of output, of course, is the central conceptual difficulty in price measurement. Such a definition may be clear for unalloyed aluminum ingot of 99.7 percent or greater purity in wide use. Consequently, its price can be compared over time with a degree of precision adequate for virtually all producers and consumers of aluminum ingot. Similarly, the prices of a ton of cold rolled steel sheet, or of a linear yard of cotton broad woven fabric, can be reasonably compared over a period of years. But when the characteristics of products and services are changing rapidly, defining the unit of output, and thereby adjusting an item's price for improvements in quality, can be exceptionally difficult. These problems are becoming pervasive in modern economies as high tech and service prices, which are generally more difficult to measure, become ever more prominent in aggregate price measures. One does not have to look only to the most advanced technology to recognize the difficulties that are faced. To take just a few examples, automobile tires, refrigerators, winter jackets, and tennis rackets have all changed in ways that make them surprisingly hard to compare to their counterparts of twenty or thirty years ago. The continual introduction of new goods and services onto the markets creates special challenges for price measurement. In some cases, a new good may best be viewed as an improved version of an old good. But, in many cases, new products may deliver services that simply were not available before. When personal computers were first introduced, the benefits ---[PAGE_BREAK]--- they brought households in terms of word processing services, financial calculations, organizational assistance, and the like, were truly unique. And, further in the past, think of the revolutionary changes that automobile ownership, or jet travel, brought to people's lives. In theory, economists understand how to value such innovations; in practice, it is an enormous challenge to construct such an estimate with any precision. The area of medical care, where technology is changing in ways that make techniques of only a decade ago seem archaic, provides some particularly striking illustrations of the difficulties involved in measuring quality-adjusted prices. Cures and preventive treatments have become available for previously untreatable diseases. Medical advances have led to new treatments that are more effective and that have increased the speed and comfort of recovery. In an area with such rapid technological change, what is the appropriate unit of output? Is it a procedure, a treatment, or a cure? How does one value the benefit to the patient when a condition that once required a complicated operation and a lengthy stay in the hospital now can be easily treated on an outpatient basis? Although we may not be able to discern its details, the pace of change and the shift toward output that is difficult to measure are more likely to quicken than to slow down. How, then, will we measure inflation in the future if our measurement techniques become increasingly obsolete? We must keep in mind that, difficult as the problem seems, consistently measured prices do exist in principle. Embodied in all products is some unit of output, and hence of price, that is recognizable to those who buy and sell the product if not to the outside observer. A company that pays a sum of money for computer software knows what it is buying, and at least has an idea about its value relative to software it has purchased in the past, and relative to other possible uses for that sum of money in the present. Furthermore, so long as people continue to exchange nominal interest rate debt instruments and contract for future payments in terms of dollars or other currencies, there must be a presumption about the future purchasing power of money no matter how complex individual products become. Market participants do have a sense of the aggregate price level and how they expect it to change over time, and these views must be embedded in the value of financial assets. The emergence of inflation-indexed bonds, while providing us with useful information, does not solve the problem of ascertaining an economically meaningful measure of the general price level. By necessity, the total return on indexed bonds must be tied to forecasts of specific published price indexes, which may or may not reflect the market's judgment of the future purchasing power of money. To the extent they do not, of course, the implicit real interest rate is biased in the opposite direction. Moreover, we are, as yet, unable to separate compensation for inflation risk from compensation for expected inflation. Eventually, financial markets may develop the instruments and associated analytical techniques for unearthing these implicit changes in the general price level with some precision. In those circumstances, then -- at least for purposes of monetary policy -- these measures could obviate the more traditional approaches to aggregate price measurement now employed. They may help us understand, for example, whether markets perceive the true change in aggregate prices to reflect fixed or variable weight indexes of the components, or whether arithmetic or logarithmic weighting of the components is more appropriate. But, for the foreseeable future, we shall have to rely on our statistical agencies to produce the price data necessary to assess economic performance and to make economic policy. ---[PAGE_BREAK]--- In that regard, assuming further advances in economic science and provided that our statistical agencies receive adequate resources, procedures should continue to improve. To be sure, progress will not be easy, for estimating the value of quality improvements is a painstaking process. It must be done methodically, item by item. But progress can be made. In recent years, we have developed an improved ability to capture quality differences by pricing the underlying characteristics of complex products. With an increasingly wide range of product variants available to the public, product characteristics are now bundled together in an enormous variety of combinations. A "personal computer" is, in actuality, an amalgamation of computing speed, memory, networking capability, graphics capability, and so on. Computer manufacturers are moving toward build-to-order systems, in which any combination of these specifications and peripheral equipment is available to each individual buyer. Other examples abound. Advancements in computer-assisted design have reduced the costs of producing multiple varieties of small machine tools. And in services, witness the plethora of products now available from financial institutions, which have allowed a more complete disentangling and exchange of economic risks across participants around the world. Although hard data are scarce, there can be little doubt that products are tailor-made for the buyer to a larger extent than ever. Gone are the days when Henry Ford could say he would sell a car of any color "so long as it's black". In such an environment, when product characteristics are bundled together in so many different combinations, defining the unit of output means unbundling these characteristics, and pricing each of them separately. The so-called hedonic technique is designed to do precisely that. This technique associates changes in a product's price with changes in product characteristics. It therefore allows a quality comparison when new products with improved characteristics are introduced. This approach has been especially useful in the pricing of computers. But hedonics are by no means a panacea. First of all, this technique obviously will be of no use in valuing the quality of an entirely new product that has fundamentally different characteristics from its predecessors. The benefits of cellular telephones, and the value they provide in terms of making calls from any location, cannot be measured from an examination of the attributes of standard telephones. In addition, the measured characteristics may only be proxies for the overall performance that consumers ultimately value. In the case of computers, the buyer ultimately cares about the quality of services that computer will provide -- word processing capabilities, database services, high-speed calculations, and so on. But, in many cases, the number of message instructions per second and the other easily measured characteristics may not be a wholly adequate proxy for the computer services that the individual buyer values. In these circumstances, the right approach, ultimately, may be to move toward directly pricing the services we obtain from our computers -- that is, word processing services, database management services, and so on -- rather than pricing separately the hardware and software. The issues surrounding the appropriate measurement of computer prices also illustrate some of the difficulties of valuing goods and services when there are significant interactions among users of the products. New generations of computers sometimes require software that is incompatible with previous generations, and some users who have no need for the improved computing power nevertheless may feel compelled to purchase the new technology because they need to remain compatible with the bulk of users who are at the frontier. Even if our techniques allow us to accurately measure consumers' valuation of the increased speed and power of the new generation of computer, we may miss the negative influence on some consumers of this incompatibility. Therefore, even in the case of personal computers, where we ---[PAGE_BREAK]--- have made such great strides in measuring quality changes, I suspect that important phenomena still may not be adequately captured by our published price indexes. Despite the advances in price measurement that have been made over the years, there remains considerable room for improvement. As you know, a group of experts empaneled by the Senate Finance Committee -- the Boskin commission -- concluded that the consumer price index has overstated changes in the cost of living by roughly one percentage point per annum in recent years. About half of this bias owed to inadequate adjustment for quality improvement and the introduction of new goods, and about half reflected the manner in which the individual prices were aggregated. Researchers at the Federal Reserve and elsewhere have come up with similar figures. Although the estimates of bias owing to inadequate adjustment for quality improvements surely are the most uncertain aspect of this calculation, the preponderance of evidence is that, on average, such a bias in quality adjustment does exist. The Boskin commission and most others estimating bias in the CPI have taken a microstatistical approach, estimating separately the magnitude of each category of potential bias. Recent work by staff economists at the Federal Reserve Board has added corroborating evidence of price mismeasurement, using a macroeconomic approach that is essentially independent of the microstatistical exercises. Specifically, employing disaggregated data from the national income and product accounts, this research finds that the measured growth of real output and productivity in the service sector is implausibly weak, given that the return to owners of businesses in that sector apparently has been well-maintained. Indeed, the published data indicate that the level of output per hour in a number of service-producing industries has been falling for more than two decades. It is simply not credible that firms in these industries have been becoming less and less efficient for more than twenty years. Much more reasonable is the view that prices have been mismeasured, and that the true quality-adjusted prices have been rising more slowly than the published price indexes. Properly measured, output and productivity trends in these service industries are doubtless considerably stronger than suggested by the published data. Assuming, for example, no change in the productivity levels for these industries in recent years would imply a price bias consistent with the Boskin commission findings. A Commerce Department official once compared a nation's statistical system to a tailor, measuring the economy much as a tailor measures a person for a suit of clothes -- with the difference that, unlike the tailor, the person we are measuring is running while we try to measure him. The only way the system can succeed, he said, is to be just as fast and twice as agile. That is the challenge that lies ahead, and it is, indeed, a large one. There are, however, reasons for optimism. The information revolution, which lies behind so much of the rapid technological change that makes prices difficult to measure, will surely play an important role in helping our statistical agencies acquire the necessary speed and agility to better capture the changes taking place in our economies. Computers, for example, might some day allow our statistical agencies to tap into a great many economic transactions on a nearly real-time basis. Utilizing data from store checkout scanners, which the BLS is now investigating, may be an important first step in that direction. But the possibilities offered by information technology for the improvement of price measurement may turn out to be much broader in scope. Just as it is difficult to predict the ways in which technology will change our consumption over time, so is it difficult to predict how economic and statistical science will make creative use of the improved technology. Such advances must be taken to ensure that our economic statistics remain adequate to support the public policy decisions that must be made. If the challenge for our ---[PAGE_BREAK]--- statistical agencies is not to lose in their race against technology, the challenge for policymakers is to make our best judgments about the limitations of the existing statistics, as we design policies to promote the economic well-being of our nations. In confronting those challenges, both government statisticians and policymakers would benefit from additional research by you, the economics profession, into the increasingly complex conceptual and empirical issues involved with accurately measuring price and quantity.	Alan Greenspan	United States	https://www.bis.org/review/r980114b.pdf	American Finance Association Remarks by Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, at the Annual Meeting of the American Economic Association and the American Finance Association held in Chicago on 3/1/98. For most of the past twenty years, the challenges confronting monetary policymakers centered on addressing the question of how inflation could be brought down with as little economic disruption as possible. Given the progress that has been made in reducing inflation, and the very solid economic performance that this low-inflation environment has helped to promote, a new set of issues is now emerging on the policy agenda. Of mounting importance is a deeper understanding of the economic characteristics of sustained price stability. We central bankers need also to better judge how to assess our performance in achieving and maintaining that objective in light of the uncertainties surrounding the accuracy of our measured price indexes. In today's advanced economies, allocative decisions are primarily made by markets. Prices of goods and services set in those markets are central guides to the efficient allocation of resources in a market economy, along with interest rates and equity values. Prices are the signals through which tastes and technology affect the decisions of consumers and producers, directing resources toward their highest valued use. Of course, this signaling process, which involves individual prices, would work with or without government statistical agencies that measure aggregate price levels, and in this sense, price measurement probably is not fundamental for the overall efficiency of the market economy. Indeed, vibrant market economies existed long before government agencies were established to measure prices. Nonetheless, in a modern monetary economy, accurate measurement of aggregate price levels is of considerable importance, increasingly so for central banks whose mandate is to maintain financial stability. Accurate price measures are necessary for understanding economic developments, not only involving inflation, but also involving real output and productivity. If the general price level is estimated to be rising more rapidly than is in fact the case, then we are simultaneously understating growth in real GDP and productivity, and real incomes and living standards are rising faster than our published data suggest. Under these circumstances, policymakers must be cognizant of the shortcomings of our published price indexes to avoid actions based on inaccurate premises that will provoke undesired consequences. Clearly, central bankers need to be conscious of the problems of price measurement as we gauge policies designed to promote price stability and maximum sustainable economic growth. Moreover, many economic transactions, both private and public, are explicitly tied to movements in some published price index, most commonly a consumer price index; and some transactions that are not explicitly tied to a published price index may, nevertheless, take such an index into account less formally. If the price index is not accurately measuring what the participants in such transactions believe it is measuring, then economic transactions will lead to sub-optimal outcomes. The remarkable progress that has been made by virtually all of the major industrial countries in achieving low rates of inflation in recent years has brought the issue of price measurement into especially sharp focus. For most purposes, biases of a few tenths in annual inflation rates do not matter when inflation is high. They do matter when, as now, inflation has become so low that policymakers need to consider at what point effective price stability has been reached. Indeed, some observers have begun to question whether deflation is now a possibility, and to assess the potential difficulties such a development might pose for the economy. Even if deflation is not considered a significant near-term risk for the economy, the increasing discussion of it could be clearer in defining the circumstance. Regrettably, the term deflation is being used to describe several different states that are not necessarily depicting similar economic conditions. One use of the term refers to an ongoing fall in the prices of existing assets. Asset prices are inherently volatile, in part because expected returns from real assets can vary for a wide variety of reasons, some of which may be only tangentially related to the state of the economy and monetary policy. Nonetheless, a drop in the prices of existing assets can feed back onto real economic activity, not only by changing incentives to consume and invest, but also by impairing the health of financial intermediaries -- as we experienced in the early 1990s and many Asian countries are learning now. But historically, it has been very rapid asset price declines -- in equity and real estate, especially -- that have held the potential to be a virulently negative force in the economy. I emphasize rapid declines because, in most circumstances, slowly deflating asset prices probably can be absorbed without the marked economic disruptions that frequently accompany sharp corrections. The severe economic contraction of the early 1930s, and the associated persistent declines in product prices, could probably not have occurred apart from the steep asset price deflation that started in 1929. While asset price deflation can occur for a number of reasons, a persistent deflation in the prices of currently produced goods and services -- just like a persistent increase in these prices -- necessarily is, at its root, a monetary phenomenon. Just as changes in monetary conditions that involve a flight from money to goods cause inflation, the onset of deflation involves a flight from goods to money. Both rapid or variable inflation and deflation can lead to a state of fear and uncertainty that is associated with significant increases in risk premiums and corresponding shortfalls in economic activity. Even a moderate rate of inflation can hamper economic performance, as I have emphasized many times before; and although we do not have any recent experience, moderate rates of deflation would most probably lead to similar problems. Deflation, like inflation, would distort resource allocation and interfere with the economy's ability to reach its full potential. It would have these effects by making long-term planning difficult, obscuring the true movements of relative prices, and interacting adversely with institutions like the tax system that function on the basis on nominal values. But deflation can be detrimental for reasons that go beyond those that are also associated with inflation. Nominal interest rates are bounded at zero, hence deflation raises the possibility of potentially significant increases in real interest rates. Some also argue that resistance to nominal wage cuts will impart an upward bias to real wages as price stability approaches or outright deflation occurs, leaving the economy with a potentially higher level of unemployment in equilibrium. A deflation that took place in an environment of rapid productivity growth, however, might be largely immune from some of these special problems. For example, in the high-tech sector of our economy today, we observe falling prices together with rapid investment and high profitability. Although real interest rates may be quite high in terms of this sector's declining product prices, rapid productivity growth has ensured that real rates of return are higher still, and investment in this sector has been robust. In practice, firms' decisions depend on an evaluation of their nominal return on investment relative to their nominal cost of capital. In this sense, the choice of a specific, sometimes arbitrary, definition of real output and hence of price by government statisticians is essentially a descriptive issue, and not one that directly affects firms' investment decisions. This is an illustration of where even individual price measurement probably is not always of direct and fundamental importance for private sector behavior. If such high-tech, high-productivity-growth firms produce an increasing share of output in the decades ahead, then, one could readily imagine the economy experiencing an overall product price deflation in which the problems associated with a zero constraint on nominal interest rates or nominal wage changes would seldom be binding. Nevertheless, even if we could ensure significantly more rapid productivity growth than we have seen recently, there are valid reasons for wishing to avoid ongoing declines in the general price level. If increases in both inflation and deflation raise risk premiums and retard growth, it follows that risk premiums are lowest at price stability. Furthermore, price stability, by reducing variation in uncertainty about the future, should also reduce variations in asset values. But how are we to know when our objective of price stability has been achieved? In price measurement, a distinction must be made between the measurement of individual prices, on the one hand, and the aggregation of those prices into indexes of the overall price level on the other. The notion of what we mean by a general price level -- or more relevantly, its change -- is never unambiguously defined. Issues of appropriate weighting in the aggregation process will presumably always bedevil us. But it is the measurement of individual prices, not their aggregation, that pose the most difficult conceptual issues. At first glance, observing and measuring prices might not appear especially daunting. But, in fact, the problem is deceptively complex. To be sure, the dollar value of most transactions is unambiguously exact, and, at least in principle, is amenable to highly accurate estimation by our statistical agencies. But dividing that nominal value change into components representing changes in real quantity versus price requires that one define a unit of output that is to remain constant in all transactions over time. Defining such a constant-quality unit of output, of course, is the central conceptual difficulty in price measurement. Such a definition may be clear for unalloyed aluminum ingot of 99.7 percent or greater purity in wide use. Consequently, its price can be compared over time with a degree of precision adequate for virtually all producers and consumers of aluminum ingot. Similarly, the prices of a ton of cold rolled steel sheet, or of a linear yard of cotton broad woven fabric, can be reasonably compared over a period of years. But when the characteristics of products and services are changing rapidly, defining the unit of output, and thereby adjusting an item's price for improvements in quality, can be exceptionally difficult. These problems are becoming pervasive in modern economies as high tech and service prices, which are generally more difficult to measure, become ever more prominent in aggregate price measures. One does not have to look only to the most advanced technology to recognize the difficulties that are faced. To take just a few examples, automobile tires, refrigerators, winter jackets, and tennis rackets have all changed in ways that make them surprisingly hard to compare to their counterparts of twenty or thirty years ago. The continual introduction of new goods and services onto the markets creates special challenges for price measurement. In some cases, a new good may best be viewed as an improved version of an old good. But, in many cases, new products may deliver services that simply were not available before. When personal computers were first introduced, the benefits they brought households in terms of word processing services, financial calculations, organizational assistance, and the like, were truly unique. And, further in the past, think of the revolutionary changes that automobile ownership, or jet travel, brought to people's lives. In theory, economists understand how to value such innovations; in practice, it is an enormous challenge to construct such an estimate with any precision. The area of medical care, where technology is changing in ways that make techniques of only a decade ago seem archaic, provides some particularly striking illustrations of the difficulties involved in measuring quality-adjusted prices. Cures and preventive treatments have become available for previously untreatable diseases. Medical advances have led to new treatments that are more effective and that have increased the speed and comfort of recovery. In an area with such rapid technological change, what is the appropriate unit of output? Is it a procedure, a treatment, or a cure? How does one value the benefit to the patient when a condition that once required a complicated operation and a lengthy stay in the hospital now can be easily treated on an outpatient basis? Although we may not be able to discern its details, the pace of change and the shift toward output that is difficult to measure are more likely to quicken than to slow down. How, then, will we measure inflation in the future if our measurement techniques become increasingly obsolete? We must keep in mind that, difficult as the problem seems, consistently measured prices do exist in principle. Embodied in all products is some unit of output, and hence of price, that is recognizable to those who buy and sell the product if not to the outside observer. A company that pays a sum of money for computer software knows what it is buying, and at least has an idea about its value relative to software it has purchased in the past, and relative to other possible uses for that sum of money in the present. Furthermore, so long as people continue to exchange nominal interest rate debt instruments and contract for future payments in terms of dollars or other currencies, there must be a presumption about the future purchasing power of money no matter how complex individual products become. Market participants do have a sense of the aggregate price level and how they expect it to change over time, and these views must be embedded in the value of financial assets. The emergence of inflation-indexed bonds, while providing us with useful information, does not solve the problem of ascertaining an economically meaningful measure of the general price level. By necessity, the total return on indexed bonds must be tied to forecasts of specific published price indexes, which may or may not reflect the market's judgment of the future purchasing power of money. To the extent they do not, of course, the implicit real interest rate is biased in the opposite direction. Moreover, we are, as yet, unable to separate compensation for inflation risk from compensation for expected inflation. Eventually, financial markets may develop the instruments and associated analytical techniques for unearthing these implicit changes in the general price level with some precision. In those circumstances, then -- at least for purposes of monetary policy -- these measures could obviate the more traditional approaches to aggregate price measurement now employed. They may help us understand, for example, whether markets perceive the true change in aggregate prices to reflect fixed or variable weight indexes of the components, or whether arithmetic or logarithmic weighting of the components is more appropriate. But, for the foreseeable future, we shall have to rely on our statistical agencies to produce the price data necessary to assess economic performance and to make economic policy. In that regard, assuming further advances in economic science and provided that our statistical agencies receive adequate resources, procedures should continue to improve. To be sure, progress will not be easy, for estimating the value of quality improvements is a painstaking process. It must be done methodically, item by item. But progress can be made. In recent years, we have developed an improved ability to capture quality differences by pricing the underlying characteristics of complex products. With an increasingly wide range of product variants available to the public, product characteristics are now bundled together in an enormous variety of combinations. A "personal computer" is, in actuality, an amalgamation of computing speed, memory, networking capability, graphics capability, and so on. Computer manufacturers are moving toward build-to-order systems, in which any combination of these specifications and peripheral equipment is available to each individual buyer. Other examples abound. Advancements in computer-assisted design have reduced the costs of producing multiple varieties of small machine tools. And in services, witness the plethora of products now available from financial institutions, which have allowed a more complete disentangling and exchange of economic risks across participants around the world. Although hard data are scarce, there can be little doubt that products are tailor-made for the buyer to a larger extent than ever. Gone are the days when Henry Ford could say he would sell a car of any color "so long as it's black". In such an environment, when product characteristics are bundled together in so many different combinations, defining the unit of output means unbundling these characteristics, and pricing each of them separately. The so-called hedonic technique is designed to do precisely that. This technique associates changes in a product's price with changes in product characteristics. It therefore allows a quality comparison when new products with improved characteristics are introduced. This approach has been especially useful in the pricing of computers. But hedonics are by no means a panacea. First of all, this technique obviously will be of no use in valuing the quality of an entirely new product that has fundamentally different characteristics from its predecessors. The benefits of cellular telephones, and the value they provide in terms of making calls from any location, cannot be measured from an examination of the attributes of standard telephones. In addition, the measured characteristics may only be proxies for the overall performance that consumers ultimately value. In the case of computers, the buyer ultimately cares about the quality of services that computer will provide -- word processing capabilities, database services, high-speed calculations, and so on. But, in many cases, the number of message instructions per second and the other easily measured characteristics may not be a wholly adequate proxy for the computer services that the individual buyer values. In these circumstances, the right approach, ultimately, may be to move toward directly pricing the services we obtain from our computers -- that is, word processing services, database management services, and so on -- rather than pricing separately the hardware and software. The issues surrounding the appropriate measurement of computer prices also illustrate some of the difficulties of valuing goods and services when there are significant interactions among users of the products. New generations of computers sometimes require software that is incompatible with previous generations, and some users who have no need for the improved computing power nevertheless may feel compelled to purchase the new technology because they need to remain compatible with the bulk of users who are at the frontier. Even if our techniques allow us to accurately measure consumers' valuation of the increased speed and power of the new generation of computer, we may miss the negative influence on some consumers of this incompatibility. Therefore, even in the case of personal computers, where we have made such great strides in measuring quality changes, I suspect that important phenomena still may not be adequately captured by our published price indexes. Despite the advances in price measurement that have been made over the years, there remains considerable room for improvement. As you know, a group of experts empaneled by the Senate Finance Committee -- the Boskin commission -- concluded that the consumer price index has overstated changes in the cost of living by roughly one percentage point per annum in recent years. About half of this bias owed to inadequate adjustment for quality improvement and the introduction of new goods, and about half reflected the manner in which the individual prices were aggregated. Researchers at the Federal Reserve and elsewhere have come up with similar figures. Although the estimates of bias owing to inadequate adjustment for quality improvements surely are the most uncertain aspect of this calculation, the preponderance of evidence is that, on average, such a bias in quality adjustment does exist. The Boskin commission and most others estimating bias in the CPI have taken a microstatistical approach, estimating separately the magnitude of each category of potential bias. Recent work by staff economists at the Federal Reserve Board has added corroborating evidence of price mismeasurement, using a macroeconomic approach that is essentially independent of the microstatistical exercises. Specifically, employing disaggregated data from the national income and product accounts, this research finds that the measured growth of real output and productivity in the service sector is implausibly weak, given that the return to owners of businesses in that sector apparently has been well-maintained. Indeed, the published data indicate that the level of output per hour in a number of service-producing industries has been falling for more than two decades. It is simply not credible that firms in these industries have been becoming less and less efficient for more than twenty years. Much more reasonable is the view that prices have been mismeasured, and that the true quality-adjusted prices have been rising more slowly than the published price indexes. Properly measured, output and productivity trends in these service industries are doubtless considerably stronger than suggested by the published data. Assuming, for example, no change in the productivity levels for these industries in recent years would imply a price bias consistent with the Boskin commission findings. A Commerce Department official once compared a nation's statistical system to a tailor, measuring the economy much as a tailor measures a person for a suit of clothes -- with the difference that, unlike the tailor, the person we are measuring is running while we try to measure him. The only way the system can succeed, he said, is to be just as fast and twice as agile. That is the challenge that lies ahead, and it is, indeed, a large one. There are, however, reasons for optimism. The information revolution, which lies behind so much of the rapid technological change that makes prices difficult to measure, will surely play an important role in helping our statistical agencies acquire the necessary speed and agility to better capture the changes taking place in our economies. Computers, for example, might some day allow our statistical agencies to tap into a great many economic transactions on a nearly real-time basis. Utilizing data from store checkout scanners, which the BLS is now investigating, may be an important first step in that direction. But the possibilities offered by information technology for the improvement of price measurement may turn out to be much broader in scope. Just as it is difficult to predict the ways in which technology will change our consumption over time, so is it difficult to predict how economic and statistical science will make creative use of the improved technology. Such advances must be taken to ensure that our economic statistics remain adequate to support the public policy decisions that must be made. If the challenge for our statistical agencies is not to lose in their race against technology, the challenge for policymakers is to make our best judgments about the limitations of the existing statistics, as we design policies to promote the economic well-being of our nations. In confronting those challenges, both government statisticians and policymakers would benefit from additional research by you, the economics profession, into the increasingly complex conceptual and empirical issues involved with accurately measuring price and quantity.
1998-01-08T00:00:00	Mr. Meyer gives his views on the US economic outlook and the challenges facing monetary policy (Central Bank Articles and Speeches, 8 Jan 98)	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the Economic Strategy Institute, Washington, D.C. on 8/1/98.	Mr. Meyer gives his views on the US economic outlook and the challenges facing Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the monetary policy US Federal Reserve System, before the Economic Strategy Institute, Washington, D.C. on 8/1/98. Three forces are likely to shape the outlook to which monetary policy will have to respond in 1998. The first is the momentum in the cyclical expansion. The second is the set of factors that have recently restrained inflation, despite persistent strong growth and a decline in the unemployment rate to the lowest level in a quarter century. And the third is the spillover from the Asian turmoil. The dominant story in 1997 was the near stand-off between the first two forces. The strength of the cyclical upswing kept monetary policy alert, but -- given the quiescence of inflation -mostly on hold, during the last year. The continued robustness of the expansion into the fourth quarter, including further tightening of the labor market in October and November, might, in my judgment, have tilted the balance toward the case for additional monetary restraint, notwithstanding the continued excellent inflation readings. But, at that very time, the growing dimension of the Asian turmoil began to cast a shadow over the forecast for 1998. It has reinforced prospects for some spontaneous slowing of the economy, introduced a downside risk that had not previously been an important consideration in policy deliberations, and added an additional restraining force on inflation immediately ahead. The task of the Federal Reserve in the coming year will be importantly shaped by the magnitude of the downdraft from the Asian crisis, how it interacts with the remaining cyclical strength in domestic demand, and the degree to which its effects on import and commodity prices help keep inflation in check. But before I return to the prospects for 1998 and the challenges for monetary policy, I will offer a retrospective on 1997. Let me emphasize that the views I present this afternoon, both about the outlook and about monetary policy, are my own views and should not be interpreted as the views of the FOMC. Retrospective on 1997 In my days as a forecaster, I found it a useful discipline to begin the year by critically reviewing the experience of the previous year, identifying the key themes that shaped the outlook, trying to learn from the forecast errors, and drawing implications for the outlook. I will follow this practice this morning. The most dramatic feature of the 1997 macro experience was clearly the combination of faster-than-expected growth and lower-than-expected inflation. This "odd couple" has spawned a search for explanations. I have led a few expeditions myself and will try to extend my analysis further this afternoon. Growth over 1997 probably exceeded 31⁄2% from the fourth quarter of 1996 through the fourth quarter of 1997, while inflation, measured by the CPI, was only about 2% over the same period. This is a remarkable outcome, particularly in relation to the consensus forecast at the beginning of 1997. In February of 1997, for example, the Blue Chip consensus forecast projected just 2% growth in GDP over 1997 and a 3% increase in the CPI. The FOMC consensus forecast and my own were not very different from this expectation. I would characterize the pace of output growth over 1997 as unsustainable, meaning that it was faster than the expansion of productive capacity and would ultimately be restrained going forward either by physical capacity constraints or by higher utilization rates, higher inflation, and policy tightening. The unemployment rate declined by about 3⁄4 percentage point this past year, consistent with the observation that growth was above trend. Most estimates would put the actual unemployment rate at the end of the year perhaps 3⁄4 percentage point below the NAIRU. The picture that emerges is of an economy operating above its point of sustainable capacity and growing beyond its sustainable rate. But we clearly have not faced the usual consequence of over-taxing capacity constraints -- namely, an acceleration in prices. While wage gains did increase, albeit very modestly, over the year, inflation remained extraordinarily well contained. The core measure of the CPI decelerated about 1⁄2 percentage point and the overall CPI slowed more than 11⁄4 percentage points. Stories I always think of defending a forecast or rationalizing an outcome relative to the forecast in terms of telling a story. By that I mean developing a theme or set of themes that tie together the projected or realized outcome and bring coherence to the data. What, then, is the story that brings coherence to the surprises of 1997? Goldilocks. The most talked-about story for 1997 is Goldilocks. This is a reference to Goldilocks finding a bowl of porridge that was neither too hot nor too cold. The analogy is to an economy where growth is neither too fast nor too slow, allowing a comfortable and peaceful expansion without inflationary overtones. I like the story, but it is not the right one for 1997. In economic terms, Goldilocks should be a story about a "soft landing", a situation where growth slows to trend just as the economy reaches full employment and inflation stabilizes at a satisfactory level. But growth over 1997 did not slow to trend, and, as a result, the unemployment rate declined to a level where overheating would normally be evident. Yet we did not get the increase in inflation. The story for 1997 ought to be one that conveys a spirit of surprise, a surprise that, at least on the surface, appears to "break the rules" and that results in a remarkably favorable but unexpected outcome. A Traditionalist's Story: Temporary Bliss. My first inclination, as a model-based forecaster, would be to identify the sources of forecast error in the traditional macro model that was the basis for my forecast. The overall forecast errors for output growth and inflation, in such a model, can be described in terms of some combination of errors made by the model's equations and incorrect assumptions about variables imposed judgmentally on the forecast. For example, consumption might have been stronger than predicted from the realized path of income and wealth, the determinants of consumption in the model. Or, the assumed path for oil and food prices might have turned out to be incorrect. I call the story that emerges from this exercise "temporary bliss". It is a story of a coincidence of favorable surprises, one set yielding stronger-than-expected growth and another set restraining inflation. It is a happy story. But it does not promise continued bliss. And, indeed, it may lean the forecast for 1998 toward slower growth and higher inflation, if one cannot identify another sequence of similarly fortunate shocks going forward. My colleague at Washington University, Murray Weidenbaum, has suggested that forecast errors are often offsetting, reflecting the work of a saint who watches over forecasters. Her name is St. Offset. Her work is often observed when a forecaster gets a forecast for GDP in a particular quarter almost perfect, but misses by a wide amount on nearly every component of GDP! St. Offset took a vacation in 1997. Nearly every major component of aggregate demand came in stronger than fundamentals (i.e., the model equations) would have justified. While I am basing my judgment here on the error patterns in the equations of the Federal Reserve's model, I expect many other models yielded similar results. Unexpected demand shocks are typically amplified by what is commonly referred to as the muliplier-accelerator process. That is, an unexpected demand shock results in higher output and income, which, in turn, further boosts consumption and investment, reinforcing the effect of the errors on income and output. This is also part of the story of faster-than-expected output growth in 1997. But unexpected strength in aggregate demand is usually damped by more restrictive financial conditions, by some combination of monetary tightening and movements in longer-term interest rates. While a 1⁄4 percentage point increase in the funds rate was implemented last March, financial conditions, more broadly, became increasingly supportive rather than more restrictive as the year progressed. Real long-term interest rates, measured using surveys of inflation expectations, were steady to declining over the year, likely reflecting a smaller-than-anticipated budget deficit and an unwinding of expectations of tighter monetary policy. Nominal rates matter, too, especially for housing, and longer-term nominal rates fell, due to the lower-than-expected inflation. Equity prices unexpectedly soared, reinforcing the strength of both consumption and investment. So, instead of financial conditions dampening the demand shocks, as would normally be the case, more supportive financial conditions actually reinforced them. This is another piece in the puzzle. Financial conditions remained supportive partly because the better-than-expected inflation outcome kept the Fed from raising the federal funds rate, except for the single 1⁄4 percentage point move in March. The decline in inflation, in turn, reflected reinforcing effects of a sharp decline in energy prices, a significant slowing in the increase in food prices, and a further decline in core inflation. Overall CPI inflation was widely expected to slow because of a projected reversal of the sharp rise in oil prices over 1996. About one percentage point of the slowing of overall CPI inflation over 1997 was, in fact, due to the relative movements of food and energy prices over 1996 and 1997. This was a somewhat sharper effect than was anticipated at the beginning of the year and accounts for a small part of the forecast error on inflation. But the greater surprise was the decline in core inflation. A major source of this error was the unexpected further appreciation of the dollar and thus the renewed decline in import prices. The dollar had been expected by many to stabilize in 1997. Instead, it appreciated sharply, by 111⁄2% based on the multi-lateral trade weighted index of other G-10 currencies and by even more for broader indexes that include other major trading partners. Continuing sharp declines in computer prices and the failure of medical benefit costs to rebound also contributed to the surprisingly favorable inflation outcome. There was upward pressure on wage change from the low and declining unemployment rate and from the increases in the minimum wage. But this was moderated by the effect on wage change of lower price inflation. There was also a sharp acceleration in productivity over 1997, which held down unit labor costs. In my view, most of this acceleration in productivity was cyclical, meaning it was in response to the faster pace of output growth. Cyclical increases in productivity mainly, in my view, result in higher profits, rather than lower prices. But, there likely was some small moderating influence on inflation from such a cyclical increase in productivity. Putting the story together, the stronger-than-expected growth is explained by unexpected strength in aggregate demand, reinforced by more supportive financial conditions. The excellent inflation outcome, in turn, is explained principally by a coincidence of favorable supply shocks. A New Era Story: Permanent Bliss. A second story that could also explain the 1997 pattern of faster-than-expected growth and lower-than-expected inflation is a structural change or a series of structural changes that ushered in a new era of faster economic growth, perhaps lower average unemployment rates, and lower inflation. I will focus specifically on the possibility of an increase in trend productivity growth, allowing faster output growth and, at least temporarily, slower inflation at the same time. But there are other potential candidates for structural change that are sometimes included as part of this story. In this story, part or all of the faster economic growth over 1997 is matched by faster growth in productive capacity, so it does not have inflationary consequences. In addition, if the increase in the productivity trend is unexpected, it will generally result in lower inflation for a while, as wage gains, based on the previous trend of productivity, are more than outpaced by the faster increase in productivity, lowering unit labor costs and hence inflation. This allows, in principle, faster real growth, lower unemployment rates, and lower inflation. An increase in the productivity trend, by raising the profitability of investment, also is consistent with an investment boom, strong corporate profits, and soaring equity prices. This has the advantage of being a simple, unified explanation, meeting the Occam's Razor test. From my perspective, however, I do not see clear evidence of a break in the productivity trend in the data. As I noted earlier, I view the acceleration in productivity over 1997 as a normal cyclical phenomenon. There was some surprise about how low productivity growth was during 1994 through 1996. But now the level of productivity has returned to where it would be expected to be in light of the cyclical rebound in output. I have kept the traditionalist and new era stories strictly distinct -- either, or. But, the truth could well be a blend of the two. Lessons and Questions What are some of the lessons and lingering questions arising from the growth and inflation outcomes last year? First, the strength of consumption over the year reaffirmed, in my view, the importance of the wealth effect. Second, the excellent price performance in 1997, in the context of the surprise of a higher dollar and the resulting sharper-than-expected decline in import prices, suggests to me that we might be underestimating the effect of import prices on overall inflation. Many models, in particular, ignore the role of falling import prices in undermining the pricing power of producers of import-competing goods. This seemed to have been a clearly important factor in pricing decisions in the domestic auto industry, for example, over the past year. Based on the experience last year, I would revisit this channel. Third, the pattern of wage change and inflation did not definitively reject the estimates of NAIRU and trend growth that underpinned my forecast; but neither did the outcome entirely reinforce my confidence in them. The poor forecast of inflation was not principally due, in my judgment, to errors in the wage and price equations. Nevertheless, I would have made smaller forecast errors if I had used an estimate of NAIRU a bit below my current estimate of 51⁄2% and would have made a smaller error forecasting inflation if I had used a slightly higher estimate of trend growth. The experience in 1997 did not put to rest these questions. Fourth, I wonder whether the divergent pattern in unemployment and capacity utilization rates contributed to the lower-than-expected inflation last year. I believe this issue deserves more attention. Traditionally, these two measures of excess demand move together over the cycle. In the current episode they have diverged. The capacity utilization rate for manufacturing barely budged over 1997, remaining slightly below the point at which it has traditionally been accompanied by an increase in inflation. If the historical relationship between unemployment and capacity utilization had been operative in this expansion, the capacity utilization rate would be more than two percentage points higher today. The failure of capacity utilization rates to move into a range that typically is associated with upward pressure on inflation likely has much to do with the perception of an absence of pricing power by firms. It also may have encouraged firms to alter the way they operate in labor markets, encouraging them to avoid increases in wages that they were going to have difficulty passing along in higher prices. The net result is that there may be less inflation pressure than would normally be associated with the current rate of unemployment. Prospects for 1998 Economic growth is likely to slow over 1998 and inflation may rise somewhat, but remain modest. However, a slowing in growth appears to be a higher probability than an increase in inflation. The economy ended 1997 with still very positive fundamentals, notwithstanding some apparent weakness in demand in the fourth quarter. Momentum in income growth, a high level of wealth, a record level of consumer confidence, lower mortgage rates, and ready availability of jobs support the household sector. Firms are highly profitable and can finance investment on attractive terms. Inflation is low. There are few imbalances in the U.S. economy that would appear to be threats to the expansion. It is from this base that growth is expected to slow over 1998 as a result of the combined effect of some spontaneous slowdown and the spillover from the Asian crisis. The slowdown should move growth closer to a sustainable rate, rather than threaten recession. A key for monetary policy will be whether growth slows to or below trend or remains above trend. This will determine whether utilization rates, especially in the labor market, stabilize, rise further, or begin to reverse. This, in turn, will be an important consideration in the inflation outcome next year and risks of higher inflation thereafter, and will, for me, be an important consideration in the decision about monetary policy. A Slowdown in Growth An important rationale for a spontaneous slowing -- that is, one occurring without further Fed tightening -- is that the pattern of consistent upside surprises across aggregate demand components over 1997 is unlikely to be repeated. In this case, the explanation for the faster-thanexpected growth over 1997 provides a rationale for a slowdown over 1998. The further appreciation of the dollar over 1997, even predating the effects of the Asian turmoil, suggests a continued drag from net exports over 1998, another factor suggesting some slowing in the expansion going forward. The mix of output in the fourth quarter may also provide an impetus for a slowdown in production going forward. GDP growth appears likely to have exceeded 3% again in the fourth quarter. The production side data -- employment, hours worked, and industrial production -- certainly seem to point to solid growth, but the available data on demand components have been on the weak side. This tension could be reconciled by an increase in inventory investment. A combination of slowing final sales and rising inventory investment in the fourth quarter would be a natural prelude to a slowing in the pace of production immediately ahead. The spillover effects from the Asian turmoil should further slow growth over 1998. The degree of slowing in growth and the size of the depreciation in the exchange rates in the region still will be affected by policy actions to be taken by those authorities and the uncertain timing of any improvement in investor confidence. As a result, developments in Asia clearly add a considerable degree of uncertainty to the outlook, though around a forecast of slower growth and lower inflation than would otherwise have been the case. At this point, I expect, the direct effect of the shock from Asian developments on U.S. net exports would slow the growth in our GDP by roughly 1⁄2 percentage point. The further multiplier effects, in this case, would yield an overall slowing in U.S. GDP in the range of 1⁄2 to 3⁄4 percentage point. This estimate, as noted above, is subject to a considerable margin of error, given the evolving nature of developments in the region. But it does suggest that the spillover from Asia will importantly shape the U.S. outlook for 1998. A slowdown of such a magnitude could be expected to substitute for some or all of the monetary tightening that otherwise might have been justified. Cross-currents on Inflation Looking ahead, powerful crosscurrents should still be operating on inflation. First, I expect upward pressure on wages from the prevailing tightness in the labor market. Second, the decline in inflation over the last year should be an important moderating force on wage change going forward, partially offsetting the first factor. Third, the set of forces that have restrained inflation over the last year, the factors I have referred to as favorable supply shocks, will continue to restrain inflation. The unemployment rate is well below most estimates of NAIRU. The resulting upward pressure on wage change and price inflation can be offset or even overwhelmed at times, as it was last year, by other influences. Nevertheless, the role of this consideration in inflation dynamics should not be overlooked or underestimated. It starts me with a bias toward higher inflation. The question is then whether there will be enough offsetting influences in 1998 to prevent inflation from rising. One such offset is the virtuous cycle set in motion by the lower inflation in 1997. The lower inflation last year should moderate the cyclical pressure for higher nominal wages over 1998. That is, the real wage increases produced by the lower inflation substitute for nominal wage gains that would otherwise have been required to achieve the higher path of real wages. The pattern in food, energy, computer, and import prices and in benefit costs will again be important factors shaping the inflation outlook this year. The movements in these prices are not closely tied to the balance of supply and demand in overall labor and product markets and are often subject to wide swings and rapid reversals. Forecasts of these prices are, as a result, often wide of the mark. It appears that energy, import, and, of course, computer prices will decline again over 1998 and food prices increases will again be modest. While there is likely to be at least a modest rebound in benefit costs, we should add to the list of factors restraining measured inflation the one to two-tenths decline in CPI inflation associated with technical revisions to be introduced by the BLS this month. The restraint likely from favorable supply shocks this year has recently been reinforced by a further decline in crude petroleum prices and the projected effect of the Asian crisis on import prices. On balance, it now appears that these forces will continue to restrain inflation over 1998 perhaps by about as much as was the case over 1997. In this case, favorable supply shocks would be neutral factor on inflation this year, neither contributing to higher or lower inflation. On balance, I expect a small increase in inflation in 1998. The upward pressure on inflation will also depend on what happens to utilization rates over the year, which in turn will depend on precisely how much growth slows. One final influence is the sharp cyclical slowing in productivity I expect. This will raise unit labor costs and mainly undermine profit growth. But it could put some upward pressure on prices as well. Two Scenarios and the Challenges Facing Monetary Policy There are many possible outcomes, particularly given the uncertainty about the degree of spontaneous slowing and the dimensions of the spillover from the Asian crisis. Because upside and downside risks for growth and inflation appear to be more balanced than had been the case earlier, I believe monetary policy also needs to be in a more balanced position. The course of monetary policy will, of course, depend on how much growth slows, what happens to utilization rates, and how the movement in utilization rates interacts with the other cross-currents affecting inflation. A much larger spillover from the Asian crisis could encourage an easing. Continued above-trend growth and a further rise utilization rates, on the other hand, could encourage further tightening. But I want to focus on two intermediate outcomes, both because I view these as more likely and because they would raise more interesting questions for monetary policy. The first scenario I call a graceful "reverse soft landing". This is my interpretation of the private sector consensus forecast. As I noted earlier, in a soft landing, growth slows from an above-trend to trend rate just as output converges from below to its full employment level. But I believe output is already beyond the full employment level. A soft landing in this case requires growth to run below trend for a period to allow productive capacity to catch up to demand and to allow utilization rates to ease to sustainable levels. Ordinarily, inflation would be rising during the transition, given initial conditions of output in excess of sustainable capacity. But, in the current episode, the virtuous cycle in play and renewal of forces that have recently been restraining inflation will continue to damp inflation over 1998, at least moderating the rise in inflation that would otherwise occur. In this scenario, real growth slows to around 2% or slightly lower, the unemployment rate edges upward, but remains below NAIRU over 1998, and inflation is slightly higher. This is a path back toward full employment, leaving inflation higher but still modest once full employment is reached, perhaps by the end of 1999. How should monetary policy respond in this scenario? Should policy ease in response to the sharp slowing in growth and rise in the unemployment rate? Or should policy remain on hold, allowing the economy to converge slowly back to full employment and a still modest inflation rate? Given the momentum in domestic demand, the still favorable financial conditions and other fundamentals, questions about the degree of spontaneous slowing, and uncertainty about the magnitude of the spillover from the Asian crisis, an equally plausible forecast is that growth slows, but only to trend. In this case, the unemployment rate would remain near its current level and inflation would increase slightly more than in the first scenario, though it would still be damped in 1998 by the virtuous cycle forces and the continued favorable supply shocks. This scenario would, however, imply greater inflation risks going forward, in light of prospects that the favorable supply shocks eventually will abate, while the prevailing high labor utilization rate will continue to push wage gains higher. How should monetary policy respond in this case? Should policy remain on hold, given the return to a sustainable rate of growth and stable utilization rates? Or, should there be a tightening of policy in light of the prospects for a gradual but persistent updrift in inflation associated with the still very high utilization rates? The latter scenario is valuable in highlighting that the risks of higher inflation are related to the level of utilization rates, not to the rate of growth of output itself. The point is that even if growth slows to trend, utilization rates could be left at unsustainable levels, leaving a risk of rising inflation over time. Unfortunately, I have run out of time before I had the opportunity to answer these questions. I will leave it to you to provide your own answers. In time, the FOMC, of course, will provide its own answer, provided these were the right questions.	---[PAGE_BREAK]--- # Mr. Meyer gives his views on the US economic outlook and the challenges facing monetary policy Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the Economic Strategy Institute, Washington, D.C. on 8/1/98. Three forces are likely to shape the outlook to which monetary policy will have to respond in 1998. The first is the momentum in the cyclical expansion. The second is the set of factors that have recently restrained inflation, despite persistent strong growth and a decline in the unemployment rate to the lowest level in a quarter century. And the third is the spillover from the Asian turmoil. The dominant story in 1997 was the near stand-off between the first two forces. The strength of the cyclical upswing kept monetary policy alert, but -- given the quiescence of inflation -mostly on hold, during the last year. The continued robustness of the expansion into the fourth quarter, including further tightening of the labor market in October and November, might, in my judgment, have tilted the balance toward the case for additional monetary restraint, notwithstanding the continued excellent inflation readings. But, at that very time, the growing dimension of the Asian turmoil began to cast a shadow over the forecast for 1998. It has reinforced prospects for some spontaneous slowing of the economy, introduced a downside risk that had not previously been an important consideration in policy deliberations, and added an additional restraining force on inflation immediately ahead. The task of the Federal Reserve in the coming year will be importantly shaped by the magnitude of the downdraft from the Asian crisis, how it interacts with the remaining cyclical strength in domestic demand, and the degree to which its effects on import and commodity prices help keep inflation in check. But before I return to the prospects for 1998 and the challenges for monetary policy, I will offer a retrospective on 1997. Let me emphasize that the views I present this afternoon, both about the outlook and about monetary policy, are my own views and should not be interpreted as the views of the FOMC. ## Retrospective on 1997 In my days as a forecaster, I found it a useful discipline to begin the year by critically reviewing the experience of the previous year, identifying the key themes that shaped the outlook, trying to learn from the forecast errors, and drawing implications for the outlook. I will follow this practice this morning. The most dramatic feature of the 1997 macro experience was clearly the combination of faster-than-expected growth and lower-than-expected inflation. This "odd couple" has spawned a search for explanations. I have led a few expeditions myself and will try to extend my analysis further this afternoon. Growth over 1997 probably exceeded $3^{1 / 2} \%$ from the fourth quarter of 1996 through the fourth quarter of 1997, while inflation, measured by the CPI, was only about $2 \%$ over the same period. This is a remarkable outcome, particularly in relation to the consensus forecast at the beginning of 1997. In February of 1997, for example, the Blue Chip consensus forecast projected just $2 \%$ growth in GDP over 1997 and a 3\% increase in the CPI. The FOMC consensus forecast and my own were not very different from this expectation. I would characterize the pace of output growth over 1997 as unsustainable, meaning that it was faster than the expansion of productive capacity and would ultimately be restrained going ---[PAGE_BREAK]--- forward either by physical capacity constraints or by higher utilization rates, higher inflation, and policy tightening. The unemployment rate declined by about $3 / 4$ percentage point this past year, consistent with the observation that growth was above trend. Most estimates would put the actual unemployment rate at the end of the year perhaps $3 / 4$ percentage point below the NAIRU. The picture that emerges is of an economy operating above its point of sustainable capacity and growing beyond its sustainable rate. But we clearly have not faced the usual consequence of over-taxing capacity constraints -- namely, an acceleration in prices. While wage gains did increase, albeit very modestly, over the year, inflation remained extraordinarily well contained. The core measure of the CPI decelerated about $1 / 2$ percentage point and the overall CPI slowed more than $1 / 4$ percentage points. # Stories I always think of defending a forecast or rationalizing an outcome relative to the forecast in terms of telling a story. By that I mean developing a theme or set of themes that tie together the projected or realized outcome and bring coherence to the data. What, then, is the story that brings coherence to the surprises of 1997 ? Goldilocks. The most talked-about story for 1997 is Goldilocks. This is a reference to Goldilocks finding a bowl of porridge that was neither too hot nor too cold. The analogy is to an economy where growth is neither too fast nor too slow, allowing a comfortable and peaceful expansion without inflationary overtones. I like the story, but it is not the right one for 1997. In economic terms, Goldilocks should be a story about a "soft landing", a situation where growth slows to trend just as the economy reaches full employment and inflation stabilizes at a satisfactory level. But growth over 1997 did not slow to trend, and, as a result, the unemployment rate declined to a level where overheating would normally be evident. Yet we did not get the increase in inflation. The story for 1997 ought to be one that conveys a spirit of surprise, a surprise that, at least on the surface, appears to "break the rules" and that results in a remarkably favorable but unexpected outcome. A Traditionalist's Story: Temporary Bliss. My first inclination, as a model-based forecaster, would be to identify the sources of forecast error in the traditional macro model that was the basis for my forecast. The overall forecast errors for output growth and inflation, in such a model, can be described in terms of some combination of errors made by the model's equations and incorrect assumptions about variables imposed judgmentally on the forecast. For example, consumption might have been stronger than predicted from the realized path of income and wealth, the determinants of consumption in the model. Or, the assumed path for oil and food prices might have turned out to be incorrect. I call the story that emerges from this exercise "temporary bliss". It is a story of a coincidence of favorable surprises, one set yielding stronger-than-expected growth and another set restraining inflation. It is a happy story. But it does not promise continued bliss. And, indeed, it may lean the forecast for 1998 toward slower growth and higher inflation, if one cannot identify another sequence of similarly fortunate shocks going forward. My colleague at Washington University, Murray Weidenbaum, has suggested that forecast errors are often offsetting, reflecting the work of a saint who watches over forecasters. Her name is St. Offset. Her work is often observed when a forecaster gets a forecast for GDP in a particular quarter almost perfect, but misses by a wide amount on nearly every component of GDP! ---[PAGE_BREAK]--- St. Offset took a vacation in 1997. Nearly every major component of aggregate demand came in stronger than fundamentals (i.e., the model equations) would have justified. While I am basing my judgment here on the error patterns in the equations of the Federal Reserve's model, I expect many other models yielded similar results. Unexpected demand shocks are typically amplified by what is commonly referred to as the muliplier-accelerator process. That is, an unexpected demand shock results in higher output and income, which, in turn, further boosts consumption and investment, reinforcing the effect of the errors on income and output. This is also part of the story of faster-than-expected output growth in 1997. But unexpected strength in aggregate demand is usually damped by more restrictive financial conditions, by some combination of monetary tightening and movements in longer-term interest rates. While a $1 / 4$ percentage point increase in the funds rate was implemented last March, financial conditions, more broadly, became increasingly supportive rather than more restrictive as the year progressed. Real long-term interest rates, measured using surveys of inflation expectations, were steady to declining over the year, likely reflecting a smaller-than-anticipated budget deficit and an unwinding of expectations of tighter monetary policy. Nominal rates matter, too, especially for housing, and longer-term nominal rates fell, due to the lower-than-expected inflation. Equity prices unexpectedly soared, reinforcing the strength of both consumption and investment. So, instead of financial conditions dampening the demand shocks, as would normally be the case, more supportive financial conditions actually reinforced them. This is another piece in the puzzle. Financial conditions remained supportive partly because the better-than-expected inflation outcome kept the Fed from raising the federal funds rate, except for the single $1 / 4$ percentage point move in March. The decline in inflation, in turn, reflected reinforcing effects of a sharp decline in energy prices, a significant slowing in the increase in food prices, and a further decline in core inflation. Overall CPI inflation was widely expected to slow because of a projected reversal of the sharp rise in oil prices over 1996. About one percentage point of the slowing of overall CPI inflation over 1997 was, in fact, due to the relative movements of food and energy prices over 1996 and 1997. This was a somewhat sharper effect than was anticipated at the beginning of the year and accounts for a small part of the forecast error on inflation. But the greater surprise was the decline in core inflation. A major source of this error was the unexpected further appreciation of the dollar and thus the renewed decline in import prices. The dollar had been expected by many to stabilize in 1997. Instead, it appreciated sharply, by $111 / 2 \%$ based on the multi-lateral trade weighted index of other G-10 currencies and by even more for broader indexes that include other major trading partners. Continuing sharp declines in computer prices and the failure of medical benefit costs to rebound also contributed to the surprisingly favorable inflation outcome. There was upward pressure on wage change from the low and declining unemployment rate and from the increases in the minimum wage. But this was moderated by the effect on wage change of lower price inflation. There was also a sharp acceleration in productivity over 1997, which held down unit labor costs. In my view, most of this acceleration in productivity was cyclical, meaning it was in response to the faster pace of output growth. Cyclical increases in productivity mainly, in my view, result in higher profits, rather than lower prices. But, there likely was some small moderating influence on inflation from such a cyclical increase in productivity. Putting the story together, the stronger-than-expected growth is explained by unexpected strength in aggregate demand, reinforced by more supportive financial conditions. The ---[PAGE_BREAK]--- excellent inflation outcome, in turn, is explained principally by a coincidence of favorable supply shocks. A New Era Story: Permanent Bliss. A second story that could also explain the 1997 pattern of faster-than-expected growth and lower-than-expected inflation is a structural change or a series of structural changes that ushered in a new era of faster economic growth, perhaps lower average unemployment rates, and lower inflation. I will focus specifically on the possibility of an increase in trend productivity growth, allowing faster output growth and, at least temporarily, slower inflation at the same time. But there are other potential candidates for structural change that are sometimes included as part of this story. In this story, part or all of the faster economic growth over 1997 is matched by faster growth in productive capacity, so it does not have inflationary consequences. In addition, if the increase in the productivity trend is unexpected, it will generally result in lower inflation for a while, as wage gains, based on the previous trend of productivity, are more than outpaced by the faster increase in productivity, lowering unit labor costs and hence inflation. This allows, in principle, faster real growth, lower unemployment rates, and lower inflation. An increase in the productivity trend, by raising the profitability of investment, also is consistent with an investment boom, strong corporate profits, and soaring equity prices. This has the advantage of being a simple, unified explanation, meeting the Occam's Razor test. From my perspective, however, I do not see clear evidence of a break in the productivity trend in the data. As I noted earlier, I view the acceleration in productivity over 1997 as a normal cyclical phenomenon. There was some surprise about how low productivity growth was during 1994 through 1996. But now the level of productivity has returned to where it would be expected to be in light of the cyclical rebound in output. I have kept the traditionalist and new era stories strictly distinct -- either, or. But, the truth could well be a blend of the two. # Lessons and Questions What are some of the lessons and lingering questions arising from the growth and inflation outcomes last year? First, the strength of consumption over the year reaffirmed, in my view, the importance of the wealth effect. Second, the excellent price performance in 1997, in the context of the surprise of a higher dollar and the resulting sharper-than-expected decline in import prices, suggests to me that we might be underestimating the effect of import prices on overall inflation. Many models, in particular, ignore the role of falling import prices in undermining the pricing power of producers of import-competing goods. This seemed to have been a clearly important factor in pricing decisions in the domestic auto industry, for example, over the past year. Based on the experience last year, I would revisit this channel. Third, the pattern of wage change and inflation did not definitively reject the estimates of NAIRU and trend growth that underpinned my forecast; but neither did the outcome entirely reinforce my confidence in them. The poor forecast of inflation was not principally due, in my judgment, to errors in the wage and price equations. Nevertheless, I would have made smaller forecast errors if I had used an estimate of NAIRU a bit below my current estimate of $51 / 2 \%$ and would have made a smaller error forecasting inflation if I had used a slightly higher estimate of trend growth. The experience in 1997 did not put to rest these questions. ---[PAGE_BREAK]--- Fourth, I wonder whether the divergent pattern in unemployment and capacity utilization rates contributed to the lower-than-expected inflation last year. I believe this issue deserves more attention. Traditionally, these two measures of excess demand move together over the cycle. In the current episode they have diverged. The capacity utilization rate for manufacturing barely budged over 1997, remaining slightly below the point at which it has traditionally been accompanied by an increase in inflation. If the historical relationship between unemployment and capacity utilization had been operative in this expansion, the capacity utilization rate would be more than two percentage points higher today. The failure of capacity utilization rates to move into a range that typically is associated with upward pressure on inflation likely has much to do with the perception of an absence of pricing power by firms. It also may have encouraged firms to alter the way they operate in labor markets, encouraging them to avoid increases in wages that they were going to have difficulty passing along in higher prices. The net result is that there may be less inflation pressure than would normally be associated with the current rate of unemployment. # Prospects for 1998 Economic growth is likely to slow over 1998 and inflation may rise somewhat, but remain modest. However, a slowing in growth appears to be a higher probability than an increase in inflation. The economy ended 1997 with still very positive fundamentals, notwithstanding some apparent weakness in demand in the fourth quarter. Momentum in income growth, a high level of wealth, a record level of consumer confidence, lower mortgage rates, and ready availability of jobs support the household sector. Firms are highly profitable and can finance investment on attractive terms. Inflation is low. There are few imbalances in the U.S. economy that would appear to be threats to the expansion. It is from this base that growth is expected to slow over 1998 as a result of the combined effect of some spontaneous slowdown and the spillover from the Asian crisis. The slowdown should move growth closer to a sustainable rate, rather than threaten recession. A key for monetary policy will be whether growth slows to or below trend or remains above trend. This will determine whether utilization rates, especially in the labor market, stabilize, rise further, or begin to reverse. This, in turn, will be an important consideration in the inflation outcome next year and risks of higher inflation thereafter, and will, for me, be an important consideration in the decision about monetary policy. ## A Slowdown in Growth An important rationale for a spontaneous slowing -- that is, one occurring without further Fed tightening -- is that the pattern of consistent upside surprises across aggregate demand components over 1997 is unlikely to be repeated. In this case, the explanation for the faster-thanexpected growth over 1997 provides a rationale for a slowdown over 1998. The further appreciation of the dollar over 1997, even predating the effects of the Asian turmoil, suggests a continued drag from net exports over 1998, another factor suggesting some slowing in the expansion going forward. The mix of output in the fourth quarter may also provide an impetus for a slowdown in production going forward. GDP growth appears likely to have exceeded $3 \%$ again in the fourth quarter. The production side data -- employment, hours worked, and industrial production -- certainly seem to point to solid growth, but the available data on demand components ---[PAGE_BREAK]--- have been on the weak side. This tension could be reconciled by an increase in inventory investment. A combination of slowing final sales and rising inventory investment in the fourth quarter would be a natural prelude to a slowing in the pace of production immediately ahead. The spillover effects from the Asian turmoil should further slow growth over 1998. The degree of slowing in growth and the size of the depreciation in the exchange rates in the region still will be affected by policy actions to be taken by those authorities and the uncertain timing of any improvement in investor confidence. As a result, developments in Asia clearly add a considerable degree of uncertainty to the outlook, though around a forecast of slower growth and lower inflation than would otherwise have been the case. At this point, I expect, the direct effect of the shock from Asian developments on U.S. net exports would slow the growth in our GDP by roughly $1 / 2$ percentage point. The further multiplier effects, in this case, would yield an overall slowing in U.S. GDP in the range of $1 / 2$ to $3 / 4$ percentage point. This estimate, as noted above, is subject to a considerable margin of error, given the evolving nature of developments in the region. But it does suggest that the spillover from Asia will importantly shape the U.S. outlook for 1998. A slowdown of such a magnitude could be expected to substitute for some or all of the monetary tightening that otherwise might have been justified. # Cross-currents on Inflation Looking ahead, powerful crosscurrents should still be operating on inflation. First, I expect upward pressure on wages from the prevailing tightness in the labor market. Second, the decline in inflation over the last year should be an important moderating force on wage change going forward, partially offsetting the first factor. Third, the set of forces that have restrained inflation over the last year, the factors I have referred to as favorable supply shocks, will continue to restrain inflation. The unemployment rate is well below most estimates of NAIRU. The resulting upward pressure on wage change and price inflation can be offset or even overwhelmed at times, as it was last year, by other influences. Nevertheless, the role of this consideration in inflation dynamics should not be overlooked or underestimated. It starts me with a bias toward higher inflation. The question is then whether there will be enough offsetting influences in 1998 to prevent inflation from rising. One such offset is the virtuous cycle set in motion by the lower inflation in 1997. The lower inflation last year should moderate the cyclical pressure for higher nominal wages over 1998. That is, the real wage increases produced by the lower inflation substitute for nominal wage gains that would otherwise have been required to achieve the higher path of real wages. The pattern in food, energy, computer, and import prices and in benefit costs will again be important factors shaping the inflation outlook this year. The movements in these prices are not closely tied to the balance of supply and demand in overall labor and product markets and are often subject to wide swings and rapid reversals. Forecasts of these prices are, as a result, often wide of the mark. It appears that energy, import, and, of course, computer prices will decline again over 1998 and food prices increases will again be modest. While there is likely to be at least a modest rebound in benefit costs, we should add to the list of factors restraining measured inflation the one to two-tenths decline in CPI inflation associated with technical revisions to be introduced by the BLS this month. The restraint likely from favorable supply shocks this year has recently been reinforced by a further decline in crude petroleum prices and the projected effect of the Asian crisis on import prices. On balance, it now appears that these forces will continue to restrain inflation over ---[PAGE_BREAK]--- 1998 perhaps by about as much as was the case over 1997. In this case, favorable supply shocks would be neutral factor on inflation this year, neither contributing to higher or lower inflation. On balance, I expect a small increase in inflation in 1998. The upward pressure on inflation will also depend on what happens to utilization rates over the year, which in turn will depend on precisely how much growth slows. One final influence is the sharp cyclical slowing in productivity I expect. This will raise unit labor costs and mainly undermine profit growth. But it could put some upward pressure on prices as well. # Two Scenarios and the Challenges Facing Monetary Policy There are many possible outcomes, particularly given the uncertainty about the degree of spontaneous slowing and the dimensions of the spillover from the Asian crisis. Because upside and downside risks for growth and inflation appear to be more balanced than had been the case earlier, I believe monetary policy also needs to be in a more balanced position. The course of monetary policy will, of course, depend on how much growth slows, what happens to utilization rates, and how the movement in utilization rates interacts with the other cross-currents affecting inflation. A much larger spillover from the Asian crisis could encourage an easing. Continued above-trend growth and a further rise utilization rates, on the other hand, could encourage further tightening. But I want to focus on two intermediate outcomes, both because I view these as more likely and because they would raise more interesting questions for monetary policy. The first scenario I call a graceful "reverse soft landing". This is my interpretation of the private sector consensus forecast. As I noted earlier, in a soft landing, growth slows from an above-trend to trend rate just as output converges from below to its full employment level. But I believe output is already beyond the full employment level. A soft landing in this case requires growth to run below trend for a period to allow productive capacity to catch up to demand and to allow utilization rates to ease to sustainable levels. Ordinarily, inflation would be rising during the transition, given initial conditions of output in excess of sustainable capacity. But, in the current episode, the virtuous cycle in play and renewal of forces that have recently been restraining inflation will continue to damp inflation over 1998, at least moderating the rise in inflation that would otherwise occur. In this scenario, real growth slows to around $2 \%$ or slightly lower, the unemployment rate edges upward, but remains below NAIRU over 1998, and inflation is slightly higher. This is a path back toward full employment, leaving inflation higher but still modest once full employment is reached, perhaps by the end of 1999. How should monetary policy respond in this scenario? Should policy ease in response to the sharp slowing in growth and rise in the unemployment rate? Or should policy remain on hold, allowing the economy to converge slowly back to full employment and a still modest inflation rate? Given the momentum in domestic demand, the still favorable financial conditions and other fundamentals, questions about the degree of spontaneous slowing, and uncertainty about the magnitude of the spillover from the Asian crisis, an equally plausible forecast is that growth slows, but only to trend. In this case, the unemployment rate would remain near its current level and inflation would increase slightly more than in the first scenario, though it would still be damped in 1998 by the virtuous cycle forces and the continued favorable supply shocks. This scenario would, however, imply greater inflation risks going forward, in light of prospects that the favorable supply shocks eventually will abate, while the prevailing high labor utilization rate will continue to push wage gains higher. ---[PAGE_BREAK]--- How should monetary policy respond in this case? Should policy remain on hold, given the return to a sustainable rate of growth and stable utilization rates? Or, should there be a tightening of policy in light of the prospects for a gradual but persistent updrift in inflation associated with the still very high utilization rates? The latter scenario is valuable in highlighting that the risks of higher inflation are related to the level of utilization rates, not to the rate of growth of output itself. The point is that even if growth slows to trend, utilization rates could be left at unsustainable levels, leaving a risk of rising inflation over time. Unfortunately, I have run out of time before I had the opportunity to answer these questions. I will leave it to you to provide your own answers. In time, the FOMC, of course, will provide its own answer, provided these were the right questions.	Laurence H Meyer	United States	https://www.bis.org/review/r980126a.pdf	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the Economic Strategy Institute, Washington, D.C. on 8/1/98. Three forces are likely to shape the outlook to which monetary policy will have to respond in 1998. The first is the momentum in the cyclical expansion. The second is the set of factors that have recently restrained inflation, despite persistent strong growth and a decline in the unemployment rate to the lowest level in a quarter century. And the third is the spillover from the Asian turmoil. The dominant story in 1997 was the near stand-off between the first two forces. The strength of the cyclical upswing kept monetary policy alert, but -- given the quiescence of inflation -mostly on hold, during the last year. The continued robustness of the expansion into the fourth quarter, including further tightening of the labor market in October and November, might, in my judgment, have tilted the balance toward the case for additional monetary restraint, notwithstanding the continued excellent inflation readings. But, at that very time, the growing dimension of the Asian turmoil began to cast a shadow over the forecast for 1998. It has reinforced prospects for some spontaneous slowing of the economy, introduced a downside risk that had not previously been an important consideration in policy deliberations, and added an additional restraining force on inflation immediately ahead. The task of the Federal Reserve in the coming year will be importantly shaped by the magnitude of the downdraft from the Asian crisis, how it interacts with the remaining cyclical strength in domestic demand, and the degree to which its effects on import and commodity prices help keep inflation in check. But before I return to the prospects for 1998 and the challenges for monetary policy, I will offer a retrospective on 1997. Let me emphasize that the views I present this afternoon, both about the outlook and about monetary policy, are my own views and should not be interpreted as the views of the FOMC. In my days as a forecaster, I found it a useful discipline to begin the year by critically reviewing the experience of the previous year, identifying the key themes that shaped the outlook, trying to learn from the forecast errors, and drawing implications for the outlook. I will follow this practice this morning. The most dramatic feature of the 1997 macro experience was clearly the combination of faster-than-expected growth and lower-than-expected inflation. This "odd couple" has spawned a search for explanations. I have led a few expeditions myself and will try to extend my analysis further this afternoon. Growth over 1997 probably exceeded $3^{1 / 2} \%$ from the fourth quarter of 1996 through the fourth quarter of 1997, while inflation, measured by the CPI, was only about $2 \%$ over the same period. This is a remarkable outcome, particularly in relation to the consensus forecast at the beginning of 1997. In February of 1997, for example, the Blue Chip consensus forecast projected just $2 \%$ growth in GDP over 1997 and a 3\% increase in the CPI. The FOMC consensus forecast and my own were not very different from this expectation. I would characterize the pace of output growth over 1997 as unsustainable, meaning that it was faster than the expansion of productive capacity and would ultimately be restrained going forward either by physical capacity constraints or by higher utilization rates, higher inflation, and policy tightening. The unemployment rate declined by about $3 / 4$ percentage point this past year, consistent with the observation that growth was above trend. Most estimates would put the actual unemployment rate at the end of the year perhaps $3 / 4$ percentage point below the NAIRU. The picture that emerges is of an economy operating above its point of sustainable capacity and growing beyond its sustainable rate. But we clearly have not faced the usual consequence of over-taxing capacity constraints -- namely, an acceleration in prices. While wage gains did increase, albeit very modestly, over the year, inflation remained extraordinarily well contained. The core measure of the CPI decelerated about $1 / 2$ percentage point and the overall CPI slowed more than $1 / 4$ percentage points. I always think of defending a forecast or rationalizing an outcome relative to the forecast in terms of telling a story. By that I mean developing a theme or set of themes that tie together the projected or realized outcome and bring coherence to the data. What, then, is the story that brings coherence to the surprises of 1997 ? Goldilocks. The most talked-about story for 1997 is Goldilocks. This is a reference to Goldilocks finding a bowl of porridge that was neither too hot nor too cold. The analogy is to an economy where growth is neither too fast nor too slow, allowing a comfortable and peaceful expansion without inflationary overtones. I like the story, but it is not the right one for 1997. In economic terms, Goldilocks should be a story about a "soft landing", a situation where growth slows to trend just as the economy reaches full employment and inflation stabilizes at a satisfactory level. But growth over 1997 did not slow to trend, and, as a result, the unemployment rate declined to a level where overheating would normally be evident. Yet we did not get the increase in inflation. The story for 1997 ought to be one that conveys a spirit of surprise, a surprise that, at least on the surface, appears to "break the rules" and that results in a remarkably favorable but unexpected outcome. A Traditionalist's Story: Temporary Bliss. My first inclination, as a model-based forecaster, would be to identify the sources of forecast error in the traditional macro model that was the basis for my forecast. The overall forecast errors for output growth and inflation, in such a model, can be described in terms of some combination of errors made by the model's equations and incorrect assumptions about variables imposed judgmentally on the forecast. For example, consumption might have been stronger than predicted from the realized path of income and wealth, the determinants of consumption in the model. Or, the assumed path for oil and food prices might have turned out to be incorrect. I call the story that emerges from this exercise "temporary bliss". It is a story of a coincidence of favorable surprises, one set yielding stronger-than-expected growth and another set restraining inflation. It is a happy story. But it does not promise continued bliss. And, indeed, it may lean the forecast for 1998 toward slower growth and higher inflation, if one cannot identify another sequence of similarly fortunate shocks going forward. My colleague at Washington University, Murray Weidenbaum, has suggested that forecast errors are often offsetting, reflecting the work of a saint who watches over forecasters. Her name is St. Offset. Her work is often observed when a forecaster gets a forecast for GDP in a particular quarter almost perfect, but misses by a wide amount on nearly every component of GDP! St. Offset took a vacation in 1997. Nearly every major component of aggregate demand came in stronger than fundamentals (i.e., the model equations) would have justified. While I am basing my judgment here on the error patterns in the equations of the Federal Reserve's model, I expect many other models yielded similar results. Unexpected demand shocks are typically amplified by what is commonly referred to as the muliplier-accelerator process. That is, an unexpected demand shock results in higher output and income, which, in turn, further boosts consumption and investment, reinforcing the effect of the errors on income and output. This is also part of the story of faster-than-expected output growth in 1997. But unexpected strength in aggregate demand is usually damped by more restrictive financial conditions, by some combination of monetary tightening and movements in longer-term interest rates. While a $1 / 4$ percentage point increase in the funds rate was implemented last March, financial conditions, more broadly, became increasingly supportive rather than more restrictive as the year progressed. Real long-term interest rates, measured using surveys of inflation expectations, were steady to declining over the year, likely reflecting a smaller-than-anticipated budget deficit and an unwinding of expectations of tighter monetary policy. Nominal rates matter, too, especially for housing, and longer-term nominal rates fell, due to the lower-than-expected inflation. Equity prices unexpectedly soared, reinforcing the strength of both consumption and investment. So, instead of financial conditions dampening the demand shocks, as would normally be the case, more supportive financial conditions actually reinforced them. This is another piece in the puzzle. Financial conditions remained supportive partly because the better-than-expected inflation outcome kept the Fed from raising the federal funds rate, except for the single $1 / 4$ percentage point move in March. The decline in inflation, in turn, reflected reinforcing effects of a sharp decline in energy prices, a significant slowing in the increase in food prices, and a further decline in core inflation. Overall CPI inflation was widely expected to slow because of a projected reversal of the sharp rise in oil prices over 1996. About one percentage point of the slowing of overall CPI inflation over 1997 was, in fact, due to the relative movements of food and energy prices over 1996 and 1997. This was a somewhat sharper effect than was anticipated at the beginning of the year and accounts for a small part of the forecast error on inflation. But the greater surprise was the decline in core inflation. A major source of this error was the unexpected further appreciation of the dollar and thus the renewed decline in import prices. The dollar had been expected by many to stabilize in 1997. Instead, it appreciated sharply, by $111 / 2 \%$ based on the multi-lateral trade weighted index of other G-10 currencies and by even more for broader indexes that include other major trading partners. Continuing sharp declines in computer prices and the failure of medical benefit costs to rebound also contributed to the surprisingly favorable inflation outcome. There was upward pressure on wage change from the low and declining unemployment rate and from the increases in the minimum wage. But this was moderated by the effect on wage change of lower price inflation. There was also a sharp acceleration in productivity over 1997, which held down unit labor costs. In my view, most of this acceleration in productivity was cyclical, meaning it was in response to the faster pace of output growth. Cyclical increases in productivity mainly, in my view, result in higher profits, rather than lower prices. But, there likely was some small moderating influence on inflation from such a cyclical increase in productivity. Putting the story together, the stronger-than-expected growth is explained by unexpected strength in aggregate demand, reinforced by more supportive financial conditions. The excellent inflation outcome, in turn, is explained principally by a coincidence of favorable supply shocks. A New Era Story: Permanent Bliss. A second story that could also explain the 1997 pattern of faster-than-expected growth and lower-than-expected inflation is a structural change or a series of structural changes that ushered in a new era of faster economic growth, perhaps lower average unemployment rates, and lower inflation. I will focus specifically on the possibility of an increase in trend productivity growth, allowing faster output growth and, at least temporarily, slower inflation at the same time. But there are other potential candidates for structural change that are sometimes included as part of this story. In this story, part or all of the faster economic growth over 1997 is matched by faster growth in productive capacity, so it does not have inflationary consequences. In addition, if the increase in the productivity trend is unexpected, it will generally result in lower inflation for a while, as wage gains, based on the previous trend of productivity, are more than outpaced by the faster increase in productivity, lowering unit labor costs and hence inflation. This allows, in principle, faster real growth, lower unemployment rates, and lower inflation. An increase in the productivity trend, by raising the profitability of investment, also is consistent with an investment boom, strong corporate profits, and soaring equity prices. This has the advantage of being a simple, unified explanation, meeting the Occam's Razor test. From my perspective, however, I do not see clear evidence of a break in the productivity trend in the data. As I noted earlier, I view the acceleration in productivity over 1997 as a normal cyclical phenomenon. There was some surprise about how low productivity growth was during 1994 through 1996. But now the level of productivity has returned to where it would be expected to be in light of the cyclical rebound in output. I have kept the traditionalist and new era stories strictly distinct -- either, or. But, the truth could well be a blend of the two. What are some of the lessons and lingering questions arising from the growth and inflation outcomes last year? First, the strength of consumption over the year reaffirmed, in my view, the importance of the wealth effect. Second, the excellent price performance in 1997, in the context of the surprise of a higher dollar and the resulting sharper-than-expected decline in import prices, suggests to me that we might be underestimating the effect of import prices on overall inflation. Many models, in particular, ignore the role of falling import prices in undermining the pricing power of producers of import-competing goods. This seemed to have been a clearly important factor in pricing decisions in the domestic auto industry, for example, over the past year. Based on the experience last year, I would revisit this channel. Third, the pattern of wage change and inflation did not definitively reject the estimates of NAIRU and trend growth that underpinned my forecast; but neither did the outcome entirely reinforce my confidence in them. The poor forecast of inflation was not principally due, in my judgment, to errors in the wage and price equations. Nevertheless, I would have made smaller forecast errors if I had used an estimate of NAIRU a bit below my current estimate of $51 / 2 \%$ and would have made a smaller error forecasting inflation if I had used a slightly higher estimate of trend growth. The experience in 1997 did not put to rest these questions. Fourth, I wonder whether the divergent pattern in unemployment and capacity utilization rates contributed to the lower-than-expected inflation last year. I believe this issue deserves more attention. Traditionally, these two measures of excess demand move together over the cycle. In the current episode they have diverged. The capacity utilization rate for manufacturing barely budged over 1997, remaining slightly below the point at which it has traditionally been accompanied by an increase in inflation. If the historical relationship between unemployment and capacity utilization had been operative in this expansion, the capacity utilization rate would be more than two percentage points higher today. The failure of capacity utilization rates to move into a range that typically is associated with upward pressure on inflation likely has much to do with the perception of an absence of pricing power by firms. It also may have encouraged firms to alter the way they operate in labor markets, encouraging them to avoid increases in wages that they were going to have difficulty passing along in higher prices. The net result is that there may be less inflation pressure than would normally be associated with the current rate of unemployment. Economic growth is likely to slow over 1998 and inflation may rise somewhat, but remain modest. However, a slowing in growth appears to be a higher probability than an increase in inflation. The economy ended 1997 with still very positive fundamentals, notwithstanding some apparent weakness in demand in the fourth quarter. Momentum in income growth, a high level of wealth, a record level of consumer confidence, lower mortgage rates, and ready availability of jobs support the household sector. Firms are highly profitable and can finance investment on attractive terms. Inflation is low. There are few imbalances in the U.S. economy that would appear to be threats to the expansion. It is from this base that growth is expected to slow over 1998 as a result of the combined effect of some spontaneous slowdown and the spillover from the Asian crisis. The slowdown should move growth closer to a sustainable rate, rather than threaten recession. A key for monetary policy will be whether growth slows to or below trend or remains above trend. This will determine whether utilization rates, especially in the labor market, stabilize, rise further, or begin to reverse. This, in turn, will be an important consideration in the inflation outcome next year and risks of higher inflation thereafter, and will, for me, be an important consideration in the decision about monetary policy. An important rationale for a spontaneous slowing -- that is, one occurring without further Fed tightening -- is that the pattern of consistent upside surprises across aggregate demand components over 1997 is unlikely to be repeated. In this case, the explanation for the faster-thanexpected growth over 1997 provides a rationale for a slowdown over 1998. The further appreciation of the dollar over 1997, even predating the effects of the Asian turmoil, suggests a continued drag from net exports over 1998, another factor suggesting some slowing in the expansion going forward. The mix of output in the fourth quarter may also provide an impetus for a slowdown in production going forward. GDP growth appears likely to have exceeded $3 \%$ again in the fourth quarter. The production side data -- employment, hours worked, and industrial production -- certainly seem to point to solid growth, but the available data on demand components have been on the weak side. This tension could be reconciled by an increase in inventory investment. A combination of slowing final sales and rising inventory investment in the fourth quarter would be a natural prelude to a slowing in the pace of production immediately ahead. The spillover effects from the Asian turmoil should further slow growth over 1998. The degree of slowing in growth and the size of the depreciation in the exchange rates in the region still will be affected by policy actions to be taken by those authorities and the uncertain timing of any improvement in investor confidence. As a result, developments in Asia clearly add a considerable degree of uncertainty to the outlook, though around a forecast of slower growth and lower inflation than would otherwise have been the case. At this point, I expect, the direct effect of the shock from Asian developments on U.S. net exports would slow the growth in our GDP by roughly $1 / 2$ percentage point. The further multiplier effects, in this case, would yield an overall slowing in U.S. GDP in the range of $1 / 2$ to $3 / 4$ percentage point. This estimate, as noted above, is subject to a considerable margin of error, given the evolving nature of developments in the region. But it does suggest that the spillover from Asia will importantly shape the U.S. outlook for 1998. A slowdown of such a magnitude could be expected to substitute for some or all of the monetary tightening that otherwise might have been justified. Looking ahead, powerful crosscurrents should still be operating on inflation. First, I expect upward pressure on wages from the prevailing tightness in the labor market. Second, the decline in inflation over the last year should be an important moderating force on wage change going forward, partially offsetting the first factor. Third, the set of forces that have restrained inflation over the last year, the factors I have referred to as favorable supply shocks, will continue to restrain inflation. The unemployment rate is well below most estimates of NAIRU. The resulting upward pressure on wage change and price inflation can be offset or even overwhelmed at times, as it was last year, by other influences. Nevertheless, the role of this consideration in inflation dynamics should not be overlooked or underestimated. It starts me with a bias toward higher inflation. The question is then whether there will be enough offsetting influences in 1998 to prevent inflation from rising. One such offset is the virtuous cycle set in motion by the lower inflation in 1997. The lower inflation last year should moderate the cyclical pressure for higher nominal wages over 1998. That is, the real wage increases produced by the lower inflation substitute for nominal wage gains that would otherwise have been required to achieve the higher path of real wages. The pattern in food, energy, computer, and import prices and in benefit costs will again be important factors shaping the inflation outlook this year. The movements in these prices are not closely tied to the balance of supply and demand in overall labor and product markets and are often subject to wide swings and rapid reversals. Forecasts of these prices are, as a result, often wide of the mark. It appears that energy, import, and, of course, computer prices will decline again over 1998 and food prices increases will again be modest. While there is likely to be at least a modest rebound in benefit costs, we should add to the list of factors restraining measured inflation the one to two-tenths decline in CPI inflation associated with technical revisions to be introduced by the BLS this month. The restraint likely from favorable supply shocks this year has recently been reinforced by a further decline in crude petroleum prices and the projected effect of the Asian crisis on import prices. On balance, it now appears that these forces will continue to restrain inflation over 1998 perhaps by about as much as was the case over 1997. In this case, favorable supply shocks would be neutral factor on inflation this year, neither contributing to higher or lower inflation. On balance, I expect a small increase in inflation in 1998. The upward pressure on inflation will also depend on what happens to utilization rates over the year, which in turn will depend on precisely how much growth slows. One final influence is the sharp cyclical slowing in productivity I expect. This will raise unit labor costs and mainly undermine profit growth. But it could put some upward pressure on prices as well. There are many possible outcomes, particularly given the uncertainty about the degree of spontaneous slowing and the dimensions of the spillover from the Asian crisis. Because upside and downside risks for growth and inflation appear to be more balanced than had been the case earlier, I believe monetary policy also needs to be in a more balanced position. The course of monetary policy will, of course, depend on how much growth slows, what happens to utilization rates, and how the movement in utilization rates interacts with the other cross-currents affecting inflation. A much larger spillover from the Asian crisis could encourage an easing. Continued above-trend growth and a further rise utilization rates, on the other hand, could encourage further tightening. But I want to focus on two intermediate outcomes, both because I view these as more likely and because they would raise more interesting questions for monetary policy. The first scenario I call a graceful "reverse soft landing". This is my interpretation of the private sector consensus forecast. As I noted earlier, in a soft landing, growth slows from an above-trend to trend rate just as output converges from below to its full employment level. But I believe output is already beyond the full employment level. A soft landing in this case requires growth to run below trend for a period to allow productive capacity to catch up to demand and to allow utilization rates to ease to sustainable levels. Ordinarily, inflation would be rising during the transition, given initial conditions of output in excess of sustainable capacity. But, in the current episode, the virtuous cycle in play and renewal of forces that have recently been restraining inflation will continue to damp inflation over 1998, at least moderating the rise in inflation that would otherwise occur. In this scenario, real growth slows to around $2 \%$ or slightly lower, the unemployment rate edges upward, but remains below NAIRU over 1998, and inflation is slightly higher. This is a path back toward full employment, leaving inflation higher but still modest once full employment is reached, perhaps by the end of 1999. How should monetary policy respond in this scenario? Should policy ease in response to the sharp slowing in growth and rise in the unemployment rate? Or should policy remain on hold, allowing the economy to converge slowly back to full employment and a still modest inflation rate? Given the momentum in domestic demand, the still favorable financial conditions and other fundamentals, questions about the degree of spontaneous slowing, and uncertainty about the magnitude of the spillover from the Asian crisis, an equally plausible forecast is that growth slows, but only to trend. In this case, the unemployment rate would remain near its current level and inflation would increase slightly more than in the first scenario, though it would still be damped in 1998 by the virtuous cycle forces and the continued favorable supply shocks. This scenario would, however, imply greater inflation risks going forward, in light of prospects that the favorable supply shocks eventually will abate, while the prevailing high labor utilization rate will continue to push wage gains higher. How should monetary policy respond in this case? Should policy remain on hold, given the return to a sustainable rate of growth and stable utilization rates? Or, should there be a tightening of policy in light of the prospects for a gradual but persistent updrift in inflation associated with the still very high utilization rates? The latter scenario is valuable in highlighting that the risks of higher inflation are related to the level of utilization rates, not to the rate of growth of output itself. The point is that even if growth slows to trend, utilization rates could be left at unsustainable levels, leaving a risk of rising inflation over time. Unfortunately, I have run out of time before I had the opportunity to answer these questions. I will leave it to you to provide your own answers. In time, the FOMC, of course, will provide its own answer, provided these were the right questions.
1998-01-29T00:00:00	Mr. Greenspan comments on the current direction of the US economy and the fiscal situation in the United States (Central Bank Articles and Speeches, 29 Jan 98)	Testimony by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on the Budget of the US Senate on 29/1/98.	Mr. Greenspan comments on the current direction of the US economy and the fiscal situation in the United States Testimony by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on the Budget of the US Senate on 29/1/98. Mr. Chairman and members of the Committee, in just a few weeks, the Federal Reserve Board will submit its semiannual report on monetary policy to the Congress. That report, and my accompanying testimony, will give a detailed assessment of the outlook for the US. economy and the implications for monetary policy. This morning, I would like to direct most of my comments to the fiscal situation. But let me begin by offering a few observations about the current direction of the economy. First, it is clear that the U.S. economy has been exceptionally healthy, with robust gains in output, employment, and income. At the same time, inflation has remained low -indeed, declining by most measures -- over the past year. Second, to date, we have as yet experienced only the peripheral winds of the Asian crisis. But before spring is over, the abrupt current-account adjustments that financial difficulties are forcing upon several of our Asian trading partners will be showing through here in reductions in demand for our exports and intensified competition from imports. All of this suggests that the growth of economic activity in this country will moderate from the recent brisk pace. Third, as I've noted previously, such a moderation would appear helpful at this juncture. The growth of output has caused employment to rise much faster than the working-age population and there are limits to how far this can go. Pressures in the labor market likely contributed to the acceleration of wages in recent months. Since price inflation has been minimal and domestic profit margins firm, productivity appears to have accelerated sufficiently last year to damp increases in unit labor costs. How long that pattern can continue is still an unresolved issue. The likelihood that we shall be seeing some lower prices on imported goods as a result of the difficulties in Asia may afford some breathing room from inflation pressures. But they will not permanently suppress the risks inherent in tightened labor markets. Conversely, a continuation of the Asian crisis should give us pause in assuming that our economy will remain robust indefinitely. As a consequence, we must be vigilant to the re-emergence of destabilizing influences -- both higher inflation, and shortfalls in demand and decreases in some prices that would press the disinflation process too far, too fast. One very favorable aspect of our economic performance over the past few years has been the remarkable improvement in the federal budget picture. The deficit dropped to its lowest level in more than two decades in fiscal 1997, and yesterday the Congressional Budget Office released projections that show the budget remaining essentially in balance over the next few years, moving to annual surpluses equal to 1 percent of GDP by the middle of the next decade. The reduction in federal borrowing to date and in prospect is already paying off for the U.S. economy by helping hold down long-term interest rates and, in turn, providing support to private capital spending and other interest-sensitive outlays. But much hard work remains to be done to ensure that the projected surpluses actually materialize and that we remain on track to address our longer-run fiscal and demographic challenges. The CBO projections provide a good starting point: They are based on sensible economic and technical assumptions and thus offer a reasonable indication of how the budget is likely to evolve over the next 10 years if economic conditions remain favorable and current budgetary policies remain in place. But, as CBO highlights in its latest report, such forecasts are subject to considerable error. Indeed, as recently as last winter, when fiscal 1997 was already well under way, both CBO and OMB were still overestimating that year's deficit by more than $100 billion. In the case of CBO, about two-thirds of the error was in receipts, including nearly $50 billion more tax receipts than would have been expected based on the actual behavior of income as measured in the national income and product accounts. This overage helped lift the receipts share of GDP to an historical high. Such "tax surprises" are nothing new -- in fact, in the early 1990s, growth of receipts fell well short of expectations based on the trends in aggregate income and the tax laws then in place. And, even after the fact, our knowledge about the sources of such surprises has been limited. Thus, we cannot rule out the possibility that the forces behind last year's tax surge will prove transitory and dissipate more rapidly than CBO has assumed, implying lower receipts and renewed deficits for the years ahead. Indeed, all else equal, had the surprise fallen on the other side -- downward instead of upward -- we would be looking at non-trivial budget deficits at least through the beginning of the coming decade. Moreover, the CBO projection assumes that discretionary spending will be held to the statutory caps, which allow almost no growth in nominal outlays through fiscal 2002. Given the declining support for further reductions in defense spending, keeping overall discretionary spending within the caps is likely to require sizable, but as yet unspecified, real declines in nondefense programs from current levels. Not surprisingly, many observers are skeptical that the caps will hold, and battles over appropriations in coming years may well expose deep divisions that could make the realization of the budget projections less likely. In addition, although last year's legislation cut Medicare spending substantially, experience has highlighted the difficulty of controlling this program, raising the possibility that the savings will not be so great as anticipated -- especially if resistance develops among beneficiaries or providers. Uncertainties such as these argue for caution as you begin work on the 1999 budget. We have no guarantee that the projected surpluses will actually materialize. An even more important consideration, though, is the need to address the erosion of the budget after the next decade, a task that will become increasingly difficult the longer it is postponed. The favorable budget picture over the next decade, unless steps are taken, will almost inevitably turn to large and sustained deficits as the baby boom generation moves into retirement, putting massive strains on the social security and Medicare programs. Indeed, especially in light of these inexorable demographic trends, I have always emphasized that we should be aiming for budgetary surpluses and using the proceeds to retire outstanding federal debt. This would put further downward pressure on long-term interest rates, which would enhance private capital investment, labor productivity, and economic growth. The outpouring of proposals for using the anticipated surplus does not bode well for the prospect of maintaining fiscal discipline. In recent years the President and the Congress have been quite successful, contrary to expectations, in placing, and especially holding, caps on discretionary spending. More recently, they have started to confront the budget implications of the surge in retirements that is only a decade away. We must not allow the recent good news on the budget to lull us into letting down our guard. Although many of the individual budget proposals may have merit, they must be considered in the context of a responsible budget strategy for the longer run. Over the decades our budgetary processes have been biased toward deficit spending. Indeed, those processes are strewn with initiatives that had only a small projected budgetary cost, but produced a sizable drain on the Treasury's coffers over time. As you are well aware, programs can be easy to initiate or expand, but extraordinarily difficult to trim or shut down once a constituency develops that has a stake in maintaining the status quo. In closing, I want to commend Chairman Domenici and the committee for your insistence on fiscal responsibility and for years of persistent effort. Your work has contributed importantly to shrinking the budget deficit and bringing surpluses within sight. These projections of surpluses, which are based on an extrapolation of steady economic growth and subdued inflation over the coming years, implicitly assume that monetary and fiscal policymakers will remain attentive to potential sources of instability. If this is the scenario that, in fact, unfolds and the budget moves into surplus within the next few years, the increase in national saving will pay off handsomely in preparing our economy and our budget for the challenges of the twenty-first century.	---[PAGE_BREAK]--- # Mr. Greenspan comments on the current direction of the US economy and the fiscal situation in the United States Testimony by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on the Budget of the US Senate on 29/1/98. Mr. Chairman and members of the Committee, in just a few weeks, the Federal Reserve Board will submit its semiannual report on monetary policy to the Congress. That report, and my accompanying testimony, will give a detailed assessment of the outlook for the US. economy and the implications for monetary policy. This morning, I would like to direct most of my comments to the fiscal situation. But let me begin by offering a few observations about the current direction of the economy. First, it is clear that the U.S. economy has been exceptionally healthy, with robust gains in output, employment, and income. At the same time, inflation has remained low -indeed, declining by most measures -- over the past year. Second, to date, we have as yet experienced only the peripheral winds of the Asian crisis. But before spring is over, the abrupt current-account adjustments that financial difficulties are forcing upon several of our Asian trading partners will be showing through here in reductions in demand for our exports and intensified competition from imports. All of this suggests that the growth of economic activity in this country will moderate from the recent brisk pace. Third, as I've noted previously, such a moderation would appear helpful at this juncture. The growth of output has caused employment to rise much faster than the working-age population and there are limits to how far this can go. Pressures in the labor market likely contributed to the acceleration of wages in recent months. Since price inflation has been minimal and domestic profit margins firm, productivity appears to have accelerated sufficiently last year to damp increases in unit labor costs. How long that pattern can continue is still an unresolved issue. The likelihood that we shall be seeing some lower prices on imported goods as a result of the difficulties in Asia may afford some breathing room from inflation pressures. But they will not permanently suppress the risks inherent in tightened labor markets. Conversely, a continuation of the Asian crisis should give us pause in assuming that our economy will remain robust indefinitely. As a consequence, we must be vigilant to the re-emergence of destabilizing influences -- both higher inflation, and shortfalls in demand and decreases in some prices that would press the disinflation process too far, too fast. One very favorable aspect of our economic performance over the past few years has been the remarkable improvement in the federal budget picture. The deficit dropped to its lowest level in more than two decades in fiscal 1997, and yesterday the Congressional Budget Office released projections that show the budget remaining essentially in balance over the next few years, moving to annual surpluses equal to 1 percent of GDP by the middle of the next decade. The reduction in federal borrowing to date and in prospect is already paying off for the U.S. economy by helping hold down long-term interest rates and, in turn, providing support to private capital spending and other interest-sensitive outlays. But much hard work remains to be done to ensure that the projected surpluses actually materialize and that we remain on track to address our longer-run fiscal and demographic challenges. The CBO projections provide a good starting point: They are based on sensible economic and technical assumptions and thus offer a reasonable indication of how the budget is likely to evolve over the next 10 years if economic conditions remain favorable and ---[PAGE_BREAK]--- current budgetary policies remain in place. But, as CBO highlights in its latest report, such forecasts are subject to considerable error. Indeed, as recently as last winter, when fiscal 1997 was already well under way, both CBO and OMB were still overestimating that year's deficit by more than $\$ 100$ billion. In the case of CBO, about two-thirds of the error was in receipts, including nearly $\$ 50$ billion more tax receipts than would have been expected based on the actual behavior of income as measured in the national income and product accounts. This overage helped lift the receipts share of GDP to an historical high. Such "tax surprises" are nothing new -- in fact, in the early 1990s, growth of receipts fell well short of expectations based on the trends in aggregate income and the tax laws then in place. And, even after the fact, our knowledge about the sources of such surprises has been limited. Thus, we cannot rule out the possibility that the forces behind last year's tax surge will prove transitory and dissipate more rapidly than CBO has assumed, implying lower receipts and renewed deficits for the years ahead. Indeed, all else equal, had the surprise fallen on the other side -- downward instead of upward -- we would be looking at non-trivial budget deficits at least through the beginning of the coming decade. Moreover, the CBO projection assumes that discretionary spending will be held to the statutory caps, which allow almost no growth in nominal outlays through fiscal 2002. Given the declining support for further reductions in defense spending, keeping overall discretionary spending within the caps is likely to require sizable, but as yet unspecified, real declines in nondefense programs from current levels. Not surprisingly, many observers are skeptical that the caps will hold, and battles over appropriations in coming years may well expose deep divisions that could make the realization of the budget projections less likely. In addition, although last year's legislation cut Medicare spending substantially, experience has highlighted the difficulty of controlling this program, raising the possibility that the savings will not be so great as anticipated -- especially if resistance develops among beneficiaries or providers. Uncertainties such as these argue for caution as you begin work on the 1999 budget. We have no guarantee that the projected surpluses will actually materialize. An even more important consideration, though, is the need to address the erosion of the budget after the next decade, a task that will become increasingly difficult the longer it is postponed. The favorable budget picture over the next decade, unless steps are taken, will almost inevitably turn to large and sustained deficits as the baby boom generation moves into retirement, putting massive strains on the social security and Medicare programs. Indeed, especially in light of these inexorable demographic trends, I have always emphasized that we should be aiming for budgetary surpluses and using the proceeds to retire outstanding federal debt. This would put further downward pressure on long-term interest rates, which would enhance private capital investment, labor productivity, and economic growth. The outpouring of proposals for using the anticipated surplus does not bode well for the prospect of maintaining fiscal discipline. In recent years the President and the Congress have been quite successful, contrary to expectations, in placing, and especially holding, caps on discretionary spending. More recently, they have started to confront the budget implications of the surge in retirements that is only a decade away. We must not allow the recent good news on the budget to lull us into letting down our guard. Although many of the individual budget proposals may have merit, they must be considered in the context of a responsible budget strategy for the longer run. ---[PAGE_BREAK]--- Over the decades our budgetary processes have been biased toward deficit spending. Indeed, those processes are strewn with initiatives that had only a small projected budgetary cost, but produced a sizable drain on the Treasury's coffers over time. As you are well aware, programs can be easy to initiate or expand, but extraordinarily difficult to trim or shut down once a constituency develops that has a stake in maintaining the status quo. In closing, I want to commend Chairman Domenici and the committee for your insistence on fiscal responsibility and for years of persistent effort. Your work has contributed importantly to shrinking the budget deficit and bringing surpluses within sight. These projections of surpluses, which are based on an extrapolation of steady economic growth and subdued inflation over the coming years, implicitly assume that monetary and fiscal policymakers will remain attentive to potential sources of instability. If this is the scenario that, in fact, unfolds and the budget moves into surplus within the next few years, the increase in national saving will pay off handsomely in preparing our economy and our budget for the challenges of the twenty-first century.	Alan Greenspan	United States	https://www.bis.org/review/r980213a.pdf	the fiscal situation in the United States Testimony by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on the Budget of the US Senate on 29/1/98. Mr. Chairman and members of the Committee, in just a few weeks, the Federal Reserve Board will submit its semiannual report on monetary policy to the Congress. That report, and my accompanying testimony, will give a detailed assessment of the outlook for the US. economy and the implications for monetary policy. This morning, I would like to direct most of my comments to the fiscal situation. But let me begin by offering a few observations about the current direction of the economy. First, it is clear that the U.S. economy has been exceptionally healthy, with robust gains in output, employment, and income. At the same time, inflation has remained low -indeed, declining by most measures -- over the past year. Second, to date, we have as yet experienced only the peripheral winds of the Asian crisis. But before spring is over, the abrupt current-account adjustments that financial difficulties are forcing upon several of our Asian trading partners will be showing through here in reductions in demand for our exports and intensified competition from imports. All of this suggests that the growth of economic activity in this country will moderate from the recent brisk pace. Third, as I've noted previously, such a moderation would appear helpful at this juncture. The growth of output has caused employment to rise much faster than the working-age population and there are limits to how far this can go. Pressures in the labor market likely contributed to the acceleration of wages in recent months. Since price inflation has been minimal and domestic profit margins firm, productivity appears to have accelerated sufficiently last year to damp increases in unit labor costs. How long that pattern can continue is still an unresolved issue. The likelihood that we shall be seeing some lower prices on imported goods as a result of the difficulties in Asia may afford some breathing room from inflation pressures. But they will not permanently suppress the risks inherent in tightened labor markets. Conversely, a continuation of the Asian crisis should give us pause in assuming that our economy will remain robust indefinitely. As a consequence, we must be vigilant to the re-emergence of destabilizing influences -- both higher inflation, and shortfalls in demand and decreases in some prices that would press the disinflation process too far, too fast. One very favorable aspect of our economic performance over the past few years has been the remarkable improvement in the federal budget picture. The deficit dropped to its lowest level in more than two decades in fiscal 1997, and yesterday the Congressional Budget Office released projections that show the budget remaining essentially in balance over the next few years, moving to annual surpluses equal to 1 percent of GDP by the middle of the next decade. The reduction in federal borrowing to date and in prospect is already paying off for the U.S. economy by helping hold down long-term interest rates and, in turn, providing support to private capital spending and other interest-sensitive outlays. But much hard work remains to be done to ensure that the projected surpluses actually materialize and that we remain on track to address our longer-run fiscal and demographic challenges. The CBO projections provide a good starting point: They are based on sensible economic and technical assumptions and thus offer a reasonable indication of how the budget is likely to evolve over the next 10 years if economic conditions remain favorable and current budgetary policies remain in place. But, as CBO highlights in its latest report, such forecasts are subject to considerable error. Indeed, as recently as last winter, when fiscal 1997 was already well under way, both CBO and OMB were still overestimating that year's deficit by more than $\$ 100$ billion. In the case of CBO, about two-thirds of the error was in receipts, including nearly $\$ 50$ billion more tax receipts than would have been expected based on the actual behavior of income as measured in the national income and product accounts. This overage helped lift the receipts share of GDP to an historical high. Such "tax surprises" are nothing new -- in fact, in the early 1990s, growth of receipts fell well short of expectations based on the trends in aggregate income and the tax laws then in place. And, even after the fact, our knowledge about the sources of such surprises has been limited. Thus, we cannot rule out the possibility that the forces behind last year's tax surge will prove transitory and dissipate more rapidly than CBO has assumed, implying lower receipts and renewed deficits for the years ahead. Indeed, all else equal, had the surprise fallen on the other side -- downward instead of upward -- we would be looking at non-trivial budget deficits at least through the beginning of the coming decade. Moreover, the CBO projection assumes that discretionary spending will be held to the statutory caps, which allow almost no growth in nominal outlays through fiscal 2002. Given the declining support for further reductions in defense spending, keeping overall discretionary spending within the caps is likely to require sizable, but as yet unspecified, real declines in nondefense programs from current levels. Not surprisingly, many observers are skeptical that the caps will hold, and battles over appropriations in coming years may well expose deep divisions that could make the realization of the budget projections less likely. In addition, although last year's legislation cut Medicare spending substantially, experience has highlighted the difficulty of controlling this program, raising the possibility that the savings will not be so great as anticipated -- especially if resistance develops among beneficiaries or providers. Uncertainties such as these argue for caution as you begin work on the 1999 budget. We have no guarantee that the projected surpluses will actually materialize. An even more important consideration, though, is the need to address the erosion of the budget after the next decade, a task that will become increasingly difficult the longer it is postponed. The favorable budget picture over the next decade, unless steps are taken, will almost inevitably turn to large and sustained deficits as the baby boom generation moves into retirement, putting massive strains on the social security and Medicare programs. Indeed, especially in light of these inexorable demographic trends, I have always emphasized that we should be aiming for budgetary surpluses and using the proceeds to retire outstanding federal debt. This would put further downward pressure on long-term interest rates, which would enhance private capital investment, labor productivity, and economic growth. The outpouring of proposals for using the anticipated surplus does not bode well for the prospect of maintaining fiscal discipline. In recent years the President and the Congress have been quite successful, contrary to expectations, in placing, and especially holding, caps on discretionary spending. More recently, they have started to confront the budget implications of the surge in retirements that is only a decade away. We must not allow the recent good news on the budget to lull us into letting down our guard. Although many of the individual budget proposals may have merit, they must be considered in the context of a responsible budget strategy for the longer run. Over the decades our budgetary processes have been biased toward deficit spending. Indeed, those processes are strewn with initiatives that had only a small projected budgetary cost, but produced a sizable drain on the Treasury's coffers over time. As you are well aware, programs can be easy to initiate or expand, but extraordinarily difficult to trim or shut down once a constituency develops that has a stake in maintaining the status quo. In closing, I want to commend Chairman Domenici and the committee for your insistence on fiscal responsibility and for years of persistent effort. Your work has contributed importantly to shrinking the budget deficit and bringing surpluses within sight. These projections of surpluses, which are based on an extrapolation of steady economic growth and subdued inflation over the coming years, implicitly assume that monetary and fiscal policymakers will remain attentive to potential sources of instability. If this is the scenario that, in fact, unfolds and the budget moves into surplus within the next few years, the increase in national saving will pay off handsomely in preparing our economy and our budget for the challenges of the twenty-first century.
1998-01-30T00:00:00	Mr. Greenspan analyses further the roots of the current crisis in Asia (Central Bank Articles and Speeches, 30 Jan 98)	Testimony by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on Banking and Financial Services of the US House of Representatives on 30/1/98.	Mr. Greenspan analyses further the roots of the current crisis in Asia Testimony by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on Banking and Financial Services of the US House of Representatives on 30/1/98. The global financial system has been evolving rapidly in recent years. New technology has radically reduced the costs of borrowing and lending across traditional national borders, facilitating the development of new instruments and drawing in new players. One result has been a massive increase in capital flows. Information is transmitted instantaneously around the world, and huge shifts in the supply and demand for funds naturally follow. This burgeoning global system has been demonstrated to be a highly efficient structure that has significantly facilitated cross-border trade in goods and services and, accordingly, has made a substantial contribution to standards of living worldwide. Its efficiency exposes and punishes underlying economic weakness swiftly and decisively. Regrettably, it also appears to have facilitated the transmission of financial disturbances far more effectively than ever before. As I testified before this Committee three years ago, the then emerging Mexican crisis was the first such episode associated with our new high-tech international financial system. The current Asian crisis is the second. We do not as yet fully understand the new system's dynamics. We are learning fast, and need to update and modify our institutions and practices to reduce the risks inherent in the new regime. Meanwhile, we have to confront the current crisis with the institutions and techniques we have. Many argue that the current crisis should be allowed to run its course without support from the International Monetary Fund or the bilateral financial backing of other nations. They assert that allowing this crisis to play out, while doubtless having additional negative effects on growth in Asia, and engendering greater spill-overs onto the rest of the world, is not likely to have a large or lasting impact on the United States and the world economy. They may well be correct in their judgment. There is, however, a small but not negligible probability that the upset in East Asia could have unexpectedly negative effects on Japan, Latin America, and eastern and central Europe that, in turn, could have repercussions elsewhere, including the United States. Thus, while the probability of such an outcome may be small, its consequences, in my judgment, should not be left solely to chance. We have observed that global financial markets, as currently organized, do not always achieve an appropriate equilibrium, or at least require time to stabilize. Opponents of IMF support also argue that the substantial financial backing, by cushioning the losses of imprudent investors, could exacerbate moral hazard. Moral hazard arises when someone can reap the rewards from their actions when things go well but do not suffer the full consequences when things go badly. Such a reward structure, obviously, could encourage excessive risk taking. To be sure, this is a problem, though with respect to Asia some investors have to date suffered substantial losses. Asian equity losses, excluding Japan, since June 1997 worldwide are estimated to have exceeded $700 billion of which more than $30 billion has been lost by U.S. investors. Substantial further losses have been recorded in bonds and real estate. Moreover, the policy conditionality, associated principally with IMF lending, which dictates economic and financial discipline and structural change, helps to mitigate some of the moral hazard concerns. Such conditionality is also critical to the success of the overall stabilization effort. As I will be discussing in a moment, at the root of the problems is poor public policy that has resulted in misguided investments and very weak financial sectors. Convincing a sovereign nation to alter destructive policies that impair its own performance and threaten contagion to its neighbors is best handled by an international financial institution, such as the IMF. What we have in place today to respond to crises should be supported even as we work to improve those mechanisms and institutions. Accordingly, I fully back the Administration's request to augment the financial resources of the IMF -- U.S. participation in the New Arrangements to Borrow and an increase in the U.S. quota in the IMF. Hopefully, neither will turn out not to be needed, and no funds will be drawn. But it is better to have it available if that turns out not to be the case and quick response to a pending crisis is essential. I also believe it is important to have mechanisms, such as the Treasury Department's Exchange Stabilization Fund, that permit the United States in exceptional circumstances to provide temporary bilateral financial support, often on short notice, under appropriate conditions and on occasion in cooperation with other countries. In my testimony before this Committee in mid-November, I endeavored to outline the roots of the current crisis. This morning I should like to carry the analysis a bit further. Companies in Korea and many other Asian countries have become formidable world-class producers in a number of manufacturing sectors using advanced technologies, but in a number of cases they permitted leverage to rise to levels that could only be sustained with continued very rapid growth. Growth, however, was destined to slow. Asian economies to varying degrees over the last half century have tried to combine rapid growth with a much higher mix of government-directed production than has been evident in the essentially market-driven economies of the West. Through government inducements, a number of select, more sophisticated manufacturing technologies borrowed from the advanced market economies were applied to these generally low-productivity and, hence, low-wage economies. Thus, for selected products, exports became competitive with those of the market economies, engendering rapid overall economic growth. There was, however, an inevitable limit to how far this specialized Asian economic regime could develop. As the process broadened beyond a few select applications of advanced technologies, overall productivity continued to increase and the associated rise in the average real wage in these economies blunted somewhat the competitive advantage enjoyed initially. As a consequence of the slackening of export expansion caused in part by losses in competitiveness because of exchange rates that were pegged to the dollar, which was appreciating against the yen, aggregate economic growth slowed somewhat, even before the current crisis. For years, domestic savings and rapidly increasing capital inflows had been directed by governments into investments that banks were required to finance. As I pointed out in previous testimony, lacking a true market test, much of that investment was unprofitable. So long as growth was vigorous, the adverse consequences of this type of non-market allocation of resources were masked. Moreover, in the context of pegged exchange rates that were presumed to continue, if not indefinitely, at least beyond the term of the loan, banks and nonbanks were willing to take the risk to borrow dollars (unhedged) to obtain the dollar-denominated interest rates that were invariably lower than those available in domestic currency. Western, especially American investors, diversified some of their huge capital gains of the 1990s into East Asian investments. In hindsight, it is evident that those economies could not provide adequate profitable opportunities at reasonable risk to absorb such a surge in funds. This surge, together with distortions caused by government planning, has resulted in huge losses. With the inevitable slowdown, business losses and nonperforming bank loans surged. Banks' capital eroded rapidly and, as a consequence, funding sources have dried up, as fears of defaults have risen dramatically. In an environment of weak financial systems, lax supervisory regimes, and vague guarantees about depositor or creditor protections, bank runs have occurred in several countries and reached crisis proportions in Indonesia. Uncertainty and retrenchment have escalated. The state of confidence so necessary to the functioning of any economy has been torn asunder. Vicious cycles of ever rising and reinforcing fears have become contagious. Some exchange rates have fallen to levels that are understandable only in the context of a veritable collapse of confidence in the functioning of an economy. A similar breakdown was also evident in Mexico three years ago, albeit to a somewhat lesser degree. In late 1994, the government was rapidly losing reserves in a vain effort to support a currency that had come under attack when the authorities failed to act expeditiously and convincingly to contain a burgeoning current account deficit financed in large part by substantial short-term flows denominated in dollars. These two recent crisis episodes have afforded us increasing insights into the dynamics of the evolving international financial system, though there is much we do not yet understand. With the new more sophisticated financial markets punishing errant government policy behavior far more profoundly than in the past, vicious cycles are evidently emerging more often. For once they are triggered, damage control is difficult. Once the web of confidence, which supports the financial system, is breached, it is difficult to restore quickly. The loss of confidence can trigger rapid and disruptive changes in the pattern of finance, which, in turn, feeds back on exchange rates and asset prices. Moreover, investor concerns that weaknesses revealed in one economy may be present in others that are similarly situated means that the loss of confidence can quickly spread to other countries. At one point the economic system appears stable, the next it behaves as though a dam has reached a breaking point, and water (read, confidence) evacuates its reservoir. The United States experienced such a sudden change with the decline in stock prices of more than 20 percent on October 19, 1987. There is no credible scenario that can readily explain so abrupt a change in the fundamentals of long-term valuation on that one day. Such market panic does not appear to reflect a simple continuum from the immediately previous period. The abrupt onset of such implosions suggests the possibility that there is a marked dividing line for confidence. When crossed, prices slip into free fall -- perhaps overshooting the long-term equilibrium -before markets will stabilize. But why do these events seem to erupt without some readily evident precursor? Certainly, the more extended the risk-taking, or more generally, the lower the discount factors applied to future outcomes, the more vulnerable are markets to a shock that abruptly triggers a revision in expectations and sets off a vicious cycle of contraction. Episodes of vicious cycles cannot be easily forecast, as our recent experience with Asia has demonstrated. The causes of such episodes are complex and often subtle. In the case of Asia, we can now say with some confidence that the economies affected by this crisis faced a critical mass of vulnerabilities; ex ante, some were more apparent than others, but the combination was not generally recognized as critical. Once the recent crisis was triggered in early July with Thailand's forced abandonment of its exchange rate peg, it was apparently the lethal combination of pegged exchange rates, high leverage, weak banking and financial systems, and declining demand in Thailand and elsewhere that transformed a correction into a collapse. Normally the presence of these factors would have produced a modest retrenchment, not the kind of discontinuous fall in confidence that leads to a vicious cycle of decline. But with a significant part of short-term liabilities, bank and nonbank, denominated in foreign currencies (predominantly dollars), unhedged, the initial pressure on domestic currencies led to a sharp crack in the fixed exchange rate structure of many East Asian economies. The belief that local currencies could, virtually without risk of loss, be converted into dollars at any time was shattered. Investors, both domestic and foreign, endeavored en masse to convert to dollars, as confidence in the ability of the local economy to earn dollars to meet their fixed obligations diminished. Local exchange rates fell against the dollar, inducing still further declines. The weakening of growth also led to lowered profit expectations and contracting net capital inflows of dollars. This was an abrupt change from the pronounced acceleration through 1996 and the first half of 1997. The combination of continued strong demand for dollars to meet debt service obligations and the slowed new supply, destabilized the previously fixed exchange rate regime. This created a marked increase in uncertainty and retrenchment, further reducing capital inflows, still further weakening local currency exchange rates. This vicious cycle will continue until either defaults or restructuring lowers debt service obligations, or the low local exchange rates finally induce a pickup in the supply of dollars. These virulent episodes appear to be at the root of our most recent breakdowns in Mexico and Asia. Their increased prevalence may, in fact, be a defining characteristic of the new high-tech international financial system. We shall never be able to alter the human response to shocks of uncertainty and withdrawal; we can only endeavor to reduce the imbalances that exacerbate them. While, as indicated earlier, I do not believe we are as yet sufficiently knowledgeable of the full complex dynamics of our increasingly developing high-tech financial system, enough insights have been gleaned from the crises in Mexico and Asia (and previous experiences) to enable us to list a few of the critical tendencies toward disequilibrium and vicious cycles that will have to be addressed if our new global economy is to limit the scope for disruptions in the future. These elements have all, in times past, been factors in international and domestic economic disruptions, but they appear more stark in today's market. 1. Leverage Certainly in Korea, probably in Thailand, and possibly elsewhere, a high degree of leverage (the ratio of debt to equity) appears to be a place to start. While the key role of debt in bank balance sheets is obvious, its role in the efficient functioning of the nonbank sector is also important. Nevertheless, exceptionally high leverage often is a symptom of excessive risk taking that leaves financial systems and economies vulnerable to loss of confidence. It is not easy to imagine the cumulative cascading of debt instruments seeking safety in a crisis when assets are heavily funded with equity. The concern is particularly relevant to banks and many other financial intermediaries, whose assets typically are less liquid than their liabilities and so depend on confidence in the payment of liabilities for their continued viability. Moreover, both financial and nonfinancial businesses can employ high leverage to mask inadequate underlying profitability and otherwise have inadequate capital cushions to match their volatile environments. Excess leverage in nonfinancial business can create problems for lenders including their banks; these problems can, in turn, spread to other borrowers that rely on these lenders. Fortunately, since lending by nonfinancial firms to other businesses is less prevalent than bank lending to other banks, direct contagion is less likely. But the leverage of South Korea's chaebols, because of their size and the pervasive distress, has clearly been an important cause of bank problems with their systemic implications. 2. Interest rate and currency risk Banks, when confronted with a generally rising yield curve, have a tendency to incur interest rate or liquidity risk by lending long and funding short. This exposes them to shocks, especially those institutions that have low capital-asset ratios. When financial intermediaries, in addition, seek low-cost, unhedged, foreign currency funding, the dangers of depositor runs, following a fall in the domestic currency, escalate. 3. Weak banking systems Banks play a crucial role in the financial market infrastructure. When they are undercapitalized, have lax lending standards, and are subjected to weak supervision and regulation, they become a source of systemic risk both domestically and internationally. 4. Interbank funding, especially in foreign currencies Despite its importance for distributing savings to their most valued use, shortterm interbank funding, especially cross border may turn out to be the Achilles' heel of an international financial system that is subject to wide variations in financial confidence. This phenomenon, which is all too common in our domestic experience, may be particularly dangerous in an international setting. 5. Moral hazard The expectation that monetary authorities or international financial institutions will come to the rescue of failing financial systems and unsound investments has clearly engendered a significant element of moral hazard and excessive risk taking. The dividing line between public and private liabilities, too often, becomes blurred. 6. Weak central banks To effectively support a stable currency, central banks need to be independent, meaning that their monetary policy decisions are not subject to the dictates of political authorities. 7. Securities markets Recent adverse banking experiences have emphasized the problems that can arise if banks are almost the sole source of intermediation. Their breakdown induces a sharp weakening in economic growth. A wider range of nonbank institutions, including viable debt and equity markets, are important safeguards of economic activity when banking fails. 8. Inadequate legal structures Finally, an effective competitive market system requires a rule of law that severely delimits government's arbitrary intrusion into commercial disputes. Defaults and restructuring will not always be avoidable. Indeed "creative destruction", as Joseph Schumpeter put it, is often an important element of renewal in a dynamic market economy, but an efficient bankruptcy statute is required to aid in this process, including in the case of cross-border defaults. * * * Interest and currency risk taking, excess leverage, weak financial systems, and interbank funding are all encouraged by the existence of a safety net. In a domestic context, it is difficult to achieve financial balance without a regulatory structure that seeks to simulate the market incentives that would tend to control these financial elements if there were not broad safety nets. It is even more difficult to achieve such a balance internationally among sovereign governments operating out of different cultures. Thus, governments have developed a patchwork of arrangements and conventions governing the functioning of the international financial system that I believe will need to be thoroughly reviewed and altered as necessary to fit the needs of the new global environment. A review of supervision and regulation of private financial institutions, especially those that are supported by a safety net, is particularly pressing because those institutions have played so prominent a role in the emergence of recent crises. As I have testified previously, I believe that, in this rapidly expanding international financial system, the primary protection from adverse financial disturbances is effective counterparty surveillance and, hence, government regulation and supervision should seek to produce an environment in which counterparties can most effectively oversee the credit risks of potential transactions. Here a major improvement in transparency, including both accounting and public disclosure, is essential. To be sure, counterparties often exchange otherwise confidential information as a condition of a transaction. But broader dissemination of detailed disclosures of governments, financial institutions, and firms, is required if the risks inherent in our global financial structure are to be contained. A market system can approach an appropriate equilibrium only if the signals to which individual market participants respond are accurate and adequate to the needs of the adjustment process. Among the important signals are product and asset prices, interest rates, debt by maturity, detailed accounts of central banks, and private enterprises. Blinded by faulty signals, a competitive free-market system cannot reach a firm balance except by chance. In today's rapidly changing market place producers need sophisticated signals to hone production schedules and investment programs to respond to consumer demand. There is sufficient bias in political systems of all varieties to substitute hope (read, wishful thinking) for possibly difficult pre-emptive policy moves, both with respect to financial systems and economic policy. There is often denial and delay in instituting proper adjustments. Recent propensities to obscure the need for change have been evidenced by unreported declines in official reserves, issuance by governments of the equivalent to foreign currency obligations, or unreported large forward short positions against foreign currencies. It is very difficult for political leaders to incur what they perceive as large immediate political costs to contain problems that they see (often dimly) as only prospective. Reality eventually replaces hope, but the cost of delay is a more abrupt and disruptive adjustment than would have been required if action had been more pre-emptive. Increased transparency for businesses, financial institutions, and governments is a key ingredient in fostering more discipline on private transactors and on government policymakers. Increased transparency can counter political bias in part by exposing for all to see the risks to stability of current policies as they develop. Under such conditions, failure to act would also be perceived as having political costs. I suspect that recent political foot dragging by governments in both developed and developing countries on the issue of greater transparency is credible evidence of its power and significance. Transparency, which is so important to foster safe and sound lending practices, is, of course, less relevant for local currency lending if banks are guaranteed with sovereign credits. Moreover, transparency becomes especially difficult to create for organizations and corporations with large interlocking ownerships. Cross holdings of stock lead too often to lending on the basis of association, not economic value. The list of problems that must be addressed to achieve balance in our future global financial system could be significantly extended, but let me end with a notion that is relevant also to today's crisis. It is becoming increasingly evident that supervision and regulation should address excess nonperforming loans expeditiously. The expected values of the losses on these loans are, of course, a subtraction from capital. But since these estimates are uncertain, they embody an additional risk premium that reduces the markets' best estimate of the size of effective equity capital even if capital is replenished. It is, hence, far better to remove these dubious assets and their associated risk premium from bank balance sheets, and dispose of them separately, preferably promptly. * * * As a consequence of the unwinding of market restrictions and regulations, and the rapid increase in technology, the international financial system has expanded at a pace far faster than either domestic GDP or cross-border trade. To reduce the risk of systemic crises in such an environment, an enhanced regime of market incentives, involving greater sensitivity to market signals, more information to make those signals more robust, and broader securities markets -coupled with better supervision -- is essential. Obviously appropriate macro policies, as ever, are assumed. But attention to micro details is becoming increasingly pressing. Nonetheless, it is reasonable to expect that despite endeavors at risk containment and prevention the system may fail in some instances, triggering vicious cycles and all the associated contagion for innocent bystanders. A backup source of international financial support provided only with agreed conditions to address underlying problems, the task assigned to the IMF, can play an essential stabilizing role. The availability of such support must be limited because its size cannot be expected to expand at the pace of the international financial system. I doubt if there will be worldwide political support for that. In closing, I should like to stress that the significant degree of volatility that continues to exist in Asian markets indicates exceptionally high levels of uncertainty, bordering on panic. It is not reasonable to expect that the substantial investments needed to implement meaningful structural reforms can proceed very far until we observe a simmering down of frenetic changes in asset prices and exchange rates. That is likely to result only when stability of banking and financial systems generally is achieved. As I indicated in my November testimony, the failure of the fragile banking systems of East Asia to hold steady as financial pressures increased was a defining element in the developing crisis. The stabilization of those banking systems is crucial, if confidence, that has been so thoroughly undercut in this most debilitating crisis, is to be restored.	---[PAGE_BREAK]--- # Mr. Greenspan analyses further the roots of the current crisis in Asia Testimony by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on Banking and Financial Services of the US House of Representatives on 30/1/98. The global financial system has been evolving rapidly in recent years. New technology has radically reduced the costs of borrowing and lending across traditional national borders, facilitating the development of new instruments and drawing in new players. One result has been a massive increase in capital flows. Information is transmitted instantaneously around the world, and huge shifts in the supply and demand for funds naturally follow. This burgeoning global system has been demonstrated to be a highly efficient structure that has significantly facilitated cross-border trade in goods and services and, accordingly, has made a substantial contribution to standards of living worldwide. Its efficiency exposes and punishes underlying economic weakness swiftly and decisively. Regrettably, it also appears to have facilitated the transmission of financial disturbances far more effectively than ever before. As I testified before this Committee three years ago, the then emerging Mexican crisis was the first such episode associated with our new high-tech international financial system. The current Asian crisis is the second. We do not as yet fully understand the new system's dynamics. We are learning fast, and need to update and modify our institutions and practices to reduce the risks inherent in the new regime. Meanwhile, we have to confront the current crisis with the institutions and techniques we have. Many argue that the current crisis should be allowed to run its course without support from the International Monetary Fund or the bilateral financial backing of other nations. They assert that allowing this crisis to play out, while doubtless having additional negative effects on growth in Asia, and engendering greater spill-overs onto the rest of the world, is not likely to have a large or lasting impact on the United States and the world economy. They may well be correct in their judgment. There is, however, a small but not negligible probability that the upset in East Asia could have unexpectedly negative effects on Japan, Latin America, and eastern and central Europe that, in turn, could have repercussions elsewhere, including the United States. Thus, while the probability of such an outcome may be small, its consequences, in my judgment, should not be left solely to chance. We have observed that global financial markets, as currently organized, do not always achieve an appropriate equilibrium, or at least require time to stabilize. Opponents of IMF support also argue that the substantial financial backing, by cushioning the losses of imprudent investors, could exacerbate moral hazard. Moral hazard arises when someone can reap the rewards from their actions when things go well but do not suffer the full consequences when things go badly. Such a reward structure, obviously, could encourage excessive risk taking. To be sure, this is a problem, though with respect to Asia some investors have to date suffered substantial losses. Asian equity losses, excluding Japan, since June 1997 worldwide are estimated to have exceeded $\$ 700$ billion of which more than $\$ 30$ billion has been lost by U.S. investors. Substantial further losses have been recorded in bonds and real estate. ---[PAGE_BREAK]--- Moreover, the policy conditionality, associated principally with IMF lending, which dictates economic and financial discipline and structural change, helps to mitigate some of the moral hazard concerns. Such conditionality is also critical to the success of the overall stabilization effort. As I will be discussing in a moment, at the root of the problems is poor public policy that has resulted in misguided investments and very weak financial sectors. Convincing a sovereign nation to alter destructive policies that impair its own performance and threaten contagion to its neighbors is best handled by an international financial institution, such as the IMF. What we have in place today to respond to crises should be supported even as we work to improve those mechanisms and institutions. Accordingly, I fully back the Administration's request to augment the financial resources of the IMF -- U.S. participation in the New Arrangements to Borrow and an increase in the U.S. quota in the IMF. Hopefully, neither will turn out not to be needed, and no funds will be drawn. But it is better to have it available if that turns out not to be the case and quick response to a pending crisis is essential. I also believe it is important to have mechanisms, such as the Treasury Department's Exchange Stabilization Fund, that permit the United States in exceptional circumstances to provide temporary bilateral financial support, often on short notice, under appropriate conditions and on occasion in cooperation with other countries. In my testimony before this Committee in mid-November, I endeavored to outline the roots of the current crisis. This morning I should like to carry the analysis a bit further. Companies in Korea and many other Asian countries have become formidable world-class producers in a number of manufacturing sectors using advanced technologies, but in a number of cases they permitted leverage to rise to levels that could only be sustained with continued very rapid growth. Growth, however, was destined to slow. Asian economies to varying degrees over the last half century have tried to combine rapid growth with a much higher mix of government-directed production than has been evident in the essentially market-driven economies of the West. Through government inducements, a number of select, more sophisticated manufacturing technologies borrowed from the advanced market economies were applied to these generally low-productivity and, hence, low-wage economies. Thus, for selected products, exports became competitive with those of the market economies, engendering rapid overall economic growth. There was, however, an inevitable limit to how far this specialized Asian economic regime could develop. As the process broadened beyond a few select applications of advanced technologies, overall productivity continued to increase and the associated rise in the average real wage in these economies blunted somewhat the competitive advantage enjoyed initially. As a consequence of the slackening of export expansion caused in part by losses in competitiveness because of exchange rates that were pegged to the dollar, which was appreciating against the yen, aggregate economic growth slowed somewhat, even before the current crisis. For years, domestic savings and rapidly increasing capital inflows had been directed by governments into investments that banks were required to finance. As I pointed out in previous testimony, lacking a true market test, much of that investment was unprofitable. So long as growth was vigorous, the adverse consequences of this type of non-market allocation of resources were masked. Moreover, in the context of pegged exchange rates that were presumed to continue, if not indefinitely, at least beyond the term of the loan, banks and nonbanks were willing to take the risk to borrow dollars (unhedged) to obtain the dollar-denominated interest ---[PAGE_BREAK]--- rates that were invariably lower than those available in domestic currency. Western, especially American investors, diversified some of their huge capital gains of the 1990s into East Asian investments. In hindsight, it is evident that those economies could not provide adequate profitable opportunities at reasonable risk to absorb such a surge in funds. This surge, together with distortions caused by government planning, has resulted in huge losses. With the inevitable slowdown, business losses and nonperforming bank loans surged. Banks' capital eroded rapidly and, as a consequence, funding sources have dried up, as fears of defaults have risen dramatically. In an environment of weak financial systems, lax supervisory regimes, and vague guarantees about depositor or creditor protections, bank runs have occurred in several countries and reached crisis proportions in Indonesia. Uncertainty and retrenchment have escalated. The state of confidence so necessary to the functioning of any economy has been torn asunder. Vicious cycles of ever rising and reinforcing fears have become contagious. Some exchange rates have fallen to levels that are understandable only in the context of a veritable collapse of confidence in the functioning of an economy. A similar breakdown was also evident in Mexico three years ago, albeit to a somewhat lesser degree. In late 1994, the government was rapidly losing reserves in a vain effort to support a currency that had come under attack when the authorities failed to act expeditiously and convincingly to contain a burgeoning current account deficit financed in large part by substantial short-term flows denominated in dollars. These two recent crisis episodes have afforded us increasing insights into the dynamics of the evolving international financial system, though there is much we do not yet understand. With the new more sophisticated financial markets punishing errant government policy behavior far more profoundly than in the past, vicious cycles are evidently emerging more often. For once they are triggered, damage control is difficult. Once the web of confidence, which supports the financial system, is breached, it is difficult to restore quickly. The loss of confidence can trigger rapid and disruptive changes in the pattern of finance, which, in turn, feeds back on exchange rates and asset prices. Moreover, investor concerns that weaknesses revealed in one economy may be present in others that are similarly situated means that the loss of confidence can quickly spread to other countries. At one point the economic system appears stable, the next it behaves as though a dam has reached a breaking point, and water (read, confidence) evacuates its reservoir. The United States experienced such a sudden change with the decline in stock prices of more than 20 percent on October 19, 1987. There is no credible scenario that can readily explain so abrupt a change in the fundamentals of long-term valuation on that one day. Such market panic does not appear to reflect a simple continuum from the immediately previous period. The abrupt onset of such implosions suggests the possibility that there is a marked dividing line for confidence. When crossed, prices slip into free fall -- perhaps overshooting the long-term equilibrium -before markets will stabilize. But why do these events seem to erupt without some readily evident precursor? Certainly, the more extended the risk-taking, or more generally, the lower the discount factors applied to future outcomes, the more vulnerable are markets to a shock that abruptly triggers a revision in expectations and sets off a vicious cycle of contraction. Episodes of vicious cycles cannot be easily forecast, as our recent experience with Asia has demonstrated. The causes of such episodes are complex and often subtle. In the case of ---[PAGE_BREAK]--- Asia, we can now say with some confidence that the economies affected by this crisis faced a critical mass of vulnerabilities; ex ante, some were more apparent than others, but the combination was not generally recognized as critical. Once the recent crisis was triggered in early July with Thailand's forced abandonment of its exchange rate peg, it was apparently the lethal combination of pegged exchange rates, high leverage, weak banking and financial systems, and declining demand in Thailand and elsewhere that transformed a correction into a collapse. Normally the presence of these factors would have produced a modest retrenchment, not the kind of discontinuous fall in confidence that leads to a vicious cycle of decline. But with a significant part of short-term liabilities, bank and nonbank, denominated in foreign currencies (predominantly dollars), unhedged, the initial pressure on domestic currencies led to a sharp crack in the fixed exchange rate structure of many East Asian economies. The belief that local currencies could, virtually without risk of loss, be converted into dollars at any time was shattered. Investors, both domestic and foreign, endeavored en masse to convert to dollars, as confidence in the ability of the local economy to earn dollars to meet their fixed obligations diminished. Local exchange rates fell against the dollar, inducing still further declines. The weakening of growth also led to lowered profit expectations and contracting net capital inflows of dollars. This was an abrupt change from the pronounced acceleration through 1996 and the first half of 1997. The combination of continued strong demand for dollars to meet debt service obligations and the slowed new supply, destabilized the previously fixed exchange rate regime. This created a marked increase in uncertainty and retrenchment, further reducing capital inflows, still further weakening local currency exchange rates. This vicious cycle will continue until either defaults or restructuring lowers debt service obligations, or the low local exchange rates finally induce a pickup in the supply of dollars. These virulent episodes appear to be at the root of our most recent breakdowns in Mexico and Asia. Their increased prevalence may, in fact, be a defining characteristic of the new high-tech international financial system. We shall never be able to alter the human response to shocks of uncertainty and withdrawal; we can only endeavor to reduce the imbalances that exacerbate them. While, as indicated earlier, I do not believe we are as yet sufficiently knowledgeable of the full complex dynamics of our increasingly developing high-tech financial system, enough insights have been gleaned from the crises in Mexico and Asia (and previous experiences) to enable us to list a few of the critical tendencies toward disequilibrium and vicious cycles that will have to be addressed if our new global economy is to limit the scope for disruptions in the future. These elements have all, in times past, been factors in international and domestic economic disruptions, but they appear more stark in today's market. # 1. Leverage Certainly in Korea, probably in Thailand, and possibly elsewhere, a high degree of leverage (the ratio of debt to equity) appears to be a place to start. While the key role of debt in bank balance sheets is obvious, its role in the efficient functioning of the nonbank sector is also important. Nevertheless, exceptionally high leverage often is a symptom of excessive risk taking that leaves financial systems and economies vulnerable to loss of confidence. It is not easy to imagine the cumulative cascading of debt instruments seeking safety in a crisis when assets are heavily funded with equity. The concern is particularly relevant to banks and many other financial intermediaries, whose assets typically are less liquid than their liabilities and so depend on confidence in the payment of ---[PAGE_BREAK]--- liabilities for their continued viability. Moreover, both financial and nonfinancial businesses can employ high leverage to mask inadequate underlying profitability and otherwise have inadequate capital cushions to match their volatile environments. Excess leverage in nonfinancial business can create problems for lenders including their banks; these problems can, in turn, spread to other borrowers that rely on these lenders. Fortunately, since lending by nonfinancial firms to other businesses is less prevalent than bank lending to other banks, direct contagion is less likely. But the leverage of South Korea's chaebols, because of their size and the pervasive distress, has clearly been an important cause of bank problems with their systemic implications. 2. Interest rate and currency risk Banks, when confronted with a generally rising yield curve, have a tendency to incur interest rate or liquidity risk by lending long and funding short. This exposes them to shocks, especially those institutions that have low capital-asset ratios. When financial intermediaries, in addition, seek low-cost, unhedged, foreign currency funding, the dangers of depositor runs, following a fall in the domestic currency, escalate. 3. Weak banking systems Banks play a crucial role in the financial market infrastructure. When they are undercapitalized, have lax lending standards, and are subjected to weak supervision and regulation, they become a source of systemic risk both domestically and internationally. 4. Interbank funding, especially in foreign currencies Despite its importance for distributing savings to their most valued use, shortterm interbank funding, especially cross border may turn out to be the Achilles' heel of an international financial system that is subject to wide variations in financial confidence. This phenomenon, which is all too common in our domestic experience, may be particularly dangerous in an international setting. 5. Moral hazard The expectation that monetary authorities or international financial institutions will come to the rescue of failing financial systems and unsound investments has clearly engendered a significant element of moral hazard and excessive risk taking. The dividing line between public and private liabilities, too often, becomes blurred. 6. Weak central banks To effectively support a stable currency, central banks need to be independent, meaning that their monetary policy decisions are not subject to the dictates of political authorities. 7. Securities markets Recent adverse banking experiences have emphasized the problems that can arise if banks are almost the sole source of intermediation. Their breakdown induces a sharp weakening in economic growth. A wider range of nonbank institutions, ---[PAGE_BREAK]--- including viable debt and equity markets, are important safeguards of economic activity when banking fails. 8. Inadequate legal structures Finally, an effective competitive market system requires a rule of law that severely delimits government's arbitrary intrusion into commercial disputes. Defaults and restructuring will not always be avoidable. Indeed "creative destruction", as Joseph Schumpeter put it, is often an important element of renewal in a dynamic market economy, but an efficient bankruptcy statute is required to aid in this process, including in the case of cross-border defaults. Interest and currency risk taking, excess leverage, weak financial systems, and interbank funding are all encouraged by the existence of a safety net. In a domestic context, it is difficult to achieve financial balance without a regulatory structure that seeks to simulate the market incentives that would tend to control these financial elements if there were not broad safety nets. It is even more difficult to achieve such a balance internationally among sovereign governments operating out of different cultures. Thus, governments have developed a patchwork of arrangements and conventions governing the functioning of the international financial system that I believe will need to be thoroughly reviewed and altered as necessary to fit the needs of the new global environment. A review of supervision and regulation of private financial institutions, especially those that are supported by a safety net, is particularly pressing because those institutions have played so prominent a role in the emergence of recent crises. As I have testified previously, I believe that, in this rapidly expanding international financial system, the primary protection from adverse financial disturbances is effective counterparty surveillance and, hence, government regulation and supervision should seek to produce an environment in which counterparties can most effectively oversee the credit risks of potential transactions. Here a major improvement in transparency, including both accounting and public disclosure, is essential. To be sure, counterparties often exchange otherwise confidential information as a condition of a transaction. But broader dissemination of detailed disclosures of governments, financial institutions, and firms, is required if the risks inherent in our global financial structure are to be contained. A market system can approach an appropriate equilibrium only if the signals to which individual market participants respond are accurate and adequate to the needs of the adjustment process. Among the important signals are product and asset prices, interest rates, debt by maturity, detailed accounts of central banks, and private enterprises. Blinded by faulty signals, a competitive free-market system cannot reach a firm balance except by chance. In today's rapidly changing market place producers need sophisticated signals to hone production schedules and investment programs to respond to consumer demand. There is sufficient bias in political systems of all varieties to substitute hope (read, wishful thinking) for possibly difficult pre-emptive policy moves, both with respect to financial systems and economic policy. There is often denial and delay in instituting proper adjustments. Recent propensities to obscure the need for change have been evidenced by unreported declines in official reserves, issuance by governments of the equivalent to foreign currency obligations, or unreported large forward short positions against foreign currencies. It is very difficult for political leaders to incur what they perceive as large immediate political costs to contain problems that they see (often dimly) as only prospective. ---[PAGE_BREAK]--- Reality eventually replaces hope, but the cost of delay is a more abrupt and disruptive adjustment than would have been required if action had been more pre-emptive. Increased transparency for businesses, financial institutions, and governments is a key ingredient in fostering more discipline on private transactors and on government policymakers. Increased transparency can counter political bias in part by exposing for all to see the risks to stability of current policies as they develop. Under such conditions, failure to act would also be perceived as having political costs. I suspect that recent political foot dragging by governments in both developed and developing countries on the issue of greater transparency is credible evidence of its power and significance. Transparency, which is so important to foster safe and sound lending practices, is, of course, less relevant for local currency lending if banks are guaranteed with sovereign credits. Moreover, transparency becomes especially difficult to create for organizations and corporations with large interlocking ownerships. Cross holdings of stock lead too often to lending on the basis of association, not economic value. The list of problems that must be addressed to achieve balance in our future global financial system could be significantly extended, but let me end with a notion that is relevant also to today's crisis. It is becoming increasingly evident that supervision and regulation should address excess nonperforming loans expeditiously. The expected values of the losses on these loans are, of course, a subtraction from capital. But since these estimates are uncertain, they embody an additional risk premium that reduces the markets' best estimate of the size of effective equity capital even if capital is replenished. It is, hence, far better to remove these dubious assets and their associated risk premium from bank balance sheets, and dispose of them separately, preferably promptly. As a consequence of the unwinding of market restrictions and regulations, and the rapid increase in technology, the international financial system has expanded at a pace far faster than either domestic GDP or cross-border trade. To reduce the risk of systemic crises in such an environment, an enhanced regime of market incentives, involving greater sensitivity to market signals, more information to make those signals more robust, and broader securities markets -coupled with better supervision -- is essential. Obviously appropriate macro policies, as ever, are assumed. But attention to micro details is becoming increasingly pressing. Nonetheless, it is reasonable to expect that despite endeavors at risk containment and prevention the system may fail in some instances, triggering vicious cycles and all the associated contagion for innocent bystanders. A backup source of international financial support provided only with agreed conditions to address underlying problems, the task assigned to the IMF, can play an essential stabilizing role. The availability of such support must be limited because its size cannot be expected to expand at the pace of the international financial system. I doubt if there will be worldwide political support for that. In closing, I should like to stress that the significant degree of volatility that continues to exist in Asian markets indicates exceptionally high levels of uncertainty, bordering on panic. It is not reasonable to expect that the substantial investments needed to implement meaningful structural reforms can proceed very far until we observe a simmering down of frenetic changes in asset prices and exchange rates. ---[PAGE_BREAK]--- That is likely to result only when stability of banking and financial systems generally is achieved. As I indicated in my November testimony, the failure of the fragile banking systems of East Asia to hold steady as financial pressures increased was a defining element in the developing crisis. The stabilization of those banking systems is crucial, if confidence, that has been so thoroughly undercut in this most debilitating crisis, is to be restored.	Alan Greenspan	United States	https://www.bis.org/review/r980213b.pdf	Testimony by the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on Banking and Financial Services of the US House of Representatives on 30/1/98. The global financial system has been evolving rapidly in recent years. New technology has radically reduced the costs of borrowing and lending across traditional national borders, facilitating the development of new instruments and drawing in new players. One result has been a massive increase in capital flows. Information is transmitted instantaneously around the world, and huge shifts in the supply and demand for funds naturally follow. This burgeoning global system has been demonstrated to be a highly efficient structure that has significantly facilitated cross-border trade in goods and services and, accordingly, has made a substantial contribution to standards of living worldwide. Its efficiency exposes and punishes underlying economic weakness swiftly and decisively. Regrettably, it also appears to have facilitated the transmission of financial disturbances far more effectively than ever before. As I testified before this Committee three years ago, the then emerging Mexican crisis was the first such episode associated with our new high-tech international financial system. The current Asian crisis is the second. We do not as yet fully understand the new system's dynamics. We are learning fast, and need to update and modify our institutions and practices to reduce the risks inherent in the new regime. Meanwhile, we have to confront the current crisis with the institutions and techniques we have. Many argue that the current crisis should be allowed to run its course without support from the International Monetary Fund or the bilateral financial backing of other nations. They assert that allowing this crisis to play out, while doubtless having additional negative effects on growth in Asia, and engendering greater spill-overs onto the rest of the world, is not likely to have a large or lasting impact on the United States and the world economy. They may well be correct in their judgment. There is, however, a small but not negligible probability that the upset in East Asia could have unexpectedly negative effects on Japan, Latin America, and eastern and central Europe that, in turn, could have repercussions elsewhere, including the United States. Thus, while the probability of such an outcome may be small, its consequences, in my judgment, should not be left solely to chance. We have observed that global financial markets, as currently organized, do not always achieve an appropriate equilibrium, or at least require time to stabilize. Opponents of IMF support also argue that the substantial financial backing, by cushioning the losses of imprudent investors, could exacerbate moral hazard. Moral hazard arises when someone can reap the rewards from their actions when things go well but do not suffer the full consequences when things go badly. Such a reward structure, obviously, could encourage excessive risk taking. To be sure, this is a problem, though with respect to Asia some investors have to date suffered substantial losses. Asian equity losses, excluding Japan, since June 1997 worldwide are estimated to have exceeded $\$ 700$ billion of which more than $\$ 30$ billion has been lost by U.S. investors. Substantial further losses have been recorded in bonds and real estate. Moreover, the policy conditionality, associated principally with IMF lending, which dictates economic and financial discipline and structural change, helps to mitigate some of the moral hazard concerns. Such conditionality is also critical to the success of the overall stabilization effort. As I will be discussing in a moment, at the root of the problems is poor public policy that has resulted in misguided investments and very weak financial sectors. Convincing a sovereign nation to alter destructive policies that impair its own performance and threaten contagion to its neighbors is best handled by an international financial institution, such as the IMF. What we have in place today to respond to crises should be supported even as we work to improve those mechanisms and institutions. Accordingly, I fully back the Administration's request to augment the financial resources of the IMF -- U.S. participation in the New Arrangements to Borrow and an increase in the U.S. quota in the IMF. Hopefully, neither will turn out not to be needed, and no funds will be drawn. But it is better to have it available if that turns out not to be the case and quick response to a pending crisis is essential. I also believe it is important to have mechanisms, such as the Treasury Department's Exchange Stabilization Fund, that permit the United States in exceptional circumstances to provide temporary bilateral financial support, often on short notice, under appropriate conditions and on occasion in cooperation with other countries. In my testimony before this Committee in mid-November, I endeavored to outline the roots of the current crisis. This morning I should like to carry the analysis a bit further. Companies in Korea and many other Asian countries have become formidable world-class producers in a number of manufacturing sectors using advanced technologies, but in a number of cases they permitted leverage to rise to levels that could only be sustained with continued very rapid growth. Growth, however, was destined to slow. Asian economies to varying degrees over the last half century have tried to combine rapid growth with a much higher mix of government-directed production than has been evident in the essentially market-driven economies of the West. Through government inducements, a number of select, more sophisticated manufacturing technologies borrowed from the advanced market economies were applied to these generally low-productivity and, hence, low-wage economies. Thus, for selected products, exports became competitive with those of the market economies, engendering rapid overall economic growth. There was, however, an inevitable limit to how far this specialized Asian economic regime could develop. As the process broadened beyond a few select applications of advanced technologies, overall productivity continued to increase and the associated rise in the average real wage in these economies blunted somewhat the competitive advantage enjoyed initially. As a consequence of the slackening of export expansion caused in part by losses in competitiveness because of exchange rates that were pegged to the dollar, which was appreciating against the yen, aggregate economic growth slowed somewhat, even before the current crisis. For years, domestic savings and rapidly increasing capital inflows had been directed by governments into investments that banks were required to finance. As I pointed out in previous testimony, lacking a true market test, much of that investment was unprofitable. So long as growth was vigorous, the adverse consequences of this type of non-market allocation of resources were masked. Moreover, in the context of pegged exchange rates that were presumed to continue, if not indefinitely, at least beyond the term of the loan, banks and nonbanks were willing to take the risk to borrow dollars (unhedged) to obtain the dollar-denominated interest rates that were invariably lower than those available in domestic currency. Western, especially American investors, diversified some of their huge capital gains of the 1990s into East Asian investments. In hindsight, it is evident that those economies could not provide adequate profitable opportunities at reasonable risk to absorb such a surge in funds. This surge, together with distortions caused by government planning, has resulted in huge losses. With the inevitable slowdown, business losses and nonperforming bank loans surged. Banks' capital eroded rapidly and, as a consequence, funding sources have dried up, as fears of defaults have risen dramatically. In an environment of weak financial systems, lax supervisory regimes, and vague guarantees about depositor or creditor protections, bank runs have occurred in several countries and reached crisis proportions in Indonesia. Uncertainty and retrenchment have escalated. The state of confidence so necessary to the functioning of any economy has been torn asunder. Vicious cycles of ever rising and reinforcing fears have become contagious. Some exchange rates have fallen to levels that are understandable only in the context of a veritable collapse of confidence in the functioning of an economy. A similar breakdown was also evident in Mexico three years ago, albeit to a somewhat lesser degree. In late 1994, the government was rapidly losing reserves in a vain effort to support a currency that had come under attack when the authorities failed to act expeditiously and convincingly to contain a burgeoning current account deficit financed in large part by substantial short-term flows denominated in dollars. These two recent crisis episodes have afforded us increasing insights into the dynamics of the evolving international financial system, though there is much we do not yet understand. With the new more sophisticated financial markets punishing errant government policy behavior far more profoundly than in the past, vicious cycles are evidently emerging more often. For once they are triggered, damage control is difficult. Once the web of confidence, which supports the financial system, is breached, it is difficult to restore quickly. The loss of confidence can trigger rapid and disruptive changes in the pattern of finance, which, in turn, feeds back on exchange rates and asset prices. Moreover, investor concerns that weaknesses revealed in one economy may be present in others that are similarly situated means that the loss of confidence can quickly spread to other countries. At one point the economic system appears stable, the next it behaves as though a dam has reached a breaking point, and water (read, confidence) evacuates its reservoir. The United States experienced such a sudden change with the decline in stock prices of more than 20 percent on October 19, 1987. There is no credible scenario that can readily explain so abrupt a change in the fundamentals of long-term valuation on that one day. Such market panic does not appear to reflect a simple continuum from the immediately previous period. The abrupt onset of such implosions suggests the possibility that there is a marked dividing line for confidence. When crossed, prices slip into free fall -- perhaps overshooting the long-term equilibrium -before markets will stabilize. But why do these events seem to erupt without some readily evident precursor? Certainly, the more extended the risk-taking, or more generally, the lower the discount factors applied to future outcomes, the more vulnerable are markets to a shock that abruptly triggers a revision in expectations and sets off a vicious cycle of contraction. Episodes of vicious cycles cannot be easily forecast, as our recent experience with Asia has demonstrated. The causes of such episodes are complex and often subtle. In the case of Asia, we can now say with some confidence that the economies affected by this crisis faced a critical mass of vulnerabilities; ex ante, some were more apparent than others, but the combination was not generally recognized as critical. Once the recent crisis was triggered in early July with Thailand's forced abandonment of its exchange rate peg, it was apparently the lethal combination of pegged exchange rates, high leverage, weak banking and financial systems, and declining demand in Thailand and elsewhere that transformed a correction into a collapse. Normally the presence of these factors would have produced a modest retrenchment, not the kind of discontinuous fall in confidence that leads to a vicious cycle of decline. But with a significant part of short-term liabilities, bank and nonbank, denominated in foreign currencies (predominantly dollars), unhedged, the initial pressure on domestic currencies led to a sharp crack in the fixed exchange rate structure of many East Asian economies. The belief that local currencies could, virtually without risk of loss, be converted into dollars at any time was shattered. Investors, both domestic and foreign, endeavored en masse to convert to dollars, as confidence in the ability of the local economy to earn dollars to meet their fixed obligations diminished. Local exchange rates fell against the dollar, inducing still further declines. The weakening of growth also led to lowered profit expectations and contracting net capital inflows of dollars. This was an abrupt change from the pronounced acceleration through 1996 and the first half of 1997. The combination of continued strong demand for dollars to meet debt service obligations and the slowed new supply, destabilized the previously fixed exchange rate regime. This created a marked increase in uncertainty and retrenchment, further reducing capital inflows, still further weakening local currency exchange rates. This vicious cycle will continue until either defaults or restructuring lowers debt service obligations, or the low local exchange rates finally induce a pickup in the supply of dollars. These virulent episodes appear to be at the root of our most recent breakdowns in Mexico and Asia. Their increased prevalence may, in fact, be a defining characteristic of the new high-tech international financial system. We shall never be able to alter the human response to shocks of uncertainty and withdrawal; we can only endeavor to reduce the imbalances that exacerbate them. While, as indicated earlier, I do not believe we are as yet sufficiently knowledgeable of the full complex dynamics of our increasingly developing high-tech financial system, enough insights have been gleaned from the crises in Mexico and Asia (and previous experiences) to enable us to list a few of the critical tendencies toward disequilibrium and vicious cycles that will have to be addressed if our new global economy is to limit the scope for disruptions in the future. These elements have all, in times past, been factors in international and domestic economic disruptions, but they appear more stark in today's market. Certainly in Korea, probably in Thailand, and possibly elsewhere, a high degree of leverage (the ratio of debt to equity) appears to be a place to start. While the key role of debt in bank balance sheets is obvious, its role in the efficient functioning of the nonbank sector is also important. Nevertheless, exceptionally high leverage often is a symptom of excessive risk taking that leaves financial systems and economies vulnerable to loss of confidence. It is not easy to imagine the cumulative cascading of debt instruments seeking safety in a crisis when assets are heavily funded with equity. The concern is particularly relevant to banks and many other financial intermediaries, whose assets typically are less liquid than their liabilities and so depend on confidence in the payment of liabilities for their continued viability. Moreover, both financial and nonfinancial businesses can employ high leverage to mask inadequate underlying profitability and otherwise have inadequate capital cushions to match their volatile environments. Excess leverage in nonfinancial business can create problems for lenders including their banks; these problems can, in turn, spread to other borrowers that rely on these lenders. Fortunately, since lending by nonfinancial firms to other businesses is less prevalent than bank lending to other banks, direct contagion is less likely. But the leverage of South Korea's chaebols, because of their size and the pervasive distress, has clearly been an important cause of bank problems with their systemic implications. Banks, when confronted with a generally rising yield curve, have a tendency to incur interest rate or liquidity risk by lending long and funding short. This exposes them to shocks, especially those institutions that have low capital-asset ratios. When financial intermediaries, in addition, seek low-cost, unhedged, foreign currency funding, the dangers of depositor runs, following a fall in the domestic currency, escalate. Banks play a crucial role in the financial market infrastructure. When they are undercapitalized, have lax lending standards, and are subjected to weak supervision and regulation, they become a source of systemic risk both domestically and internationally. Despite its importance for distributing savings to their most valued use, shortterm interbank funding, especially cross border may turn out to be the Achilles' heel of an international financial system that is subject to wide variations in financial confidence. This phenomenon, which is all too common in our domestic experience, may be particularly dangerous in an international setting. The expectation that monetary authorities or international financial institutions will come to the rescue of failing financial systems and unsound investments has clearly engendered a significant element of moral hazard and excessive risk taking. The dividing line between public and private liabilities, too often, becomes blurred. To effectively support a stable currency, central banks need to be independent, meaning that their monetary policy decisions are not subject to the dictates of political authorities. Recent adverse banking experiences have emphasized the problems that can arise if banks are almost the sole source of intermediation. Their breakdown induces a sharp weakening in economic growth. A wider range of nonbank institutions, including viable debt and equity markets, are important safeguards of economic activity when banking fails. Finally, an effective competitive market system requires a rule of law that severely delimits government's arbitrary intrusion into commercial disputes. Defaults and restructuring will not always be avoidable. Indeed "creative destruction", as Joseph Schumpeter put it, is often an important element of renewal in a dynamic market economy, but an efficient bankruptcy statute is required to aid in this process, including in the case of cross-border defaults. Interest and currency risk taking, excess leverage, weak financial systems, and interbank funding are all encouraged by the existence of a safety net. In a domestic context, it is difficult to achieve financial balance without a regulatory structure that seeks to simulate the market incentives that would tend to control these financial elements if there were not broad safety nets. It is even more difficult to achieve such a balance internationally among sovereign governments operating out of different cultures. Thus, governments have developed a patchwork of arrangements and conventions governing the functioning of the international financial system that I believe will need to be thoroughly reviewed and altered as necessary to fit the needs of the new global environment. A review of supervision and regulation of private financial institutions, especially those that are supported by a safety net, is particularly pressing because those institutions have played so prominent a role in the emergence of recent crises. As I have testified previously, I believe that, in this rapidly expanding international financial system, the primary protection from adverse financial disturbances is effective counterparty surveillance and, hence, government regulation and supervision should seek to produce an environment in which counterparties can most effectively oversee the credit risks of potential transactions. Here a major improvement in transparency, including both accounting and public disclosure, is essential. To be sure, counterparties often exchange otherwise confidential information as a condition of a transaction. But broader dissemination of detailed disclosures of governments, financial institutions, and firms, is required if the risks inherent in our global financial structure are to be contained. A market system can approach an appropriate equilibrium only if the signals to which individual market participants respond are accurate and adequate to the needs of the adjustment process. Among the important signals are product and asset prices, interest rates, debt by maturity, detailed accounts of central banks, and private enterprises. Blinded by faulty signals, a competitive free-market system cannot reach a firm balance except by chance. In today's rapidly changing market place producers need sophisticated signals to hone production schedules and investment programs to respond to consumer demand. There is sufficient bias in political systems of all varieties to substitute hope (read, wishful thinking) for possibly difficult pre-emptive policy moves, both with respect to financial systems and economic policy. There is often denial and delay in instituting proper adjustments. Recent propensities to obscure the need for change have been evidenced by unreported declines in official reserves, issuance by governments of the equivalent to foreign currency obligations, or unreported large forward short positions against foreign currencies. It is very difficult for political leaders to incur what they perceive as large immediate political costs to contain problems that they see (often dimly) as only prospective. Reality eventually replaces hope, but the cost of delay is a more abrupt and disruptive adjustment than would have been required if action had been more pre-emptive. Increased transparency for businesses, financial institutions, and governments is a key ingredient in fostering more discipline on private transactors and on government policymakers. Increased transparency can counter political bias in part by exposing for all to see the risks to stability of current policies as they develop. Under such conditions, failure to act would also be perceived as having political costs. I suspect that recent political foot dragging by governments in both developed and developing countries on the issue of greater transparency is credible evidence of its power and significance. Transparency, which is so important to foster safe and sound lending practices, is, of course, less relevant for local currency lending if banks are guaranteed with sovereign credits. Moreover, transparency becomes especially difficult to create for organizations and corporations with large interlocking ownerships. Cross holdings of stock lead too often to lending on the basis of association, not economic value. The list of problems that must be addressed to achieve balance in our future global financial system could be significantly extended, but let me end with a notion that is relevant also to today's crisis. It is becoming increasingly evident that supervision and regulation should address excess nonperforming loans expeditiously. The expected values of the losses on these loans are, of course, a subtraction from capital. But since these estimates are uncertain, they embody an additional risk premium that reduces the markets' best estimate of the size of effective equity capital even if capital is replenished. It is, hence, far better to remove these dubious assets and their associated risk premium from bank balance sheets, and dispose of them separately, preferably promptly. As a consequence of the unwinding of market restrictions and regulations, and the rapid increase in technology, the international financial system has expanded at a pace far faster than either domestic GDP or cross-border trade. To reduce the risk of systemic crises in such an environment, an enhanced regime of market incentives, involving greater sensitivity to market signals, more information to make those signals more robust, and broader securities markets -coupled with better supervision -- is essential. Obviously appropriate macro policies, as ever, are assumed. But attention to micro details is becoming increasingly pressing. Nonetheless, it is reasonable to expect that despite endeavors at risk containment and prevention the system may fail in some instances, triggering vicious cycles and all the associated contagion for innocent bystanders. A backup source of international financial support provided only with agreed conditions to address underlying problems, the task assigned to the IMF, can play an essential stabilizing role. The availability of such support must be limited because its size cannot be expected to expand at the pace of the international financial system. I doubt if there will be worldwide political support for that. In closing, I should like to stress that the significant degree of volatility that continues to exist in Asian markets indicates exceptionally high levels of uncertainty, bordering on panic. It is not reasonable to expect that the substantial investments needed to implement meaningful structural reforms can proceed very far until we observe a simmering down of frenetic changes in asset prices and exchange rates. That is likely to result only when stability of banking and financial systems generally is achieved. As I indicated in my November testimony, the failure of the fragile banking systems of East Asia to hold steady as financial pressures increased was a defining element in the developing crisis. The stabilization of those banking systems is crucial, if confidence, that has been so thoroughly undercut in this most debilitating crisis, is to be restored.
1998-02-11T00:00:00	Mr. Kelley discusses the Federal Reserve's perspective on the Year 2000 issue (Central Bank Articles and Speeches, 11 Feb 98)	Remarks by Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Florida International Bankers Association and the Miami Bond Club in Miami on 11/2/98.	Mr. Kelley discusses the Federal Reserve's perspective on the Year 2000 issue Remarks by Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Florida International Bankers Association and the Miami Bond Club in Miami on 11/2/98. It's a great pleasure to be here in Miami to speak before the Florida International Bankers Association and the Miami Bond Club to lengthen the growing list of Federal Reserve governors who have appeared before your organizations over the past few years. Tonight, I would like to discuss the Federal Reserve's perspective on the Year 2000 and share with you some of my observations and concerns about the banking industry's computer system readiness for the century date change. With the impressive growth in international banking activity in Florida since the passage of the Florida International Banking Act 20 years ago, it is particularly important to ensure that the Year 2000 challenge is effectively addressed by all banks conducting an international business in the local and state markets. The stakes are enormous, actually, nothing less than the preservation of a safe and sound financial system that can continue to operate in an orderly manner when the clock rolls over at midnight on New Year's Eve and the millennium arrives on the scene. And even the government can not declare an extension! So much has already been written about the difficulties ascribed to the Year 2000 challenge that the subject is becoming almost commonplace in most conversational circles. By now, almost everyone's familiar with the basic issue -- specifically, that information generated on computer may be miscalculated and conveyed to others, or possibly programs may be terminated because they cannot recognize dates shown as 00. The problem is even the brunt of jokes contained in the monologues of late night TV comics, one of whom laughs that he'll know when midnight, New Year's Eve, 2000 arrives because his pace maker will start to play Auld Lang Syne. Whether you think the problem funny or not, it is quite real. From the Federal Reserve's perspective as the central bank of the United States and a bank supervisor, we have been working intensively to address the issues faced by the industry and formulate an effective supervisory program tailored to those issues. To start with, it has taken an enormous effort simply to elevate the industry's senior management awareness of the seriousness and magnitude of the problem which sounds at first like a modest technical issue that's easy to fix and not terribly significant. But, if programming logic misinterprets the two-digit 00 representation of 2000 to be 1900, automated operating systems across the entire breadth of the world's economy are likely to miscalculate date-sensitive information or simply cease to operate. One reads in the press about the possibility of catastrophic failures in such vital systems as air traffic control, telecommunications, and the utilities that make up the power grid. Society depends on these vital systems to operate dependably, as it also depends on the financial systems to do likewise. And they are interdependent. Those responsible for every critical service need to review their Year 2000 plans to be sure they will be compliant in a timely manner so that, among other obvious reasons, the financial services industry can rely on them. In turn, we in the financial services industry are determined, to the very best of our ability, to be part of the solution and not part of the problem. In the context of our banking environment, calculations based on a span of time such as interest earned, interest due, settlement dates and many others, may result in the generation of misinformation and errors that would be labor intensive, slow and costly to identify and correct after the fact. In the extreme, if the problem doesn't get fixed ahead of time, a bank or securities trading firm may find itself unable to depend on the information provided by its general ledger including its funding position and the account balances of its depositors and trading customers. Obviously, a bank's inability to understand and manage its funding and liquidity positions could have disastrous consequences for the organization, its customers and its counterparties. Accordingly, the Federal Reserve and the other banking supervisors that make up the Federal Financial Institutions Examination Council, the FFIEC, have been working closely to orchestrate a uniform supervisory approach to supervising the banking industry's efforts to ensure its readiness. Supervisory Initiatives To give you an overview of the banking agencies' initiatives to date, the interagency program began in earnest in June, 1996, with the issuance of the first Year 2000 advisory distributed to all domestic and foreign banks in the United States. Following up in May, 1997, the agencies issued a second advisory entitled "Year 2000 Project Management Awareness" which alerted senior management and the boards of directors to the serious challenge facing the industry. The advisory indicated that the problem was not merely a technical issue and that top management and the board had to be directly responsible for the implementation of a suggested five-phase management process that included awareness, assessment, renovation, testing and implementation. It also alerted bank directors and senior management about the external risks relating to the Year 2000 readiness of their borrowers, vendors and counterparties. Failure of these third parties to address this issue could easily have an adverse effect on a bank's ability to conduct business. As part of the May advisory we established two particular benchmarks with respect to progress toward compliance. First, it was expected that by September 30, 1997, banks would have completed a thorough inventory of all of their mission critical applications and established a comprehensive plan and priorities for their renovation. This benchmark has passed and so the banking agencies are now increasing supervisory efforts at those few banks that have not completed such an inventory and plan. The second time frame stated that by December 31, 1998, mission critical systems should be largely renovated with testing well underway so that the balance of testing and implementation could be accomplished in 1999. The third banking agency advisory was issued last December affirming the need for thorough periodic reporting of project progress to bank management and more importantly making clear that all banking offices are ultimately responsible for their own readiness, even though they may be heavily dependent on a third-party service provider or a foreign parent for their automated data processing activities. Banks were encouraged to communicate with their vendors or parents to seek a thorough understanding of their ability to service the bank's needs. Banks have also been advised to incorporate Year 2000 credit risk into their underwriting standards and securities trading policies, given that their borrowers or counterparties could experience unresolved processing problems that might hamper their ability to meet their financial obligations on a timely basis. The Federal Reserve has also committed to conduct an examination for Year 2000 readiness of every bank subject to our supervisory authority by June 1998, and we will continue to conduct further Year 2000 examinations right up to the millennium. Industry Assessment Well, taking a step back from looking at our initiatives, it's fair to ask, "How well is the industry doing?" Most banks have completed the assessment phase; however, those that missed the September 30, 1997, time frame are going to be the subject of intensive supervisory attention. They are also likely to lag behind their peers when it comes time to test their renovated applications with their counterparties. Accordingly, in some cases, we are issuing notification letters putting lagging banks on notice that the deficiencies in their progress require specific corrective action. Most banks are now in the renovation and testing phases and are finding it more expensive and time consuming to fix and test their systems than they previously estimated. Consequently, many have had to revise their budgets upward and delay the development of new services that would divert limited programming and systems development resources. Some banks have started the validation phase and have confirmed that testing is a costly, cumbersome and time consuming process. As for the final phase of implementation, few banks have advanced this far with any more than a handful of their mission critical systems. Most have a significant amount of testing ahead of them before final implementation can be accomplished. Let's focus for a moment on the testing phase as an excellent example of the magnitude of this process. Testing Testing is one of the more crucial issues being addressed, given that it will consume more than a year and absorb as much as 70 percent of Year 2000 resources. One must focus first on internal testing and the isolation of a test environment to avoid contamination with the current production environment. Then a building block approach starts with one-by-one unit testing of a single application such as demand deposit accounting, then progresses to integration testing, which would apply to a group of applications such as those for all deposit systems for demand, time and savings deposits. Then system testing combines entire systems, which might, for example, cover all automated applications that permit the preparation of the liabilities side of the general ledger. This is often followed by regression testing which checks each variable and all combinations of variables relied on by the various systems to see if any cause a problem. Each application is also subject to external testing that is conducted with a single counter party to confirm compliance with agreed upon protocols and compatibility of different Year 2000 solution techniques that may have been used. In a trading operation, this might mean testing trades with a single counterparty. Then organizations have to test with multiple counterparties and if problems are discovered, it may require further renovation and retesting. Each step is very time consuming and absolutely essential, and it is anticipated that costs associated with getting it done will rise appreciably as strains on labor markets to support such testing grow. The banking agencies are working with the industry to develop guidance on best practices pertaining to testing. In addition, the Federal Reserve will soon be publishing a detailed schedule of testing opportunities for Fedwire, automated clearing house transactions and other services provided by the Federal Reserve. Actual testing will commence at mid-year 1998 and continue throughout 1999. It promises to be a very busy period. Contingency Planning The Federal Reserve has been involved with contingency planning and dealing with various types of emergencies for many years. Today is no different in many respects, but the need for Year 2000 readiness raises new concerns that are applicable to all banks, foreign or domestic. One is the risk of contagion. Operating problems at individual banks must not be allowed to spread and become systemic. Many experts have pointed out that counterparties to automated transactions ordinarily do not transmit material whose logic statements can act as a virus and destroy software in a receiving host. On the contrary, most exchanges are simply transmitting data that is ordinarily subject to edits intended to identify any miscalculated date sensitive information. If indeed, the sender has unintentionally transmitted erroneous, miscalculated information and it is identified as such, the recipient rejects the misinformation and is free from the problem which can then be corrected by the sender. So this very important issue should be readily manageable, but managed it must be. On the subject of operating outages, if an automated information system crashes because of a Year 2000 readiness problem, the crash must be prevented from spreading. We know that when electric utilities experience a local problem with the power grid, it has on occasion in the past taken down a wider, regional network. Could this happen with interconnected computer systems? Most professionals argue that the operational outage of one data center need not spread and disable others. Nevertheless, as a bank supervisor concerned about systemic issues, even the remote possibility for operational outages and disruptions to service require all of us to do significant contingency planning. Early in our efforts to address Year 2000 automation issues, we realized contingency planning in the Year 2000 context is made more difficult because operating centers can not fall back to an earlier version of a software package because the earlier version itself may not have been readied for Year 2000. Similarly, a US office of a foreign bank experiencing local problems may not be able to rely on its parent because it is likely that the parent depends on the same software that caused the local problem. So, in order to plan for continuation of services, it may be necessary to provide a complete, alternative service, or a service that can be repaired as a Year 2000 problem is identified. A major interagency contingency planning effort underway addresses a possible federally assisted resolution scenario that might be necessary should a bank experience extensive computer problems. If this were to lead to serious liquidity problems, the chartering authority might deem the bank nonviable, thus necessitating resolution by the FDIC together with other banking agencies that may be involved. It is also necessary for us to consider the legal and policy issues that may pertain to a US office of a foreign bank that is unable to meet its liquidity obligations. Such a case will not lend itself to a simple resolution process. Another concern of the Federal Reserve is the extent to which the industry is so heavily dependent on vendors. As I noted earlier in discussing the most recent advisory to the industry, banks are ultimately responsible for their own operations despite their reliance on third-party service providers. There are many thousands of information systems vendors of one form or another that provide services to federally insured depositories, and obtaining meaningful information on vendor plans and status has proven difficult for the industry and the regulators. If they have not already done so, vendors need to provide very soon their program to renovate and support a product relied on by banks. With sufficient information on vendor plans, banks can prepare their testing strategies. Vendors and banks are realizing that it is advantageous to make vendor plans public on web sites and through other means so that they do not have to repeatedly respond to the same questions from each of their customers. There are important opportunities for banks to work together in this area. By expanding and intensifying interbank cooperative efforts to address Year 2000 issues such as the development of common testing scripts and the sharing of information, the industry can enhance its ability to be prepared in a timely manner. International Initiatives - Foreign Banking Organizations Let me now turn more directly to international initiatives which are likely to be of particular interest here tonight given the extent of business you conduct with customers and banks outside the United States. The Federal Reserve has a keen interest in the readiness of the international community and the special problems facing foreign banks operating branches and agencies in the United States. The Federal Reserve has been involved in active dialogue with bankers and supervisors that have banks in the United States from around the world. We are involved in international visitation programs, conferences and training efforts pertaining to their preparedness efforts. On an interagency basis, the Federal Reserve, the OCC and the FDIC are all represented on the Bank for International Settlements' (BIS) Committee on Banking Supervision, referred to as the Basle Committee. The Federal Reserve is also on the BIS Committee on Payment and Settlement Systems (CPSS) which is presently chaired by William McDonough, President of the Federal Reserve Bank of New York. With the issuance of the US industry advisory in May, the Basle Committee took up the subject, forming a special task force on Year 2000. Subsequently, the G-10 governors issued an advisory on September 8 to all BIS member central banks and bank supervisors for distribution to their respective banks world-wide. It clearly spells out the issues pertaining to the challenge, and I strongly recommend you read it if you have not yet had an opportunity to do so. The Federal Reserve also produced a video entitled "Year 2000 Executive Management Awareness" and distributed it to all bank supervisors responsible for foreign banks that operate in the United States. In so doing, we encouraged foreign bank supervisors to intensify their efforts to address millennium issues in their home countries and to ensure that their banks were taking the necessary steps to ready their operations, including those conducted in the United States. The Federal Reserve and the other banking agencies are making their Year 2000 supervisory material available to domestic and foreign banks, and the general public over the Internet. The Federal Reserve has already distributed about 20,000 copies of our video, many in response to requests from abroad, and our web site hot links to that of the BIS and many other Year 2000 sites world-wide. By widening the availability of information on an international basis, we hope to encourage global readiness. The BIS is also working with the International Organization of Securities Commissioners and the International Association of Insurance Supervisors to address this important issue. Together, they will convene a meeting in April of international financial supervisors and financial organizations to focus on Year 2000 and address issues of concern to all. Based on concerns expressed by banks, the work of the BIS task force and our own inquiries, we believe that certain countries around the world have not embarked on aggressive compliance supervision and examination programs, so that there is a likelihood that banks in those countries have not yet begun to effectively address the problem and will now find it increasingly difficult to be ready. We are concerned that many US offices of foreign banks may be particularly exposed if their parent is not ready for the Year 2000. Therefore, we have asked the US branches and agencies to confirm that they will be able to continue to conduct business using the same standards for readiness that we apply to domestic banks. Those that rely heavily on their parent for information processing and risk management are expected to be able to demonstrate to examiners that these systems are being readied for the Year 2000. Further, Federal Reserve supervision policy calls for direct contact with the parent bank to ensure its awareness of the requirements. When problems are identified, contact with the home country supervisor may also be warranted to coordinate a thorough understanding of the bank's plans for the readiness of its US operations. In so doing, we hope to be better able to address any institutions that have not made sufficient progress toward resolving the issue with their US offices. Given the unique characteristics of a branch operation dependent on a foreign parent that, in turn, is subject to the authority of its home country bank supervisor, the Federal Reserve and other US banking agencies must carefully consider any necessary follow-up with the appropriate international authorities. Compounding our concerns about international readiness are a number of competing initiatives that further stretch the limited resources available to achieve preparedness. In 1999, the euro will be introduced requiring record keeping of financial transactions in a new currency. Extensive planning and programming will be necessary to permit foreign exchange trading and other cross border transactions to be conducted in the euro, with the added complexity of the continued circulation of various national currencies for several years. Of course, banks outside the European Monetary Union that are trading counterparties will also have to program their computers to accommodate the euro. Similarly, plans in Japan call for extensive deregulation of various segments of the financial markets relatively soon. These and any other high priority efforts will exacerbate the problem of preparing for the century date change by competing for limited resources. I suggest that all nations should assess their respective financial initiatives and determine if any opportunities exist to defer projects that can wait until after 2000. We all need to recognize the magnitude and overriding importance of this task and take action to protect vitally needed resources from being diverted to other projects that may be of lesser priority. Concluding Remarks In closing, let's take a moment to ask what you can do. First of all, be alert to recognize any danger signs in your own organizations and in your counterparties, customers and borrowers. For those of you involved in underwriting and dealing in securities, solid evidence of Year 2000 readiness should be part of your due diligence. You will know you likely have a problem if you hear that the Year 2000 is "not an issue for our shop", or if you hear "we can handle the Year 2000 within the normal planning process without significant budget implications", or if you hear that the Year 2000 "is a technical issue that does not require special attention by senior management and directors". Any of these comments are almost certain to be dead wrong, and probably are tip offs to the presence of dangerous complacency, ignorance, or naivete. You, of the Florida International Bankers Association and the Miami Bond Club, can also help heighten international awareness and action on the matter by ensuring that the policy statements I referred to are widely available in other languages, by discussing them at each opportunity and by building Year 2000 issues into your day-to-day lending and financing business activities, negotiations, contracts, and sales agreements as well as conferences and meetings with various international regulatory authorities. I am sure that many here have close relationships with banks in other countries. Let me urge you to delve deeply into preparations for Year 2000, and if there is evidence of a potential readiness shortfall, do everything in your power to urge the institution to get active very quickly. In so doing, you will advance the cause of readiness throughout the local community and on an international basis as well, while protecting yourself in the process. Hopefully, when the century date change arrives, we will be ready, everything will work effectively, and we will all celebrate the new millennium in a relaxed and unreserved manner. On that positive note, let me close by saying that I truly appreciate the opportunity to address the Florida International Bankers Association and the Miami Bond Club, and that I don't look forward to going back to the cold reaches of Washington tomorrow.	---[PAGE_BREAK]--- # Mr. Kelley discusses the Federal Reserve's perspective on the Year 2000 issue Remarks by Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Florida International Bankers Association and the Miami Bond Club in Miami on 11/2/98. It's a great pleasure to be here in Miami to speak before the Florida International Bankers Association and the Miami Bond Club to lengthen the growing list of Federal Reserve governors who have appeared before your organizations over the past few years. Tonight, I would like to discuss the Federal Reserve's perspective on the Year 2000 and share with you some of my observations and concerns about the banking industry's computer system readiness for the century date change. With the impressive growth in international banking activity in Florida since the passage of the Florida International Banking Act 20 years ago, it is particularly important to ensure that the Year 2000 challenge is effectively addressed by all banks conducting an international business in the local and state markets. The stakes are enormous, actually, nothing less than the preservation of a safe and sound financial system that can continue to operate in an orderly manner when the clock rolls over at midnight on New Year's Eve and the millennium arrives on the scene. And even the government can not declare an extension! So much has already been written about the difficulties ascribed to the Year 2000 challenge that the subject is becoming almost commonplace in most conversational circles. By now, almost everyone's familiar with the basic issue -- specifically, that information generated on computer may be miscalculated and conveyed to others, or possibly programs may be terminated because they cannot recognize dates shown as 00 . The problem is even the brunt of jokes contained in the monologues of late night TV comics, one of whom laughs that he'll know when midnight, New Year's Eve, 2000 arrives because his pace maker will start to play Auld Lang Syne. Whether you think the problem funny or not, it is quite real. From the Federal Reserve's perspective as the central bank of the United States and a bank supervisor, we have been working intensively to address the issues faced by the industry and formulate an effective supervisory program tailored to those issues. To start with, it has taken an enormous effort simply to elevate the industry's senior management awareness of the seriousness and magnitude of the problem which sounds at first like a modest technical issue that's easy to fix and not terribly significant. But, if programming logic misinterprets the two-digit 00 representation of 2000 to be 1900, automated operating systems across the entire breadth of the world's economy are likely to miscalculate date-sensitive information or simply cease to operate. One reads in the press about the possibility of catastrophic failures in such vital systems as air traffic control, telecommunications, and the utilities that make up the power grid. Society depends on these vital systems to operate dependably, as it also depends on the financial systems to do likewise. And they are interdependent. Those responsible for every critical service need to review their Year 2000 plans to be sure they will be compliant in a timely manner so that, among other obvious reasons, the financial services industry can rely on them. In turn, we in the financial services industry are determined, to the very best of our ability, to be part of the solution and not part of the problem. In the context of our banking environment, calculations based on a span of time such as interest earned, interest due, settlement dates and many others, may result in the generation of misinformation and errors that would be labor intensive, slow and costly to identify and correct after the fact. In the extreme, if the problem doesn't get fixed ahead of time, a bank or securities trading firm may find itself unable to depend on the information provided by ---[PAGE_BREAK]--- its general ledger including its funding position and the account balances of its depositors and trading customers. Obviously, a bank's inability to understand and manage its funding and liquidity positions could have disastrous consequences for the organization, its customers and its counterparties. Accordingly, the Federal Reserve and the other banking supervisors that make up the Federal Financial Institutions Examination Council, the FFIEC, have been working closely to orchestrate a uniform supervisory approach to supervising the banking industry's efforts to ensure its readiness. # Supervisory Initiatives To give you an overview of the banking agencies' initiatives to date, the interagency program began in earnest in June, 1996, with the issuance of the first Year 2000 advisory distributed to all domestic and foreign banks in the United States. Following up in May, 1997, the agencies issued a second advisory entitled "Year 2000 Project Management Awareness" which alerted senior management and the boards of directors to the serious challenge facing the industry. The advisory indicated that the problem was not merely a technical issue and that top management and the board had to be directly responsible for the implementation of a suggested five-phase management process that included awareness, assessment, renovation, testing and implementation. It also alerted bank directors and senior management about the external risks relating to the Year 2000 readiness of their borrowers, vendors and counterparties. Failure of these third parties to address this issue could easily have an adverse effect on a bank's ability to conduct business. As part of the May advisory we established two particular benchmarks with respect to progress toward compliance. First, it was expected that by September 30, 1997, banks would have completed a thorough inventory of all of their mission critical applications and established a comprehensive plan and priorities for their renovation. This benchmark has passed and so the banking agencies are now increasing supervisory efforts at those few banks that have not completed such an inventory and plan. The second time frame stated that by December 31, 1998, mission critical systems should be largely renovated with testing well underway so that the balance of testing and implementation could be accomplished in 1999. The third banking agency advisory was issued last December affirming the need for thorough periodic reporting of project progress to bank management and more importantly making clear that all banking offices are ultimately responsible for their own readiness, even though they may be heavily dependent on a third-party service provider or a foreign parent for their automated data processing activities. Banks were encouraged to communicate with their vendors or parents to seek a thorough understanding of their ability to service the bank's needs. Banks have also been advised to incorporate Year 2000 credit risk into their underwriting standards and securities trading policies, given that their borrowers or counterparties could experience unresolved processing problems that might hamper their ability to meet their financial obligations on a timely basis. The Federal Reserve has also committed to conduct an examination for Year 2000 readiness of every bank subject to our supervisory authority by June 1998, and we will continue to conduct further Year 2000 examinations right up to the millennium. ## Industry Assessment Well, taking a step back from looking at our initiatives, it's fair to ask, "How well is the industry doing?" Most banks have completed the assessment phase; however, those that ---[PAGE_BREAK]--- missed the September 30, 1997, time frame are going to be the subject of intensive supervisory attention. They are also likely to lag behind their peers when it comes time to test their renovated applications with their counterparties. Accordingly, in some cases, we are issuing notification letters putting lagging banks on notice that the deficiencies in their progress require specific corrective action. Most banks are now in the renovation and testing phases and are finding it more expensive and time consuming to fix and test their systems than they previously estimated. Consequently, many have had to revise their budgets upward and delay the development of new services that would divert limited programming and systems development resources. Some banks have started the validation phase and have confirmed that testing is a costly, cumbersome and time consuming process. As for the final phase of implementation, few banks have advanced this far with any more than a handful of their mission critical systems. Most have a significant amount of testing ahead of them before final implementation can be accomplished. Let's focus for a moment on the testing phase as an excellent example of the magnitude of this process. # Testing Testing is one of the more crucial issues being addressed, given that it will consume more than a year and absorb as much as 70 percent of Year 2000 resources. One must focus first on internal testing and the isolation of a test environment to avoid contamination with the current production environment. Then a building block approach starts with one-by-one unit testing of a single application such as demand deposit accounting, then progresses to integration testing, which would apply to a group of applications such as those for all deposit systems for demand, time and savings deposits. Then system testing combines entire systems, which might, for example, cover all automated applications that permit the preparation of the liabilities side of the general ledger. This is often followed by regression testing which checks each variable and all combinations of variables relied on by the various systems to see if any cause a problem. Each application is also subject to external testing that is conducted with a single counter party to confirm compliance with agreed upon protocols and compatibility of different Year 2000 solution techniques that may have been used. In a trading operation, this might mean testing trades with a single counterparty. Then organizations have to test with multiple counterparties and if problems are discovered, it may require further renovation and retesting. Each step is very time consuming and absolutely essential, and it is anticipated that costs associated with getting it done will rise appreciably as strains on labor markets to support such testing grow. The banking agencies are working with the industry to develop guidance on best practices pertaining to testing. In addition, the Federal Reserve will soon be publishing a detailed schedule of testing opportunities for Fedwire, automated clearing house transactions and other services provided by the Federal Reserve. Actual testing will commence at mid-year 1998 and continue throughout 1999. It promises to be a very busy period. ## Contingency Planning The Federal Reserve has been involved with contingency planning and dealing with various types of emergencies for many years. Today is no different in many respects, but the need for Year 2000 readiness raises new concerns that are applicable to all banks, foreign or domestic. One is the risk of contagion. Operating problems at individual banks must not be ---[PAGE_BREAK]--- allowed to spread and become systemic. Many experts have pointed out that counterparties to automated transactions ordinarily do not transmit material whose logic statements can act as a virus and destroy software in a receiving host. On the contrary, most exchanges are simply transmitting data that is ordinarily subject to edits intended to identify any miscalculated date sensitive information. If indeed, the sender has unintentionally transmitted erroneous, miscalculated information and it is identified as such, the recipient rejects the misinformation and is free from the problem which can then be corrected by the sender. So this very important issue should be readily manageable, but managed it must be. On the subject of operating outages, if an automated information system crashes because of a Year 2000 readiness problem, the crash must be prevented from spreading. We know that when electric utilities experience a local problem with the power grid, it has on occasion in the past taken down a wider, regional network. Could this happen with interconnected computer systems? Most professionals argue that the operational outage of one data center need not spread and disable others. Nevertheless, as a bank supervisor concerned about systemic issues, even the remote possibility for operational outages and disruptions to service require all of us to do significant contingency planning. Early in our efforts to address Year 2000 automation issues, we realized contingency planning in the Year 2000 context is made more difficult because operating centers can not fall back to an earlier version of a software package because the earlier version itself may not have been readied for Year 2000. Similarly, a US office of a foreign bank experiencing local problems may not be able to rely on its parent because it is likely that the parent depends on the same software that caused the local problem. So, in order to plan for continuation of services, it may be necessary to provide a complete, alternative service, or a service that can be repaired as a Year 2000 problem is identified. A major interagency contingency planning effort underway addresses a possible federally assisted resolution scenario that might be necessary should a bank experience extensive computer problems. If this were to lead to serious liquidity problems, the chartering authority might deem the bank nonviable, thus necessitating resolution by the FDIC together with other banking agencies that may be involved. It is also necessary for us to consider the legal and policy issues that may pertain to a US office of a foreign bank that is unable to meet its liquidity obligations. Such a case will not lend itself to a simple resolution process. Another concern of the Federal Reserve is the extent to which the industry is so heavily dependent on vendors. As I noted earlier in discussing the most recent advisory to the industry, banks are ultimately responsible for their own operations despite their reliance on third-party service providers. There are many thousands of information systems vendors of one form or another that provide services to federally insured depositories, and obtaining meaningful information on vendor plans and status has proven difficult for the industry and the regulators. If they have not already done so, vendors need to provide very soon their program to renovate and support a product relied on by banks. With sufficient information on vendor plans, banks can prepare their testing strategies. Vendors and banks are realizing that it is advantageous to make vendor plans public on web sites and through other means so that they do not have to repeatedly respond to the same questions from each of their customers. There are important opportunities for banks to work together in this area. By expanding and intensifying interbank cooperative efforts to address Year 2000 issues such as the development of common testing scripts and the sharing of information, the industry can enhance its ability to be prepared in a timely manner. ---[PAGE_BREAK]--- # International Initiatives - Foreign Banking Organizations Let me now turn more directly to international initiatives which are likely to be of particular interest here tonight given the extent of business you conduct with customers and banks outside the United States. The Federal Reserve has a keen interest in the readiness of the international community and the special problems facing foreign banks operating branches and agencies in the United States. The Federal Reserve has been involved in active dialogue with bankers and supervisors that have banks in the United States from around the world. We are involved in international visitation programs, conferences and training efforts pertaining to their preparedness efforts. On an interagency basis, the Federal Reserve, the OCC and the FDIC are all represented on the Bank for International Settlements' (BIS) Committee on Banking Supervision, referred to as the Basle Committee. The Federal Reserve is also on the BIS Committee on Payment and Settlement Systems (CPSS) which is presently chaired by William McDonough, President of the Federal Reserve Bank of New York. With the issuance of the US industry advisory in May, the Basle Committee took up the subject, forming a special task force on Year 2000. Subsequently, the G-10 governors issued an advisory on September 8 to all BIS member central banks and bank supervisors for distribution to their respective banks world-wide. It clearly spells out the issues pertaining to the challenge, and I strongly recommend you read it if you have not yet had an opportunity to do so. The Federal Reserve also produced a video entitled "Year 2000 Executive Management Awareness" and distributed it to all bank supervisors responsible for foreign banks that operate in the United States. In so doing, we encouraged foreign bank supervisors to intensify their efforts to address millennium issues in their home countries and to ensure that their banks were taking the necessary steps to ready their operations, including those conducted in the United States. The Federal Reserve and the other banking agencies are making their Year 2000 supervisory material available to domestic and foreign banks, and the general public over the Internet. The Federal Reserve has already distributed about 20,000 copies of our video, many in response to requests from abroad, and our web site hot links to that of the BIS and many other Year 2000 sites world-wide. By widening the availability of information on an international basis, we hope to encourage global readiness. The BIS is also working with the International Organization of Securities Commissioners and the International Association of Insurance Supervisors to address this important issue. Together, they will convene a meeting in April of international financial supervisors and financial organizations to focus on Year 2000 and address issues of concern to all. Based on concerns expressed by banks, the work of the BIS task force and our own inquiries, we believe that certain countries around the world have not embarked on aggressive compliance supervision and examination programs, so that there is a likelihood that banks in those countries have not yet begun to effectively address the problem and will now find it increasingly difficult to be ready. We are concerned that many US offices of foreign banks may be particularly exposed if their parent is not ready for the Year 2000. Therefore, we have asked the US branches and agencies to confirm that they will be able to continue to conduct business using the same standards for readiness that we apply to domestic banks. Those that rely heavily on their parent for information processing and risk management are expected to be able to demonstrate to examiners that these systems are being readied for the Year 2000. Further, Federal Reserve supervision policy calls for direct contact with the parent bank to ensure its awareness of the requirements. When problems are identified, contact with the ---[PAGE_BREAK]--- home country supervisor may also be warranted to coordinate a thorough understanding of the bank's plans for the readiness of its US operations. In so doing, we hope to be better able to address any institutions that have not made sufficient progress toward resolving the issue with their US offices. Given the unique characteristics of a branch operation dependent on a foreign parent that, in turn, is subject to the authority of its home country bank supervisor, the Federal Reserve and other US banking agencies must carefully consider any necessary follow-up with the appropriate international authorities. Compounding our concerns about international readiness are a number of competing initiatives that further stretch the limited resources available to achieve preparedness. In 1999, the euro will be introduced requiring record keeping of financial transactions in a new currency. Extensive planning and programming will be necessary to permit foreign exchange trading and other cross border transactions to be conducted in the euro, with the added complexity of the continued circulation of various national currencies for several years. Of course, banks outside the European Monetary Union that are trading counterparties will also have to program their computers to accommodate the euro. Similarly, plans in Japan call for extensive deregulation of various segments of the financial markets relatively soon. These and any other high priority efforts will exacerbate the problem of preparing for the century date change by competing for limited resources. I suggest that all nations should assess their respective financial initiatives and determine if any opportunities exist to defer projects that can wait until after 2000. We all need to recognize the magnitude and overriding importance of this task and take action to protect vitally needed resources from being diverted to other projects that may be of lesser priority. # Concluding Remarks In closing, let's take a moment to ask what you can do. First of all, be alert to recognize any danger signs in your own organizations and in your counterparties, customers and borrowers. For those of you involved in underwriting and dealing in securities, solid evidence of Year 2000 readiness should be part of your due diligence. You will know you likely have a problem if you hear that the Year 2000 is "not an issue for our shop", or if you hear "we can handle the Year 2000 within the normal planning process without significant budget implications", or if you hear that the Year 2000 "is a technical issue that does not require special attention by senior management and directors". Any of these comments are almost certain to be dead wrong, and probably are tip offs to the presence of dangerous complacency, ignorance, or naivete. You, of the Florida International Bankers Association and the Miami Bond Club, can also help heighten international awareness and action on the matter by ensuring that the policy statements I referred to are widely available in other languages, by discussing them at each opportunity and by building Year 2000 issues into your day-to-day lending and financing business activities, negotiations, contracts, and sales agreements as well as conferences and meetings with various international regulatory authorities. I am sure that many here have close relationships with banks in other countries. Let me urge you to delve deeply into preparations for Year 2000, and if there is evidence of a potential readiness shortfall, do everything in your power to urge the institution to get active very quickly. In so doing, you will advance the cause of readiness throughout the local community and on an international basis as well, while protecting yourself in the process. Hopefully, when the century date change arrives, we will be ready, everything will work effectively, and we will all celebrate the new millennium in a relaxed and unreserved ---[PAGE_BREAK]--- manner. On that positive note, let me close by saying that I truly appreciate the opportunity to address the Florida International Bankers Association and the Miami Bond Club, and that I don't look forward to going back to the cold reaches of Washington tomorrow.	Edward W Kelley, Jr	United States	https://www.bis.org/review/r980227b.pdf	issue Remarks by Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Florida International Bankers Association and the Miami Bond Club in Miami on 11/2/98. It's a great pleasure to be here in Miami to speak before the Florida International Bankers Association and the Miami Bond Club to lengthen the growing list of Federal Reserve governors who have appeared before your organizations over the past few years. Tonight, I would like to discuss the Federal Reserve's perspective on the Year 2000 and share with you some of my observations and concerns about the banking industry's computer system readiness for the century date change. With the impressive growth in international banking activity in Florida since the passage of the Florida International Banking Act 20 years ago, it is particularly important to ensure that the Year 2000 challenge is effectively addressed by all banks conducting an international business in the local and state markets. The stakes are enormous, actually, nothing less than the preservation of a safe and sound financial system that can continue to operate in an orderly manner when the clock rolls over at midnight on New Year's Eve and the millennium arrives on the scene. And even the government can not declare an extension! So much has already been written about the difficulties ascribed to the Year 2000 challenge that the subject is becoming almost commonplace in most conversational circles. By now, almost everyone's familiar with the basic issue -- specifically, that information generated on computer may be miscalculated and conveyed to others, or possibly programs may be terminated because they cannot recognize dates shown as 00 . The problem is even the brunt of jokes contained in the monologues of late night TV comics, one of whom laughs that he'll know when midnight, New Year's Eve, 2000 arrives because his pace maker will start to play Auld Lang Syne. Whether you think the problem funny or not, it is quite real. From the Federal Reserve's perspective as the central bank of the United States and a bank supervisor, we have been working intensively to address the issues faced by the industry and formulate an effective supervisory program tailored to those issues. To start with, it has taken an enormous effort simply to elevate the industry's senior management awareness of the seriousness and magnitude of the problem which sounds at first like a modest technical issue that's easy to fix and not terribly significant. But, if programming logic misinterprets the two-digit 00 representation of 2000 to be 1900, automated operating systems across the entire breadth of the world's economy are likely to miscalculate date-sensitive information or simply cease to operate. One reads in the press about the possibility of catastrophic failures in such vital systems as air traffic control, telecommunications, and the utilities that make up the power grid. Society depends on these vital systems to operate dependably, as it also depends on the financial systems to do likewise. And they are interdependent. Those responsible for every critical service need to review their Year 2000 plans to be sure they will be compliant in a timely manner so that, among other obvious reasons, the financial services industry can rely on them. In turn, we in the financial services industry are determined, to the very best of our ability, to be part of the solution and not part of the problem. In the context of our banking environment, calculations based on a span of time such as interest earned, interest due, settlement dates and many others, may result in the generation of misinformation and errors that would be labor intensive, slow and costly to identify and correct after the fact. In the extreme, if the problem doesn't get fixed ahead of time, a bank or securities trading firm may find itself unable to depend on the information provided by its general ledger including its funding position and the account balances of its depositors and trading customers. Obviously, a bank's inability to understand and manage its funding and liquidity positions could have disastrous consequences for the organization, its customers and its counterparties. Accordingly, the Federal Reserve and the other banking supervisors that make up the Federal Financial Institutions Examination Council, the FFIEC, have been working closely to orchestrate a uniform supervisory approach to supervising the banking industry's efforts to ensure its readiness. To give you an overview of the banking agencies' initiatives to date, the interagency program began in earnest in June, 1996, with the issuance of the first Year 2000 advisory distributed to all domestic and foreign banks in the United States. Following up in May, 1997, the agencies issued a second advisory entitled "Year 2000 Project Management Awareness" which alerted senior management and the boards of directors to the serious challenge facing the industry. The advisory indicated that the problem was not merely a technical issue and that top management and the board had to be directly responsible for the implementation of a suggested five-phase management process that included awareness, assessment, renovation, testing and implementation. It also alerted bank directors and senior management about the external risks relating to the Year 2000 readiness of their borrowers, vendors and counterparties. Failure of these third parties to address this issue could easily have an adverse effect on a bank's ability to conduct business. As part of the May advisory we established two particular benchmarks with respect to progress toward compliance. First, it was expected that by September 30, 1997, banks would have completed a thorough inventory of all of their mission critical applications and established a comprehensive plan and priorities for their renovation. This benchmark has passed and so the banking agencies are now increasing supervisory efforts at those few banks that have not completed such an inventory and plan. The second time frame stated that by December 31, 1998, mission critical systems should be largely renovated with testing well underway so that the balance of testing and implementation could be accomplished in 1999. The third banking agency advisory was issued last December affirming the need for thorough periodic reporting of project progress to bank management and more importantly making clear that all banking offices are ultimately responsible for their own readiness, even though they may be heavily dependent on a third-party service provider or a foreign parent for their automated data processing activities. Banks were encouraged to communicate with their vendors or parents to seek a thorough understanding of their ability to service the bank's needs. Banks have also been advised to incorporate Year 2000 credit risk into their underwriting standards and securities trading policies, given that their borrowers or counterparties could experience unresolved processing problems that might hamper their ability to meet their financial obligations on a timely basis. The Federal Reserve has also committed to conduct an examination for Year 2000 readiness of every bank subject to our supervisory authority by June 1998, and we will continue to conduct further Year 2000 examinations right up to the millennium. Well, taking a step back from looking at our initiatives, it's fair to ask, "How well is the industry doing?" Most banks have completed the assessment phase; however, those that missed the September 30, 1997, time frame are going to be the subject of intensive supervisory attention. They are also likely to lag behind their peers when it comes time to test their renovated applications with their counterparties. Accordingly, in some cases, we are issuing notification letters putting lagging banks on notice that the deficiencies in their progress require specific corrective action. Most banks are now in the renovation and testing phases and are finding it more expensive and time consuming to fix and test their systems than they previously estimated. Consequently, many have had to revise their budgets upward and delay the development of new services that would divert limited programming and systems development resources. Some banks have started the validation phase and have confirmed that testing is a costly, cumbersome and time consuming process. As for the final phase of implementation, few banks have advanced this far with any more than a handful of their mission critical systems. Most have a significant amount of testing ahead of them before final implementation can be accomplished. Let's focus for a moment on the testing phase as an excellent example of the magnitude of this process. Testing is one of the more crucial issues being addressed, given that it will consume more than a year and absorb as much as 70 percent of Year 2000 resources. One must focus first on internal testing and the isolation of a test environment to avoid contamination with the current production environment. Then a building block approach starts with one-by-one unit testing of a single application such as demand deposit accounting, then progresses to integration testing, which would apply to a group of applications such as those for all deposit systems for demand, time and savings deposits. Then system testing combines entire systems, which might, for example, cover all automated applications that permit the preparation of the liabilities side of the general ledger. This is often followed by regression testing which checks each variable and all combinations of variables relied on by the various systems to see if any cause a problem. Each application is also subject to external testing that is conducted with a single counter party to confirm compliance with agreed upon protocols and compatibility of different Year 2000 solution techniques that may have been used. In a trading operation, this might mean testing trades with a single counterparty. Then organizations have to test with multiple counterparties and if problems are discovered, it may require further renovation and retesting. Each step is very time consuming and absolutely essential, and it is anticipated that costs associated with getting it done will rise appreciably as strains on labor markets to support such testing grow. The banking agencies are working with the industry to develop guidance on best practices pertaining to testing. In addition, the Federal Reserve will soon be publishing a detailed schedule of testing opportunities for Fedwire, automated clearing house transactions and other services provided by the Federal Reserve. Actual testing will commence at mid-year 1998 and continue throughout 1999. It promises to be a very busy period. The Federal Reserve has been involved with contingency planning and dealing with various types of emergencies for many years. Today is no different in many respects, but the need for Year 2000 readiness raises new concerns that are applicable to all banks, foreign or domestic. One is the risk of contagion. Operating problems at individual banks must not be allowed to spread and become systemic. Many experts have pointed out that counterparties to automated transactions ordinarily do not transmit material whose logic statements can act as a virus and destroy software in a receiving host. On the contrary, most exchanges are simply transmitting data that is ordinarily subject to edits intended to identify any miscalculated date sensitive information. If indeed, the sender has unintentionally transmitted erroneous, miscalculated information and it is identified as such, the recipient rejects the misinformation and is free from the problem which can then be corrected by the sender. So this very important issue should be readily manageable, but managed it must be. On the subject of operating outages, if an automated information system crashes because of a Year 2000 readiness problem, the crash must be prevented from spreading. We know that when electric utilities experience a local problem with the power grid, it has on occasion in the past taken down a wider, regional network. Could this happen with interconnected computer systems? Most professionals argue that the operational outage of one data center need not spread and disable others. Nevertheless, as a bank supervisor concerned about systemic issues, even the remote possibility for operational outages and disruptions to service require all of us to do significant contingency planning. Early in our efforts to address Year 2000 automation issues, we realized contingency planning in the Year 2000 context is made more difficult because operating centers can not fall back to an earlier version of a software package because the earlier version itself may not have been readied for Year 2000. Similarly, a US office of a foreign bank experiencing local problems may not be able to rely on its parent because it is likely that the parent depends on the same software that caused the local problem. So, in order to plan for continuation of services, it may be necessary to provide a complete, alternative service, or a service that can be repaired as a Year 2000 problem is identified. A major interagency contingency planning effort underway addresses a possible federally assisted resolution scenario that might be necessary should a bank experience extensive computer problems. If this were to lead to serious liquidity problems, the chartering authority might deem the bank nonviable, thus necessitating resolution by the FDIC together with other banking agencies that may be involved. It is also necessary for us to consider the legal and policy issues that may pertain to a US office of a foreign bank that is unable to meet its liquidity obligations. Such a case will not lend itself to a simple resolution process. Another concern of the Federal Reserve is the extent to which the industry is so heavily dependent on vendors. As I noted earlier in discussing the most recent advisory to the industry, banks are ultimately responsible for their own operations despite their reliance on third-party service providers. There are many thousands of information systems vendors of one form or another that provide services to federally insured depositories, and obtaining meaningful information on vendor plans and status has proven difficult for the industry and the regulators. If they have not already done so, vendors need to provide very soon their program to renovate and support a product relied on by banks. With sufficient information on vendor plans, banks can prepare their testing strategies. Vendors and banks are realizing that it is advantageous to make vendor plans public on web sites and through other means so that they do not have to repeatedly respond to the same questions from each of their customers. There are important opportunities for banks to work together in this area. By expanding and intensifying interbank cooperative efforts to address Year 2000 issues such as the development of common testing scripts and the sharing of information, the industry can enhance its ability to be prepared in a timely manner. Let me now turn more directly to international initiatives which are likely to be of particular interest here tonight given the extent of business you conduct with customers and banks outside the United States. The Federal Reserve has a keen interest in the readiness of the international community and the special problems facing foreign banks operating branches and agencies in the United States. The Federal Reserve has been involved in active dialogue with bankers and supervisors that have banks in the United States from around the world. We are involved in international visitation programs, conferences and training efforts pertaining to their preparedness efforts. On an interagency basis, the Federal Reserve, the OCC and the FDIC are all represented on the Bank for International Settlements' (BIS) Committee on Banking Supervision, referred to as the Basle Committee. The Federal Reserve is also on the BIS Committee on Payment and Settlement Systems (CPSS) which is presently chaired by William McDonough, President of the Federal Reserve Bank of New York. With the issuance of the US industry advisory in May, the Basle Committee took up the subject, forming a special task force on Year 2000. Subsequently, the G-10 governors issued an advisory on September 8 to all BIS member central banks and bank supervisors for distribution to their respective banks world-wide. It clearly spells out the issues pertaining to the challenge, and I strongly recommend you read it if you have not yet had an opportunity to do so. The Federal Reserve also produced a video entitled "Year 2000 Executive Management Awareness" and distributed it to all bank supervisors responsible for foreign banks that operate in the United States. In so doing, we encouraged foreign bank supervisors to intensify their efforts to address millennium issues in their home countries and to ensure that their banks were taking the necessary steps to ready their operations, including those conducted in the United States. The Federal Reserve and the other banking agencies are making their Year 2000 supervisory material available to domestic and foreign banks, and the general public over the Internet. The Federal Reserve has already distributed about 20,000 copies of our video, many in response to requests from abroad, and our web site hot links to that of the BIS and many other Year 2000 sites world-wide. By widening the availability of information on an international basis, we hope to encourage global readiness. The BIS is also working with the International Organization of Securities Commissioners and the International Association of Insurance Supervisors to address this important issue. Together, they will convene a meeting in April of international financial supervisors and financial organizations to focus on Year 2000 and address issues of concern to all. Based on concerns expressed by banks, the work of the BIS task force and our own inquiries, we believe that certain countries around the world have not embarked on aggressive compliance supervision and examination programs, so that there is a likelihood that banks in those countries have not yet begun to effectively address the problem and will now find it increasingly difficult to be ready. We are concerned that many US offices of foreign banks may be particularly exposed if their parent is not ready for the Year 2000. Therefore, we have asked the US branches and agencies to confirm that they will be able to continue to conduct business using the same standards for readiness that we apply to domestic banks. Those that rely heavily on their parent for information processing and risk management are expected to be able to demonstrate to examiners that these systems are being readied for the Year 2000. Further, Federal Reserve supervision policy calls for direct contact with the parent bank to ensure its awareness of the requirements. When problems are identified, contact with the home country supervisor may also be warranted to coordinate a thorough understanding of the bank's plans for the readiness of its US operations. In so doing, we hope to be better able to address any institutions that have not made sufficient progress toward resolving the issue with their US offices. Given the unique characteristics of a branch operation dependent on a foreign parent that, in turn, is subject to the authority of its home country bank supervisor, the Federal Reserve and other US banking agencies must carefully consider any necessary follow-up with the appropriate international authorities. Compounding our concerns about international readiness are a number of competing initiatives that further stretch the limited resources available to achieve preparedness. In 1999, the euro will be introduced requiring record keeping of financial transactions in a new currency. Extensive planning and programming will be necessary to permit foreign exchange trading and other cross border transactions to be conducted in the euro, with the added complexity of the continued circulation of various national currencies for several years. Of course, banks outside the European Monetary Union that are trading counterparties will also have to program their computers to accommodate the euro. Similarly, plans in Japan call for extensive deregulation of various segments of the financial markets relatively soon. These and any other high priority efforts will exacerbate the problem of preparing for the century date change by competing for limited resources. I suggest that all nations should assess their respective financial initiatives and determine if any opportunities exist to defer projects that can wait until after 2000. We all need to recognize the magnitude and overriding importance of this task and take action to protect vitally needed resources from being diverted to other projects that may be of lesser priority. In closing, let's take a moment to ask what you can do. First of all, be alert to recognize any danger signs in your own organizations and in your counterparties, customers and borrowers. For those of you involved in underwriting and dealing in securities, solid evidence of Year 2000 readiness should be part of your due diligence. You will know you likely have a problem if you hear that the Year 2000 is "not an issue for our shop", or if you hear "we can handle the Year 2000 within the normal planning process without significant budget implications", or if you hear that the Year 2000 "is a technical issue that does not require special attention by senior management and directors". Any of these comments are almost certain to be dead wrong, and probably are tip offs to the presence of dangerous complacency, ignorance, or naivete. You, of the Florida International Bankers Association and the Miami Bond Club, can also help heighten international awareness and action on the matter by ensuring that the policy statements I referred to are widely available in other languages, by discussing them at each opportunity and by building Year 2000 issues into your day-to-day lending and financing business activities, negotiations, contracts, and sales agreements as well as conferences and meetings with various international regulatory authorities. I am sure that many here have close relationships with banks in other countries. Let me urge you to delve deeply into preparations for Year 2000, and if there is evidence of a potential readiness shortfall, do everything in your power to urge the institution to get active very quickly. In so doing, you will advance the cause of readiness throughout the local community and on an international basis as well, while protecting yourself in the process. Hopefully, when the century date change arrives, we will be ready, everything will work effectively, and we will all celebrate the new millennium in a relaxed and unreserved manner. On that positive note, let me close by saying that I truly appreciate the opportunity to address the Florida International Bankers Association and the Miami Bond Club, and that I don't look forward to going back to the cold reaches of Washington tomorrow.
1998-02-24T00:00:00	Mr. Greenspan presents the Federal Reserve's semi-annual Humphrey Hawkins monetary policy testimony and report to the US Congress (Central Bank Articles and Speeches, 24 Feb 98)	Testimony of the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the US Congress on 24/2/98.	Mr. Greenspan presents the Federal Reserve's semi-annual Humphrey Hawkins Testimony of the Chairman of the monetary policy testimony and report to the US Congress Board of the US Federal Reserve System, Mr. Alan Greenspan, before the US Congress on 24/2/98. Mr. Chairman and members of the Committee, I welcome this opportunity to present the Federal Reserve's semi-annual report on economic conditions and the conduct of monetary policy. The US Economy in 1997 The US economy delivered another exemplary performance in 1997. Over the four quarters of last year, real GDP expanded close to 4 percent, its fastest annual increase in ten years. To produce that higher output, about 3 million Americans joined the nation's payrolls, in the process contributing to a reduction in the unemployment rate to 43⁄4 percent, its lowest sustained level since the late 1960s. And our factories were working more intensively too: Industrial production increased 53⁄4 percent last year, exceeding robust additions to capacity. Those gains were shared widely. The hourly wage and salary structure rose about 4 percent, fueling impressive increases in personal incomes. Unlike some prior episodes when faster wage rate increases mainly reflected attempts to make up for more rapidly rising prices of goods and services, the fatter paychecks that workers brought home represented real increments to purchasing power. Measured consumer price inflation came in at 13⁄4 percent over the twelve months of 1997, down about 11⁄2 percentage points from the pace of the prior year. While swings in the prices of food and fuel contributed to this decline, both narrower price indexes excluding those items and broader ones including all goods and services produced in the United States also paint a portrait of continued progress toward price stability. Businesses, for the most part, were able to pay these higher real wages while still increasing their earnings. Although aggregate data on profits for all of 1997 are not yet available, corporate profit margins most likely remained in an elevated range not seen consistently since the 1960s. These healthy gains in earnings and the expectations of more to come provided important support to the equity market, with most major stock price indexes gaining more than 20 percent over the year. The strong growth of the real income of workers and corporations is not unrelated to the economy's continued good performance on inflation. Taken together, recent evidence supports the view that such low inflation, as closely approaching price stability as we have known in the United States in three decades, engenders many benefits. When changes in the general price level are small and predictable, households and firms can plan more securely for the future. The perception of reduced risk encourages investment. Low inflation also exerts a discipline on costs, fostering efforts to enhance productivity. Productivity is the ultimate source of rising standards of living, and we witnessed a notable pickup in this measure in the past two years. The robust economy has facilitated the efforts of the Congress and the Administration to restore balance in the unified federal budget. As I have indicated to the Congress on numerous occasions, moving beyond this point and putting the budget in significant surplus would be the surest and most direct way of increasing national saving. In turn, higher national saving, by promoting lower real long-term interest rates, helps spur spending to outfit American firms and their workers with the modern equipment they need to compete successfully on world markets. We have seen a partial down payment of the benefits of better budget balance already: It seems reasonable to assume that the decline in longer-term Treasury yields last year owed, in part, to reduced competition -current and prospective -- from the federal government for scarce private saving. However, additional effort remains to be exerted to address the effects on federal entitlement spending of the looming shift within the next decade in the nation's retirement demographics. As I noted earlier, our nation has been experiencing a higher growth rate of productivity -- output per hour worked -- in recent years. The dramatic improvements in computing power and communication and information technology appear to have been a major force behind this beneficial trend. Those innovations, together with fierce competitive pressures in our high-tech industries to make them available to as many homes, offices, stores, and shop floors as possible, have produced double-digit annual reductions in prices of capital goods embodying new technologies. Indeed, many products considered to be at the cutting edge of technology as recently as two to three years ago have become so standardized and inexpensive that they have achieved near " commodity" status, a development that has allowed businesses to accelerate their accumulation of more and better capital. Critical to this process has been the rapidly increasing efficiency of our financial markets -- itself a product of the new technologies and of significant market deregulation over the years. Capital now flows with relatively little friction to projects embodying new ideas. Silicon Valley is a tribute both to American ingenuity and to the financial system's ever-increasing ability to supply venture capital to the entrepreneurs who are such a dynamic force in our economy. With new high-tech tools, American businesses have shaved transportation costs, managed their production and use of inventories more efficiently, and broadened market opportunities. The threat of rising costs in tight labor markets has imparted a substantial impetus to efforts to take advantage of possible efficiencies. In my Humphrey-Hawkins testimony last July, I discussed the likelihood that the sharp acceleration in capital investment in advanced technologies beginning in 1993 reflected synergies of new ideas, embodied in increasingly inexpensive new equipment, that have elevated expected returns and have broadened investment opportunities. More recent evidence remains consistent with the view that this capital spending has contributed to a noticeable pickup in productivity -- and probably by more than can be explained by usual business cycle forces. For one, the combination of continued low inflation and stable to rising domestic profit margins implies quite subdued growth in total consolidated unit business costs. With labor costs constituting more than two-thirds of those costs and labor compensation per hour accelerating, productivity must be growing faster, and that step-up must be roughly in line with the increase in compensation growth. For another, our more direct observations on output per hour roughly tend to confirm that productivity has picked up significantly in recent years, although how much the ongoing trend of productivity has risen remains an open question. The acceleration in productivity, however, has been exceeded by the strengthening of demand for goods and services. As a consequence, employers had to expand payrolls at a pace well in excess of the growth of the working age population that profess a desire for a job, including new immigrants. As I pointed out last year in testimony before the Congress, that gap has been accommodated by declines in both the officially unemployed and those not actively seeking work but desirous of working. The number of people in those two categories decreased at a rate of about one million per year on average over the last four years. By December 1997, the sum had declined to a seasonally adjusted 101⁄2 million, or 6 percent of the working age population, the lowest ratio since detailed information on this series first became available in 1970. Anecdotal information from surveys of our twelve Reserve Banks attests to our ever tightening labor markets. Rapidly rising demand for labor has had enormous beneficial effects on our work force. Previously low- or unskilled workers have been drawn into the job market and have obtained training and experience that will help them even if they later change jobs. Large numbers of underemployed have been moved up the career ladder to match their underlying skills, and many welfare recipients have been added to payrolls as well, to the benefit of their long-term job prospects. The recent acceleration of wages likely has owed in part to the ever-tightening labor market and in part to rising productivity growth, which, through competition, induces firms to grant higher wages. It is difficult at this time, however, to disentangle the relative contributions of these factors. What is clear is that, unless demand growth softens or productivity growth accelerates even more, we will gradually run out of new workers who can be profitably employed. It is not possible to tell how many more of the 6 percent of the working-age population who want to work but do not have jobs can be added to payrolls. A significant number are so-called frictionally unemployed, as they have left one job but not yet chosen to accept another. Still others have chosen to work in only a limited geographic area where their skills may not be needed. Should demand for new workers continue to exceed new supply, we would expect wage gains increasingly to exceed productivity growth, squeezing profit margins and eventually leading to a pickup in inflation. Were a substantial pickup in inflation to occur, it could, by stunting economic growth, reverse much of the remarkable labor market progress of recent years. I will be discussing our assessment of these and other possibilities and their bearing on the outlook for 1998 shortly. Monetary Policy in 1997 History teaches us that monetary policy has been its most effective when it has been pre-emptive. The lagging relationship between the Federal Reserve's policy instrument and spending, and, even further removed, inflation, implies that if policy actions are delayed until prices begin to pick up, they will be too late to fend off at least some persistent price acceleration and attendant economic instabilities. Preemptive policymaking is keyed to judging how widespread are emerging inflationary forces, and when, and to what degree, those forces will be reflected in actual inflation. For most of last year, the evident strains on resources were sufficiently severe to steer the Federal Open Market Committee (FOMC) toward being more inclined to tighten than to ease monetary policy. Indeed, in March, when it became apparent that strains on resources seemed to be intensifying, the FOMC imposed modest incremental restraint, raising its intended federal funds rate 1⁄4 percentage point, to 51⁄2 percent. We did not increase the federal funds rate again during the summer and fall, despite further tightening of the labor market. Even though the labor market heated up and labor compensation rose, measured inflation fell, owing to the appreciation of the dollar, weakness in international commodity prices, and faster productivity growth. Those restraining forces were more evident in goods-price inflation, which in the CPI slowed substantially to only about 1⁄2 percent in 1997, than on service-price inflation, which moderated much less -- to around 3 percent. Providers of services appeared to be more pressed by mounting strains in labor markets. Hourly wages and salaries in service-producing sectors rose 41⁄2 percent last year, up considerably from the prior year and almost 11⁄2 percentage points faster than in goods-producing sectors. However, a significant portion of that differential, but by no means all, traced to commissions in the financial and real estate services sector related to one-off increases in transactions prices and in volumes of activity, rather than to increases in the underlying wage structure. Although the nominal federal funds rate was maintained after March, the apparent drop in inflation expectations over the balance of 1997 induced some firming in the stance of monetary policy by one important measure -- the real federal funds rate, or the nominal federal funds rate less a proxy for inflation expectations. Some analysts have dubbed the contribution of the reduction in inflation expectations to raising the real federal funds rate a " passive" tightening, in that it increased the amount of monetary policy restraint in place without an explicit vote by the FOMC. While the tightening may have been passive in that sense, it was by no means inadvertent. Members of the FOMC took some comfort in the upward trend of the real federal funds rate over the year and the rise in the foreign exchange value of the dollar because such additional restraint was viewed as appropriate given the strength of spending and building strains on labor resources. They also recognized that in virtually all other respects financial markets remained quite accommodative and, indeed, judging by the rise in equity prices, were providing additional impetus to domestic spending. The Outlook for 1998 There can be no doubt that domestic demand retained considerable momentum at the outset of this year. Production and employment have been on a strong uptrend in recent months. Confident households, enjoying gains in income and wealth and benefitting from the reductions in intermediate- and longer-term interest rates to date, should continue to increase their spending. Firms should find financing available on relatively attractive terms to fund profitable opportunities to enhance efficiency by investing in new capital equipment. By itself, this strength in spending would seem to presage intensifying pressures in labor markets and on prices. Yet, the outlook for total spending on goods and services produced in the United States is less assured of late because of storm clouds massing over the Western Pacific and heading our way. This is not the place to examine in detail what triggered the initial problems in Asian financial markets and why the subsequent deterioration has been so extreme. I covered that subject recently before several committees of the Congress. Rather, I shall confine my discussion this morning to the likely consequences of the Asian crisis for demand and inflation in the United States. With the crisis curtailing the financing available in foreign currencies, many Asian economies have had no choice but to cut back their imports sharply. Disruptions to their financial systems and economies more generally will further damp demands for our exports of goods and services. American exports should be held down as well by the appreciation of the dollar, which will make the prices of competing goods produced abroad more attractive, just as foreign-produced goods will be relatively more attractive to buyers here at home. As a result, we can expect a worsening net export position to exert a discernible drag on total output in the United States. For a time, such restraint might be reinforced by a reduced willingness of US firms to accumulate inventories as they foresee weaker demand ahead. The forces of Asian restraint could well be providing another, more direct offset to inflationary impulses arising domestically in the United States. In the wake of weakness in Asian economies and of lagged effects of the appreciation of the dollar more generally, the dollar prices of our non-oil imports are likely to decline further in the months ahead. These lower import prices are apparently already making domestic producers hesitant to raise their own prices for fear of losing market share, further contributing to the restraint on overall prices. Lesser demands for raw materials on the part of Asian economies as their activity slows should help to keep world commodity prices denominated in dollars in check. Import and commodity prices, however, will restrain US inflation only as long as they continue to fall, or to rise at a slower rate than the pace of overall domestic product prices. The key question going forward is whether the restraint building from the turmoil in Asia will be sufficient to check inflationary tendencies that might otherwise result from the strength of domestic spending and tightening labor markets. The depth of the adjustment abroad will depend on the extent of weakness in the financial sectors of Asian economies and the speed with which structural inefficiencies in the financial and nonfinancial sectors of those economies are corrected. If, as we suspect, the restraint coming from Asia is sufficient to bring the demand for American labor back into line with the growth of the working-age population desirous of working, labor markets will remain unusually tight, but any intensification of inflation should be delayed, very gradual, and readily reversible. However, we cannot rule out two other, more worrisome possibilities. On the one hand, should the momentum to domestic spending not be offset significantly by Asian or other developments, the US economy would be on a track along which spending could press too strongly against available resources to be consistent with contained inflation. On the other, we also need to be alert to the possibility that the forces from Asia might damp activity and prices by more than is desirable by exerting a particularly forceful drag on the volume of net exports and the prices of imports. When confronted at the beginning of this month with these, for the moment, finely balanced, though powerful forces, the members of the Federal Open Market Committee decided that monetary policy should most appropriately be kept on hold. With the continuation of a remarkable seven-year expansion at stake and so little precedent to go by, the range of our intelligence gathering in the weeks ahead must be wide and especially inclusive of international developments. The Forecasts of the Governors of the Federal Reserve Board and the Presidents of the Federal Reserve Banks. In these circumstances, the forecasts of the governors of the Federal Reserve Board and presidents of the Federal Reserve Banks for the performance of the US economy over this year are more tentative than usual. Based on information available through the first week of February, monetary policymakers were generally of the view that moderate economic growth is likely in store. The growth rate of real GDP is most commonly seen as between 2 and 23⁄4 percent over the four quarters of 1998. Given the strong performance of real GDP, these projections envisage the unemployment rate remaining in the low range of the past half year. Inflation, as measured by the four-quarter percent change in the consumer price index, is expected to be 13⁄4 to 21⁄4 percent in 1998 -- near the low rate recorded in 1997. This outlook embodies the expectation that the effects of continuing tightness in labor markets will be largely offset by technical adjustments shaving a couple tenths from the published CPI, healthy productivity growth, flat or declining import prices, and little pressure in commodity markets. But the policymakers' forecasts also reflect their determination to hold the line on inflation. The Ranges for the Debt and Monetary Aggregates The FOMC affirmed the provisional ranges for the monetary aggregates in 1998 that it had selected last July, which, once again, encompass the growth rates associated with conditions of approximate price stability, provided that these aggregates act in accord with their pre-1990s historical relationships with nominal income and interest rates. These ranges are identical to those that had prevailed for 1997 -- 1 to 5 percent for M2 and 2 to 6 percent for M3. The FOMC also reaffirmed its range of 3 to 7 percent for the debt of the domestic nonfinancial sectors for this year. I should caution, though, that the expectations of the governors and Reserve Bank presidents for the expansion of nominal GDP in 1998 suggest that growth of M2 in the upper half of its benchmark range is a distinct possibility this year. Given the continuing strength of bank credit, M3 might even be above its range as depositories use liabilities in this aggregate to fund loan growth and securities acquisitions. Nonfinancial debt should come in around the middle portion of its range. In the first part of the 1990s, money growth diverged from historical relationships with income and interest rates, in part as savers diversified into bond and stock mutual funds, which had become more readily available and whose returns were considerably more attractive than those on deposits. This anomalous behavior of velocity severely set back most analysts' confidence in the usefulness of M2 as an indicator of economic developments. In recent years, there have been tentative signs that the historical relationship linking the velocity of M2 -- measured as the ratio of nominal GDP to the money stock -- to the cost of holding M2 assets was reasserting itself. However, a persistent residual upward drift in velocity over the past few years and its apparent cessation very recently underscores our ongoing uncertainty about the stability of this relationship. The FOMC will continue to observe the evolution of the monetary and credit aggregates carefully, integrating information about these variables with a wide variety of other information in determining its policy stance. Uncertainty about the Outlook With the current situation reflecting a balance of strong countervailing forces, events in the months ahead are not likely to unfold smoothly. In that regard, I would like to flag a few areas of concern about the economy beyond those mentioned already regarding Asian developments. Without doubt, lenders have provided important support to spending in the past few years by their willingness to transact at historically small margins and in large volumes. Equity investors have contributed as well by apparently pricing in the expectation of substantial earnings gains and requiring modest compensation for the risk that those expectations could be mistaken. Approaching the eighth year of the economic expansion, this is understandable in an economic environment that, contrary to historical experience, has become increasingly benign. Businesses have been meeting obligations readily and generating high profits, putting them in outstanding financial health. But we must be concerned about becoming too complacent about evaluating repayment risks. All too often at this stage of the business cycle, the loans that banks extend later make up a disproportionate share of total nonperforming loans. In addition, quite possibly, twelve or eighteen months hence, some of the securities purchased on the market could be looked upon with some regret by investors. As one of the nation's bank supervisors, the Federal Reserve will make every effort to encourage banks to apply sound underwriting standards in their lending. Prudent lenders should consider a wide range of economic situations in evaluating credit; to do otherwise would risk contributing to potentially disruptive financial problems down the road. A second area of concern involves our nation's continuing role in the new high-tech international financial system. By joining with our major trading partners and international financial institutions in helping to stabilize the economies of Asia and promoting needed structural changes, we are also encouraging the continued expansion of world trade and global economic and financial stability on which the ongoing increase of our own standards of living depends. If we were to cede our role as a world leader, or backslide into protectionist policies, we would threaten the source of much of our own sustained economic growth. A third risk is complacency about inflation prospects. The combination and interaction of significant increases in productivity-improving technologies, sharp declines in budget deficits, and disciplined monetary policy has damped product price changes, bringing them to near stability. While part of this result owes to good policy, part is the product of the fortuitous emergence of new technologies and of some favorable price developments in imported goods. However, as history counsels, it is unwise to count on any string of good fortune to continue indefinitely. At the same time, though, it is also instructive to remember the words of an old sage that "luck is the residue of design". He meant that to some degree we can deliberately put ourselves in position to experience good fortune and be better prepared when misfortune strikes. For example, the 1970s were marked by two major oil-price shocks and a significant depreciation in the exchange value of the dollar. But those misfortunes were, in part, the result of allowing imbalances to build over the decade as policymakers lost hold of the anchor provided by price stability. Some of what we now see helping rein in inflation pressures is more likely to occur in an environment of stable prices and price expectations that thwarts producers from indiscriminately passing on higher costs, puts a premium on productivity enhancement, and rewards more effectively investment in physical and human capital. Simply put, while the pursuit of price stability does not rule out misfortune, it lowers its probability. If firms are convinced that the general price level will remain stable, they will reserve increases in their sales prices of goods and services as a last resort, for fear that such increases could mean loss of market share. Similarly, if households are convinced of price stability, they will not see variations in relative prices as reasons to change their long-run inflation expectations. Thus, continuing to make progress toward this legislated objective will make future supply shocks less likely and our nation's economy less vulnerable to those that occur.	---[PAGE_BREAK]--- # Mr. Greenspan presents the Federal Reserve's semi-annual Humphrey Hawkins monetary policy testimony and report to the US Congress Testimony of the Chairman of the Board of the US Federal Reserve System, Mr. Alan Greenspan, before the US Congress on 24/2/98. Mr. Chairman and members of the Committee, I welcome this opportunity to present the Federal Reserve's semi-annual report on economic conditions and the conduct of monetary policy. ## The US Economy in 1997 The US economy delivered another exemplary performance in 1997. Over the four quarters of last year, real GDP expanded close to 4 percent, its fastest annual increase in ten years. To produce that higher output, about 3 million Americans joined the nation's payrolls, in the process contributing to a reduction in the unemployment rate to $43 / 4$ percent, its lowest sustained level since the late 1960s. And our factories were working more intensively too: Industrial production increased $53 / 4$ percent last year, exceeding robust additions to capacity. Those gains were shared widely. The hourly wage and salary structure rose about 4 percent, fueling impressive increases in personal incomes. Unlike some prior episodes when faster wage rate increases mainly reflected attempts to make up for more rapidly rising prices of goods and services, the fatter paychecks that workers brought home represented real increments to purchasing power. Measured consumer price inflation came in at $13 / 4$ percent over the twelve months of 1997, down about $11 / 2$ percentage points from the pace of the prior year. While swings in the prices of food and fuel contributed to this decline, both narrower price indexes excluding those items and broader ones including all goods and services produced in the United States also paint a portrait of continued progress toward price stability. Businesses, for the most part, were able to pay these higher real wages while still increasing their earnings. Although aggregate data on profits for all of 1997 are not yet available, corporate profit margins most likely remained in an elevated range not seen consistently since the 1960s. These healthy gains in earnings and the expectations of more to come provided important support to the equity market, with most major stock price indexes gaining more than 20 percent over the year. The strong growth of the real income of workers and corporations is not unrelated to the economy's continued good performance on inflation. Taken together, recent evidence supports the view that such low inflation, as closely approaching price stability as we have known in the United States in three decades, engenders many benefits. When changes in the general price level are small and predictable, households and firms can plan more securely for the future. The perception of reduced risk encourages investment. Low inflation also exerts a discipline on costs, fostering efforts to enhance productivity. Productivity is the ultimate source of rising standards of living, and we witnessed a notable pickup in this measure in the past two years. The robust economy has facilitated the efforts of the Congress and the Administration to restore balance in the unified federal budget. As I have indicated to the Congress on numerous occasions, moving beyond this point and putting the budget in significant surplus would be the surest and most direct way of increasing national saving. In turn, higher national saving, by promoting lower real long-term interest rates, helps spur spending to outfit American firms and their workers with the modern equipment they need to compete successfully on world markets. We have seen a partial down payment of the benefits of better budget balance already: It seems reasonable to assume that the decline in longer-term Treasury yields last year owed, in part, to reduced competition -current and prospective -- from the federal government for scarce private saving. However, additional effort remains to be exerted to address the effects on federal entitlement spending of the looming shift within the next decade in the nation's retirement demographics. ---[PAGE_BREAK]--- As I noted earlier, our nation has been experiencing a higher growth rate of productivity -- output per hour worked -- in recent years. The dramatic improvements in computing power and communication and information technology appear to have been a major force behind this beneficial trend. Those innovations, together with fierce competitive pressures in our high-tech industries to make them available to as many homes, offices, stores, and shop floors as possible, have produced double-digit annual reductions in prices of capital goods embodying new technologies. Indeed, many products considered to be at the cutting edge of technology as recently as two to three years ago have become so standardized and inexpensive that they have achieved near " commodity" status, a development that has allowed businesses to accelerate their accumulation of more and better capital. Critical to this process has been the rapidly increasing efficiency of our financial markets -- itself a product of the new technologies and of significant market deregulation over the years. Capital now flows with relatively little friction to projects embodying new ideas. Silicon Valley is a tribute both to American ingenuity and to the financial system's ever-increasing ability to supply venture capital to the entrepreneurs who are such a dynamic force in our economy. With new high-tech tools, American businesses have shaved transportation costs, managed their production and use of inventories more efficiently, and broadened market opportunities. The threat of rising costs in tight labor markets has imparted a substantial impetus to efforts to take advantage of possible efficiencies. In my Humphrey-Hawkins testimony last July, I discussed the likelihood that the sharp acceleration in capital investment in advanced technologies beginning in 1993 reflected synergies of new ideas, embodied in increasingly inexpensive new equipment, that have elevated expected returns and have broadened investment opportunities. More recent evidence remains consistent with the view that this capital spending has contributed to a noticeable pickup in productivity -- and probably by more than can be explained by usual business cycle forces. For one, the combination of continued low inflation and stable to rising domestic profit margins implies quite subdued growth in total consolidated unit business costs. With labor costs constituting more than two-thirds of those costs and labor compensation per hour accelerating, productivity must be growing faster, and that step-up must be roughly in line with the increase in compensation growth. For another, our more direct observations on output per hour roughly tend to confirm that productivity has picked up significantly in recent years, although how much the ongoing trend of productivity has risen remains an open question. The acceleration in productivity, however, has been exceeded by the strengthening of demand for goods and services. As a consequence, employers had to expand payrolls at a pace well in excess of the growth of the working age population that profess a desire for a job, including new immigrants. As I pointed out last year in testimony before the Congress, that gap has been accommodated by declines in both the officially unemployed and those not actively seeking work but desirous of working. The number of people in those two categories decreased at a rate of about one million per year on average over the last four years. By December 1997, the sum had declined to a seasonally adjusted $101 / 2$ million, or 6 percent of the working age population, the lowest ratio since detailed information on this series first became available in 1970. Anecdotal information from surveys of our twelve Reserve Banks attests to our ever tightening labor markets. Rapidly rising demand for labor has had enormous beneficial effects on our work force. Previously low- or unskilled workers have been drawn into the job market and have obtained training and experience that will help them even if they later change jobs. Large numbers of underemployed have been moved up the career ladder to match their underlying skills, and many welfare recipients have been added to payrolls as well, to the benefit of their long-term job prospects. ---[PAGE_BREAK]--- The recent acceleration of wages likely has owed in part to the ever-tightening labor market and in part to rising productivity growth, which, through competition, induces firms to grant higher wages. It is difficult at this time, however, to disentangle the relative contributions of these factors. What is clear is that, unless demand growth softens or productivity growth accelerates even more, we will gradually run out of new workers who can be profitably employed. It is not possible to tell how many more of the 6 percent of the working-age population who want to work but do not have jobs can be added to payrolls. A significant number are so-called frictionally unemployed, as they have left one job but not yet chosen to accept another. Still others have chosen to work in only a limited geographic area where their skills may not be needed. Should demand for new workers continue to exceed new supply, we would expect wage gains increasingly to exceed productivity growth, squeezing profit margins and eventually leading to a pickup in inflation. Were a substantial pickup in inflation to occur, it could, by stunting economic growth, reverse much of the remarkable labor market progress of recent years. I will be discussing our assessment of these and other possibilities and their bearing on the outlook for 1998 shortly. # Monetary Policy in 1997 History teaches us that monetary policy has been its most effective when it has been pre-emptive. The lagging relationship between the Federal Reserve's policy instrument and spending, and, even further removed, inflation, implies that if policy actions are delayed until prices begin to pick up, they will be too late to fend off at least some persistent price acceleration and attendant economic instabilities. Preemptive policymaking is keyed to judging how widespread are emerging inflationary forces, and when, and to what degree, those forces will be reflected in actual inflation. For most of last year, the evident strains on resources were sufficiently severe to steer the Federal Open Market Committee (FOMC) toward being more inclined to tighten than to ease monetary policy. Indeed, in March, when it became apparent that strains on resources seemed to be intensifying, the FOMC imposed modest incremental restraint, raising its intended federal funds rate $1 / 4$ percentage point, to $51 / 2$ percent. We did not increase the federal funds rate again during the summer and fall, despite further tightening of the labor market. Even though the labor market heated up and labor compensation rose, measured inflation fell, owing to the appreciation of the dollar, weakness in international commodity prices, and faster productivity growth. Those restraining forces were more evident in goods-price inflation, which in the CPI slowed substantially to only about $1 / 2$ percent in 1997, than on service-price inflation, which moderated much less -- to around 3 percent. Providers of services appeared to be more pressed by mounting strains in labor markets. Hourly wages and salaries in service-producing sectors rose $41 / 2$ percent last year, up considerably from the prior year and almost $11 / 2$ percentage points faster than in goods-producing sectors. However, a significant portion of that differential, but by no means all, traced to commissions in the financial and real estate services sector related to one-off increases in transactions prices and in volumes of activity, rather than to increases in the underlying wage structure. Although the nominal federal funds rate was maintained after March, the apparent drop in inflation expectations over the balance of 1997 induced some firming in the stance of monetary policy by one important measure -- the real federal funds rate, or the nominal federal funds rate less a proxy for inflation expectations. Some analysts have dubbed the contribution of the reduction in inflation expectations to raising the real federal funds rate a " passive" tightening, in that it increased the amount of monetary policy restraint in place without an explicit vote by the FOMC. While the tightening may have been passive in that sense, it was by no means inadvertent. Members of the FOMC took some comfort in the upward trend of the real federal funds rate over the year and the rise in the foreign exchange value of the dollar because such additional restraint was viewed as ---[PAGE_BREAK]--- appropriate given the strength of spending and building strains on labor resources. They also recognized that in virtually all other respects financial markets remained quite accommodative and, indeed, judging by the rise in equity prices, were providing additional impetus to domestic spending. # The Outlook for 1998 There can be no doubt that domestic demand retained considerable momentum at the outset of this year. Production and employment have been on a strong uptrend in recent months. Confident households, enjoying gains in income and wealth and benefitting from the reductions in intermediate- and longer-term interest rates to date, should continue to increase their spending. Firms should find financing available on relatively attractive terms to fund profitable opportunities to enhance efficiency by investing in new capital equipment. By itself, this strength in spending would seem to presage intensifying pressures in labor markets and on prices. Yet, the outlook for total spending on goods and services produced in the United States is less assured of late because of storm clouds massing over the Western Pacific and heading our way. This is not the place to examine in detail what triggered the initial problems in Asian financial markets and why the subsequent deterioration has been so extreme. I covered that subject recently before several committees of the Congress. Rather, I shall confine my discussion this morning to the likely consequences of the Asian crisis for demand and inflation in the United States. With the crisis curtailing the financing available in foreign currencies, many Asian economies have had no choice but to cut back their imports sharply. Disruptions to their financial systems and economies more generally will further damp demands for our exports of goods and services. American exports should be held down as well by the appreciation of the dollar, which will make the prices of competing goods produced abroad more attractive, just as foreign-produced goods will be relatively more attractive to buyers here at home. As a result, we can expect a worsening net export position to exert a discernible drag on total output in the United States. For a time, such restraint might be reinforced by a reduced willingness of US firms to accumulate inventories as they foresee weaker demand ahead. The forces of Asian restraint could well be providing another, more direct offset to inflationary impulses arising domestically in the United States. In the wake of weakness in Asian economies and of lagged effects of the appreciation of the dollar more generally, the dollar prices of our non-oil imports are likely to decline further in the months ahead. These lower import prices are apparently already making domestic producers hesitant to raise their own prices for fear of losing market share, further contributing to the restraint on overall prices. Lesser demands for raw materials on the part of Asian economies as their activity slows should help to keep world commodity prices denominated in dollars in check. Import and commodity prices, however, will restrain US inflation only as long as they continue to fall, or to rise at a slower rate than the pace of overall domestic product prices. The key question going forward is whether the restraint building from the turmoil in Asia will be sufficient to check inflationary tendencies that might otherwise result from the strength of domestic spending and tightening labor markets. The depth of the adjustment abroad will depend on the extent of weakness in the financial sectors of Asian economies and the speed with which structural inefficiencies in the financial and nonfinancial sectors of those economies are corrected. If, as we suspect, the restraint coming from Asia is sufficient to bring the demand for American labor back into line with the growth of the working-age population desirous of working, labor markets will remain unusually tight, but any intensification of inflation should be delayed, very gradual, and readily reversible. However, we cannot rule out two other, more worrisome possibilities. On the one hand, should the momentum to domestic spending not be offset significantly by Asian or other developments, the US economy would be on a track along which spending could press too strongly ---[PAGE_BREAK]--- against available resources to be consistent with contained inflation. On the other, we also need to be alert to the possibility that the forces from Asia might damp activity and prices by more than is desirable by exerting a particularly forceful drag on the volume of net exports and the prices of imports. When confronted at the beginning of this month with these, for the moment, finely balanced, though powerful forces, the members of the Federal Open Market Committee decided that monetary policy should most appropriately be kept on hold. With the continuation of a remarkable seven-year expansion at stake and so little precedent to go by, the range of our intelligence gathering in the weeks ahead must be wide and especially inclusive of international developments. The Forecasts of the Governors of the Federal Reserve Board and the Presidents of the Federal Reserve Banks. In these circumstances, the forecasts of the governors of the Federal Reserve Board and presidents of the Federal Reserve Banks for the performance of the US economy over this year are more tentative than usual. Based on information available through the first week of February, monetary policymakers were generally of the view that moderate economic growth is likely in store. The growth rate of real GDP is most commonly seen as between 2 and $23 / 4$ percent over the four quarters of 1998. Given the strong performance of real GDP, these projections envisage the unemployment rate remaining in the low range of the past half year. Inflation, as measured by the four-quarter percent change in the consumer price index, is expected to be $13 / 4$ to $21 / 4$ percent in 1998 -- near the low rate recorded in 1997. This outlook embodies the expectation that the effects of continuing tightness in labor markets will be largely offset by technical adjustments shaving a couple tenths from the published CPI, healthy productivity growth, flat or declining import prices, and little pressure in commodity markets. But the policymakers' forecasts also reflect their determination to hold the line on inflation. # The Ranges for the Debt and Monetary Aggregates The FOMC affirmed the provisional ranges for the monetary aggregates in 1998 that it had selected last July, which, once again, encompass the growth rates associated with conditions of approximate price stability, provided that these aggregates act in accord with their pre-1990s historical relationships with nominal income and interest rates. These ranges are identical to those that had prevailed for 1997 -- 1 to 5 percent for M2 and 2 to 6 percent for M3. The FOMC also reaffirmed its range of 3 to 7 percent for the debt of the domestic nonfinancial sectors for this year. I should caution, though, that the expectations of the governors and Reserve Bank presidents for the expansion of nominal GDP in 1998 suggest that growth of M2 in the upper half of its benchmark range is a distinct possibility this year. Given the continuing strength of bank credit, M3 might even be above its range as depositories use liabilities in this aggregate to fund loan growth and securities acquisitions. Nonfinancial debt should come in around the middle portion of its range. In the first part of the 1990s, money growth diverged from historical relationships with income and interest rates, in part as savers diversified into bond and stock mutual funds, which had become more readily available and whose returns were considerably more attractive than those on deposits. This anomalous behavior of velocity severely set back most analysts' confidence in the usefulness of M2 as an indicator of economic developments. In recent years, there have been tentative signs that the historical relationship linking the velocity of M2 -- measured as the ratio of nominal GDP to the money stock -- to the cost of holding M2 assets was reasserting itself. However, a persistent residual upward drift in velocity over the past few years and its apparent cessation very recently underscores our ongoing uncertainty about the stability of this relationship. The FOMC will continue to observe the evolution of the monetary and credit aggregates carefully, integrating information about these variables with a wide variety of other information in determining its policy stance. ---[PAGE_BREAK]--- # Uncertainty about the Outlook With the current situation reflecting a balance of strong countervailing forces, events in the months ahead are not likely to unfold smoothly. In that regard, I would like to flag a few areas of concern about the economy beyond those mentioned already regarding Asian developments. Without doubt, lenders have provided important support to spending in the past few years by their willingness to transact at historically small margins and in large volumes. Equity investors have contributed as well by apparently pricing in the expectation of substantial earnings gains and requiring modest compensation for the risk that those expectations could be mistaken. Approaching the eighth year of the economic expansion, this is understandable in an economic environment that, contrary to historical experience, has become increasingly benign. Businesses have been meeting obligations readily and generating high profits, putting them in outstanding financial health. But we must be concerned about becoming too complacent about evaluating repayment risks. All too often at this stage of the business cycle, the loans that banks extend later make up a disproportionate share of total nonperforming loans. In addition, quite possibly, twelve or eighteen months hence, some of the securities purchased on the market could be looked upon with some regret by investors. As one of the nation's bank supervisors, the Federal Reserve will make every effort to encourage banks to apply sound underwriting standards in their lending. Prudent lenders should consider a wide range of economic situations in evaluating credit; to do otherwise would risk contributing to potentially disruptive financial problems down the road. A second area of concern involves our nation's continuing role in the new high-tech international financial system. By joining with our major trading partners and international financial institutions in helping to stabilize the economies of Asia and promoting needed structural changes, we are also encouraging the continued expansion of world trade and global economic and financial stability on which the ongoing increase of our own standards of living depends. If we were to cede our role as a world leader, or backslide into protectionist policies, we would threaten the source of much of our own sustained economic growth. A third risk is complacency about inflation prospects. The combination and interaction of significant increases in productivity-improving technologies, sharp declines in budget deficits, and disciplined monetary policy has damped product price changes, bringing them to near stability. While part of this result owes to good policy, part is the product of the fortuitous emergence of new technologies and of some favorable price developments in imported goods. However, as history counsels, it is unwise to count on any string of good fortune to continue indefinitely. At the same time, though, it is also instructive to remember the words of an old sage that "luck is the residue of design". He meant that to some degree we can deliberately put ourselves in position to experience good fortune and be better prepared when misfortune strikes. For example, the 1970s were marked by two major oil-price shocks and a significant depreciation in the exchange value of the dollar. But those misfortunes were, in part, the result of allowing imbalances to build over the decade as policymakers lost hold of the anchor provided by price stability. Some of what we now see helping rein in inflation pressures is more likely to occur in an environment of stable prices and price expectations that thwarts producers from indiscriminately passing on higher costs, puts a premium on productivity enhancement, and rewards more effectively investment in physical and human capital. Simply put, while the pursuit of price stability does not rule out misfortune, it lowers its probability. If firms are convinced that the general price level will remain stable, they will reserve increases in their sales prices of goods and services as a last resort, for fear that such increases could mean loss of market share. Similarly, if households are convinced of price stability, they will not see variations in relative prices as reasons to change their long-run inflation expectations. Thus, ---[PAGE_BREAK]--- continuing to make progress toward this legislated objective will make future supply shocks less likely and our nation's economy less vulnerable to those that occur.	Alan Greenspan	United States	https://www.bis.org/review/r980304c.pdf	Mr. Chairman and members of the Committee, I welcome this opportunity to present the Federal Reserve's semi-annual report on economic conditions and the conduct of monetary policy. The US economy delivered another exemplary performance in 1997. Over the four quarters of last year, real GDP expanded close to 4 percent, its fastest annual increase in ten years. To produce that higher output, about 3 million Americans joined the nation's payrolls, in the process contributing to a reduction in the unemployment rate to $43 / 4$ percent, its lowest sustained level since the late 1960s. And our factories were working more intensively too: Industrial production increased $53 / 4$ percent last year, exceeding robust additions to capacity. Those gains were shared widely. The hourly wage and salary structure rose about 4 percent, fueling impressive increases in personal incomes. Unlike some prior episodes when faster wage rate increases mainly reflected attempts to make up for more rapidly rising prices of goods and services, the fatter paychecks that workers brought home represented real increments to purchasing power. Measured consumer price inflation came in at $13 / 4$ percent over the twelve months of 1997, down about $11 / 2$ percentage points from the pace of the prior year. While swings in the prices of food and fuel contributed to this decline, both narrower price indexes excluding those items and broader ones including all goods and services produced in the United States also paint a portrait of continued progress toward price stability. Businesses, for the most part, were able to pay these higher real wages while still increasing their earnings. Although aggregate data on profits for all of 1997 are not yet available, corporate profit margins most likely remained in an elevated range not seen consistently since the 1960s. These healthy gains in earnings and the expectations of more to come provided important support to the equity market, with most major stock price indexes gaining more than 20 percent over the year. The strong growth of the real income of workers and corporations is not unrelated to the economy's continued good performance on inflation. Taken together, recent evidence supports the view that such low inflation, as closely approaching price stability as we have known in the United States in three decades, engenders many benefits. When changes in the general price level are small and predictable, households and firms can plan more securely for the future. The perception of reduced risk encourages investment. Low inflation also exerts a discipline on costs, fostering efforts to enhance productivity. Productivity is the ultimate source of rising standards of living, and we witnessed a notable pickup in this measure in the past two years. The robust economy has facilitated the efforts of the Congress and the Administration to restore balance in the unified federal budget. As I have indicated to the Congress on numerous occasions, moving beyond this point and putting the budget in significant surplus would be the surest and most direct way of increasing national saving. In turn, higher national saving, by promoting lower real long-term interest rates, helps spur spending to outfit American firms and their workers with the modern equipment they need to compete successfully on world markets. We have seen a partial down payment of the benefits of better budget balance already: It seems reasonable to assume that the decline in longer-term Treasury yields last year owed, in part, to reduced competition -current and prospective -- from the federal government for scarce private saving. However, additional effort remains to be exerted to address the effects on federal entitlement spending of the looming shift within the next decade in the nation's retirement demographics. As I noted earlier, our nation has been experiencing a higher growth rate of productivity -- output per hour worked -- in recent years. The dramatic improvements in computing power and communication and information technology appear to have been a major force behind this beneficial trend. Those innovations, together with fierce competitive pressures in our high-tech industries to make them available to as many homes, offices, stores, and shop floors as possible, have produced double-digit annual reductions in prices of capital goods embodying new technologies. Indeed, many products considered to be at the cutting edge of technology as recently as two to three years ago have become so standardized and inexpensive that they have achieved near " commodity" status, a development that has allowed businesses to accelerate their accumulation of more and better capital. Critical to this process has been the rapidly increasing efficiency of our financial markets -- itself a product of the new technologies and of significant market deregulation over the years. Capital now flows with relatively little friction to projects embodying new ideas. Silicon Valley is a tribute both to American ingenuity and to the financial system's ever-increasing ability to supply venture capital to the entrepreneurs who are such a dynamic force in our economy. With new high-tech tools, American businesses have shaved transportation costs, managed their production and use of inventories more efficiently, and broadened market opportunities. The threat of rising costs in tight labor markets has imparted a substantial impetus to efforts to take advantage of possible efficiencies. In my Humphrey-Hawkins testimony last July, I discussed the likelihood that the sharp acceleration in capital investment in advanced technologies beginning in 1993 reflected synergies of new ideas, embodied in increasingly inexpensive new equipment, that have elevated expected returns and have broadened investment opportunities. More recent evidence remains consistent with the view that this capital spending has contributed to a noticeable pickup in productivity -- and probably by more than can be explained by usual business cycle forces. For one, the combination of continued low inflation and stable to rising domestic profit margins implies quite subdued growth in total consolidated unit business costs. With labor costs constituting more than two-thirds of those costs and labor compensation per hour accelerating, productivity must be growing faster, and that step-up must be roughly in line with the increase in compensation growth. For another, our more direct observations on output per hour roughly tend to confirm that productivity has picked up significantly in recent years, although how much the ongoing trend of productivity has risen remains an open question. The acceleration in productivity, however, has been exceeded by the strengthening of demand for goods and services. As a consequence, employers had to expand payrolls at a pace well in excess of the growth of the working age population that profess a desire for a job, including new immigrants. As I pointed out last year in testimony before the Congress, that gap has been accommodated by declines in both the officially unemployed and those not actively seeking work but desirous of working. The number of people in those two categories decreased at a rate of about one million per year on average over the last four years. By December 1997, the sum had declined to a seasonally adjusted $101 / 2$ million, or 6 percent of the working age population, the lowest ratio since detailed information on this series first became available in 1970. Anecdotal information from surveys of our twelve Reserve Banks attests to our ever tightening labor markets. Rapidly rising demand for labor has had enormous beneficial effects on our work force. Previously low- or unskilled workers have been drawn into the job market and have obtained training and experience that will help them even if they later change jobs. Large numbers of underemployed have been moved up the career ladder to match their underlying skills, and many welfare recipients have been added to payrolls as well, to the benefit of their long-term job prospects. The recent acceleration of wages likely has owed in part to the ever-tightening labor market and in part to rising productivity growth, which, through competition, induces firms to grant higher wages. It is difficult at this time, however, to disentangle the relative contributions of these factors. What is clear is that, unless demand growth softens or productivity growth accelerates even more, we will gradually run out of new workers who can be profitably employed. It is not possible to tell how many more of the 6 percent of the working-age population who want to work but do not have jobs can be added to payrolls. A significant number are so-called frictionally unemployed, as they have left one job but not yet chosen to accept another. Still others have chosen to work in only a limited geographic area where their skills may not be needed. Should demand for new workers continue to exceed new supply, we would expect wage gains increasingly to exceed productivity growth, squeezing profit margins and eventually leading to a pickup in inflation. Were a substantial pickup in inflation to occur, it could, by stunting economic growth, reverse much of the remarkable labor market progress of recent years. I will be discussing our assessment of these and other possibilities and their bearing on the outlook for 1998 shortly. History teaches us that monetary policy has been its most effective when it has been pre-emptive. The lagging relationship between the Federal Reserve's policy instrument and spending, and, even further removed, inflation, implies that if policy actions are delayed until prices begin to pick up, they will be too late to fend off at least some persistent price acceleration and attendant economic instabilities. Preemptive policymaking is keyed to judging how widespread are emerging inflationary forces, and when, and to what degree, those forces will be reflected in actual inflation. For most of last year, the evident strains on resources were sufficiently severe to steer the Federal Open Market Committee (FOMC) toward being more inclined to tighten than to ease monetary policy. Indeed, in March, when it became apparent that strains on resources seemed to be intensifying, the FOMC imposed modest incremental restraint, raising its intended federal funds rate $1 / 4$ percentage point, to $51 / 2$ percent. We did not increase the federal funds rate again during the summer and fall, despite further tightening of the labor market. Even though the labor market heated up and labor compensation rose, measured inflation fell, owing to the appreciation of the dollar, weakness in international commodity prices, and faster productivity growth. Those restraining forces were more evident in goods-price inflation, which in the CPI slowed substantially to only about $1 / 2$ percent in 1997, than on service-price inflation, which moderated much less -- to around 3 percent. Providers of services appeared to be more pressed by mounting strains in labor markets. Hourly wages and salaries in service-producing sectors rose $41 / 2$ percent last year, up considerably from the prior year and almost $11 / 2$ percentage points faster than in goods-producing sectors. However, a significant portion of that differential, but by no means all, traced to commissions in the financial and real estate services sector related to one-off increases in transactions prices and in volumes of activity, rather than to increases in the underlying wage structure. Although the nominal federal funds rate was maintained after March, the apparent drop in inflation expectations over the balance of 1997 induced some firming in the stance of monetary policy by one important measure -- the real federal funds rate, or the nominal federal funds rate less a proxy for inflation expectations. Some analysts have dubbed the contribution of the reduction in inflation expectations to raising the real federal funds rate a " passive" tightening, in that it increased the amount of monetary policy restraint in place without an explicit vote by the FOMC. While the tightening may have been passive in that sense, it was by no means inadvertent. Members of the FOMC took some comfort in the upward trend of the real federal funds rate over the year and the rise in the foreign exchange value of the dollar because such additional restraint was viewed as appropriate given the strength of spending and building strains on labor resources. They also recognized that in virtually all other respects financial markets remained quite accommodative and, indeed, judging by the rise in equity prices, were providing additional impetus to domestic spending. There can be no doubt that domestic demand retained considerable momentum at the outset of this year. Production and employment have been on a strong uptrend in recent months. Confident households, enjoying gains in income and wealth and benefitting from the reductions in intermediate- and longer-term interest rates to date, should continue to increase their spending. Firms should find financing available on relatively attractive terms to fund profitable opportunities to enhance efficiency by investing in new capital equipment. By itself, this strength in spending would seem to presage intensifying pressures in labor markets and on prices. Yet, the outlook for total spending on goods and services produced in the United States is less assured of late because of storm clouds massing over the Western Pacific and heading our way. This is not the place to examine in detail what triggered the initial problems in Asian financial markets and why the subsequent deterioration has been so extreme. I covered that subject recently before several committees of the Congress. Rather, I shall confine my discussion this morning to the likely consequences of the Asian crisis for demand and inflation in the United States. With the crisis curtailing the financing available in foreign currencies, many Asian economies have had no choice but to cut back their imports sharply. Disruptions to their financial systems and economies more generally will further damp demands for our exports of goods and services. American exports should be held down as well by the appreciation of the dollar, which will make the prices of competing goods produced abroad more attractive, just as foreign-produced goods will be relatively more attractive to buyers here at home. As a result, we can expect a worsening net export position to exert a discernible drag on total output in the United States. For a time, such restraint might be reinforced by a reduced willingness of US firms to accumulate inventories as they foresee weaker demand ahead. The forces of Asian restraint could well be providing another, more direct offset to inflationary impulses arising domestically in the United States. In the wake of weakness in Asian economies and of lagged effects of the appreciation of the dollar more generally, the dollar prices of our non-oil imports are likely to decline further in the months ahead. These lower import prices are apparently already making domestic producers hesitant to raise their own prices for fear of losing market share, further contributing to the restraint on overall prices. Lesser demands for raw materials on the part of Asian economies as their activity slows should help to keep world commodity prices denominated in dollars in check. Import and commodity prices, however, will restrain US inflation only as long as they continue to fall, or to rise at a slower rate than the pace of overall domestic product prices. The key question going forward is whether the restraint building from the turmoil in Asia will be sufficient to check inflationary tendencies that might otherwise result from the strength of domestic spending and tightening labor markets. The depth of the adjustment abroad will depend on the extent of weakness in the financial sectors of Asian economies and the speed with which structural inefficiencies in the financial and nonfinancial sectors of those economies are corrected. If, as we suspect, the restraint coming from Asia is sufficient to bring the demand for American labor back into line with the growth of the working-age population desirous of working, labor markets will remain unusually tight, but any intensification of inflation should be delayed, very gradual, and readily reversible. However, we cannot rule out two other, more worrisome possibilities. On the one hand, should the momentum to domestic spending not be offset significantly by Asian or other developments, the US economy would be on a track along which spending could press too strongly against available resources to be consistent with contained inflation. On the other, we also need to be alert to the possibility that the forces from Asia might damp activity and prices by more than is desirable by exerting a particularly forceful drag on the volume of net exports and the prices of imports. When confronted at the beginning of this month with these, for the moment, finely balanced, though powerful forces, the members of the Federal Open Market Committee decided that monetary policy should most appropriately be kept on hold. With the continuation of a remarkable seven-year expansion at stake and so little precedent to go by, the range of our intelligence gathering in the weeks ahead must be wide and especially inclusive of international developments. The Forecasts of the Governors of the Federal Reserve Board and the Presidents of the Federal Reserve Banks. In these circumstances, the forecasts of the governors of the Federal Reserve Board and presidents of the Federal Reserve Banks for the performance of the US economy over this year are more tentative than usual. Based on information available through the first week of February, monetary policymakers were generally of the view that moderate economic growth is likely in store. The growth rate of real GDP is most commonly seen as between 2 and $23 / 4$ percent over the four quarters of 1998. Given the strong performance of real GDP, these projections envisage the unemployment rate remaining in the low range of the past half year. Inflation, as measured by the four-quarter percent change in the consumer price index, is expected to be $13 / 4$ to $21 / 4$ percent in 1998 -- near the low rate recorded in 1997. This outlook embodies the expectation that the effects of continuing tightness in labor markets will be largely offset by technical adjustments shaving a couple tenths from the published CPI, healthy productivity growth, flat or declining import prices, and little pressure in commodity markets. But the policymakers' forecasts also reflect their determination to hold the line on inflation. The FOMC affirmed the provisional ranges for the monetary aggregates in 1998 that it had selected last July, which, once again, encompass the growth rates associated with conditions of approximate price stability, provided that these aggregates act in accord with their pre-1990s historical relationships with nominal income and interest rates. These ranges are identical to those that had prevailed for 1997 -- 1 to 5 percent for M2 and 2 to 6 percent for M3. The FOMC also reaffirmed its range of 3 to 7 percent for the debt of the domestic nonfinancial sectors for this year. I should caution, though, that the expectations of the governors and Reserve Bank presidents for the expansion of nominal GDP in 1998 suggest that growth of M2 in the upper half of its benchmark range is a distinct possibility this year. Given the continuing strength of bank credit, M3 might even be above its range as depositories use liabilities in this aggregate to fund loan growth and securities acquisitions. Nonfinancial debt should come in around the middle portion of its range. In the first part of the 1990s, money growth diverged from historical relationships with income and interest rates, in part as savers diversified into bond and stock mutual funds, which had become more readily available and whose returns were considerably more attractive than those on deposits. This anomalous behavior of velocity severely set back most analysts' confidence in the usefulness of M2 as an indicator of economic developments. In recent years, there have been tentative signs that the historical relationship linking the velocity of M2 -- measured as the ratio of nominal GDP to the money stock -- to the cost of holding M2 assets was reasserting itself. However, a persistent residual upward drift in velocity over the past few years and its apparent cessation very recently underscores our ongoing uncertainty about the stability of this relationship. The FOMC will continue to observe the evolution of the monetary and credit aggregates carefully, integrating information about these variables with a wide variety of other information in determining its policy stance. With the current situation reflecting a balance of strong countervailing forces, events in the months ahead are not likely to unfold smoothly. In that regard, I would like to flag a few areas of concern about the economy beyond those mentioned already regarding Asian developments. Without doubt, lenders have provided important support to spending in the past few years by their willingness to transact at historically small margins and in large volumes. Equity investors have contributed as well by apparently pricing in the expectation of substantial earnings gains and requiring modest compensation for the risk that those expectations could be mistaken. Approaching the eighth year of the economic expansion, this is understandable in an economic environment that, contrary to historical experience, has become increasingly benign. Businesses have been meeting obligations readily and generating high profits, putting them in outstanding financial health. But we must be concerned about becoming too complacent about evaluating repayment risks. All too often at this stage of the business cycle, the loans that banks extend later make up a disproportionate share of total nonperforming loans. In addition, quite possibly, twelve or eighteen months hence, some of the securities purchased on the market could be looked upon with some regret by investors. As one of the nation's bank supervisors, the Federal Reserve will make every effort to encourage banks to apply sound underwriting standards in their lending. Prudent lenders should consider a wide range of economic situations in evaluating credit; to do otherwise would risk contributing to potentially disruptive financial problems down the road. A second area of concern involves our nation's continuing role in the new high-tech international financial system. By joining with our major trading partners and international financial institutions in helping to stabilize the economies of Asia and promoting needed structural changes, we are also encouraging the continued expansion of world trade and global economic and financial stability on which the ongoing increase of our own standards of living depends. If we were to cede our role as a world leader, or backslide into protectionist policies, we would threaten the source of much of our own sustained economic growth. A third risk is complacency about inflation prospects. The combination and interaction of significant increases in productivity-improving technologies, sharp declines in budget deficits, and disciplined monetary policy has damped product price changes, bringing them to near stability. While part of this result owes to good policy, part is the product of the fortuitous emergence of new technologies and of some favorable price developments in imported goods. However, as history counsels, it is unwise to count on any string of good fortune to continue indefinitely. At the same time, though, it is also instructive to remember the words of an old sage that "luck is the residue of design". He meant that to some degree we can deliberately put ourselves in position to experience good fortune and be better prepared when misfortune strikes. For example, the 1970s were marked by two major oil-price shocks and a significant depreciation in the exchange value of the dollar. But those misfortunes were, in part, the result of allowing imbalances to build over the decade as policymakers lost hold of the anchor provided by price stability. Some of what we now see helping rein in inflation pressures is more likely to occur in an environment of stable prices and price expectations that thwarts producers from indiscriminately passing on higher costs, puts a premium on productivity enhancement, and rewards more effectively investment in physical and human capital. Simply put, while the pursuit of price stability does not rule out misfortune, it lowers its probability. If firms are convinced that the general price level will remain stable, they will reserve increases in their sales prices of goods and services as a last resort, for fear that such increases could mean loss of market share. Similarly, if households are convinced of price stability, they will not see variations in relative prices as reasons to change their long-run inflation expectations. Thus, continuing to make progress toward this legislated objective will make future supply shocks less likely and our nation's economy less vulnerable to those that occur.
1998-02-26T00:00:00	Mr. Greenspan discusses the role of capital in optimal banking supervision and regulation (Central Bank Articles and Speeches, 26 Feb 98)	Remarks by the Chairman of the US Federal Reserve System, Mr. Alan Greenspan, before the Conference on Capital Regulation in the 21st Century, held at the Federal Reserve Bank of New York on 26/2/98.	Mr. Greenspan discusses the role of capital in optimal banking supervision and Remarks by the Chairman of the US Federal Reserve System, Mr. Alan Greenspan, regulation before the Conference on Capital Regulation in the 21st Century, held at the Federal Reserve Bank of New York on 26/2/98. It is my pleasure to join President McDonough and our colleagues from the Bank of Japan and the Bank of England in hosting this timely conference. Capital, of course, is a topic of never-ending importance to bankers and their counterparties, not to mention the regulators and central bankers whose job it is to oversee the stability of the financial system. Moreover, this conference comes at a most critical and opportune time. As you are aware, the current structure of regulatory bank capital standards is under the most intense scrutiny since the deliberations leading to the watershed Basle Accord of 1988 and the FDIC Improvement Act of 1991. In this tenth anniversary year of the Accord, its architects can look back with pride at the role played by the regulation in reversing the decades-long decline in bank capital cushions. At the time the Accord was drafted, the use of differential risk weights to distinguish among broad asset categories represented a truly innovative and, I believe, effective approach to formulating prudential regulations. The risk-based capital rules also set the stage for the emergence of more general risk-based policies within the supervisory process. Of course, the focus of this conference is on the future of prudential capital standards. In our deliberations we must therefore take note that observers both within the regulatory agencies and the banking industry itself are raising warning flags about the current standard. These concerns pertain to the rapid technological, financial, and institutional changes that are rendering the regulatory capital framework less effectual, if not on the verge of becoming outmoded, with respect to our largest, most complex banking organizations. In particular, it is argued that the heightened complexity of these large banks' risk-taking activities, along with the expanding scope of regulatory capital arbitrage, may cause capital ratios as calculated under the existing rules to become increasingly misleading. I, too, share these concerns. In my remarks this evening, however, I would like to step back from the technical discourse of the conference's sessions and place these concerns within their broad historical and policy contexts. Specifically, I would like to highlight the evolutionary nature of capital regulation and then discuss the policy concerns that have arisen with respect to the current capital structure. I will end with some suggestions regarding basic principles for assessing possible future changes to our system of prudential supervision and regulation. To begin, financial innovation is nothing new, and the rapidity of financial evolution is itself a relative concept -- what is "rapid" must be judged in the context of the degree of development of the economic and banking structure. Prior to World War II, banks in this country did not make commercial real estate mortgages or auto loans. Prior to the 1960s, securitization, as an alternative to the traditional "buy and hold" strategy of commercial banks, did not exist. Now, banks have expanded their securitization activities well beyond the mortgage programs of the 1970s and 1980s, to include almost all asset types, including corporate loans. And most recently, credit derivatives have been added to the growing list of financial products. Many of these products, which would have been perceived as too risky for banks in earlier periods, are now judged to be safe owing to today's more sophisticated risk measurement and containment systems. Both banking and regulation are continuously evolving disciplines, with the latter, of course, continuously adjusting to the former. Technological advances in computers and in telecommunications, together with theoretical advances -- principally in option-pricing models -- have contributed to this proliferation of ever-more complex financial products. The increased product complexity, in turn, is often cited as the primary reason why the Basle standard is in need of periodic restructuring. Indeed, the Basle standard, like the industry for which it is intended, has not stood still over the past ten years. Since its inception, significant changes have been made on a regular basis to the Accord, including, most visibly, the use of banks' internal models for assessing capital charges for market risk within trading accounts. All of these changes have been incorporated within a document that is now quite lengthy -and written in appropriately dense, regulatory style. While no one is in favor of regulatory complexity, we should be aware that capital regulation will necessarily evolve over time as the banking and financial sectors themselves evolve. Thus, it should not be surprising that we constantly need to assess possible new approaches to old problems, even as new problems become apparent. Nor should the continual search for new regulatory procedures be construed as suggesting that existing policies were ill-suited to the times for which they were developed or will be ill-suited for those banking systems at an earlier stage of development. Indeed, so long as we adhere in principle to a common prudential standard, it is appropriate that differing regulatory regimes may exist side by side at any point in time, responding to differing conditions between banking systems or across individual banks within a single system. Perhaps the appropriate analogy is with computer-chip manufacturers. Even as the next generation of chip is being planned, two or three generations of chip -- for example, Pentium IIs, Pentium Pros, and Pentium MMXs -- are being marketed, while, at the same time, older generations of chip continue to perform yeoman duty within specific applications. Given evolving financial markets, the question is not whether the Basle standard will be changed, but how and why each new round of change will occur, and to which market segment it will apply. In overseeing this necessary evolution of the Accord, as it applies to the more advanced banking systems, it would be helpful to address some of the basic issues that, in my view, have not been adequately addressed by the regulatory community. In so doing, perhaps we can shed some light on the source of our present concerns with the existing capital standard. There really are only two questions here: First, how should bank "soundness" be defined and measured? Second, what should be the minimum level of soundness set by regulators? When the Accord was being crafted, many supervisors may have had an implicit notion of what they meant by soundness -- they probably meant the likelihood of a bank becoming insolvent. While by no means the only one, this is a perfectly reasonable definition of soundness. Indeed, insolvency probability is the standard explicitly used within the internal risk measurement and capital allocation systems of our major banks. That is, many of the large banks explicitly calculate the amount of capital they need in order to reduce to a targeted percentage the probability, over a given time horizon, that losses would exceed the allocated capital and drive the bank into insolvency. But whereas our largest banks have explicitly set their own, internal soundness standards, regulators really have not. Rather, the Basle Accord set a minimum capital ratio, not a maximum insolvency probability. Capital, being the difference between assets and liabilities, is of course an abstraction. Thus, it was well understood at the time that the likelihood of insolvency is determined by the level of capital a bank holds, the maturities of its assets and liabilities, and the riskiness of its portfolio. In an attempt to relate capital requirements to risk, the Accord divided assets into four risk "buckets", corresponding to minimum total capital requirements of zero percent, 1.6 percent, 4.0 percent, and 8.0 percent, respectively. Indeed, much of the complexity of the formal capital requirements arises from rules stipulating which risk positions fit into which of the four capital "buckets". Despite the attempt to make capital requirements at least somewhat risk-based, the main criticisms of the Accord, at least as applied to the activities of our largest, most complex banking organizations, appear to be warranted. In particular, I would note three: First, the formal capital ratio requirements, because they do not flow from any particular insolvency probability standard, are, for the most part, arbitrary. All corporate loans, for example, are placed into a single 8 percent "bucket". Second, the requirements account for credit risk and market risk, but not explicitly for operating and other forms of risk that may also be important. Third, except for trading account activities, the capital standards do not take account of hedging, diversification, and differences in risk management techniques, especially portfolio management. These deficiencies were understood even as the Accord was being crafted. Indeed, it was in response to these concerns that, for much of the 1990s, regulatory agencies have focused on improving supervisory oversight of capital adequacy on a bank-by-bank basis. In recent years, the focus of supervisory efforts in the United States has been on the internal risk measurement and management processes of banks. This emphasis on internal processes has been driven partly by the need to make supervisory policies more risk-focused in light of the increasing complexity of banking activities. In addition, this approach reinforces market incentives that have prompted banks themselves to invest heavily in recent years to improve their management information systems and internal systems for quantifying, pricing, and managing risk. While it is appropriate that supervisory procedures evolve to encompass the changes in industry practices, we must also be sure that improvements in both the form and content of the formal capital regulations keep pace. Inappropriate regulatory capital standards, whether too low or too high in specific circumstances, can entail significant economic costs. This resource allocation effect of capital regulations is seen most clearly by comparing the Basle standard with the internal "economic capital" allocation processes of some of our largest banking companies. For internal purposes, these large institutions attempt explicitly to quantify their credit, market, and operating risks, by estimating loss probability distributions for various risk positions. Enough economic, as distinct from regulatory, capital is then allocated to each risk position to satisfy the institution's own standard for insolvency probability. Within credit risk models, for example, capital for internal purposes often is allocated so as to hypothetically "cover" 99.9 percent or more of the estimated loss probability distribution. These internal capital allocation models have much to teach the supervisor, and are critical to understanding the possible misallocative effects of inappropriate capital rules. For example, while the Basle standard lumps all corporate loans into the 8 percent capital "bucket", the banks' internal capital allocations for individual loans vary considerably -- from less than 1 percent to well over 30 percent -- depending on the estimated riskiness of the position in question. In the case where a group of loans attracts an internal capital charge that is very low compared to the Basle eight percent standard, the bank has a strong incentive to undertake regulatory capital arbitrage to structure the risk position in a manner that allows it to be reclassified into a lower regulatory risk category. At present, securitization is, without a doubt, the major tool used by large U.S. banks to engage in such arbitrage. Regulatory capital arbitrage, I should emphasize, is not necessarily undesirable. In many cases, regulatory capital arbitrage acts as a safety-valve for attenuating the adverse effects of those regulatory capital requirements that are well in excess of the levels warranted by a specific activity's underlying economic risk. Absent such arbitrage, a regulatory capital requirement that is inappropriately high for the economic risk of a particular activity, could cause a bank to exit that relatively low-risk business, by preventing the bank from earning an acceptable rate of return on its capital. That is, arbitrage may appropriately lower the effective capital requirements against some safe activities that banks would otherwise be forced to drop by the effects of regulation. It is clear that our major banks have become quite efficient at engaging in such desirable forms of regulatory capital arbitrage, through securitization and other devices. However, such arbitrage is not costless and therefore not without implications for resource allocation. Interestingly, one reason why the formal capital standards do not include very many risk "buckets" is that regulators did not want to influence how banks make resource allocation decisions. Ironically, the "one-size-fits-all" standard does just that, by forcing the bank into expending effort to negate the capital standard, or to exploit it, whenever there is a significant disparity between the relatively arbitrary standard and internal, economic capital requirements. The inconsistencies between internally required economic capital and the regulatory capital standard create another type of problem -- nominally high regulatory capital ratios can be used to mask the true level of insolvency probability. For example, consider the case where the bank's own risk analysis calls for a 15 percent internal economic capital assessment against its portfolio. If the bank actually holds 12 percent capital, it would, in all likelihood, be deemed to be "well-capitalized" in a regulatory sense, even though it might be undercapitalized in the economic sense. The possibility that regulatory capital ratios may mask true insolvency probability becomes more acute as banks arbitrage away inappropriately high capital requirements on their safest assets, by removing these assets from the balance sheet via securitization. The issue is not solely whether capital requirements on the bank's residual risk in the securitized assets are appropriate. We should also be concerned with the sufficiency of regulatory capital requirements on the assets remaining on the book. In the extreme, such "cherry-picking" would result in only those assets left on the balance sheet for which economic capital allocations are greater than the 8 percent regulatory standard. Given these difficulties with the one-size-fits-all nature of our current capital regulations, it is understandable that calls have arisen for reform of the Basle standard. It is, however, premature to try to predict exactly how the next generation of prudential standards will evolve. One set of possibilities revolves around market-based tools and incentives. Indeed, as banks' internal risk measurement and management technologies improve, and as the depth and sophistication of financial markets increase, bank supervisors should continually find ways to incorporate market advances into their prudential policies, where appropriate. Two potentially promising applications of this principle have been discussed at this conference. One is the use of internal credit risk models as a possible substitute for, or complement to, the current structure of ratio-based capital regulations. Another approach goes one step further and uses market-like incentives to reward and encourage improvements in internal risk measurement and management practices. A primary example is the proposed pre-commitment approach to setting capital requirements for bank trading activities. I might add that pre-commitment of capital is designed to work only for the trading account, not the banking book, and then only for strong, well-managed organizations. Proponents of an internal-models-based approach to capital regulations may be on the right track, but at this moment of regulatory development it would seem that a full-fledged, bank-wide, internal-models approach could require a very substantial amount of time and effort to develop. In a paper given earlier today by Federal Reserve Board economists David Jones and John Mingo, the authors enumerate their concerns over the reliability of the current generation of credit risk models. They go on to suggest, however, that these models may, over time, provide a basis for setting future regulatory capital requirements. Even in the shorter term, they argue, elements of internal credit risk models may prove useful within the supervisory process. Still other approaches are of course possible, including some combination of market-based and traditional, ratio-based approaches to prudential regulation. But regardless of what happens in this next stage, as I noted earlier, any new capital standard is itself likely to be superceded within a continuing process of evolving prudential regulations. Just as manufacturing companies follow a product planning cycle, bank regulators can expect to begin working on still another generation of prudential policies even as proposed modifications to the current standard are being released for public comment. In looking ahead, supervisors should, at a minimum, be aware of the increasing sophistication with which banks are responding to the existing regulatory framework and should now begin active discussions on the necessary modifications. In anticipation of such discussions, I would like to conclude by focusing on what I believe should be several core principles underlying any proposed changes to our current system of prudential regulation and supervision. First, a reasonable principle for setting regulatory soundness standards is to act much as the market would if there were no safety net and all market participants were fully informed. For example, requiring all of our regulated financial institutions to maintain insolvency probabilities that are equivalent to a triple-A rating standard would be demonstrably too stringent, because there are very few such entities among unregulated financial institutions not subject to the safety net. That is, the markets are telling us that the value of the financial firm is not, in general, maximized at default probabilities reflected in triple-A ratings. This suggests, in turn, that regulated financial intermediaries can not maximize their value to the overall economy if they are forced to operate at unreasonably high soundness levels. Nor should we require individual banks to hold capital in amounts sufficient to fully protect against those rare systemic events which, in any event, may render standard probability evaluation moot. The management of systemic risk is properly the job of the central banks. Individual banks should not be required to hold capital against the possibility of overall financial breakdown. Indeed, central banks, by their existence, appropriately offer a form of catastrophe insurance to banks against such events. Conversely, permitting regulated institutions that benefit from the safety net to take risky positions that, in the absence of the net, would earn them junk-bond ratings for their liabilities, is clearly inappropriate. In such a world, our goals of protecting taxpayers and reducing the misallocative effects of the safety net simply would not be realized. Ultimately, the setting of soundness standards should achieve a complex balance -- remembering that the goals of prudential regulation should be weighed against the need to permit banks to perform their essential risk-taking activities. Thus, capital standards should be structured to reflect the lines of business and degree of risk-taking in which the individual bank chooses to engage. A second principle should be to continue linking strong supervisory analysis and judgment with rational regulatory standards. In a banking environment characterized by continuing technological advances, this means placing an emphasis on constantly improving our supervisory techniques. In the context of bank capital adequacy, supervisors increasingly must be able to assess sophisticated internal credit risk measurement systems, as well as gauge the impact of the continued development in securitization and credit derivative markets. It is critical that supervisors incorporate, where practical, the risk analysis tools being developed and used on a daily basis within the banking industry itself. If we do not use the best analytical tools available, and place these tools in the hands of highly trained and motivated supervisory personnel, then we cannot hope to supervise under our basic principle -- supervision as if there were no safety net. Third, we have no choice but to continue to plan for a successor to the simple risk-weighting approach to capital requirements embodied within the current regulatory standard. While it is unclear at present exactly what that successor might be, it seems clear that adding more and more layers of arbitrary regulation would be counter productive. We should, rather, look for ways to harness market tools and market-like incentives wherever possible, by using banks' own policies, behaviors, and technologies in improving the supervisory process. Finally, we should always remind ourselves that supervision and regulation are neither infallible nor likely to prove sufficient to meet all our intended goals. Put another way, the Basle standard and the bank examination process, even if both are structured in optimal fashion, are a second line of support for bank soundness. Supervision and regulation can never be a substitute for a bank's own internal scrutiny of its counterparties, as well as the market's scrutiny of the bank. Therefore, we should not, for example, abandon efforts to contain the scope of the safety net, or to press for increases in the quantity and quality of financial disclosures by regulated institutions. If we follow these basic prescriptions, I suspect that history will look favorably on our attempts at crafting regulatory policy.	---[PAGE_BREAK]--- # Mr. Greenspan discusses the role of capital in optimal banking supervision and regulation Remarks by the Chairman of the US Federal Reserve System, Mr. Alan Greenspan, before the Conference on Capital Regulation in the 21st Century, held at the Federal Reserve Bank of New York on 26/2/98. It is my pleasure to join President McDonough and our colleagues from the Bank of Japan and the Bank of England in hosting this timely conference. Capital, of course, is a topic of never-ending importance to bankers and their counterparties, not to mention the regulators and central bankers whose job it is to oversee the stability of the financial system. Moreover, this conference comes at a most critical and opportune time. As you are aware, the current structure of regulatory bank capital standards is under the most intense scrutiny since the deliberations leading to the watershed Basle Accord of 1988 and the FDIC Improvement Act of 1991. In this tenth anniversary year of the Accord, its architects can look back with pride at the role played by the regulation in reversing the decades-long decline in bank capital cushions. At the time the Accord was drafted, the use of differential risk weights to distinguish among broad asset categories represented a truly innovative and, I believe, effective approach to formulating prudential regulations. The risk-based capital rules also set the stage for the emergence of more general risk-based policies within the supervisory process. Of course, the focus of this conference is on the future of prudential capital standards. In our deliberations we must therefore take note that observers both within the regulatory agencies and the banking industry itself are raising warning flags about the current standard. These concerns pertain to the rapid technological, financial, and institutional changes that are rendering the regulatory capital framework less effectual, if not on the verge of becoming outmoded, with respect to our largest, most complex banking organizations. In particular, it is argued that the heightened complexity of these large banks' risk-taking activities, along with the expanding scope of regulatory capital arbitrage, may cause capital ratios as calculated under the existing rules to become increasingly misleading. I, too, share these concerns. In my remarks this evening, however, I would like to step back from the technical discourse of the conference's sessions and place these concerns within their broad historical and policy contexts. Specifically, I would like to highlight the evolutionary nature of capital regulation and then discuss the policy concerns that have arisen with respect to the current capital structure. I will end with some suggestions regarding basic principles for assessing possible future changes to our system of prudential supervision and regulation. To begin, financial innovation is nothing new, and the rapidity of financial evolution is itself a relative concept -- what is "rapid" must be judged in the context of the degree of development of the economic and banking structure. Prior to World War II, banks in this country did not make commercial real estate mortgages or auto loans. Prior to the 1960s, securitization, as an alternative to the traditional "buy and hold" strategy of commercial banks, did not exist. Now, banks have expanded their securitization activities well beyond the mortgage programs of the 1970s and 1980s, to include almost all asset types, including corporate loans. And most recently, credit derivatives have been added to the growing list of financial products. Many of these products, which would have been perceived as too risky for banks in earlier periods, are now judged to be safe owing to today's more sophisticated risk measurement and containment systems. Both banking and regulation are continuously evolving disciplines, with the latter, of course, continuously adjusting to the former. Technological advances in computers and in telecommunications, together with theoretical advances -- principally in option-pricing models -- have contributed to this proliferation of ever-more complex financial products. The increased product complexity, in turn, is often cited as the primary reason why the Basle standard is in need of periodic restructuring. Indeed, the Basle ---[PAGE_BREAK]--- standard, like the industry for which it is intended, has not stood still over the past ten years. Since its inception, significant changes have been made on a regular basis to the Accord, including, most visibly, the use of banks' internal models for assessing capital charges for market risk within trading accounts. All of these changes have been incorporated within a document that is now quite lengthy -and written in appropriately dense, regulatory style. While no one is in favor of regulatory complexity, we should be aware that capital regulation will necessarily evolve over time as the banking and financial sectors themselves evolve. Thus, it should not be surprising that we constantly need to assess possible new approaches to old problems, even as new problems become apparent. Nor should the continual search for new regulatory procedures be construed as suggesting that existing policies were ill-suited to the times for which they were developed or will be ill-suited for those banking systems at an earlier stage of development. Indeed, so long as we adhere in principle to a common prudential standard, it is appropriate that differing regulatory regimes may exist side by side at any point in time, responding to differing conditions between banking systems or across individual banks within a single system. Perhaps the appropriate analogy is with computer-chip manufacturers. Even as the next generation of chip is being planned, two or three generations of chip -- for example, Pentium IIs, Pentium Pros, and Pentium MMXs -- are being marketed, while, at the same time, older generations of chip continue to perform yeoman duty within specific applications. Given evolving financial markets, the question is not whether the Basle standard will be changed, but how and why each new round of change will occur, and to which market segment it will apply. In overseeing this necessary evolution of the Accord, as it applies to the more advanced banking systems, it would be helpful to address some of the basic issues that, in my view, have not been adequately addressed by the regulatory community. In so doing, perhaps we can shed some light on the source of our present concerns with the existing capital standard. There really are only two questions here: First, how should bank "soundness" be defined and measured? Second, what should be the minimum level of soundness set by regulators? When the Accord was being crafted, many supervisors may have had an implicit notion of what they meant by soundness -- they probably meant the likelihood of a bank becoming insolvent. While by no means the only one, this is a perfectly reasonable definition of soundness. Indeed, insolvency probability is the standard explicitly used within the internal risk measurement and capital allocation systems of our major banks. That is, many of the large banks explicitly calculate the amount of capital they need in order to reduce to a targeted percentage the probability, over a given time horizon, that losses would exceed the allocated capital and drive the bank into insolvency. But whereas our largest banks have explicitly set their own, internal soundness standards, regulators really have not. Rather, the Basle Accord set a minimum capital ratio, not a maximum insolvency probability. Capital, being the difference between assets and liabilities, is of course an abstraction. Thus, it was well understood at the time that the likelihood of insolvency is determined by the level of capital a bank holds, the maturities of its assets and liabilities, and the riskiness of its portfolio. In an attempt to relate capital requirements to risk, the Accord divided assets into four risk "buckets", corresponding to minimum total capital requirements of zero percent, 1.6 percent, 4.0 percent, and 8.0 percent, respectively. Indeed, much of the complexity of the formal capital requirements arises from rules stipulating which risk positions fit into which of the four capital "buckets". Despite the attempt to make capital requirements at least somewhat risk-based, the main criticisms of the Accord, at least as applied to the activities of our largest, most complex banking ---[PAGE_BREAK]--- organizations, appear to be warranted. In particular, I would note three: First, the formal capital ratio requirements, because they do not flow from any particular insolvency probability standard, are, for the most part, arbitrary. All corporate loans, for example, are placed into a single 8 percent "bucket". Second, the requirements account for credit risk and market risk, but not explicitly for operating and other forms of risk that may also be important. Third, except for trading account activities, the capital standards do not take account of hedging, diversification, and differences in risk management techniques, especially portfolio management. These deficiencies were understood even as the Accord was being crafted. Indeed, it was in response to these concerns that, for much of the 1990s, regulatory agencies have focused on improving supervisory oversight of capital adequacy on a bank-by-bank basis. In recent years, the focus of supervisory efforts in the United States has been on the internal risk measurement and management processes of banks. This emphasis on internal processes has been driven partly by the need to make supervisory policies more risk-focused in light of the increasing complexity of banking activities. In addition, this approach reinforces market incentives that have prompted banks themselves to invest heavily in recent years to improve their management information systems and internal systems for quantifying, pricing, and managing risk. While it is appropriate that supervisory procedures evolve to encompass the changes in industry practices, we must also be sure that improvements in both the form and content of the formal capital regulations keep pace. Inappropriate regulatory capital standards, whether too low or too high in specific circumstances, can entail significant economic costs. This resource allocation effect of capital regulations is seen most clearly by comparing the Basle standard with the internal "economic capital" allocation processes of some of our largest banking companies. For internal purposes, these large institutions attempt explicitly to quantify their credit, market, and operating risks, by estimating loss probability distributions for various risk positions. Enough economic, as distinct from regulatory, capital is then allocated to each risk position to satisfy the institution's own standard for insolvency probability. Within credit risk models, for example, capital for internal purposes often is allocated so as to hypothetically "cover" 99.9 percent or more of the estimated loss probability distribution. These internal capital allocation models have much to teach the supervisor, and are critical to understanding the possible misallocative effects of inappropriate capital rules. For example, while the Basle standard lumps all corporate loans into the 8 percent capital "bucket", the banks' internal capital allocations for individual loans vary considerably -- from less than 1 percent to well over 30 percent -- depending on the estimated riskiness of the position in question. In the case where a group of loans attracts an internal capital charge that is very low compared to the Basle eight percent standard, the bank has a strong incentive to undertake regulatory capital arbitrage to structure the risk position in a manner that allows it to be reclassified into a lower regulatory risk category. At present, securitization is, without a doubt, the major tool used by large U.S. banks to engage in such arbitrage. Regulatory capital arbitrage, I should emphasize, is not necessarily undesirable. In many cases, regulatory capital arbitrage acts as a safety-valve for attenuating the adverse effects of those regulatory capital requirements that are well in excess of the levels warranted by a specific activity's underlying economic risk. Absent such arbitrage, a regulatory capital requirement that is inappropriately high for the economic risk of a particular activity, could cause a bank to exit that relatively low-risk business, by preventing the bank from earning an acceptable rate of return on its capital. That is, arbitrage may appropriately lower the effective capital requirements against some safe activities that banks would otherwise be forced to drop by the effects of regulation. It is clear that our major banks have become quite efficient at engaging in such desirable forms of regulatory capital arbitrage, through securitization and other devices. However, such arbitrage is not costless and therefore not without implications for resource allocation. Interestingly, ---[PAGE_BREAK]--- one reason why the formal capital standards do not include very many risk "buckets" is that regulators did not want to influence how banks make resource allocation decisions. Ironically, the "one-size-fits-all" standard does just that, by forcing the bank into expending effort to negate the capital standard, or to exploit it, whenever there is a significant disparity between the relatively arbitrary standard and internal, economic capital requirements. The inconsistencies between internally required economic capital and the regulatory capital standard create another type of problem -- nominally high regulatory capital ratios can be used to mask the true level of insolvency probability. For example, consider the case where the bank's own risk analysis calls for a 15 percent internal economic capital assessment against its portfolio. If the bank actually holds 12 percent capital, it would, in all likelihood, be deemed to be "well-capitalized" in a regulatory sense, even though it might be undercapitalized in the economic sense. The possibility that regulatory capital ratios may mask true insolvency probability becomes more acute as banks arbitrage away inappropriately high capital requirements on their safest assets, by removing these assets from the balance sheet via securitization. The issue is not solely whether capital requirements on the bank's residual risk in the securitized assets are appropriate. We should also be concerned with the sufficiency of regulatory capital requirements on the assets remaining on the book. In the extreme, such "cherry-picking" would result in only those assets left on the balance sheet for which economic capital allocations are greater than the 8 percent regulatory standard. Given these difficulties with the one-size-fits-all nature of our current capital regulations, it is understandable that calls have arisen for reform of the Basle standard. It is, however, premature to try to predict exactly how the next generation of prudential standards will evolve. One set of possibilities revolves around market-based tools and incentives. Indeed, as banks' internal risk measurement and management technologies improve, and as the depth and sophistication of financial markets increase, bank supervisors should continually find ways to incorporate market advances into their prudential policies, where appropriate. Two potentially promising applications of this principle have been discussed at this conference. One is the use of internal credit risk models as a possible substitute for, or complement to, the current structure of ratio-based capital regulations. Another approach goes one step further and uses market-like incentives to reward and encourage improvements in internal risk measurement and management practices. A primary example is the proposed pre-commitment approach to setting capital requirements for bank trading activities. I might add that pre-commitment of capital is designed to work only for the trading account, not the banking book, and then only for strong, well-managed organizations. Proponents of an internal-models-based approach to capital regulations may be on the right track, but at this moment of regulatory development it would seem that a full-fledged, bank-wide, internal-models approach could require a very substantial amount of time and effort to develop. In a paper given earlier today by Federal Reserve Board economists David Jones and John Mingo, the authors enumerate their concerns over the reliability of the current generation of credit risk models. They go on to suggest, however, that these models may, over time, provide a basis for setting future regulatory capital requirements. Even in the shorter term, they argue, elements of internal credit risk models may prove useful within the supervisory process. Still other approaches are of course possible, including some combination of market-based and traditional, ratio-based approaches to prudential regulation. But regardless of what happens in this next stage, as I noted earlier, any new capital standard is itself likely to be superceded within a continuing process of evolving prudential regulations. Just as manufacturing companies follow a product planning cycle, bank regulators can expect to begin working on still another ---[PAGE_BREAK]--- generation of prudential policies even as proposed modifications to the current standard are being released for public comment. In looking ahead, supervisors should, at a minimum, be aware of the increasing sophistication with which banks are responding to the existing regulatory framework and should now begin active discussions on the necessary modifications. In anticipation of such discussions, I would like to conclude by focusing on what I believe should be several core principles underlying any proposed changes to our current system of prudential regulation and supervision. First, a reasonable principle for setting regulatory soundness standards is to act much as the market would if there were no safety net and all market participants were fully informed. For example, requiring all of our regulated financial institutions to maintain insolvency probabilities that are equivalent to a triple-A rating standard would be demonstrably too stringent, because there are very few such entities among unregulated financial institutions not subject to the safety net. That is, the markets are telling us that the value of the financial firm is not, in general, maximized at default probabilities reflected in triple-A ratings. This suggests, in turn, that regulated financial intermediaries can not maximize their value to the overall economy if they are forced to operate at unreasonably high soundness levels. Nor should we require individual banks to hold capital in amounts sufficient to fully protect against those rare systemic events which, in any event, may render standard probability evaluation moot. The management of systemic risk is properly the job of the central banks. Individual banks should not be required to hold capital against the possibility of overall financial breakdown. Indeed, central banks, by their existence, appropriately offer a form of catastrophe insurance to banks against such events. Conversely, permitting regulated institutions that benefit from the safety net to take risky positions that, in the absence of the net, would earn them junk-bond ratings for their liabilities, is clearly inappropriate. In such a world, our goals of protecting taxpayers and reducing the misallocative effects of the safety net simply would not be realized. Ultimately, the setting of soundness standards should achieve a complex balance -- remembering that the goals of prudential regulation should be weighed against the need to permit banks to perform their essential risk-taking activities. Thus, capital standards should be structured to reflect the lines of business and degree of risk-taking in which the individual bank chooses to engage. A second principle should be to continue linking strong supervisory analysis and judgment with rational regulatory standards. In a banking environment characterized by continuing technological advances, this means placing an emphasis on constantly improving our supervisory techniques. In the context of bank capital adequacy, supervisors increasingly must be able to assess sophisticated internal credit risk measurement systems, as well as gauge the impact of the continued development in securitization and credit derivative markets. It is critical that supervisors incorporate, where practical, the risk analysis tools being developed and used on a daily basis within the banking industry itself. If we do not use the best analytical tools available, and place these tools in the hands of highly trained and motivated supervisory personnel, then we cannot hope to supervise under our basic principle -- supervision as if there were no safety net. Third, we have no choice but to continue to plan for a successor to the simple risk-weighting approach to capital requirements embodied within the current regulatory standard. While it is unclear at present exactly what that successor might be, it seems clear that adding more and more layers of arbitrary regulation would be counter productive. We should, rather, look for ways to harness market tools and market-like incentives wherever possible, by using banks' own policies, behaviors, and technologies in improving the supervisory process. ---[PAGE_BREAK]--- Finally, we should always remind ourselves that supervision and regulation are neither infallible nor likely to prove sufficient to meet all our intended goals. Put another way, the Basle standard and the bank examination process, even if both are structured in optimal fashion, are a second line of support for bank soundness. Supervision and regulation can never be a substitute for a bank's own internal scrutiny of its counterparties, as well as the market's scrutiny of the bank. Therefore, we should not, for example, abandon efforts to contain the scope of the safety net, or to press for increases in the quantity and quality of financial disclosures by regulated institutions. If we follow these basic prescriptions, I suspect that history will look favorably on our attempts at crafting regulatory policy.	Alan Greenspan	United States	https://www.bis.org/review/r980309b.pdf	regulation Remarks by the Chairman of the US Federal Reserve System, Mr. Alan Greenspan, before the Conference on Capital Regulation in the 21st Century, held at the Federal Reserve Bank of New York on 26/2/98. It is my pleasure to join President McDonough and our colleagues from the Bank of Japan and the Bank of England in hosting this timely conference. Capital, of course, is a topic of never-ending importance to bankers and their counterparties, not to mention the regulators and central bankers whose job it is to oversee the stability of the financial system. Moreover, this conference comes at a most critical and opportune time. As you are aware, the current structure of regulatory bank capital standards is under the most intense scrutiny since the deliberations leading to the watershed Basle Accord of 1988 and the FDIC Improvement Act of 1991. In this tenth anniversary year of the Accord, its architects can look back with pride at the role played by the regulation in reversing the decades-long decline in bank capital cushions. At the time the Accord was drafted, the use of differential risk weights to distinguish among broad asset categories represented a truly innovative and, I believe, effective approach to formulating prudential regulations. The risk-based capital rules also set the stage for the emergence of more general risk-based policies within the supervisory process. Of course, the focus of this conference is on the future of prudential capital standards. In our deliberations we must therefore take note that observers both within the regulatory agencies and the banking industry itself are raising warning flags about the current standard. These concerns pertain to the rapid technological, financial, and institutional changes that are rendering the regulatory capital framework less effectual, if not on the verge of becoming outmoded, with respect to our largest, most complex banking organizations. In particular, it is argued that the heightened complexity of these large banks' risk-taking activities, along with the expanding scope of regulatory capital arbitrage, may cause capital ratios as calculated under the existing rules to become increasingly misleading. I, too, share these concerns. In my remarks this evening, however, I would like to step back from the technical discourse of the conference's sessions and place these concerns within their broad historical and policy contexts. Specifically, I would like to highlight the evolutionary nature of capital regulation and then discuss the policy concerns that have arisen with respect to the current capital structure. I will end with some suggestions regarding basic principles for assessing possible future changes to our system of prudential supervision and regulation. To begin, financial innovation is nothing new, and the rapidity of financial evolution is itself a relative concept -- what is "rapid" must be judged in the context of the degree of development of the economic and banking structure. Prior to World War II, banks in this country did not make commercial real estate mortgages or auto loans. Prior to the 1960s, securitization, as an alternative to the traditional "buy and hold" strategy of commercial banks, did not exist. Now, banks have expanded their securitization activities well beyond the mortgage programs of the 1970s and 1980s, to include almost all asset types, including corporate loans. And most recently, credit derivatives have been added to the growing list of financial products. Many of these products, which would have been perceived as too risky for banks in earlier periods, are now judged to be safe owing to today's more sophisticated risk measurement and containment systems. Both banking and regulation are continuously evolving disciplines, with the latter, of course, continuously adjusting to the former. Technological advances in computers and in telecommunications, together with theoretical advances -- principally in option-pricing models -- have contributed to this proliferation of ever-more complex financial products. The increased product complexity, in turn, is often cited as the primary reason why the Basle standard is in need of periodic restructuring. Indeed, the Basle standard, like the industry for which it is intended, has not stood still over the past ten years. Since its inception, significant changes have been made on a regular basis to the Accord, including, most visibly, the use of banks' internal models for assessing capital charges for market risk within trading accounts. All of these changes have been incorporated within a document that is now quite lengthy -and written in appropriately dense, regulatory style. While no one is in favor of regulatory complexity, we should be aware that capital regulation will necessarily evolve over time as the banking and financial sectors themselves evolve. Thus, it should not be surprising that we constantly need to assess possible new approaches to old problems, even as new problems become apparent. Nor should the continual search for new regulatory procedures be construed as suggesting that existing policies were ill-suited to the times for which they were developed or will be ill-suited for those banking systems at an earlier stage of development. Indeed, so long as we adhere in principle to a common prudential standard, it is appropriate that differing regulatory regimes may exist side by side at any point in time, responding to differing conditions between banking systems or across individual banks within a single system. Perhaps the appropriate analogy is with computer-chip manufacturers. Even as the next generation of chip is being planned, two or three generations of chip -- for example, Pentium IIs, Pentium Pros, and Pentium MMXs -- are being marketed, while, at the same time, older generations of chip continue to perform yeoman duty within specific applications. Given evolving financial markets, the question is not whether the Basle standard will be changed, but how and why each new round of change will occur, and to which market segment it will apply. In overseeing this necessary evolution of the Accord, as it applies to the more advanced banking systems, it would be helpful to address some of the basic issues that, in my view, have not been adequately addressed by the regulatory community. In so doing, perhaps we can shed some light on the source of our present concerns with the existing capital standard. There really are only two questions here: First, how should bank "soundness" be defined and measured? Second, what should be the minimum level of soundness set by regulators? When the Accord was being crafted, many supervisors may have had an implicit notion of what they meant by soundness -- they probably meant the likelihood of a bank becoming insolvent. While by no means the only one, this is a perfectly reasonable definition of soundness. Indeed, insolvency probability is the standard explicitly used within the internal risk measurement and capital allocation systems of our major banks. That is, many of the large banks explicitly calculate the amount of capital they need in order to reduce to a targeted percentage the probability, over a given time horizon, that losses would exceed the allocated capital and drive the bank into insolvency. But whereas our largest banks have explicitly set their own, internal soundness standards, regulators really have not. Rather, the Basle Accord set a minimum capital ratio, not a maximum insolvency probability. Capital, being the difference between assets and liabilities, is of course an abstraction. Thus, it was well understood at the time that the likelihood of insolvency is determined by the level of capital a bank holds, the maturities of its assets and liabilities, and the riskiness of its portfolio. In an attempt to relate capital requirements to risk, the Accord divided assets into four risk "buckets", corresponding to minimum total capital requirements of zero percent, 1.6 percent, 4.0 percent, and 8.0 percent, respectively. Indeed, much of the complexity of the formal capital requirements arises from rules stipulating which risk positions fit into which of the four capital "buckets". Despite the attempt to make capital requirements at least somewhat risk-based, the main criticisms of the Accord, at least as applied to the activities of our largest, most complex banking organizations, appear to be warranted. In particular, I would note three: First, the formal capital ratio requirements, because they do not flow from any particular insolvency probability standard, are, for the most part, arbitrary. All corporate loans, for example, are placed into a single 8 percent "bucket". Second, the requirements account for credit risk and market risk, but not explicitly for operating and other forms of risk that may also be important. Third, except for trading account activities, the capital standards do not take account of hedging, diversification, and differences in risk management techniques, especially portfolio management. These deficiencies were understood even as the Accord was being crafted. Indeed, it was in response to these concerns that, for much of the 1990s, regulatory agencies have focused on improving supervisory oversight of capital adequacy on a bank-by-bank basis. In recent years, the focus of supervisory efforts in the United States has been on the internal risk measurement and management processes of banks. This emphasis on internal processes has been driven partly by the need to make supervisory policies more risk-focused in light of the increasing complexity of banking activities. In addition, this approach reinforces market incentives that have prompted banks themselves to invest heavily in recent years to improve their management information systems and internal systems for quantifying, pricing, and managing risk. While it is appropriate that supervisory procedures evolve to encompass the changes in industry practices, we must also be sure that improvements in both the form and content of the formal capital regulations keep pace. Inappropriate regulatory capital standards, whether too low or too high in specific circumstances, can entail significant economic costs. This resource allocation effect of capital regulations is seen most clearly by comparing the Basle standard with the internal "economic capital" allocation processes of some of our largest banking companies. For internal purposes, these large institutions attempt explicitly to quantify their credit, market, and operating risks, by estimating loss probability distributions for various risk positions. Enough economic, as distinct from regulatory, capital is then allocated to each risk position to satisfy the institution's own standard for insolvency probability. Within credit risk models, for example, capital for internal purposes often is allocated so as to hypothetically "cover" 99.9 percent or more of the estimated loss probability distribution. These internal capital allocation models have much to teach the supervisor, and are critical to understanding the possible misallocative effects of inappropriate capital rules. For example, while the Basle standard lumps all corporate loans into the 8 percent capital "bucket", the banks' internal capital allocations for individual loans vary considerably -- from less than 1 percent to well over 30 percent -- depending on the estimated riskiness of the position in question. In the case where a group of loans attracts an internal capital charge that is very low compared to the Basle eight percent standard, the bank has a strong incentive to undertake regulatory capital arbitrage to structure the risk position in a manner that allows it to be reclassified into a lower regulatory risk category. At present, securitization is, without a doubt, the major tool used by large U.S. banks to engage in such arbitrage. Regulatory capital arbitrage, I should emphasize, is not necessarily undesirable. In many cases, regulatory capital arbitrage acts as a safety-valve for attenuating the adverse effects of those regulatory capital requirements that are well in excess of the levels warranted by a specific activity's underlying economic risk. Absent such arbitrage, a regulatory capital requirement that is inappropriately high for the economic risk of a particular activity, could cause a bank to exit that relatively low-risk business, by preventing the bank from earning an acceptable rate of return on its capital. That is, arbitrage may appropriately lower the effective capital requirements against some safe activities that banks would otherwise be forced to drop by the effects of regulation. It is clear that our major banks have become quite efficient at engaging in such desirable forms of regulatory capital arbitrage, through securitization and other devices. However, such arbitrage is not costless and therefore not without implications for resource allocation. Interestingly, one reason why the formal capital standards do not include very many risk "buckets" is that regulators did not want to influence how banks make resource allocation decisions. Ironically, the "one-size-fits-all" standard does just that, by forcing the bank into expending effort to negate the capital standard, or to exploit it, whenever there is a significant disparity between the relatively arbitrary standard and internal, economic capital requirements. The inconsistencies between internally required economic capital and the regulatory capital standard create another type of problem -- nominally high regulatory capital ratios can be used to mask the true level of insolvency probability. For example, consider the case where the bank's own risk analysis calls for a 15 percent internal economic capital assessment against its portfolio. If the bank actually holds 12 percent capital, it would, in all likelihood, be deemed to be "well-capitalized" in a regulatory sense, even though it might be undercapitalized in the economic sense. The possibility that regulatory capital ratios may mask true insolvency probability becomes more acute as banks arbitrage away inappropriately high capital requirements on their safest assets, by removing these assets from the balance sheet via securitization. The issue is not solely whether capital requirements on the bank's residual risk in the securitized assets are appropriate. We should also be concerned with the sufficiency of regulatory capital requirements on the assets remaining on the book. In the extreme, such "cherry-picking" would result in only those assets left on the balance sheet for which economic capital allocations are greater than the 8 percent regulatory standard. Given these difficulties with the one-size-fits-all nature of our current capital regulations, it is understandable that calls have arisen for reform of the Basle standard. It is, however, premature to try to predict exactly how the next generation of prudential standards will evolve. One set of possibilities revolves around market-based tools and incentives. Indeed, as banks' internal risk measurement and management technologies improve, and as the depth and sophistication of financial markets increase, bank supervisors should continually find ways to incorporate market advances into their prudential policies, where appropriate. Two potentially promising applications of this principle have been discussed at this conference. One is the use of internal credit risk models as a possible substitute for, or complement to, the current structure of ratio-based capital regulations. Another approach goes one step further and uses market-like incentives to reward and encourage improvements in internal risk measurement and management practices. A primary example is the proposed pre-commitment approach to setting capital requirements for bank trading activities. I might add that pre-commitment of capital is designed to work only for the trading account, not the banking book, and then only for strong, well-managed organizations. Proponents of an internal-models-based approach to capital regulations may be on the right track, but at this moment of regulatory development it would seem that a full-fledged, bank-wide, internal-models approach could require a very substantial amount of time and effort to develop. In a paper given earlier today by Federal Reserve Board economists David Jones and John Mingo, the authors enumerate their concerns over the reliability of the current generation of credit risk models. They go on to suggest, however, that these models may, over time, provide a basis for setting future regulatory capital requirements. Even in the shorter term, they argue, elements of internal credit risk models may prove useful within the supervisory process. Still other approaches are of course possible, including some combination of market-based and traditional, ratio-based approaches to prudential regulation. But regardless of what happens in this next stage, as I noted earlier, any new capital standard is itself likely to be superceded within a continuing process of evolving prudential regulations. Just as manufacturing companies follow a product planning cycle, bank regulators can expect to begin working on still another generation of prudential policies even as proposed modifications to the current standard are being released for public comment. In looking ahead, supervisors should, at a minimum, be aware of the increasing sophistication with which banks are responding to the existing regulatory framework and should now begin active discussions on the necessary modifications. In anticipation of such discussions, I would like to conclude by focusing on what I believe should be several core principles underlying any proposed changes to our current system of prudential regulation and supervision. First, a reasonable principle for setting regulatory soundness standards is to act much as the market would if there were no safety net and all market participants were fully informed. For example, requiring all of our regulated financial institutions to maintain insolvency probabilities that are equivalent to a triple-A rating standard would be demonstrably too stringent, because there are very few such entities among unregulated financial institutions not subject to the safety net. That is, the markets are telling us that the value of the financial firm is not, in general, maximized at default probabilities reflected in triple-A ratings. This suggests, in turn, that regulated financial intermediaries can not maximize their value to the overall economy if they are forced to operate at unreasonably high soundness levels. Nor should we require individual banks to hold capital in amounts sufficient to fully protect against those rare systemic events which, in any event, may render standard probability evaluation moot. The management of systemic risk is properly the job of the central banks. Individual banks should not be required to hold capital against the possibility of overall financial breakdown. Indeed, central banks, by their existence, appropriately offer a form of catastrophe insurance to banks against such events. Conversely, permitting regulated institutions that benefit from the safety net to take risky positions that, in the absence of the net, would earn them junk-bond ratings for their liabilities, is clearly inappropriate. In such a world, our goals of protecting taxpayers and reducing the misallocative effects of the safety net simply would not be realized. Ultimately, the setting of soundness standards should achieve a complex balance -- remembering that the goals of prudential regulation should be weighed against the need to permit banks to perform their essential risk-taking activities. Thus, capital standards should be structured to reflect the lines of business and degree of risk-taking in which the individual bank chooses to engage. A second principle should be to continue linking strong supervisory analysis and judgment with rational regulatory standards. In a banking environment characterized by continuing technological advances, this means placing an emphasis on constantly improving our supervisory techniques. In the context of bank capital adequacy, supervisors increasingly must be able to assess sophisticated internal credit risk measurement systems, as well as gauge the impact of the continued development in securitization and credit derivative markets. It is critical that supervisors incorporate, where practical, the risk analysis tools being developed and used on a daily basis within the banking industry itself. If we do not use the best analytical tools available, and place these tools in the hands of highly trained and motivated supervisory personnel, then we cannot hope to supervise under our basic principle -- supervision as if there were no safety net. Third, we have no choice but to continue to plan for a successor to the simple risk-weighting approach to capital requirements embodied within the current regulatory standard. While it is unclear at present exactly what that successor might be, it seems clear that adding more and more layers of arbitrary regulation would be counter productive. We should, rather, look for ways to harness market tools and market-like incentives wherever possible, by using banks' own policies, behaviors, and technologies in improving the supervisory process. Finally, we should always remind ourselves that supervision and regulation are neither infallible nor likely to prove sufficient to meet all our intended goals. Put another way, the Basle standard and the bank examination process, even if both are structured in optimal fashion, are a second line of support for bank soundness. Supervision and regulation can never be a substitute for a bank's own internal scrutiny of its counterparties, as well as the market's scrutiny of the bank. Therefore, we should not, for example, abandon efforts to contain the scope of the safety net, or to press for increases in the quantity and quality of financial disclosures by regulated institutions. If we follow these basic prescriptions, I suspect that history will look favorably on our attempts at crafting regulatory policy.
1998-03-02T00:00:00	Mr. Meyer discusses financial globalization and efficient banking regulation (Central Bank Articles and Speeches, 2 Mar 98)	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the Annual Washington Conference of the Institute of International Bankers in Washington, DC on 2/3/98.	Mr. Meyer discusses financial globalization and efficient banking regulation Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the Annual Washington Conference of the Institute of International Bankers in Washington, DC on 2/3/98. The highly publicized recent events in the world's financial system have served to make certain things abundantly clear. In particular, we now have further evidence that there is a large and growing disparity between the risk management practices of what might be called the "best practice" financial institutions and those of their competitors around the globe. This disparity, moreover, runs much more deeply than the weaknesses exposed during the Asian financial crisis. In that event, bankers were seen to make the kinds of basic mistakes that have been oft repeated at other times and in other places. For example, loans were made to government-supported enterprises, either at the behest of the government itself or under the assumption that official support would be provided if the loans turned bad. At times, these loans were made to highly leveraged companies whose underlying financial ratios did not justify the origination of the loans on the terms under which they were made. To add insult to injury, the offending banks sometimes borrowed in dollars and lent in their home currencies, without hedging, believing that their government could and would continue to stabilize exchange rates. While these practices are troublesome, I am much more concerned with what I believe is both an exciting and disturbing aspect of the evolution of financial markets. Spurred by improvements in computer technology and advances in financial theory -- most notably in option-theoretic models -- new financial products, as well as the markets supporting traditional banking products, are becoming ever more sophisticated and ever more global in nature. While financial innovation and globalization can only be applauded for their salutary impact on market efficiency, they present some difficult problems for market practitioners and, where the practitioners are regulated entities, their supervisors. Today, I should like to concentrate on three themes, or principles, related to the evolution of financial markets: First, there exists a significant and dynamic connection running between market innovation and market regulation. Financial innovation often occurs in response to regulation, especially when such regulation does not make economic sense. Conversely, the evolution of regulation often is spurred by advances in the market. Second, the globalization of financial markets means that mistakes in risk management made by one or more significant players in world markets can result in real losses not only to the entity making the mistake, but also to other participants and to other countries' banking systems. Third, the economic efficiencies that are potentially associated with financial innovation can be negated by inefficient banking regulation. Efficient banking regulation, by contrast, not only provides the background against which financial advances can occur, but also permits governments to achieve social objectives where otherwise they might not, or might achieve them only at higher cost. To demonstrate these three principles, we need discuss only one aspect of banking regulation, albeit the most important -- namely prudential regulation as currently embodied within the international capital standard for banks. The Basle Accord of 1988, while it was critical to reversing the decades-long decline in bank capital ratios, has come under frequent and strong attack in recent years, both by regulators and those that are regulated. In particular, there is considerable concern that technological advances and rapid evolution in financial products are reducing the meaningfulness and effectiveness of the capital standards, at least for the largest, most sophisticated institutions. The deficiencies of the Accord are well known, but bear repeating here: First, while intended to be "risk-based", the formal capital ratio requirements nevertheless lump most bank risk positions into a single "bucket" corresponding to a rather arbitrary, minimum total capital requirement of 8 percent against the book value of the position. Second, the capital rules do not explicitly account for certain risks that may be important, such as operating risk. Finally, portfolio composition, hedging, and general portfolio management techniques are explicitly considered only within the market risk requirements for trading account activities, not for the credit or other risks that dominate within the banking book. This arbitrary, one-size-fits-all minimum capital ratio has spurred what can only be termed an avalanche of financial innovations aimed at either evading or taking advantage of the capital standard. Such regulatory capital arbitrage, as we call it, currently is carried out primarily via the securitization markets. While securitization may serve useful economic purposes having nothing to do with regulatory arbitrage, a properly structured securitization conduit can assist the sponsoring bank in lowering its effective regulatory capital requirement against a group of assets or other risk positions. In many cases, the securitization results in the bank retaining essentially all of the risk of the underlying assets, through the provision of credit enhancements to the conduit, but at lower capital requirements than if the assets remained on the bank's books. This is accomplished, for example, by having the conduit "remotely originate" credits, thus allowing the bank to circumvent recourse capital requirements that apply only to assets sold to the conduit. Alternatively, the bank can provide indirect credit enhancement to the conduit by, for example, supplying backup lines of credit to the obligors that use the conduit to raise funds. To a significant degree, the growth in securitization and other forms of regulatory arbitrage has been spurred by the inadequacies of the international capital standard. This has occurred largely because, over the last decade, many of the larger banks have developed fairly sophisticated internal models for formally quantifying risk, including credit risk within the banking book. These models are used to calculate internal economic capital allocations for various sub-portfolios of the bank, and it is because these internal capital allocations often differ substantially from the 8 percent regulatory standard that the problems arise. In the typical case, the bank attempts to formally measure each major type of risk associated with a product or business line -- credit risk, market risk, and operating risk. In the credit risk arena, for example, risk is measured as the estimated shape of a loss probability distribution over a particular horizon, generally one year. Economic, as opposed to regulatory, capital is then allocated against this loss distribution in an amount necessary to meet some corporate goal for insolvency probability. For example, several large banks allocate enough capital internally for credit risk so as to reduce to 0.03 percent the probability that credit losses will exceed allocated capital. Why is this 3 basis point standard chosen? Because that is the historical average default probability, over a one-year horizon, for double-A rated corporate instruments. In other words, the banking firm wants to hold enough capital so that the chances of it becoming insolvent are low enough to win a double-A rating on the bank's own liabilities. The problem is that, when these economic capital calculations are made, they result in a very wide range of internal capital allocations for individual positions or sub-portfolios -- as low as several basis points up to more than 30 percent of the carrying value of the risk position. When a group of loans is assigned an internal capital requirement that is very low compared with the 8 percent regulatory standard, the bank has a strong incentive to restructure the positions to allow them to be reclassified into a lower regulatory risk category, by using securitization or other devices. If the bank doesn't do this, it cannot make a market rate of return on the regulatory capital of 8 percent on the loans. Regulatory arbitrage, from the perspective of proper resource allocation, can be a good thing. If there were no way for the bank to avoid the uneconomically high regulatory requirement, it would need eventually to exit its low risk businesses because of insufficient returns to equity. In the long run, this would serve no purpose other than causing the regulated entity to shrink in size relative to its unregulated competitor. At the extreme, the one-size-fits-all capital standard, if there were no arbitrage safety valve, would cause the bank to engage in only those activities for which the economic capital requirement is greater than the 8 percent regulatory standard. That is, the regulatory standard would induce risk-taking -- perhaps excessive risk-taking. While regulatory arbitrage can be useful in negating improperly high regulatory capital requirements, it can also be used to mask the true riskiness of the bank. In the United States, for example, the top 50 bank holding companies have a mean total risk-based capital ratio of 12.1 percent. The standard deviation of this ratio across the 50 institutions is only 0.8 percent. In other words, everyone seems to be holding about the same amount of capital. Indeed, since a bank is declared to be "well-capitalized" when its total risk-based capital ratio is over 10 percent, it is not surprising that we see no top-50 banking company with its ratio less than 10 percent. But do all these banks have equally low insolvency probabilities? One simply can not tell much of anything by looking at capital ratios. It is perfectly possible that a bank may hold 12 percent capital when a more carefully constructed internal risk model would call for holding 15 percent, or even 18 percent, capital to meet the bank's internal insolvency standard. Or, the bank could have a great model, but simply have a preference for risk that is unacceptable to regulators. Such a bank may be holding risky positions for which even its own model would call for more capital, if the bank were to adhere to a lower insolvency probability standard. For such a bank, the regulatory "well-capitalized" designation may provide little comfort to supervisors or to the taxpayers we are supposed to protect. That is why, in this country, we have placed a great emphasis on the bank-by-bank supervisory process, as opposed to the formal capital regulations that apply to all banks. Just as the most sophisticated large banks have gone through a rapid evolution of their risk measurement, management, and pricing systems, so must supervisors follow suit. At the Federal Reserve we have ongoing projects aimed at providing supervisors with better tools to assess banks' internal risk systems and, ultimately, to make determinations regarding the real adequacy of bank capital on a case-by-case basis. Among these efforts is a review of the credit risk aspects of asset securitization at our major banking companies. Also, we are studying the possible uses within the supervisory process for the internal rating systems used by almost all large banks. In the past, supervisors made risk distinctions only among and between classified assets, not pass assets. Now, we are studying the possibility that future deterioration in asset quality can be foreseen to some extent by changes in the average rating, or the distribution of ratings, in a bank's pass assets. We are also spending considerable effort in tracking and understanding the developments in risk modelling, including the modelling of credit risk. At last week's conference on bank capital, hosted by the Federal Reserve, the Bank of England, and the Bank of Japan, our economists discussed the prospects of moving to a full-fledged, models-based approach to bank capital standards for the largest banks. In my personal view, moving from a ratio-based capital standard to an internal models based standard for our most complex institutions, should be high on our agenda. For the first time, we would be setting a maximum insolvency probability standard rather than simply a minimum capital ratio. This may be the only avenue before us if we wish to achieve an efficient regulatory system. In the absence of a thorough revamping of the international capital standard, we will continue to be plagued by regulatory capital ratios that, on the one hand, say little about insolvency probability, while on the other hand induce banks to engage in sometimes inefficient regulatory arbitrage simply to avoid an inherently uneconomic capital rule. Please do not misinterpret my remarks. I believe, like almost all risk practitioners, that there is no substitute for good human judgment and experience when making credit decisions. Total reliance on models is neither feasible nor desirable. But failure to use the best possible tools at hand is to fall further and further behind the best-practice techniques of the industry, with a resulting decline in risk-adjusted profitability and, inevitably, an increase in insolvency probability. We must remember that any improvement in the accuracy with which risk is measured is tantamount to a reduction in risk. Continual improvements in risk measurement techniques, therefore, should be the norm for all banks that intend to play in the global financial marketplace. Institutions, and entire banking systems, that do not adhere to this principle are doomed to repeat the blunders of the past. In this new world of financial complexity and globalization, it is extremely important that the large institutions among the developed nations all strive to keep up with the best-practice frontier. These institutions are the ones that are the price-leaders, the drivers of markets locally and internationally. If a group of important institutions in only one or two countries fails to keep pace with risk measurement practices, all banking systems are placed at risk. This risk, moreover, is not simply that a large bank failure in one country can cause counterparty failures in other countries. Systematic under-pricing of credit and other risks can be damaging to all players, not only to the bank making the pricing errors. Fortunately, the free-market mechanism for the dissemination of best-practices appears to be functioning reasonably smoothly, at least in the global sense. No single developed nation appears to have a monopoly on best-practice risk measurement techniques, if innovations in complex financial products are any indication. For example, European banks were market leaders in introducing CLOs, or collateralized loan obligations. In the field of asset-backed commercial paper facilities, US banks were the initiators, but now European and Japanese institutions are significant players. And the ubiquitous consulting firms around the world can be relied upon to spread the word of worthwhile advances in risk techniques. Still, the individual bank in each country must face the proper incentives to keep up with the most cost-effective risk techniques. Lax supervisory practices -- or, worse, government support of banks with poor risk practices -- do not provide these proper incentives. Thus, each supervisory authority in each developed nation must be ever vigilant that the disparity between the world's best-practice institutions and those large banks that are "inside" the best-practice frontier does not grow wider. Indeed, an important function of supervisors is to act as something of a clearinghouse for best practices. If the supervisor perceives a deficiency in practice, it is his responsibility to engage the bank manager in a discussion as to whether the shortcoming really exists and, if so, how to fix it. I will conclude by reiterating the three points I made at the beginning. First, there is a strong and dynamic thread running between regulation and market innovation. While the Basle Accord of 1988 was entirely appropriate to its time and circumstances, it is now clearly in danger of becoming outmoded by the pace of financial innovation. Conversely, the regulation has contributed to some market innovations that appear to be driven, if not solely, at least primarily by the need to engage in regulatory capital arbitrage. Second, the reality of globalization must be accounted for in designing and implementing our regulatory and supervisory systems. Especially among developed nations, we cannot afford a growing disparity in the quality of risk practices at our important institutions, nor a disparity in the quality of supervision of those institutions. As bankers like to say, the worst competitor is an uninformed competitor -- and that goes doubly for the competitor's supervisor. Third, given that financial markets are constantly evolving, this means that our regulatory framework must also continually evolve. The international capital standard has not changed in basic form for almost a decade -- it is still a ratio-based rule. While it may still be adequate for the vast bulk of banking institutions, it clearly is inadequate for the world's most complex banks. For these institutions, high capital ratios do not necessarily equate with low insolvency probabilities. Thus, the ratio-based standard is inefficient in achieving the supervisors' objective of limiting bank failure to acceptable levels. Worse, it may be fostering other inefficiencies in the banking system, to the extent the capital standard encourages regulatory arbitrage that entails significant transaction costs. In the absence of any viable alternatives, it is my view that we should begin now to plan for a models-based successor to the Accord. Inevitably, this will take a tremendous effort, given the complexity of the subject and the differences across institutions and between countries. Moreover, a models-based system of capital regulation would require a degree of cooperation among supervisors, quite apart from having similar written rules, that is unprecedented. But I believe the effort will be worth it. Thank you for the opportunity to air these concerns and I am looking forward to continuing the dialogue on this subject.	---[PAGE_BREAK]--- # Mr. Meyer discusses financial globalization and efficient banking regulation Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the Annual Washington Conference of the Institute of International Bankers in Washington, DC on 2/3/98. The highly publicized recent events in the world's financial system have served to make certain things abundantly clear. In particular, we now have further evidence that there is a large and growing disparity between the risk management practices of what might be called the "best practice" financial institutions and those of their competitors around the globe. This disparity, moreover, runs much more deeply than the weaknesses exposed during the Asian financial crisis. In that event, bankers were seen to make the kinds of basic mistakes that have been oft repeated at other times and in other places. For example, loans were made to government-supported enterprises, either at the behest of the government itself or under the assumption that official support would be provided if the loans turned bad. At times, these loans were made to highly leveraged companies whose underlying financial ratios did not justify the origination of the loans on the terms under which they were made. To add insult to injury, the offending banks sometimes borrowed in dollars and lent in their home currencies, without hedging, believing that their government could and would continue to stabilize exchange rates. While these practices are troublesome, I am much more concerned with what I believe is both an exciting and disturbing aspect of the evolution of financial markets. Spurred by improvements in computer technology and advances in financial theory -- most notably in option-theoretic models -- new financial products, as well as the markets supporting traditional banking products, are becoming ever more sophisticated and ever more global in nature. While financial innovation and globalization can only be applauded for their salutary impact on market efficiency, they present some difficult problems for market practitioners and, where the practitioners are regulated entities, their supervisors. Today, I should like to concentrate on three themes, or principles, related to the evolution of financial markets: First, there exists a significant and dynamic connection running between market innovation and market regulation. Financial innovation often occurs in response to regulation, especially when such regulation does not make economic sense. Conversely, the evolution of regulation often is spurred by advances in the market. Second, the globalization of financial markets means that mistakes in risk management made by one or more significant players in world markets can result in real losses not only to the entity making the mistake, but also to other participants and to other countries' banking systems. Third, the economic efficiencies that are potentially associated with financial innovation can be negated by inefficient banking regulation. Efficient banking regulation, by contrast, not only provides the background against which financial advances can occur, but also permits governments to achieve social objectives where otherwise they might not, or might achieve them only at higher cost. To demonstrate these three principles, we need discuss only one aspect of banking regulation, albeit the most important -- namely prudential regulation as currently embodied within the international capital standard for banks. The Basle Accord of 1988, while it was critical to reversing the decades-long decline in bank capital ratios, has come under frequent and strong attack in recent years, both by regulators and those that are regulated. In particular, there is considerable concern that technological advances and rapid evolution in financial products are reducing the meaningfulness and effectiveness of the capital standards, at least for the largest, most sophisticated institutions. ---[PAGE_BREAK]--- The deficiencies of the Accord are well known, but bear repeating here: First, while intended to be "risk-based", the formal capital ratio requirements nevertheless lump most bank risk positions into a single "bucket" corresponding to a rather arbitrary, minimum total capital requirement of 8 percent against the book value of the position. Second, the capital rules do not explicitly account for certain risks that may be important, such as operating risk. Finally, portfolio composition, hedging, and general portfolio management techniques are explicitly considered only within the market risk requirements for trading account activities, not for the credit or other risks that dominate within the banking book. This arbitrary, one-size-fits-all minimum capital ratio has spurred what can only be termed an avalanche of financial innovations aimed at either evading or taking advantage of the capital standard. Such regulatory capital arbitrage, as we call it, currently is carried out primarily via the securitization markets. While securitization may serve useful economic purposes having nothing to do with regulatory arbitrage, a properly structured securitization conduit can assist the sponsoring bank in lowering its effective regulatory capital requirement against a group of assets or other risk positions. In many cases, the securitization results in the bank retaining essentially all of the risk of the underlying assets, through the provision of credit enhancements to the conduit, but at lower capital requirements than if the assets remained on the bank's books. This is accomplished, for example, by having the conduit "remotely originate" credits, thus allowing the bank to circumvent recourse capital requirements that apply only to assets sold to the conduit. Alternatively, the bank can provide indirect credit enhancement to the conduit by, for example, supplying backup lines of credit to the obligors that use the conduit to raise funds. To a significant degree, the growth in securitization and other forms of regulatory arbitrage has been spurred by the inadequacies of the international capital standard. This has occurred largely because, over the last decade, many of the larger banks have developed fairly sophisticated internal models for formally quantifying risk, including credit risk within the banking book. These models are used to calculate internal economic capital allocations for various sub-portfolios of the bank, and it is because these internal capital allocations often differ substantially from the 8 percent regulatory standard that the problems arise. In the typical case, the bank attempts to formally measure each major type of risk associated with a product or business line -- credit risk, market risk, and operating risk. In the credit risk arena, for example, risk is measured as the estimated shape of a loss probability distribution over a particular horizon, generally one year. Economic, as opposed to regulatory, capital is then allocated against this loss distribution in an amount necessary to meet some corporate goal for insolvency probability. For example, several large banks allocate enough capital internally for credit risk so as to reduce to 0.03 percent the probability that credit losses will exceed allocated capital. Why is this 3 basis point standard chosen? Because that is the historical average default probability, over a one-year horizon, for double-A rated corporate instruments. In other words, the banking firm wants to hold enough capital so that the chances of it becoming insolvent are low enough to win a double-A rating on the bank's own liabilities. The problem is that, when these economic capital calculations are made, they result in a very wide range of internal capital allocations for individual positions or sub-portfolios -- as low as several basis points up to more than 30 percent of the carrying value of the risk position. When a group of loans is assigned an internal capital requirement that is very low compared with the 8 percent regulatory standard, the bank has a strong incentive to restructure the positions to allow them to be reclassified into a lower regulatory risk category, by ---[PAGE_BREAK]--- using securitization or other devices. If the bank doesn't do this, it cannot make a market rate of return on the regulatory capital of 8 percent on the loans. Regulatory arbitrage, from the perspective of proper resource allocation, can be a good thing. If there were no way for the bank to avoid the uneconomically high regulatory requirement, it would need eventually to exit its low risk businesses because of insufficient returns to equity. In the long run, this would serve no purpose other than causing the regulated entity to shrink in size relative to its unregulated competitor. At the extreme, the one-size-fits-all capital standard, if there were no arbitrage safety valve, would cause the bank to engage in only those activities for which the economic capital requirement is greater than the 8 percent regulatory standard. That is, the regulatory standard would induce risk-taking -- perhaps excessive risk-taking. While regulatory arbitrage can be useful in negating improperly high regulatory capital requirements, it can also be used to mask the true riskiness of the bank. In the United States, for example, the top 50 bank holding companies have a mean total risk-based capital ratio of 12.1 percent. The standard deviation of this ratio across the 50 institutions is only 0.8 percent. In other words, everyone seems to be holding about the same amount of capital. Indeed, since a bank is declared to be "well-capitalized" when its total risk-based capital ratio is over 10 percent, it is not surprising that we see no top-50 banking company with its ratio less than 10 percent. But do all these banks have equally low insolvency probabilities? One simply can not tell much of anything by looking at capital ratios. It is perfectly possible that a bank may hold 12 percent capital when a more carefully constructed internal risk model would call for holding 15 percent, or even 18 percent, capital to meet the bank's internal insolvency standard. Or, the bank could have a great model, but simply have a preference for risk that is unacceptable to regulators. Such a bank may be holding risky positions for which even its own model would call for more capital, if the bank were to adhere to a lower insolvency probability standard. For such a bank, the regulatory "well-capitalized" designation may provide little comfort to supervisors or to the taxpayers we are supposed to protect. That is why, in this country, we have placed a great emphasis on the bank-by-bank supervisory process, as opposed to the formal capital regulations that apply to all banks. Just as the most sophisticated large banks have gone through a rapid evolution of their risk measurement, management, and pricing systems, so must supervisors follow suit. At the Federal Reserve we have ongoing projects aimed at providing supervisors with better tools to assess banks' internal risk systems and, ultimately, to make determinations regarding the real adequacy of bank capital on a case-by-case basis. Among these efforts is a review of the credit risk aspects of asset securitization at our major banking companies. Also, we are studying the possible uses within the supervisory process for the internal rating systems used by almost all large banks. In the past, supervisors made risk distinctions only among and between classified assets, not pass assets. Now, we are studying the possibility that future deterioration in asset quality can be foreseen to some extent by changes in the average rating, or the distribution of ratings, in a bank's pass assets. We are also spending considerable effort in tracking and understanding the developments in risk modelling, including the modelling of credit risk. At last week's conference on bank capital, hosted by the Federal Reserve, the Bank of England, and the Bank of Japan, our economists discussed the prospects of moving to a full-fledged, models-based approach to bank capital standards for the largest banks. In my personal view, moving from a ratio-based capital standard to an internal models based standard for our most complex institutions, should be high on our agenda. For the first time, we would be setting a maximum ---[PAGE_BREAK]--- insolvency probability standard rather than simply a minimum capital ratio. This may be the only avenue before us if we wish to achieve an efficient regulatory system. In the absence of a thorough revamping of the international capital standard, we will continue to be plagued by regulatory capital ratios that, on the one hand, say little about insolvency probability, while on the other hand induce banks to engage in sometimes inefficient regulatory arbitrage simply to avoid an inherently uneconomic capital rule. Please do not misinterpret my remarks. I believe, like almost all risk practitioners, that there is no substitute for good human judgment and experience when making credit decisions. Total reliance on models is neither feasible nor desirable. But failure to use the best possible tools at hand is to fall further and further behind the best-practice techniques of the industry, with a resulting decline in risk-adjusted profitability and, inevitably, an increase in insolvency probability. We must remember that any improvement in the accuracy with which risk is measured is tantamount to a reduction in risk. Continual improvements in risk measurement techniques, therefore, should be the norm for all banks that intend to play in the global financial marketplace. Institutions, and entire banking systems, that do not adhere to this principle are doomed to repeat the blunders of the past. In this new world of financial complexity and globalization, it is extremely important that the large institutions among the developed nations all strive to keep up with the best-practice frontier. These institutions are the ones that are the price-leaders, the drivers of markets locally and internationally. If a group of important institutions in only one or two countries fails to keep pace with risk measurement practices, all banking systems are placed at risk. This risk, moreover, is not simply that a large bank failure in one country can cause counterparty failures in other countries. Systematic under-pricing of credit and other risks can be damaging to all players, not only to the bank making the pricing errors. Fortunately, the free-market mechanism for the dissemination of best-practices appears to be functioning reasonably smoothly, at least in the global sense. No single developed nation appears to have a monopoly on best-practice risk measurement techniques, if innovations in complex financial products are any indication. For example, European banks were market leaders in introducing CLOs, or collateralized loan obligations. In the field of asset-backed commercial paper facilities, US banks were the initiators, but now European and Japanese institutions are significant players. And the ubiquitous consulting firms around the world can be relied upon to spread the word of worthwhile advances in risk techniques. Still, the individual bank in each country must face the proper incentives to keep up with the most cost-effective risk techniques. Lax supervisory practices -- or, worse, government support of banks with poor risk practices -- do not provide these proper incentives. Thus, each supervisory authority in each developed nation must be ever vigilant that the disparity between the world's best-practice institutions and those large banks that are "inside" the best-practice frontier does not grow wider. Indeed, an important function of supervisors is to act as something of a clearinghouse for best practices. If the supervisor perceives a deficiency in practice, it is his responsibility to engage the bank manager in a discussion as to whether the shortcoming really exists and, if so, how to fix it. I will conclude by reiterating the three points I made at the beginning. First, there is a strong and dynamic thread running between regulation and market innovation. While the Basle Accord of 1988 was entirely appropriate to its time and circumstances, it is now clearly in danger of becoming outmoded by the pace of financial innovation. Conversely, the regulation ---[PAGE_BREAK]--- has contributed to some market innovations that appear to be driven, if not solely, at least primarily by the need to engage in regulatory capital arbitrage. Second, the reality of globalization must be accounted for in designing and implementing our regulatory and supervisory systems. Especially among developed nations, we cannot afford a growing disparity in the quality of risk practices at our important institutions, nor a disparity in the quality of supervision of those institutions. As bankers like to say, the worst competitor is an uninformed competitor -- and that goes doubly for the competitor's supervisor. Third, given that financial markets are constantly evolving, this means that our regulatory framework must also continually evolve. The international capital standard has not changed in basic form for almost a decade -- it is still a ratio-based rule. While it may still be adequate for the vast bulk of banking institutions, it clearly is inadequate for the world's most complex banks. For these institutions, high capital ratios do not necessarily equate with low insolvency probabilities. Thus, the ratio-based standard is inefficient in achieving the supervisors' objective of limiting bank failure to acceptable levels. Worse, it may be fostering other inefficiencies in the banking system, to the extent the capital standard encourages regulatory arbitrage that entails significant transaction costs. In the absence of any viable alternatives, it is my view that we should begin now to plan for a models-based successor to the Accord. Inevitably, this will take a tremendous effort, given the complexity of the subject and the differences across institutions and between countries. Moreover, a models-based system of capital regulation would require a degree of cooperation among supervisors, quite apart from having similar written rules, that is unprecedented. But I believe the effort will be worth it. Thank you for the opportunity to air these concerns and I am looking forward to continuing the dialogue on this subject.	Laurence H Meyer	United States	https://www.bis.org/review/r980311b.pdf	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, before the Annual Washington Conference of the Institute of International Bankers in Washington, DC on 2/3/98. The highly publicized recent events in the world's financial system have served to make certain things abundantly clear. In particular, we now have further evidence that there is a large and growing disparity between the risk management practices of what might be called the "best practice" financial institutions and those of their competitors around the globe. This disparity, moreover, runs much more deeply than the weaknesses exposed during the Asian financial crisis. In that event, bankers were seen to make the kinds of basic mistakes that have been oft repeated at other times and in other places. For example, loans were made to government-supported enterprises, either at the behest of the government itself or under the assumption that official support would be provided if the loans turned bad. At times, these loans were made to highly leveraged companies whose underlying financial ratios did not justify the origination of the loans on the terms under which they were made. To add insult to injury, the offending banks sometimes borrowed in dollars and lent in their home currencies, without hedging, believing that their government could and would continue to stabilize exchange rates. While these practices are troublesome, I am much more concerned with what I believe is both an exciting and disturbing aspect of the evolution of financial markets. Spurred by improvements in computer technology and advances in financial theory -- most notably in option-theoretic models -- new financial products, as well as the markets supporting traditional banking products, are becoming ever more sophisticated and ever more global in nature. While financial innovation and globalization can only be applauded for their salutary impact on market efficiency, they present some difficult problems for market practitioners and, where the practitioners are regulated entities, their supervisors. Today, I should like to concentrate on three themes, or principles, related to the evolution of financial markets: First, there exists a significant and dynamic connection running between market innovation and market regulation. Financial innovation often occurs in response to regulation, especially when such regulation does not make economic sense. Conversely, the evolution of regulation often is spurred by advances in the market. Second, the globalization of financial markets means that mistakes in risk management made by one or more significant players in world markets can result in real losses not only to the entity making the mistake, but also to other participants and to other countries' banking systems. Third, the economic efficiencies that are potentially associated with financial innovation can be negated by inefficient banking regulation. Efficient banking regulation, by contrast, not only provides the background against which financial advances can occur, but also permits governments to achieve social objectives where otherwise they might not, or might achieve them only at higher cost. To demonstrate these three principles, we need discuss only one aspect of banking regulation, albeit the most important -- namely prudential regulation as currently embodied within the international capital standard for banks. The Basle Accord of 1988, while it was critical to reversing the decades-long decline in bank capital ratios, has come under frequent and strong attack in recent years, both by regulators and those that are regulated. In particular, there is considerable concern that technological advances and rapid evolution in financial products are reducing the meaningfulness and effectiveness of the capital standards, at least for the largest, most sophisticated institutions. The deficiencies of the Accord are well known, but bear repeating here: First, while intended to be "risk-based", the formal capital ratio requirements nevertheless lump most bank risk positions into a single "bucket" corresponding to a rather arbitrary, minimum total capital requirement of 8 percent against the book value of the position. Second, the capital rules do not explicitly account for certain risks that may be important, such as operating risk. Finally, portfolio composition, hedging, and general portfolio management techniques are explicitly considered only within the market risk requirements for trading account activities, not for the credit or other risks that dominate within the banking book. This arbitrary, one-size-fits-all minimum capital ratio has spurred what can only be termed an avalanche of financial innovations aimed at either evading or taking advantage of the capital standard. Such regulatory capital arbitrage, as we call it, currently is carried out primarily via the securitization markets. While securitization may serve useful economic purposes having nothing to do with regulatory arbitrage, a properly structured securitization conduit can assist the sponsoring bank in lowering its effective regulatory capital requirement against a group of assets or other risk positions. In many cases, the securitization results in the bank retaining essentially all of the risk of the underlying assets, through the provision of credit enhancements to the conduit, but at lower capital requirements than if the assets remained on the bank's books. This is accomplished, for example, by having the conduit "remotely originate" credits, thus allowing the bank to circumvent recourse capital requirements that apply only to assets sold to the conduit. Alternatively, the bank can provide indirect credit enhancement to the conduit by, for example, supplying backup lines of credit to the obligors that use the conduit to raise funds. To a significant degree, the growth in securitization and other forms of regulatory arbitrage has been spurred by the inadequacies of the international capital standard. This has occurred largely because, over the last decade, many of the larger banks have developed fairly sophisticated internal models for formally quantifying risk, including credit risk within the banking book. These models are used to calculate internal economic capital allocations for various sub-portfolios of the bank, and it is because these internal capital allocations often differ substantially from the 8 percent regulatory standard that the problems arise. In the typical case, the bank attempts to formally measure each major type of risk associated with a product or business line -- credit risk, market risk, and operating risk. In the credit risk arena, for example, risk is measured as the estimated shape of a loss probability distribution over a particular horizon, generally one year. Economic, as opposed to regulatory, capital is then allocated against this loss distribution in an amount necessary to meet some corporate goal for insolvency probability. For example, several large banks allocate enough capital internally for credit risk so as to reduce to 0.03 percent the probability that credit losses will exceed allocated capital. Why is this 3 basis point standard chosen? Because that is the historical average default probability, over a one-year horizon, for double-A rated corporate instruments. In other words, the banking firm wants to hold enough capital so that the chances of it becoming insolvent are low enough to win a double-A rating on the bank's own liabilities. The problem is that, when these economic capital calculations are made, they result in a very wide range of internal capital allocations for individual positions or sub-portfolios -- as low as several basis points up to more than 30 percent of the carrying value of the risk position. When a group of loans is assigned an internal capital requirement that is very low compared with the 8 percent regulatory standard, the bank has a strong incentive to restructure the positions to allow them to be reclassified into a lower regulatory risk category, by using securitization or other devices. If the bank doesn't do this, it cannot make a market rate of return on the regulatory capital of 8 percent on the loans. Regulatory arbitrage, from the perspective of proper resource allocation, can be a good thing. If there were no way for the bank to avoid the uneconomically high regulatory requirement, it would need eventually to exit its low risk businesses because of insufficient returns to equity. In the long run, this would serve no purpose other than causing the regulated entity to shrink in size relative to its unregulated competitor. At the extreme, the one-size-fits-all capital standard, if there were no arbitrage safety valve, would cause the bank to engage in only those activities for which the economic capital requirement is greater than the 8 percent regulatory standard. That is, the regulatory standard would induce risk-taking -- perhaps excessive risk-taking. While regulatory arbitrage can be useful in negating improperly high regulatory capital requirements, it can also be used to mask the true riskiness of the bank. In the United States, for example, the top 50 bank holding companies have a mean total risk-based capital ratio of 12.1 percent. The standard deviation of this ratio across the 50 institutions is only 0.8 percent. In other words, everyone seems to be holding about the same amount of capital. Indeed, since a bank is declared to be "well-capitalized" when its total risk-based capital ratio is over 10 percent, it is not surprising that we see no top-50 banking company with its ratio less than 10 percent. But do all these banks have equally low insolvency probabilities? One simply can not tell much of anything by looking at capital ratios. It is perfectly possible that a bank may hold 12 percent capital when a more carefully constructed internal risk model would call for holding 15 percent, or even 18 percent, capital to meet the bank's internal insolvency standard. Or, the bank could have a great model, but simply have a preference for risk that is unacceptable to regulators. Such a bank may be holding risky positions for which even its own model would call for more capital, if the bank were to adhere to a lower insolvency probability standard. For such a bank, the regulatory "well-capitalized" designation may provide little comfort to supervisors or to the taxpayers we are supposed to protect. That is why, in this country, we have placed a great emphasis on the bank-by-bank supervisory process, as opposed to the formal capital regulations that apply to all banks. Just as the most sophisticated large banks have gone through a rapid evolution of their risk measurement, management, and pricing systems, so must supervisors follow suit. At the Federal Reserve we have ongoing projects aimed at providing supervisors with better tools to assess banks' internal risk systems and, ultimately, to make determinations regarding the real adequacy of bank capital on a case-by-case basis. Among these efforts is a review of the credit risk aspects of asset securitization at our major banking companies. Also, we are studying the possible uses within the supervisory process for the internal rating systems used by almost all large banks. In the past, supervisors made risk distinctions only among and between classified assets, not pass assets. Now, we are studying the possibility that future deterioration in asset quality can be foreseen to some extent by changes in the average rating, or the distribution of ratings, in a bank's pass assets. We are also spending considerable effort in tracking and understanding the developments in risk modelling, including the modelling of credit risk. At last week's conference on bank capital, hosted by the Federal Reserve, the Bank of England, and the Bank of Japan, our economists discussed the prospects of moving to a full-fledged, models-based approach to bank capital standards for the largest banks. In my personal view, moving from a ratio-based capital standard to an internal models based standard for our most complex institutions, should be high on our agenda. For the first time, we would be setting a maximum insolvency probability standard rather than simply a minimum capital ratio. This may be the only avenue before us if we wish to achieve an efficient regulatory system. In the absence of a thorough revamping of the international capital standard, we will continue to be plagued by regulatory capital ratios that, on the one hand, say little about insolvency probability, while on the other hand induce banks to engage in sometimes inefficient regulatory arbitrage simply to avoid an inherently uneconomic capital rule. Please do not misinterpret my remarks. I believe, like almost all risk practitioners, that there is no substitute for good human judgment and experience when making credit decisions. Total reliance on models is neither feasible nor desirable. But failure to use the best possible tools at hand is to fall further and further behind the best-practice techniques of the industry, with a resulting decline in risk-adjusted profitability and, inevitably, an increase in insolvency probability. We must remember that any improvement in the accuracy with which risk is measured is tantamount to a reduction in risk. Continual improvements in risk measurement techniques, therefore, should be the norm for all banks that intend to play in the global financial marketplace. Institutions, and entire banking systems, that do not adhere to this principle are doomed to repeat the blunders of the past. In this new world of financial complexity and globalization, it is extremely important that the large institutions among the developed nations all strive to keep up with the best-practice frontier. These institutions are the ones that are the price-leaders, the drivers of markets locally and internationally. If a group of important institutions in only one or two countries fails to keep pace with risk measurement practices, all banking systems are placed at risk. This risk, moreover, is not simply that a large bank failure in one country can cause counterparty failures in other countries. Systematic under-pricing of credit and other risks can be damaging to all players, not only to the bank making the pricing errors. Fortunately, the free-market mechanism for the dissemination of best-practices appears to be functioning reasonably smoothly, at least in the global sense. No single developed nation appears to have a monopoly on best-practice risk measurement techniques, if innovations in complex financial products are any indication. For example, European banks were market leaders in introducing CLOs, or collateralized loan obligations. In the field of asset-backed commercial paper facilities, US banks were the initiators, but now European and Japanese institutions are significant players. And the ubiquitous consulting firms around the world can be relied upon to spread the word of worthwhile advances in risk techniques. Still, the individual bank in each country must face the proper incentives to keep up with the most cost-effective risk techniques. Lax supervisory practices -- or, worse, government support of banks with poor risk practices -- do not provide these proper incentives. Thus, each supervisory authority in each developed nation must be ever vigilant that the disparity between the world's best-practice institutions and those large banks that are "inside" the best-practice frontier does not grow wider. Indeed, an important function of supervisors is to act as something of a clearinghouse for best practices. If the supervisor perceives a deficiency in practice, it is his responsibility to engage the bank manager in a discussion as to whether the shortcoming really exists and, if so, how to fix it. I will conclude by reiterating the three points I made at the beginning. First, there is a strong and dynamic thread running between regulation and market innovation. While the Basle Accord of 1988 was entirely appropriate to its time and circumstances, it is now clearly in danger of becoming outmoded by the pace of financial innovation. Conversely, the regulation has contributed to some market innovations that appear to be driven, if not solely, at least primarily by the need to engage in regulatory capital arbitrage. Second, the reality of globalization must be accounted for in designing and implementing our regulatory and supervisory systems. Especially among developed nations, we cannot afford a growing disparity in the quality of risk practices at our important institutions, nor a disparity in the quality of supervision of those institutions. As bankers like to say, the worst competitor is an uninformed competitor -- and that goes doubly for the competitor's supervisor. Third, given that financial markets are constantly evolving, this means that our regulatory framework must also continually evolve. The international capital standard has not changed in basic form for almost a decade -- it is still a ratio-based rule. While it may still be adequate for the vast bulk of banking institutions, it clearly is inadequate for the world's most complex banks. For these institutions, high capital ratios do not necessarily equate with low insolvency probabilities. Thus, the ratio-based standard is inefficient in achieving the supervisors' objective of limiting bank failure to acceptable levels. Worse, it may be fostering other inefficiencies in the banking system, to the extent the capital standard encourages regulatory arbitrage that entails significant transaction costs. In the absence of any viable alternatives, it is my view that we should begin now to plan for a models-based successor to the Accord. Inevitably, this will take a tremendous effort, given the complexity of the subject and the differences across institutions and between countries. Moreover, a models-based system of capital regulation would require a degree of cooperation among supervisors, quite apart from having similar written rules, that is unprecedented. But I believe the effort will be worth it. Thank you for the opportunity to air these concerns and I am looking forward to continuing the dialogue on this subject.
1998-03-03T00:00:00	Mr. Greenspan gives a testimony on the global financial system (Central Bank Articles and Speeches, 3 Mar 98)	Testimony of the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Subcommittee on Foreign Operations of the Committee on Appropriations of the US Senate on 3/3/98.	Testimony Mr. Greenspan gives a testimony on the global financial system of the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Subcommittee on Foreign Operations of the Committee on Appropriations of the US Senate on 3/3/98. The global financial system has been evolving rapidly in recent years. New technology has radically reduced the costs of borrowing and lending across traditional national borders, facilitating the development of new instruments and drawing in new players. Information is transmitted instantaneously around the world, and huge shifts in the supply and demand for funds naturally follow, resulting in a massive increase in capital flows. This burgeoning global system has been demonstrated to be a highly efficient structure that has significantly facilitated cross-border trade in goods and services and, accordingly, has made a substantial contribution to standards of living worldwide. Its efficiency exposes and punishes underlying economic imprudence swiftly and decisively. Regrettably, it also appears to have facilitated the transmission of financial disturbances far more effectively than ever before. Three years ago, the Mexican crisis was the first such episode associated with our new high-tech international financial system. The current Asian crisis is the second. We do not as yet fully understand the new system's dynamics. We are learning fast, and need to update and modify our institutions and practices to reduce the risks inherent in the new regime. Meanwhile, we have to confront the current crisis with the institutions and techniques we have. Many argue that the current crisis should be allowed to run its course without support from the International Monetary Fund or the bilateral financial backing of other nations. They assert that allowing this crisis to play out, while doubtless having additional negative effects on growth in Asia, and engendering greater spill-overs onto the rest of the world, is not likely to have a large or lasting impact on the United States and the world economy. They may well be correct in their judgment. There is, however, a small but not negligible probability that the upset in East Asia could have unexpectedly large negative effects on Japan, Latin America, and eastern and central Europe that, in turn, could have repercussions elsewhere, including the United States. Thus, while the probability of such an outcome may be small, its consequences, in my judgment, should not be left solely to chance. We have observed that global financial markets, as currently organized, do not always achieve an appropriate equilibrium, or at least require time to stabilize. Opponents of IMF support for member countries facing international financial difficulties also argue that such substantial financial backing, by cushioning the losses of imprudent investors, could encourage excessive risk-taking. There doubtless is some truth in that, though arguably it has been the expectation of governments' support of their financial systems that has been the more obvious culprit, at least in the Asian case. In any event, any expectations of broad bailouts have turned out to have been disappointed. Many if not most investors in Asian economies have to date suffered substantial losses. Asian equity losses, excluding Japanese companies, since June 1997, worldwide, are estimated to have exceeded $700 billion, at the end of January, of which more than $30 billion had been lost by US investors. Substantial further losses have been recorded in bonds and real estate. Moreover, the policy conditionality, associated principally with IMF lending, which dictates economic and financial discipline and structural change, helps to mitigate some of the inappropriate risk-taking. Such conditionality is also critical to the success of the overall stabilization effort. At the root of the problems is poor public policy that has resulted in misguided investments and very weak financial sectors. Convincing a sovereign nation to alter destructive policies that impair its own performance and threaten contagion to its neighbors is best handled by an international financial institution, such as the IMF. What we have in place today to respond to crises should be supported even as we work to improve those mechanisms and institutions. Some observers have also expressed concern about whether we can be confident that IMF programs for countries, in particular the countries of East Asia, are likely to alter their economies significantly and permanently. My sense is that one consequence of this Asian crisis is an increasing awareness in the region that market capitalism, as practiced in the West, especially in the United States, is the superior model; that is, it provides greater promise of producing rising standards of living and continuous growth. Although East Asian economies have exhibited considerable adherence to many aspects of free-market capitalism, there has, nonetheless, been a pronounced tendency toward government-directed investment, using the banking system to finance that investment. Given a record of real growth rates of close to 10 percent per annum over an extended period of time, it is not surprising that it has been difficult to convince anyone that the economic system practiced in East Asia could not continue to produce positive results indefinitely. Following the breakdown, an increasing awareness, bordering in some cases on shock, that their economic model was incomplete, or worse, has arguably emerged in the region. As a consequence, many of the leaders of these countries and their economic advisors are endeavoring to move their economies much more rapidly toward the type of economic system that we have in the United States. The IMF, whatever one might say about its policy advice in the past, is trying to play a critical role in this process, providing advice and incentives that promote sound money and long-term stability. The IMF's current approach in Asia is fully supportive of the views of those in the West who understand the importance of greater reliance on market forces, reduced government controls, scaling back of government-directed investment, and embracing greater transparency -- the publication of all the data that are relevant to the activities of the central bank, the government, financial institutions, and private companies. It is a reasonable question to ask how long this conversion to embracing market capitalism in all its details will last in countries once temporary IMF support is no longer necessary. We are, after all, dealing with sovereign nations with long traditions, not always consonant with market capitalism. There can be no guarantees, but my sense is that there is a growing understanding and appreciation of the benefits of market capitalism as we practice it -that what is being prescribed in IMF programs fosters their own interests. The just-inaugurated president of Korea, from what I can judge, is unquestionably aware of the faults of the Korean system that contributed to his country's crisis; he appears to be very strenuously endeavoring to move his economy and society in the direction of freer markets and a more flexible economy. In these efforts, he and other leaders in the region with similar views, have the support of many younger people, a large proportion educated in the West, that see the advantages of market capitalism and who will soon assume the mantle of leadership. Accordingly, I fully back the Administration's request to augment the financial resources of the IMF by approving as quickly as possible US participation in the New Arrangements to Borrow and an increase in the US quota in the IMF. Hopefully, neither will turn out to be needed, and no funds will be drawn. But it is better to have it available if that turns out not to be the case and quick response to a pending crisis is essential.	---[PAGE_BREAK]--- Mr. Greenspan gives a testimony on the global financial system Testimony of the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Subcommittee on Foreign Operations of the Committee on Appropriations of the US Senate on 3/3/98. The global financial system has been evolving rapidly in recent years. New technology has radically reduced the costs of borrowing and lending across traditional national borders, facilitating the development of new instruments and drawing in new players. Information is transmitted instantaneously around the world, and huge shifts in the supply and demand for funds naturally follow, resulting in a massive increase in capital flows. This burgeoning global system has been demonstrated to be a highly efficient structure that has significantly facilitated cross-border trade in goods and services and, accordingly, has made a substantial contribution to standards of living worldwide. Its efficiency exposes and punishes underlying economic imprudence swiftly and decisively. Regrettably, it also appears to have facilitated the transmission of financial disturbances far more effectively than ever before. Three years ago, the Mexican crisis was the first such episode associated with our new high-tech international financial system. The current Asian crisis is the second. We do not as yet fully understand the new system's dynamics. We are learning fast, and need to update and modify our institutions and practices to reduce the risks inherent in the new regime. Meanwhile, we have to confront the current crisis with the institutions and techniques we have. Many argue that the current crisis should be allowed to run its course without support from the International Monetary Fund or the bilateral financial backing of other nations. They assert that allowing this crisis to play out, while doubtless having additional negative effects on growth in Asia, and engendering greater spill-overs onto the rest of the world, is not likely to have a large or lasting impact on the United States and the world economy. They may well be correct in their judgment. There is, however, a small but not negligible probability that the upset in East Asia could have unexpectedly large negative effects on Japan, Latin America, and eastern and central Europe that, in turn, could have repercussions elsewhere, including the United States. Thus, while the probability of such an outcome may be small, its consequences, in my judgment, should not be left solely to chance. We have observed that global financial markets, as currently organized, do not always achieve an appropriate equilibrium, or at least require time to stabilize. Opponents of IMF support for member countries facing international financial difficulties also argue that such substantial financial backing, by cushioning the losses of imprudent investors, could encourage excessive risk-taking. There doubtless is some truth in that, though arguably it has been the expectation of governments' support of their financial systems that has been the more obvious culprit, at least in the Asian case. In any event, any expectations of broad bailouts have turned out to have been disappointed. Many if not most investors in Asian economies have to date suffered substantial losses. Asian equity losses, excluding Japanese companies, since June 1997, worldwide, are estimated to have exceeded $\$ 700$ billion, at the end of January, of which more than $\$ 30$ billion had been lost by US investors. Substantial further losses have been recorded in bonds and real estate. ---[PAGE_BREAK]--- Moreover, the policy conditionality, associated principally with IMF lending, which dictates economic and financial discipline and structural change, helps to mitigate some of the inappropriate risk-taking. Such conditionality is also critical to the success of the overall stabilization effort. At the root of the problems is poor public policy that has resulted in misguided investments and very weak financial sectors. Convincing a sovereign nation to alter destructive policies that impair its own performance and threaten contagion to its neighbors is best handled by an international financial institution, such as the IMF. What we have in place today to respond to crises should be supported even as we work to improve those mechanisms and institutions. Some observers have also expressed concern about whether we can be confident that IMF programs for countries, in particular the countries of East Asia, are likely to alter their economies significantly and permanently. My sense is that one consequence of this Asian crisis is an increasing awareness in the region that market capitalism, as practiced in the West, especially in the United States, is the superior model; that is, it provides greater promise of producing rising standards of living and continuous growth. Although East Asian economies have exhibited considerable adherence to many aspects of free-market capitalism, there has, nonetheless, been a pronounced tendency toward government-directed investment, using the banking system to finance that investment. Given a record of real growth rates of close to 10 percent per annum over an extended period of time, it is not surprising that it has been difficult to convince anyone that the economic system practiced in East Asia could not continue to produce positive results indefinitely. Following the breakdown, an increasing awareness, bordering in some cases on shock, that their economic model was incomplete, or worse, has arguably emerged in the region. As a consequence, many of the leaders of these countries and their economic advisors are endeavoring to move their economies much more rapidly toward the type of economic system that we have in the United States. The IMF, whatever one might say about its policy advice in the past, is trying to play a critical role in this process, providing advice and incentives that promote sound money and long-term stability. The IMF's current approach in Asia is fully supportive of the views of those in the West who understand the importance of greater reliance on market forces, reduced government controls, scaling back of government-directed investment, and embracing greater transparency -- the publication of all the data that are relevant to the activities of the central bank, the government, financial institutions, and private companies. It is a reasonable question to ask how long this conversion to embracing market capitalism in all its details will last in countries once temporary IMF support is no longer necessary. We are, after all, dealing with sovereign nations with long traditions, not always consonant with market capitalism. There can be no guarantees, but my sense is that there is a growing understanding and appreciation of the benefits of market capitalism as we practice it -that what is being prescribed in IMF programs fosters their own interests. The just-inaugurated president of Korea, from what I can judge, is unquestionably aware of the faults of the Korean system that contributed to his country's crisis; he appears to be very strenuously endeavoring to move his economy and society in the direction of freer markets and a more flexible economy. In these efforts, he and other leaders in the region with similar views, have the support of many younger people, a large proportion educated in the West, that see the advantages of market capitalism and who will soon assume the mantle of leadership. ---[PAGE_BREAK]--- Accordingly, I fully back the Administration's request to augment the financial resources of the IMF by approving as quickly as possible US participation in the New Arrangements to Borrow and an increase in the US quota in the IMF. Hopefully, neither will turn out to be needed, and no funds will be drawn. But it is better to have it available if that turns out not to be the case and quick response to a pending crisis is essential.	Alan Greenspan	United States	https://www.bis.org/review/r980318e.pdf	Mr. Greenspan gives a testimony on the global financial system Testimony of the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Subcommittee on Foreign Operations of the Committee on Appropriations of the US Senate on 3/3/98. The global financial system has been evolving rapidly in recent years. New technology has radically reduced the costs of borrowing and lending across traditional national borders, facilitating the development of new instruments and drawing in new players. Information is transmitted instantaneously around the world, and huge shifts in the supply and demand for funds naturally follow, resulting in a massive increase in capital flows. This burgeoning global system has been demonstrated to be a highly efficient structure that has significantly facilitated cross-border trade in goods and services and, accordingly, has made a substantial contribution to standards of living worldwide. Its efficiency exposes and punishes underlying economic imprudence swiftly and decisively. Regrettably, it also appears to have facilitated the transmission of financial disturbances far more effectively than ever before. Three years ago, the Mexican crisis was the first such episode associated with our new high-tech international financial system. The current Asian crisis is the second. We do not as yet fully understand the new system's dynamics. We are learning fast, and need to update and modify our institutions and practices to reduce the risks inherent in the new regime. Meanwhile, we have to confront the current crisis with the institutions and techniques we have. Many argue that the current crisis should be allowed to run its course without support from the International Monetary Fund or the bilateral financial backing of other nations. They assert that allowing this crisis to play out, while doubtless having additional negative effects on growth in Asia, and engendering greater spill-overs onto the rest of the world, is not likely to have a large or lasting impact on the United States and the world economy. They may well be correct in their judgment. There is, however, a small but not negligible probability that the upset in East Asia could have unexpectedly large negative effects on Japan, Latin America, and eastern and central Europe that, in turn, could have repercussions elsewhere, including the United States. Thus, while the probability of such an outcome may be small, its consequences, in my judgment, should not be left solely to chance. We have observed that global financial markets, as currently organized, do not always achieve an appropriate equilibrium, or at least require time to stabilize. Opponents of IMF support for member countries facing international financial difficulties also argue that such substantial financial backing, by cushioning the losses of imprudent investors, could encourage excessive risk-taking. There doubtless is some truth in that, though arguably it has been the expectation of governments' support of their financial systems that has been the more obvious culprit, at least in the Asian case. In any event, any expectations of broad bailouts have turned out to have been disappointed. Many if not most investors in Asian economies have to date suffered substantial losses. Asian equity losses, excluding Japanese companies, since June 1997, worldwide, are estimated to have exceeded $\$ 700$ billion, at the end of January, of which more than $\$ 30$ billion had been lost by US investors. Substantial further losses have been recorded in bonds and real estate. Moreover, the policy conditionality, associated principally with IMF lending, which dictates economic and financial discipline and structural change, helps to mitigate some of the inappropriate risk-taking. Such conditionality is also critical to the success of the overall stabilization effort. At the root of the problems is poor public policy that has resulted in misguided investments and very weak financial sectors. Convincing a sovereign nation to alter destructive policies that impair its own performance and threaten contagion to its neighbors is best handled by an international financial institution, such as the IMF. What we have in place today to respond to crises should be supported even as we work to improve those mechanisms and institutions. Some observers have also expressed concern about whether we can be confident that IMF programs for countries, in particular the countries of East Asia, are likely to alter their economies significantly and permanently. My sense is that one consequence of this Asian crisis is an increasing awareness in the region that market capitalism, as practiced in the West, especially in the United States, is the superior model; that is, it provides greater promise of producing rising standards of living and continuous growth. Although East Asian economies have exhibited considerable adherence to many aspects of free-market capitalism, there has, nonetheless, been a pronounced tendency toward government-directed investment, using the banking system to finance that investment. Given a record of real growth rates of close to 10 percent per annum over an extended period of time, it is not surprising that it has been difficult to convince anyone that the economic system practiced in East Asia could not continue to produce positive results indefinitely. Following the breakdown, an increasing awareness, bordering in some cases on shock, that their economic model was incomplete, or worse, has arguably emerged in the region. As a consequence, many of the leaders of these countries and their economic advisors are endeavoring to move their economies much more rapidly toward the type of economic system that we have in the United States. The IMF, whatever one might say about its policy advice in the past, is trying to play a critical role in this process, providing advice and incentives that promote sound money and long-term stability. The IMF's current approach in Asia is fully supportive of the views of those in the West who understand the importance of greater reliance on market forces, reduced government controls, scaling back of government-directed investment, and embracing greater transparency -- the publication of all the data that are relevant to the activities of the central bank, the government, financial institutions, and private companies. It is a reasonable question to ask how long this conversion to embracing market capitalism in all its details will last in countries once temporary IMF support is no longer necessary. We are, after all, dealing with sovereign nations with long traditions, not always consonant with market capitalism. There can be no guarantees, but my sense is that there is a growing understanding and appreciation of the benefits of market capitalism as we practice it -that what is being prescribed in IMF programs fosters their own interests. The just-inaugurated president of Korea, from what I can judge, is unquestionably aware of the faults of the Korean system that contributed to his country's crisis; he appears to be very strenuously endeavoring to move his economy and society in the direction of freer markets and a more flexible economy. In these efforts, he and other leaders in the region with similar views, have the support of many younger people, a large proportion educated in the West, that see the advantages of market capitalism and who will soon assume the mantle of leadership. Accordingly, I fully back the Administration's request to augment the financial resources of the IMF by approving as quickly as possible US participation in the New Arrangements to Borrow and an increase in the US quota in the IMF. Hopefully, neither will turn out to be needed, and no funds will be drawn. But it is better to have it available if that turns out not to be the case and quick response to a pending crisis is essential.
1998-03-09T00:00:00	Mr. Patrikis discusses global electronic commerce (Central Bank Articles and Speeches, 9 Mar 98)	Speech by the First Vice-President of the Federal Reserve Bank of New York, Mr. Ernest T. Patrikis, at the 1998 International ACH Conference in Seattle on 9/3/98.	Mr. Meyer addresses the competitiveness of financial centres from a Swiss perspective Address by the Chairman of the Governing Board of the Swiss National Bank, Mr. Hans Meyer, at the International Bankers Club Luxembourg, held in Luxembourg on 23/3/98. Both Luxembourg and Switzerland are major financial centres in Europe. The performance and competitiveness of the financial services industry are thus of key economic and social importance to both countries. I should like to use this opportunity to say a few words on the subject from what may be a somewhat unusual perspective. The factors which determine the competitiveness of an industry are basically the same as those determining the success of the entire economy. In both cases, we are looking at a multitude of quite diverse factors with varying degrees of importance. Today, I would like to single out just three of them which I believe are of particular significance: economic stability, social equilibrium (i.e. political stability), and the human factor. Although each of these elements could be dealt with separately, they should ultimately be viewed in a broader context. Let's start with economic stability. I define this as a state of balanced development across the economy as a whole, characterised by steady growth, a modest inflation rate and low unemployment. One of the main prerequisites for achieving such a state is the ability not only to create but to sustain an appropriate economic framework. This is primarily an objective for monetary policy, fiscal policy and competition policy. The main goal of monetary policy is to maintain price stability. This is of course not an end in itself, but a means to an end. A non-inflationary climate facilitates the free play of market forces and keeps socially damaging developments at bay. Fiscal policy must, basically, aim in the longer term to balance the public budgets. As with monetary policy, it is a question of steady, ongoing efforts. This should be no surprise, considering that the whole spectrum of public sector activities is reflected in the public budgets. This in turn raises the question of what services the state should perform, who should pay for them and how public-services can most efficiently be provided. Where competition policy is concerned, the aim is to create conditions conducive to the free play of market forces. In recent decades, it has unfortunately not always been possible to gain consensus support for the idea of free competition, which is still regarded with scepticism and suspicion by many people. Provided that free competition is able to develop in a stable environment, there can be little doubt that it is the best means to assure optimal use of available resources. When things go wrong, it is generally due not to the principle of free competition itself but to the lack of a stable environment. I would like to stress once again that the task of creating a stable economic framework is a never-ending one: it is a question of constantly working towards - but never actually reaching - the intended goal. Success in this endeavour is not just a question of thinking things through in a consistent way but, above all, of adopting a persevering and workmanlike approach. Economic stability in the sense of a balanced development of the economy as a whole is the sine qua non for a financial centre. It is essential if investors are to gain sufficient confidence in the prospect of sustainable business success. Stable prices, low interest rates, modest rates of taxation and a solid currency are the crucial factors. To what extent - if at all - is a financial centre reliant on its economic hinterland? This question is less easy to answer. Although a well-balanced interdependency might seem to be desirable here as well, this is not necessarily confirmed by experience. In fact, there never seems to have been any close correlation, and with modern technology enhancing the mobility of people, goods and services, the links have become even looser. Our two countries at least are proof of the fact that there need not be any close correlation between the importance of a country's economy and that of its financial sector. Talking about economic stability, I referred to the need for perseverance. This is precisely where I see the link with social and political stability. The central task of any community is to provide its members with the greatest possible degree of security, freedom and general welfare. The last - 2 - of these factors - the general welfare of the population - is dependent precisely on the creation of the appropriate economic framework I mentioned earlier. I should add that this task can only be accomplished if a sufficient number of citizens actively help in shaping developments. This is especially the case in the sphere of fiscal policy. In the wake of extremely dynamic growth, public budgets have grown considerably in all developed countries over the past few decades. While the original purpose of this spending was to meet a pressing and legitimate need such as in the area of social security - there has been a growing disparity between the claims made on the public purse and the willingness to generate the necessary resources. Today, we have reached a point where this trend needs to be reversed. However, neither rules and regulations nor government ordinances can achieve this alone. Instead, we have to take small but persistent steps to rectify the situation both from the spending and the revenues side, and - not least of all - to improve productivity. Because such ongoing measures need the backing of the community, the chances of success tend to be greater in smaller communities than in larger ones. Our experience suggests that a federally structured society based on direct democracy is well suited to achieving the interaction between economic and political stability I have just outlined. Here again, though, I should add that we are always on the way towards our goals and will never actually meet them. Even in the conditions we enjoy, it is not easy to reach the necessary consensus. This brings me to the "human factor". The background conditions I have been talking about are aimed in no small measure at enabling individuals to develop their own interests as well as those of society. This symbiosis is essential to the prosperity of the economy as a whole. Where human resources are concerned, what is needed most of all is adequate training, motivation and the right mentality. Over the course of time, the development of the economy and the associated structural change have constantly thrown up new challenges for everyone involved. This can be seen, for example, in the phenomenon of structural unemployment, arising from an imbalance in supply and demand for specific skills. Although the need for continuous training and retraining is nothing new, it has now become an urgent concern. But qualifications alone are not sufficient. They only come into their own when the people in question are also motivated. If we were to restrict ourselves purely to economic activities, we could leave it at that. But after what I said about the correlations between the economy and society, there is clearly more to it. In a democratic community, we don't just need "economic subjects" who contribute their skills in specific areas and with the right mentality. We also need citizens who are willing and able to concern themselves at all times with developments in the community and to help shape these developments. If progress is to be made towards achieving balanced - and therefore stable growth, it is especially important that individuals should be able to identify with the community as a whole. Clear interdependencies with the economy emerge here as a key aspect of social coexistence. Only if the individual members of society are assimilated into a balanced and flourishing economic environment will they identify with society to the extent that they work actively towards its goals - which in turn is essential to the successful shaping of the appropriate economic framework. The resulting social equilibrium, i.e. political stability, creates the necessary confidence in a stable and sustainable development that is so essential to a financial centre. Today, there is a tendency for people to retreat into the role of the pure economic subject. I see this as a worrying development, and indeed as posing a threat to both the economy and society. Based on what I said earlier, the economy and society can only flourish in a balanced environment. But this balance can only be achieved if the citizens are aware of their dual responsibility and act accordingly. - 3 - We have talked about economic stability, political stability and the human factor. These are the elements which define the substance of a financial centre, and the necessary symbiosis between them hinges on the actions of the individual. But we should not forget the importance of other major aspects such as a clearly defined legal system and a properly functioning technical and organisational infrastructure. I would also like to address another aspect that is of particular importance to a central bank: the stability of the system. Maintaining stability in the financial sphere should not be viewed in isolation, as it is closely interlinked with the human and economic factors discussed earlier. Political and economic stability, the quality of the human contribution, a clearly defined legal order and an efficient infrastructure are the keys to the success of a financial centre. To this, we should add a reputation which is founded upon a sound attitude and a good track record, going beyond the criteria we have enumerated. Stability of the financial system is a concern primarily for the market participants themselves. Furthermore, it comes within the remit both of the bank supervisors and of the central bank, which is responsible for monetary policy. As you know, responsibilities and powers are kept separate in my country, the task of supervising the banks being assigned to an independent body, the Federal Banking Commission. Discussion about whether it would be preferable to unite the two institutions under one roof has been going on for a long time. Both solutions clearly have their advantages and disadvantages, each of which may be weighted differently depending on the requirements of society. Consequently, the debate must be pragmatic and not dogmatic. We believe that our approach has proved its worth and do not see any need for radical change. It is clear, though, that the separation of responsibilities and powers can only function on a basis of close cooperation and trust. I should like to touch upon two areas in which fundamental changes are needed. First, the financial systems have obviously been becoming more complex with regard to the roles played by their major participants. The traditional approach of focusing supervisory activities on the banks thus seems less and less appropriate. A more comprehensive supervisory system, covering the financial markets as a whole, would be preferable, with particular attention being paid to the transparency of market activities. Moreover, bank supervision should take account of the increasingly international nature of the financial markets. There would appear to be good reason to call for a globalisation of the supervisory system. But globalisation is one of those "in" words that has to be treated with caution. As a matter of fact, individual financial markets are still embedded in a national economic and social environment. What we need is for cooperation between the national supervisory bodies to be gradually intensified - which is in fact happening. True supranational supervision is still a long way off, as the necessary economic and social framework is lacking. For this reason, I should now like to focus on the role that an individual central bank has to play in helping to safeguard the stability of the financial system. I have already spoken about the general prerequisites needed for a financial market to flourish. Within the scope defined by the operating conditions mentioned, market players are basically responsible themselves for what they do or don't do. Their prime concern is to stay solvent at all times by adopting sound business practices and putting an effective organisation in place. To prevent problems from occurring, the responsible bodies at the individual banks must be able at all times, and with a minimum of delay, to accurately assess their risk situation and to take rapid and appropriate action. Of course, it is never possible to rule out the possibility of an individual bank running into difficulties. In such cases, a solution must first be sought through the market. Solidarity among the other market players should provide a "first line of defence". Seeking funds from the central bank can only be contemplated in the last instance - hence the expression "lender of last resort". Obtaining credit from the central bank presupposes that the liquidity requirements are only temporary. If the solvency of a - 4 - bank is in peril because of a threat to its capital, the problem is a matter for the supervisory authorities and possibly for the state itself. In practice, the boundary between liquidity and solvency problems can be a fluid one. In my view, it is important for everyone involved not to lose sight of these principles which are in fact quite simple. It should not be assumed that the central bank might take action beyond the limits outlined. But this does not mean that it cannot assist in the search for solutions, as far as they do not involve extending further credit. If the problems of individual banks multiply, there is a danger that liquidity may dry out throughout the entire system. In such a case, the central bank would basically be able to supply the market with the necessary liquidity. However, it may then come into conflict with the requirements of a policy geared to economic stability. Consequently, the short-term benefits of an easing of monetary policy should be weighed against the longer-term risks. I would like to sum up my thoughts as follows: 1. Three factors are of prime importance to the competitiveness of a financial centre: economic stability, political stability and the "human factor" (i.e. professionalism, motivation and mentality). Although these factors can each be viewed separately, it is the interaction between them that really counts. 2. Economic stability, in the sense of a balanced development of the economy as a whole, is made possible by the existence of an appropriate economic framework. This is created first and foremost by monetary policy, fiscal policy and competition policy. Economic stability provides the financial services industry with a favourable climate in terms of low inflation and interest rates, moderate tax levels and appropriate exchange rates. 3. Favourable economic conditions are planned and implemented as part of the process of social coexistence. This can best be achieved when the largest possible number of the community's members are involved. 4 Individuals are at the same time citizens and economic subjects, thereby creating a crucial interdependency. Proper integration into a balanced economic environment is an important prerequisite for developing a sense of common purpose - in other words, identifying with society and thus also displaying a willingness to actively help shape its progress. This ultimately means that economic and social development can only progress in a sustainable and balanced way if an appropriate equilibrium can be maintained between them. 5. Even at a time when global economic and social developments are becoming more and more closely intertwined, being an integral part of a national community still plays an important role. It is still essential that these national communities should strive first and foremost to keep their own house in order - a house, though, which should not just be stable but open as well. 6. Ensuring the stability of the financial system is one of the core tasks of the supervisory authorities and of the central bank in its capacity as lender of last resort. However, the market players' sense of individual responsibility is also of key importance. If a third party is to offer assistance in a system run on free market principles, this can and should be seen as nothing more nor less - than helping the others to help themselves.	---[PAGE_BREAK]--- # Mr. Meyer addresses the competitiveness of financial centres from a Swiss perspective Address by the Chairman of the Governing Board of the Swiss National Bank, Mr. Hans Meyer, at the International Bankers Club Luxembourg, held in Luxembourg on 23/3/98. Both Luxembourg and Switzerland are major financial centres in Europe. The performance and competitiveness of the financial services industry are thus of key economic and social importance to both countries. I should like to use this opportunity to say a few words on the subject from what may be a somewhat unusual perspective. The factors which determine the competitiveness of an industry are basically the same as those determining the success of the entire economy. In both cases, we are looking at a multitude of quite diverse factors with varying degrees of importance. Today, I would like to single out just three of them which I believe are of particular significance: economic stability, social equilibrium (i.e. political stability), and the human factor. Although each of these elements could be dealt with separately, they should ultimately be viewed in a broader context. Let's start with economic stability. I define this as a state of balanced development across the economy as a whole, characterised by steady growth, a modest inflation rate and low unemployment. One of the main prerequisites for achieving such a state is the ability not only to create but to sustain an appropriate economic framework. This is primarily an objective for monetary policy, fiscal policy and competition policy. The main goal of monetary policy is to maintain price stability. This is of course not an end in itself, but a means to an end. A non-inflationary climate facilitates the free play of market forces and keeps socially damaging developments at bay. Fiscal policy must, basically, aim in the longer term to balance the public budgets. As with monetary policy, it is a question of steady, ongoing efforts. This should be no surprise, considering that the whole spectrum of public sector activities is reflected in the public budgets. This in turn raises the question of what services the state should perform, who should pay for them and how public-services can most efficiently be provided. Where competition policy is concerned, the aim is to create conditions conducive to the free play of market forces. In recent decades, it has unfortunately not always been possible to gain consensus support for the idea of free competition, which is still regarded with scepticism and suspicion by many people. Provided that free competition is able to develop in a stable environment, there can be little doubt that it is the best means to assure optimal use of available resources. When things go wrong, it is generally due not to the principle of free competition itself but to the lack of a stable environment. I would like to stress once again that the task of creating a stable economic framework is a never-ending one: it is a question of constantly working towards - but never actually reaching - the intended goal. Success in this endeavour is not just a question of thinking things through in a consistent way but, above all, of adopting a persevering and workmanlike approach. Economic stability in the sense of a balanced development of the economy as a whole is the sine qua non for a financial centre. It is essential if investors are to gain sufficient confidence in the prospect of sustainable business success. Stable prices, low interest rates, modest rates of taxation and a solid currency are the crucial factors. To what extent - if at all - is a financial centre reliant on its economic hinterland? This question is less easy to answer. Although a well-balanced interdependency might seem to be desirable here as well, this is not necessarily confirmed by experience. In fact, there never seems to have been any close correlation, and with modern technology enhancing the mobility of people, goods and services, the links have become even looser. Our two countries at least are proof of the fact that there need not be any close correlation between the importance of a country's economy and that of its financial sector. Talking about economic stability, I referred to the need for perseverance. This is precisely where I see the link with social and political stability. The central task of any community is to provide its members with the greatest possible degree of security, freedom and general welfare. The last ---[PAGE_BREAK]--- of these factors - the general welfare of the population - is dependent precisely on the creation of the appropriate economic framework I mentioned earlier. I should add that this task can only be accomplished if a sufficient number of citizens actively help in shaping developments. This is especially the case in the sphere of fiscal policy. In the wake of extremely dynamic growth, public budgets have grown considerably in all developed countries over the past few decades. While the original purpose of this spending was to meet a pressing and legitimate need such as in the area of social security - there has been a growing disparity between the claims made on the public purse and the willingness to generate the necessary resources. Today, we have reached a point where this trend needs to be reversed. However, neither rules and regulations nor government ordinances can achieve this alone. Instead, we have to take small but persistent steps to rectify the situation both from the spending and the revenues side, and - not least of all - to improve productivity. Because such ongoing measures need the backing of the community, the chances of success tend to be greater in smaller communities than in larger ones. Our experience suggests that a federally structured society based on direct democracy is well suited to achieving the interaction between economic and political stability I have just outlined. Here again, though, I should add that we are always on the way towards our goals and will never actually meet them. Even in the conditions we enjoy, it is not easy to reach the necessary consensus. This brings me to the "human factor". The background conditions I have been talking about are aimed in no small measure at enabling individuals to develop their own interests as well as those of society. This symbiosis is essential to the prosperity of the economy as a whole. Where human resources are concerned, what is needed most of all is adequate training, motivation and the right mentality. Over the course of time, the development of the economy and the associated structural change have constantly thrown up new challenges for everyone involved. This can be seen, for example, in the phenomenon of structural unemployment, arising from an imbalance in supply and demand for specific skills. Although the need for continuous training and retraining is nothing new, it has now become an urgent concern. But qualifications alone are not sufficient. They only come into their own when the people in question are also motivated. If we were to restrict ourselves purely to economic activities, we could leave it at that. But after what I said about the correlations between the economy and society, there is clearly more to it. In a democratic community, we don't just need "economic subjects" who contribute their skills in specific areas and with the right mentality. We also need citizens who are willing and able to concern themselves at all times with developments in the community and to help shape these developments. If progress is to be made towards achieving balanced - and therefore stable growth, it is especially important that individuals should be able to identify with the community as a whole. Clear interdependencies with the economy emerge here as a key aspect of social coexistence. Only if the individual members of society are assimilated into a balanced and flourishing economic environment will they identify with society to the extent that they work actively towards its goals - which in turn is essential to the successful shaping of the appropriate economic framework. The resulting social equilibrium, i.e. political stability, creates the necessary confidence in a stable and sustainable development that is so essential to a financial centre. Today, there is a tendency for people to retreat into the role of the pure economic subject. I see this as a worrying development, and indeed as posing a threat to both the economy and society. Based on what I said earlier, the economy and society can only flourish in a balanced environment. But this balance can only be achieved if the citizens are aware of their dual responsibility and act accordingly. ---[PAGE_BREAK]--- We have talked about economic stability, political stability and the human factor. These are the elements which define the substance of a financial centre, and the necessary symbiosis between them hinges on the actions of the individual. But we should not forget the importance of other major aspects such as a clearly defined legal system and a properly functioning technical and organisational infrastructure. I would also like to address another aspect that is of particular importance to a central bank: the stability of the system. Maintaining stability in the financial sphere should not be viewed in isolation, as it is closely interlinked with the human and economic factors discussed earlier. Political and economic stability, the quality of the human contribution, a clearly defined legal order and an efficient infrastructure are the keys to the success of a financial centre. To this, we should add a reputation which is founded upon a sound attitude and a good track record, going beyond the criteria we have enumerated. Stability of the financial system is a concern primarily for the market participants themselves. Furthermore, it comes within the remit both of the bank supervisors and of the central bank, which is responsible for monetary policy. As you know, responsibilities and powers are kept separate in my country, the task of supervising the banks being assigned to an independent body, the Federal Banking Commission. Discussion about whether it would be preferable to unite the two institutions under one roof has been going on for a long time. Both solutions clearly have their advantages and disadvantages, each of which may be weighted differently depending on the requirements of society. Consequently, the debate must be pragmatic and not dogmatic. We believe that our approach has proved its worth and do not see any need for radical change. It is clear, though, that the separation of responsibilities and powers can only function on a basis of close cooperation and trust. I should like to touch upon two areas in which fundamental changes are needed. First, the financial systems have obviously been becoming more complex with regard to the roles played by their major participants. The traditional approach of focusing supervisory activities on the banks thus seems less and less appropriate. A more comprehensive supervisory system, covering the financial markets as a whole, would be preferable, with particular attention being paid to the transparency of market activities. Moreover, bank supervision should take account of the increasingly international nature of the financial markets. There would appear to be good reason to call for a globalisation of the supervisory system. But globalisation is one of those "in" words that has to be treated with caution. As a matter of fact, individual financial markets are still embedded in a national economic and social environment. What we need is for cooperation between the national supervisory bodies to be gradually intensified - which is in fact happening. True supranational supervision is still a long way off, as the necessary economic and social framework is lacking. For this reason, I should now like to focus on the role that an individual central bank has to play in helping to safeguard the stability of the financial system. I have already spoken about the general prerequisites needed for a financial market to flourish. Within the scope defined by the operating conditions mentioned, market players are basically responsible themselves for what they do or don't do. Their prime concern is to stay solvent at all times by adopting sound business practices and putting an effective organisation in place. To prevent problems from occurring, the responsible bodies at the individual banks must be able at all times, and with a minimum of delay, to accurately assess their risk situation and to take rapid and appropriate action. Of course, it is never possible to rule out the possibility of an individual bank running into difficulties. In such cases, a solution must first be sought through the market. Solidarity among the other market players should provide a "first line of defence". Seeking funds from the central bank can only be contemplated in the last instance - hence the expression "lender of last resort". Obtaining credit from the central bank presupposes that the liquidity requirements are only temporary. If the solvency of a ---[PAGE_BREAK]--- bank is in peril because of a threat to its capital, the problem is a matter for the supervisory authorities and possibly for the state itself. In practice, the boundary between liquidity and solvency problems can be a fluid one. In my view, it is important for everyone involved not to lose sight of these principles which are in fact quite simple. It should not be assumed that the central bank might take action beyond the limits outlined. But this does not mean that it cannot assist in the search for solutions, as far as they do not involve extending further credit. If the problems of individual banks multiply, there is a danger that liquidity may dry out throughout the entire system. In such a case, the central bank would basically be able to supply the market with the necessary liquidity. However, it may then come into conflict with the requirements of a policy geared to economic stability. Consequently, the short-term benefits of an easing of monetary policy should be weighed against the longer-term risks. I would like to sum up my thoughts as follows: 1. Three factors are of prime importance to the competitiveness of a financial centre: economic stability, political stability and the "human factor" (i.e. professionalism, motivation and mentality). Although these factors can each be viewed separately, it is the interaction between them that really counts. 2. Economic stability, in the sense of a balanced development of the economy as a whole, is made possible by the existence of an appropriate economic framework. This is created first and foremost by monetary policy, fiscal policy and competition policy. Economic stability provides the financial services industry with a favourable climate in terms of low inflation and interest rates, moderate tax levels and appropriate exchange rates. 3. Favourable economic conditions are planned and implemented as part of the process of social coexistence. This can best be achieved when the largest possible number of the community's members are involved. 4 Individuals are at the same time citizens and economic subjects, thereby creating a crucial interdependency. Proper integration into a balanced economic environment is an important prerequisite for developing a sense of common purpose - in other words, identifying with society and thus also displaying a willingness to actively help shape its progress. This ultimately means that economic and social development can only progress in a sustainable and balanced way if an appropriate equilibrium can be maintained between them. 5. Even at a time when global economic and social developments are becoming more and more closely intertwined, being an integral part of a national community still plays an important role. It is still essential that these national communities should strive first and foremost to keep their own house in order - a house, though, which should not just be stable but open as well. 6. Ensuring the stability of the financial system is one of the core tasks of the supervisory authorities and of the central bank in its capacity as lender of last resort. However, the market players' sense of individual responsibility is also of key importance. If a third party is to offer assistance in a system run on free market principles, this can and should be seen as nothing more nor less - than helping the others to help themselves.	Ernest T Patrikis	United States	https://www.bis.org/review/r980327c.pdf	perspective Address by the Chairman of the Governing Board of the Swiss National Bank, Mr. Hans Meyer, at the International Bankers Club Luxembourg, held in Luxembourg on 23/3/98. Both Luxembourg and Switzerland are major financial centres in Europe. The performance and competitiveness of the financial services industry are thus of key economic and social importance to both countries. I should like to use this opportunity to say a few words on the subject from what may be a somewhat unusual perspective. The factors which determine the competitiveness of an industry are basically the same as those determining the success of the entire economy. In both cases, we are looking at a multitude of quite diverse factors with varying degrees of importance. Today, I would like to single out just three of them which I believe are of particular significance: economic stability, social equilibrium (i.e. political stability), and the human factor. Although each of these elements could be dealt with separately, they should ultimately be viewed in a broader context. Let's start with economic stability. I define this as a state of balanced development across the economy as a whole, characterised by steady growth, a modest inflation rate and low unemployment. One of the main prerequisites for achieving such a state is the ability not only to create but to sustain an appropriate economic framework. This is primarily an objective for monetary policy, fiscal policy and competition policy. The main goal of monetary policy is to maintain price stability. This is of course not an end in itself, but a means to an end. A non-inflationary climate facilitates the free play of market forces and keeps socially damaging developments at bay. Fiscal policy must, basically, aim in the longer term to balance the public budgets. As with monetary policy, it is a question of steady, ongoing efforts. This should be no surprise, considering that the whole spectrum of public sector activities is reflected in the public budgets. This in turn raises the question of what services the state should perform, who should pay for them and how public-services can most efficiently be provided. Where competition policy is concerned, the aim is to create conditions conducive to the free play of market forces. In recent decades, it has unfortunately not always been possible to gain consensus support for the idea of free competition, which is still regarded with scepticism and suspicion by many people. Provided that free competition is able to develop in a stable environment, there can be little doubt that it is the best means to assure optimal use of available resources. When things go wrong, it is generally due not to the principle of free competition itself but to the lack of a stable environment. I would like to stress once again that the task of creating a stable economic framework is a never-ending one: it is a question of constantly working towards - but never actually reaching - the intended goal. Success in this endeavour is not just a question of thinking things through in a consistent way but, above all, of adopting a persevering and workmanlike approach. Economic stability in the sense of a balanced development of the economy as a whole is the sine qua non for a financial centre. It is essential if investors are to gain sufficient confidence in the prospect of sustainable business success. Stable prices, low interest rates, modest rates of taxation and a solid currency are the crucial factors. To what extent - if at all - is a financial centre reliant on its economic hinterland? This question is less easy to answer. Although a well-balanced interdependency might seem to be desirable here as well, this is not necessarily confirmed by experience. In fact, there never seems to have been any close correlation, and with modern technology enhancing the mobility of people, goods and services, the links have become even looser. Our two countries at least are proof of the fact that there need not be any close correlation between the importance of a country's economy and that of its financial sector. Talking about economic stability, I referred to the need for perseverance. This is precisely where I see the link with social and political stability. The central task of any community is to provide its members with the greatest possible degree of security, freedom and general welfare. The last of these factors - the general welfare of the population - is dependent precisely on the creation of the appropriate economic framework I mentioned earlier. I should add that this task can only be accomplished if a sufficient number of citizens actively help in shaping developments. This is especially the case in the sphere of fiscal policy. In the wake of extremely dynamic growth, public budgets have grown considerably in all developed countries over the past few decades. While the original purpose of this spending was to meet a pressing and legitimate need such as in the area of social security - there has been a growing disparity between the claims made on the public purse and the willingness to generate the necessary resources. Today, we have reached a point where this trend needs to be reversed. However, neither rules and regulations nor government ordinances can achieve this alone. Instead, we have to take small but persistent steps to rectify the situation both from the spending and the revenues side, and - not least of all - to improve productivity. Because such ongoing measures need the backing of the community, the chances of success tend to be greater in smaller communities than in larger ones. Our experience suggests that a federally structured society based on direct democracy is well suited to achieving the interaction between economic and political stability I have just outlined. Here again, though, I should add that we are always on the way towards our goals and will never actually meet them. Even in the conditions we enjoy, it is not easy to reach the necessary consensus. This brings me to the "human factor". The background conditions I have been talking about are aimed in no small measure at enabling individuals to develop their own interests as well as those of society. This symbiosis is essential to the prosperity of the economy as a whole. Where human resources are concerned, what is needed most of all is adequate training, motivation and the right mentality. Over the course of time, the development of the economy and the associated structural change have constantly thrown up new challenges for everyone involved. This can be seen, for example, in the phenomenon of structural unemployment, arising from an imbalance in supply and demand for specific skills. Although the need for continuous training and retraining is nothing new, it has now become an urgent concern. But qualifications alone are not sufficient. They only come into their own when the people in question are also motivated. If we were to restrict ourselves purely to economic activities, we could leave it at that. But after what I said about the correlations between the economy and society, there is clearly more to it. In a democratic community, we don't just need "economic subjects" who contribute their skills in specific areas and with the right mentality. We also need citizens who are willing and able to concern themselves at all times with developments in the community and to help shape these developments. If progress is to be made towards achieving balanced - and therefore stable growth, it is especially important that individuals should be able to identify with the community as a whole. Clear interdependencies with the economy emerge here as a key aspect of social coexistence. Only if the individual members of society are assimilated into a balanced and flourishing economic environment will they identify with society to the extent that they work actively towards its goals - which in turn is essential to the successful shaping of the appropriate economic framework. The resulting social equilibrium, i.e. political stability, creates the necessary confidence in a stable and sustainable development that is so essential to a financial centre. Today, there is a tendency for people to retreat into the role of the pure economic subject. I see this as a worrying development, and indeed as posing a threat to both the economy and society. Based on what I said earlier, the economy and society can only flourish in a balanced environment. But this balance can only be achieved if the citizens are aware of their dual responsibility and act accordingly. We have talked about economic stability, political stability and the human factor. These are the elements which define the substance of a financial centre, and the necessary symbiosis between them hinges on the actions of the individual. But we should not forget the importance of other major aspects such as a clearly defined legal system and a properly functioning technical and organisational infrastructure. I would also like to address another aspect that is of particular importance to a central bank: the stability of the system. Maintaining stability in the financial sphere should not be viewed in isolation, as it is closely interlinked with the human and economic factors discussed earlier. Political and economic stability, the quality of the human contribution, a clearly defined legal order and an efficient infrastructure are the keys to the success of a financial centre. To this, we should add a reputation which is founded upon a sound attitude and a good track record, going beyond the criteria we have enumerated. Stability of the financial system is a concern primarily for the market participants themselves. Furthermore, it comes within the remit both of the bank supervisors and of the central bank, which is responsible for monetary policy. As you know, responsibilities and powers are kept separate in my country, the task of supervising the banks being assigned to an independent body, the Federal Banking Commission. Discussion about whether it would be preferable to unite the two institutions under one roof has been going on for a long time. Both solutions clearly have their advantages and disadvantages, each of which may be weighted differently depending on the requirements of society. Consequently, the debate must be pragmatic and not dogmatic. We believe that our approach has proved its worth and do not see any need for radical change. It is clear, though, that the separation of responsibilities and powers can only function on a basis of close cooperation and trust. I should like to touch upon two areas in which fundamental changes are needed. First, the financial systems have obviously been becoming more complex with regard to the roles played by their major participants. The traditional approach of focusing supervisory activities on the banks thus seems less and less appropriate. A more comprehensive supervisory system, covering the financial markets as a whole, would be preferable, with particular attention being paid to the transparency of market activities. Moreover, bank supervision should take account of the increasingly international nature of the financial markets. There would appear to be good reason to call for a globalisation of the supervisory system. But globalisation is one of those "in" words that has to be treated with caution. As a matter of fact, individual financial markets are still embedded in a national economic and social environment. What we need is for cooperation between the national supervisory bodies to be gradually intensified - which is in fact happening. True supranational supervision is still a long way off, as the necessary economic and social framework is lacking. For this reason, I should now like to focus on the role that an individual central bank has to play in helping to safeguard the stability of the financial system. I have already spoken about the general prerequisites needed for a financial market to flourish. Within the scope defined by the operating conditions mentioned, market players are basically responsible themselves for what they do or don't do. Their prime concern is to stay solvent at all times by adopting sound business practices and putting an effective organisation in place. To prevent problems from occurring, the responsible bodies at the individual banks must be able at all times, and with a minimum of delay, to accurately assess their risk situation and to take rapid and appropriate action. Of course, it is never possible to rule out the possibility of an individual bank running into difficulties. In such cases, a solution must first be sought through the market. Solidarity among the other market players should provide a "first line of defence". Seeking funds from the central bank can only be contemplated in the last instance - hence the expression "lender of last resort". Obtaining credit from the central bank presupposes that the liquidity requirements are only temporary. If the solvency of a bank is in peril because of a threat to its capital, the problem is a matter for the supervisory authorities and possibly for the state itself. In practice, the boundary between liquidity and solvency problems can be a fluid one. In my view, it is important for everyone involved not to lose sight of these principles which are in fact quite simple. It should not be assumed that the central bank might take action beyond the limits outlined. But this does not mean that it cannot assist in the search for solutions, as far as they do not involve extending further credit. If the problems of individual banks multiply, there is a danger that liquidity may dry out throughout the entire system. In such a case, the central bank would basically be able to supply the market with the necessary liquidity. However, it may then come into conflict with the requirements of a policy geared to economic stability. Consequently, the short-term benefits of an easing of monetary policy should be weighed against the longer-term risks. I would like to sum up my thoughts as follows:
1998-03-09T00:00:00	Mr. Ferguson looks at bank supervision from the consulting perspective (Central Bank Articles and Speeches, 9 Mar 98)	Remarks by Mr. Roger W. Ferguson, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Conference of State Bank Supervisors in Washington, DC on 9/3/98.	Mr. Ferguson looks at bank supervision from the consulting perspective Remarks by Mr. Roger W. Ferguson, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Conference of State Bank Supervisors in Washington, DC on 9/3/98. It is my pleasure to join you today. The Federal Reserve has long enjoyed a cooperative relationship with the Conference of State Bank Supervisors, and I expect that relationship to continue. As you are well aware, technological and financial innovation have become the norm in banking and bank supervision. These innovations have accelerated the pace of transactions and increased the complexity of transactions seen throughout the banking system. This is a pattern we can expect to continue in the years ahead. Indeed, it is this complexity and innovation that leads us, as supervisors, toward a more risk-focused supervisory approach with a greater emphasis on sound management processes. Only by ensuring that a bank's management and control processes are sound can we be confident that its risks will remain contained throughout business and market cycles. It is not my intention today to espouse the merits of risk-focused examinations, since I trust we all recognize the value of that approach, especially in the case of larger, more-complex banking institutions. I would like to focus on a challenge that we face as we move more toward risk-focused examinations. This challenge or conundrum is captured in a comment I heard last year at a dinner hosted by the Bank Administration Institute. A leading banker at dinner complimented a regulator for having supervisors and examiners who provided "consultations" at the end of examinations. Since reviewing management and control processes is very much a "consultative" activity, I suspect such comments will become more commonplace. Being perceived as being like consultants is useful, but it is not an unalloyed blessing. As I reflected on the compliment I heard, I wondered if the consulting metaphor was really one we should encourage. We should all do what we can to maintain a strong and vibrant banking system that is responsive to the needs of the public. That is part of our role as supervisors. We should also work hard to ensure that the supervision and examination processes are not unduly burdensome to the banks we examine. We should be supportive of financial modernization, a process that is overdue in the banking industry. We also want to provide guidance to banks on sound practices and to evaluate the extent to which they conduct their activities in prudent ways. But we should be cautious in fully adopting the label "consultants." In my comments this morning, I would like to draw on my experience as a consultant to banks and other financial institutions to discuss some similarities and differences, as I see them, between the role of consultant and the role of supervisor. I raise this topic today because the recent turmoil in Asia has some roots in poor banking performance and poor banking supervision. I believe that the market is ultimately the best regulator of financial services, but we will still need supervision and regulation to offset the limitations inherent in regulation from the market. The recent turmoil in Asia serves as a reminder of the risks that financial institutions take and the systemic impact that can emerge if supervisors are not mindful of the important role that they continue to play in containing that risk. Why Do We Need Management Consultants and Supervisors Let me begin with the basic question of why firms hire management consultants. Many large companies that hire management consultants have substantial talent, resources and expertise of their own. A key reason they seek outside guidance is that the employees of these companies often lack the objectivity, the cross-company and cross-industry experience, or the specific, technical expertise that the company needs. Companies also hire consultants simply because they want to avoid distracting key individuals from their on-going operational duties in order to conduct a project that an outsider can perform. Why, on the other hand, do banks hire bank supervisors? The obvious answer is that they do not hire them at all. Supervision is found to be necessary -- not only here but also in virtually every country abroad -- to protect the public's interest in the lending and deposit-taking process. The fact that we continue to regulate banks reflects the economic concept of "externalities" and the need to protect the safety net that most societies extend to banks. It is not the impact of one bank's decisions on the wealth of its owners and the job security of its workers that worries us. Bank managers must be allowed to make managerial decisions with a minimum amount of regulatory and supervisory interference. Bank directors and managers have strong incentives to take care in their decisions due to a natural concern for personal job security, personal wealth, and continuing control in the active market for bank consolidation. Some will make wise decisions, and their institutions will thrive; others will make decisions that prove to be incorrect and their banks will suffer. However, we know that no single bank management team, regardless of how well intentioned, can accurately value the cost of its decisions, good or bad, on the banking system and economy as a whole. Therefore, supervision is a way of forcing banks, individually and collectively, to recognize the broader impact that their risk-taking and risk-mediation decisions might have on society at large. It also substitutes for some of the market discipline lost, and attempts to offset the "moral hazard" that arises, due to the existence of the safety net. It is the possibility that poor managerial decisions by one bank will then spill over to other banks and eventually to the public at large that provides the rationale for supervision and regulation. That possibility is also a key factor driving the Federal Reserve's need to remain a bank supervisor. Without such active, on-site experience supervising and evaluating bank activities, the central bank would, I believe, be less prepared to deal with financial crises that inevitably arise. In addition, the Federal Reserve is the operator of important parts of the nation's payment system, both wholesale and retail, and as such has a stake in the proper functioning of banks and the banking industry. However, we should also recognize that supervision and regulation are not without costs to banks and, in turn, to society. Therefore, I believe that we should aspire to the minimum amount of regulation and supervision that is consistent with maintaining safety and soundness of the banking system and with maintaining financial stability. After all, the marketplace is ultimately the best regulator, and we should look to the market for guidance and feedback, wherever possible. Similarities between Consultants and Supervisors Given these fundamentally different incentives for banks to have consultants and supervisors, why would an obviously intelligent CEO of a major bank compliment us on providing "consultations"? The answer is that a good examiner brings some of the same strengths to an examination that a good consultant brings to a consulting assignment, namely objectivity, cross-firm experience and critical technical expertise. Like consultants, the independent assessments that examiners make are becoming more dependent on statistical sampling and on the accuracy of a bank's internal information systems. Requiring banks to have, on an on-going basis, sound internal procedures should reduce risks to the financial system and lead to fewer surprises overall. Reviewing procedures, though, entails a more subjective approach than reviewing credits. Although analyzing credits can be complex, the potential resolutions are few. The examiner reaches a conclusion about individual credits and the overall quality of the loan portfolio, and his findings are communicated to the bank. Some loans are charged-off, others are written down, and the results are clear. Addressing procedural problems, however, is rarely so decisive because we get into judgmental areas and into a range of potentially acceptable -- and unacceptable -- resolutions. In this, supervision and consulting are very similar. One approach consultants use to resolve the challenge of dealing with more subjective judgments is to maintain open lines of communication between consultant and top management. The results of a consulting assignment are rarely a surprise when the final report is presented, and management has had an opportunity to respond to early findings and present their perspectives. Similarly, the results of a bank examination should not come as a surprise to bank leadership. Clear and frequent communication of supervisory guidance on sound practice is of critical importance. Particularly in new or innovative activities, bankers need to hear clearly which arrangements the supervisor will accept. Another technique consultants use to analyze a subjective topic, such as bank processes, in which several practices might be acceptable, is to have open lines of communication within the consulting team. All team members have a chance to add their perspectives to the potential solution. Similarly, examiners from different agencies examining a single banking entity should be able to share perspectives and findings. While both consultants and examiners may be forced to make judgments regarding management processes, it is essential that such judgments be made only after reviewing the relevant facts. For consultants, those facts may encompass a wide array of market or company data. For examiners, those facts may be gleaned from a credit analysis and the review of credit files. Despite all the innovation and structural changes we have witnessed throughout the financial system, extending credit and limiting the volume of bad loans remain the primary business of banks. Examiners will continue to need to evaluate whether a bank's own internal assessment of its exposures is sound, which will by necessity involve a review of a sample of loans. In another, less appealing, way consultants and bank examiners are quite similar. In both cases the process can be obtrusive, with outsiders asking for scarce time and attention from bank employees. Consultants and examiners alike must learn to adjust their professional approach to minimize the degree of disruption to the institution being served. In this regard, the move toward more off-site work and preparatory work is to be commended, and I am certain that it is appreciated by banks. So in many ways, while the goals of the consultant and examiner are different, the techniques used may be quite similar. One can imagine an effective examination process resembling a good consulting process. Both rely, in part, on internal data. Both should be characterized by frequent and candid conversations between bank leadership and the leadership of the examination team. Both should help bank leadership to understand what is considered sound practice. Both consultants and supervisors must at some level analyze the tangible results of the management processes, be that loan quality or some other measure of corporate performance. Finally, to be successful both consulting and examination must be carried out with the minimum of on-site disruption after careful off-site planning. Sharing Knowledge among Examiners Another similarity between consultants and examiners is that there is much practical experience gained by the professionals that must be shared with their co-workers or team members or even more broadly among the community of professionals. For the community of supervisors, these insights are the results of many years of first-hand experience with banks. Consultants have developed the fancy phrase of "knowledge management" for the process of building individual insights, sharing them with others, and finally applying the collective knowledge through an individual professional working with a client. The challenge, of course, is how to complete this cycle of "build-share-apply" when the community spans several thousand people, across multiple locations and, possibly, multiple agencies. This gathering is an example of one possible solution to this challenge. Technology, through group software and the creation of more common, interagency tools, might prove to be another solution. I shall return to the need for broadly shared common technology platforms. Distinctions between Consultants and Supervisors Now let me turn to the numerous differences between consultants and supervisors. In adding value to the banking industry, supervisors have a major advantage over consultants in that we have the standing and authority to influence actions industry-wide. That ability to influence state or national policies is an important aspect of our work and one that helps to motivate and retain our key people. This fact ties directly to the sound practice papers we provide. As supervisors, we need to share what we learn to help the industry manage and control its risk. To develop industry guidance, we do well in looking to leaders within the industry, and to institutions that know their business best. The knowledge we gain from our associations with so many banks also accommodates the development of new regulatory paradigms. The recently adopted rule for market risk that is based on the internal models of banks is a good example. Without the in-depth access to virtually all of the world's leading trading banks and to their experiences and observations, supervisors collectively could not have developed their own understanding and the willingness to pursue this approach. This new approach highlights a series of significant differences between consultants and supervisors. First, consultants often find themselves acting as "change leaders", attempting to get their clients to take greater business risk based on consulting judgment. Supervisors recognize that banks are in the business of taking risk, but our goal is not to encourage or to discourage risk-taking by individual banks. Our goal is to have banks recognize and manage well the risk they are taking, price the risk appropriately and avoid undue concentrations of risk. In that way we hope to reduce systemic risk. A second difference between consultants and supervisors is in the need for consistency across banks. Consultants generally place little value on consistency across clients. The best consultants tailor solutions to each individual client. Therefore, two clients served by the same consulting firm on the same topic may receive different sets of recommendations. Supervisors, by comparison, properly put a premium on consistency across banks and over time. We do not want to create an unstable market by giving inconsistent examination advice. A third difference that emerges is an appetite for novel professional approaches. Senior consultants reward younger professionals who develop new approaches. Within the fraternity of supervisors we want to maintain modern approaches to examination and supervision, but should only adopt them widely once we are sure they lead to the desired outcome. Finally, you may recall that earlier I referred to the communication and feedback required in order for an examination to have the impact of a good consultative process. The challenge in providing this feedback is in knowing just how far to go. As supervisors, we need to communicate our views, but we must avoid making operating decisions for banks. Supervisors, unlike consultants, must let banks make independent judgments. The responsibility for sound banking is with the banks, and it is they who must, ultimately, develop and take full responsibility for their decisions. Supervisors must be free to criticize conditions that, if not corrected, may lead to heightened risk in the future. Unlike consultants, supervisors have in their arsenal the power to effect change not only through examination of findings but also through moral suasion, a strong bully pulpit and ultimately, supervisory guidance, regulations and enforcement actions. One critical area where currently we are exercising the power of moral suasion is in connection with the possible decline in credit underwriting standards that may be becoming widespread. For more than two years now, we have heard persistent reports of declines in lending terms, conditions, and standards. It is not just isolated reports from some examiners. Leading bankers, such as John Medlin of Wachovia, and survey data, also support these reports. The question then becomes "what should we do?" We can certainly expect that in the next economic downturn credit problems will rise and weaker lending standards, if they exist, will only make matters worse. While the lending decision is ultimately that of the banks, this is an important area in which we can offer advice and general counsel. We should not create an artificial credit crunch, and I do not think that we are at risk of doing that, but we can and should urge caution that is based simply on our long experience in watching business cycles. We can continue to make sure that bankers, themselves, understand their own procedures and the risks that they face. We all seem to be taking a more aggressive approach on this issue, and I expect that we will remain vigilant to sound the alarm when necessary. Interagency Coordination Efforts Throughout my comments I have noted a number of points that bear directly on initiatives of state and federal supervisors to work together toward a stronger supervisory process. As the US banking system becomes more entwined through interstate banking and branching, it becomes ever more critical that we all coordinate our efforts in maintaining a healthy, viable, and attractive dual banking system. It is also important for states to work to minimize unnecessary distinctions that slow the progress of interstate banking. I mentioned, for example, the need to modernize US banking laws, share practical supervisory experiences, maintain consistency, reduce intrusion during the bank examination process and, in general, improve the overall efficiency of our staffs. These are not new challenges and, indeed, are goals that we collectively have been working toward successfully for some time through the State-Federal Working Group and other forums. As we all know, state banking authorities have done much to advance interstate banking and branching and to work together and with federal authorities toward a seamless oversight process. The state-federal protocol has helped greatly to bring about that seamless approach and is a crucial element in maintaining the viability of the state banking charter. Individual states and the state charter, in turn, have provided the industry with important flexibility to experiment in developing new banking products and delivery systems. In this and in many other ways, the state charter and the dual banking system have served the country well. Fortunately, the dual banking system seems healthy. Consider, for example, that of the 207 new banking institutions chartered last year, 146 were state chartered. Adapting available technology to examinations and to sharing insights among examiners is another area in which significant progress has been made through our joint efforts to produce more efficient examinations. As you may know, the FDIC's ALERT system now permits examiners to download bank data onto their own PCs in order to analyze exposures and prepare for upcoming examinations. It is being used widely by many states and by a number of Federal Reserve Banks; more are likely to learn about and use it in the months ahead. The Fed's own ELVIS program is another important advance that assists examiners through the risk-focused process for community banks that is being used by the Fed and FDIC and by most states. Looking forward, examiners should soon be able to use the "GENESYS" system to access a broad range of automated information contained in supervisory databases and download it into their examination reports. Together, these and other initiatives -- including greater use of analyst and examiner electronic desktops, new web pages, and expanded data access techniques between state and federal supervisors -- have helped significantly to improve the efficiency of our examiners and to create a less intrusive supervisory process. We should all be pleased with these results and should expect the process to become even better in the months and years to come. Conclusion In closing, I see many challenges ahead for us all, as we adapt the supervisory process to keep pace with events in financial markets. In some respects consultants and bank supervisors have much to share and can learn from one another: 1. Consultants and supervisors must have open, trust-based channels of communication with bank management and among their peers. Both must add value by analyzing both processes and the outcomes of those processes. They are both well advised to limit their intrusiveness while not foregoing a thorough and professional inquiry. 2. Both consultants and supervisors face the challenge of building, sharing and applying professional knowledge and skills in a rapidly changing business environment. The failure to manage our knowledge within teams, within agencies and even across agencies will certainly result in wasted effort and may even result in a caliber of supervision that does not keep pace with changing financial technology and increased sophistication by banks. The Federal-state coordination efforts that I mentioned are an example of this needed cooperation. However, while it might be quite appealing to speak of supervisors as acting more like consultants, in many critical ways the consulting metaphor does not work very well for supervisors. There are at least three factors that make consulting an inappropriate model for supervisors to follow: 1. Consultants are hired by management and work to add value to the shareholders that management represents. Supervisors, in contrast, ultimately work for the public at large. Rather than adding shareholder value, supervisors seek to reduce or eliminate excessive risks to the financial system and the federal safety net. 2. Supervisors have much more impact in the banking industry than even the most savvy or articulate consultant. We must be willing to exercise that moral and legal authority to forestall as best we can practices that we know might become harmful even before the full results of such practices become evident. In this we may not always be popular. 3. Finally, consultants can be wrong with only relatively limited consequences. The caliber of their advice is rarely subject to after-the-fact scrutiny. When a consulting firm makes a mistake, it may lose a client and that company may lose some money. When a banking agency fails to act, the consequences can be widespread for the economy and the public at large. To keep the public's trust, we need to be ever mindful of whose interests we serve. We do want to minimize the burden of supervision. We do want to foster modernization. We must stay current with the latest financial techniques. We can assist institutions by identifying weaknesses and, at times, we can offer views toward resolution. Ultimately, however, we are forced to supervise and regulate banks in the interest of the public.	---[PAGE_BREAK]--- # Mr. Ferguson looks at bank supervision from the consulting perspective Remarks by Mr. Roger W. Ferguson, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Conference of State Bank Supervisors in Washington, DC on 9/3/98. It is my pleasure to join you today. The Federal Reserve has long enjoyed a cooperative relationship with the Conference of State Bank Supervisors, and I expect that relationship to continue. As you are well aware, technological and financial innovation have become the norm in banking and bank supervision. These innovations have accelerated the pace of transactions and increased the complexity of transactions seen throughout the banking system. This is a pattern we can expect to continue in the years ahead. Indeed, it is this complexity and innovation that leads us, as supervisors, toward a more risk-focused supervisory approach with a greater emphasis on sound management processes. Only by ensuring that a bank's management and control processes are sound can we be confident that its risks will remain contained throughout business and market cycles. It is not my intention today to espouse the merits of risk-focused examinations, since I trust we all recognize the value of that approach, especially in the case of larger, more-complex banking institutions. I would like to focus on a challenge that we face as we move more toward risk-focused examinations. This challenge or conundrum is captured in a comment I heard last year at a dinner hosted by the Bank Administration Institute. A leading banker at dinner complimented a regulator for having supervisors and examiners who provided "consultations" at the end of examinations. Since reviewing management and control processes is very much a "consultative" activity, I suspect such comments will become more commonplace. Being perceived as being like consultants is useful, but it is not an unalloyed blessing. As I reflected on the compliment I heard, I wondered if the consulting metaphor was really one we should encourage. We should all do what we can to maintain a strong and vibrant banking system that is responsive to the needs of the public. That is part of our role as supervisors. We should also work hard to ensure that the supervision and examination processes are not unduly burdensome to the banks we examine. We should be supportive of financial modernization, a process that is overdue in the banking industry. We also want to provide guidance to banks on sound practices and to evaluate the extent to which they conduct their activities in prudent ways. But we should be cautious in fully adopting the label "consultants." In my comments this morning, I would like to draw on my experience as a consultant to banks and other financial institutions to discuss some similarities and differences, as I see them, between the role of consultant and the role of supervisor. I raise this topic today because the recent turmoil in Asia has some roots in poor banking performance and poor banking supervision. I believe that the market is ultimately the best regulator of financial services, but we will still need supervision and regulation to offset the limitations inherent in regulation from the market. The recent turmoil in Asia serves as a reminder of the risks that financial institutions take and the systemic impact that can emerge if supervisors are not mindful of the important role that they continue to play in containing that risk. ---[PAGE_BREAK]--- # Why Do We Need Management Consultants and Supervisors Let me begin with the basic question of why firms hire management consultants. Many large companies that hire management consultants have substantial talent, resources and expertise of their own. A key reason they seek outside guidance is that the employees of these companies often lack the objectivity, the cross-company and cross-industry experience, or the specific, technical expertise that the company needs. Companies also hire consultants simply because they want to avoid distracting key individuals from their on-going operational duties in order to conduct a project that an outsider can perform. Why, on the other hand, do banks hire bank supervisors? The obvious answer is that they do not hire them at all. Supervision is found to be necessary -- not only here but also in virtually every country abroad -- to protect the public's interest in the lending and deposit-taking process. The fact that we continue to regulate banks reflects the economic concept of "externalities" and the need to protect the safety net that most societies extend to banks. It is not the impact of one bank's decisions on the wealth of its owners and the job security of its workers that worries us. Bank managers must be allowed to make managerial decisions with a minimum amount of regulatory and supervisory interference. Bank directors and managers have strong incentives to take care in their decisions due to a natural concern for personal job security, personal wealth, and continuing control in the active market for bank consolidation. Some will make wise decisions, and their institutions will thrive; others will make decisions that prove to be incorrect and their banks will suffer. However, we know that no single bank management team, regardless of how well intentioned, can accurately value the cost of its decisions, good or bad, on the banking system and economy as a whole. Therefore, supervision is a way of forcing banks, individually and collectively, to recognize the broader impact that their risk-taking and risk-mediation decisions might have on society at large. It also substitutes for some of the market discipline lost, and attempts to offset the "moral hazard" that arises, due to the existence of the safety net. It is the possibility that poor managerial decisions by one bank will then spill over to other banks and eventually to the public at large that provides the rationale for supervision and regulation. That possibility is also a key factor driving the Federal Reserve's need to remain a bank supervisor. Without such active, on-site experience supervising and evaluating bank activities, the central bank would, I believe, be less prepared to deal with financial crises that inevitably arise. In addition, the Federal Reserve is the operator of important parts of the nation's payment system, both wholesale and retail, and as such has a stake in the proper functioning of banks and the banking industry. However, we should also recognize that supervision and regulation are not without costs to banks and, in turn, to society. Therefore, I believe that we should aspire to the minimum amount of regulation and supervision that is consistent with maintaining safety and soundness of the banking system and with maintaining financial stability. After all, the marketplace is ultimately the best regulator, and we should look to the market for guidance and feedback, wherever possible. ## Similarities between Consultants and Supervisors Given these fundamentally different incentives for banks to have consultants and supervisors, why would an obviously intelligent CEO of a major bank compliment us on providing "consultations"? The answer is that a good examiner brings some of the same strengths to an examination that a good consultant brings to a consulting assignment, namely ---[PAGE_BREAK]--- objectivity, cross-firm experience and critical technical expertise. Like consultants, the independent assessments that examiners make are becoming more dependent on statistical sampling and on the accuracy of a bank's internal information systems. Requiring banks to have, on an on-going basis, sound internal procedures should reduce risks to the financial system and lead to fewer surprises overall. Reviewing procedures, though, entails a more subjective approach than reviewing credits. Although analyzing credits can be complex, the potential resolutions are few. The examiner reaches a conclusion about individual credits and the overall quality of the loan portfolio, and his findings are communicated to the bank. Some loans are charged-off, others are written down, and the results are clear. Addressing procedural problems, however, is rarely so decisive because we get into judgmental areas and into a range of potentially acceptable -- and unacceptable -- resolutions. In this, supervision and consulting are very similar. One approach consultants use to resolve the challenge of dealing with more subjective judgments is to maintain open lines of communication between consultant and top management. The results of a consulting assignment are rarely a surprise when the final report is presented, and management has had an opportunity to respond to early findings and present their perspectives. Similarly, the results of a bank examination should not come as a surprise to bank leadership. Clear and frequent communication of supervisory guidance on sound practice is of critical importance. Particularly in new or innovative activities, bankers need to hear clearly which arrangements the supervisor will accept. Another technique consultants use to analyze a subjective topic, such as bank processes, in which several practices might be acceptable, is to have open lines of communication within the consulting team. All team members have a chance to add their perspectives to the potential solution. Similarly, examiners from different agencies examining a single banking entity should be able to share perspectives and findings. While both consultants and examiners may be forced to make judgments regarding management processes, it is essential that such judgments be made only after reviewing the relevant facts. For consultants, those facts may encompass a wide array of market or company data. For examiners, those facts may be gleaned from a credit analysis and the review of credit files. Despite all the innovation and structural changes we have witnessed throughout the financial system, extending credit and limiting the volume of bad loans remain the primary business of banks. Examiners will continue to need to evaluate whether a bank's own internal assessment of its exposures is sound, which will by necessity involve a review of a sample of loans. In another, less appealing, way consultants and bank examiners are quite similar. In both cases the process can be obtrusive, with outsiders asking for scarce time and attention from bank employees. Consultants and examiners alike must learn to adjust their professional approach to minimize the degree of disruption to the institution being served. In this regard, the move toward more off-site work and preparatory work is to be commended, and I am certain that it is appreciated by banks. So in many ways, while the goals of the consultant and examiner are different, the techniques used may be quite similar. One can imagine an effective examination process resembling a good consulting process. Both rely, in part, on internal data. Both should be characterized by frequent and candid conversations between bank leadership and the leadership ---[PAGE_BREAK]--- of the examination team. Both should help bank leadership to understand what is considered sound practice. Both consultants and supervisors must at some level analyze the tangible results of the management processes, be that loan quality or some other measure of corporate performance. Finally, to be successful both consulting and examination must be carried out with the minimum of on-site disruption after careful off-site planning. # Sharing Knowledge among Examiners Another similarity between consultants and examiners is that there is much practical experience gained by the professionals that must be shared with their co-workers or team members or even more broadly among the community of professionals. For the community of supervisors, these insights are the results of many years of first-hand experience with banks. Consultants have developed the fancy phrase of "knowledge management" for the process of building individual insights, sharing them with others, and finally applying the collective knowledge through an individual professional working with a client. The challenge, of course, is how to complete this cycle of "build-share-apply" when the community spans several thousand people, across multiple locations and, possibly, multiple agencies. This gathering is an example of one possible solution to this challenge. Technology, through group software and the creation of more common, interagency tools, might prove to be another solution. I shall return to the need for broadly shared common technology platforms. ## Distinctions between Consultants and Supervisors Now let me turn to the numerous differences between consultants and supervisors. In adding value to the banking industry, supervisors have a major advantage over consultants in that we have the standing and authority to influence actions industry-wide. That ability to influence state or national policies is an important aspect of our work and one that helps to motivate and retain our key people. This fact ties directly to the sound practice papers we provide. As supervisors, we need to share what we learn to help the industry manage and control its risk. To develop industry guidance, we do well in looking to leaders within the industry, and to institutions that know their business best. The knowledge we gain from our associations with so many banks also accommodates the development of new regulatory paradigms. The recently adopted rule for market risk that is based on the internal models of banks is a good example. Without the in-depth access to virtually all of the world's leading trading banks and to their experiences and observations, supervisors collectively could not have developed their own understanding and the willingness to pursue this approach. This new approach highlights a series of significant differences between consultants and supervisors. First, consultants often find themselves acting as "change leaders", attempting to get their clients to take greater business risk based on consulting judgment. Supervisors recognize that banks are in the business of taking risk, but our goal is not to encourage or to discourage risk-taking by individual banks. Our goal is to have banks recognize and manage well the risk they are taking, price the risk appropriately and avoid undue concentrations of risk. In that way we hope to reduce systemic risk. A second difference between consultants and supervisors is in the need for consistency across banks. Consultants generally place little value on consistency across clients. The best consultants tailor solutions to each individual client. Therefore, two clients served by ---[PAGE_BREAK]--- the same consulting firm on the same topic may receive different sets of recommendations. Supervisors, by comparison, properly put a premium on consistency across banks and over time. We do not want to create an unstable market by giving inconsistent examination advice. A third difference that emerges is an appetite for novel professional approaches. Senior consultants reward younger professionals who develop new approaches. Within the fraternity of supervisors we want to maintain modern approaches to examination and supervision, but should only adopt them widely once we are sure they lead to the desired outcome. Finally, you may recall that earlier I referred to the communication and feedback required in order for an examination to have the impact of a good consultative process. The challenge in providing this feedback is in knowing just how far to go. As supervisors, we need to communicate our views, but we must avoid making operating decisions for banks. Supervisors, unlike consultants, must let banks make independent judgments. The responsibility for sound banking is with the banks, and it is they who must, ultimately, develop and take full responsibility for their decisions. Supervisors must be free to criticize conditions that, if not corrected, may lead to heightened risk in the future. Unlike consultants, supervisors have in their arsenal the power to effect change not only through examination of findings but also through moral suasion, a strong bully pulpit and ultimately, supervisory guidance, regulations and enforcement actions. One critical area where currently we are exercising the power of moral suasion is in connection with the possible decline in credit underwriting standards that may be becoming widespread. For more than two years now, we have heard persistent reports of declines in lending terms, conditions, and standards. It is not just isolated reports from some examiners. Leading bankers, such as John Medlin of Wachovia, and survey data, also support these reports. The question then becomes "what should we do?" We can certainly expect that in the next economic downturn credit problems will rise and weaker lending standards, if they exist, will only make matters worse. While the lending decision is ultimately that of the banks, this is an important area in which we can offer advice and general counsel. We should not create an artificial credit crunch, and I do not think that we are at risk of doing that, but we can and should urge caution that is based simply on our long experience in watching business cycles. We can continue to make sure that bankers, themselves, understand their own procedures and the risks that they face. We all seem to be taking a more aggressive approach on this issue, and I expect that we will remain vigilant to sound the alarm when necessary. # Interagency Coordination Efforts Throughout my comments I have noted a number of points that bear directly on initiatives of state and federal supervisors to work together toward a stronger supervisory process. As the US banking system becomes more entwined through interstate banking and branching, it becomes ever more critical that we all coordinate our efforts in maintaining a healthy, viable, and attractive dual banking system. It is also important for states to work to minimize unnecessary distinctions that slow the progress of interstate banking. I mentioned, for example, the need to modernize US banking laws, share practical supervisory experiences, maintain consistency, reduce intrusion during the bank examination process and, in general, improve the overall efficiency of our staffs. These are not ---[PAGE_BREAK]--- new challenges and, indeed, are goals that we collectively have been working toward successfully for some time through the State-Federal Working Group and other forums. As we all know, state banking authorities have done much to advance interstate banking and branching and to work together and with federal authorities toward a seamless oversight process. The state-federal protocol has helped greatly to bring about that seamless approach and is a crucial element in maintaining the viability of the state banking charter. Individual states and the state charter, in turn, have provided the industry with important flexibility to experiment in developing new banking products and delivery systems. In this and in many other ways, the state charter and the dual banking system have served the country well. Fortunately, the dual banking system seems healthy. Consider, for example, that of the 207 new banking institutions chartered last year, 146 were state chartered. Adapting available technology to examinations and to sharing insights among examiners is another area in which significant progress has been made through our joint efforts to produce more efficient examinations. As you may know, the FDIC's ALERT system now permits examiners to download bank data onto their own PCs in order to analyze exposures and prepare for upcoming examinations. It is being used widely by many states and by a number of Federal Reserve Banks; more are likely to learn about and use it in the months ahead. The Fed's own ELVIS program is another important advance that assists examiners through the risk-focused process for community banks that is being used by the Fed and FDIC and by most states. Looking forward, examiners should soon be able to use the "GENESYS" system to access a broad range of automated information contained in supervisory databases and download it into their examination reports. Together, these and other initiatives -- including greater use of analyst and examiner electronic desktops, new web pages, and expanded data access techniques between state and federal supervisors -- have helped significantly to improve the efficiency of our examiners and to create a less intrusive supervisory process. We should all be pleased with these results and should expect the process to become even better in the months and years to come. # Conclusion In closing, I see many challenges ahead for us all, as we adapt the supervisory process to keep pace with events in financial markets. In some respects consultants and bank supervisors have much to share and can learn from one another: 1. Consultants and supervisors must have open, trust-based channels of communication with bank management and among their peers. Both must add value by analyzing both processes and the outcomes of those processes. They are both well advised to limit their intrusiveness while not foregoing a thorough and professional inquiry. 2. Both consultants and supervisors face the challenge of building, sharing and applying professional knowledge and skills in a rapidly changing business environment. The failure to manage our knowledge within teams, within agencies and even across agencies will certainly result in wasted effort and may even result in a caliber of supervision that does not keep pace with changing financial technology and increased sophistication by banks. The Federal-state coordination efforts that I mentioned are an example of this needed cooperation. ---[PAGE_BREAK]--- However, while it might be quite appealing to speak of supervisors as acting more like consultants, in many critical ways the consulting metaphor does not work very well for supervisors. There are at least three factors that make consulting an inappropriate model for supervisors to follow: 1. Consultants are hired by management and work to add value to the shareholders that management represents. Supervisors, in contrast, ultimately work for the public at large. Rather than adding shareholder value, supervisors seek to reduce or eliminate excessive risks to the financial system and the federal safety net. 2. Supervisors have much more impact in the banking industry than even the most savvy or articulate consultant. We must be willing to exercise that moral and legal authority to forestall as best we can practices that we know might become harmful even before the full results of such practices become evident. In this we may not always be popular. 3. Finally, consultants can be wrong with only relatively limited consequences. The caliber of their advice is rarely subject to after-the-fact scrutiny. When a consulting firm makes a mistake, it may lose a client and that company may lose some money. When a banking agency fails to act, the consequences can be widespread for the economy and the public at large. To keep the public's trust, we need to be ever mindful of whose interests we serve. We do want to minimize the burden of supervision. We do want to foster modernization. We must stay current with the latest financial techniques. We can assist institutions by identifying weaknesses and, at times, we can offer views toward resolution. Ultimately, however, we are forced to supervise and regulate banks in the interest of the public.	Roger W Ferguson	United States	https://www.bis.org/review/r980325b.pdf	Remarks by Mr. Roger W. Ferguson, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Conference of State Bank Supervisors in Washington, DC on 9/3/98. It is my pleasure to join you today. The Federal Reserve has long enjoyed a cooperative relationship with the Conference of State Bank Supervisors, and I expect that relationship to continue. As you are well aware, technological and financial innovation have become the norm in banking and bank supervision. These innovations have accelerated the pace of transactions and increased the complexity of transactions seen throughout the banking system. This is a pattern we can expect to continue in the years ahead. Indeed, it is this complexity and innovation that leads us, as supervisors, toward a more risk-focused supervisory approach with a greater emphasis on sound management processes. Only by ensuring that a bank's management and control processes are sound can we be confident that its risks will remain contained throughout business and market cycles. It is not my intention today to espouse the merits of risk-focused examinations, since I trust we all recognize the value of that approach, especially in the case of larger, more-complex banking institutions. I would like to focus on a challenge that we face as we move more toward risk-focused examinations. This challenge or conundrum is captured in a comment I heard last year at a dinner hosted by the Bank Administration Institute. A leading banker at dinner complimented a regulator for having supervisors and examiners who provided "consultations" at the end of examinations. Since reviewing management and control processes is very much a "consultative" activity, I suspect such comments will become more commonplace. Being perceived as being like consultants is useful, but it is not an unalloyed blessing. As I reflected on the compliment I heard, I wondered if the consulting metaphor was really one we should encourage. We should all do what we can to maintain a strong and vibrant banking system that is responsive to the needs of the public. That is part of our role as supervisors. We should also work hard to ensure that the supervision and examination processes are not unduly burdensome to the banks we examine. We should be supportive of financial modernization, a process that is overdue in the banking industry. We also want to provide guidance to banks on sound practices and to evaluate the extent to which they conduct their activities in prudent ways. But we should be cautious in fully adopting the label "consultants." In my comments this morning, I would like to draw on my experience as a consultant to banks and other financial institutions to discuss some similarities and differences, as I see them, between the role of consultant and the role of supervisor. I raise this topic today because the recent turmoil in Asia has some roots in poor banking performance and poor banking supervision. I believe that the market is ultimately the best regulator of financial services, but we will still need supervision and regulation to offset the limitations inherent in regulation from the market. The recent turmoil in Asia serves as a reminder of the risks that financial institutions take and the systemic impact that can emerge if supervisors are not mindful of the important role that they continue to play in containing that risk. Let me begin with the basic question of why firms hire management consultants. Many large companies that hire management consultants have substantial talent, resources and expertise of their own. A key reason they seek outside guidance is that the employees of these companies often lack the objectivity, the cross-company and cross-industry experience, or the specific, technical expertise that the company needs. Companies also hire consultants simply because they want to avoid distracting key individuals from their on-going operational duties in order to conduct a project that an outsider can perform. Why, on the other hand, do banks hire bank supervisors? The obvious answer is that they do not hire them at all. Supervision is found to be necessary -- not only here but also in virtually every country abroad -- to protect the public's interest in the lending and deposit-taking process. The fact that we continue to regulate banks reflects the economic concept of "externalities" and the need to protect the safety net that most societies extend to banks. It is not the impact of one bank's decisions on the wealth of its owners and the job security of its workers that worries us. Bank managers must be allowed to make managerial decisions with a minimum amount of regulatory and supervisory interference. Bank directors and managers have strong incentives to take care in their decisions due to a natural concern for personal job security, personal wealth, and continuing control in the active market for bank consolidation. Some will make wise decisions, and their institutions will thrive; others will make decisions that prove to be incorrect and their banks will suffer. However, we know that no single bank management team, regardless of how well intentioned, can accurately value the cost of its decisions, good or bad, on the banking system and economy as a whole. Therefore, supervision is a way of forcing banks, individually and collectively, to recognize the broader impact that their risk-taking and risk-mediation decisions might have on society at large. It also substitutes for some of the market discipline lost, and attempts to offset the "moral hazard" that arises, due to the existence of the safety net. It is the possibility that poor managerial decisions by one bank will then spill over to other banks and eventually to the public at large that provides the rationale for supervision and regulation. That possibility is also a key factor driving the Federal Reserve's need to remain a bank supervisor. Without such active, on-site experience supervising and evaluating bank activities, the central bank would, I believe, be less prepared to deal with financial crises that inevitably arise. In addition, the Federal Reserve is the operator of important parts of the nation's payment system, both wholesale and retail, and as such has a stake in the proper functioning of banks and the banking industry. However, we should also recognize that supervision and regulation are not without costs to banks and, in turn, to society. Therefore, I believe that we should aspire to the minimum amount of regulation and supervision that is consistent with maintaining safety and soundness of the banking system and with maintaining financial stability. After all, the marketplace is ultimately the best regulator, and we should look to the market for guidance and feedback, wherever possible. Given these fundamentally different incentives for banks to have consultants and supervisors, why would an obviously intelligent CEO of a major bank compliment us on providing "consultations"? The answer is that a good examiner brings some of the same strengths to an examination that a good consultant brings to a consulting assignment, namely objectivity, cross-firm experience and critical technical expertise. Like consultants, the independent assessments that examiners make are becoming more dependent on statistical sampling and on the accuracy of a bank's internal information systems. Requiring banks to have, on an on-going basis, sound internal procedures should reduce risks to the financial system and lead to fewer surprises overall. Reviewing procedures, though, entails a more subjective approach than reviewing credits. Although analyzing credits can be complex, the potential resolutions are few. The examiner reaches a conclusion about individual credits and the overall quality of the loan portfolio, and his findings are communicated to the bank. Some loans are charged-off, others are written down, and the results are clear. Addressing procedural problems, however, is rarely so decisive because we get into judgmental areas and into a range of potentially acceptable -- and unacceptable -- resolutions. In this, supervision and consulting are very similar. One approach consultants use to resolve the challenge of dealing with more subjective judgments is to maintain open lines of communication between consultant and top management. The results of a consulting assignment are rarely a surprise when the final report is presented, and management has had an opportunity to respond to early findings and present their perspectives. Similarly, the results of a bank examination should not come as a surprise to bank leadership. Clear and frequent communication of supervisory guidance on sound practice is of critical importance. Particularly in new or innovative activities, bankers need to hear clearly which arrangements the supervisor will accept. Another technique consultants use to analyze a subjective topic, such as bank processes, in which several practices might be acceptable, is to have open lines of communication within the consulting team. All team members have a chance to add their perspectives to the potential solution. Similarly, examiners from different agencies examining a single banking entity should be able to share perspectives and findings. While both consultants and examiners may be forced to make judgments regarding management processes, it is essential that such judgments be made only after reviewing the relevant facts. For consultants, those facts may encompass a wide array of market or company data. For examiners, those facts may be gleaned from a credit analysis and the review of credit files. Despite all the innovation and structural changes we have witnessed throughout the financial system, extending credit and limiting the volume of bad loans remain the primary business of banks. Examiners will continue to need to evaluate whether a bank's own internal assessment of its exposures is sound, which will by necessity involve a review of a sample of loans. In another, less appealing, way consultants and bank examiners are quite similar. In both cases the process can be obtrusive, with outsiders asking for scarce time and attention from bank employees. Consultants and examiners alike must learn to adjust their professional approach to minimize the degree of disruption to the institution being served. In this regard, the move toward more off-site work and preparatory work is to be commended, and I am certain that it is appreciated by banks. So in many ways, while the goals of the consultant and examiner are different, the techniques used may be quite similar. One can imagine an effective examination process resembling a good consulting process. Both rely, in part, on internal data. Both should be characterized by frequent and candid conversations between bank leadership and the leadership of the examination team. Both should help bank leadership to understand what is considered sound practice. Both consultants and supervisors must at some level analyze the tangible results of the management processes, be that loan quality or some other measure of corporate performance. Finally, to be successful both consulting and examination must be carried out with the minimum of on-site disruption after careful off-site planning. Another similarity between consultants and examiners is that there is much practical experience gained by the professionals that must be shared with their co-workers or team members or even more broadly among the community of professionals. For the community of supervisors, these insights are the results of many years of first-hand experience with banks. Consultants have developed the fancy phrase of "knowledge management" for the process of building individual insights, sharing them with others, and finally applying the collective knowledge through an individual professional working with a client. The challenge, of course, is how to complete this cycle of "build-share-apply" when the community spans several thousand people, across multiple locations and, possibly, multiple agencies. This gathering is an example of one possible solution to this challenge. Technology, through group software and the creation of more common, interagency tools, might prove to be another solution. I shall return to the need for broadly shared common technology platforms. Now let me turn to the numerous differences between consultants and supervisors. In adding value to the banking industry, supervisors have a major advantage over consultants in that we have the standing and authority to influence actions industry-wide. That ability to influence state or national policies is an important aspect of our work and one that helps to motivate and retain our key people. This fact ties directly to the sound practice papers we provide. As supervisors, we need to share what we learn to help the industry manage and control its risk. To develop industry guidance, we do well in looking to leaders within the industry, and to institutions that know their business best. The knowledge we gain from our associations with so many banks also accommodates the development of new regulatory paradigms. The recently adopted rule for market risk that is based on the internal models of banks is a good example. Without the in-depth access to virtually all of the world's leading trading banks and to their experiences and observations, supervisors collectively could not have developed their own understanding and the willingness to pursue this approach. This new approach highlights a series of significant differences between consultants and supervisors. First, consultants often find themselves acting as "change leaders", attempting to get their clients to take greater business risk based on consulting judgment. Supervisors recognize that banks are in the business of taking risk, but our goal is not to encourage or to discourage risk-taking by individual banks. Our goal is to have banks recognize and manage well the risk they are taking, price the risk appropriately and avoid undue concentrations of risk. In that way we hope to reduce systemic risk. A second difference between consultants and supervisors is in the need for consistency across banks. Consultants generally place little value on consistency across clients. The best consultants tailor solutions to each individual client. Therefore, two clients served by the same consulting firm on the same topic may receive different sets of recommendations. Supervisors, by comparison, properly put a premium on consistency across banks and over time. We do not want to create an unstable market by giving inconsistent examination advice. A third difference that emerges is an appetite for novel professional approaches. Senior consultants reward younger professionals who develop new approaches. Within the fraternity of supervisors we want to maintain modern approaches to examination and supervision, but should only adopt them widely once we are sure they lead to the desired outcome. Finally, you may recall that earlier I referred to the communication and feedback required in order for an examination to have the impact of a good consultative process. The challenge in providing this feedback is in knowing just how far to go. As supervisors, we need to communicate our views, but we must avoid making operating decisions for banks. Supervisors, unlike consultants, must let banks make independent judgments. The responsibility for sound banking is with the banks, and it is they who must, ultimately, develop and take full responsibility for their decisions. Supervisors must be free to criticize conditions that, if not corrected, may lead to heightened risk in the future. Unlike consultants, supervisors have in their arsenal the power to effect change not only through examination of findings but also through moral suasion, a strong bully pulpit and ultimately, supervisory guidance, regulations and enforcement actions. One critical area where currently we are exercising the power of moral suasion is in connection with the possible decline in credit underwriting standards that may be becoming widespread. For more than two years now, we have heard persistent reports of declines in lending terms, conditions, and standards. It is not just isolated reports from some examiners. Leading bankers, such as John Medlin of Wachovia, and survey data, also support these reports. The question then becomes "what should we do?" We can certainly expect that in the next economic downturn credit problems will rise and weaker lending standards, if they exist, will only make matters worse. While the lending decision is ultimately that of the banks, this is an important area in which we can offer advice and general counsel. We should not create an artificial credit crunch, and I do not think that we are at risk of doing that, but we can and should urge caution that is based simply on our long experience in watching business cycles. We can continue to make sure that bankers, themselves, understand their own procedures and the risks that they face. We all seem to be taking a more aggressive approach on this issue, and I expect that we will remain vigilant to sound the alarm when necessary. Throughout my comments I have noted a number of points that bear directly on initiatives of state and federal supervisors to work together toward a stronger supervisory process. As the US banking system becomes more entwined through interstate banking and branching, it becomes ever more critical that we all coordinate our efforts in maintaining a healthy, viable, and attractive dual banking system. It is also important for states to work to minimize unnecessary distinctions that slow the progress of interstate banking. I mentioned, for example, the need to modernize US banking laws, share practical supervisory experiences, maintain consistency, reduce intrusion during the bank examination process and, in general, improve the overall efficiency of our staffs. These are not new challenges and, indeed, are goals that we collectively have been working toward successfully for some time through the State-Federal Working Group and other forums. As we all know, state banking authorities have done much to advance interstate banking and branching and to work together and with federal authorities toward a seamless oversight process. The state-federal protocol has helped greatly to bring about that seamless approach and is a crucial element in maintaining the viability of the state banking charter. Individual states and the state charter, in turn, have provided the industry with important flexibility to experiment in developing new banking products and delivery systems. In this and in many other ways, the state charter and the dual banking system have served the country well. Fortunately, the dual banking system seems healthy. Consider, for example, that of the 207 new banking institutions chartered last year, 146 were state chartered. Adapting available technology to examinations and to sharing insights among examiners is another area in which significant progress has been made through our joint efforts to produce more efficient examinations. As you may know, the FDIC's ALERT system now permits examiners to download bank data onto their own PCs in order to analyze exposures and prepare for upcoming examinations. It is being used widely by many states and by a number of Federal Reserve Banks; more are likely to learn about and use it in the months ahead. The Fed's own ELVIS program is another important advance that assists examiners through the risk-focused process for community banks that is being used by the Fed and FDIC and by most states. Looking forward, examiners should soon be able to use the "GENESYS" system to access a broad range of automated information contained in supervisory databases and download it into their examination reports. Together, these and other initiatives -- including greater use of analyst and examiner electronic desktops, new web pages, and expanded data access techniques between state and federal supervisors -- have helped significantly to improve the efficiency of our examiners and to create a less intrusive supervisory process. We should all be pleased with these results and should expect the process to become even better in the months and years to come. In closing, I see many challenges ahead for us all, as we adapt the supervisory process to keep pace with events in financial markets. In some respects consultants and bank supervisors have much to share and can learn from one another: However, while it might be quite appealing to speak of supervisors as acting more like consultants, in many critical ways the consulting metaphor does not work very well for supervisors. There are at least three factors that make consulting an inappropriate model for supervisors to follow: To keep the public's trust, we need to be ever mindful of whose interests we serve. We do want to minimize the burden of supervision. We do want to foster modernization. We must stay current with the latest financial techniques. We can assist institutions by identifying weaknesses and, at times, we can offer views toward resolution. Ultimately, however, we are forced to supervise and regulate banks in the interest of the public.
1998-03-16T00:00:00	Mr. Meyer remarks on the strategy of monetary policy in the United States (Central Bank Articles and Speeches, 16 Mar 98)	Text of the Alan R. Holmes Lecture by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, held at Middlebury College, Middlebury, Vermont on 16/3/98.	Mr. Meyer remarks on the strategy of monetary policy in the United States Text of the Alan R. Holmes Lecture by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, held at Middlebury College, Middlebury, Vermont on 16/3/98. When I was asked to deliver the Alan R. Holmes Lecture, it seemed appropriate to focus on a topic directly related to the interests and contributions of Alan Holmes. It was not hard to find such a topic, because Alan Holmes served with distinction in a position that was at the very core of monetary policymaking. Monetary policy begins with a set of objectives, which identify where policymakers want the economy to be, a preferred or ideal state of macroeconomic performance. The heart of monetary policy is about designing and implementing a strategy to guide policymakers in decisions about the setting of open market operations, the principal instrument of monetary policy, so as to contribute to achieving the objectives. This is the subject of my lecture today and it was very much the subject of Alan Holmes' career. He was an economist for 31 years at the Federal Reserve Bank of New York, and for many years served as Executive Vice President of the Federal Reserve Bank of New York and as Manager of the System Open Market Account. In that position he was directly responsible for implementing policies of the Federal Open Market Committee, the FOMC, specifically the day-to-day decisions about open market operations. The FOMC consists of the seven members of the Board of Governors and five presidents of the regional Federal Reserve banks. There is no official operating manual for members of the committee that identifies the guiding principles, no "official doctrine". While the views I present here are my own perspectives on strategy, my purpose in this lecture is not to articulate a singular view of the strategy of monetary policy, but rather to shed light on some of the mystery about monetary policy. A former Alan Homes Professor of Economics at Middlebury College and good friend, Dewey Daane, co-edited a book in honor of Alan Holmes, entitled The Art of Monetary Policy. In his forward to the book, William Simon called Alan Holmes a "monetary policy artist". As I develop my perspective on monetary policy, I will try to blend the role of art and science, of economic theory and practical judgments that Alan Holmes so well understood. Objectives Monetary policymaking naturally begins with an understanding of the objectives of policy, because that is what good policy should deliver. It is widely accepted that there are three fundamental norms of macroeconomic performance, which I summarize as full employment, growth, and price stability, and these norms are a useful point of departure to thinking about the objectives for monetary policy. Full employment can be interpreted as achieving the maximum sustainable level of employment and production. It basically means avoiding waste, in the sense of failing to use all the available productive resources. By sustainable, I mean the highest level of output that can be sustained without imposing unacceptable costs, a consideration I will return to shortly. By growth, I am referring to the desire to achieve both a high average level and rate of growth in living standards, on average, over time. We usually measure living standards in terms of real income per capita. We can be at full employment and yet be poor. We want to be at full employment and be rich. And we want our living standards to be improving over time. I'll refer to the average rate of growth in output in the long run as the economy's trend rate of growth. Price stability refers to the stability of the overall price level, measured, for example, by the price index for overall output (the chain-weighted price index of GDP) or for consumer goods and services (the Consumer Price Index). We often satisfy ourselves with the norm of low and stable - 2 - inflation. At any rate, price stability is really more an intermediate goal than an ultimate objective. The reason we care about price stability is that we believe that it contributes to a high and rising level of living standards. Indeed, it is viewed as so important in this regard that we identify it as a separate and free-standing norm. And we will soon see we have particular reason to do so from the perspective of monetary policy. Implications of Economic Theory I am going to assert some conclusions based on economic theory that help to understand the potential for monetary policy to achieve these objectives and the consistency among them. These conclusions are widely though not universally shared, but they do guide my views of what monetary policy can and should do. First, monetary policy cannot influence real variables -- such as output and employment -- in the long run (except via the contribution of price stability to living standards). This is often referred to as the principle of the neutrality of money. This proposition removes "growth" as an objective for monetary policy and also means that monetary policy cannot materially affect the level of output or employment corresponding to "full employment". Second, monetary policy is the principal determinant of inflation in the long run. This proposition immediately makes price stability (in some shape or form) the direct, unequivocal, and singular long-term objective of monetary policy. No central bank around the world would argue otherwise. When it comes to price stability, the buck, literally, stops at the central bank. Third, because prices in many markets may be slow to adjust to equate supply and demand, shocks to the economy can lead to persistent departures of the economy from full employment -- in both directions. This proposition offers at least the potential for monetary policy to play a role in smoothing out business cycles. Fourth, full employment and price stability are compatible. Now, by full employment I do not mean literally zero unemployment. Instead full employment is better thought of as the lowest possible rate of unemployment that can be sustained without rising inflation. If unemployment remains, on average, at this level, inflation tends to remain constant. This rate -- which is often called the non-accelerating inflation rate of unemployment (or NAIRU) -- is a fact of life outside the control of the FOMC. This definition of full employment insures that the two objectives left for monetary policy -- full employment and price stability -- are compatible in the long run. Fifth, inflation pressures arise, in large part, in response to departures of the economy from full employment. If the economy moves below full employment, for example, the resulting slack results in disinflation, that is, downward pressure on inflation. When the economy moves above this threshold there is continuing upward pressure on inflation. This implies that the two objectives of price stability and full employment can conflict in the short run. This leaves us with dual objectives for monetary policy: short-run stabilization of output relative to potential and long-run price stability. Fortunately, this is also the legislative mandate Congress has set for monetary policy in the Full Employment and Balanced Growth Act of 1978, often referred to as the Humphrey-Hawkins Act, at least by my interpretation. There are many interesting issues and controversies related to the choice and definition of objectives. These include the definition of an inflation target that corresponds to price stability and the estimate of the unemployment threshold that corresponds to full employment. I'll assume that the inflation target is set to reflect the expected bias in inflation measurement or to be slightly above this estimate. Many commentators view a 2% inflation rate as a reasonable inflation objective and many countries with explicit inflation targets use a 1% - 3% range. As for the definition of full employment, I'll use a consensus estimate of the unemployment threshold, which is currently around 51⁄2%. I might add that there is considerable uncertainty about this estimate, particularly in light of the consistent - 3 - surprise of declining inflation even as the unemployment rate has fallen well below this threshold. I have focused a number of my speeches on this very topic, but, for today, it is mainly a reminder of the uncertainty that monetary policymakers face about the structure of the economy, especially when the structure changes over time. Instruments The next step is to identify the instruments through which monetary policy influences the economy. While there are, in principle, three instruments through which monetary policy affects the macroeconomy -- open market operations, the discount rate, and the reserve requirement ratio -- as Alan Holmes certainly appreciated, open market operations are the principal instrument of monetary policy, and so I will focus on open market operations. The Federal Reserve holds a portfolio of government securities. It injects or withdraws reserves by buying for or selling from this portfolio. When it purchases securities from the private sector, it injects reserves and normally puts downward pressure on short-term market interest rates. So open market operations can be viewed as implementing either a path of reserves or achieving a level of short-term interest rates. In practice, nearly all central banks target a short-term interest rate rather than reserves with their open market operations. This is because reserves are most useful for close control of the money supply and money supplies have proven to have only a loose, long-term relationship to the objectives of monetary policy. Natural Hurdles If we knew precisely where we were, understood precisely the relationship between our instruments and macroeconomic performance, had a single objective, and could instantly affect the variable or variables associated with our target(s), implementing policy would be easy. Indeed, this lecture would be nearly over, because we would not have to worry about a strategy for monetary policy. It is precisely because none of these preconditions hold that monetary policy is so difficult and principles are needed to guide its implementation. First, it is clearly important to know where you are in relation to where you want to be. But we do not have timely and accurate information about where we are. The data trickles in with a lag, often involves considerable noise, and is subject to revision, even after which it may remain less precise than we would prefer. Because of the noise in economic measures, considerable effort is needed to extract the meaningful signal from the data. Second, we are working with a caricature of the economy in the form of our empirical models that guide both forecasting and policy decisions. The models reflect our imperfect state of knowledge about how the economy works. In addition, as I just noted, the relationships among the variables in the economy shift over time and we only gradually learn and adjust to such structural changes. Third, monetary policy affects aggregate demand and inflation with a lag. The major effect of a policy action today is not felt until about a year from now. Therefore, when we are thinking about affecting inflation, we better be thinking about affecting inflation next year, rather than tomorrow. One implication of lags is that policy has to be forward looking. If we want to affect inflation next year, we have to act today. We therefore have to try to anticipate problems rather than simply react to them. That means that forecasting is an inherent part of the policy process and policy has to have a pre-emptive quality. Fourth, we have multiple objectives, but only a single instrument. Simple models of policy normally imply that to achieve two objectives simultaneously, you need two instruments. How can we therefore juggle our dual targets? Fortunately, theory and evidence suggest, as I noted earlier, that the objectives of full employment and price stability are consistent in the long run. Short-run conflicts - 4 - between the targets arise in one of two circumstances. A conflict arises if we begin with inflation above our objective. Unfortunately, monetary policy can reduce inflation only by temporarily imposing some slack in the economy. In this case, lowering inflation would mean departing for a while from full employment. Once inflation had fallen to its target level, the economy could return to full employment and enjoy the consistency of the two objectives. A second source of conflict arises in response to a supply shock, such as an increase in oil prices. Assume we begin with full employment and price stability and there is a sharp rise in oil prices. This will tend to both raise inflation in the short run and depress output. What should monetary policy do? Tighten to unwind the increase in inflation? Or loosen to counter the increase in unemployment? The natural hurdles make monetary policy a challenging task, requiring the application of both good judgment and appropriate models, art and science. Operating Strategies and the FOMC Meeting Now that we appreciate the challenging nature of monetary policy, we are ready to develop a strategy for implementing open market operations. The first question we ask is whether policy should be carried out according to some well-defined and precise formula, or rule, or whether it should be implemented judgmentally. My point here is not to recall the longstanding debate about rules vs. discretion, but to emphasize that good policy should be systematic or rule-like, even when it is not formally tied to a specific rule. In addition, we can learn a lot about principles for guiding discretionary policy by examining rules that can be shown to have effective stabilizing properties in our models. As I noted earlier, monetary policy is implemented in the United States, as in most central banks, through the control of interest rates. At each meeting, the FOMC sets an intended federal funds rate target. The federal funds rate is the interest rate on overnight loans in the inter-bank market. It is therefore the rate paid when reserves are borrowed and lent among banks. And it is a natural target to achieve via open market operations since these operations in effect inject or withdraw reserves. The federal funds rate is currently 5.5%. The FOMC announces any change in this target immediately following the conclusion of its meetings. It also explicitly incorporates this target funds rate in a "directive" to the Manager of the System Open Market Account, the position Alan Holmes held at the Federal Reserve Bank of New York. This directive instructs the Manager to implement open market operations during the period between this and the next FOMC meeting so as to maintain the federal funds rate as close as possible to the intended rate. Point of Departure: Constant Money Growth Rule Given that the Federal Reserve, like most other central bank today, operates by setting a near-term interest rate target, my focus is on developing some guiding principles for setting the interest rate target, more precisely, for adjusting the interest rate target in response to changing economic conditions. I have found it useful to begin this search, perhaps surprisingly, by developing the properties of a constant money supply growth rule. This both helps to identify some of the essential properties of a monetary policy strategy, which will apply to interest rate targeting as well, and highlights the practical difficulties in carrying out monetary policy using money supply targets. Another reason for starting with a monetary aggregate strategy is that monetary aggregates played a more significant role in the implementation of monetary policy during Holmes' service as Manager of the System Open Market Account. The directive to the Manager from the FOMC during this period was often specified in terms of maintaining or changing "money market conditions" (a code for the federal funds rate), unless growth in the monetary aggregates departed significantly from the midpoints of their specified ranges. Sometimes the directive was specified directly in terms of the desired course of the monetary aggregates, in this case typically subject to an acceptable range for the federal funds rate. This gave money growth a more direct role in the conduct of policy than it has today. - 5 - Let's now see why money growth might be a useful target for implementing monetary policy. Economic theory suggests that, if the demand for money is stable, the rate of money growth will pin down the rate of growth in nominal income. Under reasonable assumptions, a constant rate of money growth will yield growth of nominal income, on average, at the same rate. The rate of money growth should be set to achieve a rate of nominal income growth that just equals the rate of trend growth in real output and the rate of inflation consistent with the policy objective. On average and in the long run, this rate of money growth will achieve the Fed's inflation objective. So the first proposition is that a money growth target provides a nominal anchor which pins down the long-run inflation rate. This strategy immediately allows a translation of the long-run price stability objective into a more near-term money supply growth target. And, by implication, any monetary policy strategy must mimic the nominal anchor property of a money supply target, if it is to be consistent with the Federal Reserve's mandate for price stability. Next, let's ask what would happen if the economy was subject to a shock that moved it away from price stability and full employment. If real output increases faster than trend and/or inflation increases relative to the Fed's objective, the resulting higher nominal income growth, relative to the constant rate of money growth, would result in an increase in interest rates. The second property of a money supply target is that it builds stability into the economy by insuring pro-cyclical movements in the interest rate in response to demand shocks. Another way of saying this is that it insures that monetary policy automatically leans against the cyclical winds to stabilize the economy. The Taylor Rule as a Strategy for an Interest Rate Operating Procedure Despite the desirable properties of a constant money growth rule, in principle, most central banks implement policy by setting short-term interest rates in practice. This choice reflects at least two considerations. First, instability in money demand reduces the usefulness of money supply targets. Second, interest rate targets allow the central bank to smooth out the effects of transitory shocks to financial markets. But how should the Fed vary its interest rate "instrument" to achieve its ultimate objectives? The simplest answer is that interest rates should vary to imitate qualitatively the way they would behave if the Fed were implementing a money supply target. In other words, interest rates need to be varied systematically to effectively impose a nominal anchor and to insure that policy leans against the cyclical winds. Setting monetary policy in this manner via an interest rate target, in principle, allows the Fed to achieve the best of both worlds. It can impose the same nominal anchor and short-run stabilization properties as would be the case with a money growth rule, but, at the same time, smooth out shorter-run volatility in interest rates. In addition, by careful choice of the degree of response of interest rates to changing economic conditions, the rule can, in principle, improve upon the stabilization properties of a money supply rule. A simple specification of a strategy for varying the federal funds rate in response to changing economic conditions is provided by the Taylor Rule, a rule developed by John Taylor, a professor at Stanford University. The appeal of the Taylor Rule is that it is simple and specifies how the federal funds rate (effectively the Fed's instrument) should be varied directly in response to inflation and to deviations of output and inflation from the Fed's ultimate targets of full employment and price stability. My point here is not to extol the virtues of the precise specification in the Taylor Rule, but to use it to highlight some of the central principles that should guide decisions about the setting of the funds rate. It is useful to appreciate how Taylor derived his rule and how he views its role in monetary policy. The rule emerged from Taylor's analysis of simulations of a variety of rules in a variety of models. He concluded that the simple form embodied in the Taylor Rule had, based on this work, excellent stabilizing properties. The rule was therefore initially developed as a normative guide, meaning - 6 - a set of principles to guide policy that, if followed, would result in relatively good economic performance, at least compared to other rules and perhaps relative to historic US economic performance. Subsequently, Taylor found the rule described reasonably well the way policy was indeed carried out over the last decade. That is, the rule was also descriptive of recent policymaking. The Taylor Rule begins by assuming that there is some level of real federal funds rate consistent with full employment and stable inflation. The real interest rate is the nominal interest rate less some measure of inflation expectations (measured by Taylor as actual inflation over the last year) -- a measure of the increase in purchasing power (rather than in dollars) associated with holding an asset. Taylor calls this the equilibrium real interest rate and assumed it was 2%. Let's assume that the economy is initially at full employment and price stability. Then the level of real and nominal interest rates would be set at 2%. I am not going to quibble with this choice, because I am focusing on general principles rather than precise details. The economy is, of course, not always at full employment and price stability and the purpose of the Taylor Rule is to specify how the federal funds rate should respond to shocks that push the economy away from price stability and/or full employment. Because both objectives are explicitly incorporated into the rule, it provides a disciplined approach to juggling the dual mandate for monetary policy. The real equilibrium interest rate is viewed as consistent with full employment and any stable rate of inflation. So the first implication of this rule is that, in order to be consistent with full employment, nominal interest rates should be adjusted in response to inflation to maintain the equilibrium real interest rate. The next message of the rule concerns how the real federal funds rate should be adjusted in response to deviations of output and inflation from full employment and price stability. According to the rule, when output rises relative to potential output, real interest rates should rise. When inflation rises relative to the inflation target, real interest rates should also rise. These movements of real interest rates in response to departures of inflation and output from their target levels can be shown to stabilize output and inflation relative to their targets. The Dangers of an Interest Rate Strategy There are natural dangers inherent in interest rate targeting, at least in the absence of a rule that guides its adjustment to changing economic conditions. If cyclical movements in output are dominated by demand shocks, the failure to move interest rates aggressively enough in response to the shocks can result in monetary policy destabilizing rather than stabilizing the economy. For example, if there is a demand shock resulting in higher income and/or prices, the demand for money will increase, putting upward pressure on interest rates. If the Fed maintains an unchanged nominal interest rate target, it will have to add reserves to support a higher money supply at the initial interest rate. This means that, under a constant interest rate target, a demand shock would lead to perverse monetary policy, specifically to stimulative open market operations, reinforcing rather than damping the demand shock. The inherent danger in interest rate targeting is reinforced by the preference for central bankers for smoothing interest rates. This preference takes two forms. First, there is a preference for implementing a rise in rates in a series of small changes in the same direction. Second, there is a reluctance to change the direction of policy, without particularly strong rationale. Nevertheless, interest rate targets can, in principle, be implemented in a way that avoids this pitfall, and one of the values of rules is to remind policymakers of the importance of adjusting interest rates in response to changing economic conditions, thereby preventing policy from becoming destabilizing. - 7 - Principles to Guide the Setting of Interest Rates We are now ready to identify a set of principles to guide decisions about the setting of the federal funds rate at FOMC meetings. Underlying these principles are the lessons gleaned from both the constant money growth rule and from the Taylor Rule. Both rules highlight the importance of imposing a nominal anchor to pin down the long-run inflation rate and of varying real interest rates pro-cyclically to lean against the cyclical winds. The Taylor Rule also highlights the critical importance of real interest rates in the conduct of monetary policy. There is one very important difference between the constant money growth and Taylor rules that deserves comment. While a constant rate of money growth will not always be optimal, if money demand is sufficiently stable, and not particularly interest sensitive, it will pin down inflation in the long run and help smooth the business cycle in the short run. That is, under a money growth target, doing nothing (that is, maintaining an unchanged rate of money growth) may not always be the best choice, but, for the most part, it won't get you into serious trouble and will in fact do some considerable good, although it would likely involve a considerable variation in interest rates on a day-to-day basis. Under an interest rate targeting regime, on the other hand, doing nothing can potentially get you into great difficulty -- sometimes quite quickly. In this case, policy must constantly be prepared to adjust to changing economic conditions, to avoid the potential for becoming a destabilizing influence on the economy. Rule No. 1: Vary real interest rates in response to departures of inflation from its target. For example, if inflation increases, relative to its target, the real interest rate should be increased. This is perhaps the single most important discipline for monetary policy under an interest rate regime. When inflation increases, nominal interest rates must first be increased just to avoid a decline in the real rate. But to counter the rise in inflation relative to its target, the real interest rate has to rise. That means that nominal rates have to rise by more than the increase in inflation. In the Taylor Rule, for example, the nominal federal funds rate rises by 1.5 percentage points for every one percentage-point increase in inflation. Rule No. 2: Vary (nominal and real) interest rates in response to changes in resource utilization rates. Under a money supply growth rule, interest rates rise whenever growth in real GDP exceeds the trend GDP growth assumption embedded in the money growth target. Whenever growth is above trend, the unemployment rate falls and the capacity utilization rate rises. By adjusting real interest rates in response to such changes in utilization rates, for a given inflation rate, an interest rate regime insures the same qualitative stabilization property that a constant money growth rule automatically yields. In implementing this principle, real interest rates would rise gradually but systematically during expansions, fall when growth slows to below trend, and decline sharply when the actual level of output declines, at least for those cyclical episodes where supply shocks (see below) are not very important. Just following this simple principle will help stabilize output relative to full employment and inflation relative to the inflation target. It is a reminder that there ought to be nothing startling or dramatic in FOMC decisions to adjust the federal funds rate. Indeed, the question that might be asked when nominal rates are constant for long periods is how does the FOMC justify such stability in the face of changing economic conditions! You might, therefore, ask whether or not the near constancy of the nominal funds rate over the most recent episode has been appropriate. I believe monetary policy has, in fact, been excellent over this period. But this has been a very unusual period with remarkable crosscurrents that balanced out to allow such stable short-term rates. It should not lull us into believing that stable interest rates and good monetary policy naturally go together. Rule No. 3: In setting rates, be forward looking. I noted earlier that, because of lags, monetary policy has to be forward looking. There are, however, different degrees of forward lookingness that we could incorporate into policymaking. For example, because higher utilization rates today raise the - 8 - risk of higher inflation in the future, raising interest rates today in response to observed increases in utilization rates is a forward-looking policy relative to simply responding to current inflation. Forward-looking policy is sometimes said to be pre-emptive. A movement in interest rates in response to rising utilization rates would be said to be a pre-emptive move against inflation. The Taylor Rule thus allows for a combination of pre-emptive policy, changes in interest rates in response to changes in utilization rates, and reactive policy, changes in interest rates in response to movements in inflation itself. So good policy can be both pre-emptive and reactive. A still more forward-looking approach would be for policymakers to respond not to actual inflation and utilization rates, as in the Taylor Rule, but to forecasts of projected inflation and utilization rates, assuming an unchanged nominal federal funds rate. A good reason for responding to forecasts of inflation is that the effects of monetary policy on the economy mostly occur about a year from now. There is a considerable amount of work under way to assess the usefulness of using forecasts as opposed to past information on unemployment and inflation in the specification of interest rate rules. There are clear historical examples when a forward-looking policy would be an improvement. These episodes illustrate that simple rules are only guides and that good policy sometimes means following the rule and sometimes means using judgment to improve upon the rule. Judgement is especially called for in situations where special events point to future changes in output and inflation that would ordinarily be viewed as unlikely. The current episode provides a good example of such a situation in which there is much to be gained from forward-looking policy. The economy entered 1998 with considerable forward momentum, already operating at very high utilization rates. This momentum reflected persistent strength in domestic demand, particularly consumer spending and business fixed investment. However, the financial and currency crises in Asia are projected to result in a sharper decline in net exports than would otherwise have occurred and this promises to slow the expansion in the absence of any policy action, perhaps substituting for monetary tightening that otherwise might have been justified. In this environment, a backward-looking policy that ignored the potential drag on future demand from Asia could risk magnifying the effect of the shift in aggregate demand. Rule No. 4: The appropriate policy response may depend on the source and persistence of the shock. Let me distinguish two types of shocks to the economy. The first is a persistent demand shock -- for example, an increase in aggregate demand that results in a persistent departure from trend growth and persistent changes in utilization rates. This will have symmetric effects, raising both output and inflation, and presents a relatively straightforward monetary policy problem that is well handled by the first set of rules. A second source of shock is a supply shock, an example of which would be a one-time, permanent increase in oil prices. We have had several examples of very sharp increases in oil prices, especially in the 1970s, and, more recently, oil prices have been declining since the end of 1996. When there is a sharp rise in oil prices, there will be a temporary burst of inflation. In addition, an adverse supply shock will typically result in a decline in aggregate demand and hence in output and employment. This is thus an example of a situation in which there can be a conflict between the dual objectives of full employment and price stability, and, as such, this represents one of the greatest challenges for monetary policy. The surge in inflation appears to demand a rise in real interest rates, and hence a particularly sharp increase in nominal rates; while the decline in output and employment appears to call for a decline in real interest rates. Experience suggests that supply shocks yield a sharp transitory increase in inflation, often followed by a smaller, more permanent effect, though the longer-run effect on inflation will obviously be importantly dictated by the response of monetary policy. Given the transitory nature of the initial inflation surge, policy does well to look through it and instead focus on the more persistent (and modest) inflation consequences of the shock. By doing so policymakers respond expeditiously to the bad news, but avoid the mistake of overreacting. - 9 - One reason for this cautious approach is that policy cannot much affect inflation in the near term, but instead has its primary effect over the coming year or two. Hence policy today should focus on inflation next year. Policy should tighten, that is real interest rates should rise, to the extent that inflation is expected to be higher next year on account of the supply shock. This might reflect the effect of a supply shock as today's oil prices raise overall inflation, and, through the effect of inflation on wage bargaining, impact on broader measures of price change in subsequent quarters. One way to handle that within the Taylor Rule is to specify the rule using a measure of core inflation, meaning one that excludes oil and food prices, the price components most subject to supply shocks. This will help policy to "look through" the initial burst of inflation, but it may fail to produce an appropriate immediate adjustment to counter the more permanent effect of the shock on inflation in subsequent quarters. Another and perhaps better way to respond to supply shocks is to be forward looking and respond to forecasts of future inflation, rather than to the current inflation. This avoids both an overly aggressive response to the initial burst of overall inflation and an insufficient immediate response because of an inappropriate focus on a measure of inflation that ignores the current rise in oil prices. Art and Science Work on policy rules and experience with implementing policy in an interest rate regime have, I believe, helped to define the set of principles I have just discussed. They are, I would remind you, only my perspective on the strategy of monetary policy, not official doctrine of the FOMC. We have much to learn, both about the structure of the economy and about the best way to implement policy. The role of rules is best viewed in my judgment as informing the monetary policy decision, not dictating it. No single rule will be the best policy in all circumstances, as I hope I have demonstrated with my discussion. Sometimes responding to recent trends in the data will work well, but sometimes a forward-looking policy will be critical, as might be the case in the current environment. Sometimes an unusual circumstance will dictate a departure from what the rule might have suggested. An example here would be maintaining a very stimulative policy -- effectively a zero real federal funds rate -- during 1992 and 1993, a period well into the current expansion. This turned out, in my judgment, to be very excellent policy, though a departure from the Taylor Rule, because it took account of the unusual structural drags that were restraining the expansion and justified maintaining monetary stimulus longer than normal into an expansion. And, finally, monetary policy has to be sensitive to the potential for structural changes to alter fundamental relationships. Science in the form of economic theory, econometric models, and carefully designed rules can improve the conduct of monetary policy. But good policy will always be, as Alan Holmes understood so well, a blend of art and science. Each of us on the FOMC strive to become the monetary policy artist that Alan Holmes was as he participated in the FOMC during his distinguished career.	---[PAGE_BREAK]--- Mr. Meyer remarks on the strategy of monetary policy in the United States Text of the Alan R. Holmes Lecture by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, held at Middlebury College, Middlebury, Vermont on 16/3/98. When I was asked to deliver the Alan R. Holmes Lecture, it seemed appropriate to focus on a topic directly related to the interests and contributions of Alan Holmes. It was not hard to find such a topic, because Alan Holmes served with distinction in a position that was at the very core of monetary policymaking. Monetary policy begins with a set of objectives, which identify where policymakers want the economy to be, a preferred or ideal state of macroeconomic performance. The heart of monetary policy is about designing and implementing a strategy to guide policymakers in decisions about the setting of open market operations, the principal instrument of monetary policy, so as to contribute to achieving the objectives. This is the subject of my lecture today and it was very much the subject of Alan Holmes' career. He was an economist for 31 years at the Federal Reserve Bank of New York, and for many years served as Executive Vice President of the Federal Reserve Bank of New York and as Manager of the System Open Market Account. In that position he was directly responsible for implementing policies of the Federal Open Market Committee, the FOMC, specifically the day-to-day decisions about open market operations. The FOMC consists of the seven members of the Board of Governors and five presidents of the regional Federal Reserve banks. There is no official operating manual for members of the committee that identifies the guiding principles, no "official doctrine". While the views I present here are my own perspectives on strategy, my purpose in this lecture is not to articulate a singular view of the strategy of monetary policy, but rather to shed light on some of the mystery about monetary policy. A former Alan Homes Professor of Economics at Middlebury College and good friend, Dewey Daane, co-edited a book in honor of Alan Holmes, entitled The Art of Monetary Policy. In his forward to the book, William Simon called Alan Holmes a "monetary policy artist". As I develop my perspective on monetary policy, I will try to blend the role of art and science, of economic theory and practical judgments that Alan Holmes so well understood. Objectives Monetary policymaking naturally begins with an understanding of the objectives of policy, because that is what good policy should deliver. It is widely accepted that there are three fundamental norms of macroeconomic performance, which I summarize as full employment, growth, and price stability, and these norms are a useful point of departure to thinking about the objectives for monetary policy. Full employment can be interpreted as achieving the maximum sustainable level of employment and production. It basically means avoiding waste, in the sense of failing to use all the available productive resources. By sustainable, I mean the highest level of output that can be sustained without imposing unacceptable costs, a consideration I will return to shortly. By growth, I am referring to the desire to achieve both a high average level and rate of growth in living standards, on average, over time. We usually measure living standards in terms of real income per capita. We can be at full employment and yet be poor. We want to be at full employment and be rich. And we want our living standards to be improving over time. I'll refer to the average rate of growth in output in the long run as the economy's trend rate of growth. Price stability refers to the stability of the overall price level, measured, for example, by the price index for overall output (the chain-weighted price index of GDP) or for consumer goods and services (the Consumer Price Index). We often satisfy ourselves with the norm of low and stable ---[PAGE_BREAK]--- inflation. At any rate, price stability is really more an intermediate goal than an ultimate objective. The reason we care about price stability is that we believe that it contributes to a high and rising level of living standards. Indeed, it is viewed as so important in this regard that we identify it as a separate and free-standing norm. And we will soon see we have particular reason to do so from the perspective of monetary policy. # Implications of Economic Theory I am going to assert some conclusions based on economic theory that help to understand the potential for monetary policy to achieve these objectives and the consistency among them. These conclusions are widely though not universally shared, but they do guide my views of what monetary policy can and should do. First, monetary policy cannot influence real variables -- such as output and employment -- in the long run (except via the contribution of price stability to living standards). This is often referred to as the principle of the neutrality of money. This proposition removes "growth" as an objective for monetary policy and also means that monetary policy cannot materially affect the level of output or employment corresponding to "full employment". Second, monetary policy is the principal determinant of inflation in the long run. This proposition immediately makes price stability (in some shape or form) the direct, unequivocal, and singular long-term objective of monetary policy. No central bank around the world would argue otherwise. When it comes to price stability, the buck, literally, stops at the central bank. Third, because prices in many markets may be slow to adjust to equate supply and demand, shocks to the economy can lead to persistent departures of the economy from full employment -- in both directions. This proposition offers at least the potential for monetary policy to play a role in smoothing out business cycles. Fourth, full employment and price stability are compatible. Now, by full employment I do not mean literally zero unemployment. Instead full employment is better thought of as the lowest possible rate of unemployment that can be sustained without rising inflation. If unemployment remains, on average, at this level, inflation tends to remain constant. This rate -- which is often called the non-accelerating inflation rate of unemployment (or NAIRU) -- is a fact of life outside the control of the FOMC. This definition of full employment insures that the two objectives left for monetary policy -- full employment and price stability -- are compatible in the long run. Fifth, inflation pressures arise, in large part, in response to departures of the economy from full employment. If the economy moves below full employment, for example, the resulting slack results in disinflation, that is, downward pressure on inflation. When the economy moves above this threshold there is continuing upward pressure on inflation. This implies that the two objectives of price stability and full employment can conflict in the short run. This leaves us with dual objectives for monetary policy: short-run stabilization of output relative to potential and long-run price stability. Fortunately, this is also the legislative mandate Congress has set for monetary policy in the Full Employment and Balanced Growth Act of 1978, often referred to as the Humphrey-Hawkins Act, at least by my interpretation. There are many interesting issues and controversies related to the choice and definition of objectives. These include the definition of an inflation target that corresponds to price stability and the estimate of the unemployment threshold that corresponds to full employment. I'll assume that the inflation target is set to reflect the expected bias in inflation measurement or to be slightly above this estimate. Many commentators view a $2 \%$ inflation rate as a reasonable inflation objective and many countries with explicit inflation targets use a $1 \%$ - $3 \%$ range. As for the definition of full employment, I'll use a consensus estimate of the unemployment threshold, which is currently around $51 / 2 \%$. I might add that there is considerable uncertainty about this estimate, particularly in light of the consistent ---[PAGE_BREAK]--- surprise of declining inflation even as the unemployment rate has fallen well below this threshold. I have focused a number of my speeches on this very topic, but, for today, it is mainly a reminder of the uncertainty that monetary policymakers face about the structure of the economy, especially when the structure changes over time. # Instruments The next step is to identify the instruments through which monetary policy influences the economy. While there are, in principle, three instruments through which monetary policy affects the macroeconomy -- open market operations, the discount rate, and the reserve requirement ratio -- as Alan Holmes certainly appreciated, open market operations are the principal instrument of monetary policy, and so I will focus on open market operations. The Federal Reserve holds a portfolio of government securities. It injects or withdraws reserves by buying for or selling from this portfolio. When it purchases securities from the private sector, it injects reserves and normally puts downward pressure on short-term market interest rates. So open market operations can be viewed as implementing either a path of reserves or achieving a level of short-term interest rates. In practice, nearly all central banks target a short-term interest rate rather than reserves with their open market operations. This is because reserves are most useful for close control of the money supply and money supplies have proven to have only a loose, long-term relationship to the objectives of monetary policy. ## Natural Hurdles If we knew precisely where we were, understood precisely the relationship between our instruments and macroeconomic performance, had a single objective, and could instantly affect the variable or variables associated with our target(s), implementing policy would be easy. Indeed, this lecture would be nearly over, because we would not have to worry about a strategy for monetary policy. It is precisely because none of these preconditions hold that monetary policy is so difficult and principles are needed to guide its implementation. First, it is clearly important to know where you are in relation to where you want to be. But we do not have timely and accurate information about where we are. The data trickles in with a lag, often involves considerable noise, and is subject to revision, even after which it may remain less precise than we would prefer. Because of the noise in economic measures, considerable effort is needed to extract the meaningful signal from the data. Second, we are working with a caricature of the economy in the form of our empirical models that guide both forecasting and policy decisions. The models reflect our imperfect state of knowledge about how the economy works. In addition, as I just noted, the relationships among the variables in the economy shift over time and we only gradually learn and adjust to such structural changes. Third, monetary policy affects aggregate demand and inflation with a lag. The major effect of a policy action today is not felt until about a year from now. Therefore, when we are thinking about affecting inflation, we better be thinking about affecting inflation next year, rather than tomorrow. One implication of lags is that policy has to be forward looking. If we want to affect inflation next year, we have to act today. We therefore have to try to anticipate problems rather than simply react to them. That means that forecasting is an inherent part of the policy process and policy has to have a pre-emptive quality. Fourth, we have multiple objectives, but only a single instrument. Simple models of policy normally imply that to achieve two objectives simultaneously, you need two instruments. How can we therefore juggle our dual targets? Fortunately, theory and evidence suggest, as I noted earlier, that the objectives of full employment and price stability are consistent in the long run. Short-run conflicts ---[PAGE_BREAK]--- between the targets arise in one of two circumstances. A conflict arises if we begin with inflation above our objective. Unfortunately, monetary policy can reduce inflation only by temporarily imposing some slack in the economy. In this case, lowering inflation would mean departing for a while from full employment. Once inflation had fallen to its target level, the economy could return to full employment and enjoy the consistency of the two objectives. A second source of conflict arises in response to a supply shock, such as an increase in oil prices. Assume we begin with full employment and price stability and there is a sharp rise in oil prices. This will tend to both raise inflation in the short run and depress output. What should monetary policy do? Tighten to unwind the increase in inflation? Or loosen to counter the increase in unemployment? The natural hurdles make monetary policy a challenging task, requiring the application of both good judgment and appropriate models, art and science. # Operating Strategies and the FOMC Meeting Now that we appreciate the challenging nature of monetary policy, we are ready to develop a strategy for implementing open market operations. The first question we ask is whether policy should be carried out according to some well-defined and precise formula, or rule, or whether it should be implemented judgmentally. My point here is not to recall the longstanding debate about rules vs. discretion, but to emphasize that good policy should be systematic or rule-like, even when it is not formally tied to a specific rule. In addition, we can learn a lot about principles for guiding discretionary policy by examining rules that can be shown to have effective stabilizing properties in our models. As I noted earlier, monetary policy is implemented in the United States, as in most central banks, through the control of interest rates. At each meeting, the FOMC sets an intended federal funds rate target. The federal funds rate is the interest rate on overnight loans in the inter-bank market. It is therefore the rate paid when reserves are borrowed and lent among banks. And it is a natural target to achieve via open market operations since these operations in effect inject or withdraw reserves. The federal funds rate is currently 5.5\%. The FOMC announces any change in this target immediately following the conclusion of its meetings. It also explicitly incorporates this target funds rate in a "directive" to the Manager of the System Open Market Account, the position Alan Holmes held at the Federal Reserve Bank of New York. This directive instructs the Manager to implement open market operations during the period between this and the next FOMC meeting so as to maintain the federal funds rate as close as possible to the intended rate. ## Point of Departure: Constant Money Growth Rule Given that the Federal Reserve, like most other central bank today, operates by setting a near-term interest rate target, my focus is on developing some guiding principles for setting the interest rate target, more precisely, for adjusting the interest rate target in response to changing economic conditions. I have found it useful to begin this search, perhaps surprisingly, by developing the properties of a constant money supply growth rule. This both helps to identify some of the essential properties of a monetary policy strategy, which will apply to interest rate targeting as well, and highlights the practical difficulties in carrying out monetary policy using money supply targets. Another reason for starting with a monetary aggregate strategy is that monetary aggregates played a more significant role in the implementation of monetary policy during Holmes' service as Manager of the System Open Market Account. The directive to the Manager from the FOMC during this period was often specified in terms of maintaining or changing "money market conditions" (a code for the federal funds rate), unless growth in the monetary aggregates departed significantly from the midpoints of their specified ranges. Sometimes the directive was specified directly in terms of the desired course of the monetary aggregates, in this case typically subject to an acceptable range for the federal funds rate. This gave money growth a more direct role in the conduct of policy than it has today. ---[PAGE_BREAK]--- Let's now see why money growth might be a useful target for implementing monetary policy. Economic theory suggests that, if the demand for money is stable, the rate of money growth will pin down the rate of growth in nominal income. Under reasonable assumptions, a constant rate of money growth will yield growth of nominal income, on average, at the same rate. The rate of money growth should be set to achieve a rate of nominal income growth that just equals the rate of trend growth in real output and the rate of inflation consistent with the policy objective. On average and in the long run, this rate of money growth will achieve the Fed's inflation objective. So the first proposition is that a money growth target provides a nominal anchor which pins down the long-run inflation rate. This strategy immediately allows a translation of the long-run price stability objective into a more near-term money supply growth target. And, by implication, any monetary policy strategy must mimic the nominal anchor property of a money supply target, if it is to be consistent with the Federal Reserve's mandate for price stability. Next, let's ask what would happen if the economy was subject to a shock that moved it away from price stability and full employment. If real output increases faster than trend and/or inflation increases relative to the Fed's objective, the resulting higher nominal income growth, relative to the constant rate of money growth, would result in an increase in interest rates. The second property of a money supply target is that it builds stability into the economy by insuring pro-cyclical movements in the interest rate in response to demand shocks. Another way of saying this is that it insures that monetary policy automatically leans against the cyclical winds to stabilize the economy. # The Taylor Rule as a Strategy for an Interest Rate Operating Procedure Despite the desirable properties of a constant money growth rule, in principle, most central banks implement policy by setting short-term interest rates in practice. This choice reflects at least two considerations. First, instability in money demand reduces the usefulness of money supply targets. Second, interest rate targets allow the central bank to smooth out the effects of transitory shocks to financial markets. But how should the Fed vary its interest rate "instrument" to achieve its ultimate objectives? The simplest answer is that interest rates should vary to imitate qualitatively the way they would behave if the Fed were implementing a money supply target. In other words, interest rates need to be varied systematically to effectively impose a nominal anchor and to insure that policy leans against the cyclical winds. Setting monetary policy in this manner via an interest rate target, in principle, allows the Fed to achieve the best of both worlds. It can impose the same nominal anchor and short-run stabilization properties as would be the case with a money growth rule, but, at the same time, smooth out shorter-run volatility in interest rates. In addition, by careful choice of the degree of response of interest rates to changing economic conditions, the rule can, in principle, improve upon the stabilization properties of a money supply rule. A simple specification of a strategy for varying the federal funds rate in response to changing economic conditions is provided by the Taylor Rule, a rule developed by John Taylor, a professor at Stanford University. The appeal of the Taylor Rule is that it is simple and specifies how the federal funds rate (effectively the Fed's instrument) should be varied directly in response to inflation and to deviations of output and inflation from the Fed's ultimate targets of full employment and price stability. My point here is not to extol the virtues of the precise specification in the Taylor Rule, but to use it to highlight some of the central principles that should guide decisions about the setting of the funds rate. It is useful to appreciate how Taylor derived his rule and how he views its role in monetary policy. The rule emerged from Taylor's analysis of simulations of a variety of rules in a variety of models. He concluded that the simple form embodied in the Taylor Rule had, based on this work, excellent stabilizing properties. The rule was therefore initially developed as a normative guide, meaning ---[PAGE_BREAK]--- a set of principles to guide policy that, if followed, would result in relatively good economic performance, at least compared to other rules and perhaps relative to historic US economic performance. Subsequently, Taylor found the rule described reasonably well the way policy was indeed carried out over the last decade. That is, the rule was also descriptive of recent policymaking. The Taylor Rule begins by assuming that there is some level of real federal funds rate consistent with full employment and stable inflation. The real interest rate is the nominal interest rate less some measure of inflation expectations (measured by Taylor as actual inflation over the last year) -- a measure of the increase in purchasing power (rather than in dollars) associated with holding an asset. Taylor calls this the equilibrium real interest rate and assumed it was $2 \%$. Let's assume that the economy is initially at full employment and price stability. Then the level of real and nominal interest rates would be set at $2 \%$. I am not going to quibble with this choice, because I am focusing on general principles rather than precise details. The economy is, of course, not always at full employment and price stability and the purpose of the Taylor Rule is to specify how the federal funds rate should respond to shocks that push the economy away from price stability and/or full employment. Because both objectives are explicitly incorporated into the rule, it provides a disciplined approach to juggling the dual mandate for monetary policy. The real equilibrium interest rate is viewed as consistent with full employment and any stable rate of inflation. So the first implication of this rule is that, in order to be consistent with full employment, nominal interest rates should be adjusted in response to inflation to maintain the equilibrium real interest rate. The next message of the rule concerns how the real federal funds rate should be adjusted in response to deviations of output and inflation from full employment and price stability. According to the rule, when output rises relative to potential output, real interest rates should rise. When inflation rises relative to the inflation target, real interest rates should also rise. These movements of real interest rates in response to departures of inflation and output from their target levels can be shown to stabilize output and inflation relative to their targets. # The Dangers of an Interest Rate Strategy There are natural dangers inherent in interest rate targeting, at least in the absence of a rule that guides its adjustment to changing economic conditions. If cyclical movements in output are dominated by demand shocks, the failure to move interest rates aggressively enough in response to the shocks can result in monetary policy destabilizing rather than stabilizing the economy. For example, if there is a demand shock resulting in higher income and/or prices, the demand for money will increase, putting upward pressure on interest rates. If the Fed maintains an unchanged nominal interest rate target, it will have to add reserves to support a higher money supply at the initial interest rate. This means that, under a constant interest rate target, a demand shock would lead to perverse monetary policy, specifically to stimulative open market operations, reinforcing rather than damping the demand shock. The inherent danger in interest rate targeting is reinforced by the preference for central bankers for smoothing interest rates. This preference takes two forms. First, there is a preference for implementing a rise in rates in a series of small changes in the same direction. Second, there is a reluctance to change the direction of policy, without particularly strong rationale. Nevertheless, interest rate targets can, in principle, be implemented in a way that avoids this pitfall, and one of the values of rules is to remind policymakers of the importance of adjusting interest rates in response to changing economic conditions, thereby preventing policy from becoming destabilizing. ---[PAGE_BREAK]--- # Principles to Guide the Setting of Interest Rates We are now ready to identify a set of principles to guide decisions about the setting of the federal funds rate at FOMC meetings. Underlying these principles are the lessons gleaned from both the constant money growth rule and from the Taylor Rule. Both rules highlight the importance of imposing a nominal anchor to pin down the long-run inflation rate and of varying real interest rates pro-cyclically to lean against the cyclical winds. The Taylor Rule also highlights the critical importance of real interest rates in the conduct of monetary policy. There is one very important difference between the constant money growth and Taylor rules that deserves comment. While a constant rate of money growth will not always be optimal, if money demand is sufficiently stable, and not particularly interest sensitive, it will pin down inflation in the long run and help smooth the business cycle in the short run. That is, under a money growth target, doing nothing (that is, maintaining an unchanged rate of money growth) may not always be the best choice, but, for the most part, it won't get you into serious trouble and will in fact do some considerable good, although it would likely involve a considerable variation in interest rates on a day-to-day basis. Under an interest rate targeting regime, on the other hand, doing nothing can potentially get you into great difficulty -- sometimes quite quickly. In this case, policy must constantly be prepared to adjust to changing economic conditions, to avoid the potential for becoming a destabilizing influence on the economy. Rule No. 1: Vary real interest rates in response to departures of inflation from its target. For example, if inflation increases, relative to its target, the real interest rate should be increased. This is perhaps the single most important discipline for monetary policy under an interest rate regime. When inflation increases, nominal interest rates must first be increased just to avoid a decline in the real rate. But to counter the rise in inflation relative to its target, the real interest rate has to rise. That means that nominal rates have to rise by more than the increase in inflation. In the Taylor Rule, for example, the nominal federal funds rate rises by 1.5 percentage points for every one percentage-point increase in inflation. Rule No. 2: Vary (nominal and real) interest rates in response to changes in resource utilization rates. Under a money supply growth rule, interest rates rise whenever growth in real GDP exceeds the trend GDP growth assumption embedded in the money growth target. Whenever growth is above trend, the unemployment rate falls and the capacity utilization rate rises. By adjusting real interest rates in response to such changes in utilization rates, for a given inflation rate, an interest rate regime insures the same qualitative stabilization property that a constant money growth rule automatically yields. In implementing this principle, real interest rates would rise gradually but systematically during expansions, fall when growth slows to below trend, and decline sharply when the actual level of output declines, at least for those cyclical episodes where supply shocks (see below) are not very important. Just following this simple principle will help stabilize output relative to full employment and inflation relative to the inflation target. It is a reminder that there ought to be nothing startling or dramatic in FOMC decisions to adjust the federal funds rate. Indeed, the question that might be asked when nominal rates are constant for long periods is how does the FOMC justify such stability in the face of changing economic conditions! You might, therefore, ask whether or not the near constancy of the nominal funds rate over the most recent episode has been appropriate. I believe monetary policy has, in fact, been excellent over this period. But this has been a very unusual period with remarkable crosscurrents that balanced out to allow such stable short-term rates. It should not lull us into believing that stable interest rates and good monetary policy naturally go together. Rule No. 3: In setting rates, be forward looking. I noted earlier that, because of lags, monetary policy has to be forward looking. There are, however, different degrees of forward lookingness that we could incorporate into policymaking. For example, because higher utilization rates today raise the ---[PAGE_BREAK]--- risk of higher inflation in the future, raising interest rates today in response to observed increases in utilization rates is a forward-looking policy relative to simply responding to current inflation. Forward-looking policy is sometimes said to be pre-emptive. A movement in interest rates in response to rising utilization rates would be said to be a pre-emptive move against inflation. The Taylor Rule thus allows for a combination of pre-emptive policy, changes in interest rates in response to changes in utilization rates, and reactive policy, changes in interest rates in response to movements in inflation itself. So good policy can be both pre-emptive and reactive. A still more forward-looking approach would be for policymakers to respond not to actual inflation and utilization rates, as in the Taylor Rule, but to forecasts of projected inflation and utilization rates, assuming an unchanged nominal federal funds rate. A good reason for responding to forecasts of inflation is that the effects of monetary policy on the economy mostly occur about a year from now. There is a considerable amount of work under way to assess the usefulness of using forecasts as opposed to past information on unemployment and inflation in the specification of interest rate rules. There are clear historical examples when a forward-looking policy would be an improvement. These episodes illustrate that simple rules are only guides and that good policy sometimes means following the rule and sometimes means using judgment to improve upon the rule. Judgement is especially called for in situations where special events point to future changes in output and inflation that would ordinarily be viewed as unlikely. The current episode provides a good example of such a situation in which there is much to be gained from forward-looking policy. The economy entered 1998 with considerable forward momentum, already operating at very high utilization rates. This momentum reflected persistent strength in domestic demand, particularly consumer spending and business fixed investment. However, the financial and currency crises in Asia are projected to result in a sharper decline in net exports than would otherwise have occurred and this promises to slow the expansion in the absence of any policy action, perhaps substituting for monetary tightening that otherwise might have been justified. In this environment, a backward-looking policy that ignored the potential drag on future demand from Asia could risk magnifying the effect of the shift in aggregate demand. Rule No. 4: The appropriate policy response may depend on the source and persistence of the shock. Let me distinguish two types of shocks to the economy. The first is a persistent demand shock -- for example, an increase in aggregate demand that results in a persistent departure from trend growth and persistent changes in utilization rates. This will have symmetric effects, raising both output and inflation, and presents a relatively straightforward monetary policy problem that is well handled by the first set of rules. A second source of shock is a supply shock, an example of which would be a one-time, permanent increase in oil prices. We have had several examples of very sharp increases in oil prices, especially in the 1970s, and, more recently, oil prices have been declining since the end of 1996. When there is a sharp rise in oil prices, there will be a temporary burst of inflation. In addition, an adverse supply shock will typically result in a decline in aggregate demand and hence in output and employment. This is thus an example of a situation in which there can be a conflict between the dual objectives of full employment and price stability, and, as such, this represents one of the greatest challenges for monetary policy. The surge in inflation appears to demand a rise in real interest rates, and hence a particularly sharp increase in nominal rates; while the decline in output and employment appears to call for a decline in real interest rates. Experience suggests that supply shocks yield a sharp transitory increase in inflation, often followed by a smaller, more permanent effect, though the longer-run effect on inflation will obviously be importantly dictated by the response of monetary policy. Given the transitory nature of the initial inflation surge, policy does well to look through it and instead focus on the more persistent (and modest) inflation consequences of the shock. By doing so policymakers respond expeditiously to the bad news, but avoid the mistake of overreacting. ---[PAGE_BREAK]--- One reason for this cautious approach is that policy cannot much affect inflation in the near term, but instead has its primary effect over the coming year or two. Hence policy today should focus on inflation next year. Policy should tighten, that is real interest rates should rise, to the extent that inflation is expected to be higher next year on account of the supply shock. This might reflect the effect of a supply shock as today's oil prices raise overall inflation, and, through the effect of inflation on wage bargaining, impact on broader measures of price change in subsequent quarters. One way to handle that within the Taylor Rule is to specify the rule using a measure of core inflation, meaning one that excludes oil and food prices, the price components most subject to supply shocks. This will help policy to "look through" the initial burst of inflation, but it may fail to produce an appropriate immediate adjustment to counter the more permanent effect of the shock on inflation in subsequent quarters. Another and perhaps better way to respond to supply shocks is to be forward looking and respond to forecasts of future inflation, rather than to the current inflation. This avoids both an overly aggressive response to the initial burst of overall inflation and an insufficient immediate response because of an inappropriate focus on a measure of inflation that ignores the current rise in oil prices. # Art and Science Work on policy rules and experience with implementing policy in an interest rate regime have, I believe, helped to define the set of principles I have just discussed. They are, I would remind you, only my perspective on the strategy of monetary policy, not official doctrine of the FOMC. We have much to learn, both about the structure of the economy and about the best way to implement policy. The role of rules is best viewed in my judgment as informing the monetary policy decision, not dictating it. No single rule will be the best policy in all circumstances, as I hope I have demonstrated with my discussion. Sometimes responding to recent trends in the data will work well, but sometimes a forward-looking policy will be critical, as might be the case in the current environment. Sometimes an unusual circumstance will dictate a departure from what the rule might have suggested. An example here would be maintaining a very stimulative policy -- effectively a zero real federal funds rate -- during 1992 and 1993, a period well into the current expansion. This turned out, in my judgment, to be very excellent policy, though a departure from the Taylor Rule, because it took account of the unusual structural drags that were restraining the expansion and justified maintaining monetary stimulus longer than normal into an expansion. And, finally, monetary policy has to be sensitive to the potential for structural changes to alter fundamental relationships. Science in the form of economic theory, econometric models, and carefully designed rules can improve the conduct of monetary policy. But good policy will always be, as Alan Holmes understood so well, a blend of art and science. Each of us on the FOMC strive to become the monetary policy artist that Alan Holmes was as he participated in the FOMC during his distinguished career.	Laurence H Meyer	United States	https://www.bis.org/review/r980325d.pdf	Mr. Meyer remarks on the strategy of monetary policy in the United States Text of the Alan R. Holmes Lecture by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, held at Middlebury College, Middlebury, Vermont on 16/3/98. When I was asked to deliver the Alan R. Holmes Lecture, it seemed appropriate to focus on a topic directly related to the interests and contributions of Alan Holmes. It was not hard to find such a topic, because Alan Holmes served with distinction in a position that was at the very core of monetary policymaking. Monetary policy begins with a set of objectives, which identify where policymakers want the economy to be, a preferred or ideal state of macroeconomic performance. The heart of monetary policy is about designing and implementing a strategy to guide policymakers in decisions about the setting of open market operations, the principal instrument of monetary policy, so as to contribute to achieving the objectives. This is the subject of my lecture today and it was very much the subject of Alan Holmes' career. He was an economist for 31 years at the Federal Reserve Bank of New York, and for many years served as Executive Vice President of the Federal Reserve Bank of New York and as Manager of the System Open Market Account. In that position he was directly responsible for implementing policies of the Federal Open Market Committee, the FOMC, specifically the day-to-day decisions about open market operations. The FOMC consists of the seven members of the Board of Governors and five presidents of the regional Federal Reserve banks. There is no official operating manual for members of the committee that identifies the guiding principles, no "official doctrine". While the views I present here are my own perspectives on strategy, my purpose in this lecture is not to articulate a singular view of the strategy of monetary policy, but rather to shed light on some of the mystery about monetary policy. A former Alan Homes Professor of Economics at Middlebury College and good friend, Dewey Daane, co-edited a book in honor of Alan Holmes, entitled The Art of Monetary Policy. In his forward to the book, William Simon called Alan Holmes a "monetary policy artist". As I develop my perspective on monetary policy, I will try to blend the role of art and science, of economic theory and practical judgments that Alan Holmes so well understood. Objectives Monetary policymaking naturally begins with an understanding of the objectives of policy, because that is what good policy should deliver. It is widely accepted that there are three fundamental norms of macroeconomic performance, which I summarize as full employment, growth, and price stability, and these norms are a useful point of departure to thinking about the objectives for monetary policy. Full employment can be interpreted as achieving the maximum sustainable level of employment and production. It basically means avoiding waste, in the sense of failing to use all the available productive resources. By sustainable, I mean the highest level of output that can be sustained without imposing unacceptable costs, a consideration I will return to shortly. By growth, I am referring to the desire to achieve both a high average level and rate of growth in living standards, on average, over time. We usually measure living standards in terms of real income per capita. We can be at full employment and yet be poor. We want to be at full employment and be rich. And we want our living standards to be improving over time. I'll refer to the average rate of growth in output in the long run as the economy's trend rate of growth. Price stability refers to the stability of the overall price level, measured, for example, by the price index for overall output (the chain-weighted price index of GDP) or for consumer goods and services (the Consumer Price Index). We often satisfy ourselves with the norm of low and stable inflation. At any rate, price stability is really more an intermediate goal than an ultimate objective. The reason we care about price stability is that we believe that it contributes to a high and rising level of living standards. Indeed, it is viewed as so important in this regard that we identify it as a separate and free-standing norm. And we will soon see we have particular reason to do so from the perspective of monetary policy. I am going to assert some conclusions based on economic theory that help to understand the potential for monetary policy to achieve these objectives and the consistency among them. These conclusions are widely though not universally shared, but they do guide my views of what monetary policy can and should do. First, monetary policy cannot influence real variables -- such as output and employment -- in the long run (except via the contribution of price stability to living standards). This is often referred to as the principle of the neutrality of money. This proposition removes "growth" as an objective for monetary policy and also means that monetary policy cannot materially affect the level of output or employment corresponding to "full employment". Second, monetary policy is the principal determinant of inflation in the long run. This proposition immediately makes price stability (in some shape or form) the direct, unequivocal, and singular long-term objective of monetary policy. No central bank around the world would argue otherwise. When it comes to price stability, the buck, literally, stops at the central bank. Third, because prices in many markets may be slow to adjust to equate supply and demand, shocks to the economy can lead to persistent departures of the economy from full employment -- in both directions. This proposition offers at least the potential for monetary policy to play a role in smoothing out business cycles. Fourth, full employment and price stability are compatible. Now, by full employment I do not mean literally zero unemployment. Instead full employment is better thought of as the lowest possible rate of unemployment that can be sustained without rising inflation. If unemployment remains, on average, at this level, inflation tends to remain constant. This rate -- which is often called the non-accelerating inflation rate of unemployment (or NAIRU) -- is a fact of life outside the control of the FOMC. This definition of full employment insures that the two objectives left for monetary policy -- full employment and price stability -- are compatible in the long run. Fifth, inflation pressures arise, in large part, in response to departures of the economy from full employment. If the economy moves below full employment, for example, the resulting slack results in disinflation, that is, downward pressure on inflation. When the economy moves above this threshold there is continuing upward pressure on inflation. This implies that the two objectives of price stability and full employment can conflict in the short run. This leaves us with dual objectives for monetary policy: short-run stabilization of output relative to potential and long-run price stability. Fortunately, this is also the legislative mandate Congress has set for monetary policy in the Full Employment and Balanced Growth Act of 1978, often referred to as the Humphrey-Hawkins Act, at least by my interpretation. There are many interesting issues and controversies related to the choice and definition of objectives. These include the definition of an inflation target that corresponds to price stability and the estimate of the unemployment threshold that corresponds to full employment. I'll assume that the inflation target is set to reflect the expected bias in inflation measurement or to be slightly above this estimate. Many commentators view a $2 \%$ inflation rate as a reasonable inflation objective and many countries with explicit inflation targets use a $1 \%$ - $3 \%$ range. As for the definition of full employment, I'll use a consensus estimate of the unemployment threshold, which is currently around $51 / 2 \%$. I might add that there is considerable uncertainty about this estimate, particularly in light of the consistent surprise of declining inflation even as the unemployment rate has fallen well below this threshold. I have focused a number of my speeches on this very topic, but, for today, it is mainly a reminder of the uncertainty that monetary policymakers face about the structure of the economy, especially when the structure changes over time. The next step is to identify the instruments through which monetary policy influences the economy. While there are, in principle, three instruments through which monetary policy affects the macroeconomy -- open market operations, the discount rate, and the reserve requirement ratio -- as Alan Holmes certainly appreciated, open market operations are the principal instrument of monetary policy, and so I will focus on open market operations. The Federal Reserve holds a portfolio of government securities. It injects or withdraws reserves by buying for or selling from this portfolio. When it purchases securities from the private sector, it injects reserves and normally puts downward pressure on short-term market interest rates. So open market operations can be viewed as implementing either a path of reserves or achieving a level of short-term interest rates. In practice, nearly all central banks target a short-term interest rate rather than reserves with their open market operations. This is because reserves are most useful for close control of the money supply and money supplies have proven to have only a loose, long-term relationship to the objectives of monetary policy. If we knew precisely where we were, understood precisely the relationship between our instruments and macroeconomic performance, had a single objective, and could instantly affect the variable or variables associated with our target(s), implementing policy would be easy. Indeed, this lecture would be nearly over, because we would not have to worry about a strategy for monetary policy. It is precisely because none of these preconditions hold that monetary policy is so difficult and principles are needed to guide its implementation. First, it is clearly important to know where you are in relation to where you want to be. But we do not have timely and accurate information about where we are. The data trickles in with a lag, often involves considerable noise, and is subject to revision, even after which it may remain less precise than we would prefer. Because of the noise in economic measures, considerable effort is needed to extract the meaningful signal from the data. Second, we are working with a caricature of the economy in the form of our empirical models that guide both forecasting and policy decisions. The models reflect our imperfect state of knowledge about how the economy works. In addition, as I just noted, the relationships among the variables in the economy shift over time and we only gradually learn and adjust to such structural changes. Third, monetary policy affects aggregate demand and inflation with a lag. The major effect of a policy action today is not felt until about a year from now. Therefore, when we are thinking about affecting inflation, we better be thinking about affecting inflation next year, rather than tomorrow. One implication of lags is that policy has to be forward looking. If we want to affect inflation next year, we have to act today. We therefore have to try to anticipate problems rather than simply react to them. That means that forecasting is an inherent part of the policy process and policy has to have a pre-emptive quality. Fourth, we have multiple objectives, but only a single instrument. Simple models of policy normally imply that to achieve two objectives simultaneously, you need two instruments. How can we therefore juggle our dual targets? Fortunately, theory and evidence suggest, as I noted earlier, that the objectives of full employment and price stability are consistent in the long run. Short-run conflicts between the targets arise in one of two circumstances. A conflict arises if we begin with inflation above our objective. Unfortunately, monetary policy can reduce inflation only by temporarily imposing some slack in the economy. In this case, lowering inflation would mean departing for a while from full employment. Once inflation had fallen to its target level, the economy could return to full employment and enjoy the consistency of the two objectives. A second source of conflict arises in response to a supply shock, such as an increase in oil prices. Assume we begin with full employment and price stability and there is a sharp rise in oil prices. This will tend to both raise inflation in the short run and depress output. What should monetary policy do? Tighten to unwind the increase in inflation? Or loosen to counter the increase in unemployment? The natural hurdles make monetary policy a challenging task, requiring the application of both good judgment and appropriate models, art and science. Now that we appreciate the challenging nature of monetary policy, we are ready to develop a strategy for implementing open market operations. The first question we ask is whether policy should be carried out according to some well-defined and precise formula, or rule, or whether it should be implemented judgmentally. My point here is not to recall the longstanding debate about rules vs. discretion, but to emphasize that good policy should be systematic or rule-like, even when it is not formally tied to a specific rule. In addition, we can learn a lot about principles for guiding discretionary policy by examining rules that can be shown to have effective stabilizing properties in our models. As I noted earlier, monetary policy is implemented in the United States, as in most central banks, through the control of interest rates. At each meeting, the FOMC sets an intended federal funds rate target. The federal funds rate is the interest rate on overnight loans in the inter-bank market. It is therefore the rate paid when reserves are borrowed and lent among banks. And it is a natural target to achieve via open market operations since these operations in effect inject or withdraw reserves. The federal funds rate is currently 5.5\%. The FOMC announces any change in this target immediately following the conclusion of its meetings. It also explicitly incorporates this target funds rate in a "directive" to the Manager of the System Open Market Account, the position Alan Holmes held at the Federal Reserve Bank of New York. This directive instructs the Manager to implement open market operations during the period between this and the next FOMC meeting so as to maintain the federal funds rate as close as possible to the intended rate. Given that the Federal Reserve, like most other central bank today, operates by setting a near-term interest rate target, my focus is on developing some guiding principles for setting the interest rate target, more precisely, for adjusting the interest rate target in response to changing economic conditions. I have found it useful to begin this search, perhaps surprisingly, by developing the properties of a constant money supply growth rule. This both helps to identify some of the essential properties of a monetary policy strategy, which will apply to interest rate targeting as well, and highlights the practical difficulties in carrying out monetary policy using money supply targets. Another reason for starting with a monetary aggregate strategy is that monetary aggregates played a more significant role in the implementation of monetary policy during Holmes' service as Manager of the System Open Market Account. The directive to the Manager from the FOMC during this period was often specified in terms of maintaining or changing "money market conditions" (a code for the federal funds rate), unless growth in the monetary aggregates departed significantly from the midpoints of their specified ranges. Sometimes the directive was specified directly in terms of the desired course of the monetary aggregates, in this case typically subject to an acceptable range for the federal funds rate. This gave money growth a more direct role in the conduct of policy than it has today. Let's now see why money growth might be a useful target for implementing monetary policy. Economic theory suggests that, if the demand for money is stable, the rate of money growth will pin down the rate of growth in nominal income. Under reasonable assumptions, a constant rate of money growth will yield growth of nominal income, on average, at the same rate. The rate of money growth should be set to achieve a rate of nominal income growth that just equals the rate of trend growth in real output and the rate of inflation consistent with the policy objective. On average and in the long run, this rate of money growth will achieve the Fed's inflation objective. So the first proposition is that a money growth target provides a nominal anchor which pins down the long-run inflation rate. This strategy immediately allows a translation of the long-run price stability objective into a more near-term money supply growth target. And, by implication, any monetary policy strategy must mimic the nominal anchor property of a money supply target, if it is to be consistent with the Federal Reserve's mandate for price stability. Next, let's ask what would happen if the economy was subject to a shock that moved it away from price stability and full employment. If real output increases faster than trend and/or inflation increases relative to the Fed's objective, the resulting higher nominal income growth, relative to the constant rate of money growth, would result in an increase in interest rates. The second property of a money supply target is that it builds stability into the economy by insuring pro-cyclical movements in the interest rate in response to demand shocks. Another way of saying this is that it insures that monetary policy automatically leans against the cyclical winds to stabilize the economy. Despite the desirable properties of a constant money growth rule, in principle, most central banks implement policy by setting short-term interest rates in practice. This choice reflects at least two considerations. First, instability in money demand reduces the usefulness of money supply targets. Second, interest rate targets allow the central bank to smooth out the effects of transitory shocks to financial markets. But how should the Fed vary its interest rate "instrument" to achieve its ultimate objectives? The simplest answer is that interest rates should vary to imitate qualitatively the way they would behave if the Fed were implementing a money supply target. In other words, interest rates need to be varied systematically to effectively impose a nominal anchor and to insure that policy leans against the cyclical winds. Setting monetary policy in this manner via an interest rate target, in principle, allows the Fed to achieve the best of both worlds. It can impose the same nominal anchor and short-run stabilization properties as would be the case with a money growth rule, but, at the same time, smooth out shorter-run volatility in interest rates. In addition, by careful choice of the degree of response of interest rates to changing economic conditions, the rule can, in principle, improve upon the stabilization properties of a money supply rule. A simple specification of a strategy for varying the federal funds rate in response to changing economic conditions is provided by the Taylor Rule, a rule developed by John Taylor, a professor at Stanford University. The appeal of the Taylor Rule is that it is simple and specifies how the federal funds rate (effectively the Fed's instrument) should be varied directly in response to inflation and to deviations of output and inflation from the Fed's ultimate targets of full employment and price stability. My point here is not to extol the virtues of the precise specification in the Taylor Rule, but to use it to highlight some of the central principles that should guide decisions about the setting of the funds rate. It is useful to appreciate how Taylor derived his rule and how he views its role in monetary policy. The rule emerged from Taylor's analysis of simulations of a variety of rules in a variety of models. He concluded that the simple form embodied in the Taylor Rule had, based on this work, excellent stabilizing properties. The rule was therefore initially developed as a normative guide, meaning a set of principles to guide policy that, if followed, would result in relatively good economic performance, at least compared to other rules and perhaps relative to historic US economic performance. Subsequently, Taylor found the rule described reasonably well the way policy was indeed carried out over the last decade. That is, the rule was also descriptive of recent policymaking. The Taylor Rule begins by assuming that there is some level of real federal funds rate consistent with full employment and stable inflation. The real interest rate is the nominal interest rate less some measure of inflation expectations (measured by Taylor as actual inflation over the last year) -- a measure of the increase in purchasing power (rather than in dollars) associated with holding an asset. Taylor calls this the equilibrium real interest rate and assumed it was $2 \%$. Let's assume that the economy is initially at full employment and price stability. Then the level of real and nominal interest rates would be set at $2 \%$. I am not going to quibble with this choice, because I am focusing on general principles rather than precise details. The economy is, of course, not always at full employment and price stability and the purpose of the Taylor Rule is to specify how the federal funds rate should respond to shocks that push the economy away from price stability and/or full employment. Because both objectives are explicitly incorporated into the rule, it provides a disciplined approach to juggling the dual mandate for monetary policy. The real equilibrium interest rate is viewed as consistent with full employment and any stable rate of inflation. So the first implication of this rule is that, in order to be consistent with full employment, nominal interest rates should be adjusted in response to inflation to maintain the equilibrium real interest rate. The next message of the rule concerns how the real federal funds rate should be adjusted in response to deviations of output and inflation from full employment and price stability. According to the rule, when output rises relative to potential output, real interest rates should rise. When inflation rises relative to the inflation target, real interest rates should also rise. These movements of real interest rates in response to departures of inflation and output from their target levels can be shown to stabilize output and inflation relative to their targets. There are natural dangers inherent in interest rate targeting, at least in the absence of a rule that guides its adjustment to changing economic conditions. If cyclical movements in output are dominated by demand shocks, the failure to move interest rates aggressively enough in response to the shocks can result in monetary policy destabilizing rather than stabilizing the economy. For example, if there is a demand shock resulting in higher income and/or prices, the demand for money will increase, putting upward pressure on interest rates. If the Fed maintains an unchanged nominal interest rate target, it will have to add reserves to support a higher money supply at the initial interest rate. This means that, under a constant interest rate target, a demand shock would lead to perverse monetary policy, specifically to stimulative open market operations, reinforcing rather than damping the demand shock. The inherent danger in interest rate targeting is reinforced by the preference for central bankers for smoothing interest rates. This preference takes two forms. First, there is a preference for implementing a rise in rates in a series of small changes in the same direction. Second, there is a reluctance to change the direction of policy, without particularly strong rationale. Nevertheless, interest rate targets can, in principle, be implemented in a way that avoids this pitfall, and one of the values of rules is to remind policymakers of the importance of adjusting interest rates in response to changing economic conditions, thereby preventing policy from becoming destabilizing. We are now ready to identify a set of principles to guide decisions about the setting of the federal funds rate at FOMC meetings. Underlying these principles are the lessons gleaned from both the constant money growth rule and from the Taylor Rule. Both rules highlight the importance of imposing a nominal anchor to pin down the long-run inflation rate and of varying real interest rates pro-cyclically to lean against the cyclical winds. The Taylor Rule also highlights the critical importance of real interest rates in the conduct of monetary policy. There is one very important difference between the constant money growth and Taylor rules that deserves comment. While a constant rate of money growth will not always be optimal, if money demand is sufficiently stable, and not particularly interest sensitive, it will pin down inflation in the long run and help smooth the business cycle in the short run. That is, under a money growth target, doing nothing (that is, maintaining an unchanged rate of money growth) may not always be the best choice, but, for the most part, it won't get you into serious trouble and will in fact do some considerable good, although it would likely involve a considerable variation in interest rates on a day-to-day basis. Under an interest rate targeting regime, on the other hand, doing nothing can potentially get you into great difficulty -- sometimes quite quickly. In this case, policy must constantly be prepared to adjust to changing economic conditions, to avoid the potential for becoming a destabilizing influence on the economy. Rule No. 1: Vary real interest rates in response to departures of inflation from its target. For example, if inflation increases, relative to its target, the real interest rate should be increased. This is perhaps the single most important discipline for monetary policy under an interest rate regime. When inflation increases, nominal interest rates must first be increased just to avoid a decline in the real rate. But to counter the rise in inflation relative to its target, the real interest rate has to rise. That means that nominal rates have to rise by more than the increase in inflation. In the Taylor Rule, for example, the nominal federal funds rate rises by 1.5 percentage points for every one percentage-point increase in inflation. Rule No. 2: Vary (nominal and real) interest rates in response to changes in resource utilization rates. Under a money supply growth rule, interest rates rise whenever growth in real GDP exceeds the trend GDP growth assumption embedded in the money growth target. Whenever growth is above trend, the unemployment rate falls and the capacity utilization rate rises. By adjusting real interest rates in response to such changes in utilization rates, for a given inflation rate, an interest rate regime insures the same qualitative stabilization property that a constant money growth rule automatically yields. In implementing this principle, real interest rates would rise gradually but systematically during expansions, fall when growth slows to below trend, and decline sharply when the actual level of output declines, at least for those cyclical episodes where supply shocks (see below) are not very important. Just following this simple principle will help stabilize output relative to full employment and inflation relative to the inflation target. It is a reminder that there ought to be nothing startling or dramatic in FOMC decisions to adjust the federal funds rate. Indeed, the question that might be asked when nominal rates are constant for long periods is how does the FOMC justify such stability in the face of changing economic conditions! You might, therefore, ask whether or not the near constancy of the nominal funds rate over the most recent episode has been appropriate. I believe monetary policy has, in fact, been excellent over this period. But this has been a very unusual period with remarkable crosscurrents that balanced out to allow such stable short-term rates. It should not lull us into believing that stable interest rates and good monetary policy naturally go together. Rule No. 3: In setting rates, be forward looking. I noted earlier that, because of lags, monetary policy has to be forward looking. There are, however, different degrees of forward lookingness that we could incorporate into policymaking. For example, because higher utilization rates today raise the risk of higher inflation in the future, raising interest rates today in response to observed increases in utilization rates is a forward-looking policy relative to simply responding to current inflation. Forward-looking policy is sometimes said to be pre-emptive. A movement in interest rates in response to rising utilization rates would be said to be a pre-emptive move against inflation. The Taylor Rule thus allows for a combination of pre-emptive policy, changes in interest rates in response to changes in utilization rates, and reactive policy, changes in interest rates in response to movements in inflation itself. So good policy can be both pre-emptive and reactive. A still more forward-looking approach would be for policymakers to respond not to actual inflation and utilization rates, as in the Taylor Rule, but to forecasts of projected inflation and utilization rates, assuming an unchanged nominal federal funds rate. A good reason for responding to forecasts of inflation is that the effects of monetary policy on the economy mostly occur about a year from now. There is a considerable amount of work under way to assess the usefulness of using forecasts as opposed to past information on unemployment and inflation in the specification of interest rate rules. There are clear historical examples when a forward-looking policy would be an improvement. These episodes illustrate that simple rules are only guides and that good policy sometimes means following the rule and sometimes means using judgment to improve upon the rule. Judgement is especially called for in situations where special events point to future changes in output and inflation that would ordinarily be viewed as unlikely. The current episode provides a good example of such a situation in which there is much to be gained from forward-looking policy. The economy entered 1998 with considerable forward momentum, already operating at very high utilization rates. This momentum reflected persistent strength in domestic demand, particularly consumer spending and business fixed investment. However, the financial and currency crises in Asia are projected to result in a sharper decline in net exports than would otherwise have occurred and this promises to slow the expansion in the absence of any policy action, perhaps substituting for monetary tightening that otherwise might have been justified. In this environment, a backward-looking policy that ignored the potential drag on future demand from Asia could risk magnifying the effect of the shift in aggregate demand. Rule No. 4: The appropriate policy response may depend on the source and persistence of the shock. Let me distinguish two types of shocks to the economy. The first is a persistent demand shock -- for example, an increase in aggregate demand that results in a persistent departure from trend growth and persistent changes in utilization rates. This will have symmetric effects, raising both output and inflation, and presents a relatively straightforward monetary policy problem that is well handled by the first set of rules. A second source of shock is a supply shock, an example of which would be a one-time, permanent increase in oil prices. We have had several examples of very sharp increases in oil prices, especially in the 1970s, and, more recently, oil prices have been declining since the end of 1996. When there is a sharp rise in oil prices, there will be a temporary burst of inflation. In addition, an adverse supply shock will typically result in a decline in aggregate demand and hence in output and employment. This is thus an example of a situation in which there can be a conflict between the dual objectives of full employment and price stability, and, as such, this represents one of the greatest challenges for monetary policy. The surge in inflation appears to demand a rise in real interest rates, and hence a particularly sharp increase in nominal rates; while the decline in output and employment appears to call for a decline in real interest rates. Experience suggests that supply shocks yield a sharp transitory increase in inflation, often followed by a smaller, more permanent effect, though the longer-run effect on inflation will obviously be importantly dictated by the response of monetary policy. Given the transitory nature of the initial inflation surge, policy does well to look through it and instead focus on the more persistent (and modest) inflation consequences of the shock. By doing so policymakers respond expeditiously to the bad news, but avoid the mistake of overreacting. One reason for this cautious approach is that policy cannot much affect inflation in the near term, but instead has its primary effect over the coming year or two. Hence policy today should focus on inflation next year. Policy should tighten, that is real interest rates should rise, to the extent that inflation is expected to be higher next year on account of the supply shock. This might reflect the effect of a supply shock as today's oil prices raise overall inflation, and, through the effect of inflation on wage bargaining, impact on broader measures of price change in subsequent quarters. One way to handle that within the Taylor Rule is to specify the rule using a measure of core inflation, meaning one that excludes oil and food prices, the price components most subject to supply shocks. This will help policy to "look through" the initial burst of inflation, but it may fail to produce an appropriate immediate adjustment to counter the more permanent effect of the shock on inflation in subsequent quarters. Another and perhaps better way to respond to supply shocks is to be forward looking and respond to forecasts of future inflation, rather than to the current inflation. This avoids both an overly aggressive response to the initial burst of overall inflation and an insufficient immediate response because of an inappropriate focus on a measure of inflation that ignores the current rise in oil prices. Work on policy rules and experience with implementing policy in an interest rate regime have, I believe, helped to define the set of principles I have just discussed. They are, I would remind you, only my perspective on the strategy of monetary policy, not official doctrine of the FOMC. We have much to learn, both about the structure of the economy and about the best way to implement policy. The role of rules is best viewed in my judgment as informing the monetary policy decision, not dictating it. No single rule will be the best policy in all circumstances, as I hope I have demonstrated with my discussion. Sometimes responding to recent trends in the data will work well, but sometimes a forward-looking policy will be critical, as might be the case in the current environment. Sometimes an unusual circumstance will dictate a departure from what the rule might have suggested. An example here would be maintaining a very stimulative policy -- effectively a zero real federal funds rate -- during 1992 and 1993, a period well into the current expansion. This turned out, in my judgment, to be very excellent policy, though a departure from the Taylor Rule, because it took account of the unusual structural drags that were restraining the expansion and justified maintaining monetary stimulus longer than normal into an expansion. And, finally, monetary policy has to be sensitive to the potential for structural changes to alter fundamental relationships. Science in the form of economic theory, econometric models, and carefully designed rules can improve the conduct of monetary policy. But good policy will always be, as Alan Holmes understood so well, a blend of art and science. Each of us on the FOMC strive to become the monetary policy artist that Alan Holmes was as he participated in the FOMC during his distinguished career.
1998-03-17T00:00:00	Ms. Phillips focuses on four themes underlying sound international banking supervision (Central Bank Articles and Speeches, 17 Mar 98)	Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, before the Conference on Coping with Financial Crisis in Developing and Transition Countries: Regulatory and Supervisory Challenges in a New Era of Global Finance, Forum on Debt and Development held at the Netherlands Bank in Amsterdam on 17/3/98.	Ms. Phillips focuses on four themes underlying sound international banking supervision Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, before the Conference on Coping with Financial Crisis in Developing and Transition Countries: Regulatory and Supervisory Challenges in a New Era of Global Finance, Forum on Debt and Development held at the Netherlands Bank in Amsterdam on 17/3/98. It is a pleasure to be here to address this international conference of fellow banking supervisors and other distinguished international participants. Conferences like this one are important forums for discussing current issues in international banking supervision among the supervisors, bankers, and other financial industry participants of many nations. Such communication has become critical as the financial operations of the banks we supervise become more global, complex, fast paced, and interwoven. I would like to thank the Forum on Debt and Development and other co-sponsors for organizing this conference, which I hope will help us build essential bridges among banking supervisors and open new channels of communication internationally at all levels. I would like to focus my remarks today on four fundamental themes underlying the 1997 Basle Supervisors Committee's Core Principles of Effective Banking Supervision. As I discuss each theme, I will naturally draw on our experience in the United States, while making a few observations about the applicability to the current Asian banking situation. • The first theme is the need to focus supervisory efforts on the specific risk profile of individual institutions. • My second theme is the need for sound accounting and disclosure systems to provide sufficient transparency to allow the financial markets and supervisory agencies to evaluate institutions' financial conditions. • My third theme is the need for adequate capital and the challenges we face in keeping capital standards current. • Finally, we must recognize the need for international banking supervisors to work closely and cooperatively together to achieve effective coordinated supervision of global banks and other financial firms. I. Risk-Focused Supervisory Approach One of the goals of banking supervisors is to help identify and address weak banking practices early so that small or emerging problems can be addressed before they become large and costly. To do that in today's global fast-paced markets, and in an environment in which technology and financial innovation can lead to rapid change, the Federal Reserve is pursuing a risk-focused supervisory approach. Such supervision plays a critical role in helping us to achieve our responsibilities of: • working to ensure the safe and sound operation of the banking organizations that we supervise, • promoting an efficient and effective financial system that finances economic growth, and • ensuring that financial institutions do not become a source of systemic risk, threat to the payment system, or burden to taxpayers by making them absorb losses arising from inappropriate extension of the federal safety net. The Federal Reserve has undertaken its new risk-focused examination approach to respond to the dramatic changes that are occurring in the banking and financial services business, including tremendous advancement in technology and securitization, the breakdown of traditional product lines, the expansion of banks' global operations in the world's financial markets, and the development of new risk management systems. Furthermore, developments in technology and financial products, combined with the increased depth and liquidity of domestic and global financial markets, have enabled banks to change their risk profiles faster than ever before. A key goal of the Federal Reserve's risk-focused approach is to enable banks to compete effectively in this dynamic financial services sector, while focusing examiners on banks' ability and willingness to deal effectively with their own risk exposures rather than on standardized examination checklists. US banking supervisors in the past focused primarily on validating bank balance sheets, particularly the value of loan portfolios, as of a specific point in time. Losses on banks' loan portfolios historically have been the principal source of their financial problems. Concentrating on the quality of banks' loans and the adequacy of their reserves was, and continues to be, essential to sound banking supervision. As part of the examination process, examiners reviewed the soundness of management practices, internal controls, and internal audit activities, but that review was not the examination's primary focus. The Federal Reserve's adoption of a risk-focused approach, however, reflects its view that examiners should target their work on individual banks' specific risk profiles, including the traditional examination of loan quality and reserves. This need for fundamental change in the traditional approaches of bankers and supervisors became evident in reviewing the lessons learned from the turmoil, stress, and change in the US banking system over the past decade. Ten years ago, many of the United States' largest banks announced huge loan loss provisions on doubtful loans to developing countries, while many banks were also struggling under the weight of loans to the energy, agriculture and commercial real estate sectors. By the end of the 1980's, more than 200 banks were failing annually. There were more than 1,000 banks on the problem list of the Federal Deposit Insurance Corporation, which is the US banking agency that insures bank deposits and serves as receiver for failed banks. This period includes the costly crisis of the US savings and loan industry -- which is composed of institutions chartered to make home loans available to the American public. In response to these systemic developments, bankers and supervisors each changed their fundamental ways of operating and managing risks. For their part, bankers recognized the need to rebuild their capital and reserves; strengthen their internal controls; diversify their risks; and improve internal risk management systems. The Federal Reserve, in turn, responded to these changes by adopting its risk-focused examination system tailored to assessing the quality of individual banks' internal processes and risk management systems. The need for this approach is illustrated by the failure of several high-profile international banking organizations that did not have adequate internal control and risk management systems. Adopting a risk-focused approach improves the examination process by targeting examinations more directly on specific institutions' problems. However, it also makes such examinations more challenging for examiners because they must be knowledgeable about each bank's business activities, risk profiles, and risk management systems. Furthermore, we are trying to make these examinations more efficient for examiners and bankers by employing valid statistical sampling methods, which will free examiner time to devote to banks' specific risk exposures. In addition, banking supervisors need to assess the integrity and independence of a bank's decision-making processes, giving special attention to any conflicts of interest or insider influence that could distort this process. The Basle Committee's Core Principles for Effective Banking Supervision address this point by recognizing the need for effective measures to control directed lending and transactions with affiliates that are not on an arm's-length basis. Specifically, the Core Principles state that, to prevent abuses arising from connected lending, banking supervisors should require that any loans banks make to related companies and individuals be on an arm's-length basis; that such extensions of credit be effectively monitored; and that other appropriate steps are taken to control or mitigate the risks. For example, the Federal Reserve's Regulation O, whose application was expanded to directors in the early 1990s, is aimed at making sure that any loans a bank makes to officers or directors are on the same terms that are available to the general public. Finally, the Federal Reserve places great reliance on on-site examinations to make the presence of supervisors tangible to bankers and to facilitate the review of records and documents that are essential to assessing a bank's financial condition. Such on-site examinations also permit examiners to observe whether bank policies are being followed in practice, or, alternatively, whether they only exist on paper. Although I recognize that many other countries do not conduct on-site examinations for legal and other reasons, the Federal Reserve concurs with the position taken by the Basle Committee's Core Principles that it is important for supervisors to perform some on-site supervision. II. Need for Sound Accounting and Financial Transparency The Federal Reserve believes that sound accounting and transparent financial information is a fundamental pillar of a strong banking -- and, indeed, financial -- system. Transparency is essential for the market to be able to make decisions on an informed basis. The arms-length negotiations of informed investors and issuing banks provide the strongest market basis for the issuance and pricing of equity and debt securities, as well as loans. Banking supervisors should strongly advocate transparency to aid effective supervision and market discipline. Indeed, they can encourage the process directly through appropriate regulatory reporting requirements and even making all or part of those reports public. It is important for governments to allow market forces to reward prudent behavior and penalize excessive risk-taking. Sound, well-managed firms can benefit if better disclosure enables them to obtain funds at risk premiums that accurately reflect lower risk profiles. Inadequate financial disclosure, on the other hand, could penalize well-managed firms, or even countries, if market participants do not trust their ability to assess firms' or countries' fundamental financial strength. Regulatory structures that overly protect banks from market forces, or that allow lax accounting and disclosure to disguise firms' financial problems, remove market discipline on banks and permit them to operate less efficiently. Deposit insurance systems and the public safety net are examples of regulatory interference with market forces, despite their public benefit. They create a moral hazard by allowing institutions to take on what might be excessive risk without proportional fear that their ability to raise funds at favorable rates will be impaired. This is illustrated by the costly US savings and loan crisis of the 1980s. Lax accounting and capital standards allowed economically insolvent institutions to continue operating and attracting insured deposits at attractive rates because the deposits were government insured. This, in turn, delayed government and public recognition of the scope of the problem and tremendously increased the cost of its resolution to the deposit insurance system and the American taxpayer. To be credible to global investors, accounting standards should be established by independent professional organizations and enforced by a combination of market discipline and national oversight authorities. Particular to banking and the credibility of banks' financial statements is the establishment of prudent levels of reserves. Investors must be confident that banks are establishing sufficient levels of reserves and recognizing loan impairment in a timely fashion. Compliance with sound accounting, disclosure, and reserving standards not only protects safety and soundness, but also gives the world's investment community confidence in its analysis of risk exposure from investing in various countries and companies. The absence of such confidence, on the other hand, may lead investors to overreact to adverse financial events in such countries by ceasing investment, immediately withdrawing current investment funds and demanding a high return for any remaining or renegotiated investment in such countries. Today's technology and global financial markets enable investors to take these actions very quickly with dramatic consequences, as has recently happened in some Asian countries. Another issue related to the efficient operation of market forces is that government intervention in the credit and investment decisions of banks distorts market discipline and pricing. Such programs frequently cause banks to make less than arm's-length investments in, and loans to, non-economic government-affiliated projects or to individuals associated with such projects. Once these loans are made, it is difficult for national supervisors to demand that banks apply prudent reserve and charge-off policies, let alone foreclose on such loans. In addressing governmental interference with market forces at their meeting in London in February, representatives of the G-7 countries unanimously supported the International Monetary Fund's requirement that countries receiving IMF funds make structural reforms to reduce inappropriate government interference in the market economy. The message that governments should heed is that, ultimately, market forces will come to bear with severe results if firms or nations are artificially protected from market forces. III. Sound Capital as a Risk-Absorbing Buffer My third major theme today -- the importance of adequate capital -- has drawn much attention in the past decade as a result of the Basle Accord. The idea is pretty simple: if we want banks to be prudent in their risk-taking, there is no substitute for requiring banks' owners to have their own money at risk. With that requirement, supervisory interests and banks' private interests are more closely aligned and banks have fewer incentives to take excessive risks. When banks' managers and directors assess the riskiness and profitability of prospective business opportunities, they will weigh heavily the potential effect of new business activities on their banks' capital positions. Capital must be sufficient, but "How much capital is enough?" The answer is linked, of course, to the level of risk that an institution takes. Institutions that aggressively pursue risky business strategies clearly need a stronger capital base than those with more conservative objectives and products. While a fairly simple approach, the Basle risk-based capital framework has proven to be a balanced risk-focused framework for setting minimum capital standards for thousands of banks of all sizes worldwide. It is important, though, that banks not misuse this minimum prudential standard by substituting it for more rigorous internal evaluations of capital adequacy suitable for their own risk exposure and the sophistication of their financial strategies. For example, US supervisors support the development by a limited number of sophisticated banks of advanced credit risk models for assessing such institutions' internal capital needs to keep their probability of default within their established parameters. Such systems represent significant advances in developing systems to tailor banks' assessments of their capital needs to their credit risk exposure. On the other hand, the cost and complexity of such systems raises issues about their current feasibility as part of the uniform capital measure for all institutions. In any case, banks must rely on their own internal capital assessment systems targeted to their risk profiles and financial sophistication, as well as complying with the necessarily broadbrush, uniform capital standard established under the Basle Accord. We must look constantly for better ways to design regulatory capital standards and to promote adequate risk measurement in banks. On this note, the US Federal Financial Institutions Examination Council held a conference for bankers and supervisors last December to consider a myriad of views on ways that capital regulation should be modified to address changes in banking and risk management. The New York Clearing House Association just completed a pilot study of the pre-commitment approach to capital requirements for market risk. The Federal Reserve Bank of New York also recently organized a conference, in conjunction with the Bank of England, Bank of Japan, and the Federal Reserve Board, for the exchange of economic papers on developments in risk assessment and management, as well as on how such advances should be incorporated into the international capital framework. Although considerable progress has been made in amending the Basle standards in such areas as market risk, there will no doubt be additional changes as new tools are developed to address credit risk differentials, interest rate risk and, perhaps even, operational and legal risk. Indeed, capital standards should be thought of as an evolving process. IV. Coordinated International Supervision We all recognize the need to achieve coordinated international banking supervision based on cooperation and strong working relationships between home country and host country supervisors. New challenges in attaining this goal are presented by the advent of new technologies, the geographic expansion of banking activities, and the globalization of financial markets. We should work together, relying on the leadership of home country supervisors, to analyze banks on a consolidated global basis as the financial market does. Home country supervisors need sufficient global information and international cooperation to perform their supervisory responsibilities, while enabling host country supervisors to oversee the activities of international banks in their countries. A key issue arising for all of us, both internationally and domestically, is the growing prevalence in world markets of financial conglomerates -- which blend banking, insurance, securities, and other financial activities in a single diversified global entity. Universal banking in some nations' financial firms has long combined banking and securities activities, and to some extent insurance powers, in a single entity. Such financial conglomerates, which are growing in number and size, engage simultaneously in a myriad of businesses and seek to integrate those businesses to cross market their varied products. This presents a significant supervisory challenge because most of our legal frameworks use separate and different approaches for each traditional segment of the financial industry. The challenge of achieving coordinated international supervision of such conglomerates is addressed in the consultative documents, "Supervision of Financial Conglomerates," developed by the Joint Forum on Financial Conglomerates. These working papers were announced on February 16th by the Basle Committee on Banking Supervision, the International Organization of Securities Commissions (IOSCO), and the International Association of Insurance Supervisors (IAIS). The Joint Forum, which was formed to help coordinate the international and inter-industry supervision of financial conglomerates, requested comment by July on these papers. The documents make concrete recommendations for steps that supervisors in each of the securities, insurance, and banking sectors can take to enhance supervision of the group-wide risk exposures of these global and inter-industry conglomerates. The documents also stress the need to enhance cooperation and information exchange among the supervisors in each country and industry segment. Implementing these recommendations may necessitate changing the legal framework of our financial oversight frameworks, but major changes in our financial institutions and markets demand changes in the supervisory frameworks of our countries. The United States is no exception. Conclusion In closing, I want to reiterate that banking supervisors must work together to achieve effective consolidated supervision of global banks under a shared set of supervisory principles, such as the Basle Committee's Core Principles. Furthermore, I believe that the best way to implement coordinated global supervision is to focus on the four themes that I have highlighted today -- the benefits of risk-focused supervision, the value of sound accounting and disclosure, the need for adequate capital, and the importance of international supervisory coordination. I appreciate having the opportunity to meet with you today to discuss key supervisory issues. I look forward to our continuing joint supervisory efforts toward coordinated international bank supervision.	---[PAGE_BREAK]--- # Ms. Phillips focuses on four themes underlying sound international banking supervision Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, before the Conference on Coping with Financial Crisis in Developing and Transition Countries: Regulatory and Supervisory Challenges in a New Era of Global Finance, Forum on Debt and Development held at the Netherlands Bank in Amsterdam on $17 / 3 / 98$. It is a pleasure to be here to address this international conference of fellow banking supervisors and other distinguished international participants. Conferences like this one are important forums for discussing current issues in international banking supervision among the supervisors, bankers, and other financial industry participants of many nations. Such communication has become critical as the financial operations of the banks we supervise become more global, complex, fast paced, and interwoven. I would like to thank the Forum on Debt and Development and other co-sponsors for organizing this conference, which I hope will help us build essential bridges among banking supervisors and open new channels of communication internationally at all levels. I would like to focus my remarks today on four fundamental themes underlying the 1997 Basle Supervisors Committee's Core Principles of Effective Banking Supervision. As I discuss each theme, I will naturally draw on our experience in the United States, while making a few observations about the applicability to the current Asian banking situation. - $\quad$ The first theme is the need to focus supervisory efforts on the specific risk profile of individual institutions. - My second theme is the need for sound accounting and disclosure systems to provide sufficient transparency to allow the financial markets and supervisory agencies to evaluate institutions' financial conditions. - My third theme is the need for adequate capital and the challenges we face in keeping capital standards current. - Finally, we must recognize the need for international banking supervisors to work closely and cooperatively together to achieve effective coordinated supervision of global banks and other financial firms. ## I. Risk-Focused Supervisory Approach One of the goals of banking supervisors is to help identify and address weak banking practices early so that small or emerging problems can be addressed before they become large and costly. To do that in today's global fast-paced markets, and in an environment in which technology and financial innovation can lead to rapid change, the Federal Reserve is pursuing a risk-focused supervisory approach. Such supervision plays a critical role in helping us to achieve our responsibilities of: - working to ensure the safe and sound operation of the banking organizations that we supervise, - promoting an efficient and effective financial system that finances economic growth, and - ensuring that financial institutions do not become a source of systemic risk, threat to the payment system, or burden to taxpayers by making them absorb losses arising from inappropriate extension of the federal safety net. ---[PAGE_BREAK]--- The Federal Reserve has undertaken its new risk-focused examination approach to respond to the dramatic changes that are occurring in the banking and financial services business, including tremendous advancement in technology and securitization, the breakdown of traditional product lines, the expansion of banks' global operations in the world's financial markets, and the development of new risk management systems. Furthermore, developments in technology and financial products, combined with the increased depth and liquidity of domestic and global financial markets, have enabled banks to change their risk profiles faster than ever before. A key goal of the Federal Reserve's risk-focused approach is to enable banks to compete effectively in this dynamic financial services sector, while focusing examiners on banks' ability and willingness to deal effectively with their own risk exposures rather than on standardized examination checklists. US banking supervisors in the past focused primarily on validating bank balance sheets, particularly the value of loan portfolios, as of a specific point in time. Losses on banks' loan portfolios historically have been the principal source of their financial problems. Concentrating on the quality of banks' loans and the adequacy of their reserves was, and continues to be, essential to sound banking supervision. As part of the examination process, examiners reviewed the soundness of management practices, internal controls, and internal audit activities, but that review was not the examination's primary focus. The Federal Reserve's adoption of a risk-focused approach, however, reflects its view that examiners should target their work on individual banks' specific risk profiles, including the traditional examination of loan quality and reserves. This need for fundamental change in the traditional approaches of bankers and supervisors became evident in reviewing the lessons learned from the turmoil, stress, and change in the US banking system over the past decade. Ten years ago, many of the United States' largest banks announced huge loan loss provisions on doubtful loans to developing countries, while many banks were also struggling under the weight of loans to the energy, agriculture and commercial real estate sectors. By the end of the 1980's, more than 200 banks were failing annually. There were more than 1,000 banks on the problem list of the Federal Deposit Insurance Corporation, which is the US banking agency that insures bank deposits and serves as receiver for failed banks. This period includes the costly crisis of the US savings and loan industry -- which is composed of institutions chartered to make home loans available to the American public. In response to these systemic developments, bankers and supervisors each changed their fundamental ways of operating and managing risks. For their part, bankers recognized the need to rebuild their capital and reserves; strengthen their internal controls; diversify their risks; and improve internal risk management systems. The Federal Reserve, in turn, responded to these changes by adopting its risk-focused examination system tailored to assessing the quality of individual banks' internal processes and risk management systems. The need for this approach is illustrated by the failure of several high-profile international banking organizations that did not have adequate internal control and risk management systems. Adopting a risk-focused approach improves the examination process by targeting examinations more directly on specific institutions' problems. However, it also makes such examinations more challenging for examiners because they must be knowledgeable about each bank's business activities, risk profiles, and risk management systems. Furthermore, we are trying to make these examinations more efficient for examiners and bankers by employing valid statistical sampling methods, which will free examiner time to devote to banks' specific risk exposures. ---[PAGE_BREAK]--- In addition, banking supervisors need to assess the integrity and independence of a bank's decision-making processes, giving special attention to any conflicts of interest or insider influence that could distort this process. The Basle Committee's Core Principles for Effective Banking Supervision address this point by recognizing the need for effective measures to control directed lending and transactions with affiliates that are not on an arm's-length basis. Specifically, the Core Principles state that, to prevent abuses arising from connected lending, banking supervisors should require that any loans banks make to related companies and individuals be on an arm's-length basis; that such extensions of credit be effectively monitored; and that other appropriate steps are taken to control or mitigate the risks. For example, the Federal Reserve's Regulation O, whose application was expanded to directors in the early 1990s, is aimed at making sure that any loans a bank makes to officers or directors are on the same terms that are available to the general public. Finally, the Federal Reserve places great reliance on on-site examinations to make the presence of supervisors tangible to bankers and to facilitate the review of records and documents that are essential to assessing a bank's financial condition. Such on-site examinations also permit examiners to observe whether bank policies are being followed in practice, or, alternatively, whether they only exist on paper. Although I recognize that many other countries do not conduct on-site examinations for legal and other reasons, the Federal Reserve concurs with the position taken by the Basle Committee's Core Principles that it is important for supervisors to perform some on-site supervision. # II. Need for Sound Accounting and Financial Transparency The Federal Reserve believes that sound accounting and transparent financial information is a fundamental pillar of a strong banking -- and, indeed, financial -- system. Transparency is essential for the market to be able to make decisions on an informed basis. The arms-length negotiations of informed investors and issuing banks provide the strongest market basis for the issuance and pricing of equity and debt securities, as well as loans. Banking supervisors should strongly advocate transparency to aid effective supervision and market discipline. Indeed, they can encourage the process directly through appropriate regulatory reporting requirements and even making all or part of those reports public. It is important for governments to allow market forces to reward prudent behavior and penalize excessive risk-taking. Sound, well-managed firms can benefit if better disclosure enables them to obtain funds at risk premiums that accurately reflect lower risk profiles. Inadequate financial disclosure, on the other hand, could penalize well-managed firms, or even countries, if market participants do not trust their ability to assess firms' or countries' fundamental financial strength. Regulatory structures that overly protect banks from market forces, or that allow lax accounting and disclosure to disguise firms' financial problems, remove market discipline on banks and permit them to operate less efficiently. Deposit insurance systems and the public safety net are examples of regulatory interference with market forces, despite their public benefit. They create a moral hazard by allowing institutions to take on what might be excessive risk without proportional fear that their ability to raise funds at favorable rates will be impaired. This is illustrated by the costly US savings and loan crisis of the 1980s. Lax accounting and capital standards allowed economically insolvent institutions to continue operating and attracting insured deposits at attractive rates because the deposits were government insured. This, in turn, delayed government and public recognition of the scope of ---[PAGE_BREAK]--- the problem and tremendously increased the cost of its resolution to the deposit insurance system and the American taxpayer. To be credible to global investors, accounting standards should be established by independent professional organizations and enforced by a combination of market discipline and national oversight authorities. Particular to banking and the credibility of banks' financial statements is the establishment of prudent levels of reserves. Investors must be confident that banks are establishing sufficient levels of reserves and recognizing loan impairment in a timely fashion. Compliance with sound accounting, disclosure, and reserving standards not only protects safety and soundness, but also gives the world's investment community confidence in its analysis of risk exposure from investing in various countries and companies. The absence of such confidence, on the other hand, may lead investors to overreact to adverse financial events in such countries by ceasing investment, immediately withdrawing current investment funds and demanding a high return for any remaining or renegotiated investment in such countries. Today's technology and global financial markets enable investors to take these actions very quickly with dramatic consequences, as has recently happened in some Asian countries. Another issue related to the efficient operation of market forces is that government intervention in the credit and investment decisions of banks distorts market discipline and pricing. Such programs frequently cause banks to make less than arm's-length investments in, and loans to, non-economic government-affiliated projects or to individuals associated with such projects. Once these loans are made, it is difficult for national supervisors to demand that banks apply prudent reserve and charge-off policies, let alone foreclose on such loans. In addressing governmental interference with market forces at their meeting in London in February, representatives of the G-7 countries unanimously supported the International Monetary Fund's requirement that countries receiving IMF funds make structural reforms to reduce inappropriate government interference in the market economy. The message that governments should heed is that, ultimately, market forces will come to bear with severe results if firms or nations are artificially protected from market forces. # III. Sound Capital as a Risk-Absorbing Buffer My third major theme today -- the importance of adequate capital -- has drawn much attention in the past decade as a result of the Basle Accord. The idea is pretty simple: if we want banks to be prudent in their risk-taking, there is no substitute for requiring banks' owners to have their own money at risk. With that requirement, supervisory interests and banks' private interests are more closely aligned and banks have fewer incentives to take excessive risks. When banks' managers and directors assess the riskiness and profitability of prospective business opportunities, they will weigh heavily the potential effect of new business activities on their banks' capital positions. Capital must be sufficient, but "How much capital is enough?" The answer is linked, of course, to the level of risk that an institution takes. Institutions that aggressively pursue risky business strategies clearly need a stronger capital base than those with more conservative objectives and products. While a fairly simple approach, the Basle risk-based capital framework has proven to be a balanced risk-focused framework for setting minimum capital standards for thousands of banks of all sizes worldwide. It is important, though, that banks not misuse this minimum prudential standard by substituting it for more rigorous internal evaluations of capital adequacy suitable for their own risk exposure and the sophistication of their financial ---[PAGE_BREAK]--- strategies. For example, US supervisors support the development by a limited number of sophisticated banks of advanced credit risk models for assessing such institutions' internal capital needs to keep their probability of default within their established parameters. Such systems represent significant advances in developing systems to tailor banks' assessments of their capital needs to their credit risk exposure. On the other hand, the cost and complexity of such systems raises issues about their current feasibility as part of the uniform capital measure for all institutions. In any case, banks must rely on their own internal capital assessment systems targeted to their risk profiles and financial sophistication, as well as complying with the necessarily broadbrush, uniform capital standard established under the Basle Accord. We must look constantly for better ways to design regulatory capital standards and to promote adequate risk measurement in banks. On this note, the US Federal Financial Institutions Examination Council held a conference for bankers and supervisors last December to consider a myriad of views on ways that capital regulation should be modified to address changes in banking and risk management. The New York Clearing House Association just completed a pilot study of the pre-commitment approach to capital requirements for market risk. The Federal Reserve Bank of New York also recently organized a conference, in conjunction with the Bank of England, Bank of Japan, and the Federal Reserve Board, for the exchange of economic papers on developments in risk assessment and management, as well as on how such advances should be incorporated into the international capital framework. Although considerable progress has been made in amending the Basle standards in such areas as market risk, there will no doubt be additional changes as new tools are developed to address credit risk differentials, interest rate risk and, perhaps even, operational and legal risk. Indeed, capital standards should be thought of as an evolving process. # IV. Coordinated International Supervision We all recognize the need to achieve coordinated international banking supervision based on cooperation and strong working relationships between home country and host country supervisors. New challenges in attaining this goal are presented by the advent of new technologies, the geographic expansion of banking activities, and the globalization of financial markets. We should work together, relying on the leadership of home country supervisors, to analyze banks on a consolidated global basis as the financial market does. Home country supervisors need sufficient global information and international cooperation to perform their supervisory responsibilities, while enabling host country supervisors to oversee the activities of international banks in their countries. A key issue arising for all of us, both internationally and domestically, is the growing prevalence in world markets of financial conglomerates -- which blend banking, insurance, securities, and other financial activities in a single diversified global entity. Universal banking in some nations' financial firms has long combined banking and securities activities, and to some extent insurance powers, in a single entity. Such financial conglomerates, which are growing in number and size, engage simultaneously in a myriad of businesses and seek to integrate those businesses to cross market their varied products. This presents a significant supervisory challenge because most of our legal frameworks use separate and different approaches for each traditional segment of the financial industry. The challenge of achieving coordinated international supervision of such conglomerates is addressed in the consultative documents, "Supervision of Financial Conglomerates," developed by the Joint Forum on Financial Conglomerates. These working papers were announced on February 16th by the Basle Committee on Banking Supervision, the ---[PAGE_BREAK]--- International Organization of Securities Commissions (IOSCO), and the International Association of Insurance Supervisors (IAIS). The Joint Forum, which was formed to help coordinate the international and inter-industry supervision of financial conglomerates, requested comment by July on these papers. The documents make concrete recommendations for steps that supervisors in each of the securities, insurance, and banking sectors can take to enhance supervision of the group-wide risk exposures of these global and inter-industry conglomerates. The documents also stress the need to enhance cooperation and information exchange among the supervisors in each country and industry segment. Implementing these recommendations may necessitate changing the legal framework of our financial oversight frameworks, but major changes in our financial institutions and markets demand changes in the supervisory frameworks of our countries. The United States is no exception. # Conclusion In closing, I want to reiterate that banking supervisors must work together to achieve effective consolidated supervision of global banks under a shared set of supervisory principles, such as the Basle Committee's Core Principles. Furthermore, I believe that the best way to implement coordinated global supervision is to focus on the four themes that I have highlighted today -- the benefits of risk-focused supervision, the value of sound accounting and disclosure, the need for adequate capital, and the importance of international supervisory coordination. I appreciate having the opportunity to meet with you today to discuss key supervisory issues. I look forward to our continuing joint supervisory efforts toward coordinated international bank supervision.	Susan M Phillips	United States	https://www.bis.org/review/r980325c.pdf	supervision Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, before the Conference on Coping with Financial Crisis in Developing and Transition Countries: Regulatory and Supervisory Challenges in a New Era of Global Finance, Forum on Debt and Development held at the Netherlands Bank in Amsterdam on $17 / 3 / 98$. It is a pleasure to be here to address this international conference of fellow banking supervisors and other distinguished international participants. Conferences like this one are important forums for discussing current issues in international banking supervision among the supervisors, bankers, and other financial industry participants of many nations. Such communication has become critical as the financial operations of the banks we supervise become more global, complex, fast paced, and interwoven. I would like to thank the Forum on Debt and Development and other co-sponsors for organizing this conference, which I hope will help us build essential bridges among banking supervisors and open new channels of communication internationally at all levels. I would like to focus my remarks today on four fundamental themes underlying the 1997 Basle Supervisors Committee's Core Principles of Effective Banking Supervision. As I discuss each theme, I will naturally draw on our experience in the United States, while making a few observations about the applicability to the current Asian banking situation. My second theme is the need for sound accounting and disclosure systems to provide sufficient transparency to allow the financial markets and supervisory agencies to evaluate institutions' financial conditions. My third theme is the need for adequate capital and the challenges we face in keeping capital standards current. Finally, we must recognize the need for international banking supervisors to work closely and cooperatively together to achieve effective coordinated supervision of global banks and other financial firms. One of the goals of banking supervisors is to help identify and address weak banking practices early so that small or emerging problems can be addressed before they become large and costly. To do that in today's global fast-paced markets, and in an environment in which technology and financial innovation can lead to rapid change, the Federal Reserve is pursuing a risk-focused supervisory approach. Such supervision plays a critical role in helping us to achieve our responsibilities of: working to ensure the safe and sound operation of the banking organizations that we supervise,. promoting an efficient and effective financial system that finances economic growth, and. ensuring that financial institutions do not become a source of systemic risk, threat to the payment system, or burden to taxpayers by making them absorb losses arising from inappropriate extension of the federal safety net. The Federal Reserve has undertaken its new risk-focused examination approach to respond to the dramatic changes that are occurring in the banking and financial services business, including tremendous advancement in technology and securitization, the breakdown of traditional product lines, the expansion of banks' global operations in the world's financial markets, and the development of new risk management systems. Furthermore, developments in technology and financial products, combined with the increased depth and liquidity of domestic and global financial markets, have enabled banks to change their risk profiles faster than ever before. A key goal of the Federal Reserve's risk-focused approach is to enable banks to compete effectively in this dynamic financial services sector, while focusing examiners on banks' ability and willingness to deal effectively with their own risk exposures rather than on standardized examination checklists. US banking supervisors in the past focused primarily on validating bank balance sheets, particularly the value of loan portfolios, as of a specific point in time. Losses on banks' loan portfolios historically have been the principal source of their financial problems. Concentrating on the quality of banks' loans and the adequacy of their reserves was, and continues to be, essential to sound banking supervision. As part of the examination process, examiners reviewed the soundness of management practices, internal controls, and internal audit activities, but that review was not the examination's primary focus. The Federal Reserve's adoption of a risk-focused approach, however, reflects its view that examiners should target their work on individual banks' specific risk profiles, including the traditional examination of loan quality and reserves. This need for fundamental change in the traditional approaches of bankers and supervisors became evident in reviewing the lessons learned from the turmoil, stress, and change in the US banking system over the past decade. Ten years ago, many of the United States' largest banks announced huge loan loss provisions on doubtful loans to developing countries, while many banks were also struggling under the weight of loans to the energy, agriculture and commercial real estate sectors. By the end of the 1980's, more than 200 banks were failing annually. There were more than 1,000 banks on the problem list of the Federal Deposit Insurance Corporation, which is the US banking agency that insures bank deposits and serves as receiver for failed banks. This period includes the costly crisis of the US savings and loan industry -- which is composed of institutions chartered to make home loans available to the American public. In response to these systemic developments, bankers and supervisors each changed their fundamental ways of operating and managing risks. For their part, bankers recognized the need to rebuild their capital and reserves; strengthen their internal controls; diversify their risks; and improve internal risk management systems. The Federal Reserve, in turn, responded to these changes by adopting its risk-focused examination system tailored to assessing the quality of individual banks' internal processes and risk management systems. The need for this approach is illustrated by the failure of several high-profile international banking organizations that did not have adequate internal control and risk management systems. Adopting a risk-focused approach improves the examination process by targeting examinations more directly on specific institutions' problems. However, it also makes such examinations more challenging for examiners because they must be knowledgeable about each bank's business activities, risk profiles, and risk management systems. Furthermore, we are trying to make these examinations more efficient for examiners and bankers by employing valid statistical sampling methods, which will free examiner time to devote to banks' specific risk exposures. In addition, banking supervisors need to assess the integrity and independence of a bank's decision-making processes, giving special attention to any conflicts of interest or insider influence that could distort this process. The Basle Committee's Core Principles for Effective Banking Supervision address this point by recognizing the need for effective measures to control directed lending and transactions with affiliates that are not on an arm's-length basis. Specifically, the Core Principles state that, to prevent abuses arising from connected lending, banking supervisors should require that any loans banks make to related companies and individuals be on an arm's-length basis; that such extensions of credit be effectively monitored; and that other appropriate steps are taken to control or mitigate the risks. For example, the Federal Reserve's Regulation O, whose application was expanded to directors in the early 1990s, is aimed at making sure that any loans a bank makes to officers or directors are on the same terms that are available to the general public. Finally, the Federal Reserve places great reliance on on-site examinations to make the presence of supervisors tangible to bankers and to facilitate the review of records and documents that are essential to assessing a bank's financial condition. Such on-site examinations also permit examiners to observe whether bank policies are being followed in practice, or, alternatively, whether they only exist on paper. Although I recognize that many other countries do not conduct on-site examinations for legal and other reasons, the Federal Reserve concurs with the position taken by the Basle Committee's Core Principles that it is important for supervisors to perform some on-site supervision. The Federal Reserve believes that sound accounting and transparent financial information is a fundamental pillar of a strong banking -- and, indeed, financial -- system. Transparency is essential for the market to be able to make decisions on an informed basis. The arms-length negotiations of informed investors and issuing banks provide the strongest market basis for the issuance and pricing of equity and debt securities, as well as loans. Banking supervisors should strongly advocate transparency to aid effective supervision and market discipline. Indeed, they can encourage the process directly through appropriate regulatory reporting requirements and even making all or part of those reports public. It is important for governments to allow market forces to reward prudent behavior and penalize excessive risk-taking. Sound, well-managed firms can benefit if better disclosure enables them to obtain funds at risk premiums that accurately reflect lower risk profiles. Inadequate financial disclosure, on the other hand, could penalize well-managed firms, or even countries, if market participants do not trust their ability to assess firms' or countries' fundamental financial strength. Regulatory structures that overly protect banks from market forces, or that allow lax accounting and disclosure to disguise firms' financial problems, remove market discipline on banks and permit them to operate less efficiently. Deposit insurance systems and the public safety net are examples of regulatory interference with market forces, despite their public benefit. They create a moral hazard by allowing institutions to take on what might be excessive risk without proportional fear that their ability to raise funds at favorable rates will be impaired. This is illustrated by the costly US savings and loan crisis of the 1980s. Lax accounting and capital standards allowed economically insolvent institutions to continue operating and attracting insured deposits at attractive rates because the deposits were government insured. This, in turn, delayed government and public recognition of the scope of the problem and tremendously increased the cost of its resolution to the deposit insurance system and the American taxpayer. To be credible to global investors, accounting standards should be established by independent professional organizations and enforced by a combination of market discipline and national oversight authorities. Particular to banking and the credibility of banks' financial statements is the establishment of prudent levels of reserves. Investors must be confident that banks are establishing sufficient levels of reserves and recognizing loan impairment in a timely fashion. Compliance with sound accounting, disclosure, and reserving standards not only protects safety and soundness, but also gives the world's investment community confidence in its analysis of risk exposure from investing in various countries and companies. The absence of such confidence, on the other hand, may lead investors to overreact to adverse financial events in such countries by ceasing investment, immediately withdrawing current investment funds and demanding a high return for any remaining or renegotiated investment in such countries. Today's technology and global financial markets enable investors to take these actions very quickly with dramatic consequences, as has recently happened in some Asian countries. Another issue related to the efficient operation of market forces is that government intervention in the credit and investment decisions of banks distorts market discipline and pricing. Such programs frequently cause banks to make less than arm's-length investments in, and loans to, non-economic government-affiliated projects or to individuals associated with such projects. Once these loans are made, it is difficult for national supervisors to demand that banks apply prudent reserve and charge-off policies, let alone foreclose on such loans. In addressing governmental interference with market forces at their meeting in London in February, representatives of the G-7 countries unanimously supported the International Monetary Fund's requirement that countries receiving IMF funds make structural reforms to reduce inappropriate government interference in the market economy. The message that governments should heed is that, ultimately, market forces will come to bear with severe results if firms or nations are artificially protected from market forces. My third major theme today -- the importance of adequate capital -- has drawn much attention in the past decade as a result of the Basle Accord. The idea is pretty simple: if we want banks to be prudent in their risk-taking, there is no substitute for requiring banks' owners to have their own money at risk. With that requirement, supervisory interests and banks' private interests are more closely aligned and banks have fewer incentives to take excessive risks. When banks' managers and directors assess the riskiness and profitability of prospective business opportunities, they will weigh heavily the potential effect of new business activities on their banks' capital positions. Capital must be sufficient, but "How much capital is enough?" The answer is linked, of course, to the level of risk that an institution takes. Institutions that aggressively pursue risky business strategies clearly need a stronger capital base than those with more conservative objectives and products. While a fairly simple approach, the Basle risk-based capital framework has proven to be a balanced risk-focused framework for setting minimum capital standards for thousands of banks of all sizes worldwide. It is important, though, that banks not misuse this minimum prudential standard by substituting it for more rigorous internal evaluations of capital adequacy suitable for their own risk exposure and the sophistication of their financial strategies. For example, US supervisors support the development by a limited number of sophisticated banks of advanced credit risk models for assessing such institutions' internal capital needs to keep their probability of default within their established parameters. Such systems represent significant advances in developing systems to tailor banks' assessments of their capital needs to their credit risk exposure. On the other hand, the cost and complexity of such systems raises issues about their current feasibility as part of the uniform capital measure for all institutions. In any case, banks must rely on their own internal capital assessment systems targeted to their risk profiles and financial sophistication, as well as complying with the necessarily broadbrush, uniform capital standard established under the Basle Accord. We must look constantly for better ways to design regulatory capital standards and to promote adequate risk measurement in banks. On this note, the US Federal Financial Institutions Examination Council held a conference for bankers and supervisors last December to consider a myriad of views on ways that capital regulation should be modified to address changes in banking and risk management. The New York Clearing House Association just completed a pilot study of the pre-commitment approach to capital requirements for market risk. The Federal Reserve Bank of New York also recently organized a conference, in conjunction with the Bank of England, Bank of Japan, and the Federal Reserve Board, for the exchange of economic papers on developments in risk assessment and management, as well as on how such advances should be incorporated into the international capital framework. Although considerable progress has been made in amending the Basle standards in such areas as market risk, there will no doubt be additional changes as new tools are developed to address credit risk differentials, interest rate risk and, perhaps even, operational and legal risk. Indeed, capital standards should be thought of as an evolving process. We all recognize the need to achieve coordinated international banking supervision based on cooperation and strong working relationships between home country and host country supervisors. New challenges in attaining this goal are presented by the advent of new technologies, the geographic expansion of banking activities, and the globalization of financial markets. We should work together, relying on the leadership of home country supervisors, to analyze banks on a consolidated global basis as the financial market does. Home country supervisors need sufficient global information and international cooperation to perform their supervisory responsibilities, while enabling host country supervisors to oversee the activities of international banks in their countries. A key issue arising for all of us, both internationally and domestically, is the growing prevalence in world markets of financial conglomerates -- which blend banking, insurance, securities, and other financial activities in a single diversified global entity. Universal banking in some nations' financial firms has long combined banking and securities activities, and to some extent insurance powers, in a single entity. Such financial conglomerates, which are growing in number and size, engage simultaneously in a myriad of businesses and seek to integrate those businesses to cross market their varied products. This presents a significant supervisory challenge because most of our legal frameworks use separate and different approaches for each traditional segment of the financial industry. The challenge of achieving coordinated international supervision of such conglomerates is addressed in the consultative documents, "Supervision of Financial Conglomerates," developed by the Joint Forum on Financial Conglomerates. These working papers were announced on February 16th by the Basle Committee on Banking Supervision, the International Organization of Securities Commissions (IOSCO), and the International Association of Insurance Supervisors (IAIS). The Joint Forum, which was formed to help coordinate the international and inter-industry supervision of financial conglomerates, requested comment by July on these papers. The documents make concrete recommendations for steps that supervisors in each of the securities, insurance, and banking sectors can take to enhance supervision of the group-wide risk exposures of these global and inter-industry conglomerates. The documents also stress the need to enhance cooperation and information exchange among the supervisors in each country and industry segment. Implementing these recommendations may necessitate changing the legal framework of our financial oversight frameworks, but major changes in our financial institutions and markets demand changes in the supervisory frameworks of our countries. The United States is no exception. In closing, I want to reiterate that banking supervisors must work together to achieve effective consolidated supervision of global banks under a shared set of supervisory principles, such as the Basle Committee's Core Principles. Furthermore, I believe that the best way to implement coordinated global supervision is to focus on the four themes that I have highlighted today -- the benefits of risk-focused supervision, the value of sound accounting and disclosure, the need for adequate capital, and the importance of international supervisory coordination. I appreciate having the opportunity to meet with you today to discuss key supervisory issues. I look forward to our continuing joint supervisory efforts toward coordinated international bank supervision.
1998-03-26T00:00:00	Ms. Phillips reviews major milestones, key factors and future directions of the OTC derivatives market (Central Bank Articles and Speeches, 26 Mar 98)	Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, before the International Swaps and Derivatives Association, 13th Annual General Meeting in Rome on 26/3/98.	Ms. Phillips reviews major milestones, key factors and future directions of Remarks by Ms. Susan M. Phillips, a member of the Board of the OTC derivatives market Governors of the US Federal Reserve System, before the International Swaps and Derivatives Association, 13th Annual General Meeting in Rome on 26/3/98. Lessons and Perspectives Thank you for inviting me to speak at this annual meeting of ISDA. When visiting Rome, we are all conscious of the rich history and grandeur of the Roman Empire. This setting puts into perspective the short history of the swaps and derivatives market -- despite having come a long way, the market for over-the-counter derivatives is still relatively young. Nonetheless, it is not so young that it cannot benefit from a reassessment of its past development, with an eye toward using those lessons to inform and guide the future. Major Milestones At meetings such as this one, it often is the practice to review major events in the development of the over-the-counter (OTC) derivatives market and to chronicle its growth. The milestones of the market are often recorded as the introduction of new products, be they currency swaps, interest rate swaps, caps, collars, floors, or credit derivatives. While this approach puts products in their historical context, it does not provide a framework against which to evaluate subsequent evolution of products and the market. An alternative approach that may be more informative is to focus on OTC derivative dealers and how their role in the market has evolved, that is, to chronicle changes in the ways dealers conduct their business and manage their risk. From this latter perspective, the first stage in the evolution of OTC derivatives was characterized by matched transactions. Intermediaries arranged deals directly between counterparties, serving as brokers rather than dealers. This activity evolved to a second stage in which the intermediary began dealing rather than brokering. Intermediaries took the opposite sides of contracts with their counterparties and in effect became OTC derivatives dealers. Positions were warehoused by the dealers until their risk could be offset by a mirroring transaction with another counterparty. Dealers incurred exposures, but these exposures arose because of the asynchronous nature of the business. Over the long haul, their books remained basically matched. The need to find a pairwise offsetting transaction obviously limited the growth potential of the market. The most critical stage in the evolution of OTC derivatives dealing, one that vastly expanded the potential growth of the market, was dealers' adoption of a portfolio approach to their business. Instead of offsetting individual deals, dealers came to view the business as a portfolio of cash flows whose risk could be managed. This approach to risk management was a necessary condition for the subsequent expansion in both the volume and the range of products that has been a characteristic of the industry. Dealers could never reasonably hope to match or to pairwise offset individual structured products. They could, however, manage the exposures to the basic risk factors that were embodied in the cash flows of these deals. The risk management processes of dealers now involve highly sophisticated systems and modeling of portfolios. In essence, the emphasis had changed from individual product design to system design and portfolio risk management. The development of this systems portfolio approach then set the stage for the phenomenal growth the market has experienced. Key Factors Supporting the Growth in the Industry In order for dealers to implement this portfolio management approach and thereby support the growth in the industry, certain essential elements also needed to be in place. Reliable methods for determining market values of individual instruments and portfolios were necessary. The value-at-risk approach of mapping instruments into common risk factors needed to be broadly accepted. Data on common risk factors such as zero coupon yields, exchange rates, and volatilities had to be readily available and in some cases, had to be developed. Finally, the availability of liquid hedging vehicles, such as Eurodollar futures and Treasury repo markets, that allow dealers to adjust their exposures to the common risk factors was key. A focus on these supporting factors -- valuation and risk management methods, data and hedging vehicles -- is useful as an analytical device because it helps identify factors that may either foster or inhibit the growth of new or future products. Take credit derivatives as an example. Credit derivatives are one of the most interesting products developed in the OTC derivative market in quite some time. They offer a means for counterparties to directly adjust credit exposures to specific firms or to diversify industry or geographic concentrations. Their potential is enormous because credit risk is the major risk faced by financial service firms. Credit derivatives' growth to date, however, has been fairly limited, and this limited growth can be traced to deficiencies in some of these supporting factors. Data to price the instruments is relatively poor. Analysts typically look to corporate bonds, but historical data on bonds are fairly limited. Information on loan values is even more difficult to obtain. The growth of credit derivatives also has been constrained by the lack of hedging instruments. There really are no exchange-traded instruments that can be used to effectively hedge credit risk. Given my earlier association with exchange-traded markets, I am surprised that this profit opportunity has not yet been exploited. It illustrates, no doubt, the difficulty of overcoming the impediment of data availability and of pricing credit risk. A discussion of factors that have supported the growth of OTC derivative markets would not be complete without also noting the importance of infrastrucuture developments and ISDA's contributions in that area. Master agreements have played a critical role, enabling counterparties to manage the credit risk of their positions more effectively. ISDA and its members perceived the value of uniform documentation and supported development of a standard master agreement that allows for acceleration and close-out netting in the event of default. Work didn't end with the creation of the master agreement, however, and ISDA has played a continuing role educating counterparties about the importance of utilizing master agreements. As time passes, I have come to appreciate more and more the role that infrastructure elements play in fostering the growth of markets. ISDA has developed standard documentation for some credit derivatives, for example, which should aid in the development of that product. Collateral agreements are another development that shows great promise for helping market participants manage their credit risk and for facilitating growth of the market. Here also, ISDA has made useful contributions. Standard collateral agreements, either title transfer or pledge, have been developed for several jurisdictions. Collateral agreements, like the master agreement, must be based upon sound legal foundations, and ISDA has supported analysis in this area, too. These efforts give market participants additional tools to help them manage the risks in their OTC business and ensure that any perceived reductions in risk rest on a sound legal foundation. Viewed broadly, the Group of Thirty study of derivatives ranks as another key supporting factor in the development of the market. As I noted earlier, the broad acceptance of the value-at-risk approach for managing portfolios of derivative instruments fostered the growth of the market and the diversity of products that could be offered. Discussions in the G-30 Report also formed the basis of the internal-models approach that supervisors ultimately adopted for the capitalization of market risk in trading accounts. The Report defined a set of sound risk management practices for dealers and end-users as well as describing VaR techniques. Roots of both the qualitative and quantitative standards in the internal-models approach can be found in the Report's discussions. Derivatives No Longer the Scapegoat It is, no doubt, a reflection of the overall quality of risk management in the OTC derivatives business, and the widespread acceptance of the principles articulated in the G-30 Report, that derivatives are no longer the scapegoat for all episodes of market volatility. The role that derivatives can play in allowing counterparties to manage risks is now widely accepted. Previously, counterparties might simply have borne these risks or elected not to undertake the business that entailed the risks. Derivatives are now seen as an essential tool that market participants have for managing risk. The rhetoric even from banking supervisors and central banks has become more muted of late as they also acknowledge derivatives' role and utilize market developments and models in new supervisory standards. This change in the attitude toward derivatives has occurred in no small part because more and more observers of the market are learning to distinguish between the instrument itself and the way in which that instrument is used by market participants. Derivatives are a means of shifting risk. Problems do not arise simply because a party that is better able to bear risk agrees, for a fee, to assume that risk from a party that is less able to bear it. Instead, problems arise if the parties to the agreement do not understand the risks that they are assuming or have inadequate controls for managing that risk. Much of the shift in attitude toward derivatives has occurred because "problems" with derivatives are correctly seen as arising in the behavior of the parties entering into the contracts rather than in the contracts themselves. Perspectives on Asia Events in Asia are providing a test of more than just attitudes toward derivatives. Turmoil in these markets also has provided an important test of the risk management processes that OTC derivatives dealers have put in place and the infrastructure supporting those systems. The jury is still out in some respects, but preliminary reports of how U.S. banks have fared provides valuable insights and lessons. Perhaps most importantly, evidence indicates that global risk management processes and the tools of risk management such as value-at-risk systems worked as expected. Most banks had identified Asia as an area of potential risk during the early going. Robust internal communication channels along with the timely identification of risks enabled banks to take steps to mitigate some of that risk. Positions were reduced in some instances, and hedges were put in place in others. In reviews of events, the basic elements of portfolio management also were cast under a bright light. Banks reported that their ability to revalue positions generally held up. Furthermore, the discipline of identifying and reporting sources of profits and losses in each of their trading businesses on a daily basis was very valuable. Banks also reported that their VaR systems worked as expected. Of course, VaR is only designed to cover 95 or 99 percent of price moves, and many of the price changes observed were certainly draws from the tails of distributions. The occurrence of these large price moves strongly reinforces the need for VaR techniques to be supplemented by a program of stress testing. Stress tests, after all, should encompass precisely the type of events that have been occurring. When done rigorously, banks reported that stress tests were accurate and led in some instances to reductions in positions before the market turmoil was fully blown. Stress tests that had been done by a centralized risk management function also provided an additional check on the exposures of business line units that inevitably have a narrower perspective on risk. The results of these stress tests also served as sources of discussion for centralized decision-making by senior management. This record, while reassuring, should not imply that areas in need of improvement were not also exposed. Some of these areas were unexpected and are of the nature of typical lessons that one discovers as one lives through a crisis. Other areas for improvement are more basic, however, and indicate practices that should become a standard part of banks' risk management tool kits. If we go back to the basic factors that were essential for a portfolio management approach to the OTC derivatives business -- valuation techniques, risk management methods, data, and hedging vehicles -- the events in Asia exposed areas for improvement in each. While banks reported that their ability to value positions held up, they also noted that they had difficulties revaluing the less liquid positions. This observation probably says more about the ability to evaluate the liquidity risk in positions than valuation techniques per se. Nonetheless, an analysis of lessons to be drawn from these events probably should include more systematic approaches to incorporating liquidity risk in valuation techniques and reserving methodologies. Events also point to areas in which risk management methods could and should be strengthened. As banks trade new and innovative products or employ new and sophisticated trading strategies, it is important that risk management methodologies continue to improve as well. Where simplistic risk modeling techniques are employed, they often do not allow management to have a complete understanding of the risks being borne. Similarly, banks have noted the importance of stress tests in identifying significant concentrations of risk. They also have noted, however, that events unfolded over much longer periods of time than the typical oneday horizon of a stress test and that contagion across markets was faster than anticipated. This argues for assumptions of multi-day events in some stress scenarios, particularly when dealing with less liquid instruments. Making appropriate judgements about the liquidity of instruments, or lack thereof, in determining the size of acceptable exposures is a theme that emerges in a variety of contexts when assessing market movements of the fourth quarter. Another area in which valuable lessons were learned is the importance of having hedging instruments available for the full range of risks that are being assumed through product offerings. Banks have reported that liquidity dried up in some instruments they were depending upon for hedging. This forced them into proxy hedging strategies using instruments that inevitably exposed them to basis risk. As I noted earlier, the availability of hedging instruments has been key to the growth and the broad product line that is found in OTC markets. Events of the last year may, however, have highlighted the fact that some dealers are not thinking carefully and critically enough about the ways they are going to hedge the risks assumed in various lines of business. In this area also, the theme of the availability of liquidity emerges. The final area related to the lessons of Asia that I would like to touch on is that old-fashioned topic of concentrations of credit risk. The turmoil in Asian markets has clearly provided a test of the risk management processes associated with derivatives dealing. But at the end of the day, the lessons to be learned may be related less to derivatives themselves than to why dealers analyze credit risk and view diversification. Prices moved dramatically and market risk became credit exposures. These events raised the sensitivity of bank management to the potentially high correlation between credit exposures and the probability of counterparty default during stressful times. At a minimum, they illustrate the importance of diversification in all lines of business and the need to view diversification in the broadest context. Despite the fact that I think there are numerous improvements dealers could make to their risk management systems, I do not want to end with the impression that derivatives dealers and their systems somehow failed this test of market volatility. Systems generally performed well. The very conduct of a post mortem, after all, demonstrates the basic quality of existing procedures and systems. That said, however, we should not forego the opportunity to learn from the events and possibly strengthen systems even further. Future Directions Looking to the future, the lessons of Asia provide sign posts for the areas of risk management in which work by both market participants and supervisors is likely to be concentrated. Volatility, after all, usually leads to innovations to help deal with it. Credit risk management emerged as one theme in assessments of the Asian volatility. A reassessment of liquidity risk was another. An emphasis on the infrastructure of the market no doubt will continue as well. Firms already were working upon ways to apply techniques developed for the management of market risk in the context of credit risk. Supervisors also were evaluating the potential for applying such an internal models approach to the determination of regulatory capital requirements for credit risk. Events in Asia highlight not only the promise of such approaches but also the hurdles that must be overcome if their potential is to be realized. Once one recognizes the correlation between market risk and credit risk, the next step is a consideration of a global approach to risk management and the possibility of extending an internal models approach beyond market risk. The application of that approach implies, however, that prices can be obtained from thin markets and used effectively in risk measurement. As we continue to pursue new approaches to credit risk management, the basic questions arise again and again: Are data and techniques for revaluing positions available? Can acceptable risk measurement models be developed? Are hedging vehicles available? These questions represent hurdles that must be jumped. They will not necessarily be easy, but neither were other hurdles that this industry has overcome. Another theme that emerges is liquidity risk. A fundamental assumption of many risk management procedures is the ability to get out of a position or to hedge it. Events in Asia demonstrated once again that assumptions about liquidity in normal markets rarely hold in more volatile ones. This argues both for a reassessment of the assumptions themselves and for more careful and fundamental thinking about liquidity risk in risk management procedures. At the outset of my remarks, I noted my appreciation for infrastructure developments as a foundation for the growth of the market. Certainly, their importance is unlikely to diminish in the near term. Market participants generally have an appreciation for potential legal risk but continuing reassessment is valuable. Episodes of volatility give some counterparties strong incentives to try to walk away from losing contracts. Such events indicate areas where further legal work may be necessary to ensure that the market's infrastructure remains sound. The industry has had a phenomenal record of growth and innovation over the past few years, but plenty of work remains to be done over the next few years. Many of the issues to be faced are not easy. However, I have no doubt that the energy, creativity, and competitive spirit of the industry will ensure that these issues are dealt with and that the future of OTC derivatives is a bright one. The leadership role that ISDA has played in the past will undoubtedly be called upon in the future.	---[PAGE_BREAK]--- # Ms. Phillips reviews major milestones, key factors and future directions of the OTC derivatives market Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, before the International Swaps and Derivatives Association, 13th Annual General Meeting in Rome on 26/3/98. ## Lessons and Perspectives Thank you for inviting me to speak at this annual meeting of ISDA. When visiting Rome, we are all conscious of the rich history and grandeur of the Roman Empire. This setting puts into perspective the short history of the swaps and derivatives market -- despite having come a long way, the market for over-the-counter derivatives is still relatively young. Nonetheless, it is not so young that it cannot benefit from a reassessment of its past development, with an eye toward using those lessons to inform and guide the future. ## Major Milestones At meetings such as this one, it often is the practice to review major events in the development of the over-the-counter (OTC) derivatives market and to chronicle its growth. The milestones of the market are often recorded as the introduction of new products, be they currency swaps, interest rate swaps, caps, collars, floors, or credit derivatives. While this approach puts products in their historical context, it does not provide a framework against which to evaluate subsequent evolution of products and the market. An alternative approach that may be more informative is to focus on OTC derivative dealers and how their role in the market has evolved, that is, to chronicle changes in the ways dealers conduct their business and manage their risk. From this latter perspective, the first stage in the evolution of OTC derivatives was characterized by matched transactions. Intermediaries arranged deals directly between counterparties, serving as brokers rather than dealers. This activity evolved to a second stage in which the intermediary began dealing rather than brokering. Intermediaries took the opposite sides of contracts with their counterparties and in effect became OTC derivatives dealers. Positions were warehoused by the dealers until their risk could be offset by a mirroring transaction with another counterparty. Dealers incurred exposures, but these exposures arose because of the asynchronous nature of the business. Over the long haul, their books remained basically matched. The need to find a pairwise offsetting transaction obviously limited the growth potential of the market. The most critical stage in the evolution of OTC derivatives dealing, one that vastly expanded the potential growth of the market, was dealers' adoption of a portfolio approach to their business. Instead of offsetting individual deals, dealers came to view the business as a portfolio of cash flows whose risk could be managed. This approach to risk management was a necessary condition for the subsequent expansion in both the volume and the range of products that has been a characteristic of the industry. Dealers could never reasonably hope to match or to pairwise offset individual structured products. They could, however, manage the exposures to the basic risk factors that were embodied in the cash flows of these deals. The risk management processes of dealers now involve highly sophisticated systems and modeling of portfolios. In essence, the emphasis had changed from individual product design to system design and portfolio risk management. The development of this systems portfolio approach then set the stage for the phenomenal growth the market has experienced. ---[PAGE_BREAK]--- # Key Factors Supporting the Growth in the Industry In order for dealers to implement this portfolio management approach and thereby support the growth in the industry, certain essential elements also needed to be in place. Reliable methods for determining market values of individual instruments and portfolios were necessary. The value-at-risk approach of mapping instruments into common risk factors needed to be broadly accepted. Data on common risk factors such as zero coupon yields, exchange rates, and volatilities had to be readily available and in some cases, had to be developed. Finally, the availability of liquid hedging vehicles, such as Eurodollar futures and Treasury repo markets, that allow dealers to adjust their exposures to the common risk factors was key. A focus on these supporting factors -- valuation and risk management methods, data and hedging vehicles -- is useful as an analytical device because it helps identify factors that may either foster or inhibit the growth of new or future products. Take credit derivatives as an example. Credit derivatives are one of the most interesting products developed in the OTC derivative market in quite some time. They offer a means for counterparties to directly adjust credit exposures to specific firms or to diversify industry or geographic concentrations. Their potential is enormous because credit risk is the major risk faced by financial service firms. Credit derivatives' growth to date, however, has been fairly limited, and this limited growth can be traced to deficiencies in some of these supporting factors. Data to price the instruments is relatively poor. Analysts typically look to corporate bonds, but historical data on bonds are fairly limited. Information on loan values is even more difficult to obtain. The growth of credit derivatives also has been constrained by the lack of hedging instruments. There really are no exchange-traded instruments that can be used to effectively hedge credit risk. Given my earlier association with exchange-traded markets, I am surprised that this profit opportunity has not yet been exploited. It illustrates, no doubt, the difficulty of overcoming the impediment of data availability and of pricing credit risk. A discussion of factors that have supported the growth of OTC derivative markets would not be complete without also noting the importance of infrastrucuture developments and ISDA's contributions in that area. Master agreements have played a critical role, enabling counterparties to manage the credit risk of their positions more effectively. ISDA and its members perceived the value of uniform documentation and supported development of a standard master agreement that allows for acceleration and close-out netting in the event of default. Work didn't end with the creation of the master agreement, however, and ISDA has played a continuing role educating counterparties about the importance of utilizing master agreements. As time passes, I have come to appreciate more and more the role that infrastructure elements play in fostering the growth of markets. ISDA has developed standard documentation for some credit derivatives, for example, which should aid in the development of that product. Collateral agreements are another development that shows great promise for helping market participants manage their credit risk and for facilitating growth of the market. Here also, ISDA has made useful contributions. Standard collateral agreements, either title transfer or pledge, have been developed for several jurisdictions. Collateral agreements, like the master agreement, must be based upon sound legal foundations, and ISDA has supported analysis in this area, too. These efforts give market participants additional tools to help them manage the risks in their OTC business and ensure that any perceived reductions in risk rest on a sound legal foundation. ---[PAGE_BREAK]--- Viewed broadly, the Group of Thirty study of derivatives ranks as another key supporting factor in the development of the market. As I noted earlier, the broad acceptance of the value-at-risk approach for managing portfolios of derivative instruments fostered the growth of the market and the diversity of products that could be offered. Discussions in the G-30 Report also formed the basis of the internal-models approach that supervisors ultimately adopted for the capitalization of market risk in trading accounts. The Report defined a set of sound risk management practices for dealers and end-users as well as describing VaR techniques. Roots of both the qualitative and quantitative standards in the internal-models approach can be found in the Report's discussions. # Derivatives No Longer the Scapegoat It is, no doubt, a reflection of the overall quality of risk management in the OTC derivatives business, and the widespread acceptance of the principles articulated in the G-30 Report, that derivatives are no longer the scapegoat for all episodes of market volatility. The role that derivatives can play in allowing counterparties to manage risks is now widely accepted. Previously, counterparties might simply have borne these risks or elected not to undertake the business that entailed the risks. Derivatives are now seen as an essential tool that market participants have for managing risk. The rhetoric even from banking supervisors and central banks has become more muted of late as they also acknowledge derivatives' role and utilize market developments and models in new supervisory standards. This change in the attitude toward derivatives has occurred in no small part because more and more observers of the market are learning to distinguish between the instrument itself and the way in which that instrument is used by market participants. Derivatives are a means of shifting risk. Problems do not arise simply because a party that is better able to bear risk agrees, for a fee, to assume that risk from a party that is less able to bear it. Instead, problems arise if the parties to the agreement do not understand the risks that they are assuming or have inadequate controls for managing that risk. Much of the shift in attitude toward derivatives has occurred because "problems" with derivatives are correctly seen as arising in the behavior of the parties entering into the contracts rather than in the contracts themselves. ## Perspectives on Asia Events in Asia are providing a test of more than just attitudes toward derivatives. Turmoil in these markets also has provided an important test of the risk management processes that OTC derivatives dealers have put in place and the infrastructure supporting those systems. The jury is still out in some respects, but preliminary reports of how U.S. banks have fared provides valuable insights and lessons. Perhaps most importantly, evidence indicates that global risk management processes and the tools of risk management such as value-at-risk systems worked as expected. Most banks had identified Asia as an area of potential risk during the early going. Robust internal communication channels along with the timely identification of risks enabled banks to take steps to mitigate some of that risk. Positions were reduced in some instances, and hedges were put in place in others. In reviews of events, the basic elements of portfolio management also were cast under a bright light. Banks reported that their ability to revalue positions generally held up. Furthermore, the discipline of identifying and reporting sources of profits and losses in each of ---[PAGE_BREAK]--- their trading businesses on a daily basis was very valuable. Banks also reported that their VaR systems worked as expected. Of course, VaR is only designed to cover 95 or 99 percent of price moves, and many of the price changes observed were certainly draws from the tails of distributions. The occurrence of these large price moves strongly reinforces the need for VaR techniques to be supplemented by a program of stress testing. Stress tests, after all, should encompass precisely the type of events that have been occurring. When done rigorously, banks reported that stress tests were accurate and led in some instances to reductions in positions before the market turmoil was fully blown. Stress tests that had been done by a centralized risk management function also provided an additional check on the exposures of business line units that inevitably have a narrower perspective on risk. The results of these stress tests also served as sources of discussion for centralized decision-making by senior management. This record, while reassuring, should not imply that areas in need of improvement were not also exposed. Some of these areas were unexpected and are of the nature of typical lessons that one discovers as one lives through a crisis. Other areas for improvement are more basic, however, and indicate practices that should become a standard part of banks' risk management tool kits. If we go back to the basic factors that were essential for a portfolio management approach to the OTC derivatives business -- valuation techniques, risk management methods, data, and hedging vehicles -- the events in Asia exposed areas for improvement in each. While banks reported that their ability to value positions held up, they also noted that they had difficulties revaluing the less liquid positions. This observation probably says more about the ability to evaluate the liquidity risk in positions than valuation techniques per se. Nonetheless, an analysis of lessons to be drawn from these events probably should include more systematic approaches to incorporating liquidity risk in valuation techniques and reserving methodologies. Events also point to areas in which risk management methods could and should be strengthened. As banks trade new and innovative products or employ new and sophisticated trading strategies, it is important that risk management methodologies continue to improve as well. Where simplistic risk modeling techniques are employed, they often do not allow management to have a complete understanding of the risks being borne. Similarly, banks have noted the importance of stress tests in identifying significant concentrations of risk. They also have noted, however, that events unfolded over much longer periods of time than the typical oneday horizon of a stress test and that contagion across markets was faster than anticipated. This argues for assumptions of multi-day events in some stress scenarios, particularly when dealing with less liquid instruments. Making appropriate judgements about the liquidity of instruments, or lack thereof, in determining the size of acceptable exposures is a theme that emerges in a variety of contexts when assessing market movements of the fourth quarter. Another area in which valuable lessons were learned is the importance of having hedging instruments available for the full range of risks that are being assumed through product offerings. Banks have reported that liquidity dried up in some instruments they were depending upon for hedging. This forced them into proxy hedging strategies using instruments that inevitably exposed them to basis risk. As I noted earlier, the availability of hedging instruments has been key to the growth and the broad product line that is found in OTC markets. Events of the last year may, however, have highlighted the fact that some dealers are not thinking carefully and critically enough about the ways they are going to hedge the risks assumed in various lines of business. In this area also, the theme of the availability of liquidity emerges. ---[PAGE_BREAK]--- The final area related to the lessons of Asia that I would like to touch on is that old-fashioned topic of concentrations of credit risk. The turmoil in Asian markets has clearly provided a test of the risk management processes associated with derivatives dealing. But at the end of the day, the lessons to be learned may be related less to derivatives themselves than to why dealers analyze credit risk and view diversification. Prices moved dramatically and market risk became credit exposures. These events raised the sensitivity of bank management to the potentially high correlation between credit exposures and the probability of counterparty default during stressful times. At a minimum, they illustrate the importance of diversification in all lines of business and the need to view diversification in the broadest context. Despite the fact that I think there are numerous improvements dealers could make to their risk management systems, I do not want to end with the impression that derivatives dealers and their systems somehow failed this test of market volatility. Systems generally performed well. The very conduct of a post mortem, after all, demonstrates the basic quality of existing procedures and systems. That said, however, we should not forego the opportunity to learn from the events and possibly strengthen systems even further. # Future Directions Looking to the future, the lessons of Asia provide sign posts for the areas of risk management in which work by both market participants and supervisors is likely to be concentrated. Volatility, after all, usually leads to innovations to help deal with it. Credit risk management emerged as one theme in assessments of the Asian volatility. A reassessment of liquidity risk was another. An emphasis on the infrastructure of the market no doubt will continue as well. Firms already were working upon ways to apply techniques developed for the management of market risk in the context of credit risk. Supervisors also were evaluating the potential for applying such an internal models approach to the determination of regulatory capital requirements for credit risk. Events in Asia highlight not only the promise of such approaches but also the hurdles that must be overcome if their potential is to be realized. Once one recognizes the correlation between market risk and credit risk, the next step is a consideration of a global approach to risk management and the possibility of extending an internal models approach beyond market risk. The application of that approach implies, however, that prices can be obtained from thin markets and used effectively in risk measurement. As we continue to pursue new approaches to credit risk management, the basic questions arise again and again: Are data and techniques for revaluing positions available? Can acceptable risk measurement models be developed? Are hedging vehicles available? These questions represent hurdles that must be jumped. They will not necessarily be easy, but neither were other hurdles that this industry has overcome. Another theme that emerges is liquidity risk. A fundamental assumption of many risk management procedures is the ability to get out of a position or to hedge it. Events in Asia demonstrated once again that assumptions about liquidity in normal markets rarely hold in more volatile ones. This argues both for a reassessment of the assumptions themselves and for more careful and fundamental thinking about liquidity risk in risk management procedures. At the outset of my remarks, I noted my appreciation for infrastructure developments as a foundation for the growth of the market. Certainly, their importance is ---[PAGE_BREAK]--- unlikely to diminish in the near term. Market participants generally have an appreciation for potential legal risk but continuing reassessment is valuable. Episodes of volatility give some counterparties strong incentives to try to walk away from losing contracts. Such events indicate areas where further legal work may be necessary to ensure that the market's infrastructure remains sound. The industry has had a phenomenal record of growth and innovation over the past few years, but plenty of work remains to be done over the next few years. Many of the issues to be faced are not easy. However, I have no doubt that the energy, creativity, and competitive spirit of the industry will ensure that these issues are dealt with and that the future of OTC derivatives is a bright one. The leadership role that ISDA has played in the past will undoubtedly be called upon in the future.	Susan M Phillips	United States	https://www.bis.org/review/r980401b.pdf	the OTC derivatives market Remarks by Ms. Susan M. Phillips, a member of the Board of Governors of the US Federal Reserve System, before the International Swaps and Derivatives Association, 13th Annual General Meeting in Rome on 26/3/98. Thank you for inviting me to speak at this annual meeting of ISDA. When visiting Rome, we are all conscious of the rich history and grandeur of the Roman Empire. This setting puts into perspective the short history of the swaps and derivatives market -- despite having come a long way, the market for over-the-counter derivatives is still relatively young. Nonetheless, it is not so young that it cannot benefit from a reassessment of its past development, with an eye toward using those lessons to inform and guide the future. At meetings such as this one, it often is the practice to review major events in the development of the over-the-counter (OTC) derivatives market and to chronicle its growth. The milestones of the market are often recorded as the introduction of new products, be they currency swaps, interest rate swaps, caps, collars, floors, or credit derivatives. While this approach puts products in their historical context, it does not provide a framework against which to evaluate subsequent evolution of products and the market. An alternative approach that may be more informative is to focus on OTC derivative dealers and how their role in the market has evolved, that is, to chronicle changes in the ways dealers conduct their business and manage their risk. From this latter perspective, the first stage in the evolution of OTC derivatives was characterized by matched transactions. Intermediaries arranged deals directly between counterparties, serving as brokers rather than dealers. This activity evolved to a second stage in which the intermediary began dealing rather than brokering. Intermediaries took the opposite sides of contracts with their counterparties and in effect became OTC derivatives dealers. Positions were warehoused by the dealers until their risk could be offset by a mirroring transaction with another counterparty. Dealers incurred exposures, but these exposures arose because of the asynchronous nature of the business. Over the long haul, their books remained basically matched. The need to find a pairwise offsetting transaction obviously limited the growth potential of the market. The most critical stage in the evolution of OTC derivatives dealing, one that vastly expanded the potential growth of the market, was dealers' adoption of a portfolio approach to their business. Instead of offsetting individual deals, dealers came to view the business as a portfolio of cash flows whose risk could be managed. This approach to risk management was a necessary condition for the subsequent expansion in both the volume and the range of products that has been a characteristic of the industry. Dealers could never reasonably hope to match or to pairwise offset individual structured products. They could, however, manage the exposures to the basic risk factors that were embodied in the cash flows of these deals. The risk management processes of dealers now involve highly sophisticated systems and modeling of portfolios. In essence, the emphasis had changed from individual product design to system design and portfolio risk management. The development of this systems portfolio approach then set the stage for the phenomenal growth the market has experienced. In order for dealers to implement this portfolio management approach and thereby support the growth in the industry, certain essential elements also needed to be in place. Reliable methods for determining market values of individual instruments and portfolios were necessary. The value-at-risk approach of mapping instruments into common risk factors needed to be broadly accepted. Data on common risk factors such as zero coupon yields, exchange rates, and volatilities had to be readily available and in some cases, had to be developed. Finally, the availability of liquid hedging vehicles, such as Eurodollar futures and Treasury repo markets, that allow dealers to adjust their exposures to the common risk factors was key. A focus on these supporting factors -- valuation and risk management methods, data and hedging vehicles -- is useful as an analytical device because it helps identify factors that may either foster or inhibit the growth of new or future products. Take credit derivatives as an example. Credit derivatives are one of the most interesting products developed in the OTC derivative market in quite some time. They offer a means for counterparties to directly adjust credit exposures to specific firms or to diversify industry or geographic concentrations. Their potential is enormous because credit risk is the major risk faced by financial service firms. Credit derivatives' growth to date, however, has been fairly limited, and this limited growth can be traced to deficiencies in some of these supporting factors. Data to price the instruments is relatively poor. Analysts typically look to corporate bonds, but historical data on bonds are fairly limited. Information on loan values is even more difficult to obtain. The growth of credit derivatives also has been constrained by the lack of hedging instruments. There really are no exchange-traded instruments that can be used to effectively hedge credit risk. Given my earlier association with exchange-traded markets, I am surprised that this profit opportunity has not yet been exploited. It illustrates, no doubt, the difficulty of overcoming the impediment of data availability and of pricing credit risk. A discussion of factors that have supported the growth of OTC derivative markets would not be complete without also noting the importance of infrastrucuture developments and ISDA's contributions in that area. Master agreements have played a critical role, enabling counterparties to manage the credit risk of their positions more effectively. ISDA and its members perceived the value of uniform documentation and supported development of a standard master agreement that allows for acceleration and close-out netting in the event of default. Work didn't end with the creation of the master agreement, however, and ISDA has played a continuing role educating counterparties about the importance of utilizing master agreements. As time passes, I have come to appreciate more and more the role that infrastructure elements play in fostering the growth of markets. ISDA has developed standard documentation for some credit derivatives, for example, which should aid in the development of that product. Collateral agreements are another development that shows great promise for helping market participants manage their credit risk and for facilitating growth of the market. Here also, ISDA has made useful contributions. Standard collateral agreements, either title transfer or pledge, have been developed for several jurisdictions. Collateral agreements, like the master agreement, must be based upon sound legal foundations, and ISDA has supported analysis in this area, too. These efforts give market participants additional tools to help them manage the risks in their OTC business and ensure that any perceived reductions in risk rest on a sound legal foundation. Viewed broadly, the Group of Thirty study of derivatives ranks as another key supporting factor in the development of the market. As I noted earlier, the broad acceptance of the value-at-risk approach for managing portfolios of derivative instruments fostered the growth of the market and the diversity of products that could be offered. Discussions in the G-30 Report also formed the basis of the internal-models approach that supervisors ultimately adopted for the capitalization of market risk in trading accounts. The Report defined a set of sound risk management practices for dealers and end-users as well as describing VaR techniques. Roots of both the qualitative and quantitative standards in the internal-models approach can be found in the Report's discussions. It is, no doubt, a reflection of the overall quality of risk management in the OTC derivatives business, and the widespread acceptance of the principles articulated in the G-30 Report, that derivatives are no longer the scapegoat for all episodes of market volatility. The role that derivatives can play in allowing counterparties to manage risks is now widely accepted. Previously, counterparties might simply have borne these risks or elected not to undertake the business that entailed the risks. Derivatives are now seen as an essential tool that market participants have for managing risk. The rhetoric even from banking supervisors and central banks has become more muted of late as they also acknowledge derivatives' role and utilize market developments and models in new supervisory standards. This change in the attitude toward derivatives has occurred in no small part because more and more observers of the market are learning to distinguish between the instrument itself and the way in which that instrument is used by market participants. Derivatives are a means of shifting risk. Problems do not arise simply because a party that is better able to bear risk agrees, for a fee, to assume that risk from a party that is less able to bear it. Instead, problems arise if the parties to the agreement do not understand the risks that they are assuming or have inadequate controls for managing that risk. Much of the shift in attitude toward derivatives has occurred because "problems" with derivatives are correctly seen as arising in the behavior of the parties entering into the contracts rather than in the contracts themselves. Events in Asia are providing a test of more than just attitudes toward derivatives. Turmoil in these markets also has provided an important test of the risk management processes that OTC derivatives dealers have put in place and the infrastructure supporting those systems. The jury is still out in some respects, but preliminary reports of how U.S. banks have fared provides valuable insights and lessons. Perhaps most importantly, evidence indicates that global risk management processes and the tools of risk management such as value-at-risk systems worked as expected. Most banks had identified Asia as an area of potential risk during the early going. Robust internal communication channels along with the timely identification of risks enabled banks to take steps to mitigate some of that risk. Positions were reduced in some instances, and hedges were put in place in others. In reviews of events, the basic elements of portfolio management also were cast under a bright light. Banks reported that their ability to revalue positions generally held up. Furthermore, the discipline of identifying and reporting sources of profits and losses in each of their trading businesses on a daily basis was very valuable. Banks also reported that their VaR systems worked as expected. Of course, VaR is only designed to cover 95 or 99 percent of price moves, and many of the price changes observed were certainly draws from the tails of distributions. The occurrence of these large price moves strongly reinforces the need for VaR techniques to be supplemented by a program of stress testing. Stress tests, after all, should encompass precisely the type of events that have been occurring. When done rigorously, banks reported that stress tests were accurate and led in some instances to reductions in positions before the market turmoil was fully blown. Stress tests that had been done by a centralized risk management function also provided an additional check on the exposures of business line units that inevitably have a narrower perspective on risk. The results of these stress tests also served as sources of discussion for centralized decision-making by senior management. This record, while reassuring, should not imply that areas in need of improvement were not also exposed. Some of these areas were unexpected and are of the nature of typical lessons that one discovers as one lives through a crisis. Other areas for improvement are more basic, however, and indicate practices that should become a standard part of banks' risk management tool kits. If we go back to the basic factors that were essential for a portfolio management approach to the OTC derivatives business -- valuation techniques, risk management methods, data, and hedging vehicles -- the events in Asia exposed areas for improvement in each. While banks reported that their ability to value positions held up, they also noted that they had difficulties revaluing the less liquid positions. This observation probably says more about the ability to evaluate the liquidity risk in positions than valuation techniques per se. Nonetheless, an analysis of lessons to be drawn from these events probably should include more systematic approaches to incorporating liquidity risk in valuation techniques and reserving methodologies. Events also point to areas in which risk management methods could and should be strengthened. As banks trade new and innovative products or employ new and sophisticated trading strategies, it is important that risk management methodologies continue to improve as well. Where simplistic risk modeling techniques are employed, they often do not allow management to have a complete understanding of the risks being borne. Similarly, banks have noted the importance of stress tests in identifying significant concentrations of risk. They also have noted, however, that events unfolded over much longer periods of time than the typical oneday horizon of a stress test and that contagion across markets was faster than anticipated. This argues for assumptions of multi-day events in some stress scenarios, particularly when dealing with less liquid instruments. Making appropriate judgements about the liquidity of instruments, or lack thereof, in determining the size of acceptable exposures is a theme that emerges in a variety of contexts when assessing market movements of the fourth quarter. Another area in which valuable lessons were learned is the importance of having hedging instruments available for the full range of risks that are being assumed through product offerings. Banks have reported that liquidity dried up in some instruments they were depending upon for hedging. This forced them into proxy hedging strategies using instruments that inevitably exposed them to basis risk. As I noted earlier, the availability of hedging instruments has been key to the growth and the broad product line that is found in OTC markets. Events of the last year may, however, have highlighted the fact that some dealers are not thinking carefully and critically enough about the ways they are going to hedge the risks assumed in various lines of business. In this area also, the theme of the availability of liquidity emerges. The final area related to the lessons of Asia that I would like to touch on is that old-fashioned topic of concentrations of credit risk. The turmoil in Asian markets has clearly provided a test of the risk management processes associated with derivatives dealing. But at the end of the day, the lessons to be learned may be related less to derivatives themselves than to why dealers analyze credit risk and view diversification. Prices moved dramatically and market risk became credit exposures. These events raised the sensitivity of bank management to the potentially high correlation between credit exposures and the probability of counterparty default during stressful times. At a minimum, they illustrate the importance of diversification in all lines of business and the need to view diversification in the broadest context. Despite the fact that I think there are numerous improvements dealers could make to their risk management systems, I do not want to end with the impression that derivatives dealers and their systems somehow failed this test of market volatility. Systems generally performed well. The very conduct of a post mortem, after all, demonstrates the basic quality of existing procedures and systems. That said, however, we should not forego the opportunity to learn from the events and possibly strengthen systems even further. Looking to the future, the lessons of Asia provide sign posts for the areas of risk management in which work by both market participants and supervisors is likely to be concentrated. Volatility, after all, usually leads to innovations to help deal with it. Credit risk management emerged as one theme in assessments of the Asian volatility. A reassessment of liquidity risk was another. An emphasis on the infrastructure of the market no doubt will continue as well. Firms already were working upon ways to apply techniques developed for the management of market risk in the context of credit risk. Supervisors also were evaluating the potential for applying such an internal models approach to the determination of regulatory capital requirements for credit risk. Events in Asia highlight not only the promise of such approaches but also the hurdles that must be overcome if their potential is to be realized. Once one recognizes the correlation between market risk and credit risk, the next step is a consideration of a global approach to risk management and the possibility of extending an internal models approach beyond market risk. The application of that approach implies, however, that prices can be obtained from thin markets and used effectively in risk measurement. As we continue to pursue new approaches to credit risk management, the basic questions arise again and again: Are data and techniques for revaluing positions available? Can acceptable risk measurement models be developed? Are hedging vehicles available? These questions represent hurdles that must be jumped. They will not necessarily be easy, but neither were other hurdles that this industry has overcome. Another theme that emerges is liquidity risk. A fundamental assumption of many risk management procedures is the ability to get out of a position or to hedge it. Events in Asia demonstrated once again that assumptions about liquidity in normal markets rarely hold in more volatile ones. This argues both for a reassessment of the assumptions themselves and for more careful and fundamental thinking about liquidity risk in risk management procedures. At the outset of my remarks, I noted my appreciation for infrastructure developments as a foundation for the growth of the market. Certainly, their importance is unlikely to diminish in the near term. Market participants generally have an appreciation for potential legal risk but continuing reassessment is valuable. Episodes of volatility give some counterparties strong incentives to try to walk away from losing contracts. Such events indicate areas where further legal work may be necessary to ensure that the market's infrastructure remains sound. The industry has had a phenomenal record of growth and innovation over the past few years, but plenty of work remains to be done over the next few years. Many of the issues to be faced are not easy. However, I have no doubt that the energy, creativity, and competitive spirit of the industry will ensure that these issues are dealt with and that the future of OTC derivatives is a bright one. The leadership role that ISDA has played in the past will undoubtedly be called upon in the future.
1998-04-02T00:00:00	Mr. Greenspan discusses the ascendance of market capitalism (Central Bank Articles and Speeches, 2 Apr 98)	Remarks by Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Annual Convention of the American Society of Newspaper Editors held in Washington, D.C. on 2/4/98.	Mr. Greenspan discusses the ascendance of market capitalism Remarks by Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Annual Convention of the American Society of Newspaper Editors held in Washington, D.C. on 2/4/98. The Ascendance of Market Capitalism The current turmoil in East Asia is easy to categorize as one of many such crises over the decades. Nonetheless, it appears to be an important milestone in what evidently has been a significant and seemingly inexorable trend toward market capitalism and political systems that stress the rule of law. The shifts have been gradual but persistent. Markets today are responding far more rapidly to subtle changes in consumers' values and choices than ever before. While advancing technology has always been a factor sensitizing markets to changing consumer tastes, what is so striking in recent years is how pervasive that force has become. Just-in-time inventory systems have enabled production to more rapidly adjust to changing consumption. Satellite coordinated trucking moves goods to destinations of optimal use. Bar coding has facilitated a major revolution in retailing. For supermarkets, for example, checkout scanning devices have facilitated the creation of a variety of wares reflecting the most current consumer wants. Those producers who cannot keep up with this technologically driven surge to efficiency fall by the wayside. Those exceptionally skilled in advanced engineering and computer programming, for example, are rewarded with significantly higher levels of income relative to the less facile. It is difficult to prove, but arguably luck, the great random leveler in the market place, appears to play an ever smaller role in determining success and failure in today's just-in-time, high quality, productive systems. Those systems appear to be especially rewarding to financial skills. The advent of computer and telecommunications technology has spawned a vast proliferation of new financial derivatives products crafted by mathematicians and finance technicians who had never previously found favor on either Wall or Lombard Streets. The above-average earnings they receive reflect the increasing value added created by financial institutions, which, in turn, results from their enhanced ability to marshal savings to support investment in the most productive physical capital. Not unexpectedly, as the share of Gross Domestic Product has shifted persistently to conceptual products and services from those requiring physical brawn to produce, the wage premium for skills and education has risen significantly, especially during the past two decades. As one might surmise, the shift arguably has led to the sharply higher college enrollments that we see here in the United States and elsewhere. But the resulting increased supply of skills has apparently generally not been sufficient to offset the increasing demand, as net returns to education, at least until quite recently, have continued to rise. Left to its own devices, this new high-tech competitive system appears to exhibit little leeway for inefficiency. Inefficiencies expose potential unexploited profit opportunities, that in full, open, and effectively competitive markets induce new resources to be brought to bear to eliminate bottlenecks and other, less than optimum, uses of capital. Of course, little of this is new. Market economies have succeeded over the centuries by thoroughly weeding out the inefficient and poorly equipped, and by granting rewards to those who could anticipate consumer demand and meet it with minimum use of labor and capital resources. But the newer technologies are goading this process. For good or ill, an unforgiving capitalist process is driving wealth creation. It has become increasingly difficult for policymakers who wish to practice, as they put it, a more "caring" capitalism to realize the full potential of their economies. Their choices have become limited. To the extent they block themselves or portions of their population from what they perceive as harsh competitive pressures, they must accept a lower average standard of living for their populace. As a consequence, increasingly, nations appear to be opting to open themselves to competition, however harsh, and become producers that can compete in world markets. Not irrelevant to the choice is that major advances in telecommunications have made it troublesome for politicians and policymakers to go too far in pre-empting market forces when the material affluence of market-based economies has become so evident to ubiquitous television watchers, their constituents, around the world. It was not always thus. In the first decades following World War II, before the advent of significant advances in computer and telecommunications technologies, market economies appeared less daunting. Adjustments were slower. International trade comprised a far smaller share of domestic economies. Tariff walls blocked out competition, and capital controls often constrained cross-border currency flows. In retrospect, the economic environment appeared less competitive, more tranquil, and certainly less threatening to those with only moderate or lesser skills. Indeed, before computer technology automated many repetitive tasks, the unskilled were able to contribute significant value added and earn a respectable wage relative to the skilled. In this less demanding world, governments were able to construct social safety nets and engaged in policies intended to redistribute income. Even though such initiatives often were recognized as adding substantial cost to labor and product markets, and thereby reducing their flexibility, they were not judged as meaningful impediments to economic growth. In economies not broadly subject to international trade, competition was not as punishing to the less efficient as it is today. To be sure, average standards of living were less than they could have been, and the composition of output was far less sensitive to changing consumer tastes than is the case in today's high-tech environment. There is clearly a significant segment of society that looks back at that period with affectionate nostalgia. But maintaining the kind of safety net that, for example, is prevalent in most continental European countries where high unemployment appears chronic is proving increasingly problematic in today's altered environment. Governments of all persuasions still may choose to help people acquire the skills they need to utilize new technologies. And they generally endeavor to support the incomes of those who have been less able to adapt. But technology and competition are extracting a high price for the more intrusive forms of intervention that impair market incentives to work, save, invest, and innovate. International competitive pressures are narrowing the choices for economies with broad safety nets: the choice of accepting shortfalls in standards of living, relative to the less burdened economies, or loosening the social safety net and acquiescing in the greater concentrations of income that seem to be associated with our high-tech environment. Erecting trade barriers to shut off cross-border competition leads to the loss of the great advantages of the international division of labor and cannot be considered a realistic alternative for societies choosing to realize the full benefits of technological advances. Fortunately, for the moment at least, there appears limited sentiment in Europe or elsewhere to move in that direction. Clearly, the synergies of transistor, laser, and satellite technologies have created a computer and telecommunications revolution over the last half century that is altering the way people interact with each other and with their institutions. We are adding to our knowledge of which economic and political systems contribute to welfare and wealth and which do not. This process, of course, has been ongoing especially since the advent of the Industrial Revolution when the emergence of significant wealth creation first offered meaningful alternatives. But in the post World War II years most of what had been open to conjecture and debate throughout the nineteenth century and first half of the twentieth, is gradually being settled by the sharp realities of recent experience. I am not alleging that the human race is about to irreversibly accept market capitalism as the only relevant form of economic and social organization and that this great debate is over. There remains a large segment of the population that still considers capitalism and its emphasis on materialism, in all its forms, degrading to man's spiritual nature. In addition, even some of those who seek material welfare, view competitive markets as subject to manipulation by mass promotion and advertising that drives consumers to desire and seek superficial and ephemeral values. Some governments even now attempt to override the evident preferences of their citizens, by limiting their access to foreign media because they judge such media will undermine their culture. Finally, there remains a latent protectionism, in the United States and elsewhere, which could emerge as a potent force against globalization should the current high-tech world economy falter. Moreover, I certainly have no doubt that in the event of problems in today's new, more Spencerian, form of capitalism, governments would increase their interventions in an endeavor to alter market results. And, as history amply demonstrates, most recently in East Asia, market -- or mostly market -- systems can produce crises that tempt government intervention. Such crises arise on occasion when confidence unexpectedly fails and is replaced by fear and a loss of trust, inducing a vicious cycle of retrenchment in economic activity and government endeavors to counter it. Nonetheless, in light of the record of failures of intrusive intervention over recent decades, it is difficult to imagine such activism persisting much beyond any immediate crisis. The history of the twentieth century has been a testing ground for innumerable theories of social and economic organization that have been tried and found wanting. The way people respond to incentives and rewards persists from generation to generation suggesting a deeply imbedded set of stabilities in human nature. We see this, for example, in remarkable consistencies in the behavior of markets over time. Nonetheless, history is strewn with examples of economic and social systems that have tried to counter, or alter, human nature and failed. Despite an unrelenting effort over more than seven decades, the system in the Soviet Union was unable to mold human responses to fit the Soviet view of human destiny and how society should be organized. The post mortem of what went wrong clearly exposed the fatal flaws as internal to the system, and not the result of external forces, although the arms race may have hastened the process. The lesson that appears to be emerging is that only free market systems exhibit the flexibility and robustness to accommodate human nature and harness rapidly advancing technology to consistently advance living standards. To get a better sense of the forces that are driving the world's economies, especially in the second half of the twentieth century, it is useful to understand why the Soviet experiment in central planning failed. Indeed, it is not an exaggeration to state that from this failure we have learned as much about why our free capitalist systems work, as about why central planning does not. The Soviet economic failure was so unambiguous that it proffered a new set of standards to better gauge alternative economic paradigms. It, for example, afforded us a far better understanding of why some of the mercantilistic capitalist economies of East Asia worked for awhile but then did not. Centrally planned economic systems, such as that which existed in the Soviet Union, had great difficulty in creating wealth and rising standards of living. In theory, and to a large extent in practice, production and distribution were determined by specific instructions -- often in the form of state orders -- coming from the central planning agencies to the various different producing establishments, indicating from whom, and in what quantities, they should receive their raw materials and services, and to whom they should distribute their final outputs. Without an effective market clearing mechanism, the consequences of such a paradigm, as one might readily anticipate, were both huge surpluses of goods that were not wanted by the populace, and huge shortages of products that consumers desired, but were not produced in adequate quantities. The imbalance of demand over supply of these latter products inevitably required rationing or its equivalent -- standing in queues for limited quantities of goods and services. One might think that the planning authorities should have been able to adjust to these distortions. They tried. But they faced insurmountable handicaps in that they did not have access to the immediate signals of price changes that so effectively facilitate the clearing of markets in capitalist economies. Movements in prices give incentives to adjust the allocation of physical resources to accommodate the changing technology of production and the shifting tastes of consumers. Among the key prices central planning systems lacked were the signals of finance -equity values and the broad array of interest rates. In a centrally planned system, finance plays a decidedly minor role. Since the production and distribution of goods and services are essentially driven by state orders and rationing, finance amounts to little more than a system for record keeping. While there are pro-forma payment transfers among state-owned enterprises, few if any actions are driven by them. Payment arrears, or even defaults, are largely irrelevant in the sense that they are essentially intra-company transactions among enterprises owned by the same entity, that is, the state. Under central planning there are no credit standards, no interest rate risks, no market value changes -- none of the key financial signals that determine in a market economy who gets credit and who does not, and hence who produces what and sells to whom. In short, none of the financial infrastructure that converts the changing valuations of consumers and shifting efficiencies of capital equipment into market signals that direct production for profit is available. But it didn't matter in the Soviet-bloc economies. Few decisions in those centrally planned systems were affected by the lack of a developed financial system. Regrettably, until the Berlin Wall was breached in 1989, and the need to develop market economies out of the rubble of Eastern Europe's central planning regime became apparent, little contemporary thought had been given to the institutional infrastructure required of markets. In the West, that infrastructure had developed pragmatically, interacting with, and facilitating the evolution of, the markets themselves. In the years immediately following the fall of the Berlin Wall, many of the states of the former Soviet bloc did get something akin to a market system in the form of a rapid growth of black markets that replicated some of what seemingly goes on in a market economy. But only in part. Black markets, by definition, are not supported by the rule of law. There are no rights to own and dispose of property protected by the enforcement power of the state. There are no laws of contract or bankruptcy, or judicial review and determination again enforced by the state. The essential infrastructure of a market economy is missing. Black markets offer few of the benefits of legally sanctioned trade. To know that the state will protect one's rights to property will encourage the taking of risks that create wealth and foster growth. Few will risk their capital, however, if there is little assurance that the rewards of risk are secure from the arbitrary actions of government, or street mobs. Indeed, the presumption of property ownership and the legality of its transfer must be deeply embedded in the culture of a society for free market economies to function effectively. In capitalist societies, and especially under British common law and its derivatives, the moral validity of property rights is accepted, or at least acquiesced in, by virtually the whole of the population. Accordingly, a negligible proportion of commercial contracts has to be adjudicated through the courts. If it were otherwise, the system could not function. Most other rights that we Americans and others cherish -- protection against extralegal violence or intimidation by the state, confiscation of property without due process, as well as freedom of speech and of the press, and an absence of discrimination -- are all essential to a fully effective, functioning market system. Indeed a list or bill of rights enforced by an impartial judiciary is, and I hesitate to use the analogy, what substitutes for the central planning function as the guiding mechanism of a free market economy. It is these "rights" that enable the value judgements of millions of consumers to be converted through a legally protected free market into prices of products and financial instruments; and it is, of course, these market prices that substitute for the state orders of the centrally planned economies. The increasing recognition of a rule of law and its associated rights as being indispensable to an effective functioning market system, is pressuring political leaders to a greater acceptance of that framework. Economic necessity appears to be functioning, but not in the way Karl Marx contemplated. The broad acceptance of market economics -- and the political rights associated with it -- is impressive. Clearly, not all states protect the right of private property with the same fervor. Indeed, they vary widely. Nor is it the case that all societies with firmly protected property rights bend invariably to the majority will of the populace on all public issues. But the pressures to meld democracy and property rights appear persistent. Centrally planned economies tend to be frozen in time. They cannot readily accommodate innovation, new ideas, new products, and altered specifications. In sharp contrast, market economies are driven by what Professor Joseph Schumpeter, a number of decades ago, called "creative destruction". By this he meant newer ways of doing things, newer products, and novel engineering and architectural insights that induce the continuous obsolescence and retirement of factories and equipment and a reshuffling of workers to new and different activities. Market economies in that sense are continuously renewing themselves. Innovation, risk-taking, and competition are the driving forces that propel standards of living progressively higher. The bold, if unintended, experiment in economic and social systems, which began after World War II in Europe, did not come to a full resting place with the fall of the Berlin Wall in 1989. Despite the ebb and flow of governments of differing persuasions, the face of the world economy continues to edge evermore toward free market-oriented societies. It is true in Eastern Europe, Latin America, and Asia. Even many of the socialistic economies of Africa are embracing free market capitalism. The current crisis in East Asia is likely to hasten that trend as hard-learned lessons of economic structure lead to significant reform. The economies in crisis did not use central planning of the pervasive Soviet Union style. They relied on markets in most respects, but they also used elements of central planning in the form of credit allocation, and those elements, in my view, turned out to be their Achilles heel. The crises have their roots in the endeavor of some East Asian countries to open up their economies to world competition, while still mandating a significant proportion of their output through government directives. It is, of course, possible for a time to clear a market through central planning, albeit at a lower standard of living, by restricting alternatives available to a population as the Soviet system demonstrated. It is also possible to clear the market through the free play of competitive forces with consumers' choices governing what is produced. A market will not readily clear and achieve stability, except by chance, however, if consumers are largely free to choose, but production is set significantly by government directives. For it is only by chance that governments, meaning planning agencies, can successfully gauge the rapidly changing tastes of consumers and evolving technologies of production. It is much too difficult a task. Only sophisticated market mechanisms can do that. Partial planning of the sort practiced by some East Asian countries can look very successful for a time because they started from a low technological base and had sufficient flexibility to allow business units to borrow the more advanced technology of the fully market economies. But there are limits to this process as economies mature. Many Asian policymakers are learning that government-directed investments, backed by government inducements to banks to finance them, can lead to substantial gains in output for a number of years in economies with low real wages and low productivity (as it did in the Soviet Union). Eventually and inevitably, however, such a regime leads to establish facilities that produce goods and services that domestic consumers and export customers apparently no longer want. The consequent losses to companies, and the resultant buildup of nonperforming bank loans, hobble financial intermediation and the economy. There has been, to be sure, much pain and periodic backtracking among a number of the nations that discarded the mantle of some forms of central planning or mercantilist capitalism. There will doubtless be more. But as a consequence of the experience of the last half century, market capitalism has clearly become ascendant, at least for now. Advancing technologies have spurred the competitive forces of the market to accelerate the rise in consumer wealth and living standards. So long as material well being holds a high priority in a nation's value system, the persistence of technological advance should foster this process. If we can continue to adapt to our new frenetic high tech economy, that is not a bad prospect for the next century.	---[PAGE_BREAK]--- Mr. Greenspan discusses the ascendance of market capitalism Remarks by Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Annual Convention of the American Society of Newspaper Editors held in Washington, D.C. on $2 / 4 / 98$. # The Ascendance of Market Capitalism The current turmoil in East Asia is easy to categorize as one of many such crises over the decades. Nonetheless, it appears to be an important milestone in what evidently has been a significant and seemingly inexorable trend toward market capitalism and political systems that stress the rule of law. The shifts have been gradual but persistent. Markets today are responding far more rapidly to subtle changes in consumers' values and choices than ever before. While advancing technology has always been a factor sensitizing markets to changing consumer tastes, what is so striking in recent years is how pervasive that force has become. Just-in-time inventory systems have enabled production to more rapidly adjust to changing consumption. Satellite coordinated trucking moves goods to destinations of optimal use. Bar coding has facilitated a major revolution in retailing. For supermarkets, for example, checkout scanning devices have facilitated the creation of a variety of wares reflecting the most current consumer wants. Those producers who cannot keep up with this technologically driven surge to efficiency fall by the wayside. Those exceptionally skilled in advanced engineering and computer programming, for example, are rewarded with significantly higher levels of income relative to the less facile. It is difficult to prove, but arguably luck, the great random leveler in the market place, appears to play an ever smaller role in determining success and failure in today's just-in-time, high quality, productive systems. Those systems appear to be especially rewarding to financial skills. The advent of computer and telecommunications technology has spawned a vast proliferation of new financial derivatives products crafted by mathematicians and finance technicians who had never previously found favor on either Wall or Lombard Streets. The above-average earnings they receive reflect the increasing value added created by financial institutions, which, in turn, results from their enhanced ability to marshal savings to support investment in the most productive physical capital. Not unexpectedly, as the share of Gross Domestic Product has shifted persistently to conceptual products and services from those requiring physical brawn to produce, the wage premium for skills and education has risen significantly, especially during the past two decades. As one might surmise, the shift arguably has led to the sharply higher college enrollments that we see here in the United States and elsewhere. But the resulting increased supply of skills has apparently generally not been sufficient to offset the increasing demand, as net returns to education, at least until quite recently, have continued to rise. Left to its own devices, this new high-tech competitive system appears to exhibit little leeway for inefficiency. Inefficiencies expose potential unexploited profit opportunities, that in full, open, and effectively competitive markets induce new resources to be brought to bear to eliminate bottlenecks and other, less than optimum, uses of capital. Of course, little of this is new. Market economies have succeeded over the centuries by thoroughly weeding out the inefficient and poorly equipped, and by granting rewards to those who could anticipate consumer demand and meet it with minimum use of labor and capital resources. But the newer technologies are goading this process. For good or ill, an unforgiving capitalist process is driving wealth creation. It has become increasingly difficult for policymakers who wish to practice, as they put it, a more "caring" capitalism to realize the full potential of their economies. ---[PAGE_BREAK]--- Their choices have become limited. To the extent they block themselves or portions of their population from what they perceive as harsh competitive pressures, they must accept a lower average standard of living for their populace. As a consequence, increasingly, nations appear to be opting to open themselves to competition, however harsh, and become producers that can compete in world markets. Not irrelevant to the choice is that major advances in telecommunications have made it troublesome for politicians and policymakers to go too far in pre-empting market forces when the material affluence of market-based economies has become so evident to ubiquitous television watchers, their constituents, around the world. It was not always thus. In the first decades following World War II, before the advent of significant advances in computer and telecommunications technologies, market economies appeared less daunting. Adjustments were slower. International trade comprised a far smaller share of domestic economies. Tariff walls blocked out competition, and capital controls often constrained cross-border currency flows. In retrospect, the economic environment appeared less competitive, more tranquil, and certainly less threatening to those with only moderate or lesser skills. Indeed, before computer technology automated many repetitive tasks, the unskilled were able to contribute significant value added and earn a respectable wage relative to the skilled. In this less demanding world, governments were able to construct social safety nets and engaged in policies intended to redistribute income. Even though such initiatives often were recognized as adding substantial cost to labor and product markets, and thereby reducing their flexibility, they were not judged as meaningful impediments to economic growth. In economies not broadly subject to international trade, competition was not as punishing to the less efficient as it is today. To be sure, average standards of living were less than they could have been, and the composition of output was far less sensitive to changing consumer tastes than is the case in today's high-tech environment. There is clearly a significant segment of society that looks back at that period with affectionate nostalgia. But maintaining the kind of safety net that, for example, is prevalent in most continental European countries where high unemployment appears chronic is proving increasingly problematic in today's altered environment. Governments of all persuasions still may choose to help people acquire the skills they need to utilize new technologies. And they generally endeavor to support the incomes of those who have been less able to adapt. But technology and competition are extracting a high price for the more intrusive forms of intervention that impair market incentives to work, save, invest, and innovate. International competitive pressures are narrowing the choices for economies with broad safety nets: the choice of accepting shortfalls in standards of living, relative to the less burdened economies, or loosening the social safety net and acquiescing in the greater concentrations of income that seem to be associated with our high-tech environment. Erecting trade barriers to shut off cross-border competition leads to the loss of the great advantages of the international division of labor and cannot be considered a realistic alternative for societies choosing to realize the full benefits of technological advances. Fortunately, for the moment at least, there appears limited sentiment in Europe or elsewhere to move in that direction. Clearly, the synergies of transistor, laser, and satellite technologies have created a computer and telecommunications revolution over the last half century that is altering the way people interact with each other and with their institutions. We are adding to our knowledge of which economic and political systems contribute to welfare and wealth and which do not. This process, of course, has been ongoing especially since the advent of the Industrial Revolution when the emergence of significant wealth creation first offered meaningful alternatives. But in the post World War II years most of what had been open to conjecture and debate throughout the nineteenth century and first half of the twentieth, is gradually being settled by the sharp realities of recent experience. ---[PAGE_BREAK]--- I am not alleging that the human race is about to irreversibly accept market capitalism as the only relevant form of economic and social organization and that this great debate is over. There remains a large segment of the population that still considers capitalism and its emphasis on materialism, in all its forms, degrading to man's spiritual nature. In addition, even some of those who seek material welfare, view competitive markets as subject to manipulation by mass promotion and advertising that drives consumers to desire and seek superficial and ephemeral values. Some governments even now attempt to override the evident preferences of their citizens, by limiting their access to foreign media because they judge such media will undermine their culture. Finally, there remains a latent protectionism, in the United States and elsewhere, which could emerge as a potent force against globalization should the current high-tech world economy falter. Moreover, I certainly have no doubt that in the event of problems in today's new, more Spencerian, form of capitalism, governments would increase their interventions in an endeavor to alter market results. And, as history amply demonstrates, most recently in East Asia, market -- or mostly market -- systems can produce crises that tempt government intervention. Such crises arise on occasion when confidence unexpectedly fails and is replaced by fear and a loss of trust, inducing a vicious cycle of retrenchment in economic activity and government endeavors to counter it. Nonetheless, in light of the record of failures of intrusive intervention over recent decades, it is difficult to imagine such activism persisting much beyond any immediate crisis. The history of the twentieth century has been a testing ground for innumerable theories of social and economic organization that have been tried and found wanting. The way people respond to incentives and rewards persists from generation to generation suggesting a deeply imbedded set of stabilities in human nature. We see this, for example, in remarkable consistencies in the behavior of markets over time. Nonetheless, history is strewn with examples of economic and social systems that have tried to counter, or alter, human nature and failed. Despite an unrelenting effort over more than seven decades, the system in the Soviet Union was unable to mold human responses to fit the Soviet view of human destiny and how society should be organized. The post mortem of what went wrong clearly exposed the fatal flaws as internal to the system, and not the result of external forces, although the arms race may have hastened the process. The lesson that appears to be emerging is that only free market systems exhibit the flexibility and robustness to accommodate human nature and harness rapidly advancing technology to consistently advance living standards. To get a better sense of the forces that are driving the world's economies, especially in the second half of the twentieth century, it is useful to understand why the Soviet experiment in central planning failed. Indeed, it is not an exaggeration to state that from this failure we have learned as much about why our free capitalist systems work, as about why central planning does not. The Soviet economic failure was so unambiguous that it proffered a new set of standards to better gauge alternative economic paradigms. It, for example, afforded us a far better understanding of why some of the mercantilistic capitalist economies of East Asia worked for awhile but then did not. Centrally planned economic systems, such as that which existed in the Soviet Union, had great difficulty in creating wealth and rising standards of living. In theory, and to a large extent in practice, production and distribution were determined by specific instructions -- often in the form of state orders -- coming from the central planning agencies to the various different producing establishments, indicating from whom, and in what quantities, they should receive their raw materials and services, and to whom they should distribute their final outputs. ---[PAGE_BREAK]--- Without an effective market clearing mechanism, the consequences of such a paradigm, as one might readily anticipate, were both huge surpluses of goods that were not wanted by the populace, and huge shortages of products that consumers desired, but were not produced in adequate quantities. The imbalance of demand over supply of these latter products inevitably required rationing or its equivalent -- standing in queues for limited quantities of goods and services. One might think that the planning authorities should have been able to adjust to these distortions. They tried. But they faced insurmountable handicaps in that they did not have access to the immediate signals of price changes that so effectively facilitate the clearing of markets in capitalist economies. Movements in prices give incentives to adjust the allocation of physical resources to accommodate the changing technology of production and the shifting tastes of consumers. Among the key prices central planning systems lacked were the signals of finance -equity values and the broad array of interest rates. In a centrally planned system, finance plays a decidedly minor role. Since the production and distribution of goods and services are essentially driven by state orders and rationing, finance amounts to little more than a system for record keeping. While there are pro-forma payment transfers among state-owned enterprises, few if any actions are driven by them. Payment arrears, or even defaults, are largely irrelevant in the sense that they are essentially intra-company transactions among enterprises owned by the same entity, that is, the state. Under central planning there are no credit standards, no interest rate risks, no market value changes -- none of the key financial signals that determine in a market economy who gets credit and who does not, and hence who produces what and sells to whom. In short, none of the financial infrastructure that converts the changing valuations of consumers and shifting efficiencies of capital equipment into market signals that direct production for profit is available. But it didn't matter in the Soviet-bloc economies. Few decisions in those centrally planned systems were affected by the lack of a developed financial system. Regrettably, until the Berlin Wall was breached in 1989, and the need to develop market economies out of the rubble of Eastern Europe's central planning regime became apparent, little contemporary thought had been given to the institutional infrastructure required of markets. In the West, that infrastructure had developed pragmatically, interacting with, and facilitating the evolution of, the markets themselves. In the years immediately following the fall of the Berlin Wall, many of the states of the former Soviet bloc did get something akin to a market system in the form of a rapid growth of black markets that replicated some of what seemingly goes on in a market economy. But only in part. Black markets, by definition, are not supported by the rule of law. There are no rights to own and dispose of property protected by the enforcement power of the state. There are no laws of contract or bankruptcy, or judicial review and determination again enforced by the state. The essential infrastructure of a market economy is missing. Black markets offer few of the benefits of legally sanctioned trade. To know that the state will protect one's rights to property will encourage the taking of risks that create wealth and foster growth. Few will risk their capital, however, if there is little assurance that the rewards of risk are secure from the arbitrary actions of government, or street mobs. Indeed, the presumption of property ownership and the legality of its transfer must be deeply embedded in the culture of a society for free market economies to function effectively. In capitalist societies, and especially under British common law and its derivatives, the moral validity of property rights is accepted, or at least acquiesced in, by virtually the whole of the population. ---[PAGE_BREAK]--- Accordingly, a negligible proportion of commercial contracts has to be adjudicated through the courts. If it were otherwise, the system could not function. Most other rights that we Americans and others cherish -- protection against extralegal violence or intimidation by the state, confiscation of property without due process, as well as freedom of speech and of the press, and an absence of discrimination -- are all essential to a fully effective, functioning market system. Indeed a list or bill of rights enforced by an impartial judiciary is, and I hesitate to use the analogy, what substitutes for the central planning function as the guiding mechanism of a free market economy. It is these "rights" that enable the value judgements of millions of consumers to be converted through a legally protected free market into prices of products and financial instruments; and it is, of course, these market prices that substitute for the state orders of the centrally planned economies. The increasing recognition of a rule of law and its associated rights as being indispensable to an effective functioning market system, is pressuring political leaders to a greater acceptance of that framework. Economic necessity appears to be functioning, but not in the way Karl Marx contemplated. The broad acceptance of market economics -- and the political rights associated with it -- is impressive. Clearly, not all states protect the right of private property with the same fervor. Indeed, they vary widely. Nor is it the case that all societies with firmly protected property rights bend invariably to the majority will of the populace on all public issues. But the pressures to meld democracy and property rights appear persistent. Centrally planned economies tend to be frozen in time. They cannot readily accommodate innovation, new ideas, new products, and altered specifications. In sharp contrast, market economies are driven by what Professor Joseph Schumpeter, a number of decades ago, called "creative destruction". By this he meant newer ways of doing things, newer products, and novel engineering and architectural insights that induce the continuous obsolescence and retirement of factories and equipment and a reshuffling of workers to new and different activities. Market economies in that sense are continuously renewing themselves. Innovation, risk-taking, and competition are the driving forces that propel standards of living progressively higher. The bold, if unintended, experiment in economic and social systems, which began after World War II in Europe, did not come to a full resting place with the fall of the Berlin Wall in 1989. Despite the ebb and flow of governments of differing persuasions, the face of the world economy continues to edge evermore toward free market-oriented societies. It is true in Eastern Europe, Latin America, and Asia. Even many of the socialistic economies of Africa are embracing free market capitalism. The current crisis in East Asia is likely to hasten that trend as hard-learned lessons of economic structure lead to significant reform. The economies in crisis did not use central planning of the pervasive Soviet Union style. They relied on markets in most respects, but they also used elements of central planning in the form of credit allocation, and those elements, in my view, turned out to be their Achilles heel. The crises have their roots in the endeavor of some East Asian countries to open up their economies to world competition, while still mandating a significant proportion of their output through government directives. It is, of course, possible for a time to clear a market through central planning, albeit at a lower standard of living, by restricting alternatives available to a population as ---[PAGE_BREAK]--- the Soviet system demonstrated. It is also possible to clear the market through the free play of competitive forces with consumers' choices governing what is produced. A market will not readily clear and achieve stability, except by chance, however, if consumers are largely free to choose, but production is set significantly by government directives. For it is only by chance that governments, meaning planning agencies, can successfully gauge the rapidly changing tastes of consumers and evolving technologies of production. It is much too difficult a task. Only sophisticated market mechanisms can do that. Partial planning of the sort practiced by some East Asian countries can look very successful for a time because they started from a low technological base and had sufficient flexibility to allow business units to borrow the more advanced technology of the fully market economies. But there are limits to this process as economies mature. Many Asian policymakers are learning that government-directed investments, backed by government inducements to banks to finance them, can lead to substantial gains in output for a number of years in economies with low real wages and low productivity (as it did in the Soviet Union). Eventually and inevitably, however, such a regime leads to establish facilities that produce goods and services that domestic consumers and export customers apparently no longer want. The consequent losses to companies, and the resultant buildup of nonperforming bank loans, hobble financial intermediation and the economy. There has been, to be sure, much pain and periodic backtracking among a number of the nations that discarded the mantle of some forms of central planning or mercantilist capitalism. There will doubtless be more. But as a consequence of the experience of the last half century, market capitalism has clearly become ascendant, at least for now. Advancing technologies have spurred the competitive forces of the market to accelerate the rise in consumer wealth and living standards. So long as material well being holds a high priority in a nation's value system, the persistence of technological advance should foster this process. If we can continue to adapt to our new frenetic high tech economy, that is not a bad prospect for the next century.	Alan Greenspan	United States	https://www.bis.org/review/r980417c.pdf	Mr. Greenspan discusses the ascendance of market capitalism Remarks by Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Annual Convention of the American Society of Newspaper Editors held in Washington, D.C. on $2 / 4 / 98$. The current turmoil in East Asia is easy to categorize as one of many such crises over the decades. Nonetheless, it appears to be an important milestone in what evidently has been a significant and seemingly inexorable trend toward market capitalism and political systems that stress the rule of law. The shifts have been gradual but persistent. Markets today are responding far more rapidly to subtle changes in consumers' values and choices than ever before. While advancing technology has always been a factor sensitizing markets to changing consumer tastes, what is so striking in recent years is how pervasive that force has become. Just-in-time inventory systems have enabled production to more rapidly adjust to changing consumption. Satellite coordinated trucking moves goods to destinations of optimal use. Bar coding has facilitated a major revolution in retailing. For supermarkets, for example, checkout scanning devices have facilitated the creation of a variety of wares reflecting the most current consumer wants. Those producers who cannot keep up with this technologically driven surge to efficiency fall by the wayside. Those exceptionally skilled in advanced engineering and computer programming, for example, are rewarded with significantly higher levels of income relative to the less facile. It is difficult to prove, but arguably luck, the great random leveler in the market place, appears to play an ever smaller role in determining success and failure in today's just-in-time, high quality, productive systems. Those systems appear to be especially rewarding to financial skills. The advent of computer and telecommunications technology has spawned a vast proliferation of new financial derivatives products crafted by mathematicians and finance technicians who had never previously found favor on either Wall or Lombard Streets. The above-average earnings they receive reflect the increasing value added created by financial institutions, which, in turn, results from their enhanced ability to marshal savings to support investment in the most productive physical capital. Not unexpectedly, as the share of Gross Domestic Product has shifted persistently to conceptual products and services from those requiring physical brawn to produce, the wage premium for skills and education has risen significantly, especially during the past two decades. As one might surmise, the shift arguably has led to the sharply higher college enrollments that we see here in the United States and elsewhere. But the resulting increased supply of skills has apparently generally not been sufficient to offset the increasing demand, as net returns to education, at least until quite recently, have continued to rise. Left to its own devices, this new high-tech competitive system appears to exhibit little leeway for inefficiency. Inefficiencies expose potential unexploited profit opportunities, that in full, open, and effectively competitive markets induce new resources to be brought to bear to eliminate bottlenecks and other, less than optimum, uses of capital. Of course, little of this is new. Market economies have succeeded over the centuries by thoroughly weeding out the inefficient and poorly equipped, and by granting rewards to those who could anticipate consumer demand and meet it with minimum use of labor and capital resources. But the newer technologies are goading this process. For good or ill, an unforgiving capitalist process is driving wealth creation. It has become increasingly difficult for policymakers who wish to practice, as they put it, a more "caring" capitalism to realize the full potential of their economies. Their choices have become limited. To the extent they block themselves or portions of their population from what they perceive as harsh competitive pressures, they must accept a lower average standard of living for their populace. As a consequence, increasingly, nations appear to be opting to open themselves to competition, however harsh, and become producers that can compete in world markets. Not irrelevant to the choice is that major advances in telecommunications have made it troublesome for politicians and policymakers to go too far in pre-empting market forces when the material affluence of market-based economies has become so evident to ubiquitous television watchers, their constituents, around the world. It was not always thus. In the first decades following World War II, before the advent of significant advances in computer and telecommunications technologies, market economies appeared less daunting. Adjustments were slower. International trade comprised a far smaller share of domestic economies. Tariff walls blocked out competition, and capital controls often constrained cross-border currency flows. In retrospect, the economic environment appeared less competitive, more tranquil, and certainly less threatening to those with only moderate or lesser skills. Indeed, before computer technology automated many repetitive tasks, the unskilled were able to contribute significant value added and earn a respectable wage relative to the skilled. In this less demanding world, governments were able to construct social safety nets and engaged in policies intended to redistribute income. Even though such initiatives often were recognized as adding substantial cost to labor and product markets, and thereby reducing their flexibility, they were not judged as meaningful impediments to economic growth. In economies not broadly subject to international trade, competition was not as punishing to the less efficient as it is today. To be sure, average standards of living were less than they could have been, and the composition of output was far less sensitive to changing consumer tastes than is the case in today's high-tech environment. There is clearly a significant segment of society that looks back at that period with affectionate nostalgia. But maintaining the kind of safety net that, for example, is prevalent in most continental European countries where high unemployment appears chronic is proving increasingly problematic in today's altered environment. Governments of all persuasions still may choose to help people acquire the skills they need to utilize new technologies. And they generally endeavor to support the incomes of those who have been less able to adapt. But technology and competition are extracting a high price for the more intrusive forms of intervention that impair market incentives to work, save, invest, and innovate. International competitive pressures are narrowing the choices for economies with broad safety nets: the choice of accepting shortfalls in standards of living, relative to the less burdened economies, or loosening the social safety net and acquiescing in the greater concentrations of income that seem to be associated with our high-tech environment. Erecting trade barriers to shut off cross-border competition leads to the loss of the great advantages of the international division of labor and cannot be considered a realistic alternative for societies choosing to realize the full benefits of technological advances. Fortunately, for the moment at least, there appears limited sentiment in Europe or elsewhere to move in that direction. Clearly, the synergies of transistor, laser, and satellite technologies have created a computer and telecommunications revolution over the last half century that is altering the way people interact with each other and with their institutions. We are adding to our knowledge of which economic and political systems contribute to welfare and wealth and which do not. This process, of course, has been ongoing especially since the advent of the Industrial Revolution when the emergence of significant wealth creation first offered meaningful alternatives. But in the post World War II years most of what had been open to conjecture and debate throughout the nineteenth century and first half of the twentieth, is gradually being settled by the sharp realities of recent experience. I am not alleging that the human race is about to irreversibly accept market capitalism as the only relevant form of economic and social organization and that this great debate is over. There remains a large segment of the population that still considers capitalism and its emphasis on materialism, in all its forms, degrading to man's spiritual nature. In addition, even some of those who seek material welfare, view competitive markets as subject to manipulation by mass promotion and advertising that drives consumers to desire and seek superficial and ephemeral values. Some governments even now attempt to override the evident preferences of their citizens, by limiting their access to foreign media because they judge such media will undermine their culture. Finally, there remains a latent protectionism, in the United States and elsewhere, which could emerge as a potent force against globalization should the current high-tech world economy falter. Moreover, I certainly have no doubt that in the event of problems in today's new, more Spencerian, form of capitalism, governments would increase their interventions in an endeavor to alter market results. And, as history amply demonstrates, most recently in East Asia, market -- or mostly market -- systems can produce crises that tempt government intervention. Such crises arise on occasion when confidence unexpectedly fails and is replaced by fear and a loss of trust, inducing a vicious cycle of retrenchment in economic activity and government endeavors to counter it. Nonetheless, in light of the record of failures of intrusive intervention over recent decades, it is difficult to imagine such activism persisting much beyond any immediate crisis. The history of the twentieth century has been a testing ground for innumerable theories of social and economic organization that have been tried and found wanting. The way people respond to incentives and rewards persists from generation to generation suggesting a deeply imbedded set of stabilities in human nature. We see this, for example, in remarkable consistencies in the behavior of markets over time. Nonetheless, history is strewn with examples of economic and social systems that have tried to counter, or alter, human nature and failed. Despite an unrelenting effort over more than seven decades, the system in the Soviet Union was unable to mold human responses to fit the Soviet view of human destiny and how society should be organized. The post mortem of what went wrong clearly exposed the fatal flaws as internal to the system, and not the result of external forces, although the arms race may have hastened the process. The lesson that appears to be emerging is that only free market systems exhibit the flexibility and robustness to accommodate human nature and harness rapidly advancing technology to consistently advance living standards. To get a better sense of the forces that are driving the world's economies, especially in the second half of the twentieth century, it is useful to understand why the Soviet experiment in central planning failed. Indeed, it is not an exaggeration to state that from this failure we have learned as much about why our free capitalist systems work, as about why central planning does not. The Soviet economic failure was so unambiguous that it proffered a new set of standards to better gauge alternative economic paradigms. It, for example, afforded us a far better understanding of why some of the mercantilistic capitalist economies of East Asia worked for awhile but then did not. Centrally planned economic systems, such as that which existed in the Soviet Union, had great difficulty in creating wealth and rising standards of living. In theory, and to a large extent in practice, production and distribution were determined by specific instructions -- often in the form of state orders -- coming from the central planning agencies to the various different producing establishments, indicating from whom, and in what quantities, they should receive their raw materials and services, and to whom they should distribute their final outputs. Without an effective market clearing mechanism, the consequences of such a paradigm, as one might readily anticipate, were both huge surpluses of goods that were not wanted by the populace, and huge shortages of products that consumers desired, but were not produced in adequate quantities. The imbalance of demand over supply of these latter products inevitably required rationing or its equivalent -- standing in queues for limited quantities of goods and services. One might think that the planning authorities should have been able to adjust to these distortions. They tried. But they faced insurmountable handicaps in that they did not have access to the immediate signals of price changes that so effectively facilitate the clearing of markets in capitalist economies. Movements in prices give incentives to adjust the allocation of physical resources to accommodate the changing technology of production and the shifting tastes of consumers. Among the key prices central planning systems lacked were the signals of finance -equity values and the broad array of interest rates. In a centrally planned system, finance plays a decidedly minor role. Since the production and distribution of goods and services are essentially driven by state orders and rationing, finance amounts to little more than a system for record keeping. While there are pro-forma payment transfers among state-owned enterprises, few if any actions are driven by them. Payment arrears, or even defaults, are largely irrelevant in the sense that they are essentially intra-company transactions among enterprises owned by the same entity, that is, the state. Under central planning there are no credit standards, no interest rate risks, no market value changes -- none of the key financial signals that determine in a market economy who gets credit and who does not, and hence who produces what and sells to whom. In short, none of the financial infrastructure that converts the changing valuations of consumers and shifting efficiencies of capital equipment into market signals that direct production for profit is available. But it didn't matter in the Soviet-bloc economies. Few decisions in those centrally planned systems were affected by the lack of a developed financial system. Regrettably, until the Berlin Wall was breached in 1989, and the need to develop market economies out of the rubble of Eastern Europe's central planning regime became apparent, little contemporary thought had been given to the institutional infrastructure required of markets. In the West, that infrastructure had developed pragmatically, interacting with, and facilitating the evolution of, the markets themselves. In the years immediately following the fall of the Berlin Wall, many of the states of the former Soviet bloc did get something akin to a market system in the form of a rapid growth of black markets that replicated some of what seemingly goes on in a market economy. But only in part. Black markets, by definition, are not supported by the rule of law. There are no rights to own and dispose of property protected by the enforcement power of the state. There are no laws of contract or bankruptcy, or judicial review and determination again enforced by the state. The essential infrastructure of a market economy is missing. Black markets offer few of the benefits of legally sanctioned trade. To know that the state will protect one's rights to property will encourage the taking of risks that create wealth and foster growth. Few will risk their capital, however, if there is little assurance that the rewards of risk are secure from the arbitrary actions of government, or street mobs. Indeed, the presumption of property ownership and the legality of its transfer must be deeply embedded in the culture of a society for free market economies to function effectively. In capitalist societies, and especially under British common law and its derivatives, the moral validity of property rights is accepted, or at least acquiesced in, by virtually the whole of the population. Accordingly, a negligible proportion of commercial contracts has to be adjudicated through the courts. If it were otherwise, the system could not function. Most other rights that we Americans and others cherish -- protection against extralegal violence or intimidation by the state, confiscation of property without due process, as well as freedom of speech and of the press, and an absence of discrimination -- are all essential to a fully effective, functioning market system. Indeed a list or bill of rights enforced by an impartial judiciary is, and I hesitate to use the analogy, what substitutes for the central planning function as the guiding mechanism of a free market economy. It is these "rights" that enable the value judgements of millions of consumers to be converted through a legally protected free market into prices of products and financial instruments; and it is, of course, these market prices that substitute for the state orders of the centrally planned economies. The increasing recognition of a rule of law and its associated rights as being indispensable to an effective functioning market system, is pressuring political leaders to a greater acceptance of that framework. Economic necessity appears to be functioning, but not in the way Karl Marx contemplated. The broad acceptance of market economics -- and the political rights associated with it -- is impressive. Clearly, not all states protect the right of private property with the same fervor. Indeed, they vary widely. Nor is it the case that all societies with firmly protected property rights bend invariably to the majority will of the populace on all public issues. But the pressures to meld democracy and property rights appear persistent. Centrally planned economies tend to be frozen in time. They cannot readily accommodate innovation, new ideas, new products, and altered specifications. In sharp contrast, market economies are driven by what Professor Joseph Schumpeter, a number of decades ago, called "creative destruction". By this he meant newer ways of doing things, newer products, and novel engineering and architectural insights that induce the continuous obsolescence and retirement of factories and equipment and a reshuffling of workers to new and different activities. Market economies in that sense are continuously renewing themselves. Innovation, risk-taking, and competition are the driving forces that propel standards of living progressively higher. The bold, if unintended, experiment in economic and social systems, which began after World War II in Europe, did not come to a full resting place with the fall of the Berlin Wall in 1989. Despite the ebb and flow of governments of differing persuasions, the face of the world economy continues to edge evermore toward free market-oriented societies. It is true in Eastern Europe, Latin America, and Asia. Even many of the socialistic economies of Africa are embracing free market capitalism. The current crisis in East Asia is likely to hasten that trend as hard-learned lessons of economic structure lead to significant reform. The economies in crisis did not use central planning of the pervasive Soviet Union style. They relied on markets in most respects, but they also used elements of central planning in the form of credit allocation, and those elements, in my view, turned out to be their Achilles heel. The crises have their roots in the endeavor of some East Asian countries to open up their economies to world competition, while still mandating a significant proportion of their output through government directives. It is, of course, possible for a time to clear a market through central planning, albeit at a lower standard of living, by restricting alternatives available to a population as the Soviet system demonstrated. It is also possible to clear the market through the free play of competitive forces with consumers' choices governing what is produced. A market will not readily clear and achieve stability, except by chance, however, if consumers are largely free to choose, but production is set significantly by government directives. For it is only by chance that governments, meaning planning agencies, can successfully gauge the rapidly changing tastes of consumers and evolving technologies of production. It is much too difficult a task. Only sophisticated market mechanisms can do that. Partial planning of the sort practiced by some East Asian countries can look very successful for a time because they started from a low technological base and had sufficient flexibility to allow business units to borrow the more advanced technology of the fully market economies. But there are limits to this process as economies mature. Many Asian policymakers are learning that government-directed investments, backed by government inducements to banks to finance them, can lead to substantial gains in output for a number of years in economies with low real wages and low productivity (as it did in the Soviet Union). Eventually and inevitably, however, such a regime leads to establish facilities that produce goods and services that domestic consumers and export customers apparently no longer want. The consequent losses to companies, and the resultant buildup of nonperforming bank loans, hobble financial intermediation and the economy. There has been, to be sure, much pain and periodic backtracking among a number of the nations that discarded the mantle of some forms of central planning or mercantilist capitalism. There will doubtless be more. But as a consequence of the experience of the last half century, market capitalism has clearly become ascendant, at least for now. Advancing technologies have spurred the competitive forces of the market to accelerate the rise in consumer wealth and living standards. So long as material well being holds a high priority in a nation's value system, the persistence of technological advance should foster this process. If we can continue to adapt to our new frenetic high tech economy, that is not a bad prospect for the next century.
1998-04-04T00:00:00	Mr. Ferguson remarks on the Federal Reserve's Role in the payments system (Central Bank Articles and Speeches, 4 Apr 98)	Address by Mr. Roger W. Ferguson, Jr., a member of the Board Governors of the US Federal Reserve System, before the Bankers' Roundtable held in Phoenix, Arizona on 4/4/98.	Mr. Ferguson remarks on the Federal Reserve's Role in the payments system Address by Mr. Roger W. Ferguson, Jr., a member of the Board Governors of the US Federal Reserve System, before the Bankers' Roundtable held in Phoenix, Arizona on 4/4/98. Thank you for inviting me to speak with you today. I am pleased to have this opportunity to discuss the Federal Reserve's role in the payments system with you for two reasons. The Bankers' Roundtable includes many of the major participants in the U.S. payments system. Also, our role in the payments system has received considerable attention recently not only by the Federal Reserve itself but also by Congress, the GAO, and the banking industry, including the Bankers' Roundtable. As a central bank, the Federal Reserve needs to ensure that the payments system of the United States (1) supports economic growth, which can best be done by ensuring open access, (2) manages risk well, (3) is resilient in the face of crisis, and (4) continues to evolve to keep pace with the needs of an evolving economy. To achieve these goals, we serve as both payments provider and regulator. Today, I would like to focus on how the Federal Reserve influences the level of competition in the market for payment services and how we hope, through competition, to foster continuing improvements in the payments system. Current Role of Federal Reserve as Service Provider As you know, the Federal Reserve Banks provide a range of payment-related services. Some of these services are generally viewed as critical to the execution of the Federal Reserve's core central bank responsibilities. For example, the Federal Reserve's cash services are integral to one the Fed's primary responsibilities -- to provide for an elastic currency. The Fedwire funds transfer system facilitates final settlement of interbank payments in central bank money and provides liquidity to the financial markets to support a growing economy. Our net settlement service facilitates the final settlement in central bank funds of payments cleared by outside the Federal Reserve. For retail payments, however, the appropriate role of the Federal Reserve is not so obvious. Historically, we can understand why the Federal Reserve began to process check and ACH payments. In an era of rudimentary communications and a fragmented banking system in the early part of this century, the Reserve Banks' involvement in check collection helped to improve the workings of the national economy, spur trade, and overcome some of the structural impediments that had contributed to the financial panics in the late 1800s and early 1900s. At that time, checks were used far differently than they are today, and represented a primary means of making interbank wholesale transfers. Sixty years later, in the 1970s, the Federal Reserve's early participation in and subsidization of the automated clearing house system provided the impetus to launch that new nationwide electronic payment mechanism. I believe that fostering a competitive environment is critically important for all portions of the retail payments system, including those in which the Federal Reserve is a participant. Indeed, the effectiveness of the U.S. retail payments systems can be credited largely to the competitive marketplace in which payments are provided. The Federal Reserve promotes a competitive marketplace in part through innovations that enhance the cost effectiveness and quality of our services. An example of current initiatives we have underway that I think holds great potential is the use of web browser software to enable banks to communicate with the Federal Reserve to send and retrieve information. This technology will make it much easier, for instance, for banks to order cash, retrieve images of checks, and submit the financial information that we ask banks to provide regularly. It will also significantly improve our ability to respond quickly to the evolving needs of our customers. The Federal Reserve is also working to streamline the check collection process through the use of electronics and image processing. Last year, more than 2.2 billion checks -or about 14 percent of all checks collected by the Reserve Banks -- were presented electronically. In addition to the growing array of image services provided by the Reserve Banks, the Fed is also leading efforts to develop industry standards for the exchange of check images. Another example of current Fed innovation is in the ACH arena. The Federal Reserve will soon provide financial EDI translation capability available to all banks that receive ACH transactions through our Fedline software. This capability will support the Treasury's EFT99 initiative and help facilitate end-to-end electronic payments. In 1980, in part to promote competition among the Federal Reserve and private-sector service providers, Congress enacted the Monetary Control Act. MCA requires the Federal Reserve to price its payment services to recover all costs of providing the services over the long run, including imputed costs that would have been incurred and imputed profits that would have been earned had the services been provided by a private firm. The Federal Reserve has fully met this requirement, and I believe MCA has enhanced the competitive environment for the provision of payment services and has improved payments system efficiency. We must recognize, however, that the competitive market envisioned by Congress in the Monetary Control Act may not be fully realized due to several fundamental differences between the Federal Reserve and private firms. First, the Federal Reserve is immune to insolvency or default. Therefore, its customers do not need to concern themselves with credit risk associated with using the Federal Reserve as an intermediary bank in payment services. Second, the Reserve Banks continue to have some legal advantages over other providers of check services, even though the Federal Reserve Board has taken steps to reduce these advantages through its Regulation CC same-day settlement rule. Third, the Federal Reserve has a different risk-taking profile than do the private firms with which it competes. As you know all too well, many innovations that appear to have great promise fail in the marketplace, while others succeed. The public nature of the Federal Reserve, along with its self-imposed objective of achieving industry average profit margins on each service line, virtually dictates a more conservative approach in the marketplace. In contrast, a private firm may be more willing to risk the funds of its shareholders in anticipation of achieving significantly higher profit margins. Finally, Federal Reserve Banks lack the flexibility afforded their private-sector competitors to be selective in the customers to which they will provide payment services and in their pricing of those payment services. We are also subject to far greater public scrutiny and disclosure than our competitors. You can see from these examples that the Federal Reserve has some material advantages as a competitor, but also some impediments to being an effective competitor. Both the advantages and the impediments should be kept in mind. Rivlin Committee Study Because of these competitive inequities, it is all the more important that the Federal Reserve periodically reassess the need to continue to provide check and ACH services as market structure, technology, and competitive conditions evolve. We last did so in 1996 and 1997 after Chairman Greenspan established the Committee on the Role of the Federal Reserve in the Payments System, or the so-called Rivlin Committee. The Committee examined a range of alternative scenarios under which payments could be provided and sought views from a large number of payments system participants. Most participants urged the Federal Reserve to continue to provide check and ACH services. Many expressed concern as to whether private-sector service providers would adequately meet the needs of all depository institutions, especially small institutions and those in remote locations, if the Federal Reserve were to exit these services. In particular, they noted that the Federal Reserve serves certain market segments that may not yet have demonstrated adequate market competition, specifically, providing check and ACH services to low-volume banks and providing check services to banks throughout the country that need to collect checks drawn on small, remote banks. The Rivlin Committee concluded that the Federal Reserve should continue to provide check and ACH services, with the objectives of enhancing efficiency, promoting integrity, and ensuring access. Given the Federal Reserve's current dominant market position in these services and the risk of disruption if the Federal Reserve were to exit quickly, this conclusion makes sense. The Committee also concluded that we should play a more active role, working collaboratively with providers and users of the payments system, to help evolve strategies for moving to the next generation of payment instruments. Future Role of the Federal Reserve as Service Provider For the longer term, will the conclusion that the Federal Reserve should be a provider continue to be the correct one? This question hinges in large part on the extent to which the Federal Reserve's participation is needed to ensure the smooth functioning of the payments system that achieves the four goals I outlined earlier and whether there are significant barriers to private firms entry into the interbank check and ACH markets. In other words, we need to assess whether the Federal Reserve's operational involvement in retail payment services would foster or impede competition and progress as the market for these payment services evolves. There has been much debate regarding the extent to which check markets are "contestable," or truly subject to competition, particularly those segments of the market that only the Federal Reserve serves. Are there significant barriers to competition in these markets? If so, can they be reduced? The Federal Reserve's market position in some segments may simply indicate that there is insufficient volume to support more than one bank presenting checks to very low-volume endpoints. If that is the case, does this suggest that a private-sector provider could fill the gap if the Fed were to exit this service? If the market will only support one provider, would potential entrants provide sufficient market discipline on that provider to ensure that the terms of its service are reasonable or would regulation be required? One possible barrier to correspondent banks providing services equivalent to the Federal Reserve's is their more limited presentment abilities. As I will discuss shortly, we are currently evaluating this issue. Private-sector entry into ACH appears to face different obstacles. Today, the ACH service exhibits economies of scale over broad volume levels, which suggests that efficiency may be enhanced and unit costs minimized by having few ACH operators. Thus, the Federal Reserve may have an advantage because it processes the large bulk of ACH payments. We believe that the competitive environment that results from multiple ACH operators will best ensure continued efficiency improvements and innovation in this service. I believe it is important that the Federal Reserve take appropriate steps to stimulate the competitive environment in the ACH. Our planned enhancements to our net settlement service, which will provide significant operational benefits for private-sector ACH operators and other private clearing arrangements, is clearly a step in this direction. As market conditions change, we should reassess the ability of the private marketplace to foster the efficiency and integrity of, and access to the full range of, retail payment services without the Federal Reserve's operational involvement. In particular, continued geographic expansion by major correspondent banks resulting from interstate branch banking will lessen the Federal Reserve's distinction as a nationwide service provider. In addition, continued fast-paced technological advancements will likely result in further substantial reductions in the cost of data processing and data communication services. These technological improvements may reduce the barriers faced by other firms in establishing or expanding the scope of their payment services. Finally, the Federal Reserve's operational role in retail payments will decline inevitably as other types of retail payments not provided by the Federal Reserve grow. These changes may promote the competitive environment for the provision of retail payment services and may diminish the Federal Reserve's dominant market position in the provision of these services. Emerging Retail Payment Systems I know some of us are impatient with the pace of the migration of retail payments to electronic alternatives. Earlier predictions of a cashless, checkless society clearly missed their mark. Technological advances, however, are providing new opportunities to accelerate the migration to electronic payments. New payment methods will likely continue to supplement, rather than supplant, existing forms of payment. Given the track record of previous forecasts, I will refrain from speculating on the future pace of this shift from paper to electronic payments. The stakes for banks in making the transition from paper-based retail payments to electronic ones are high. Some industry observers estimate that payments businesses represent as much as one-third of industry revenues, expenses, and profits. The risk to banks is that expenses from the current payments systems stay while significant new investments for emerging payment methods are required. As I see it, banks would be well advised to manage the transition, leverage their advantage from established customer relationships and information, and harness industry-wide energy. Experience has taught us that there are often significant lags between the introduction of a new payment instrument and its widespread use. These lags are due to several factors, such as the time required for the needed physical infrastructure to emerge, the time required for consumers and businesses to become familiar and comfortable with using a new payment method, and the time necessary to achieve the critical mass of acceptance by both payors and payees. In addition, it often takes a long time for service providers to realize the scale economies that would make the new instrument cost effective compared to existing ones. Moreover, the speed of adoption depends on the distribution of risks, costs, and benefits of the new payment methods among the end users of the payments as well as resistance from incumbent service providers. Even if the marginal cost of a new payment technology is equivalent to that of an existing payment, incumbents may have advantages over rivals with new technologies because they may have already incurred the fixed costs of providing their service or may have already gained market share and familiarity with consumers. For example, incumbents may have achieved the benefits from a large network of users, referred to as network externalities by economists. Adoption of new technologies may also be slowed if they require considerable amounts of coordination. A technological leader can try to establish the de facto standard. Or, developers can try to negotiate common standards, which is a time-consuming process that may constrain technological innovation, but spreads risk while permitting competition for customers. The result is a natural tension between maintaining an adequate level of competition and achieving a level of cooperation that enhances efficiency and consumer welfare. I do not believe that the market for new retail electronic payment services reflects the existence of market failures that would suggest a need for direct Federal Reserve operational involvement. These products, and the markets in which they operate, appear to be evolving adequately on their own, just as the credit card, debit card, and ATM networks evolved without a Federal Reserve operational presence. Therefore, with respect to the Federal Reserve as a service provider, I think we have a role as provider and enhancer in traditional payment services, check and ACH, but probably will not be a provider of newer retail services. I have confidence that the private-sector marketplace can provide the combination of new products, services, and service providers to meet the needs of consumers and businesses. Our goal is to determine how we can best aid the process of moving to these new instruments without pre-empting private sector creativity and problem solving. Federal Reserve as Regulator I've focused my comments thus far on the Federal Reserve's operational role in the payments system. In addition to the Reserve Banks' role as provider of payment services, the Federal Reserve Board also regulates aspects of the payments system. While our role as provider of payment services goes back to the inception of the Federal Reserve, our authority to regulate the interbank collection or execution of payments not processed by the Federal Reserve is only about a decade old. In exercising this regulatory authority, the Board has focused in large part on improving the competitiveness of the market for interbank check collection. The Board's 1994 same-day settlement rule enhanced the ability of correspondent banks to compete with the Federal Reserve Banks in collecting checks. The Board adopted this rule because it believed it was in the best interest of the payments system, even though it knew the rule would reduce the Reserve Banks' check volume. Our goal was competition in the check collection market, not preserving Federal Reserve market share. As I mentioned earlier, even with the same-day settlement rule, correspondent banks may still have difficulty competing with Federal Reserve Banks in some check collection markets due to their more limited presentment abilities. Several weeks ago, the Board issued an advanced notice of proposed rulemaking designed to assess market experience under the sameday settlement rule. The comments we receive will be helpful in assessing whether further reductions in the legal disparities between the Federal Reserve Banks and private-sector banks would further enhance competition and the overall efficiencies that could result from that competition. This analysis is a complex one. I believe that in principle reduction in legal disparities between the Federal Reserve and private-sector banks will enhance market competition. The benefits of regulatory change, however, have to be balanced with a potential increase in costs to paying banks and their check-writing customers. In other words, we should continue to look for ways to reduce legal disparities between the Federal Reserve and privatesector banks, but some of these changes may not reduce costs for all participants in the system. The Federal Reserve's role should also include identifying and reducing regulatory burdens that unreasonably inhibit innovations that improve the efficiency, security, and convenience of payment methods. Regulation may reduce uncertainty for some, but it may also discourage investment in new products or technologies by others. This is particularly true if the product is relatively new and demand for it is relatively uncertain, as is currently the case with a number of emerging electronic payment methods, such as stored-value cards. The government should avoid regulatory actions that may inhibit the evolution of emerging payments products and services or prevent the effective operation of competitive market forces. It is not clear whether, or what type of, regulation will be needed for many new products and it is important to avoid jumping to the conclusion that such regulations are inevitable over the longer term. Often the best regulation is that which addresses specific abuses or public policy concerns. Regulation that anticipates potential future problems runs the risk of resulting in overregulation that unduly stifles innovation. Conclusion I'd like to conclude by re-emphasizing the role of competitive markets in fostering continued efficiency and innovation in the U.S. payments system. The Federal Reserve is striving to foster the competitive environment for those retail payment services in which it plays an operational role as well as those services in which it does not. For those services in which the Reserve Banks have an operational role, they strive to provide them in a cost-effective, highquality manner and take advantage of technological advances. We also plan to enhance the efficiency and help to foster improvements in the services in which we have an operational role. I believe the Federal Reserve has an obligation as a public entity to periodically assess -- as we have just done -- the extent to which it needs to continue to provide interbank retail payment services in competition with private firms. For newer payments mechanisms, we do not strive to become an active provider. However, we can encourage private-sector initiatives and remove regulatory hurdles to experimentation, where appropriate. We can also help, in collaboration with the private sector, to overcome barriers and market imperfections. Ultimately, however, the marketplace will decide which payment products and services will best meet the needs of households and businesses for reliable, secure, and efficient payments. No matter whether we are discussing existing services, possible new products, or regulatory actions, the Federal Reserve seeks to foster efficiency, integrity, and broad access in the payments system. Our attention to this area reflects our recognition that a smooth functioning payments system is critical to the smooth functioning of the nation's economy.	---[PAGE_BREAK]--- # Mr. Ferguson remarks on the Federal Reserve's Role in the payments system Address by Mr. Roger W. Ferguson, Jr., a member of the Board Governors of the US Federal Reserve System, before the Bankers' Roundtable held in Phoenix, Arizona on 4/4/98. Thank you for inviting me to speak with you today. I am pleased to have this opportunity to discuss the Federal Reserve's role in the payments system with you for two reasons. The Bankers' Roundtable includes many of the major participants in the U.S. payments system. Also, our role in the payments system has received considerable attention recently not only by the Federal Reserve itself but also by Congress, the GAO, and the banking industry, including the Bankers' Roundtable. As a central bank, the Federal Reserve needs to ensure that the payments system of the United States (1) supports economic growth, which can best be done by ensuring open access, (2) manages risk well, (3) is resilient in the face of crisis, and (4) continues to evolve to keep pace with the needs of an evolving economy. To achieve these goals, we serve as both payments provider and regulator. Today, I would like to focus on how the Federal Reserve influences the level of competition in the market for payment services and how we hope, through competition, to foster continuing improvements in the payments system. ## Current Role of Federal Reserve as Service Provider As you know, the Federal Reserve Banks provide a range of payment-related services. Some of these services are generally viewed as critical to the execution of the Federal Reserve's core central bank responsibilities. For example, the Federal Reserve's cash services are integral to one the Fed's primary responsibilities -- to provide for an elastic currency. The Fedwire funds transfer system facilitates final settlement of interbank payments in central bank money and provides liquidity to the financial markets to support a growing economy. Our net settlement service facilitates the final settlement in central bank funds of payments cleared by outside the Federal Reserve. For retail payments, however, the appropriate role of the Federal Reserve is not so obvious. Historically, we can understand why the Federal Reserve began to process check and ACH payments. In an era of rudimentary communications and a fragmented banking system in the early part of this century, the Reserve Banks' involvement in check collection helped to improve the workings of the national economy, spur trade, and overcome some of the structural impediments that had contributed to the financial panics in the late 1800s and early 1900s. At that time, checks were used far differently than they are today, and represented a primary means of making interbank wholesale transfers. Sixty years later, in the 1970s, the Federal Reserve's early participation in and subsidization of the automated clearing house system provided the impetus to launch that new nationwide electronic payment mechanism. I believe that fostering a competitive environment is critically important for all portions of the retail payments system, including those in which the Federal Reserve is a participant. Indeed, the effectiveness of the U.S. retail payments systems can be credited largely to the competitive marketplace in which payments are provided. The Federal Reserve promotes a competitive marketplace in part through innovations that enhance the cost effectiveness and quality of our services. An example of current initiatives we have underway that I think holds great potential is the use of web browser software to enable banks to communicate with the Federal Reserve to send and retrieve information. This technology will make it much easier, for ---[PAGE_BREAK]--- instance, for banks to order cash, retrieve images of checks, and submit the financial information that we ask banks to provide regularly. It will also significantly improve our ability to respond quickly to the evolving needs of our customers. The Federal Reserve is also working to streamline the check collection process through the use of electronics and image processing. Last year, more than 2.2 billion checks -or about 14 percent of all checks collected by the Reserve Banks -- were presented electronically. In addition to the growing array of image services provided by the Reserve Banks, the Fed is also leading efforts to develop industry standards for the exchange of check images. Another example of current Fed innovation is in the ACH arena. The Federal Reserve will soon provide financial EDI translation capability available to all banks that receive ACH transactions through our Fedline software. This capability will support the Treasury's EFT99 initiative and help facilitate end-to-end electronic payments. In 1980, in part to promote competition among the Federal Reserve and private-sector service providers, Congress enacted the Monetary Control Act. MCA requires the Federal Reserve to price its payment services to recover all costs of providing the services over the long run, including imputed costs that would have been incurred and imputed profits that would have been earned had the services been provided by a private firm. The Federal Reserve has fully met this requirement, and I believe MCA has enhanced the competitive environment for the provision of payment services and has improved payments system efficiency. We must recognize, however, that the competitive market envisioned by Congress in the Monetary Control Act may not be fully realized due to several fundamental differences between the Federal Reserve and private firms. First, the Federal Reserve is immune to insolvency or default. Therefore, its customers do not need to concern themselves with credit risk associated with using the Federal Reserve as an intermediary bank in payment services. Second, the Reserve Banks continue to have some legal advantages over other providers of check services, even though the Federal Reserve Board has taken steps to reduce these advantages through its Regulation CC same-day settlement rule. Third, the Federal Reserve has a different risk-taking profile than do the private firms with which it competes. As you know all too well, many innovations that appear to have great promise fail in the marketplace, while others succeed. The public nature of the Federal Reserve, along with its self-imposed objective of achieving industry average profit margins on each service line, virtually dictates a more conservative approach in the marketplace. In contrast, a private firm may be more willing to risk the funds of its shareholders in anticipation of achieving significantly higher profit margins. Finally, Federal Reserve Banks lack the flexibility afforded their private-sector competitors to be selective in the customers to which they will provide payment services and in their pricing of those payment services. We are also subject to far greater public scrutiny and disclosure than our competitors. You can see from these examples that the Federal Reserve has some material advantages as a competitor, but also some impediments to being an effective competitor. Both the advantages and the impediments should be kept in mind. ---[PAGE_BREAK]--- # Rivlin Committee Study Because of these competitive inequities, it is all the more important that the Federal Reserve periodically reassess the need to continue to provide check and ACH services as market structure, technology, and competitive conditions evolve. We last did so in 1996 and 1997 after Chairman Greenspan established the Committee on the Role of the Federal Reserve in the Payments System, or the so-called Rivlin Committee. The Committee examined a range of alternative scenarios under which payments could be provided and sought views from a large number of payments system participants. Most participants urged the Federal Reserve to continue to provide check and ACH services. Many expressed concern as to whether private-sector service providers would adequately meet the needs of all depository institutions, especially small institutions and those in remote locations, if the Federal Reserve were to exit these services. In particular, they noted that the Federal Reserve serves certain market segments that may not yet have demonstrated adequate market competition, specifically, providing check and ACH services to low-volume banks and providing check services to banks throughout the country that need to collect checks drawn on small, remote banks. The Rivlin Committee concluded that the Federal Reserve should continue to provide check and ACH services, with the objectives of enhancing efficiency, promoting integrity, and ensuring access. Given the Federal Reserve's current dominant market position in these services and the risk of disruption if the Federal Reserve were to exit quickly, this conclusion makes sense. The Committee also concluded that we should play a more active role, working collaboratively with providers and users of the payments system, to help evolve strategies for moving to the next generation of payment instruments. ## Future Role of the Federal Reserve as Service Provider For the longer term, will the conclusion that the Federal Reserve should be a provider continue to be the correct one? This question hinges in large part on the extent to which the Federal Reserve's participation is needed to ensure the smooth functioning of the payments system that achieves the four goals I outlined earlier and whether there are significant barriers to private firms entry into the interbank check and ACH markets. In other words, we need to assess whether the Federal Reserve's operational involvement in retail payment services would foster or impede competition and progress as the market for these payment services evolves. There has been much debate regarding the extent to which check markets are "contestable," or truly subject to competition, particularly those segments of the market that only the Federal Reserve serves. Are there significant barriers to competition in these markets? If so, can they be reduced? The Federal Reserve's market position in some segments may simply indicate that there is insufficient volume to support more than one bank presenting checks to very low-volume endpoints. If that is the case, does this suggest that a private-sector provider could fill the gap if the Fed were to exit this service? If the market will only support one provider, would potential entrants provide sufficient market discipline on that provider to ensure that the terms of its service are reasonable or would regulation be required? One possible barrier to correspondent banks providing services equivalent to the Federal Reserve's is their more limited presentment abilities. As I will discuss shortly, we are currently evaluating this issue. Private-sector entry into ACH appears to face different obstacles. Today, the ACH service exhibits economies of scale over broad volume levels, which suggests that ---[PAGE_BREAK]--- efficiency may be enhanced and unit costs minimized by having few ACH operators. Thus, the Federal Reserve may have an advantage because it processes the large bulk of ACH payments. We believe that the competitive environment that results from multiple ACH operators will best ensure continued efficiency improvements and innovation in this service. I believe it is important that the Federal Reserve take appropriate steps to stimulate the competitive environment in the ACH . Our planned enhancements to our net settlement service, which will provide significant operational benefits for private-sector ACH operators and other private clearing arrangements, is clearly a step in this direction. As market conditions change, we should reassess the ability of the private marketplace to foster the efficiency and integrity of, and access to the full range of, retail payment services without the Federal Reserve's operational involvement. In particular, continued geographic expansion by major correspondent banks resulting from interstate branch banking will lessen the Federal Reserve's distinction as a nationwide service provider. In addition, continued fast-paced technological advancements will likely result in further substantial reductions in the cost of data processing and data communication services. These technological improvements may reduce the barriers faced by other firms in establishing or expanding the scope of their payment services. Finally, the Federal Reserve's operational role in retail payments will decline inevitably as other types of retail payments not provided by the Federal Reserve grow. These changes may promote the competitive environment for the provision of retail payment services and may diminish the Federal Reserve's dominant market position in the provision of these services. # Emerging Retail Payment Systems I know some of us are impatient with the pace of the migration of retail payments to electronic alternatives. Earlier predictions of a cashless, checkless society clearly missed their mark. Technological advances, however, are providing new opportunities to accelerate the migration to electronic payments. New payment methods will likely continue to supplement, rather than supplant, existing forms of payment. Given the track record of previous forecasts, I will refrain from speculating on the future pace of this shift from paper to electronic payments. The stakes for banks in making the transition from paper-based retail payments to electronic ones are high. Some industry observers estimate that payments businesses represent as much as one-third of industry revenues, expenses, and profits. The risk to banks is that expenses from the current payments systems stay while significant new investments for emerging payment methods are required. As I see it, banks would be well advised to manage the transition, leverage their advantage from established customer relationships and information, and harness industry-wide energy. Experience has taught us that there are often significant lags between the introduction of a new payment instrument and its widespread use. These lags are due to several factors, such as the time required for the needed physical infrastructure to emerge, the time required for consumers and businesses to become familiar and comfortable with using a new payment method, and the time necessary to achieve the critical mass of acceptance by both payors and payees. In addition, it often takes a long time for service providers to realize the scale economies that would make the new instrument cost effective compared to existing ones. Moreover, the speed of adoption depends on the distribution of risks, costs, and benefits of the new payment methods among the end users of the payments as well as resistance ---[PAGE_BREAK]--- from incumbent service providers. Even if the marginal cost of a new payment technology is equivalent to that of an existing payment, incumbents may have advantages over rivals with new technologies because they may have already incurred the fixed costs of providing their service or may have already gained market share and familiarity with consumers. For example, incumbents may have achieved the benefits from a large network of users, referred to as network externalities by economists. Adoption of new technologies may also be slowed if they require considerable amounts of coordination. A technological leader can try to establish the de facto standard. Or, developers can try to negotiate common standards, which is a time-consuming process that may constrain technological innovation, but spreads risk while permitting competition for customers. The result is a natural tension between maintaining an adequate level of competition and achieving a level of cooperation that enhances efficiency and consumer welfare. I do not believe that the market for new retail electronic payment services reflects the existence of market failures that would suggest a need for direct Federal Reserve operational involvement. These products, and the markets in which they operate, appear to be evolving adequately on their own, just as the credit card, debit card, and ATM networks evolved without a Federal Reserve operational presence. Therefore, with respect to the Federal Reserve as a service provider, I think we have a role as provider and enhancer in traditional payment services, check and ACH , but probably will not be a provider of newer retail services. I have confidence that the private-sector marketplace can provide the combination of new products, services, and service providers to meet the needs of consumers and businesses. Our goal is to determine how we can best aid the process of moving to these new instruments without pre-empting private sector creativity and problem solving. # Federal Reserve as Regulator I've focused my comments thus far on the Federal Reserve's operational role in the payments system. In addition to the Reserve Banks' role as provider of payment services, the Federal Reserve Board also regulates aspects of the payments system. While our role as provider of payment services goes back to the inception of the Federal Reserve, our authority to regulate the interbank collection or execution of payments not processed by the Federal Reserve is only about a decade old. In exercising this regulatory authority, the Board has focused in large part on improving the competitiveness of the market for interbank check collection. The Board's 1994 same-day settlement rule enhanced the ability of correspondent banks to compete with the Federal Reserve Banks in collecting checks. The Board adopted this rule because it believed it was in the best interest of the payments system, even though it knew the rule would reduce the Reserve Banks' check volume. Our goal was competition in the check collection market, not preserving Federal Reserve market share. As I mentioned earlier, even with the same-day settlement rule, correspondent banks may still have difficulty competing with Federal Reserve Banks in some check collection markets due to their more limited presentment abilities. Several weeks ago, the Board issued an advanced notice of proposed rulemaking designed to assess market experience under the sameday settlement rule. The comments we receive will be helpful in assessing whether further reductions in the legal disparities between the Federal Reserve Banks and private-sector banks ---[PAGE_BREAK]--- would further enhance competition and the overall efficiencies that could result from that competition. This analysis is a complex one. I believe that in principle reduction in legal disparities between the Federal Reserve and private-sector banks will enhance market competition. The benefits of regulatory change, however, have to be balanced with a potential increase in costs to paying banks and their check-writing customers. In other words, we should continue to look for ways to reduce legal disparities between the Federal Reserve and privatesector banks, but some of these changes may not reduce costs for all participants in the system. The Federal Reserve's role should also include identifying and reducing regulatory burdens that unreasonably inhibit innovations that improve the efficiency, security, and convenience of payment methods. Regulation may reduce uncertainty for some, but it may also discourage investment in new products or technologies by others. This is particularly true if the product is relatively new and demand for it is relatively uncertain, as is currently the case with a number of emerging electronic payment methods, such as stored-value cards. The government should avoid regulatory actions that may inhibit the evolution of emerging payments products and services or prevent the effective operation of competitive market forces. It is not clear whether, or what type of, regulation will be needed for many new products and it is important to avoid jumping to the conclusion that such regulations are inevitable over the longer term. Often the best regulation is that which addresses specific abuses or public policy concerns. Regulation that anticipates potential future problems runs the risk of resulting in overregulation that unduly stifles innovation. # Conclusion I'd like to conclude by re-emphasizing the role of competitive markets in fostering continued efficiency and innovation in the U.S. payments system. The Federal Reserve is striving to foster the competitive environment for those retail payment services in which it plays an operational role as well as those services in which it does not. For those services in which the Reserve Banks have an operational role, they strive to provide them in a cost-effective, highquality manner and take advantage of technological advances. We also plan to enhance the efficiency and help to foster improvements in the services in which we have an operational role. I believe the Federal Reserve has an obligation as a public entity to periodically assess -- as we have just done -- the extent to which it needs to continue to provide interbank retail payment services in competition with private firms. For newer payments mechanisms, we do not strive to become an active provider. However, we can encourage private-sector initiatives and remove regulatory hurdles to experimentation, where appropriate. We can also help, in collaboration with the private sector, to overcome barriers and market imperfections. Ultimately, however, the marketplace will decide which payment products and services will best meet the needs of households and businesses for reliable, secure, and efficient payments. No matter whether we are discussing existing services, possible new products, or regulatory actions, the Federal Reserve seeks to foster efficiency, integrity, and broad access in the payments system. Our attention to this area reflects our recognition that a smooth functioning payments system is critical to the smooth functioning of the nation's economy.	Roger W Ferguson	United States	https://www.bis.org/review/r980421b.pdf	Address by Mr. Roger W. Ferguson, Jr., a member of the Board Governors of the US Federal Reserve System, before the Bankers' Roundtable held in Phoenix, Arizona on 4/4/98. Thank you for inviting me to speak with you today. I am pleased to have this opportunity to discuss the Federal Reserve's role in the payments system with you for two reasons. The Bankers' Roundtable includes many of the major participants in the U.S. payments system. Also, our role in the payments system has received considerable attention recently not only by the Federal Reserve itself but also by Congress, the GAO, and the banking industry, including the Bankers' Roundtable. As a central bank, the Federal Reserve needs to ensure that the payments system of the United States (1) supports economic growth, which can best be done by ensuring open access, (2) manages risk well, (3) is resilient in the face of crisis, and (4) continues to evolve to keep pace with the needs of an evolving economy. To achieve these goals, we serve as both payments provider and regulator. Today, I would like to focus on how the Federal Reserve influences the level of competition in the market for payment services and how we hope, through competition, to foster continuing improvements in the payments system. As you know, the Federal Reserve Banks provide a range of payment-related services. Some of these services are generally viewed as critical to the execution of the Federal Reserve's core central bank responsibilities. For example, the Federal Reserve's cash services are integral to one the Fed's primary responsibilities -- to provide for an elastic currency. The Fedwire funds transfer system facilitates final settlement of interbank payments in central bank money and provides liquidity to the financial markets to support a growing economy. Our net settlement service facilitates the final settlement in central bank funds of payments cleared by outside the Federal Reserve. For retail payments, however, the appropriate role of the Federal Reserve is not so obvious. Historically, we can understand why the Federal Reserve began to process check and ACH payments. In an era of rudimentary communications and a fragmented banking system in the early part of this century, the Reserve Banks' involvement in check collection helped to improve the workings of the national economy, spur trade, and overcome some of the structural impediments that had contributed to the financial panics in the late 1800s and early 1900s. At that time, checks were used far differently than they are today, and represented a primary means of making interbank wholesale transfers. Sixty years later, in the 1970s, the Federal Reserve's early participation in and subsidization of the automated clearing house system provided the impetus to launch that new nationwide electronic payment mechanism. I believe that fostering a competitive environment is critically important for all portions of the retail payments system, including those in which the Federal Reserve is a participant. Indeed, the effectiveness of the U.S. retail payments systems can be credited largely to the competitive marketplace in which payments are provided. The Federal Reserve promotes a competitive marketplace in part through innovations that enhance the cost effectiveness and quality of our services. An example of current initiatives we have underway that I think holds great potential is the use of web browser software to enable banks to communicate with the Federal Reserve to send and retrieve information. This technology will make it much easier, for instance, for banks to order cash, retrieve images of checks, and submit the financial information that we ask banks to provide regularly. It will also significantly improve our ability to respond quickly to the evolving needs of our customers. The Federal Reserve is also working to streamline the check collection process through the use of electronics and image processing. Last year, more than 2.2 billion checks -or about 14 percent of all checks collected by the Reserve Banks -- were presented electronically. In addition to the growing array of image services provided by the Reserve Banks, the Fed is also leading efforts to develop industry standards for the exchange of check images. Another example of current Fed innovation is in the ACH arena. The Federal Reserve will soon provide financial EDI translation capability available to all banks that receive ACH transactions through our Fedline software. This capability will support the Treasury's EFT99 initiative and help facilitate end-to-end electronic payments. In 1980, in part to promote competition among the Federal Reserve and private-sector service providers, Congress enacted the Monetary Control Act. MCA requires the Federal Reserve to price its payment services to recover all costs of providing the services over the long run, including imputed costs that would have been incurred and imputed profits that would have been earned had the services been provided by a private firm. The Federal Reserve has fully met this requirement, and I believe MCA has enhanced the competitive environment for the provision of payment services and has improved payments system efficiency. We must recognize, however, that the competitive market envisioned by Congress in the Monetary Control Act may not be fully realized due to several fundamental differences between the Federal Reserve and private firms. First, the Federal Reserve is immune to insolvency or default. Therefore, its customers do not need to concern themselves with credit risk associated with using the Federal Reserve as an intermediary bank in payment services. Second, the Reserve Banks continue to have some legal advantages over other providers of check services, even though the Federal Reserve Board has taken steps to reduce these advantages through its Regulation CC same-day settlement rule. Third, the Federal Reserve has a different risk-taking profile than do the private firms with which it competes. As you know all too well, many innovations that appear to have great promise fail in the marketplace, while others succeed. The public nature of the Federal Reserve, along with its self-imposed objective of achieving industry average profit margins on each service line, virtually dictates a more conservative approach in the marketplace. In contrast, a private firm may be more willing to risk the funds of its shareholders in anticipation of achieving significantly higher profit margins. Finally, Federal Reserve Banks lack the flexibility afforded their private-sector competitors to be selective in the customers to which they will provide payment services and in their pricing of those payment services. We are also subject to far greater public scrutiny and disclosure than our competitors. You can see from these examples that the Federal Reserve has some material advantages as a competitor, but also some impediments to being an effective competitor. Both the advantages and the impediments should be kept in mind. Because of these competitive inequities, it is all the more important that the Federal Reserve periodically reassess the need to continue to provide check and ACH services as market structure, technology, and competitive conditions evolve. We last did so in 1996 and 1997 after Chairman Greenspan established the Committee on the Role of the Federal Reserve in the Payments System, or the so-called Rivlin Committee. The Committee examined a range of alternative scenarios under which payments could be provided and sought views from a large number of payments system participants. Most participants urged the Federal Reserve to continue to provide check and ACH services. Many expressed concern as to whether private-sector service providers would adequately meet the needs of all depository institutions, especially small institutions and those in remote locations, if the Federal Reserve were to exit these services. In particular, they noted that the Federal Reserve serves certain market segments that may not yet have demonstrated adequate market competition, specifically, providing check and ACH services to low-volume banks and providing check services to banks throughout the country that need to collect checks drawn on small, remote banks. The Rivlin Committee concluded that the Federal Reserve should continue to provide check and ACH services, with the objectives of enhancing efficiency, promoting integrity, and ensuring access. Given the Federal Reserve's current dominant market position in these services and the risk of disruption if the Federal Reserve were to exit quickly, this conclusion makes sense. The Committee also concluded that we should play a more active role, working collaboratively with providers and users of the payments system, to help evolve strategies for moving to the next generation of payment instruments. For the longer term, will the conclusion that the Federal Reserve should be a provider continue to be the correct one? This question hinges in large part on the extent to which the Federal Reserve's participation is needed to ensure the smooth functioning of the payments system that achieves the four goals I outlined earlier and whether there are significant barriers to private firms entry into the interbank check and ACH markets. In other words, we need to assess whether the Federal Reserve's operational involvement in retail payment services would foster or impede competition and progress as the market for these payment services evolves. There has been much debate regarding the extent to which check markets are "contestable," or truly subject to competition, particularly those segments of the market that only the Federal Reserve serves. Are there significant barriers to competition in these markets? If so, can they be reduced? The Federal Reserve's market position in some segments may simply indicate that there is insufficient volume to support more than one bank presenting checks to very low-volume endpoints. If that is the case, does this suggest that a private-sector provider could fill the gap if the Fed were to exit this service? If the market will only support one provider, would potential entrants provide sufficient market discipline on that provider to ensure that the terms of its service are reasonable or would regulation be required? One possible barrier to correspondent banks providing services equivalent to the Federal Reserve's is their more limited presentment abilities. As I will discuss shortly, we are currently evaluating this issue. Private-sector entry into ACH appears to face different obstacles. Today, the ACH service exhibits economies of scale over broad volume levels, which suggests that efficiency may be enhanced and unit costs minimized by having few ACH operators. Thus, the Federal Reserve may have an advantage because it processes the large bulk of ACH payments. We believe that the competitive environment that results from multiple ACH operators will best ensure continued efficiency improvements and innovation in this service. I believe it is important that the Federal Reserve take appropriate steps to stimulate the competitive environment in the ACH . Our planned enhancements to our net settlement service, which will provide significant operational benefits for private-sector ACH operators and other private clearing arrangements, is clearly a step in this direction. As market conditions change, we should reassess the ability of the private marketplace to foster the efficiency and integrity of, and access to the full range of, retail payment services without the Federal Reserve's operational involvement. In particular, continued geographic expansion by major correspondent banks resulting from interstate branch banking will lessen the Federal Reserve's distinction as a nationwide service provider. In addition, continued fast-paced technological advancements will likely result in further substantial reductions in the cost of data processing and data communication services. These technological improvements may reduce the barriers faced by other firms in establishing or expanding the scope of their payment services. Finally, the Federal Reserve's operational role in retail payments will decline inevitably as other types of retail payments not provided by the Federal Reserve grow. These changes may promote the competitive environment for the provision of retail payment services and may diminish the Federal Reserve's dominant market position in the provision of these services. I know some of us are impatient with the pace of the migration of retail payments to electronic alternatives. Earlier predictions of a cashless, checkless society clearly missed their mark. Technological advances, however, are providing new opportunities to accelerate the migration to electronic payments. New payment methods will likely continue to supplement, rather than supplant, existing forms of payment. Given the track record of previous forecasts, I will refrain from speculating on the future pace of this shift from paper to electronic payments. The stakes for banks in making the transition from paper-based retail payments to electronic ones are high. Some industry observers estimate that payments businesses represent as much as one-third of industry revenues, expenses, and profits. The risk to banks is that expenses from the current payments systems stay while significant new investments for emerging payment methods are required. As I see it, banks would be well advised to manage the transition, leverage their advantage from established customer relationships and information, and harness industry-wide energy. Experience has taught us that there are often significant lags between the introduction of a new payment instrument and its widespread use. These lags are due to several factors, such as the time required for the needed physical infrastructure to emerge, the time required for consumers and businesses to become familiar and comfortable with using a new payment method, and the time necessary to achieve the critical mass of acceptance by both payors and payees. In addition, it often takes a long time for service providers to realize the scale economies that would make the new instrument cost effective compared to existing ones. Moreover, the speed of adoption depends on the distribution of risks, costs, and benefits of the new payment methods among the end users of the payments as well as resistance from incumbent service providers. Even if the marginal cost of a new payment technology is equivalent to that of an existing payment, incumbents may have advantages over rivals with new technologies because they may have already incurred the fixed costs of providing their service or may have already gained market share and familiarity with consumers. For example, incumbents may have achieved the benefits from a large network of users, referred to as network externalities by economists. Adoption of new technologies may also be slowed if they require considerable amounts of coordination. A technological leader can try to establish the de facto standard. Or, developers can try to negotiate common standards, which is a time-consuming process that may constrain technological innovation, but spreads risk while permitting competition for customers. The result is a natural tension between maintaining an adequate level of competition and achieving a level of cooperation that enhances efficiency and consumer welfare. I do not believe that the market for new retail electronic payment services reflects the existence of market failures that would suggest a need for direct Federal Reserve operational involvement. These products, and the markets in which they operate, appear to be evolving adequately on their own, just as the credit card, debit card, and ATM networks evolved without a Federal Reserve operational presence. Therefore, with respect to the Federal Reserve as a service provider, I think we have a role as provider and enhancer in traditional payment services, check and ACH , but probably will not be a provider of newer retail services. I have confidence that the private-sector marketplace can provide the combination of new products, services, and service providers to meet the needs of consumers and businesses. Our goal is to determine how we can best aid the process of moving to these new instruments without pre-empting private sector creativity and problem solving. I've focused my comments thus far on the Federal Reserve's operational role in the payments system. In addition to the Reserve Banks' role as provider of payment services, the Federal Reserve Board also regulates aspects of the payments system. While our role as provider of payment services goes back to the inception of the Federal Reserve, our authority to regulate the interbank collection or execution of payments not processed by the Federal Reserve is only about a decade old. In exercising this regulatory authority, the Board has focused in large part on improving the competitiveness of the market for interbank check collection. The Board's 1994 same-day settlement rule enhanced the ability of correspondent banks to compete with the Federal Reserve Banks in collecting checks. The Board adopted this rule because it believed it was in the best interest of the payments system, even though it knew the rule would reduce the Reserve Banks' check volume. Our goal was competition in the check collection market, not preserving Federal Reserve market share. As I mentioned earlier, even with the same-day settlement rule, correspondent banks may still have difficulty competing with Federal Reserve Banks in some check collection markets due to their more limited presentment abilities. Several weeks ago, the Board issued an advanced notice of proposed rulemaking designed to assess market experience under the sameday settlement rule. The comments we receive will be helpful in assessing whether further reductions in the legal disparities between the Federal Reserve Banks and private-sector banks would further enhance competition and the overall efficiencies that could result from that competition. This analysis is a complex one. I believe that in principle reduction in legal disparities between the Federal Reserve and private-sector banks will enhance market competition. The benefits of regulatory change, however, have to be balanced with a potential increase in costs to paying banks and their check-writing customers. In other words, we should continue to look for ways to reduce legal disparities between the Federal Reserve and privatesector banks, but some of these changes may not reduce costs for all participants in the system. The Federal Reserve's role should also include identifying and reducing regulatory burdens that unreasonably inhibit innovations that improve the efficiency, security, and convenience of payment methods. Regulation may reduce uncertainty for some, but it may also discourage investment in new products or technologies by others. This is particularly true if the product is relatively new and demand for it is relatively uncertain, as is currently the case with a number of emerging electronic payment methods, such as stored-value cards. The government should avoid regulatory actions that may inhibit the evolution of emerging payments products and services or prevent the effective operation of competitive market forces. It is not clear whether, or what type of, regulation will be needed for many new products and it is important to avoid jumping to the conclusion that such regulations are inevitable over the longer term. Often the best regulation is that which addresses specific abuses or public policy concerns. Regulation that anticipates potential future problems runs the risk of resulting in overregulation that unduly stifles innovation. I'd like to conclude by re-emphasizing the role of competitive markets in fostering continued efficiency and innovation in the U.S. payments system. The Federal Reserve is striving to foster the competitive environment for those retail payment services in which it plays an operational role as well as those services in which it does not. For those services in which the Reserve Banks have an operational role, they strive to provide them in a cost-effective, highquality manner and take advantage of technological advances. We also plan to enhance the efficiency and help to foster improvements in the services in which we have an operational role. I believe the Federal Reserve has an obligation as a public entity to periodically assess -- as we have just done -- the extent to which it needs to continue to provide interbank retail payment services in competition with private firms. For newer payments mechanisms, we do not strive to become an active provider. However, we can encourage private-sector initiatives and remove regulatory hurdles to experimentation, where appropriate. We can also help, in collaboration with the private sector, to overcome barriers and market imperfections. Ultimately, however, the marketplace will decide which payment products and services will best meet the needs of households and businesses for reliable, secure, and efficient payments. No matter whether we are discussing existing services, possible new products, or regulatory actions, the Federal Reserve seeks to foster efficiency, integrity, and broad access in the payments system. Our attention to this area reflects our recognition that a smooth functioning payments system is critical to the smooth functioning of the nation's economy.
1998-04-09T00:00:00	Mr. Meyer remarks on the economic outlook and the challenges facing monetary policy (Central Bank Articles and Speeches, 9 Apr 98)	Address by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, presented at the Public Policy Meeting, Federal Reserve Bank of Atlanta, on 9/4/98.	Mr. Meyer remarks on the economic outlook and the challenges facing Address by Mr. Laurence H. Meyer, a member of the Board of Governors of monetary policy the US Federal Reserve System, presented at the Public Policy Meeting, Federal Reserve Bank of Atlanta, on 9/4/98. Recent economic performance has been exceptional. I want to focus on the forces responsible for this performance and how much credit economic policy deserves for the outcome. Then I will assess the crosscurrents shaping prospects going forward and the sustainability of recent economic performance and give my perspective on challenges facing monetary policy. Let me emphasize that the views about the economic outlook and about monetary policy I present here are my own and should not be interpreted as the position of the Board of Governors or the FOMC. Where We Are and How We Got There Three forces have driven recent economic performance. First, there has been strong momentum in private domestic demand - the sum of consumption, private fixed investment and residential construction - only partially offset by a decline in net exports. The result has been consistent above-trend growth and a rise in resource utilization rates, particularly in the labor market. Second, the strength in the aggregate demand for goods and services has been encouraged by favorable financial conditions. Whereas, normally, financial conditions become less favorable during an expansion and ultimately constrain demand, in this expansion financial conditions have become increasingly favorable and therefore have continued to support above-trend growth. An important element in the favorable financing conditions has, of course, been the soaring stock market. Third, a coincidence of favorable shocks has enabled businesses to produce at a lower cost; in the short run, at least, this restrains inflation. The result has been a slower increase in the CPI and other measures of the overall price level, even as the economy has raced ahead to higher utilization rates. The favorable shocks have included a decline in oil prices, a decline in import prices associated with the cumulative appreciation in the dollar, technological innovations that have sped the reduction in computer prices, changes in medical care management that have held down the increase in benefit costs, and improved crops that have damped food prices. The resulting economic performance has consistently exceeded expectations. I have said many times that if I had a dime for every time I have had to say faster-than-expected growth and lower-than-expected inflation, I would be a rich man today! Growth over 1998 was nearly 4%, the highest annual growth in about a decade. The unemployment rate declined by about 3⁄4 percentage point last year to a quarter-century low. And inflation declined to a more than 30-year low. There is much to like about this outcome and the policy that supported it. Monetary policy has helped deliver a low inflation environment and the strong economy and disciplined fiscal policy have delivered a balanced budget. In the case of monetary policy, the low inflation environment is one we believe encourages efficient resource allocation and perhaps higher levels of saving and investment. In the case of fiscal policy, the government is no longer competing with the private sector for private saving, contributing to lower real interest rates and higher rates of capital formation. In combination, monetary and fiscal policies have set a stable foundation for private sector decision making. As good as policy has been, it clearly does not deserve all the credit for the exceptional recent performance. I have a rule I religiously follow: If you didn't predict it, don't take credit for it. We did not predict this exceptional performance and we should not take more credit for it than we deserve. Still, there should be little question that policy has made an important contribution to the exceptional performance. The net result of these forces has been that the economy has, in my view, moved beyond the point of sustainable capacity. That is, output is above it's long-run sustainable level. Normally, this would result in rising inflation, but the favorable supply shocks have not only prevented a rise in inflation, but have allowed inflation to decline. Monetary policy has accommodated the above-trend growth and rising utilization rates precisely because they have been accompanied by declining inflation. Contradictions I always appreciated, as a private sector forecaster, that, in any interpretation of the economy, there were always some tensions or contradictions. This reflects the reality that the interpretation of the data is never perfectly clear, always subject to some uncertainty. And so it is today. Let me highlight three uncertainties. First, there is some question about whether or not or, at least, to what degree the economy is operating beyond the point of sustainable capacity. The unemployment rate is below the consensus estimates of the threshold consistent with stable inflation, although there is somewhat greater than normal uncertainty about this estimate. This threshold is called NAIRU, the nonaccelerating inflation rate of unemployment. The President's Council of Economic Advisers estimates this threshold, for example, at 5.4%, Congressional Budget Office at 5.8%, and I have used 5.5% as my best guess. There is, at any rate, no question about labor markets being very tight. On the other hand, the measures of resource utilization in the product market, notably the capacity utilization rate in the manufacturing sector, do not suggest excess demand. There is, in fact, an unusual discrepancy between the unemployment and capacity utilization rates, compared to previous expansions; that is, the capacity utilization rate is lower than would have been expected, based on past experience, at the prevailing unemployment rate. This undoubtedly accounts for the perception of limited pricing leverage and has contributed to the restrained inflation, despite the low unemployment rate. Nevertheless, the very tight labor markets can be expected to put upward pressure on wage change and hence inflation, once the special forces restraining inflation dissipate or reverse. Second, there is some question about how to assess the degree of restraint or stimulus associated with current monetary policy. Although the nominal federal funds rate has remained nearly constant, the decline in inflation has raised the real federal funds rate. Many have observed the rise in the real federal funds rate to a level well above its historical average and concluded that monetary policy is currently restrictive. The implication is that monetary policy is already well positioned to slow the expansion. On the other hand, many other measures of financial conditions appear to be indicating, to the contrary, that financial conditions are very favorable, highly supportive of contained momentum in aggregate demand and perhaps becoming even more so. This interpretation appears to be confirmed by the continued strength in aggregate demand in general and in interest-sensitive sectors in particular. Real long-term interest rates, based on survey measures of inflation, have been stable to declining, equity prices have been soaring, credit availability has been more than ample, underwriting standards may have eased some, loan pricing is aggressive, spreads between safe and risky assets have narrowed, and the money supply is growing rapidly. I conclude that, notwithstanding the recent rise in the real federal funds rate, neither financial conditions in general nor monetary policy in particular are currently restraining aggregate demand. Third, there has been a significant rebound in productivity growth over 1996 and 1997, compared to the previous two years. That is clear from the data. The question that the data do not immediately reveal is whether this rebound was a normal cyclical rebound or marks a significant increase in trend productivity growth. My view has and continues to be that the increase is predominantly a cyclical rebound. This leads me into my next topic. Stories In my last outlook talk I developed two "stories" that provide alternative explanations for the recent exceptional economic performance. Each story carries with it an implication about the sustainability of recent performance and a challenge for monetary policy. I call one story "temporary bliss." This story emphasizes the role of good fortune in the current exceptional performance and highlights the potential that we may not be able to maintain the recent rate of growth and the current high labor utilization rates for much longer without ultimately suffering an increase in inflation. The key to this story is the series of favorable supply shocks that have, in my judgment, masked, for a time, the normal consequences of very tight labor markets and permitted the economy to operate beyond the point of long-run sustainable capacity without the usual inflationary consequences. The challenge facing monetary policy, in this interpretation, is to facilitate a transition to a more sustainable state before the favorable supply shocks dissipate or reverse. The second story I call "permanent bliss." This story emphasizes the possibility that structural changes have permanently altered what the economy is capable of delivering in terms of both average growth and the unemployment rate consistent with stable inflation. In this interpretation, monetary policy must be careful not to interfere with the economy taking advantage of its improved potential. The truth, as I have noted previously, is likely some combination of the two stories. I keep them separate to highlight the differences in policy implications between temporary supply shocks and permanent structural change. I have said previously that I have lowered my estimate of NAIRU, for example, from 6% to 5 1/2%, in response to my reading of the evidence of the last several years. I have also raised my estimate of trend productivity -- from 1.1%, the average rate for the 20 years prior to the current expansion to 1.3% or 1.4%. A tenth of this increase in trend productivity growth reflects the technical revisions to the CPI which have lowered the chain measure of the GDP deflator by a tenth. This is not an increase in trend productivity in this expansion, relative to previous expansions, but rather an upward revision to productivity growth over the entire postwar period, the mirror image of a decline in the upward bias to measured inflation. It should be noted, nevertheless, that the technical revisions to measured inflation do account for part of the appearance of improved economic performance. In addition, the data suggest to me, as to many private sector forecasters, that there might be a tenth or two increase in trend productivity, an improvement that is generally associated with capital deepening, an increase in the amount of equipment each worker has at its disposal, as a result of the strength of investment in this expansion. As such, this improvement in productivity growth may itself be transitory, part of a one-time increase in the level of productivity associated with a transition to a higher capital-to-labor ratio. Nevertheless, even a couple of tenths improvement in productivity growth, if sustained for some period, would give an important boost to higher living standards over time. But this upward adjustment in my estimate of the productivity trend plays only a negligible role in explaining how we have managed such exceptional economic performance over the last couple of years. It goes in the right direction, but it is simply too small to carry much of the burden. The major player in my view, in addition to the decline in NAIRU, is the coincidence of favorable supply shocks. The relative weights here are very important because they affect the challenge for monetary policy. Challenges for Monetary Policy The challenge for monetary policy, as always, is to sustain the best possible economic performance. The emphasis here is on the "possible." Sometimes we are expected to deliver more than what is possible. We aim for maximum sustainable growth and maximum sustainable levels of output and employment. The emphasis here is on "sustainable." Trying to do more threatens to introduce unnecessary instability into the economy and ultimately to cut short an expansion that otherwise has the potential to continue for some time. Trying to do more threatens to give back some of the reduction in inflation that has moved the U.S. to a position very close to the Federal Reserve's objective of price stability. The bottom line is that it is essential that growth slow from the near 4% over 1997 to and perhaps below trend for a while to allow the economy to move toward a more sustainable state. Prospects There are two sets of crosscurrents that are likely to shape the outlook immediately ahead. First, there is a tug of war between the continued exceptional momentum in private domestic demand and the external drag from the Asian crisis. The latter shock also reinforces the restraint that had been projected from a cumulative appreciation of the dollar that predated the Asian crisis. The result should almost certainly be some slowing in the expansion, relative to 1997. Still, the sharper-than-expected decline in oil prices, the decline in long-term bond yields and the further rise in equity prices in recent months are providing some offset to the external drag coming from Asia and the appreciation of the dollar. The question is when and how much of a slowing results, and whether the slowdown takes growth to or below trend, or leaves growth still above trend. There is still considerable uncertainty about how these crosscurrents will balance out. Second, there is a tug of war between the very tight labor market and the set of forces that have been restraining inflation. The forces restraining inflation have been winning this battle to date, and they have been reinforced this year by the sharper-than-expected decline in oil prices, by the even more extraordinary decline in computer prices in recent months, and by the decline in commodity prices and further downward pressure on import prices associated with the crisis in Asia. Nevertheless, at some point, the favorable supply shocks will dissipate or reverse. As the economy entered 1998, continued momentum in private domestic demand was clearly evident, while the drag from Asia was less obvious. But there was clear evidence in the trade data among the Asian developing economies that a significant swing was under way in their trade balances and there is little doubt that the U.S. economy will bear the greatest burden of this turnaround. The March employment report was the strongest evidence to date that a slowing is under way, although it should be appreciated that there is often more noise than signal in one month's data. And, even with the unexpectedly weak March reading, hours worked advanced at a robust 4.8% annual rate in the first quarter. So there is still considerable uncertainty about whether the spillover from Asia and the earlier cumulative appreciation of the dollar will slow the expansion to or below trend immediately ahead. In terms of inflation, there is no evidence to date that wage pressures are building, relative to last year, and certainly no evidence of a pickup in inflation, though the recent data for core CPI has hinted that the earlier downward trend may now be behind us. At any rate, it appears likely, given the renewal of favorable supply shocks, that inflation will remain well contained this year. But monetary policy has little ability to affect inflation this year. We should, therefore, be focusing on inflation prospects for next year. As I noted earlier, some upward pressure on inflation is likely going forward as forces retraining inflation dissipate or reverse, though a similar statement would have been in order at this time last year. The expected persistence of the special forces restraining inflation is therefore an important consideration in forecasting inflation and in assessing the appropriate course of monetary policy. It is important that, as the forces retraining inflation dissipate or reverse, that this upward pressure on inflation is not reinforced by inflationary pressures generated from very high utilization rates. The key to sustaining the best possible performance going forward is making the transition from the current state where performance is exceptional but unsustainable to the best possible sustainable state. That will require a slowdown in growth, preferably in the near term. Asia may accomplish this, in which case it would substitute for monetary tightening that in my judgment would otherwise be required.	---[PAGE_BREAK]--- # Mr. Meyer remarks on the economic outlook and the challenges facing monetary policy Address by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, presented at the Public Policy Meeting, Federal Reserve Bank of Atlanta, on 9/4/98. Recent economic performance has been exceptional. I want to focus on the forces responsible for this performance and how much credit economic policy deserves for the outcome. Then I will assess the crosscurrents shaping prospects going forward and the sustainability of recent economic performance and give my perspective on challenges facing monetary policy. Let me emphasize that the views about the economic outlook and about monetary policy I present here are my own and should not be interpreted as the position of the Board of Governors or the FOMC. ## Where We Are and How We Got There Three forces have driven recent economic performance. First, there has been strong momentum in private domestic demand - the sum of consumption, private fixed investment and residential construction - only partially offset by a decline in net exports. The result has been consistent above-trend growth and a rise in resource utilization rates, particularly in the labor market. Second, the strength in the aggregate demand for goods and services has been encouraged by favorable financial conditions. Whereas, normally, financial conditions become less favorable during an expansion and ultimately constrain demand, in this expansion financial conditions have become increasingly favorable and therefore have continued to support above-trend growth. An important element in the favorable financing conditions has, of course, been the soaring stock market. Third, a coincidence of favorable shocks has enabled businesses to produce at a lower cost; in the short run, at least, this restrains inflation. The result has been a slower increase in the CPI and other measures of the overall price level, even as the economy has raced ahead to higher utilization rates. The favorable shocks have included a decline in oil prices, a decline in import prices associated with the cumulative appreciation in the dollar, technological innovations that have sped the reduction in computer prices, changes in medical care management that have held down the increase in benefit costs, and improved crops that have damped food prices. The resulting economic performance has consistently exceeded expectations. I have said many times that if I had a dime for every time I have had to say faster-than-expected growth and lower-than-expected inflation, I would be a rich man today! Growth over 1998 was nearly $4 \%$, the highest annual growth in about a decade. The unemployment rate declined by about $3 / 4$ percentage point last year to a quarter-century low. And inflation declined to a more than 30-year low. There is much to like about this outcome and the policy that supported it. Monetary policy has helped deliver a low inflation environment and the strong economy and disciplined fiscal policy have delivered a balanced budget. In the case of monetary policy, the low inflation environment is one we believe encourages efficient resource allocation and perhaps higher levels of saving and investment. In the case of fiscal policy, the government is no longer competing ---[PAGE_BREAK]--- with the private sector for private saving, contributing to lower real interest rates and higher rates of capital formation. In combination, monetary and fiscal policies have set a stable foundation for private sector decision making. As good as policy has been, it clearly does not deserve all the credit for the exceptional recent performance. I have a rule I religiously follow: If you didn't predict it, don't take credit for it. We did not predict this exceptional performance and we should not take more credit for it than we deserve. Still, there should be little question that policy has made an important contribution to the exceptional performance. The net result of these forces has been that the economy has, in my view, moved beyond the point of sustainable capacity. That is, output is above it's long-run sustainable level. Normally, this would result in rising inflation, but the favorable supply shocks have not only prevented a rise in inflation, but have allowed inflation to decline. Monetary policy has accommodated the above-trend growth and rising utilization rates precisely because they have been accompanied by declining inflation. # Contradictions I always appreciated, as a private sector forecaster, that, in any interpretation of the economy, there were always some tensions or contradictions. This reflects the reality that the interpretation of the data is never perfectly clear, always subject to some uncertainty. And so it is today. Let me highlight three uncertainties. First, there is some question about whether or not or, at least, to what degree the economy is operating beyond the point of sustainable capacity. The unemployment rate is below the consensus estimates of the threshold consistent with stable inflation, although there is somewhat greater than normal uncertainty about this estimate. This threshold is called NAIRU, the nonaccelerating inflation rate of unemployment. The President's Council of Economic Advisers estimates this threshold, for example, at 5.4\%, Congressional Budget Office at 5.8\%, and I have used $5.5 \%$ as my best guess. There is, at any rate, no question about labor markets being very tight. On the other hand, the measures of resource utilization in the product market, notably the capacity utilization rate in the manufacturing sector, do not suggest excess demand. There is, in fact, an unusual discrepancy between the unemployment and capacity utilization rates, compared to previous expansions; that is, the capacity utilization rate is lower than would have been expected, based on past experience, at the prevailing unemployment rate. This undoubtedly accounts for the perception of limited pricing leverage and has contributed to the restrained inflation, despite the low unemployment rate. Nevertheless, the very tight labor markets can be expected to put upward pressure on wage change and hence inflation, once the special forces restraining inflation dissipate or reverse. Second, there is some question about how to assess the degree of restraint or stimulus associated with current monetary policy. Although the nominal federal funds rate has remained nearly constant, the decline in inflation has raised the real federal funds rate. Many have observed the rise in the real federal funds rate to a level well above its historical average and concluded that monetary policy is currently restrictive. The implication is that monetary policy is already well positioned to slow the expansion. On the other hand, many other measures of financial conditions appear to be indicating, to the contrary, that financial conditions are very favorable, highly supportive of contained momentum in aggregate demand and perhaps becoming even more so. This ---[PAGE_BREAK]--- interpretation appears to be confirmed by the continued strength in aggregate demand in general and in interest-sensitive sectors in particular. Real long-term interest rates, based on survey measures of inflation, have been stable to declining, equity prices have been soaring, credit availability has been more than ample, underwriting standards may have eased some, loan pricing is aggressive, spreads between safe and risky assets have narrowed, and the money supply is growing rapidly. I conclude that, notwithstanding the recent rise in the real federal funds rate, neither financial conditions in general nor monetary policy in particular are currently restraining aggregate demand. Third, there has been a significant rebound in productivity growth over 1996 and 1997, compared to the previous two years. That is clear from the data. The question that the data do not immediately reveal is whether this rebound was a normal cyclical rebound or marks a significant increase in trend productivity growth. My view has and continues to be that the increase is predominantly a cyclical rebound. This leads me into my next topic. # Stories In my last outlook talk I developed two "stories" that provide alternative explanations for the recent exceptional economic performance. Each story carries with it an implication about the sustainability of recent performance and a challenge for monetary policy. I call one story "temporary bliss." This story emphasizes the role of good fortune in the current exceptional performance and highlights the potential that we may not be able to maintain the recent rate of growth and the current high labor utilization rates for much longer without ultimately suffering an increase in inflation. The key to this story is the series of favorable supply shocks that have, in my judgment, masked, for a time, the normal consequences of very tight labor markets and permitted the economy to operate beyond the point of long-run sustainable capacity without the usual inflationary consequences. The challenge facing monetary policy, in this interpretation, is to facilitate a transition to a more sustainable state before the favorable supply shocks dissipate or reverse. The second story I call "permanent bliss." This story emphasizes the possibility that structural changes have permanently altered what the economy is capable of delivering in terms of both average growth and the unemployment rate consistent with stable inflation. In this interpretation, monetary policy must be careful not to interfere with the economy taking advantage of its improved potential. The truth, as I have noted previously, is likely some combination of the two stories. I keep them separate to highlight the differences in policy implications between temporary supply shocks and permanent structural change. I have said previously that I have lowered my estimate of NAIRU, for example, from $6 \%$ to $51 / 2 \%$, in response to my reading of the evidence of the last several years. I have also raised my estimate of trend productivity -- from $1.1 \%$, the average rate for the 20 years prior to the current expansion to $1.3 \%$ or $1.4 \%$. A tenth of this increase in trend productivity growth reflects the technical revisions to the CPI which have lowered the chain measure of the GDP deflator by a tenth. This is not an increase in trend productivity in this expansion, relative to previous expansions, but rather an upward revision to productivity growth over the entire postwar period, the mirror image of a decline in the upward bias to measured inflation. It should be noted, nevertheless, that the technical revisions to measured inflation do account for part of the appearance of improved economic performance. ---[PAGE_BREAK]--- In addition, the data suggest to me, as to many private sector forecasters, that there might be a tenth or two increase in trend productivity, an improvement that is generally associated with capital deepening, an increase in the amount of equipment each worker has at its disposal, as a result of the strength of investment in this expansion. As such, this improvement in productivity growth may itself be transitory, part of a one-time increase in the level of productivity associated with a transition to a higher capital-to-labor ratio. Nevertheless, even a couple of tenths improvement in productivity growth, if sustained for some period, would give an important boost to higher living standards over time. But this upward adjustment in my estimate of the productivity trend plays only a negligible role in explaining how we have managed such exceptional economic performance over the last couple of years. It goes in the right direction, but it is simply too small to carry much of the burden. The major player in my view, in addition to the decline in NAIRU, is the coincidence of favorable supply shocks. The relative weights here are very important because they affect the challenge for monetary policy. # Challenges for Monetary Policy The challenge for monetary policy, as always, is to sustain the best possible economic performance. The emphasis here is on the "possible." Sometimes we are expected to deliver more than what is possible. We aim for maximum sustainable growth and maximum sustainable levels of output and employment. The emphasis here is on "sustainable." Trying to do more threatens to introduce unnecessary instability into the economy and ultimately to cut short an expansion that otherwise has the potential to continue for some time. Trying to do more threatens to give back some of the reduction in inflation that has moved the U.S. to a position very close to the Federal Reserve's objective of price stability. The bottom line is that it is essential that growth slow from the near $4 \%$ over 1997 to and perhaps below trend for a while to allow the economy to move toward a more sustainable state. ## Prospects There are two sets of crosscurrents that are likely to shape the outlook immediately ahead. First, there is a tug of war between the continued exceptional momentum in private domestic demand and the external drag from the Asian crisis. The latter shock also reinforces the restraint that had been projected from a cumulative appreciation of the dollar that predated the Asian crisis. The result should almost certainly be some slowing in the expansion, relative to 1997. Still, the sharper-than-expected decline in oil prices, the decline in long-term bond yields and the further rise in equity prices in recent months are providing some offset to the external drag coming from Asia and the appreciation of the dollar. The question is when and how much of a slowing results, and whether the slowdown takes growth to or below trend, or leaves growth still above trend. There is still considerable uncertainty about how these crosscurrents will balance out. Second, there is a tug of war between the very tight labor market and the set of forces that have been restraining inflation. The forces restraining inflation have been winning this battle to date, and they have been reinforced this year by the sharper-than-expected decline in oil prices, by the even more extraordinary decline in computer prices in recent months, and by the decline in commodity prices and further downward pressure on import prices associated with the crisis in Asia. Nevertheless, at some point, the favorable supply shocks will dissipate or reverse. ---[PAGE_BREAK]--- As the economy entered 1998, continued momentum in private domestic demand was clearly evident, while the drag from Asia was less obvious. But there was clear evidence in the trade data among the Asian developing economies that a significant swing was under way in their trade balances and there is little doubt that the U.S. economy will bear the greatest burden of this turnaround. The March employment report was the strongest evidence to date that a slowing is under way, although it should be appreciated that there is often more noise than signal in one month's data. And, even with the unexpectedly weak March reading, hours worked advanced at a robust $4.8 \%$ annual rate in the first quarter. So there is still considerable uncertainty about whether the spillover from Asia and the earlier cumulative appreciation of the dollar will slow the expansion to or below trend immediately ahead. In terms of inflation, there is no evidence to date that wage pressures are building, relative to last year, and certainly no evidence of a pickup in inflation, though the recent data for core CPI has hinted that the earlier downward trend may now be behind us. At any rate, it appears likely, given the renewal of favorable supply shocks, that inflation will remain well contained this year. But monetary policy has little ability to affect inflation this year. We should, therefore, be focusing on inflation prospects for next year. As I noted earlier, some upward pressure on inflation is likely going forward as forces retraining inflation dissipate or reverse, though a similar statement would have been in order at this time last year. The expected persistence of the special forces restraining inflation is therefore an important consideration in forecasting inflation and in assessing the appropriate course of monetary policy. It is important that, as the forces retraining inflation dissipate or reverse, that this upward pressure on inflation is not reinforced by inflationary pressures generated from very high utilization rates. The key to sustaining the best possible performance going forward is making the transition from the current state where performance is exceptional but unsustainable to the best possible sustainable state. That will require a slowdown in growth, preferably in the near term. Asia may accomplish this, in which case it would substitute for monetary tightening that in my judgment would otherwise be required.	Laurence H Meyer	United States	https://www.bis.org/review/r980518a.pdf	Recent economic performance has been exceptional. I want to focus on the forces responsible for this performance and how much credit economic policy deserves for the outcome. Then I will assess the crosscurrents shaping prospects going forward and the sustainability of recent economic performance and give my perspective on challenges facing monetary policy. Let me emphasize that the views about the economic outlook and about monetary policy I present here are my own and should not be interpreted as the position of the Board of Governors or the FOMC. Three forces have driven recent economic performance. First, there has been strong momentum in private domestic demand - the sum of consumption, private fixed investment and residential construction - only partially offset by a decline in net exports. The result has been consistent above-trend growth and a rise in resource utilization rates, particularly in the labor market. Second, the strength in the aggregate demand for goods and services has been encouraged by favorable financial conditions. Whereas, normally, financial conditions become less favorable during an expansion and ultimately constrain demand, in this expansion financial conditions have become increasingly favorable and therefore have continued to support above-trend growth. An important element in the favorable financing conditions has, of course, been the soaring stock market. Third, a coincidence of favorable shocks has enabled businesses to produce at a lower cost; in the short run, at least, this restrains inflation. The result has been a slower increase in the CPI and other measures of the overall price level, even as the economy has raced ahead to higher utilization rates. The favorable shocks have included a decline in oil prices, a decline in import prices associated with the cumulative appreciation in the dollar, technological innovations that have sped the reduction in computer prices, changes in medical care management that have held down the increase in benefit costs, and improved crops that have damped food prices. The resulting economic performance has consistently exceeded expectations. I have said many times that if I had a dime for every time I have had to say faster-than-expected growth and lower-than-expected inflation, I would be a rich man today! Growth over 1998 was nearly $4 \%$, the highest annual growth in about a decade. The unemployment rate declined by about $3 / 4$ percentage point last year to a quarter-century low. And inflation declined to a more than 30-year low. There is much to like about this outcome and the policy that supported it. Monetary policy has helped deliver a low inflation environment and the strong economy and disciplined fiscal policy have delivered a balanced budget. In the case of monetary policy, the low inflation environment is one we believe encourages efficient resource allocation and perhaps higher levels of saving and investment. In the case of fiscal policy, the government is no longer competing with the private sector for private saving, contributing to lower real interest rates and higher rates of capital formation. In combination, monetary and fiscal policies have set a stable foundation for private sector decision making. As good as policy has been, it clearly does not deserve all the credit for the exceptional recent performance. I have a rule I religiously follow: If you didn't predict it, don't take credit for it. We did not predict this exceptional performance and we should not take more credit for it than we deserve. Still, there should be little question that policy has made an important contribution to the exceptional performance. The net result of these forces has been that the economy has, in my view, moved beyond the point of sustainable capacity. That is, output is above it's long-run sustainable level. Normally, this would result in rising inflation, but the favorable supply shocks have not only prevented a rise in inflation, but have allowed inflation to decline. Monetary policy has accommodated the above-trend growth and rising utilization rates precisely because they have been accompanied by declining inflation. I always appreciated, as a private sector forecaster, that, in any interpretation of the economy, there were always some tensions or contradictions. This reflects the reality that the interpretation of the data is never perfectly clear, always subject to some uncertainty. And so it is today. Let me highlight three uncertainties. First, there is some question about whether or not or, at least, to what degree the economy is operating beyond the point of sustainable capacity. The unemployment rate is below the consensus estimates of the threshold consistent with stable inflation, although there is somewhat greater than normal uncertainty about this estimate. This threshold is called NAIRU, the nonaccelerating inflation rate of unemployment. The President's Council of Economic Advisers estimates this threshold, for example, at 5.4\%, Congressional Budget Office at 5.8\%, and I have used $5.5 \%$ as my best guess. There is, at any rate, no question about labor markets being very tight. On the other hand, the measures of resource utilization in the product market, notably the capacity utilization rate in the manufacturing sector, do not suggest excess demand. There is, in fact, an unusual discrepancy between the unemployment and capacity utilization rates, compared to previous expansions; that is, the capacity utilization rate is lower than would have been expected, based on past experience, at the prevailing unemployment rate. This undoubtedly accounts for the perception of limited pricing leverage and has contributed to the restrained inflation, despite the low unemployment rate. Nevertheless, the very tight labor markets can be expected to put upward pressure on wage change and hence inflation, once the special forces restraining inflation dissipate or reverse. Second, there is some question about how to assess the degree of restraint or stimulus associated with current monetary policy. Although the nominal federal funds rate has remained nearly constant, the decline in inflation has raised the real federal funds rate. Many have observed the rise in the real federal funds rate to a level well above its historical average and concluded that monetary policy is currently restrictive. The implication is that monetary policy is already well positioned to slow the expansion. On the other hand, many other measures of financial conditions appear to be indicating, to the contrary, that financial conditions are very favorable, highly supportive of contained momentum in aggregate demand and perhaps becoming even more so. This interpretation appears to be confirmed by the continued strength in aggregate demand in general and in interest-sensitive sectors in particular. Real long-term interest rates, based on survey measures of inflation, have been stable to declining, equity prices have been soaring, credit availability has been more than ample, underwriting standards may have eased some, loan pricing is aggressive, spreads between safe and risky assets have narrowed, and the money supply is growing rapidly. I conclude that, notwithstanding the recent rise in the real federal funds rate, neither financial conditions in general nor monetary policy in particular are currently restraining aggregate demand. Third, there has been a significant rebound in productivity growth over 1996 and 1997, compared to the previous two years. That is clear from the data. The question that the data do not immediately reveal is whether this rebound was a normal cyclical rebound or marks a significant increase in trend productivity growth. My view has and continues to be that the increase is predominantly a cyclical rebound. This leads me into my next topic. In my last outlook talk I developed two "stories" that provide alternative explanations for the recent exceptional economic performance. Each story carries with it an implication about the sustainability of recent performance and a challenge for monetary policy. I call one story "temporary bliss." This story emphasizes the role of good fortune in the current exceptional performance and highlights the potential that we may not be able to maintain the recent rate of growth and the current high labor utilization rates for much longer without ultimately suffering an increase in inflation. The key to this story is the series of favorable supply shocks that have, in my judgment, masked, for a time, the normal consequences of very tight labor markets and permitted the economy to operate beyond the point of long-run sustainable capacity without the usual inflationary consequences. The challenge facing monetary policy, in this interpretation, is to facilitate a transition to a more sustainable state before the favorable supply shocks dissipate or reverse. The second story I call "permanent bliss." This story emphasizes the possibility that structural changes have permanently altered what the economy is capable of delivering in terms of both average growth and the unemployment rate consistent with stable inflation. In this interpretation, monetary policy must be careful not to interfere with the economy taking advantage of its improved potential. The truth, as I have noted previously, is likely some combination of the two stories. I keep them separate to highlight the differences in policy implications between temporary supply shocks and permanent structural change. I have said previously that I have lowered my estimate of NAIRU, for example, from $6 \%$ to $51 / 2 \%$, in response to my reading of the evidence of the last several years. I have also raised my estimate of trend productivity -- from $1.1 \%$, the average rate for the 20 years prior to the current expansion to $1.3 \%$ or $1.4 \%$. A tenth of this increase in trend productivity growth reflects the technical revisions to the CPI which have lowered the chain measure of the GDP deflator by a tenth. This is not an increase in trend productivity in this expansion, relative to previous expansions, but rather an upward revision to productivity growth over the entire postwar period, the mirror image of a decline in the upward bias to measured inflation. It should be noted, nevertheless, that the technical revisions to measured inflation do account for part of the appearance of improved economic performance. In addition, the data suggest to me, as to many private sector forecasters, that there might be a tenth or two increase in trend productivity, an improvement that is generally associated with capital deepening, an increase in the amount of equipment each worker has at its disposal, as a result of the strength of investment in this expansion. As such, this improvement in productivity growth may itself be transitory, part of a one-time increase in the level of productivity associated with a transition to a higher capital-to-labor ratio. Nevertheless, even a couple of tenths improvement in productivity growth, if sustained for some period, would give an important boost to higher living standards over time. But this upward adjustment in my estimate of the productivity trend plays only a negligible role in explaining how we have managed such exceptional economic performance over the last couple of years. It goes in the right direction, but it is simply too small to carry much of the burden. The major player in my view, in addition to the decline in NAIRU, is the coincidence of favorable supply shocks. The relative weights here are very important because they affect the challenge for monetary policy. The challenge for monetary policy, as always, is to sustain the best possible economic performance. The emphasis here is on the "possible." Sometimes we are expected to deliver more than what is possible. We aim for maximum sustainable growth and maximum sustainable levels of output and employment. The emphasis here is on "sustainable." Trying to do more threatens to introduce unnecessary instability into the economy and ultimately to cut short an expansion that otherwise has the potential to continue for some time. Trying to do more threatens to give back some of the reduction in inflation that has moved the U.S. to a position very close to the Federal Reserve's objective of price stability. The bottom line is that it is essential that growth slow from the near $4 \%$ over 1997 to and perhaps below trend for a while to allow the economy to move toward a more sustainable state. There are two sets of crosscurrents that are likely to shape the outlook immediately ahead. First, there is a tug of war between the continued exceptional momentum in private domestic demand and the external drag from the Asian crisis. The latter shock also reinforces the restraint that had been projected from a cumulative appreciation of the dollar that predated the Asian crisis. The result should almost certainly be some slowing in the expansion, relative to 1997. Still, the sharper-than-expected decline in oil prices, the decline in long-term bond yields and the further rise in equity prices in recent months are providing some offset to the external drag coming from Asia and the appreciation of the dollar. The question is when and how much of a slowing results, and whether the slowdown takes growth to or below trend, or leaves growth still above trend. There is still considerable uncertainty about how these crosscurrents will balance out. Second, there is a tug of war between the very tight labor market and the set of forces that have been restraining inflation. The forces restraining inflation have been winning this battle to date, and they have been reinforced this year by the sharper-than-expected decline in oil prices, by the even more extraordinary decline in computer prices in recent months, and by the decline in commodity prices and further downward pressure on import prices associated with the crisis in Asia. Nevertheless, at some point, the favorable supply shocks will dissipate or reverse. As the economy entered 1998, continued momentum in private domestic demand was clearly evident, while the drag from Asia was less obvious. But there was clear evidence in the trade data among the Asian developing economies that a significant swing was under way in their trade balances and there is little doubt that the U.S. economy will bear the greatest burden of this turnaround. The March employment report was the strongest evidence to date that a slowing is under way, although it should be appreciated that there is often more noise than signal in one month's data. And, even with the unexpectedly weak March reading, hours worked advanced at a robust $4.8 \%$ annual rate in the first quarter. So there is still considerable uncertainty about whether the spillover from Asia and the earlier cumulative appreciation of the dollar will slow the expansion to or below trend immediately ahead. In terms of inflation, there is no evidence to date that wage pressures are building, relative to last year, and certainly no evidence of a pickup in inflation, though the recent data for core CPI has hinted that the earlier downward trend may now be behind us. At any rate, it appears likely, given the renewal of favorable supply shocks, that inflation will remain well contained this year. But monetary policy has little ability to affect inflation this year. We should, therefore, be focusing on inflation prospects for next year. As I noted earlier, some upward pressure on inflation is likely going forward as forces retraining inflation dissipate or reverse, though a similar statement would have been in order at this time last year. The expected persistence of the special forces restraining inflation is therefore an important consideration in forecasting inflation and in assessing the appropriate course of monetary policy. It is important that, as the forces retraining inflation dissipate or reverse, that this upward pressure on inflation is not reinforced by inflationary pressures generated from very high utilization rates. The key to sustaining the best possible performance going forward is making the transition from the current state where performance is exceptional but unsustainable to the best possible sustainable state. That will require a slowdown in growth, preferably in the near term. Asia may accomplish this, in which case it would substitute for monetary tightening that in my judgment would otherwise be required.
1998-04-16T00:00:00	Mr. Meyer discusses the Federal Reserve and bank supervision and regulation (Central Bank Articles and Speeches, 16 Apr 98)	Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, presented before the 'Spring 1998 Banking and Finance Lecture', Widener University, Chester, Pennsylvania, on 16/4/98	Mr. Meyer discusses the Federal Reserve and bank supervision and Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the regulation US Federal Reserve System, presented before the "Spring 1998 Banking and Finance Lecture", Widener University, Chester, Pennsylvania, on 16/4/98. It is a pleasure to continue what is becoming a tradition of Federal Reserve Governors speaking at Widener University. When you think of the Federal Reserve, I am pretty sure that, in addition to speakers at your university, most of you think of monetary policy, interest rates, international finance, and the Fed's macroeconomic responsibilities in all of these areas. And, of course, macroeconomics lies at the core of what any central bank does. However, for a variety of reasons that I will discuss shortly, the Federal Reserve plays a major role in the supervision and regulation of banks. Moreover, I believe that the connections between bank supervision and macroeconomic policy are not only little understood, but also quite close. No economy can grow and provide an increasing standard of living for its citizens without also having a stable and efficient banking system. Recent events in Asia are just the most current reminder of this truth. I will begin my remarks today by summarizing, very briefly, why and how banks are regulated in the United States. Then I will outline the key trends that I see affecting the banking and financial sector, and the challenges that these trends pose for bank supervisors. In the final portion of my remarks, I will suggest some directions that I believe we should consider when thinking about how bank supervision should evolve over time. Bank Supervision and Regulation in the United States Why do we supervise and regulate banks? The reasons are very straightforward. First and foremost, problems in only a small number of banks can, under the right circumstances, become problems in the entire banking and financial systems, with potentially major risks to the real economy. Traditionally, this meant protecting against a panic-driven flight to currency otherwise known as a contagious series of bank runs, that caused a catastrophic decrease in the money supply and the collapse of financial intermediation. Today, largely because of deposit insurance and the Federal Reserve discount window, flights to currency are not a real concern in the United States. Rather, the stability of the electronic, large dollar payments system, which moves trillions of dollars a day and in which banks play a pivotal role, is critical in limiting systemic risk. Other potential pressure points, in all of which banks play a key role, include the liquidity of securities, financial derivatives, and interbank funding markets. Our very success at virtually eliminating the risk of bank runs in the United States has led to a second major reason for supervising and regulating banks. Deposit insurance, the discount window, and Federal Reserve payment system guarantees - the very things that have eliminated bank runs - create what is called a "safety net" for banks. The existence of this safety net gives the government a direct stake in keeping bank risks under control, just as a private insurance company has a stake in controlling the risks of policyholders. Because deposit insurance and other parts of the safety net can never be fully and accurately priced, it is necessary for us to monitor and sometimes to act to control bank risks in order to protect the potential call on taxpayer funds. An equally important, if unintended, consequence of the safety net is that it creates what economists term "moral hazard" incentives for some banks to take excessive risks. That is, the safety net creates incentives for banks to take larger risks than otherwise, because the safety net, and potentially taxpayers, may absorb most of the losses if the gamble fails. Such incentives are especially strong if the bank is close to failure since, at this point, bank stockholders have virtually nothing to lose. Moral hazard is surely not much of a problem today, when banks are healthy and bank capital ratios are high. But back in the late 1980s when over 200 banks were failing each year, moral hazard was a serious concern. All right, you may say, I understand why we supervise and regulate banks. But why do both the federal and state governments regulate banks, and why do three federal government agencies have bank supervisory responsibilities? And, I hesitate to even ask, why there are separate federal and state supervisors for thrift institutions and credit unions? Just in case even the questions confused you, let me step back and outline the structure of the bank supervisory system in the United States. If you want to open a bank in the United States, you must get permission - that is, a charter - from a government agency. There are two ways to do this: state governments charter "state banks," and the federal government, through the Office of the Comptroller of the Currency, charters "national banks." Thus, each state has a state bank supervisor. At the federal level, things get a bit more complicated. The Comptroller of the Currency supervises national banks. But since the FDIC insures certain deposits of both state and national banks, the FDIC also has supervisory authority over the state and national banks that it insures. Moreover, national banks must be, and state banks may be, members of the Federal Reserve System. In addition, most banks are organized in bank holding companies, and the Federal Reserve is the exclusive supervisor of bank holding companies. Savings and loans and credit unions get separate charters, and each has its own state or federal supervisor. In reality, the supervisory system is not quite as complex as it sounds, because, believe it or not, both statutes and agreements among supervisors divide up supervisory authority so that regulatory overlap is, to a significant degree, minimized. This division of labor involves the allocation of primary federal regulator to the Federal Reserve for state member banks, to the OCC for national banks, and to the FDIC for insured state non-member banks. In addition, the coordination among the federal regulators in the interest of consistent treatment of banks is facilitated by the Federal Financial Institutions Examination Council (FFEIC). Still, despite the division of labor and the coordination through the FFEIC, the U.S. system is rather complicated. Why do we have such a "Balkanized" structure of bank chartering and supervision and regulation? In large part, it is not so much by design as it is the result of reacting to many individual problems. But I believe that there is at least one systematic factor - the long-standing desire of many Americans for a decentralized banking system. An important theme in American political philosophy has been distrust of concentrations of power, especially concentrations of financial power. Thus, from the start of our republic individual states insisted on being able to charter their own banks, and were suspicious of the federal government's efforts to do so. It was not until the trauma of the Civil War that Congress passed a National Bank Act that allowed for extensive federal chartering and supervision of banks. Even after passage of the National Bank Act, virtually all banks were severely restricted in their ability to operate across state lines. Indeed, until passage of the McFadden Act in 1927 national banks could only have one office. While this restriction was relaxed in 1933, national banks and state banks that were members of the Fed were prohibited from branching outside of their home state. Restrictions on interstate banking were viewed as important for maintaining a "dual" banking system in which both federal and state governments could charter banks, and in which no one bank, or group of banks, could gain too much power. Restrictions on interstate banking only began to be dismantled within the last two decades, and were pretty much entirely gone by the end of 1997. However, concerns about preserving a viable dual banking system are still very much alive. Today, bank supervision and regulation focus on three primary areas of public policy concern. Safety and soundness supervision attempts to ensure that banks are managed prudently and in ways that maintain the stability of the banking system. Enforcement of the antitrust laws in banking seeks to foster open and competitive markets that provide high quality banking services at minimum prices. Consumer protection laws and the Community Reinvestment Act are aimed at making sure consumers are fully informed about the most critical characteristics of banking products and services, and that banks meet the financial services needs of their local communities, with particular attention to the needs of low and moderate income neighborhoods. Congress has required the Federal Reserve to play an active role in all of these areas. The fact that the Federal Reserve has responsibilities in all of these areas is sometimes strongly questioned. There has been more than one proposal over the years to remove the Fed from bank supervision and regulation. I must confess that sometimes when I am involved in a complicated supervision issue, I am tempted to feel that someone else should do it. But in my saner and more reflective moments, I remain convinced that removing the Fed from bank supervision and regulation would be a serious mistake. Let me try to explain why. The central bank, in my experience, needs direct, hands-on involvement in the supervision and regulation of a broad cross-section of banks in order to carry out the Fed's core responsibilities of conducting monetary policy, ensuring the stability of the financial system, acting as the lender of last resort, protecting the payments system, and managing a financial crisis. Meeting all of these responsibilities is not just an academic exercise, it requires practical knowledge of financial institutions and markets, knowledge that comes with being deeply involved in supervising individual banking organizations. Without such involvement, the Federal Reserve would be much less able to maintain both its practical knowledge of banking and other financial markets, and the influence and authority necessary for macroeconomic policy and crisis management. Ivory towers are great for universities, but they are not desirable for central banks. While our supervisory responsibilities make us a better macroeconomic policymaker, I believe that our macroeconomic policy responsibilities make us a better bank supervisor. In the course of designing and implementing our supervisory policies, we must weigh safety and soundness concerns against the potentially adverse effects on the economy of excessively rigid regulations. As Chairman Greenspan has observed, the optimal rate of bank failure is not zero. Banks must be allowed to perform their economic functions of measuring, accepting, and managing risk. Taking and managing risk mean that sometimes risk will have costs, including failure. In my judgement, the central bank is in a unique position to balance the complex and sometimes conflicting objectives of financial stability and a growing economy. The Fed is less likely to engage in an unnecessarily restrictive or, for that matter, excessively loose, supervisory policy than is an agency focused either solely on bank safety and soundness or solely on growth. Finally, the U.S. central bank, because of its extensive and well-established relationships with foreign central banks is ideally positioned to engage in coordinated action in managing international financial crises and in supervising institutions that have a substantial international presence. The on-going crisis in Asian financial markets is our most recent example of the need for such coordination of supervision. The Federal Reserve is the primary bank regulator of only 5 of the largest 25 banks, the large, complex and internationally active banks that are the major sources of systemic risk. The Federal Reserve is able, nevertheless, to maintain a flow of information about the risk profiles and risk management practices of all large banking organizations through its responsibilities as exclusive supervisor of all bank holding companies. It is for this reason that the Federal Reserve places such a great emphasis on maintaining its role as supervisor of bank holding companies. Key Trends Challenging Bank Supervisors Let me turn now to a discussion of the key trends in banking and financial markets that are challenging bank supervisors. Surely the most profound force that has been transforming the financial, and other sectors of our economy, is the rapid growth of computer and telecommunications technology. In finance, a critical and complementary force has been the development of intellectual "technologies" that enable financial engineers to separate risk into its various components, and price each component in an economically rational way. Indeed, Nobel Prizes have been awarded for some of these discoveries. Implementation of financial engineering strategies typically requires massive amounts of cheap data processing; and the cheap data processing would not be useful without the formulas required to compute prices. The combination of the two has led to a virtual explosion in the number and types of financial instruments. Key examples include virtually all types of financial derivatives, such as interest rate and currency swaps and, more recently, credit derivatives. Asset-backed securities, from mortgage-backed securities to credit card receivables to collateralized loan obligations, provide additional examples of what can result from the mixing of technological and intellectual innovation. Such products have lowered the cost and broadened the scope of financial services, making it possible for borrowers and lenders to transact directly with each other, for a wide range of financial products to be tailored for very specific purposes, and for financial risk to be managed in ever more sophisticated ways. Financial innovation has been the driving force behind a second major trend in banking - the blurring of distinctions among what were, traditionally, very distinct forms of financial firms. One of the first such innovations, with which we are all now very familiar, was money market mutual funds. Money market mutual funds took off in the late 1970s as market interest rates rose above rates that banks were allowed to pay on deposits. Eventually the entire system of interest rate controls, known as Federal Reserve Regulation Q, was dismantled by market realities and then, as a result, by the law. In the 1980s, banks began to challenge whether the Glass-Steagall Act prohibited combinations of commercial and investment banking. Today, both the regulators and the courts agree that Glass-Steagall does not imply a total prohibition, and bank supervisors have allowed a substantial blending of commercial and investment banking in the form of so-called Section 20 subsidiaries of bank holding companies. More recently, traditional separations of banking and insurance sales have also begun to fall, with support from the supervisors and the courts. A major result of the continued blurring of distinctions among commercial banking, investment banking, and insurance is a tremendous increase in competition in markets for many financial services. Greatly intensified competition has also led to increasing pressure for revisions to many of the banking laws and regulations, such as the Glass-Steagall Act, that, despite some successful efforts at relaxing them, continue to exert outdated and costly restraints on the banking and financial system. However, the issues involved are often complex and highly political, and so far efforts to achieve "financial modernization" have been more piecemeal than I would desire. Nevertheless, deregulation has been a major force for change in the banking and financial services industries. Two decades ago we still had Regulation Q, the Glass-Steagall Act was widely viewed as requiring a virtual prohibition of combinations of commercial and investment banking, and interstate banking and branching were barely fantasies even at the state level, let alone applications for combinations of insurance and banking. Just a few days ago, the House of Representatives almost voted on a massive re-write of the laws on permissible bank holding company activities and is now scheduled to consider the issue early next month. It is difficult to predict the outcome of that bill, and I will not. But I will note that the pressures of market developments for changes in the rules set up during the Great Depression are immense. If Congress does not act, loopholes and regulatory changes will continue to be exploited - with or without bank participation. The forces of technology and globalization will deregulate in one way or another. I and my colleagues would prefer that the Congress would guide those changes in the public interest, but legislative deadlock will not do the job because the status quo will not hold. The fourth major force transforming the banking landscape is the globalization of banking and financial markets. Indeed, globalization has been reshaping not only the financial, but also the real economy for at least the last three decades. The interactions of developments in both the financial and real economies have expanded cross-border asset holdings, trading, and credit flows. In response, financial intermediaries, including banks and securities firms, have increased their cross-border operations. Once again, a critical result of this rapid evolution has been a substantial increase in competition both at home and abroad. Today, for example, almost 40 percent of the U.S. domestic commercial and industrial bank loan market is accounted for by foreign-owned banks. The final significant trend I will highlight is the on-going consolidation of the U.S. banking industry. I think that it is fair to say that the American banking system is currently in the midst of the most significant consolidation in its history. As I mentioned earlier, in the last two decades nearly all of the traditional barriers to geographic expansion of U.S. banks have crumbled. While the states took the lead in eliminating these barriers beginning in the late 1970s, the final step was taken by the federal government with passage of the Riegle-Neal Act in 1994. Under this Act, virtually full interstate branch banking became possible in June 1997. A few facts will perhaps give you a feel for the profound changes occurring in the structure of the U.S. banking system. In 1980 there were about 14,400 banks in the U.S. organized into about 12,300 banking organizations. By the end of 1997, the number of banks had fallen to just under 9,100, and the number of banking organizations to not quite 7,200. This 42 percent decline in the number of banking organizations was due in part, but only in part, to the large number of bank failures in the late 1980s and early 1990s. A more important factor was mergers among healthy banks. Since the early 1980s, it has not been unusual to see 400 or more mergers among healthy banks each year. While mergers have occurred, and continue to occur, among banks of all sizes, I would emphasize three aspects of the current bank merger movement. First is the high incidence of "mega mergers," or mergers among very large banking organizations. Several mergers of the last few years have been either the largest at the time, or among the largest bank mergers in U.S. history. Examples include the combining of Chase Manhattan and Chemical Bank, Wells Fargo and First Interstate, NationsBank and Barnett, and, most recently, First Union and CoreStates. Second, despite all of the merger activity, a large number of medium to small banks remain in the United States. Moreover, by most measures of performance these small banks are more than a match for their larger brethren for many bank products and services. Indeed, when a mega merger is announced it is not uncommon to read in the press how small banks in the affected markets are licking their chops at the business opportunities created thereby. Research seems to support their optimism. Lastly, while the overall number of banking organizations has fallen since 1980, this does not mean that new, or de novo, entry has not occurred. From 1980 through 1997 some 3,600 new banks were formed in the United States. My bottom line? The U.S. banking structure is highly dynamic, is adjusting to a variety of forces, and defies easy generalizations. The current wave of bank mergers has led to a substantial increase in bank concentration at the national level. For example, the percentage of banking assets controlled by the top 10 banking organizations rose from about 22 percent in 1980 to 34 percent in 1997. The percentage held by the top 25 increased from 33 to 53 percent. Are these increases in national concentration a public policy concern? In my view, the answer to this question is "no," at least at this time, because virtually all the evidence we have strongly suggests that competition problems almost always arise in banking at the local level. That is, to the extent that banks are able to exert market power, the exercise of such power tends to occur in retail markets that are relatively narrow in geographic scope, and for a fairly well-defined set of customers, usually households and small businesses. However, a special influence on local market competition may develop as bank consolidation and interstate branching continue, resulting in the largest banks competing with each other in an increasing number of local markets. Such widespread competitive contacts may cause these firms to temper their competitive behavior in individual markets in recognition of the potential for responses by their rivals in other common markets and in recognition of their widespread mutual interests. So, what has happened to banking concentration in local markets since 1980? The answer is, "not much". For example, the average three-bank deposit concentration ratio in Metropolitan Statistical Areas, a common measure of local urban markets, hovered between 65 and 68 percent between 1980 and 1997. Concentration measures for rural counties show similar results, with the average three-bank concentration ratio remaining at about 89 percent throughout the period. Other measures of local market concentration show similar results for both urban and rural areas. The stability of local market concentration in the face of such a large consolidation of the banking industry is remarkable. While there is no single reason for this stability, I would point to two factors as being of particular importance. Many mergers, including some mergers of very large banks, involve institutions that do not compete in the same local markets. In such cases, local market concentration is obviously not affected. Where the merging banks do compete in the same local markets, enforcement of the antitrust laws has been an important factor limiting the growth of local market concentration. Moreover, antitrust enforcement has no doubt deterred some highly anti-competitive mergers from even being proposed. Why have banks been consolidating in number and expanding in size and geography? Again, no one answer is appropriate, and each merger is somewhat unique and reflects more than one factor. In recent years many banks have been responding to the removal of barriers to interstate banking and branching that restricted entry and divided markets. In such cases, the twin desires to diversify risk geographically and to expand sources of "core" deposits have surely been important motivating forces. Moreover, geographic barriers had constrained natural market developments; in an important sense their removal has simply allowed the market to adjust to a new economic equilibrium from a previously legally mandated equilibrium. Beyond such adjustments, scale economies are mentioned frequently by bankers as a causal factor in bank consolidation, although academic research has not tended to find much evidence of overall economies of scale in banking. Still, economies of scale certainly exist for some bank operations, such as many back office functions. In addition, some lines of business, such as securities underwriting and market making, require large levels of activity to be viable. Increased competitive pressures caused by rapid technological change and the resulting blurring of distinctions between banks and other types of financial firms, lower barriers to entry due to deregulation, and increased globalization are also important factors. For example, greater competition forces inefficient banks to become more efficient, accept lower profits, close up shop, or - in order to exit a market in which they cannot survive - merge with another bank. Other possible motives for mergers include the simple desire to achieve market power, or efforts by management to build empires and enhance compensation. Some mergers probably occur as an effort to prevent the acquiring bank from itself being acquired, or, alternatively, to enhance a bank's attractiveness to other buyers. No matter why banks are merging, the bottom line is that the United States is well on its way to developing a truly national banking structure for the first time in its history. We are not quite there yet, but I do not think it will take too many more years. What will this structure look like? Well, that is obviously a very complex question, the answer to which involves forecasting years in advance. And I can tell you from many years of experience, forecasting the economy even one year in advance is a very risky and humbling business. Thus, any prognostications about future banking structure should be taken with very many grains of salt. Still, some economists at the Fed have tried to look through this dark glass to see the future United States banking structure. For all of the reasons I have discussed, it seems reasonable to expect a continued high level of merger activity for the foreseeable future. Very large mergers will not be uncommon. Studies based on historical experience suggest that in around a decade there will likely be about 3,000 to 4,000 banking organizations, down from about 7,000 today. Although the top 10 or so banking organizations will almost certainly account for a larger share of U.S. banking assets than they do today, the overall size distribution of banks will probably remain about the same. That is, there will likely be a few very large organizations, and an increasing number of firms as we move down the size scale. Importantly, a large number of small banks is expected to remain. Future Directions in Bank Supervision What do all of these changes mean for how we supervise and regulate banks? Analysis of competition Clearly, as the banking industry consolidates we need to maintain competitive markets. Competitive markets are our best assurance that consumers receive the highest quality products at the lowest possible prices. As I discussed earlier, there are many reasons to believe that in recent years competition has increased greatly in markets for a large number of financial products and services. This is true for many products purchased in local, regional and national markets. However, in some cases we still observe potential competitive problems with a proposed bank merger. Fortunately, the antitrust laws, as written into the banking statutes, give us the means to maintain competition in such situations. These laws require that the Board approve only those mergers that are not expected to substantially harm competition. When implementing this policy, the Board may require changes to a merger proposal, and may even deny an application, if the merger or acquisition would result in a highly concentrated market, or an excessively large increase in concentration. As I indicated a few minutes ago, the focus of our analysis is normally on local retail markets for banking products and services. Over the past year or so, quite a few applicants have pushed very hard at the Board's frontier for approving merger applications. Some applicants appear to have held the view that almost any merger could be approved, even if it violated the screening guidelines that both the Federal Reserve and the Department of Justice use to decide which mergers require close examination. In response, the Board has occasionally felt compelled to remind applicants, especially those proposing a merger that would affect a large number of local markets, that substantial changes in market concentrations will receive careful review. Moreover, when mergers would exceed the screening guidelines, "mitigating" factors must be present. By mitigating factors I mean conditions that tend to create a more competitive market than is suggested by market concentration alone. These would include characteristics that make a market highly attractive for new entry, or situations where nonbank providers of financial services are unusually strong. The greater the deviation from the screening guidelines, the more powerful and convincing the mitigating factors must be. I have been particularly concerned with cases where a large number of local markets are affected. In such cases, even if the adverse effect is fairly small in each of several local markets, it seems to me that the cumulative, or total, adverse effect might be significant. Thus, when a large number of markets are affected adversely, I believe that we should be especially careful to assure ourselves that there are substantial mitigating factors. In addition, when a merger would cause a large change in concentration in a market that is, or becomes, highly concentrated, I think we need to give special attention to the impact on competition. The reason for this is that I think when the change in concentration is large, the effect on interfirm relationships, market dynamics and thus competition is likely to be more pronounced, other things equal. Assessing safety and soundness Technological change, financial innovation, the acquisition of new powers by banking organizations, the increasing geographic scope of banks, and the globalization of financial markets all challenge our ability to examine and assess the safety and soundness of individual banking firms. One way that examiners are adapting to this changed world is to focus much of their attention on the information and risk management systems of banks. The key question they ask is: How effectively are these systems measuring and controlling an institution's rapidly changing risk profile? The emphasis on risk management is most critical at our largest, most sophisticated, and most internationally active banks. Many of these banks use advanced economic and statistical models to evaluate their market and credit risks. These models are used for a variety of purposes, including allocating capital on a risk adjusted basis and pricing loans and credit guarantees. The development by some banks of increasingly accurate models for measuring, managing, and pricing risk has called into question the continuing usefulness of one of the foundations of bank supervision - the so-called risk-based capital standards, or the Basle Accord. The Basle Accord capital standards were adopted in 1988 by most of the world's industrialized nations in an effort to encourage stronger capital at riskier banks, to include off-balance sheet exposures in the assessment of capital adequacy, and to establish more consistent capital standards across nations. The Accord was a major advance in 1988, and has proved to be very useful since then. But in recent years calls for reform have begun to grow. I will outline briefly one of the key problems we are currently facing with the Basle Accord. The Basle Accord capital standards divide bank on- and off-balance sheet assets into four risk buckets, and then apply a different capital weight to each bucket. These weights increase roughly with the riskiness of the assets in a given bucket. The basic idea is that more capital should be required to be held against riskier assets. However, the relationship is rough. Perhaps most troublesome, the same risk weight is applied to all loans. Thus, for example, a loan to a very risky "junk bond" company gets the same weight as a loan to a "triple A" rated firm. While the Accord has the virtue of being relatively easy to administer and enforce, it also clearly gives banks an incentive to find ways to avoid the regulatory capital standard for loans that their internal models say need less capital than is required by the Basle Accord. Conversely, banks should want to keep loans which their models say require more capital than does the Basle standard. And, guess what, banks have been doing just that. This so-called "regulatory arbitrage" may not be all bad, but it surely causes some serious problems as well. For one thing, it makes reported capital ratios - a key measure of bank soundness used by supervisors and investors - less meaningful for government supervisors and private analysts. Finding ways around this problem is a high priority at the Federal Reserve. The arbitraging of regulatory capital requirements is but one of a host of similar conflicts between banks and bank supervisory rules and regulations. Indeed, one can view much of the long history of bank supervision and regulation as something of a battle between supervisors who want to deter excessive risk taking and banks who seek ways around sometimes inefficient, or just plain uneconomic, regulations. This long history leads me to seek supervisory strategies that are, in the economist's jargon, incentive compatible. By incentive compatible, I mean supervisory policies and procedures that give banks strong internal incentives to manage their risks prudently and minimize the exploitation of moral hazard. Put differently, we need to design strategies that encourage banks, in their own self-interest, to work with us, not against us. One promising possibility for incentive compatible regulation is what has come to be called the "pre-commitment" approach to bank capital standards. The basic idea is to allow the bank to pre-commit to the supervisor its capital allocation for risks in the bank's trading account - those assets held as part of the bank's securities dealing activities. If the bank's losses for that portion of its total risk exceed the pre-committed amount of capital over some fixed time period, the bank would pay a penalty, or perhaps have to disclose to the market its violation of its pre-commitment. Such an approach would utilize the bank's own internal models and risk management procedures to achieve supervisory goals, and give the bank a strong incentive to improve its risk management, since by doing so it could lower its pre-committed capital requirement and not increase the risk of paying a penalty. There are both benefits and difficulties with the approach that we are discussing with other supervisors both in the U.S. and abroad. It may well be that some form of an incentive compatible strategy might be linked with a regulatory minimum capital as a modification to the Basle standard for market risk. Such a modification would be to the existing standard that, it is important to emphasize, already uses a bank's internal risk management models to help achieve supervisory goals. U.S. bank supervisors began last year to require large, internationally active American banks to meet the Basle Accord's capital requirements for market risk in trading accounts using their own internal models, with appropriate review and monitoring by supervisors. As I suggested at the beginning of my remarks, the possibility of a systemic failure of the banking system, and the moral hazard incentives created by the safety net that is designed to contain systemic risk, require some government supervision of banks. But we should always remember that the first line of defense against excessive risk-taking by banks is the market itself. Market discipline can be, and often is, highly effective at deterring excessive risk. Indeed, a primary goal of many of the bank regulatory reforms implemented in the wake of the banking and thrift crises of the 1980s and early 1990s was either to increase market discipline or to make supervisors behave more like the market would behave. Market discipline was increased by raising capital standards, thus giving the owners of the firm a greater incentive to control risk, and by mandating greater public disclosure by a bank of its financial condition. Prompt closure rules that required supervisors to impose increasingly severe penalties on a bank as its financial condition deteriorated, and the adoption of risk-based deposit insurance premiums are examples of encouraging supervisors to act like the market. The reforms of the early 1990s were a good start. But I believe that there may well be more that we can do here. Such comments may sound out of place today. Times are good, and almost everyone seems quite satisfied with the current deposit insurance system. But good times may be precisely when we should develop ideas for an even more effective system. The crucible of a crisis is not always the best time to think up reforms - witness the error we made in passing the Glass-Steagall Act, an error we have yet to correct after 65 years! Indeed, it is in part for this very reason that the Board continues to urge Congress to pass financial modernization legislation. So, in the spirit of being forward looking, let me attempt to give you the flavor of what I am thinking about. It may, for example, be possible to increase market discipline by requiring large, internationally active banks to issue a minimum amount of certain types of uninsured subordinated debt to the public. Holders of such debt would have a strong incentive to require the bank to manage its risk prudently. In addition, it would be highly desirable if this debt were traded on the open market, thereby providing a clear signal of the market's evaluation of the bank's financial condition. Another possibility is further reforms of the deposit insurance system. For example, most observers believe that the current risk-based premiums do not adequately reflect risk differences between banks, in part because current law limits the growth of deposit insurance reserves. Loosening this constraint might allow for more accurate pricing of deposit insurance. Dealing with globalization The final area I will highlight today is a potentially critical implication of financial globalization for the supervision of large, internationally active banking organizations. In this world of financial globalization, complexity, and rapid telecommunications, it is extremely important that all of the large banking institutions in the developed nations strive to keep up with the state-of-art in risk measurement and management. If a group of important institutions in only one or two countries fails to keep pace, all banking systems are placed at increased risk. This risk, moreover, is not simply that a large bank failure in one country can cause counter-party failures in other nations. Systematic underestimation of credit and other risks can result in underpricing those risks, which can be damaging to all players, not only to the banks making the risk measurement errors. Fortunately, the free market dissemination of best practices appears to be functioning fairly well. No single developed nation has a monopoly on best practice risk measurement and management, if innovations in complex financial products are any indication. For example, European banks were market leaders in introducing collateralized loan obligations. In the field of asset-backed commercial paper facilities, U.S. banks were the initiators, but European and Japanese institutions are now significant players. And, the ubiquitous consulting firms around the world can be relied upon to spread the word on advances in risk management techniques. Still, individual banks in each country, not just the U.S., must face the proper incentives to keep up with an ever changing technology. Lax supervisory practices - or, worse, government support of banks with poor risk practices - do not provide proper incentives. Thus, each supervisory authority in each developed nation must be vigilant that the disparities between the world's best practice institutions and those large banks inside the best practices frontier do not grow wider. Indeed, I believe that an important function of supervisors is to act as something of a clearinghouse for best practices. Internationally, supervisors from the major industrialized nations have been performing this function more and more through their joint efforts. In the United States, the clearinghouse function is an important component of the on-site examination. Conclusion In conclusion, I hope that my remarks have helped you to better understand the forces affecting our banking and financial system. Equally important, I hope that I have given you a good feel for the challenges these forces have created for bank supervision, how we are meeting these challenges today, how we may deal with them in the future, and the role of the Federal Reserve in these complex, dynamic, and exciting issues. All of us have a very big stake in the continued health, stability, and competitiveness of our banking system. I encourage each of you to think deeply about what is required to achieve these goals. ̋	---[PAGE_BREAK]--- # Mr. Meyer discusses the Federal Reserve and bank supervision and regulation Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, presented before the "Spring 1998 Banking and Finance Lecture", Widener University, Chester, Pennsylvania, on 16/4/98. It is a pleasure to continue what is becoming a tradition of Federal Reserve Governors speaking at Widener University. When you think of the Federal Reserve, I am pretty sure that, in addition to speakers at your university, most of you think of monetary policy, interest rates, international finance, and the Fed's macroeconomic responsibilities in all of these areas. And, of course, macroeconomics lies at the core of what any central bank does. However, for a variety of reasons that I will discuss shortly, the Federal Reserve plays a major role in the supervision and regulation of banks. Moreover, I believe that the connections between bank supervision and macroeconomic policy are not only little understood, but also quite close. No economy can grow and provide an increasing standard of living for its citizens without also having a stable and efficient banking system. Recent events in Asia are just the most current reminder of this truth. I will begin my remarks today by summarizing, very briefly, why and how banks are regulated in the United States. Then I will outline the key trends that I see affecting the banking and financial sector, and the challenges that these trends pose for bank supervisors. In the final portion of my remarks, I will suggest some directions that I believe we should consider when thinking about how bank supervision should evolve over time. ## Bank Supervision and Regulation in the United States Why do we supervise and regulate banks? The reasons are very straightforward. First and foremost, problems in only a small number of banks can, under the right circumstances, become problems in the entire banking and financial systems, with potentially major risks to the real economy. Traditionally, this meant protecting against a panic-driven flight to currency otherwise known as a contagious series of bank runs, that caused a catastrophic decrease in the money supply and the collapse of financial intermediation. Today, largely because of deposit insurance and the Federal Reserve discount window, flights to currency are not a real concern in the United States. Rather, the stability of the electronic, large dollar payments system, which moves trillions of dollars a day and in which banks play a pivotal role, is critical in limiting systemic risk. Other potential pressure points, in all of which banks play a key role, include the liquidity of securities, financial derivatives, and interbank funding markets. Our very success at virtually eliminating the risk of bank runs in the United States has led to a second major reason for supervising and regulating banks. Deposit insurance, the discount window, and Federal Reserve payment system guarantees - the very things that have eliminated bank runs - create what is called a "safety net" for banks. The existence of this safety net gives the government a direct stake in keeping bank risks under control, just as a private insurance company has a stake in controlling the risks of policyholders. Because deposit insurance and other parts of the safety net can never be fully and accurately priced, it is necessary for us to monitor and sometimes to act to control bank risks in order to protect the potential call on taxpayer funds. An equally important, if unintended, consequence of the safety net is that it creates what economists term "moral hazard" incentives for some banks to take excessive risks. That is, the safety net creates incentives for banks to take larger risks than otherwise, because the safety net, and potentially taxpayers, may absorb most of the losses if the ---[PAGE_BREAK]--- gamble fails. Such incentives are especially strong if the bank is close to failure since, at this point, bank stockholders have virtually nothing to lose. Moral hazard is surely not much of a problem today, when banks are healthy and bank capital ratios are high. But back in the late 1980s when over 200 banks were failing each year, moral hazard was a serious concern. All right, you may say, I understand why we supervise and regulate banks. But why do both the federal and state governments regulate banks, and why do three federal government agencies have bank supervisory responsibilities? And, I hesitate to even ask, why there are separate federal and state supervisors for thrift institutions and credit unions? Just in case even the questions confused you, let me step back and outline the structure of the bank supervisory system in the United States. If you want to open a bank in the United States, you must get permission - that is, a charter - from a government agency. There are two ways to do this: state governments charter "state banks," and the federal government, through the Office of the Comptroller of the Currency, charters "national banks." Thus, each state has a state bank supervisor. At the federal level, things get a bit more complicated. The Comptroller of the Currency supervises national banks. But since the FDIC insures certain deposits of both state and national banks, the FDIC also has supervisory authority over the state and national banks that it insures. Moreover, national banks must be, and state banks may be, members of the Federal Reserve System. In addition, most banks are organized in bank holding companies, and the Federal Reserve is the exclusive supervisor of bank holding companies. Savings and loans and credit unions get separate charters, and each has its own state or federal supervisor. In reality, the supervisory system is not quite as complex as it sounds, because, believe it or not, both statutes and agreements among supervisors divide up supervisory authority so that regulatory overlap is, to a significant degree, minimized. This division of labor involves the allocation of primary federal regulator to the Federal Reserve for state member banks, to the OCC for national banks, and to the FDIC for insured state non-member banks. In addition, the coordination among the federal regulators in the interest of consistent treatment of banks is facilitated by the Federal Financial Institutions Examination Council (FFEIC). Still, despite the division of labor and the coordination through the FFEIC, the U.S. system is rather complicated. Why do we have such a "Balkanized" structure of bank chartering and supervision and regulation? In large part, it is not so much by design as it is the result of reacting to many individual problems. But I believe that there is at least one systematic factor - the long-standing desire of many Americans for a decentralized banking system. An important theme in American political philosophy has been distrust of concentrations of power, especially concentrations of financial power. Thus, from the start of our republic individual states insisted on being able to charter their own banks, and were suspicious of the federal government's efforts to do so. It was not until the trauma of the Civil War that Congress passed a National Bank Act that allowed for extensive federal chartering and supervision of banks. Even after passage of the National Bank Act, virtually all banks were severely restricted in their ability to operate across state lines. Indeed, until passage of the McFadden Act in 1927 national banks could only have one office. While this restriction was relaxed in 1933, national banks and state banks that were members of the Fed were prohibited from branching outside of their home state. Restrictions on interstate banking were viewed as important for maintaining a "dual" banking system in which both federal and state governments could charter banks, and in which no one bank, or group of banks, could gain too much power. Restrictions on interstate banking only began to be dismantled within the last two decades, and were pretty much ---[PAGE_BREAK]--- entirely gone by the end of 1997. However, concerns about preserving a viable dual banking system are still very much alive. Today, bank supervision and regulation focus on three primary areas of public policy concern. Safety and soundness supervision attempts to ensure that banks are managed prudently and in ways that maintain the stability of the banking system. Enforcement of the antitrust laws in banking seeks to foster open and competitive markets that provide high quality banking services at minimum prices. Consumer protection laws and the Community Reinvestment Act are aimed at making sure consumers are fully informed about the most critical characteristics of banking products and services, and that banks meet the financial services needs of their local communities, with particular attention to the needs of low and moderate income neighborhoods. Congress has required the Federal Reserve to play an active role in all of these areas. The fact that the Federal Reserve has responsibilities in all of these areas is sometimes strongly questioned. There has been more than one proposal over the years to remove the Fed from bank supervision and regulation. I must confess that sometimes when I am involved in a complicated supervision issue, I am tempted to feel that someone else should do it. But in my saner and more reflective moments, I remain convinced that removing the Fed from bank supervision and regulation would be a serious mistake. Let me try to explain why. The central bank, in my experience, needs direct, hands-on involvement in the supervision and regulation of a broad cross-section of banks in order to carry out the Fed's core responsibilities of conducting monetary policy, ensuring the stability of the financial system, acting as the lender of last resort, protecting the payments system, and managing a financial crisis. Meeting all of these responsibilities is not just an academic exercise, it requires practical knowledge of financial institutions and markets, knowledge that comes with being deeply involved in supervising individual banking organizations. Without such involvement, the Federal Reserve would be much less able to maintain both its practical knowledge of banking and other financial markets, and the influence and authority necessary for macroeconomic policy and crisis management. Ivory towers are great for universities, but they are not desirable for central banks. While our supervisory responsibilities make us a better macroeconomic policymaker, I believe that our macroeconomic policy responsibilities make us a better bank supervisor. In the course of designing and implementing our supervisory policies, we must weigh safety and soundness concerns against the potentially adverse effects on the economy of excessively rigid regulations. As Chairman Greenspan has observed, the optimal rate of bank failure is not zero. Banks must be allowed to perform their economic functions of measuring, accepting, and managing risk. Taking and managing risk mean that sometimes risk will have costs, including failure. In my judgement, the central bank is in a unique position to balance the complex and sometimes conflicting objectives of financial stability and a growing economy. The Fed is less likely to engage in an unnecessarily restrictive or, for that matter, excessively loose, supervisory policy than is an agency focused either solely on bank safety and soundness or solely on growth. Finally, the U.S. central bank, because of its extensive and well-established relationships with foreign central banks is ideally positioned to engage in coordinated action in managing international financial crises and in supervising institutions that have a substantial international presence. The on-going crisis in Asian financial markets is our most recent example of the need for such coordination of supervision. ---[PAGE_BREAK]--- The Federal Reserve is the primary bank regulator of only 5 of the largest 25 banks, the large, complex and internationally active banks that are the major sources of systemic risk. The Federal Reserve is able, nevertheless, to maintain a flow of information about the risk profiles and risk management practices of all large banking organizations through its responsibilities as exclusive supervisor of all bank holding companies. It is for this reason that the Federal Reserve places such a great emphasis on maintaining its role as supervisor of bank holding companies. # Key Trends Challenging Bank Supervisors Let me turn now to a discussion of the key trends in banking and financial markets that are challenging bank supervisors. Surely the most profound force that has been transforming the financial, and other sectors of our economy, is the rapid growth of computer and telecommunications technology. In finance, a critical and complementary force has been the development of intellectual "technologies" that enable financial engineers to separate risk into its various components, and price each component in an economically rational way. Indeed, Nobel Prizes have been awarded for some of these discoveries. Implementation of financial engineering strategies typically requires massive amounts of cheap data processing; and the cheap data processing would not be useful without the formulas required to compute prices. The combination of the two has led to a virtual explosion in the number and types of financial instruments. Key examples include virtually all types of financial derivatives, such as interest rate and currency swaps and, more recently, credit derivatives. Asset-backed securities, from mortgage-backed securities to credit card receivables to collateralized loan obligations, provide additional examples of what can result from the mixing of technological and intellectual innovation. Such products have lowered the cost and broadened the scope of financial services, making it possible for borrowers and lenders to transact directly with each other, for a wide range of financial products to be tailored for very specific purposes, and for financial risk to be managed in ever more sophisticated ways. Financial innovation has been the driving force behind a second major trend in banking - the blurring of distinctions among what were, traditionally, very distinct forms of financial firms. One of the first such innovations, with which we are all now very familiar, was money market mutual funds. Money market mutual funds took off in the late 1970s as market interest rates rose above rates that banks were allowed to pay on deposits. Eventually the entire system of interest rate controls, known as Federal Reserve Regulation Q, was dismantled by market realities and then, as a result, by the law. In the 1980s, banks began to challenge whether the Glass-Steagall Act prohibited combinations of commercial and investment banking. Today, both the regulators and the courts agree that Glass-Steagall does not imply a total prohibition, and bank supervisors have allowed a substantial blending of commercial and investment banking in the form of so-called Section 20 subsidiaries of bank holding companies. More recently, traditional separations of banking and insurance sales have also begun to fall, with support from the supervisors and the courts. A major result of the continued blurring of distinctions among commercial banking, investment banking, and insurance is a tremendous increase in competition in markets for many financial services. Greatly intensified competition has also led to increasing pressure for revisions to many of the banking laws and regulations, such as the Glass-Steagall Act, that, despite some successful efforts at relaxing them, continue to exert outdated and costly restraints on the banking and financial system. However, the issues involved are often complex and highly ---[PAGE_BREAK]--- political, and so far efforts to achieve "financial modernization" have been more piecemeal than I would desire. Nevertheless, deregulation has been a major force for change in the banking and financial services industries. Two decades ago we still had Regulation Q, the Glass-Steagall Act was widely viewed as requiring a virtual prohibition of combinations of commercial and investment banking, and interstate banking and branching were barely fantasies even at the state level, let alone applications for combinations of insurance and banking. Just a few days ago, the House of Representatives almost voted on a massive re-write of the laws on permissible bank holding company activities and is now scheduled to consider the issue early next month. It is difficult to predict the outcome of that bill, and I will not. But I will note that the pressures of market developments for changes in the rules set up during the Great Depression are immense. If Congress does not act, loopholes and regulatory changes will continue to be exploited - with or without bank participation. The forces of technology and globalization will deregulate in one way or another. I and my colleagues would prefer that the Congress would guide those changes in the public interest, but legislative deadlock will not do the job because the status quo will not hold. The fourth major force transforming the banking landscape is the globalization of banking and financial markets. Indeed, globalization has been reshaping not only the financial, but also the real economy for at least the last three decades. The interactions of developments in both the financial and real economies have expanded cross-border asset holdings, trading, and credit flows. In response, financial intermediaries, including banks and securities firms, have increased their cross-border operations. Once again, a critical result of this rapid evolution has been a substantial increase in competition both at home and abroad. Today, for example, almost 40 percent of the U.S. domestic commercial and industrial bank loan market is accounted for by foreign-owned banks. The final significant trend I will highlight is the on-going consolidation of the U.S. banking industry. I think that it is fair to say that the American banking system is currently in the midst of the most significant consolidation in its history. As I mentioned earlier, in the last two decades nearly all of the traditional barriers to geographic expansion of U.S. banks have crumbled. While the states took the lead in eliminating these barriers beginning in the late 1970s, the final step was taken by the federal government with passage of the Riegle-Neal Act in 1994. Under this Act, virtually full interstate branch banking became possible in June 1997. A few facts will perhaps give you a feel for the profound changes occurring in the structure of the U.S. banking system. In 1980 there were about 14,400 banks in the U.S. organized into about 12,300 banking organizations. By the end of 1997, the number of banks had fallen to just under 9,100, and the number of banking organizations to not quite 7,200. This 42 percent decline in the number of banking organizations was due in part, but only in part, to the large number of bank failures in the late 1980s and early 1990s. A more important factor was mergers among healthy banks. Since the early 1980s, it has not been unusual to see 400 or more mergers among healthy banks each year. While mergers have occurred, and continue to occur, among banks of all sizes, I would emphasize three aspects of the current bank merger movement. First is the high incidence of "mega mergers," or mergers among very large banking organizations. Several mergers of the last few years have been either the largest at the time, or among the largest bank mergers in U.S. history. Examples include the combining of Chase Manhattan and Chemical Bank, Wells Fargo and First Interstate, NationsBank and Barnett, and, most recently, First Union and CoreStates. ---[PAGE_BREAK]--- Second, despite all of the merger activity, a large number of medium to small banks remain in the United States. Moreover, by most measures of performance these small banks are more than a match for their larger brethren for many bank products and services. Indeed, when a mega merger is announced it is not uncommon to read in the press how small banks in the affected markets are licking their chops at the business opportunities created thereby. Research seems to support their optimism. Lastly, while the overall number of banking organizations has fallen since 1980, this does not mean that new, or de novo, entry has not occurred. From 1980 through 1997 some 3,600 new banks were formed in the United States. My bottom line? The U.S. banking structure is highly dynamic, is adjusting to a variety of forces, and defies easy generalizations. The current wave of bank mergers has led to a substantial increase in bank concentration at the national level. For example, the percentage of banking assets controlled by the top 10 banking organizations rose from about 22 percent in 1980 to 34 percent in 1997. The percentage held by the top 25 increased from 33 to 53 percent. Are these increases in national concentration a public policy concern? In my view, the answer to this question is "no," at least at this time, because virtually all the evidence we have strongly suggests that competition problems almost always arise in banking at the local level. That is, to the extent that banks are able to exert market power, the exercise of such power tends to occur in retail markets that are relatively narrow in geographic scope, and for a fairly well-defined set of customers, usually households and small businesses. However, a special influence on local market competition may develop as bank consolidation and interstate branching continue, resulting in the largest banks competing with each other in an increasing number of local markets. Such widespread competitive contacts may cause these firms to temper their competitive behavior in individual markets in recognition of the potential for responses by their rivals in other common markets and in recognition of their widespread mutual interests. So, what has happened to banking concentration in local markets since 1980? The answer is, "not much". For example, the average three-bank deposit concentration ratio in Metropolitan Statistical Areas, a common measure of local urban markets, hovered between 65 and 68 percent between 1980 and 1997. Concentration measures for rural counties show similar results, with the average three-bank concentration ratio remaining at about 89 percent throughout the period. Other measures of local market concentration show similar results for both urban and rural areas. The stability of local market concentration in the face of such a large consolidation of the banking industry is remarkable. While there is no single reason for this stability, I would point to two factors as being of particular importance. Many mergers, including some mergers of very large banks, involve institutions that do not compete in the same local markets. In such cases, local market concentration is obviously not affected. Where the merging banks do compete in the same local markets, enforcement of the antitrust laws has been an important factor limiting the growth of local market concentration. Moreover, antitrust enforcement has no doubt deterred some highly anti-competitive mergers from even being proposed. Why have banks been consolidating in number and expanding in size and geography? Again, no one answer is appropriate, and each merger is somewhat unique and reflects more than one factor. In recent years many banks have been responding to the removal ---[PAGE_BREAK]--- of barriers to interstate banking and branching that restricted entry and divided markets. In such cases, the twin desires to diversify risk geographically and to expand sources of "core" deposits have surely been important motivating forces. Moreover, geographic barriers had constrained natural market developments; in an important sense their removal has simply allowed the market to adjust to a new economic equilibrium from a previously legally mandated equilibrium. Beyond such adjustments, scale economies are mentioned frequently by bankers as a causal factor in bank consolidation, although academic research has not tended to find much evidence of overall economies of scale in banking. Still, economies of scale certainly exist for some bank operations, such as many back office functions. In addition, some lines of business, such as securities underwriting and market making, require large levels of activity to be viable. Increased competitive pressures caused by rapid technological change and the resulting blurring of distinctions between banks and other types of financial firms, lower barriers to entry due to deregulation, and increased globalization are also important factors. For example, greater competition forces inefficient banks to become more efficient, accept lower profits, close up shop, or - in order to exit a market in which they cannot survive - merge with another bank. Other possible motives for mergers include the simple desire to achieve market power, or efforts by management to build empires and enhance compensation. Some mergers probably occur as an effort to prevent the acquiring bank from itself being acquired, or, alternatively, to enhance a bank's attractiveness to other buyers. No matter why banks are merging, the bottom line is that the United States is well on its way to developing a truly national banking structure for the first time in its history. We are not quite there yet, but I do not think it will take too many more years. What will this structure look like? Well, that is obviously a very complex question, the answer to which involves forecasting years in advance. And I can tell you from many years of experience, forecasting the economy even one year in advance is a very risky and humbling business. Thus, any prognostications about future banking structure should be taken with very many grains of salt. Still, some economists at the Fed have tried to look through this dark glass to see the future United States banking structure. For all of the reasons I have discussed, it seems reasonable to expect a continued high level of merger activity for the foreseeable future. Very large mergers will not be uncommon. Studies based on historical experience suggest that in around a decade there will likely be about 3,000 to 4,000 banking organizations, down from about 7,000 today. Although the top 10 or so banking organizations will almost certainly account for a larger share of U.S. banking assets than they do today, the overall size distribution of banks will probably remain about the same. That is, there will likely be a few very large organizations, and an increasing number of firms as we move down the size scale. Importantly, a large number of small banks is expected to remain. Future Directions in Bank Supervision What do all of these changes mean for how we supervise and regulate banks? # Analysis of competition Clearly, as the banking industry consolidates we need to maintain competitive markets. Competitive markets are our best assurance that consumers receive the highest quality products at the lowest possible prices. As I discussed earlier, there are many reasons to believe that in recent years competition has increased greatly in markets for a large number of financial ---[PAGE_BREAK]--- products and services. This is true for many products purchased in local, regional and national markets. However, in some cases we still observe potential competitive problems with a proposed bank merger. Fortunately, the antitrust laws, as written into the banking statutes, give us the means to maintain competition in such situations. These laws require that the Board approve only those mergers that are not expected to substantially harm competition. When implementing this policy, the Board may require changes to a merger proposal, and may even deny an application, if the merger or acquisition would result in a highly concentrated market, or an excessively large increase in concentration. As I indicated a few minutes ago, the focus of our analysis is normally on local retail markets for banking products and services. Over the past year or so, quite a few applicants have pushed very hard at the Board's frontier for approving merger applications. Some applicants appear to have held the view that almost any merger could be approved, even if it violated the screening guidelines that both the Federal Reserve and the Department of Justice use to decide which mergers require close examination. In response, the Board has occasionally felt compelled to remind applicants, especially those proposing a merger that would affect a large number of local markets, that substantial changes in market concentrations will receive careful review. Moreover, when mergers would exceed the screening guidelines, "mitigating" factors must be present. By mitigating factors I mean conditions that tend to create a more competitive market than is suggested by market concentration alone. These would include characteristics that make a market highly attractive for new entry, or situations where nonbank providers of financial services are unusually strong. The greater the deviation from the screening guidelines, the more powerful and convincing the mitigating factors must be. I have been particularly concerned with cases where a large number of local markets are affected. In such cases, even if the adverse effect is fairly small in each of several local markets, it seems to me that the cumulative, or total, adverse effect might be significant. Thus, when a large number of markets are affected adversely, I believe that we should be especially careful to assure ourselves that there are substantial mitigating factors. In addition, when a merger would cause a large change in concentration in a market that is, or becomes, highly concentrated, I think we need to give special attention to the impact on competition. The reason for this is that I think when the change in concentration is large, the effect on interfirm relationships, market dynamics and thus competition is likely to be more pronounced, other things equal. Assessing safety and soundness Technological change, financial innovation, the acquisition of new powers by banking organizations, the increasing geographic scope of banks, and the globalization of financial markets all challenge our ability to examine and assess the safety and soundness of individual banking firms. One way that examiners are adapting to this changed world is to focus much of their attention on the information and risk management systems of banks. The key question they ask is: How effectively are these systems measuring and controlling an institution's rapidly changing risk profile? The emphasis on risk management is most critical at our largest, most sophisticated, and most internationally active banks. Many of these banks use advanced economic and statistical models to evaluate their market and credit risks. These models are used for a variety of purposes, including allocating capital on a risk adjusted basis and pricing loans and credit guarantees. ---[PAGE_BREAK]--- The development by some banks of increasingly accurate models for measuring, managing, and pricing risk has called into question the continuing usefulness of one of the foundations of bank supervision - the so-called risk-based capital standards, or the Basle Accord. The Basle Accord capital standards were adopted in 1988 by most of the world's industrialized nations in an effort to encourage stronger capital at riskier banks, to include off-balance sheet exposures in the assessment of capital adequacy, and to establish more consistent capital standards across nations. The Accord was a major advance in 1988, and has proved to be very useful since then. But in recent years calls for reform have begun to grow. I will outline briefly one of the key problems we are currently facing with the Basle Accord. The Basle Accord capital standards divide bank on- and off-balance sheet assets into four risk buckets, and then apply a different capital weight to each bucket. These weights increase roughly with the riskiness of the assets in a given bucket. The basic idea is that more capital should be required to be held against riskier assets. However, the relationship is rough. Perhaps most troublesome, the same risk weight is applied to all loans. Thus, for example, a loan to a very risky "junk bond" company gets the same weight as a loan to a "triple A" rated firm. While the Accord has the virtue of being relatively easy to administer and enforce, it also clearly gives banks an incentive to find ways to avoid the regulatory capital standard for loans that their internal models say need less capital than is required by the Basle Accord. Conversely, banks should want to keep loans which their models say require more capital than does the Basle standard. And, guess what, banks have been doing just that. This so-called "regulatory arbitrage" may not be all bad, but it surely causes some serious problems as well. For one thing, it makes reported capital ratios - a key measure of bank soundness used by supervisors and investors - less meaningful for government supervisors and private analysts. Finding ways around this problem is a high priority at the Federal Reserve. The arbitraging of regulatory capital requirements is but one of a host of similar conflicts between banks and bank supervisory rules and regulations. Indeed, one can view much of the long history of bank supervision and regulation as something of a battle between supervisors who want to deter excessive risk taking and banks who seek ways around sometimes inefficient, or just plain uneconomic, regulations. This long history leads me to seek supervisory strategies that are, in the economist's jargon, incentive compatible. By incentive compatible, I mean supervisory policies and procedures that give banks strong internal incentives to manage their risks prudently and minimize the exploitation of moral hazard. Put differently, we need to design strategies that encourage banks, in their own self-interest, to work with us, not against us. One promising possibility for incentive compatible regulation is what has come to be called the "pre-commitment" approach to bank capital standards. The basic idea is to allow the bank to pre-commit to the supervisor its capital allocation for risks in the bank's trading account - those assets held as part of the bank's securities dealing activities. If the bank's losses for that portion of its total risk exceed the pre-committed amount of capital over some fixed time period, the bank would pay a penalty, or perhaps have to disclose to the market its violation of its pre-commitment. Such an approach would utilize the bank's own internal models and risk management procedures to achieve supervisory goals, and give the bank a strong incentive to improve its risk management, since by doing so it could lower its pre-committed capital requirement and not increase the risk of paying a penalty. ---[PAGE_BREAK]--- There are both benefits and difficulties with the approach that we are discussing with other supervisors both in the U.S. and abroad. It may well be that some form of an incentive compatible strategy might be linked with a regulatory minimum capital as a modification to the Basle standard for market risk. Such a modification would be to the existing standard that, it is important to emphasize, already uses a bank's internal risk management models to help achieve supervisory goals. U.S. bank supervisors began last year to require large, internationally active American banks to meet the Basle Accord's capital requirements for market risk in trading accounts using their own internal models, with appropriate review and monitoring by supervisors. As I suggested at the beginning of my remarks, the possibility of a systemic failure of the banking system, and the moral hazard incentives created by the safety net that is designed to contain systemic risk, require some government supervision of banks. But we should always remember that the first line of defense against excessive risk-taking by banks is the market itself. Market discipline can be, and often is, highly effective at deterring excessive risk. Indeed, a primary goal of many of the bank regulatory reforms implemented in the wake of the banking and thrift crises of the 1980s and early 1990s was either to increase market discipline or to make supervisors behave more like the market would behave. Market discipline was increased by raising capital standards, thus giving the owners of the firm a greater incentive to control risk, and by mandating greater public disclosure by a bank of its financial condition. Prompt closure rules that required supervisors to impose increasingly severe penalties on a bank as its financial condition deteriorated, and the adoption of risk-based deposit insurance premiums are examples of encouraging supervisors to act like the market. The reforms of the early 1990s were a good start. But I believe that there may well be more that we can do here. Such comments may sound out of place today. Times are good, and almost everyone seems quite satisfied with the current deposit insurance system. But good times may be precisely when we should develop ideas for an even more effective system. The crucible of a crisis is not always the best time to think up reforms - witness the error we made in passing the Glass-Steagall Act, an error we have yet to correct after 65 years! Indeed, it is in part for this very reason that the Board continues to urge Congress to pass financial modernization legislation. So, in the spirit of being forward looking, let me attempt to give you the flavor of what I am thinking about. It may, for example, be possible to increase market discipline by requiring large, internationally active banks to issue a minimum amount of certain types of uninsured subordinated debt to the public. Holders of such debt would have a strong incentive to require the bank to manage its risk prudently. In addition, it would be highly desirable if this debt were traded on the open market, thereby providing a clear signal of the market's evaluation of the bank's financial condition. Another possibility is further reforms of the deposit insurance system. For example, most observers believe that the current risk-based premiums do not adequately reflect risk differences between banks, in part because current law limits the growth of deposit insurance reserves. Loosening this constraint might allow for more accurate pricing of deposit insurance. # Dealing with globalization The final area I will highlight today is a potentially critical implication of financial globalization for the supervision of large, internationally active banking organizations. In this world of financial globalization, complexity, and rapid telecommunications, it is extremely important that all of the large banking institutions in the developed nations strive to ---[PAGE_BREAK]--- keep up with the state-of-art in risk measurement and management. If a group of important institutions in only one or two countries fails to keep pace, all banking systems are placed at increased risk. This risk, moreover, is not simply that a large bank failure in one country can cause counter-party failures in other nations. Systematic underestimation of credit and other risks can result in underpricing those risks, which can be damaging to all players, not only to the banks making the risk measurement errors. Fortunately, the free market dissemination of best practices appears to be functioning fairly well. No single developed nation has a monopoly on best practice risk measurement and management, if innovations in complex financial products are any indication. For example, European banks were market leaders in introducing collateralized loan obligations. In the field of asset-backed commercial paper facilities, U.S. banks were the initiators, but European and Japanese institutions are now significant players. And, the ubiquitous consulting firms around the world can be relied upon to spread the word on advances in risk management techniques. Still, individual banks in each country, not just the U.S., must face the proper incentives to keep up with an ever changing technology. Lax supervisory practices - or, worse, government support of banks with poor risk practices - do not provide proper incentives. Thus, each supervisory authority in each developed nation must be vigilant that the disparities between the world's best practice institutions and those large banks inside the best practices frontier do not grow wider. Indeed, I believe that an important function of supervisors is to act as something of a clearinghouse for best practices. Internationally, supervisors from the major industrialized nations have been performing this function more and more through their joint efforts. In the United States, the clearinghouse function is an important component of the on-site examination. # Conclusion In conclusion, I hope that my remarks have helped you to better understand the forces affecting our banking and financial system. Equally important, I hope that I have given you a good feel for the challenges these forces have created for bank supervision, how we are meeting these challenges today, how we may deal with them in the future, and the role of the Federal Reserve in these complex, dynamic, and exciting issues. All of us have a very big stake in the continued health, stability, and competitiveness of our banking system. I encourage each of you to think deeply about what is required to achieve these goals.	Laurence H Meyer	United States	https://www.bis.org/review/r980518b.pdf	regulation Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, presented before the "Spring 1998 Banking and Finance Lecture", Widener University, Chester, Pennsylvania, on 16/4/98. It is a pleasure to continue what is becoming a tradition of Federal Reserve Governors speaking at Widener University. When you think of the Federal Reserve, I am pretty sure that, in addition to speakers at your university, most of you think of monetary policy, interest rates, international finance, and the Fed's macroeconomic responsibilities in all of these areas. And, of course, macroeconomics lies at the core of what any central bank does. However, for a variety of reasons that I will discuss shortly, the Federal Reserve plays a major role in the supervision and regulation of banks. Moreover, I believe that the connections between bank supervision and macroeconomic policy are not only little understood, but also quite close. No economy can grow and provide an increasing standard of living for its citizens without also having a stable and efficient banking system. Recent events in Asia are just the most current reminder of this truth. I will begin my remarks today by summarizing, very briefly, why and how banks are regulated in the United States. Then I will outline the key trends that I see affecting the banking and financial sector, and the challenges that these trends pose for bank supervisors. In the final portion of my remarks, I will suggest some directions that I believe we should consider when thinking about how bank supervision should evolve over time. Why do we supervise and regulate banks? The reasons are very straightforward. First and foremost, problems in only a small number of banks can, under the right circumstances, become problems in the entire banking and financial systems, with potentially major risks to the real economy. Traditionally, this meant protecting against a panic-driven flight to currency otherwise known as a contagious series of bank runs, that caused a catastrophic decrease in the money supply and the collapse of financial intermediation. Today, largely because of deposit insurance and the Federal Reserve discount window, flights to currency are not a real concern in the United States. Rather, the stability of the electronic, large dollar payments system, which moves trillions of dollars a day and in which banks play a pivotal role, is critical in limiting systemic risk. Other potential pressure points, in all of which banks play a key role, include the liquidity of securities, financial derivatives, and interbank funding markets. Our very success at virtually eliminating the risk of bank runs in the United States has led to a second major reason for supervising and regulating banks. Deposit insurance, the discount window, and Federal Reserve payment system guarantees - the very things that have eliminated bank runs - create what is called a "safety net" for banks. The existence of this safety net gives the government a direct stake in keeping bank risks under control, just as a private insurance company has a stake in controlling the risks of policyholders. Because deposit insurance and other parts of the safety net can never be fully and accurately priced, it is necessary for us to monitor and sometimes to act to control bank risks in order to protect the potential call on taxpayer funds. An equally important, if unintended, consequence of the safety net is that it creates what economists term "moral hazard" incentives for some banks to take excessive risks. That is, the safety net creates incentives for banks to take larger risks than otherwise, because the safety net, and potentially taxpayers, may absorb most of the losses if the gamble fails. Such incentives are especially strong if the bank is close to failure since, at this point, bank stockholders have virtually nothing to lose. Moral hazard is surely not much of a problem today, when banks are healthy and bank capital ratios are high. But back in the late 1980s when over 200 banks were failing each year, moral hazard was a serious concern. All right, you may say, I understand why we supervise and regulate banks. But why do both the federal and state governments regulate banks, and why do three federal government agencies have bank supervisory responsibilities? And, I hesitate to even ask, why there are separate federal and state supervisors for thrift institutions and credit unions? Just in case even the questions confused you, let me step back and outline the structure of the bank supervisory system in the United States. If you want to open a bank in the United States, you must get permission - that is, a charter - from a government agency. There are two ways to do this: state governments charter "state banks," and the federal government, through the Office of the Comptroller of the Currency, charters "national banks." Thus, each state has a state bank supervisor. At the federal level, things get a bit more complicated. The Comptroller of the Currency supervises national banks. But since the FDIC insures certain deposits of both state and national banks, the FDIC also has supervisory authority over the state and national banks that it insures. Moreover, national banks must be, and state banks may be, members of the Federal Reserve System. In addition, most banks are organized in bank holding companies, and the Federal Reserve is the exclusive supervisor of bank holding companies. Savings and loans and credit unions get separate charters, and each has its own state or federal supervisor. In reality, the supervisory system is not quite as complex as it sounds, because, believe it or not, both statutes and agreements among supervisors divide up supervisory authority so that regulatory overlap is, to a significant degree, minimized. This division of labor involves the allocation of primary federal regulator to the Federal Reserve for state member banks, to the OCC for national banks, and to the FDIC for insured state non-member banks. In addition, the coordination among the federal regulators in the interest of consistent treatment of banks is facilitated by the Federal Financial Institutions Examination Council (FFEIC). Still, despite the division of labor and the coordination through the FFEIC, the U.S. system is rather complicated. Why do we have such a "Balkanized" structure of bank chartering and supervision and regulation? In large part, it is not so much by design as it is the result of reacting to many individual problems. But I believe that there is at least one systematic factor - the long-standing desire of many Americans for a decentralized banking system. An important theme in American political philosophy has been distrust of concentrations of power, especially concentrations of financial power. Thus, from the start of our republic individual states insisted on being able to charter their own banks, and were suspicious of the federal government's efforts to do so. It was not until the trauma of the Civil War that Congress passed a National Bank Act that allowed for extensive federal chartering and supervision of banks. Even after passage of the National Bank Act, virtually all banks were severely restricted in their ability to operate across state lines. Indeed, until passage of the McFadden Act in 1927 national banks could only have one office. While this restriction was relaxed in 1933, national banks and state banks that were members of the Fed were prohibited from branching outside of their home state. Restrictions on interstate banking were viewed as important for maintaining a "dual" banking system in which both federal and state governments could charter banks, and in which no one bank, or group of banks, could gain too much power. Restrictions on interstate banking only began to be dismantled within the last two decades, and were pretty much entirely gone by the end of 1997. However, concerns about preserving a viable dual banking system are still very much alive. Today, bank supervision and regulation focus on three primary areas of public policy concern. Safety and soundness supervision attempts to ensure that banks are managed prudently and in ways that maintain the stability of the banking system. Enforcement of the antitrust laws in banking seeks to foster open and competitive markets that provide high quality banking services at minimum prices. Consumer protection laws and the Community Reinvestment Act are aimed at making sure consumers are fully informed about the most critical characteristics of banking products and services, and that banks meet the financial services needs of their local communities, with particular attention to the needs of low and moderate income neighborhoods. Congress has required the Federal Reserve to play an active role in all of these areas. The fact that the Federal Reserve has responsibilities in all of these areas is sometimes strongly questioned. There has been more than one proposal over the years to remove the Fed from bank supervision and regulation. I must confess that sometimes when I am involved in a complicated supervision issue, I am tempted to feel that someone else should do it. But in my saner and more reflective moments, I remain convinced that removing the Fed from bank supervision and regulation would be a serious mistake. Let me try to explain why. The central bank, in my experience, needs direct, hands-on involvement in the supervision and regulation of a broad cross-section of banks in order to carry out the Fed's core responsibilities of conducting monetary policy, ensuring the stability of the financial system, acting as the lender of last resort, protecting the payments system, and managing a financial crisis. Meeting all of these responsibilities is not just an academic exercise, it requires practical knowledge of financial institutions and markets, knowledge that comes with being deeply involved in supervising individual banking organizations. Without such involvement, the Federal Reserve would be much less able to maintain both its practical knowledge of banking and other financial markets, and the influence and authority necessary for macroeconomic policy and crisis management. Ivory towers are great for universities, but they are not desirable for central banks. While our supervisory responsibilities make us a better macroeconomic policymaker, I believe that our macroeconomic policy responsibilities make us a better bank supervisor. In the course of designing and implementing our supervisory policies, we must weigh safety and soundness concerns against the potentially adverse effects on the economy of excessively rigid regulations. As Chairman Greenspan has observed, the optimal rate of bank failure is not zero. Banks must be allowed to perform their economic functions of measuring, accepting, and managing risk. Taking and managing risk mean that sometimes risk will have costs, including failure. In my judgement, the central bank is in a unique position to balance the complex and sometimes conflicting objectives of financial stability and a growing economy. The Fed is less likely to engage in an unnecessarily restrictive or, for that matter, excessively loose, supervisory policy than is an agency focused either solely on bank safety and soundness or solely on growth. Finally, the U.S. central bank, because of its extensive and well-established relationships with foreign central banks is ideally positioned to engage in coordinated action in managing international financial crises and in supervising institutions that have a substantial international presence. The on-going crisis in Asian financial markets is our most recent example of the need for such coordination of supervision. The Federal Reserve is the primary bank regulator of only 5 of the largest 25 banks, the large, complex and internationally active banks that are the major sources of systemic risk. The Federal Reserve is able, nevertheless, to maintain a flow of information about the risk profiles and risk management practices of all large banking organizations through its responsibilities as exclusive supervisor of all bank holding companies. It is for this reason that the Federal Reserve places such a great emphasis on maintaining its role as supervisor of bank holding companies. Let me turn now to a discussion of the key trends in banking and financial markets that are challenging bank supervisors. Surely the most profound force that has been transforming the financial, and other sectors of our economy, is the rapid growth of computer and telecommunications technology. In finance, a critical and complementary force has been the development of intellectual "technologies" that enable financial engineers to separate risk into its various components, and price each component in an economically rational way. Indeed, Nobel Prizes have been awarded for some of these discoveries. Implementation of financial engineering strategies typically requires massive amounts of cheap data processing; and the cheap data processing would not be useful without the formulas required to compute prices. The combination of the two has led to a virtual explosion in the number and types of financial instruments. Key examples include virtually all types of financial derivatives, such as interest rate and currency swaps and, more recently, credit derivatives. Asset-backed securities, from mortgage-backed securities to credit card receivables to collateralized loan obligations, provide additional examples of what can result from the mixing of technological and intellectual innovation. Such products have lowered the cost and broadened the scope of financial services, making it possible for borrowers and lenders to transact directly with each other, for a wide range of financial products to be tailored for very specific purposes, and for financial risk to be managed in ever more sophisticated ways. Financial innovation has been the driving force behind a second major trend in banking - the blurring of distinctions among what were, traditionally, very distinct forms of financial firms. One of the first such innovations, with which we are all now very familiar, was money market mutual funds. Money market mutual funds took off in the late 1970s as market interest rates rose above rates that banks were allowed to pay on deposits. Eventually the entire system of interest rate controls, known as Federal Reserve Regulation Q, was dismantled by market realities and then, as a result, by the law. In the 1980s, banks began to challenge whether the Glass-Steagall Act prohibited combinations of commercial and investment banking. Today, both the regulators and the courts agree that Glass-Steagall does not imply a total prohibition, and bank supervisors have allowed a substantial blending of commercial and investment banking in the form of so-called Section 20 subsidiaries of bank holding companies. More recently, traditional separations of banking and insurance sales have also begun to fall, with support from the supervisors and the courts. A major result of the continued blurring of distinctions among commercial banking, investment banking, and insurance is a tremendous increase in competition in markets for many financial services. Greatly intensified competition has also led to increasing pressure for revisions to many of the banking laws and regulations, such as the Glass-Steagall Act, that, despite some successful efforts at relaxing them, continue to exert outdated and costly restraints on the banking and financial system. However, the issues involved are often complex and highly political, and so far efforts to achieve "financial modernization" have been more piecemeal than I would desire. Nevertheless, deregulation has been a major force for change in the banking and financial services industries. Two decades ago we still had Regulation Q, the Glass-Steagall Act was widely viewed as requiring a virtual prohibition of combinations of commercial and investment banking, and interstate banking and branching were barely fantasies even at the state level, let alone applications for combinations of insurance and banking. Just a few days ago, the House of Representatives almost voted on a massive re-write of the laws on permissible bank holding company activities and is now scheduled to consider the issue early next month. It is difficult to predict the outcome of that bill, and I will not. But I will note that the pressures of market developments for changes in the rules set up during the Great Depression are immense. If Congress does not act, loopholes and regulatory changes will continue to be exploited - with or without bank participation. The forces of technology and globalization will deregulate in one way or another. I and my colleagues would prefer that the Congress would guide those changes in the public interest, but legislative deadlock will not do the job because the status quo will not hold. The fourth major force transforming the banking landscape is the globalization of banking and financial markets. Indeed, globalization has been reshaping not only the financial, but also the real economy for at least the last three decades. The interactions of developments in both the financial and real economies have expanded cross-border asset holdings, trading, and credit flows. In response, financial intermediaries, including banks and securities firms, have increased their cross-border operations. Once again, a critical result of this rapid evolution has been a substantial increase in competition both at home and abroad. Today, for example, almost 40 percent of the U.S. domestic commercial and industrial bank loan market is accounted for by foreign-owned banks. The final significant trend I will highlight is the on-going consolidation of the U.S. banking industry. I think that it is fair to say that the American banking system is currently in the midst of the most significant consolidation in its history. As I mentioned earlier, in the last two decades nearly all of the traditional barriers to geographic expansion of U.S. banks have crumbled. While the states took the lead in eliminating these barriers beginning in the late 1970s, the final step was taken by the federal government with passage of the Riegle-Neal Act in 1994. Under this Act, virtually full interstate branch banking became possible in June 1997. A few facts will perhaps give you a feel for the profound changes occurring in the structure of the U.S. banking system. In 1980 there were about 14,400 banks in the U.S. organized into about 12,300 banking organizations. By the end of 1997, the number of banks had fallen to just under 9,100, and the number of banking organizations to not quite 7,200. This 42 percent decline in the number of banking organizations was due in part, but only in part, to the large number of bank failures in the late 1980s and early 1990s. A more important factor was mergers among healthy banks. Since the early 1980s, it has not been unusual to see 400 or more mergers among healthy banks each year. While mergers have occurred, and continue to occur, among banks of all sizes, I would emphasize three aspects of the current bank merger movement. First is the high incidence of "mega mergers," or mergers among very large banking organizations. Several mergers of the last few years have been either the largest at the time, or among the largest bank mergers in U.S. history. Examples include the combining of Chase Manhattan and Chemical Bank, Wells Fargo and First Interstate, NationsBank and Barnett, and, most recently, First Union and CoreStates. Second, despite all of the merger activity, a large number of medium to small banks remain in the United States. Moreover, by most measures of performance these small banks are more than a match for their larger brethren for many bank products and services. Indeed, when a mega merger is announced it is not uncommon to read in the press how small banks in the affected markets are licking their chops at the business opportunities created thereby. Research seems to support their optimism. Lastly, while the overall number of banking organizations has fallen since 1980, this does not mean that new, or de novo, entry has not occurred. From 1980 through 1997 some 3,600 new banks were formed in the United States. My bottom line? The U.S. banking structure is highly dynamic, is adjusting to a variety of forces, and defies easy generalizations. The current wave of bank mergers has led to a substantial increase in bank concentration at the national level. For example, the percentage of banking assets controlled by the top 10 banking organizations rose from about 22 percent in 1980 to 34 percent in 1997. The percentage held by the top 25 increased from 33 to 53 percent. Are these increases in national concentration a public policy concern? In my view, the answer to this question is "no," at least at this time, because virtually all the evidence we have strongly suggests that competition problems almost always arise in banking at the local level. That is, to the extent that banks are able to exert market power, the exercise of such power tends to occur in retail markets that are relatively narrow in geographic scope, and for a fairly well-defined set of customers, usually households and small businesses. However, a special influence on local market competition may develop as bank consolidation and interstate branching continue, resulting in the largest banks competing with each other in an increasing number of local markets. Such widespread competitive contacts may cause these firms to temper their competitive behavior in individual markets in recognition of the potential for responses by their rivals in other common markets and in recognition of their widespread mutual interests. So, what has happened to banking concentration in local markets since 1980? The answer is, "not much". For example, the average three-bank deposit concentration ratio in Metropolitan Statistical Areas, a common measure of local urban markets, hovered between 65 and 68 percent between 1980 and 1997. Concentration measures for rural counties show similar results, with the average three-bank concentration ratio remaining at about 89 percent throughout the period. Other measures of local market concentration show similar results for both urban and rural areas. The stability of local market concentration in the face of such a large consolidation of the banking industry is remarkable. While there is no single reason for this stability, I would point to two factors as being of particular importance. Many mergers, including some mergers of very large banks, involve institutions that do not compete in the same local markets. In such cases, local market concentration is obviously not affected. Where the merging banks do compete in the same local markets, enforcement of the antitrust laws has been an important factor limiting the growth of local market concentration. Moreover, antitrust enforcement has no doubt deterred some highly anti-competitive mergers from even being proposed. Why have banks been consolidating in number and expanding in size and geography? Again, no one answer is appropriate, and each merger is somewhat unique and reflects more than one factor. In recent years many banks have been responding to the removal of barriers to interstate banking and branching that restricted entry and divided markets. In such cases, the twin desires to diversify risk geographically and to expand sources of "core" deposits have surely been important motivating forces. Moreover, geographic barriers had constrained natural market developments; in an important sense their removal has simply allowed the market to adjust to a new economic equilibrium from a previously legally mandated equilibrium. Beyond such adjustments, scale economies are mentioned frequently by bankers as a causal factor in bank consolidation, although academic research has not tended to find much evidence of overall economies of scale in banking. Still, economies of scale certainly exist for some bank operations, such as many back office functions. In addition, some lines of business, such as securities underwriting and market making, require large levels of activity to be viable. Increased competitive pressures caused by rapid technological change and the resulting blurring of distinctions between banks and other types of financial firms, lower barriers to entry due to deregulation, and increased globalization are also important factors. For example, greater competition forces inefficient banks to become more efficient, accept lower profits, close up shop, or - in order to exit a market in which they cannot survive - merge with another bank. Other possible motives for mergers include the simple desire to achieve market power, or efforts by management to build empires and enhance compensation. Some mergers probably occur as an effort to prevent the acquiring bank from itself being acquired, or, alternatively, to enhance a bank's attractiveness to other buyers. No matter why banks are merging, the bottom line is that the United States is well on its way to developing a truly national banking structure for the first time in its history. We are not quite there yet, but I do not think it will take too many more years. What will this structure look like? Well, that is obviously a very complex question, the answer to which involves forecasting years in advance. And I can tell you from many years of experience, forecasting the economy even one year in advance is a very risky and humbling business. Thus, any prognostications about future banking structure should be taken with very many grains of salt. Still, some economists at the Fed have tried to look through this dark glass to see the future United States banking structure. For all of the reasons I have discussed, it seems reasonable to expect a continued high level of merger activity for the foreseeable future. Very large mergers will not be uncommon. Studies based on historical experience suggest that in around a decade there will likely be about 3,000 to 4,000 banking organizations, down from about 7,000 today. Although the top 10 or so banking organizations will almost certainly account for a larger share of U.S. banking assets than they do today, the overall size distribution of banks will probably remain about the same. That is, there will likely be a few very large organizations, and an increasing number of firms as we move down the size scale. Importantly, a large number of small banks is expected to remain. Future Directions in Bank Supervision What do all of these changes mean for how we supervise and regulate banks? Clearly, as the banking industry consolidates we need to maintain competitive markets. Competitive markets are our best assurance that consumers receive the highest quality products at the lowest possible prices. As I discussed earlier, there are many reasons to believe that in recent years competition has increased greatly in markets for a large number of financial products and services. This is true for many products purchased in local, regional and national markets. However, in some cases we still observe potential competitive problems with a proposed bank merger. Fortunately, the antitrust laws, as written into the banking statutes, give us the means to maintain competition in such situations. These laws require that the Board approve only those mergers that are not expected to substantially harm competition. When implementing this policy, the Board may require changes to a merger proposal, and may even deny an application, if the merger or acquisition would result in a highly concentrated market, or an excessively large increase in concentration. As I indicated a few minutes ago, the focus of our analysis is normally on local retail markets for banking products and services. Over the past year or so, quite a few applicants have pushed very hard at the Board's frontier for approving merger applications. Some applicants appear to have held the view that almost any merger could be approved, even if it violated the screening guidelines that both the Federal Reserve and the Department of Justice use to decide which mergers require close examination. In response, the Board has occasionally felt compelled to remind applicants, especially those proposing a merger that would affect a large number of local markets, that substantial changes in market concentrations will receive careful review. Moreover, when mergers would exceed the screening guidelines, "mitigating" factors must be present. By mitigating factors I mean conditions that tend to create a more competitive market than is suggested by market concentration alone. These would include characteristics that make a market highly attractive for new entry, or situations where nonbank providers of financial services are unusually strong. The greater the deviation from the screening guidelines, the more powerful and convincing the mitigating factors must be. I have been particularly concerned with cases where a large number of local markets are affected. In such cases, even if the adverse effect is fairly small in each of several local markets, it seems to me that the cumulative, or total, adverse effect might be significant. Thus, when a large number of markets are affected adversely, I believe that we should be especially careful to assure ourselves that there are substantial mitigating factors. In addition, when a merger would cause a large change in concentration in a market that is, or becomes, highly concentrated, I think we need to give special attention to the impact on competition. The reason for this is that I think when the change in concentration is large, the effect on interfirm relationships, market dynamics and thus competition is likely to be more pronounced, other things equal. Assessing safety and soundness Technological change, financial innovation, the acquisition of new powers by banking organizations, the increasing geographic scope of banks, and the globalization of financial markets all challenge our ability to examine and assess the safety and soundness of individual banking firms. One way that examiners are adapting to this changed world is to focus much of their attention on the information and risk management systems of banks. The key question they ask is: How effectively are these systems measuring and controlling an institution's rapidly changing risk profile? The emphasis on risk management is most critical at our largest, most sophisticated, and most internationally active banks. Many of these banks use advanced economic and statistical models to evaluate their market and credit risks. These models are used for a variety of purposes, including allocating capital on a risk adjusted basis and pricing loans and credit guarantees. The development by some banks of increasingly accurate models for measuring, managing, and pricing risk has called into question the continuing usefulness of one of the foundations of bank supervision - the so-called risk-based capital standards, or the Basle Accord. The Basle Accord capital standards were adopted in 1988 by most of the world's industrialized nations in an effort to encourage stronger capital at riskier banks, to include off-balance sheet exposures in the assessment of capital adequacy, and to establish more consistent capital standards across nations. The Accord was a major advance in 1988, and has proved to be very useful since then. But in recent years calls for reform have begun to grow. I will outline briefly one of the key problems we are currently facing with the Basle Accord. The Basle Accord capital standards divide bank on- and off-balance sheet assets into four risk buckets, and then apply a different capital weight to each bucket. These weights increase roughly with the riskiness of the assets in a given bucket. The basic idea is that more capital should be required to be held against riskier assets. However, the relationship is rough. Perhaps most troublesome, the same risk weight is applied to all loans. Thus, for example, a loan to a very risky "junk bond" company gets the same weight as a loan to a "triple A" rated firm. While the Accord has the virtue of being relatively easy to administer and enforce, it also clearly gives banks an incentive to find ways to avoid the regulatory capital standard for loans that their internal models say need less capital than is required by the Basle Accord. Conversely, banks should want to keep loans which their models say require more capital than does the Basle standard. And, guess what, banks have been doing just that. This so-called "regulatory arbitrage" may not be all bad, but it surely causes some serious problems as well. For one thing, it makes reported capital ratios - a key measure of bank soundness used by supervisors and investors - less meaningful for government supervisors and private analysts. Finding ways around this problem is a high priority at the Federal Reserve. The arbitraging of regulatory capital requirements is but one of a host of similar conflicts between banks and bank supervisory rules and regulations. Indeed, one can view much of the long history of bank supervision and regulation as something of a battle between supervisors who want to deter excessive risk taking and banks who seek ways around sometimes inefficient, or just plain uneconomic, regulations. This long history leads me to seek supervisory strategies that are, in the economist's jargon, incentive compatible. By incentive compatible, I mean supervisory policies and procedures that give banks strong internal incentives to manage their risks prudently and minimize the exploitation of moral hazard. Put differently, we need to design strategies that encourage banks, in their own self-interest, to work with us, not against us. One promising possibility for incentive compatible regulation is what has come to be called the "pre-commitment" approach to bank capital standards. The basic idea is to allow the bank to pre-commit to the supervisor its capital allocation for risks in the bank's trading account - those assets held as part of the bank's securities dealing activities. If the bank's losses for that portion of its total risk exceed the pre-committed amount of capital over some fixed time period, the bank would pay a penalty, or perhaps have to disclose to the market its violation of its pre-commitment. Such an approach would utilize the bank's own internal models and risk management procedures to achieve supervisory goals, and give the bank a strong incentive to improve its risk management, since by doing so it could lower its pre-committed capital requirement and not increase the risk of paying a penalty. There are both benefits and difficulties with the approach that we are discussing with other supervisors both in the U.S. and abroad. It may well be that some form of an incentive compatible strategy might be linked with a regulatory minimum capital as a modification to the Basle standard for market risk. Such a modification would be to the existing standard that, it is important to emphasize, already uses a bank's internal risk management models to help achieve supervisory goals. U.S. bank supervisors began last year to require large, internationally active American banks to meet the Basle Accord's capital requirements for market risk in trading accounts using their own internal models, with appropriate review and monitoring by supervisors. As I suggested at the beginning of my remarks, the possibility of a systemic failure of the banking system, and the moral hazard incentives created by the safety net that is designed to contain systemic risk, require some government supervision of banks. But we should always remember that the first line of defense against excessive risk-taking by banks is the market itself. Market discipline can be, and often is, highly effective at deterring excessive risk. Indeed, a primary goal of many of the bank regulatory reforms implemented in the wake of the banking and thrift crises of the 1980s and early 1990s was either to increase market discipline or to make supervisors behave more like the market would behave. Market discipline was increased by raising capital standards, thus giving the owners of the firm a greater incentive to control risk, and by mandating greater public disclosure by a bank of its financial condition. Prompt closure rules that required supervisors to impose increasingly severe penalties on a bank as its financial condition deteriorated, and the adoption of risk-based deposit insurance premiums are examples of encouraging supervisors to act like the market. The reforms of the early 1990s were a good start. But I believe that there may well be more that we can do here. Such comments may sound out of place today. Times are good, and almost everyone seems quite satisfied with the current deposit insurance system. But good times may be precisely when we should develop ideas for an even more effective system. The crucible of a crisis is not always the best time to think up reforms - witness the error we made in passing the Glass-Steagall Act, an error we have yet to correct after 65 years! Indeed, it is in part for this very reason that the Board continues to urge Congress to pass financial modernization legislation. So, in the spirit of being forward looking, let me attempt to give you the flavor of what I am thinking about. It may, for example, be possible to increase market discipline by requiring large, internationally active banks to issue a minimum amount of certain types of uninsured subordinated debt to the public. Holders of such debt would have a strong incentive to require the bank to manage its risk prudently. In addition, it would be highly desirable if this debt were traded on the open market, thereby providing a clear signal of the market's evaluation of the bank's financial condition. Another possibility is further reforms of the deposit insurance system. For example, most observers believe that the current risk-based premiums do not adequately reflect risk differences between banks, in part because current law limits the growth of deposit insurance reserves. Loosening this constraint might allow for more accurate pricing of deposit insurance. The final area I will highlight today is a potentially critical implication of financial globalization for the supervision of large, internationally active banking organizations. In this world of financial globalization, complexity, and rapid telecommunications, it is extremely important that all of the large banking institutions in the developed nations strive to keep up with the state-of-art in risk measurement and management. If a group of important institutions in only one or two countries fails to keep pace, all banking systems are placed at increased risk. This risk, moreover, is not simply that a large bank failure in one country can cause counter-party failures in other nations. Systematic underestimation of credit and other risks can result in underpricing those risks, which can be damaging to all players, not only to the banks making the risk measurement errors. Fortunately, the free market dissemination of best practices appears to be functioning fairly well. No single developed nation has a monopoly on best practice risk measurement and management, if innovations in complex financial products are any indication. For example, European banks were market leaders in introducing collateralized loan obligations. In the field of asset-backed commercial paper facilities, U.S. banks were the initiators, but European and Japanese institutions are now significant players. And, the ubiquitous consulting firms around the world can be relied upon to spread the word on advances in risk management techniques. Still, individual banks in each country, not just the U.S., must face the proper incentives to keep up with an ever changing technology. Lax supervisory practices - or, worse, government support of banks with poor risk practices - do not provide proper incentives. Thus, each supervisory authority in each developed nation must be vigilant that the disparities between the world's best practice institutions and those large banks inside the best practices frontier do not grow wider. Indeed, I believe that an important function of supervisors is to act as something of a clearinghouse for best practices. Internationally, supervisors from the major industrialized nations have been performing this function more and more through their joint efforts. In the United States, the clearinghouse function is an important component of the on-site examination. In conclusion, I hope that my remarks have helped you to better understand the forces affecting our banking and financial system. Equally important, I hope that I have given you a good feel for the challenges these forces have created for bank supervision, how we are meeting these challenges today, how we may deal with them in the future, and the role of the Federal Reserve in these complex, dynamic, and exciting issues. All of us have a very big stake in the continued health, stability, and competitiveness of our banking system. I encourage each of you to think deeply about what is required to achieve these goals.
1998-04-23T00:00:00	Ms. Rivlin remarks on lessons drawn from the Asian financial crisis (Central Bank Articles and Speeches, 23 Apr 98)	Remarks by the Vice-Chair of the US Federal Reserve System, Ms. Alice M. Rivlin, before the Hyman P. Minsky Conference on Financial Structure at The Levy Institute in Annandale-on-Hudson, New York on 23/4/98.	Remarks Ms. Rivlin remarks on lessons drawn from the Asian financial crisis by the Vice-Chair of the US Federal Reserve System, Ms. Alice M. Rivlin, before the Hyman P. Minsky Conference on Financial Structure at The Levy Institute in Annandale-on-Hudson, New York on 23/4/98. Toward A Better Class of Financial Crises: Some Lessons from Asia Drawing lessons from the Asian financial crisis has become a minor industry, partially offsetting the impact of the crisis on developed economies -- at least for economists. It contributes to conference budgets, airline revenues, bar tabs, and the length of academic resumes. The opining classes can turn almost any bad news into an excuse for more meetings in beautiful settings like Bard College. Some of the talk has been devoted to the blame game. Was the crisis (or rather the rolling set of interrelated crises) home-grown, that is, brought on by ill-conceived investment, over-leveraged companies, lax banking supervision and crony capitalism in the borrowing countries? Was it the greed, inattention, or herd instinct of the lenders? Or was it the inherent instability of international capital flows? Did the IMF step in just in time to avert total meltdown or did it fail to provide early enough warning? Did the conditions imposed on borrowers help restore investor confidence or further undermine it? The quick answer is that all of the alleged culprits bear part of the responsibility. International flows of capital can be unstable -- what flows in can quickly flow out -- and fast. The enormous escalation in the volume of private capital flows, coupled with the advent of simultaneous communication in all the world's markets, has greatly increased the exposure of economies to rapid turnarounds in cross-border flows. Decades of rapid growth and apparently unending capital inflow had made the Asian emerging markets, until recently known as "tigers", believe they were immune from the reversals of investor confidence that beset other parts of the world and produced an incaution that led to over investment in some sectors, inflated equity and real estate prices, and some ill-thought-out projects, public and private. Close relations between companies, banks and governments created false senses of security, as well as uneconomic "policy" loans and investments. Weak supervision of financial institutions and markets, on top of traditions of secrecy in business and governmental transactions, aggravated the crises when things turned down. At the same time, foreign investors and creditors asked too few questions, were hesitant to reign in the galloping goose that had laid so many golden eggs, and reinforced each other's reluctance to be the first to pull back. As tensions were developing, the IMF pointed to some of the dangers without getting much response, and missed some others, as did the much-vaunted market gurus and rating agencies. When the crises hit, the IMF quickly crafted rescue packages that imposed serious structural reform as conditions of aid, inevitably making some mistakes in the process, but arresting the spreading downward spiral and restoring enough confidence to allow the countries to get their policies in shape to support the climb back to economic health. No one thinks the climb will be easy, but the best bet is that the worst is over. Now the talk has shifted to the more difficult subject of what the international community can do to prevent, mitigate and manage financial crises in the future. The stakes are high, for industrial and emerging market countries alike. When international capital markets function well, they help achieve rising standards of living for both creditor and debtor countries. When the markets crash, they bring incredible hardship to ordinary workers and their families -- often people who have been pulled out of their traditional occupations and communities by economic change and may have nothing to fall back on. Two sets of prescriptions are relatively uncontroversial, albeit deceptively hard to achieve. First, the world's capital markets and the machinery designed to stabilize them would function better with more complete, accessible and timely information flows. Investors can make better decisions and lenders can exercise more discipline over borrower behavior if they have more accurate and more complete information and have it sooner. Both international and domestic officials can monitor, supervise and warn of impending danger only if they know the facts. Improving transparency should apply not only to businesses and banks, but to official bodies, both national and international. It's important to know what a country's budget deficit really is (on budget and off budget) and what its exchange reserves really are, including any operations in the forward markets. The Asian crisis was certainly exacerbated by lack of information of many sorts, including accurate data on reserves. There is currently a great flurry of activity in various international fora to raise standards of accounting and reporting on business, banking and governmental activity and balance sheets. Progress will be made. But one should not expect too much. Although post mortems on financial crises, especially reviews of investor decisions that went sour, feature a great deal of if-only-we-had-known rhetoric, in actual fact a great deal of information usually turns out to have been available which no one ever looked at or effectively analyzed. For transparency to be useful, people need to actually want to look -- and too often those who are making high profits would rather not hear bad news. Second, a major sustained international effort is needed to strengthen the structure, functioning and supervision of financial systems in emerging market countries. A clear lesson of recent economic history (and not just in emerging market countries) is the crucial importance of strong banks and other financial institutions, adequately capitalized and able to manage risk, overseen by serious prudential supervision and an independent well managed central bank. Industrial countries can ill-afford to be sanctimonious on this score -- many of us have experienced the adverse effects of poor prudential supervision or lack of political will to close failing financial institutions -but good management and strong supervision of financial institutions is clearly a key to withstanding economic shocks. Here, too, consensus is strong and serious activity is underway under the aegis of a variety of international bodies, perhaps too many, to evolve clear rules for financial supervision and help countries implement them. The task will require time, patience and resources. It is not just bank examiners, but bankers who need training in how to do their jobs in modern, fast moving internationally exposed economies. Strengthening financial systems, including improving corporate governance, goes hand in hand with efforts to improve transparency and information flows -- to investors, shareholders, supervisors and international agencies -- and both will require sustained effort and run into significant resistance. The first two prescriptions are preventive, designed to reduce the frequency and amplitude of financial crises. But no one with a sense of history -- or reality -- believes that crises can be eliminated. Hence, a third prescription also appears on everybody's list, albeit with far less agreement on what it means, namely, private creditors should take on a greater portion of the burden of resolving future international financial crises. Sharing the burden is a far more difficult issue to come to grips with conceptually than either the need for greater transparency or the need for stronger, better supervised financial systems. Not much intellectual structure yet exists for thinking about burden-sharing in international financial crises. Moreover, cross-border financing is growing so rapidly and market instruments are morphing so fast that designing ways of sharing the burden is like changing the tires on a moving car -- pretty exciting and not obviously doable. The task cannot be set aside, however, for at least two reasons. First, the cost of resolving international financial crises is outrunning the likely resources available for that purpose. The volume of cross-border flows has grown precipitously and the cost of breakdown has escalated with it. High speed traffic on a six lane freeway moves a lot of people to their destinations fast, but the pile-up in a wreck is a lot more expensive than on a winding two lane road. If recent trends continue, managing the next crisis will call for more resources than taxpayers in the United States and other developed countries are likely to feel comfortable turning over to the IMF and other international organizations, even if they are reasonably confident that the borrowing countries will pay the loans back, as experience indicates they will. Second, and far more important, the perception that official resources can be counted on to bail out creditors (directly or indirectly) arguably generates moral hazard. It could lead to excessive risk-taking by lenders and funding of less economically defensible projects. It may also channel financing into less stable forms whose overuse makes crises more likely to occur. In recent episodes, direct investors and holders of equity and long-term debt have taken serious losses, but short-term lenders, especially interbank lenders, have been largely protected. While a country in trouble has understandable reasons for not wanting to cut itself off from short-term bank credit and for using its scarce international resources to keep this lifeline attached, the result may be to reinforce excessive dependence on debt rather than equity and on short, rather than longer-term financing. Both reasons combine to create an urgent need for serious and creative thought on the part of the international community about how to "bail in" private sector financiers, in order to reduce the impact on the financial resources of official institutions like the IMF, the World Bank and the regional development banks, to reduce moral hazard leading to excessive risk-taking, especially short-term inter-bank borrowing, and to improve risk assessment. Designing mechanisms for appropriate burden sharing among private sector investor/creditors is inherently hard because it runs into some very sticky and fundamental dilemmas. The basic principle from which all borrowing and lending must proceed is that people who use other people's money have a firm obligation to pay it back. Hence, a suspension of payments or a work-out arrangement must be clearly rare and exceptional, resorted to only in extreme situations. Raising fears that suspensions are likely or work-outs normal could unnecessarily increase the cost of capital, cause drastic reductions in cross-border flows and diminish future incomes of debtors and creditors alike. Yet having no known or understood process for dealing with default can, as has been seen in Asia, lead to inequitable burden sharing, high official cost and potential future moral hazard. A related basic dilemma involves the timing of a suspension of payments. Authorities have to hold off long enough to be sure there is no other choice, but not wait so long that creditors are running for the doors and irreversible damage is already done. The problem is, of course, not entirely new. International borrowers have gotten into trouble before, and precedents for workouts have been developed -- Paris Club procedures for resolving sovereign debts to public creditors; London Club for resolving sovereign debts to private banks. But each crisis is different from the last. A critical element in the Mexican crisis of 1994-95 was the threat of default on dollar-indexed Mexican short-term bonds (tesebonos 1) for which no work-out process existed. Dealing with bond holders (who are likely to be numerous and scattered) is more complex than dealing with lending governments or a relatively small (and known) group of 1 Tesebonos were technically denominated in pesos. international banks. The recent Asian crises posed still another problem. The borrowers were not governments, but private banks and corporations, a situation that may be typical of future crises, and one that adds greatly to the legal and organizational complexities of sharing the burden of financial distress. When the debt in question is sovereign debt, whether to banks or other lenders, it may not be hard to re-establish stability and confidence in the sovereign. The IMF can lend enough to solve the borrowing government's immediate liquidity problem while the government works out a debt restructuring with its creditors. IMF rules permit "lending into arrears" in these circumstances. If the creditors are bondholders, as they were in Mexico, the situation is more difficult. IMF rules do not at present permit a government borrowing from the IMF when it is unable to pay its bondholders. Even a small minority of the bondholders can use their bargaining power to obstruct a resolution of the crisis in hopes of getting a better deal. After the Mexican crisis had been resolved with the help of significant new official lending to Mexico, the international community focused on how to improve the bargaining position of the debtor government with its bondholders if such a crisis should arise in the future. The "Rey Report" on Sovereign Liquidity Crises (named for its author, Jean-Jacques Rey of the Central Bank of Belgium) was a major effort by the G-10 countries to learn the lessons of Mexico. It recommended two new steps: • First, the IMF should expand its willingness to lend into arrears to cover the situation in which a sovereign was making a good faith effort to work out a debt restructuring with its bondholders. • Second, it recommended that bonds issued in international markets contain clauses that would facilitate debt restructuring if it became necessary. Clauses could be added to provide for debt-holder representation in negotiations with the sovereign or qualified majority voting on changes in terms. Such clauses would make it harder for minority creditors to block restructuring or exact a higher price than necessary to satisfy the majority. Neither of these recommendations received much official attention until the Asian crisis hit. Although the recommendations were not actually germane to the situation in Asia, the IMF reviewed the recommendations at its Interim Committee meeting in April 1998 and action in the near future seems more likely than a year ago. Perhaps the official community will always be one crisis late. Unlike the sovereign debt crises in Latin America, the situation in Asia involved private debts (of banks in Korea, corporations in Indonesia, and some of each in Thailand) to private creditors, mostly banks. Hence, it was inherently harder, as currency values plummeted and reserves all but disappeared, to design ways either to restore stability or to organize work-outs. An additional complication was the fact that, although the debts were private, some of them involved varying types of implied government guarantees. In Korea, the Finance Minister ill-advisedly volunteered that the Korean government would honor foreign debts of Korean banks. When the Korean banks experienced difficulty rolling over their international bank loans, the Bank of Korea provided the reserves they needed to repay the loans, in effect delivering on the guarantee, but rapidly depleting the central bank's reserves in the process. Guarantees of this sort clearly create moral hazard. Pre-crisis, they result in more bank lending than would otherwise have taken place, and when trouble begins they may accelerate a bank run. But much less explicit guarantees can be trouble as well. Where governments are heavily intertwined with banks and companies, as has been normal throughout much of Asia, foreign lenders and investors may well assume that the government will not allow favored operations to fail. One of the challenges of mitigating and managing future crises, therefore, is finding ways to discourage emerging market governments from guaranteeing private debts or being so closely involved with private enterprises that these enterprises are seen as immune from market forces. The expectation that future borrowers in international markets will be mostly private enterprises, greatly increases the importance of the first two prescriptions -- increasing transparency and strengthening financial system surveillance -- not just to prevent and mitigate crises, but to manage them when they happen. In an economy that tolerates secrecy in business and financial dealings and where information disclosures are limited, firms with fairly shaky fundamentals may be able to borrow easily in a boom. They will be carried along by the general optimism, since everyone wants to believe the best and there is no tradition of asking hard questions anyway. But in a crisis, market participants tend to believe the worst. To contain the crisis and restore confidence, it is necessary both for managers and public authorities to be able to deliver the bad news and be believed by the markets. If there is no tradition of accurate, high quality information that can be relied on, market participants and bank depositors are likely to believe that things are substantially worse than they really are and proceed to prove it by their actions. A culture of transparency and timely, accurate information can serve as an economic stabilizer in both directions. It can restrain the boom by enabling investors to assess risk more accurately, and it can cushion over-reaction once a downward slide begins. But such a culture cannot be built quickly, and even where it exists, has to be assiduously maintained. Similarly, prudential supervision of financial institutions may be thought of as primarily valuable for crisis prevention -- useful for ensuring that financial institutions are adequately capitalized, don't take unacceptable risks with other people's money, and that the weak ones are required to shape up or go under. Once a crisis hits, however, it is important to be able to distinguish strong from weak institutions, those that ought to be rescued from those that ought to be closed. Unless supervision has been effective on an ongoing basis, however, the supervisors will not be able to tell strong from weak and will not be able to find out fast enough to prevent a rout. Good institutions then go down with the bad. It is actually in the long-run interest of financial institutions that aspire to be the survivors of a shake-out to insist that supervisors are well informed and applying a high standard. Another lesson of recent events in Asia has been the importance of clear, enforceable bankruptcy laws in dealing with a crisis, as well as helping to prevent one. Bankruptcy provides an opportunity, not only for closing down truly insolvent enterprises in an orderly way, but for rescuing troubled ones by allowing them to cut a deal with their creditors, restructure their obligations, and go on operating on a sounder basis. But bankruptcy procedures cannot be rapidly invented or first tested in a crisis. For bankruptcy procedures to mitigate crises effectively and help to get survivors on their feet, there has to be a "culture of bankruptcy" which operates in good times as well as bad. Debtors, creditors, lawyers and courts have to be used in the process, know what to do, be able, because they have done it before, to cut the deals that will minimize the damage and keep potentially profitable enterprises afloat. Asian countries, most obviously Indonesia, found that since their modern market experience had been primarily one of boom and growth, they had inadequate bankruptcy laws and little "culture of bankruptcy" to help manage a sudden negative turn of events. Improving transparency, supervision and bankruptcy procedures will help emerging market economies grow more sustainably (albeit perhaps slower) and manage downturns better when they happen. But the conceptually hard questions involve international collective action and how it can manage major crises more effectively. Once a crisis hits one country, especially a country of significant size and linkage with others, the whole international community has a strong interest in rapid action to isolate markets and prevent the contagion from spreading and engulfing others. At this moment, the community looks to the IMF to act quickly, provide liquidity and restore confidence, especially the confidence that the crises has bottomed out and will not be part of a continuing downward spiral. Asia in 1997 was a demonstration of how fast the dominoes could fall. When the root cause of the problem is inappropriate macro-economic policy, especially big budget deficits and easy money combined with a pegged exchange rate, it may not be difficult for the IMF to restore confidence by injecting enough liquidity to pay short-term claims in foreign currency in return for rapid changes in policy. When macro policy is not obviously the chief culprit, restoring confidence may be harder and more expensive. Injecting new money in exchange for reforms may still be the primary answer, but the patience of taxpayers wears thin as amounts escalate and it is perceived that some classes of creditors are being bailed out with official international resources -- creditors who should have calculated the risks more accurately and should bear the cost of not having done so, so they won't do it again. Some have asked whether official resources could be saved and moral hazard reduced by designing an automatic international bankruptcy-like process, known in advance, by which a standstill could be triggered, followed by a set procedure for sharing the burden among all the relevant creditors. Serious thought is being devoted to this issue. It is not hard to imagine such an approach, but all crises are different and applying a cooky cutter solution could well do more harm than good. The next few years will be a testing time for what I think of as the "cross-border community", meaning the organizations, public and private, dedicated to making the cross-border relationships (especially business and financial ones) work better. The "cross-border community" includes mega firms that produce goods and deliver financial services on a worldwide scale, and associations of accountants, lawyers, bankers, securities dealers, insurance underwriters and various kinds of financial regulators as well as general international financial institutions (the IMF and the World Bank) and more specialized ones such as the Bank for International Settlements, and the regional development banks -- to mention only a few of the more obvious members of a burgeoning species. The benefits of cross-border trade and capital flows for raising the world standard of living are clear, but so are some of the costs -- especially the costs to ordinary people of being caught in the backwash when there is a crisis. If these costs are not taken seriously and methods designed to mitigate and manage financial crises better, a wave of political backlash against capitalism, foreigners and what we all think is "progress" could result. One lesson of recent crises is that factories, banks, shiny buildings, and eager investors do not by themselves create the underpinnings of modern economic society able to withstand shocks with minimal damage. That takes -- in addition to good fiscal, monetary and other public policies -- an infrastructure of laws and traditions and expectations that cannot be built overnight or imposed from the outside. The challenge for the cross-border community will be to work closely with emerging market economies to help them build this infrastructure in ways that work for them. Wading in and saying, "do it our way" won't work. The process will involve continuous interaction and adaptation and may well result in better functioning economies in the so-called developed world, as well. - 7 -	---[PAGE_BREAK]--- Ms. Rivlin remarks on lessons drawn from the Asian financial crisis Remarks by the Vice-Chair of the US Federal Reserve System, Ms. Alice M. Rivlin, before the Hyman P. Minsky Conference on Financial Structure at The Levy Institute in Annandale-on-Hudson, New York on 23/4/98. # Toward A Better Class of Financial Crises: Some Lessons from Asia Drawing lessons from the Asian financial crisis has become a minor industry, partially offsetting the impact of the crisis on developed economies -- at least for economists. It contributes to conference budgets, airline revenues, bar tabs, and the length of academic resumes. The opining classes can turn almost any bad news into an excuse for more meetings in beautiful settings like Bard College. Some of the talk has been devoted to the blame game. Was the crisis (or rather the rolling set of interrelated crises) home-grown, that is, brought on by ill-conceived investment, over-leveraged companies, lax banking supervision and crony capitalism in the borrowing countries? Was it the greed, inattention, or herd instinct of the lenders? Or was it the inherent instability of international capital flows? Did the IMF step in just in time to avert total meltdown or did it fail to provide early enough warning? Did the conditions imposed on borrowers help restore investor confidence or further undermine it? The quick answer is that all of the alleged culprits bear part of the responsibility. International flows of capital can be unstable -- what flows in can quickly flow out -- and fast. The enormous escalation in the volume of private capital flows, coupled with the advent of simultaneous communication in all the world's markets, has greatly increased the exposure of economies to rapid turnarounds in cross-border flows. Decades of rapid growth and apparently unending capital inflow had made the Asian emerging markets, until recently known as "tigers", believe they were immune from the reversals of investor confidence that beset other parts of the world and produced an incaution that led to over investment in some sectors, inflated equity and real estate prices, and some ill-thought-out projects, public and private. Close relations between companies, banks and governments created false senses of security, as well as uneconomic "policy" loans and investments. Weak supervision of financial institutions and markets, on top of traditions of secrecy in business and governmental transactions, aggravated the crises when things turned down. At the same time, foreign investors and creditors asked too few questions, were hesitant to reign in the galloping goose that had laid so many golden eggs, and reinforced each other's reluctance to be the first to pull back. As tensions were developing, the IMF pointed to some of the dangers without getting much response, and missed some others, as did the much-vaunted market gurus and rating agencies. When the crises hit, the IMF quickly crafted rescue packages that imposed serious structural reform as conditions of aid, inevitably making some mistakes in the process, but arresting the spreading downward spiral and restoring enough confidence to allow the countries to get their policies in shape to support the climb back to economic health. No one thinks the climb will be easy, but the best bet is that the worst is over. Now the talk has shifted to the more difficult subject of what the international community can do to prevent, mitigate and manage financial crises in the future. The stakes are high, for industrial and emerging market countries alike. When international capital markets function well, they help achieve rising standards of living for both creditor and debtor countries. When the markets crash, they bring incredible hardship to ordinary workers and their families -- often people who have been pulled out of their traditional occupations and communities by economic change and may have nothing to fall back on. ---[PAGE_BREAK]--- Two sets of prescriptions are relatively uncontroversial, albeit deceptively hard to achieve. First, the world's capital markets and the machinery designed to stabilize them would function better with more complete, accessible and timely information flows. Investors can make better decisions and lenders can exercise more discipline over borrower behavior if they have more accurate and more complete information and have it sooner. Both international and domestic officials can monitor, supervise and warn of impending danger only if they know the facts. Improving transparency should apply not only to businesses and banks, but to official bodies, both national and international. It's important to know what a country's budget deficit really is (on budget and off budget) and what its exchange reserves really are, including any operations in the forward markets. The Asian crisis was certainly exacerbated by lack of information of many sorts, including accurate data on reserves. There is currently a great flurry of activity in various international fora to raise standards of accounting and reporting on business, banking and governmental activity and balance sheets. Progress will be made. But one should not expect too much. Although post mortems on financial crises, especially reviews of investor decisions that went sour, feature a great deal of if-only-we-had-known rhetoric, in actual fact a great deal of information usually turns out to have been available which no one ever looked at or effectively analyzed. For transparency to be useful, people need to actually want to look -- and too often those who are making high profits would rather not hear bad news. Second, a major sustained international effort is needed to strengthen the structure, functioning and supervision of financial systems in emerging market countries. A clear lesson of recent economic history (and not just in emerging market countries) is the crucial importance of strong banks and other financial institutions, adequately capitalized and able to manage risk, overseen by serious prudential supervision and an independent well managed central bank. Industrial countries can ill-afford to be sanctimonious on this score -- many of us have experienced the adverse effects of poor prudential supervision or lack of political will to close failing financial institutions -but good management and strong supervision of financial institutions is clearly a key to withstanding economic shocks. Here, too, consensus is strong and serious activity is underway under the aegis of a variety of international bodies, perhaps too many, to evolve clear rules for financial supervision and help countries implement them. The task will require time, patience and resources. It is not just bank examiners, but bankers who need training in how to do their jobs in modern, fast moving internationally exposed economies. Strengthening financial systems, including improving corporate governance, goes hand in hand with efforts to improve transparency and information flows -- to investors, shareholders, supervisors and international agencies -- and both will require sustained effort and run into significant resistance. The first two prescriptions are preventive, designed to reduce the frequency and amplitude of financial crises. But no one with a sense of history -- or reality -- believes that crises can be eliminated. Hence, a third prescription also appears on everybody's list, albeit with far less agreement on what it means, namely, private creditors should take on a greater portion of the burden of resolving future international financial crises. Sharing the burden is a far more difficult issue to come to grips with conceptually than either the need for greater transparency or the need for stronger, better supervised financial systems. Not much intellectual structure yet exists for thinking about burden-sharing in international financial crises. Moreover, cross-border financing is growing so rapidly and market instruments are morphing so fast that designing ways of sharing the burden is like changing the tires on a moving car -- pretty exciting and not obviously doable. ---[PAGE_BREAK]--- The task cannot be set aside, however, for at least two reasons. First, the cost of resolving international financial crises is outrunning the likely resources available for that purpose. The volume of cross-border flows has grown precipitously and the cost of breakdown has escalated with it. High speed traffic on a six lane freeway moves a lot of people to their destinations fast, but the pile-up in a wreck is a lot more expensive than on a winding two lane road. If recent trends continue, managing the next crisis will call for more resources than taxpayers in the United States and other developed countries are likely to feel comfortable turning over to the IMF and other international organizations, even if they are reasonably confident that the borrowing countries will pay the loans back, as experience indicates they will. Second, and far more important, the perception that official resources can be counted on to bail out creditors (directly or indirectly) arguably generates moral hazard. It could lead to excessive risk-taking by lenders and funding of less economically defensible projects. It may also channel financing into less stable forms whose overuse makes crises more likely to occur. In recent episodes, direct investors and holders of equity and long-term debt have taken serious losses, but short-term lenders, especially interbank lenders, have been largely protected. While a country in trouble has understandable reasons for not wanting to cut itself off from short-term bank credit and for using its scarce international resources to keep this lifeline attached, the result may be to reinforce excessive dependence on debt rather than equity and on short, rather than longer-term financing. Both reasons combine to create an urgent need for serious and creative thought on the part of the international community about how to "bail in" private sector financiers, in order to reduce the impact on the financial resources of official institutions like the IMF, the World Bank and the regional development banks, to reduce moral hazard leading to excessive risk-taking, especially short-term inter-bank borrowing, and to improve risk assessment. Designing mechanisms for appropriate burden sharing among private sector investor/creditors is inherently hard because it runs into some very sticky and fundamental dilemmas. The basic principle from which all borrowing and lending must proceed is that people who use other people's money have a firm obligation to pay it back. Hence, a suspension of payments or a work-out arrangement must be clearly rare and exceptional, resorted to only in extreme situations. Raising fears that suspensions are likely or work-outs normal could unnecessarily increase the cost of capital, cause drastic reductions in cross-border flows and diminish future incomes of debtors and creditors alike. Yet having no known or understood process for dealing with default can, as has been seen in Asia, lead to inequitable burden sharing, high official cost and potential future moral hazard. A related basic dilemma involves the timing of a suspension of payments. Authorities have to hold off long enough to be sure there is no other choice, but not wait so long that creditors are running for the doors and irreversible damage is already done. The problem is, of course, not entirely new. International borrowers have gotten into trouble before, and precedents for workouts have been developed -- Paris Club procedures for resolving sovereign debts to public creditors; London Club for resolving sovereign debts to private banks. But each crisis is different from the last. A critical element in the Mexican crisis of 1994-95 was the threat of default on dollar-indexed Mexican short-term bonds (tesebonos') for which no work-out process existed. Dealing with bond holders (who are likely to be numerous and scattered) is more complex than dealing with lending governments or a relatively small (and known) group of [^0] [^0]: ${ }^{1}$ Tesebonos were technically denominated in pesos. ---[PAGE_BREAK]--- international banks. The recent Asian crises posed still another problem. The borrowers were not governments, but private banks and corporations, a situation that may be typical of future crises, and one that adds greatly to the legal and organizational complexities of sharing the burden of financial distress. When the debt in question is sovereign debt, whether to banks or other lenders, it may not be hard to re-establish stability and confidence in the sovereign. The IMF can lend enough to solve the borrowing government's immediate liquidity problem while the government works out a debt restructuring with its creditors. IMF rules permit "lending into arrears" in these circumstances. If the creditors are bondholders, as they were in Mexico, the situation is more difficult. IMF rules do not at present permit a government borrowing from the IMF when it is unable to pay its bondholders. Even a small minority of the bondholders can use their bargaining power to obstruct a resolution of the crisis in hopes of getting a better deal. After the Mexican crisis had been resolved with the help of significant new official lending to Mexico, the international community focused on how to improve the bargaining position of the debtor government with its bondholders if such a crisis should arise in the future. The "Rey Report" on Sovereign Liquidity Crises (named for its author, Jean-Jacques Rey of the Central Bank of Belgium) was a major effort by the G-10 countries to learn the lessons of Mexico. It recommended two new steps: - First, the IMF should expand its willingness to lend into arrears to cover the situation in which a sovereign was making a good faith effort to work out a debt restructuring with its bondholders. - Second, it recommended that bonds issued in international markets contain clauses that would facilitate debt restructuring if it became necessary. Clauses could be added to provide for debt-holder representation in negotiations with the sovereign or qualified majority voting on changes in terms. Such clauses would make it harder for minority creditors to block restructuring or exact a higher price than necessary to satisfy the majority. Neither of these recommendations received much official attention until the Asian crisis hit. Although the recommendations were not actually germane to the situation in Asia, the IMF reviewed the recommendations at its Interim Committee meeting in April 1998 and action in the near future seems more likely than a year ago. Perhaps the official community will always be one crisis late. Unlike the sovereign debt crises in Latin America, the situation in Asia involved private debts (of banks in Korea, corporations in Indonesia, and some of each in Thailand) to private creditors, mostly banks. Hence, it was inherently harder, as currency values plummeted and reserves all but disappeared, to design ways either to restore stability or to organize work-outs. An additional complication was the fact that, although the debts were private, some of them involved varying types of implied government guarantees. In Korea, the Finance Minister ill-advisedly volunteered that the Korean government would honor foreign debts of Korean banks. When the Korean banks experienced difficulty rolling over their international bank loans, the Bank of Korea provided the reserves they needed to repay the loans, in effect delivering on the guarantee, but rapidly depleting the central bank's reserves in the process. Guarantees of this sort clearly create moral hazard. Pre-crisis, they result in more bank lending than would otherwise have taken place, and when trouble begins they may accelerate a bank run. But much less explicit guarantees can be ---[PAGE_BREAK]--- trouble as well. Where governments are heavily intertwined with banks and companies, as has been normal throughout much of Asia, foreign lenders and investors may well assume that the government will not allow favored operations to fail. One of the challenges of mitigating and managing future crises, therefore, is finding ways to discourage emerging market governments from guaranteeing private debts or being so closely involved with private enterprises that these enterprises are seen as immune from market forces. The expectation that future borrowers in international markets will be mostly private enterprises, greatly increases the importance of the first two prescriptions -- increasing transparency and strengthening financial system surveillance -- not just to prevent and mitigate crises, but to manage them when they happen. In an economy that tolerates secrecy in business and financial dealings and where information disclosures are limited, firms with fairly shaky fundamentals may be able to borrow easily in a boom. They will be carried along by the general optimism, since everyone wants to believe the best and there is no tradition of asking hard questions anyway. But in a crisis, market participants tend to believe the worst. To contain the crisis and restore confidence, it is necessary both for managers and public authorities to be able to deliver the bad news and be believed by the markets. If there is no tradition of accurate, high quality information that can be relied on, market participants and bank depositors are likely to believe that things are substantially worse than they really are and proceed to prove it by their actions. A culture of transparency and timely, accurate information can serve as an economic stabilizer in both directions. It can restrain the boom by enabling investors to assess risk more accurately, and it can cushion over-reaction once a downward slide begins. But such a culture cannot be built quickly, and even where it exists, has to be assiduously maintained. Similarly, prudential supervision of financial institutions may be thought of as primarily valuable for crisis prevention -- useful for ensuring that financial institutions are adequately capitalized, don't take unacceptable risks with other people's money, and that the weak ones are required to shape up or go under. Once a crisis hits, however, it is important to be able to distinguish strong from weak institutions, those that ought to be rescued from those that ought to be closed. Unless supervision has been effective on an ongoing basis, however, the supervisors will not be able to tell strong from weak and will not be able to find out fast enough to prevent a rout. Good institutions then go down with the bad. It is actually in the long-run interest of financial institutions that aspire to be the survivors of a shake-out to insist that supervisors are well informed and applying a high standard. Another lesson of recent events in Asia has been the importance of clear, enforceable bankruptcy laws in dealing with a crisis, as well as helping to prevent one. Bankruptcy provides an opportunity, not only for closing down truly insolvent enterprises in an orderly way, but for rescuing troubled ones by allowing them to cut a deal with their creditors, restructure their obligations, and go on operating on a sounder basis. But bankruptcy procedures cannot be rapidly invented or first tested in a crisis. For bankruptcy procedures to mitigate crises effectively and help to get survivors on their feet, there has to be a "culture of bankruptcy" which operates in good times as well as bad. Debtors, creditors, lawyers and courts have to be used in the process, know what to do, be able, because they have done it before, to cut the deals that will minimize the damage and keep potentially profitable enterprises afloat. Asian countries, most obviously Indonesia, found that since their modern market experience had been primarily one of boom and growth, they had inadequate bankruptcy laws and little "culture of bankruptcy" to help manage a sudden negative turn of events. Improving transparency, supervision and bankruptcy procedures will help emerging market economies grow more sustainably (albeit perhaps slower) and manage downturns better ---[PAGE_BREAK]--- when they happen. But the conceptually hard questions involve international collective action and how it can manage major crises more effectively. Once a crisis hits one country, especially a country of significant size and linkage with others, the whole international community has a strong interest in rapid action to isolate markets and prevent the contagion from spreading and engulfing others. At this moment, the community looks to the IMF to act quickly, provide liquidity and restore confidence, especially the confidence that the crises has bottomed out and will not be part of a continuing downward spiral. Asia in 1997 was a demonstration of how fast the dominoes could fall. When the root cause of the problem is inappropriate macro-economic policy, especially big budget deficits and easy money combined with a pegged exchange rate, it may not be difficult for the IMF to restore confidence by injecting enough liquidity to pay short-term claims in foreign currency in return for rapid changes in policy. When macro policy is not obviously the chief culprit, restoring confidence may be harder and more expensive. Injecting new money in exchange for reforms may still be the primary answer, but the patience of taxpayers wears thin as amounts escalate and it is perceived that some classes of creditors are being bailed out with official international resources -- creditors who should have calculated the risks more accurately and should bear the cost of not having done so, so they won't do it again. Some have asked whether official resources could be saved and moral hazard reduced by designing an automatic international bankruptcy-like process, known in advance, by which a standstill could be triggered, followed by a set procedure for sharing the burden among all the relevant creditors. Serious thought is being devoted to this issue. It is not hard to imagine such an approach, but all crises are different and applying a cooky cutter solution could well do more harm than good. The next few years will be a testing time for what I think of as the "cross-border community", meaning the organizations, public and private, dedicated to making the cross-border relationships (especially business and financial ones) work better. The "cross-border community" includes mega firms that produce goods and deliver financial services on a worldwide scale, and associations of accountants, lawyers, bankers, securities dealers, insurance underwriters and various kinds of financial regulators as well as general international financial institutions (the IMF and the World Bank) and more specialized ones such as the Bank for International Settlements, and the regional development banks -- to mention only a few of the more obvious members of a burgeoning species. The benefits of cross-border trade and capital flows for raising the world standard of living are clear, but so are some of the costs -- especially the costs to ordinary people of being caught in the backwash when there is a crisis. If these costs are not taken seriously and methods designed to mitigate and manage financial crises better, a wave of political backlash against capitalism, foreigners and what we all think is "progress" could result. One lesson of recent crises is that factories, banks, shiny buildings, and eager investors do not by themselves create the underpinnings of modern economic society able to withstand shocks with minimal damage. That takes -- in addition to good fiscal, monetary and other public policies -- an infrastructure of laws and traditions and expectations that cannot be built overnight or imposed from the outside. The challenge for the cross-border community will be to work closely with emerging market economies to help them build this infrastructure in ways that work for them. Wading in and saying, "do it our way" won't work. The process will involve continuous interaction and adaptation and may well result in better functioning economies in the so-called developed world, as well. ---[PAGE_BREAK]--- BIS Review 41/1998	Alice M Rivlin	United States	https://www.bis.org/review/r980518q.pdf	Ms. Rivlin remarks on lessons drawn from the Asian financial crisis Remarks by the Vice-Chair of the US Federal Reserve System, Ms. Alice M. Rivlin, before the Hyman P. Minsky Conference on Financial Structure at The Levy Institute in Annandale-on-Hudson, New York on 23/4/98. Drawing lessons from the Asian financial crisis has become a minor industry, partially offsetting the impact of the crisis on developed economies -- at least for economists. It contributes to conference budgets, airline revenues, bar tabs, and the length of academic resumes. The opining classes can turn almost any bad news into an excuse for more meetings in beautiful settings like Bard College. Some of the talk has been devoted to the blame game. Was the crisis (or rather the rolling set of interrelated crises) home-grown, that is, brought on by ill-conceived investment, over-leveraged companies, lax banking supervision and crony capitalism in the borrowing countries? Was it the greed, inattention, or herd instinct of the lenders? Or was it the inherent instability of international capital flows? Did the IMF step in just in time to avert total meltdown or did it fail to provide early enough warning? Did the conditions imposed on borrowers help restore investor confidence or further undermine it? The quick answer is that all of the alleged culprits bear part of the responsibility. International flows of capital can be unstable -- what flows in can quickly flow out -- and fast. The enormous escalation in the volume of private capital flows, coupled with the advent of simultaneous communication in all the world's markets, has greatly increased the exposure of economies to rapid turnarounds in cross-border flows. Decades of rapid growth and apparently unending capital inflow had made the Asian emerging markets, until recently known as "tigers", believe they were immune from the reversals of investor confidence that beset other parts of the world and produced an incaution that led to over investment in some sectors, inflated equity and real estate prices, and some ill-thought-out projects, public and private. Close relations between companies, banks and governments created false senses of security, as well as uneconomic "policy" loans and investments. Weak supervision of financial institutions and markets, on top of traditions of secrecy in business and governmental transactions, aggravated the crises when things turned down. At the same time, foreign investors and creditors asked too few questions, were hesitant to reign in the galloping goose that had laid so many golden eggs, and reinforced each other's reluctance to be the first to pull back. As tensions were developing, the IMF pointed to some of the dangers without getting much response, and missed some others, as did the much-vaunted market gurus and rating agencies. When the crises hit, the IMF quickly crafted rescue packages that imposed serious structural reform as conditions of aid, inevitably making some mistakes in the process, but arresting the spreading downward spiral and restoring enough confidence to allow the countries to get their policies in shape to support the climb back to economic health. No one thinks the climb will be easy, but the best bet is that the worst is over. Now the talk has shifted to the more difficult subject of what the international community can do to prevent, mitigate and manage financial crises in the future. The stakes are high, for industrial and emerging market countries alike. When international capital markets function well, they help achieve rising standards of living for both creditor and debtor countries. When the markets crash, they bring incredible hardship to ordinary workers and their families -- often people who have been pulled out of their traditional occupations and communities by economic change and may have nothing to fall back on. Two sets of prescriptions are relatively uncontroversial, albeit deceptively hard to achieve. First, the world's capital markets and the machinery designed to stabilize them would function better with more complete, accessible and timely information flows. Investors can make better decisions and lenders can exercise more discipline over borrower behavior if they have more accurate and more complete information and have it sooner. Both international and domestic officials can monitor, supervise and warn of impending danger only if they know the facts. Improving transparency should apply not only to businesses and banks, but to official bodies, both national and international. It's important to know what a country's budget deficit really is (on budget and off budget) and what its exchange reserves really are, including any operations in the forward markets. The Asian crisis was certainly exacerbated by lack of information of many sorts, including accurate data on reserves. There is currently a great flurry of activity in various international fora to raise standards of accounting and reporting on business, banking and governmental activity and balance sheets. Progress will be made. But one should not expect too much. Although post mortems on financial crises, especially reviews of investor decisions that went sour, feature a great deal of if-only-we-had-known rhetoric, in actual fact a great deal of information usually turns out to have been available which no one ever looked at or effectively analyzed. For transparency to be useful, people need to actually want to look -- and too often those who are making high profits would rather not hear bad news. Second, a major sustained international effort is needed to strengthen the structure, functioning and supervision of financial systems in emerging market countries. A clear lesson of recent economic history (and not just in emerging market countries) is the crucial importance of strong banks and other financial institutions, adequately capitalized and able to manage risk, overseen by serious prudential supervision and an independent well managed central bank. Industrial countries can ill-afford to be sanctimonious on this score -- many of us have experienced the adverse effects of poor prudential supervision or lack of political will to close failing financial institutions -but good management and strong supervision of financial institutions is clearly a key to withstanding economic shocks. Here, too, consensus is strong and serious activity is underway under the aegis of a variety of international bodies, perhaps too many, to evolve clear rules for financial supervision and help countries implement them. The task will require time, patience and resources. It is not just bank examiners, but bankers who need training in how to do their jobs in modern, fast moving internationally exposed economies. Strengthening financial systems, including improving corporate governance, goes hand in hand with efforts to improve transparency and information flows -- to investors, shareholders, supervisors and international agencies -- and both will require sustained effort and run into significant resistance. The first two prescriptions are preventive, designed to reduce the frequency and amplitude of financial crises. But no one with a sense of history -- or reality -- believes that crises can be eliminated. Hence, a third prescription also appears on everybody's list, albeit with far less agreement on what it means, namely, private creditors should take on a greater portion of the burden of resolving future international financial crises. Sharing the burden is a far more difficult issue to come to grips with conceptually than either the need for greater transparency or the need for stronger, better supervised financial systems. Not much intellectual structure yet exists for thinking about burden-sharing in international financial crises. Moreover, cross-border financing is growing so rapidly and market instruments are morphing so fast that designing ways of sharing the burden is like changing the tires on a moving car -- pretty exciting and not obviously doable. The task cannot be set aside, however, for at least two reasons. First, the cost of resolving international financial crises is outrunning the likely resources available for that purpose. The volume of cross-border flows has grown precipitously and the cost of breakdown has escalated with it. High speed traffic on a six lane freeway moves a lot of people to their destinations fast, but the pile-up in a wreck is a lot more expensive than on a winding two lane road. If recent trends continue, managing the next crisis will call for more resources than taxpayers in the United States and other developed countries are likely to feel comfortable turning over to the IMF and other international organizations, even if they are reasonably confident that the borrowing countries will pay the loans back, as experience indicates they will. Second, and far more important, the perception that official resources can be counted on to bail out creditors (directly or indirectly) arguably generates moral hazard. It could lead to excessive risk-taking by lenders and funding of less economically defensible projects. It may also channel financing into less stable forms whose overuse makes crises more likely to occur. In recent episodes, direct investors and holders of equity and long-term debt have taken serious losses, but short-term lenders, especially interbank lenders, have been largely protected. While a country in trouble has understandable reasons for not wanting to cut itself off from short-term bank credit and for using its scarce international resources to keep this lifeline attached, the result may be to reinforce excessive dependence on debt rather than equity and on short, rather than longer-term financing. Both reasons combine to create an urgent need for serious and creative thought on the part of the international community about how to "bail in" private sector financiers, in order to reduce the impact on the financial resources of official institutions like the IMF, the World Bank and the regional development banks, to reduce moral hazard leading to excessive risk-taking, especially short-term inter-bank borrowing, and to improve risk assessment. Designing mechanisms for appropriate burden sharing among private sector investor/creditors is inherently hard because it runs into some very sticky and fundamental dilemmas. The basic principle from which all borrowing and lending must proceed is that people who use other people's money have a firm obligation to pay it back. Hence, a suspension of payments or a work-out arrangement must be clearly rare and exceptional, resorted to only in extreme situations. Raising fears that suspensions are likely or work-outs normal could unnecessarily increase the cost of capital, cause drastic reductions in cross-border flows and diminish future incomes of debtors and creditors alike. Yet having no known or understood process for dealing with default can, as has been seen in Asia, lead to inequitable burden sharing, high official cost and potential future moral hazard. A related basic dilemma involves the timing of a suspension of payments. Authorities have to hold off long enough to be sure there is no other choice, but not wait so long that creditors are running for the doors and irreversible damage is already done. The problem is, of course, not entirely new. International borrowers have gotten into trouble before, and precedents for workouts have been developed -- Paris Club procedures for resolving sovereign debts to public creditors; London Club for resolving sovereign debts to private banks. But each crisis is different from the last. A critical element in the Mexican crisis of 1994-95 was the threat of default on dollar-indexed Mexican short-term bonds (tesebonos') for which no work-out process existed. Dealing with bond holders (who are likely to be numerous and scattered) is more complex than dealing with lending governments or a relatively small (and known) group of international banks. The recent Asian crises posed still another problem. The borrowers were not governments, but private banks and corporations, a situation that may be typical of future crises, and one that adds greatly to the legal and organizational complexities of sharing the burden of financial distress. When the debt in question is sovereign debt, whether to banks or other lenders, it may not be hard to re-establish stability and confidence in the sovereign. The IMF can lend enough to solve the borrowing government's immediate liquidity problem while the government works out a debt restructuring with its creditors. IMF rules permit "lending into arrears" in these circumstances. If the creditors are bondholders, as they were in Mexico, the situation is more difficult. IMF rules do not at present permit a government borrowing from the IMF when it is unable to pay its bondholders. Even a small minority of the bondholders can use their bargaining power to obstruct a resolution of the crisis in hopes of getting a better deal. After the Mexican crisis had been resolved with the help of significant new official lending to Mexico, the international community focused on how to improve the bargaining position of the debtor government with its bondholders if such a crisis should arise in the future. The "Rey Report" on Sovereign Liquidity Crises (named for its author, Jean-Jacques Rey of the Central Bank of Belgium) was a major effort by the G-10 countries to learn the lessons of Mexico. It recommended two new steps: First, the IMF should expand its willingness to lend into arrears to cover the situation in which a sovereign was making a good faith effort to work out a debt restructuring with its bondholders. Second, it recommended that bonds issued in international markets contain clauses that would facilitate debt restructuring if it became necessary. Clauses could be added to provide for debt-holder representation in negotiations with the sovereign or qualified majority voting on changes in terms. Such clauses would make it harder for minority creditors to block restructuring or exact a higher price than necessary to satisfy the majority. Neither of these recommendations received much official attention until the Asian crisis hit. Although the recommendations were not actually germane to the situation in Asia, the IMF reviewed the recommendations at its Interim Committee meeting in April 1998 and action in the near future seems more likely than a year ago. Perhaps the official community will always be one crisis late. Unlike the sovereign debt crises in Latin America, the situation in Asia involved private debts (of banks in Korea, corporations in Indonesia, and some of each in Thailand) to private creditors, mostly banks. Hence, it was inherently harder, as currency values plummeted and reserves all but disappeared, to design ways either to restore stability or to organize work-outs. An additional complication was the fact that, although the debts were private, some of them involved varying types of implied government guarantees. In Korea, the Finance Minister ill-advisedly volunteered that the Korean government would honor foreign debts of Korean banks. When the Korean banks experienced difficulty rolling over their international bank loans, the Bank of Korea provided the reserves they needed to repay the loans, in effect delivering on the guarantee, but rapidly depleting the central bank's reserves in the process. Guarantees of this sort clearly create moral hazard. Pre-crisis, they result in more bank lending than would otherwise have taken place, and when trouble begins they may accelerate a bank run. But much less explicit guarantees can be trouble as well. Where governments are heavily intertwined with banks and companies, as has been normal throughout much of Asia, foreign lenders and investors may well assume that the government will not allow favored operations to fail. One of the challenges of mitigating and managing future crises, therefore, is finding ways to discourage emerging market governments from guaranteeing private debts or being so closely involved with private enterprises that these enterprises are seen as immune from market forces. The expectation that future borrowers in international markets will be mostly private enterprises, greatly increases the importance of the first two prescriptions -- increasing transparency and strengthening financial system surveillance -- not just to prevent and mitigate crises, but to manage them when they happen. In an economy that tolerates secrecy in business and financial dealings and where information disclosures are limited, firms with fairly shaky fundamentals may be able to borrow easily in a boom. They will be carried along by the general optimism, since everyone wants to believe the best and there is no tradition of asking hard questions anyway. But in a crisis, market participants tend to believe the worst. To contain the crisis and restore confidence, it is necessary both for managers and public authorities to be able to deliver the bad news and be believed by the markets. If there is no tradition of accurate, high quality information that can be relied on, market participants and bank depositors are likely to believe that things are substantially worse than they really are and proceed to prove it by their actions. A culture of transparency and timely, accurate information can serve as an economic stabilizer in both directions. It can restrain the boom by enabling investors to assess risk more accurately, and it can cushion over-reaction once a downward slide begins. But such a culture cannot be built quickly, and even where it exists, has to be assiduously maintained. Similarly, prudential supervision of financial institutions may be thought of as primarily valuable for crisis prevention -- useful for ensuring that financial institutions are adequately capitalized, don't take unacceptable risks with other people's money, and that the weak ones are required to shape up or go under. Once a crisis hits, however, it is important to be able to distinguish strong from weak institutions, those that ought to be rescued from those that ought to be closed. Unless supervision has been effective on an ongoing basis, however, the supervisors will not be able to tell strong from weak and will not be able to find out fast enough to prevent a rout. Good institutions then go down with the bad. It is actually in the long-run interest of financial institutions that aspire to be the survivors of a shake-out to insist that supervisors are well informed and applying a high standard. Another lesson of recent events in Asia has been the importance of clear, enforceable bankruptcy laws in dealing with a crisis, as well as helping to prevent one. Bankruptcy provides an opportunity, not only for closing down truly insolvent enterprises in an orderly way, but for rescuing troubled ones by allowing them to cut a deal with their creditors, restructure their obligations, and go on operating on a sounder basis. But bankruptcy procedures cannot be rapidly invented or first tested in a crisis. For bankruptcy procedures to mitigate crises effectively and help to get survivors on their feet, there has to be a "culture of bankruptcy" which operates in good times as well as bad. Debtors, creditors, lawyers and courts have to be used in the process, know what to do, be able, because they have done it before, to cut the deals that will minimize the damage and keep potentially profitable enterprises afloat. Asian countries, most obviously Indonesia, found that since their modern market experience had been primarily one of boom and growth, they had inadequate bankruptcy laws and little "culture of bankruptcy" to help manage a sudden negative turn of events. Improving transparency, supervision and bankruptcy procedures will help emerging market economies grow more sustainably (albeit perhaps slower) and manage downturns better when they happen. But the conceptually hard questions involve international collective action and how it can manage major crises more effectively. Once a crisis hits one country, especially a country of significant size and linkage with others, the whole international community has a strong interest in rapid action to isolate markets and prevent the contagion from spreading and engulfing others. At this moment, the community looks to the IMF to act quickly, provide liquidity and restore confidence, especially the confidence that the crises has bottomed out and will not be part of a continuing downward spiral. Asia in 1997 was a demonstration of how fast the dominoes could fall. When the root cause of the problem is inappropriate macro-economic policy, especially big budget deficits and easy money combined with a pegged exchange rate, it may not be difficult for the IMF to restore confidence by injecting enough liquidity to pay short-term claims in foreign currency in return for rapid changes in policy. When macro policy is not obviously the chief culprit, restoring confidence may be harder and more expensive. Injecting new money in exchange for reforms may still be the primary answer, but the patience of taxpayers wears thin as amounts escalate and it is perceived that some classes of creditors are being bailed out with official international resources -- creditors who should have calculated the risks more accurately and should bear the cost of not having done so, so they won't do it again. Some have asked whether official resources could be saved and moral hazard reduced by designing an automatic international bankruptcy-like process, known in advance, by which a standstill could be triggered, followed by a set procedure for sharing the burden among all the relevant creditors. Serious thought is being devoted to this issue. It is not hard to imagine such an approach, but all crises are different and applying a cooky cutter solution could well do more harm than good. The next few years will be a testing time for what I think of as the "cross-border community", meaning the organizations, public and private, dedicated to making the cross-border relationships (especially business and financial ones) work better. The "cross-border community" includes mega firms that produce goods and deliver financial services on a worldwide scale, and associations of accountants, lawyers, bankers, securities dealers, insurance underwriters and various kinds of financial regulators as well as general international financial institutions (the IMF and the World Bank) and more specialized ones such as the Bank for International Settlements, and the regional development banks -- to mention only a few of the more obvious members of a burgeoning species. The benefits of cross-border trade and capital flows for raising the world standard of living are clear, but so are some of the costs -- especially the costs to ordinary people of being caught in the backwash when there is a crisis. If these costs are not taken seriously and methods designed to mitigate and manage financial crises better, a wave of political backlash against capitalism, foreigners and what we all think is "progress" could result. One lesson of recent crises is that factories, banks, shiny buildings, and eager investors do not by themselves create the underpinnings of modern economic society able to withstand shocks with minimal damage. That takes -- in addition to good fiscal, monetary and other public policies -- an infrastructure of laws and traditions and expectations that cannot be built overnight or imposed from the outside. The challenge for the cross-border community will be to work closely with emerging market economies to help them build this infrastructure in ways that work for them. Wading in and saying, "do it our way" won't work. The process will involve continuous interaction and adaptation and may well result in better functioning economies in the so-called developed world, as well. BIS Review 41/1998
1998-04-28T00:00:00	Mr. Kelley discusses the Year 2000 issue (Central Bank Articles and Speeches, 28 Apr 98)	Testimony of Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Committee on Commerce, Science, and Transportation at the US Senate on 28/4/98.	Testimony of Mr. Kelley discusses the Year 2000 issue Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Committee on Commerce, Science, and Transportation at the US Senate on 28/4/98. I am pleased to appear before the Committee today to discuss the Year 2000 computer systems issue and the Federal Reserve's efforts to address it. The stakes are enormous, nothing less than the preservation of a safe and sound financial system that can continue to operate in an orderly manner when the clock rolls over at midnight on New Year's Eve and the millennium arrives. So much has been written about the difficulties ascribed to the Year 2000 challenge that by now almost everyone is familiar with the basic issue - specifically, that information generated by computers may be inaccurate or that programs may be terminated because they cannot process Year 2000 dates. The Federal Reserve System has developed and is executing a comprehensive plan to ensure its own Year 2000 readiness, and the bank supervision function is well along in a cooperative, interagency effort, to promote timely remediation and testing by the banking industry. This morning I shall first focus on the potential macroeconomic consequences of the Year 2000 issue. Then I shall discuss actions being taken by the Federal Reserve System to address its internal systems, including Reserve Bank testing with depository institutions, and its bank supervision efforts. The Macroeconomic Effects of the Millennium Bug The Year 2000 ("Y2K") problem will touch much more than just our financial system and could temporarily have adverse effects on the performance of the overall US economy as well as the economies of many, or all, other nations if it is not corrected. The spectrum of possible outcomes is broad, for the truth of the matter is that this episode is unique. We have no previous experiences to give us adequate guideposts. A few economists already are suggesting that Y2K-related disruptions will induce a deep recession in the year 2000. That is probably a stretch, but I do not think that we shall escape unaffected. Some of the more frightening scenarios are not without a certain plausibility, if this challenge were being ignored. But it is not being ignored. While it is probable that preparations may in some instances prove to be inadequate or ineffective, an enormous amount of work is being done in anticipation of the rollover of the millennium. It is impossible today to forecast the impact of this event, and the range of possibilities runs from minimal to extremely serious. In that spirit, let me review with you some of the ways in which the millennium bug already is influencing the US economy and discuss some of the possible outcomes for economic activity early in the next century. Corporate business is spending vast amounts of money to tackle the Y2K problem. To try to get a handle on the magnitude of these Y2K expenditures, we have reviewed the most recent 10-K reports filed with the SEC by approximately 95 percent of the firms in the Fortune 500. These are the largest businesses in our economy, with revenues of around $51⁄2 trillion annually, and are likely to be on the cutting edge of efforts to deal with the millennium bug. Before the end of the decade, these firms report that they expect to spend about $11 billion in dealing with the Y2K problem. (Of this total, financial corporations are planning expenditures of $31⁄2 billion, while companies in the nonfinancial sector have budgeted funds of around $71⁄2 billion.) These estimates undoubtably understate the magnitude of the Y2K reprogramming efforts. In culling through the 10-K reports, we found that many companies reported incurring no additional costs associated with Y2K remediation efforts. I doubt such firms are unaware of the problem. Rather, I suspect that some firms did not view their Y2K spending as having a "material" effect on their bottom line, and some companies probably have funded Y2K programs with monies already budgeted to their information technology functions. Making an allowance for all costs - whether explicitly stated or not - and recognizing that these Fortune 500 firms are only part of the picture, an educated guess of the sunk cost of Y2K remedial efforts in the US private sector might be roughly $50 billion. To put this number into perspective, the Gartner Group has estimated that Y2K remediation efforts will total $300 to $600 billion on a worldwide basis. The US economy accounts for about one-fifth of world output, and thus our estimate seems broadly consistent with the lower end of their range. Given the experience of our own Y2K efforts to date, I would expect to see costs rise further once all these Y2K programs are fully under way - ultimately pushing costs up within the Gartner Group range. Corporate efforts to deal with the Y2K problem are affecting economic activity in a variety of ways. On the positive side, an important element in some Y2K programs is the replacement of aging computer systems with modern, state-of-the-art hardware and software. Such capital expenditures - which I should note are not included in the $50 billion cost estimate will raise the level of productivity in those enterprises, and, in general, the need to address the Y2K problem has increased the awareness on the part of senior executives of the complexity and importance of managing corporate information technology resources. The increased replacement demand also has contributed to the spectacular growth recently in this country's computer hardware and software industries - a process that I would expect to continue for a while longer. But, ultimately, we are largely shifting the timing of these investment expenditures: Today's added growth is likely "borrowed" from spending at some time in the future. And, if analyzing the dynamics of this situation were not already complicated enough, some firms may "freeze" their systems in the middle of 1999 - effectively forgoing the installation of new hardware and software systems just before the millennium. This, too, could influence spending on computer equipment - shifting some of it from 1999 into 2000. While Year 2000 remediation efforts may give a temporary boost to economic activity in some sectors, the net effect probably is negative. I suspect the majority of Y2K expenditures should be viewed as increased outlays for maintenance of existing systems, which are additional costs on businesses. Other than the very valuable ability to maintain its operations into the year 2000, few quantifiable benefits accrue to the firm - and overall productivity gains are reduced by the extra hours devoted to reprogramming and testing. Conservative estimates suggest that the net effect of Y2K remediation efforts might shave a tenth or two a year off the growth of our nation's overall labor productivity, and a more substantial effect is possible if some of the larger estimates of Y2K costs are used in these calculations. The effects on real gross domestic product are likely to be somewhat smaller than this but could still total a tenth of a percentage point or so a year over the next two years. The United States is not alone in working to deal with the millennium bug. Efforts by our major trading partners also are under way, although in many cases they probably are not yet at so advanced a stage as in this country. In Europe, the need to reprogram computer systems to handle the conversion to the euro seems to have taken precedence over Y2K efforts, although there may be efficiencies in dealing with the two problems at once. The financial difficulties of Japan and other Asian economies certainly have diverted attention and resources in those countries from the Y2K problem, increasing the risk of a Y2K shock from one or more of these countries. But, on the positive side, large multinational corporations are acutely aware of the Y2K problem, and their remediation efforts are independent of national boundaries. There also are anecdotal reports that many of these companies are extending their influence by demanding that their extensive networks of smaller suppliers prepare themselves as a condition of maintaining their business relationship. Obviously, a great deal of work either is planned or is under way to deal with the Year 2000 problem. But what if something slips through the cracks, and we experience the failure of some "mission critical" systems? How will a computer failure in one industry affect the ability of other industries to continue to operate smoothly? The number of possible scenarios of this type is endless, and today no one can say with any confidence how severe any Y2K disruptions could be or how a failure in one sector would influence activity in others. We have many examples of how economic activity was affected by disruptions to the physical infrastructure of this country. Although the Y2K problem clearly is unique, some of these disruptions to our physical infrastructure may be useful in organizing our thinking about the consequences of short-lived interruptions in our information infrastructure. In early 1996, a major winter storm paralyzed large portions of the country. Commerce ground to a halt for up to a week in some areas but activity bounced back rapidly once the roads were cleared again. Although individual firms and households were adversely affected by these disruptions, in the aggregate, the economy quickly recovered most of the output lost due to the storm. In this instance, the shock to our physical infrastructure was transitory in nature, and, critically, the recovery process was under way before any adverse "feedback" effects were produced. Last summer's strike by workers at the United Parcel Service is a second example. UPS is a major player in the package delivery industry in this country, and the strike disrupted the shipping patterns of many businesses. Some sales were lost, but in many instances alternative shipping services were found for high-priority packages. Some businesses were hurt by the strike, but its effect on economic activity was small in the aggregate. Hopefully, any Y2K shock to our information infrastructure would also be transitory and would share the characteristics of these shocks to our physical infrastructure. What can monetary policy do to offset any macroeconomic effects? The truthful answer is "not much". Just as we were not able to plow the streets in 1996 or deliver packages in 1997, the central bank will be unable to reprogram the nation's computers for the year 2000. The Y2K problem is primarily an issue affecting the aggregate "supply" side of the economy, whereas the Federal Reserve's monetary policy works mainly on aggregate "demand". We all understand how creating more money and lowering the level of short-term interest rates gives a boost to interest-sensitive sectors (such as homebuilding), but these tools are unlikely to be very effective in generating more Y2K remediation efforts or accelerating the recovery process if a company experiences some type of Year 2000 disruption. We will, of course, be ready if people want to hold more cash on New Year's Eve 1999, and we will be prepared to lend to financial institutions through the discount window under appropriate circumstances or to provide needed reserves to the banking system. But there is nothing monetary policy can do to offset the direct effects of a severe Y2K disruption. As a result, our Year 2000 focus has been in areas where we can make a difference: conforming our own systems, overseeing the preparations of the banking industry, preparing the payments system, and contingency planning. Additionally, we are doing all we can to increase awareness of this problem and to energize preparations both here at home and in other parts of the world. Background on Federal Reserve Year 2000 Preparations The Federal Reserve operates several payments applications that process and settle payments and securities transactions between depository institutions in the United States. These systems are critical national utility services, moving funds much as the national power grid moves electricity. Fedwire is a large-value payments mechanism for US dollar interbank funds transfers and US government securities transfers primarily used by depository institutions and government agencies. These applications, as well as the supporting accounting systems and other payment applications such as the Automated Clearing House (ACH), run on mainframe computer systems operated by Federal Reserve Automation Services (FRAS), the internal organizational unit that processes applications on behalf of the Federal Reserve Banks and operates the Federal Reserve's national communications network. The Reserve Banks also operate check processing systems that provide check services to depository institutions and the US government. In addition to centralized applications on the mainframe, the Reserve Banks operate a range of applications in a distributed computing environment, supporting business functions such as currency distribution, banking supervision and regulation, research, public information, and human resources. The scope of the Federal Reserve's Year 2000 activities includes remediation of all of these processing environments and the supporting telecommunications network, called FEDNET. Our Year 2000 preparations also address our computerized environmental and facilities management systems, such as power, heating and cooling, voice communications, elevators, and vaults. Year 2000 Readiness of Internal Systems The Federal Reserve is giving the Year 2000 its highest priority, consistent with our goal of maintaining the stability of the nation's financial markets and payments systems, preserving public confidence, and supporting reliable government operations. The Federal Reserve completed assessment of its applications in 1997; our most significant applications have been renovated; and internal testing is underway using dedicated Y2K computer systems and date-simulation tools. Changes to mission critical computer programs, as well as system and user-acceptance testing, are on schedule to be completed by year-end 1998. Further, systems supporting the delivery of critical financial services that interface with the depository institutions will be Year 2000 ready by this July and a depository institution test program will be in place at that time. This schedule will permit approximately 18 months for customer testing, to which we are dedicating considerable support resources. Our Y2K project is being closely coordinated among the Reserve Banks, the Board of Governors, numerous vendors and service providers, approximately 13,000 customers, and government agencies. We are stressing effective, consistent, and timely communication, both internal and external, to promote awareness and commitment at all levels of our own organization and the financial services industry, more generally. A significant challenge in meeting our Y2K readiness objectives is our reliance on commercial hardware and software products and services. Much of our information processing and communications infrastructure, as well as our administrative functions and other operations, is composed of hardware and software products from third-party vendors. As a result, we must coordinate with numerous vendors and manufacturers to ensure that all of our hardware, software, and services are Year 2000 ready. In many cases, compliance requires upgrading, or, in some cases, replacing, equipment and software. We have a complete inventory of vendor components used in our mainframe, telecommunications, and distributed computing environments, and vendor coordination and system change are progressing well. We are particularly sensitive to telecommunications, an essential infrastructure element in our ability to maintain a satisfactorily high level of financial and business services. We have been working with our financial institutions and our telecommunications servicers to find ways to facilitate preparations and testing programs that will ensure Y2K readiness. Nonetheless, this is an area that many financial institutions regard as needing attention. We strongly support the FCC's program to draw increased attention to the Y2K issue and the progress of the telecommunications companies in the United States. Oversight of Banking Industry Preparations Ultimately, the boards of directors and senior management of banks and other financial institutions must shoulder the responsibility for ensuring that the institutions they manage are able to provide high quality and continuous services beginning on the first business day in January of the Year 2000 and beyond. This critical obligation must be among the very highest of priorities for bank management and boards of directors. Nevertheless, bank supervisors can provide guidance, encouragement, and strong incentives to the banking industry to address this challenge. Accordingly, the Federal Reserve and the other banking supervisors that make up the Federal Financial Institutions Examination Council, the FFIEC, have been working closely to orchestrate a uniform supervisory approach to supervising the banking industry's efforts to ensure its readiness. Detailed information about our supervisory program is attached as an Addendum to this testimony and is readily available on a web site maintained by the Federal Reserve on behalf of these agencies. Preparing the Payments Systems In order to ensure the readiness of the payments system, the Federal Reserve has prepared a special central environment for the testing of high-risk dates, such as the rollover to the Year 2000 and leap year. Testing will be conducted through a combination of future-dating our computer systems to verify the readiness of our infrastructure, and testing critical future dates within interfaces to other institutions. Internal testing is expected to be completed by July, and external testing with customers and other counterparties will then commence and continue throughout 1999. Network communications components are also being tested and certified in a special test lab environment. We have published a detailed schedule of testing opportunities for Fedwire, ACH transactions and other services provided by the Federal Reserve. Our test environments have been configured to provide flexible and nearly continuous access by customers. The Reserve Banks are implementing processes to identify which depositories have tested with us, so that we may follow up on any laggards. We are also researching, in conjunction with our counterparties, the benefits of Y2K testing that would span the entire business process. As part of this effort, the Federal Reserve is coordinating with the Clearing House for Interbank Payment Systems (CHIPS) and the Society for Worldwide Interbank Financial Telecommunication (SWIFT) to provide a common test day for customers of all three systems on September 26, 1998. The New York Clearing House is coordinating an effort to establish common global test dates among major funds transfer systems during April and May 1999. We are also coordinating with the international community of financial regulators to help mobilize global preparations more generally. These efforts are discussed more fully in the Addendum. In particular, through the auspices of the Bank for International Settlements, international regulators for banking, securities, and insurance along with global payments specialists recently jointly hosted a Year 2000 Round Table, which was attended by over 50 countries. A Joint Council was formed that will promote readiness and serve as a global clearing house on Year 2000 issues. In the final analysis, however, the regulatory community recognizes that it cannot solve the problem for the financial industry. Every financial institution must complete its own program and thoroughly test its applications with counterparties and customers if problems are to be avoided. Contingency Planning Despite our intensive efforts to prepare our computer systems, we must also make plans for dealing with problems that might occur at the Year 2000 rollover. As you know, the Federal Reserve has been involved in contingency planning and has dealt with various types of emergencies for many years. In response to past disasters we worked closely with the affected financial institutions to ensure that adequate supplies of cash were available to the community, and that backup systems supported our operations without interruption during the crisis period. These efforts primarily focused on the orderly resumption of business operations resulting from hardware failures or processing-site problems. In addition to disruptions to hardware or processing sites, Y2K contingency planning must be directed at potential software failures and interdependency problems with financial and non-financial counterparties. Within this context, business resumption is made more difficult because we cannot fall back to an earlier version of a software package as this version itself may not have been readied for the Year 2000. Y2K disruptions to utility services or depository institutions can also directly affect the Federal Reserve's ability to conduct business. So, in order to plan for the continuity of services, it may be necessary to consider available alternate ways to provide services if a Year 2000 problem is identified. The Federal Reserve has formed a task force to address the contingency readiness of our payments applications. Although we have no grounds for anticipating that specific failures could occur and we cannot act as an operational backstop for the nation's financial industry, we view it as our responsibility to take action to ensure that we are as well positioned as possible to address major failures should they occur. We are currently focusing on contingency planning for external Y2K-related disruptions, such as those affecting utility companies, telecommunications providers, large banks, and difficulties abroad that affect US markets or institutions. The Federal Reserve has established higher standards for testing institutions that serve as the backbone for the transactions that support domestic and international financial markets and whose failure could pose a systemic risk to the payments system. We recognize that, despite their best efforts, some depository institutions may experience operating difficulties, either as a result of their own computer problems or those of their customers, counterparties, or others. These problems could be manifested in a number of ways and could involve temporary funding difficulties. The Federal Reserve plans to be prepared to provide information to depository institutions on the balances in their accounts with us throughout the day, so that they can identify shortfalls and seek funding in the market. The System will also be prepared to lend in appropriate circumstances and with adequate collateral to depository institutions when market sources of funding are not reasonably available. Our preparations for possible liquidity difficulties extend as well to the foreign bank branches and agencies in the US that may be adversely affected directly by their own computer systems or through difficulties caused by the linkage and dependence on their parent bank. Such circumstances would necessitate coordination with the home country supervisor. Moreover, consistent with current policy, foreign central banks will be expected to provide liquidity support to any of their banking organizations that experience a funding shortfall. Closing Remarks To sum up, the macroeconomic effects of Year 2000 preparations are quite complex. As I have discussed, some industries may benefit in the near term from increased sales associated with the accelerated pace of replacement of obsolete computer systems, and their customers presumably will have more productive systems in place sooner than might otherwise have been the case. But, in the aggregate, preparing for the Y2K problem is likely exerting a slight drag on the US economy. The Y2K problem, in effect, raises the rate of depreciation of the nation's stock of plant and equipment. It forces businesses to devote additional programming resources simply to maintain the existing flow of services from its computers. As a provider of financial services to the economy, we are on schedule with our own internal remediation efforts and will shortly begin testing our interfaces with financial institutions. While we have made significant progress in our Year 2000 preparations, our challenge now is to ensure that our efforts remain on schedule and that problems are addressed in a timely fashion. In particular, we shall be paying special attention to the testing needs of depository institutions and the financial industry and are prepared to adjust our support for them as required by experience. As a bank supervisor, the Federal Reserve will continue to address the financial services industry's preparedness, monitor progress, and target for special supervisory attention those institutions that are most in need of assistance. In addition, we shall track the Y2K progress of external vendors and critical infrastructure suppliers, such as telecommunications and electrical power utilities. The problems presented to the world by the potential for computer failures as the millennium arrives are real and serious. Because these problems are unique to our experience in many ways, and because the impact of computer-driven systems has become so ubiquitous, the event is unlikely to be trouble free. While we can't predict with any certainty, there clearly is the potential for problems to develop, but these need not be traumatic if we all do our part in preparation. As the world's largest economy, the heaviest burden of preparation falls on the United States. But it is truly a worldwide issue and, to the extent that some are not adequately prepared and experience breakdowns of unforeseeable dimension, we shall all be affected accordingly. There is much work to be done. We intend to do our utmost, and hope and trust that others will do likewise. In this spirit, Mr. Chairman, I want to commend the Committee for inviting this panel to testify together on Y2K issues. This is the first time that the Board has testified next to representatives of the Departments of Commerce and Transportation, and the FCC. This is wholly appropriate because our success in preparing for the millennium will ultimately depend very much on one another's efforts. Addendum: Supervisory Elements of the Federal Reserve's Year 2000 Preparations 1. Interagency Statements and Other Guidance The Federal Financial Institutions Examination Council(FFIEC) - composed of the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the National Credit Union Administration has issued a series of six advisory statements since June 1996, including statements on the Year 2000 effect on computers, project management, business risk, readiness of service providers, guidance to address customer risk, and testing for readiness. An advisory on contingency planning is being prepared. As a result of these advisory statements, the industry's awareness and the extent of its remediation efforts have significantly increased over the past two years. The FFIEC is considering additional guidance to financial institutions on the development of customer awareness programs and the need to communicate with and address questions of retail customers regarding Year 2000 issues. 2. Supervisory Reviews In May 1997, the banking agencies committed to conduct a supervisory review by June 30, 1998, of all insured depositories to assess the state of their Y2K readiness. Subsequent reviews and examinations will continue throughout 1999. Through March 31, 1998, the Federal Reserve has conducted reviews of approximately 1,100 organizations. The Federal Reserve and the other agencies appear to be on schedule to meet their stated goal. These reviews have resulted in a significant focus of attention on the subject matter within the industry and the agencies as well. Deficient organizations are subject to increased monitoring and supervisory follow-up including more frequent reviews. Restrictions on expansionary activities by organizations that are deficient in their Year 2000 preparations have also been put into place. 3. Assessment of Supervision Review Results The Federal Reserve has been conducting Year 2000 supervisory reviews of financial organizations subject to our supervisory authority, coordinating closely with state banking departments and other federal banking agencies that may share responsibility for the banking organizations. Based on these reviews, we conclude that management awareness of, and attention to, the Year 2000 problem has improved notably since the Federal Reserve and the other banking agencies escalated efforts in early 1997 to focus the industry's attention on ensuring Y2K readiness. Banking organizations are making substantial progress in renovating their systems and, with some exceptions, are on track to meet FFIEC guidelines. Most large organizations are actively engaged in the renovation and testing of their mission critical systems. Smaller organizations are working closely with their service providers in an effort to confirm the readiness and reliability of the services and products on which they depend. Similarly, many of the US offices of foreign banks are heavily dependent on their parent bank for their Year 2000 readiness. 4. Supervision Follow up To address deficient organizations, the Federal Reserve is issuing a confidential Deficiency Notification Letter to those rated less than satisfactory with respect to their Y2K readiness program. We call for a corrective action plan and put the organization on a 30-day reporting regimen to monitor its progress. Given our concern that the organization needs to use its resources to address its deficiencies, rather than expanding, the Federal Reserve also asks the organization for advance notification before entering into any contractual commitments or making public announcements pertaining to prospective acquisitions that require Federal Reserve approval. The agency can then determine the possible effects of the expansionary proposal on the organization's deficient Y2K readiness efforts, and possibly discourage or deny expansion if financial and managerial factors are inconsistent with approval of the application. 5. Outreach Initiatives The Federal Reserve is actively participating in numerous outreach initiatives with the banking industry, trade associations, regulatory authorities and other groups that are hosting conferences, seminars and training opportunities that focus on the Year 2000 and help participants understand better the issues that need to be addressed. Throughout the country, the federal banking agencies have been working with state banking departments and local bankers associations in order to develop coordinated and comprehensive efforts to improve the local and regional programs intended to focus attention on the Year 2000. These efforts will continue consistent with the requirements contained in the Examination Parity and Year 2000 Readiness for Financial Institutions Act (Public Law 105-164), enacted March 20, 1998, which call, in part, for the banking agencies to conduct seminars for depository institutions on the implications of the Y2K problem on their ability to conduct safe and sound operations. 6. International Scope The Federal Reserve has worked actively within the Bank for International Settlements (BIS) to ensure that financial regulators around the world are aware of the dangers posed by the Year 2000 and are working to see that the markets and institutions they oversee are ready for the century date change. Last September, the G-10 Governors issued a Year 2000 advisory that included a paper prepared by the Basle Committee on Banking Supervision (Basle Supervisors) describing the serious nature of the problem, identifying the issues that must be addressed, and outlining how programs to address the issue should be structured. The BIS Committee on Payment and Settlement Services (CPSS) has established a web site on which payment systems around the world are posting short reports describing the status of their readiness in order to promote the transparent sharing of Year 2000 information. We continue to participate in international meetings focusing on the Year 2000 issue in order to increase awareness and promote greater understanding and cooperation. Earlier this month, the BIS was the site for the Year 2000 Round Table sponsored jointly by the CPSS, Basle Supervisors, the International Organization of Securities Commissioners, and the International Association of Insurance Supervisors. This meeting, which was attended by financial supervisors and representatives from the private sector from more than 50 countries, highlighted cross-border dependencies and the need for international cooperation to ensure that the issue is managed to minimize any disruptions and possible economic ramifications. As a result of the Round Table, a Joint Year 2000 Council of financial regulators was formed with the First Vice-President of the Federal Reserve Bank of New York serving as the chair. The Council will serve as a contact point between the financial market regulators and market participants including private sector groups specifically focused on international issues. It will also promote readiness, identify sound practices for dealing with the issue, and serve as a global clearing house on Year 2000 issues more generally. A survey by the Basle Supervisors conducted late last year indicated that global awareness of the issue is increasing rapidly but that much work remains to be done. While most central banks and regulators express cautious optimism that their payments systems and financial institutions will generally be ready, there is increasing recognition that some problems are inevitable. To this end, increasing attention is being focused on the need to identify likely potential problems before reaching the century date change and to develop contingency plans to ensure the stability of global financial markets. The majority of foreign central banks are confident that payment and settlement applications under their management will be Y2K ready. Like the Federal Reserve, however, the operation of foreign central bank payment systems is dependent on compliant products from hardware and software suppliers and the readiness of telecommunication and electric power infrastructures. Foreign central banks consider Y2K readiness testing to be a critical and complex issue. The approach of foreign central banks toward raising banking industry awareness varies widely. We are aware that many European banks are stretched for resources as a result of the world-wide demand for information technology staff resources and their conversion to a single currency. Similarly, Asian financial institutions are focusing on their well-known problems, possibly placing full Y2K preparations in jeopardy. 7. Communications Efforts We have been working intensively to address the issues faced by the industry and to formulate an effective communications program tailored to those issues. Our public awareness program concentrates on communications with the financial services industry related to our Y2K readiness, our testing efforts, and our overall concerns about the industry's readiness. We have inaugurated a Year 2000 industry newsletter, have published periodic bulletins addressing specific technical issues, and have established an Internet Web site that can be accessed at the following Internet address: http://www.frbsf.org/fiservices/cdc. In addition, we have published a set of guidelines for small businesses, including depository institutions, on Year 2000 issues and project management. On behalf of the FFIEC, the Federal Reserve has developed a Year 2000 information distribution system, including an Internet Web site and a toll free Fax Back service (888-882-0982). The Web site provides easy access to policy statements, guidance to examiners, and paths to other Year 2000 Web sites available from numerous other sources. It can be accessed at the following Internet address: http://www.ffiec.gov/y2k. The Federal Reserve has also produced a ten-minute video entitled "Year 2000 Executive Awareness", intended for viewing by a bank's board of directors and senior management, that presents a summary of the Year 2000 five-phase project management plan outlined in the interagency policy statement. In introductory remarks on the video, it is stressed that senior bank officials should be directly involved in managing the Year 2000 project to ensure that it is given the appropriate level of attention and sufficient resources to address the issue on a timely basis. The video can be ordered through the Board's Web site: http:\\www.bog.frb.fed.us/y2k.	---[PAGE_BREAK]--- Mr. Kelley discusses the Year 2000 issue Testimony of Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Committee on Commerce, Science, and Transportation at the US Senate on $28 / 4 / 98$. I am pleased to appear before the Committee today to discuss the Year 2000 computer systems issue and the Federal Reserve's efforts to address it. The stakes are enormous, nothing less than the preservation of a safe and sound financial system that can continue to operate in an orderly manner when the clock rolls over at midnight on New Year's Eve and the millennium arrives. So much has been written about the difficulties ascribed to the Year 2000 challenge that by now almost everyone is familiar with the basic issue - specifically, that information generated by computers may be inaccurate or that programs may be terminated because they cannot process Year 2000 dates. The Federal Reserve System has developed and is executing a comprehensive plan to ensure its own Year 2000 readiness, and the bank supervision function is well along in a cooperative, interagency effort, to promote timely remediation and testing by the banking industry. This morning I shall first focus on the potential macroeconomic consequences of the Year 2000 issue. Then I shall discuss actions being taken by the Federal Reserve System to address its internal systems, including Reserve Bank testing with depository institutions, and its bank supervision efforts. # The Macroeconomic Effects of the Millennium Bug The Year 2000 ("Y2K") problem will touch much more than just our financial system and could temporarily have adverse effects on the performance of the overall US economy as well as the economies of many, or all, other nations if it is not corrected. The spectrum of possible outcomes is broad, for the truth of the matter is that this episode is unique. We have no previous experiences to give us adequate guideposts. A few economists already are suggesting that Y2K-related disruptions will induce a deep recession in the year 2000. That is probably a stretch, but I do not think that we shall escape unaffected. Some of the more frightening scenarios are not without a certain plausibility, if this challenge were being ignored. But it is not being ignored. While it is probable that preparations may in some instances prove to be inadequate or ineffective, an enormous amount of work is being done in anticipation of the rollover of the millennium. It is impossible today to forecast the impact of this event, and the range of possibilities runs from minimal to extremely serious. In that spirit, let me review with you some of the ways in which the millennium bug already is influencing the US economy and discuss some of the possible outcomes for economic activity early in the next century. Corporate business is spending vast amounts of money to tackle the Y2K problem. To try to get a handle on the magnitude of these Y2K expenditures, we have reviewed the most recent $10-\mathrm{K}$ reports filed with the SEC by approximately 95 percent of the firms in the Fortune 500. These are the largest businesses in our economy, with revenues of around $\$ 51 / 2$ trillion annually, and are likely to be on the cutting edge of efforts to deal with the millennium bug. Before the end of the decade, these firms report that they expect to spend about $\$ 11$ billion in dealing with the Y2K problem. (Of this total, financial corporations are planning expenditures of $\$ 31 / 2$ billion, while companies in the nonfinancial sector have budgeted funds of around $\$ 71 / 2$ billion.) These estimates undoubtably understate the magnitude of the Y2K reprogramming efforts. In culling through the $10-\mathrm{K}$ reports, we found that many companies ---[PAGE_BREAK]--- reported incurring no additional costs associated with Y2K remediation efforts. I doubt such firms are unaware of the problem. Rather, I suspect that some firms did not view their Y2K spending as having a "material" effect on their bottom line, and some companies probably have funded Y2K programs with monies already budgeted to their information technology functions. Making an allowance for all costs - whether explicitly stated or not - and recognizing that these Fortune 500 firms are only part of the picture, an educated guess of the sunk cost of Y2K remedial efforts in the US private sector might be roughly $\$ 50$ billion. To put this number into perspective, the Gartner Group has estimated that Y2K remediation efforts will total $\$ 300$ to $\$ 600$ billion on a worldwide basis. The US economy accounts for about one-fifth of world output, and thus our estimate seems broadly consistent with the lower end of their range. Given the experience of our own Y2K efforts to date, I would expect to see costs rise further once all these Y2K programs are fully under way - ultimately pushing costs up within the Gartner Group range. Corporate efforts to deal with the Y2K problem are affecting economic activity in a variety of ways. On the positive side, an important element in some Y2K programs is the replacement of aging computer systems with modern, state-of-the-art hardware and software. Such capital expenditures - which I should note are not included in the $\$ 50$ billion cost estimate will raise the level of productivity in those enterprises, and, in general, the need to address the Y2K problem has increased the awareness on the part of senior executives of the complexity and importance of managing corporate information technology resources. The increased replacement demand also has contributed to the spectacular growth recently in this country's computer hardware and software industries - a process that I would expect to continue for a while longer. But, ultimately, we are largely shifting the timing of these investment expenditures: Today's added growth is likely "borrowed" from spending at some time in the future. And, if analyzing the dynamics of this situation were not already complicated enough, some firms may "freeze" their systems in the middle of 1999 - effectively forgoing the installation of new hardware and software systems just before the millennium. This, too, could influence spending on computer equipment - shifting some of it from 1999 into 2000. While Year 2000 remediation efforts may give a temporary boost to economic activity in some sectors, the net effect probably is negative. I suspect the majority of Y2K expenditures should be viewed as increased outlays for maintenance of existing systems, which are additional costs on businesses. Other than the very valuable ability to maintain its operations into the year 2000, few quantifiable benefits accrue to the firm - and overall productivity gains are reduced by the extra hours devoted to reprogramming and testing. Conservative estimates suggest that the net effect of Y2K remediation efforts might shave a tenth or two a year off the growth of our nation's overall labor productivity, and a more substantial effect is possible if some of the larger estimates of Y2K costs are used in these calculations. The effects on real gross domestic product are likely to be somewhat smaller than this but could still total a tenth of a percentage point or so a year over the next two years. The United States is not alone in working to deal with the millennium bug. Efforts by our major trading partners also are under way, although in many cases they probably are not yet at so advanced a stage as in this country. In Europe, the need to reprogram computer systems to handle the conversion to the euro seems to have taken precedence over Y2K efforts, although there may be efficiencies in dealing with the two problems at once. The financial difficulties of Japan and other Asian economies certainly have diverted attention and resources in those countries from the Y2K problem, increasing the risk of a Y2K shock from one or more of these countries. But, on the positive side, large multinational corporations are acutely aware of the Y2K problem, and their remediation efforts are independent of national boundaries. There ---[PAGE_BREAK]--- also are anecdotal reports that many of these companies are extending their influence by demanding that their extensive networks of smaller suppliers prepare themselves as a condition of maintaining their business relationship. Obviously, a great deal of work either is planned or is under way to deal with the Year 2000 problem. But what if something slips through the cracks, and we experience the failure of some "mission critical" systems? How will a computer failure in one industry affect the ability of other industries to continue to operate smoothly? The number of possible scenarios of this type is endless, and today no one can say with any confidence how severe any Y2K disruptions could be or how a failure in one sector would influence activity in others. We have many examples of how economic activity was affected by disruptions to the physical infrastructure of this country. Although the Y2K problem clearly is unique, some of these disruptions to our physical infrastructure may be useful in organizing our thinking about the consequences of short-lived interruptions in our information infrastructure. In early 1996, a major winter storm paralyzed large portions of the country. Commerce ground to a halt for up to a week in some areas but activity bounced back rapidly once the roads were cleared again. Although individual firms and households were adversely affected by these disruptions, in the aggregate, the economy quickly recovered most of the output lost due to the storm. In this instance, the shock to our physical infrastructure was transitory in nature, and, critically, the recovery process was under way before any adverse "feedback" effects were produced. Last summer's strike by workers at the United Parcel Service is a second example. UPS is a major player in the package delivery industry in this country, and the strike disrupted the shipping patterns of many businesses. Some sales were lost, but in many instances alternative shipping services were found for high-priority packages. Some businesses were hurt by the strike, but its effect on economic activity was small in the aggregate. Hopefully, any Y2K shock to our information infrastructure would also be transitory and would share the characteristics of these shocks to our physical infrastructure. What can monetary policy do to offset any macroeconomic effects? The truthful answer is "not much". Just as we were not able to plow the streets in 1996 or deliver packages in 1997, the central bank will be unable to reprogram the nation's computers for the year 2000. The Y2K problem is primarily an issue affecting the aggregate "supply" side of the economy, whereas the Federal Reserve's monetary policy works mainly on aggregate "demand". We all understand how creating more money and lowering the level of short-term interest rates gives a boost to interest-sensitive sectors (such as homebuilding), but these tools are unlikely to be very effective in generating more Y2K remediation efforts or accelerating the recovery process if a company experiences some type of Year 2000 disruption. We will, of course, be ready if people want to hold more cash on New Year's Eve 1999, and we will be prepared to lend to financial institutions through the discount window under appropriate circumstances or to provide needed reserves to the banking system. But there is nothing monetary policy can do to offset the direct effects of a severe Y2K disruption. As a result, our Year 2000 focus has been in areas where we can make a difference: conforming our own systems, overseeing the preparations of the banking industry, preparing the payments system, and contingency planning. Additionally, we are doing all we can to increase awareness of this problem and to energize preparations both here at home and in other parts of the world. # Background on Federal Reserve Year 2000 Preparations The Federal Reserve operates several payments applications that process and settle payments and securities transactions between depository institutions in the United States. ---[PAGE_BREAK]--- These systems are critical national utility services, moving funds much as the national power grid moves electricity. Fedwire is a large-value payments mechanism for US dollar interbank funds transfers and US government securities transfers primarily used by depository institutions and government agencies. These applications, as well as the supporting accounting systems and other payment applications such as the Automated Clearing House (ACH), run on mainframe computer systems operated by Federal Reserve Automation Services (FRAS), the internal organizational unit that processes applications on behalf of the Federal Reserve Banks and operates the Federal Reserve's national communications network. The Reserve Banks also operate check processing systems that provide check services to depository institutions and the US government. In addition to centralized applications on the mainframe, the Reserve Banks operate a range of applications in a distributed computing environment, supporting business functions such as currency distribution, banking supervision and regulation, research, public information, and human resources. The scope of the Federal Reserve's Year 2000 activities includes remediation of all of these processing environments and the supporting telecommunications network, called FEDNET. Our Year 2000 preparations also address our computerized environmental and facilities management systems, such as power, heating and cooling, voice communications, elevators, and vaults. # Year 2000 Readiness of Internal Systems The Federal Reserve is giving the Year 2000 its highest priority, consistent with our goal of maintaining the stability of the nation's financial markets and payments systems, preserving public confidence, and supporting reliable government operations. The Federal Reserve completed assessment of its applications in 1997; our most significant applications have been renovated; and internal testing is underway using dedicated Y2K computer systems and date-simulation tools. Changes to mission critical computer programs, as well as system and user-acceptance testing, are on schedule to be completed by year-end 1998. Further, systems supporting the delivery of critical financial services that interface with the depository institutions will be Year 2000 ready by this July and a depository institution test program will be in place at that time. This schedule will permit approximately 18 months for customer testing, to which we are dedicating considerable support resources. Our Y2K project is being closely coordinated among the Reserve Banks, the Board of Governors, numerous vendors and service providers, approximately 13,000 customers, and government agencies. We are stressing effective, consistent, and timely communication, both internal and external, to promote awareness and commitment at all levels of our own organization and the financial services industry, more generally. A significant challenge in meeting our Y2K readiness objectives is our reliance on commercial hardware and software products and services. Much of our information processing and communications infrastructure, as well as our administrative functions and other operations, is composed of hardware and software products from third-party vendors. As a result, we must coordinate with numerous vendors and manufacturers to ensure that all of our hardware, software, and services are Year 2000 ready. In many cases, compliance requires upgrading, or, in some cases, replacing, equipment and software. We have a complete inventory of vendor components used in our mainframe, telecommunications, and distributed computing environments, and vendor coordination and system change are progressing well. We are particularly sensitive to telecommunications, an essential infrastructure element in our ability to maintain a satisfactorily high level of financial and business services. We have been working with our financial institutions and our telecommunications servicers to find ways to facilitate ---[PAGE_BREAK]--- preparations and testing programs that will ensure Y2K readiness. Nonetheless, this is an area that many financial institutions regard as needing attention. We strongly support the FCC's program to draw increased attention to the Y2K issue and the progress of the telecommunications companies in the United States. # Oversight of Banking Industry Preparations Ultimately, the boards of directors and senior management of banks and other financial institutions must shoulder the responsibility for ensuring that the institutions they manage are able to provide high quality and continuous services beginning on the first business day in January of the Year 2000 and beyond. This critical obligation must be among the very highest of priorities for bank management and boards of directors. Nevertheless, bank supervisors can provide guidance, encouragement, and strong incentives to the banking industry to address this challenge. Accordingly, the Federal Reserve and the other banking supervisors that make up the Federal Financial Institutions Examination Council, the FFIEC, have been working closely to orchestrate a uniform supervisory approach to supervising the banking industry's efforts to ensure its readiness. Detailed information about our supervisory program is attached as an Addendum to this testimony and is readily available on a web site maintained by the Federal Reserve on behalf of these agencies. ## Preparing the Payments Systems In order to ensure the readiness of the payments system, the Federal Reserve has prepared a special central environment for the testing of high-risk dates, such as the rollover to the Year 2000 and leap year. Testing will be conducted through a combination of future-dating our computer systems to verify the readiness of our infrastructure, and testing critical future dates within interfaces to other institutions. Internal testing is expected to be completed by July, and external testing with customers and other counterparties will then commence and continue throughout 1999. Network communications components are also being tested and certified in a special test lab environment. We have published a detailed schedule of testing opportunities for Fedwire, ACH transactions and other services provided by the Federal Reserve. Our test environments have been configured to provide flexible and nearly continuous access by customers. The Reserve Banks are implementing processes to identify which depositories have tested with us, so that we may follow up on any laggards. We are also researching, in conjunction with our counterparties, the benefits of Y2K testing that would span the entire business process. As part of this effort, the Federal Reserve is coordinating with the Clearing House for Interbank Payment Systems (CHIPS) and the Society for Worldwide Interbank Financial Telecommunication (SWIFT) to provide a common test day for customers of all three systems on September 26, 1998. The New York Clearing House is coordinating an effort to establish common global test dates among major funds transfer systems during April and May 1999. We are also coordinating with the international community of financial regulators to help mobilize global preparations more generally. These efforts are discussed more fully in the Addendum. In particular, through the auspices of the Bank for International Settlements, international regulators for banking, securities, and insurance along with global payments specialists recently jointly hosted a Year 2000 Round Table, which was attended by over 50 countries. A Joint Council was formed that will promote readiness and serve as a global clearing house on Year 2000 issues. In the final analysis, however, the regulatory community recognizes that it cannot solve the problem for the financial industry. Every financial institution must ---[PAGE_BREAK]--- complete its own program and thoroughly test its applications with counterparties and customers if problems are to be avoided. # Contingency Planning Despite our intensive efforts to prepare our computer systems, we must also make plans for dealing with problems that might occur at the Year 2000 rollover. As you know, the Federal Reserve has been involved in contingency planning and has dealt with various types of emergencies for many years. In response to past disasters we worked closely with the affected financial institutions to ensure that adequate supplies of cash were available to the community, and that backup systems supported our operations without interruption during the crisis period. These efforts primarily focused on the orderly resumption of business operations resulting from hardware failures or processing-site problems. In addition to disruptions to hardware or processing sites, Y2K contingency planning must be directed at potential software failures and interdependency problems with financial and non-financial counterparties. Within this context, business resumption is made more difficult because we cannot fall back to an earlier version of a software package as this version itself may not have been readied for the Year 2000. Y2K disruptions to utility services or depository institutions can also directly affect the Federal Reserve's ability to conduct business. So, in order to plan for the continuity of services, it may be necessary to consider available alternate ways to provide services if a Year 2000 problem is identified. The Federal Reserve has formed a task force to address the contingency readiness of our payments applications. Although we have no grounds for anticipating that specific failures could occur and we cannot act as an operational backstop for the nation's financial industry, we view it as our responsibility to take action to ensure that we are as well positioned as possible to address major failures should they occur. We are currently focusing on contingency planning for external Y2K-related disruptions, such as those affecting utility companies, telecommunications providers, large banks, and difficulties abroad that affect US markets or institutions. The Federal Reserve has established higher standards for testing institutions that serve as the backbone for the transactions that support domestic and international financial markets and whose failure could pose a systemic risk to the payments system. We recognize that, despite their best efforts, some depository institutions may experience operating difficulties, either as a result of their own computer problems or those of their customers, counterparties, or others. These problems could be manifested in a number of ways and could involve temporary funding difficulties. The Federal Reserve plans to be prepared to provide information to depository institutions on the balances in their accounts with us throughout the day, so that they can identify shortfalls and seek funding in the market. The System will also be prepared to lend in appropriate circumstances and with adequate collateral to depository institutions when market sources of funding are not reasonably available. Our preparations for possible liquidity difficulties extend as well to the foreign bank branches and agencies in the US that may be adversely affected directly by their own computer systems or through difficulties caused by the linkage and dependence on their parent bank. Such circumstances would necessitate coordination with the home country supervisor. Moreover, consistent with current policy, foreign central banks will be expected to provide liquidity support to any of their banking organizations that experience a funding shortfall. ## Closing Remarks ---[PAGE_BREAK]--- To sum up, the macroeconomic effects of Year 2000 preparations are quite complex. As I have discussed, some industries may benefit in the near term from increased sales associated with the accelerated pace of replacement of obsolete computer systems, and their customers presumably will have more productive systems in place sooner than might otherwise have been the case. But, in the aggregate, preparing for the Y2K problem is likely exerting a slight drag on the US economy. The Y2K problem, in effect, raises the rate of depreciation of the nation's stock of plant and equipment. It forces businesses to devote additional programming resources simply to maintain the existing flow of services from its computers. As a provider of financial services to the economy, we are on schedule with our own internal remediation efforts and will shortly begin testing our interfaces with financial institutions. While we have made significant progress in our Year 2000 preparations, our challenge now is to ensure that our efforts remain on schedule and that problems are addressed in a timely fashion. In particular, we shall be paying special attention to the testing needs of depository institutions and the financial industry and are prepared to adjust our support for them as required by experience. As a bank supervisor, the Federal Reserve will continue to address the financial services industry's preparedness, monitor progress, and target for special supervisory attention those institutions that are most in need of assistance. In addition, we shall track the Y2K progress of external vendors and critical infrastructure suppliers, such as telecommunications and electrical power utilities. The problems presented to the world by the potential for computer failures as the millennium arrives are real and serious. Because these problems are unique to our experience in many ways, and because the impact of computer-driven systems has become so ubiquitous, the event is unlikely to be trouble free. While we can't predict with any certainty, there clearly is the potential for problems to develop, but these need not be traumatic if we all do our part in preparation. As the world's largest economy, the heaviest burden of preparation falls on the United States. But it is truly a worldwide issue and, to the extent that some are not adequately prepared and experience breakdowns of unforeseeable dimension, we shall all be affected accordingly. There is much work to be done. We intend to do our utmost, and hope and trust that others will do likewise. In this spirit, Mr. Chairman, I want to commend the Committee for inviting this panel to testify together on Y2K issues. This is the first time that the Board has testified next to representatives of the Departments of Commerce and Transportation, and the FCC. This is wholly appropriate because our success in preparing for the millennium will ultimately depend very much on one another's efforts. # Addendum: Supervisory Elements of the Federal Reserve's Year 2000 Preparations ## 1. Interagency Statements and Other Guidance The Federal Financial Institutions Examination Council(FFIEC) - composed of the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the National Credit Union Administration has issued a series of six advisory statements since June 1996, including statements on the ---[PAGE_BREAK]--- Year 2000 effect on computers, project management, business risk, readiness of service providers, guidance to address customer risk, and testing for readiness. An advisory on contingency planning is being prepared. As a result of these advisory statements, the industry's awareness and the extent of its remediation efforts have significantly increased over the past two years. The FFIEC is considering additional guidance to financial institutions on the development of customer awareness programs and the need to communicate with and address questions of retail customers regarding Year 2000 issues. # 2. Supervisory Reviews In May 1997, the banking agencies committed to conduct a supervisory review by June 30, 1998, of all insured depositories to assess the state of their Y2K readiness. Subsequent reviews and examinations will continue throughout 1999. Through March 31, 1998, the Federal Reserve has conducted reviews of approximately 1,100 organizations. The Federal Reserve and the other agencies appear to be on schedule to meet their stated goal. These reviews have resulted in a significant focus of attention on the subject matter within the industry and the agencies as well. Deficient organizations are subject to increased monitoring and supervisory follow-up including more frequent reviews. Restrictions on expansionary activities by organizations that are deficient in their Year 2000 preparations have also been put into place. ## 3. Assessment of Supervision Review Results The Federal Reserve has been conducting Year 2000 supervisory reviews of financial organizations subject to our supervisory authority, coordinating closely with state banking departments and other federal banking agencies that may share responsibility for the banking organizations. Based on these reviews, we conclude that management awareness of, and attention to, the Year 2000 problem has improved notably since the Federal Reserve and the other banking agencies escalated efforts in early 1997 to focus the industry's attention on ensuring Y2K readiness. Banking organizations are making substantial progress in renovating their systems and, with some exceptions, are on track to meet FFIEC guidelines. Most large organizations are actively engaged in the renovation and testing of their mission critical systems. Smaller organizations are working closely with their service providers in an effort to confirm the readiness and reliability of the services and products on which they depend. Similarly, many of the US offices of foreign banks are heavily dependent on their parent bank for their Year 2000 readiness. ## 4. Supervision Follow up To address deficient organizations, the Federal Reserve is issuing a confidential Deficiency Notification Letter to those rated less than satisfactory with respect to their Y2K readiness program. We call for a corrective action plan and put the organization on a 30-day reporting regimen to monitor its progress. Given our concern that the organization needs to use its resources to address its deficiencies, rather than expanding, the Federal Reserve also asks the organization for advance notification before entering into any contractual commitments or making public announcements pertaining to prospective acquisitions that require Federal Reserve approval. The agency can then determine the possible effects of the expansionary ---[PAGE_BREAK]--- proposal on the organization's deficient Y2K readiness efforts, and possibly discourage or deny expansion if financial and managerial factors are inconsistent with approval of the application. # 5. Outreach Initiatives The Federal Reserve is actively participating in numerous outreach initiatives with the banking industry, trade associations, regulatory authorities and other groups that are hosting conferences, seminars and training opportunities that focus on the Year 2000 and help participants understand better the issues that need to be addressed. Throughout the country, the federal banking agencies have been working with state banking departments and local bankers associations in order to develop coordinated and comprehensive efforts to improve the local and regional programs intended to focus attention on the Year 2000. These efforts will continue consistent with the requirements contained in the Examination Parity and Year 2000 Readiness for Financial Institutions Act (Public Law 105-164), enacted March 20, 1998, which call, in part, for the banking agencies to conduct seminars for depository institutions on the implications of the Y2K problem on their ability to conduct safe and sound operations. ## 6. International Scope The Federal Reserve has worked actively within the Bank for International Settlements (BIS) to ensure that financial regulators around the world are aware of the dangers posed by the Year 2000 and are working to see that the markets and institutions they oversee are ready for the century date change. Last September, the G-10 Governors issued a Year 2000 advisory that included a paper prepared by the Basle Committee on Banking Supervision (Basle Supervisors) describing the serious nature of the problem, identifying the issues that must be addressed, and outlining how programs to address the issue should be structured. The BIS Committee on Payment and Settlement Services (CPSS) has established a web site on which payment systems around the world are posting short reports describing the status of their readiness in order to promote the transparent sharing of Year 2000 information. We continue to participate in international meetings focusing on the Year 2000 issue in order to increase awareness and promote greater understanding and cooperation. Earlier this month, the BIS was the site for the Year 2000 Round Table sponsored jointly by the CPSS, Basle Supervisors, the International Organization of Securities Commissioners, and the International Association of Insurance Supervisors. This meeting, which was attended by financial supervisors and representatives from the private sector from more than 50 countries, highlighted cross-border dependencies and the need for international cooperation to ensure that the issue is managed to minimize any disruptions and possible economic ramifications. As a result of the Round Table, a Joint Year 2000 Council of financial regulators was formed with the First Vice-President of the Federal Reserve Bank of New York serving as the chair. The Council will serve as a contact point between the financial market regulators and market participants including private sector groups specifically focused on international issues. It will also promote readiness, identify sound practices for dealing with the issue, and serve as a global clearing house on Year 2000 issues more generally. A survey by the Basle Supervisors conducted late last year indicated that global awareness of the issue is increasing rapidly but that much work remains to be done. While most central banks and regulators express cautious optimism that their payments systems and financial ---[PAGE_BREAK]--- institutions will generally be ready, there is increasing recognition that some problems are inevitable. To this end, increasing attention is being focused on the need to identify likely potential problems before reaching the century date change and to develop contingency plans to ensure the stability of global financial markets. The majority of foreign central banks are confident that payment and settlement applications under their management will be Y2K ready. Like the Federal Reserve, however, the operation of foreign central bank payment systems is dependent on compliant products from hardware and software suppliers and the readiness of telecommunication and electric power infrastructures. Foreign central banks consider Y2K readiness testing to be a critical and complex issue. The approach of foreign central banks toward raising banking industry awareness varies widely. We are aware that many European banks are stretched for resources as a result of the world-wide demand for information technology staff resources and their conversion to a single currency. Similarly, Asian financial institutions are focusing on their well-known problems, possibly placing full Y2K preparations in jeopardy. # 7. Communications Efforts We have been working intensively to address the issues faced by the industry and to formulate an effective communications program tailored to those issues. Our public awareness program concentrates on communications with the financial services industry related to our Y2K readiness, our testing efforts, and our overall concerns about the industry's readiness. We have inaugurated a Year 2000 industry newsletter, have published periodic bulletins addressing specific technical issues, and have established an Internet Web site that can be accessed at the following Internet address: http://www.frbsf.org/fiservices/cdc. In addition, we have published a set of guidelines for small businesses, including depository institutions, on Year 2000 issues and project management. On behalf of the FFIEC, the Federal Reserve has developed a Year 2000 information distribution system, including an Internet Web site and a toll free Fax Back service (888-882-0982). The Web site provides easy access to policy statements, guidance to examiners, and paths to other Year 2000 Web sites available from numerous other sources. It can be accessed at the following Internet address: http://www.ffiec.gov/y2k. The Federal Reserve has also produced a ten-minute video entitled "Year 2000 Executive Awareness", intended for viewing by a bank's board of directors and senior management, that presents a summary of the Year 2000 five-phase project management plan outlined in the interagency policy statement. In introductory remarks on the video, it is stressed that senior bank officials should be directly involved in managing the Year 2000 project to ensure that it is given the appropriate level of attention and sufficient resources to address the issue on a timely basis. The video can be ordered through the Board's Web site: http: $\backslash$ www.bog.frb.fed.us/y2k.	Edward W Kelley, Jr	United States	https://www.bis.org/review/r980518h.pdf	Mr. Kelley discusses the Year 2000 issue Testimony of Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Committee on Commerce, Science, and Transportation at the US Senate on $28 / 4 / 98$. I am pleased to appear before the Committee today to discuss the Year 2000 computer systems issue and the Federal Reserve's efforts to address it. The stakes are enormous, nothing less than the preservation of a safe and sound financial system that can continue to operate in an orderly manner when the clock rolls over at midnight on New Year's Eve and the millennium arrives. So much has been written about the difficulties ascribed to the Year 2000 challenge that by now almost everyone is familiar with the basic issue - specifically, that information generated by computers may be inaccurate or that programs may be terminated because they cannot process Year 2000 dates. The Federal Reserve System has developed and is executing a comprehensive plan to ensure its own Year 2000 readiness, and the bank supervision function is well along in a cooperative, interagency effort, to promote timely remediation and testing by the banking industry. This morning I shall first focus on the potential macroeconomic consequences of the Year 2000 issue. Then I shall discuss actions being taken by the Federal Reserve System to address its internal systems, including Reserve Bank testing with depository institutions, and its bank supervision efforts. The Year 2000 ("Y2K") problem will touch much more than just our financial system and could temporarily have adverse effects on the performance of the overall US economy as well as the economies of many, or all, other nations if it is not corrected. The spectrum of possible outcomes is broad, for the truth of the matter is that this episode is unique. We have no previous experiences to give us adequate guideposts. A few economists already are suggesting that Y2K-related disruptions will induce a deep recession in the year 2000. That is probably a stretch, but I do not think that we shall escape unaffected. Some of the more frightening scenarios are not without a certain plausibility, if this challenge were being ignored. But it is not being ignored. While it is probable that preparations may in some instances prove to be inadequate or ineffective, an enormous amount of work is being done in anticipation of the rollover of the millennium. It is impossible today to forecast the impact of this event, and the range of possibilities runs from minimal to extremely serious. In that spirit, let me review with you some of the ways in which the millennium bug already is influencing the US economy and discuss some of the possible outcomes for economic activity early in the next century. Corporate business is spending vast amounts of money to tackle the Y2K problem. To try to get a handle on the magnitude of these Y2K expenditures, we have reviewed the most recent $10-\mathrm{K}$ reports filed with the SEC by approximately 95 percent of the firms in the Fortune 500. These are the largest businesses in our economy, with revenues of around $\$ 51 / 2$ trillion annually, and are likely to be on the cutting edge of efforts to deal with the millennium bug. Before the end of the decade, these firms report that they expect to spend about $\$ 11$ billion in dealing with the Y2K problem. (Of this total, financial corporations are planning expenditures of $\$ 31 / 2$ billion, while companies in the nonfinancial sector have budgeted funds of around $\$ 71 / 2$ billion.) These estimates undoubtably understate the magnitude of the Y2K reprogramming efforts. In culling through the $10-\mathrm{K}$ reports, we found that many companies reported incurring no additional costs associated with Y2K remediation efforts. I doubt such firms are unaware of the problem. Rather, I suspect that some firms did not view their Y2K spending as having a "material" effect on their bottom line, and some companies probably have funded Y2K programs with monies already budgeted to their information technology functions. Making an allowance for all costs - whether explicitly stated or not - and recognizing that these Fortune 500 firms are only part of the picture, an educated guess of the sunk cost of Y2K remedial efforts in the US private sector might be roughly $\$ 50$ billion. To put this number into perspective, the Gartner Group has estimated that Y2K remediation efforts will total $\$ 300$ to $\$ 600$ billion on a worldwide basis. The US economy accounts for about one-fifth of world output, and thus our estimate seems broadly consistent with the lower end of their range. Given the experience of our own Y2K efforts to date, I would expect to see costs rise further once all these Y2K programs are fully under way - ultimately pushing costs up within the Gartner Group range. Corporate efforts to deal with the Y2K problem are affecting economic activity in a variety of ways. On the positive side, an important element in some Y2K programs is the replacement of aging computer systems with modern, state-of-the-art hardware and software. Such capital expenditures - which I should note are not included in the $\$ 50$ billion cost estimate will raise the level of productivity in those enterprises, and, in general, the need to address the Y2K problem has increased the awareness on the part of senior executives of the complexity and importance of managing corporate information technology resources. The increased replacement demand also has contributed to the spectacular growth recently in this country's computer hardware and software industries - a process that I would expect to continue for a while longer. But, ultimately, we are largely shifting the timing of these investment expenditures: Today's added growth is likely "borrowed" from spending at some time in the future. And, if analyzing the dynamics of this situation were not already complicated enough, some firms may "freeze" their systems in the middle of 1999 - effectively forgoing the installation of new hardware and software systems just before the millennium. This, too, could influence spending on computer equipment - shifting some of it from 1999 into 2000. While Year 2000 remediation efforts may give a temporary boost to economic activity in some sectors, the net effect probably is negative. I suspect the majority of Y2K expenditures should be viewed as increased outlays for maintenance of existing systems, which are additional costs on businesses. Other than the very valuable ability to maintain its operations into the year 2000, few quantifiable benefits accrue to the firm - and overall productivity gains are reduced by the extra hours devoted to reprogramming and testing. Conservative estimates suggest that the net effect of Y2K remediation efforts might shave a tenth or two a year off the growth of our nation's overall labor productivity, and a more substantial effect is possible if some of the larger estimates of Y2K costs are used in these calculations. The effects on real gross domestic product are likely to be somewhat smaller than this but could still total a tenth of a percentage point or so a year over the next two years. The United States is not alone in working to deal with the millennium bug. Efforts by our major trading partners also are under way, although in many cases they probably are not yet at so advanced a stage as in this country. In Europe, the need to reprogram computer systems to handle the conversion to the euro seems to have taken precedence over Y2K efforts, although there may be efficiencies in dealing with the two problems at once. The financial difficulties of Japan and other Asian economies certainly have diverted attention and resources in those countries from the Y2K problem, increasing the risk of a Y2K shock from one or more of these countries. But, on the positive side, large multinational corporations are acutely aware of the Y2K problem, and their remediation efforts are independent of national boundaries. There also are anecdotal reports that many of these companies are extending their influence by demanding that their extensive networks of smaller suppliers prepare themselves as a condition of maintaining their business relationship. Obviously, a great deal of work either is planned or is under way to deal with the Year 2000 problem. But what if something slips through the cracks, and we experience the failure of some "mission critical" systems? How will a computer failure in one industry affect the ability of other industries to continue to operate smoothly? The number of possible scenarios of this type is endless, and today no one can say with any confidence how severe any Y2K disruptions could be or how a failure in one sector would influence activity in others. We have many examples of how economic activity was affected by disruptions to the physical infrastructure of this country. Although the Y2K problem clearly is unique, some of these disruptions to our physical infrastructure may be useful in organizing our thinking about the consequences of short-lived interruptions in our information infrastructure. In early 1996, a major winter storm paralyzed large portions of the country. Commerce ground to a halt for up to a week in some areas but activity bounced back rapidly once the roads were cleared again. Although individual firms and households were adversely affected by these disruptions, in the aggregate, the economy quickly recovered most of the output lost due to the storm. In this instance, the shock to our physical infrastructure was transitory in nature, and, critically, the recovery process was under way before any adverse "feedback" effects were produced. Last summer's strike by workers at the United Parcel Service is a second example. UPS is a major player in the package delivery industry in this country, and the strike disrupted the shipping patterns of many businesses. Some sales were lost, but in many instances alternative shipping services were found for high-priority packages. Some businesses were hurt by the strike, but its effect on economic activity was small in the aggregate. Hopefully, any Y2K shock to our information infrastructure would also be transitory and would share the characteristics of these shocks to our physical infrastructure. What can monetary policy do to offset any macroeconomic effects? The truthful answer is "not much". Just as we were not able to plow the streets in 1996 or deliver packages in 1997, the central bank will be unable to reprogram the nation's computers for the year 2000. The Y2K problem is primarily an issue affecting the aggregate "supply" side of the economy, whereas the Federal Reserve's monetary policy works mainly on aggregate "demand". We all understand how creating more money and lowering the level of short-term interest rates gives a boost to interest-sensitive sectors (such as homebuilding), but these tools are unlikely to be very effective in generating more Y2K remediation efforts or accelerating the recovery process if a company experiences some type of Year 2000 disruption. We will, of course, be ready if people want to hold more cash on New Year's Eve 1999, and we will be prepared to lend to financial institutions through the discount window under appropriate circumstances or to provide needed reserves to the banking system. But there is nothing monetary policy can do to offset the direct effects of a severe Y2K disruption. As a result, our Year 2000 focus has been in areas where we can make a difference: conforming our own systems, overseeing the preparations of the banking industry, preparing the payments system, and contingency planning. Additionally, we are doing all we can to increase awareness of this problem and to energize preparations both here at home and in other parts of the world. The Federal Reserve operates several payments applications that process and settle payments and securities transactions between depository institutions in the United States. These systems are critical national utility services, moving funds much as the national power grid moves electricity. Fedwire is a large-value payments mechanism for US dollar interbank funds transfers and US government securities transfers primarily used by depository institutions and government agencies. These applications, as well as the supporting accounting systems and other payment applications such as the Automated Clearing House (ACH), run on mainframe computer systems operated by Federal Reserve Automation Services (FRAS), the internal organizational unit that processes applications on behalf of the Federal Reserve Banks and operates the Federal Reserve's national communications network. The Reserve Banks also operate check processing systems that provide check services to depository institutions and the US government. In addition to centralized applications on the mainframe, the Reserve Banks operate a range of applications in a distributed computing environment, supporting business functions such as currency distribution, banking supervision and regulation, research, public information, and human resources. The scope of the Federal Reserve's Year 2000 activities includes remediation of all of these processing environments and the supporting telecommunications network, called FEDNET. Our Year 2000 preparations also address our computerized environmental and facilities management systems, such as power, heating and cooling, voice communications, elevators, and vaults. The Federal Reserve is giving the Year 2000 its highest priority, consistent with our goal of maintaining the stability of the nation's financial markets and payments systems, preserving public confidence, and supporting reliable government operations. The Federal Reserve completed assessment of its applications in 1997; our most significant applications have been renovated; and internal testing is underway using dedicated Y2K computer systems and date-simulation tools. Changes to mission critical computer programs, as well as system and user-acceptance testing, are on schedule to be completed by year-end 1998. Further, systems supporting the delivery of critical financial services that interface with the depository institutions will be Year 2000 ready by this July and a depository institution test program will be in place at that time. This schedule will permit approximately 18 months for customer testing, to which we are dedicating considerable support resources. Our Y2K project is being closely coordinated among the Reserve Banks, the Board of Governors, numerous vendors and service providers, approximately 13,000 customers, and government agencies. We are stressing effective, consistent, and timely communication, both internal and external, to promote awareness and commitment at all levels of our own organization and the financial services industry, more generally. A significant challenge in meeting our Y2K readiness objectives is our reliance on commercial hardware and software products and services. Much of our information processing and communications infrastructure, as well as our administrative functions and other operations, is composed of hardware and software products from third-party vendors. As a result, we must coordinate with numerous vendors and manufacturers to ensure that all of our hardware, software, and services are Year 2000 ready. In many cases, compliance requires upgrading, or, in some cases, replacing, equipment and software. We have a complete inventory of vendor components used in our mainframe, telecommunications, and distributed computing environments, and vendor coordination and system change are progressing well. We are particularly sensitive to telecommunications, an essential infrastructure element in our ability to maintain a satisfactorily high level of financial and business services. We have been working with our financial institutions and our telecommunications servicers to find ways to facilitate preparations and testing programs that will ensure Y2K readiness. Nonetheless, this is an area that many financial institutions regard as needing attention. We strongly support the FCC's program to draw increased attention to the Y2K issue and the progress of the telecommunications companies in the United States. Ultimately, the boards of directors and senior management of banks and other financial institutions must shoulder the responsibility for ensuring that the institutions they manage are able to provide high quality and continuous services beginning on the first business day in January of the Year 2000 and beyond. This critical obligation must be among the very highest of priorities for bank management and boards of directors. Nevertheless, bank supervisors can provide guidance, encouragement, and strong incentives to the banking industry to address this challenge. Accordingly, the Federal Reserve and the other banking supervisors that make up the Federal Financial Institutions Examination Council, the FFIEC, have been working closely to orchestrate a uniform supervisory approach to supervising the banking industry's efforts to ensure its readiness. Detailed information about our supervisory program is attached as an Addendum to this testimony and is readily available on a web site maintained by the Federal Reserve on behalf of these agencies. In order to ensure the readiness of the payments system, the Federal Reserve has prepared a special central environment for the testing of high-risk dates, such as the rollover to the Year 2000 and leap year. Testing will be conducted through a combination of future-dating our computer systems to verify the readiness of our infrastructure, and testing critical future dates within interfaces to other institutions. Internal testing is expected to be completed by July, and external testing with customers and other counterparties will then commence and continue throughout 1999. Network communications components are also being tested and certified in a special test lab environment. We have published a detailed schedule of testing opportunities for Fedwire, ACH transactions and other services provided by the Federal Reserve. Our test environments have been configured to provide flexible and nearly continuous access by customers. The Reserve Banks are implementing processes to identify which depositories have tested with us, so that we may follow up on any laggards. We are also researching, in conjunction with our counterparties, the benefits of Y2K testing that would span the entire business process. As part of this effort, the Federal Reserve is coordinating with the Clearing House for Interbank Payment Systems (CHIPS) and the Society for Worldwide Interbank Financial Telecommunication (SWIFT) to provide a common test day for customers of all three systems on September 26, 1998. The New York Clearing House is coordinating an effort to establish common global test dates among major funds transfer systems during April and May 1999. We are also coordinating with the international community of financial regulators to help mobilize global preparations more generally. These efforts are discussed more fully in the Addendum. In particular, through the auspices of the Bank for International Settlements, international regulators for banking, securities, and insurance along with global payments specialists recently jointly hosted a Year 2000 Round Table, which was attended by over 50 countries. A Joint Council was formed that will promote readiness and serve as a global clearing house on Year 2000 issues. In the final analysis, however, the regulatory community recognizes that it cannot solve the problem for the financial industry. Every financial institution must complete its own program and thoroughly test its applications with counterparties and customers if problems are to be avoided. Despite our intensive efforts to prepare our computer systems, we must also make plans for dealing with problems that might occur at the Year 2000 rollover. As you know, the Federal Reserve has been involved in contingency planning and has dealt with various types of emergencies for many years. In response to past disasters we worked closely with the affected financial institutions to ensure that adequate supplies of cash were available to the community, and that backup systems supported our operations without interruption during the crisis period. These efforts primarily focused on the orderly resumption of business operations resulting from hardware failures or processing-site problems. In addition to disruptions to hardware or processing sites, Y2K contingency planning must be directed at potential software failures and interdependency problems with financial and non-financial counterparties. Within this context, business resumption is made more difficult because we cannot fall back to an earlier version of a software package as this version itself may not have been readied for the Year 2000. Y2K disruptions to utility services or depository institutions can also directly affect the Federal Reserve's ability to conduct business. So, in order to plan for the continuity of services, it may be necessary to consider available alternate ways to provide services if a Year 2000 problem is identified. The Federal Reserve has formed a task force to address the contingency readiness of our payments applications. Although we have no grounds for anticipating that specific failures could occur and we cannot act as an operational backstop for the nation's financial industry, we view it as our responsibility to take action to ensure that we are as well positioned as possible to address major failures should they occur. We are currently focusing on contingency planning for external Y2K-related disruptions, such as those affecting utility companies, telecommunications providers, large banks, and difficulties abroad that affect US markets or institutions. The Federal Reserve has established higher standards for testing institutions that serve as the backbone for the transactions that support domestic and international financial markets and whose failure could pose a systemic risk to the payments system. We recognize that, despite their best efforts, some depository institutions may experience operating difficulties, either as a result of their own computer problems or those of their customers, counterparties, or others. These problems could be manifested in a number of ways and could involve temporary funding difficulties. The Federal Reserve plans to be prepared to provide information to depository institutions on the balances in their accounts with us throughout the day, so that they can identify shortfalls and seek funding in the market. The System will also be prepared to lend in appropriate circumstances and with adequate collateral to depository institutions when market sources of funding are not reasonably available. Our preparations for possible liquidity difficulties extend as well to the foreign bank branches and agencies in the US that may be adversely affected directly by their own computer systems or through difficulties caused by the linkage and dependence on their parent bank. Such circumstances would necessitate coordination with the home country supervisor. Moreover, consistent with current policy, foreign central banks will be expected to provide liquidity support to any of their banking organizations that experience a funding shortfall. To sum up, the macroeconomic effects of Year 2000 preparations are quite complex. As I have discussed, some industries may benefit in the near term from increased sales associated with the accelerated pace of replacement of obsolete computer systems, and their customers presumably will have more productive systems in place sooner than might otherwise have been the case. But, in the aggregate, preparing for the Y2K problem is likely exerting a slight drag on the US economy. The Y2K problem, in effect, raises the rate of depreciation of the nation's stock of plant and equipment. It forces businesses to devote additional programming resources simply to maintain the existing flow of services from its computers. As a provider of financial services to the economy, we are on schedule with our own internal remediation efforts and will shortly begin testing our interfaces with financial institutions. While we have made significant progress in our Year 2000 preparations, our challenge now is to ensure that our efforts remain on schedule and that problems are addressed in a timely fashion. In particular, we shall be paying special attention to the testing needs of depository institutions and the financial industry and are prepared to adjust our support for them as required by experience. As a bank supervisor, the Federal Reserve will continue to address the financial services industry's preparedness, monitor progress, and target for special supervisory attention those institutions that are most in need of assistance. In addition, we shall track the Y2K progress of external vendors and critical infrastructure suppliers, such as telecommunications and electrical power utilities. The problems presented to the world by the potential for computer failures as the millennium arrives are real and serious. Because these problems are unique to our experience in many ways, and because the impact of computer-driven systems has become so ubiquitous, the event is unlikely to be trouble free. While we can't predict with any certainty, there clearly is the potential for problems to develop, but these need not be traumatic if we all do our part in preparation. As the world's largest economy, the heaviest burden of preparation falls on the United States. But it is truly a worldwide issue and, to the extent that some are not adequately prepared and experience breakdowns of unforeseeable dimension, we shall all be affected accordingly. There is much work to be done. We intend to do our utmost, and hope and trust that others will do likewise. In this spirit, Mr. Chairman, I want to commend the Committee for inviting this panel to testify together on Y2K issues. This is the first time that the Board has testified next to representatives of the Departments of Commerce and Transportation, and the FCC. This is wholly appropriate because our success in preparing for the millennium will ultimately depend very much on one another's efforts. The Federal Financial Institutions Examination Council(FFIEC) - composed of the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the National Credit Union Administration has issued a series of six advisory statements since June 1996, including statements on the Year 2000 effect on computers, project management, business risk, readiness of service providers, guidance to address customer risk, and testing for readiness. An advisory on contingency planning is being prepared. As a result of these advisory statements, the industry's awareness and the extent of its remediation efforts have significantly increased over the past two years. The FFIEC is considering additional guidance to financial institutions on the development of customer awareness programs and the need to communicate with and address questions of retail customers regarding Year 2000 issues. In May 1997, the banking agencies committed to conduct a supervisory review by June 30, 1998, of all insured depositories to assess the state of their Y2K readiness. Subsequent reviews and examinations will continue throughout 1999. Through March 31, 1998, the Federal Reserve has conducted reviews of approximately 1,100 organizations. The Federal Reserve and the other agencies appear to be on schedule to meet their stated goal. These reviews have resulted in a significant focus of attention on the subject matter within the industry and the agencies as well. Deficient organizations are subject to increased monitoring and supervisory follow-up including more frequent reviews. Restrictions on expansionary activities by organizations that are deficient in their Year 2000 preparations have also been put into place. The Federal Reserve has been conducting Year 2000 supervisory reviews of financial organizations subject to our supervisory authority, coordinating closely with state banking departments and other federal banking agencies that may share responsibility for the banking organizations. Based on these reviews, we conclude that management awareness of, and attention to, the Year 2000 problem has improved notably since the Federal Reserve and the other banking agencies escalated efforts in early 1997 to focus the industry's attention on ensuring Y2K readiness. Banking organizations are making substantial progress in renovating their systems and, with some exceptions, are on track to meet FFIEC guidelines. Most large organizations are actively engaged in the renovation and testing of their mission critical systems. Smaller organizations are working closely with their service providers in an effort to confirm the readiness and reliability of the services and products on which they depend. Similarly, many of the US offices of foreign banks are heavily dependent on their parent bank for their Year 2000 readiness. To address deficient organizations, the Federal Reserve is issuing a confidential Deficiency Notification Letter to those rated less than satisfactory with respect to their Y2K readiness program. We call for a corrective action plan and put the organization on a 30-day reporting regimen to monitor its progress. Given our concern that the organization needs to use its resources to address its deficiencies, rather than expanding, the Federal Reserve also asks the organization for advance notification before entering into any contractual commitments or making public announcements pertaining to prospective acquisitions that require Federal Reserve approval. The agency can then determine the possible effects of the expansionary proposal on the organization's deficient Y2K readiness efforts, and possibly discourage or deny expansion if financial and managerial factors are inconsistent with approval of the application. The Federal Reserve is actively participating in numerous outreach initiatives with the banking industry, trade associations, regulatory authorities and other groups that are hosting conferences, seminars and training opportunities that focus on the Year 2000 and help participants understand better the issues that need to be addressed. Throughout the country, the federal banking agencies have been working with state banking departments and local bankers associations in order to develop coordinated and comprehensive efforts to improve the local and regional programs intended to focus attention on the Year 2000. These efforts will continue consistent with the requirements contained in the Examination Parity and Year 2000 Readiness for Financial Institutions Act (Public Law 105-164), enacted March 20, 1998, which call, in part, for the banking agencies to conduct seminars for depository institutions on the implications of the Y2K problem on their ability to conduct safe and sound operations. The Federal Reserve has worked actively within the Bank for International Settlements (BIS) to ensure that financial regulators around the world are aware of the dangers posed by the Year 2000 and are working to see that the markets and institutions they oversee are ready for the century date change. Last September, the G-10 Governors issued a Year 2000 advisory that included a paper prepared by the Basle Committee on Banking Supervision (Basle Supervisors) describing the serious nature of the problem, identifying the issues that must be addressed, and outlining how programs to address the issue should be structured. The BIS Committee on Payment and Settlement Services (CPSS) has established a web site on which payment systems around the world are posting short reports describing the status of their readiness in order to promote the transparent sharing of Year 2000 information. We continue to participate in international meetings focusing on the Year 2000 issue in order to increase awareness and promote greater understanding and cooperation. Earlier this month, the BIS was the site for the Year 2000 Round Table sponsored jointly by the CPSS, Basle Supervisors, the International Organization of Securities Commissioners, and the International Association of Insurance Supervisors. This meeting, which was attended by financial supervisors and representatives from the private sector from more than 50 countries, highlighted cross-border dependencies and the need for international cooperation to ensure that the issue is managed to minimize any disruptions and possible economic ramifications. As a result of the Round Table, a Joint Year 2000 Council of financial regulators was formed with the First Vice-President of the Federal Reserve Bank of New York serving as the chair. The Council will serve as a contact point between the financial market regulators and market participants including private sector groups specifically focused on international issues. It will also promote readiness, identify sound practices for dealing with the issue, and serve as a global clearing house on Year 2000 issues more generally. A survey by the Basle Supervisors conducted late last year indicated that global awareness of the issue is increasing rapidly but that much work remains to be done. While most central banks and regulators express cautious optimism that their payments systems and financial institutions will generally be ready, there is increasing recognition that some problems are inevitable. To this end, increasing attention is being focused on the need to identify likely potential problems before reaching the century date change and to develop contingency plans to ensure the stability of global financial markets. The majority of foreign central banks are confident that payment and settlement applications under their management will be Y2K ready. Like the Federal Reserve, however, the operation of foreign central bank payment systems is dependent on compliant products from hardware and software suppliers and the readiness of telecommunication and electric power infrastructures. Foreign central banks consider Y2K readiness testing to be a critical and complex issue. The approach of foreign central banks toward raising banking industry awareness varies widely. We are aware that many European banks are stretched for resources as a result of the world-wide demand for information technology staff resources and their conversion to a single currency. Similarly, Asian financial institutions are focusing on their well-known problems, possibly placing full Y2K preparations in jeopardy. We have been working intensively to address the issues faced by the industry and to formulate an effective communications program tailored to those issues. Our public awareness program concentrates on communications with the financial services industry related to our Y2K readiness, our testing efforts, and our overall concerns about the industry's readiness. We have inaugurated a Year 2000 industry newsletter, have published periodic bulletins addressing specific technical issues, and have established an Internet Web site that can be accessed at the following Internet address: http://www.frbsf.org/fiservices/cdc. In addition, we have published a set of guidelines for small businesses, including depository institutions, on Year 2000 issues and project management. On behalf of the FFIEC, the Federal Reserve has developed a Year 2000 information distribution system, including an Internet Web site and a toll free Fax Back service (888-882-0982). The Web site provides easy access to policy statements, guidance to examiners, and paths to other Year 2000 Web sites available from numerous other sources. It can be accessed at the following Internet address: http://www.ffiec.gov/y2k. The Federal Reserve has also produced a ten-minute video entitled "Year 2000 Executive Awareness", intended for viewing by a bank's board of directors and senior management, that presents a summary of the Year 2000 five-phase project management plan outlined in the interagency policy statement. In introductory remarks on the video, it is stressed that senior bank officials should be directly involved in managing the Year 2000 project to ensure that it is given the appropriate level of attention and sufficient resources to address the issue on a timely basis. The video can be ordered through the Board's Web site: http: $\backslash$ www.bog.frb.fed.us/y2k.
1998-05-07T00:00:00	Mr. Greenspan examines the crises in Asia, considers the existence and provision of safety nets and ponders possible policy responses to problems in the international financial system (Central Bank Articles and Speeches, 7 May 98)	Remarks by Chairman of the US Federal Reserve System, Mr. Alan Greenspan, before the 34th Annual Conference on Bank Structure and Competition of the Federal Reserve Bank of Chicago on 7/5/98.	Mr. Greenspan examines the crises in Asia, considers the existence and provision of safety nets and ponders possible policy responses to problems in the international financial Remarks by Chairman of the US Federal Reserve System, Mr. Alan Greenspan, before the system 34th Annual Conference on Bank Structure and Competition of the Federal Reserve Bank of Chicago on 7/5/98. Events in Asia over the past year reinforce once more the fact that, while our burgeoning global system is efficient and makes a substantial contribution to standards of living worldwide, that same efficiency exposes and punishes underlying economic imprudence swiftly and decisively. These global financial markets, engendered by the rapid proliferation of cross-border financial flows and products, have developed a capability of transmitting mistakes at a far faster pace throughout the financial system in ways that were unknown a generation ago. Today's international financial system is sufficiently different, in so many respects, from its predecessors that it can reasonably be characterized as new, as distinct from being merely a continuing evolution from the past. As a consequence, it is urgent that we accelerate our efforts to develop a sophisticated understanding of how this high-tech financial system works. Specifically, we need such an understanding if we are to minimize the chances that we will experience a systemic disruption beyond our degree of comprehension or our ability to respond effectively. We need it if we are to continue to make progress in reducing settlement risk in foreign exchange markets and to ensure a sound infrastructure for payments and settlement systems generally. And we need it if we are to have confidence in our processes of supervision and regulation. In this regard, I intend to focus my remarks this morning on three related topics: I will start by examining the crises in Asia, which, along with the one in Mexico just a few years ago, provide the first evidence of how crises arise in the new system, especially the central role that banks play. I will note that, while the support provided to banks by public safety nets appears to be an element of stability in the new system, it has also been part of the process that engendered recent crises. Next, I will consider why, if the existence of safety nets can encourage crises, we continue to provide them. Finally, I will consider possible policy responses to some of the system's evident problems and tensions. Put differently, can we learn to stabilize our burgeoning, sometimes frenetic, new international financial system so that we can realize its full potential? * * * Let me start with Asia. In hindsight, it is evident that those leveraged economies could not provide adequate profitable opportunities at reasonable risk in the 1990s to absorb the surge in capital inflows. That surge reflected in part the diversification of the western equity markets' huge capital gains to a sector of the world which was perceived as offering above average returns. Together with distortions caused by a long-entrenched government planning ethos, the flood of investment resulted -- some would say inevitably -- in massive deadweight losses. As activity slowed, burdened by fixed-cost obligations that were undertaken on the presumption of continuing growth, business losses and nonperforming bank loans surged. The capital of banks in Asian economies -- especially when properly accounted for -- eroded rapidly. As a consequence, funding sources dried up as fears of defaults rose dramatically. In an environment of weak financial systems, lax supervisory regimes, and vague assurances about depositor or creditor protections, the state of confidence so necessary to the functioning of any banking system was torn asunder. Bank runs occurred in several countries and reached crisis proportions in Indonesia. Uncertainty and retrenchment escalated. In short, the slowing in activity in Asia exposed the high fixed costs of a leveraged economy, especially one with fixed obligations in foreign currencies. Failures to make payments induced vicious cycles of contagious, ever rising, and reinforcing fears. It is quite difficult to anticipate such crises. Every borrower, whether a bank or a nonbank company, presumably structures its balance sheet to provide a sufficient buffer against the emergence of illiquidity or insolvency. The scramble by borrowers to protect their balance sheets when this buffer is unexpectedly breached can lead to a surge in the demand for liquidity that in turn produces a run on the financial system. At one moment, an economy appears stable, the next it is subject to an implosion of fear-induced contraction. In this context a preventive effort to lessen the probabilities of such crises arising -for example, by bolstering the financial system's buffer through more capital or improved bank supervision -- may not in itself further insulate a country from crisis if financial institutions, now faced with a lower cost of capital or lower spread on their debt, leverage away the increased buffer. Indeed, one form of moral hazard is that an initially sound financial system that attracts low risk premia could merely induce a ratcheting up of the risks that a nation's borrowers choose to take on. This is not to disparage endeavors to bolster financial systems. But we should keep in mind that some of the advantages of such initiatives could be drained away by moral hazard. What is becoming increasingly clear, and what is particularly relevant to this conference, is that, in virtually all cases, what turns otherwise seemingly minor imbalances into a crisis is an actual or anticipated disruption to the liquidity or solvency of the banking system, or at least of its major participants. That fact is of critical importance for understanding both the Asian and the previous Latin American crises. Depending on circumstances, the original impulse for the crisis may begin in the banking system or it may begin elsewhere and cause a problem in the banking system that converts a troubling event into an implosive crisis. The aspects of the banking system that produce such outcomes are not particularly opaque. First, exceptionally high leverage has often been a symptom of excessive risk-taking that left financial systems and economies vulnerable to loss of confidence. It is not easy to imagine the cumulative cascading of debt instruments seeking safety in a crisis when assets are heavily funded with equity. Moreover, financial (as well as nonfinancial) businesses have employed high leverage to mask inadequate underlying profitability and did not have adequate capital cushions to match their volatile environments. Second, banks, when confronted with a generally rising yield curve, which is more often the case than not, have had a tendency to incur interest rate or liquidity risk by lending long and funding short. This has exposed banks, especially those that had inadequate capital to begin with, to a collapse of confidence when interest rates spiked and capital was eroded. In addition, when financial intermediaries, in an environment of fixed exchange rates, but still high inflation premiums and domestic currency interest rates, sought low-cost, unhedged, foreign currency funding, the dangers of depositor runs, following a fall in the domestic currency, escalated. Third, banks play a crucial role in the financial market infrastructure. A sound institution can fend off unexpected shocks. But when they are undercapitalized, have lax lending standards, and are subjected to weak supervision and regulation, they have become a source of systemic risk to both domestic and international financial systems. Fourth, recent adverse banking experiences have emphasized the problems that can arise if banks, especially vulnerable banks, are almost the sole source of intermediation. Their breakdown induces a marked weakening in economic growth. A wider range of nonbank institutions, including viable debt and equity markets, can provide important safeguards of economic activity when the banking system fails. Fifth, despite its importance for distributing savings to their most valued investment use, excessive short-term interbank funding, especially cross border, may turn out to be the Achilles' heel of an international financial system that is subject to wide variations in financial confidence. This phenomenon, which is all too common in our domestic experience, may be particularly dangerous in an international setting. I shall return to this issue later. Finally, an important contributor to past crises has been moral hazard, that is, a distortion of incentives that occurs when the party that determines the level of risk receives the gains from, but does not bear the full costs of, the risks taken. Interest rate and currency risk-taking, excess leverage, weak financial systems, and interbank funding have all been encouraged by the existence of a safety net. The expectation that national monetary authorities or international financial institutions will come to the rescue of failing financial systems and unsound investments clearly has engendered a significant element of excessive risk-taking. The dividing line between public and private liabilities, too often, has become blurred. * * * Given that the existence of safety nets generates moral hazard, and moral hazard distorts incentives, why do we continue to provide safety nets to support our financial systems? It is important to remember that, notwithstanding the possibility of excessive leverage, many of the benefits banks provide modern societies derive from their willingness to take risks and from their use of a relatively high degree of financial leverage. Through leverage, in the form principally of taking deposits, banks perform a critical role in the financial intermediation process; they provide savers with additional investment choices and borrowers with a greater range of sources of credit, thereby facilitating a more sophisticated allocation of resources that appears to contribute importantly to greater economic growth. Indeed, it has been the evident value of intermediation and leverage that has shaped the development of our financial systems from the earliest times -- certainly since Renaissance goldsmiths discovered that lending out deposited gold was both feasible and profitable. In addition, central bank provision of a mechanism for converting highly illiquid portfolios into liquid ones, in extraordinary circumstances, has led to a greater degree of leverage in banking than market forces alone would support. Traditionally this has been accomplished by making discount or Lombard facilities available, so that individual depositories could turn illiquid assets into liquid resources and not exacerbate unsettled market conditions by the forced selling of such assets or the calling of loans. More broadly, open market operations, in situations like that which followed the crash of stock markets around the world in 1987, satisfy marked increased needs for liquidity for the system as a whole that otherwise could feed cumulative, self-reinforcing, contractions across many financial markets. To be sure, we should recognize that if we choose to have the advantages of a leveraged system of financial intermediaries, the burden of managing risk in the financial system will not lie with the private sector alone. As I noted, with leveraging there will always exist a possibility, however remote, of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked. Only a central bank, with its unlimited power to create money, can with a high probability thwart such a process before it becomes destructive. Hence, central banks will of necessity be drawn into becoming lenders of last resort. But implicit in the existence of such a role is that there will be some form of allocation between the public and private sectors of the burden of risk, with central banks responsible for managing the most extreme, that is the most systemically sensitive, outcomes. Thus, central banks have been led to provide what essentially amounts to catastrophic financial insurance coverage. Such a public subsidy should be reserved for only the rarest of disasters. If the owners or managers of private financial institutions were to anticipate being propped up frequently by government support, it would only encourage reckless and irresponsible practices. In theory, the allocation of responsibility for risk-bearing between the private sector and the central bank depends upon the private cost of capital. In order to attract, or at least retain, capital, a private financial institution must earn at minimum the overall economy's marginal cost of riskless capital, adjusted for firm-specific risk. In competitive financial markets, the greater the leverage, the higher the rate of return, before adjustment for risk. If private financial institutions have to absorb all financial risk, then the degree to which they can leverage will be restrained, the financial sector smaller, and its contribution to the economy more limited. On the other hand, if central banks effectively insulate private institutions from potential losses, however incurred, increased laxity could threaten a major drain on taxpayers or produce inflationary instability as a consequence of excess money creation. Once a private financial institution infers the amount of capital it must devote to ensure against, first, illiquidity and, finally, insolvency, the size of its balance sheet for maximum rate of return on equity, adjusted for risk, is determined. That inference depends on the institution's judgment of how much of the tail of its risk distribution requires a capital provision. The central bank is presumed to respond to the remainder of the risk tail by lending freely and reducing the danger of illiquidity. Protecting private financial institutions' solvency through guarantees of liabilities risks significant moral hazard. In practice, the policy choice of how much, if any, of the extreme market risk that government authorities should absorb is fraught with many complexities. Yet we central bankers make this decision every day, either explicitly or by default. Moreover, we can never know for sure whether the decisions we made were appropriate. The question is not whether our actions are seen to have been necessary in retrospect; the absence of a fire does not mean that we should not have paid for fire insurance. Rather, the question is whether, ex ante, the probability of a systemic collapse was sufficient to warrant intervention. Often, we cannot wait to see whether, in hindsight, the problem will be judged to have been an isolated event and largely benign. Thus, governments, including central banks, have been given certain responsibilities related to their banking and financial systems that must be balanced. We have the responsibility to prevent major financial market disruptions through development and enforcement of prudent regulatory standards and, if necessary in rare circumstances, through direct intervention in market events. But we also have the responsibility to ensure that private sector institutions have the capacity to take prudent and appropriate risks, even though such risks will sometimes result in unanticipated bank losses or even bank failures. Our goal as supervisors, therefore, should not be to prevent all bank failures, as I have suggested to this conference many times, but to maintain sufficient prudential standards so that banking problems that do occur do not become widespread. We try to achieve the proper balance through official regulations, as well as through formal and informal supervisory policies and procedures. To some extent, we do this over time by signalling to the market, through our actions, the kinds of circumstances in which we might be willing to intervene to quell financial turmoil, and conversely, what levels of difficulties we expect private institutions to resolve by themselves. The market, then, responds by adjusting the risk premium addition to the riskless cost of capital available to banks. * * * To return to the question I raised at the beginning: Can we learn to stabilize our burgeoning, sometimes frenetic, new international financial system so that we can realize its full potential? What types of regulatory initiatives appear fruitful in achieving the benefits and minimizing the costs of the new system? In addressing those questions, I will confine myself again to issues related more narrowly to banks: in particular, to bank supervision and to possible ways in which the behavior of individual banks could be improved. I will not discuss the important issues concerning the need for efficient bankruptcy procedures or for alternative means for coordinating debtors and creditors, both in the domestic context in many countries and in the cross-border context, that may be required in our new system. While failures will inevitably occur in a dynamic market, the safety net -- not to mention concerns over systemic risk -- requires, to repeat, that regulators not be indifferent to how banks manage their risks. To avoid having to resort to numbing micromanagement, regulators have increasingly insisted that banks put in place systems that allow management to have both the information and procedures to be aware of their own true risk exposures on a global basis and to be able to manage such exposures. The better these risk information and control systems, the more risk a bank can prudently assume. In that context, an enhanced regime of market incentives, involving greater sensitivity to market signals and more information to make those signals more robust, is essential. In this rapidly expanding international financial system, the primary protection from adverse financial disturbances is effective counterparty surveillance and, hence, government regulation and supervision should seek to produce an environment in which counterparties can most effectively oversee the credit risks of potential transactions. Here a major improvement in transparency is essential. To be sure, counterparties often exchange otherwise confidential information as a condition of a transaction. But broader dissemination of detailed disclosures of governments, financial institutions, and firms is required if the risks inherent in our global financial structure are to be contained. A market system can approach an appropriate equilibrium only if the signals to which individual market participants respond are accurate and adequate to the needs of the adjustment process. Among the important signals are product and asset prices, interest rates, debt by maturity, and detailed accounts of central banks and private enterprises. I find it difficult to believe, for example, that the crises that arose in Thailand and Korea would have been nearly so virulent had their central banks published data prior to the crises on net reserves instead of the not very informative gross reserve positions only. Some inappropriate capital inflows would almost surely have been withheld and policymakers would have been forced to make difficult choices more promptly if earlier evidences of difficulty had emerged. Increased transparency can expose the prevalence of pending problems, but it cannot be expected to discourage all aberrant behavior. It has not prevented reliance on real estate for collateral from becoming problematic from time to time. East Asia has been no exception. When real estate values fall sharply, as they do from time to time, such collateral tends to become highly illiquid. Removal of legal impediments to more widespread forms of collateral and to prompt access to collateral would be helpful in dealing with these problems. It is increasingly evident that nonperforming loans should be dealt with expeditiously and not allowed to fester. The expected values of the losses on these loans are, of course, a subtraction from capital. But since these estimates are uncertain, they embody an additional risk premium that further reduces the market's best estimate of the size of effective equity capital. Funding becomes more difficult. Partly reflecting uncertainties with respect to their nonperforming loans, Japanese banks in London, for example, are currently required to pay about a 15 basis point add-on over what markets require for major western banks for short-term deposits denominated in yen. It is, hence, far better to remove these dubious assets and their associated risk premium from bank balance sheets, and dispose of them separately, preferably promptly. A predicate to addressing nonperforming loans expeditiously is better and more forceful supervision, which requires more knowledgeable bank examiners than, unfortunately, many economies enjoy. In all countries, we need independent bank examiners who understand banking and business risk, who could in effect, make sound loans themselves because they understand the process. Similarly, we need loan officers at banks that understand their customers' business -- loan officers that could, in effect, step into the shoes of their customers. Lack of a cadre of loan officers who have experience in judging lending risk can produce debilitating losses even when lending is not directed by government inducement or the need to support members of an associated group of companies. Experienced bank supervision cannot fully substitute for poor lending procedures, but presumably it could encourage better practice. Apparently even that has been lacking in many economies. And training personnel and developing adequate supervisory systems will take time. I pointed earlier to cross-border interbank funding as potentially the Achilles' heel of the international financial system. Creditor banks expect claims on banks, especially banks in emerging economies, to be protected by a safety net and, consequently, consider them to be essentially sovereign claims. Unless those expectations are substantially altered -- as when banks actually incur significant losses -- governments can be faced with the choice either of validating those expectations or of risking serious disruption to payments systems and to financial markets in general. Arguably expectations of safety net support have increased the level of cross-border interbank lending from that which would be supported by unsubsidized markets themselves. This would suggest resource misallocation. Accordingly, it might be useful to consider ways in which some added discipline could be imposed on the interbank market. Such discipline, in principle, could be imposed on either debtor or creditor banks. For example, capital requirements could be raised on borrowing banks by making the required level of capital dependent not just on the nature of the banks' assets but also on the nature of their funding. An increase in required capital can be thought of as providing a larger cushion for the sovereign guarantor in the event of a bank's failure. That is, it would shift more of the burden of the failure onto the private sector. Alternatively, the issue of moral hazard in interbank markets could be addressed by charging banks for the existence of the sovereign guarantee, particularly in more vulnerable countries where that guarantee is more likely to be called upon and whose cost might deter some aberrant borrowing. For example, sovereigns could charge an explicit premium, or could impose reserve requirements, earning low or even zero interest rates, on interbank liabilities. Increasing the capital charge on lending banks, instead of on borrowing banks, might also be effective. Under the Basle capital accord, short-term claims on banks from any country carry only a twenty percent risk weight. The higher cost to the lending banks associated with a higher risk weight would presumably be passed on to the borrowing banks. Borrowing banks, at the margin, might reduce their total borrowing or shift their borrowing to nonbank sources of funds, perhaps with the shift facilitated by the lending banks, who might advert to securitization of short-term interbank lending if regulatory capital charges exceeded internal requirements. In either case, there would tend to be a reduction in interbank exposures, a significant source of systemic risk. To be evaluated in any such initiative is whether such regulation would disrupt liquidity in the interbank market to a point where such costs exceed the benefits of reduced interbank exposure. * * * We are interacting every day with an emerging new international financial structure, one with great potential for facilitating the creation of wealth and rising standards of living. Our understanding of the new system continues to improve, as does our ability to gauge and manage risks. Still, the new system will doubtless at times appear threatening and unstable. But that is the price of progress. In my judgment, at the end of the day, it will be a price well worth paying.	---[PAGE_BREAK]--- # Mr. Greenspan examines the crises in Asia, considers the existence and provision of safety nets and ponders possible policy responses to problems in the international financial system Remarks by Chairman of the US Federal Reserve System, Mr. Alan Greenspan, before the 34th Annual Conference on Bank Structure and Competition of the Federal Reserve Bank of Chicago on $7 / 5 / 98$. Events in Asia over the past year reinforce once more the fact that, while our burgeoning global system is efficient and makes a substantial contribution to standards of living worldwide, that same efficiency exposes and punishes underlying economic imprudence swiftly and decisively. These global financial markets, engendered by the rapid proliferation of cross-border financial flows and products, have developed a capability of transmitting mistakes at a far faster pace throughout the financial system in ways that were unknown a generation ago. Today's international financial system is sufficiently different, in so many respects, from its predecessors that it can reasonably be characterized as new, as distinct from being merely a continuing evolution from the past. As a consequence, it is urgent that we accelerate our efforts to develop a sophisticated understanding of how this high-tech financial system works. Specifically, we need such an understanding if we are to minimize the chances that we will experience a systemic disruption beyond our degree of comprehension or our ability to respond effectively. We need it if we are to continue to make progress in reducing settlement risk in foreign exchange markets and to ensure a sound infrastructure for payments and settlement systems generally. And we need it if we are to have confidence in our processes of supervision and regulation. In this regard, I intend to focus my remarks this morning on three related topics: I will start by examining the crises in Asia, which, along with the one in Mexico just a few years ago, provide the first evidence of how crises arise in the new system, especially the central role that banks play. I will note that, while the support provided to banks by public safety nets appears to be an element of stability in the new system, it has also been part of the process that engendered recent crises. Next, I will consider why, if the existence of safety nets can encourage crises, we continue to provide them. Finally, I will consider possible policy responses to some of the system's evident problems and tensions. Put differently, can we learn to stabilize our burgeoning, sometimes frenetic, new international financial system so that we can realize its full potential? Let me start with Asia. In hindsight, it is evident that those leveraged economies could not provide adequate profitable opportunities at reasonable risk in the 1990s to absorb the surge in capital inflows. That surge reflected in part the diversification of the western equity markets' huge capital gains to a sector of the world which was perceived as offering above average returns. Together with distortions caused by a long-entrenched government planning ethos, the flood of investment resulted -- some would say inevitably -- in massive deadweight losses. As activity slowed, burdened by fixed-cost obligations that were undertaken on the presumption of continuing growth, business losses and nonperforming bank loans surged. The capital of banks in Asian economies -- especially when properly accounted for -- eroded rapidly. As a consequence, funding sources dried up as fears of defaults rose dramatically. In an environment of weak financial systems, lax supervisory regimes, and vague assurances about depositor or creditor protections, the state of confidence so necessary to the functioning of any banking system was torn asunder. Bank runs occurred in several countries and reached crisis proportions in Indonesia. Uncertainty and retrenchment escalated. ---[PAGE_BREAK]--- In short, the slowing in activity in Asia exposed the high fixed costs of a leveraged economy, especially one with fixed obligations in foreign currencies. Failures to make payments induced vicious cycles of contagious, ever rising, and reinforcing fears. It is quite difficult to anticipate such crises. Every borrower, whether a bank or a nonbank company, presumably structures its balance sheet to provide a sufficient buffer against the emergence of illiquidity or insolvency. The scramble by borrowers to protect their balance sheets when this buffer is unexpectedly breached can lead to a surge in the demand for liquidity that in turn produces a run on the financial system. At one moment, an economy appears stable, the next it is subject to an implosion of fear-induced contraction. In this context a preventive effort to lessen the probabilities of such crises arising -for example, by bolstering the financial system's buffer through more capital or improved bank supervision -- may not in itself further insulate a country from crisis if financial institutions, now faced with a lower cost of capital or lower spread on their debt, leverage away the increased buffer. Indeed, one form of moral hazard is that an initially sound financial system that attracts low risk premia could merely induce a ratcheting up of the risks that a nation's borrowers choose to take on. This is not to disparage endeavors to bolster financial systems. But we should keep in mind that some of the advantages of such initiatives could be drained away by moral hazard. What is becoming increasingly clear, and what is particularly relevant to this conference, is that, in virtually all cases, what turns otherwise seemingly minor imbalances into a crisis is an actual or anticipated disruption to the liquidity or solvency of the banking system, or at least of its major participants. That fact is of critical importance for understanding both the Asian and the previous Latin American crises. Depending on circumstances, the original impulse for the crisis may begin in the banking system or it may begin elsewhere and cause a problem in the banking system that converts a troubling event into an implosive crisis. The aspects of the banking system that produce such outcomes are not particularly opaque. First, exceptionally high leverage has often been a symptom of excessive risk-taking that left financial systems and economies vulnerable to loss of confidence. It is not easy to imagine the cumulative cascading of debt instruments seeking safety in a crisis when assets are heavily funded with equity. Moreover, financial (as well as nonfinancial) businesses have employed high leverage to mask inadequate underlying profitability and did not have adequate capital cushions to match their volatile environments. Second, banks, when confronted with a generally rising yield curve, which is more often the case than not, have had a tendency to incur interest rate or liquidity risk by lending long and funding short. This has exposed banks, especially those that had inadequate capital to begin with, to a collapse of confidence when interest rates spiked and capital was eroded. In addition, when financial intermediaries, in an environment of fixed exchange rates, but still high inflation premiums and domestic currency interest rates, sought low-cost, unhedged, foreign currency funding, the dangers of depositor runs, following a fall in the domestic currency, escalated. Third, banks play a crucial role in the financial market infrastructure. A sound institution can fend off unexpected shocks. But when they are undercapitalized, have lax lending standards, and are subjected to weak supervision and regulation, they have become a source of systemic risk to both domestic and international financial systems. ---[PAGE_BREAK]--- Fourth, recent adverse banking experiences have emphasized the problems that can arise if banks, especially vulnerable banks, are almost the sole source of intermediation. Their breakdown induces a marked weakening in economic growth. A wider range of nonbank institutions, including viable debt and equity markets, can provide important safeguards of economic activity when the banking system fails. Fifth, despite its importance for distributing savings to their most valued investment use, excessive short-term interbank funding, especially cross border, may turn out to be the Achilles' heel of an international financial system that is subject to wide variations in financial confidence. This phenomenon, which is all too common in our domestic experience, may be particularly dangerous in an international setting. I shall return to this issue later. Finally, an important contributor to past crises has been moral hazard, that is, a distortion of incentives that occurs when the party that determines the level of risk receives the gains from, but does not bear the full costs of, the risks taken. Interest rate and currency risk-taking, excess leverage, weak financial systems, and interbank funding have all been encouraged by the existence of a safety net. The expectation that national monetary authorities or international financial institutions will come to the rescue of failing financial systems and unsound investments clearly has engendered a significant element of excessive risk-taking. The dividing line between public and private liabilities, too often, has become blurred. Given that the existence of safety nets generates moral hazard, and moral hazard distorts incentives, why do we continue to provide safety nets to support our financial systems? It is important to remember that, notwithstanding the possibility of excessive leverage, many of the benefits banks provide modern societies derive from their willingness to take risks and from their use of a relatively high degree of financial leverage. Through leverage, in the form principally of taking deposits, banks perform a critical role in the financial intermediation process; they provide savers with additional investment choices and borrowers with a greater range of sources of credit, thereby facilitating a more sophisticated allocation of resources that appears to contribute importantly to greater economic growth. Indeed, it has been the evident value of intermediation and leverage that has shaped the development of our financial systems from the earliest times -- certainly since Renaissance goldsmiths discovered that lending out deposited gold was both feasible and profitable. In addition, central bank provision of a mechanism for converting highly illiquid portfolios into liquid ones, in extraordinary circumstances, has led to a greater degree of leverage in banking than market forces alone would support. Traditionally this has been accomplished by making discount or Lombard facilities available, so that individual depositories could turn illiquid assets into liquid resources and not exacerbate unsettled market conditions by the forced selling of such assets or the calling of loans. More broadly, open market operations, in situations like that which followed the crash of stock markets around the world in 1987, satisfy marked increased needs for liquidity for the system as a whole that otherwise could feed cumulative, self-reinforcing, contractions across many financial markets. To be sure, we should recognize that if we choose to have the advantages of a leveraged system of financial intermediaries, the burden of managing risk in the financial system will not lie with the private sector alone. As I noted, with leveraging there will always exist a possibility, however remote, of a chain reaction, a cascading sequence of defaults that will culminate in financial ---[PAGE_BREAK]--- implosion if it proceeds unchecked. Only a central bank, with its unlimited power to create money, can with a high probability thwart such a process before it becomes destructive. Hence, central banks will of necessity be drawn into becoming lenders of last resort. But implicit in the existence of such a role is that there will be some form of allocation between the public and private sectors of the burden of risk, with central banks responsible for managing the most extreme, that is the most systemically sensitive, outcomes. Thus, central banks have been led to provide what essentially amounts to catastrophic financial insurance coverage. Such a public subsidy should be reserved for only the rarest of disasters. If the owners or managers of private financial institutions were to anticipate being propped up frequently by government support, it would only encourage reckless and irresponsible practices. In theory, the allocation of responsibility for risk-bearing between the private sector and the central bank depends upon the private cost of capital. In order to attract, or at least retain, capital, a private financial institution must earn at minimum the overall economy's marginal cost of riskless capital, adjusted for firm-specific risk. In competitive financial markets, the greater the leverage, the higher the rate of return, before adjustment for risk. If private financial institutions have to absorb all financial risk, then the degree to which they can leverage will be restrained, the financial sector smaller, and its contribution to the economy more limited. On the other hand, if central banks effectively insulate private institutions from potential losses, however incurred, increased laxity could threaten a major drain on taxpayers or produce inflationary instability as a consequence of excess money creation. Once a private financial institution infers the amount of capital it must devote to ensure against, first, illiquidity and, finally, insolvency, the size of its balance sheet for maximum rate of return on equity, adjusted for risk, is determined. That inference depends on the institution's judgment of how much of the tail of its risk distribution requires a capital provision. The central bank is presumed to respond to the remainder of the risk tail by lending freely and reducing the danger of illiquidity. Protecting private financial institutions' solvency through guarantees of liabilities risks significant moral hazard. In practice, the policy choice of how much, if any, of the extreme market risk that government authorities should absorb is fraught with many complexities. Yet we central bankers make this decision every day, either explicitly or by default. Moreover, we can never know for sure whether the decisions we made were appropriate. The question is not whether our actions are seen to have been necessary in retrospect; the absence of a fire does not mean that we should not have paid for fire insurance. Rather, the question is whether, ex ante, the probability of a systemic collapse was sufficient to warrant intervention. Often, we cannot wait to see whether, in hindsight, the problem will be judged to have been an isolated event and largely benign. Thus, governments, including central banks, have been given certain responsibilities related to their banking and financial systems that must be balanced. We have the responsibility to prevent major financial market disruptions through development and enforcement of prudent regulatory standards and, if necessary in rare circumstances, through direct intervention in market events. But we also have the responsibility to ensure that private sector institutions have the capacity to take prudent and appropriate risks, even though such risks will sometimes result in unanticipated bank losses or even bank failures. Our goal as supervisors, therefore, should not be to prevent all bank failures, as I have suggested to this conference many times, but to maintain sufficient prudential standards so that banking problems that do occur do not become widespread. We try to achieve the proper balance ---[PAGE_BREAK]--- through official regulations, as well as through formal and informal supervisory policies and procedures. To some extent, we do this over time by signalling to the market, through our actions, the kinds of circumstances in which we might be willing to intervene to quell financial turmoil, and conversely, what levels of difficulties we expect private institutions to resolve by themselves. The market, then, responds by adjusting the risk premium addition to the riskless cost of capital available to banks. To return to the question I raised at the beginning: Can we learn to stabilize our burgeoning, sometimes frenetic, new international financial system so that we can realize its full potential? What types of regulatory initiatives appear fruitful in achieving the benefits and minimizing the costs of the new system? In addressing those questions, I will confine myself again to issues related more narrowly to banks: in particular, to bank supervision and to possible ways in which the behavior of individual banks could be improved. I will not discuss the important issues concerning the need for efficient bankruptcy procedures or for alternative means for coordinating debtors and creditors, both in the domestic context in many countries and in the cross-border context, that may be required in our new system. While failures will inevitably occur in a dynamic market, the safety net -- not to mention concerns over systemic risk -- requires, to repeat, that regulators not be indifferent to how banks manage their risks. To avoid having to resort to numbing micromanagement, regulators have increasingly insisted that banks put in place systems that allow management to have both the information and procedures to be aware of their own true risk exposures on a global basis and to be able to manage such exposures. The better these risk information and control systems, the more risk a bank can prudently assume. In that context, an enhanced regime of market incentives, involving greater sensitivity to market signals and more information to make those signals more robust, is essential. In this rapidly expanding international financial system, the primary protection from adverse financial disturbances is effective counterparty surveillance and, hence, government regulation and supervision should seek to produce an environment in which counterparties can most effectively oversee the credit risks of potential transactions. Here a major improvement in transparency is essential. To be sure, counterparties often exchange otherwise confidential information as a condition of a transaction. But broader dissemination of detailed disclosures of governments, financial institutions, and firms is required if the risks inherent in our global financial structure are to be contained. A market system can approach an appropriate equilibrium only if the signals to which individual market participants respond are accurate and adequate to the needs of the adjustment process. Among the important signals are product and asset prices, interest rates, debt by maturity, and detailed accounts of central banks and private enterprises. I find it difficult to believe, for example, that the crises that arose in Thailand and Korea would have been nearly so virulent had their central banks published data prior to the crises on net reserves instead of the not very informative gross reserve positions only. Some inappropriate capital inflows would almost surely have been withheld and policymakers would have been forced to make difficult choices more promptly if earlier evidences of difficulty had emerged. ---[PAGE_BREAK]--- Increased transparency can expose the prevalence of pending problems, but it cannot be expected to discourage all aberrant behavior. It has not prevented reliance on real estate for collateral from becoming problematic from time to time. East Asia has been no exception. When real estate values fall sharply, as they do from time to time, such collateral tends to become highly illiquid. Removal of legal impediments to more widespread forms of collateral and to prompt access to collateral would be helpful in dealing with these problems. It is increasingly evident that nonperforming loans should be dealt with expeditiously and not allowed to fester. The expected values of the losses on these loans are, of course, a subtraction from capital. But since these estimates are uncertain, they embody an additional risk premium that further reduces the market's best estimate of the size of effective equity capital. Funding becomes more difficult. Partly reflecting uncertainties with respect to their nonperforming loans, Japanese banks in London, for example, are currently required to pay about a 15 basis point add-on over what markets require for major western banks for short-term deposits denominated in yen. It is, hence, far better to remove these dubious assets and their associated risk premium from bank balance sheets, and dispose of them separately, preferably promptly. A predicate to addressing nonperforming loans expeditiously is better and more forceful supervision, which requires more knowledgeable bank examiners than, unfortunately, many economies enjoy. In all countries, we need independent bank examiners who understand banking and business risk, who could in effect, make sound loans themselves because they understand the process. Similarly, we need loan officers at banks that understand their customers' business -- loan officers that could, in effect, step into the shoes of their customers. Lack of a cadre of loan officers who have experience in judging lending risk can produce debilitating losses even when lending is not directed by government inducement or the need to support members of an associated group of companies. Experienced bank supervision cannot fully substitute for poor lending procedures, but presumably it could encourage better practice. Apparently even that has been lacking in many economies. And training personnel and developing adequate supervisory systems will take time. I pointed earlier to cross-border interbank funding as potentially the Achilles' heel of the international financial system. Creditor banks expect claims on banks, especially banks in emerging economies, to be protected by a safety net and, consequently, consider them to be essentially sovereign claims. Unless those expectations are substantially altered -- as when banks actually incur significant losses -- governments can be faced with the choice either of validating those expectations or of risking serious disruption to payments systems and to financial markets in general. Arguably expectations of safety net support have increased the level of cross-border interbank lending from that which would be supported by unsubsidized markets themselves. This would suggest resource misallocation. Accordingly, it might be useful to consider ways in which some added discipline could be imposed on the interbank market. Such discipline, in principle, could be imposed on either debtor or creditor banks. For example, capital requirements could be raised on borrowing banks by making the required level of capital dependent not just on the nature of the banks' assets but also on the nature of their funding. An increase in required capital can be thought of as providing a larger cushion for the sovereign guarantor in the event of a bank's failure. That is, it would shift more of the burden of the failure onto the private sector. Alternatively, the issue of moral hazard in interbank markets could be addressed by charging banks for the existence of the sovereign guarantee, particularly in more vulnerable countries where that guarantee is more likely to be called upon and whose cost might deter some aberrant borrowing. For example, sovereigns could charge an explicit premium, or could impose reserve requirements, earning low or even zero interest rates, on interbank liabilities. ---[PAGE_BREAK]--- Increasing the capital charge on lending banks, instead of on borrowing banks, might also be effective. Under the Basle capital accord, short-term claims on banks from any country carry only a twenty percent risk weight. The higher cost to the lending banks associated with a higher risk weight would presumably be passed on to the borrowing banks. Borrowing banks, at the margin, might reduce their total borrowing or shift their borrowing to nonbank sources of funds, perhaps with the shift facilitated by the lending banks, who might advert to securitization of short-term interbank lending if regulatory capital charges exceeded internal requirements. In either case, there would tend to be a reduction in interbank exposures, a significant source of systemic risk. To be evaluated in any such initiative is whether such regulation would disrupt liquidity in the interbank market to a point where such costs exceed the benefits of reduced interbank exposure. We are interacting every day with an emerging new international financial structure, one with great potential for facilitating the creation of wealth and rising standards of living. Our understanding of the new system continues to improve, as does our ability to gauge and manage risks. Still, the new system will doubtless at times appear threatening and unstable. But that is the price of progress. In my judgment, at the end of the day, it will be a price well worth paying.	Alan Greenspan	United States	https://www.bis.org/review/r980518l.pdf	system Remarks by Chairman of the US Federal Reserve System, Mr. Alan Greenspan, before the 34th Annual Conference on Bank Structure and Competition of the Federal Reserve Bank of Chicago on $7 / 5 / 98$. Events in Asia over the past year reinforce once more the fact that, while our burgeoning global system is efficient and makes a substantial contribution to standards of living worldwide, that same efficiency exposes and punishes underlying economic imprudence swiftly and decisively. These global financial markets, engendered by the rapid proliferation of cross-border financial flows and products, have developed a capability of transmitting mistakes at a far faster pace throughout the financial system in ways that were unknown a generation ago. Today's international financial system is sufficiently different, in so many respects, from its predecessors that it can reasonably be characterized as new, as distinct from being merely a continuing evolution from the past. As a consequence, it is urgent that we accelerate our efforts to develop a sophisticated understanding of how this high-tech financial system works. Specifically, we need such an understanding if we are to minimize the chances that we will experience a systemic disruption beyond our degree of comprehension or our ability to respond effectively. We need it if we are to continue to make progress in reducing settlement risk in foreign exchange markets and to ensure a sound infrastructure for payments and settlement systems generally. And we need it if we are to have confidence in our processes of supervision and regulation. In this regard, I intend to focus my remarks this morning on three related topics: I will start by examining the crises in Asia, which, along with the one in Mexico just a few years ago, provide the first evidence of how crises arise in the new system, especially the central role that banks play. I will note that, while the support provided to banks by public safety nets appears to be an element of stability in the new system, it has also been part of the process that engendered recent crises. Next, I will consider why, if the existence of safety nets can encourage crises, we continue to provide them. Finally, I will consider possible policy responses to some of the system's evident problems and tensions. Put differently, can we learn to stabilize our burgeoning, sometimes frenetic, new international financial system so that we can realize its full potential? Let me start with Asia. In hindsight, it is evident that those leveraged economies could not provide adequate profitable opportunities at reasonable risk in the 1990s to absorb the surge in capital inflows. That surge reflected in part the diversification of the western equity markets' huge capital gains to a sector of the world which was perceived as offering above average returns. Together with distortions caused by a long-entrenched government planning ethos, the flood of investment resulted -- some would say inevitably -- in massive deadweight losses. As activity slowed, burdened by fixed-cost obligations that were undertaken on the presumption of continuing growth, business losses and nonperforming bank loans surged. The capital of banks in Asian economies -- especially when properly accounted for -- eroded rapidly. As a consequence, funding sources dried up as fears of defaults rose dramatically. In an environment of weak financial systems, lax supervisory regimes, and vague assurances about depositor or creditor protections, the state of confidence so necessary to the functioning of any banking system was torn asunder. Bank runs occurred in several countries and reached crisis proportions in Indonesia. Uncertainty and retrenchment escalated. In short, the slowing in activity in Asia exposed the high fixed costs of a leveraged economy, especially one with fixed obligations in foreign currencies. Failures to make payments induced vicious cycles of contagious, ever rising, and reinforcing fears. It is quite difficult to anticipate such crises. Every borrower, whether a bank or a nonbank company, presumably structures its balance sheet to provide a sufficient buffer against the emergence of illiquidity or insolvency. The scramble by borrowers to protect their balance sheets when this buffer is unexpectedly breached can lead to a surge in the demand for liquidity that in turn produces a run on the financial system. At one moment, an economy appears stable, the next it is subject to an implosion of fear-induced contraction. In this context a preventive effort to lessen the probabilities of such crises arising -for example, by bolstering the financial system's buffer through more capital or improved bank supervision -- may not in itself further insulate a country from crisis if financial institutions, now faced with a lower cost of capital or lower spread on their debt, leverage away the increased buffer. Indeed, one form of moral hazard is that an initially sound financial system that attracts low risk premia could merely induce a ratcheting up of the risks that a nation's borrowers choose to take on. This is not to disparage endeavors to bolster financial systems. But we should keep in mind that some of the advantages of such initiatives could be drained away by moral hazard. What is becoming increasingly clear, and what is particularly relevant to this conference, is that, in virtually all cases, what turns otherwise seemingly minor imbalances into a crisis is an actual or anticipated disruption to the liquidity or solvency of the banking system, or at least of its major participants. That fact is of critical importance for understanding both the Asian and the previous Latin American crises. Depending on circumstances, the original impulse for the crisis may begin in the banking system or it may begin elsewhere and cause a problem in the banking system that converts a troubling event into an implosive crisis. The aspects of the banking system that produce such outcomes are not particularly opaque. First, exceptionally high leverage has often been a symptom of excessive risk-taking that left financial systems and economies vulnerable to loss of confidence. It is not easy to imagine the cumulative cascading of debt instruments seeking safety in a crisis when assets are heavily funded with equity. Moreover, financial (as well as nonfinancial) businesses have employed high leverage to mask inadequate underlying profitability and did not have adequate capital cushions to match their volatile environments. Second, banks, when confronted with a generally rising yield curve, which is more often the case than not, have had a tendency to incur interest rate or liquidity risk by lending long and funding short. This has exposed banks, especially those that had inadequate capital to begin with, to a collapse of confidence when interest rates spiked and capital was eroded. In addition, when financial intermediaries, in an environment of fixed exchange rates, but still high inflation premiums and domestic currency interest rates, sought low-cost, unhedged, foreign currency funding, the dangers of depositor runs, following a fall in the domestic currency, escalated. Third, banks play a crucial role in the financial market infrastructure. A sound institution can fend off unexpected shocks. But when they are undercapitalized, have lax lending standards, and are subjected to weak supervision and regulation, they have become a source of systemic risk to both domestic and international financial systems. Fourth, recent adverse banking experiences have emphasized the problems that can arise if banks, especially vulnerable banks, are almost the sole source of intermediation. Their breakdown induces a marked weakening in economic growth. A wider range of nonbank institutions, including viable debt and equity markets, can provide important safeguards of economic activity when the banking system fails. Fifth, despite its importance for distributing savings to their most valued investment use, excessive short-term interbank funding, especially cross border, may turn out to be the Achilles' heel of an international financial system that is subject to wide variations in financial confidence. This phenomenon, which is all too common in our domestic experience, may be particularly dangerous in an international setting. I shall return to this issue later. Finally, an important contributor to past crises has been moral hazard, that is, a distortion of incentives that occurs when the party that determines the level of risk receives the gains from, but does not bear the full costs of, the risks taken. Interest rate and currency risk-taking, excess leverage, weak financial systems, and interbank funding have all been encouraged by the existence of a safety net. The expectation that national monetary authorities or international financial institutions will come to the rescue of failing financial systems and unsound investments clearly has engendered a significant element of excessive risk-taking. The dividing line between public and private liabilities, too often, has become blurred. Given that the existence of safety nets generates moral hazard, and moral hazard distorts incentives, why do we continue to provide safety nets to support our financial systems? It is important to remember that, notwithstanding the possibility of excessive leverage, many of the benefits banks provide modern societies derive from their willingness to take risks and from their use of a relatively high degree of financial leverage. Through leverage, in the form principally of taking deposits, banks perform a critical role in the financial intermediation process; they provide savers with additional investment choices and borrowers with a greater range of sources of credit, thereby facilitating a more sophisticated allocation of resources that appears to contribute importantly to greater economic growth. Indeed, it has been the evident value of intermediation and leverage that has shaped the development of our financial systems from the earliest times -- certainly since Renaissance goldsmiths discovered that lending out deposited gold was both feasible and profitable. In addition, central bank provision of a mechanism for converting highly illiquid portfolios into liquid ones, in extraordinary circumstances, has led to a greater degree of leverage in banking than market forces alone would support. Traditionally this has been accomplished by making discount or Lombard facilities available, so that individual depositories could turn illiquid assets into liquid resources and not exacerbate unsettled market conditions by the forced selling of such assets or the calling of loans. More broadly, open market operations, in situations like that which followed the crash of stock markets around the world in 1987, satisfy marked increased needs for liquidity for the system as a whole that otherwise could feed cumulative, self-reinforcing, contractions across many financial markets. To be sure, we should recognize that if we choose to have the advantages of a leveraged system of financial intermediaries, the burden of managing risk in the financial system will not lie with the private sector alone. As I noted, with leveraging there will always exist a possibility, however remote, of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked. Only a central bank, with its unlimited power to create money, can with a high probability thwart such a process before it becomes destructive. Hence, central banks will of necessity be drawn into becoming lenders of last resort. But implicit in the existence of such a role is that there will be some form of allocation between the public and private sectors of the burden of risk, with central banks responsible for managing the most extreme, that is the most systemically sensitive, outcomes. Thus, central banks have been led to provide what essentially amounts to catastrophic financial insurance coverage. Such a public subsidy should be reserved for only the rarest of disasters. If the owners or managers of private financial institutions were to anticipate being propped up frequently by government support, it would only encourage reckless and irresponsible practices. In theory, the allocation of responsibility for risk-bearing between the private sector and the central bank depends upon the private cost of capital. In order to attract, or at least retain, capital, a private financial institution must earn at minimum the overall economy's marginal cost of riskless capital, adjusted for firm-specific risk. In competitive financial markets, the greater the leverage, the higher the rate of return, before adjustment for risk. If private financial institutions have to absorb all financial risk, then the degree to which they can leverage will be restrained, the financial sector smaller, and its contribution to the economy more limited. On the other hand, if central banks effectively insulate private institutions from potential losses, however incurred, increased laxity could threaten a major drain on taxpayers or produce inflationary instability as a consequence of excess money creation. Once a private financial institution infers the amount of capital it must devote to ensure against, first, illiquidity and, finally, insolvency, the size of its balance sheet for maximum rate of return on equity, adjusted for risk, is determined. That inference depends on the institution's judgment of how much of the tail of its risk distribution requires a capital provision. The central bank is presumed to respond to the remainder of the risk tail by lending freely and reducing the danger of illiquidity. Protecting private financial institutions' solvency through guarantees of liabilities risks significant moral hazard. In practice, the policy choice of how much, if any, of the extreme market risk that government authorities should absorb is fraught with many complexities. Yet we central bankers make this decision every day, either explicitly or by default. Moreover, we can never know for sure whether the decisions we made were appropriate. The question is not whether our actions are seen to have been necessary in retrospect; the absence of a fire does not mean that we should not have paid for fire insurance. Rather, the question is whether, ex ante, the probability of a systemic collapse was sufficient to warrant intervention. Often, we cannot wait to see whether, in hindsight, the problem will be judged to have been an isolated event and largely benign. Thus, governments, including central banks, have been given certain responsibilities related to their banking and financial systems that must be balanced. We have the responsibility to prevent major financial market disruptions through development and enforcement of prudent regulatory standards and, if necessary in rare circumstances, through direct intervention in market events. But we also have the responsibility to ensure that private sector institutions have the capacity to take prudent and appropriate risks, even though such risks will sometimes result in unanticipated bank losses or even bank failures. Our goal as supervisors, therefore, should not be to prevent all bank failures, as I have suggested to this conference many times, but to maintain sufficient prudential standards so that banking problems that do occur do not become widespread. We try to achieve the proper balance through official regulations, as well as through formal and informal supervisory policies and procedures. To some extent, we do this over time by signalling to the market, through our actions, the kinds of circumstances in which we might be willing to intervene to quell financial turmoil, and conversely, what levels of difficulties we expect private institutions to resolve by themselves. The market, then, responds by adjusting the risk premium addition to the riskless cost of capital available to banks. To return to the question I raised at the beginning: Can we learn to stabilize our burgeoning, sometimes frenetic, new international financial system so that we can realize its full potential? What types of regulatory initiatives appear fruitful in achieving the benefits and minimizing the costs of the new system? In addressing those questions, I will confine myself again to issues related more narrowly to banks: in particular, to bank supervision and to possible ways in which the behavior of individual banks could be improved. I will not discuss the important issues concerning the need for efficient bankruptcy procedures or for alternative means for coordinating debtors and creditors, both in the domestic context in many countries and in the cross-border context, that may be required in our new system. While failures will inevitably occur in a dynamic market, the safety net -- not to mention concerns over systemic risk -- requires, to repeat, that regulators not be indifferent to how banks manage their risks. To avoid having to resort to numbing micromanagement, regulators have increasingly insisted that banks put in place systems that allow management to have both the information and procedures to be aware of their own true risk exposures on a global basis and to be able to manage such exposures. The better these risk information and control systems, the more risk a bank can prudently assume. In that context, an enhanced regime of market incentives, involving greater sensitivity to market signals and more information to make those signals more robust, is essential. In this rapidly expanding international financial system, the primary protection from adverse financial disturbances is effective counterparty surveillance and, hence, government regulation and supervision should seek to produce an environment in which counterparties can most effectively oversee the credit risks of potential transactions. Here a major improvement in transparency is essential. To be sure, counterparties often exchange otherwise confidential information as a condition of a transaction. But broader dissemination of detailed disclosures of governments, financial institutions, and firms is required if the risks inherent in our global financial structure are to be contained. A market system can approach an appropriate equilibrium only if the signals to which individual market participants respond are accurate and adequate to the needs of the adjustment process. Among the important signals are product and asset prices, interest rates, debt by maturity, and detailed accounts of central banks and private enterprises. I find it difficult to believe, for example, that the crises that arose in Thailand and Korea would have been nearly so virulent had their central banks published data prior to the crises on net reserves instead of the not very informative gross reserve positions only. Some inappropriate capital inflows would almost surely have been withheld and policymakers would have been forced to make difficult choices more promptly if earlier evidences of difficulty had emerged. Increased transparency can expose the prevalence of pending problems, but it cannot be expected to discourage all aberrant behavior. It has not prevented reliance on real estate for collateral from becoming problematic from time to time. East Asia has been no exception. When real estate values fall sharply, as they do from time to time, such collateral tends to become highly illiquid. Removal of legal impediments to more widespread forms of collateral and to prompt access to collateral would be helpful in dealing with these problems. It is increasingly evident that nonperforming loans should be dealt with expeditiously and not allowed to fester. The expected values of the losses on these loans are, of course, a subtraction from capital. But since these estimates are uncertain, they embody an additional risk premium that further reduces the market's best estimate of the size of effective equity capital. Funding becomes more difficult. Partly reflecting uncertainties with respect to their nonperforming loans, Japanese banks in London, for example, are currently required to pay about a 15 basis point add-on over what markets require for major western banks for short-term deposits denominated in yen. It is, hence, far better to remove these dubious assets and their associated risk premium from bank balance sheets, and dispose of them separately, preferably promptly. A predicate to addressing nonperforming loans expeditiously is better and more forceful supervision, which requires more knowledgeable bank examiners than, unfortunately, many economies enjoy. In all countries, we need independent bank examiners who understand banking and business risk, who could in effect, make sound loans themselves because they understand the process. Similarly, we need loan officers at banks that understand their customers' business -- loan officers that could, in effect, step into the shoes of their customers. Lack of a cadre of loan officers who have experience in judging lending risk can produce debilitating losses even when lending is not directed by government inducement or the need to support members of an associated group of companies. Experienced bank supervision cannot fully substitute for poor lending procedures, but presumably it could encourage better practice. Apparently even that has been lacking in many economies. And training personnel and developing adequate supervisory systems will take time. I pointed earlier to cross-border interbank funding as potentially the Achilles' heel of the international financial system. Creditor banks expect claims on banks, especially banks in emerging economies, to be protected by a safety net and, consequently, consider them to be essentially sovereign claims. Unless those expectations are substantially altered -- as when banks actually incur significant losses -- governments can be faced with the choice either of validating those expectations or of risking serious disruption to payments systems and to financial markets in general. Arguably expectations of safety net support have increased the level of cross-border interbank lending from that which would be supported by unsubsidized markets themselves. This would suggest resource misallocation. Accordingly, it might be useful to consider ways in which some added discipline could be imposed on the interbank market. Such discipline, in principle, could be imposed on either debtor or creditor banks. For example, capital requirements could be raised on borrowing banks by making the required level of capital dependent not just on the nature of the banks' assets but also on the nature of their funding. An increase in required capital can be thought of as providing a larger cushion for the sovereign guarantor in the event of a bank's failure. That is, it would shift more of the burden of the failure onto the private sector. Alternatively, the issue of moral hazard in interbank markets could be addressed by charging banks for the existence of the sovereign guarantee, particularly in more vulnerable countries where that guarantee is more likely to be called upon and whose cost might deter some aberrant borrowing. For example, sovereigns could charge an explicit premium, or could impose reserve requirements, earning low or even zero interest rates, on interbank liabilities. Increasing the capital charge on lending banks, instead of on borrowing banks, might also be effective. Under the Basle capital accord, short-term claims on banks from any country carry only a twenty percent risk weight. The higher cost to the lending banks associated with a higher risk weight would presumably be passed on to the borrowing banks. Borrowing banks, at the margin, might reduce their total borrowing or shift their borrowing to nonbank sources of funds, perhaps with the shift facilitated by the lending banks, who might advert to securitization of short-term interbank lending if regulatory capital charges exceeded internal requirements. In either case, there would tend to be a reduction in interbank exposures, a significant source of systemic risk. To be evaluated in any such initiative is whether such regulation would disrupt liquidity in the interbank market to a point where such costs exceed the benefits of reduced interbank exposure. We are interacting every day with an emerging new international financial structure, one with great potential for facilitating the creation of wealth and rising standards of living. Our understanding of the new system continues to improve, as does our ability to gauge and manage risks. Still, the new system will doubtless at times appear threatening and unstable. But that is the price of progress. In my judgment, at the end of the day, it will be a price well worth paying.
1998-05-17T22:00:00	Mr. Ferguson discusses the role of banking in the global market-place (Central Bank Articles and Speeches, 16 Apr 98)	Remarks by Mr. Roger W. Ferguson, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Urban Bankers Coalition, Inc., in New York on 4/16/98.	Mr. Ferguson discusses the role of banking in the global market-place Remarks by Mr. Roger W. Ferguson, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Urban Bankers Coalition, Inc., in New York on 4/16/98. Are Banks Safe for the World and Is the World Safe for Banks? Thank you for your kind invitation to speak to you this evening. Your topic, banking in the global market-place, is obviously timely. Given the role of international capital flows, I expect that this is a topic that will continue to be the focus of a great deal of attention. The current crisis in Asia, which is both a banking crisis and a macroeconomic crisis, is the starting point of my talk this evening. As I considered the Asian crisis, I became curious to know whether it is a unique problem due to a unique set of circumstances, or an accident that happened in a few Asian countries this time, but could occur in other countries at almost any time. I would like to share with you the results of my inquiries. Banks Continue To Be Important in a Global Context The starting point of my research was to confirm the critical role banks continue to play in global finance, particularly for countries with relatively underdeveloped capital markets. For example, the Bank for International Settlements estimates that the stock of international bank loans had grown to $8.5 trillion at the end of September 1997 - almost 30 times the level 25 years earlier. Importantly, loans to developing countries now total about $1 trillion. While it is true that international bond and equity flows have grown during the period, new issues of bonds only exceeded bank lending 10 years ago, and the stock of outstanding loans is still considerably greater. This flow of capital has been critical in increasing the standard of living around the globe. Funds have flowed internationally from savers to borrowers, who generally tend to be entrepreneurs and others in business who need capital to build businesses and serve customers, both in their home countries and overseas. This international flow moves capital toward its most productive use, in principle, from the higher saving industrialized world to the high return, capital-short developing nations. Are there issues that should give us concern in this benign picture? Unfortunately, there are many. I would like to turn now to the question of whether banks are safe for the world economy and if the world economy is safe for banking. Are Banks Safe for the Global Economy? The current crisis in Asia led me to ask how many other countries have experienced banking crises, either domestic or cross-border? The answer I found may surprise you. Research done by economists of the International Monetary Fund indicates that 133 of the 181 countries who are members of the Fund, more than two-thirds, have experienced significant banking problems at some time since 19801. Thirty-six of those instances would be described as banking "crises" in that there were runs or other portfolio shifts, collapses of financial firms, or massive government intervention. Several countries experienced multiple banking crises. Banking crises have affected developed countries, such as the United States, Sweden, France, and Norway, as well as rapidly developing or "transitional" countries, including now Korea, Indonesia and Malaysia, but earlier Mexico, Argentina, and Chile. Banks fail for a number of reasons, including poor management, excessive risk taking, fraud and a poor operating environment. Individual bankers too often forget the fundamental tenets of banking, which are universal and apply to internationally active banks in Amsterdam as well as to community banks here in New Amsterdam. These tenets include: Know your customer; understand the legal framework in which you are working; thoroughly understand the sources of repayment and the risk of nonperformance; and price your services accordingly. We know that in Asia banks violated some of these rules. Banks often engaged in directed lending, either directed by government bureaucrats or commercial enterprises under shared ownership with the bank. Because of government intervention in the lending process, Asian banks had not developed the necessary credit risk skills, and bank supervisors were incapable of enforcing reasonable standards of behavior on the part of local banks. In the international context, the interbank lending problem that emerged in Asia arose in part because of a lack of transparency in the financial system, making it difficult for foreign bank lenders to know the quality of the ultimate credit. More importantly, however, foreign banks that funded Asian banks may have assumed an implicit government guarantee of inter-bank counter-parties because a history of supporting troubled institutions may have left that impression. What is the impact of a banking crisis? First, the financial cost of fixing an insolvent banking system is high, and that cost is ultimately borne by the taxpayer. For example, in Australia's banking crisis of 1989-1992, the IMF estimates the cost of rescuing state-owned banks to be nearly 2% of GDP. In Mexico, the overall cost of several programs to support the banking system is estimated (in present value) at 6.5% of GDP. Currently in Japan, the government has announced an intention to spend as much as 30 trillion yen, 6% of GDP, to support its banking system. For Finland, Chile, and Argentina, the IMF estimated the fiscal impact of banking crises to have been between 4% and 8% of GDP. Finally, in the United States, resolution of the S&L crisis is estimated to have cost $150 billion, approximately 3% of GDP in 1990. In addition to the cost imposed upon society, an unsound banking system cannot carry out its credit-creation function and can distort macroeconomic performance. Unsound banks, ones with sufficient liquidity but a high percentage of nonperforming loans and a deteriorating capital base, act on a different set of incentives than do sound banks. First, unable to declare loans in default unless they admit their own insolvency, such banks may continue to lend to nonperforming borrowers or, alternatively, capitalize unpaid - and uncollectible - interest. That is, they may act to defer recognition of their problems. At the same time, they might seek riskier investments to try to offset their problems with higher earnings. In addition, such banks may attempt to attract depositors by paying higher interest rates than their solvent competitors. A high percentage of nonperforming loans may also lead to a contraction of credit, a "credit crunch," as banks turn away sound borrowers in order to continue to support unsound ones or unduly raise underwriting standards in fear of making more weak loans. Finally, a banking system that is unsound cannot perform its role as a transmitter of monetary policy. Particularly in emerging economies, in which other financial markets are not well developed, banks transmit monetary policy by expanding or contracting their balance sheets, i.e., engaging in more or less lending. An economy which is relatively stagnant cannot easily recover using monetary policy if it is saddled with an unsound banking system, because efforts to stimulate growth by lowering interest rates may not lead to a sufficient expansion of lending. In an international context with cross-border lending, the same issues may apply. Banks that are saddled with a large number of nonperforming loans from another country, either private or public debt, will have a need to work out those loans, and continue to support those borrowers rather than engage in new lending, either domestic or cross-border. Similarly, such banks are unlikely to be as efficient as they otherwise would be in transmitting the monetary policy of their home country central bank into their home country macroeconomy. So it is clear that an insolvent banking system is bad for a local, and indeed, the global economy. The costs to fix such as system can be substantial, the credit function cannot be carried out properly by such a system, and monetary policy may be hampered. Is the Global Economy Safe for Banking? Obviously, however, the record of banking crises around the globe does not prove that banking is the source of all problems. Macroeconomic policy and the performance of policymakers also have the potential to create systemic problems. Macroeconomic conditions or policies that undergo sufficiently significant and unexpected changes impact all banks, well managed and poorly managed alike. Unfortunately, the current Asian crisis and previous bank crises, including our own, indicate that a range of macroeconomic mistakes can lead to an unsound banking system. Put another way, there are many macroeconomic roads to ruin. First, let's start with Asia. The countries currently in crisis followed traditional macroeconomic policies that in the main were sound. They avoided fiscal deficits, and in some cases ran surpluses. In addition, they avoided a general inflation in the prices of goods and services. However, notwithstanding responsible macroeconomic policies, strong increases in private spending, much of it financed by bank credit and capital inflows, turned out ex post to have been unwarranted. Much of the increased investment spending was concentrated in stocks and real estate, and asset price bubbles emerged. Moreover, exchange rates were in some cases allowed to get out of line with fundamental forces in the economy, leading to sharp increases in imports and a widening of trade deficits. To some extent this effect was a result of pegging exchange rates to the U.S. dollar, or to a basket of currencies in which the dollar had a large weight, at a time when the value of the dollar was rising against the yen. Exchange rate and capital flow problems could similarly be assigned blame in several earlier banking crises, as well. For example, in the late 1970s, the Chilean government followed a policy of rapid exchange rate appreciation, culminating in a fixed exchange rate in 1979. Credit to the private sector rose sharply as massive capital inflows followed. An international slowdown in the early 1980s resulted in a collapse in the price of copper, Chile's major export, an increase in the country's trade deficit, and a sudden reversal of its capital flows. Recession followed and banks were left with unserviceable, foreign-currency-denominated debts. However, exchange rate problems are only one type of macroeconomic concern. Other countries, such as Finland, Sweden and Norway, experienced banking crises following explosions in central bank credit and bubbles in asset prices or in credit creation by banks. Fiscal and monetary policy, and the need to reverse policy unexpectedly, can also lead to banking crises if bubbles arise in asset markets and banks are heavily exposed to assets with inflated values through their lending practices or balance sheets. Other countries, particularly those that rely heavily on a single international commodity export, such as oil, have experienced banking crises following rapid adjustment in the prices for those commodities. Often in these cases, the government attempts to use fiscal or monetary stimulus to offset the loss of standard of living that results from a decline in commodity prices. This policy generally only succeeds in inducing a cycle of strong inflation, perhaps accompanied by pressures on exchange rates, followed by a steep correction. Finally, here in the United States, the S&L crisis was due in part to deregulation of interest rates on deposits, that left S&Ls with low returns on assets but a high cost of funds. In a scramble for new sources of revenues and an effort to generate earnings, S&Ls took on greater and greater risk. Potential Solutions Given this history of banking crises throughout the world - some the result of poor banking practices, some tied to the rapid ebb and flow of cross-border capital, and some due to internal macroeconomic policies - what should one recommend? I would like to focus on three sets of solutions designed to minimize the risk of future cross-border banking crises: (1) improvements in supervision and basic banking skills; (2) international transparency, including sound accounting standards; and (3) ways to avoid potential problems in capital flows. This analysis also points to a responsible policy for countries faced with unsound banking systems. First, with respect to banking supervision, the faster pace and increasing complexity of financial services mean that banking supervision has had to change its methods to rely more heavily on market forces as a means of regulating banks. For example, the Federal Reserve has become more focused on how individual institutions, including community banks, manage the risks of banking. In the international arena, the Federal Reserve is working with the Basle Committee on Banking Supervision, which was established by the central banks of the major industrial countries, to increase outreach to emerging-market countries. The Basle Committee has recently published a set of core principles for effective banking supervision. The implementation of these core principles should aid many countries in making their supervision more effective. I believe that adopting these principles, or something like them, is an important first step as countries move to participate more actively in global financial markets. The time is probably near when we have to determine how to encourage more countries to adopt and fully comply with these principles, or their equivalents. The world should not be subject to weak bank supervision in any country. Having sound banking practices may also be a necessary condition for having fully open capital markets. In general, the skill building and training problem for banks in transitional countries is immense. I believe that governments should probably spend as much time determining how to transfer solid banking skills into domestic banks as they spend trying to determine whether to open capital markets. To date debate has probably centered a bit too much on the latter and not enough on the former. Second, with respect to transparency, the Basle Committee is now exploring the possibility of setting benchmarks for information about individual financial institutions that should be available to both supervisors and markets. More broadly, the time may be appropriate to hasten the adoption of widely accepted international accounting and disclosure principles that raise the standard for accounting treatments in all countries. These standards might focus on four key areas: (1) complete financial statements; (2) management disclosure about risk profiles, risk management practices and performance; (3) timeliness of disclosure and (4) control and audit environment. The goal would be three-fold. First, any international accounting principles should provide the basis for depicting a clear and fair picture of the condition of the bank and of corporate creditors. Second, any principles should provide a means by which firms identify and disclose their major risks, such as funding, foreign exchange or concentrations. Finally, compliance with these principles should be sufficient to support market confidence in the basic integrity of a firm's published financial statements and other disclosures. Such transparency is important because, ultimately, the market is the best regulator. However, adequate market discipline can be brought to bear only if investors have information that is sufficient in quantity, reliability and timeliness. As my colleague Susan Phillips has said: "Well-managed firms can benefit if better disclosure enables them to obtain funds at risk premiums that accurately reflect lower risk profiles. Inadequate financial disclosures, on the other hand, could penalize well-managed firms, or even countries, if market participants do not trust their ability to assess firms' or countries' fundamental financial strength." I indicated that historical experience teaches that volatile short-term capital flows, particularly those involving banks, are often at the heart of banking crises. A third policy challenge, therefore, is how to minimize the impact of these flows without attempting to limit them altogether, which is neither beneficial nor feasible. One approach advocated by many is the so-called Chilean model. This includes a system in which firms and banks that borrow funds from abroad maintain a non-interest-bearing cash reserve at the central bank for one year. The one-year term of the reserve deposit makes the requirement most onerous for short-term positions, which is of course the intent. Proponents argue that these controls encourage longer-term, more stable investments. However, there are downsides. Over time, controls can, and almost certainly will, be circumvented, which might encourage even more controls. Also controls, if successful, tend to perpetuate or create distortions and inefficiencies - including the protection of weak and poorly managed domestic financial institutions. On balance, even recognizing these potential problems, I believe that short-term capital controls may be appropriate, if they are a temporary part of an orderly entry by a small country into the global capital market. All of the above initiatives and approaches are aimed at avoiding an insolvent banking system. Nevertheless, since we know that banking accidents will happen in the global market place, what is the best solution for countries that face an insolvent banking system? The best solution to emerge from these crises and significant banking problems appears to be to remove the nonperforming loans from the bank system, even if only through government (or quasi-governmental) purchases, and then resell them to private market participants at the best prices available. To the extent that the government is involved, a number of questions arise. First, should nonperforming loans be purchased at par to help recapitalize banks? This approach has been followed in some countries, but providing such a subsidy to banks does not deal with the issue of removing excess banking capacity nor does it discourage the repetition of similar mistakes. Second, what process should be used to determine which banks need to be closed, or merged, and which can continue to operate on a recapitalized basis, probably with new owners and managers? Third, how much support should the government provide, through guarantees for example, to purchasers of nonperforming loans? Our experience in the United States indicates that the scale of such support, however structured, must be commensurate to the problem. Finally, and by no means least important, we must consider how official assistance can be structured, if at all, to minimize moral hazard. Do we understand how to achieve burden sharing with the private sector? A critical point, though, is to act decisively to restore market mechanisms and place nonperforming assets in the hands of those capable of putting them to greatest use. Allowing a serious problem to languish can be a great and costly mistake. Conclusion In conclusion, we know that the banking industry plays and will continue to play an important role in the global market place. Unfortunately, a combination of poor banking practice, weak supervision and a number of macroeconomic shocks can destabilize a banking system. The solutions might include bank supervision at the best international levels, greater transparency, and, perhaps, some interference with capital flows. When a banking system becomes insolvent, however, there is no substitute for stripping away the bad assets in order to allow banks to once again perform their special role in society. Who bears the costs and how to ensure market discipline may be the most important issues to be addressed in that solution. Unfortunately, given changes in technology and global economic forces, I am sure that we will not stop discussing the issue of banking crises. I appreciate the chance to share these thoughts with you this evening.	---[PAGE_BREAK]--- # Mr. Ferguson discusses the role of banking in the global market-place Remarks by Mr. Roger W. Ferguson, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Urban Bankers Coalition, Inc., in New York on 4/16/98. ## Are Banks Safe for the World and Is the World Safe for Banks? Thank you for your kind invitation to speak to you this evening. Your topic, banking in the global market-place, is obviously timely. Given the role of international capital flows, I expect that this is a topic that will continue to be the focus of a great deal of attention. The current crisis in Asia, which is both a banking crisis and a macroeconomic crisis, is the starting point of my talk this evening. As I considered the Asian crisis, I became curious to know whether it is a unique problem due to a unique set of circumstances, or an accident that happened in a few Asian countries this time, but could occur in other countries at almost any time. I would like to share with you the results of my inquiries. ## Banks Continue To Be Important in a Global Context The starting point of my research was to confirm the critical role banks continue to play in global finance, particularly for countries with relatively underdeveloped capital markets. For example, the Bank for International Settlements estimates that the stock of international bank loans had grown to $\$ 8.5$ trillion at the end of September 1997 - almost 30 times the level 25 years earlier. Importantly, loans to developing countries now total about $\$ 1$ trillion. While it is true that international bond and equity flows have grown during the period, new issues of bonds only exceeded bank lending 10 years ago, and the stock of outstanding loans is still considerably greater. This flow of capital has been critical in increasing the standard of living around the globe. Funds have flowed internationally from savers to borrowers, who generally tend to be entrepreneurs and others in business who need capital to build businesses and serve customers, both in their home countries and overseas. This international flow moves capital toward its most productive use, in principle, from the higher saving industrialized world to the high return, capital-short developing nations. Are there issues that should give us concern in this benign picture? Unfortunately, there are many. I would like to turn now to the question of whether banks are safe for the world economy and if the world economy is safe for banking. ## Are Banks Safe for the Global Economy? The current crisis in Asia led me to ask how many other countries have experienced banking crises, either domestic or cross-border? The answer I found may surprise you. Research done by economists of the International Monetary Fund indicates that 133 of the 181 countries who are members of the Fund, more than two-thirds, have experienced significant banking problems at some time since $1980^{1}$. Thirty-six of those instances would be described as banking "crises" in that there were runs or other portfolio shifts, collapses of financial firms, or massive government intervention. Several countries experienced multiple banking crises. Banking crises have affected developed countries, such as the United States, Sweden, France, [^0] [^0]: 1 See "Bank Soundness and Macroeconomic Policy", C. $\downarrow$ Lindgren, G. Garcia, and M.I. Saal, International Monetary Fund, 1996. ---[PAGE_BREAK]--- and Norway, as well as rapidly developing or "transitional" countries, including now Korea, Indonesia and Malaysia, but earlier Mexico, Argentina, and Chile. Banks fail for a number of reasons, including poor management, excessive risk taking, fraud and a poor operating environment. Individual bankers too often forget the fundamental tenets of banking, which are universal and apply to internationally active banks in Amsterdam as well as to community banks here in New Amsterdam. These tenets include: Know your customer; understand the legal framework in which you are working; thoroughly understand the sources of repayment and the risk of nonperformance; and price your services accordingly. We know that in Asia banks violated some of these rules. Banks often engaged in directed lending, either directed by government bureaucrats or commercial enterprises under shared ownership with the bank. Because of government intervention in the lending process, Asian banks had not developed the necessary credit risk skills, and bank supervisors were incapable of enforcing reasonable standards of behavior on the part of local banks. In the international context, the interbank lending problem that emerged in Asia arose in part because of a lack of transparency in the financial system, making it difficult for foreign bank lenders to know the quality of the ultimate credit. More importantly, however, foreign banks that funded Asian banks may have assumed an implicit government guarantee of inter-bank counter-parties because a history of supporting troubled institutions may have left that impression. What is the impact of a banking crisis? First, the financial cost of fixing an insolvent banking system is high, and that cost is ultimately borne by the taxpayer. For example, in Australia's banking crisis of 1989-1992, the IMF estimates the cost of rescuing state-owned banks to be nearly $2 \%$ of GDP. In Mexico, the overall cost of several programs to support the banking system is estimated (in present value) at $6.5 \%$ of GDP. Currently in Japan, the government has announced an intention to spend as much as 30 trillion yen, $6 \%$ of GDP, to support its banking system. For Finland, Chile, and Argentina, the IMF estimated the fiscal impact of banking crises to have been between $4 \%$ and $8 \%$ of GDP. Finally, in the United States, resolution of the S\&L crisis is estimated to have cost $\$ 150$ billion, approximately $3 \%$ of GDP in 1990. In addition to the cost imposed upon society, an unsound banking system cannot carry out its credit-creation function and can distort macroeconomic performance. Unsound banks, ones with sufficient liquidity but a high percentage of nonperforming loans and a deteriorating capital base, act on a different set of incentives than do sound banks. First, unable to declare loans in default unless they admit their own insolvency, such banks may continue to lend to nonperforming borrowers or, alternatively, capitalize unpaid - and uncollectible - interest. That is, they may act to defer recognition of their problems. At the same time, they might seek riskier investments to try to offset their problems with higher earnings. In addition, such banks may attempt to attract depositors by paying higher interest rates than their solvent competitors. A high percentage of nonperforming loans may also lead to a contraction of credit, a "credit crunch," as banks turn away sound borrowers in order to continue to support unsound ones or unduly raise underwriting standards in fear of making more weak loans. Finally, a banking system that is unsound cannot perform its role as a transmitter of monetary policy. Particularly in emerging economies, in which other financial markets are not well developed, banks transmit monetary policy by expanding or contracting their balance sheets, i.e., engaging in more or less lending. An economy which is relatively stagnant cannot easily recover using monetary policy if it is saddled with an unsound banking system, because efforts to stimulate growth by lowering interest rates may not lead to a sufficient expansion of lending. ---[PAGE_BREAK]--- In an international context with cross-border lending, the same issues may apply. Banks that are saddled with a large number of nonperforming loans from another country, either private or public debt, will have a need to work out those loans, and continue to support those borrowers rather than engage in new lending, either domestic or cross-border. Similarly, such banks are unlikely to be as efficient as they otherwise would be in transmitting the monetary policy of their home country central bank into their home country macroeconomy. So it is clear that an insolvent banking system is bad for a local, and indeed, the global economy. The costs to fix such as system can be substantial, the credit function cannot be carried out properly by such a system, and monetary policy may be hampered. # Is the Global Economy Safe for Banking? Obviously, however, the record of banking crises around the globe does not prove that banking is the source of all problems. Macroeconomic policy and the performance of policymakers also have the potential to create systemic problems. Macroeconomic conditions or policies that undergo sufficiently significant and unexpected changes impact all banks, well managed and poorly managed alike. Unfortunately, the current Asian crisis and previous bank crises, including our own, indicate that a range of macroeconomic mistakes can lead to an unsound banking system. Put another way, there are many macroeconomic roads to ruin. First, let's start with Asia. The countries currently in crisis followed traditional macroeconomic policies that in the main were sound. They avoided fiscal deficits, and in some cases ran surpluses. In addition, they avoided a general inflation in the prices of goods and services. However, notwithstanding responsible macroeconomic policies, strong increases in private spending, much of it financed by bank credit and capital inflows, turned out ex post to have been unwarranted. Much of the increased investment spending was concentrated in stocks and real estate, and asset price bubbles emerged. Moreover, exchange rates were in some cases allowed to get out of line with fundamental forces in the economy, leading to sharp increases in imports and a widening of trade deficits. To some extent this effect was a result of pegging exchange rates to the U.S. dollar, or to a basket of currencies in which the dollar had a large weight, at a time when the value of the dollar was rising against the yen. Exchange rate and capital flow problems could similarly be assigned blame in several earlier banking crises, as well. For example, in the late 1970s, the Chilean government followed a policy of rapid exchange rate appreciation, culminating in a fixed exchange rate in 1979. Credit to the private sector rose sharply as massive capital inflows followed. An international slowdown in the early 1980s resulted in a collapse in the price of copper, Chile's major export, an increase in the country's trade deficit, and a sudden reversal of its capital flows. Recession followed and banks were left with unserviceable, foreign-currency-denominated debts. However, exchange rate problems are only one type of macroeconomic concern. Other countries, such as Finland, Sweden and Norway, experienced banking crises following explosions in central bank credit and bubbles in asset prices or in credit creation by banks. Fiscal and monetary policy, and the need to reverse policy unexpectedly, can also lead to banking crises if bubbles arise in asset markets and banks are heavily exposed to assets with inflated values through their lending practices or balance sheets. ---[PAGE_BREAK]--- Other countries, particularly those that rely heavily on a single international commodity export, such as oil, have experienced banking crises following rapid adjustment in the prices for those commodities. Often in these cases, the government attempts to use fiscal or monetary stimulus to offset the loss of standard of living that results from a decline in commodity prices. This policy generally only succeeds in inducing a cycle of strong inflation, perhaps accompanied by pressures on exchange rates, followed by a steep correction. Finally, here in the United States, the S\&L crisis was due in part to deregulation of interest rates on deposits, that left S\&Ls with low returns on assets but a high cost of funds. In a scramble for new sources of revenues and an effort to generate earnings, S\&Ls took on greater and greater risk. # Potential Solutions Given this history of banking crises throughout the world - some the result of poor banking practices, some tied to the rapid ebb and flow of cross-border capital, and some due to internal macroeconomic policies - what should one recommend? I would like to focus on three sets of solutions designed to minimize the risk of future cross-border banking crises: (1) improvements in supervision and basic banking skills; (2) international transparency, including sound accounting standards; and (3) ways to avoid potential problems in capital flows. This analysis also points to a responsible policy for countries faced with unsound banking systems. First, with respect to banking supervision, the faster pace and increasing complexity of financial services mean that banking supervision has had to change its methods to rely more heavily on market forces as a means of regulating banks. For example, the Federal Reserve has become more focused on how individual institutions, including community banks, manage the risks of banking. In the international arena, the Federal Reserve is working with the Basle Committee on Banking Supervision, which was established by the central banks of the major industrial countries, to increase outreach to emerging-market countries. The Basle Committee has recently published a set of core principles for effective banking supervision. The implementation of these core principles should aid many countries in making their supervision more effective. I believe that adopting these principles, or something like them, is an important first step as countries move to participate more actively in global financial markets. The time is probably near when we have to determine how to encourage more countries to adopt and fully comply with these principles, or their equivalents. The world should not be subject to weak bank supervision in any country. Having sound banking practices may also be a necessary condition for having fully open capital markets. In general, the skill building and training problem for banks in transitional countries is immense. I believe that governments should probably spend as much time determining how to transfer solid banking skills into domestic banks as they spend trying to determine whether to open capital markets. To date debate has probably centered a bit too much on the latter and not enough on the former. Second, with respect to transparency, the Basle Committee is now exploring the possibility of setting benchmarks for information about individual financial institutions that should be available to both supervisors and markets. ---[PAGE_BREAK]--- More broadly, the time may be appropriate to hasten the adoption of widely accepted international accounting and disclosure principles that raise the standard for accounting treatments in all countries. These standards might focus on four key areas: (1) complete financial statements; (2) management disclosure about risk profiles, risk management practices and performance; (3) timeliness of disclosure and (4) control and audit environment. The goal would be three-fold. First, any international accounting principles should provide the basis for depicting a clear and fair picture of the condition of the bank and of corporate creditors. Second, any principles should provide a means by which firms identify and disclose their major risks, such as funding, foreign exchange or concentrations. Finally, compliance with these principles should be sufficient to support market confidence in the basic integrity of a firm's published financial statements and other disclosures. Such transparency is important because, ultimately, the market is the best regulator. However, adequate market discipline can be brought to bear only if investors have information that is sufficient in quantity, reliability and timeliness. As my colleague Susan Phillips has said: "Well-managed firms can benefit if better disclosure enables them to obtain funds at risk premiums that accurately reflect lower risk profiles. Inadequate financial disclosures, on the other hand, could penalize well-managed firms, or even countries, if market participants do not trust their ability to assess firms' or countries' fundamental financial strength." I indicated that historical experience teaches that volatile short-term capital flows, particularly those involving banks, are often at the heart of banking crises. A third policy challenge, therefore, is how to minimize the impact of these flows without attempting to limit them altogether, which is neither beneficial nor feasible. One approach advocated by many is the so-called Chilean model. This includes a system in which firms and banks that borrow funds from abroad maintain a non-interest-bearing cash reserve at the central bank for one year. The one-year term of the reserve deposit makes the requirement most onerous for short-term positions, which is of course the intent. Proponents argue that these controls encourage longer-term, more stable investments. However, there are downsides. Over time, controls can, and almost certainly will, be circumvented, which might encourage even more controls. Also controls, if successful, tend to perpetuate or create distortions and inefficiencies - including the protection of weak and poorly managed domestic financial institutions. On balance, even recognizing these potential problems, I believe that short-term capital controls may be appropriate, if they are a temporary part of an orderly entry by a small country into the global capital market. All of the above initiatives and approaches are aimed at avoiding an insolvent banking system. Nevertheless, since we know that banking accidents will happen in the global market place, what is the best solution for countries that face an insolvent banking system? The best solution to emerge from these crises and significant banking problems appears to be to remove the nonperforming loans from the bank system, even if only through government (or quasi-governmental) purchases, and then resell them to private market participants at the best prices available. To the extent that the government is involved, a number of questions arise. First, should nonperforming loans be purchased at par to help recapitalize banks? This approach has been followed in some countries, but providing such a subsidy to banks does not deal with the issue of removing excess banking capacity nor does it discourage the repetition of similar mistakes. Second, what process should be used to determine which banks need to be closed, or merged, and which can continue to operate on a recapitalized basis, probably with new owners and managers? Third, how much support should the government provide, through guarantees for example, to purchasers of nonperforming loans? Our experience in the United States indicates ---[PAGE_BREAK]--- that the scale of such support, however structured, must be commensurate to the problem. Finally, and by no means least important, we must consider how official assistance can be structured, if at all, to minimize moral hazard. Do we understand how to achieve burden sharing with the private sector? A critical point, though, is to act decisively to restore market mechanisms and place nonperforming assets in the hands of those capable of putting them to greatest use. Allowing a serious problem to languish can be a great and costly mistake. # Conclusion In conclusion, we know that the banking industry plays and will continue to play an important role in the global market place. Unfortunately, a combination of poor banking practice, weak supervision and a number of macroeconomic shocks can destabilize a banking system. The solutions might include bank supervision at the best international levels, greater transparency, and, perhaps, some interference with capital flows. When a banking system becomes insolvent, however, there is no substitute for stripping away the bad assets in order to allow banks to once again perform their special role in society. Who bears the costs and how to ensure market discipline may be the most important issues to be addressed in that solution. Unfortunately, given changes in technology and global economic forces, I am sure that we will not stop discussing the issue of banking crises. I appreciate the chance to share these thoughts with you this evening.	Roger W Ferguson	United States	https://www.bis.org/review/r980518c.pdf	Remarks by Mr. Roger W. Ferguson, Jr., a member of the Board of Governors of the US Federal Reserve System, before the Urban Bankers Coalition, Inc., in New York on 4/16/98. Thank you for your kind invitation to speak to you this evening. Your topic, banking in the global market-place, is obviously timely. Given the role of international capital flows, I expect that this is a topic that will continue to be the focus of a great deal of attention. The current crisis in Asia, which is both a banking crisis and a macroeconomic crisis, is the starting point of my talk this evening. As I considered the Asian crisis, I became curious to know whether it is a unique problem due to a unique set of circumstances, or an accident that happened in a few Asian countries this time, but could occur in other countries at almost any time. I would like to share with you the results of my inquiries. The starting point of my research was to confirm the critical role banks continue to play in global finance, particularly for countries with relatively underdeveloped capital markets. For example, the Bank for International Settlements estimates that the stock of international bank loans had grown to $\$ 8.5$ trillion at the end of September 1997 - almost 30 times the level 25 years earlier. Importantly, loans to developing countries now total about $\$ 1$ trillion. While it is true that international bond and equity flows have grown during the period, new issues of bonds only exceeded bank lending 10 years ago, and the stock of outstanding loans is still considerably greater. This flow of capital has been critical in increasing the standard of living around the globe. Funds have flowed internationally from savers to borrowers, who generally tend to be entrepreneurs and others in business who need capital to build businesses and serve customers, both in their home countries and overseas. This international flow moves capital toward its most productive use, in principle, from the higher saving industrialized world to the high return, capital-short developing nations. Are there issues that should give us concern in this benign picture? Unfortunately, there are many. I would like to turn now to the question of whether banks are safe for the world economy and if the world economy is safe for banking. The current crisis in Asia led me to ask how many other countries have experienced banking crises, either domestic or cross-border? The answer I found may surprise you. Research done by economists of the International Monetary Fund indicates that 133 of the 181 countries who are members of the Fund, more than two-thirds, have experienced significant banking problems at some time since $1980^{1}$. Thirty-six of those instances would be described as banking "crises" in that there were runs or other portfolio shifts, collapses of financial firms, or massive government intervention. Several countries experienced multiple banking crises. Banking crises have affected developed countries, such as the United States, Sweden, France, and Norway, as well as rapidly developing or "transitional" countries, including now Korea, Indonesia and Malaysia, but earlier Mexico, Argentina, and Chile. Banks fail for a number of reasons, including poor management, excessive risk taking, fraud and a poor operating environment. Individual bankers too often forget the fundamental tenets of banking, which are universal and apply to internationally active banks in Amsterdam as well as to community banks here in New Amsterdam. These tenets include: Know your customer; understand the legal framework in which you are working; thoroughly understand the sources of repayment and the risk of nonperformance; and price your services accordingly. We know that in Asia banks violated some of these rules. Banks often engaged in directed lending, either directed by government bureaucrats or commercial enterprises under shared ownership with the bank. Because of government intervention in the lending process, Asian banks had not developed the necessary credit risk skills, and bank supervisors were incapable of enforcing reasonable standards of behavior on the part of local banks. In the international context, the interbank lending problem that emerged in Asia arose in part because of a lack of transparency in the financial system, making it difficult for foreign bank lenders to know the quality of the ultimate credit. More importantly, however, foreign banks that funded Asian banks may have assumed an implicit government guarantee of inter-bank counter-parties because a history of supporting troubled institutions may have left that impression. What is the impact of a banking crisis? First, the financial cost of fixing an insolvent banking system is high, and that cost is ultimately borne by the taxpayer. For example, in Australia's banking crisis of 1989-1992, the IMF estimates the cost of rescuing state-owned banks to be nearly $2 \%$ of GDP. In Mexico, the overall cost of several programs to support the banking system is estimated (in present value) at $6.5 \%$ of GDP. Currently in Japan, the government has announced an intention to spend as much as 30 trillion yen, $6 \%$ of GDP, to support its banking system. For Finland, Chile, and Argentina, the IMF estimated the fiscal impact of banking crises to have been between $4 \%$ and $8 \%$ of GDP. Finally, in the United States, resolution of the S\&L crisis is estimated to have cost $\$ 150$ billion, approximately $3 \%$ of GDP in 1990. In addition to the cost imposed upon society, an unsound banking system cannot carry out its credit-creation function and can distort macroeconomic performance. Unsound banks, ones with sufficient liquidity but a high percentage of nonperforming loans and a deteriorating capital base, act on a different set of incentives than do sound banks. First, unable to declare loans in default unless they admit their own insolvency, such banks may continue to lend to nonperforming borrowers or, alternatively, capitalize unpaid - and uncollectible - interest. That is, they may act to defer recognition of their problems. At the same time, they might seek riskier investments to try to offset their problems with higher earnings. In addition, such banks may attempt to attract depositors by paying higher interest rates than their solvent competitors. A high percentage of nonperforming loans may also lead to a contraction of credit, a "credit crunch," as banks turn away sound borrowers in order to continue to support unsound ones or unduly raise underwriting standards in fear of making more weak loans. Finally, a banking system that is unsound cannot perform its role as a transmitter of monetary policy. Particularly in emerging economies, in which other financial markets are not well developed, banks transmit monetary policy by expanding or contracting their balance sheets, i.e., engaging in more or less lending. An economy which is relatively stagnant cannot easily recover using monetary policy if it is saddled with an unsound banking system, because efforts to stimulate growth by lowering interest rates may not lead to a sufficient expansion of lending. In an international context with cross-border lending, the same issues may apply. Banks that are saddled with a large number of nonperforming loans from another country, either private or public debt, will have a need to work out those loans, and continue to support those borrowers rather than engage in new lending, either domestic or cross-border. Similarly, such banks are unlikely to be as efficient as they otherwise would be in transmitting the monetary policy of their home country central bank into their home country macroeconomy. So it is clear that an insolvent banking system is bad for a local, and indeed, the global economy. The costs to fix such as system can be substantial, the credit function cannot be carried out properly by such a system, and monetary policy may be hampered. Obviously, however, the record of banking crises around the globe does not prove that banking is the source of all problems. Macroeconomic policy and the performance of policymakers also have the potential to create systemic problems. Macroeconomic conditions or policies that undergo sufficiently significant and unexpected changes impact all banks, well managed and poorly managed alike. Unfortunately, the current Asian crisis and previous bank crises, including our own, indicate that a range of macroeconomic mistakes can lead to an unsound banking system. Put another way, there are many macroeconomic roads to ruin. First, let's start with Asia. The countries currently in crisis followed traditional macroeconomic policies that in the main were sound. They avoided fiscal deficits, and in some cases ran surpluses. In addition, they avoided a general inflation in the prices of goods and services. However, notwithstanding responsible macroeconomic policies, strong increases in private spending, much of it financed by bank credit and capital inflows, turned out ex post to have been unwarranted. Much of the increased investment spending was concentrated in stocks and real estate, and asset price bubbles emerged. Moreover, exchange rates were in some cases allowed to get out of line with fundamental forces in the economy, leading to sharp increases in imports and a widening of trade deficits. To some extent this effect was a result of pegging exchange rates to the U.S. dollar, or to a basket of currencies in which the dollar had a large weight, at a time when the value of the dollar was rising against the yen. Exchange rate and capital flow problems could similarly be assigned blame in several earlier banking crises, as well. For example, in the late 1970s, the Chilean government followed a policy of rapid exchange rate appreciation, culminating in a fixed exchange rate in 1979. Credit to the private sector rose sharply as massive capital inflows followed. An international slowdown in the early 1980s resulted in a collapse in the price of copper, Chile's major export, an increase in the country's trade deficit, and a sudden reversal of its capital flows. Recession followed and banks were left with unserviceable, foreign-currency-denominated debts. However, exchange rate problems are only one type of macroeconomic concern. Other countries, such as Finland, Sweden and Norway, experienced banking crises following explosions in central bank credit and bubbles in asset prices or in credit creation by banks. Fiscal and monetary policy, and the need to reverse policy unexpectedly, can also lead to banking crises if bubbles arise in asset markets and banks are heavily exposed to assets with inflated values through their lending practices or balance sheets. Other countries, particularly those that rely heavily on a single international commodity export, such as oil, have experienced banking crises following rapid adjustment in the prices for those commodities. Often in these cases, the government attempts to use fiscal or monetary stimulus to offset the loss of standard of living that results from a decline in commodity prices. This policy generally only succeeds in inducing a cycle of strong inflation, perhaps accompanied by pressures on exchange rates, followed by a steep correction. Finally, here in the United States, the S\&L crisis was due in part to deregulation of interest rates on deposits, that left S\&Ls with low returns on assets but a high cost of funds. In a scramble for new sources of revenues and an effort to generate earnings, S\&Ls took on greater and greater risk. Given this history of banking crises throughout the world - some the result of poor banking practices, some tied to the rapid ebb and flow of cross-border capital, and some due to internal macroeconomic policies - what should one recommend? I would like to focus on three sets of solutions designed to minimize the risk of future cross-border banking crises: (1) improvements in supervision and basic banking skills; (2) international transparency, including sound accounting standards; and (3) ways to avoid potential problems in capital flows. This analysis also points to a responsible policy for countries faced with unsound banking systems. First, with respect to banking supervision, the faster pace and increasing complexity of financial services mean that banking supervision has had to change its methods to rely more heavily on market forces as a means of regulating banks. For example, the Federal Reserve has become more focused on how individual institutions, including community banks, manage the risks of banking. In the international arena, the Federal Reserve is working with the Basle Committee on Banking Supervision, which was established by the central banks of the major industrial countries, to increase outreach to emerging-market countries. The Basle Committee has recently published a set of core principles for effective banking supervision. The implementation of these core principles should aid many countries in making their supervision more effective. I believe that adopting these principles, or something like them, is an important first step as countries move to participate more actively in global financial markets. The time is probably near when we have to determine how to encourage more countries to adopt and fully comply with these principles, or their equivalents. The world should not be subject to weak bank supervision in any country. Having sound banking practices may also be a necessary condition for having fully open capital markets. In general, the skill building and training problem for banks in transitional countries is immense. I believe that governments should probably spend as much time determining how to transfer solid banking skills into domestic banks as they spend trying to determine whether to open capital markets. To date debate has probably centered a bit too much on the latter and not enough on the former. Second, with respect to transparency, the Basle Committee is now exploring the possibility of setting benchmarks for information about individual financial institutions that should be available to both supervisors and markets. More broadly, the time may be appropriate to hasten the adoption of widely accepted international accounting and disclosure principles that raise the standard for accounting treatments in all countries. These standards might focus on four key areas: (1) complete financial statements; (2) management disclosure about risk profiles, risk management practices and performance; (3) timeliness of disclosure and (4) control and audit environment. The goal would be three-fold. First, any international accounting principles should provide the basis for depicting a clear and fair picture of the condition of the bank and of corporate creditors. Second, any principles should provide a means by which firms identify and disclose their major risks, such as funding, foreign exchange or concentrations. Finally, compliance with these principles should be sufficient to support market confidence in the basic integrity of a firm's published financial statements and other disclosures. Such transparency is important because, ultimately, the market is the best regulator. However, adequate market discipline can be brought to bear only if investors have information that is sufficient in quantity, reliability and timeliness. As my colleague Susan Phillips has said: "Well-managed firms can benefit if better disclosure enables them to obtain funds at risk premiums that accurately reflect lower risk profiles. Inadequate financial disclosures, on the other hand, could penalize well-managed firms, or even countries, if market participants do not trust their ability to assess firms' or countries' fundamental financial strength." I indicated that historical experience teaches that volatile short-term capital flows, particularly those involving banks, are often at the heart of banking crises. A third policy challenge, therefore, is how to minimize the impact of these flows without attempting to limit them altogether, which is neither beneficial nor feasible. One approach advocated by many is the so-called Chilean model. This includes a system in which firms and banks that borrow funds from abroad maintain a non-interest-bearing cash reserve at the central bank for one year. The one-year term of the reserve deposit makes the requirement most onerous for short-term positions, which is of course the intent. Proponents argue that these controls encourage longer-term, more stable investments. However, there are downsides. Over time, controls can, and almost certainly will, be circumvented, which might encourage even more controls. Also controls, if successful, tend to perpetuate or create distortions and inefficiencies - including the protection of weak and poorly managed domestic financial institutions. On balance, even recognizing these potential problems, I believe that short-term capital controls may be appropriate, if they are a temporary part of an orderly entry by a small country into the global capital market. All of the above initiatives and approaches are aimed at avoiding an insolvent banking system. Nevertheless, since we know that banking accidents will happen in the global market place, what is the best solution for countries that face an insolvent banking system? The best solution to emerge from these crises and significant banking problems appears to be to remove the nonperforming loans from the bank system, even if only through government (or quasi-governmental) purchases, and then resell them to private market participants at the best prices available. To the extent that the government is involved, a number of questions arise. First, should nonperforming loans be purchased at par to help recapitalize banks? This approach has been followed in some countries, but providing such a subsidy to banks does not deal with the issue of removing excess banking capacity nor does it discourage the repetition of similar mistakes. Second, what process should be used to determine which banks need to be closed, or merged, and which can continue to operate on a recapitalized basis, probably with new owners and managers? Third, how much support should the government provide, through guarantees for example, to purchasers of nonperforming loans? Our experience in the United States indicates that the scale of such support, however structured, must be commensurate to the problem. Finally, and by no means least important, we must consider how official assistance can be structured, if at all, to minimize moral hazard. Do we understand how to achieve burden sharing with the private sector? A critical point, though, is to act decisively to restore market mechanisms and place nonperforming assets in the hands of those capable of putting them to greatest use. Allowing a serious problem to languish can be a great and costly mistake. In conclusion, we know that the banking industry plays and will continue to play an important role in the global market place. Unfortunately, a combination of poor banking practice, weak supervision and a number of macroeconomic shocks can destabilize a banking system. The solutions might include bank supervision at the best international levels, greater transparency, and, perhaps, some interference with capital flows. When a banking system becomes insolvent, however, there is no substitute for stripping away the bad assets in order to allow banks to once again perform their special role in society. Who bears the costs and how to ensure market discipline may be the most important issues to be addressed in that solution. Unfortunately, given changes in technology and global economic forces, I am sure that we will not stop discussing the issue of banking crises. I appreciate the chance to share these thoughts with you this evening.
1998-05-21T00:00:00	Mr. Greenspan gives a testimony on the global financial system and the role of the IMF in the Asian crisis (Central Bank Articles and Speeches, 21 May 98)	Testimony of the Chairman of the Board of Governors of the US Federal Reserve, Mr. Alan Greenspan, before the Committee on Agriculture of the US House of Representatives on 21/5/98.	Mr. Greenspan gives a testimony on the global financial system and the role of Testimony of the Chairman of the Board of Governors of the US the IMF in the Asian crisis Federal Reserve, Mr. Alan Greenspan, before the Committee on Agriculture of the US House of Representatives on 21/5/98. The global financial system has been evolving rapidly in recent years. New technology has radically reduced the costs of borrowing and lending across traditional national borders, facilitating the development of new instruments and drawing in new players. Information is transmitted instantaneously around the world, and huge shifts in the supply and demand for funds naturally follow, resulting in a massive increase in capital flows. This burgeoning global system has been demonstrated to be a highly efficient structure that has significantly facilitated cross-border trade in goods and services and, accordingly, has made a substantial contribution to standards of living worldwide. Its efficiency exposes and punishes underlying economic imprudence swiftly and decisively. Regrettably, it also appears to have facilitated the transmission of financial disturbances far more effectively than ever before. Three years ago, the Mexican crisis was the first episode associated with our new high-tech international financial system. The current Asian crisis is the second. We do not as yet fully understand the new system's dynamics. We are learning fast, and need to update and modify our institutions and practices to reduce the risks inherent in the new regime. Meanwhile, we have had to confront the current crisis with the institutions and techniques we have. Many argued that the Asian crisis should be allowed to run its course without support from the International Monetary Fund or the bilateral financial backing of other nations. They asserted that allowing this crisis to play out, while doubtless having additional negative effects on growth in Asia, and engendering greater spill-overs onto the rest of the world, would not likely have a large or lasting impact on the United States and the world economy. They may well have been correct in their judgment, and some would argue that events over the past six months have proved them right; we have so far avoided the type of continuing downward spiral that some feared. There was and is, however, a small but not negligible probability that the upset in East Asia could have unexpectedly large negative effects on Japan, Latin America, and eastern and central Europe that, in turn, could have repercussions elsewhere, including the United States. Thus, while the probability of such an outcome may be small, its consequences, in my judgment, should not have been left solely to chance. We have observed that global financial markets, as currently organized, do not always achieve an appropriate equilibrium, or at least require time to stabilize. Moreover, the effects of the Asian crisis on the real economies of the immediately affected countries, as well as on our own economy, are only now just being felt. Opponents of IMF support for member countries facing international financial difficulties also argued that such substantial financial backing, by cushioning the losses of imprudent investors, encourages excessive risk-taking. There doubtless is some truth in that, though arguably it has been the expectation of governments' support of their financial systems that has been the more obvious culprit, at least in the Asian case. In any event, any expectations of broad bailouts have turned out to have been disappointed. Many if not most investors in Asian economies have to date suffered substantial losses. Moreover, the policy conditionality, associated principally with IMF lending, which dictates economic and financial discipline and structural change, helps to mitigate some of the inappropriate risk-taking on the part of governmental authorities. At the root of the problems has been poor public policy that has resulted in misguided investments and very weak financial sectors. Convincing a sovereign nation to alter destructive policies that impair its own performance and threaten contagion to its neighbors is best handled by an international financial institution, such as the IMF. What we have in place today to respond to crises should be supported even as we work to improve those mechanisms and institutions. Some observers have also expressed concern about whether we can be confident that IMF programs for countries, in particular the countries of East Asia, are likely to alter their economies significantly and permanently. My sense is that one consequence of this Asian crisis is an increasing awareness in the region that market capitalism, as practiced in the West, especially in the United States, is the superior model; that is, it provides greater promise of producing rising standards of living and continuous growth. Although East Asian economies have exhibited considerable adherence to many aspects of free-market capitalism, there has, nonetheless, been a pronounced tendency toward government-directed investment, using the banking system to finance that investment. Given a record of real growth rates of close to 10 percent per annum over an extended period of time, it is not surprising that it has been difficult to convince anyone that the economic system practiced in East Asia could not continue to produce positive results indefinitely. Following the breakdown, an increasing awareness, bordering in some cases on shock, that their economic model was incomplete, or worse, has arguably emerged in the region. As a consequence, many of the leaders of these countries and their economic advisors are endeavoring to move their economies much more rapidly toward the type of economic system that we have in the United States. The IMF, whatever one might say about its policy advice in the past, has played an important role in this process, providing advice and incentives that promote sound money and long-term stability. The IMF's current approach in Asia is fully supportive of the views of those in the West who understand the importance of greater reliance on market forces, reduced government controls, scaling back of government-directed investment, and embracing greater transparency -- the publication of all the data that are relevant to the activities of the central bank, the government, financial institutions, and private companies. It is a reasonable question to ask how long this conversion to embracing market capitalism in all its details will last in countries once temporary IMF financial support has come to an end. We are, after all, dealing with sovereign nations with long traditions, not always consonant with market capitalism. But my sense is that there is a growing understanding and appreciation of the benefits of market capitalism as we practice it, and that what is being prescribed in IMF-supported programs fosters their own interests. Similarly, it is a reasonable question to ask whether the US authorities should not seek greater assurance that the ongoing process of reform in the IMF's policies and operations will produce additional concrete results before we agree to augment the IMF's resources. I have reason to believe that the management and staff of the IMF are committed to a process of change. We face a somewhat more difficult task in convincing the IMF's membership as a whole of the need for change. However, I am confident that our leverage in this regard would be reduced if the United States failed to agree promptly to the proposed increases in the IMF's resources. Accordingly, I continue fully to back the Administration's request to augment the financial resources of the IMF by approving as quickly as possible US participation in the New Arrangements to Borrow and an increase in the US quota in the IMF. Hopefully, neither will turn out to be needed, and no funds will be drawn. Although the tendency in recent months toward stabilization in the East Asian economies is encouraging, clearly those economies are not out of the woods as recent events attest. Moreover, we have not yet put in place the strengthening of the international financial architecture that would enable us in the future to place less reliance on the IMF to deal with potential systemic crises. Thus it is better to have the IMF fully equipped if a quick response to a pending crisis is essential.	---[PAGE_BREAK]--- # Mr. Greenspan gives a testimony on the global financial system and the role of the IMF in the Asian crisis Testimony of the Chairman of the Board of Governors of the US Federal Reserve, Mr. Alan Greenspan, before the Committee on Agriculture of the US House of Representatives on 21/5/98. The global financial system has been evolving rapidly in recent years. New technology has radically reduced the costs of borrowing and lending across traditional national borders, facilitating the development of new instruments and drawing in new players. Information is transmitted instantaneously around the world, and huge shifts in the supply and demand for funds naturally follow, resulting in a massive increase in capital flows. This burgeoning global system has been demonstrated to be a highly efficient structure that has significantly facilitated cross-border trade in goods and services and, accordingly, has made a substantial contribution to standards of living worldwide. Its efficiency exposes and punishes underlying economic imprudence swiftly and decisively. Regrettably, it also appears to have facilitated the transmission of financial disturbances far more effectively than ever before. Three years ago, the Mexican crisis was the first episode associated with our new high-tech international financial system. The current Asian crisis is the second. We do not as yet fully understand the new system's dynamics. We are learning fast, and need to update and modify our institutions and practices to reduce the risks inherent in the new regime. Meanwhile, we have had to confront the current crisis with the institutions and techniques we have. Many argued that the Asian crisis should be allowed to run its course without support from the International Monetary Fund or the bilateral financial backing of other nations. They asserted that allowing this crisis to play out, while doubtless having additional negative effects on growth in Asia, and engendering greater spill-overs onto the rest of the world, would not likely have a large or lasting impact on the United States and the world economy. They may well have been correct in their judgment, and some would argue that events over the past six months have proved them right; we have so far avoided the type of continuing downward spiral that some feared. There was and is, however, a small but not negligible probability that the upset in East Asia could have unexpectedly large negative effects on Japan, Latin America, and eastern and central Europe that, in turn, could have repercussions elsewhere, including the United States. Thus, while the probability of such an outcome may be small, its consequences, in my judgment, should not have been left solely to chance. We have observed that global financial markets, as currently organized, do not always achieve an appropriate equilibrium, or at least require time to stabilize. Moreover, the effects of the Asian crisis on the real economies of the immediately affected countries, as well as on our own economy, are only now just being felt. Opponents of IMF support for member countries facing international financial difficulties also argued that such substantial financial backing, by cushioning the losses of imprudent investors, encourages excessive risk-taking. There doubtless is some truth in that, though arguably it has been the expectation of governments' support of their financial systems that has been the more obvious culprit, at least in the Asian case. In any event, any expectations of broad bailouts have turned out to have been disappointed. Many if not most investors in Asian economies have to date suffered substantial losses. Moreover, the policy conditionality, associated principally with IMF lending, which dictates economic and financial discipline and structural change, helps to mitigate some of the ---[PAGE_BREAK]--- inappropriate risk-taking on the part of governmental authorities. At the root of the problems has been poor public policy that has resulted in misguided investments and very weak financial sectors. Convincing a sovereign nation to alter destructive policies that impair its own performance and threaten contagion to its neighbors is best handled by an international financial institution, such as the IMF. What we have in place today to respond to crises should be supported even as we work to improve those mechanisms and institutions. Some observers have also expressed concern about whether we can be confident that IMF programs for countries, in particular the countries of East Asia, are likely to alter their economies significantly and permanently. My sense is that one consequence of this Asian crisis is an increasing awareness in the region that market capitalism, as practiced in the West, especially in the United States, is the superior model; that is, it provides greater promise of producing rising standards of living and continuous growth. Although East Asian economies have exhibited considerable adherence to many aspects of free-market capitalism, there has, nonetheless, been a pronounced tendency toward government-directed investment, using the banking system to finance that investment. Given a record of real growth rates of close to 10 percent per annum over an extended period of time, it is not surprising that it has been difficult to convince anyone that the economic system practiced in East Asia could not continue to produce positive results indefinitely. Following the breakdown, an increasing awareness, bordering in some cases on shock, that their economic model was incomplete, or worse, has arguably emerged in the region. As a consequence, many of the leaders of these countries and their economic advisors are endeavoring to move their economies much more rapidly toward the type of economic system that we have in the United States. The IMF, whatever one might say about its policy advice in the past, has played an important role in this process, providing advice and incentives that promote sound money and long-term stability. The IMF's current approach in Asia is fully supportive of the views of those in the West who understand the importance of greater reliance on market forces, reduced government controls, scaling back of government-directed investment, and embracing greater transparency -- the publication of all the data that are relevant to the activities of the central bank, the government, financial institutions, and private companies. It is a reasonable question to ask how long this conversion to embracing market capitalism in all its details will last in countries once temporary IMF financial support has come to an end. We are, after all, dealing with sovereign nations with long traditions, not always consonant with market capitalism. But my sense is that there is a growing understanding and appreciation of the benefits of market capitalism as we practice it, and that what is being prescribed in IMF-supported programs fosters their own interests. Similarly, it is a reasonable question to ask whether the US authorities should not seek greater assurance that the ongoing process of reform in the IMF's policies and operations will produce additional concrete results before we agree to augment the IMF's resources. I have reason to believe that the management and staff of the IMF are committed to a process of change. We face a somewhat more difficult task in convincing the IMF's membership as a whole of the need for change. However, I am confident that our leverage in this regard would be reduced if the United States failed to agree promptly to the proposed increases in the IMF's resources. Accordingly, I continue fully to back the Administration's request to augment the financial resources of the IMF by approving as quickly as possible US participation in the New Arrangements to Borrow and an increase in the US quota in the IMF. Hopefully, neither will turn out to be needed, and no funds will be drawn. Although the tendency in recent months toward stabilization in the East Asian economies is encouraging, clearly those economies are not out of the woods as recent events attest. Moreover, we have not yet put in place the strengthening of the ---[PAGE_BREAK]--- international financial architecture that would enable us in the future to place less reliance on the IMF to deal with potential systemic crises. Thus it is better to have the IMF fully equipped if a quick response to a pending crisis is essential.	Alan Greenspan	United States	https://www.bis.org/review/r980603c.pdf	the IMF in the Asian crisis Testimony of the Chairman of the Board of Governors of the US Federal Reserve, Mr. Alan Greenspan, before the Committee on Agriculture of the US House of Representatives on 21/5/98. The global financial system has been evolving rapidly in recent years. New technology has radically reduced the costs of borrowing and lending across traditional national borders, facilitating the development of new instruments and drawing in new players. Information is transmitted instantaneously around the world, and huge shifts in the supply and demand for funds naturally follow, resulting in a massive increase in capital flows. This burgeoning global system has been demonstrated to be a highly efficient structure that has significantly facilitated cross-border trade in goods and services and, accordingly, has made a substantial contribution to standards of living worldwide. Its efficiency exposes and punishes underlying economic imprudence swiftly and decisively. Regrettably, it also appears to have facilitated the transmission of financial disturbances far more effectively than ever before. Three years ago, the Mexican crisis was the first episode associated with our new high-tech international financial system. The current Asian crisis is the second. We do not as yet fully understand the new system's dynamics. We are learning fast, and need to update and modify our institutions and practices to reduce the risks inherent in the new regime. Meanwhile, we have had to confront the current crisis with the institutions and techniques we have. Many argued that the Asian crisis should be allowed to run its course without support from the International Monetary Fund or the bilateral financial backing of other nations. They asserted that allowing this crisis to play out, while doubtless having additional negative effects on growth in Asia, and engendering greater spill-overs onto the rest of the world, would not likely have a large or lasting impact on the United States and the world economy. They may well have been correct in their judgment, and some would argue that events over the past six months have proved them right; we have so far avoided the type of continuing downward spiral that some feared. There was and is, however, a small but not negligible probability that the upset in East Asia could have unexpectedly large negative effects on Japan, Latin America, and eastern and central Europe that, in turn, could have repercussions elsewhere, including the United States. Thus, while the probability of such an outcome may be small, its consequences, in my judgment, should not have been left solely to chance. We have observed that global financial markets, as currently organized, do not always achieve an appropriate equilibrium, or at least require time to stabilize. Moreover, the effects of the Asian crisis on the real economies of the immediately affected countries, as well as on our own economy, are only now just being felt. Opponents of IMF support for member countries facing international financial difficulties also argued that such substantial financial backing, by cushioning the losses of imprudent investors, encourages excessive risk-taking. There doubtless is some truth in that, though arguably it has been the expectation of governments' support of their financial systems that has been the more obvious culprit, at least in the Asian case. In any event, any expectations of broad bailouts have turned out to have been disappointed. Many if not most investors in Asian economies have to date suffered substantial losses. Moreover, the policy conditionality, associated principally with IMF lending, which dictates economic and financial discipline and structural change, helps to mitigate some of the inappropriate risk-taking on the part of governmental authorities. At the root of the problems has been poor public policy that has resulted in misguided investments and very weak financial sectors. Convincing a sovereign nation to alter destructive policies that impair its own performance and threaten contagion to its neighbors is best handled by an international financial institution, such as the IMF. What we have in place today to respond to crises should be supported even as we work to improve those mechanisms and institutions. Some observers have also expressed concern about whether we can be confident that IMF programs for countries, in particular the countries of East Asia, are likely to alter their economies significantly and permanently. My sense is that one consequence of this Asian crisis is an increasing awareness in the region that market capitalism, as practiced in the West, especially in the United States, is the superior model; that is, it provides greater promise of producing rising standards of living and continuous growth. Although East Asian economies have exhibited considerable adherence to many aspects of free-market capitalism, there has, nonetheless, been a pronounced tendency toward government-directed investment, using the banking system to finance that investment. Given a record of real growth rates of close to 10 percent per annum over an extended period of time, it is not surprising that it has been difficult to convince anyone that the economic system practiced in East Asia could not continue to produce positive results indefinitely. Following the breakdown, an increasing awareness, bordering in some cases on shock, that their economic model was incomplete, or worse, has arguably emerged in the region. As a consequence, many of the leaders of these countries and their economic advisors are endeavoring to move their economies much more rapidly toward the type of economic system that we have in the United States. The IMF, whatever one might say about its policy advice in the past, has played an important role in this process, providing advice and incentives that promote sound money and long-term stability. The IMF's current approach in Asia is fully supportive of the views of those in the West who understand the importance of greater reliance on market forces, reduced government controls, scaling back of government-directed investment, and embracing greater transparency -- the publication of all the data that are relevant to the activities of the central bank, the government, financial institutions, and private companies. It is a reasonable question to ask how long this conversion to embracing market capitalism in all its details will last in countries once temporary IMF financial support has come to an end. We are, after all, dealing with sovereign nations with long traditions, not always consonant with market capitalism. But my sense is that there is a growing understanding and appreciation of the benefits of market capitalism as we practice it, and that what is being prescribed in IMF-supported programs fosters their own interests. Similarly, it is a reasonable question to ask whether the US authorities should not seek greater assurance that the ongoing process of reform in the IMF's policies and operations will produce additional concrete results before we agree to augment the IMF's resources. I have reason to believe that the management and staff of the IMF are committed to a process of change. We face a somewhat more difficult task in convincing the IMF's membership as a whole of the need for change. However, I am confident that our leverage in this regard would be reduced if the United States failed to agree promptly to the proposed increases in the IMF's resources. Accordingly, I continue fully to back the Administration's request to augment the financial resources of the IMF by approving as quickly as possible US participation in the New Arrangements to Borrow and an increase in the US quota in the IMF. Hopefully, neither will turn out to be needed, and no funds will be drawn. Although the tendency in recent months toward stabilization in the East Asian economies is encouraging, clearly those economies are not out of the woods as recent events attest. Moreover, we have not yet put in place the strengthening of the international financial architecture that would enable us in the future to place less reliance on the IMF to deal with potential systemic crises. Thus it is better to have the IMF fully equipped if a quick response to a pending crisis is essential.
1998-06-09T00:00:00	Mr. Meyer discusses issues and trends in bank regulatory policy and financial modernization in the United States (Central Bank Articles and Speeches, 9 Jun 98)	Remarks by Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the Bank Administration Institute, Finance and Accounting Management Conference held in Washington, DC on 9/6/98.	Mr. Meyer discusses issues and trends in bank regulatory policy and financial Remarks by Laurence H. Meyer, a member of the Board of modernization in the United States Governors of the US Federal Reserve System, at the Bank Administration Institute, Finance and Accounting Management Conference held in Washington, DC on 9/6/98. It is a pleasure to be here today, and I thank the Bank Administration Institute for inviting me to be a part of your discussions. When people think of the Federal Reserve, I am pretty sure that most Americans think of monetary policy, interest rates, international finance, and the Fed's macroeconomic responsibilities in all of these areas. And, of course, macroeconomics lies at the core of what any central bank does. However, as everyone at this conference appreciates, another major function of the Federal Reserve is the supervision and regulation of banks and bank holding companies. I would like to use my time this afternoon to discuss some key aspects of this side of the Fed's activities. I will begin by outlining, very briefly, some of the key trends affecting the banking and financial sector. I will then focus on what I see as the most important challenges that these trends pose for bank supervisors, and suggest some directions that I believe we should consider when thinking about how bank supervision should evolve over time. Lastly, I will discuss current legislative efforts to modernize our banking system. Key Trends Challenging Bank Supervisors Surely the most profound force transforming the financial, and for that matter other sectors of our economy, is the rapid growth of computer and telecommunications technology. In finance, a critical and complementary force is the development of intellectual "technologies" that enable financial engineers to separate risk into its various components, and price each component in an economically rational way. Implementation of financial engineering strategies typically requires massive amounts of cheap data processing; and the cheap data processing would not be useful without the formulas required to compute prices. The combination of the two has led to a virtual explosion in the number and types of financial instruments. Such products have lowered the cost and broadened the scope of financial services, making it possible for borrowers and lenders to transact directly with each other, for a wide range of financial products to be tailored for very specific purposes, and for financial risk to be managed in ever more sophisticated ways. Financial innovation has been the driving force behind a second major trend in banking -- the blurring of distinctions among what were, traditionally, very distinct forms of financial firms. One of the first such innovations, with which we are all now very familiar, was money market mutual funds. In the 1980s, banks began to challenge whether the Glass-Steagall Act prohibited combinations of commercial and investment banking. Today, both the regulators and the courts agree that Glass-Steagall does not imply a total prohibition. More recently, traditional separations of banking and insurance sales have also begun to fall, with support from the supervisors and the courts. A major result of the continued blurring of distinctions among commercial banking, investment banking, and insurance is a tremendous increase in competition for many financial services. Greatly intensified competition has also led to increasing pressure for revisions to many of the banking laws and regulations that, despite some successful efforts at relaxation or repeal, continue to exert outdated and costly restraints on the banking and financial system. Indeed, despite its often frustratingly slow pace, there seems little doubt that deregulation has been a major force for change in the banking and financial services industries. Two decades ago we still had Regulation Q, the Glass-Steagall Act was widely viewed as requiring a virtual prohibition of combinations of commercial and investment banking, and interstate banking and branching, let alone combinations of banking and insurance, were barely fantasies even at the state level. The fourth major force transforming the banking landscape is the globalization not only of banking and financial markets, but also of the real economy. The interactions of developments in both the financial and real economies have expanded cross-border asset holdings, trading, and credit flows. In response, financial intermediaries, including banks and securities firms, have increased their cross-border operations. Once again, a critical result of this rapid evolution has been a substantial increase in competition both at home and abroad. The final significant trend I will highlight is the on-going consolidation of the U.S. banking industry. I think that it is fair to say that the American banking system is currently in the midst of the most significant consolidation in its history. In 1980 there were about 14,400 banks in the U.S. organized into about 12,300 banking organizations. By the end of 1997, the number of banks had fallen to just under 9,100, and the number of banking organizations to not quite 7,200. This 42 percent decline in the number of banking organizations was due in part, but only in part, to the large number of bank failures in the late 1980s and early 1990s. A more important factor was mergers among healthy banks. Since the early 1980s, it has not been unusual to see 400 or more mergers among healthy banks each year. While mergers have occurred, and continue to occur, among banks of all sizes, I would emphasize three aspects of the current bank merger movement. First is the high incidence of "megamergers", or mergers among very large banking organizations. Several mergers of the last few years have been either the largest at the time, or among the largest bank mergers in U.S. history. And, of course, that trend continues. Second, despite all of the merger activity, a large number of medium to small banks remain in the United States. Moreover, by most measures of performance these small banks are more than a match for their larger brethren for many bank products and services. When a megamerger is announced it is not uncommon to read in the press how small banks in the affected markets are looking to take advantage of the business opportunities created thereby. Research seems to support their optimism. Lastly, while the overall number of banking organizations has fallen since 1980, this does not mean that new, or de novo, entry has not occurred. From 1980 through 1997 some 3,600 new banks were formed in the United States. In large part because of the continued viability of smaller banks, while the national concentration of banking assets has increased substantially since 1980, measures of local market banking concentration have remained essentially unchanged. Indeed, the stability of local market concentration in the face of such a large consolidation of the banking industry is remarkable, and bodes well for the competitive vitality of local banking markets. While the reasons for bank mergers are varied, the bottom line is that the United States is well on its way to developing a truly national banking structure for the first time in its history. We are not quite there yet, but I do not think it will take too many more years. Future Directions in Bank Supervision What do all of these changes mean for how we supervise and regulate banks? Analysis of Competition Clearly, as the banking industry consolidates we need to maintain competitive markets. Competitive markets are our best assurance that consumers receive the highest quality products at the lowest possible prices. As I discussed earlier, there are many reasons to believe that in recent years competition has increased greatly in markets for a large number of financial products and services. This is true for many products purchased in local, regional and national markets. However, in some cases we still observe potential competitive problems with a proposed bank merger. Fortunately, the antitrust laws, as written into the banking statutes, give us the means to maintain competition in such situations. These laws require that the Board approve only those mergers that are not expected to substantially harm competition. Over the past year or so, quite a few applicants have pushed very hard at the Board's frontier for approving merger applications. In response, the Board has occasionally felt compelled to remind applicants, especially those proposing a merger that would affect a large number of local markets, that substantial changes in market concentrations will receive careful review. Moreover, when mergers would exceed the screening guidelines, "mitigating" factors must be present. By mitigating factors I mean conditions that tend to create a more competitive market than is suggested by market concentration alone. The greater the deviation from the screening guidelines, the more powerful and convincing the mitigating factors must be. I have personally been particularly concerned with cases where a large number of local markets are affected. In such cases, even if the adverse effect is fairly small in each of several local markets, it seems to me that the cumulative, or total, adverse effect might be significant. When a large number of markets are affected adversely, I believe that we should be especially careful to assure ourselves that there are substantial mitigating factors. In addition, when a merger would cause a large change in concentration in a market that is, or becomes, highly concentrated, I think we need to give special attention to the impact on competition. Assessing Safety and Soundness Technological change, financial innovation, the acquisition of new powers by banking organizations, the increasing geographic scope of banks, and the globalization of financial markets all challenge our ability to examine and assess the safety and soundness of individual banking firms. One way that examiners are adapting to this changed world is to focus much of their attention on the information and risk management systems of banks. The key question they ask is: How effectively are these systems measuring and controlling an institution's rapidly changing risk profile? The emphasis on risk management is most critical at our largest, most sophisticated, and most internationally active banks. Many of these banks use advanced economic and statistical models to evaluate their market and credit risks. These models are used for a variety of purposes, including allocating capital on a risk adjusted basis and pricing loans and credit guarantees. The development by some banks of increasingly accurate models for measuring, managing, and pricing risk has called into question the continuing usefulness of one of the foundations of bank supervision -- the so-called risk-based capital standards, or the Basle Accord. The Basle Accord capital standards were adopted in 1988 by most of the world's industrialized nations in an effort to encourage stronger capital at riskier banks, to include off-balance sheet exposures in the assessment of capital adequacy, and to establish more consistent capital standards across nations. The Accord was a major advance in 1988, and has proved to be very useful since then. But in recent years calls for reform have begun to grow. I will outline briefly one of the key problems we are currently facing with the Basle Accord. The Basle Accord capital standards divide bank on- and off-balance-sheet assets into four risk buckets, and then apply a different capital weight to each bucket. These weights increase roughly with the riskiness of the assets in a given bucket. However, the relationship is rough. Perhaps most troublesome, the same risk weight is applied to all loans. Thus, for example, a loan to a very risky "junk bond" company gets the same weight as a loan to a "triple A" rated firm. This aspect of the Accord clearly gives banks an incentive to find ways to avoid the regulatory capital standard for loans that their internal models say need less capital than is required by the Basle Accord. Conversely, banks should want to keep loans which their models say require more capital than does the Basle standard. And, guess what, banks have been doing just that. This so-called "regulatory arbitrage" may not be all bad, but it surely causes some serious problems as well. For one thing, it makes reported capital ratios -- a key measure of bank soundness used by supervisors and investors -- less meaningful for government supervisors and private analysts. Finding ways around this problem is a high priority at the Federal Reserve. The arbitraging of regulatory capital requirements is but one of a host of similar conflicts between banks and bank supervisory rules and regulations. Indeed, one can view much of the long history of bank supervision and regulation as something of a contest between supervisors who want to deter excessive risk taking and banks who seek ways around sometimes inefficient, or just plain uneconomic, regulations. This long history leads me to seek supervisory strategies that are, in the economist's jargon, incentive compatible. By incentive compatible, I mean supervisory policies and procedures that give banks strong internal incentives to manage their risks prudently and minimize the exploitation of moral hazard. Put differently, we need to design strategies that encourage banks, in their own self-interest, to work with us, not against us. When designing supervisory policy, we should always remember that the first line of defense against excessive risk-taking by banks is the market itself. Market discipline can be, and often is, highly effective at deterring excessive risk. Indeed, a primary goal of many of the bank regulatory reforms implemented in the wake of the banking and thrift crises of the 1980s and early 1990s was either to increase market discipline or to make supervisors behave more like the market would behave. Market discipline was increased, for example, by raising capital standards and by mandating greater public disclosure by a bank of its financial condition. Prompt corrective action rules that require supervisors to impose increasingly severe penalties on a bank as its financial condition deteriorates, and the adoption of risk-based deposit insurance premiums are examples of encouraging supervisors to act like the market. The reforms of the early 1990s were a good start. But I believe that there may well be more that we can do. Such comments may sound out of place today. Times are good, and almost everyone seems quite satisfied with the current deposit insurance system. But good times may be precisely when we should develop ideas for an even more effective system. The crucible of a crisis is not always the best time to think up reforms -- witness the error we made in passing the GlassSteagall Act, an error we have yet to correct after 65 years! Indeed, it is in part for this very reason that the Board continues to urge Congress to pass financial modernization legislation. So, in the spirit of being forward looking, let me attempt to give you the flavor of one idea that seems worth considering. It may be possible to increase market discipline by requiring large, internationally active banks to issue a minimum amount of certain types of subordinated debt to the public. An appealing aspect of this approach is that subordinated debt holders, so long as they are not bank "insiders," face only downside risk, and thus their risk preferences are very close to those of the FDIC. Subordinated debt holders would therefore be expected to impose market discipline on the bank that is quite consistent with what bank supervisors are trying to do, including encouraging banks to disclose more information about their financial condition. Observed risk premiums on subordinated debt could perhaps be used to help the FDIC set more accurate risk-based deposit insurance premiums, and such debt would provide an extra cushion of protection for taxpayers. An additional benefit of having subordinated debt traded on the open market is that price movements would provide a clear signal of the market's evaluation of the bank's financial condition that, even if it were not used to help price deposit insurance, could serve as an early warning aid to supervisors. Subordinated debt is not, however, without its problems. For example, the risk preferences of such creditors are aligned with those of the FDIC only when the bank is clearly solvent. At or near insolvency, subordinated debt holders may be willing to "bet the bank" in order to increase the chances that they will not suffer a loss. The fact that the bank closure decision is still in the supervisor's hands is another complicating factor. In addition, it is unclear just how deep and liquid a market in bank subordinated debt would be, although limiting any requirements to the largest banks would ease this concern. For example, at the end of last year only one-half percent of banks with less than $50 million in assets issued subordinated debt, but 83 percent of banks with total assets of $10 billion or more did so. However, it appears that much of existing bank subordinated debt is held by the bank's parent holding company, not independent third parties. Thus, the question of how deep and liquid a market might evolve remains. For these and other reasons, an operationally feasible program for mandatory subordinated debt would require a considerable amount of careful thought. Still, in my judgment it is thought that might prove very worthwhile. The Need For Financial Modernization Technology and globalization are changing markets all over the world, but perhaps none have been more affected than the financial markets. Yet in the United States much of our legal framework has essentially not changed since the 1930s. The resultant pressure on financial institutions to be able to compete has thus been reflected in the search for loopholes and in efforts by regulatory authorities to find ways within their charter to permit new activities. The process is not only inefficient, but creates new inequities, institutions that may be producing unintended risks, and the misallocation of resources. That is why my colleagues and I are such strong supporters of H.R. 10, The Financial Modernization Act of 1998, which the House passed last month and the Senate Banking Committee will be discussing next week. This bill brings our financial institutions into the 21st century in a framework that minimizes risks and inequities. The task it sets for itself is not easy. Each set of our financial institutions -- and their regulators -- have special privileges and advantages that they wish to maintain and limits and restraints that they wish to shed. Balancing these realities results in provisions in the bill that no one -- including me -- can say that they like completely. But the balancing in H.R. 10 is, I think, the best that is possible; indeed, in many respects it is so balanced that most adjustments to address the concerns of one set of institutions would probably eliminate the support of another set of institutions. What is critical, it seems to me, is that the bill not only does a fine balancing job, but it is in the public interest, something that I am sorry to say that all too frequently we lose sight of. Let me share with you the specific reasons why I think this is a bill that deserves support. First and foremost is that the bill would finally let financial institutions get into each other's businesses, and thus widen the scope and range over which institutions can compete for the public's business. Mind you, this is not a statement that says financial supermarkets and/or large institutions will be better or more successful than specialized and/or smaller institutions. But the benefit is that the public, not regulators, will decide which will prosper as competitors all bend their efforts to serve the consumer. That is the bottom line. It's the reason why there should be financial modernization. But the structure that the bill establishes is consistent both with efficient resource allocation and with minimizing risk to the stability of the economy and the taxpayer. Let's take a closer look at that structure. The most critical element is that H.R. 10 would permit banks to conduct in their own subsidiaries (so-called operating subsidiaries or "op subs") only the same activities that they may already conduct in the bank and financial agency activities, which by their nature require minimal funding and create minimal risk. These limitations, it seems to me, are crucial for several reasons. Banks have a lower cost of funds than other financial entities because of the safety net -- the name we give the collection of deposit insurance, access to the discount window, and access to the payments system. This subsidy is provided by the government in order to buy systemic stability, but it has a cost: increased risk taking by banks, reduced market discipline, and consequently the need for more onerous bank supervision in order to balance the resultant moral hazard. The last thing we should want is to extend that subsidy over a wider range of activities, which is, I believe, exactly what would happen if bank op subs could engage in wider nonbank financial activities. Not only would that increase the moral hazard -- and the need for bank-like supervision -- but it would also unbalance the competitive playing field between bank subs and independent firms engaging in the same business, a strange result for legislation whose ultimate purpose is to increase the competition for financial services. The subsidy that is so integral to the op sub would surely induce banks and other financial institutions to organize in a form that would maximize their use of that subsidy. Indeed, stockholders would have every reason to be critical of management that did not avail itself of the opportunity to raise low cost funds. The profits of bank subsidiaries would surely benefit the bank parent since GAAP accounting, economic and legal reality, and common sense all call for consolidation. But losses, too, would consolidate into the bank parent and such losses would fall directly on the safety net, and ultimately the taxpayer. These safety and soundness and safety net risks ultimately would bring with them the need to regulate op subs the way banks are regulated, creating inefficiencies and reductions in innovation, let alone conflicts with functional regulators. The legislation I support would require that organizations that conduct both banking and other financial businesses organize in a holding company form where the bank and the other activities are both subs of the holding company. Profits and losses of the business lines accrue to the holding company and thus do not directly benefit nor endanger the bank, the safety net, or the taxpayer. The safety net subsidy is not directly available to the holding company affiliates and competition is thus more balanced. Moreover, traditional regulators like the SEC and the state insurance commissioners still regulate the entities engaged in nonbank activities as if they were independent firms. Functional regulation is desirable not only for competitive equity, but is a political necessity and a practical reality in the process of balancing that is required to move financial regulation. In principle, functional regulation could also be applied to op subs, but the safety net, I submit, would soon create regulatory conflict with that structure. Importantly, the bill passed by the House would prohibit commercial affiliations with banks. There is no doubt that it is becoming increasingly difficult to draw a bright line that separates financial services from nonfinancial businesses; it will only become more difficult to do so. But, the truth is that we are not sure enough of the implications of combining banking and commerce -potential conflicts of interest, concentration of power, and safety net and stability concerns -- to move forward in this area. Better, I think, to digest financial reform before moving in an area that will be very difficult to reverse. The bill, by the way, would shut down new unitary thrifts that can affiliate with non-financial firms, but grandfathers the rights of the over 700 existing unitary thrift holding companies to acquire or be acquired by commercial enterprises. I would hope the Senate would instead freeze such activities in place until the banking and commerce issue is addressed directly; the fact that the House did not simply reinforces my point on how hard it is to reverse such powers once gained. Finally, I support H.R. 10 because the holding company framework would keep the Federal Reserve -- the central bank of the United States -- as the umbrella supervisor. I believe that the Fed has an important role to play in banking supervision in order to carry out its responsibilities for monetary policy, economic stabilization, and crisis management. I cannot grasp how we could possibly understand what is happening in banking markets, what innovations are occurring and their implications, and the nature and quality of the risk exposures and controls so critical for crisis management and policy formulation without the hands-on practical exposure that comes from supervision. An umbrella supervisor is needed for complex organizations in order to assure that the entire organization and its policies and controls are well managed and consistent with financial stability. At least for the large organizations, I believe that supervisor should be the Federal Reserve so that we can play our role as a central bank and international crisis manager. Many people are surprised to hear that the Fed directly supervises only 5 of the largest 25 banks -- the state members. Our window into banking is through our umbrella supervision of bank holding companies. Unfortunately, but understandably, the view that the Fed wants new activities to be in a bank holding company is often construed as a "turf" issue. I believe that there are two separable arguments. I would prefer the holding company -- for reasons I have discussed -- even if the Fed were not the umbrella supervisor. But I also think that we have to be involved in bank supervision -again for the reasons I have discussed. Who should be involved in what activities, and who should supervise the resultant organization and its component parts are genuine and important policy issues that should be debated and decided by the Congress. To simply dismiss them as turf issues misses the point, I think, and chokes off that debate. Conclusion In conclusion, I hope that my remarks have helped you to better understand the forces affecting our banking and financial system. Equally important, I hope that I have given you a good feel for the challenges these forces have created for bank supervision, how we are meeting these challenges today, and how we may deal with them in the future. Even more importantly, I hope that I have convinced you to support enthusiastically H.R. 10! In all seriousness, it really is time that we modernized our financial system and got on with the business of serving consumers and maintaining a healthy, stable, and competitive banking system.	---[PAGE_BREAK]--- # Mr. Meyer discusses issues and trends in bank regulatory policy and financial modernization in the United States Remarks by Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the Bank Administration Institute, Finance and Accounting Management Conference held in Washington, DC on 9/6/98. It is a pleasure to be here today, and I thank the Bank Administration Institute for inviting me to be a part of your discussions. When people think of the Federal Reserve, I am pretty sure that most Americans think of monetary policy, interest rates, international finance, and the Fed's macroeconomic responsibilities in all of these areas. And, of course, macroeconomics lies at the core of what any central bank does. However, as everyone at this conference appreciates, another major function of the Federal Reserve is the supervision and regulation of banks and bank holding companies. I would like to use my time this afternoon to discuss some key aspects of this side of the Fed's activities. I will begin by outlining, very briefly, some of the key trends affecting the banking and financial sector. I will then focus on what I see as the most important challenges that these trends pose for bank supervisors, and suggest some directions that I believe we should consider when thinking about how bank supervision should evolve over time. Lastly, I will discuss current legislative efforts to modernize our banking system. ## Key Trends Challenging Bank Supervisors Surely the most profound force transforming the financial, and for that matter other sectors of our economy, is the rapid growth of computer and telecommunications technology. In finance, a critical and complementary force is the development of intellectual "technologies" that enable financial engineers to separate risk into its various components, and price each component in an economically rational way. Implementation of financial engineering strategies typically requires massive amounts of cheap data processing; and the cheap data processing would not be useful without the formulas required to compute prices. The combination of the two has led to a virtual explosion in the number and types of financial instruments. Such products have lowered the cost and broadened the scope of financial services, making it possible for borrowers and lenders to transact directly with each other, for a wide range of financial products to be tailored for very specific purposes, and for financial risk to be managed in ever more sophisticated ways. Financial innovation has been the driving force behind a second major trend in banking -- the blurring of distinctions among what were, traditionally, very distinct forms of financial firms. One of the first such innovations, with which we are all now very familiar, was money market mutual funds. In the 1980s, banks began to challenge whether the Glass-Steagall Act prohibited combinations of commercial and investment banking. Today, both the regulators and the courts agree that Glass-Steagall does not imply a total prohibition. More recently, traditional separations of banking and insurance sales have also begun to fall, with support from the supervisors and the courts. A major result of the continued blurring of distinctions among commercial banking, investment banking, and insurance is a tremendous increase in competition for many financial services. Greatly intensified competition has also led to increasing pressure for revisions to many of the banking laws and regulations that, despite some successful efforts at relaxation or repeal, continue to exert outdated and costly restraints on the banking and financial system. ---[PAGE_BREAK]--- Indeed, despite its often frustratingly slow pace, there seems little doubt that deregulation has been a major force for change in the banking and financial services industries. Two decades ago we still had Regulation Q, the Glass-Steagall Act was widely viewed as requiring a virtual prohibition of combinations of commercial and investment banking, and interstate banking and branching, let alone combinations of banking and insurance, were barely fantasies even at the state level. The fourth major force transforming the banking landscape is the globalization not only of banking and financial markets, but also of the real economy. The interactions of developments in both the financial and real economies have expanded cross-border asset holdings, trading, and credit flows. In response, financial intermediaries, including banks and securities firms, have increased their cross-border operations. Once again, a critical result of this rapid evolution has been a substantial increase in competition both at home and abroad. The final significant trend I will highlight is the on-going consolidation of the U.S. banking industry. I think that it is fair to say that the American banking system is currently in the midst of the most significant consolidation in its history. In 1980 there were about 14,400 banks in the U.S. organized into about 12,300 banking organizations. By the end of 1997, the number of banks had fallen to just under 9,100, and the number of banking organizations to not quite 7,200. This 42 percent decline in the number of banking organizations was due in part, but only in part, to the large number of bank failures in the late 1980s and early 1990s. A more important factor was mergers among healthy banks. Since the early 1980s, it has not been unusual to see 400 or more mergers among healthy banks each year. While mergers have occurred, and continue to occur, among banks of all sizes, I would emphasize three aspects of the current bank merger movement. First is the high incidence of "megamergers", or mergers among very large banking organizations. Several mergers of the last few years have been either the largest at the time, or among the largest bank mergers in U.S. history. And, of course, that trend continues. Second, despite all of the merger activity, a large number of medium to small banks remain in the United States. Moreover, by most measures of performance these small banks are more than a match for their larger brethren for many bank products and services. When a megamerger is announced it is not uncommon to read in the press how small banks in the affected markets are looking to take advantage of the business opportunities created thereby. Research seems to support their optimism. Lastly, while the overall number of banking organizations has fallen since 1980, this does not mean that new, or de novo, entry has not occurred. From 1980 through 1997 some 3,600 new banks were formed in the United States. In large part because of the continued viability of smaller banks, while the national concentration of banking assets has increased substantially since 1980, measures of local market banking concentration have remained essentially unchanged. Indeed, the stability of local market concentration in the face of such a large consolidation of the banking industry is remarkable, and bodes well for the competitive vitality of local banking markets. While the reasons for bank mergers are varied, the bottom line is that the United States is well on its way to developing a truly national banking structure for the first time in its history. We are not quite there yet, but I do not think it will take too many more years. Future Directions in Bank Supervision ---[PAGE_BREAK]--- What do all of these changes mean for how we supervise and regulate banks? # Analysis of Competition Clearly, as the banking industry consolidates we need to maintain competitive markets. Competitive markets are our best assurance that consumers receive the highest quality products at the lowest possible prices. As I discussed earlier, there are many reasons to believe that in recent years competition has increased greatly in markets for a large number of financial products and services. This is true for many products purchased in local, regional and national markets. However, in some cases we still observe potential competitive problems with a proposed bank merger. Fortunately, the antitrust laws, as written into the banking statutes, give us the means to maintain competition in such situations. These laws require that the Board approve only those mergers that are not expected to substantially harm competition. Over the past year or so, quite a few applicants have pushed very hard at the Board's frontier for approving merger applications. In response, the Board has occasionally felt compelled to remind applicants, especially those proposing a merger that would affect a large number of local markets, that substantial changes in market concentrations will receive careful review. Moreover, when mergers would exceed the screening guidelines, "mitigating" factors must be present. By mitigating factors I mean conditions that tend to create a more competitive market than is suggested by market concentration alone. The greater the deviation from the screening guidelines, the more powerful and convincing the mitigating factors must be. I have personally been particularly concerned with cases where a large number of local markets are affected. In such cases, even if the adverse effect is fairly small in each of several local markets, it seems to me that the cumulative, or total, adverse effect might be significant. When a large number of markets are affected adversely, I believe that we should be especially careful to assure ourselves that there are substantial mitigating factors. In addition, when a merger would cause a large change in concentration in a market that is, or becomes, highly concentrated, I think we need to give special attention to the impact on competition. ## Assessing Safety and Soundness Technological change, financial innovation, the acquisition of new powers by banking organizations, the increasing geographic scope of banks, and the globalization of financial markets all challenge our ability to examine and assess the safety and soundness of individual banking firms. One way that examiners are adapting to this changed world is to focus much of their attention on the information and risk management systems of banks. The key question they ask is: How effectively are these systems measuring and controlling an institution's rapidly changing risk profile? The emphasis on risk management is most critical at our largest, most sophisticated, and most internationally active banks. Many of these banks use advanced economic and statistical models to evaluate their market and credit risks. These models are used for a variety of purposes, including allocating capital on a risk adjusted basis and pricing loans and credit guarantees. The development by some banks of increasingly accurate models for measuring, managing, and pricing risk has called into question the continuing usefulness of one of the foundations of bank supervision -- the so-called risk-based capital standards, or the Basle Accord. The Basle Accord capital standards were adopted in 1988 by most of the world's industrialized nations in an effort to encourage stronger capital at riskier banks, to include off-balance sheet exposures in the assessment of capital adequacy, and to establish more consistent capital standards across nations. The Accord was a major advance in 1988, and has proved to be very useful since ---[PAGE_BREAK]--- then. But in recent years calls for reform have begun to grow. I will outline briefly one of the key problems we are currently facing with the Basle Accord. The Basle Accord capital standards divide bank on- and off-balance-sheet assets into four risk buckets, and then apply a different capital weight to each bucket. These weights increase roughly with the riskiness of the assets in a given bucket. However, the relationship is rough. Perhaps most troublesome, the same risk weight is applied to all loans. Thus, for example, a loan to a very risky "junk bond" company gets the same weight as a loan to a "triple A" rated firm. This aspect of the Accord clearly gives banks an incentive to find ways to avoid the regulatory capital standard for loans that their internal models say need less capital than is required by the Basle Accord. Conversely, banks should want to keep loans which their models say require more capital than does the Basle standard. And, guess what, banks have been doing just that. This so-called "regulatory arbitrage" may not be all bad, but it surely causes some serious problems as well. For one thing, it makes reported capital ratios -- a key measure of bank soundness used by supervisors and investors -- less meaningful for government supervisors and private analysts. Finding ways around this problem is a high priority at the Federal Reserve. The arbitraging of regulatory capital requirements is but one of a host of similar conflicts between banks and bank supervisory rules and regulations. Indeed, one can view much of the long history of bank supervision and regulation as something of a contest between supervisors who want to deter excessive risk taking and banks who seek ways around sometimes inefficient, or just plain uneconomic, regulations. This long history leads me to seek supervisory strategies that are, in the economist's jargon, incentive compatible. By incentive compatible, I mean supervisory policies and procedures that give banks strong internal incentives to manage their risks prudently and minimize the exploitation of moral hazard. Put differently, we need to design strategies that encourage banks, in their own self-interest, to work with us, not against us. When designing supervisory policy, we should always remember that the first line of defense against excessive risk-taking by banks is the market itself. Market discipline can be, and often is, highly effective at deterring excessive risk. Indeed, a primary goal of many of the bank regulatory reforms implemented in the wake of the banking and thrift crises of the 1980s and early 1990s was either to increase market discipline or to make supervisors behave more like the market would behave. Market discipline was increased, for example, by raising capital standards and by mandating greater public disclosure by a bank of its financial condition. Prompt corrective action rules that require supervisors to impose increasingly severe penalties on a bank as its financial condition deteriorates, and the adoption of risk-based deposit insurance premiums are examples of encouraging supervisors to act like the market. The reforms of the early 1990s were a good start. But I believe that there may well be more that we can do. Such comments may sound out of place today. Times are good, and almost everyone seems quite satisfied with the current deposit insurance system. But good times may be precisely when we should develop ideas for an even more effective system. The crucible of a crisis is not always the best time to think up reforms -- witness the error we made in passing the GlassSteagall Act, an error we have yet to correct after 65 years! Indeed, it is in part for this very reason that the Board continues to urge Congress to pass financial modernization legislation. So, in the spirit of being forward looking, let me attempt to give you the flavor of one idea that seems worth considering. It may be possible to increase market discipline by requiring large, internationally active banks to issue a minimum amount of certain types of subordinated debt to the public. An appealing aspect of this approach is that subordinated debt holders, so long as they are not bank ---[PAGE_BREAK]--- "insiders," face only downside risk, and thus their risk preferences are very close to those of the FDIC. Subordinated debt holders would therefore be expected to impose market discipline on the bank that is quite consistent with what bank supervisors are trying to do, including encouraging banks to disclose more information about their financial condition. Observed risk premiums on subordinated debt could perhaps be used to help the FDIC set more accurate risk-based deposit insurance premiums, and such debt would provide an extra cushion of protection for taxpayers. An additional benefit of having subordinated debt traded on the open market is that price movements would provide a clear signal of the market's evaluation of the bank's financial condition that, even if it were not used to help price deposit insurance, could serve as an early warning aid to supervisors. Subordinated debt is not, however, without its problems. For example, the risk preferences of such creditors are aligned with those of the FDIC only when the bank is clearly solvent. At or near insolvency, subordinated debt holders may be willing to "bet the bank" in order to increase the chances that they will not suffer a loss. The fact that the bank closure decision is still in the supervisor's hands is another complicating factor. In addition, it is unclear just how deep and liquid a market in bank subordinated debt would be, although limiting any requirements to the largest banks would ease this concern. For example, at the end of last year only one-half percent of banks with less than $\$ 50$ million in assets issued subordinated debt, but 83 percent of banks with total assets of $\$ 10$ billion or more did so. However, it appears that much of existing bank subordinated debt is held by the bank's parent holding company, not independent third parties. Thus, the question of how deep and liquid a market might evolve remains. For these and other reasons, an operationally feasible program for mandatory subordinated debt would require a considerable amount of careful thought. Still, in my judgment it is thought that might prove very worthwhile. # The Need For Financial Modernization Technology and globalization are changing markets all over the world, but perhaps none have been more affected than the financial markets. Yet in the United States much of our legal framework has essentially not changed since the 1930s. The resultant pressure on financial institutions to be able to compete has thus been reflected in the search for loopholes and in efforts by regulatory authorities to find ways within their charter to permit new activities. The process is not only inefficient, but creates new inequities, institutions that may be producing unintended risks, and the misallocation of resources. That is why my colleagues and I are such strong supporters of H.R. 10, The Financial Modernization Act of 1998, which the House passed last month and the Senate Banking Committee will be discussing next week. This bill brings our financial institutions into the 21 st century in a framework that minimizes risks and inequities. The task it sets for itself is not easy. Each set of our financial institutions -- and their regulators -- have special privileges and advantages that they wish to maintain and limits and restraints that they wish to shed. Balancing these realities results in provisions in the bill that no one -- including me -- can say that they like completely. But the balancing in H.R. 10 is, I think, the best that is possible; indeed, in many respects it is so balanced that most adjustments to address the concerns of one set of institutions would probably eliminate the support of another set of institutions. What is critical, it seems to me, is that the bill not only does a fine balancing job, but it is in the public interest, something that I am sorry to say that all too frequently we lose sight of. Let me share with you the specific reasons why I think this is a bill that deserves support. First and foremost is that the bill would finally let financial institutions get into each other's businesses, and thus widen the scope and range over which institutions can compete for the public's business. Mind you, this is not a statement that says financial supermarkets and/or large institutions will be better or more successful than specialized and/or smaller institutions. But the ---[PAGE_BREAK]--- benefit is that the public, not regulators, will decide which will prosper as competitors all bend their efforts to serve the consumer. That is the bottom line. It's the reason why there should be financial modernization. But the structure that the bill establishes is consistent both with efficient resource allocation and with minimizing risk to the stability of the economy and the taxpayer. Let's take a closer look at that structure. The most critical element is that H.R. 10 would permit banks to conduct in their own subsidiaries (so-called operating subsidiaries or "op subs") only the same activities that they may already conduct in the bank and financial agency activities, which by their nature require minimal funding and create minimal risk. These limitations, it seems to me, are crucial for several reasons. Banks have a lower cost of funds than other financial entities because of the safety net -- the name we give the collection of deposit insurance, access to the discount window, and access to the payments system. This subsidy is provided by the government in order to buy systemic stability, but it has a cost: increased risk taking by banks, reduced market discipline, and consequently the need for more onerous bank supervision in order to balance the resultant moral hazard. The last thing we should want is to extend that subsidy over a wider range of activities, which is, I believe, exactly what would happen if bank op subs could engage in wider nonbank financial activities. Not only would that increase the moral hazard -- and the need for bank-like supervision -- but it would also unbalance the competitive playing field between bank subs and independent firms engaging in the same business, a strange result for legislation whose ultimate purpose is to increase the competition for financial services. The subsidy that is so integral to the op sub would surely induce banks and other financial institutions to organize in a form that would maximize their use of that subsidy. Indeed, stockholders would have every reason to be critical of management that did not avail itself of the opportunity to raise low cost funds. The profits of bank subsidiaries would surely benefit the bank parent since GAAP accounting, economic and legal reality, and common sense all call for consolidation. But losses, too, would consolidate into the bank parent and such losses would fall directly on the safety net, and ultimately the taxpayer. These safety and soundness and safety net risks ultimately would bring with them the need to regulate op subs the way banks are regulated, creating inefficiencies and reductions in innovation, let alone conflicts with functional regulators. The legislation I support would require that organizations that conduct both banking and other financial businesses organize in a holding company form where the bank and the other activities are both subs of the holding company. Profits and losses of the business lines accrue to the holding company and thus do not directly benefit nor endanger the bank, the safety net, or the taxpayer. The safety net subsidy is not directly available to the holding company affiliates and competition is thus more balanced. Moreover, traditional regulators like the SEC and the state insurance commissioners still regulate the entities engaged in nonbank activities as if they were independent firms. Functional regulation is desirable not only for competitive equity, but is a political necessity and a practical reality in the process of balancing that is required to move financial regulation. In principle, functional regulation could also be applied to op subs, but the safety net, I submit, would soon create regulatory conflict with that structure. Importantly, the bill passed by the House would prohibit commercial affiliations with banks. There is no doubt that it is becoming increasingly difficult to draw a bright line that separates financial services from nonfinancial businesses; it will only become more difficult to do so. But, the truth is that we are not sure enough of the implications of combining banking and commerce -potential conflicts of interest, concentration of power, and safety net and stability concerns -- to move forward in this area. Better, I think, to digest financial reform before moving in an area that ---[PAGE_BREAK]--- will be very difficult to reverse. The bill, by the way, would shut down new unitary thrifts that can affiliate with non-financial firms, but grandfathers the rights of the over 700 existing unitary thrift holding companies to acquire or be acquired by commercial enterprises. I would hope the Senate would instead freeze such activities in place until the banking and commerce issue is addressed directly; the fact that the House did not simply reinforces my point on how hard it is to reverse such powers once gained. Finally, I support H.R. 10 because the holding company framework would keep the Federal Reserve -- the central bank of the United States -- as the umbrella supervisor. I believe that the Fed has an important role to play in banking supervision in order to carry out its responsibilities for monetary policy, economic stabilization, and crisis management. I cannot grasp how we could possibly understand what is happening in banking markets, what innovations are occurring and their implications, and the nature and quality of the risk exposures and controls so critical for crisis management and policy formulation without the hands-on practical exposure that comes from supervision. An umbrella supervisor is needed for complex organizations in order to assure that the entire organization and its policies and controls are well managed and consistent with financial stability. At least for the large organizations, I believe that supervisor should be the Federal Reserve so that we can play our role as a central bank and international crisis manager. Many people are surprised to hear that the Fed directly supervises only 5 of the largest 25 banks -- the state members. Our window into banking is through our umbrella supervision of bank holding companies. Unfortunately, but understandably, the view that the Fed wants new activities to be in a bank holding company is often construed as a "turf" issue. I believe that there are two separable arguments. I would prefer the holding company -- for reasons I have discussed -- even if the Fed were not the umbrella supervisor. But I also think that we have to be involved in bank supervision -again for the reasons I have discussed. Who should be involved in what activities, and who should supervise the resultant organization and its component parts are genuine and important policy issues that should be debated and decided by the Congress. To simply dismiss them as turf issues misses the point, I think, and chokes off that debate. # Conclusion In conclusion, I hope that my remarks have helped you to better understand the forces affecting our banking and financial system. Equally important, I hope that I have given you a good feel for the challenges these forces have created for bank supervision, how we are meeting these challenges today, and how we may deal with them in the future. Even more importantly, I hope that I have convinced you to support enthusiastically H.R. 10! In all seriousness, it really is time that we modernized our financial system and got on with the business of serving consumers and maintaining a healthy, stable, and competitive banking system.	Laurence H Meyer	United States	https://www.bis.org/review/r980626a.pdf	modernization in the United States Remarks by Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve System, at the Bank Administration Institute, Finance and Accounting Management Conference held in Washington, DC on 9/6/98. It is a pleasure to be here today, and I thank the Bank Administration Institute for inviting me to be a part of your discussions. When people think of the Federal Reserve, I am pretty sure that most Americans think of monetary policy, interest rates, international finance, and the Fed's macroeconomic responsibilities in all of these areas. And, of course, macroeconomics lies at the core of what any central bank does. However, as everyone at this conference appreciates, another major function of the Federal Reserve is the supervision and regulation of banks and bank holding companies. I would like to use my time this afternoon to discuss some key aspects of this side of the Fed's activities. I will begin by outlining, very briefly, some of the key trends affecting the banking and financial sector. I will then focus on what I see as the most important challenges that these trends pose for bank supervisors, and suggest some directions that I believe we should consider when thinking about how bank supervision should evolve over time. Lastly, I will discuss current legislative efforts to modernize our banking system. Surely the most profound force transforming the financial, and for that matter other sectors of our economy, is the rapid growth of computer and telecommunications technology. In finance, a critical and complementary force is the development of intellectual "technologies" that enable financial engineers to separate risk into its various components, and price each component in an economically rational way. Implementation of financial engineering strategies typically requires massive amounts of cheap data processing; and the cheap data processing would not be useful without the formulas required to compute prices. The combination of the two has led to a virtual explosion in the number and types of financial instruments. Such products have lowered the cost and broadened the scope of financial services, making it possible for borrowers and lenders to transact directly with each other, for a wide range of financial products to be tailored for very specific purposes, and for financial risk to be managed in ever more sophisticated ways. Financial innovation has been the driving force behind a second major trend in banking -- the blurring of distinctions among what were, traditionally, very distinct forms of financial firms. One of the first such innovations, with which we are all now very familiar, was money market mutual funds. In the 1980s, banks began to challenge whether the Glass-Steagall Act prohibited combinations of commercial and investment banking. Today, both the regulators and the courts agree that Glass-Steagall does not imply a total prohibition. More recently, traditional separations of banking and insurance sales have also begun to fall, with support from the supervisors and the courts. A major result of the continued blurring of distinctions among commercial banking, investment banking, and insurance is a tremendous increase in competition for many financial services. Greatly intensified competition has also led to increasing pressure for revisions to many of the banking laws and regulations that, despite some successful efforts at relaxation or repeal, continue to exert outdated and costly restraints on the banking and financial system. Indeed, despite its often frustratingly slow pace, there seems little doubt that deregulation has been a major force for change in the banking and financial services industries. Two decades ago we still had Regulation Q, the Glass-Steagall Act was widely viewed as requiring a virtual prohibition of combinations of commercial and investment banking, and interstate banking and branching, let alone combinations of banking and insurance, were barely fantasies even at the state level. The fourth major force transforming the banking landscape is the globalization not only of banking and financial markets, but also of the real economy. The interactions of developments in both the financial and real economies have expanded cross-border asset holdings, trading, and credit flows. In response, financial intermediaries, including banks and securities firms, have increased their cross-border operations. Once again, a critical result of this rapid evolution has been a substantial increase in competition both at home and abroad. The final significant trend I will highlight is the on-going consolidation of the U.S. banking industry. I think that it is fair to say that the American banking system is currently in the midst of the most significant consolidation in its history. In 1980 there were about 14,400 banks in the U.S. organized into about 12,300 banking organizations. By the end of 1997, the number of banks had fallen to just under 9,100, and the number of banking organizations to not quite 7,200. This 42 percent decline in the number of banking organizations was due in part, but only in part, to the large number of bank failures in the late 1980s and early 1990s. A more important factor was mergers among healthy banks. Since the early 1980s, it has not been unusual to see 400 or more mergers among healthy banks each year. While mergers have occurred, and continue to occur, among banks of all sizes, I would emphasize three aspects of the current bank merger movement. First is the high incidence of "megamergers", or mergers among very large banking organizations. Several mergers of the last few years have been either the largest at the time, or among the largest bank mergers in U.S. history. And, of course, that trend continues. Second, despite all of the merger activity, a large number of medium to small banks remain in the United States. Moreover, by most measures of performance these small banks are more than a match for their larger brethren for many bank products and services. When a megamerger is announced it is not uncommon to read in the press how small banks in the affected markets are looking to take advantage of the business opportunities created thereby. Research seems to support their optimism. Lastly, while the overall number of banking organizations has fallen since 1980, this does not mean that new, or de novo, entry has not occurred. From 1980 through 1997 some 3,600 new banks were formed in the United States. In large part because of the continued viability of smaller banks, while the national concentration of banking assets has increased substantially since 1980, measures of local market banking concentration have remained essentially unchanged. Indeed, the stability of local market concentration in the face of such a large consolidation of the banking industry is remarkable, and bodes well for the competitive vitality of local banking markets. While the reasons for bank mergers are varied, the bottom line is that the United States is well on its way to developing a truly national banking structure for the first time in its history. We are not quite there yet, but I do not think it will take too many more years. Future Directions in Bank Supervision What do all of these changes mean for how we supervise and regulate banks? Clearly, as the banking industry consolidates we need to maintain competitive markets. Competitive markets are our best assurance that consumers receive the highest quality products at the lowest possible prices. As I discussed earlier, there are many reasons to believe that in recent years competition has increased greatly in markets for a large number of financial products and services. This is true for many products purchased in local, regional and national markets. However, in some cases we still observe potential competitive problems with a proposed bank merger. Fortunately, the antitrust laws, as written into the banking statutes, give us the means to maintain competition in such situations. These laws require that the Board approve only those mergers that are not expected to substantially harm competition. Over the past year or so, quite a few applicants have pushed very hard at the Board's frontier for approving merger applications. In response, the Board has occasionally felt compelled to remind applicants, especially those proposing a merger that would affect a large number of local markets, that substantial changes in market concentrations will receive careful review. Moreover, when mergers would exceed the screening guidelines, "mitigating" factors must be present. By mitigating factors I mean conditions that tend to create a more competitive market than is suggested by market concentration alone. The greater the deviation from the screening guidelines, the more powerful and convincing the mitigating factors must be. I have personally been particularly concerned with cases where a large number of local markets are affected. In such cases, even if the adverse effect is fairly small in each of several local markets, it seems to me that the cumulative, or total, adverse effect might be significant. When a large number of markets are affected adversely, I believe that we should be especially careful to assure ourselves that there are substantial mitigating factors. In addition, when a merger would cause a large change in concentration in a market that is, or becomes, highly concentrated, I think we need to give special attention to the impact on competition. Technological change, financial innovation, the acquisition of new powers by banking organizations, the increasing geographic scope of banks, and the globalization of financial markets all challenge our ability to examine and assess the safety and soundness of individual banking firms. One way that examiners are adapting to this changed world is to focus much of their attention on the information and risk management systems of banks. The key question they ask is: How effectively are these systems measuring and controlling an institution's rapidly changing risk profile? The emphasis on risk management is most critical at our largest, most sophisticated, and most internationally active banks. Many of these banks use advanced economic and statistical models to evaluate their market and credit risks. These models are used for a variety of purposes, including allocating capital on a risk adjusted basis and pricing loans and credit guarantees. The development by some banks of increasingly accurate models for measuring, managing, and pricing risk has called into question the continuing usefulness of one of the foundations of bank supervision -- the so-called risk-based capital standards, or the Basle Accord. The Basle Accord capital standards were adopted in 1988 by most of the world's industrialized nations in an effort to encourage stronger capital at riskier banks, to include off-balance sheet exposures in the assessment of capital adequacy, and to establish more consistent capital standards across nations. The Accord was a major advance in 1988, and has proved to be very useful since then. But in recent years calls for reform have begun to grow. I will outline briefly one of the key problems we are currently facing with the Basle Accord. The Basle Accord capital standards divide bank on- and off-balance-sheet assets into four risk buckets, and then apply a different capital weight to each bucket. These weights increase roughly with the riskiness of the assets in a given bucket. However, the relationship is rough. Perhaps most troublesome, the same risk weight is applied to all loans. Thus, for example, a loan to a very risky "junk bond" company gets the same weight as a loan to a "triple A" rated firm. This aspect of the Accord clearly gives banks an incentive to find ways to avoid the regulatory capital standard for loans that their internal models say need less capital than is required by the Basle Accord. Conversely, banks should want to keep loans which their models say require more capital than does the Basle standard. And, guess what, banks have been doing just that. This so-called "regulatory arbitrage" may not be all bad, but it surely causes some serious problems as well. For one thing, it makes reported capital ratios -- a key measure of bank soundness used by supervisors and investors -- less meaningful for government supervisors and private analysts. Finding ways around this problem is a high priority at the Federal Reserve. The arbitraging of regulatory capital requirements is but one of a host of similar conflicts between banks and bank supervisory rules and regulations. Indeed, one can view much of the long history of bank supervision and regulation as something of a contest between supervisors who want to deter excessive risk taking and banks who seek ways around sometimes inefficient, or just plain uneconomic, regulations. This long history leads me to seek supervisory strategies that are, in the economist's jargon, incentive compatible. By incentive compatible, I mean supervisory policies and procedures that give banks strong internal incentives to manage their risks prudently and minimize the exploitation of moral hazard. Put differently, we need to design strategies that encourage banks, in their own self-interest, to work with us, not against us. When designing supervisory policy, we should always remember that the first line of defense against excessive risk-taking by banks is the market itself. Market discipline can be, and often is, highly effective at deterring excessive risk. Indeed, a primary goal of many of the bank regulatory reforms implemented in the wake of the banking and thrift crises of the 1980s and early 1990s was either to increase market discipline or to make supervisors behave more like the market would behave. Market discipline was increased, for example, by raising capital standards and by mandating greater public disclosure by a bank of its financial condition. Prompt corrective action rules that require supervisors to impose increasingly severe penalties on a bank as its financial condition deteriorates, and the adoption of risk-based deposit insurance premiums are examples of encouraging supervisors to act like the market. The reforms of the early 1990s were a good start. But I believe that there may well be more that we can do. Such comments may sound out of place today. Times are good, and almost everyone seems quite satisfied with the current deposit insurance system. But good times may be precisely when we should develop ideas for an even more effective system. The crucible of a crisis is not always the best time to think up reforms -- witness the error we made in passing the GlassSteagall Act, an error we have yet to correct after 65 years! Indeed, it is in part for this very reason that the Board continues to urge Congress to pass financial modernization legislation. So, in the spirit of being forward looking, let me attempt to give you the flavor of one idea that seems worth considering. It may be possible to increase market discipline by requiring large, internationally active banks to issue a minimum amount of certain types of subordinated debt to the public. An appealing aspect of this approach is that subordinated debt holders, so long as they are not bank "insiders," face only downside risk, and thus their risk preferences are very close to those of the FDIC. Subordinated debt holders would therefore be expected to impose market discipline on the bank that is quite consistent with what bank supervisors are trying to do, including encouraging banks to disclose more information about their financial condition. Observed risk premiums on subordinated debt could perhaps be used to help the FDIC set more accurate risk-based deposit insurance premiums, and such debt would provide an extra cushion of protection for taxpayers. An additional benefit of having subordinated debt traded on the open market is that price movements would provide a clear signal of the market's evaluation of the bank's financial condition that, even if it were not used to help price deposit insurance, could serve as an early warning aid to supervisors. Subordinated debt is not, however, without its problems. For example, the risk preferences of such creditors are aligned with those of the FDIC only when the bank is clearly solvent. At or near insolvency, subordinated debt holders may be willing to "bet the bank" in order to increase the chances that they will not suffer a loss. The fact that the bank closure decision is still in the supervisor's hands is another complicating factor. In addition, it is unclear just how deep and liquid a market in bank subordinated debt would be, although limiting any requirements to the largest banks would ease this concern. For example, at the end of last year only one-half percent of banks with less than $\$ 50$ million in assets issued subordinated debt, but 83 percent of banks with total assets of $\$ 10$ billion or more did so. However, it appears that much of existing bank subordinated debt is held by the bank's parent holding company, not independent third parties. Thus, the question of how deep and liquid a market might evolve remains. For these and other reasons, an operationally feasible program for mandatory subordinated debt would require a considerable amount of careful thought. Still, in my judgment it is thought that might prove very worthwhile. Technology and globalization are changing markets all over the world, but perhaps none have been more affected than the financial markets. Yet in the United States much of our legal framework has essentially not changed since the 1930s. The resultant pressure on financial institutions to be able to compete has thus been reflected in the search for loopholes and in efforts by regulatory authorities to find ways within their charter to permit new activities. The process is not only inefficient, but creates new inequities, institutions that may be producing unintended risks, and the misallocation of resources. That is why my colleagues and I are such strong supporters of H.R. 10, The Financial Modernization Act of 1998, which the House passed last month and the Senate Banking Committee will be discussing next week. This bill brings our financial institutions into the 21 st century in a framework that minimizes risks and inequities. The task it sets for itself is not easy. Each set of our financial institutions -- and their regulators -- have special privileges and advantages that they wish to maintain and limits and restraints that they wish to shed. Balancing these realities results in provisions in the bill that no one -- including me -- can say that they like completely. But the balancing in H.R. 10 is, I think, the best that is possible; indeed, in many respects it is so balanced that most adjustments to address the concerns of one set of institutions would probably eliminate the support of another set of institutions. What is critical, it seems to me, is that the bill not only does a fine balancing job, but it is in the public interest, something that I am sorry to say that all too frequently we lose sight of. Let me share with you the specific reasons why I think this is a bill that deserves support. First and foremost is that the bill would finally let financial institutions get into each other's businesses, and thus widen the scope and range over which institutions can compete for the public's business. Mind you, this is not a statement that says financial supermarkets and/or large institutions will be better or more successful than specialized and/or smaller institutions. But the benefit is that the public, not regulators, will decide which will prosper as competitors all bend their efforts to serve the consumer. That is the bottom line. It's the reason why there should be financial modernization. But the structure that the bill establishes is consistent both with efficient resource allocation and with minimizing risk to the stability of the economy and the taxpayer. Let's take a closer look at that structure. The most critical element is that H.R. 10 would permit banks to conduct in their own subsidiaries (so-called operating subsidiaries or "op subs") only the same activities that they may already conduct in the bank and financial agency activities, which by their nature require minimal funding and create minimal risk. These limitations, it seems to me, are crucial for several reasons. Banks have a lower cost of funds than other financial entities because of the safety net -- the name we give the collection of deposit insurance, access to the discount window, and access to the payments system. This subsidy is provided by the government in order to buy systemic stability, but it has a cost: increased risk taking by banks, reduced market discipline, and consequently the need for more onerous bank supervision in order to balance the resultant moral hazard. The last thing we should want is to extend that subsidy over a wider range of activities, which is, I believe, exactly what would happen if bank op subs could engage in wider nonbank financial activities. Not only would that increase the moral hazard -- and the need for bank-like supervision -- but it would also unbalance the competitive playing field between bank subs and independent firms engaging in the same business, a strange result for legislation whose ultimate purpose is to increase the competition for financial services. The subsidy that is so integral to the op sub would surely induce banks and other financial institutions to organize in a form that would maximize their use of that subsidy. Indeed, stockholders would have every reason to be critical of management that did not avail itself of the opportunity to raise low cost funds. The profits of bank subsidiaries would surely benefit the bank parent since GAAP accounting, economic and legal reality, and common sense all call for consolidation. But losses, too, would consolidate into the bank parent and such losses would fall directly on the safety net, and ultimately the taxpayer. These safety and soundness and safety net risks ultimately would bring with them the need to regulate op subs the way banks are regulated, creating inefficiencies and reductions in innovation, let alone conflicts with functional regulators. The legislation I support would require that organizations that conduct both banking and other financial businesses organize in a holding company form where the bank and the other activities are both subs of the holding company. Profits and losses of the business lines accrue to the holding company and thus do not directly benefit nor endanger the bank, the safety net, or the taxpayer. The safety net subsidy is not directly available to the holding company affiliates and competition is thus more balanced. Moreover, traditional regulators like the SEC and the state insurance commissioners still regulate the entities engaged in nonbank activities as if they were independent firms. Functional regulation is desirable not only for competitive equity, but is a political necessity and a practical reality in the process of balancing that is required to move financial regulation. In principle, functional regulation could also be applied to op subs, but the safety net, I submit, would soon create regulatory conflict with that structure. Importantly, the bill passed by the House would prohibit commercial affiliations with banks. There is no doubt that it is becoming increasingly difficult to draw a bright line that separates financial services from nonfinancial businesses; it will only become more difficult to do so. But, the truth is that we are not sure enough of the implications of combining banking and commerce -potential conflicts of interest, concentration of power, and safety net and stability concerns -- to move forward in this area. Better, I think, to digest financial reform before moving in an area that will be very difficult to reverse. The bill, by the way, would shut down new unitary thrifts that can affiliate with non-financial firms, but grandfathers the rights of the over 700 existing unitary thrift holding companies to acquire or be acquired by commercial enterprises. I would hope the Senate would instead freeze such activities in place until the banking and commerce issue is addressed directly; the fact that the House did not simply reinforces my point on how hard it is to reverse such powers once gained. Finally, I support H.R. 10 because the holding company framework would keep the Federal Reserve -- the central bank of the United States -- as the umbrella supervisor. I believe that the Fed has an important role to play in banking supervision in order to carry out its responsibilities for monetary policy, economic stabilization, and crisis management. I cannot grasp how we could possibly understand what is happening in banking markets, what innovations are occurring and their implications, and the nature and quality of the risk exposures and controls so critical for crisis management and policy formulation without the hands-on practical exposure that comes from supervision. An umbrella supervisor is needed for complex organizations in order to assure that the entire organization and its policies and controls are well managed and consistent with financial stability. At least for the large organizations, I believe that supervisor should be the Federal Reserve so that we can play our role as a central bank and international crisis manager. Many people are surprised to hear that the Fed directly supervises only 5 of the largest 25 banks -- the state members. Our window into banking is through our umbrella supervision of bank holding companies. Unfortunately, but understandably, the view that the Fed wants new activities to be in a bank holding company is often construed as a "turf" issue. I believe that there are two separable arguments. I would prefer the holding company -- for reasons I have discussed -- even if the Fed were not the umbrella supervisor. But I also think that we have to be involved in bank supervision -again for the reasons I have discussed. Who should be involved in what activities, and who should supervise the resultant organization and its component parts are genuine and important policy issues that should be debated and decided by the Congress. To simply dismiss them as turf issues misses the point, I think, and chokes off that debate. In conclusion, I hope that my remarks have helped you to better understand the forces affecting our banking and financial system. Equally important, I hope that I have given you a good feel for the challenges these forces have created for bank supervision, how we are meeting these challenges today, and how we may deal with them in the future. Even more importantly, I hope that I have convinced you to support enthusiastically H.R. 10! In all seriousness, it really is time that we modernized our financial system and got on with the business of serving consumers and maintaining a healthy, stable, and competitive banking system.
1998-06-10T00:00:00	Mr. Greenspan presents an update on economic conditions in the United States (Central Bank Articles and Speeches, 10 Jun 98)	Testimony of the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Joint Economic Committee of the US Congress on 10/6/98.	Mr. Greenspan presents an update on economic conditions in the United States Testimony of the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Joint Economic Committee of the US Congress on 10/6/98. Mr. Chairman and members of the Committee, I am pleased to have the opportunity to present an update on economic conditions in the United States. Such an assessment cannot be made in isolation but rather depends critically on what is happening in the rest of the world and how those developments affect the performance of the American economy. In my previous appearance before this Committee last October, my remarks focused mainly on the turbulence that was then evident in world financial markets and, in particular, on the problems that had emerged in a number of Asian economies. The tentative assessment offered then was that the economies of Asia were in for some trying times but that the situation did not seem likely to threaten the expansion of this country's economy. That assessment, I believe, still is essentially correct, although uncertainties about the degree of restraint that will be coming from abroad remain substantial. Earlier this year, the situations in most of the Asian countries seemed to be stabilizing in some respects, but, as the events of the past few weeks have demonstrated, the restoration of normally functioning economies will not necessarily go smoothly. In some cases, the adjustments that are needed to improve external balances and to correct existing misallocations of resources have been accompanied by sharp increases in inflation, rising unemployment, abrupt cutbacks in living standards, and increases in uncertainty and insecurity. The heightened social and political pressures that can develop in such circumstances not only introduce added complications into economic policymaking but also make it even more difficult to foresee how the processes of adjustment will play out across the afflicted economies. That the American economy would be affected to some degree by spillover from the problems in Asia was never in doubt, even though the timing and magnitude of the impact have been difficult to predict with much confidence. Many months ago, businesses in this country began anticipating a worsening of our trade balance with the Asian countries, and incoming economic data have since confirmed those expectations. Meanwhile, other influences on trade -- such as the strength of demand growth in the United States and a dollar that has been strong against a wide array of currencies -have persisted. In total, US exports of goods and services turned down in real terms in the first quarter of 1998, the first such decline in four years, and real imports of goods and services continued to rise very rapidly. The combined effect of these changes exerted a drag of 21⁄2 percentage points on the annual growth rate of real GDP last quarter. Weaknesses in Asia appear to account for approximately one-half of that deterioration. Not only have export volumes been affected, but producers in both industry and agriculture also are having to adjust to the lower product prices that have come with slower economic growth abroad and the increase in the competitiveness of foreign producers induced largely by depreciations of their currencies. But even with substantial drag from the external sector, the US economy has continued to expand at a robust pace. In the first quarter, real GDP grew even faster than it had in 1997. Employment has continued to increase rapidly this year, and the unemployment rate has fallen further, reaching its lowest level since 1970. Incomes have continued to climb, and gains in household and business expenditures have been exceptionally strong. Although the data on hours worked suggest that growth of the economy has likely slowed this quarter from the first quarter's torrid pace, the degree of slowdown remains in question. Evidence to date of a moderation in underlying domestic spending still is sparse. The strength of domestic spending has been fueled, in part, by conditions in financial markets. Although real short-term interest rates have been rising, equity prices have moved still higher, credit has been readily available at slender margins over Treasury interest rates, and nominal long-term interest rates have remained near the lowest levels of recent decades. Rapid growth of money this year is - 2 - a further indication that financial conditions are accommodating strong domestic spending, although we still are uncertain how reliable that relationship will prove to be over time. In short, our economy is still enjoying a virtuous cycle, in which, in the context of subdued inflation and generally supportive credit conditions, rising equity values are providing impetus for spending and, in turn, the expansion of output, employment, and productivity-enhancing capital investment. The hopes for accelerated productivity growth have been bolstering expectations of future corporate earnings and thereby fueling still further increases in equity values. The essential precondition for the emergence, and persistence, of this virtuous cycle is arguably the decline in the rate of inflation to near price stability. Continued low product price inflation and expectations that it will persist have brought increasing stability to financial markets and fostered perceptions that the degree of risk in the financial outlook has been moving ever lower. These perceptions, in turn, have reduced the extra compensation that investors require for making loans to, or taking ownership positions in, private firms. To a considerable extent, investors seem to be expecting that low inflation and stronger productivity growth will allow the extraordinary growth of profits to be extended into the distant future. Indeed, expectations of per share earnings growth over the longer term have been undergoing continuous upward revision by security analysts since 1994. These rising expectations have, in turn, driven stock prices sharply higher and credit spreads lower, perhaps to levels that will be difficult to sustain unless economic conditions remain exceptionally favorable -- more so than might be anticipated from historical relationships. In any event, primarily because of the rise in stock prices, about $12 trillion has been added to the value of household assets since the end of 1994. Probably only a few percent of these largely unrealized capital gains have been transformed into the purchase of goods and services in consumer markets. But that increment to spending, combined with the sharp increase in equipment investment, which has stemmed from the low cost of both equity and debt relative to expected profits on capital, has propelled the economy forward. The current economic performance, with its combination of strong growth and low inflation, is as impressive as any I have witnessed in my near half-century of daily observation of the American economy. The consequences for the American worker have been dramatic and, for the most part, highly favorable. A great many chronically underemployed people have been given the opportunity to work, and many others have been able to upgrade their skills as a result of work experience, extensive increases in on-the-job training, or increased enrollment in technical programs. Welfare recipients appear to have been absorbed into the work force in significant numbers. Government finances have improved as well. The taxes paid on huge realized capital gains and other incomes related to the stock market, coupled with taxes on markedly higher corporate profits, have joined with restraint on spending to produce a unified federal budget surplus for the first time in nearly three decades. April's budget surplus of $125 billion was the largest monthly surplus on record. Widespread improvement also has been evident in the financial positions of state and local governments. The fact that economic performance strengthened as inflation subsided should not have been surprising, given that risk premiums and economic disincentives to invest in productive capital diminish as product prices become more stable. But the extent to which strong growth and high resource utilization have been joined with low inflation over an extended period is nevertheless extraordinary. Indeed, the broadest measures of price change indicate that the inflation rate moved down further in the first quarter of this year, even as the economy strengthened. Although declining oil prices contributed to this result, pricing leverage in the goods-producing sector more generally was held in check by rising industrial capacity, reduced demand in Asia that, among other things, has led to a softening of commodity prices, and a strong dollar that has contributed to bargain prices on many imports. Some elements in this mix clearly were transitory, and the very recent price data suggest that consumer price inflation has moved up in the second quarter. But, even so, the rate of rise remains quite moderate - 3 - overall. At this point, at least, the adverse wage-price interactions that played so central a role in pushing inflation higher in many past business expansions -- eventually bringing those expansions to an end -- do not appear to have gained a significant toe-hold in the current expansion. There are many reasons why the wage-price interactions have been so well-contained in this expansion. For one thing, increases in hourly compensation have been slower to pick up than in most other recent expansions, although, to be sure, wages have started to accelerate in the past couple of years as the labor market has become tighter and tighter. In the first few years of the expansion, the subdued rate of rise in hourly compensation seemed to be, in part, a reflection of greater concerns among workers about job security. We now seem to have moved beyond that period of especially acute concern, though the flux of technology may still leave many workers with fears of job skill obsolescence and a willingness to trade wage gains for job security. This may explain why, despite the recent acceleration of wages, the resulting level of compensation has fallen short of what the experience of previous expansions would have led us to anticipate given the current degree of labor market tightness. In the past couple of years, of course, workers have not had to press especially hard for nominal pay gains to realize sizable increases in their real wages. In contrast to the pattern that developed in several previous business expansions, when workers required substantial increases in pay just to cover increases in the cost of living, consumer prices have been generally well-behaved in the current expansion. Changes this past year in prices of both goods and services have been among the smallest of recent decades. In addition, the rate of rise in the cost of benefits that employers provide to workers has been remarkably subdued over the past few years, although a gradual upward tilt has become evident of late. A variety of factors -- including the strength of the economy and rising equity values, which have reduced the need for payments into unemployment trust funds and pension plans, and the restructuring of the health care sector -- have been working to keep benefit costs in check in this expansion. But, in the medical area at least, the most recent developments suggest that the favorable trend may have run its course. The slowing of price increases for medical services seems to have come to a halt, at least for a time, and, with the cost-saving shift to managed care having been largely completed, the potential for businesses to achieve further savings in that regard appears to be rather limited at this point. There have been a few striking instances this past year of employers boosting outlays for health benefits by substantial amounts. A couple of years ago -- almost at the same time that increases in total hourly compensation began trending up in nominal terms -- evidence of a long-awaited pickup in the growth of labor productivity began to show through more strongly in the data; and this accelerated increase in output per hour has enabled firms to meet workers' real wage demands while holding the line on price increases. Gains in productivity usually vary with the strength of the economy, and the favorable results that we have observed during the past two years or so, when the economy has been growing more rapidly, surely overstate the degree of pickup that can be sustained. But evidence continues to mount that the trend has picked up, even if the extent of that improvement is as yet unclear. Signs of a major technological transformation of the economy are all around us, and the benefits are evident not only in high-tech industries but also in production processes that have long been part of our industrial economy. Notwithstanding a reasonably optimistic interpretation of the recent productivity numbers, it would not be prudent to assume that rising productivity, by itself, can ensure a non-inflationary future. Certainly wage increases, per se, are not inflationary. To be avoided are those that exceed productivity growth, thereby creating pressure for inflationary price increases that can eventually undermine economic growth and employment. Because the level of productivity is tied to an important degree to the physical stock of capital, which turns over only gradually, increases in the trend growth of productivity probably also occur rather gradually. By contrast, the potential for abrupt acceleration of nominal hourly compensation is surely greater. Still, a strong signal of inflation pressures building because of compensation increases markedly in excess of productivity gains has not yet clearly emerged in this expansion. Among nonfinancial corporations, our most reliable source of consolidated - 4 - costs, trends in costs seem to have accelerated from their lows, but the rates of increase in both unit labor costs and total unit costs are still quite low. Nonetheless, as I have noted in previous appearances before Congress, I remain concerned that economic growth will run into constraints as the reservoir of unemployed people available to work is drawn down. The annual increase in the working-age population (from 16 to 64 years of age), including immigrants, has been approximately 1 percent a year in recent years. Yet employment, measured by the count of persons who are working rather than by the count of jobs, has been rising 2 percent a year since 1995 despite the acceleration in the growth of output per hour. The gap between employment growth and population growth, amounting to about 1.2 million a year on average, has been made up, in part, by a decline in the number of individuals who are counted as unemployed -those persons who are actively seeking work -- of approximately 700,000 a year, on average, since the end of 1995. The remainder of the gap has reflected a rise in labor force participation that can be traced to a decline of more than 500,000 a year in the number of individuals (age 16 to 64) wanting a job but not actively seeking one. Presumably, many of the persons who once were in this group have more recently become active and successful job-seekers as the economy has strengthened, thereby preventing a still sharper drop in the official unemployment rate. In May, the number of persons aged 16 to 64 who wanted to work but who did not have jobs was 9.7 million on a seasonally adjusted basis, slightly more than 51⁄2 percent of the working-age population. This percentage is a record low for the series, which first became available in 1970. The gap between the growth in employment and that of the working-age population will inevitably close. What is crucial to sustaining this unprecedented period of prosperity is whether that closing occurs in a disruptive or gradual, balanced manner. The effects of the crisis in Asia will almost certainly damp net exports further, potentially moderating the growth of domestic production and hence employment. The strength of domestic spending that has been bolstering output growth and the demand for labor also could ebb if recent indications of a narrowing in domestic profit margins were to prove to be the forerunner of a reassessment of the expected rates of return on plant and equipment. Reduced prospects for the return to capital would not only affect investment directly but could also affect consumption as stock prices adjusted to a less optimistic view of earnings prospects. Finally, the clearly unsustainable rise of inventories that has been evident in recent quarters will be slowing at some point, perhaps abruptly. An easing of the demand for labor would be an expected consequence of a slowdown in either final sales or inventory accumulation. Of course, the demand for labor that is consistent with a particular rate of output growth also could be lowered if productivity were to continue to accelerate. And, on the supply side of the labor market, faster growth of the labor force could emerge as the result of delayed retirements or increased immigration. If developments such as these do not bring labor demand into line with its sustainable supply, tighter economic policy may be necessary to help guard against a buildup of pressures that could derail the current prosperity. Fortunately, fiscal policy has been moving toward restraint to some degree, although recent budgetary discussions do not appear to be focused on extending that tendency. Monetary policy might need to tighten if demand were to continue to exhibit few signs of abating noticeably, thereby threatening to place still further strains on our labor markets. We at the Federal Reserve, recognizing the powerful forces of productivity growth and global restraint on inflation, have not perceived to date the need to tighten policy in response to strong demand, beyond what has occurred through falling inflation's upward pressure on the real federal funds rate and the modest increase in the nominal rate that we initiated in March of 1997. But, we are monitoring the evolving forces very closely to determine whether the recent acceleration of costs, albeit moderate, is likely to prove transitory or the start of a more worrisome pattern that may well require a response. In summary, Mr. Chairman, our economy has remained strong this year despite evidence of substantial drag from Asia, and, at the same time, inflation has remained low. As I have indicated, this set of circumstances is not what historical relationships would have led us to expect at this point in the business expansion, and while it is possible that we have, in a sense, moved "beyond history", we also have to be alert to the possibility that less favorable historical relationships will eventually reassert - 5 - themselves. That is why we are remaining watchful for signs of potential inflationary imbalances, even as the economy continues to perform more impressively than it has in a very long time.	---[PAGE_BREAK]--- # Mr. Greenspan presents an update on economic conditions in the United States Testimony of the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Joint Economic Committee of the US Congress on 10/6/98. Mr. Chairman and members of the Committee, I am pleased to have the opportunity to present an update on economic conditions in the United States. Such an assessment cannot be made in isolation but rather depends critically on what is happening in the rest of the world and how those developments affect the performance of the American economy. In my previous appearance before this Committee last October, my remarks focused mainly on the turbulence that was then evident in world financial markets and, in particular, on the problems that had emerged in a number of Asian economies. The tentative assessment offered then was that the economies of Asia were in for some trying times but that the situation did not seem likely to threaten the expansion of this country's economy. That assessment, I believe, still is essentially correct, although uncertainties about the degree of restraint that will be coming from abroad remain substantial. Earlier this year, the situations in most of the Asian countries seemed to be stabilizing in some respects, but, as the events of the past few weeks have demonstrated, the restoration of normally functioning economies will not necessarily go smoothly. In some cases, the adjustments that are needed to improve external balances and to correct existing misallocations of resources have been accompanied by sharp increases in inflation, rising unemployment, abrupt cutbacks in living standards, and increases in uncertainty and insecurity. The heightened social and political pressures that can develop in such circumstances not only introduce added complications into economic policymaking but also make it even more difficult to foresee how the processes of adjustment will play out across the afflicted economies. That the American economy would be affected to some degree by spillover from the problems in Asia was never in doubt, even though the timing and magnitude of the impact have been difficult to predict with much confidence. Many months ago, businesses in this country began anticipating a worsening of our trade balance with the Asian countries, and incoming economic data have since confirmed those expectations. Meanwhile, other influences on trade -- such as the strength of demand growth in the United States and a dollar that has been strong against a wide array of currencies -have persisted. In total, US exports of goods and services turned down in real terms in the first quarter of 1998, the first such decline in four years, and real imports of goods and services continued to rise very rapidly. The combined effect of these changes exerted a drag of $21 / 2$ percentage points on the annual growth rate of real GDP last quarter. Weaknesses in Asia appear to account for approximately one-half of that deterioration. Not only have export volumes been affected, but producers in both industry and agriculture also are having to adjust to the lower product prices that have come with slower economic growth abroad and the increase in the competitiveness of foreign producers induced largely by depreciations of their currencies. But even with substantial drag from the external sector, the US economy has continued to expand at a robust pace. In the first quarter, real GDP grew even faster than it had in 1997. Employment has continued to increase rapidly this year, and the unemployment rate has fallen further, reaching its lowest level since 1970. Incomes have continued to climb, and gains in household and business expenditures have been exceptionally strong. Although the data on hours worked suggest that growth of the economy has likely slowed this quarter from the first quarter's torrid pace, the degree of slowdown remains in question. Evidence to date of a moderation in underlying domestic spending still is sparse. The strength of domestic spending has been fueled, in part, by conditions in financial markets. Although real short-term interest rates have been rising, equity prices have moved still higher, credit has been readily available at slender margins over Treasury interest rates, and nominal long-term interest rates have remained near the lowest levels of recent decades. Rapid growth of money this year is ---[PAGE_BREAK]--- a further indication that financial conditions are accommodating strong domestic spending, although we still are uncertain how reliable that relationship will prove to be over time. In short, our economy is still enjoying a virtuous cycle, in which, in the context of subdued inflation and generally supportive credit conditions, rising equity values are providing impetus for spending and, in turn, the expansion of output, employment, and productivity-enhancing capital investment. The hopes for accelerated productivity growth have been bolstering expectations of future corporate earnings and thereby fueling still further increases in equity values. The essential precondition for the emergence, and persistence, of this virtuous cycle is arguably the decline in the rate of inflation to near price stability. Continued low product price inflation and expectations that it will persist have brought increasing stability to financial markets and fostered perceptions that the degree of risk in the financial outlook has been moving ever lower. These perceptions, in turn, have reduced the extra compensation that investors require for making loans to, or taking ownership positions in, private firms. To a considerable extent, investors seem to be expecting that low inflation and stronger productivity growth will allow the extraordinary growth of profits to be extended into the distant future. Indeed, expectations of per share earnings growth over the longer term have been undergoing continuous upward revision by security analysts since 1994. These rising expectations have, in turn, driven stock prices sharply higher and credit spreads lower, perhaps to levels that will be difficult to sustain unless economic conditions remain exceptionally favorable -- more so than might be anticipated from historical relationships. In any event, primarily because of the rise in stock prices, about $\$ 12$ trillion has been added to the value of household assets since the end of 1994. Probably only a few percent of these largely unrealized capital gains have been transformed into the purchase of goods and services in consumer markets. But that increment to spending, combined with the sharp increase in equipment investment, which has stemmed from the low cost of both equity and debt relative to expected profits on capital, has propelled the economy forward. The current economic performance, with its combination of strong growth and low inflation, is as impressive as any I have witnessed in my near half-century of daily observation of the American economy. The consequences for the American worker have been dramatic and, for the most part, highly favorable. A great many chronically underemployed people have been given the opportunity to work, and many others have been able to upgrade their skills as a result of work experience, extensive increases in on-the-job training, or increased enrollment in technical programs. Welfare recipients appear to have been absorbed into the work force in significant numbers. Government finances have improved as well. The taxes paid on huge realized capital gains and other incomes related to the stock market, coupled with taxes on markedly higher corporate profits, have joined with restraint on spending to produce a unified federal budget surplus for the first time in nearly three decades. April's budget surplus of $\$ 125$ billion was the largest monthly surplus on record. Widespread improvement also has been evident in the financial positions of state and local governments. The fact that economic performance strengthened as inflation subsided should not have been surprising, given that risk premiums and economic disincentives to invest in productive capital diminish as product prices become more stable. But the extent to which strong growth and high resource utilization have been joined with low inflation over an extended period is nevertheless extraordinary. Indeed, the broadest measures of price change indicate that the inflation rate moved down further in the first quarter of this year, even as the economy strengthened. Although declining oil prices contributed to this result, pricing leverage in the goods-producing sector more generally was held in check by rising industrial capacity, reduced demand in Asia that, among other things, has led to a softening of commodity prices, and a strong dollar that has contributed to bargain prices on many imports. Some elements in this mix clearly were transitory, and the very recent price data suggest that consumer price inflation has moved up in the second quarter. But, even so, the rate of rise remains quite moderate ---[PAGE_BREAK]--- overall. At this point, at least, the adverse wage-price interactions that played so central a role in pushing inflation higher in many past business expansions -- eventually bringing those expansions to an end -- do not appear to have gained a significant toe-hold in the current expansion. There are many reasons why the wage-price interactions have been so well-contained in this expansion. For one thing, increases in hourly compensation have been slower to pick up than in most other recent expansions, although, to be sure, wages have started to accelerate in the past couple of years as the labor market has become tighter and tighter. In the first few years of the expansion, the subdued rate of rise in hourly compensation seemed to be, in part, a reflection of greater concerns among workers about job security. We now seem to have moved beyond that period of especially acute concern, though the flux of technology may still leave many workers with fears of job skill obsolescence and a willingness to trade wage gains for job security. This may explain why, despite the recent acceleration of wages, the resulting level of compensation has fallen short of what the experience of previous expansions would have led us to anticipate given the current degree of labor market tightness. In the past couple of years, of course, workers have not had to press especially hard for nominal pay gains to realize sizable increases in their real wages. In contrast to the pattern that developed in several previous business expansions, when workers required substantial increases in pay just to cover increases in the cost of living, consumer prices have been generally well-behaved in the current expansion. Changes this past year in prices of both goods and services have been among the smallest of recent decades. In addition, the rate of rise in the cost of benefits that employers provide to workers has been remarkably subdued over the past few years, although a gradual upward tilt has become evident of late. A variety of factors -- including the strength of the economy and rising equity values, which have reduced the need for payments into unemployment trust funds and pension plans, and the restructuring of the health care sector -- have been working to keep benefit costs in check in this expansion. But, in the medical area at least, the most recent developments suggest that the favorable trend may have run its course. The slowing of price increases for medical services seems to have come to a halt, at least for a time, and, with the cost-saving shift to managed care having been largely completed, the potential for businesses to achieve further savings in that regard appears to be rather limited at this point. There have been a few striking instances this past year of employers boosting outlays for health benefits by substantial amounts. A couple of years ago -- almost at the same time that increases in total hourly compensation began trending up in nominal terms -- evidence of a long-awaited pickup in the growth of labor productivity began to show through more strongly in the data; and this accelerated increase in output per hour has enabled firms to meet workers' real wage demands while holding the line on price increases. Gains in productivity usually vary with the strength of the economy, and the favorable results that we have observed during the past two years or so, when the economy has been growing more rapidly, surely overstate the degree of pickup that can be sustained. But evidence continues to mount that the trend has picked up, even if the extent of that improvement is as yet unclear. Signs of a major technological transformation of the economy are all around us, and the benefits are evident not only in high-tech industries but also in production processes that have long been part of our industrial economy. Notwithstanding a reasonably optimistic interpretation of the recent productivity numbers, it would not be prudent to assume that rising productivity, by itself, can ensure a non-inflationary future. Certainly wage increases, per se, are not inflationary. To be avoided are those that exceed productivity growth, thereby creating pressure for inflationary price increases that can eventually undermine economic growth and employment. Because the level of productivity is tied to an important degree to the physical stock of capital, which turns over only gradually, increases in the trend growth of productivity probably also occur rather gradually. By contrast, the potential for abrupt acceleration of nominal hourly compensation is surely greater. Still, a strong signal of inflation pressures building because of compensation increases markedly in excess of productivity gains has not yet clearly emerged in this expansion. Among nonfinancial corporations, our most reliable source of consolidated ---[PAGE_BREAK]--- costs, trends in costs seem to have accelerated from their lows, but the rates of increase in both unit labor costs and total unit costs are still quite low. Nonetheless, as I have noted in previous appearances before Congress, I remain concerned that economic growth will run into constraints as the reservoir of unemployed people available to work is drawn down. The annual increase in the working-age population (from 16 to 64 years of age), including immigrants, has been approximately 1 percent a year in recent years. Yet employment, measured by the count of persons who are working rather than by the count of jobs, has been rising 2 percent a year since 1995 despite the acceleration in the growth of output per hour. The gap between employment growth and population growth, amounting to about 1.2 million a year on average, has been made up, in part, by a decline in the number of individuals who are counted as unemployed those persons who are actively seeking work -- of approximately 700,000 a year, on average, since the end of 1995. The remainder of the gap has reflected a rise in labor force participation that can be traced to a decline of more than 500,000 a year in the number of individuals (age 16 to 64) wanting a job but not actively seeking one. Presumably, many of the persons who once were in this group have more recently become active and successful job-seekers as the economy has strengthened, thereby preventing a still sharper drop in the official unemployment rate. In May, the number of persons aged 16 to 64 who wanted to work but who did not have jobs was 9.7 million on a seasonally adjusted basis, slightly more than $51 / 2$ percent of the working-age population. This percentage is a record low for the series, which first became available in 1970. The gap between the growth in employment and that of the working-age population will inevitably close. What is crucial to sustaining this unprecedented period of prosperity is whether that closing occurs in a disruptive or gradual, balanced manner. The effects of the crisis in Asia will almost certainly damp net exports further, potentially moderating the growth of domestic production and hence employment. The strength of domestic spending that has been bolstering output growth and the demand for labor also could ebb if recent indications of a narrowing in domestic profit margins were to prove to be the forerunner of a reassessment of the expected rates of return on plant and equipment. Reduced prospects for the return to capital would not only affect investment directly but could also affect consumption as stock prices adjusted to a less optimistic view of earnings prospects. Finally, the clearly unsustainable rise of inventories that has been evident in recent quarters will be slowing at some point, perhaps abruptly. An easing of the demand for labor would be an expected consequence of a slowdown in either final sales or inventory accumulation. Of course, the demand for labor that is consistent with a particular rate of output growth also could be lowered if productivity were to continue to accelerate. And, on the supply side of the labor market, faster growth of the labor force could emerge as the result of delayed retirements or increased immigration. If developments such as these do not bring labor demand into line with its sustainable supply, tighter economic policy may be necessary to help guard against a buildup of pressures that could derail the current prosperity. Fortunately, fiscal policy has been moving toward restraint to some degree, although recent budgetary discussions do not appear to be focused on extending that tendency. Monetary policy might need to tighten if demand were to continue to exhibit few signs of abating noticeably, thereby threatening to place still further strains on our labor markets. We at the Federal Reserve, recognizing the powerful forces of productivity growth and global restraint on inflation, have not perceived to date the need to tighten policy in response to strong demand, beyond what has occurred through falling inflation's upward pressure on the real federal funds rate and the modest increase in the nominal rate that we initiated in March of 1997. But, we are monitoring the evolving forces very closely to determine whether the recent acceleration of costs, albeit moderate, is likely to prove transitory or the start of a more worrisome pattern that may well require a response. In summary, Mr. Chairman, our economy has remained strong this year despite evidence of substantial drag from Asia, and, at the same time, inflation has remained low. As I have indicated, this set of circumstances is not what historical relationships would have led us to expect at this point in the business expansion, and while it is possible that we have, in a sense, moved "beyond history", we also have to be alert to the possibility that less favorable historical relationships will eventually reassert ---[PAGE_BREAK]--- themselves. That is why we are remaining watchful for signs of potential inflationary imbalances, even as the economy continues to perform more impressively than it has in a very long time.	Alan Greenspan	United States	https://www.bis.org/review/r980616a.pdf	Testimony of the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Joint Economic Committee of the US Congress on 10/6/98. Mr. Chairman and members of the Committee, I am pleased to have the opportunity to present an update on economic conditions in the United States. Such an assessment cannot be made in isolation but rather depends critically on what is happening in the rest of the world and how those developments affect the performance of the American economy. In my previous appearance before this Committee last October, my remarks focused mainly on the turbulence that was then evident in world financial markets and, in particular, on the problems that had emerged in a number of Asian economies. The tentative assessment offered then was that the economies of Asia were in for some trying times but that the situation did not seem likely to threaten the expansion of this country's economy. That assessment, I believe, still is essentially correct, although uncertainties about the degree of restraint that will be coming from abroad remain substantial. Earlier this year, the situations in most of the Asian countries seemed to be stabilizing in some respects, but, as the events of the past few weeks have demonstrated, the restoration of normally functioning economies will not necessarily go smoothly. In some cases, the adjustments that are needed to improve external balances and to correct existing misallocations of resources have been accompanied by sharp increases in inflation, rising unemployment, abrupt cutbacks in living standards, and increases in uncertainty and insecurity. The heightened social and political pressures that can develop in such circumstances not only introduce added complications into economic policymaking but also make it even more difficult to foresee how the processes of adjustment will play out across the afflicted economies. That the American economy would be affected to some degree by spillover from the problems in Asia was never in doubt, even though the timing and magnitude of the impact have been difficult to predict with much confidence. Many months ago, businesses in this country began anticipating a worsening of our trade balance with the Asian countries, and incoming economic data have since confirmed those expectations. Meanwhile, other influences on trade -- such as the strength of demand growth in the United States and a dollar that has been strong against a wide array of currencies -have persisted. In total, US exports of goods and services turned down in real terms in the first quarter of 1998, the first such decline in four years, and real imports of goods and services continued to rise very rapidly. The combined effect of these changes exerted a drag of $21 / 2$ percentage points on the annual growth rate of real GDP last quarter. Weaknesses in Asia appear to account for approximately one-half of that deterioration. Not only have export volumes been affected, but producers in both industry and agriculture also are having to adjust to the lower product prices that have come with slower economic growth abroad and the increase in the competitiveness of foreign producers induced largely by depreciations of their currencies. But even with substantial drag from the external sector, the US economy has continued to expand at a robust pace. In the first quarter, real GDP grew even faster than it had in 1997. Employment has continued to increase rapidly this year, and the unemployment rate has fallen further, reaching its lowest level since 1970. Incomes have continued to climb, and gains in household and business expenditures have been exceptionally strong. Although the data on hours worked suggest that growth of the economy has likely slowed this quarter from the first quarter's torrid pace, the degree of slowdown remains in question. Evidence to date of a moderation in underlying domestic spending still is sparse. The strength of domestic spending has been fueled, in part, by conditions in financial markets. Although real short-term interest rates have been rising, equity prices have moved still higher, credit has been readily available at slender margins over Treasury interest rates, and nominal long-term interest rates have remained near the lowest levels of recent decades. Rapid growth of money this year is a further indication that financial conditions are accommodating strong domestic spending, although we still are uncertain how reliable that relationship will prove to be over time. In short, our economy is still enjoying a virtuous cycle, in which, in the context of subdued inflation and generally supportive credit conditions, rising equity values are providing impetus for spending and, in turn, the expansion of output, employment, and productivity-enhancing capital investment. The hopes for accelerated productivity growth have been bolstering expectations of future corporate earnings and thereby fueling still further increases in equity values. The essential precondition for the emergence, and persistence, of this virtuous cycle is arguably the decline in the rate of inflation to near price stability. Continued low product price inflation and expectations that it will persist have brought increasing stability to financial markets and fostered perceptions that the degree of risk in the financial outlook has been moving ever lower. These perceptions, in turn, have reduced the extra compensation that investors require for making loans to, or taking ownership positions in, private firms. To a considerable extent, investors seem to be expecting that low inflation and stronger productivity growth will allow the extraordinary growth of profits to be extended into the distant future. Indeed, expectations of per share earnings growth over the longer term have been undergoing continuous upward revision by security analysts since 1994. These rising expectations have, in turn, driven stock prices sharply higher and credit spreads lower, perhaps to levels that will be difficult to sustain unless economic conditions remain exceptionally favorable -- more so than might be anticipated from historical relationships. In any event, primarily because of the rise in stock prices, about $\$ 12$ trillion has been added to the value of household assets since the end of 1994. Probably only a few percent of these largely unrealized capital gains have been transformed into the purchase of goods and services in consumer markets. But that increment to spending, combined with the sharp increase in equipment investment, which has stemmed from the low cost of both equity and debt relative to expected profits on capital, has propelled the economy forward. The current economic performance, with its combination of strong growth and low inflation, is as impressive as any I have witnessed in my near half-century of daily observation of the American economy. The consequences for the American worker have been dramatic and, for the most part, highly favorable. A great many chronically underemployed people have been given the opportunity to work, and many others have been able to upgrade their skills as a result of work experience, extensive increases in on-the-job training, or increased enrollment in technical programs. Welfare recipients appear to have been absorbed into the work force in significant numbers. Government finances have improved as well. The taxes paid on huge realized capital gains and other incomes related to the stock market, coupled with taxes on markedly higher corporate profits, have joined with restraint on spending to produce a unified federal budget surplus for the first time in nearly three decades. April's budget surplus of $\$ 125$ billion was the largest monthly surplus on record. Widespread improvement also has been evident in the financial positions of state and local governments. The fact that economic performance strengthened as inflation subsided should not have been surprising, given that risk premiums and economic disincentives to invest in productive capital diminish as product prices become more stable. But the extent to which strong growth and high resource utilization have been joined with low inflation over an extended period is nevertheless extraordinary. Indeed, the broadest measures of price change indicate that the inflation rate moved down further in the first quarter of this year, even as the economy strengthened. Although declining oil prices contributed to this result, pricing leverage in the goods-producing sector more generally was held in check by rising industrial capacity, reduced demand in Asia that, among other things, has led to a softening of commodity prices, and a strong dollar that has contributed to bargain prices on many imports. Some elements in this mix clearly were transitory, and the very recent price data suggest that consumer price inflation has moved up in the second quarter. But, even so, the rate of rise remains quite moderate overall. At this point, at least, the adverse wage-price interactions that played so central a role in pushing inflation higher in many past business expansions -- eventually bringing those expansions to an end -- do not appear to have gained a significant toe-hold in the current expansion. There are many reasons why the wage-price interactions have been so well-contained in this expansion. For one thing, increases in hourly compensation have been slower to pick up than in most other recent expansions, although, to be sure, wages have started to accelerate in the past couple of years as the labor market has become tighter and tighter. In the first few years of the expansion, the subdued rate of rise in hourly compensation seemed to be, in part, a reflection of greater concerns among workers about job security. We now seem to have moved beyond that period of especially acute concern, though the flux of technology may still leave many workers with fears of job skill obsolescence and a willingness to trade wage gains for job security. This may explain why, despite the recent acceleration of wages, the resulting level of compensation has fallen short of what the experience of previous expansions would have led us to anticipate given the current degree of labor market tightness. In the past couple of years, of course, workers have not had to press especially hard for nominal pay gains to realize sizable increases in their real wages. In contrast to the pattern that developed in several previous business expansions, when workers required substantial increases in pay just to cover increases in the cost of living, consumer prices have been generally well-behaved in the current expansion. Changes this past year in prices of both goods and services have been among the smallest of recent decades. In addition, the rate of rise in the cost of benefits that employers provide to workers has been remarkably subdued over the past few years, although a gradual upward tilt has become evident of late. A variety of factors -- including the strength of the economy and rising equity values, which have reduced the need for payments into unemployment trust funds and pension plans, and the restructuring of the health care sector -- have been working to keep benefit costs in check in this expansion. But, in the medical area at least, the most recent developments suggest that the favorable trend may have run its course. The slowing of price increases for medical services seems to have come to a halt, at least for a time, and, with the cost-saving shift to managed care having been largely completed, the potential for businesses to achieve further savings in that regard appears to be rather limited at this point. There have been a few striking instances this past year of employers boosting outlays for health benefits by substantial amounts. A couple of years ago -- almost at the same time that increases in total hourly compensation began trending up in nominal terms -- evidence of a long-awaited pickup in the growth of labor productivity began to show through more strongly in the data; and this accelerated increase in output per hour has enabled firms to meet workers' real wage demands while holding the line on price increases. Gains in productivity usually vary with the strength of the economy, and the favorable results that we have observed during the past two years or so, when the economy has been growing more rapidly, surely overstate the degree of pickup that can be sustained. But evidence continues to mount that the trend has picked up, even if the extent of that improvement is as yet unclear. Signs of a major technological transformation of the economy are all around us, and the benefits are evident not only in high-tech industries but also in production processes that have long been part of our industrial economy. Notwithstanding a reasonably optimistic interpretation of the recent productivity numbers, it would not be prudent to assume that rising productivity, by itself, can ensure a non-inflationary future. Certainly wage increases, per se, are not inflationary. To be avoided are those that exceed productivity growth, thereby creating pressure for inflationary price increases that can eventually undermine economic growth and employment. Because the level of productivity is tied to an important degree to the physical stock of capital, which turns over only gradually, increases in the trend growth of productivity probably also occur rather gradually. By contrast, the potential for abrupt acceleration of nominal hourly compensation is surely greater. Still, a strong signal of inflation pressures building because of compensation increases markedly in excess of productivity gains has not yet clearly emerged in this expansion. Among nonfinancial corporations, our most reliable source of consolidated costs, trends in costs seem to have accelerated from their lows, but the rates of increase in both unit labor costs and total unit costs are still quite low. Nonetheless, as I have noted in previous appearances before Congress, I remain concerned that economic growth will run into constraints as the reservoir of unemployed people available to work is drawn down. The annual increase in the working-age population (from 16 to 64 years of age), including immigrants, has been approximately 1 percent a year in recent years. Yet employment, measured by the count of persons who are working rather than by the count of jobs, has been rising 2 percent a year since 1995 despite the acceleration in the growth of output per hour. The gap between employment growth and population growth, amounting to about 1.2 million a year on average, has been made up, in part, by a decline in the number of individuals who are counted as unemployed those persons who are actively seeking work -- of approximately 700,000 a year, on average, since the end of 1995. The remainder of the gap has reflected a rise in labor force participation that can be traced to a decline of more than 500,000 a year in the number of individuals (age 16 to 64) wanting a job but not actively seeking one. Presumably, many of the persons who once were in this group have more recently become active and successful job-seekers as the economy has strengthened, thereby preventing a still sharper drop in the official unemployment rate. In May, the number of persons aged 16 to 64 who wanted to work but who did not have jobs was 9.7 million on a seasonally adjusted basis, slightly more than $51 / 2$ percent of the working-age population. This percentage is a record low for the series, which first became available in 1970. The gap between the growth in employment and that of the working-age population will inevitably close. What is crucial to sustaining this unprecedented period of prosperity is whether that closing occurs in a disruptive or gradual, balanced manner. The effects of the crisis in Asia will almost certainly damp net exports further, potentially moderating the growth of domestic production and hence employment. The strength of domestic spending that has been bolstering output growth and the demand for labor also could ebb if recent indications of a narrowing in domestic profit margins were to prove to be the forerunner of a reassessment of the expected rates of return on plant and equipment. Reduced prospects for the return to capital would not only affect investment directly but could also affect consumption as stock prices adjusted to a less optimistic view of earnings prospects. Finally, the clearly unsustainable rise of inventories that has been evident in recent quarters will be slowing at some point, perhaps abruptly. An easing of the demand for labor would be an expected consequence of a slowdown in either final sales or inventory accumulation. Of course, the demand for labor that is consistent with a particular rate of output growth also could be lowered if productivity were to continue to accelerate. And, on the supply side of the labor market, faster growth of the labor force could emerge as the result of delayed retirements or increased immigration. If developments such as these do not bring labor demand into line with its sustainable supply, tighter economic policy may be necessary to help guard against a buildup of pressures that could derail the current prosperity. Fortunately, fiscal policy has been moving toward restraint to some degree, although recent budgetary discussions do not appear to be focused on extending that tendency. Monetary policy might need to tighten if demand were to continue to exhibit few signs of abating noticeably, thereby threatening to place still further strains on our labor markets. We at the Federal Reserve, recognizing the powerful forces of productivity growth and global restraint on inflation, have not perceived to date the need to tighten policy in response to strong demand, beyond what has occurred through falling inflation's upward pressure on the real federal funds rate and the modest increase in the nominal rate that we initiated in March of 1997. But, we are monitoring the evolving forces very closely to determine whether the recent acceleration of costs, albeit moderate, is likely to prove transitory or the start of a more worrisome pattern that may well require a response. In summary, Mr. Chairman, our economy has remained strong this year despite evidence of substantial drag from Asia, and, at the same time, inflation has remained low. As I have indicated, this set of circumstances is not what historical relationships would have led us to expect at this point in the business expansion, and while it is possible that we have, in a sense, moved "beyond history", we also have to be alert to the possibility that less favorable historical relationships will eventually reassert themselves. That is why we are remaining watchful for signs of potential inflationary imbalances, even as the economy continues to perform more impressively than it has in a very long time.
1998-06-23T00:00:00	Mr. Patrikis discusses the implications of the Year 2000 computer problem for international banking and finance (Central Bank Articles and Speeches, 23 Jun 98)	Statement by the First Vice-President of the Federal Reserve Bank of New York, Mr. Ernest T. Patrikis, before the Committee on Banking and Financial Services of the US House of Representatives on 23/6/98.	Mr. Patrikis discusses the implications of the Year 2000 computer problem for Statement by the First Vice-President of the Federal Reserve international banking and finance Bank of New York, Mr. Ernest T. Patrikis, before the Committee on Banking and Financial Services of the US House of Representatives on 23/6/98. I am pleased to appear before the Committee today to discuss the implications of the Year 2000 computer problem for international banking and finance. I am appearing in my capacity as Chairman of the Joint Year 2000 Council, which is sponsored jointly by the Basle Committee on Banking Supervision, the G-10 central bank governors' Committee on Payment and Settlement Systems, the International Association of Insurance Supervisors, and the International Organization of Securities Commissions (collectively referred to as the "Sponsoring Organizations"). The international financial community has much work to do to prepare itself for the challenges posed by the Year 2000 ("Y2K") problem. While much good work is being done and progress in many areas is evident, more needs doing. The Sponsoring Organizations believe that mutual cooperation and information sharing can play a key role in helping individual market participants carry out these preparations and limit the scope of Y2K-related disruptions. Our major concern, of course, will be the possible impact of the Y2K problem on the functioning of the international financial system as a whole. Federal Reserve Governor Edward W. Kelley, Jr. has recently elaborated on the activities of the Federal Reserve System in connection with the Y2K problem, as well on possible macroeconomic implications.1 I will not attempt to cover those topics again here. Instead, this morning I will begin with some background on the possible implications of the Y2K problem for international banking and finance. Second, I will describe how various supervisory initiatives led to the formation of the Joint Year 2000 Council a little more than two months ago. Third, I will discuss the actions being taken by the Joint Year 2000 Council, particularly in the areas of raising awareness, improving preparedness, and contingency planning. Background on the International Implications of the Y2K Problem The Y2K bug potentially affects all organizations that are dependent on computer software applications or on embedded computer chips. In other words, nearly all financial organizations worldwide are potentially at risk. Even those whose own operations remain strictly paper-based are likely to be dependent on power, water, and telecommunications utilities, which must themselves address possible Y2K problems. Also, many non-financial customers have dependencies on technology. All countries of the world, therefore, need to address the Y2K problem and its potential effects on their domestic financial markets. In some cases, it is said that computer systems in particular countries are not much affected because their national calendars are not based on the conventional Gregorian calendar used in the United States and many other countries. I do not derive much comfort from these statements because in most cases operating systems and the software applications running on them count internally with a conventional date system that may not be Y2K-compliant. These systems typically also need to connect and interact with other systems that use conventional dates, so these interfaces must be tested for Y2K-compliance. More broadly, mere assertions that computer applications are unaffected cannot be seen as a substitute for the rigorous assessment, remediation, and testing efforts that should be undertaken by financial market participants worldwide. The increasing extent of cross-border, financial-market activity has been much remarked on in recent years. Perhaps less well known is the fact that this activity is dependent on a large, geographically diverse, and highly computer-intensive global infrastructure for each of the key phases of this activity -- from trade execution through to payment and settlement. As an example, consider the daily financial market activities of a hypothetical US-based mutual fund holding stocks and bonds in a number of foreign jurisdictions. Such a mutual fund would likely execute trades via relationships with a set of securities dealers, who themselves might make use of other securities brokers and dealers, including some outside the United States. The operational integrity of the major securities dealers in each national securities market is critical to the smooth functioning of those markets. In addition, securities trading in most countries is reliant on the proper functioning of the respective exchanges, brokerage networks, or electronic trading systems and the national telecommunications infrastructure on which these all depend. Financial markets today are also highly dependent on the availability of real-time price and trade quotations provided by financial information services. For record-keeping, administration, and trade settlement purposes, our hypothetical mutual fund would also likely maintain a relationship with one or more global custodians (banks or brokerage firms), who themselves would typically maintain relationships with a network of sub-custodians located in various domestic markets around the world. Actual settlement of securities transactions typically occurs over the books of a domestic securities depository, such as the Depository Trust Company ("DTC") or the Fedwire National Book-Entry System in the United States, or at one of the two major international securities depositories, Euroclear and Cedel. Additional clearing firms, such as the National Securities Clearing Corporation ("NSCC") and the Government Securities Clearing Corporation ("GSCC") in the United States, may also occupy central roles in the trade clearance and settlement process. Payments and foreign exchange transactions on behalf of the mutual fund would involve the use of correspondent banks, both for the US dollar and for other relevant currencies. These transactions would typically settle over the books of domestic wholesale payment systems, such as the Clearing House Interbank Payments System ("CHIPS") or Fedwire in the United States, and the new TARGET system for the euro. Correspondent banks are also heavily dependent on the use of cross-border payments messaging through the network maintained by the Society for Worldwide Interbank Financial Telecommunications ("S.W.I.F.T.") to advise and confirm payments. To provide some sense of the magnitudes involved here, consider that the Fedwire and CHIPS systems process a combined $3 trillion in funds transfers on an average day (split roughly evenly between the two systems). While S.W.I.F.T. itself does not transfer funds, its messaging network carries over three million messages per day relating to financial transactions worldwide. The many interconnections of the global financial market infrastructure imply that financial market participants in the United States could be affected by Y2K-related disruptions in other financial markets. In assessing the scope of any such potential problems, we should be realistic in accepting that some disruptions are inevitable, while also recognizing that not all countries confront Y2K problems of similar magnitudes. The problem simply affects too many organizations and too many systems to expect that 100 percent readiness will be achieved throughout the world. Nor are the best efforts of supervisors and regulators capable of completely eradicating the risk of disruption. Ultimately, the work of fixing the Y2K problem rests with firms themselves, and even some of the most determined and well-funded Year 2000 efforts may miss something. Global Year 2000 Round Table Recognizing the global nature of the issues surrounding the Y2K problem, each of the Sponsoring Organizations undertook initiatives in 1997 to raise awareness, enhance disclosure, and prompt appropriate action within the financial industry. Their decision last fall to organize a Global Year 2000 Round Table was motivated by a growing sense of the seriousness of the Y2K challenges posed in many countries and of the potentially severe consequences for financial markets that fail to meet these challenges. The Global Year 2000 Round Table was held at the Bank for International Settlements on April 8, 1998. It was attended by more than 200 senior executives from 52 countries, representing a variety of private and public organizations in the financial, information technology, telecommunications, and business communities around the world.2 The discussions at the Round Table confirmed that the Y2K issue must be a top priority for directors and senior management, and that the public and private sectors should increase efforts to share information. The importance of thorough testing, both internally and with counterparties, was emphasized as the most effective way to ensure that Y2K problems are minimized. Round Table participants identified the need to continue the widening and strengthening of external testing programs in many countries. The communiqué issued by the four Sponsoring Organizations at the close of the Round Table recommended that market participants from regions that have not yet vigorously tackled the problem should consider the need to invest significant resources in the short time that remains. The Sponsoring Organizations further recommended that external testing programs be developed and expanded and that all financial market supervisors worldwide should implement programs that enable them to assess the Y2K readiness of the firms and market infrastructures that they supervise. The Sponsoring Organizations urged telecommunications and electricity providers to share information on the state of their own preparations and encouraged market participants and supervisors and regulators to consider the need to develop appropriate contingency procedures. At the Round Table, a new private-sector initiative known as the Global 2000 Coordinating Group was announced. The aims of the Global 2000 effort are to identify and support coordinated initiatives by the global financial community to improve the Y2K readiness of financial markets worldwide. For example, current Global 2000 projects include the development of recommendations for financial infrastructure testing and guidelines for addressing Y2K compliance issues related to vendors and service providers. The Global 2000 Coordinating Group, which includes representatives from over 75 financial institutions in 18 countries, represents an extremely valuable private-sector attempt at cooperation on this important issue. At the same time, however, the international financial supervisory community recognized that it would be useful to establish a public-sector group, called the Joint Year 2000 Council, that would work with the private sector and also maintain a high level of attention on the Y2K problem among financial market supervisors and regulators worldwide. Joint Year 2000 Council The formation of the Joint Year 2000 Council was announced at the end of the Global Year 2000 Round Table on April 8, 1998. The Joint Year 2000 Council consists of senior members of the four Sponsoring Organizations. Every continent is represented by at least one member on the Council. The Secretariat of the Council is provided by the Bank for International Settlements. I am honored to serve as the Chairman of the Joint Year 2000 Council. The mission of the Joint Year 2000 Council has four parts: First, to ensure a high level of attention on the Y2K computer challenge within the global financial supervisory community; second, to share information on regulatory and supervisory strategies and approaches; third, to discuss possible contingency measures; and fourth, to serve as a point of contact with national and international private-sector initiatives. After their meetings on May 8-9, 1998, the G-7 finance ministers called on the Joint Year 2000 Council and its Sponsoring Organizations to monitor the Y2K-related work in the financial industry worldwide and to take all possible steps to encourage readiness. The Council has met twice since being formed in early April and plans to meet frequently, almost monthly, between now and January, 2000. At our first meeting, we organized our work projects and approved our mission statement. At our second meeting, we met for the first time with an External Consultative Committee consisting of international public-sector and private-sector organizations. Meeting with this External Consultative Committee is intended to enhance the degree of information sharing and the raising of awareness on different aspects of the Year 2000 problem by both public and private sectors within the global financial markets. The External Consultative Committee includes representatives from international payment and settlement mechanisms (such as S.W.I.F.T., Euroclear, Cedel, and VISA), from international financial market associations (such as the International Swaps and Derivatives Association, the International Institute of Finance, and the Global 2000 Coordinating Group), from multilateral organizations (such as the IMF, OECD, and World Bank), from the financial rating agencies (such as Moody's and Standard & Poor's), and from a number of other international organizations (such as the International Telecommunications Union, Reuters, the International Federation of Accountants, and the International Chamber of Commerce). This diversity of perspectives led to an extremely valuable discussion with the Joint Year 2000 Council and stimulated work on several projects to be taken forward with input from both the public and private sectors, for example, the initiatives on Y2K testing and self-assessment that I will describe shortly. Further sessions with the External Consultative Committee are planned on a quarterly basis. It is important at the outset for me to be clear that the Joint Year 2000 Council is not intended to become a global Y2K regulatory authority, with sweeping powers to coordinate international action or to take responsibility for ensuring Y2K readiness in every financial market worldwide. Through our ability to serve as a clearinghouse for Y2K information, however, I believe that the Joint Year 2000 Council will play a positive role in three areas: (1) raising awareness, (2) improving preparedness, and (3) contingency planning. In the next portion of my remarks, I would like to address each of these roles in turn. Efforts to Promote Awareness The Joint Year 2000 Council is undertaking a series of initiatives that may be described under the heading of promoting awareness. By this term, I do not mean to include only those initiatives aimed at raising general awareness, although that too is still needed in some cases. I mean to include efforts to promote better awareness of the many efforts currently under way to tackle the Y2K problem. I have found that, while many organizations are working hard on various aspects of the Y2K challenge, in many cases these efforts would be enhanced by a greater degree of information sharing with others. For example, at the Federal Reserve Bank of New York, we have been holding quarterly Y2K forums with a diverse set of financial organizations in the area. Participants have requested that we continue to hold these meetings -- in fact, to hold them even more frequently -- because they believe that the contacts and the exchange of views are broadly beneficial. We hope to use the Joint Year 2000 Council to achieve similar goals. Each of the members of the Joint Year 2000 Council has committed to help play a leading role in promoting awareness of Y2K initiatives within their region. Each of us will help in coordinating regional Y2K forums or conferences and will publicly promote the goals of the Joint Year 2000 Council in speeches and on conference programs. The Joint Year 2000 Council will also maintain extensive world-wide-web pages that can be accessed freely over the Internet.3 These pages are being maintained through the support the Council has received from the Bank for International Settlements, in particular from the General Manager, Andrew Crockett. These web pages will maintain current information on the activities of the Joint Year 2000 Council. The most extensive aspect of the Council's web site will be a series of country pages, one for each country in the world. For each country, the page will contain contact information for government entities (including national coordinators), financial industry supervisors and regulators (including central banks, banking supervisors, insurance supervisors, and securities regulators), financial industry associations, payment, settlement and trading systems, chambers of commerce, and major utility associations or supervisors. For each of these organizations, a name, address, phone number, fax number, electronic mail and web site address will be provided. Other relevant information on an organization's Y2K preparations may also be included, for example, whether it has a dedicated Y2K contact or has taken specific action with respect to the Y2K problem. The motivation for developing these country pages is to increase awareness of the work that is being done to address the Y2K problem and to enable market participants to easily find out more information about the state of preparations worldwide. Establishing these national contacts will also help to develop the informal networks and arrangements that may be needed in addressing other Y2K-related issues, for example, in formulating contingency measures. Finally, of course, the presence of the country pages may exert pressure on those countries where more vigorous action is needed. A blank or uninformative country listing would probably not be seen as a good sign by some financial market participants. In addition, the web pages of the Joint Year 2000 Council will also provide summaries of the efforts being undertaken by its Sponsoring Organizations as well as links to the relevant web sites. For example, reports on Y2K surveys of supervisors and regulators being undertaken by the Basle Committee on Banking Supervision and by the International Organization of Securities Commissions are planned to be made available on the Joint Year 2000 Council web site. Public papers produced by the Joint Year 2000 Council will also be available on the web site. A listing of international conferences and seminars related to Y2K will be posted on the web site, together with links to other Y2K web sites and documents. At this stage, each member of the Joint Year 2000 Council is in the process of finalizing the country page for its respective country. Last week, I wrote to every contact provided by 3 The web pages of the Joint Year 2000 Council can be reached at the web site of the Bank for International Settlements (www.bis.org). These pages will also be registered under the name jy2kcouncil.org in the near future. the four Sponsoring Organizations (almost 600 contacts in over 170 countries), asking for assistance in coordinating the development of their country page. This also provided a further opportunity to raise the awareness of the Year 2000 problem at the most senior levels of financial market authorities and supervisors in countries around the world. Through the effort to develop this web site and other similar efforts by the Joint Year 2000 Council, I believe we can succeed at keeping the awareness of the issue at a very high level within the global financial supervisory community. Efforts to Improve Preparedness Of course, awareness of the Year 2000 problem is only the first step in addressing it. Global efforts to prepare for Year 2000 vary widely, and many countries believe that more coordinated national action will be necessary to tackle the problem as effectively as possible. At our second meeting of the Joint Year 2000 Council, a strong consensus emerged that a national government body in each country could play a helpful role in coordinating preparations for Y2K. While the Council did not have a strong view on what particular form or what specific authority such a body would require in each specific country, the Council members felt strongly that involvement in some fashion by the national government could be beneficial. Accordingly, the Joint Year 2000 Council plans to issue a statement in the near future providing general support for the concept of a national-level coordinating body for the Y2K problem. In the United States, of course, the White House has established the President's Council on Year 2000 Conversion, headed by John Koskinen. This effort, as well as those of this committee under the leadership of Chairman Leach, and of the other Congressional committees that have addressed the Y2K problem, has shown that national government bodies have a very important and useful role to play in encouraging progress in addressing the Y2K problem. Turning now to the question of how financial supervisors can implement effective Y2K programs, the Joint Year 2000 Council intends to promote the sharing of strategies and approaches. For example, the Basle Committee on Banking Supervision has prepared a paper containing "Supervisory Guidance on Independent Assessment of Bank Year 2000 Preparations". This document is aimed at moving supervisors worldwide from a level of general awareness to a specific, concrete program of action for overseeing Y2K preparations, both on an individual bank basis and on a system-wide basis. The Joint Year 2000 Council intends to adapt this paper for use by financial market regulators and supervisors more broadly and to issue it as rapidly as possible with the endorsement of all four Sponsoring Organizations. The goal will be to provide guidance in developing specific Year 2000 action plans for all types of financial market authorities. Supervisors in countries that have gotten a head start on the issue can thereby provide the benefit of their experience to those who are starting later. Those supervisors getting a late start have a need for tools of this type. The Joint Year 2000 Council will also be working with the members of our External Consultative Committee, particularly the Global 2000 Coordinating Group, to build on this effort and develop a Y2K self-assessment tool that could be used broadly by the financial industry in countries around the world. We also intend to develop additional papers on a variety of Y2K topics that might be of interest to the global financial supervisory community. At this point, I am sure that members of the Committee have questions regarding the state of Y2K preparations in various parts of the world. I think that it is fair to say that most believe a spectrum exists, with the United States at one end of the spectrum, and emerging market and undeveloped countries at the other end. There are likely exceptions of course; some developed countries are probably less far along than they should be. Some emerging market countries, on the other hand, appear to be quite advanced in their preparations. Overall, however, there is still not nearly enough concrete, comparable information on the preparations of individual institutions to be able to make any confident statements about the state of global preparations in any detail. Over the time remaining until January 2000, we hope to use the Joint Year 2000 Council as a means of gathering a better picture of the state of global preparations, and to help direct resources and attention to those regions that appear to be faltering in their efforts. We will use the information provided for our web site and the discussions with members of our External Consultative Committee as our primary resources in seeking to identify "hot spots" where more urgent efforts are needed. If we identify regions where more needs to be done, our first step will be to work through the relevant national financial supervisors and regulators to increase the urgency of efforts in their jurisdiction. We may also involve multilateral institutions, such as the World Bank, to help increase national attention on the issue. I do not believe that calling public attention to problems in specific countries would be a constructive step for us to take at this stage as we are still trying to build cooperation and our current information is incomplete. In this context, I would also point out that the market itself will begin to bring strong pressures to bear on specific firms and markets that exhibit signs of being ill-prepared during the course of 1999. In conjunction with preparations for Y2K, the recent discussion of the Joint Year 2000 Council with the External Consultative Committee raised several important issues. First, in every national market there is the question of the dependence of the banking and financial sectors on core infrastructure such as telecommunications, power, water, sewer, and transportation. In all cases, it seems that it is not an everyday occurrence for representatives of these differing sectors to get together with financial sector representatives and discuss their mutual concerns. Yet, this must be made a priority if financial firms and their counterparties are to achieve comfort that their own efforts to prepare for Year 2000 will not be compromised by the failures of systems beyond their control. A representative of the International Telecommunications Union is a member of our External Consultative Committee. At our meeting earlier this month, he provided useful factual information on the preparations being undertaken by telecommunications firms and indicated that a further global survey and report on this topic is due to be completed soon. This is the type of information sharing that helps all parties understand the scope of the problem, as well as the efforts that others are undertaking. We intend to encourage further information sharing between the financial sector and core infrastructure providers at future meetings of the Joint Year 2000 Council and the External Consultative Committee. I would also strongly encourage such mutual cooperation on Y2K preparations within each national jurisdiction. Another issue that some participants in our Joint Year 2000 Council are concerned about in regard to preparations in their countries relates to the availability of human resources. In some regions, the supply of available information technology professionals may be hard-pressed to meet the challenges posed by Y2K. For each organization facing resource constraints, this situation clearly indicates the need to develop action plans for Y2K that set clear priorities among systems and projects. More broadly, we must also recognize that the lack of available programming resources will be a significant overall constraint on the scale of Y2K remediation efforts globally. As a result, the cost of hiring computer professionals capable of addressing the problem will continue to rise. Wealthy countries are undoubtedly in a better position to bear these increasing costs than are poor countries. A number of participants from our External Consultative Committee cited the recent grant of £10 million sterling by the British Government to the World Bank as a positive development. Among other projects, the World Bank intends to use this grant to fund a variety of educational and awareness-raising events related to Y2K over the next several months. Given the potential consequences of a failure to prepare for Y2K, the World Bank indicated to the Joint Year 2000 Council that it intends to take on an aggressive role in promoting and assisting Y2K efforts in countries around the world. The Joint Year 2000 Council intends to work closely with the World Bank to enhance our mutual efforts on the Y2K problem. The subject of appropriate Y2K disclosure was also discussed by members of the External Consultative Committee. Many of those present agreed that greater disclosures would be helpful. However, there was skepticism that a standardized disclosure format would be effective in eliciting meaningful information for a wide class of financial firms, given the complexity and variety of Y2K issues facing these firms worldwide. It was also noted that disclosure which relies primarily on a firm's own subjective assessments of its Y2K problems inevitably will suffer from an optimistic bias. In addition, most Y2K efforts will not reach the serious testing phase until 1999. The purpose of the testing will be to uncover areas where additional work is required, so that the first round of tests can be expected to encounter problems. In this environment, it may be difficult for firms themselves to assess the true state of their Y2K preparations. Also, firms who believe they are going to be ready will be directed by legal counsel not to make too strong a statement to avoid liability claims in case of unforeseen problems. On the other hand, firms that do not believe they can get ready in time will seek to avoid stating this clearly to protect their activities during 1999. For all of these reasons, I am doubtful that specific, reliable information on the state of Y2K preparations by individual firms worldwide will become publicly available. Finally, in the area of improving preparedness, I have saved the most important topic for last -- namely, testing. Testing programs, particularly external testing programs, are universally regarded as the most critical element of serious Y2K preparations in the financial sector. The Joint Year 2000 Council encourages all firms and institutions active in the financial markets to engage in internal and external testing of their important applications and interfaces. To this end, many major payment and settlement systems around the world have developed extensive testing programs and procedures for their participants. In the United States, for example, Fedwire, CHIPS, and S.W.I.F.T. have coordinated shared testing days for the purpose of testing the major international wholesale payments infrastructure for the US dollar. The Securities Industry Association ("SIA") has been at the forefront of an ambitious program to develop a coordinated industry-wide test of all aspects of the trading and settlement infrastructure for the US stock market. The FFIEC's efforts have also been extremely beneficial in stressing the importance of testing within the banking sector generally. Yet, external testing programs globally need to be dramatically extended and expanded. To that end, the G-10 Committee on Payment and Settlement Systems last year started to collect information on the state of preparedness and testing of payment and settlement systems worldwide. To date, over 150 systems in 47 countries have responded to the framework and posted such plans.4 The Joint Year 2000 Council intends to expand the coverage of this framework to exchanges and trading systems, as well as major financial information services providers, and hopes to expand the number of countries and systems that are included. We will also collate and present the information graphically to help highlight anomalies in testing schedules, and to facilitate the efforts of systems to coordinate test scheduling where feasible. 4 The relevant information can now be found on the pages of the Joint Year 2000 Council. Primarily, I see this as an exercise in peer pressure. If we list every country in the world on our web site and the public can see that some countries have scheduled mandatory external tests of their major trading and settlement systems, while other countries do not provide any information, that second country may come under greater pressure to organize an external testing program. This is our stated goal. We will simply have blanks for those countries that do not respond to our requests for information. Of course, if the Joint Year 2000 Council is going to encourage testing to such an extent, then it is only appropriate that we also help provide some tools for those countries trying to get a serious testing effort underway in a short amount of time. This is another of our high-priority projects. We will be working with members of the External Consultative Committee -- including representatives of the Global 2000 Coordinating Group, S.W.I.F.T., and the World Bank -- to rapidly develop a series of documents that help countries set up testing programs and overcome common obstacles. We intend to issue these documents broadly by the end of the summer, and some parts well before that. In closing this section of my statement, I do not think it is possible to over-emphasize the importance of testing to help improve readiness. To illustrate this point, I would like to draw on our experiences with Fedwire, the Federal Reserve's wholesale interbank payments system. Much of the current Fedwire software application was written in the last five years, with the Y2K problem in mind. Nevertheless, some of the older software code that was carried over into the new application was not Y2K-compliant. Without the rigorous internal Y2K testing program that the Federal Reserve adopted, our Y2K remediation efforts might, therefore, have been incomplete. I think of this experience whenever I hear it said that some countries are immune to Y2K because they have only recently introduced information technology and that recent software programs are less affected by Y2K. I ask whether those programs have truly been thoroughly tested for Y2K compliance. Contingency Planning Efforts The third major role of the Joint Year 2000 Council will relate to contingency planning. In this context, I should note that contingency planning is something that most financial market authorities, particularly central banks, undertake regularly with regard to a wide variety of potential market disruptions. Most private-sector financial firms, as well, have well developed contingency and business continuity plans in place for their operations. Nevertheless, it is clear that contingency planning for Y2K problems has a number of unique characteristics. First, of course, is the fact that one cannot rely on a backup computer site for Y2K contingency if that site also uses the same software that is the cause of the Y2K problem at the main site. In some cases, it is impractical to build a duplicate software system from scratch simply to provide for Y2K contingency. In these cases, as a senior banker explained at one of our New York Y2K forums, contingency planning amounts to, "Testing, testing, and more testing." Contingency planning can also be separated into components that are firm-specific and those that are market-wide. Each individual firm will need to develop its own contingency plans designed to maintain the integrity of its operations during the changeover to the Year 2000. The FFIEC has recently issued guidance to banks in the United States regarding the core elements of their own contingency planning.5 The Joint Year 2000 Council will also be developing a paper on contingency planning for the benefit of the global financial supervisory community. This paper will seek to address firm-level contingency as well as issues of market-wide contingency. Market-wide contingency refers to the planning by participants and supervisors done to ensure that individual disruptions can be managed in ways that will prevent them from causing disruptions to critical market infrastructures. For instance, we at the Federal Reserve have gone to great lengths to ensure that barriers are in place to prevent Y2K problems with a Fedwire participant from causing problems on the Fedwire system itself. We are also now actively researching additional steps that the Federal Reserve could take to better prepare the financial markets as a whole to function in spite of disruptions at individual firms. It is also important to realize that contingency planning for Y2K is not solely an operational issue. Financial firms may seek to adopt a defensive posture in the marketplace well ahead of Monday, January 3, 2000 (the first business day of the new year in the United States). For example, market participants may seek to minimize the number of transactions that would be scheduled for settlement on January 3 or January 4, or that would require open positions to be maintained over the century date change weekend. Contingency planning involves a series of elements, many of which must be put in place well before January 2000. For example, we must consider many possible sources of disruption and determine what approaches could be available to limit the impact of each possible disruption. The sooner such thinking occurs, the more opportunity we have to plan around the possible disruptions. In this context, members of our External Consultative Committee noted that one of the key obstacles to effective contingency planning is the inability to list and consider all possible disruption scenarios. Several of these participants noted that their firms were engaging consultants or other procedures to expand the number of scenarios for inclusion in their Y2K contingency planning. In New York, we will be using our Y2K forum next month to discuss contingency planning with a diverse set of market participants. These local market participants will provide helpful insights for the Joint Year 2000 Council. Clearly, more work is needed on contingency planning for Y2K, especially at the international level. Once we get beyond the early fall of this year, I believe that these efforts will begin to receive much greater focus and attention, and -- together with testing -- will dominate our discussions of Y2K during 1999. Closing Remarks In closing, I would like to thank the Committee for the opportunity to appear and submit a statement on this important issue. I hope that the efforts of the Joint Year 2000 Council will help to make a difference in improving the state of Y2K preparations in the international financial community. Realistically, however, I believe that it is important to understand the limits of what financial market supervisors can accomplish, either individually or collectively. Only firms themselves have the ability to address the Year 2000 problems that exist within their own organizations. Only firms working together can assure that local markets will function normally. Supervisors and regulators cannot guarantee that disruptions will not occur. Given the sheer number of organizations that are potentially at risk, it is inevitable that Y2K-related disruptions will occur. Today it would be impossible to predict the precise nature of these disruptions. However, we do know that financial markets have in the past survived many other serious disruptions, including blackouts, snow storms, ice storms, and floods. We will also have a very interesting case at the end of this year with the changeover to monetary union in Europe. We will all be watching carefully to see whether the extent of operational problems related to this event is greater or less than expected. I would also like to say at this point that my discussions with other members of the Joint Year 2000 Council and with members of the External Consultative Committee have convinced me that successful efforts to address the Y2K problem will be dependent on the credibility of those calling for action. Those of us - such as members of this Committee as well as others in Congress - who are seriously engaged and concerned need to be able to persuade others of the need to take appropriate actions promptly. It would be unfortunate if general perceptions of the Y2K problem are driven primarily by unofficial commentators whose rhetoric is seen to exceed the facts on which it is based, and therefore easily dismissed. As a central banker and bank supervisor, my major concern must be with the system as a whole. At this point, I believe that we are doing everything possible to limit the possibility that Y2K disruptions will have systemic consequences in our markets. However, we must all continue to work hard -- both individually and cooperatively -- in the time that remains to ensure that this threat does not become more concrete. In that spirit, Mr. Chairman, I would like to end my remarks by commending the Committee for organizing these hearings on the implications of the Year 2000 computer problem for international banking and finance.	---[PAGE_BREAK]--- # Mr. Patrikis discusses the implications of the Year 2000 computer problem for international banking and finance Statement by the First Vice-President of the Federal Reserve Bank of New York, Mr. Ernest T. Patrikis, before the Committee on Banking and Financial Services of the US House of Representatives on 23/6/98. I am pleased to appear before the Committee today to discuss the implications of the Year 2000 computer problem for international banking and finance. I am appearing in my capacity as Chairman of the Joint Year 2000 Council, which is sponsored jointly by the Basle Committee on Banking Supervision, the G-10 central bank governors' Committee on Payment and Settlement Systems, the International Association of Insurance Supervisors, and the International Organization of Securities Commissions (collectively referred to as the "Sponsoring Organizations"). The international financial community has much work to do to prepare itself for the challenges posed by the Year 2000 ("Y2K") problem. While much good work is being done and progress in many areas is evident, more needs doing. The Sponsoring Organizations believe that mutual cooperation and information sharing can play a key role in helping individual market participants carry out these preparations and limit the scope of Y2K-related disruptions. Our major concern, of course, will be the possible impact of the Y2K problem on the functioning of the international financial system as a whole. Federal Reserve Governor Edward W. Kelley, Jr. has recently elaborated on the activities of the Federal Reserve System in connection with the Y2K problem, as well on possible macroeconomic implications. ${ }^{1}$ I will not attempt to cover those topics again here. Instead, this morning I will begin with some background on the possible implications of the Y2K problem for international banking and finance. Second, I will describe how various supervisory initiatives led to the formation of the Joint Year 2000 Council a little more than two months ago. Third, I will discuss the actions being taken by the Joint Year 2000 Council, particularly in the areas of raising awareness, improving preparedness, and contingency planning. ## Background on the International Implications of the Y2K Problem The Y2K bug potentially affects all organizations that are dependent on computer software applications or on embedded computer chips. In other words, nearly all financial organizations worldwide are potentially at risk. Even those whose own operations remain strictly paper-based are likely to be dependent on power, water, and telecommunications utilities, which must themselves address possible Y2K problems. Also, many non-financial customers have dependencies on technology. All countries of the world, therefore, need to address the Y2K problem and its potential effects on their domestic financial markets. In some cases, it is said that computer systems in particular countries are not much affected because their national calendars are not based on the conventional Gregorian calendar used in the United States and many other countries. I do not derive much comfort from these statements because in most cases operating systems and the software applications running on them count internally with a conventional date system that may not be Y2K-compliant. These systems typically also need to connect and interact with other systems that use conventional dates, so these interfaces must be tested for Y2K-compliance. More broadly, mere assertions that computer applications are unaffected cannot be seen as a substitute for the rigorous [^0] [^0]: 1 See Testimony of Governor Edward W. Kelley, ir. Before the Committee on Commerce, Science, and Transportation, U.S. Senate. April 28, 1998. ---[PAGE_BREAK]--- assessment, remediation, and testing efforts that should be undertaken by financial market participants worldwide. The increasing extent of cross-border, financial-market activity has been much remarked on in recent years. Perhaps less well known is the fact that this activity is dependent on a large, geographically diverse, and highly computer-intensive global infrastructure for each of the key phases of this activity -- from trade execution through to payment and settlement. As an example, consider the daily financial market activities of a hypothetical US-based mutual fund holding stocks and bonds in a number of foreign jurisdictions. Such a mutual fund would likely execute trades via relationships with a set of securities dealers, who themselves might make use of other securities brokers and dealers, including some outside the United States. The operational integrity of the major securities dealers in each national securities market is critical to the smooth functioning of those markets. In addition, securities trading in most countries is reliant on the proper functioning of the respective exchanges, brokerage networks, or electronic trading systems and the national telecommunications infrastructure on which these all depend. Financial markets today are also highly dependent on the availability of real-time price and trade quotations provided by financial information services. For record-keeping, administration, and trade settlement purposes, our hypothetical mutual fund would also likely maintain a relationship with one or more global custodians (banks or brokerage firms), who themselves would typically maintain relationships with a network of sub-custodians located in various domestic markets around the world. Actual settlement of securities transactions typically occurs over the books of a domestic securities depository, such as the Depository Trust Company ("DTC") or the Fedwire National Book-Entry System in the United States, or at one of the two major international securities depositories, Euroclear and Cedel. Additional clearing firms, such as the National Securities Clearing Corporation ("NSCC") and the Government Securities Clearing Corporation ("GSCC") in the United States, may also occupy central roles in the trade clearance and settlement process. Payments and foreign exchange transactions on behalf of the mutual fund would involve the use of correspondent banks, both for the US dollar and for other relevant currencies. These transactions would typically settle over the books of domestic wholesale payment systems, such as the Clearing House Interbank Payments System ("CHIPS") or Fedwire in the United States, and the new TARGET system for the euro. Correspondent banks are also heavily dependent on the use of cross-border payments messaging through the network maintained by the Society for Worldwide Interbank Financial Telecommunications ("S.W.I.F.T.") to advise and confirm payments. To provide some sense of the magnitudes involved here, consider that the Fedwire and CHIPS systems process a combined $\$ 3$ trillion in funds transfers on an average day (split roughly evenly between the two systems). While S.W.I.F.T. itself does not transfer funds, its messaging network carries over three million messages per day relating to financial transactions worldwide. The many interconnections of the global financial market infrastructure imply that financial market participants in the United States could be affected by Y2K-related disruptions in other financial markets. In assessing the scope of any such potential problems, we should be realistic in accepting that some disruptions are inevitable, while also recognizing that not all countries confront Y2K problems of similar magnitudes. The problem simply affects too many organizations and too many systems to expect that 100 percent readiness will be achieved throughout the world. Nor are the best efforts of supervisors and regulators capable of completely eradicating the risk of disruption. Ultimately, the work of fixing the Y2K problem rests with firms themselves, and even some of the most determined and well-funded Year 2000 efforts may miss something. Global Year 2000 Round Table ---[PAGE_BREAK]--- Recognizing the global nature of the issues surrounding the Y2K problem, each of the Sponsoring Organizations undertook initiatives in 1997 to raise awareness, enhance disclosure, and prompt appropriate action within the financial industry. Their decision last fall to organize a Global Year 2000 Round Table was motivated by a growing sense of the seriousness of the Y2K challenges posed in many countries and of the potentially severe consequences for financial markets that fail to meet these challenges. The Global Year 2000 Round Table was held at the Bank for International Settlements on April 8, 1998. It was attended by more than 200 senior executives from 52 countries, representing a variety of private and public organizations in the financial, information technology, telecommunications, and business communities around the world. ${ }^{2}$ The discussions at the Round Table confirmed that the Y2K issue must be a top priority for directors and senior management, and that the public and private sectors should increase efforts to share information. The importance of thorough testing, both internally and with counterparties, was emphasized as the most effective way to ensure that Y2K problems are minimized. Round Table participants identified the need to continue the widening and strengthening of external testing programs in many countries. The communiqué issued by the four Sponsoring Organizations at the close of the Round Table recommended that market participants from regions that have not yet vigorously tackled the problem should consider the need to invest significant resources in the short time that remains. The Sponsoring Organizations further recommended that external testing programs be developed and expanded and that all financial market supervisors worldwide should implement programs that enable them to assess the Y2K readiness of the firms and market infrastructures that they supervise. The Sponsoring Organizations urged telecommunications and electricity providers to share information on the state of their own preparations and encouraged market participants and supervisors and regulators to consider the need to develop appropriate contingency procedures. At the Round Table, a new private-sector initiative known as the Global 2000 Coordinating Group was announced. The aims of the Global 2000 effort are to identify and support coordinated initiatives by the global financial community to improve the Y2K readiness of financial markets worldwide. For example, current Global 2000 projects include the development of recommendations for financial infrastructure testing and guidelines for addressing Y2K compliance issues related to vendors and service providers. The Global 2000 Coordinating Group, which includes representatives from over 75 financial institutions in 18 countries, represents an extremely valuable private-sector attempt at cooperation on this important issue. At the same time, however, the international financial supervisory community recognized that it would be useful to establish a public-sector group, called the Joint Year 2000 Council, that would work with the private sector and also maintain a high level of attention on the Y2K problem among financial market supervisors and regulators worldwide. [^0] [^0]: 2 A videotape containing highlights of the Global Year 2000 Round Table is available free of charge from the Bank for International Settlements. Please contact the Joint Year 2000 Council Secretariat at the Bank for International Settlements, Centralbahnplatz 2, CH-4002 Basle, Switzerland. (telephone: 4161 2808432, fax: 4161280 9100, email: jy2kcouncil.bis.org) The Federal Financial Institutions Examinations Council ("FFIEC") has also placed the entirety of this videotape on its web site, where it is available for downloading in whole or in part. Please see http://www.bog.frb.fed.us/y2k/video_index.htm\#19980408 ---[PAGE_BREAK]--- Joint Year 2000 Council The formation of the Joint Year 2000 Council was announced at the end of the Global Year 2000 Round Table on April 8, 1998. The Joint Year 2000 Council consists of senior members of the four Sponsoring Organizations. Every continent is represented by at least one member on the Council. The Secretariat of the Council is provided by the Bank for International Settlements. I am honored to serve as the Chairman of the Joint Year 2000 Council. The mission of the Joint Year 2000 Council has four parts: First, to ensure a high level of attention on the Y2K computer challenge within the global financial supervisory community; second, to share information on regulatory and supervisory strategies and approaches; third, to discuss possible contingency measures; and fourth, to serve as a point of contact with national and international private-sector initiatives. After their meetings on May 8-9, 1998, the G-7 finance ministers called on the Joint Year 2000 Council and its Sponsoring Organizations to monitor the Y2K-related work in the financial industry worldwide and to take all possible steps to encourage readiness. The Council has met twice since being formed in early April and plans to meet frequently, almost monthly, between now and January, 2000. At our first meeting, we organized our work projects and approved our mission statement. At our second meeting, we met for the first time with an External Consultative Committee consisting of international public-sector and private-sector organizations. Meeting with this External Consultative Committee is intended to enhance the degree of information sharing and the raising of awareness on different aspects of the Year 2000 problem by both public and private sectors within the global financial markets. The External Consultative Committee includes representatives from international payment and settlement mechanisms (such as S.W.I.F.T., Euroclear, Cedel, and VISA), from international financial market associations (such as the International Swaps and Derivatives Association, the International Institute of Finance, and the Global 2000 Coordinating Group), from multilateral organizations (such as the IMF, OECD, and World Bank), from the financial rating agencies (such as Moody's and Standard \& Poor's), and from a number of other international organizations (such as the International Telecommunications Union, Reuters, the International Federation of Accountants, and the International Chamber of Commerce). This diversity of perspectives led to an extremely valuable discussion with the Joint Year 2000 Council and stimulated work on several projects to be taken forward with input from both the public and private sectors, for example, the initiatives on Y2K testing and self-assessment that I will describe shortly. Further sessions with the External Consultative Committee are planned on a quarterly basis. It is important at the outset for me to be clear that the Joint Year 2000 Council is not intended to become a global Y2K regulatory authority, with sweeping powers to coordinate international action or to take responsibility for ensuring Y2K readiness in every financial market worldwide. Through our ability to serve as a clearinghouse for Y2K information, however, I believe that the Joint Year 2000 Council will play a positive role in three areas: (1) raising awareness, (2) improving preparedness, and (3) contingency planning. In the next portion of my remarks, I would like to address each of these roles in turn. Efforts to Promote Awareness The Joint Year 2000 Council is undertaking a series of initiatives that may be described under the heading of promoting awareness. By this term, I do not mean to include only those initiatives aimed at raising general awareness, although that too is still needed in some cases. I mean to include efforts to promote better awareness of the many efforts currently under way to ---[PAGE_BREAK]--- tackle the Y2K problem. I have found that, while many organizations are working hard on various aspects of the Y2K challenge, in many cases these efforts would be enhanced by a greater degree of information sharing with others. For example, at the Federal Reserve Bank of New York, we have been holding quarterly Y2K forums with a diverse set of financial organizations in the area. Participants have requested that we continue to hold these meetings -- in fact, to hold them even more frequently -- because they believe that the contacts and the exchange of views are broadly beneficial. We hope to use the Joint Year 2000 Council to achieve similar goals. Each of the members of the Joint Year 2000 Council has committed to help play a leading role in promoting awareness of Y2K initiatives within their region. Each of us will help in coordinating regional Y2K forums or conferences and will publicly promote the goals of the Joint Year 2000 Council in speeches and on conference programs. The Joint Year 2000 Council will also maintain extensive world-wide-web pages that can be accessed freely over the Internet. ${ }^{3}$ These pages are being maintained through the support the Council has received from the Bank for International Settlements, in particular from the General Manager, Andrew Crockett. These web pages will maintain current information on the activities of the Joint Year 2000 Council. The most extensive aspect of the Council's web site will be a series of country pages, one for each country in the world. For each country, the page will contain contact information for government entities (including national coordinators), financial industry supervisors and regulators (including central banks, banking supervisors, insurance supervisors, and securities regulators), financial industry associations, payment, settlement and trading systems, chambers of commerce, and major utility associations or supervisors. For each of these organizations, a name, address, phone number, fax number, electronic mail and web site address will be provided. Other relevant information on an organization's Y2K preparations may also be included, for example, whether it has a dedicated Y2K contact or has taken specific action with respect to the Y2K problem. The motivation for developing these country pages is to increase awareness of the work that is being done to address the Y2K problem and to enable market participants to easily find out more information about the state of preparations worldwide. Establishing these national contacts will also help to develop the informal networks and arrangements that may be needed in addressing other Y2K-related issues, for example, in formulating contingency measures. Finally, of course, the presence of the country pages may exert pressure on those countries where more vigorous action is needed. A blank or uninformative country listing would probably not be seen as a good sign by some financial market participants. In addition, the web pages of the Joint Year 2000 Council will also provide summaries of the efforts being undertaken by its Sponsoring Organizations as well as links to the relevant web sites. For example, reports on Y2K surveys of supervisors and regulators being undertaken by the Basle Committee on Banking Supervision and by the International Organization of Securities Commissions are planned to be made available on the Joint Year 2000 Council web site. Public papers produced by the Joint Year 2000 Council will also be available on the web site. A listing of international conferences and seminars related to Y2K will be posted on the web site, together with links to other Y2K web sites and documents. At this stage, each member of the Joint Year 2000 Council is in the process of finalizing the country page for its respective country. Last week, I wrote to every contact provided by [^0] [^0]: 3 The web pages of the joint Year 2000 Council can be reached at the web site of the Bank for International Settlements (www.bis.org). These pages will also be registered under the name jy2kcouncil.org in the near future. ---[PAGE_BREAK]--- the four Sponsoring Organizations (almost 600 contacts in over 170 countries), asking for assistance in coordinating the development of their country page. This also provided a further opportunity to raise the awareness of the Year 2000 problem at the most senior levels of financial market authorities and supervisors in countries around the world. Through the effort to develop this web site and other similar efforts by the Joint Year 2000 Council, I believe we can succeed at keeping the awareness of the issue at a very high level within the global financial supervisory community. # Efforts to Improve Preparedness Of course, awareness of the Year 2000 problem is only the first step in addressing it. Global efforts to prepare for Year 2000 vary widely, and many countries believe that more coordinated national action will be necessary to tackle the problem as effectively as possible. At our second meeting of the Joint Year 2000 Council, a strong consensus emerged that a national government body in each country could play a helpful role in coordinating preparations for Y2K. While the Council did not have a strong view on what particular form or what specific authority such a body would require in each specific country, the Council members felt strongly that involvement in some fashion by the national government could be beneficial. Accordingly, the Joint Year 2000 Council plans to issue a statement in the near future providing general support for the concept of a national-level coordinating body for the Y2K problem. In the United States, of course, the White House has established the President's Council on Year 2000 Conversion, headed by John Koskinen. This effort, as well as those of this committee under the leadership of Chairman Leach, and of the other Congressional committees that have addressed the Y2K problem, has shown that national government bodies have a very important and useful role to play in encouraging progress in addressing the Y2K problem. Turning now to the question of how financial supervisors can implement effective Y2K programs, the Joint Year 2000 Council intends to promote the sharing of strategies and approaches. For example, the Basle Committee on Banking Supervision has prepared a paper containing "Supervisory Guidance on Independent Assessment of Bank Year 2000 Preparations". This document is aimed at moving supervisors worldwide from a level of general awareness to a specific, concrete program of action for overseeing Y2K preparations, both on an individual bank basis and on a system-wide basis. The Joint Year 2000 Council intends to adapt this paper for use by financial market regulators and supervisors more broadly and to issue it as rapidly as possible with the endorsement of all four Sponsoring Organizations. The goal will be to provide guidance in developing specific Year 2000 action plans for all types of financial market authorities. Supervisors in countries that have gotten a head start on the issue can thereby provide the benefit of their experience to those who are starting later. Those supervisors getting a late start have a need for tools of this type. The Joint Year 2000 Council will also be working with the members of our External Consultative Committee, particularly the Global 2000 Coordinating Group, to build on this effort and develop a Y2K self-assessment tool that could be used broadly by the financial industry in countries around the world. We also intend to develop additional papers on a variety of Y2K topics that might be of interest to the global financial supervisory community. At this point, I am sure that members of the Committee have questions regarding the state of Y2K preparations in various parts of the world. I think that it is fair to say that most believe a spectrum exists, with the United States at one end of the spectrum, and emerging market and undeveloped countries at the other end. There are likely exceptions of course; some developed ---[PAGE_BREAK]--- countries are probably less far along than they should be. Some emerging market countries, on the other hand, appear to be quite advanced in their preparations. Overall, however, there is still not nearly enough concrete, comparable information on the preparations of individual institutions to be able to make any confident statements about the state of global preparations in any detail. Over the time remaining until January 2000, we hope to use the Joint Year 2000 Council as a means of gathering a better picture of the state of global preparations, and to help direct resources and attention to those regions that appear to be faltering in their efforts. We will use the information provided for our web site and the discussions with members of our External Consultative Committee as our primary resources in seeking to identify "hot spots" where more urgent efforts are needed. If we identify regions where more needs to be done, our first step will be to work through the relevant national financial supervisors and regulators to increase the urgency of efforts in their jurisdiction. We may also involve multilateral institutions, such as the World Bank, to help increase national attention on the issue. I do not believe that calling public attention to problems in specific countries would be a constructive step for us to take at this stage as we are still trying to build cooperation and our current information is incomplete. In this context, I would also point out that the market itself will begin to bring strong pressures to bear on specific firms and markets that exhibit signs of being ill-prepared during the course of 1999. In conjunction with preparations for Y2K, the recent discussion of the Joint Year 2000 Council with the External Consultative Committee raised several important issues. First, in every national market there is the question of the dependence of the banking and financial sectors on core infrastructure such as telecommunications, power, water, sewer, and transportation. In all cases, it seems that it is not an everyday occurrence for representatives of these differing sectors to get together with financial sector representatives and discuss their mutual concerns. Yet, this must be made a priority if financial firms and their counterparties are to achieve comfort that their own efforts to prepare for Year 2000 will not be compromised by the failures of systems beyond their control. A representative of the International Telecommunications Union is a member of our External Consultative Committee. At our meeting earlier this month, he provided useful factual information on the preparations being undertaken by telecommunications firms and indicated that a further global survey and report on this topic is due to be completed soon. This is the type of information sharing that helps all parties understand the scope of the problem, as well as the efforts that others are undertaking. We intend to encourage further information sharing between the financial sector and core infrastructure providers at future meetings of the Joint Year 2000 Council and the External Consultative Committee. I would also strongly encourage such mutual cooperation on Y2K preparations within each national jurisdiction. Another issue that some participants in our Joint Year 2000 Council are concerned about in regard to preparations in their countries relates to the availability of human resources. In some regions, the supply of available information technology professionals may be hard-pressed to meet the challenges posed by Y2K. For each organization facing resource constraints, this situation clearly indicates the need to develop action plans for Y2K that set clear priorities among systems and projects. More broadly, we must also recognize that the lack of available programming resources will be a significant overall constraint on the scale of Y2K remediation efforts globally. As a result, the cost of hiring computer professionals capable of addressing the problem will continue to rise. Wealthy countries are undoubtedly in a better position to bear these increasing costs than are poor countries. ---[PAGE_BREAK]--- A number of participants from our External Consultative Committee cited the recent grant of $£ 10$ million sterling by the British Government to the World Bank as a positive development. Among other projects, the World Bank intends to use this grant to fund a variety of educational and awareness-raising events related to Y2K over the next several months. Given the potential consequences of a failure to prepare for Y2K, the World Bank indicated to the Joint Year 2000 Council that it intends to take on an aggressive role in promoting and assisting Y2K efforts in countries around the world. The Joint Year 2000 Council intends to work closely with the World Bank to enhance our mutual efforts on the Y2K problem. The subject of appropriate Y2K disclosure was also discussed by members of the External Consultative Committee. Many of those present agreed that greater disclosures would be helpful. However, there was skepticism that a standardized disclosure format would be effective in eliciting meaningful information for a wide class of financial firms, given the complexity and variety of Y2K issues facing these firms worldwide. It was also noted that disclosure which relies primarily on a firm's own subjective assessments of its Y2K problems inevitably will suffer from an optimistic bias. In addition, most Y2K efforts will not reach the serious testing phase until 1999. The purpose of the testing will be to uncover areas where additional work is required, so that the first round of tests can be expected to encounter problems. In this environment, it may be difficult for firms themselves to assess the true state of their Y2K preparations. Also, firms who believe they are going to be ready will be directed by legal counsel not to make too strong a statement to avoid liability claims in case of unforeseen problems. On the other hand, firms that do not believe they can get ready in time will seek to avoid stating this clearly to protect their activities during 1999. For all of these reasons, I am doubtful that specific, reliable information on the state of Y2K preparations by individual firms worldwide will become publicly available. Finally, in the area of improving preparedness, I have saved the most important topic for last -- namely, testing. Testing programs, particularly external testing programs, are universally regarded as the most critical element of serious Y2K preparations in the financial sector. The Joint Year 2000 Council encourages all firms and institutions active in the financial markets to engage in internal and external testing of their important applications and interfaces. To this end, many major payment and settlement systems around the world have developed extensive testing programs and procedures for their participants. In the United States, for example, Fedwire, CHIPS, and S.W.I.F.T. have coordinated shared testing days for the purpose of testing the major international wholesale payments infrastructure for the US dollar. The Securities Industry Association ("SIA") has been at the forefront of an ambitious program to develop a coordinated industry-wide test of all aspects of the trading and settlement infrastructure for the US stock market. The FFIEC's efforts have also been extremely beneficial in stressing the importance of testing within the banking sector generally. Yet, external testing programs globally need to be dramatically extended and expanded. To that end, the G-10 Committee on Payment and Settlement Systems last year started to collect information on the state of preparedness and testing of payment and settlement systems worldwide. To date, over 150 systems in 47 countries have responded to the framework and posted such plans. ${ }^{4}$ The Joint Year 2000 Council intends to expand the coverage of this framework to exchanges and trading systems, as well as major financial information services providers, and hopes to expand the number of countries and systems that are included. We will also collate and present the information graphically to help highlight anomalies in testing schedules, and to facilitate the efforts of systems to coordinate test scheduling where feasible. [^0] [^0]: 4 The relevant information can now be found on the pages of the Joint Year 2000 Council. ---[PAGE_BREAK]--- Primarily, I see this as an exercise in peer pressure. If we list every country in the world on our web site and the public can see that some countries have scheduled mandatory external tests of their major trading and settlement systems, while other countries do not provide any information, that second country may come under greater pressure to organize an external testing program. This is our stated goal. We will simply have blanks for those countries that do not respond to our requests for information. Of course, if the Joint Year 2000 Council is going to encourage testing to such an extent, then it is only appropriate that we also help provide some tools for those countries trying to get a serious testing effort underway in a short amount of time. This is another of our high-priority projects. We will be working with members of the External Consultative Committee -- including representatives of the Global 2000 Coordinating Group, S.W.I.F.T., and the World Bank -- to rapidly develop a series of documents that help countries set up testing programs and overcome common obstacles. We intend to issue these documents broadly by the end of the summer, and some parts well before that. In closing this section of my statement, I do not think it is possible to over-emphasize the importance of testing to help improve readiness. To illustrate this point, I would like to draw on our experiences with Fedwire, the Federal Reserve's wholesale interbank payments system. Much of the current Fedwire software application was written in the last five years, with the Y2K problem in mind. Nevertheless, some of the older software code that was carried over into the new application was not Y2K-compliant. Without the rigorous internal Y2K testing program that the Federal Reserve adopted, our Y2K remediation efforts might, therefore, have been incomplete. I think of this experience whenever I hear it said that some countries are immune to Y2K because they have only recently introduced information technology and that recent software programs are less affected by Y2K. I ask whether those programs have truly been thoroughly tested for Y2K compliance. # Contingency Planning Efforts The third major role of the Joint Year 2000 Council will relate to contingency planning. In this context, I should note that contingency planning is something that most financial market authorities, particularly central banks, undertake regularly with regard to a wide variety of potential market disruptions. Most private-sector financial firms, as well, have well developed contingency and business continuity plans in place for their operations. Nevertheless, it is clear that contingency planning for Y2K problems has a number of unique characteristics. First, of course, is the fact that one cannot rely on a backup computer site for Y2K contingency if that site also uses the same software that is the cause of the Y2K problem at the main site. In some cases, it is impractical to build a duplicate software system from scratch simply to provide for Y2K contingency. In these cases, as a senior banker explained at one of our New York Y2K forums, contingency planning amounts to, "Testing, testing, and more testing." Contingency planning can also be separated into components that are firm-specific and those that are market-wide. Each individual firm will need to develop its own contingency plans designed to maintain the integrity of its operations during the changeover to the Year 2000. The FFIEC has recently issued guidance to banks in the United States regarding the core elements of their own contingency planning. ${ }^{5}$ The Joint Year 2000 Council will also be developing a paper on contingency planning for the benefit of the global financial supervisory community. This paper will seek to address firm-level contingency as well as issues of market-wide contingency. ---[PAGE_BREAK]--- Market-wide contingency refers to the planning by participants and supervisors done to ensure that individual disruptions can be managed in ways that will prevent them from causing disruptions to critical market infrastructures. For instance, we at the Federal Reserve have gone to great lengths to ensure that barriers are in place to prevent Y2K problems with a Fedwire participant from causing problems on the Fedwire system itself. We are also now actively researching additional steps that the Federal Reserve could take to better prepare the financial markets as a whole to function in spite of disruptions at individual firms. It is also important to realize that contingency planning for Y 2 K is not solely an operational issue. Financial firms may seek to adopt a defensive posture in the marketplace well ahead of Monday, January 3, 2000 (the first business day of the new year in the United States). For example, market participants may seek to minimize the number of transactions that would be scheduled for settlement on January 3 or January 4, or that would require open positions to be maintained over the century date change weekend. Contingency planning involves a series of elements, many of which must be put in place well before January 2000. For example, we must consider many possible sources of disruption and determine what approaches could be available to limit the impact of each possible disruption. The sooner such thinking occurs, the more opportunity we have to plan around the possible disruptions. In this context, members of our External Consultative Committee noted that one of the key obstacles to effective contingency planning is the inability to list and consider all possible disruption scenarios. Several of these participants noted that their firms were engaging consultants or other procedures to expand the number of scenarios for inclusion in their Y2K contingency planning. In New York, we will be using our Y2K forum next month to discuss contingency planning with a diverse set of market participants. These local market participants will provide helpful insights for the Joint Year 2000 Council. Clearly, more work is needed on contingency planning for Y2K, especially at the international level. Once we get beyond the early fall of this year, I believe that these efforts will begin to receive much greater focus and attention, and -- together with testing -- will dominate our discussions of Y2K during 1999. # Closing Remarks In closing, I would like to thank the Committee for the opportunity to appear and submit a statement on this important issue. I hope that the efforts of the Joint Year 2000 Council will help to make a difference in improving the state of Y2K preparations in the international financial community. Realistically, however, I believe that it is important to understand the limits of what financial market supervisors can accomplish, either individually or collectively. Only firms themselves have the ability to address the Year 2000 problems that exist within their own organizations. Only firms working together can assure that local markets will function normally. Supervisors and regulators cannot guarantee that disruptions will not occur. Given the sheer number of organizations that are potentially at risk, it is inevitable that Y2K-related disruptions will occur. Today it would be impossible to predict the precise nature of these disruptions. However, we do know that financial markets have in the past survived many other serious disruptions, including blackouts, snow storms, ice storms, and floods. We will also have a very interesting case at the end of this year with the changeover to monetary union in Europe. We will all be watching carefully to see whether the extent of operational problems related to this event is greater or less than expected. ---[PAGE_BREAK]--- I would also like to say at this point that my discussions with other members of the Joint Year 2000 Council and with members of the External Consultative Committee have convinced me that successful efforts to address the Y2K problem will be dependent on the credibility of those calling for action. Those of us - such as members of this Committee as well as others in Congress - who are seriously engaged and concerned need to be able to persuade others of the need to take appropriate actions promptly. It would be unfortunate if general perceptions of the Y2K problem are driven primarily by unofficial commentators whose rhetoric is seen to exceed the facts on which it is based, and therefore easily dismissed. As a central banker and bank supervisor, my major concern must be with the system as a whole. At this point, I believe that we are doing everything possible to limit the possibility that Y2K disruptions will have systemic consequences in our markets. However, we must all continue to work hard -- both individually and cooperatively -- in the time that remains to ensure that this threat does not become more concrete. In that spirit, Mr. Chairman, I would like to end my remarks by commending the Committee for organizing these hearings on the implications of the Year 2000 computer problem for international banking and finance.	Ernest T Patrikis	United States	https://www.bis.org/review/r980626d.pdf	international banking and finance Statement by the First Vice-President of the Federal Reserve Bank of New York, Mr. Ernest T. Patrikis, before the Committee on Banking and Financial Services of the US House of Representatives on 23/6/98. I am pleased to appear before the Committee today to discuss the implications of the Year 2000 computer problem for international banking and finance. I am appearing in my capacity as Chairman of the Joint Year 2000 Council, which is sponsored jointly by the Basle Committee on Banking Supervision, the G-10 central bank governors' Committee on Payment and Settlement Systems, the International Association of Insurance Supervisors, and the International Organization of Securities Commissions (collectively referred to as the "Sponsoring Organizations"). The international financial community has much work to do to prepare itself for the challenges posed by the Year 2000 ("Y2K") problem. While much good work is being done and progress in many areas is evident, more needs doing. The Sponsoring Organizations believe that mutual cooperation and information sharing can play a key role in helping individual market participants carry out these preparations and limit the scope of Y2K-related disruptions. Our major concern, of course, will be the possible impact of the Y2K problem on the functioning of the international financial system as a whole. Federal Reserve Governor Edward W. Kelley, Jr. has recently elaborated on the activities of the Federal Reserve System in connection with the Y2K problem, as well on possible macroeconomic implications. I will not attempt to cover those topics again here. Instead, this morning I will begin with some background on the possible implications of the Y2K problem for international banking and finance. Second, I will describe how various supervisory initiatives led to the formation of the Joint Year 2000 Council a little more than two months ago. Third, I will discuss the actions being taken by the Joint Year 2000 Council, particularly in the areas of raising awareness, improving preparedness, and contingency planning. The Y2K bug potentially affects all organizations that are dependent on computer software applications or on embedded computer chips. In other words, nearly all financial organizations worldwide are potentially at risk. Even those whose own operations remain strictly paper-based are likely to be dependent on power, water, and telecommunications utilities, which must themselves address possible Y2K problems. Also, many non-financial customers have dependencies on technology. All countries of the world, therefore, need to address the Y2K problem and its potential effects on their domestic financial markets. In some cases, it is said that computer systems in particular countries are not much affected because their national calendars are not based on the conventional Gregorian calendar used in the United States and many other countries. I do not derive much comfort from these statements because in most cases operating systems and the software applications running on them count internally with a conventional date system that may not be Y2K-compliant. These systems typically also need to connect and interact with other systems that use conventional dates, so these interfaces must be tested for Y2K-compliance. More broadly, mere assertions that computer applications are unaffected cannot be seen as a substitute for the rigorous assessment, remediation, and testing efforts that should be undertaken by financial market participants worldwide. The increasing extent of cross-border, financial-market activity has been much remarked on in recent years. Perhaps less well known is the fact that this activity is dependent on a large, geographically diverse, and highly computer-intensive global infrastructure for each of the key phases of this activity -- from trade execution through to payment and settlement. As an example, consider the daily financial market activities of a hypothetical US-based mutual fund holding stocks and bonds in a number of foreign jurisdictions. Such a mutual fund would likely execute trades via relationships with a set of securities dealers, who themselves might make use of other securities brokers and dealers, including some outside the United States. The operational integrity of the major securities dealers in each national securities market is critical to the smooth functioning of those markets. In addition, securities trading in most countries is reliant on the proper functioning of the respective exchanges, brokerage networks, or electronic trading systems and the national telecommunications infrastructure on which these all depend. Financial markets today are also highly dependent on the availability of real-time price and trade quotations provided by financial information services. For record-keeping, administration, and trade settlement purposes, our hypothetical mutual fund would also likely maintain a relationship with one or more global custodians (banks or brokerage firms), who themselves would typically maintain relationships with a network of sub-custodians located in various domestic markets around the world. Actual settlement of securities transactions typically occurs over the books of a domestic securities depository, such as the Depository Trust Company ("DTC") or the Fedwire National Book-Entry System in the United States, or at one of the two major international securities depositories, Euroclear and Cedel. Additional clearing firms, such as the National Securities Clearing Corporation ("NSCC") and the Government Securities Clearing Corporation ("GSCC") in the United States, may also occupy central roles in the trade clearance and settlement process. Payments and foreign exchange transactions on behalf of the mutual fund would involve the use of correspondent banks, both for the US dollar and for other relevant currencies. These transactions would typically settle over the books of domestic wholesale payment systems, such as the Clearing House Interbank Payments System ("CHIPS") or Fedwire in the United States, and the new TARGET system for the euro. Correspondent banks are also heavily dependent on the use of cross-border payments messaging through the network maintained by the Society for Worldwide Interbank Financial Telecommunications ("S.W.I.F.T.") to advise and confirm payments. To provide some sense of the magnitudes involved here, consider that the Fedwire and CHIPS systems process a combined $\$ 3$ trillion in funds transfers on an average day (split roughly evenly between the two systems). While S.W.I.F.T. itself does not transfer funds, its messaging network carries over three million messages per day relating to financial transactions worldwide. The many interconnections of the global financial market infrastructure imply that financial market participants in the United States could be affected by Y2K-related disruptions in other financial markets. In assessing the scope of any such potential problems, we should be realistic in accepting that some disruptions are inevitable, while also recognizing that not all countries confront Y2K problems of similar magnitudes. The problem simply affects too many organizations and too many systems to expect that 100 percent readiness will be achieved throughout the world. Nor are the best efforts of supervisors and regulators capable of completely eradicating the risk of disruption. Ultimately, the work of fixing the Y2K problem rests with firms themselves, and even some of the most determined and well-funded Year 2000 efforts may miss something. Global Year 2000 Round Table Recognizing the global nature of the issues surrounding the Y2K problem, each of the Sponsoring Organizations undertook initiatives in 1997 to raise awareness, enhance disclosure, and prompt appropriate action within the financial industry. Their decision last fall to organize a Global Year 2000 Round Table was motivated by a growing sense of the seriousness of the Y2K challenges posed in many countries and of the potentially severe consequences for financial markets that fail to meet these challenges. The Global Year 2000 Round Table was held at the Bank for International Settlements on April 8, 1998. It was attended by more than 200 senior executives from 52 countries, representing a variety of private and public organizations in the financial, information technology, telecommunications, and business communities around the world. The discussions at the Round Table confirmed that the Y2K issue must be a top priority for directors and senior management, and that the public and private sectors should increase efforts to share information. The importance of thorough testing, both internally and with counterparties, was emphasized as the most effective way to ensure that Y2K problems are minimized. Round Table participants identified the need to continue the widening and strengthening of external testing programs in many countries. The communiqué issued by the four Sponsoring Organizations at the close of the Round Table recommended that market participants from regions that have not yet vigorously tackled the problem should consider the need to invest significant resources in the short time that remains. The Sponsoring Organizations further recommended that external testing programs be developed and expanded and that all financial market supervisors worldwide should implement programs that enable them to assess the Y2K readiness of the firms and market infrastructures that they supervise. The Sponsoring Organizations urged telecommunications and electricity providers to share information on the state of their own preparations and encouraged market participants and supervisors and regulators to consider the need to develop appropriate contingency procedures. At the Round Table, a new private-sector initiative known as the Global 2000 Coordinating Group was announced. The aims of the Global 2000 effort are to identify and support coordinated initiatives by the global financial community to improve the Y2K readiness of financial markets worldwide. For example, current Global 2000 projects include the development of recommendations for financial infrastructure testing and guidelines for addressing Y2K compliance issues related to vendors and service providers. The Global 2000 Coordinating Group, which includes representatives from over 75 financial institutions in 18 countries, represents an extremely valuable private-sector attempt at cooperation on this important issue. At the same time, however, the international financial supervisory community recognized that it would be useful to establish a public-sector group, called the Joint Year 2000 Council, that would work with the private sector and also maintain a high level of attention on the Y2K problem among financial market supervisors and regulators worldwide. Joint Year 2000 Council The formation of the Joint Year 2000 Council was announced at the end of the Global Year 2000 Round Table on April 8, 1998. The Joint Year 2000 Council consists of senior members of the four Sponsoring Organizations. Every continent is represented by at least one member on the Council. The Secretariat of the Council is provided by the Bank for International Settlements. I am honored to serve as the Chairman of the Joint Year 2000 Council. The mission of the Joint Year 2000 Council has four parts: First, to ensure a high level of attention on the Y2K computer challenge within the global financial supervisory community; second, to share information on regulatory and supervisory strategies and approaches; third, to discuss possible contingency measures; and fourth, to serve as a point of contact with national and international private-sector initiatives. After their meetings on May 8-9, 1998, the G-7 finance ministers called on the Joint Year 2000 Council and its Sponsoring Organizations to monitor the Y2K-related work in the financial industry worldwide and to take all possible steps to encourage readiness. The Council has met twice since being formed in early April and plans to meet frequently, almost monthly, between now and January, 2000. At our first meeting, we organized our work projects and approved our mission statement. At our second meeting, we met for the first time with an External Consultative Committee consisting of international public-sector and private-sector organizations. Meeting with this External Consultative Committee is intended to enhance the degree of information sharing and the raising of awareness on different aspects of the Year 2000 problem by both public and private sectors within the global financial markets. The External Consultative Committee includes representatives from international payment and settlement mechanisms (such as S.W.I.F.T., Euroclear, Cedel, and VISA), from international financial market associations (such as the International Swaps and Derivatives Association, the International Institute of Finance, and the Global 2000 Coordinating Group), from multilateral organizations (such as the IMF, OECD, and World Bank), from the financial rating agencies (such as Moody's and Standard \& Poor's), and from a number of other international organizations (such as the International Telecommunications Union, Reuters, the International Federation of Accountants, and the International Chamber of Commerce). This diversity of perspectives led to an extremely valuable discussion with the Joint Year 2000 Council and stimulated work on several projects to be taken forward with input from both the public and private sectors, for example, the initiatives on Y2K testing and self-assessment that I will describe shortly. Further sessions with the External Consultative Committee are planned on a quarterly basis. It is important at the outset for me to be clear that the Joint Year 2000 Council is not intended to become a global Y2K regulatory authority, with sweeping powers to coordinate international action or to take responsibility for ensuring Y2K readiness in every financial market worldwide. Through our ability to serve as a clearinghouse for Y2K information, however, I believe that the Joint Year 2000 Council will play a positive role in three areas: (1) raising awareness, (2) improving preparedness, and (3) contingency planning. In the next portion of my remarks, I would like to address each of these roles in turn. Efforts to Promote Awareness The Joint Year 2000 Council is undertaking a series of initiatives that may be described under the heading of promoting awareness. By this term, I do not mean to include only those initiatives aimed at raising general awareness, although that too is still needed in some cases. I mean to include efforts to promote better awareness of the many efforts currently under way to tackle the Y2K problem. I have found that, while many organizations are working hard on various aspects of the Y2K challenge, in many cases these efforts would be enhanced by a greater degree of information sharing with others. For example, at the Federal Reserve Bank of New York, we have been holding quarterly Y2K forums with a diverse set of financial organizations in the area. Participants have requested that we continue to hold these meetings -- in fact, to hold them even more frequently -- because they believe that the contacts and the exchange of views are broadly beneficial. We hope to use the Joint Year 2000 Council to achieve similar goals. Each of the members of the Joint Year 2000 Council has committed to help play a leading role in promoting awareness of Y2K initiatives within their region. Each of us will help in coordinating regional Y2K forums or conferences and will publicly promote the goals of the Joint Year 2000 Council in speeches and on conference programs. The Joint Year 2000 Council will also maintain extensive world-wide-web pages that can be accessed freely over the Internet. These pages are being maintained through the support the Council has received from the Bank for International Settlements, in particular from the General Manager, Andrew Crockett. These web pages will maintain current information on the activities of the Joint Year 2000 Council. The most extensive aspect of the Council's web site will be a series of country pages, one for each country in the world. For each country, the page will contain contact information for government entities (including national coordinators), financial industry supervisors and regulators (including central banks, banking supervisors, insurance supervisors, and securities regulators), financial industry associations, payment, settlement and trading systems, chambers of commerce, and major utility associations or supervisors. For each of these organizations, a name, address, phone number, fax number, electronic mail and web site address will be provided. Other relevant information on an organization's Y2K preparations may also be included, for example, whether it has a dedicated Y2K contact or has taken specific action with respect to the Y2K problem. The motivation for developing these country pages is to increase awareness of the work that is being done to address the Y2K problem and to enable market participants to easily find out more information about the state of preparations worldwide. Establishing these national contacts will also help to develop the informal networks and arrangements that may be needed in addressing other Y2K-related issues, for example, in formulating contingency measures. Finally, of course, the presence of the country pages may exert pressure on those countries where more vigorous action is needed. A blank or uninformative country listing would probably not be seen as a good sign by some financial market participants. In addition, the web pages of the Joint Year 2000 Council will also provide summaries of the efforts being undertaken by its Sponsoring Organizations as well as links to the relevant web sites. For example, reports on Y2K surveys of supervisors and regulators being undertaken by the Basle Committee on Banking Supervision and by the International Organization of Securities Commissions are planned to be made available on the Joint Year 2000 Council web site. Public papers produced by the Joint Year 2000 Council will also be available on the web site. A listing of international conferences and seminars related to Y2K will be posted on the web site, together with links to other Y2K web sites and documents. At this stage, each member of the Joint Year 2000 Council is in the process of finalizing the country page for its respective country. Last week, I wrote to every contact provided by the four Sponsoring Organizations (almost 600 contacts in over 170 countries), asking for assistance in coordinating the development of their country page. This also provided a further opportunity to raise the awareness of the Year 2000 problem at the most senior levels of financial market authorities and supervisors in countries around the world. Through the effort to develop this web site and other similar efforts by the Joint Year 2000 Council, I believe we can succeed at keeping the awareness of the issue at a very high level within the global financial supervisory community. Of course, awareness of the Year 2000 problem is only the first step in addressing it. Global efforts to prepare for Year 2000 vary widely, and many countries believe that more coordinated national action will be necessary to tackle the problem as effectively as possible. At our second meeting of the Joint Year 2000 Council, a strong consensus emerged that a national government body in each country could play a helpful role in coordinating preparations for Y2K. While the Council did not have a strong view on what particular form or what specific authority such a body would require in each specific country, the Council members felt strongly that involvement in some fashion by the national government could be beneficial. Accordingly, the Joint Year 2000 Council plans to issue a statement in the near future providing general support for the concept of a national-level coordinating body for the Y2K problem. In the United States, of course, the White House has established the President's Council on Year 2000 Conversion, headed by John Koskinen. This effort, as well as those of this committee under the leadership of Chairman Leach, and of the other Congressional committees that have addressed the Y2K problem, has shown that national government bodies have a very important and useful role to play in encouraging progress in addressing the Y2K problem. Turning now to the question of how financial supervisors can implement effective Y2K programs, the Joint Year 2000 Council intends to promote the sharing of strategies and approaches. For example, the Basle Committee on Banking Supervision has prepared a paper containing "Supervisory Guidance on Independent Assessment of Bank Year 2000 Preparations". This document is aimed at moving supervisors worldwide from a level of general awareness to a specific, concrete program of action for overseeing Y2K preparations, both on an individual bank basis and on a system-wide basis. The Joint Year 2000 Council intends to adapt this paper for use by financial market regulators and supervisors more broadly and to issue it as rapidly as possible with the endorsement of all four Sponsoring Organizations. The goal will be to provide guidance in developing specific Year 2000 action plans for all types of financial market authorities. Supervisors in countries that have gotten a head start on the issue can thereby provide the benefit of their experience to those who are starting later. Those supervisors getting a late start have a need for tools of this type. The Joint Year 2000 Council will also be working with the members of our External Consultative Committee, particularly the Global 2000 Coordinating Group, to build on this effort and develop a Y2K self-assessment tool that could be used broadly by the financial industry in countries around the world. We also intend to develop additional papers on a variety of Y2K topics that might be of interest to the global financial supervisory community. At this point, I am sure that members of the Committee have questions regarding the state of Y2K preparations in various parts of the world. I think that it is fair to say that most believe a spectrum exists, with the United States at one end of the spectrum, and emerging market and undeveloped countries at the other end. There are likely exceptions of course; some developed countries are probably less far along than they should be. Some emerging market countries, on the other hand, appear to be quite advanced in their preparations. Overall, however, there is still not nearly enough concrete, comparable information on the preparations of individual institutions to be able to make any confident statements about the state of global preparations in any detail. Over the time remaining until January 2000, we hope to use the Joint Year 2000 Council as a means of gathering a better picture of the state of global preparations, and to help direct resources and attention to those regions that appear to be faltering in their efforts. We will use the information provided for our web site and the discussions with members of our External Consultative Committee as our primary resources in seeking to identify "hot spots" where more urgent efforts are needed. If we identify regions where more needs to be done, our first step will be to work through the relevant national financial supervisors and regulators to increase the urgency of efforts in their jurisdiction. We may also involve multilateral institutions, such as the World Bank, to help increase national attention on the issue. I do not believe that calling public attention to problems in specific countries would be a constructive step for us to take at this stage as we are still trying to build cooperation and our current information is incomplete. In this context, I would also point out that the market itself will begin to bring strong pressures to bear on specific firms and markets that exhibit signs of being ill-prepared during the course of 1999. In conjunction with preparations for Y2K, the recent discussion of the Joint Year 2000 Council with the External Consultative Committee raised several important issues. First, in every national market there is the question of the dependence of the banking and financial sectors on core infrastructure such as telecommunications, power, water, sewer, and transportation. In all cases, it seems that it is not an everyday occurrence for representatives of these differing sectors to get together with financial sector representatives and discuss their mutual concerns. Yet, this must be made a priority if financial firms and their counterparties are to achieve comfort that their own efforts to prepare for Year 2000 will not be compromised by the failures of systems beyond their control. A representative of the International Telecommunications Union is a member of our External Consultative Committee. At our meeting earlier this month, he provided useful factual information on the preparations being undertaken by telecommunications firms and indicated that a further global survey and report on this topic is due to be completed soon. This is the type of information sharing that helps all parties understand the scope of the problem, as well as the efforts that others are undertaking. We intend to encourage further information sharing between the financial sector and core infrastructure providers at future meetings of the Joint Year 2000 Council and the External Consultative Committee. I would also strongly encourage such mutual cooperation on Y2K preparations within each national jurisdiction. Another issue that some participants in our Joint Year 2000 Council are concerned about in regard to preparations in their countries relates to the availability of human resources. In some regions, the supply of available information technology professionals may be hard-pressed to meet the challenges posed by Y2K. For each organization facing resource constraints, this situation clearly indicates the need to develop action plans for Y2K that set clear priorities among systems and projects. More broadly, we must also recognize that the lack of available programming resources will be a significant overall constraint on the scale of Y2K remediation efforts globally. As a result, the cost of hiring computer professionals capable of addressing the problem will continue to rise. Wealthy countries are undoubtedly in a better position to bear these increasing costs than are poor countries. A number of participants from our External Consultative Committee cited the recent grant of $£ 10$ million sterling by the British Government to the World Bank as a positive development. Among other projects, the World Bank intends to use this grant to fund a variety of educational and awareness-raising events related to Y2K over the next several months. Given the potential consequences of a failure to prepare for Y2K, the World Bank indicated to the Joint Year 2000 Council that it intends to take on an aggressive role in promoting and assisting Y2K efforts in countries around the world. The Joint Year 2000 Council intends to work closely with the World Bank to enhance our mutual efforts on the Y2K problem. The subject of appropriate Y2K disclosure was also discussed by members of the External Consultative Committee. Many of those present agreed that greater disclosures would be helpful. However, there was skepticism that a standardized disclosure format would be effective in eliciting meaningful information for a wide class of financial firms, given the complexity and variety of Y2K issues facing these firms worldwide. It was also noted that disclosure which relies primarily on a firm's own subjective assessments of its Y2K problems inevitably will suffer from an optimistic bias. In addition, most Y2K efforts will not reach the serious testing phase until 1999. The purpose of the testing will be to uncover areas where additional work is required, so that the first round of tests can be expected to encounter problems. In this environment, it may be difficult for firms themselves to assess the true state of their Y2K preparations. Also, firms who believe they are going to be ready will be directed by legal counsel not to make too strong a statement to avoid liability claims in case of unforeseen problems. On the other hand, firms that do not believe they can get ready in time will seek to avoid stating this clearly to protect their activities during 1999. For all of these reasons, I am doubtful that specific, reliable information on the state of Y2K preparations by individual firms worldwide will become publicly available. Finally, in the area of improving preparedness, I have saved the most important topic for last -- namely, testing. Testing programs, particularly external testing programs, are universally regarded as the most critical element of serious Y2K preparations in the financial sector. The Joint Year 2000 Council encourages all firms and institutions active in the financial markets to engage in internal and external testing of their important applications and interfaces. To this end, many major payment and settlement systems around the world have developed extensive testing programs and procedures for their participants. In the United States, for example, Fedwire, CHIPS, and S.W.I.F.T. have coordinated shared testing days for the purpose of testing the major international wholesale payments infrastructure for the US dollar. The Securities Industry Association ("SIA") has been at the forefront of an ambitious program to develop a coordinated industry-wide test of all aspects of the trading and settlement infrastructure for the US stock market. The FFIEC's efforts have also been extremely beneficial in stressing the importance of testing within the banking sector generally. Yet, external testing programs globally need to be dramatically extended and expanded. To that end, the G-10 Committee on Payment and Settlement Systems last year started to collect information on the state of preparedness and testing of payment and settlement systems worldwide. To date, over 150 systems in 47 countries have responded to the framework and posted such plans. The Joint Year 2000 Council intends to expand the coverage of this framework to exchanges and trading systems, as well as major financial information services providers, and hopes to expand the number of countries and systems that are included. We will also collate and present the information graphically to help highlight anomalies in testing schedules, and to facilitate the efforts of systems to coordinate test scheduling where feasible. Primarily, I see this as an exercise in peer pressure. If we list every country in the world on our web site and the public can see that some countries have scheduled mandatory external tests of their major trading and settlement systems, while other countries do not provide any information, that second country may come under greater pressure to organize an external testing program. This is our stated goal. We will simply have blanks for those countries that do not respond to our requests for information. Of course, if the Joint Year 2000 Council is going to encourage testing to such an extent, then it is only appropriate that we also help provide some tools for those countries trying to get a serious testing effort underway in a short amount of time. This is another of our high-priority projects. We will be working with members of the External Consultative Committee -- including representatives of the Global 2000 Coordinating Group, S.W.I.F.T., and the World Bank -- to rapidly develop a series of documents that help countries set up testing programs and overcome common obstacles. We intend to issue these documents broadly by the end of the summer, and some parts well before that. In closing this section of my statement, I do not think it is possible to over-emphasize the importance of testing to help improve readiness. To illustrate this point, I would like to draw on our experiences with Fedwire, the Federal Reserve's wholesale interbank payments system. Much of the current Fedwire software application was written in the last five years, with the Y2K problem in mind. Nevertheless, some of the older software code that was carried over into the new application was not Y2K-compliant. Without the rigorous internal Y2K testing program that the Federal Reserve adopted, our Y2K remediation efforts might, therefore, have been incomplete. I think of this experience whenever I hear it said that some countries are immune to Y2K because they have only recently introduced information technology and that recent software programs are less affected by Y2K. I ask whether those programs have truly been thoroughly tested for Y2K compliance. The third major role of the Joint Year 2000 Council will relate to contingency planning. In this context, I should note that contingency planning is something that most financial market authorities, particularly central banks, undertake regularly with regard to a wide variety of potential market disruptions. Most private-sector financial firms, as well, have well developed contingency and business continuity plans in place for their operations. Nevertheless, it is clear that contingency planning for Y2K problems has a number of unique characteristics. First, of course, is the fact that one cannot rely on a backup computer site for Y2K contingency if that site also uses the same software that is the cause of the Y2K problem at the main site. In some cases, it is impractical to build a duplicate software system from scratch simply to provide for Y2K contingency. In these cases, as a senior banker explained at one of our New York Y2K forums, contingency planning amounts to, "Testing, testing, and more testing." Contingency planning can also be separated into components that are firm-specific and those that are market-wide. Each individual firm will need to develop its own contingency plans designed to maintain the integrity of its operations during the changeover to the Year 2000. The FFIEC has recently issued guidance to banks in the United States regarding the core elements of their own contingency planning. The Joint Year 2000 Council will also be developing a paper on contingency planning for the benefit of the global financial supervisory community. This paper will seek to address firm-level contingency as well as issues of market-wide contingency. Market-wide contingency refers to the planning by participants and supervisors done to ensure that individual disruptions can be managed in ways that will prevent them from causing disruptions to critical market infrastructures. For instance, we at the Federal Reserve have gone to great lengths to ensure that barriers are in place to prevent Y2K problems with a Fedwire participant from causing problems on the Fedwire system itself. We are also now actively researching additional steps that the Federal Reserve could take to better prepare the financial markets as a whole to function in spite of disruptions at individual firms. It is also important to realize that contingency planning for Y 2 K is not solely an operational issue. Financial firms may seek to adopt a defensive posture in the marketplace well ahead of Monday, January 3, 2000 (the first business day of the new year in the United States). For example, market participants may seek to minimize the number of transactions that would be scheduled for settlement on January 3 or January 4, or that would require open positions to be maintained over the century date change weekend. Contingency planning involves a series of elements, many of which must be put in place well before January 2000. For example, we must consider many possible sources of disruption and determine what approaches could be available to limit the impact of each possible disruption. The sooner such thinking occurs, the more opportunity we have to plan around the possible disruptions. In this context, members of our External Consultative Committee noted that one of the key obstacles to effective contingency planning is the inability to list and consider all possible disruption scenarios. Several of these participants noted that their firms were engaging consultants or other procedures to expand the number of scenarios for inclusion in their Y2K contingency planning. In New York, we will be using our Y2K forum next month to discuss contingency planning with a diverse set of market participants. These local market participants will provide helpful insights for the Joint Year 2000 Council. Clearly, more work is needed on contingency planning for Y2K, especially at the international level. Once we get beyond the early fall of this year, I believe that these efforts will begin to receive much greater focus and attention, and -- together with testing -- will dominate our discussions of Y2K during 1999. In closing, I would like to thank the Committee for the opportunity to appear and submit a statement on this important issue. I hope that the efforts of the Joint Year 2000 Council will help to make a difference in improving the state of Y2K preparations in the international financial community. Realistically, however, I believe that it is important to understand the limits of what financial market supervisors can accomplish, either individually or collectively. Only firms themselves have the ability to address the Year 2000 problems that exist within their own organizations. Only firms working together can assure that local markets will function normally. Supervisors and regulators cannot guarantee that disruptions will not occur. Given the sheer number of organizations that are potentially at risk, it is inevitable that Y2K-related disruptions will occur. Today it would be impossible to predict the precise nature of these disruptions. However, we do know that financial markets have in the past survived many other serious disruptions, including blackouts, snow storms, ice storms, and floods. We will also have a very interesting case at the end of this year with the changeover to monetary union in Europe. We will all be watching carefully to see whether the extent of operational problems related to this event is greater or less than expected. I would also like to say at this point that my discussions with other members of the Joint Year 2000 Council and with members of the External Consultative Committee have convinced me that successful efforts to address the Y2K problem will be dependent on the credibility of those calling for action. Those of us - such as members of this Committee as well as others in Congress - who are seriously engaged and concerned need to be able to persuade others of the need to take appropriate actions promptly. It would be unfortunate if general perceptions of the Y2K problem are driven primarily by unofficial commentators whose rhetoric is seen to exceed the facts on which it is based, and therefore easily dismissed. As a central banker and bank supervisor, my major concern must be with the system as a whole. At this point, I believe that we are doing everything possible to limit the possibility that Y2K disruptions will have systemic consequences in our markets. However, we must all continue to work hard -- both individually and cooperatively -- in the time that remains to ensure that this threat does not become more concrete. In that spirit, Mr. Chairman, I would like to end my remarks by commending the Committee for organizing these hearings on the implications of the Year 2000 computer problem for international banking and finance.
1998-07-08T00:00:00	Mr. Duisenberg reports on the outcome of the second meeting of the Governing Council of the European Central Bank (Central Bank Articles and Speeches, 8 Jul 98)	Introductory statement by the President of the European Central Bank, Dr. W. Duisenberg, at the press conference held in Frankfurt on 8/7/98.	The Governing Council first assessed current economic developments in the euro area. The general picture is one of continued economic expansion combined with broadly low inflation. Several forecasts made during spring 1998 have even suggested slightly lower rates of inflation for 1998-99 compared with expectations in autumn 1997. As far as price developments are concerned, inflation as measured by the harmonised consumer price index (HICP) is estimated to have risen slightly in April, to 1.4%, but has not increased further in May. Output growth has remained strong in recent quarters, with annual growth rates close to or even exceeding 3%. Economic growth has been driven increasingly by domestic demand rather than net exports, as might be expected at this stage of the cycle. Private consumption and stockbuilding have been the main factors underlying domestic demand to date. The favourable conjunctural situation has started to feed through into the labour market, although improvements here have in some countries been too slow to appear. It is evident, however, that economic growth alone will not reduce the urgency to proceed with structural adjustments in order to tackle unacceptably high rates of unemployment. As regards monetary and financial developments in the euro area, the annual growth rate of the broad money supply (M3H) accelerated in April to around 6% from 5.5% in March. The growth rate of M1, the narrow money supply, also picked up, to around 10%. We shall monitor these developments very carefully. In principle, the economic performance I have just described provides a favourable environment for continued fiscal consolidation. It is with some concern that we observe that in a number of member countries the prospects for this to actually develop seem to be, to put it mildly, rather subdued. In this respect, I should like to underline three aspects. First, any "growth dividend" resulting from the current cyclical upturn should be used to bring deficit and debt levels down, rather than relaxing control over expenditure. Second, most Member States need to go a step further, and indeed improve structural balances as they are not yet in compliance with the obligations under the Stability and Growth Pact. This implies that the benchmark for fiscal policy must now be a budget close to balance or in surplus - in surplus especially in countries with high ratios of debt to GDP. Third, further structural adjustments in fiscal policy would also help to improve the policy mix in some countries and in the euro area as a whole from the start of Stage Three. I would not at the present time want to try to convey too strong an impression of the implications of these various economic developments for the appropriate stance of monetary policies in euro area Member States. Although the responsibility for these policies remains with national central banks until the end of this year, the Governing Council had an extensive and thorough discussion on a euro area perspective of monetary policy. We will continue to study this issue closely before we enter the regime of a single monetary policy. For the time being, it is encouraging to see the credibility of monetary policy being reflected in the exchange rates of euro countries. There is currently no sign of exchange rate tensions among euro area currencies. Forward exchange rates are expected to be virtually identical to central rates, suggesting that the pre-announced rates are considered credible. I consider this a remarkable achievement. Following its review of economic developments, the Governing Council settled a number of organisational issues. i. It adopted the Rules of Procedure of the European Central Bank. These will be published in the Official Journal of the European Communities; ii. It approved, in accordance with the Rules of Procedure, the establishment of eleven ESCB committees to assist in the work of the European System of Central Banks (ESCB). The committees are as follows (listed in alphabetical order): Accounting and Monetary Income Committee, Banking Supervision Committee, Banknote Committee, External Communications Committee, Information Technology Committee, Internal Auditors Committee, Legal Committee, Market Operations Committee, Monetary Policy Committee, Payment and Settlement Systems Committee, and Statistics Committee; iii. It formally adopted a budget for the European Central Bank for the second half of 1998 and agreed on the establishment of a Budget Committee to assist the Governing Council in ECB budget-related matters; iv. It laid down specific rules applicable to staff transferring from the European Monetary Institute to the European Central Bank. ECB Decisions relating to the Conditions of Employment will be published in the Official Journal of the European Communities. The Governing Council also took a number of decisions relating to various aspects of its preparatory work for Stage Three. (a) Monetary policy issues The Governing Council decided on the introduction of a minimum reserve system by the ESCB at the start of Stage Three. Among the three main functions that a minimum reserve system could usefully perform, the Governing Council attaches particularly high importance to its contributions to the stabilisation of money market interest rates and to the enlargement of the demand for central bank money by creating or enlarging a structural liquidity shortage in the market. In the light of the potential burden which a minimum reserve system could impose on the private sector and the effects it might have on the financial activity of credit institutions in the euro area, the Governing Council has decided on features which fulfil the two money market management purposes outlined above, while at the same time allowing an adequate remuneration of minimum reserves. A number of details of the minimum reserve system that will be applied were already specified in previous documents published by the European Monetary Institute. Additional features agreed upon yesterday include the liability base, the lump-sum allowance and the rate of remuneration. With regard to the latter, the ECB will remunerate minimum reserve holdings at a level corresponding to the rate of its main refinancing operations. The Governing Council intends to decide on the exact specification of the minimum reserve system in November 1998 at the latest. This decision, in particular as regards the reserve ratio (which is currently defined within a range of 1.5% - 2.5%), will be based on the early data from the new system for money and banking statistics. Further details are provided in the separate press release that is being issued to you this morning. It is intended that the precise features of the minimum reserve system will be published in the form of an EU Council Regulation. For this purpose, the Governing Council adopted an ECB Recommendation for an EU Council Regulation on the application of minimum reserves by the European Central Bank. In accordance with the provisions of the Statute of the ESCB, the EU Council, acting by a qualified majority and after consulting the European Parliament and the Commission, is expected to adopt this Regulation. The Governing Council also adopted ECB Recommendations for EU Council Regulations concerning the collection of statistical information by the ECB and concerning the powers of the ECB to impose sanctions. All three ECB Recommendations will be published in the Official Journal of the European Communities for general notice. (b) Foreign exchange issues The Governing Council decided on the size and form of the initial transfer of foreign reserve assets to the European Central Bank from the national central banks participating in the euro area. This transfer is to take place on the first day of 1999. It has been decided that the initial transfer will be to the maximum allowed amount of EUR 50 billion, adjusted downwards by deducting the shares in the ECB's capital subscription key of the EU central banks which will not participate in the euro area at the outset. The transfer will thus be equal to 78.9153% of EUR 50 billion, i.e. approximately EUR 39.46 billion. The Governing Council furthermore agreed that this initial transfer should be in gold in an amount equivalent to 15% of the sum I have just mentioned, with the remaining 85% being transferred in foreign currency assets. I should stress that the decision on the percentage of gold to be transferred to the ECB will have no implications for the consolidated gold holdings of the ESCB. The precise modalities of the initial transfer will be finalised before the end of the year. Before the end of the current year the Governing Council will also have to adopt an ECB Guideline pursuant to Article 31.3 of the Statute of the ESCB, which will subject all operations in foreign reserve assets remaining with the national central banks - including gold to approval by the ECB. In connection with the setting-up of common market standards, the Governing Council also reached agreement on a number of issues related to the quotation and publication of reference exchange rates for the euro. Specifically, it was agreed to recommend to market participants the "certain" method for quoting the exchange rates for the euro (i.e. 1 euro = X foreign currency units) and to have daily reference exchange rates for the euro computed and published by the ECB. Further details are provided in the separate press release that is being issued to you this morning. (c) Payment systems issues The Governing Council decided on the conditions for the participation of the non-euro area EU central banks and credit institutions in the TARGET (Trans-European Automated Real-time Gross settlement Express Transfer) system. In TARGET the ESCB will provide central bank liquidity in the course of the day (i.e. intraday liquidity) to the extent necessary to avoid delays in the execution of payment orders. If intraday liquidity is not reimbursed at the end of the day it becomes overnight credit granted by the ESCB, which, for evident monetary policy reasons, cannot be offered to institutions outside the euro area. Nonetheless, non-euro area EU central banks and institutions in those countries will be connected to TARGET. The Governing Council considered that giving such institutions outside the euro area unlimited access to intraday credit would have created risks for the conduct of monetary policy that it was not ready to take. A facility will therefore be put in place to enable the non-euro area EU central banks to provide collateralised intraday credit in euro to their credit institutions, subject to a ceiling both at the level of the non-euro area EU central banks and at that of non-euro area credit institutions. There will also be a liquidity deadline, set at 5 p.m., for non-euro area credit institutions so that they do not incur an overnight overdraft in euro. Further details are provided in the separate press release that is being issued to you this morning. The Governing Council also agreed that a report on recent developments in the field of electronic money - and their monetary policy implications - would be published in September 1998. (d) Legal protection of euro banknotes Finally, the Governing Council agreed on a number of legal instruments aimed at enhancing the protection of euro banknotes. In particular, an ECB Decision on the denominations, specifications, reproduction, exchange and withdrawal of banknotes has been adopted, as well as an ECB Recommendation regarding the adoption of certain measures to enhance the legal protection of euro banknotes and coins. Both documents will be published for general information in the Official Journal of the European Communities.	---[PAGE_BREAK]--- # Mr. Duisenberg reports on the outcome of the second meeting of the Governing Council of the European Central Bank Introductory statement by the President of the European Central Bank, Dr. W. Duisenberg, at the press conference held in Frankfurt on 8/7/98. The Governing Council first assessed current economic developments in the euro area. The general picture is one of continued economic expansion combined with broadly low inflation. Several forecasts made during spring 1998 have even suggested slightly lower rates of inflation for 1998-99 compared with expectations in autumn 1997. As far as price developments are concerned, inflation as measured by the harmonised consumer price index (HICP) is estimated to have risen slightly in April, to $1.4 \%$, but has not increased further in May. Output growth has remained strong in recent quarters, with annual growth rates close to or even exceeding 3\%. Economic growth has been driven increasingly by domestic demand rather than net exports, as might be expected at this stage of the cycle. Private consumption and stockbuilding have been the main factors underlying domestic demand to date. The favourable conjunctural situation has started to feed through into the labour market, although improvements here have in some countries been too slow to appear. It is evident, however, that economic growth alone will not reduce the urgency to proceed with structural adjustments in order to tackle unacceptably high rates of unemployment. As regards monetary and financial developments in the euro area, the annual growth rate of the broad money supply (M3H) accelerated in April to around 6\% from 5.5\% in March. The growth rate of M1, the narrow money supply, also picked up, to around 10\%. We shall monitor these developments very carefully. In principle, the economic performance I have just described provides a favourable environment for continued fiscal consolidation. It is with some concern that we observe that in a number of member countries the prospects for this to actually develop seem to be, to put it mildly, rather subdued. In this respect, I should like to underline three aspects. First, any "growth dividend" resulting from the current cyclical upturn should be used to bring deficit and debt levels down, rather than relaxing control over expenditure. Second, most Member States need to go a step further, and indeed improve structural balances as they are not yet in compliance with the obligations under the Stability and Growth Pact. This implies that the benchmark for fiscal policy must now be a budget close to balance or in surplus - in surplus especially in countries with high ratios of debt to GDP. Third, further structural adjustments in fiscal policy would also help to improve the policy mix in some countries and in the euro area as a whole from the start of Stage Three. I would not at the present time want to try to convey too strong an impression of the implications of these various economic developments for the appropriate stance of monetary policies in euro area Member States. Although the responsibility for these policies remains with national central banks until the end of this year, the Governing Council had an extensive and thorough discussion on a euro area perspective of monetary policy. We will continue to study this issue closely before we enter the regime of a single monetary policy. For the time being, it is encouraging to see the credibility of monetary policy being reflected in the exchange rates of ---[PAGE_BREAK]--- euro countries. There is currently no sign of exchange rate tensions among euro area currencies. Forward exchange rates are expected to be virtually identical to central rates, suggesting that the pre-announced rates are considered credible. I consider this a remarkable achievement. Following its review of economic developments, the Governing Council settled a number of organisational issues. i. It adopted the Rules of Procedure of the European Central Bank. These will be published in the Official Journal of the European Communities; ii. It approved, in accordance with the Rules of Procedure, the establishment of eleven ESCB committees to assist in the work of the European System of Central Banks (ESCB). The committees are as follows (listed in alphabetical order): Accounting and Monetary Income Committee, Banking Supervision Committee, Banknote Committee, External Communications Committee, Information Technology Committee, Internal Auditors Committee, Legal Committee, Market Operations Committee, Monetary Policy Committee, Payment and Settlement Systems Committee, and Statistics Committee; iii. It formally adopted a budget for the European Central Bank for the second half of 1998 and agreed on the establishment of a Budget Committee to assist the Governing Council in ECB budget-related matters; iv. It laid down specific rules applicable to staff transferring from the European Monetary Institute to the European Central Bank. ECB Decisions relating to the Conditions of Employment will be published in the Official Journal of the European Communities. The Governing Council also took a number of decisions relating to various aspects of its preparatory work for Stage Three. # (a) Monetary policy issues The Governing Council decided on the introduction of a minimum reserve system by the ESCB at the start of Stage Three. Among the three main functions that a minimum reserve system could usefully perform, the Governing Council attaches particularly high importance to its contributions to the stabilisation of money market interest rates and to the enlargement of the demand for central bank money by creating or enlarging a structural liquidity shortage in the market. In the light of the potential burden which a minimum reserve system could impose on the private sector and the effects it might have on the financial activity of credit institutions in the euro area, the Governing Council has decided on features which fulfil the two money market management purposes outlined above, while at the same time allowing an adequate remuneration of minimum reserves. A number of details of the minimum reserve system that will be applied were already specified in previous documents published by the European Monetary Institute. Additional features agreed upon yesterday include the liability base, the lump-sum allowance and the rate of remuneration. With regard to the latter, the ECB will remunerate minimum reserve holdings at a level corresponding to the rate of its main refinancing operations. The Governing Council intends to decide on the exact specification of the minimum reserve system in November ---[PAGE_BREAK]--- 1998 at the latest. This decision, in particular as regards the reserve ratio (which is currently defined within a range of $1.5 \%-2.5 \%$ ), will be based on the early data from the new system for money and banking statistics. Further details are provided in the separate press release that is being issued to you this morning. It is intended that the precise features of the minimum reserve system will be published in the form of an EU Council Regulation. For this purpose, the Governing Council adopted an ECB Recommendation for an EU Council Regulation on the application of minimum reserves by the European Central Bank. In accordance with the provisions of the Statute of the ESCB, the EU Council, acting by a qualified majority and after consulting the European Parliament and the Commission, is expected to adopt this Regulation. The Governing Council also adopted ECB Recommendations for EU Council Regulations concerning the collection of statistical information by the ECB and concerning the powers of the ECB to impose sanctions. All three ECB Recommendations will be published in the Official Journal of the European Communities for general notice. # (b) Foreign exchange issues The Governing Council decided on the size and form of the initial transfer of foreign reserve assets to the European Central Bank from the national central banks participating in the euro area. This transfer is to take place on the first day of 1999. It has been decided that the initial transfer will be to the maximum allowed amount of EUR 50 billion, adjusted downwards by deducting the shares in the ECB's capital subscription key of the EU central banks which will not participate in the euro area at the outset. The transfer will thus be equal to $78.9153 \%$ of EUR 50 billion, i.e. approximately EUR 39.46 billion. The Governing Council furthermore agreed that this initial transfer should be in gold in an amount equivalent to $15 \%$ of the sum I have just mentioned, with the remaining $85 \%$ being transferred in foreign currency assets. I should stress that the decision on the percentage of gold to be transferred to the ECB will have no implications for the consolidated gold holdings of the ESCB. The precise modalities of the initial transfer will be finalised before the end of the year. Before the end of the current year the Governing Council will also have to adopt an ECB Guideline pursuant to Article 31.3 of the Statute of the ESCB, which will subject all operations in foreign reserve assets remaining with the national central banks - including gold to approval by the ECB. In connection with the setting-up of common market standards, the Governing Council also reached agreement on a number of issues related to the quotation and publication of reference exchange rates for the euro. Specifically, it was agreed to recommend to market participants the "certain" method for quoting the exchange rates for the euro (i.e. 1 euro $=\mathrm{X}$ foreign currency units) and to have daily reference exchange rates for the euro computed and published by the ECB. ---[PAGE_BREAK]--- Further details are provided in the separate press release that is being issued to you this morning. # (c) Payment systems issues The Governing Council decided on the conditions for the participation of the non-euro area EU central banks and credit institutions in the TARGET (Trans-European Automated Real-time Gross settlement Express Transfer) system. In TARGET the ESCB will provide central bank liquidity in the course of the day (i.e. intraday liquidity) to the extent necessary to avoid delays in the execution of payment orders. If intraday liquidity is not reimbursed at the end of the day it becomes overnight credit granted by the ESCB, which, for evident monetary policy reasons, cannot be offered to institutions outside the euro area. Nonetheless, non-euro area EU central banks and institutions in those countries will be connected to TARGET. The Governing Council considered that giving such institutions outside the euro area unlimited access to intraday credit would have created risks for the conduct of monetary policy that it was not ready to take. A facility will therefore be put in place to enable the non-euro area EU central banks to provide collateralised intraday credit in euro to their credit institutions, subject to a ceiling both at the level of the non-euro area EU central banks and at that of non-euro area credit institutions. There will also be a liquidity deadline, set at 5 p.m., for non-euro area credit institutions so that they do not incur an overnight overdraft in euro. Further details are provided in the separate press release that is being issued to you this morning. The Governing Council also agreed that a report on recent developments in the field of electronic money - and their monetary policy implications - would be published in September 1998. ## (d) Legal protection of euro banknotes Finally, the Governing Council agreed on a number of legal instruments aimed at enhancing the protection of euro banknotes. In particular, an ECB Decision on the denominations, specifications, reproduction, exchange and withdrawal of banknotes has been adopted, as well as an ECB Recommendation regarding the adoption of certain measures to enhance the legal protection of euro banknotes and coins. Both documents will be published for general information in the Official Journal of the European Communities.	Willem F Duisenberg	Euro area	https://www.bis.org/review/r980717b.pdf	Council of the European Central Bank Introductory statement by the President of the European Central Bank, Dr. W. Duisenberg, at the press conference held in Frankfurt on 8/7/98. The Governing Council first assessed current economic developments in the euro area. The general picture is one of continued economic expansion combined with broadly low inflation. Several forecasts made during spring 1998 have even suggested slightly lower rates of inflation for 1998-99 compared with expectations in autumn 1997. As far as price developments are concerned, inflation as measured by the harmonised consumer price index (HICP) is estimated to have risen slightly in April, to $1.4 \%$, but has not increased further in May. Output growth has remained strong in recent quarters, with annual growth rates close to or even exceeding 3\%. Economic growth has been driven increasingly by domestic demand rather than net exports, as might be expected at this stage of the cycle. Private consumption and stockbuilding have been the main factors underlying domestic demand to date. The favourable conjunctural situation has started to feed through into the labour market, although improvements here have in some countries been too slow to appear. It is evident, however, that economic growth alone will not reduce the urgency to proceed with structural adjustments in order to tackle unacceptably high rates of unemployment. As regards monetary and financial developments in the euro area, the annual growth rate of the broad money supply (M3H) accelerated in April to around 6\% from 5.5\% in March. The growth rate of M1, the narrow money supply, also picked up, to around 10\%. We shall monitor these developments very carefully. In principle, the economic performance I have just described provides a favourable environment for continued fiscal consolidation. It is with some concern that we observe that in a number of member countries the prospects for this to actually develop seem to be, to put it mildly, rather subdued. In this respect, I should like to underline three aspects. First, any "growth dividend" resulting from the current cyclical upturn should be used to bring deficit and debt levels down, rather than relaxing control over expenditure. Second, most Member States need to go a step further, and indeed improve structural balances as they are not yet in compliance with the obligations under the Stability and Growth Pact. This implies that the benchmark for fiscal policy must now be a budget close to balance or in surplus - in surplus especially in countries with high ratios of debt to GDP. Third, further structural adjustments in fiscal policy would also help to improve the policy mix in some countries and in the euro area as a whole from the start of Stage Three. I would not at the present time want to try to convey too strong an impression of the implications of these various economic developments for the appropriate stance of monetary policies in euro area Member States. Although the responsibility for these policies remains with national central banks until the end of this year, the Governing Council had an extensive and thorough discussion on a euro area perspective of monetary policy. We will continue to study this issue closely before we enter the regime of a single monetary policy. For the time being, it is encouraging to see the credibility of monetary policy being reflected in the exchange rates of euro countries. There is currently no sign of exchange rate tensions among euro area currencies. Forward exchange rates are expected to be virtually identical to central rates, suggesting that the pre-announced rates are considered credible. I consider this a remarkable achievement. Following its review of economic developments, the Governing Council settled a number of organisational issues. i. It adopted the Rules of Procedure of the European Central Bank. These will be published in the Official Journal of the European Communities; ii. It approved, in accordance with the Rules of Procedure, the establishment of eleven ESCB committees to assist in the work of the European System of Central Banks (ESCB). The committees are as follows (listed in alphabetical order): Accounting and Monetary Income Committee, Banking Supervision Committee, Banknote Committee, External Communications Committee, Information Technology Committee, Internal Auditors Committee, Legal Committee, Market Operations Committee, Monetary Policy Committee, Payment and Settlement Systems Committee, and Statistics Committee; iii. It formally adopted a budget for the European Central Bank for the second half of 1998 and agreed on the establishment of a Budget Committee to assist the Governing Council in ECB budget-related matters; iv. It laid down specific rules applicable to staff transferring from the European Monetary Institute to the European Central Bank. ECB Decisions relating to the Conditions of Employment will be published in the Official Journal of the European Communities. The Governing Council also took a number of decisions relating to various aspects of its preparatory work for Stage Three. The Governing Council decided on the introduction of a minimum reserve system by the ESCB at the start of Stage Three. Among the three main functions that a minimum reserve system could usefully perform, the Governing Council attaches particularly high importance to its contributions to the stabilisation of money market interest rates and to the enlargement of the demand for central bank money by creating or enlarging a structural liquidity shortage in the market. In the light of the potential burden which a minimum reserve system could impose on the private sector and the effects it might have on the financial activity of credit institutions in the euro area, the Governing Council has decided on features which fulfil the two money market management purposes outlined above, while at the same time allowing an adequate remuneration of minimum reserves. A number of details of the minimum reserve system that will be applied were already specified in previous documents published by the European Monetary Institute. Additional features agreed upon yesterday include the liability base, the lump-sum allowance and the rate of remuneration. With regard to the latter, the ECB will remunerate minimum reserve holdings at a level corresponding to the rate of its main refinancing operations. The Governing Council intends to decide on the exact specification of the minimum reserve system in November 1998 at the latest. This decision, in particular as regards the reserve ratio (which is currently defined within a range of $1.5 \%-2.5 \%$ ), will be based on the early data from the new system for money and banking statistics. Further details are provided in the separate press release that is being issued to you this morning. It is intended that the precise features of the minimum reserve system will be published in the form of an EU Council Regulation. For this purpose, the Governing Council adopted an ECB Recommendation for an EU Council Regulation on the application of minimum reserves by the European Central Bank. In accordance with the provisions of the Statute of the ESCB, the EU Council, acting by a qualified majority and after consulting the European Parliament and the Commission, is expected to adopt this Regulation. The Governing Council also adopted ECB Recommendations for EU Council Regulations concerning the collection of statistical information by the ECB and concerning the powers of the ECB to impose sanctions. All three ECB Recommendations will be published in the Official Journal of the European Communities for general notice. The Governing Council decided on the size and form of the initial transfer of foreign reserve assets to the European Central Bank from the national central banks participating in the euro area. This transfer is to take place on the first day of 1999. It has been decided that the initial transfer will be to the maximum allowed amount of EUR 50 billion, adjusted downwards by deducting the shares in the ECB's capital subscription key of the EU central banks which will not participate in the euro area at the outset. The transfer will thus be equal to $78.9153 \%$ of EUR 50 billion, i.e. approximately EUR 39.46 billion. The Governing Council furthermore agreed that this initial transfer should be in gold in an amount equivalent to $15 \%$ of the sum I have just mentioned, with the remaining $85 \%$ being transferred in foreign currency assets. I should stress that the decision on the percentage of gold to be transferred to the ECB will have no implications for the consolidated gold holdings of the ESCB. The precise modalities of the initial transfer will be finalised before the end of the year. Before the end of the current year the Governing Council will also have to adopt an ECB Guideline pursuant to Article 31.3 of the Statute of the ESCB, which will subject all operations in foreign reserve assets remaining with the national central banks - including gold to approval by the ECB. In connection with the setting-up of common market standards, the Governing Council also reached agreement on a number of issues related to the quotation and publication of reference exchange rates for the euro. Specifically, it was agreed to recommend to market participants the "certain" method for quoting the exchange rates for the euro (i.e. 1 euro $=\mathrm{X}$ foreign currency units) and to have daily reference exchange rates for the euro computed and published by the ECB. Further details are provided in the separate press release that is being issued to you this morning. The Governing Council decided on the conditions for the participation of the non-euro area EU central banks and credit institutions in the TARGET (Trans-European Automated Real-time Gross settlement Express Transfer) system. In TARGET the ESCB will provide central bank liquidity in the course of the day (i.e. intraday liquidity) to the extent necessary to avoid delays in the execution of payment orders. If intraday liquidity is not reimbursed at the end of the day it becomes overnight credit granted by the ESCB, which, for evident monetary policy reasons, cannot be offered to institutions outside the euro area. Nonetheless, non-euro area EU central banks and institutions in those countries will be connected to TARGET. The Governing Council considered that giving such institutions outside the euro area unlimited access to intraday credit would have created risks for the conduct of monetary policy that it was not ready to take. A facility will therefore be put in place to enable the non-euro area EU central banks to provide collateralised intraday credit in euro to their credit institutions, subject to a ceiling both at the level of the non-euro area EU central banks and at that of non-euro area credit institutions. There will also be a liquidity deadline, set at 5 p.m., for non-euro area credit institutions so that they do not incur an overnight overdraft in euro. Further details are provided in the separate press release that is being issued to you this morning. The Governing Council also agreed that a report on recent developments in the field of electronic money - and their monetary policy implications - would be published in September 1998. Finally, the Governing Council agreed on a number of legal instruments aimed at enhancing the protection of euro banknotes. In particular, an ECB Decision on the denominations, specifications, reproduction, exchange and withdrawal of banknotes has been adopted, as well as an ECB Recommendation regarding the adoption of certain measures to enhance the legal protection of euro banknotes and coins. Both documents will be published for general information in the Official Journal of the European Communities.
1998-07-09T00:00:00	Mr. Ferguson gives his views on exercising caution and vigilance in monetary policy in the United States (Central Bank Articles and Speeches, 9 Jul 98)	Remarks by Mr. Roger W. Ferguson, Jr., a member of the Board of Governors of the US Federal Reserve System, on the occasion of the Distinguished Speaker Series, held at the Federal Reserve Bank of Atlanta on 9/7/98.	Mr. Ferguson gives his views on exercising caution and vigilance in monetary Remarks by Mr. Roger W. Ferguson, Jr., a member of the Board of policy in the United States Governors of the US Federal Reserve System, on the occasion of the Distinguished Speaker Series, held at the Federal Reserve Bank of Atlanta on 9/7/98. Introduction These are fascinating times for monetary policy. As we progress through the eighth year of the current economic expansion, economic growth has continued at a robust pace with unemployment reaching a 28-year low, while inflation has remained remarkably subdued. To be sure, not all recent developments have been altogether positive, especially considering the current situation in Asia. Nonetheless, the performance of the American economy in recent years has exceeded expectations in a rather extraordinary fashion. But recent developments have challenged our understanding of the workings of the macroeconomy. Although the recent surprises of both low unemployment and well-behaved inflation have been quite favorable, they have been surprises nonetheless and not easily reconcilable with each other based on old relationships and our earlier assessment of the economy's potential. These developments have increased the uncertainty about the economic outlook and about the appropriate response of monetary policy in general to new developments. I want to take this opportunity to discuss some implications of this increased uncertainty for the conduct of monetary policy. Before starting, let me remind you that these views are personal and do not necessarily reflect the views of other members of the FOMC or the Board of Governors. Objectives and Strategy for Monetary Policy To evaluate the proper strategy for monetary policy, we must first understand the Federal Reserve's policy objectives and then recognize the parameters within which policy operates in attaining these objectives. The long-run goal of monetary policy is straightforward. The Federal Reserve Act mandates that we promote price stability and maximum employment. Sometimes this dual objective is misunderstood, with the misconception that these inflation and employment goals cannot be attained simultaneously -- that there is a tradeoff in the long run between one and the other. It is worthwhile repeating what I am sure all of you already understand well: the long-run goals of price stability and maximum employment are not mutually exclusive. Not so long ago, mainstream macroeconomists thought that employment and growth were by and large independent of inflation in the long run. But the evidence accumulating in the 1990s seems to suggest that low inflation contributes to real economic performance in ways not fully appreciated before. If anything, our approach to price stability, by reducing uncertainty and making long-run savings and investment decisions easier, seems to have enhanced the growth of productivity, real GDP, and employment. This indirect benefit, of course, reinforces the price stability goal. It is the rate of inflation that monetary policy determines in the long run, and this means that price stability in a straightforward way is elevated to the status of the primary long-run goal of monetary policy. Where a tradeoff can appear, and this I think is the source of occasional confusion, is over shorter periods. In the shorter run, inflation may rise and fall depending on where the economy is operating relative to its potential. When the economy has become overextended, with output exceeding the economy's potential, employment beyond sustainable norms, and production surpassing normal capacity limits, then prices have tended to increase at an ever faster rate. Likewise, when aggregate demand has fallen short of the economy's potential, inflation has tended to fall. And this is where the short-run setting of monetary policy comes into play. By moving short-term interest rates, monetary policy can affect other financial conditions and end up exerting a substantial influence on aggregate demand. Decisions by businesses about investment and by households about housing and consumption are altered by changes in interest rates and other credit conditions. Monetary policy also can indirectly impinge upon other components of aggregate demand. As a result, in the shorter run, monetary policy can play an important role in stabilizing the economy from undesired fluctuations in economic activity and inflation. The strategy for monetary policy geared towards these shorter-run concerns can be briefly described. It is to restrict monetary conditions when the economy seems on the way to becoming overheated and inflation is threatening and ease monetary conditions when signs of weakness in demand appear on the horizon. But it is important that we pursue these short-run goals keeping in mind our primary long-run goal of price stability. Of course, other forces besides the state of the economy relative to its potential can influence inflation in the short run. Even prior to the anomalous experience of recent years, which I will discuss later in detail, supply shocks, such as a sudden hike in oil prices, have dramatically affected inflation. Such forces can also cause short-term fluctuations in the economy that are, at least in part, beyond the control of monetary policy. However, active stabilization policy may still have a role to play as a buffer, helping the economy to absorb such disturbances in the short run, while counteracting any persistent deviations from price stability. But monetary policy operates with a long lag, with a policy change exhibiting material effects on the economy (excluding the immediate impact on financial markets) only several quarters after its implementation. By some estimates it may be almost a year before the brunt of the effect of an interest rate change is felt on aggregate demand, although the influence appears sooner in some sectors of the economy than in others. And it may generally take longer still for a policy change to alter the course of inflation. Consequently, active stabilization policy is most successful when it is pre-emptive, responding to early warning signals or forecasts of unfavorable developments on the inflation and employment fronts. In this regard, by identifying past regularities in relationships among economic variables and understanding their conceptual underpinnings, we can use the most recent economic data to update forecasts of where the economy is headed. Based on these forecasts we can then take steps to adjust the stance of monetary policy as necessary, in accordance with our objectives. Uncertainties: Old and new To be useful for monetary policy, forecasts of the future health of the economy need to be reasonably reliable. Good forecasts rest on theories about empirical regularities that can be confidently relied upon to provide guidance. Regrettably, accepted theories are found lacking at times, empirical models break down, and forecasts based on them prove unusually inaccurate. If monetary policy were naively to follow guidelines based on past regularities that are increasingly failing to reflect new realities, it would unintentionally introduce undesirable gyrations in the economy. Thus, heightened uncertainties regarding the workings of the economy pose an additional source of stress in policy design. To ascertain the appropriate framework for policy analysis we must first be aware of some key sources of uncertainty. In recent years, traditional views of the economy perhaps have been most challenged by the phenomenon of declining inflation despite increasing tightness in labor markets as evidenced by reductions in the unemployment rate to its lowest level in almost three decades. Many believe that there is an unemployment rate, the non-accelerating inflation rate of unemployment (the "NAIRU"), that would be consistent with a stable inflation rate, once other short-run influences on inflation dissipate. To these economists, inflationary pressures tend to increase when unemployment remains below the NAIRU and tend to decrease when unemployment stays above the NAIRU. For many years proponents of this view considered 6 percent a reasonable estimate of the NAIRU. Since 1995, however, the unemployment rate has been below this level, and substantially below of late, while inflation has continued to progress toward our price-stability objective. In response, over the past few years, many observers have revised their estimates of the NAIRU down by half a percentage point or more. Yet considerable uncertainty remains about the confidence with which the new estimates can be relied upon for evaluating inflationary pressures. The NAIRU never was measured with precision; statistical inference has always provided a distribution of likely values around a point estimate. And several factors, for instance the demographic composition of the labor force, have long been known to introduce systematic variation in its value over time. Nonetheless, the uncertainties about how structural forces may be changing the NAIRU seem unusually large at present and cannot be ignored. And for some the present uncertainties have called into further question the basic usefulness of the concept, or at least of a point estimate held with any confidence. A related uncertainty concerns the underlying trend growth of labor productivity. Until fairly recently, this trend had seemed to have been about constant since the mid 1970s. But there are many that believe that a pickup may have occurred in the last few years, and a faster productivity trend would help to explain the unexpectedly favorable economic growth-unemployment-inflation nexus in recent years. Unfortunately, much as with the NAIRU, our understanding of the forces that drive the productivity trend is less than perfect. Certainly, the investment boom of the current expansion has raised the amount of capital for each worker and contributed to an increase in labor productivity, and it may be that advancing technology is making the capital stock and workforce more productive. However, some of the recent pickup in productivity is the normal response to the faster output growth of late, so the degree to which there is a new higher trend remains an open question. Another difficulty in assessing the current amount of slack in the economy, and a third uncertainty, concerns the divergent patterns in alternative measures of excess demand. Capacity utilization in manufacturing and the rate of unemployment have historically moved together over the cycle. Unexpectedly, they have diverged in the current expansion, in part as the surge in investment has kept capacity utilization in the manufacturing sector near its historic average while labor markets have become tighter and tighter. Recent developments in South-East Asia also have contributed to uncertainty about the current monetary policy environment. One place where the effect of the crisis is being felt is in the prices of primary commodities. Since such commodities are traded on world markets, lower demand from Asia is reflected in lower prices world-wide, which benefit US producers that use commodities as inputs. This development serves as a short-run boost, a positive supply shock, to the US economy, one that also helps contain inflationary pressures, as does the more general decline in import prices as the US dollar appreciates. But the Asian crisis can be expected to continue to have an adverse impact on trade-sensitive industries. Some evidence of a deterioration of our trade balance with the region's economies has already appeared. With little historical guidance to draw from, however, considerable uncertainty prevails regarding the extent to which the present Asian situation may contribute to slower US growth as well as the timing of such a slowdown. For instance, despite expectations that the crisis would have contributed to a slowdown in economic activity earlier this year, the economy's growth in the first quarter of this year exceeded even the remarkable performance of 1997. However, more recent data reflecting developments in the second quarter, including survey information, do give some evidence of a slowing in the overall economy, especially the manufacturing sector, perhaps due to Asian financial turmoil. As you might suspect, we will continue to watch incoming data quite closely as the year progresses to get a better handle on this situation. To be sure, uncertainties such as these have loomed large at times in the past, and we can learn much from those experiences. The uncertainties faced by policymakers during the 1970s about the economy's potential provide an enlightening perspective on the present situation. Following a period of rapid productivity gains during the 1950s and 1960s, the economy's performance during the 1970s appeared out of line with previous experience. Starting in 1973, in particular, inflation rose more than expected, at times considerably'so, while economic growth tended to disappoint expectations for a number of years. At first, it appeared reasonable to assume that the observed productivity'slowdown was temporary. Reflecting this assumption, for instance, the Council of Economic Advisors gave a 4 percent estimate of potential output growth in the 1974 Economic Report of the President, as would have been consistent with the earlier trends. Increased uncertainty regarding this estimate was evident in the 1975 and 1976 Reports, but not until 1977 was the point estimate of potential output growth revised downward, to 3.6 percent. As the economy's performance continued to disappoint, further downward revisions followed, to 3 percent in 1979 and to 2.5 percent to close the decade in 1980. Only several years after the fact was a trend break in productivity recognized as likely to have occurred in 1973. And even today our understanding of the forces contributing to the slowdown is not entirely satisfactory. As inflation accelerated as the 1970s continued, critics blamed the Federal Reserve's operating procedures for placing too little weight on money growth and too much on interest rates in the conduct of policy. In response, the Federal Reserve in late 1979 put added emphasis on monetary growth targets. But the FOMC abandoned the strict regime of targeting M1 through reserve quantities in 1982 once evidence accumulated that the character of M1 demand had been altered by the spread of interest-bearing NOW accounts. Later, the break in the behavior of M2 velocity during the early 1990s from its earlier historical pattern undercut the indicator properties of that aggregate as well. In 1993, the FOMC de-emphasized the role of the broader aggregates in policymaking. Despite recent tentative signs that the relationship between M2 velocity and the cost of holding M2 assets may be returning to its earlier historical norms, uncertainty persists regarding the continued stability of this relationship. In terms of the performance of inflation and unemployment, the experience of the past few years has not been unlike a mirror image of the 1970s. While the consequences are a lot more pleasant, unexpectedly low inflation and unemployment do raise some complicated issues for monetary policy. Strategy in Uncertain Times: Caution and Vigilance This account of the sources of uncertainty that we face in designing the proper course of monetary policy should not leave the impression that our task is so daunting that the policy waters are unnavigable. But such an account does serve a valuable purpose in reminding us that in designing policy we should recognize our ignorance as well as trust our knowledge. For instance, we need to recognize the difficulties of inferring the true structure of the economy by interpreting incoming data. How do we know whether unexpected developments are just temporary moves away from stable longer-run relationships or are manifestations of changes in the underlying economic structure? In many cases this judgment is difficult to make with much confidence until considerably after the fact. In the meantime, we must bear in mind that the statistical relationships we work with are only loose approximations of underlying reality, which is constantly evolving, at least to some extent, in response to changes in technology, consumer preferences, and government policies. Our vision is always obstructed by some haze. But sometimes the picture is clearer than at other times. Because of these difficulties in assessing the situation, a balanced judgment is required in evaluating whether historical regularities are indeed changing significantly and are not just subject to temporary aberrations. I believe that one should guard against holding to old truths that may no longer be valid, but one should also be cautious about declaring that permanent changes have occurred, for there are too many examples of proclaimed "new eras" that did not in fact come to pass. Erroneously dismissing the continued validity of old truths could result in bad policy just as easily as failing to correctly recognize new realities when change occurs. What should be done when uncertainties seem particularly acute? When we suspect that our understanding of the macroeconomic environment has deteriorated appreciably, as evidenced by strings of surprises difficult to reconcile with our earlier beliefs, I think that the appropriate response is to rely less upon the future predicted by the increasingly unreliable old gauges and more upon inferences from the more recent past, weighing incoming data more heavily relative to more distant data in trying to discern the new environment. Even for those of us who take this more pragmatic approach, there are challenges. Recent data, on which our understanding of the new reality is based, are subject to revision as more reliable or more complete sources become available. Moreover, there are often several indices for measuring underlying economic circumstances, requiring one to consider various measures simultaneously. In the current context, the considerable uncertainty regarding our previous estimates of the capacity of the economy and its sustainable rate of growth in my judgment suggest the need to downplay forecasts of inflation based on those earlier assessments. By necessity, I believe heightened reliance needs to be placed on more recent observations of inflation and costs for inferring future inflationary pressures. We are not precluded from acting pre-emptively if new information were to tip the balance of risks in the outlook toward higher inflation, but are naturally a little more cautious in acting on forecasts as long as substantial uncertainty persists. As a consequence, the lead times for pre-emptive action are likely to be shorter. And, in my judgment, we may have to rely more on measures other than apparent excess demand to get reliable indications of pending changes in inflationary pressures. For instance, unit labor costs may have to be watched especially closely, and the rate of unemployment perhaps less closely than we are used to. But a pattern of unsustainable growth characterized by a continuously declining unemployment rate still may increasingly suggest greater inflation risk. Even if the limits of the economy's growth potential have moved, there are still limits that need to be respected. The increased uncertainty also implies that continued strong economic growth with low inflation is not outside the realm of possibility, and by adopting a cautious policy posture we may learn more clearly if that possibility is likely or remote. It should be clear that the creation of new jobs, by itself, is a welcomed development. There are benefits to all from the skill building that occurs on the job. It is important, however, that these jobs be the result of sustainable growth, and not the result of excesses and imbalances. However, caution can be excessive, running the risk that inflation may in fact reappear and require a more wrenching readjustment than if it had been anticipated. Uncertainty should not induce paralysis. We need to be willing to move, even if cautiously, knowing that we may have to reverse our action if subsequent developments differ from our expectations. Moreover, we must be willing to act forcefully if information suggesting a threat to our goal of price stability becomes available. Inflation is an insidious tax on all of our citizens, perhaps impacting low and moderate-income citizens more than others because there are fewer ways available to them to protect their income and their assets against an erosion of purchasing power. If evidence of an incipient rise in inflation were to appear, decisive action would provide a counterweight to minimize the building of a temporary inflationary aberration into inflation expectations, which could be disruptive. And this is why caution and vigilance go hand in hand under these circumstances of increased uncertainty. Moreover, it is at uncertain times such as these that the wisdom underlying the institutional structure of the FOMC becomes most apparent. A committee with broad representation can bring a variety of perspectives and analyses to bear on difficult economic problems. In addition, the real-time reports the presidents of the Federal Reserve Banks bring from their districts are especially valuable in the decision-making process at times like these because they afford a contemporaneous sense of what is going on in the economy. Such diversity of information sources becomes particularly useful when our earlier assessment of the economy's potential has been drawn into question by surprises, even pleasant ones. Conclusion A string of favorable surprises yielding strong growth, high employment and low inflation is by far the most pleasant environment under which to come to the realization that our understanding of the workings of our complex economy is not infallible. A sound economy with subdued inflation makes dealing with the greater uncertainty much easier indeed! The Federal Reserve has an important trust to help safeguard the health of the United States economy. What we should do in the face of some uncertainty is to act cautiously while remaining vigilant, to take measured steps when necessary, and to adjust to the occasional unforeseen change. In this way we will raise the odds of achieving our goals of stable prices and maximum employment, not only providing benefits to Americans, but also a stable anchor for a volatile world economy.	---[PAGE_BREAK]--- Mr. Ferguson gives his views on exercising caution and vigilance in monetary policy in the United States Remarks by Mr. Roger W. Ferguson, Jr., a member of the Board of Governors of the US Federal Reserve System, on the occasion of the Distinguished Speaker Series, held at the Federal Reserve Bank of Atlanta on 9/7/98. # Introduction These are fascinating times for monetary policy. As we progress through the eighth year of the current economic expansion, economic growth has continued at a robust pace with unemployment reaching a 28 -year low, while inflation has remained remarkably subdued. To be sure, not all recent developments have been altogether positive, especially considering the current situation in Asia. Nonetheless, the performance of the American economy in recent years has exceeded expectations in a rather extraordinary fashion. But recent developments have challenged our understanding of the workings of the macroeconomy. Although the recent surprises of both low unemployment and well-behaved inflation have been quite favorable, they have been surprises nonetheless and not easily reconcilable with each other based on old relationships and our earlier assessment of the economy's potential. These developments have increased the uncertainty about the economic outlook and about the appropriate response of monetary policy in general to new developments. I want to take this opportunity to discuss some implications of this increased uncertainty for the conduct of monetary policy. Before starting, let me remind you that these views are personal and do not necessarily reflect the views of other members of the FOMC or the Board of Governors. ## Objectives and Strategy for Monetary Policy To evaluate the proper strategy for monetary policy, we must first understand the Federal Reserve's policy objectives and then recognize the parameters within which policy operates in attaining these objectives. The long-run goal of monetary policy is straightforward. The Federal Reserve Act mandates that we promote price stability and maximum employment. Sometimes this dual objective is misunderstood, with the misconception that these inflation and employment goals cannot be attained simultaneously -- that there is a tradeoff in the long run between one and the other. It is worthwhile repeating what I am sure all of you already understand well: the long-run goals of price stability and maximum employment are not mutually exclusive. Not so long ago, mainstream macroeconomists thought that employment and growth were by and large independent of inflation in the long run. But the evidence accumulating in the 1990s seems to suggest that low inflation contributes to real economic performance in ways not fully appreciated before. If anything, our approach to price stability, by reducing uncertainty and making long-run savings and investment decisions easier, seems to have enhanced the growth of productivity, real GDP, and employment. This indirect benefit, of course, reinforces the price stability goal. It is the rate of inflation that monetary policy determines in the long run, and this means that price stability in a straightforward way is elevated to the status of the primary long-run goal of monetary policy. ---[PAGE_BREAK]--- Where a tradeoff can appear, and this I think is the source of occasional confusion, is over shorter periods. In the shorter run, inflation may rise and fall depending on where the economy is operating relative to its potential. When the economy has become overextended, with output exceeding the economy's potential, employment beyond sustainable norms, and production surpassing normal capacity limits, then prices have tended to increase at an ever faster rate. Likewise, when aggregate demand has fallen short of the economy's potential, inflation has tended to fall. And this is where the short-run setting of monetary policy comes into play. By moving short-term interest rates, monetary policy can affect other financial conditions and end up exerting a substantial influence on aggregate demand. Decisions by businesses about investment and by households about housing and consumption are altered by changes in interest rates and other credit conditions. Monetary policy also can indirectly impinge upon other components of aggregate demand. As a result, in the shorter run, monetary policy can play an important role in stabilizing the economy from undesired fluctuations in economic activity and inflation. The strategy for monetary policy geared towards these shorter-run concerns can be briefly described. It is to restrict monetary conditions when the economy seems on the way to becoming overheated and inflation is threatening and ease monetary conditions when signs of weakness in demand appear on the horizon. But it is important that we pursue these short-run goals keeping in mind our primary long-run goal of price stability. Of course, other forces besides the state of the economy relative to its potential can influence inflation in the short run. Even prior to the anomalous experience of recent years, which I will discuss later in detail, supply shocks, such as a sudden hike in oil prices, have dramatically affected inflation. Such forces can also cause short-term fluctuations in the economy that are, at least in part, beyond the control of monetary policy. However, active stabilization policy may still have a role to play as a buffer, helping the economy to absorb such disturbances in the short run, while counteracting any persistent deviations from price stability. But monetary policy operates with a long lag, with a policy change exhibiting material effects on the economy (excluding the immediate impact on financial markets) only several quarters after its implementation. By some estimates it may be almost a year before the brunt of the effect of an interest rate change is felt on aggregate demand, although the influence appears sooner in some sectors of the economy than in others. And it may generally take longer still for a policy change to alter the course of inflation. Consequently, active stabilization policy is most successful when it is pre-emptive, responding to early warning signals or forecasts of unfavorable developments on the inflation and employment fronts. In this regard, by identifying past regularities in relationships among economic variables and understanding their conceptual underpinnings, we can use the most recent economic data to update forecasts of where the economy is headed. Based on these forecasts we can then take steps to adjust the stance of monetary policy as necessary, in accordance with our objectives. ---[PAGE_BREAK]--- # Uncertainties: Old and new To be useful for monetary policy, forecasts of the future health of the economy need to be reasonably reliable. Good forecasts rest on theories about empirical regularities that can be confidently relied upon to provide guidance. Regrettably, accepted theories are found lacking at times, empirical models break down, and forecasts based on them prove unusually inaccurate. If monetary policy were naively to follow guidelines based on past regularities that are increasingly failing to reflect new realities, it would unintentionally introduce undesirable gyrations in the economy. Thus, heightened uncertainties regarding the workings of the economy pose an additional source of stress in policy design. To ascertain the appropriate framework for policy analysis we must first be aware of some key sources of uncertainty. In recent years, traditional views of the economy perhaps have been most challenged by the phenomenon of declining inflation despite increasing tightness in labor markets as evidenced by reductions in the unemployment rate to its lowest level in almost three decades. Many believe that there is an unemployment rate, the non-accelerating inflation rate of unemployment (the "NAIRU"), that would be consistent with a stable inflation rate, once other short-run influences on inflation dissipate. To these economists, inflationary pressures tend to increase when unemployment remains below the NAIRU and tend to decrease when unemployment stays above the NAIRU. For many years proponents of this view considered 6 percent a reasonable estimate of the NAIRU. Since 1995, however, the unemployment rate has been below this level, and substantially below of late, while inflation has continued to progress toward our price-stability objective. In response, over the past few years, many observers have revised their estimates of the NAIRU down by half a percentage point or more. Yet considerable uncertainty remains about the confidence with which the new estimates can be relied upon for evaluating inflationary pressures. The NAIRU never was measured with precision; statistical inference has always provided a distribution of likely values around a point estimate. And several factors, for instance the demographic composition of the labor force, have long been known to introduce systematic variation in its value over time. Nonetheless, the uncertainties about how structural forces may be changing the NAIRU seem unusually large at present and cannot be ignored. And for some the present uncertainties have called into further question the basic usefulness of the concept, or at least of a point estimate held with any confidence. A related uncertainty concerns the underlying trend growth of labor productivity. Until fairly recently, this trend had seemed to have been about constant since the mid 1970s. But there are many that believe that a pickup may have occurred in the last few years, and a faster productivity trend would help to explain the unexpectedly favorable economic growth-unemployment-inflation nexus in recent years. Unfortunately, much as with the NAIRU, our understanding of the forces that drive the productivity trend is less than perfect. Certainly, the investment boom of the current expansion has raised the amount of capital for each worker and contributed to an increase in labor productivity, and it may be that advancing technology is making the capital stock and workforce more productive. However, some of the recent pickup in productivity is the normal response to the faster output growth of late, so the degree to which there is a new higher trend remains an open question. ---[PAGE_BREAK]--- Another difficulty in assessing the current amount of slack in the economy, and a third uncertainty, concerns the divergent patterns in alternative measures of excess demand. Capacity utilization in manufacturing and the rate of unemployment have historically moved together over the cycle. Unexpectedly, they have diverged in the current expansion, in part as the surge in investment has kept capacity utilization in the manufacturing sector near its historic average while labor markets have become tighter and tighter. Recent developments in South-East Asia also have contributed to uncertainty about the current monetary policy environment. One place where the effect of the crisis is being felt is in the prices of primary commodities. Since such commodities are traded on world markets, lower demand from Asia is reflected in lower prices world-wide, which benefit US producers that use commodities as inputs. This development serves as a short-run boost, a positive supply shock, to the US economy, one that also helps contain inflationary pressures, as does the more general decline in import prices as the US dollar appreciates. But the Asian crisis can be expected to continue to have an adverse impact on trade-sensitive industries. Some evidence of a deterioration of our trade balance with the region's economies has already appeared. With little historical guidance to draw from, however, considerable uncertainty prevails regarding the extent to which the present Asian situation may contribute to slower US growth as well as the timing of such a slowdown. For instance, despite expectations that the crisis would have contributed to a slowdown in economic activity earlier this year, the economy's growth in the first quarter of this year exceeded even the remarkable performance of 1997. However, more recent data reflecting developments in the second quarter, including survey information, do give some evidence of a slowing in the overall economy, especially the manufacturing sector, perhaps due to Asian financial turmoil. As you might suspect, we will continue to watch incoming data quite closely as the year progresses to get a better handle on this situation. To be sure, uncertainties such as these have loomed large at times in the past, and we can learn much from those experiences. The uncertainties faced by policymakers during the 1970s about the economy's potential provide an enlightening perspective on the present situation. Following a period of rapid productivity gains during the 1950s and 1960s, the economy's performance during the 1970s appeared out of line with previous experience. Starting in 1973, in particular, inflation rose more than expected, at times considerably'so, while economic growth tended to disappoint expectations for a number of years. At first, it appeared reasonable to assume that the observed productivity'slowdown was temporary. Reflecting this assumption, for instance, the Council of Economic Advisors gave a 4 percent estimate of potential output growth in the 1974 Economic Report of the President, as would have been consistent with the earlier trends. Increased uncertainty regarding this estimate was evident in the 1975 and 1976 Reports, but not until 1977 was the point estimate of potential output growth revised downward, to 3.6 percent. As the economy's performance continued to disappoint, further downward revisions followed, to 3 percent in 1979 and to 2.5 percent to close the decade in 1980. Only several years after the fact was a trend break in productivity recognized as likely to have occurred in 1973. And even today our understanding of the forces contributing to the slowdown is not entirely satisfactory. ---[PAGE_BREAK]--- As inflation accelerated as the 1970s continued, critics blamed the Federal Reserve's operating procedures for placing too little weight on money growth and too much on interest rates in the conduct of policy. In response, the Federal Reserve in late 1979 put added emphasis on monetary growth targets. But the FOMC abandoned the strict regime of targeting M1 through reserve quantities in 1982 once evidence accumulated that the character of M1 demand had been altered by the spread of interest-bearing NOW accounts. Later, the break in the behavior of M2 velocity during the early 1990s from its earlier historical pattern undercut the indicator properties of that aggregate as well. In 1993, the FOMC de-emphasized the role of the broader aggregates in policymaking. Despite recent tentative signs that the relationship between M2 velocity and the cost of holding M2 assets may be returning to its earlier historical norms, uncertainty persists regarding the continued stability of this relationship. In terms of the performance of inflation and unemployment, the experience of the past few years has not been unlike a mirror image of the 1970s. While the consequences are a lot more pleasant, unexpectedly low inflation and unemployment do raise some complicated issues for monetary policy. # Strategy in Uncertain Times: Caution and Vigilance This account of the sources of uncertainty that we face in designing the proper course of monetary policy should not leave the impression that our task is so daunting that the policy waters are unnavigable. But such an account does serve a valuable purpose in reminding us that in designing policy we should recognize our ignorance as well as trust our knowledge. For instance, we need to recognize the difficulties of inferring the true structure of the economy by interpreting incoming data. How do we know whether unexpected developments are just temporary moves away from stable longer-run relationships or are manifestations of changes in the underlying economic structure? In many cases this judgment is difficult to make with much confidence until considerably after the fact. In the meantime, we must bear in mind that the statistical relationships we work with are only loose approximations of underlying reality, which is constantly evolving, at least to some extent, in response to changes in technology, consumer preferences, and government policies. Our vision is always obstructed by some haze. But sometimes the picture is clearer than at other times. Because of these difficulties in assessing the situation, a balanced judgment is required in evaluating whether historical regularities are indeed changing significantly and are not just subject to temporary aberrations. I believe that one should guard against holding to old truths that may no longer be valid, but one should also be cautious about declaring that permanent changes have occurred, for there are too many examples of proclaimed "new eras" that did not in fact come to pass. Erroneously dismissing the continued validity of old truths could result in bad policy just as easily as failing to correctly recognize new realities when change occurs. What should be done when uncertainties seem particularly acute? When we suspect that our understanding of the macroeconomic environment has deteriorated appreciably, as evidenced by strings of surprises difficult to reconcile with our earlier beliefs, I think that the appropriate response is to rely less upon the future predicted by the increasingly unreliable old gauges and more upon inferences from the more recent past, weighing incoming data more heavily relative to more distant data in trying to discern the new environment. ---[PAGE_BREAK]--- Even for those of us who take this more pragmatic approach, there are challenges. Recent data, on which our understanding of the new reality is based, are subject to revision as more reliable or more complete sources become available. Moreover, there are often several indices for measuring underlying economic circumstances, requiring one to consider various measures simultaneously. In the current context, the considerable uncertainty regarding our previous estimates of the capacity of the economy and its sustainable rate of growth in my judgment suggest the need to downplay forecasts of inflation based on those earlier assessments. By necessity, I believe heightened reliance needs to be placed on more recent observations of inflation and costs for inferring future inflationary pressures. We are not precluded from acting pre-emptively if new information were to tip the balance of risks in the outlook toward higher inflation, but are naturally a little more cautious in acting on forecasts as long as substantial uncertainty persists. As a consequence, the lead times for pre-emptive action are likely to be shorter. And, in my judgment, we may have to rely more on measures other than apparent excess demand to get reliable indications of pending changes in inflationary pressures. For instance, unit labor costs may have to be watched especially closely, and the rate of unemployment perhaps less closely than we are used to. But a pattern of unsustainable growth characterized by a continuously declining unemployment rate still may increasingly suggest greater inflation risk. Even if the limits of the economy's growth potential have moved, there are still limits that need to be respected. The increased uncertainty also implies that continued strong economic growth with low inflation is not outside the realm of possibility, and by adopting a cautious policy posture we may learn more clearly if that possibility is likely or remote. It should be clear that the creation of new jobs, by itself, is a welcomed development. There are benefits to all from the skill building that occurs on the job. It is important, however, that these jobs be the result of sustainable growth, and not the result of excesses and imbalances. However, caution can be excessive, running the risk that inflation may in fact reappear and require a more wrenching readjustment than if it had been anticipated. Uncertainty should not induce paralysis. We need to be willing to move, even if cautiously, knowing that we may have to reverse our action if subsequent developments differ from our expectations. Moreover, we must be willing to act forcefully if information suggesting a threat to our goal of price stability becomes available. Inflation is an insidious tax on all of our citizens, perhaps impacting low and moderate-income citizens more than others because there are fewer ways available to them to protect their income and their assets against an erosion of purchasing power. If evidence of an incipient rise in inflation were to appear, decisive action would provide a counterweight to minimize the building of a temporary inflationary aberration into inflation expectations, which could be disruptive. And this is why caution and vigilance go hand in hand under these circumstances of increased uncertainty. Moreover, it is at uncertain times such as these that the wisdom underlying the institutional structure of the FOMC becomes most apparent. A committee with broad representation can bring a variety of perspectives and analyses to bear on difficult economic problems. In addition, the real-time reports the presidents of the Federal Reserve Banks bring from their districts are especially valuable in the decision-making process at times like these because they afford a contemporaneous sense of what is going on in the economy. Such diversity ---[PAGE_BREAK]--- of information sources becomes particularly useful when our earlier assessment of the economy's potential has been drawn into question by surprises, even pleasant ones. # Conclusion A string of favorable surprises yielding strong growth, high employment and low inflation is by far the most pleasant environment under which to come to the realization that our understanding of the workings of our complex economy is not infallible. A sound economy with subdued inflation makes dealing with the greater uncertainty much easier indeed! The Federal Reserve has an important trust to help safeguard the health of the United States economy. What we should do in the face of some uncertainty is to act cautiously while remaining vigilant, to take measured steps when necessary, and to adjust to the occasional unforeseen change. In this way we will raise the odds of achieving our goals of stable prices and maximum employment, not only providing benefits to Americans, but also a stable anchor for a volatile world economy.	Roger W Ferguson	United States	https://www.bis.org/review/r980717a.pdf	Mr. Ferguson gives his views on exercising caution and vigilance in monetary policy in the United States Remarks by Mr. Roger W. Ferguson, Jr., a member of the Board of Governors of the US Federal Reserve System, on the occasion of the Distinguished Speaker Series, held at the Federal Reserve Bank of Atlanta on 9/7/98. These are fascinating times for monetary policy. As we progress through the eighth year of the current economic expansion, economic growth has continued at a robust pace with unemployment reaching a 28 -year low, while inflation has remained remarkably subdued. To be sure, not all recent developments have been altogether positive, especially considering the current situation in Asia. Nonetheless, the performance of the American economy in recent years has exceeded expectations in a rather extraordinary fashion. But recent developments have challenged our understanding of the workings of the macroeconomy. Although the recent surprises of both low unemployment and well-behaved inflation have been quite favorable, they have been surprises nonetheless and not easily reconcilable with each other based on old relationships and our earlier assessment of the economy's potential. These developments have increased the uncertainty about the economic outlook and about the appropriate response of monetary policy in general to new developments. I want to take this opportunity to discuss some implications of this increased uncertainty for the conduct of monetary policy. Before starting, let me remind you that these views are personal and do not necessarily reflect the views of other members of the FOMC or the Board of Governors. To evaluate the proper strategy for monetary policy, we must first understand the Federal Reserve's policy objectives and then recognize the parameters within which policy operates in attaining these objectives. The long-run goal of monetary policy is straightforward. The Federal Reserve Act mandates that we promote price stability and maximum employment. Sometimes this dual objective is misunderstood, with the misconception that these inflation and employment goals cannot be attained simultaneously -- that there is a tradeoff in the long run between one and the other. It is worthwhile repeating what I am sure all of you already understand well: the long-run goals of price stability and maximum employment are not mutually exclusive. Not so long ago, mainstream macroeconomists thought that employment and growth were by and large independent of inflation in the long run. But the evidence accumulating in the 1990s seems to suggest that low inflation contributes to real economic performance in ways not fully appreciated before. If anything, our approach to price stability, by reducing uncertainty and making long-run savings and investment decisions easier, seems to have enhanced the growth of productivity, real GDP, and employment. This indirect benefit, of course, reinforces the price stability goal. It is the rate of inflation that monetary policy determines in the long run, and this means that price stability in a straightforward way is elevated to the status of the primary long-run goal of monetary policy. Where a tradeoff can appear, and this I think is the source of occasional confusion, is over shorter periods. In the shorter run, inflation may rise and fall depending on where the economy is operating relative to its potential. When the economy has become overextended, with output exceeding the economy's potential, employment beyond sustainable norms, and production surpassing normal capacity limits, then prices have tended to increase at an ever faster rate. Likewise, when aggregate demand has fallen short of the economy's potential, inflation has tended to fall. And this is where the short-run setting of monetary policy comes into play. By moving short-term interest rates, monetary policy can affect other financial conditions and end up exerting a substantial influence on aggregate demand. Decisions by businesses about investment and by households about housing and consumption are altered by changes in interest rates and other credit conditions. Monetary policy also can indirectly impinge upon other components of aggregate demand. As a result, in the shorter run, monetary policy can play an important role in stabilizing the economy from undesired fluctuations in economic activity and inflation. The strategy for monetary policy geared towards these shorter-run concerns can be briefly described. It is to restrict monetary conditions when the economy seems on the way to becoming overheated and inflation is threatening and ease monetary conditions when signs of weakness in demand appear on the horizon. But it is important that we pursue these short-run goals keeping in mind our primary long-run goal of price stability. Of course, other forces besides the state of the economy relative to its potential can influence inflation in the short run. Even prior to the anomalous experience of recent years, which I will discuss later in detail, supply shocks, such as a sudden hike in oil prices, have dramatically affected inflation. Such forces can also cause short-term fluctuations in the economy that are, at least in part, beyond the control of monetary policy. However, active stabilization policy may still have a role to play as a buffer, helping the economy to absorb such disturbances in the short run, while counteracting any persistent deviations from price stability. But monetary policy operates with a long lag, with a policy change exhibiting material effects on the economy (excluding the immediate impact on financial markets) only several quarters after its implementation. By some estimates it may be almost a year before the brunt of the effect of an interest rate change is felt on aggregate demand, although the influence appears sooner in some sectors of the economy than in others. And it may generally take longer still for a policy change to alter the course of inflation. Consequently, active stabilization policy is most successful when it is pre-emptive, responding to early warning signals or forecasts of unfavorable developments on the inflation and employment fronts. In this regard, by identifying past regularities in relationships among economic variables and understanding their conceptual underpinnings, we can use the most recent economic data to update forecasts of where the economy is headed. Based on these forecasts we can then take steps to adjust the stance of monetary policy as necessary, in accordance with our objectives. To be useful for monetary policy, forecasts of the future health of the economy need to be reasonably reliable. Good forecasts rest on theories about empirical regularities that can be confidently relied upon to provide guidance. Regrettably, accepted theories are found lacking at times, empirical models break down, and forecasts based on them prove unusually inaccurate. If monetary policy were naively to follow guidelines based on past regularities that are increasingly failing to reflect new realities, it would unintentionally introduce undesirable gyrations in the economy. Thus, heightened uncertainties regarding the workings of the economy pose an additional source of stress in policy design. To ascertain the appropriate framework for policy analysis we must first be aware of some key sources of uncertainty. In recent years, traditional views of the economy perhaps have been most challenged by the phenomenon of declining inflation despite increasing tightness in labor markets as evidenced by reductions in the unemployment rate to its lowest level in almost three decades. Many believe that there is an unemployment rate, the non-accelerating inflation rate of unemployment (the "NAIRU"), that would be consistent with a stable inflation rate, once other short-run influences on inflation dissipate. To these economists, inflationary pressures tend to increase when unemployment remains below the NAIRU and tend to decrease when unemployment stays above the NAIRU. For many years proponents of this view considered 6 percent a reasonable estimate of the NAIRU. Since 1995, however, the unemployment rate has been below this level, and substantially below of late, while inflation has continued to progress toward our price-stability objective. In response, over the past few years, many observers have revised their estimates of the NAIRU down by half a percentage point or more. Yet considerable uncertainty remains about the confidence with which the new estimates can be relied upon for evaluating inflationary pressures. The NAIRU never was measured with precision; statistical inference has always provided a distribution of likely values around a point estimate. And several factors, for instance the demographic composition of the labor force, have long been known to introduce systematic variation in its value over time. Nonetheless, the uncertainties about how structural forces may be changing the NAIRU seem unusually large at present and cannot be ignored. And for some the present uncertainties have called into further question the basic usefulness of the concept, or at least of a point estimate held with any confidence. A related uncertainty concerns the underlying trend growth of labor productivity. Until fairly recently, this trend had seemed to have been about constant since the mid 1970s. But there are many that believe that a pickup may have occurred in the last few years, and a faster productivity trend would help to explain the unexpectedly favorable economic growth-unemployment-inflation nexus in recent years. Unfortunately, much as with the NAIRU, our understanding of the forces that drive the productivity trend is less than perfect. Certainly, the investment boom of the current expansion has raised the amount of capital for each worker and contributed to an increase in labor productivity, and it may be that advancing technology is making the capital stock and workforce more productive. However, some of the recent pickup in productivity is the normal response to the faster output growth of late, so the degree to which there is a new higher trend remains an open question. Another difficulty in assessing the current amount of slack in the economy, and a third uncertainty, concerns the divergent patterns in alternative measures of excess demand. Capacity utilization in manufacturing and the rate of unemployment have historically moved together over the cycle. Unexpectedly, they have diverged in the current expansion, in part as the surge in investment has kept capacity utilization in the manufacturing sector near its historic average while labor markets have become tighter and tighter. Recent developments in South-East Asia also have contributed to uncertainty about the current monetary policy environment. One place where the effect of the crisis is being felt is in the prices of primary commodities. Since such commodities are traded on world markets, lower demand from Asia is reflected in lower prices world-wide, which benefit US producers that use commodities as inputs. This development serves as a short-run boost, a positive supply shock, to the US economy, one that also helps contain inflationary pressures, as does the more general decline in import prices as the US dollar appreciates. But the Asian crisis can be expected to continue to have an adverse impact on trade-sensitive industries. Some evidence of a deterioration of our trade balance with the region's economies has already appeared. With little historical guidance to draw from, however, considerable uncertainty prevails regarding the extent to which the present Asian situation may contribute to slower US growth as well as the timing of such a slowdown. For instance, despite expectations that the crisis would have contributed to a slowdown in economic activity earlier this year, the economy's growth in the first quarter of this year exceeded even the remarkable performance of 1997. However, more recent data reflecting developments in the second quarter, including survey information, do give some evidence of a slowing in the overall economy, especially the manufacturing sector, perhaps due to Asian financial turmoil. As you might suspect, we will continue to watch incoming data quite closely as the year progresses to get a better handle on this situation. To be sure, uncertainties such as these have loomed large at times in the past, and we can learn much from those experiences. The uncertainties faced by policymakers during the 1970s about the economy's potential provide an enlightening perspective on the present situation. Following a period of rapid productivity gains during the 1950s and 1960s, the economy's performance during the 1970s appeared out of line with previous experience. Starting in 1973, in particular, inflation rose more than expected, at times considerably'so, while economic growth tended to disappoint expectations for a number of years. At first, it appeared reasonable to assume that the observed productivity'slowdown was temporary. Reflecting this assumption, for instance, the Council of Economic Advisors gave a 4 percent estimate of potential output growth in the 1974 Economic Report of the President, as would have been consistent with the earlier trends. Increased uncertainty regarding this estimate was evident in the 1975 and 1976 Reports, but not until 1977 was the point estimate of potential output growth revised downward, to 3.6 percent. As the economy's performance continued to disappoint, further downward revisions followed, to 3 percent in 1979 and to 2.5 percent to close the decade in 1980. Only several years after the fact was a trend break in productivity recognized as likely to have occurred in 1973. And even today our understanding of the forces contributing to the slowdown is not entirely satisfactory. As inflation accelerated as the 1970s continued, critics blamed the Federal Reserve's operating procedures for placing too little weight on money growth and too much on interest rates in the conduct of policy. In response, the Federal Reserve in late 1979 put added emphasis on monetary growth targets. But the FOMC abandoned the strict regime of targeting M1 through reserve quantities in 1982 once evidence accumulated that the character of M1 demand had been altered by the spread of interest-bearing NOW accounts. Later, the break in the behavior of M2 velocity during the early 1990s from its earlier historical pattern undercut the indicator properties of that aggregate as well. In 1993, the FOMC de-emphasized the role of the broader aggregates in policymaking. Despite recent tentative signs that the relationship between M2 velocity and the cost of holding M2 assets may be returning to its earlier historical norms, uncertainty persists regarding the continued stability of this relationship. In terms of the performance of inflation and unemployment, the experience of the past few years has not been unlike a mirror image of the 1970s. While the consequences are a lot more pleasant, unexpectedly low inflation and unemployment do raise some complicated issues for monetary policy. This account of the sources of uncertainty that we face in designing the proper course of monetary policy should not leave the impression that our task is so daunting that the policy waters are unnavigable. But such an account does serve a valuable purpose in reminding us that in designing policy we should recognize our ignorance as well as trust our knowledge. For instance, we need to recognize the difficulties of inferring the true structure of the economy by interpreting incoming data. How do we know whether unexpected developments are just temporary moves away from stable longer-run relationships or are manifestations of changes in the underlying economic structure? In many cases this judgment is difficult to make with much confidence until considerably after the fact. In the meantime, we must bear in mind that the statistical relationships we work with are only loose approximations of underlying reality, which is constantly evolving, at least to some extent, in response to changes in technology, consumer preferences, and government policies. Our vision is always obstructed by some haze. But sometimes the picture is clearer than at other times. Because of these difficulties in assessing the situation, a balanced judgment is required in evaluating whether historical regularities are indeed changing significantly and are not just subject to temporary aberrations. I believe that one should guard against holding to old truths that may no longer be valid, but one should also be cautious about declaring that permanent changes have occurred, for there are too many examples of proclaimed "new eras" that did not in fact come to pass. Erroneously dismissing the continued validity of old truths could result in bad policy just as easily as failing to correctly recognize new realities when change occurs. What should be done when uncertainties seem particularly acute? When we suspect that our understanding of the macroeconomic environment has deteriorated appreciably, as evidenced by strings of surprises difficult to reconcile with our earlier beliefs, I think that the appropriate response is to rely less upon the future predicted by the increasingly unreliable old gauges and more upon inferences from the more recent past, weighing incoming data more heavily relative to more distant data in trying to discern the new environment. Even for those of us who take this more pragmatic approach, there are challenges. Recent data, on which our understanding of the new reality is based, are subject to revision as more reliable or more complete sources become available. Moreover, there are often several indices for measuring underlying economic circumstances, requiring one to consider various measures simultaneously. In the current context, the considerable uncertainty regarding our previous estimates of the capacity of the economy and its sustainable rate of growth in my judgment suggest the need to downplay forecasts of inflation based on those earlier assessments. By necessity, I believe heightened reliance needs to be placed on more recent observations of inflation and costs for inferring future inflationary pressures. We are not precluded from acting pre-emptively if new information were to tip the balance of risks in the outlook toward higher inflation, but are naturally a little more cautious in acting on forecasts as long as substantial uncertainty persists. As a consequence, the lead times for pre-emptive action are likely to be shorter. And, in my judgment, we may have to rely more on measures other than apparent excess demand to get reliable indications of pending changes in inflationary pressures. For instance, unit labor costs may have to be watched especially closely, and the rate of unemployment perhaps less closely than we are used to. But a pattern of unsustainable growth characterized by a continuously declining unemployment rate still may increasingly suggest greater inflation risk. Even if the limits of the economy's growth potential have moved, there are still limits that need to be respected. The increased uncertainty also implies that continued strong economic growth with low inflation is not outside the realm of possibility, and by adopting a cautious policy posture we may learn more clearly if that possibility is likely or remote. It should be clear that the creation of new jobs, by itself, is a welcomed development. There are benefits to all from the skill building that occurs on the job. It is important, however, that these jobs be the result of sustainable growth, and not the result of excesses and imbalances. However, caution can be excessive, running the risk that inflation may in fact reappear and require a more wrenching readjustment than if it had been anticipated. Uncertainty should not induce paralysis. We need to be willing to move, even if cautiously, knowing that we may have to reverse our action if subsequent developments differ from our expectations. Moreover, we must be willing to act forcefully if information suggesting a threat to our goal of price stability becomes available. Inflation is an insidious tax on all of our citizens, perhaps impacting low and moderate-income citizens more than others because there are fewer ways available to them to protect their income and their assets against an erosion of purchasing power. If evidence of an incipient rise in inflation were to appear, decisive action would provide a counterweight to minimize the building of a temporary inflationary aberration into inflation expectations, which could be disruptive. And this is why caution and vigilance go hand in hand under these circumstances of increased uncertainty. Moreover, it is at uncertain times such as these that the wisdom underlying the institutional structure of the FOMC becomes most apparent. A committee with broad representation can bring a variety of perspectives and analyses to bear on difficult economic problems. In addition, the real-time reports the presidents of the Federal Reserve Banks bring from their districts are especially valuable in the decision-making process at times like these because they afford a contemporaneous sense of what is going on in the economy. Such diversity of information sources becomes particularly useful when our earlier assessment of the economy's potential has been drawn into question by surprises, even pleasant ones. A string of favorable surprises yielding strong growth, high employment and low inflation is by far the most pleasant environment under which to come to the realization that our understanding of the workings of our complex economy is not infallible. A sound economy with subdued inflation makes dealing with the greater uncertainty much easier indeed! The Federal Reserve has an important trust to help safeguard the health of the United States economy. What we should do in the face of some uncertainty is to act cautiously while remaining vigilant, to take measured steps when necessary, and to adjust to the occasional unforeseen change. In this way we will raise the odds of achieving our goals of stable prices and maximum employment, not only providing benefits to Americans, but also a stable anchor for a volatile world economy.
1998-07-20T00:00:00	Mr. Ferguson remarks on themes in international bank supervision (Central Bank Articles and Speeches, 20 Jul 98)	Remarks by Mr. Roger W. Ferguson, Jr., a member of the Board of the Governors of the US Federal Reserve System, before the International Banking Conference, Federal Financial Institutions Examination Council, in Arlington, Virginia on 20/7/98.	Remarks by Mr. Ferguson remarks on themes in international bank supervision Mr. Roger W. Ferguson, Jr., a member of the Board of the Governors of the US Federal Reserve System, before the International Banking Conference, Federal Financial Institutions Examination Council, in Arlington, Virginia on 20/7/98. Themes in International Bank Supervision The scope of my introductory remarks for your conference today is broad and touches on a number of topics, some of which will be more fully developed by other speakers later in this seminar. Risks and Benefits of a Global Banking System Let me start by addressing the question of what value and what risks might arise from having a more global banking system such as the one developing currently. Academic and popular literature is full of articles arguing both sides of the case. Conceptually, global banking, by which I mean both direct entry and cross-border inter-bank lending, may influence macro-stability in both positive and harmful ways. Those who see potential harm argue that trans-national banks stimulate capital flight, particularly in developing markets, and in stressful times may be a source of capital outflows and currency crises. Second, some analysts argue that foreign banks may lack commitment to their host country and will flee, or withdraw credit, when faced with problems in local markets or in their home market. A third concern is that the participation of foreign banks may be associated with broader efforts at deregulation and may overwhelm domestic banking supervisors, creating a riskier environment. Those on the other side of the debate argue that participation in global banking is a source of stability and improved banking practice. Proponents of this view claim that foreign banks may directly bring new and better basic banking skills, more sophisticated management techniques, and products better suited to managing and spreading risk. Through the benefits of competition, these commentators argue, local banking skills and services will be improved. In addition, some observers see indirect benefits from the participation of foreign banks. They argue that global banks, as either direct entrants or as inter-bank lenders, may accelerate the development of ancillary institutions, such as rating agencies, accounting and auditing firms, and credit bureaus, which acquire and process information. Similarly, banks that participate in many national markets may improve information disclosure about the banks themselves as the foreign banks compete to gain market share by demonstrating their comparatively sound financial condition. Finally, the proponents of this view argue that participation by cross-border banks may stimulate improvements in the supervisory and regulatory framework. I believe that those who argue for the benefits of having a country open to global banking may have the better of the argument. We know, however, that whether foreign banks are a source of stability or fragility depends very much on the market, banking and supervisory environments that they find in the host country. There are conditions that must accompany, or better still, precede a country's decision to participate in today's global banking market. If the participation of foreign banking competitors, either directly or through inter-bank lending, comes with improvements in the underlying bank credit underwriting culture, the capability of bank supervisors, and the degree of transparency, then the benefits of foreign bank participation will eventually emerge. On the other hand, if foreign banks participate in a country in which neither the market transparency, nor domestic banks, nor bank supervisors are prepared to change, I believe that the participation of foreign banks, by itself, will not necessarily be beneficial and could prove to be negative. Therefore, entry of foreign banks, either directly or as participants in the inter-bank lending market, without movement to better information, better supervision and better banking, provides access to credit, but not necessarily an increase in macro-stability. To argue the benefits of global banking in the abstract, removed from these required conditions, therefore seems to miss the true focus. Lessons from the Asian Crises Let me now turn to the broad-based lessons that the Asian crisis teaches us. One of the most important contributing factors to the current financial crisis in many of the emerging Asian nations was the weakness of their banking systems, as well as weakness of bank supervision within those countries. It seems clear now that, Asian banks, as well as their government supervisors, violated some of the fundamental principles of banking and banking supervision. Banks' managers had not developed adequate processes for underwriting loans and monitoring their continued performance, or of establishing sufficient and timely reserves to buffer expected loan losses. Some of these problems stemmed from lending directed by governments, which led to expectations that the government would support such loans, if needed. But, the primary cause of these credit problems stemmed from banks' failure to deploy effective tools of credit risk analysis. The absence of credit risk analysis led to financial structures that were inherently fragile. Banking supervisors in these countries proved ill-equipped to compensate for the fragility. Poor allocation of credit undermined the prospects for sustained economic growth. Some borrowers could not service their loans. As these domestic banks' loan portfolios deteriorated and their financial condition eroded, their creditors, domestic and foreign, looked at them more critically, and began to withdraw their funding. In short, the deteriorating condition of borrowers hurt the banking system, which increased economic harm to the rest of these countries' economies. Two other features of these countries' financial systems have compounded the problems caused by poor lending practices and inadequate supervision. First, standards for the transparency and disclosure of private financial information were extremely lax. It was difficult for creditors, foreign or domestic, to distinguish good risks from bad, and this caused them to both grant and, later, withdraw credit from borrowers within these countries without full knowledge of borrowers' creditworthiness. This latter reaction exacerbated the crisis for the businesses and citizens of these countries. Second, creditors to banks no doubt relied to some extent on a public safety net to back up their claims. This was true not only of small depositors, but also of foreign bank creditors. As it turned out, the presumption of public support was at least to some extent misplaced. Therefore, participation in the global banking market did not work to save these countries from fundamental information, banking and supervisory weakness. The fact that the information, credit and supervisory cultures had not yet changed, even with the participation of foreign banks and the extension of inter-bank credit, meant that ultimately these financial systems were proved fundamentally flawed. We have also learned, or relearned, other lessons because of the handling of these crises. First, prolonged delay in tackling systemic banking sector weakness invites further weakness, not strengthening. Delay in the hopes that the economy will grow banks out of their problems, is attractive, but is actually a trap. Because of the credit allocation role that banks play in many economies, delay allows problems to grow. Inefficient banks are allowed to allocate credit inefficiently, and open, insolvent banks, in effect distribute taxpayer money to bank shareholders, employees and borrowers. Second, extra attention is required to solve systemic bank weaknesses because of the inherent pitfalls associated with banks that are "too-big-to-fail". Because the threat of closing very large banks may not be credible, it may be more difficult for supervisors to pressure very large banks to improve their operations. As a consequence, supervisors need to have clear legal authority, and political support, to order banks to take a variety of steps to improve their operations. This is a lesson that we in the United States learned only recently, and supervisors here are now required to order banks to take remedial actions as capital falls below 8 percent. Reactions of the International Supervisory Community The international supervisory community has heeded these lessons and reacted to them. International recognition of the need for strong, effectively-supervised banking systems is the reason that the Basle Supervisors Committee issued its 1997 paper, "Core Principles of Effective Banking Supervision." Bill Rutledge, Senior Vice President of the Federal Reserve Bank of New York, will discuss this paper with you after your break this morning. I cannot overstate the importance of adopting such core principles of sound banking and banking supervision in the international banking system, and also the need to develop a workable mechanism for enforcing the implementation of these standards. The Asian crisis also underscores the importance of transparency. Adequate market discipline depends on investors having information that is sufficient in quantity, reliability, and timeliness. In recognition of this, the Basle Committee is now exploring the possibility of setting benchmarks for providing information about financial institutions that should be available to both supervisors and markets. International progress toward greater transparency is a vital initiative for the markets and sound supervision. More broadly, I believe that the time is appropriate to hasten the wide-spread adoption of international accounting and disclosure principles that raise the standard for accounting treatments in all countries. These standards should focus on three goals. First, any international accounting principles should provide the basis for depicting a clear and fair picture of the condition of the bank and of corporate creditors. Second, any principles should provide a means by which firms identify and disclose their major risks, such as funding, foreign exchange or concentrations. Finally, compliance with these principles should be sufficient to support market confidence in the basic integrity of a firm's published financial statements and other disclosures. Because of the increasing complexity of financial instruments and the speed of movement in financial markets, intrusive supervision has become less meaningful, if not virtually impossible. Thus the federal banking agencies have adopted a risk-focused approach to banking supervision that emphasizes the adequacy of banks' internal risk management systems. Events in the financial markets today occur too quickly to give anyone a comfortable learning curve in grappling with financial problems. I believe that our objective should be to make managers and institutions behave as if there were no safety net and align their natural market-driven decisions with supervisory objectives. Together with the traditional approaches of loan review and transaction monitoring, market-based supervision will best ensure the continued viability of the banking sector. We should, and are, actively searching for other methods to create incentive-compatible regulation and supervision. The Asian situation highlights the value of a reliable system for US banking supervisors to assess banks' country risk, which I know has occupied some of you recently. As many of you are aware, the federal banking agencies, through the Interagency Country Risk Exposure Review Committee (ICERC), are developing an improved guide for examiners in evaluating the country-risk exposure in banks. This system will permit examiners to be more thoroughly informed on countries in which US banks have exposure and allow for a better cross check against banks' country risk management systems. New risk-focused examination procedures will also be a by-product of the current review of management practices. Finally, the Asian crisis and the speed with which it occurred demonstrate the need for effective international communication and coordination. You confront this need in your daily work in supervising global financial conglomerates. These large diversified companies, which are becoming more prevalent in domestic and global markets, blend banking, securities, and other financial activities in a single diversified company operating across national borders and traditional industry lines. This presents a significant supervisory and examination challenge because most of the legal systems of the countries in which these firms operate are structured along national or smaller geographic regions. Many of these countries, including the United States, continue to employ different supervisory approaches, implemented by different regulators, for each traditional sector of the financial services industry. The crossing of national and industry lines can result in numerous financial services supervisors having responsibility for theoretically distinct pieces of these financial conglomerates, but no supervisor having clear authority to coordinate supervision of the entire jigsaw puzzle of each conglomerate. This is a critical deficiency because these conglomerates are working to coordinate and integrate their business operations and supporting systems to the greatest extent feasible. This is why the Joint Forum on Financial Conglomerates in February issued its consultative documents, "Supervision of Financial Conglomerates". This international coordinating group is a joint initiative of the Basle Committee on Banking Supervision, the International Organization of Securities Commissions (IOSCO), and the International Association of Insurance Supervisors (IAIS). The Joint Forum's consultative documents make concrete recommendations for steps that supervisors in each of the securities, insurance, and banking sectors can take to enhance supervision of the group-wide risk exposures of these global and inter-industry conglomerates. One key recommendation is for the international supervisory community to agree on one or more coordinators to facilitate international and inter-industry cooperation. The specifics need to be clarified, but you should all be aware of this international initiative, while also recognizing that more work remains to be done in this country to deal with the complex issues that arise from the international and inter-industry activities of these firms. Domestic Supervision of Foreign Banking Organizations Moving now from Asia to domestic issues, the International Banking Act (IBA) is perhaps the most notable of the laws governing the activities of foreign banking organizations (FBOs) here in the United States. The IBA requires, among other things, that, in order to approve a branch application, the Board must determine that a foreign bank is subject to comprehensive supervision or regulation on a consolidated basis by its home country supervisor. This requirement, as you are undoubtedly aware, is commonly known by the initials CCS. I believe that the Federal Reserve should continue to be rigorous in applying the CCS standard. The Board should also take great care in allowing entry into the United States by foreign banks from a country where CCS is not yet in place. In these countries, appropriate conditions could be imposed on the operations of the US branch to help compensate for the lack of full CCS. Finally, let me raise an issue that symbolizes our global interdependence: the major challenge of being ready to turn the calendar page on December 31, 1999. As you are all well aware, the Federal Reserve, as well as the other banking agencies, have a keen interest in the Year 2000 readiness of all banks in the United States and overseas. While all banks must address Year 2000 readiness issues within their organizations, the issue appears to pose special problems for foreign banks operating branches and agencies in the United States. To address the Year 2000 problem for these banks, and international banking generally, the Federal Reserve is taking an active role in a number of international initiatives, most notably including the Joint Year 2000 Council, which is jointly sponsored by the major international bodies for cooperation between financial market regulators. The Joint Year 2000 Council has made a good start at its task. I am sure that it will continue to raise the visibility of this issue, help all countries recognize the magnitude of the Year 2000 challenge, and provide guidance to and assistance for supervisors and financial market participants in understanding the steps they need to take to meet the challenge. I refer you in particular to the Council's current paper on guidance to supervisors, which gives concrete steps on assessing preparations by financial institutions. Going forward I know that the Council intends to provide guidance on developing testing programs and contingency plans. One focus of our concern with protecting the banking system in the United States is that many US offices of foreign banks may be particularly exposed if their parents are not ready for the Year 2000. Therefore, we have asked the US branches and agencies to confirm that they will be able to continue to conduct business using the usual standards for readiness that we apply to domestic banks. We are also examining foreign banking branches and agencies, as we have with domestic banks under our supervisory authority. The initial round of examination of US branches and agencies has been completed, and individual foreign banks are being made aware of the results. There are, of course, a number of competing initiatives that further stretch the limited information systems resources available to achieve preparedness. In Europe and other parts of the world, the introduction of the Euro, and the coordination of systems within the Euro-countries, is requiring extensive planning and programming. In Japan, the "Big Bang" will likely take top management focus from Year 2000 systems issues. Particularly in light of these competing demands for system resources internationally, foreign and US banks need to recognize the magnitude and importance of the Year 2000 conversion effort. Banks need to take action now to devote sufficient resources to this critical mission. Senior management of banks and FBOs is responsible for dealing with Year 2000 issues. It is not a technical issue alone; it is also a strategic business issue. Conclusion I believe that the emergence of modern international banking is probably likely to be beneficial. While international banking holds the potential for macro-stability, the history of financial crises, including the current ones in Asia, also shows how weakness in banking systems and banking supervision may contribute to macro-instability. The prescription to avoid, or at least minimize the impact of, future crises includes a combination of solid banking skills, well-conceived banking oversight at the national level, greater transparency, risk-focused and incentive-compatible banking supervision, and coordination among international banking supervisors. While creating this long-term environment, we must also respond to the more immediate challenge of protecting our domestic financial system from poorly supervised foreign entities and from the risks inherent in technology as we go into the new millenium.	---[PAGE_BREAK]--- Mr. Ferguson remarks on themes in international bank supervision Remarks by Mr. Roger W. Ferguson, Jr., a member of the Board of the Governors of the US Federal Reserve System, before the International Banking Conference, Federal Financial Institutions Examination Council, in Arlington, Virginia on 20/7/98. # Themes in International Bank Supervision The scope of my introductory remarks for your conference today is broad and touches on a number of topics, some of which will be more fully developed by other speakers later in this seminar. ## Risks and Benefits of a Global Banking System Let me start by addressing the question of what value and what risks might arise from having a more global banking system such as the one developing currently. Academic and popular literature is full of articles arguing both sides of the case. Conceptually, global banking, by which I mean both direct entry and cross-border inter-bank lending, may influence macro-stability in both positive and harmful ways. Those who see potential harm argue that trans-national banks stimulate capital flight, particularly in developing markets, and in stressful times may be a source of capital outflows and currency crises. Second, some analysts argue that foreign banks may lack commitment to their host country and will flee, or withdraw credit, when faced with problems in local markets or in their home market. A third concern is that the participation of foreign banks may be associated with broader efforts at deregulation and may overwhelm domestic banking supervisors, creating a riskier environment. Those on the other side of the debate argue that participation in global banking is a source of stability and improved banking practice. Proponents of this view claim that foreign banks may directly bring new and better basic banking skills, more sophisticated management techniques, and products better suited to managing and spreading risk. Through the benefits of competition, these commentators argue, local banking skills and services will be improved. In addition, some observers see indirect benefits from the participation of foreign banks. They argue that global banks, as either direct entrants or as inter-bank lenders, may accelerate the development of ancillary institutions, such as rating agencies, accounting and auditing firms, and credit bureaus, which acquire and process information. Similarly, banks that participate in many national markets may improve information disclosure about the banks themselves as the foreign banks compete to gain market share by demonstrating their comparatively sound financial condition. Finally, the proponents of this view argue that participation by cross-border banks may stimulate improvements in the supervisory and regulatory framework. I believe that those who argue for the benefits of having a country open to global banking may have the better of the argument. We know, however, that whether foreign banks are a source of stability or fragility depends very much on the market, banking and supervisory environments that they find in the host country. There are conditions that must accompany, or better still, precede a country's decision to participate in today's global banking market. If the participation of foreign banking competitors, either directly or through inter-bank lending, comes with improvements in the underlying bank credit underwriting culture, the capability of bank supervisors, and the degree of transparency, then the benefits of foreign bank participation will eventually emerge. On the other hand, if foreign banks participate in a country in which neither the market transparency, nor domestic banks, nor bank supervisors are prepared to change, I believe that the participation of foreign banks, by itself, will not necessarily be beneficial and could prove to be ---[PAGE_BREAK]--- negative. Therefore, entry of foreign banks, either directly or as participants in the inter-bank lending market, without movement to better information, better supervision and better banking, provides access to credit, but not necessarily an increase in macro-stability. To argue the benefits of global banking in the abstract, removed from these required conditions, therefore seems to miss the true focus. Lessons from the Asian Crises Let me now turn to the broad-based lessons that the Asian crisis teaches us. One of the most important contributing factors to the current financial crisis in many of the emerging Asian nations was the weakness of their banking systems, as well as weakness of bank supervision within those countries. It seems clear now that, Asian banks, as well as their government supervisors, violated some of the fundamental principles of banking and banking supervision. Banks' managers had not developed adequate processes for underwriting loans and monitoring their continued performance, or of establishing sufficient and timely reserves to buffer expected loan losses. Some of these problems stemmed from lending directed by governments, which led to expectations that the government would support such loans, if needed. But, the primary cause of these credit problems stemmed from banks' failure to deploy effective tools of credit risk analysis. The absence of credit risk analysis led to financial structures that were inherently fragile. Banking supervisors in these countries proved ill-equipped to compensate for the fragility. Poor allocation of credit undermined the prospects for sustained economic growth. Some borrowers could not service their loans. As these domestic banks' loan portfolios deteriorated and their financial condition eroded, their creditors, domestic and foreign, looked at them more critically, and began to withdraw their funding. In short, the deteriorating condition of borrowers hurt the banking system, which increased economic harm to the rest of these countries' economies. Two other features of these countries' financial systems have compounded the problems caused by poor lending practices and inadequate supervision. First, standards for the transparency and disclosure of private financial information were extremely lax. It was difficult for creditors, foreign or domestic, to distinguish good risks from bad, and this caused them to both grant and, later, withdraw credit from borrowers within these countries without full knowledge of borrowers' creditworthiness. This latter reaction exacerbated the crisis for the businesses and citizens of these countries. Second, creditors to banks no doubt relied to some extent on a public safety net to back up their claims. This was true not only of small depositors, but also of foreign bank creditors. As it turned out, the presumption of public support was at least to some extent misplaced. Therefore, participation in the global banking market did not work to save these countries from fundamental information, banking and supervisory weakness. The fact that the information, credit and supervisory cultures had not yet changed, even with the participation of foreign banks and the extension of inter-bank credit, meant that ultimately these financial systems were proved fundamentally flawed. We have also learned, or relearned, other lessons because of the handling of these crises. First, prolonged delay in tackling systemic banking sector weakness invites further weakness, not strengthening. Delay in the hopes that the economy will grow banks out of their problems, is attractive, but is actually a trap. Because of the credit allocation role that banks play in many economies, delay allows problems to grow. Inefficient banks are allowed to allocate credit inefficiently, and open, insolvent banks, in effect distribute taxpayer money to bank shareholders, employees and borrowers. Second, extra attention is required to solve systemic bank weaknesses because of the inherent pitfalls associated with banks that are "too-big-to-fail". Because the threat of ---[PAGE_BREAK]--- closing very large banks may not be credible, it may be more difficult for supervisors to pressure very large banks to improve their operations. As a consequence, supervisors need to have clear legal authority, and political support, to order banks to take a variety of steps to improve their operations. This is a lesson that we in the United States learned only recently, and supervisors here are now required to order banks to take remedial actions as capital falls below 8 percent. # Reactions of the International Supervisory Community The international supervisory community has heeded these lessons and reacted to them. International recognition of the need for strong, effectively-supervised banking systems is the reason that the Basle Supervisors Committee issued its 1997 paper, "Core Principles of Effective Banking Supervision." Bill Rutledge, Senior Vice President of the Federal Reserve Bank of New York, will discuss this paper with you after your break this morning. I cannot overstate the importance of adopting such core principles of sound banking and banking supervision in the international banking system, and also the need to develop a workable mechanism for enforcing the implementation of these standards. The Asian crisis also underscores the importance of transparency. Adequate market discipline depends on investors having information that is sufficient in quantity, reliability, and timeliness. In recognition of this, the Basle Committee is now exploring the possibility of setting benchmarks for providing information about financial institutions that should be available to both supervisors and markets. International progress toward greater transparency is a vital initiative for the markets and sound supervision. More broadly, I believe that the time is appropriate to hasten the wide-spread adoption of international accounting and disclosure principles that raise the standard for accounting treatments in all countries. These standards should focus on three goals. First, any international accounting principles should provide the basis for depicting a clear and fair picture of the condition of the bank and of corporate creditors. Second, any principles should provide a means by which firms identify and disclose their major risks, such as funding, foreign exchange or concentrations. Finally, compliance with these principles should be sufficient to support market confidence in the basic integrity of a firm's published financial statements and other disclosures. Because of the increasing complexity of financial instruments and the speed of movement in financial markets, intrusive supervision has become less meaningful, if not virtually impossible. Thus the federal banking agencies have adopted a risk-focused approach to banking supervision that emphasizes the adequacy of banks' internal risk management systems. Events in the financial markets today occur too quickly to give anyone a comfortable learning curve in grappling with financial problems. I believe that our objective should be to make managers and institutions behave as if there were no safety net and align their natural market-driven decisions with supervisory objectives. Together with the traditional approaches of loan review and transaction monitoring, market-based supervision will best ensure the continued viability of the banking sector. We should, and are, actively searching for other methods to create incentive-compatible regulation and supervision. The Asian situation highlights the value of a reliable system for US banking supervisors to assess banks' country risk, which I know has occupied some of you recently. As many of you are aware, the federal banking agencies, through the Interagency Country Risk Exposure Review Committee (ICERC), are developing an improved guide for examiners in evaluating the country-risk exposure in banks. This system will permit examiners to be more thoroughly informed on countries in which US banks have exposure and allow for a better cross check against banks' country risk management systems. New risk-focused examination procedures will also be a by-product of the current review of management practices. ---[PAGE_BREAK]--- Finally, the Asian crisis and the speed with which it occurred demonstrate the need for effective international communication and coordination. You confront this need in your daily work in supervising global financial conglomerates. These large diversified companies, which are becoming more prevalent in domestic and global markets, blend banking, securities, and other financial activities in a single diversified company operating across national borders and traditional industry lines. This presents a significant supervisory and examination challenge because most of the legal systems of the countries in which these firms operate are structured along national or smaller geographic regions. Many of these countries, including the United States, continue to employ different supervisory approaches, implemented by different regulators, for each traditional sector of the financial services industry. The crossing of national and industry lines can result in numerous financial services supervisors having responsibility for theoretically distinct pieces of these financial conglomerates, but no supervisor having clear authority to coordinate supervision of the entire jigsaw puzzle of each conglomerate. This is a critical deficiency because these conglomerates are working to coordinate and integrate their business operations and supporting systems to the greatest extent feasible. This is why the Joint Forum on Financial Conglomerates in February issued its consultative documents, "Supervision of Financial Conglomerates". This international coordinating group is a joint initiative of the Basle Committee on Banking Supervision, the International Organization of Securities Commissions (IOSCO), and the International Association of Insurance Supervisors (IAIS). The Joint Forum's consultative documents make concrete recommendations for steps that supervisors in each of the securities, insurance, and banking sectors can take to enhance supervision of the group-wide risk exposures of these global and inter-industry conglomerates. One key recommendation is for the international supervisory community to agree on one or more coordinators to facilitate international and inter-industry cooperation. The specifics need to be clarified, but you should all be aware of this international initiative, while also recognizing that more work remains to be done in this country to deal with the complex issues that arise from the international and inter-industry activities of these firms. # Domestic Supervision of Foreign Banking Organizations Moving now from Asia to domestic issues, the International Banking Act (IBA) is perhaps the most notable of the laws governing the activities of foreign banking organizations (FBOs) here in the United States. The IBA requires, among other things, that, in order to approve a branch application, the Board must determine that a foreign bank is subject to comprehensive supervision or regulation on a consolidated basis by its home country supervisor. This requirement, as you are undoubtedly aware, is commonly known by the initials CCS. I believe that the Federal Reserve should continue to be rigorous in applying the CCS standard. The Board should also take great care in allowing entry into the United States by foreign banks from a country where CCS is not yet in place. In these countries, appropriate conditions could be imposed on the operations of the US branch to help compensate for the lack of full CCS. Finally, let me raise an issue that symbolizes our global interdependence: the major challenge of being ready to turn the calendar page on December 31, 1999. As you are all well aware, the Federal Reserve, as well as the other banking agencies, have a keen interest in the Year 2000 readiness of all banks in the United States and overseas. While all banks must address Year 2000 readiness issues within their organizations, the issue appears to pose special problems for foreign banks operating branches and agencies in the United States. To address the Year 2000 problem for these banks, and international banking generally, the Federal Reserve is taking an active role in a number of international initiatives, most notably including the Joint Year 2000 Council, which is jointly sponsored by the major international bodies for cooperation between financial market regulators. The Joint Year 2000 Council has made a good start at its task. I am sure that it will ---[PAGE_BREAK]--- continue to raise the visibility of this issue, help all countries recognize the magnitude of the Year 2000 challenge, and provide guidance to and assistance for supervisors and financial market participants in understanding the steps they need to take to meet the challenge. I refer you in particular to the Council's current paper on guidance to supervisors, which gives concrete steps on assessing preparations by financial institutions. Going forward I know that the Council intends to provide guidance on developing testing programs and contingency plans. One focus of our concern with protecting the banking system in the United States is that many US offices of foreign banks may be particularly exposed if their parents are not ready for the Year 2000. Therefore, we have asked the US branches and agencies to confirm that they will be able to continue to conduct business using the usual standards for readiness that we apply to domestic banks. We are also examining foreign banking branches and agencies, as we have with domestic banks under our supervisory authority. The initial round of examination of US branches and agencies has been completed, and individual foreign banks are being made aware of the results. There are, of course, a number of competing initiatives that further stretch the limited information systems resources available to achieve preparedness. In Europe and other parts of the world, the introduction of the Euro, and the coordination of systems within the Euro-countries, is requiring extensive planning and programming. In Japan, the "Big Bang" will likely take top management focus from Year 2000 systems issues. Particularly in light of these competing demands for system resources internationally, foreign and US banks need to recognize the magnitude and importance of the Year 2000 conversion effort. Banks need to take action now to devote sufficient resources to this critical mission. Senior management of banks and FBOs is responsible for dealing with Year 2000 issues. It is not a technical issue alone; it is also a strategic business issue. # Conclusion I believe that the emergence of modern international banking is probably likely to be beneficial. While international banking holds the potential for macro-stability, the history of financial crises, including the current ones in Asia, also shows how weakness in banking systems and banking supervision may contribute to macro-instability. The prescription to avoid, or at least minimize the impact of, future crises includes a combination of solid banking skills, well-conceived banking oversight at the national level, greater transparency, risk-focused and incentive-compatible banking supervision, and coordination among international banking supervisors. While creating this long-term environment, we must also respond to the more immediate challenge of protecting our domestic financial system from poorly supervised foreign entities and from the risks inherent in technology as we go into the new millenium.	Roger W Ferguson	United States	https://www.bis.org/review/r980804a.pdf	Mr. Ferguson remarks on themes in international bank supervision Remarks by Mr. Roger W. Ferguson, Jr., a member of the Board of the Governors of the US Federal Reserve System, before the International Banking Conference, Federal Financial Institutions Examination Council, in Arlington, Virginia on 20/7/98. The scope of my introductory remarks for your conference today is broad and touches on a number of topics, some of which will be more fully developed by other speakers later in this seminar. Let me start by addressing the question of what value and what risks might arise from having a more global banking system such as the one developing currently. Academic and popular literature is full of articles arguing both sides of the case. Conceptually, global banking, by which I mean both direct entry and cross-border inter-bank lending, may influence macro-stability in both positive and harmful ways. Those who see potential harm argue that trans-national banks stimulate capital flight, particularly in developing markets, and in stressful times may be a source of capital outflows and currency crises. Second, some analysts argue that foreign banks may lack commitment to their host country and will flee, or withdraw credit, when faced with problems in local markets or in their home market. A third concern is that the participation of foreign banks may be associated with broader efforts at deregulation and may overwhelm domestic banking supervisors, creating a riskier environment. Those on the other side of the debate argue that participation in global banking is a source of stability and improved banking practice. Proponents of this view claim that foreign banks may directly bring new and better basic banking skills, more sophisticated management techniques, and products better suited to managing and spreading risk. Through the benefits of competition, these commentators argue, local banking skills and services will be improved. In addition, some observers see indirect benefits from the participation of foreign banks. They argue that global banks, as either direct entrants or as inter-bank lenders, may accelerate the development of ancillary institutions, such as rating agencies, accounting and auditing firms, and credit bureaus, which acquire and process information. Similarly, banks that participate in many national markets may improve information disclosure about the banks themselves as the foreign banks compete to gain market share by demonstrating their comparatively sound financial condition. Finally, the proponents of this view argue that participation by cross-border banks may stimulate improvements in the supervisory and regulatory framework. I believe that those who argue for the benefits of having a country open to global banking may have the better of the argument. We know, however, that whether foreign banks are a source of stability or fragility depends very much on the market, banking and supervisory environments that they find in the host country. There are conditions that must accompany, or better still, precede a country's decision to participate in today's global banking market. If the participation of foreign banking competitors, either directly or through inter-bank lending, comes with improvements in the underlying bank credit underwriting culture, the capability of bank supervisors, and the degree of transparency, then the benefits of foreign bank participation will eventually emerge. On the other hand, if foreign banks participate in a country in which neither the market transparency, nor domestic banks, nor bank supervisors are prepared to change, I believe that the participation of foreign banks, by itself, will not necessarily be beneficial and could prove to be negative. Therefore, entry of foreign banks, either directly or as participants in the inter-bank lending market, without movement to better information, better supervision and better banking, provides access to credit, but not necessarily an increase in macro-stability. To argue the benefits of global banking in the abstract, removed from these required conditions, therefore seems to miss the true focus. Lessons from the Asian Crises Let me now turn to the broad-based lessons that the Asian crisis teaches us. One of the most important contributing factors to the current financial crisis in many of the emerging Asian nations was the weakness of their banking systems, as well as weakness of bank supervision within those countries. It seems clear now that, Asian banks, as well as their government supervisors, violated some of the fundamental principles of banking and banking supervision. Banks' managers had not developed adequate processes for underwriting loans and monitoring their continued performance, or of establishing sufficient and timely reserves to buffer expected loan losses. Some of these problems stemmed from lending directed by governments, which led to expectations that the government would support such loans, if needed. But, the primary cause of these credit problems stemmed from banks' failure to deploy effective tools of credit risk analysis. The absence of credit risk analysis led to financial structures that were inherently fragile. Banking supervisors in these countries proved ill-equipped to compensate for the fragility. Poor allocation of credit undermined the prospects for sustained economic growth. Some borrowers could not service their loans. As these domestic banks' loan portfolios deteriorated and their financial condition eroded, their creditors, domestic and foreign, looked at them more critically, and began to withdraw their funding. In short, the deteriorating condition of borrowers hurt the banking system, which increased economic harm to the rest of these countries' economies. Two other features of these countries' financial systems have compounded the problems caused by poor lending practices and inadequate supervision. First, standards for the transparency and disclosure of private financial information were extremely lax. It was difficult for creditors, foreign or domestic, to distinguish good risks from bad, and this caused them to both grant and, later, withdraw credit from borrowers within these countries without full knowledge of borrowers' creditworthiness. This latter reaction exacerbated the crisis for the businesses and citizens of these countries. Second, creditors to banks no doubt relied to some extent on a public safety net to back up their claims. This was true not only of small depositors, but also of foreign bank creditors. As it turned out, the presumption of public support was at least to some extent misplaced. Therefore, participation in the global banking market did not work to save these countries from fundamental information, banking and supervisory weakness. The fact that the information, credit and supervisory cultures had not yet changed, even with the participation of foreign banks and the extension of inter-bank credit, meant that ultimately these financial systems were proved fundamentally flawed. We have also learned, or relearned, other lessons because of the handling of these crises. First, prolonged delay in tackling systemic banking sector weakness invites further weakness, not strengthening. Delay in the hopes that the economy will grow banks out of their problems, is attractive, but is actually a trap. Because of the credit allocation role that banks play in many economies, delay allows problems to grow. Inefficient banks are allowed to allocate credit inefficiently, and open, insolvent banks, in effect distribute taxpayer money to bank shareholders, employees and borrowers. Second, extra attention is required to solve systemic bank weaknesses because of the inherent pitfalls associated with banks that are "too-big-to-fail". Because the threat of closing very large banks may not be credible, it may be more difficult for supervisors to pressure very large banks to improve their operations. As a consequence, supervisors need to have clear legal authority, and political support, to order banks to take a variety of steps to improve their operations. This is a lesson that we in the United States learned only recently, and supervisors here are now required to order banks to take remedial actions as capital falls below 8 percent. The international supervisory community has heeded these lessons and reacted to them. International recognition of the need for strong, effectively-supervised banking systems is the reason that the Basle Supervisors Committee issued its 1997 paper, "Core Principles of Effective Banking Supervision." Bill Rutledge, Senior Vice President of the Federal Reserve Bank of New York, will discuss this paper with you after your break this morning. I cannot overstate the importance of adopting such core principles of sound banking and banking supervision in the international banking system, and also the need to develop a workable mechanism for enforcing the implementation of these standards. The Asian crisis also underscores the importance of transparency. Adequate market discipline depends on investors having information that is sufficient in quantity, reliability, and timeliness. In recognition of this, the Basle Committee is now exploring the possibility of setting benchmarks for providing information about financial institutions that should be available to both supervisors and markets. International progress toward greater transparency is a vital initiative for the markets and sound supervision. More broadly, I believe that the time is appropriate to hasten the wide-spread adoption of international accounting and disclosure principles that raise the standard for accounting treatments in all countries. These standards should focus on three goals. First, any international accounting principles should provide the basis for depicting a clear and fair picture of the condition of the bank and of corporate creditors. Second, any principles should provide a means by which firms identify and disclose their major risks, such as funding, foreign exchange or concentrations. Finally, compliance with these principles should be sufficient to support market confidence in the basic integrity of a firm's published financial statements and other disclosures. Because of the increasing complexity of financial instruments and the speed of movement in financial markets, intrusive supervision has become less meaningful, if not virtually impossible. Thus the federal banking agencies have adopted a risk-focused approach to banking supervision that emphasizes the adequacy of banks' internal risk management systems. Events in the financial markets today occur too quickly to give anyone a comfortable learning curve in grappling with financial problems. I believe that our objective should be to make managers and institutions behave as if there were no safety net and align their natural market-driven decisions with supervisory objectives. Together with the traditional approaches of loan review and transaction monitoring, market-based supervision will best ensure the continued viability of the banking sector. We should, and are, actively searching for other methods to create incentive-compatible regulation and supervision. The Asian situation highlights the value of a reliable system for US banking supervisors to assess banks' country risk, which I know has occupied some of you recently. As many of you are aware, the federal banking agencies, through the Interagency Country Risk Exposure Review Committee (ICERC), are developing an improved guide for examiners in evaluating the country-risk exposure in banks. This system will permit examiners to be more thoroughly informed on countries in which US banks have exposure and allow for a better cross check against banks' country risk management systems. New risk-focused examination procedures will also be a by-product of the current review of management practices. Finally, the Asian crisis and the speed with which it occurred demonstrate the need for effective international communication and coordination. You confront this need in your daily work in supervising global financial conglomerates. These large diversified companies, which are becoming more prevalent in domestic and global markets, blend banking, securities, and other financial activities in a single diversified company operating across national borders and traditional industry lines. This presents a significant supervisory and examination challenge because most of the legal systems of the countries in which these firms operate are structured along national or smaller geographic regions. Many of these countries, including the United States, continue to employ different supervisory approaches, implemented by different regulators, for each traditional sector of the financial services industry. The crossing of national and industry lines can result in numerous financial services supervisors having responsibility for theoretically distinct pieces of these financial conglomerates, but no supervisor having clear authority to coordinate supervision of the entire jigsaw puzzle of each conglomerate. This is a critical deficiency because these conglomerates are working to coordinate and integrate their business operations and supporting systems to the greatest extent feasible. This is why the Joint Forum on Financial Conglomerates in February issued its consultative documents, "Supervision of Financial Conglomerates". This international coordinating group is a joint initiative of the Basle Committee on Banking Supervision, the International Organization of Securities Commissions (IOSCO), and the International Association of Insurance Supervisors (IAIS). The Joint Forum's consultative documents make concrete recommendations for steps that supervisors in each of the securities, insurance, and banking sectors can take to enhance supervision of the group-wide risk exposures of these global and inter-industry conglomerates. One key recommendation is for the international supervisory community to agree on one or more coordinators to facilitate international and inter-industry cooperation. The specifics need to be clarified, but you should all be aware of this international initiative, while also recognizing that more work remains to be done in this country to deal with the complex issues that arise from the international and inter-industry activities of these firms. Moving now from Asia to domestic issues, the International Banking Act (IBA) is perhaps the most notable of the laws governing the activities of foreign banking organizations (FBOs) here in the United States. The IBA requires, among other things, that, in order to approve a branch application, the Board must determine that a foreign bank is subject to comprehensive supervision or regulation on a consolidated basis by its home country supervisor. This requirement, as you are undoubtedly aware, is commonly known by the initials CCS. I believe that the Federal Reserve should continue to be rigorous in applying the CCS standard. The Board should also take great care in allowing entry into the United States by foreign banks from a country where CCS is not yet in place. In these countries, appropriate conditions could be imposed on the operations of the US branch to help compensate for the lack of full CCS. Finally, let me raise an issue that symbolizes our global interdependence: the major challenge of being ready to turn the calendar page on December 31, 1999. As you are all well aware, the Federal Reserve, as well as the other banking agencies, have a keen interest in the Year 2000 readiness of all banks in the United States and overseas. While all banks must address Year 2000 readiness issues within their organizations, the issue appears to pose special problems for foreign banks operating branches and agencies in the United States. To address the Year 2000 problem for these banks, and international banking generally, the Federal Reserve is taking an active role in a number of international initiatives, most notably including the Joint Year 2000 Council, which is jointly sponsored by the major international bodies for cooperation between financial market regulators. The Joint Year 2000 Council has made a good start at its task. I am sure that it will continue to raise the visibility of this issue, help all countries recognize the magnitude of the Year 2000 challenge, and provide guidance to and assistance for supervisors and financial market participants in understanding the steps they need to take to meet the challenge. I refer you in particular to the Council's current paper on guidance to supervisors, which gives concrete steps on assessing preparations by financial institutions. Going forward I know that the Council intends to provide guidance on developing testing programs and contingency plans. One focus of our concern with protecting the banking system in the United States is that many US offices of foreign banks may be particularly exposed if their parents are not ready for the Year 2000. Therefore, we have asked the US branches and agencies to confirm that they will be able to continue to conduct business using the usual standards for readiness that we apply to domestic banks. We are also examining foreign banking branches and agencies, as we have with domestic banks under our supervisory authority. The initial round of examination of US branches and agencies has been completed, and individual foreign banks are being made aware of the results. There are, of course, a number of competing initiatives that further stretch the limited information systems resources available to achieve preparedness. In Europe and other parts of the world, the introduction of the Euro, and the coordination of systems within the Euro-countries, is requiring extensive planning and programming. In Japan, the "Big Bang" will likely take top management focus from Year 2000 systems issues. Particularly in light of these competing demands for system resources internationally, foreign and US banks need to recognize the magnitude and importance of the Year 2000 conversion effort. Banks need to take action now to devote sufficient resources to this critical mission. Senior management of banks and FBOs is responsible for dealing with Year 2000 issues. It is not a technical issue alone; it is also a strategic business issue. I believe that the emergence of modern international banking is probably likely to be beneficial. While international banking holds the potential for macro-stability, the history of financial crises, including the current ones in Asia, also shows how weakness in banking systems and banking supervision may contribute to macro-instability. The prescription to avoid, or at least minimize the impact of, future crises includes a combination of solid banking skills, well-conceived banking oversight at the national level, greater transparency, risk-focused and incentive-compatible banking supervision, and coordination among international banking supervisors. While creating this long-term environment, we must also respond to the more immediate challenge of protecting our domestic financial system from poorly supervised foreign entities and from the risks inherent in technology as we go into the new millenium.
1998-07-21T00:00:00	Mr. Greenspan presents the US Federal Reserve's mid-year report on monetary policy (Central Bank Articles and Speeches, 21 Jul 98)	Testimony by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on Banking, Housing, and Urban Affairs of the US Senate on 21/7/98.	Mr. Greenspan presents the US Federal Reserve's mid-year report on monetary policy Testimony by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on Banking, Housing, and Urban Affairs of the US Senate on 21/7/98. Mr. Chairman and members of the Committee, I appreciate this opportunity to present the Federal Reserve's mid-year report on monetary policy. Overall, the performance of the US economy continues to be impressive. Over the first part of the year, we experienced further gains in output and employment, subdued prices, and moderate long-term interest rates. Important crosscurrents, however, have been impacting the economy. With labor markets very tight and domestic final demand retaining considerable momentum, the risks of a pickup in inflation remain significant. But inventory investment, which was quite rapid late last year and early this year, appears to have slowed, perhaps appreciably. Moreover, the economic and financial troubles in Asian economies are now demonstrably restraining demands for US goods and services - and those troubles could intensify and spread further. Weighing these forces, the Federal Open Market Committee chose to keep the stance of policy unchanged over the first half of 1998. However, should pressures on labor resources begin to show through more impressively in cost increases, policy action may need to counter any associated tendency for prices to accelerate before it undermines this extraordinary expansion. Recent Developments When I appeared before your committee in February, I noted that a key question for monetary policy was whether the consequences of the turmoil in Asia would be sufficient to check inflationary tendencies that might otherwise result from the strength of domestic spending and tightening labor markets. After the economy's surge in 1996 and, especially, last year, resource utilization, particularly that of the labor force, had risen to a very high level. Although some signs pointed to stepped-up increases in productivity, the speed at which the demand for goods and services had been growing clearly exceeded the rate of expansion of the economy's long-run potential to produce. Maintenance of such a pace would put even greater pressures on the economy's resources, threatening the balance and longevity of the expansion. However, it appeared likely that the difficulties being encountered by Asian economies, by cutting into US exports, would be a potentially important factor slowing the growth of aggregate demand in the United States. But uncertainties about the timing and dimensions of that development were considerable given the difficulties in assessing the extent of the problems in East Asia. In the event, the contraction of output and incomes in a number of Asian economies has turned out to be more substantial than most had anticipated. Moreover, financial markets in Asia and in emerging market economies generally have remained unsettled, portending further difficult adjustments. The contraction in Asian economies, along with the rise in the foreign exchange value of the dollar over 1997, prompted a sharp deterioration in the US balance of trade in the first quarter. Nonetheless, the American economy proved to be unexpectedly robust in that period. The growth of real GDP not only failed to slow, it climbed further, to about a 51⁄2 percent annual rate in the first quarter, according to the current national income accounts. Domestic private demand for goods and services - including personal consumption expenditures, business investment, and residential expenditures - was exceptionally strong. Evidently, optimism about jobs, incomes, and profits, high and rising wealth-to-income ratios, low financing costs, and falling prices for high-tech goods fed the appetites of households and businesses for consumer durables and capital equipment. In addition, inventory investment contributed significantly to growth in the first quarter; indeed, the growth of stocks of materials and goods outpaced that of overall output by a wide margin during the first quarter, adding 1 percentage points to the annualized growth rate of GDP. Although accumulation of some products likely was unintended, surveys - 2 - indicate that much of the stockbuilding probably reflected firms' confidence in the prospects for continued growth. As evidence piled up that the economy continued to run hot during the winter, the Federal Reserve's concerns about inflationary pressures mounted. Domestic demand clearly had more underlying momentum than we had anticipated, supported in part by financial conditions that were quite accommodative. Credit remained extremely easy for most borrowers to obtain; intermediate- and long-term interest rates were at relatively low levels; equity prices soared higher, despite some disappointing earnings reports; and growth in the monetary aggregates was rapid. Indeed, the crises in Asia, by lowering longer-term US interest rates - through stronger preferences for dollar investments and expectations of slower growth ahead - and by reducing commodity prices, probably added to the positive forces boosting domestic spending in the first half, especially in the interest-sensitive housing sector. The robust expansion of demand tightened labor markets further, giving additional impetus to the upward trend in labor costs. Inflation was low - though, given the lags with which monetary policy affects the economy and prices, we had to be mainly concerned not with conditions at the moment but with those likely to prevail many months ahead. In these circumstances, the Federal Open Market Committee elected in March to move to a state of heightened alert against inflation, but left the stance of policy unchanged. Although national income and product data for the second quarter have not yet been published, growth of US output appears to have slowed sharply. The auto strike has brought General Motor's production essentially to a halt, probably reducing real GDP in the second quarter by about 1⁄2 percentage point at an annual rate. The limited available information on inventory investment suggests that stockbuilding dropped markedly from its unsustainable pace of the first quarter. In addition to the slower pace of inventory building, Asian economies have continued to deteriorate, further retarding our exports in recent months. Indeed, readings on the elements that make up the real GDP have led many analysts to anticipate a decline in that measure in the second quarter, after the first-quarter surge. Given the upcoming revisions to the national income accounts, such assessments would have to be regarded as conjectural. It is worth noting in any case that other indicators of output, including worker hours and manufacturing production, show a somewhat steadier, though slowing, path over the first half of the year. And underlying trends in domestic final demand have remained strong, imparting impetus to the continuing economic expansion. During the first half of the year, measures of resource utilization diverged. Pressures on manufacturing facilities appeared to be easing. Plant capacity was growing rapidly as a result of vigorous investment. And growth of industrial output was dropping off from its brisk pace of 1997, importantly reflecting the deceleration in world demand for manufactured goods that resulted from the Asian economic difficulties. But labor markets, in contrast, became increasingly taut during the first half. Total payroll jobs rose about one-and-one-half million over the first six months of the year. The civilian unemployment rate dropped to a bit below 41⁄2 percent in the second quarter, its lowest level in three decades. Firms resorted to a variety of tactics to attract and retain workers, such as paying various types of monetary bonuses and raising basic wage rates. But, at least through the first quarter, the effects of a rising wage bill on production costs were moderated by strong gains in productivity. Indeed, inflation stayed remarkably damped during the first quarter. The consumer price index as well as broader measures of prices indicate that inflation moved down further, even as the economy strengthened. Although declining oil prices contributed to this development, pricing leverage in the goods-producing sector more generally was held in check by reduced demand from Asia that, among other things, has led to a softening of commodity prices, a strong dollar that has contributed to bargain prices on many imports, and rising industrial capacity. Service price inflation, less influenced by - 3 - international events, has remained steady at about a 3 percent rate since before the beginning of the crisis. Some elements in the goods price mix clearly were transitory. Indeed, the more recent price data suggest that overall consumer price inflation moved up in the second quarter. But, even so, the increase remained moderate. In any event, it would be a mistake for monetary policy makers to focus on any single index in gauging inflation pressures in the economy. Although much public attention is directed to the CPI, the Federal Reserve monitors a wide variety of aggregate price measures. Each is designed for a particular purpose and has its own strengths and weaknesses. Price pressures appear especially absent in some of the measures in the national income accounts, which are available through the first quarter. The chain-weight price index for personal consumption expenditures excluding food and energy, for example, rose 1.5 percent over the year ending in the first quarter, considerably less than the 2.3 percent rise in the core CPI over the same period. An even broader price measure, that for overall GDP, rose 1.4 percent. These indexes, while certainly subject to many of the measurement difficulties the Bureau of Labor Statistics has been grappling with in the CPI, have the advantages that their chain-weighting avoids some aspects of so-called substitution bias and that already published data can be revised to incorporate new information and measurement techniques. Taken together, while the various price indexes show some differences, the basic message is that inflation to date has remained low. Economic Fundamentals: The Virtuous Cycle So far this year, our economy has continued to enjoy a virtuous cycle. Evidence of accelerated productivity has been bolstering expectations of future corporate earnings, thereby fueling still further increases in equity values, and the improvements in productivity have been helping to reduce inflation. In the context of subdued price increases and generally supportive credit conditions, rising equity values have provided impetus to spending and, in turn, the expansion of output, employment, and productivity-enhancing capital investment. The essential precondition for the emergence, and persistence, of this virtuous cycle is arguably the decline in the rate of inflation to near price stability. In recent years, continued low product price inflation and expectations that it will persist have promoted stability in financial markets and fostered perceptions that the degree of risk in the financial outlook has been moving ever lower. These perceptions, in turn, have reduced the extra compensation that investors require for making loans to, or taking ownership positions in, private firms. With risks in the domestic economy judged to be low, credit and equity capital have been readily available for many businesses, fostering strong investment. And low mortgage interest rates have allowed many households to purchase homes and to refinance outstanding debt. The reduction in debt servicing costs has contributed to an apparent stabilization of the financial strains on the household sector that seemed to emerge a couple of years ago and has buoyed consumer demand. To a considerable extent, investors seem to be expecting that low inflation and stronger productivity growth will allow the extraordinary growth of profits to be extended into the distant future. Indeed, expectations of earnings growth over the longer term have been undergoing continual upward revision by security analysts since early 1995. These rising expectations have, in turn, driven stock prices sharply higher and credit spreads lower, perhaps in both cases to levels that will be difficult to sustain unless the virtuous cycle continues. In any event, primarily because of the rise in stock prices, about $121⁄2 trillion has been added to the value of household assets since the end of 1994. Probably only a few percent of these largely unrealized capital gains have been transformed into the purchase of goods and services in consumer markets. But that increment to spending, combined with the sharp increase in equipment investment, which has stemmed from the low cost of both equity and debt relative to expected profits on capital, has been instrumental in propelling the economy forward. - 4 - The consequences for the American worker have been dramatic and, for the most part, highly favorable. A great many chronically underemployed people have been given the opportunity to work, and many others have been able to upgrade their skills as a result of work experience, extensive increases in on-the-job training, or increased enrollment in technical programs in community colleges and elsewhere. In addition, former welfare recipients appear to have been absorbed into the work force in significant numbers. Government finances have been enhanced as well. Widespread improvement has been evident in the financial positions of state and local governments. In the federal sector, the taxes paid on huge realized capital gains and other incomes related to stock market advances, coupled with taxes on markedly higher corporate profits, have joined with restraint on spending to produce a unified budget surplus for the first time in nearly three decades. The important steps taken by the Congress and the Administration to put federal finances on a sounder footing have added to national saving, relieving pressures on credit markets. The paydown of debt associated with the federal surplus has helped to hold down longer-term interest rates, which in turn has encouraged capital formation and reduced debt burdens. Maintaining this disciplined budget stance would be most helpful in supporting a continuation of our current robust economic performance in the years ahead. The fact that economic performance has strengthened as inflation subsided should not have been surprising, given that risk premiums and economic disincentives to invest in productive capital diminish as the economy approaches price stability. But the extent to which strong growth and high labor force utilization have been joined with low inflation over an extended period is, nevertheless, exceptional. So far, at least, the adverse wage-price interactions that played so central a role in pressuring inflation higher in many past business expansions - eventually bringing those expansions to an end - have not played a significant role in the current expansion. For one thing, increases in hourly compensation have been slower to pick up than in most other recent expansions, although, to be sure, wages have started to accelerate in the past couple of years as the labor market has become progressively tighter. In the first few years of the expansion, the subdued rate of rise in hourly compensation seemed to be, in part, a reflection of greater concerns among workers about job security. We now seem to have moved beyond that phase of especially acute concern, though the flux of technology may still be leaving many workers with fears of job skill obsolescence and a willingness to trade wage gains for job security. In the past couple of years, of course, workers have not had to press especially hard for nominal pay gains to realize sizable increases in their real wages. In contrast to the pattern that developed in several previous business expansions, when workers required substantial increases in pay just to cover increases in the cost of living, consumer prices have been generally well-behaved in the current expansion. A couple of years ago - almost at the same time that increases in total hourly compensation began trending up in nominal terms - evidence of a long-awaited pickup in the growth of labor productivity began to show through more strongly in the data; and this accelerated increase in output per hour has enabled firms to raise workers' real wages while holding the line on price increases. Gains in productivity usually vary with the strength of the economy, and the favorable results that we have observed during the past two years or so, when the economy has been growing more rapidly, almost certainly overstate the degree of structural improvement. But evidence continues to mount that the trend of productivity has accelerated, even if the extent of that pickup is as yet unclear. Signs of major technological improvements are all around us, and the benefits are evident not only in high-tech industries but also in production processes that have long been part of our industrial economy. Those technological innovations and the rapidly declining cost of capital equipment that embodies them in turn seem to be a major factor behind the recent enlarged gains in productivity. Evidently, plant managers who were involved in planning capital investments anticipated that a significant increase in the real rates of return on facilities could be achieved by exploiting emerging new technologies. If that had been a mistake on their part, one would have expected capital investment to run up briefly and then start down again when the lower-than-anticipated rates of return developed. But we - 5 - have instead seen sustained gains in investment, indicating that hoped-for rates of return apparently have been realized. Notwithstanding a reasonably optimistic interpretation of the recent productivity numbers, it would not be prudent to assume that even strongly rising productivity, by itself, can ensure a non-inflationary future. Certainly wage increases, per se, are not inflationary, unless they exceed productivity growth, thereby creating pressure for inflationary price increases that can eventually undermine economic growth and employment. Because the level of productivity is tied to an important degree to the stock of capital, which turns over only gradually, increases in the trend growth of productivity probably also occur rather gradually. By contrast, the potential for abrupt acceleration of nominal hourly compensation is surely greater. As I have noted in previous appearances before Congress, economic growth at rates experienced on average over the past several years would eventually run into constraints as the reservoir of unemployed people available to work is drawn down. The annual increase in the working-age population (from 16 to 64 years of age), including immigrants, has been approximately 1 percent a year in recent years. Yet employment, measured by the count of persons who are working rather than by the count of jobs, has been rising 2 percent a year since 1995, despite the acceleration in the growth of output per hour. The gap between employment growth and population growth, amounting to about 1.1 million persons a year on average since the end of 1995, has been made up, in part, by a decline in the number of individuals who are counted as unemployed - those persons who are actively seeking work - of approximately 650,000 a year, on average, over the past two and one-half years. The remainder of the gap has reflected a rise in labor force participation that can be traced largely to a decline of almost 300,000 a year in the number of individuals (aged 16 to 64) wanting a job but not actively seeking one. Presumably, many of the persons who once were in this group have more recently become active and successful job-seekers as the economy has strengthened, thereby preventing a still sharper drop in the official unemployment rate. In June, the number of persons aged 16 to 64 who wanted to work but who did not have jobs was 10.6 million on a seasonally adjusted basis, roughly 6 percent of the working-age population. Despite an uptick in joblessness in June, this percentage is only fractionally above the record low reached in May for these data, which can be calculated back to 1970. Nonetheless, a strong signal of inflation pressures building because of compensation increases markedly in excess of productivity gains has not yet clearly emerged in this expansion. Among nonfinancial corporations (our most recent source of data on consolidated income statements), trends in costs seem to have accelerated from their lows, but the rates of increase in both unit labor costs and total unit costs are still quite low. Still, the gap between the growth in employment and that of the working-age population will inevitably close. What is crucial to sustaining this unprecedented period of prosperity is that it close reasonably promptly, given already stretched labor resources, and that labor markets find a balance consistent with sustained growth marked by compensation gains in line with productivity advances. Whether these adjustments will occur without monetary policy action remains an open question. Foreign Developments While the United States has been benefiting from a virtuous economic cycle, a number of other economies unfortunately have been spiraling in quite the opposite direction. The United States, Canada, and Western Europe have been enjoying solid economic growth, with relatively low inflation and declining unemployment, but the economic performance in many developing and transition nations and Japan has been deteriorating. How quickly the latter erosion is arrested and reversed will be a key factor in shaping US economic and financial trends in the period ahead. With all that is at stake, it would be difficult to overstate how crucial it is that the authorities in the relevant economies promptly implement effective policies to correct the structural problems underlying recent weaknesses and to promote sustainable economic growth before patterns of reinforcing contraction become difficult to contain. - 6 - Conditions in Asia are of particular concern. Aggregate output of the Asian developing economies has plunged, with particularly steep declines in Korea, Malaysia, Thailand, and Indonesia. Even the economies of the stalwart tigers - Hong Kong, Singapore, and Taiwan - have softened. Economic growth in China has also slowed, owing largely to the currency depreciations among its neighbors and the sharp declines in their demand for imports. Russia has also experienced some spillover from the Asian difficulties, but Russia's problems are mostly homegrown. Large fiscal deficits stem from high effective marginal tax rates that encourage avoidance and do not raise adequate revenue. This and the recent declines in prices of oil and other commodities have rendered Russian financial markets and the ruble vulnerable, particularly in an environment of heightened concern about all emerging markets. The Russian government has recently promulgated a set of new policy measures in connection with an expanded IMF support package in an effort to address these problems. In Latin America, conditions vary: Economies that are heavily dependent on exports of oil and other commodities have suffered as prices of those items have fallen, and several countries in that region have received more intensive scrutiny in international capital markets, but, on the whole, Latin American economies continue to perform reasonably well. Disappointingly, economic activity in Japan - a crucial engine of Asian economic growth - has turned down after a long period of subpar growth. Gross domestic product fell at a 51⁄4 percent annual rate in the first quarter. More recently, confidence of households and businesses has continued to erode, the sharp contraction elsewhere in Asia has fed back onto Japan, and the dwindling domestic demand for goods and services in that country has been further constrained by a mounting credit crunch. Nonperforming loans have risen sharply as real estate values fell following the bursting of the asset bubble in 1991. Problems in the banking sector, exacerbated by the broader Asian financial crisis, have led to market concerns about the adequacy of the capital of many Japanese banks and have engendered a premium in the market for Japanese banks' borrowing. This resulting squeeze to profit margins has led to a reluctance to lend in dollars or yen. In response to the weakening economy and deteriorating banking situation, the Japanese yen has tended to weaken significantly, in often-volatile markets, against the dollar and major European currencies. As you know, we have sought to be helpful in the Japanese government's efforts to stabilize their economy and financial system, reflecting our awareness of the important role that Japanese financial and economic performance plays in the world economy, including that of the United States. We have consulted with the relevant Japanese authorities on methods for resolving difficulties in their banking system and have urged them to take effective measures to stimulate their economy. I believe that the Japanese authorities recognize the urgency of the situation. That a number of foreign economies are currently experiencing difficulties is not surprising. Although many had previously realized a substantial measure of success in developing their economies, a number had leaned heavily on command-type systems rather than relying primarily on market mechanisms. This characteristic has been evident not only in their industrial sectors but in banking where government intervention is typically heavy, where long-standing personal and corporate relationships are the predominant factor in financing arrangements, and where market-based credit assessments are the exception rather than the rule. Recent events confirm that these sorts of structures are ill-suited to today's dynamic global economy, in which national economies must be capable of adapting flexibly and rapidly to changing conditions. Responses in countries currently experiencing difficulties have varied considerably. Some have reacted quickly and, in general terms, appropriately. But in others, a variety of political considerations appear to have militated against prompt and effective action. - 7 - As a consequence, the risks of further adverse developments in these economies remain substantial. And given the pervasive interconnections of virtually all economies and financial systems in the world today, the associated uncertainties for the United States and other developed economies remain substantial as well. In the current circumstances, we need to be aware that monetary policy tightening actions in the United States could have outsized effects on very sensitive financial markets in Asia, a development that could have substantial adverse repercussions on US financial markets and, over time, on our own economy. But while we must take account of such foreign interactions, we must be careful that our responses ultimately are consistent with a monetary policy aimed at optimal performance of the US economy. Our objectives relate to domestic economic performance, and price stability and maximum sustainable economic growth here at home would best serve the long-run interests of troubled financial markets and economies abroad. The Economic Outlook The Federal Open Market Committee believes that the conditions for continued growth with low inflation are in place here in the United States. As I noted previously, an important issue for policy is how the imbalance of recent years between the demand for labor and the growth of the working-age population is resolved. In that regard, we see a slowing of the growth in aggregate demand as a necessary element in the mix. At this time, some of the key factors that have supported strong final demand by domestic purchasers remain favorable. Although real short-term interest rates have risen as the federal funds rate has been held unchanged while inflation expectations have declined, the financial conditions that have fostered the strength in demand are still in place. With their incomes and wealth having been on a strong upward track, American consumers remain quite upbeat. For businesses, decreasing costs of and high rates of return on investment, as well as the scarcity of labor, could keep capital spending elevated. These factors suggest some risk that the labor market could get even tighter. And even if it does not, under prevailing tight labor markets increasingly confident workers might place gradually escalating pressures on wages and costs, which would eventually feed through to prices. But a number of factors likely will serve to damp growth in aggregate demand, helping to foster a reasonably smooth transition to a more sustainable rate of growth and reasonable balance in labor markets. We have yet to see the full effects of the crisis in East Asia on US employment and income. Residential and business fixed investment already have reached such high levels that further gains approaching those experienced recently would imply very rapid growth of the stocks of housing and plant and equipment relative to income trends. Moreover, business investment will be damped if recent indications of a narrowing in domestic operating profit margins prompt a reassessment of the expected rates of return on investment in plant and equipment. Reduced prospects for the return to capital would not only affect investment directly but could also affect consumption if stock prices adjust to a less optimistic view of earnings prospects. Of course, the demand for labor that is consistent with a particular rate of output growth also could be lowered if productivity growth were to increase more. And, on the supply side of the labor market, faster growth of the labor force could emerge as the result of increased immigration or delayed retirements. Nonetheless, it appears most probable that the necessary slower absorption of labor into employment will reflect, in part, a deceleration of output growth, as a consequence of evolving market forces. Failing that, firming actions on the part of the Federal Reserve may be necessary to ensure a track of expansion that is capable of being sustained. Thus, members of the Board of Governors and presidents of the Federal Reserve Banks anticipate a slowing in the rate of economic growth. The central tendency of their forecasts is that real GDP will rise 3 to 31⁄4 percent over 1998 as a whole and 2 to 21⁄2 percent in 1999. With the rise in the demand for workers coming into line with that of the labor force, the unemployment rate is expected to change little from its current level, finishing next year in the neighborhood of 41⁄2 to 43⁄4 percent. - 8 - Inflation performance will be affected by developments abroad as well as those here at home. The extent and pace of recovery of Asian economies currently experiencing a severe downturn will have important implications for prices of energy and other commodities, the strength of the dollar, and competitive conditions on world product markets. Should the situation abroad remain unsettled, these factors would probably continue to contribute to good price performance in the United States in the period ahead. But it is important to recognize that the damping influence of these factors on inflation is mostly temporary. At some point, the dollar will stop rising, foreign demand will begin to recover, and oil and other commodity prices will stop falling and could even back up some. Indeed, a brisk snap-back in foreign economic activity, should that occur, would add, at least temporarily, to price pressures in the United States. On a more fundamental level, it is the balance of supply and demand in labor and product markets in the United States that will have the greatest effect on inflation rates here. As I noted previously, wage and benefit costs have been remarkably subdued in the current expansion. Nonetheless, an accelerating trend in wages has been apparent for some time. In addition, a gradual upward tilt in benefit costs has become evident of late. A variety of factors - including the strength of the economy and rising equity values, which have reduced the need for payments into unemployment trust funds and pension plans, and the restructuring of the health care sector - have been working to keep benefit costs in check in this expansion. But, in the medical area at least, the most recent developments suggest that the favorable trend may have run its course. The slowing of price increases for medical services seems to have come to a halt, at least for a time, and, with the cost-saving shift to managed care having been largely completed, the potential for businesses to achieve further savings in that regard appears to be rather limited at this point. There have been a few striking instances this past year of employers boosting outlays for health benefits by substantial amounts. Given that compensation costs are likely to accelerate at least a little further, productivity trends and profit margins will be key to determining price performance in the period ahead. Whether the recent strong performance of productivity can be extended remains to be seen. It does seem likely that productivity calculated for the entire economy using GDP data weakened in the second quarter. This development clearly owed, at least in some degree, to the deceleration of output in that period. In manufacturing, where our data are better measured, productivity appears still to have registered a solid increase. We will be closely monitoring a variety of indicators to assess how productivity is performing in the months ahead. Monetary policymakers see the most likely outcome as modestly higher inflation rates in the next one and one-half years. The central tendency of monetary policymakers' CPI inflation forecasts is for an increase of 13⁄4 to 2 percent during 1998 and 2 to 21⁄2 percent next year. As noted, the ebbing of the special factors reducing inflation over the past year or so, such as the decline in oil prices, will account for some of this uptick. But the Federal Open Market Committee will need to remain particularly alert to the possibility that more fundamental imbalances are increasing inflationary pressures. The Committee would need to resist vigorously any tendency for an upward trend, which could become embedded in the inflationary process. The Committee recognizes that significant risks attend the outlook: One is that the impending constraint from domestic labor markets could bind more abruptly than it has to date, intensifying inflation pressures. The other is the potential for further adverse developments abroad, which could reduce the demand for US goods and services more sharply than anticipated and which would thereby ease pressures on labor markets. While we expect that the situation will develop relatively smoothly, the Committee believes that, given the current tightness in labor markets, the potential for accelerating inflation is probably greater than the risk of protracted, excessive weakness in the economy. In any case, it will need to continue to monitor evolving circumstances closely, and adjust the stance of monetary policy as appropriate, in order to help establish conditions consistent with progress towards the Federal Reserve's goals of price stability and maximum sustainable economic growth. - 9 - Ranges for Money and Credit Growth Indeed, recognition of the benefits of low inflation and our commitment to the Federal Reserve's statutory objective of price stability were once again dominant in the Committee's semiannual review of the ranges for the monetary and debt aggregates. The FOMC noted that the behavior of the monetary aggregates had been somewhat more predictable over the past few years than it had been earlier in the 1990s. The rapid growth of M2 and M3 over the first half of the year, which lifted those measures above the upper ends of the target ranges established in February, was consistent with the unexpectedly strong advance in aggregate demand. However, movements in velocity remain difficult to predict. The FOMC will continue to interpret the monetary ranges as benchmarks for the achievement of price stability under conditions of historically normal velocity behavior. Consistent with that interpretation, the Committee decided to retain the current ranges for the monetary aggregates for 1998, as well as the range for debt, and to carry them over on a provisional basis to next year. Although near-term prospects for velocity behavior are uncertain, the Committee recognizes that monetary growth does appear to provide some information about trends in the economy and inflation. Therefore, we will be carefully evaluating the aggregates, relative both to forecasts and to their ranges, in the context of other readings on other variables in our efforts to promote optimum macroeconomic conditions. Concluding Comments As I have stated in previous testimony, the recent economic performance, with its combination of strong growth and low inflation, is as impressive as any I have witnessed in my near half-century of daily observation of the American economy. Although the reasons for this development are complex, our success can be attributed in part to sound economic policy. The Congress and the Administration have successfully balanced the budget and, indeed, achieved a near-term surplus, a development that tends to boost national saving and investment. The Federal Reserve has pursued monetary conditions consistent with maximum sustainable long-run growth by seeking price stability. These policies have helped bring about a healthy macroeconomic environment for productivity-boosting investment and innovation, factors that have lifted living standards for most Americans. The task before us is to maintain disciplined economic policies and thereby contribute to maintaining and extending these gains in the years ahead.	---[PAGE_BREAK]--- # Mr. Greenspan presents the US Federal Reserve's mid-year report on monetary policy Testimony by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on Banking, Housing, and Urban Affairs of the US Senate on $21 / 7 / 98$. Mr. Chairman and members of the Committee, I appreciate this opportunity to present the Federal Reserve's mid-year report on monetary policy. Overall, the performance of the US economy continues to be impressive. Over the first part of the year, we experienced further gains in output and employment, subdued prices, and moderate long-term interest rates. Important crosscurrents, however, have been impacting the economy. With labor markets very tight and domestic final demand retaining considerable momentum, the risks of a pickup in inflation remain significant. But inventory investment, which was quite rapid late last year and early this year, appears to have slowed, perhaps appreciably. Moreover, the economic and financial troubles in Asian economies are now demonstrably restraining demands for US goods and services - and those troubles could intensify and spread further. Weighing these forces, the Federal Open Market Committee chose to keep the stance of policy unchanged over the first half of 1998. However, should pressures on labor resources begin to show through more impressively in cost increases, policy action may need to counter any associated tendency for prices to accelerate before it undermines this extraordinary expansion. ## Recent Developments When I appeared before your committee in February, I noted that a key question for monetary policy was whether the consequences of the turmoil in Asia would be sufficient to check inflationary tendencies that might otherwise result from the strength of domestic spending and tightening labor markets. After the economy's surge in 1996 and, especially, last year, resource utilization, particularly that of the labor force, had risen to a very high level. Although some signs pointed to stepped-up increases in productivity, the speed at which the demand for goods and services had been growing clearly exceeded the rate of expansion of the economy's long-run potential to produce. Maintenance of such a pace would put even greater pressures on the economy's resources, threatening the balance and longevity of the expansion. However, it appeared likely that the difficulties being encountered by Asian economies, by cutting into US exports, would be a potentially important factor slowing the growth of aggregate demand in the United States. But uncertainties about the timing and dimensions of that development were considerable given the difficulties in assessing the extent of the problems in East Asia. In the event, the contraction of output and incomes in a number of Asian economies has turned out to be more substantial than most had anticipated. Moreover, financial markets in Asia and in emerging market economies generally have remained unsettled, portending further difficult adjustments. The contraction in Asian economies, along with the rise in the foreign exchange value of the dollar over 1997, prompted a sharp deterioration in the US balance of trade in the first quarter. Nonetheless, the American economy proved to be unexpectedly robust in that period. The growth of real GDP not only failed to slow, it climbed further, to about a $51 / 2$ percent annual rate in the first quarter, according to the current national income accounts. Domestic private demand for goods and services - including personal consumption expenditures, business investment, and residential expenditures - was exceptionally strong. Evidently, optimism about jobs, incomes, and profits, high and rising wealth-to-income ratios, low financing costs, and falling prices for high-tech goods fed the appetites of households and businesses for consumer durables and capital equipment. In addition, inventory investment contributed significantly to growth in the first quarter; indeed, the growth of stocks of materials and goods outpaced that of overall output by a wide margin during the first quarter, adding 1 percentage points to the annualized growth rate of GDP. Although accumulation of some products likely was unintended, surveys ---[PAGE_BREAK]--- indicate that much of the stockbuilding probably reflected firms' confidence in the prospects for continued growth. As evidence piled up that the economy continued to run hot during the winter, the Federal Reserve's concerns about inflationary pressures mounted. Domestic demand clearly had more underlying momentum than we had anticipated, supported in part by financial conditions that were quite accommodative. Credit remained extremely easy for most borrowers to obtain; intermediate- and long-term interest rates were at relatively low levels; equity prices soared higher, despite some disappointing earnings reports; and growth in the monetary aggregates was rapid. Indeed, the crises in Asia, by lowering longer-term US interest rates - through stronger preferences for dollar investments and expectations of slower growth ahead - and by reducing commodity prices, probably added to the positive forces boosting domestic spending in the first half, especially in the interest-sensitive housing sector. The robust expansion of demand tightened labor markets further, giving additional impetus to the upward trend in labor costs. Inflation was low - though, given the lags with which monetary policy affects the economy and prices, we had to be mainly concerned not with conditions at the moment but with those likely to prevail many months ahead. In these circumstances, the Federal Open Market Committee elected in March to move to a state of heightened alert against inflation, but left the stance of policy unchanged. Although national income and product data for the second quarter have not yet been published, growth of US output appears to have slowed sharply. The auto strike has brought General Motor's production essentially to a halt, probably reducing real GDP in the second quarter by about $1 / 2$ percentage point at an annual rate. The limited available information on inventory investment suggests that stockbuilding dropped markedly from its unsustainable pace of the first quarter. In addition to the slower pace of inventory building, Asian economies have continued to deteriorate, further retarding our exports in recent months. Indeed, readings on the elements that make up the real GDP have led many analysts to anticipate a decline in that measure in the second quarter, after the first-quarter surge. Given the upcoming revisions to the national income accounts, such assessments would have to be regarded as conjectural. It is worth noting in any case that other indicators of output, including worker hours and manufacturing production, show a somewhat steadier, though slowing, path over the first half of the year. And underlying trends in domestic final demand have remained strong, imparting impetus to the continuing economic expansion. During the first half of the year, measures of resource utilization diverged. Pressures on manufacturing facilities appeared to be easing. Plant capacity was growing rapidly as a result of vigorous investment. And growth of industrial output was dropping off from its brisk pace of 1997, importantly reflecting the deceleration in world demand for manufactured goods that resulted from the Asian economic difficulties. But labor markets, in contrast, became increasingly taut during the first half. Total payroll jobs rose about one-and-one-half million over the first six months of the year. The civilian unemployment rate dropped to a bit below $41 / 2$ percent in the second quarter, its lowest level in three decades. Firms resorted to a variety of tactics to attract and retain workers, such as paying various types of monetary bonuses and raising basic wage rates. But, at least through the first quarter, the effects of a rising wage bill on production costs were moderated by strong gains in productivity. Indeed, inflation stayed remarkably damped during the first quarter. The consumer price index as well as broader measures of prices indicate that inflation moved down further, even as the economy strengthened. Although declining oil prices contributed to this development, pricing leverage in the goods-producing sector more generally was held in check by reduced demand from Asia that, among other things, has led to a softening of commodity prices, a strong dollar that has contributed to bargain prices on many imports, and rising industrial capacity. Service price inflation, less influenced by ---[PAGE_BREAK]--- international events, has remained steady at about a 3 percent rate since before the beginning of the crisis. Some elements in the goods price mix clearly were transitory. Indeed, the more recent price data suggest that overall consumer price inflation moved up in the second quarter. But, even so, the increase remained moderate. In any event, it would be a mistake for monetary policy makers to focus on any single index in gauging inflation pressures in the economy. Although much public attention is directed to the CPI, the Federal Reserve monitors a wide variety of aggregate price measures. Each is designed for a particular purpose and has its own strengths and weaknesses. Price pressures appear especially absent in some of the measures in the national income accounts, which are available through the first quarter. The chain-weight price index for personal consumption expenditures excluding food and energy, for example, rose 1.5 percent over the year ending in the first quarter, considerably less than the 2.3 percent rise in the core CPI over the same period. An even broader price measure, that for overall GDP, rose 1.4 percent. These indexes, while certainly subject to many of the measurement difficulties the Bureau of Labor Statistics has been grappling with in the CPI, have the advantages that their chain-weighting avoids some aspects of so-called substitution bias and that already published data can be revised to incorporate new information and measurement techniques. Taken together, while the various price indexes show some differences, the basic message is that inflation to date has remained low. # Economic Fundamentals: The Virtuous Cycle So far this year, our economy has continued to enjoy a virtuous cycle. Evidence of accelerated productivity has been bolstering expectations of future corporate earnings, thereby fueling still further increases in equity values, and the improvements in productivity have been helping to reduce inflation. In the context of subdued price increases and generally supportive credit conditions, rising equity values have provided impetus to spending and, in turn, the expansion of output, employment, and productivity-enhancing capital investment. The essential precondition for the emergence, and persistence, of this virtuous cycle is arguably the decline in the rate of inflation to near price stability. In recent years, continued low product price inflation and expectations that it will persist have promoted stability in financial markets and fostered perceptions that the degree of risk in the financial outlook has been moving ever lower. These perceptions, in turn, have reduced the extra compensation that investors require for making loans to, or taking ownership positions in, private firms. With risks in the domestic economy judged to be low, credit and equity capital have been readily available for many businesses, fostering strong investment. And low mortgage interest rates have allowed many households to purchase homes and to refinance outstanding debt. The reduction in debt servicing costs has contributed to an apparent stabilization of the financial strains on the household sector that seemed to emerge a couple of years ago and has buoyed consumer demand. To a considerable extent, investors seem to be expecting that low inflation and stronger productivity growth will allow the extraordinary growth of profits to be extended into the distant future. Indeed, expectations of earnings growth over the longer term have been undergoing continual upward revision by security analysts since early 1995. These rising expectations have, in turn, driven stock prices sharply higher and credit spreads lower, perhaps in both cases to levels that will be difficult to sustain unless the virtuous cycle continues. In any event, primarily because of the rise in stock prices, about $\$ 12^{1 / 2}$ trillion has been added to the value of household assets since the end of 1994. Probably only a few percent of these largely unrealized capital gains have been transformed into the purchase of goods and services in consumer markets. But that increment to spending, combined with the sharp increase in equipment investment, which has stemmed from the low cost of both equity and debt relative to expected profits on capital, has been instrumental in propelling the economy forward. ---[PAGE_BREAK]--- The consequences for the American worker have been dramatic and, for the most part, highly favorable. A great many chronically underemployed people have been given the opportunity to work, and many others have been able to upgrade their skills as a result of work experience, extensive increases in on-the-job training, or increased enrollment in technical programs in community colleges and elsewhere. In addition, former welfare recipients appear to have been absorbed into the work force in significant numbers. Government finances have been enhanced as well. Widespread improvement has been evident in the financial positions of state and local governments. In the federal sector, the taxes paid on huge realized capital gains and other incomes related to stock market advances, coupled with taxes on markedly higher corporate profits, have joined with restraint on spending to produce a unified budget surplus for the first time in nearly three decades. The important steps taken by the Congress and the Administration to put federal finances on a sounder footing have added to national saving, relieving pressures on credit markets. The paydown of debt associated with the federal surplus has helped to hold down longer-term interest rates, which in turn has encouraged capital formation and reduced debt burdens. Maintaining this disciplined budget stance would be most helpful in supporting a continuation of our current robust economic performance in the years ahead. The fact that economic performance has strengthened as inflation subsided should not have been surprising, given that risk premiums and economic disincentives to invest in productive capital diminish as the economy approaches price stability. But the extent to which strong growth and high labor force utilization have been joined with low inflation over an extended period is, nevertheless, exceptional. So far, at least, the adverse wage-price interactions that played so central a role in pressuring inflation higher in many past business expansions - eventually bringing those expansions to an end - have not played a significant role in the current expansion. For one thing, increases in hourly compensation have been slower to pick up than in most other recent expansions, although, to be sure, wages have started to accelerate in the past couple of years as the labor market has become progressively tighter. In the first few years of the expansion, the subdued rate of rise in hourly compensation seemed to be, in part, a reflection of greater concerns among workers about job security. We now seem to have moved beyond that phase of especially acute concern, though the flux of technology may still be leaving many workers with fears of job skill obsolescence and a willingness to trade wage gains for job security. In the past couple of years, of course, workers have not had to press especially hard for nominal pay gains to realize sizable increases in their real wages. In contrast to the pattern that developed in several previous business expansions, when workers required substantial increases in pay just to cover increases in the cost of living, consumer prices have been generally well-behaved in the current expansion. A couple of years ago - almost at the same time that increases in total hourly compensation began trending up in nominal terms - evidence of a long-awaited pickup in the growth of labor productivity began to show through more strongly in the data; and this accelerated increase in output per hour has enabled firms to raise workers' real wages while holding the line on price increases. Gains in productivity usually vary with the strength of the economy, and the favorable results that we have observed during the past two years or so, when the economy has been growing more rapidly, almost certainly overstate the degree of structural improvement. But evidence continues to mount that the trend of productivity has accelerated, even if the extent of that pickup is as yet unclear. Signs of major technological improvements are all around us, and the benefits are evident not only in high-tech industries but also in production processes that have long been part of our industrial economy. Those technological innovations and the rapidly declining cost of capital equipment that embodies them in turn seem to be a major factor behind the recent enlarged gains in productivity. Evidently, plant managers who were involved in planning capital investments anticipated that a significant increase in the real rates of return on facilities could be achieved by exploiting emerging new technologies. If that had been a mistake on their part, one would have expected capital investment to run up briefly and then start down again when the lower-than-anticipated rates of return developed. But we ---[PAGE_BREAK]--- have instead seen sustained gains in investment, indicating that hoped-for rates of return apparently have been realized. Notwithstanding a reasonably optimistic interpretation of the recent productivity numbers, it would not be prudent to assume that even strongly rising productivity, by itself, can ensure a non-inflationary future. Certainly wage increases, per se, are not inflationary, unless they exceed productivity growth, thereby creating pressure for inflationary price increases that can eventually undermine economic growth and employment. Because the level of productivity is tied to an important degree to the stock of capital, which turns over only gradually, increases in the trend growth of productivity probably also occur rather gradually. By contrast, the potential for abrupt acceleration of nominal hourly compensation is surely greater. As I have noted in previous appearances before Congress, economic growth at rates experienced on average over the past several years would eventually run into constraints as the reservoir of unemployed people available to work is drawn down. The annual increase in the working-age population (from 16 to 64 years of age), including immigrants, has been approximately 1 percent a year in recent years. Yet employment, measured by the count of persons who are working rather than by the count of jobs, has been rising 2 percent a year since 1995, despite the acceleration in the growth of output per hour. The gap between employment growth and population growth, amounting to about 1.1 million persons a year on average since the end of 1995, has been made up, in part, by a decline in the number of individuals who are counted as unemployed - those persons who are actively seeking work - of approximately 650,000 a year, on average, over the past two and one-half years. The remainder of the gap has reflected a rise in labor force participation that can be traced largely to a decline of almost 300,000 a year in the number of individuals (aged 16 to 64) wanting a job but not actively seeking one. Presumably, many of the persons who once were in this group have more recently become active and successful job-seekers as the economy has strengthened, thereby preventing a still sharper drop in the official unemployment rate. In June, the number of persons aged 16 to 64 who wanted to work but who did not have jobs was 10.6 million on a seasonally adjusted basis, roughly 6 percent of the working-age population. Despite an uptick in joblessness in June, this percentage is only fractionally above the record low reached in May for these data, which can be calculated back to 1970. Nonetheless, a strong signal of inflation pressures building because of compensation increases markedly in excess of productivity gains has not yet clearly emerged in this expansion. Among nonfinancial corporations (our most recent source of data on consolidated income statements), trends in costs seem to have accelerated from their lows, but the rates of increase in both unit labor costs and total unit costs are still quite low. Still, the gap between the growth in employment and that of the working-age population will inevitably close. What is crucial to sustaining this unprecedented period of prosperity is that it close reasonably promptly, given already stretched labor resources, and that labor markets find a balance consistent with sustained growth marked by compensation gains in line with productivity advances. Whether these adjustments will occur without monetary policy action remains an open question. # Foreign Developments While the United States has been benefiting from a virtuous economic cycle, a number of other economies unfortunately have been spiraling in quite the opposite direction. The United States, Canada, and Western Europe have been enjoying solid economic growth, with relatively low inflation and declining unemployment, but the economic performance in many developing and transition nations and Japan has been deteriorating. How quickly the latter erosion is arrested and reversed will be a key factor in shaping US economic and financial trends in the period ahead. With all that is at stake, it would be difficult to overstate how crucial it is that the authorities in the relevant economies promptly implement effective policies to correct the structural problems underlying recent weaknesses and to promote sustainable economic growth before patterns of reinforcing contraction become difficult to contain. ---[PAGE_BREAK]--- Conditions in Asia are of particular concern. Aggregate output of the Asian developing economies has plunged, with particularly steep declines in Korea, Malaysia, Thailand, and Indonesia. Even the economies of the stalwart tigers - Hong Kong, Singapore, and Taiwan - have softened. Economic growth in China has also slowed, owing largely to the currency depreciations among its neighbors and the sharp declines in their demand for imports. Russia has also experienced some spillover from the Asian difficulties, but Russia's problems are mostly homegrown. Large fiscal deficits stem from high effective marginal tax rates that encourage avoidance and do not raise adequate revenue. This and the recent declines in prices of oil and other commodities have rendered Russian financial markets and the ruble vulnerable, particularly in an environment of heightened concern about all emerging markets. The Russian government has recently promulgated a set of new policy measures in connection with an expanded IMF support package in an effort to address these problems. In Latin America, conditions vary: Economies that are heavily dependent on exports of oil and other commodities have suffered as prices of those items have fallen, and several countries in that region have received more intensive scrutiny in international capital markets, but, on the whole, Latin American economies continue to perform reasonably well. Disappointingly, economic activity in Japan - a crucial engine of Asian economic growth - has turned down after a long period of subpar growth. Gross domestic product fell at a 514 percent annual rate in the first quarter. More recently, confidence of households and businesses has continued to erode, the sharp contraction elsewhere in Asia has fed back onto Japan, and the dwindling domestic demand for goods and services in that country has been further constrained by a mounting credit crunch. Nonperforming loans have risen sharply as real estate values fell following the bursting of the asset bubble in 1991. Problems in the banking sector, exacerbated by the broader Asian financial crisis, have led to market concerns about the adequacy of the capital of many Japanese banks and have engendered a premium in the market for Japanese banks' borrowing. This resulting squeeze to profit margins has led to a reluctance to lend in dollars or yen. In response to the weakening economy and deteriorating banking situation, the Japanese yen has tended to weaken significantly, in often-volatile markets, against the dollar and major European currencies. As you know, we have sought to be helpful in the Japanese government's efforts to stabilize their economy and financial system, reflecting our awareness of the important role that Japanese financial and economic performance plays in the world economy, including that of the United States. We have consulted with the relevant Japanese authorities on methods for resolving difficulties in their banking system and have urged them to take effective measures to stimulate their economy. I believe that the Japanese authorities recognize the urgency of the situation. That a number of foreign economies are currently experiencing difficulties is not surprising. Although many had previously realized a substantial measure of success in developing their economies, a number had leaned heavily on command-type systems rather than relying primarily on market mechanisms. This characteristic has been evident not only in their industrial sectors but in banking where government intervention is typically heavy, where long-standing personal and corporate relationships are the predominant factor in financing arrangements, and where market-based credit assessments are the exception rather than the rule. Recent events confirm that these sorts of structures are ill-suited to today's dynamic global economy, in which national economies must be capable of adapting flexibly and rapidly to changing conditions. Responses in countries currently experiencing difficulties have varied considerably. Some have reacted quickly and, in general terms, appropriately. But in others, a variety of political considerations appear to have militated against prompt and effective action. ---[PAGE_BREAK]--- As a consequence, the risks of further adverse developments in these economies remain substantial. And given the pervasive interconnections of virtually all economies and financial systems in the world today, the associated uncertainties for the United States and other developed economies remain substantial as well. In the current circumstances, we need to be aware that monetary policy tightening actions in the United States could have outsized effects on very sensitive financial markets in Asia, a development that could have substantial adverse repercussions on US financial markets and, over time, on our own economy. But while we must take account of such foreign interactions, we must be careful that our responses ultimately are consistent with a monetary policy aimed at optimal performance of the US economy. Our objectives relate to domestic economic performance, and price stability and maximum sustainable economic growth here at home would best serve the long-run interests of troubled financial markets and economies abroad. # The Economic Outlook The Federal Open Market Committee believes that the conditions for continued growth with low inflation are in place here in the United States. As I noted previously, an important issue for policy is how the imbalance of recent years between the demand for labor and the growth of the working-age population is resolved. In that regard, we see a slowing of the growth in aggregate demand as a necessary element in the mix. At this time, some of the key factors that have supported strong final demand by domestic purchasers remain favorable. Although real short-term interest rates have risen as the federal funds rate has been held unchanged while inflation expectations have declined, the financial conditions that have fostered the strength in demand are still in place. With their incomes and wealth having been on a strong upward track, American consumers remain quite upbeat. For businesses, decreasing costs of and high rates of return on investment, as well as the scarcity of labor, could keep capital spending elevated. These factors suggest some risk that the labor market could get even tighter. And even if it does not, under prevailing tight labor markets increasingly confident workers might place gradually escalating pressures on wages and costs, which would eventually feed through to prices. But a number of factors likely will serve to damp growth in aggregate demand, helping to foster a reasonably smooth transition to a more sustainable rate of growth and reasonable balance in labor markets. We have yet to see the full effects of the crisis in East Asia on US employment and income. Residential and business fixed investment already have reached such high levels that further gains approaching those experienced recently would imply very rapid growth of the stocks of housing and plant and equipment relative to income trends. Moreover, business investment will be damped if recent indications of a narrowing in domestic operating profit margins prompt a reassessment of the expected rates of return on investment in plant and equipment. Reduced prospects for the return to capital would not only affect investment directly but could also affect consumption if stock prices adjust to a less optimistic view of earnings prospects. Of course, the demand for labor that is consistent with a particular rate of output growth also could be lowered if productivity growth were to increase more. And, on the supply side of the labor market, faster growth of the labor force could emerge as the result of increased immigration or delayed retirements. Nonetheless, it appears most probable that the necessary slower absorption of labor into employment will reflect, in part, a deceleration of output growth, as a consequence of evolving market forces. Failing that, firming actions on the part of the Federal Reserve may be necessary to ensure a track of expansion that is capable of being sustained. Thus, members of the Board of Governors and presidents of the Federal Reserve Banks anticipate a slowing in the rate of economic growth. The central tendency of their forecasts is that real GDP will rise 3 to 31/4 percent over 1998 as a whole and 2 to $21 / 2$ percent in 1999. With the rise in the demand for workers coming into line with that of the labor force, the unemployment rate is expected to change little from its current level, finishing next year in the neighborhood of $41 / 2$ to $43 / 4$ percent. ---[PAGE_BREAK]--- Inflation performance will be affected by developments abroad as well as those here at home. The extent and pace of recovery of Asian economies currently experiencing a severe downturn will have important implications for prices of energy and other commodities, the strength of the dollar, and competitive conditions on world product markets. Should the situation abroad remain unsettled, these factors would probably continue to contribute to good price performance in the United States in the period ahead. But it is important to recognize that the damping influence of these factors on inflation is mostly temporary. At some point, the dollar will stop rising, foreign demand will begin to recover, and oil and other commodity prices will stop falling and could even back up some. Indeed, a brisk snap-back in foreign economic activity, should that occur, would add, at least temporarily, to price pressures in the United States. On a more fundamental level, it is the balance of supply and demand in labor and product markets in the United States that will have the greatest effect on inflation rates here. As I noted previously, wage and benefit costs have been remarkably subdued in the current expansion. Nonetheless, an accelerating trend in wages has been apparent for some time. In addition, a gradual upward tilt in benefit costs has become evident of late. A variety of factors - including the strength of the economy and rising equity values, which have reduced the need for payments into unemployment trust funds and pension plans, and the restructuring of the health care sector - have been working to keep benefit costs in check in this expansion. But, in the medical area at least, the most recent developments suggest that the favorable trend may have run its course. The slowing of price increases for medical services seems to have come to a halt, at least for a time, and, with the cost-saving shift to managed care having been largely completed, the potential for businesses to achieve further savings in that regard appears to be rather limited at this point. There have been a few striking instances this past year of employers boosting outlays for health benefits by substantial amounts. Given that compensation costs are likely to accelerate at least a little further, productivity trends and profit margins will be key to determining price performance in the period ahead. Whether the recent strong performance of productivity can be extended remains to be seen. It does seem likely that productivity calculated for the entire economy using GDP data weakened in the second quarter. This development clearly owed, at least in some degree, to the deceleration of output in that period. In manufacturing, where our data are better measured, productivity appears still to have registered a solid increase. We will be closely monitoring a variety of indicators to assess how productivity is performing in the months ahead. Monetary policymakers see the most likely outcome as modestly higher inflation rates in the next one and one-half years. The central tendency of monetary policymakers' CPI inflation forecasts is for an increase of $13 / 4$ to 2 percent during 1998 and 2 to $21 / 2$ percent next year. As noted, the ebbing of the special factors reducing inflation over the past year or so, such as the decline in oil prices, will account for some of this uptick. But the Federal Open Market Committee will need to remain particularly alert to the possibility that more fundamental imbalances are increasing inflationary pressures. The Committee would need to resist vigorously any tendency for an upward trend, which could become embedded in the inflationary process. The Committee recognizes that significant risks attend the outlook: One is that the impending constraint from domestic labor markets could bind more abruptly than it has to date, intensifying inflation pressures. The other is the potential for further adverse developments abroad, which could reduce the demand for US goods and services more sharply than anticipated and which would thereby ease pressures on labor markets. While we expect that the situation will develop relatively smoothly, the Committee believes that, given the current tightness in labor markets, the potential for accelerating inflation is probably greater than the risk of protracted, excessive weakness in the economy. In any case, it will need to continue to monitor evolving circumstances closely, and adjust the stance of monetary policy as appropriate, in order to help establish conditions consistent with progress towards the Federal Reserve's goals of price stability and maximum sustainable economic growth. ---[PAGE_BREAK]--- # Ranges for Money and Credit Growth Indeed, recognition of the benefits of low inflation and our commitment to the Federal Reserve's statutory objective of price stability were once again dominant in the Committee's semiannual review of the ranges for the monetary and debt aggregates. The FOMC noted that the behavior of the monetary aggregates had been somewhat more predictable over the past few years than it had been earlier in the 1990s. The rapid growth of M2 and M3 over the first half of the year, which lifted those measures above the upper ends of the target ranges established in February, was consistent with the unexpectedly strong advance in aggregate demand. However, movements in velocity remain difficult to predict. The FOMC will continue to interpret the monetary ranges as benchmarks for the achievement of price stability under conditions of historically normal velocity behavior. Consistent with that interpretation, the Committee decided to retain the current ranges for the monetary aggregates for 1998, as well as the range for debt, and to carry them over on a provisional basis to next year. Although near-term prospects for velocity behavior are uncertain, the Committee recognizes that monetary growth does appear to provide some information about trends in the economy and inflation. Therefore, we will be carefully evaluating the aggregates, relative both to forecasts and to their ranges, in the context of other readings on other variables in our efforts to promote optimum macroeconomic conditions. ## Concluding Comments As I have stated in previous testimony, the recent economic performance, with its combination of strong growth and low inflation, is as impressive as any I have witnessed in my near half-century of daily observation of the American economy. Although the reasons for this development are complex, our success can be attributed in part to sound economic policy. The Congress and the Administration have successfully balanced the budget and, indeed, achieved a near-term surplus, a development that tends to boost national saving and investment. The Federal Reserve has pursued monetary conditions consistent with maximum sustainable long-run growth by seeking price stability. These policies have helped bring about a healthy macroeconomic environment for productivity-boosting investment and innovation, factors that have lifted living standards for most Americans. The task before us is to maintain disciplined economic policies and thereby contribute to maintaining and extending these gains in the years ahead.	Alan Greenspan	United States	https://www.bis.org/review/r980724b.pdf	policy Testimony by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on Banking, Housing, and Urban Affairs of the US Senate on $21 / 7 / 98$. Mr. Chairman and members of the Committee, I appreciate this opportunity to present the Federal Reserve's mid-year report on monetary policy. Overall, the performance of the US economy continues to be impressive. Over the first part of the year, we experienced further gains in output and employment, subdued prices, and moderate long-term interest rates. Important crosscurrents, however, have been impacting the economy. With labor markets very tight and domestic final demand retaining considerable momentum, the risks of a pickup in inflation remain significant. But inventory investment, which was quite rapid late last year and early this year, appears to have slowed, perhaps appreciably. Moreover, the economic and financial troubles in Asian economies are now demonstrably restraining demands for US goods and services - and those troubles could intensify and spread further. Weighing these forces, the Federal Open Market Committee chose to keep the stance of policy unchanged over the first half of 1998. However, should pressures on labor resources begin to show through more impressively in cost increases, policy action may need to counter any associated tendency for prices to accelerate before it undermines this extraordinary expansion. When I appeared before your committee in February, I noted that a key question for monetary policy was whether the consequences of the turmoil in Asia would be sufficient to check inflationary tendencies that might otherwise result from the strength of domestic spending and tightening labor markets. After the economy's surge in 1996 and, especially, last year, resource utilization, particularly that of the labor force, had risen to a very high level. Although some signs pointed to stepped-up increases in productivity, the speed at which the demand for goods and services had been growing clearly exceeded the rate of expansion of the economy's long-run potential to produce. Maintenance of such a pace would put even greater pressures on the economy's resources, threatening the balance and longevity of the expansion. However, it appeared likely that the difficulties being encountered by Asian economies, by cutting into US exports, would be a potentially important factor slowing the growth of aggregate demand in the United States. But uncertainties about the timing and dimensions of that development were considerable given the difficulties in assessing the extent of the problems in East Asia. In the event, the contraction of output and incomes in a number of Asian economies has turned out to be more substantial than most had anticipated. Moreover, financial markets in Asia and in emerging market economies generally have remained unsettled, portending further difficult adjustments. The contraction in Asian economies, along with the rise in the foreign exchange value of the dollar over 1997, prompted a sharp deterioration in the US balance of trade in the first quarter. Nonetheless, the American economy proved to be unexpectedly robust in that period. The growth of real GDP not only failed to slow, it climbed further, to about a $51 / 2$ percent annual rate in the first quarter, according to the current national income accounts. Domestic private demand for goods and services - including personal consumption expenditures, business investment, and residential expenditures - was exceptionally strong. Evidently, optimism about jobs, incomes, and profits, high and rising wealth-to-income ratios, low financing costs, and falling prices for high-tech goods fed the appetites of households and businesses for consumer durables and capital equipment. In addition, inventory investment contributed significantly to growth in the first quarter; indeed, the growth of stocks of materials and goods outpaced that of overall output by a wide margin during the first quarter, adding 1 percentage points to the annualized growth rate of GDP. Although accumulation of some products likely was unintended, surveys indicate that much of the stockbuilding probably reflected firms' confidence in the prospects for continued growth. As evidence piled up that the economy continued to run hot during the winter, the Federal Reserve's concerns about inflationary pressures mounted. Domestic demand clearly had more underlying momentum than we had anticipated, supported in part by financial conditions that were quite accommodative. Credit remained extremely easy for most borrowers to obtain; intermediate- and long-term interest rates were at relatively low levels; equity prices soared higher, despite some disappointing earnings reports; and growth in the monetary aggregates was rapid. Indeed, the crises in Asia, by lowering longer-term US interest rates - through stronger preferences for dollar investments and expectations of slower growth ahead - and by reducing commodity prices, probably added to the positive forces boosting domestic spending in the first half, especially in the interest-sensitive housing sector. The robust expansion of demand tightened labor markets further, giving additional impetus to the upward trend in labor costs. Inflation was low - though, given the lags with which monetary policy affects the economy and prices, we had to be mainly concerned not with conditions at the moment but with those likely to prevail many months ahead. In these circumstances, the Federal Open Market Committee elected in March to move to a state of heightened alert against inflation, but left the stance of policy unchanged. Although national income and product data for the second quarter have not yet been published, growth of US output appears to have slowed sharply. The auto strike has brought General Motor's production essentially to a halt, probably reducing real GDP in the second quarter by about $1 / 2$ percentage point at an annual rate. The limited available information on inventory investment suggests that stockbuilding dropped markedly from its unsustainable pace of the first quarter. In addition to the slower pace of inventory building, Asian economies have continued to deteriorate, further retarding our exports in recent months. Indeed, readings on the elements that make up the real GDP have led many analysts to anticipate a decline in that measure in the second quarter, after the first-quarter surge. Given the upcoming revisions to the national income accounts, such assessments would have to be regarded as conjectural. It is worth noting in any case that other indicators of output, including worker hours and manufacturing production, show a somewhat steadier, though slowing, path over the first half of the year. And underlying trends in domestic final demand have remained strong, imparting impetus to the continuing economic expansion. During the first half of the year, measures of resource utilization diverged. Pressures on manufacturing facilities appeared to be easing. Plant capacity was growing rapidly as a result of vigorous investment. And growth of industrial output was dropping off from its brisk pace of 1997, importantly reflecting the deceleration in world demand for manufactured goods that resulted from the Asian economic difficulties. But labor markets, in contrast, became increasingly taut during the first half. Total payroll jobs rose about one-and-one-half million over the first six months of the year. The civilian unemployment rate dropped to a bit below $41 / 2$ percent in the second quarter, its lowest level in three decades. Firms resorted to a variety of tactics to attract and retain workers, such as paying various types of monetary bonuses and raising basic wage rates. But, at least through the first quarter, the effects of a rising wage bill on production costs were moderated by strong gains in productivity. Indeed, inflation stayed remarkably damped during the first quarter. The consumer price index as well as broader measures of prices indicate that inflation moved down further, even as the economy strengthened. Although declining oil prices contributed to this development, pricing leverage in the goods-producing sector more generally was held in check by reduced demand from Asia that, among other things, has led to a softening of commodity prices, a strong dollar that has contributed to bargain prices on many imports, and rising industrial capacity. Service price inflation, less influenced by international events, has remained steady at about a 3 percent rate since before the beginning of the crisis. Some elements in the goods price mix clearly were transitory. Indeed, the more recent price data suggest that overall consumer price inflation moved up in the second quarter. But, even so, the increase remained moderate. In any event, it would be a mistake for monetary policy makers to focus on any single index in gauging inflation pressures in the economy. Although much public attention is directed to the CPI, the Federal Reserve monitors a wide variety of aggregate price measures. Each is designed for a particular purpose and has its own strengths and weaknesses. Price pressures appear especially absent in some of the measures in the national income accounts, which are available through the first quarter. The chain-weight price index for personal consumption expenditures excluding food and energy, for example, rose 1.5 percent over the year ending in the first quarter, considerably less than the 2.3 percent rise in the core CPI over the same period. An even broader price measure, that for overall GDP, rose 1.4 percent. These indexes, while certainly subject to many of the measurement difficulties the Bureau of Labor Statistics has been grappling with in the CPI, have the advantages that their chain-weighting avoids some aspects of so-called substitution bias and that already published data can be revised to incorporate new information and measurement techniques. Taken together, while the various price indexes show some differences, the basic message is that inflation to date has remained low. So far this year, our economy has continued to enjoy a virtuous cycle. Evidence of accelerated productivity has been bolstering expectations of future corporate earnings, thereby fueling still further increases in equity values, and the improvements in productivity have been helping to reduce inflation. In the context of subdued price increases and generally supportive credit conditions, rising equity values have provided impetus to spending and, in turn, the expansion of output, employment, and productivity-enhancing capital investment. The essential precondition for the emergence, and persistence, of this virtuous cycle is arguably the decline in the rate of inflation to near price stability. In recent years, continued low product price inflation and expectations that it will persist have promoted stability in financial markets and fostered perceptions that the degree of risk in the financial outlook has been moving ever lower. These perceptions, in turn, have reduced the extra compensation that investors require for making loans to, or taking ownership positions in, private firms. With risks in the domestic economy judged to be low, credit and equity capital have been readily available for many businesses, fostering strong investment. And low mortgage interest rates have allowed many households to purchase homes and to refinance outstanding debt. The reduction in debt servicing costs has contributed to an apparent stabilization of the financial strains on the household sector that seemed to emerge a couple of years ago and has buoyed consumer demand. To a considerable extent, investors seem to be expecting that low inflation and stronger productivity growth will allow the extraordinary growth of profits to be extended into the distant future. Indeed, expectations of earnings growth over the longer term have been undergoing continual upward revision by security analysts since early 1995. These rising expectations have, in turn, driven stock prices sharply higher and credit spreads lower, perhaps in both cases to levels that will be difficult to sustain unless the virtuous cycle continues. In any event, primarily because of the rise in stock prices, about $\$ 12^{1 / 2}$ trillion has been added to the value of household assets since the end of 1994. Probably only a few percent of these largely unrealized capital gains have been transformed into the purchase of goods and services in consumer markets. But that increment to spending, combined with the sharp increase in equipment investment, which has stemmed from the low cost of both equity and debt relative to expected profits on capital, has been instrumental in propelling the economy forward. The consequences for the American worker have been dramatic and, for the most part, highly favorable. A great many chronically underemployed people have been given the opportunity to work, and many others have been able to upgrade their skills as a result of work experience, extensive increases in on-the-job training, or increased enrollment in technical programs in community colleges and elsewhere. In addition, former welfare recipients appear to have been absorbed into the work force in significant numbers. Government finances have been enhanced as well. Widespread improvement has been evident in the financial positions of state and local governments. In the federal sector, the taxes paid on huge realized capital gains and other incomes related to stock market advances, coupled with taxes on markedly higher corporate profits, have joined with restraint on spending to produce a unified budget surplus for the first time in nearly three decades. The important steps taken by the Congress and the Administration to put federal finances on a sounder footing have added to national saving, relieving pressures on credit markets. The paydown of debt associated with the federal surplus has helped to hold down longer-term interest rates, which in turn has encouraged capital formation and reduced debt burdens. Maintaining this disciplined budget stance would be most helpful in supporting a continuation of our current robust economic performance in the years ahead. The fact that economic performance has strengthened as inflation subsided should not have been surprising, given that risk premiums and economic disincentives to invest in productive capital diminish as the economy approaches price stability. But the extent to which strong growth and high labor force utilization have been joined with low inflation over an extended period is, nevertheless, exceptional. So far, at least, the adverse wage-price interactions that played so central a role in pressuring inflation higher in many past business expansions - eventually bringing those expansions to an end - have not played a significant role in the current expansion. For one thing, increases in hourly compensation have been slower to pick up than in most other recent expansions, although, to be sure, wages have started to accelerate in the past couple of years as the labor market has become progressively tighter. In the first few years of the expansion, the subdued rate of rise in hourly compensation seemed to be, in part, a reflection of greater concerns among workers about job security. We now seem to have moved beyond that phase of especially acute concern, though the flux of technology may still be leaving many workers with fears of job skill obsolescence and a willingness to trade wage gains for job security. In the past couple of years, of course, workers have not had to press especially hard for nominal pay gains to realize sizable increases in their real wages. In contrast to the pattern that developed in several previous business expansions, when workers required substantial increases in pay just to cover increases in the cost of living, consumer prices have been generally well-behaved in the current expansion. A couple of years ago - almost at the same time that increases in total hourly compensation began trending up in nominal terms - evidence of a long-awaited pickup in the growth of labor productivity began to show through more strongly in the data; and this accelerated increase in output per hour has enabled firms to raise workers' real wages while holding the line on price increases. Gains in productivity usually vary with the strength of the economy, and the favorable results that we have observed during the past two years or so, when the economy has been growing more rapidly, almost certainly overstate the degree of structural improvement. But evidence continues to mount that the trend of productivity has accelerated, even if the extent of that pickup is as yet unclear. Signs of major technological improvements are all around us, and the benefits are evident not only in high-tech industries but also in production processes that have long been part of our industrial economy. Those technological innovations and the rapidly declining cost of capital equipment that embodies them in turn seem to be a major factor behind the recent enlarged gains in productivity. Evidently, plant managers who were involved in planning capital investments anticipated that a significant increase in the real rates of return on facilities could be achieved by exploiting emerging new technologies. If that had been a mistake on their part, one would have expected capital investment to run up briefly and then start down again when the lower-than-anticipated rates of return developed. But we have instead seen sustained gains in investment, indicating that hoped-for rates of return apparently have been realized. Notwithstanding a reasonably optimistic interpretation of the recent productivity numbers, it would not be prudent to assume that even strongly rising productivity, by itself, can ensure a non-inflationary future. Certainly wage increases, per se, are not inflationary, unless they exceed productivity growth, thereby creating pressure for inflationary price increases that can eventually undermine economic growth and employment. Because the level of productivity is tied to an important degree to the stock of capital, which turns over only gradually, increases in the trend growth of productivity probably also occur rather gradually. By contrast, the potential for abrupt acceleration of nominal hourly compensation is surely greater. As I have noted in previous appearances before Congress, economic growth at rates experienced on average over the past several years would eventually run into constraints as the reservoir of unemployed people available to work is drawn down. The annual increase in the working-age population (from 16 to 64 years of age), including immigrants, has been approximately 1 percent a year in recent years. Yet employment, measured by the count of persons who are working rather than by the count of jobs, has been rising 2 percent a year since 1995, despite the acceleration in the growth of output per hour. The gap between employment growth and population growth, amounting to about 1.1 million persons a year on average since the end of 1995, has been made up, in part, by a decline in the number of individuals who are counted as unemployed - those persons who are actively seeking work - of approximately 650,000 a year, on average, over the past two and one-half years. The remainder of the gap has reflected a rise in labor force participation that can be traced largely to a decline of almost 300,000 a year in the number of individuals (aged 16 to 64) wanting a job but not actively seeking one. Presumably, many of the persons who once were in this group have more recently become active and successful job-seekers as the economy has strengthened, thereby preventing a still sharper drop in the official unemployment rate. In June, the number of persons aged 16 to 64 who wanted to work but who did not have jobs was 10.6 million on a seasonally adjusted basis, roughly 6 percent of the working-age population. Despite an uptick in joblessness in June, this percentage is only fractionally above the record low reached in May for these data, which can be calculated back to 1970. Nonetheless, a strong signal of inflation pressures building because of compensation increases markedly in excess of productivity gains has not yet clearly emerged in this expansion. Among nonfinancial corporations (our most recent source of data on consolidated income statements), trends in costs seem to have accelerated from their lows, but the rates of increase in both unit labor costs and total unit costs are still quite low. Still, the gap between the growth in employment and that of the working-age population will inevitably close. What is crucial to sustaining this unprecedented period of prosperity is that it close reasonably promptly, given already stretched labor resources, and that labor markets find a balance consistent with sustained growth marked by compensation gains in line with productivity advances. Whether these adjustments will occur without monetary policy action remains an open question. While the United States has been benefiting from a virtuous economic cycle, a number of other economies unfortunately have been spiraling in quite the opposite direction. The United States, Canada, and Western Europe have been enjoying solid economic growth, with relatively low inflation and declining unemployment, but the economic performance in many developing and transition nations and Japan has been deteriorating. How quickly the latter erosion is arrested and reversed will be a key factor in shaping US economic and financial trends in the period ahead. With all that is at stake, it would be difficult to overstate how crucial it is that the authorities in the relevant economies promptly implement effective policies to correct the structural problems underlying recent weaknesses and to promote sustainable economic growth before patterns of reinforcing contraction become difficult to contain. Conditions in Asia are of particular concern. Aggregate output of the Asian developing economies has plunged, with particularly steep declines in Korea, Malaysia, Thailand, and Indonesia. Even the economies of the stalwart tigers - Hong Kong, Singapore, and Taiwan - have softened. Economic growth in China has also slowed, owing largely to the currency depreciations among its neighbors and the sharp declines in their demand for imports. Russia has also experienced some spillover from the Asian difficulties, but Russia's problems are mostly homegrown. Large fiscal deficits stem from high effective marginal tax rates that encourage avoidance and do not raise adequate revenue. This and the recent declines in prices of oil and other commodities have rendered Russian financial markets and the ruble vulnerable, particularly in an environment of heightened concern about all emerging markets. The Russian government has recently promulgated a set of new policy measures in connection with an expanded IMF support package in an effort to address these problems. In Latin America, conditions vary: Economies that are heavily dependent on exports of oil and other commodities have suffered as prices of those items have fallen, and several countries in that region have received more intensive scrutiny in international capital markets, but, on the whole, Latin American economies continue to perform reasonably well. Disappointingly, economic activity in Japan - a crucial engine of Asian economic growth - has turned down after a long period of subpar growth. Gross domestic product fell at a 514 percent annual rate in the first quarter. More recently, confidence of households and businesses has continued to erode, the sharp contraction elsewhere in Asia has fed back onto Japan, and the dwindling domestic demand for goods and services in that country has been further constrained by a mounting credit crunch. Nonperforming loans have risen sharply as real estate values fell following the bursting of the asset bubble in 1991. Problems in the banking sector, exacerbated by the broader Asian financial crisis, have led to market concerns about the adequacy of the capital of many Japanese banks and have engendered a premium in the market for Japanese banks' borrowing. This resulting squeeze to profit margins has led to a reluctance to lend in dollars or yen. In response to the weakening economy and deteriorating banking situation, the Japanese yen has tended to weaken significantly, in often-volatile markets, against the dollar and major European currencies. As you know, we have sought to be helpful in the Japanese government's efforts to stabilize their economy and financial system, reflecting our awareness of the important role that Japanese financial and economic performance plays in the world economy, including that of the United States. We have consulted with the relevant Japanese authorities on methods for resolving difficulties in their banking system and have urged them to take effective measures to stimulate their economy. I believe that the Japanese authorities recognize the urgency of the situation. That a number of foreign economies are currently experiencing difficulties is not surprising. Although many had previously realized a substantial measure of success in developing their economies, a number had leaned heavily on command-type systems rather than relying primarily on market mechanisms. This characteristic has been evident not only in their industrial sectors but in banking where government intervention is typically heavy, where long-standing personal and corporate relationships are the predominant factor in financing arrangements, and where market-based credit assessments are the exception rather than the rule. Recent events confirm that these sorts of structures are ill-suited to today's dynamic global economy, in which national economies must be capable of adapting flexibly and rapidly to changing conditions. Responses in countries currently experiencing difficulties have varied considerably. Some have reacted quickly and, in general terms, appropriately. But in others, a variety of political considerations appear to have militated against prompt and effective action. As a consequence, the risks of further adverse developments in these economies remain substantial. And given the pervasive interconnections of virtually all economies and financial systems in the world today, the associated uncertainties for the United States and other developed economies remain substantial as well. In the current circumstances, we need to be aware that monetary policy tightening actions in the United States could have outsized effects on very sensitive financial markets in Asia, a development that could have substantial adverse repercussions on US financial markets and, over time, on our own economy. But while we must take account of such foreign interactions, we must be careful that our responses ultimately are consistent with a monetary policy aimed at optimal performance of the US economy. Our objectives relate to domestic economic performance, and price stability and maximum sustainable economic growth here at home would best serve the long-run interests of troubled financial markets and economies abroad. The Federal Open Market Committee believes that the conditions for continued growth with low inflation are in place here in the United States. As I noted previously, an important issue for policy is how the imbalance of recent years between the demand for labor and the growth of the working-age population is resolved. In that regard, we see a slowing of the growth in aggregate demand as a necessary element in the mix. At this time, some of the key factors that have supported strong final demand by domestic purchasers remain favorable. Although real short-term interest rates have risen as the federal funds rate has been held unchanged while inflation expectations have declined, the financial conditions that have fostered the strength in demand are still in place. With their incomes and wealth having been on a strong upward track, American consumers remain quite upbeat. For businesses, decreasing costs of and high rates of return on investment, as well as the scarcity of labor, could keep capital spending elevated. These factors suggest some risk that the labor market could get even tighter. And even if it does not, under prevailing tight labor markets increasingly confident workers might place gradually escalating pressures on wages and costs, which would eventually feed through to prices. But a number of factors likely will serve to damp growth in aggregate demand, helping to foster a reasonably smooth transition to a more sustainable rate of growth and reasonable balance in labor markets. We have yet to see the full effects of the crisis in East Asia on US employment and income. Residential and business fixed investment already have reached such high levels that further gains approaching those experienced recently would imply very rapid growth of the stocks of housing and plant and equipment relative to income trends. Moreover, business investment will be damped if recent indications of a narrowing in domestic operating profit margins prompt a reassessment of the expected rates of return on investment in plant and equipment. Reduced prospects for the return to capital would not only affect investment directly but could also affect consumption if stock prices adjust to a less optimistic view of earnings prospects. Of course, the demand for labor that is consistent with a particular rate of output growth also could be lowered if productivity growth were to increase more. And, on the supply side of the labor market, faster growth of the labor force could emerge as the result of increased immigration or delayed retirements. Nonetheless, it appears most probable that the necessary slower absorption of labor into employment will reflect, in part, a deceleration of output growth, as a consequence of evolving market forces. Failing that, firming actions on the part of the Federal Reserve may be necessary to ensure a track of expansion that is capable of being sustained. Thus, members of the Board of Governors and presidents of the Federal Reserve Banks anticipate a slowing in the rate of economic growth. The central tendency of their forecasts is that real GDP will rise 3 to 31/4 percent over 1998 as a whole and 2 to $21 / 2$ percent in 1999. With the rise in the demand for workers coming into line with that of the labor force, the unemployment rate is expected to change little from its current level, finishing next year in the neighborhood of $41 / 2$ to $43 / 4$ percent. Inflation performance will be affected by developments abroad as well as those here at home. The extent and pace of recovery of Asian economies currently experiencing a severe downturn will have important implications for prices of energy and other commodities, the strength of the dollar, and competitive conditions on world product markets. Should the situation abroad remain unsettled, these factors would probably continue to contribute to good price performance in the United States in the period ahead. But it is important to recognize that the damping influence of these factors on inflation is mostly temporary. At some point, the dollar will stop rising, foreign demand will begin to recover, and oil and other commodity prices will stop falling and could even back up some. Indeed, a brisk snap-back in foreign economic activity, should that occur, would add, at least temporarily, to price pressures in the United States. On a more fundamental level, it is the balance of supply and demand in labor and product markets in the United States that will have the greatest effect on inflation rates here. As I noted previously, wage and benefit costs have been remarkably subdued in the current expansion. Nonetheless, an accelerating trend in wages has been apparent for some time. In addition, a gradual upward tilt in benefit costs has become evident of late. A variety of factors - including the strength of the economy and rising equity values, which have reduced the need for payments into unemployment trust funds and pension plans, and the restructuring of the health care sector - have been working to keep benefit costs in check in this expansion. But, in the medical area at least, the most recent developments suggest that the favorable trend may have run its course. The slowing of price increases for medical services seems to have come to a halt, at least for a time, and, with the cost-saving shift to managed care having been largely completed, the potential for businesses to achieve further savings in that regard appears to be rather limited at this point. There have been a few striking instances this past year of employers boosting outlays for health benefits by substantial amounts. Given that compensation costs are likely to accelerate at least a little further, productivity trends and profit margins will be key to determining price performance in the period ahead. Whether the recent strong performance of productivity can be extended remains to be seen. It does seem likely that productivity calculated for the entire economy using GDP data weakened in the second quarter. This development clearly owed, at least in some degree, to the deceleration of output in that period. In manufacturing, where our data are better measured, productivity appears still to have registered a solid increase. We will be closely monitoring a variety of indicators to assess how productivity is performing in the months ahead. Monetary policymakers see the most likely outcome as modestly higher inflation rates in the next one and one-half years. The central tendency of monetary policymakers' CPI inflation forecasts is for an increase of $13 / 4$ to 2 percent during 1998 and 2 to $21 / 2$ percent next year. As noted, the ebbing of the special factors reducing inflation over the past year or so, such as the decline in oil prices, will account for some of this uptick. But the Federal Open Market Committee will need to remain particularly alert to the possibility that more fundamental imbalances are increasing inflationary pressures. The Committee would need to resist vigorously any tendency for an upward trend, which could become embedded in the inflationary process. The Committee recognizes that significant risks attend the outlook: One is that the impending constraint from domestic labor markets could bind more abruptly than it has to date, intensifying inflation pressures. The other is the potential for further adverse developments abroad, which could reduce the demand for US goods and services more sharply than anticipated and which would thereby ease pressures on labor markets. While we expect that the situation will develop relatively smoothly, the Committee believes that, given the current tightness in labor markets, the potential for accelerating inflation is probably greater than the risk of protracted, excessive weakness in the economy. In any case, it will need to continue to monitor evolving circumstances closely, and adjust the stance of monetary policy as appropriate, in order to help establish conditions consistent with progress towards the Federal Reserve's goals of price stability and maximum sustainable economic growth. Indeed, recognition of the benefits of low inflation and our commitment to the Federal Reserve's statutory objective of price stability were once again dominant in the Committee's semiannual review of the ranges for the monetary and debt aggregates. The FOMC noted that the behavior of the monetary aggregates had been somewhat more predictable over the past few years than it had been earlier in the 1990s. The rapid growth of M2 and M3 over the first half of the year, which lifted those measures above the upper ends of the target ranges established in February, was consistent with the unexpectedly strong advance in aggregate demand. However, movements in velocity remain difficult to predict. The FOMC will continue to interpret the monetary ranges as benchmarks for the achievement of price stability under conditions of historically normal velocity behavior. Consistent with that interpretation, the Committee decided to retain the current ranges for the monetary aggregates for 1998, as well as the range for debt, and to carry them over on a provisional basis to next year. Although near-term prospects for velocity behavior are uncertain, the Committee recognizes that monetary growth does appear to provide some information about trends in the economy and inflation. Therefore, we will be carefully evaluating the aggregates, relative both to forecasts and to their ranges, in the context of other readings on other variables in our efforts to promote optimum macroeconomic conditions. As I have stated in previous testimony, the recent economic performance, with its combination of strong growth and low inflation, is as impressive as any I have witnessed in my near half-century of daily observation of the American economy. Although the reasons for this development are complex, our success can be attributed in part to sound economic policy. The Congress and the Administration have successfully balanced the budget and, indeed, achieved a near-term surplus, a development that tends to boost national saving and investment. The Federal Reserve has pursued monetary conditions consistent with maximum sustainable long-run growth by seeking price stability. These policies have helped bring about a healthy macroeconomic environment for productivity-boosting investment and innovation, factors that have lifted living standards for most Americans. The task before us is to maintain disciplined economic policies and thereby contribute to maintaining and extending these gains in the years ahead.
1998-07-22T00:00:00	Mr. McDonough discusses the importance of sound financial systems (Central Bank Articles and Speeches, 22 Jul 98)	Remarks by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough, at a presentation in Mexico City, Mexico on 22/7/98.	Remarks Mr. McDonough discusses the importance of sound financial systems by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough, at a presentation in Mexico City, Mexico on 22/7/98. Introduction I am delighted to be here today in my second-favorite country in the world to address you on the very timely subject of the importance of sound financial systems. Having worked closely with my friends in the public and private sectors here over the years, I know the importance of these issues to them. Judging by the attendance here today, this interest appears very broad indeed, a positive sign for the continued revitalization and strengthening of Mexico's banking sector. My remarks today, necessarily, reflect my perspective as president of the Federal Reserve Bank of New York, which supervises the majority of domestic and foreign bank assets in the United States, and as Chairman of the Basle Committee on Banking Supervision, a position I accepted last month. These positions allow me a front-row seat on the wide range of developments taking place in international banking and banking supervision, a perspective which I hope to share with you today. To understand the importance of sound financial systems, one need only look at the impact of financial system breakdowns, of which, unfortunately, there are many recent examples. Indeed, prior to the onset of the Asian crisis, the IMF had estimated that fully three-quarters of its member countries had experienced significant banking sector problems since 1980. Banking problems have afflicted both industrial and emerging market countries, including the US, which weathered the savings and loans and banking problems of the 1980s and early 1990s. Crises around the world have exacted a high price, with direct fiscal costs of associated resolutions typically starting at roughly 5 percent of GDP (in the US case, such costs ran more than $100 billion). To these substantial sums, one must add the less quantifiable, but no less real, consequences for the economy and financial system. A weakened financial sector cannot serve its role as intermediary - as banks seek to repair their balance sheets, restrict new lending, and shore up capital - leading to diminished growth prospects. In a number of Asian countries today, exporters have difficulty obtaining trade financing from domestic banks, delaying the process of economic recovery and raising fears of a credit crunch in which even sound companies are driven into bankruptcy. Banking sector problems reduce depositor confidence in the banking system and can trigger capital flight. Banking system problems, significant in their own right, can cause distortions in monetary policy, render monetary policy tools less effective, and put at risk the integrity of the payments system. In an integrated international financial system, it is increasingly difficult to contain a banking crisis within a country's borders. Finally, we must not forget the human consequences of a financial and broader economic crisis, which disproportionately fall on those least able to weather the storm. Clearly we need to learn what we can from recent history and take steps now to make domestic and international financial systems more resilient. Crises are opportunities for implementing change, and in the US and internationally, significant reforms traditionally have been born of crisis. To effect meaningful and appropriate reform, however, we must fully understand cause and effect and the broader trends of international financial intermediation. Today, I would like to share with you my perspective on these issues based on US and international experience, with special emphasis on the need for additional preventive measures. Importance of sound banking systems Over the long run, a nation must be able to mobilize domestic savings and other sources of funds needed to finance investment and other productive expenditures. This requires the development of an effective banking system that transfers surplus funds of households and businesses to borrowers and investors. Fair and impartial allocation of credit accommodates the economic development that results in improved national living standards. Notwithstanding broad changes in the intermediation process which have reduced the role of banks in favor of the capital markets, banks retain a critical role in direct intermediation and as managers of financial risk. Sound financial institutions, and banks particularly, remain integral to a sound economy. Effective financial intermediation is particularly important in the context of most emerging market countries given the relative scarcity of savings, a relatively underbanked population, and large-scale investment needs. The banking sector in emerging market countries also tends to be more concentrated and represents a larger share of the domestic financial system, suggesting that problems there will have an amplified effect on the economy and on the fiscal costs associated with bank rescues. Causes of banking system problems Banking system crises have many and complex causes, both macro and microeconomic. Macroeconomic causes include exogenous shocks, sustained or sharp declines in real growth, accelerating inflation, deterioration in the terms of trade, and changes in the policy regime. Macroeconomic shocks also typically expose underlying microeconomic deficiencies in risk management practices and internal controls at financial institutions such as weak underwriting standards, insider lending, excessive credit growth and credit concentrations, interest rate and exchange rate mismatches, and fraud. They also tend to reveal weaknesses in financial system supervision and regulation. The threats to financial system stability are many and interact in complex ways. Policy responses Reflecting the many causes of financial system distress and differences in country conditions and institutional settings, responses to financial system crises typically have been varied and hybrid. Banking sector restructurings are art as well as science, and can be influenced by a host of factors, such as the depth and breadth of problems in the banking, corporate and household sectors. Other critical factors include the existence of adequate enforcement mechanisms to achieve corrective action and of financial markets that are deep enough to permit the orderly disposal of problem bank assets. Indeed, there is no "one size fits all" solution, and individual countries must tailor their approach to their own conditions. Moreover, crises typically evolve in unpredictable ways, and policy must be sufficiently fluid to adjust to changing conditions. Nonetheless, past crises have taught us important lessons applicable to the current situation worldwide. First, it is imperative that bankers and authorities be realistic about the size of the problems they face. While it is often difficult to accurately gauge the scale of problems at the outset of the crisis, history shows that problems usually are much larger than they first appear, and estimates often are subject to frequent and significant upward revision. While pressures to muddle through may, at times, be almost irresistible, policymakers and bankers must realize that the costs of inaction and denial are substantial and that problems left unaddressed grow rapidly over time. Second, it is important to recognize that financial system distress typically encompasses weaknesses in many individual areas, and effective solutions need to be comprehensive and multidimensional. Solutions usually involve complex tensions and trade-offs: improving the condition of the banking sector, for example, may have the effect of worsening the condition of the corporate and household sectors, which may, in turn, negatively affect the banks. Similarly, liquidating problem banking assets may put additional downward pressure on a broader range of asset markets and further exacerbate banking sector problems. However, asset retention more often than not erodes values and freezes market liquidity. Policymakers face difficult choices in managing problem bank restructurings, and there is a great need for creativity in devising solutions. Third, crisis situations cry out for solutions to be adopted quickly to stem further deterioration. At the same time, however, solutions adopted in the short term need to account for the long-term consequences for market efficiency, particularly with respect to moral hazard. The highest priority at the outset of a crisis is usually to restore confidence in the banking system. To this end, authorities in a number of countries have implemented guarantees of bank deposits or broader bank liabilities, in some cases both domestic and foreign, followed by concrete actions to make deposit insurance schemes more explicit and bolster the insurance fund. To minimize the moral hazard implications of such arrangements, however, it is critical that guarantees be established for a defined transitional period, and that supervision of financial institutions simultaneously be stepped up. Issues of moral hazard also need to be considered in authorities' actions in cases of financial institution insolvency. Supervisors have adopted varying approaches to insolvent institutions, including mergers, purchases and assumptions, nationalization, and liquidation. While the authorities should have a general bias toward writing-off existing shareholders and removing management and directors of troubled institutions, such actions may need to be balanced against arguments that current owners and management may be best positioned to achieve an effective work-out. Fourth, I think we should bear in mind that banking sector crises often are not just short-term aberrations, but usually are manifestations of longer-term structural problems. Therefore, it is crucial that policymakers address not only the immediate stock of problem assets through "bad bank/good bank" vehicles, but also structural problems, or weaknesses in core profitability stemming from high overhead, low margins, and excessive regulatory costs. To the extent that underlying problems are not addressed, the banking sector will remain vulnerable to future instability. Thus, at the same time as authorities seek to battle a crisis, they also may be compelled to undertake a range of longer-term reforms to banking sector infrastructure, most notably in areas of accounting, disclosure, capital, and supervision and regulation. These changes often involve bringing domestic standards in line with international standards, and can involve difficult trade-offs, in that, for example, fuller disclosure of problem loans may undermine depositor confidence. Finally, the scale of banking sector problems in a number of countries has necessitated opening up the sector to significant foreign investment. Clearly, such a course brings political tensions and possible domestic backlash. Notwithstanding these concerns, foreign ownership is both inevitable and positive as foreign capital brings not only additional financial strength to a domestic banking sector, but also frequently needed technology and skills transfer. Overall summary of initiatives What has been the success of responses to recent banking crises? While it is still premature to draw firm conclusions, based on the experience in Latin America and early indications from Asia, I believe that, on the whole, policy responses have been meaningful and have strengthened domestic safety and soundness considerably. Let me briefly review the new, post-crisis, financial landscape in Latin America. Crises have left perhaps their greatest imprint on domestic financial system structure. Financial systems have generally experienced significant consolidation - leading to a less fragmented banking market - as weaker and more marginal players have been forced to exit. Foreign capital now accounts for a noteworthy share of banking assets across a number of countries, bringing additional financial strength and know-how. Many governments have sought to reduce their direct role in the financial system through the privatization of state banks, although this will likely remain a longerterm policy objective for many countries. Authorities also have made tremendous strides in improving system infrastructure. Disclosure standards have been greatly improved, and in some Latin American countries, disclosure standards are now comparable to that of G-10 countries. Recognizing the greater historical volatility in emerging market economies, minimum capital requirements have also been raised to levels above Basle minima, and now incorporate additional sources of risk, such as market risk. Financial supervision and regulation has been improved, with additional resources dedicated to the hiring and training of examinations staff and to investments by regulators in information technology. Authorities have been tested and have established more effective mechanisms for addressing problem bank situations. Financial institutions have undertaken a range of measures themselves to improve risk management practices, operational controls, and core profitability. Some institutions have attempted to comply with international standards, notwithstanding lower domestic requirements. These reforms are especially important in light of the fact that the obligation to promote financial soundness rests mainly with financial institutions themselves. Taken together, these reforms indicate progress toward reduced systemic risk, heightened competition, increased banking services provided to the domestic population, and higher standards of conduct better approximating international standards. Work Ahead Notwithstanding this progress, much work remains ahead. While crises have motivated a great deal of reform in individual countries, and standards are approaching international norms, the international financial system remains a patchwork of varying standards and guidelines. While international disclosure standards have improved markedly in recent years, greater disclosure still is required, particularly with respect to bank asset quality, both in emerging and industrial countries alike. In seeking to make these improvements, however, we should avoid a "checklist" approach which may not address the risks of a given country and may soon become outdated. Improved disclosure will require more than a comprehensive framework. Accounting standards also need to be upgraded to reflect innovations in financial products and risk management techniques. The process of upgrading accounting standards, in turn, would benefit from greater harmonization of accounting standards that would facilitate comparison of global financial institutions and result in more uniform capital standards across countries. At a fundamental level, I wonder whether the crisis has engendered the most important reform of all - the development of a true credit "culture". While necessarily a longer-term process, the existence of a sound credit culture is the sine qua non of long-term financial stability. Improved disclosure requirements for nonperforming loans, for example, will be meaningless to the extent that credit standards are weak to begin with, or that there is widespread tolerance regarding the restructuring of past-due loans, motivated by an unwillingness to admit that the loans are troubled. Further enhancements to the bankruptcy and legal codes to increase the efficiency and transparency of collateral recovery are equally necessary. While supervisors have made tremendous strides to effect comprehensive, consolidated supervision globally, significant work remains to be done (and perhaps always will). The rapidly evolving international financial system, in which institutions operate to a greater degree across national borders through a variety of entities and, increasingly, in combination with securities underwriting and insurance businesses, poses continued challenges to supervisory frameworks organized primarily on a national, legal-entity, and business-specific framework. The existence of parallel, offshore, and other unregulated structures also will continue to present obstacles to the full implementation of comprehensive, consolidated supervision on a global basis. Managing these issues will require intensified coordination and information-sharing among international supervisors. Authorities need to ensure that capital adequacy guidelines keep pace with developments in internal risk measurement techniques and changes in the business of banking. To that end, the Basle Capital Accord's market risk amendment, which went into effect at year-end 1997, represents a significant shift in capital supervision, moving away for the first time from the prevailing approach of a mandated and rigid regulatory formula or ratio. The amendment also represents a major step toward a more market-based approach to supervision that draws on banks' internal methodologies for risk measurement, places greater emphasis on promoting sound risk management and control processes, and encourages further innovation and improvement in the banks' internal models. While the market risk amendment is a major step in the right direction, we need to begin thinking now about a conceptual framework for the next generation of capital rules, particularly given the long lead times involved. The original Basle Capital Accord took about five years to develop, and almost seven more years were required to reach agreement on the market risk amendment. I intend to do whatever I can as chairman of the Banking Supervision Committee to raise the relevant issues and promote the development of new approaches to capital adequacy as early as possible. In discussing the challenges ahead, I should also note some recent accomplishments, particularly the work of the BIS Committee on Payments and Settlements Systems, of which I was the former chair, on reducing Herstatt risk in foreign exchange settlements. Previous work by the Committee, embodied in a March 1996 report, recognized that settlement risk depends not only on the payments system infrastructure, but also on the way market participants use this infrastructure and manage their internal processes. A follow-up report was issued one week ago that applauded the progress made, while noting that there were further opportunities for private sector initiatives in reducing settlement risk. The central banks, of course, are ready to work closely with the private sector in achieving this goal. Closing Preventing future banking crises poses difficult issues for policymakers. Given the indispensable role that banks play in a nation's economic well-being, all governments have found it important that financial institutions be subject to regulation or oversight. It is important to understand from the start, however, that there are limits to the supervisory process. Supervisors have limited ability, for example, to detect fraud. Most important, in a market-oriented banking system, bank directors and management must have the ability to set the bank's overall course, to seek a reasonable profit, and to innovate and experiment with new banking activities and products. In other words, supervision can not be so heavy-handed as to stifle competition and innovation. As such, the supervisory process has an inherent tension between the freedom banks need in order to earn reasonable profits and the latitude to take such large risks that their future could be endangered. In seeking reforms to supervision and regulation in response to financial system crisis, we need to ensure a proper balancing of these trade-offs. While I am broadly encouraged by the international policy responses to recent financial crises, I recognize fully that more work remains to be done. I look forward to taking up these challenges in my new position on the Banking Supervision Committee, and to our continued cooperation as we work together toward building a sounder international financial system.	---[PAGE_BREAK]--- Mr. McDonough discusses the importance of sound financial systems Remarks by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough, at a presentation in Mexico City, Mexico on 22/7/98. # Introduction I am delighted to be here today in my second-favorite country in the world to address you on the very timely subject of the importance of sound financial systems. Having worked closely with my friends in the public and private sectors here over the years, I know the importance of these issues to them. Judging by the attendance here today, this interest appears very broad indeed, a positive sign for the continued revitalization and strengthening of Mexico's banking sector. My remarks today, necessarily, reflect my perspective as president of the Federal Reserve Bank of New York, which supervises the majority of domestic and foreign bank assets in the United States, and as Chairman of the Basle Committee on Banking Supervision, a position I accepted last month. These positions allow me a front-row seat on the wide range of developments taking place in international banking and banking supervision, a perspective which I hope to share with you today. To understand the importance of sound financial systems, one need only look at the impact of financial system breakdowns, of which, unfortunately, there are many recent examples. Indeed, prior to the onset of the Asian crisis, the IMF had estimated that fully three-quarters of its member countries had experienced significant banking sector problems since 1980. Banking problems have afflicted both industrial and emerging market countries, including the US, which weathered the savings and loans and banking problems of the 1980s and early 1990s. Crises around the world have exacted a high price, with direct fiscal costs of associated resolutions typically starting at roughly 5 percent of GDP (in the US case, such costs ran more than $\$ 100$ billion). To these substantial sums, one must add the less quantifiable, but no less real, consequences for the economy and financial system. A weakened financial sector cannot serve its role as intermediary - as banks seek to repair their balance sheets, restrict new lending, and shore up capital - leading to diminished growth prospects. In a number of Asian countries today, exporters have difficulty obtaining trade financing from domestic banks, delaying the process of economic recovery and raising fears of a credit crunch in which even sound companies are driven into bankruptcy. Banking sector problems reduce depositor confidence in the banking system and can trigger capital flight. Banking system problems, significant in their own right, can cause distortions in monetary policy, render monetary policy tools less effective, and put at risk the integrity of the payments system. In an integrated international financial system, it is increasingly difficult to contain a banking crisis within a country's borders. Finally, we must not forget the human consequences of a financial and broader economic crisis, which disproportionately fall on those least able to weather the storm. Clearly we need to learn what we can from recent history and take steps now to make domestic and international financial systems more resilient. Crises are opportunities for implementing change, and in the US and internationally, significant reforms traditionally have been born of crisis. To effect meaningful and appropriate reform, however, we must fully understand cause and effect and the broader trends of international financial intermediation. Today, I would like to share with you my perspective on these issues based on US and international experience, with special emphasis on the need for additional preventive measures. ---[PAGE_BREAK]--- # Importance of sound banking systems Over the long run, a nation must be able to mobilize domestic savings and other sources of funds needed to finance investment and other productive expenditures. This requires the development of an effective banking system that transfers surplus funds of households and businesses to borrowers and investors. Fair and impartial allocation of credit accommodates the economic development that results in improved national living standards. Notwithstanding broad changes in the intermediation process which have reduced the role of banks in favor of the capital markets, banks retain a critical role in direct intermediation and as managers of financial risk. Sound financial institutions, and banks particularly, remain integral to a sound economy. Effective financial intermediation is particularly important in the context of most emerging market countries given the relative scarcity of savings, a relatively underbanked population, and large-scale investment needs. The banking sector in emerging market countries also tends to be more concentrated and represents a larger share of the domestic financial system, suggesting that problems there will have an amplified effect on the economy and on the fiscal costs associated with bank rescues. ## Causes of banking system problems Banking system crises have many and complex causes, both macro and microeconomic. Macroeconomic causes include exogenous shocks, sustained or sharp declines in real growth, accelerating inflation, deterioration in the terms of trade, and changes in the policy regime. Macroeconomic shocks also typically expose underlying microeconomic deficiencies in risk management practices and internal controls at financial institutions such as weak underwriting standards, insider lending, excessive credit growth and credit concentrations, interest rate and exchange rate mismatches, and fraud. They also tend to reveal weaknesses in financial system supervision and regulation. The threats to financial system stability are many and interact in complex ways. ## Policy responses Reflecting the many causes of financial system distress and differences in country conditions and institutional settings, responses to financial system crises typically have been varied and hybrid. Banking sector restructurings are art as well as science, and can be influenced by a host of factors, such as the depth and breadth of problems in the banking, corporate and household sectors. Other critical factors include the existence of adequate enforcement mechanisms to achieve corrective action and of financial markets that are deep enough to permit the orderly disposal of problem bank assets. Indeed, there is no "one size fits all" solution, and individual countries must tailor their approach to their own conditions. Moreover, crises typically evolve in unpredictable ways, and policy must be sufficiently fluid to adjust to changing conditions. Nonetheless, past crises have taught us important lessons applicable to the current situation worldwide. First, it is imperative that bankers and authorities be realistic about the size of the problems they face. While it is often difficult to accurately gauge the scale of problems at the outset of the crisis, history shows that problems usually are much larger than they first appear, and estimates often are subject to frequent and significant upward revision. While pressures to muddle through may, at times, be almost irresistible, policymakers and bankers must realize that the costs of inaction and denial are substantial and that problems left unaddressed grow rapidly over time. Second, it is important to recognize that financial system distress typically encompasses weaknesses in many individual areas, and effective solutions need to be comprehensive ---[PAGE_BREAK]--- and multidimensional. Solutions usually involve complex tensions and trade-offs: improving the condition of the banking sector, for example, may have the effect of worsening the condition of the corporate and household sectors, which may, in turn, negatively affect the banks. Similarly, liquidating problem banking assets may put additional downward pressure on a broader range of asset markets and further exacerbate banking sector problems. However, asset retention more often than not erodes values and freezes market liquidity. Policymakers face difficult choices in managing problem bank restructurings, and there is a great need for creativity in devising solutions. Third, crisis situations cry out for solutions to be adopted quickly to stem further deterioration. At the same time, however, solutions adopted in the short term need to account for the long-term consequences for market efficiency, particularly with respect to moral hazard. The highest priority at the outset of a crisis is usually to restore confidence in the banking system. To this end, authorities in a number of countries have implemented guarantees of bank deposits or broader bank liabilities, in some cases both domestic and foreign, followed by concrete actions to make deposit insurance schemes more explicit and bolster the insurance fund. To minimize the moral hazard implications of such arrangements, however, it is critical that guarantees be established for a defined transitional period, and that supervision of financial institutions simultaneously be stepped up. Issues of moral hazard also need to be considered in authorities' actions in cases of financial institution insolvency. Supervisors have adopted varying approaches to insolvent institutions, including mergers, purchases and assumptions, nationalization, and liquidation. While the authorities should have a general bias toward writing-off existing shareholders and removing management and directors of troubled institutions, such actions may need to be balanced against arguments that current owners and management may be best positioned to achieve an effective work-out. Fourth, I think we should bear in mind that banking sector crises often are not just short-term aberrations, but usually are manifestations of longer-term structural problems. Therefore, it is crucial that policymakers address not only the immediate stock of problem assets through "bad bank/good bank" vehicles, but also structural problems, or weaknesses in core profitability stemming from high overhead, low margins, and excessive regulatory costs. To the extent that underlying problems are not addressed, the banking sector will remain vulnerable to future instability. Thus, at the same time as authorities seek to battle a crisis, they also may be compelled to undertake a range of longer-term reforms to banking sector infrastructure, most notably in areas of accounting, disclosure, capital, and supervision and regulation. These changes often involve bringing domestic standards in line with international standards, and can involve difficult trade-offs, in that, for example, fuller disclosure of problem loans may undermine depositor confidence. Finally, the scale of banking sector problems in a number of countries has necessitated opening up the sector to significant foreign investment. Clearly, such a course brings political tensions and possible domestic backlash. Notwithstanding these concerns, foreign ownership is both inevitable and positive as foreign capital brings not only additional financial strength to a domestic banking sector, but also frequently needed technology and skills transfer. # Overall summary of initiatives What has been the success of responses to recent banking crises? While it is still premature to draw firm conclusions, based on the experience in Latin America and early indications from Asia, I believe that, on the whole, policy responses have been meaningful and have ---[PAGE_BREAK]--- strengthened domestic safety and soundness considerably. Let me briefly review the new, post-crisis, financial landscape in Latin America. Crises have left perhaps their greatest imprint on domestic financial system structure. Financial systems have generally experienced significant consolidation - leading to a less fragmented banking market - as weaker and more marginal players have been forced to exit. Foreign capital now accounts for a noteworthy share of banking assets across a number of countries, bringing additional financial strength and know-how. Many governments have sought to reduce their direct role in the financial system through the privatization of state banks, although this will likely remain a longerterm policy objective for many countries. Authorities also have made tremendous strides in improving system infrastructure. Disclosure standards have been greatly improved, and in some Latin American countries, disclosure standards are now comparable to that of G-10 countries. Recognizing the greater historical volatility in emerging market economies, minimum capital requirements have also been raised to levels above Basle minima, and now incorporate additional sources of risk, such as market risk. Financial supervision and regulation has been improved, with additional resources dedicated to the hiring and training of examinations staff and to investments by regulators in information technology. Authorities have been tested and have established more effective mechanisms for addressing problem bank situations. Financial institutions have undertaken a range of measures themselves to improve risk management practices, operational controls, and core profitability. Some institutions have attempted to comply with international standards, notwithstanding lower domestic requirements. These reforms are especially important in light of the fact that the obligation to promote financial soundness rests mainly with financial institutions themselves. Taken together, these reforms indicate progress toward reduced systemic risk, heightened competition, increased banking services provided to the domestic population, and higher standards of conduct better approximating international standards. # Work Ahead Notwithstanding this progress, much work remains ahead. While crises have motivated a great deal of reform in individual countries, and standards are approaching international norms, the international financial system remains a patchwork of varying standards and guidelines. While international disclosure standards have improved markedly in recent years, greater disclosure still is required, particularly with respect to bank asset quality, both in emerging and industrial countries alike. In seeking to make these improvements, however, we should avoid a "checklist" approach which may not address the risks of a given country and may soon become outdated. Improved disclosure will require more than a comprehensive framework. Accounting standards also need to be upgraded to reflect innovations in financial products and risk management techniques. The process of upgrading accounting standards, in turn, would benefit from greater harmonization of accounting standards that would facilitate comparison of global financial institutions and result in more uniform capital standards across countries. At a fundamental level, I wonder whether the crisis has engendered the most important reform of all - the development of a true credit "culture". While necessarily a longer-term process, the existence of a sound credit culture is the sine qua non of long-term financial stability. Improved disclosure requirements for nonperforming loans, for example, will be meaningless to the ---[PAGE_BREAK]--- extent that credit standards are weak to begin with, or that there is widespread tolerance regarding the restructuring of past-due loans, motivated by an unwillingness to admit that the loans are troubled. Further enhancements to the bankruptcy and legal codes to increase the efficiency and transparency of collateral recovery are equally necessary. While supervisors have made tremendous strides to effect comprehensive, consolidated supervision globally, significant work remains to be done (and perhaps always will). The rapidly evolving international financial system, in which institutions operate to a greater degree across national borders through a variety of entities and, increasingly, in combination with securities underwriting and insurance businesses, poses continued challenges to supervisory frameworks organized primarily on a national, legal-entity, and business-specific framework. The existence of parallel, offshore, and other unregulated structures also will continue to present obstacles to the full implementation of comprehensive, consolidated supervision on a global basis. Managing these issues will require intensified coordination and information-sharing among international supervisors. Authorities need to ensure that capital adequacy guidelines keep pace with developments in internal risk measurement techniques and changes in the business of banking. To that end, the Basle Capital Accord's market risk amendment, which went into effect at year-end 1997, represents a significant shift in capital supervision, moving away for the first time from the prevailing approach of a mandated and rigid regulatory formula or ratio. The amendment also represents a major step toward a more market-based approach to supervision that draws on banks' internal methodologies for risk measurement, places greater emphasis on promoting sound risk management and control processes, and encourages further innovation and improvement in the banks' internal models. While the market risk amendment is a major step in the right direction, we need to begin thinking now about a conceptual framework for the next generation of capital rules, particularly given the long lead times involved. The original Basle Capital Accord took about five years to develop, and almost seven more years were required to reach agreement on the market risk amendment. I intend to do whatever I can as chairman of the Banking Supervision Committee to raise the relevant issues and promote the development of new approaches to capital adequacy as early as possible. In discussing the challenges ahead, I should also note some recent accomplishments, particularly the work of the BIS Committee on Payments and Settlements Systems, of which I was the former chair, on reducing Herstatt risk in foreign exchange settlements. Previous work by the Committee, embodied in a March 1996 report, recognized that settlement risk depends not only on the payments system infrastructure, but also on the way market participants use this infrastructure and manage their internal processes. A follow-up report was issued one week ago that applauded the progress made, while noting that there were further opportunities for private sector initiatives in reducing settlement risk. The central banks, of course, are ready to work closely with the private sector in achieving this goal. # Closing Preventing future banking crises poses difficult issues for policymakers. Given the indispensable role that banks play in a nation's economic well-being, all governments have found it important that financial institutions be subject to regulation or oversight. It is important to understand from the start, however, that there are limits to the supervisory process. Supervisors have limited ability, for example, to detect fraud. Most important, in a market-oriented banking system, bank directors and management must have the ability to set the bank's overall course, to seek a ---[PAGE_BREAK]--- reasonable profit, and to innovate and experiment with new banking activities and products. In other words, supervision can not be so heavy-handed as to stifle competition and innovation. As such, the supervisory process has an inherent tension between the freedom banks need in order to earn reasonable profits and the latitude to take such large risks that their future could be endangered. In seeking reforms to supervision and regulation in response to financial system crisis, we need to ensure a proper balancing of these trade-offs. While I am broadly encouraged by the international policy responses to recent financial crises, I recognize fully that more work remains to be done. I look forward to taking up these challenges in my new position on the Banking Supervision Committee, and to our continued cooperation as we work together toward building a sounder international financial system.	William J McDonough	United States	https://www.bis.org/review/r980804b.pdf	Mr. McDonough discusses the importance of sound financial systems Remarks by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough, at a presentation in Mexico City, Mexico on 22/7/98. I am delighted to be here today in my second-favorite country in the world to address you on the very timely subject of the importance of sound financial systems. Having worked closely with my friends in the public and private sectors here over the years, I know the importance of these issues to them. Judging by the attendance here today, this interest appears very broad indeed, a positive sign for the continued revitalization and strengthening of Mexico's banking sector. My remarks today, necessarily, reflect my perspective as president of the Federal Reserve Bank of New York, which supervises the majority of domestic and foreign bank assets in the United States, and as Chairman of the Basle Committee on Banking Supervision, a position I accepted last month. These positions allow me a front-row seat on the wide range of developments taking place in international banking and banking supervision, a perspective which I hope to share with you today. To understand the importance of sound financial systems, one need only look at the impact of financial system breakdowns, of which, unfortunately, there are many recent examples. Indeed, prior to the onset of the Asian crisis, the IMF had estimated that fully three-quarters of its member countries had experienced significant banking sector problems since 1980. Banking problems have afflicted both industrial and emerging market countries, including the US, which weathered the savings and loans and banking problems of the 1980s and early 1990s. Crises around the world have exacted a high price, with direct fiscal costs of associated resolutions typically starting at roughly 5 percent of GDP (in the US case, such costs ran more than $\$ 100$ billion). To these substantial sums, one must add the less quantifiable, but no less real, consequences for the economy and financial system. A weakened financial sector cannot serve its role as intermediary - as banks seek to repair their balance sheets, restrict new lending, and shore up capital - leading to diminished growth prospects. In a number of Asian countries today, exporters have difficulty obtaining trade financing from domestic banks, delaying the process of economic recovery and raising fears of a credit crunch in which even sound companies are driven into bankruptcy. Banking sector problems reduce depositor confidence in the banking system and can trigger capital flight. Banking system problems, significant in their own right, can cause distortions in monetary policy, render monetary policy tools less effective, and put at risk the integrity of the payments system. In an integrated international financial system, it is increasingly difficult to contain a banking crisis within a country's borders. Finally, we must not forget the human consequences of a financial and broader economic crisis, which disproportionately fall on those least able to weather the storm. Clearly we need to learn what we can from recent history and take steps now to make domestic and international financial systems more resilient. Crises are opportunities for implementing change, and in the US and internationally, significant reforms traditionally have been born of crisis. To effect meaningful and appropriate reform, however, we must fully understand cause and effect and the broader trends of international financial intermediation. Today, I would like to share with you my perspective on these issues based on US and international experience, with special emphasis on the need for additional preventive measures. Over the long run, a nation must be able to mobilize domestic savings and other sources of funds needed to finance investment and other productive expenditures. This requires the development of an effective banking system that transfers surplus funds of households and businesses to borrowers and investors. Fair and impartial allocation of credit accommodates the economic development that results in improved national living standards. Notwithstanding broad changes in the intermediation process which have reduced the role of banks in favor of the capital markets, banks retain a critical role in direct intermediation and as managers of financial risk. Sound financial institutions, and banks particularly, remain integral to a sound economy. Effective financial intermediation is particularly important in the context of most emerging market countries given the relative scarcity of savings, a relatively underbanked population, and large-scale investment needs. The banking sector in emerging market countries also tends to be more concentrated and represents a larger share of the domestic financial system, suggesting that problems there will have an amplified effect on the economy and on the fiscal costs associated with bank rescues. Banking system crises have many and complex causes, both macro and microeconomic. Macroeconomic causes include exogenous shocks, sustained or sharp declines in real growth, accelerating inflation, deterioration in the terms of trade, and changes in the policy regime. Macroeconomic shocks also typically expose underlying microeconomic deficiencies in risk management practices and internal controls at financial institutions such as weak underwriting standards, insider lending, excessive credit growth and credit concentrations, interest rate and exchange rate mismatches, and fraud. They also tend to reveal weaknesses in financial system supervision and regulation. The threats to financial system stability are many and interact in complex ways. Reflecting the many causes of financial system distress and differences in country conditions and institutional settings, responses to financial system crises typically have been varied and hybrid. Banking sector restructurings are art as well as science, and can be influenced by a host of factors, such as the depth and breadth of problems in the banking, corporate and household sectors. Other critical factors include the existence of adequate enforcement mechanisms to achieve corrective action and of financial markets that are deep enough to permit the orderly disposal of problem bank assets. Indeed, there is no "one size fits all" solution, and individual countries must tailor their approach to their own conditions. Moreover, crises typically evolve in unpredictable ways, and policy must be sufficiently fluid to adjust to changing conditions. Nonetheless, past crises have taught us important lessons applicable to the current situation worldwide. First, it is imperative that bankers and authorities be realistic about the size of the problems they face. While it is often difficult to accurately gauge the scale of problems at the outset of the crisis, history shows that problems usually are much larger than they first appear, and estimates often are subject to frequent and significant upward revision. While pressures to muddle through may, at times, be almost irresistible, policymakers and bankers must realize that the costs of inaction and denial are substantial and that problems left unaddressed grow rapidly over time. Second, it is important to recognize that financial system distress typically encompasses weaknesses in many individual areas, and effective solutions need to be comprehensive and multidimensional. Solutions usually involve complex tensions and trade-offs: improving the condition of the banking sector, for example, may have the effect of worsening the condition of the corporate and household sectors, which may, in turn, negatively affect the banks. Similarly, liquidating problem banking assets may put additional downward pressure on a broader range of asset markets and further exacerbate banking sector problems. However, asset retention more often than not erodes values and freezes market liquidity. Policymakers face difficult choices in managing problem bank restructurings, and there is a great need for creativity in devising solutions. Third, crisis situations cry out for solutions to be adopted quickly to stem further deterioration. At the same time, however, solutions adopted in the short term need to account for the long-term consequences for market efficiency, particularly with respect to moral hazard. The highest priority at the outset of a crisis is usually to restore confidence in the banking system. To this end, authorities in a number of countries have implemented guarantees of bank deposits or broader bank liabilities, in some cases both domestic and foreign, followed by concrete actions to make deposit insurance schemes more explicit and bolster the insurance fund. To minimize the moral hazard implications of such arrangements, however, it is critical that guarantees be established for a defined transitional period, and that supervision of financial institutions simultaneously be stepped up. Issues of moral hazard also need to be considered in authorities' actions in cases of financial institution insolvency. Supervisors have adopted varying approaches to insolvent institutions, including mergers, purchases and assumptions, nationalization, and liquidation. While the authorities should have a general bias toward writing-off existing shareholders and removing management and directors of troubled institutions, such actions may need to be balanced against arguments that current owners and management may be best positioned to achieve an effective work-out. Fourth, I think we should bear in mind that banking sector crises often are not just short-term aberrations, but usually are manifestations of longer-term structural problems. Therefore, it is crucial that policymakers address not only the immediate stock of problem assets through "bad bank/good bank" vehicles, but also structural problems, or weaknesses in core profitability stemming from high overhead, low margins, and excessive regulatory costs. To the extent that underlying problems are not addressed, the banking sector will remain vulnerable to future instability. Thus, at the same time as authorities seek to battle a crisis, they also may be compelled to undertake a range of longer-term reforms to banking sector infrastructure, most notably in areas of accounting, disclosure, capital, and supervision and regulation. These changes often involve bringing domestic standards in line with international standards, and can involve difficult trade-offs, in that, for example, fuller disclosure of problem loans may undermine depositor confidence. Finally, the scale of banking sector problems in a number of countries has necessitated opening up the sector to significant foreign investment. Clearly, such a course brings political tensions and possible domestic backlash. Notwithstanding these concerns, foreign ownership is both inevitable and positive as foreign capital brings not only additional financial strength to a domestic banking sector, but also frequently needed technology and skills transfer. What has been the success of responses to recent banking crises? While it is still premature to draw firm conclusions, based on the experience in Latin America and early indications from Asia, I believe that, on the whole, policy responses have been meaningful and have strengthened domestic safety and soundness considerably. Let me briefly review the new, post-crisis, financial landscape in Latin America. Crises have left perhaps their greatest imprint on domestic financial system structure. Financial systems have generally experienced significant consolidation - leading to a less fragmented banking market - as weaker and more marginal players have been forced to exit. Foreign capital now accounts for a noteworthy share of banking assets across a number of countries, bringing additional financial strength and know-how. Many governments have sought to reduce their direct role in the financial system through the privatization of state banks, although this will likely remain a longerterm policy objective for many countries. Authorities also have made tremendous strides in improving system infrastructure. Disclosure standards have been greatly improved, and in some Latin American countries, disclosure standards are now comparable to that of G-10 countries. Recognizing the greater historical volatility in emerging market economies, minimum capital requirements have also been raised to levels above Basle minima, and now incorporate additional sources of risk, such as market risk. Financial supervision and regulation has been improved, with additional resources dedicated to the hiring and training of examinations staff and to investments by regulators in information technology. Authorities have been tested and have established more effective mechanisms for addressing problem bank situations. Financial institutions have undertaken a range of measures themselves to improve risk management practices, operational controls, and core profitability. Some institutions have attempted to comply with international standards, notwithstanding lower domestic requirements. These reforms are especially important in light of the fact that the obligation to promote financial soundness rests mainly with financial institutions themselves. Taken together, these reforms indicate progress toward reduced systemic risk, heightened competition, increased banking services provided to the domestic population, and higher standards of conduct better approximating international standards. Notwithstanding this progress, much work remains ahead. While crises have motivated a great deal of reform in individual countries, and standards are approaching international norms, the international financial system remains a patchwork of varying standards and guidelines. While international disclosure standards have improved markedly in recent years, greater disclosure still is required, particularly with respect to bank asset quality, both in emerging and industrial countries alike. In seeking to make these improvements, however, we should avoid a "checklist" approach which may not address the risks of a given country and may soon become outdated. Improved disclosure will require more than a comprehensive framework. Accounting standards also need to be upgraded to reflect innovations in financial products and risk management techniques. The process of upgrading accounting standards, in turn, would benefit from greater harmonization of accounting standards that would facilitate comparison of global financial institutions and result in more uniform capital standards across countries. At a fundamental level, I wonder whether the crisis has engendered the most important reform of all - the development of a true credit "culture". While necessarily a longer-term process, the existence of a sound credit culture is the sine qua non of long-term financial stability. Improved disclosure requirements for nonperforming loans, for example, will be meaningless to the extent that credit standards are weak to begin with, or that there is widespread tolerance regarding the restructuring of past-due loans, motivated by an unwillingness to admit that the loans are troubled. Further enhancements to the bankruptcy and legal codes to increase the efficiency and transparency of collateral recovery are equally necessary. While supervisors have made tremendous strides to effect comprehensive, consolidated supervision globally, significant work remains to be done (and perhaps always will). The rapidly evolving international financial system, in which institutions operate to a greater degree across national borders through a variety of entities and, increasingly, in combination with securities underwriting and insurance businesses, poses continued challenges to supervisory frameworks organized primarily on a national, legal-entity, and business-specific framework. The existence of parallel, offshore, and other unregulated structures also will continue to present obstacles to the full implementation of comprehensive, consolidated supervision on a global basis. Managing these issues will require intensified coordination and information-sharing among international supervisors. Authorities need to ensure that capital adequacy guidelines keep pace with developments in internal risk measurement techniques and changes in the business of banking. To that end, the Basle Capital Accord's market risk amendment, which went into effect at year-end 1997, represents a significant shift in capital supervision, moving away for the first time from the prevailing approach of a mandated and rigid regulatory formula or ratio. The amendment also represents a major step toward a more market-based approach to supervision that draws on banks' internal methodologies for risk measurement, places greater emphasis on promoting sound risk management and control processes, and encourages further innovation and improvement in the banks' internal models. While the market risk amendment is a major step in the right direction, we need to begin thinking now about a conceptual framework for the next generation of capital rules, particularly given the long lead times involved. The original Basle Capital Accord took about five years to develop, and almost seven more years were required to reach agreement on the market risk amendment. I intend to do whatever I can as chairman of the Banking Supervision Committee to raise the relevant issues and promote the development of new approaches to capital adequacy as early as possible. In discussing the challenges ahead, I should also note some recent accomplishments, particularly the work of the BIS Committee on Payments and Settlements Systems, of which I was the former chair, on reducing Herstatt risk in foreign exchange settlements. Previous work by the Committee, embodied in a March 1996 report, recognized that settlement risk depends not only on the payments system infrastructure, but also on the way market participants use this infrastructure and manage their internal processes. A follow-up report was issued one week ago that applauded the progress made, while noting that there were further opportunities for private sector initiatives in reducing settlement risk. The central banks, of course, are ready to work closely with the private sector in achieving this goal. Preventing future banking crises poses difficult issues for policymakers. Given the indispensable role that banks play in a nation's economic well-being, all governments have found it important that financial institutions be subject to regulation or oversight. It is important to understand from the start, however, that there are limits to the supervisory process. Supervisors have limited ability, for example, to detect fraud. Most important, in a market-oriented banking system, bank directors and management must have the ability to set the bank's overall course, to seek a reasonable profit, and to innovate and experiment with new banking activities and products. In other words, supervision can not be so heavy-handed as to stifle competition and innovation. As such, the supervisory process has an inherent tension between the freedom banks need in order to earn reasonable profits and the latitude to take such large risks that their future could be endangered. In seeking reforms to supervision and regulation in response to financial system crisis, we need to ensure a proper balancing of these trade-offs. While I am broadly encouraged by the international policy responses to recent financial crises, I recognize fully that more work remains to be done. I look forward to taking up these challenges in my new position on the Banking Supervision Committee, and to our continued cooperation as we work together toward building a sounder international financial system.
1998-08-28T00:00:00	Mr. Greenspan remarks on income inequality (Central Bank Articles and Speeches, 28 Aug 98)	Remarks by Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at a symposium sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole, Wyoming on 28/8/98.	Mr. Greenspan remarks on income inequality Remarks by Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at a symposium sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole, Wyoming on 28/8/98. Income Inequality: Issues and Policy Options I am pleased once again to open this annual symposium. At the outset, I wish to thank Tom Hoenig and his staff for assembling a highly capable group of experts to inform us and to stimulate discussion on an important issue in the world economy. The study of income inequality - its causes, its consequences, and its potential policy implications - has a long history in economics, although it has not always had a high profile among researchers and policymakers. To borrow a phrase from Professor Atkinson, income distribution in recent years has been "brought in from the cold." In part, that awareness has resulted from the experience of many industrialized economies with widening earnings inequality in the 1980s and 1990s. It has been heightened by interest in the consequences of economic change in developing, newly industrialized, and transition economies. The experience of industrialized countries, including the United States, with growing income inequality has spawned a great deal of research on the functioning of labor markets, on the sources of shifts in the demand for various types of skills, on the supply responses of workers, and on the efficacy of government efforts to intervene in the operation of labor markets. A number of those who have contributed importantly to this work will be participating in this conference. One story that has emerged from that body of research is now familiar: Rising demand for those workers who have the skills to effectively harness new technologies has been outpacing supply, and, thus, the compensation of those workers has been increasing more rapidly than for the lesser skilled segment of the workforce. That this supply-demand gap has been an important source of widening earnings inequality is now widely accepted within the economics profession. However, the considerable diversity of experiences across countries as well as the finding that earnings inequality has also increased within groups of workers with similar measured skills and experience suggest that we may need to look deeper than skill-biased technological change if we are to fully understand widening wage dispersion. In particular, how have private and public institutions influenced inequality over the past two decades? What roles have been played by growing international trade and the evolving ways in which production is organized? Again, the participants in this symposium are well-equipped to speak to these issues, and we should learn much more about the causes of widening inequality during the next two days. In discussing the extent to which large portions of the population are not reaping the benefits of economic growth, I hope that the participants at this conference will not stop with an analysis of trends in earnings - or, for that matter, even trends in income more broadly defined. Ultimately, we are interested in the question of relative standards of living and economic well-being. Thus, we need also to examine trends in the distribution of wealth, which, more fundamentally than earnings or income, represents a measure of the ability of households to consume. And we will even want to consider the distribution of consumption, which likely has the advantage of smoothing through transitory shocks affecting particular individuals or households for just a year or two. Among these more comprehensive measures, data for the United States from the Federal Reserve's Survey of Consumer Finances suggest that inequality in household wealth - that is, in net worth - was somewhat higher in 1989 than at the time of our earlier survey in 1963. Subsequently, the 1992 and 1995 surveys - and here our data are statistically more comparable from survey to survey than they were earlier - showed that wealth inequality remained little changed in terms of the broad measures.1 Nonetheless, that stability masks considerable churning among the subgroups. One particularly notable change was an apparent rise in the share of wealth held by the wealthiest families at the expense of other wealthy families; most of the change occurred within the top 10 percent of the distribution. Moreover, our research using the survey suggests that conclusions about the distribution of wealth are sensitive - although to a lesser degree than income - to the state of the economy and to - 2 - institutional arrangements for saving. For instance, among the wealthiest 1⁄2 percent of households, business assets, which tend to be quite cyclical, are particularly important. At the other end of the distribution, owned principal residences, the values of which are not as sensitive to business cycle conditions, are a typical household's most important asset. Another interesting finding is that if we expand the definition of wealth to include estimates of Social Security and pension wealth, the distribution among U.S. households becomes much more even.2 This finding suggests that, in addition to factors influencing private wealth accumulation, the evolution of institutional arrangements for saving that has taken place over the last two decades may have played an important role in affecting changes in the distribution of wealth over time. What about the effect of the recent rise in stock and bond market values? The typical view is that the growth in mutual funds and other financial investment avenues has allowed individuals further down in the wealth distribution to take advantage of the strength in equity markets. Certainly, our figures show that households lower in the income distribution are now more likely to own stocks than a decade ago.3 However, between the 1992 and 1995 surveys, the spread of stock ownership and the rise in prices did not lead to a rise in the share of stock and mutual fund assets owned by the bottom 90 percent of the wealth distribution. Although their dollar holdings rose rapidly, the increases were not as large as those for households at the top of the wealth distribution. If patterns of equity ownership have not changed much since 1995, the steep rise in stock prices over the past several years would suggest a further increase in the concentration of net worth. This influence could be offset, to some extent, by a continued broadening in the ownership of equities, particularly through tax-deferred savings accounts. Moreover, some additional offset may have occurred through rising house prices, an important asset of middle class families. Our 1998 survey, which is now in the field, will yield a clearer reading both on how wealth concentration has changed and on the relative importance of different assets in that change. Despite our best efforts to measure trends in income and wealth, I believe that even those measures - by themselves - cannot yield a complete answer to the question of trends in material or economic well-being. In the United States, we observe a noticeable difference between trends in the dispersion of holdings of claims to goods and services - that is, income and wealth - and trends in the dispersion of actual consumption, the bottom-line determinant of material well-being. Ultimately, we are interested in whether households have the means to meet their needs for goods and for services, including those such as education and medical care, that build and maintain human capital. Using data from the Consumer Expenditure Survey that the U.S. Bureau of Labor Statistics conducts, researchers have found that inequality in consumption, when measured by current outlays, is less than inequality in income.4 These findings are not surprising. As is well known, consumers tend to maintain their levels of consumption in the face of temporary fluctuations in income. Variations in asset holdings and debt typically act as buffers to changes in income. Thus, consumption patterns tend to look more like patterns in income that have been averaged over several years - a finding that should remind us of the pitfalls of reading too much into any year-to-year change in our measures of economic well-being. The BLS's consumer expenditure data suggest a rise in inequality over the 1980s comparable to that shown by the Census family income figures. However, during the first half of the 1990s, inequality partially receded for consumer expenditures while for income it continued to rise (table 1). The consumption data used in these calculations include only what individuals purchase directly out of their incomes and accumulated savings. Recently, researchers have extended the analysis using a more complete and more theoretically appealing measure of consumption that includes the indirect flow of services from the stock of durable goods that they already own - houses, vehicles, and major appliances.5 As one might expect, although this measure of consumption has a profile somewhat similar to that seen in the current expenditure data over the 1980s and the first half of the 1990s, it shows still lower levels of inequality overall and a clearer pattern of consumption smoothing during the 1981-83 recession. The information available from the Consumer Expenditure Survey can be used to calculate another interesting measure of the well-being of households: changes in inequality in the ownership of consumer durables. The BLS staff has updated tabulations of these data that they prepared - 3 - for me several years ago (table 2). Of course, ownership rates for household durables clearly rise with income. But for a number of goods - for example, dishwashers, clothes dryers, microwaves, and motor vehicles - the distribution of ownership rates by income decile has become more equal over time. Even though we may be able to develop an array of measures of current and past trends in inequality - such as those that I have described and potentially others that may be presented at this symposium - we will likely still face considerable uncertainty about how to interpret those measures and about what the future may hold for the trend and the distribution of economic well-being. Wealth has always been created, virtually by definition, when individuals use their growing knowledge, in conjunction with an expanding capital stock, to produce goods and services of value. The process of wealth creation in the United States has evolved in a number of important ways. Over the last century, we have learned how to be more efficient in meeting the needs of consumers, and thus we have moved from producing essentials to the production of more discretionary goods and services. Moreover, these goods and services have been, over time, increasingly less constrained by the limits of physical bulk. More recently, we have found ways to unbundle the particular characteristics of each good and service to maximize its value to each individual. That striving to expand the options for satisfying the particular needs of individuals has resulted in a shift toward value created through the exploitation of ideas and concepts and away from the more straightforward utilization of physical resources and manual labor. The new thrust has led to structural changes in the way that we organize the production and the distribution of goods and services. It has increased the demand for, and the compensation of, workers who have the ability to create, analyze, and transform information and to interact effectively with others. Most important, it has accorded particularly high value to the application of advanced computer and telecommunications technologies to the generation of economic wealth. At the same time, however, the consequences of technological advances and their implications for the creation of wealth have become increasingly unpredictable. We have found that we cannot forecast with any precision which particular technology or synergies of technologies will add significantly to our knowledge and to our ability to gain from that knowledge. Even if future technological change were to occur at a steady rate, variations in our capacity to absorb and apply advances would likely lead to an uneven rate of increase - over time and across individuals - in returns to expanded investment in knowledge: Supplies of appropriately skilled workers can vary. In some cases, the initial choices in the exploitation of advances may turn out to be sub-optimal. In other cases, the full potential of advances may be realized only after extensive improvements or after complementary innovations in other fields of science. As we consider the causes and consequences of inequality, we should also be mindful that, over time, the relationship of economic growth, increases in standards of living, and the distribution of wealth has evolved differently in various political and institutional settings. Thus, generalizations about the past and the future may be hard to make, particularly in the current dynamic and uncertain environment of economic change. We need to ask, for example, whether we should be concerned with the degree of income inequality if all groups are experiencing relatively rapid gains in their real incomes, though those rates of gain may differ. And, we cannot ignore what is happening to the level of average income while looking at trends in the distribution. In this regard, our goal as central bankers should be clear: We must pursue monetary conditions in which stable prices contribute to maximizing sustainable long-run growth. Such disciplined policies will offer the best underpinnings for identifying opportunities to channel growing knowledge, innovation, and capital investment into the creation of wealth that, in turn, will lift living standards as broadly as possible. Moreover, as evidenced by this symposium, sustaining a healthy economy and a stable financial system naturally permits us to take the time to focus efforts on addressing the distributional issues facing our society and on other challenging issues that may remain out in the cold. Table 1 "GINI COEFFICIENTS" FOR U.S. CONSUMER EXPENDITURES AND INCOME - 4 - Consumption Income 1980 .290 .365 1981 .285 .369 1982 .302 .380 1983 .305 .382 1984 .312 .383 1985 .319 .389 1986 .327 .392 1987 .328 .393 1988 .323 .395 1989 .325 .401 1990 .328 .396 1991 .320 .397 1992 .329 .404 1993 .320 .429 1994 .318 .426 1995 .317 .421 1996 n.a. .425 Source: Consumer expenditure data are from the Consumer Expenditure Survey, U.S. Bureau of Labor Statistics. Income data are for families as of March of the following year from the Current Population Survey, U.S. Census Bureau. Table 2 "GINI COEFFICIENTS" FOR OWNERSHIP RATES OF SELECTED CONSUMER DURABLES (By income decile) 1980 1995 Microwave ovens .28 .07 Dishwashers .29 .23 Clothes dryers .17 .12 Garbage disposals .26 .21 Motor vehicles .09 .07 Freezers .06 .07 Clothes washers .08 .09 Refrigerators .01 .01 Stoves .01 .01 Source: Based on tabulations from the Consumer Expenditure Survey, U.S. Bureau of Labor Statistics. Note: The Gini coefficient is defined as one minus twice the area under the cumulative probability distribution (CPD). The Ginis computed here do not have the properties of a "true" Gini coefficient. For example, a true Gini must lie between zero and one. The Ginis calculated here could be negative if low-income individuals had a higher ownership rate than high- income individuals. Using percent ownership. The percent ownership rates by decile are transformed into a discrete probability distribution. The formula is: pi = ri /3ri the sum is over i = 1 to 10 where pi is the fraction of all households that own the durable good who are in income decile i or ri is the actual ownership rate for the ith decile. By construction, the sum of the pi=s is equal to one. For goods that have ownership rates that are relatively equal across deciles, regardless of the level of the ownership rate, the probability distributions are fairly flat with values for pi close to 0.1. For goods that are more concentrated among the affluent households, the probability distributions tend to rise across the income deciles. - 5 - * * * Footnotes 1 Arthur B. Kennickell and R. Louise Woodburn, "Consistent Weight Design for the 1989, 1992 and 1995 SCFs, and the Distribution of Wealth," manuscript, August 1997. 2 Arthur B. Kennickell and Annika E. Sunden, "Pensions, Social Security, and the Distribution of Wealth," Finance and Economics Discussion Series, 1997-55, Board of Governors of the Federal Reserve System, November 1997. 3 Martha Starr-McClure, "Stock Market Wealth and Consumer Spending," Finance and Economics Discussion Series, 1998-20, Board of Governors of the Federal Reserve System, April 1998. 4 These results were originally reported in Report on the American Workforce, U.S. Department of Labor, 1995 and will appear in David S. Johnson and Stephanie Shipp, " Inequality and the Business Cycle: A Consumption Viewpoint," forthcoming, Journal of Empirical Economics. David S. Johnson of the U.S. Bureau of Labor Statistics provided the updated data shown in table 1. 5 David S. Johnson and Timothy M. Smeeding, "Measuring Trends in Inequality and Individuals and Families: Income and Consumption," mimeo., March 1998.	---[PAGE_BREAK]--- Mr. Greenspan remarks on income inequality Remarks by Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at a symposium sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole, Wyoming on 28/8/98. # Income Inequality: Issues and Policy Options I am pleased once again to open this annual symposium. At the outset, I wish to thank Tom Hoenig and his staff for assembling a highly capable group of experts to inform us and to stimulate discussion on an important issue in the world economy. The study of income inequality - its causes, its consequences, and its potential policy implications - has a long history in economics, although it has not always had a high profile among researchers and policymakers. To borrow a phrase from Professor Atkinson, income distribution in recent years has been "brought in from the cold." In part, that awareness has resulted from the experience of many industrialized economies with widening earnings inequality in the 1980s and 1990s. It has been heightened by interest in the consequences of economic change in developing, newly industrialized, and transition economies. The experience of industrialized countries, including the United States, with growing income inequality has spawned a great deal of research on the functioning of labor markets, on the sources of shifts in the demand for various types of skills, on the supply responses of workers, and on the efficacy of government efforts to intervene in the operation of labor markets. A number of those who have contributed importantly to this work will be participating in this conference. One story that has emerged from that body of research is now familiar: Rising demand for those workers who have the skills to effectively harness new technologies has been outpacing supply, and, thus, the compensation of those workers has been increasing more rapidly than for the lesser skilled segment of the workforce. That this supply-demand gap has been an important source of widening earnings inequality is now widely accepted within the economics profession. However, the considerable diversity of experiences across countries as well as the finding that earnings inequality has also increased within groups of workers with similar measured skills and experience suggest that we may need to look deeper than skill-biased technological change if we are to fully understand widening wage dispersion. In particular, how have private and public institutions influenced inequality over the past two decades? What roles have been played by growing international trade and the evolving ways in which production is organized? Again, the participants in this symposium are well-equipped to speak to these issues, and we should learn much more about the causes of widening inequality during the next two days. In discussing the extent to which large portions of the population are not reaping the benefits of economic growth, I hope that the participants at this conference will not stop with an analysis of trends in earnings - or, for that matter, even trends in income more broadly defined. Ultimately, we are interested in the question of relative standards of living and economic well-being. Thus, we need also to examine trends in the distribution of wealth, which, more fundamentally than earnings or income, represents a measure of the ability of households to consume. And we will even want to consider the distribution of consumption, which likely has the advantage of smoothing through transitory shocks affecting particular individuals or households for just a year or two. Among these more comprehensive measures, data for the United States from the Federal Reserve's Survey of Consumer Finances suggest that inequality in household wealth - that is, in net worth - was somewhat higher in 1989 than at the time of our earlier survey in 1963. Subsequently, the 1992 and 1995 surveys - and here our data are statistically more comparable from survey to survey than they were earlier - showed that wealth inequality remained little changed in terms of the broad measures. ${ }^{1}$ Nonetheless, that stability masks considerable churning among the subgroups. One particularly notable change was an apparent rise in the share of wealth held by the wealthiest families at the expense of other wealthy families; most of the change occurred within the top 10 percent of the distribution. Moreover, our research using the survey suggests that conclusions about the distribution of wealth are sensitive - although to a lesser degree than income - to the state of the economy and to ---[PAGE_BREAK]--- institutional arrangements for saving. For instance, among the wealthiest $1 / 2$ percent of households, business assets, which tend to be quite cyclical, are particularly important. At the other end of the distribution, owned principal residences, the values of which are not as sensitive to business cycle conditions, are a typical household's most important asset. Another interesting finding is that if we expand the definition of wealth to include estimates of Social Security and pension wealth, the distribution among U.S. households becomes much more even. ${ }^{2}$ This finding suggests that, in addition to factors influencing private wealth accumulation, the evolution of institutional arrangements for saving that has taken place over the last two decades may have played an important role in affecting changes in the distribution of wealth over time. What about the effect of the recent rise in stock and bond market values? The typical view is that the growth in mutual funds and other financial investment avenues has allowed individuals further down in the wealth distribution to take advantage of the strength in equity markets. Certainly, our figures show that households lower in the income distribution are now more likely to own stocks than a decade ago. ${ }^{3}$ However, between the 1992 and 1995 surveys, the spread of stock ownership and the rise in prices did not lead to a rise in the share of stock and mutual fund assets owned by the bottom 90 percent of the wealth distribution. Although their dollar holdings rose rapidly, the increases were not as large as those for households at the top of the wealth distribution. If patterns of equity ownership have not changed much since 1995, the steep rise in stock prices over the past several years would suggest a further increase in the concentration of net worth. This influence could be offset, to some extent, by a continued broadening in the ownership of equities, particularly through tax-deferred savings accounts. Moreover, some additional offset may have occurred through rising house prices, an important asset of middle class families. Our 1998 survey, which is now in the field, will yield a clearer reading both on how wealth concentration has changed and on the relative importance of different assets in that change. Despite our best efforts to measure trends in income and wealth, I believe that even those measures - by themselves - cannot yield a complete answer to the question of trends in material or economic well-being. In the United States, we observe a noticeable difference between trends in the dispersion of holdings of claims to goods and services - that is, income and wealth - and trends in the dispersion of actual consumption, the bottom-line determinant of material well-being. Ultimately, we are interested in whether households have the means to meet their needs for goods and for services, including those such as education and medical care, that build and maintain human capital. Using data from the Consumer Expenditure Survey that the U.S. Bureau of Labor Statistics conducts, researchers have found that inequality in consumption, when measured by current outlays, is less than inequality in income. ${ }^{4}$ These findings are not surprising. As is well known, consumers tend to maintain their levels of consumption in the face of temporary fluctuations in income. Variations in asset holdings and debt typically act as buffers to changes in income. Thus, consumption patterns tend to look more like patterns in income that have been averaged over several years - a finding that should remind us of the pitfalls of reading too much into any year-to-year change in our measures of economic well-being. The BLS's consumer expenditure data suggest a rise in inequality over the 1980s comparable to that shown by the Census family income figures. However, during the first half of the 1990s, inequality partially receded for consumer expenditures while for income it continued to rise (table 1). The consumption data used in these calculations include only what individuals purchase directly out of their incomes and accumulated savings. Recently, researchers have extended the analysis using a more complete and more theoretically appealing measure of consumption that includes the indirect flow of services from the stock of durable goods that they already own - houses, vehicles, and major appliances. ${ }^{5}$ As one might expect, although this measure of consumption has a profile somewhat similar to that seen in the current expenditure data over the 1980s and the first half of the 1990s, it shows still lower levels of inequality overall and a clearer pattern of consumption smoothing during the 1981-83 recession. The information available from the Consumer Expenditure Survey can be used to calculate another interesting measure of the well-being of households: changes in inequality in the ownership of consumer durables. The BLS staff has updated tabulations of these data that they prepared ---[PAGE_BREAK]--- for me several years ago (table 2). Of course, ownership rates for household durables clearly rise with income. But for a number of goods - for example, dishwashers, clothes dryers, microwaves, and motor vehicles - the distribution of ownership rates by income decile has become more equal over time. Even though we may be able to develop an array of measures of current and past trends in inequality - such as those that I have described and potentially others that may be presented at this symposium - we will likely still face considerable uncertainty about how to interpret those measures and about what the future may hold for the trend and the distribution of economic well-being. Wealth has always been created, virtually by definition, when individuals use their growing knowledge, in conjunction with an expanding capital stock, to produce goods and services of value. The process of wealth creation in the United States has evolved in a number of important ways. Over the last century, we have learned how to be more efficient in meeting the needs of consumers, and thus we have moved from producing essentials to the production of more discretionary goods and services. Moreover, these goods and services have been, over time, increasingly less constrained by the limits of physical bulk. More recently, we have found ways to unbundle the particular characteristics of each good and service to maximize its value to each individual. That striving to expand the options for satisfying the particular needs of individuals has resulted in a shift toward value created through the exploitation of ideas and concepts and away from the more straightforward utilization of physical resources and manual labor. The new thrust has led to structural changes in the way that we organize the production and the distribution of goods and services. It has increased the demand for, and the compensation of, workers who have the ability to create, analyze, and transform information and to interact effectively with others. Most important, it has accorded particularly high value to the application of advanced computer and telecommunications technologies to the generation of economic wealth. At the same time, however, the consequences of technological advances and their implications for the creation of wealth have become increasingly unpredictable. We have found that we cannot forecast with any precision which particular technology or synergies of technologies will add significantly to our knowledge and to our ability to gain from that knowledge. Even if future technological change were to occur at a steady rate, variations in our capacity to absorb and apply advances would likely lead to an uneven rate of increase - over time and across individuals - in returns to expanded investment in knowledge: Supplies of appropriately skilled workers can vary. In some cases, the initial choices in the exploitation of advances may turn out to be sub-optimal. In other cases, the full potential of advances may be realized only after extensive improvements or after complementary innovations in other fields of science. As we consider the causes and consequences of inequality, we should also be mindful that, over time, the relationship of economic growth, increases in standards of living, and the distribution of wealth has evolved differently in various political and institutional settings. Thus, generalizations about the past and the future may be hard to make, particularly in the current dynamic and uncertain environment of economic change. We need to ask, for example, whether we should be concerned with the degree of income inequality if all groups are experiencing relatively rapid gains in their real incomes, though those rates of gain may differ. And, we cannot ignore what is happening to the level of average income while looking at trends in the distribution. In this regard, our goal as central bankers should be clear: We must pursue monetary conditions in which stable prices contribute to maximizing sustainable long-run growth. Such disciplined policies will offer the best underpinnings for identifying opportunities to channel growing knowledge, innovation, and capital investment into the creation of wealth that, in turn, will lift living standards as broadly as possible. Moreover, as evidenced by this symposium, sustaining a healthy economy and a stable financial system naturally permits us to take the time to focus efforts on addressing the distributional issues facing our society and on other challenging issues that may remain out in the cold. Table 1 "GINI COEFFICIENTS" FOR U.S. CONSUMER EXPENDITURES AND INCOME ---[PAGE_BREAK]--- \| \| Consumption \| Income \| \| :--: \| :--: \| :--: \| \| 1980 \| .290 \| .365 \| \| 1981 \| .285 \| .369 \| \| 1982 \| .302 \| .380 \| \| 1983 \| .305 \| .382 \| \| 1984 \| .312 \| .383 \| \| 1985 \| .319 \| .389 \| \| 1986 \| .327 \| .392 \| \| 1987 \| .328 \| .393 \| \| 1988 \| .323 \| .395 \| \| 1989 \| .325 \| .401 \| \| 1990 \| .328 \| .396 \| \| 1991 \| .320 \| .397 \| \| 1992 \| .329 \| .404 \| \| 1993 \| .320 \| .429 \| \| 1994 \| .318 \| .426 \| \| 1995 \| .317 \| .421 \| \| 1996 \| n.a. \| .425 \| Source: Consumer expenditure data are from the Consumer Expenditure Survey, U.S. Bureau of Labor Statistics. Income data are for families as of March of the following year from the Current Population Survey, U.S. Census Bureau. Table 2 "GINI COEFFICIENTS" FOR OWNERSHIP RATES OF SELECTED CONSUMER DURABLES (By income decile) \| \| 1980 \| 1995 \| \| :-- \| :-- \| :-- \| \| Microwave ovens \| .28 \| .07 \| \| Dishwashers \| .29 \| .23 \| \| Clothes dryers \| .17 \| .12 \| \| Garbage disposals \| .26 \| .21 \| \| Motor vehicles \| .09 \| .07 \| \| Freezers \| .06 \| .07 \| \| Clothes washers \| .08 \| .09 \| \| Refrigerators \| .01 \| .01 \| \| Stoves \| .01 \| .01 \| Source: Based on tabulations from the Consumer Expenditure Survey, U.S. Bureau of Labor Statistics. Note: The Gini coefficient is defined as one minus twice the area under the cumulative probability distribution (CPD). The Ginis computed here do not have the properties of a "true" Gini coefficient. For example, a true Gini must lie between zero and one. The Ginis calculated here could be negative if low-income individuals had a higher ownership rate than high- income individuals. Using percent ownership. The percent ownership rates by decile are transformed into a discrete probability distribution. The formula is: $\mathrm{pi}=\mathrm{ri} / 3 \mathrm{ri}$ the sum is over $\mathrm{i}=1$ to 10 where pi is the fraction of all households that own the durable good who are in income decile i or ri is the actual ownership rate for the ith decile. By construction, the sum of the pi=s is equal to one. For goods that have ownership rates that are relatively equal across deciles, regardless of the level of the ownership rate, the probability distributions are fairly flat with values for pi close to 0.1 . For goods that are more concentrated among the affluent households, the probability distributions tend to rise across the income deciles. ---[PAGE_BREAK]--- # Footnotes 1 Arthur B. Kennickell and R. Louise Woodburn, "Consistent Weight Design for the 1989, 1992 and 1995 SCFs, and the Distribution of Wealth," manuscript, August 1997. 2 Arthur B. Kennickell and Annika E. Sunden, "Pensions, Social Security, and the Distribution of Wealth," Finance and Economics Discussion Series, 1997-55, Board of Governors of the Federal Reserve System, November 1997. 3 Martha Starr-McClure, "Stock Market Wealth and Consumer Spending," Finance and Economics Discussion Series, 1998-20, Board of Governors of the Federal Reserve System, April 1998. 4 These results were originally reported in Report on the American Workforce, U.S. Department of Labor, 1995 and will appear in David S. Johnson and Stephanie Shipp, " Inequality and the Business Cycle: A Consumption Viewpoint," forthcoming, Journal of Empirical Economics. David S. Johnson of the U.S. Bureau of Labor Statistics provided the updated data shown in table 1. 5 David S. Johnson and Timothy M. Smeeding, "Measuring Trends in Inequality and Individuals and Families: Income and Consumption," mimeo., March 1998.	Alan Greenspan	United States	https://www.bis.org/review/r980904c.pdf	Mr. Greenspan remarks on income inequality Remarks by Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at a symposium sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole, Wyoming on 28/8/98. I am pleased once again to open this annual symposium. At the outset, I wish to thank Tom Hoenig and his staff for assembling a highly capable group of experts to inform us and to stimulate discussion on an important issue in the world economy. The study of income inequality - its causes, its consequences, and its potential policy implications - has a long history in economics, although it has not always had a high profile among researchers and policymakers. To borrow a phrase from Professor Atkinson, income distribution in recent years has been "brought in from the cold." In part, that awareness has resulted from the experience of many industrialized economies with widening earnings inequality in the 1980s and 1990s. It has been heightened by interest in the consequences of economic change in developing, newly industrialized, and transition economies. The experience of industrialized countries, including the United States, with growing income inequality has spawned a great deal of research on the functioning of labor markets, on the sources of shifts in the demand for various types of skills, on the supply responses of workers, and on the efficacy of government efforts to intervene in the operation of labor markets. A number of those who have contributed importantly to this work will be participating in this conference. One story that has emerged from that body of research is now familiar: Rising demand for those workers who have the skills to effectively harness new technologies has been outpacing supply, and, thus, the compensation of those workers has been increasing more rapidly than for the lesser skilled segment of the workforce. That this supply-demand gap has been an important source of widening earnings inequality is now widely accepted within the economics profession. However, the considerable diversity of experiences across countries as well as the finding that earnings inequality has also increased within groups of workers with similar measured skills and experience suggest that we may need to look deeper than skill-biased technological change if we are to fully understand widening wage dispersion. In particular, how have private and public institutions influenced inequality over the past two decades? What roles have been played by growing international trade and the evolving ways in which production is organized? Again, the participants in this symposium are well-equipped to speak to these issues, and we should learn much more about the causes of widening inequality during the next two days. In discussing the extent to which large portions of the population are not reaping the benefits of economic growth, I hope that the participants at this conference will not stop with an analysis of trends in earnings - or, for that matter, even trends in income more broadly defined. Ultimately, we are interested in the question of relative standards of living and economic well-being. Thus, we need also to examine trends in the distribution of wealth, which, more fundamentally than earnings or income, represents a measure of the ability of households to consume. And we will even want to consider the distribution of consumption, which likely has the advantage of smoothing through transitory shocks affecting particular individuals or households for just a year or two. Among these more comprehensive measures, data for the United States from the Federal Reserve's Survey of Consumer Finances suggest that inequality in household wealth - that is, in net worth - was somewhat higher in 1989 than at the time of our earlier survey in 1963. Subsequently, the 1992 and 1995 surveys - and here our data are statistically more comparable from survey to survey than they were earlier - showed that wealth inequality remained little changed in terms of the broad measures. Nonetheless, that stability masks considerable churning among the subgroups. One particularly notable change was an apparent rise in the share of wealth held by the wealthiest families at the expense of other wealthy families; most of the change occurred within the top 10 percent of the distribution. Moreover, our research using the survey suggests that conclusions about the distribution of wealth are sensitive - although to a lesser degree than income - to the state of the economy and to institutional arrangements for saving. For instance, among the wealthiest $1 / 2$ percent of households, business assets, which tend to be quite cyclical, are particularly important. At the other end of the distribution, owned principal residences, the values of which are not as sensitive to business cycle conditions, are a typical household's most important asset. Another interesting finding is that if we expand the definition of wealth to include estimates of Social Security and pension wealth, the distribution among U.S. households becomes much more even. This finding suggests that, in addition to factors influencing private wealth accumulation, the evolution of institutional arrangements for saving that has taken place over the last two decades may have played an important role in affecting changes in the distribution of wealth over time. What about the effect of the recent rise in stock and bond market values? The typical view is that the growth in mutual funds and other financial investment avenues has allowed individuals further down in the wealth distribution to take advantage of the strength in equity markets. Certainly, our figures show that households lower in the income distribution are now more likely to own stocks than a decade ago. However, between the 1992 and 1995 surveys, the spread of stock ownership and the rise in prices did not lead to a rise in the share of stock and mutual fund assets owned by the bottom 90 percent of the wealth distribution. Although their dollar holdings rose rapidly, the increases were not as large as those for households at the top of the wealth distribution. If patterns of equity ownership have not changed much since 1995, the steep rise in stock prices over the past several years would suggest a further increase in the concentration of net worth. This influence could be offset, to some extent, by a continued broadening in the ownership of equities, particularly through tax-deferred savings accounts. Moreover, some additional offset may have occurred through rising house prices, an important asset of middle class families. Our 1998 survey, which is now in the field, will yield a clearer reading both on how wealth concentration has changed and on the relative importance of different assets in that change. Despite our best efforts to measure trends in income and wealth, I believe that even those measures - by themselves - cannot yield a complete answer to the question of trends in material or economic well-being. In the United States, we observe a noticeable difference between trends in the dispersion of holdings of claims to goods and services - that is, income and wealth - and trends in the dispersion of actual consumption, the bottom-line determinant of material well-being. Ultimately, we are interested in whether households have the means to meet their needs for goods and for services, including those such as education and medical care, that build and maintain human capital. Using data from the Consumer Expenditure Survey that the U.S. Bureau of Labor Statistics conducts, researchers have found that inequality in consumption, when measured by current outlays, is less than inequality in income. These findings are not surprising. As is well known, consumers tend to maintain their levels of consumption in the face of temporary fluctuations in income. Variations in asset holdings and debt typically act as buffers to changes in income. Thus, consumption patterns tend to look more like patterns in income that have been averaged over several years - a finding that should remind us of the pitfalls of reading too much into any year-to-year change in our measures of economic well-being. The BLS's consumer expenditure data suggest a rise in inequality over the 1980s comparable to that shown by the Census family income figures. However, during the first half of the 1990s, inequality partially receded for consumer expenditures while for income it continued to rise (table 1). The consumption data used in these calculations include only what individuals purchase directly out of their incomes and accumulated savings. Recently, researchers have extended the analysis using a more complete and more theoretically appealing measure of consumption that includes the indirect flow of services from the stock of durable goods that they already own - houses, vehicles, and major appliances. As one might expect, although this measure of consumption has a profile somewhat similar to that seen in the current expenditure data over the 1980s and the first half of the 1990s, it shows still lower levels of inequality overall and a clearer pattern of consumption smoothing during the 1981-83 recession. The information available from the Consumer Expenditure Survey can be used to calculate another interesting measure of the well-being of households: changes in inequality in the ownership of consumer durables. The BLS staff has updated tabulations of these data that they prepared for me several years ago (table 2). Of course, ownership rates for household durables clearly rise with income. But for a number of goods - for example, dishwashers, clothes dryers, microwaves, and motor vehicles - the distribution of ownership rates by income decile has become more equal over time. Even though we may be able to develop an array of measures of current and past trends in inequality - such as those that I have described and potentially others that may be presented at this symposium - we will likely still face considerable uncertainty about how to interpret those measures and about what the future may hold for the trend and the distribution of economic well-being. Wealth has always been created, virtually by definition, when individuals use their growing knowledge, in conjunction with an expanding capital stock, to produce goods and services of value. The process of wealth creation in the United States has evolved in a number of important ways. Over the last century, we have learned how to be more efficient in meeting the needs of consumers, and thus we have moved from producing essentials to the production of more discretionary goods and services. Moreover, these goods and services have been, over time, increasingly less constrained by the limits of physical bulk. More recently, we have found ways to unbundle the particular characteristics of each good and service to maximize its value to each individual. That striving to expand the options for satisfying the particular needs of individuals has resulted in a shift toward value created through the exploitation of ideas and concepts and away from the more straightforward utilization of physical resources and manual labor. The new thrust has led to structural changes in the way that we organize the production and the distribution of goods and services. It has increased the demand for, and the compensation of, workers who have the ability to create, analyze, and transform information and to interact effectively with others. Most important, it has accorded particularly high value to the application of advanced computer and telecommunications technologies to the generation of economic wealth. At the same time, however, the consequences of technological advances and their implications for the creation of wealth have become increasingly unpredictable. We have found that we cannot forecast with any precision which particular technology or synergies of technologies will add significantly to our knowledge and to our ability to gain from that knowledge. Even if future technological change were to occur at a steady rate, variations in our capacity to absorb and apply advances would likely lead to an uneven rate of increase - over time and across individuals - in returns to expanded investment in knowledge: Supplies of appropriately skilled workers can vary. In some cases, the initial choices in the exploitation of advances may turn out to be sub-optimal. In other cases, the full potential of advances may be realized only after extensive improvements or after complementary innovations in other fields of science. As we consider the causes and consequences of inequality, we should also be mindful that, over time, the relationship of economic growth, increases in standards of living, and the distribution of wealth has evolved differently in various political and institutional settings. Thus, generalizations about the past and the future may be hard to make, particularly in the current dynamic and uncertain environment of economic change. We need to ask, for example, whether we should be concerned with the degree of income inequality if all groups are experiencing relatively rapid gains in their real incomes, though those rates of gain may differ. And, we cannot ignore what is happening to the level of average income while looking at trends in the distribution. In this regard, our goal as central bankers should be clear: We must pursue monetary conditions in which stable prices contribute to maximizing sustainable long-run growth. Such disciplined policies will offer the best underpinnings for identifying opportunities to channel growing knowledge, innovation, and capital investment into the creation of wealth that, in turn, will lift living standards as broadly as possible. Moreover, as evidenced by this symposium, sustaining a healthy economy and a stable financial system naturally permits us to take the time to focus efforts on addressing the distributional issues facing our society and on other challenging issues that may remain out in the cold. "GINI COEFFICIENTS" FOR U.S. CONSUMER EXPENDITURES AND INCOME "GINI COEFFICIENTS" FOR OWNERSHIP RATES OF SELECTED CONSUMER DURABLES (By income decile)
1998-09-04T00:00:00	Mr. Greenspan considers whether there has been a profound and fundamental alteration in the way the economy works in the United States (Central Bank Articles and Speeches, 4 Sep 98)	Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Haas Annual Business Faculty Research Dialogue, University of California, Berkeley, California on 4/9/98.	Mr. Greenspan considers whether there has been a profound and Remarks by the fundamental alteration in the way the economy works in the United States Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Haas Annual Business Faculty Research Dialogue, University of California, Berkeley, California on 4/9/98. Question: Is There a New Economy? The question posed for this lecture of whether there is a new economy reaches beyond the obvious: Our economy, of course, is changing everyday, and in that sense it is always "new". The deeper question is whether there has been a profound and fundamental alteration in the way our economy works that creates discontinuity from the past and promises a significantly higher path of growth than we have experienced in recent decades. The question has arisen because the economic performance of the United States in the past five years has in certain respects been unprecedented. Contrary to conventional wisdom and the detailed historic economic modelling on which it is based, it is most unusual for inflation to be falling this far into a business expansion. Many of the imbalances observed during the few times in the past that a business expansion has lasted more than seven years are largely absent today. To be sure, labor markets are unusually tight, and we should remain concerned that pressures in these markets could spill over to costs and prices. But, to date, they have not. Moreover, it is just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress. Developments overseas have contributed to holding down prices and aggregate demand in the United States in the face of strong domestic spending. As dislocations abroad mount, feeding back on our financial markets, restraint is likely to intensify. In the spring and early summer, the Federal Open Market Committee was concerned that a rise in inflation was the primary threat to the continued expansion of the economy. By the time of the Committee's August meeting, the risks had become balanced, and the Committee will need to consider carefully the potential ramifications of ongoing developments since that meeting. Some of those who advocate a "new economy" attribute it generally to technological innovations and breakthroughs in globalization that raise productivity and proffer new capacity on demand and that have, accordingly, removed pricing power from the world's producers on a more lasting basis. There is, clearly, an element of truth in this proposition. In the United States, for example, a technologically driven decline is evident in the average lead times on the purchase of new capital equipment that has kept capacity utilization at moderate levels and virtually eliminated most of the goods shortages and bottlenecks that were prevalent in earlier periods of sustained strong economic growth. But, although there doubtless have been profound changes in the way we organize our capital facilities, engage in just-in-time inventory regimes, and intertwine our newly sophisticated risk-sensitive financial system into this process, there is one important caveat to the notion that we live in a new economy, and that is human psychology. The same enthusiasms and fears that gripped our forebears, are, in every way, visible in the generations now actively participating in the American economy. Human actions are always rooted in a forecast of the consequences of those actions. When the future becomes sufficiently clouded, people eschew actions and disengage from previous commitments. To be sure, the degree of risk aversion differs from person to person, but judging the way prices behave in today's markets compared with those of a century or more ago, one is hard pressed to find significant differences. The way we evaluate assets, and the way changes in those values affect our economy, do not appear to be coming out of a set of rules that is different from the one that governed the actions of our forebears. Hence, as the first cut at the question "Is there a new economy?" the answer in a more profound sense is no. As in the past, our advanced economy is primarily driven by how human psychology moulds the value system that drives a competitive market economy. And that process is inextricably linked to human nature, which appears essentially immutable and, thus, anchors the future to the past. But having said that, important technological changes have been emerging in recent years that are altering, in ways with few precedents, the manner in which we organize production, trade across countries, and deliver value to consumers. To explore the significance of those changes and their relevance to the possibility of a "new economy", we need to first detail some key features of our system. The American economy, like all advanced capitalist economies, is continually in the process of what Joseph Schumpeter, a number of decades ago, called "creative destruction". Capital equipment, production processes, financial and labor market infrastructure, and the whole panoply of private institutions that make up a market economy are always in a state of flux -- in almost all cases evolving into more efficient regimes. The capital stock -- the plant and equipment that facilitates our production of goods and services -- can be viewed, with only a little exaggeration, as continuously being torn down and rebuilt. Our capital stock and the level of skills of our workforce are effectively being upgraded as competition presses business managements to find increasingly innovative and efficient ways to meet the ever-rising demands of consumers for quantity, quality, and variety. Supply and demand have been interacting over the generations in a competitive environment to propel standards of living higher. Indeed, this is the process that, in fits and starts, has characterized our and other market economies since the beginning of the Industrial Revolution. Earlier, standards of living barely changed from one generation to the next. This is the tautological sense in which every evolving market economy, our own included, is always, in some sense, "new", as we struggle to increase standards of living. In the early part of the 19th century, the United States, as a developing country, borrowed much technology and savings from Europe to get a toehold on the growth ladder. But over the past century, America has moved to the cutting edge of technology. There is no question that events are continually altering the shape and nature of our economic processes, especially the extent to which technological breakthroughs have advanced and perhaps, most recently, even accelerated the pace of conceptualization of our gross domestic product. We have dramatically reduced the size of our radios, for example, by substituting transistors for vacuum tubes. Thin fiber-optic cable has replaced huge tonnages of copper wire. New architectural, engineering, and materials technologies have enabled the construction of buildings enclosing the same space but with far less physical material than was required, say, 50 or 100 years ago. Most recently, mobile phones have been markedly downsized as they have been improved. As a consequence, the physical weight of our GDP is growing only very gradually. The exploitation of new concepts accounts for virtually all of the inflation-adjusted growth in output. The cause of this dramatic shift toward product downsizing during the past half century can only be surmised. Perhaps the physical limitations of accumulating goods and moving them in an ever more crowded geographical environment resulted in cost pressures to economize on size and space. Similarly, perhaps it was the prospect of increasing costs of processing ever larger quantities of physical resources that shifted producers toward downsized alternatives. Remember, it was less than three decades ago that the Club of Rome issued its dire warnings about the prospects of running out of the physical resources that allegedly were necessary to support our standards of living. Finally, as we moved the technological frontier forward and pressed for information processing to speed up, for example, the laws of physics required the relevant microchips to become ever more compact. But what was always true in the past, and will remain so in the future, is that the output of a free market economy and the notion of wealth creation will reflect the value preferences of people. Indeed, the very concept of wealth has no meaning other than as a reflection of human value preferences. There is no intrinsic value in wheat, a machine, or a software program. It is only as these products satisfy human needs currently, or are perceived to be able do so in the future, that they are valued. And it is such value preferences, as they express themselves in the market's key signals -- product and asset prices -- that inform producers of what is considered valuable and, together with the state of technology, what could be profitably produced. To get back to basics, the value of any physical production facility depends on the perceived value of the goods and services that the facility is projected to produce. More formally, the current value of the facility can be viewed as the sum of the discounted value of all future outputs, net of costs. An identical physical facility with the same capacity to produce can have different values in the marketplace at different times, depending on the degree to which the investing public feels confident about the ability of the firm to perceive and respond to the future environments in which the plant will be turning out goods and services. The value of a steel mill, which has an unchanging ability to turn out sheet steel, for example, can vary widely in the marketplace depending on the level of interest rates, the overall rate of inflation, and a number of other factors that have nothing to do with the engineering aspects of the production of steel. What matters is how investors view the markets into which the steel from the mill is expected to be sold over the years ahead. When that degree of confidence in judging the future is high, discounted future values also are high -- and so are the prices of equities, which, of course, are the claims on our productive assets. The forces that shape the degree of confidence are largely endogenous to an economic process that is generally self-correcting as consumers and investors interact with a continually changing market reality. I do not claim that all market behavior is a rational response to changes in the real world. But most of it must be. For, were it otherwise, the relatively stable economic environments that have been evident among the major industrial countries over the generations would not be possible. Certainly, the degree of confidence that future outcomes are perceivable and projectable, and hence valued, depends in large part on the underlying political stability of any country with a market-oriented economy. Unless market participants are assured that their future commitments and contracts are protected by a rule of law, such commitments will not be made; productive efforts will be focused to address only the immediate short-term imperatives of survival; and efforts to build an infrastructure to provide for future needs will be stunted. A society that protects claims to long-lived productive assets thereby surely encourages their development. That spurs levels of production to go beyond the needs of the moment, the needs of immediate consumption, because claims on future production values will be discounted far less than in an environment of political instability and, for example, a weak law of contracts. At that point, the makings of a sophisticated economy based on longer-term commitments are in place. It will be an economy that saves and invests -- that is, commits to the future -- and, hence, one that will grow. But every competitive market economy, even one solidly based on a rule of law, is always in a state of flux, and its perceived productiveness is always subject to degrees of uncertainty that are inevitably associated with endeavors to anticipate future outcomes. Thus, while the general state of confidence and consumers' and investors' willingness to commit to long-term investment is buttressed by the perceptions of the stability of the society and economy, history demonstrates that that degree of confidence is subject to wide variations. Most of those variations are the result of the sheer difficulty in making judgments and, therefore, commitments about, and to, the future. On occasion, this very difficulty leads to less-disciplined evaluations, which foster price volatility and, in some cases, what we term market bubbles -- that is, asset values inflated more on the expectation that others will pay higher prices than on a knowledgeable judgment of true value. The behavior of market economies across the globe in recent years, especially in Asia and the United States, has underscored how large a role expectations have come to play in real economic development. Economists use the term "time preference" to identify the broader tradeoff that individuals are willing to make, even without concern for risk, between current consumption and claims to future consumption. Measurable discount factors are intended to capture in addition the various types of uncertainties that inevitably cloud the future. Dramatic changes in the latter underscore how human evaluation, interacting with the more palpable changes in real output, can have profound effects on an economy, as the experiences in Asia have so amply demonstrated during the past year. Vicious cycles have arisen across South-East Asia with virtually no notice. At one point, an economy would appear to be struggling, but no more than had been the case many times in the past. The next moment, market prices and the economy appeared in free fall. Our experiences with these vicious cycles in Asia emphasize the key role in a market economy of a critical human attribute: confidence or trust in the functioning of a market system. Implicitly, we engage in a division of labor because we trust that others will produce and be willing to trade the goods and services we do not produce ourselves. We take for granted that contracts will be fulfilled in the normal course of business, relying on the rule of law, especially the law of contracts. But if trust evaporated and every contract had to be adjudicated, the division of labor would collapse. A key characteristic, perhaps the fundamental cause of a vicious cycle, is the loss of trust. We did not foresee such a breakdown in Asia. I suspect that the very nature of the process may make it virtually impossible to anticipate. It is like water pressing against a dam. Everything appears normal until a crack brings a deluge. The immediate cause of the breakdown was an evident pulling back from future commitments, arguably, the result of the emergence among international lenders of widening doubt that the dramatic growth evident among the Asian "tigers" could be sustained. The emergence of excess worldwide capacity in semiconductors, a valued export for the tigers, may have been among the precipitating events. In any case, the initial rise in market uncertainty led to a sharp rise in discounts on future claims to income and, accordingly, falling prices of real estate and equities. The process became self-feeding as disengagement from future commitments led to still greater disruption and uncertainty, rising risk premiums and discount factors, and a sharp fall in production. While the reverse phenomenon, a virtuous cycle, is not fully symmetrical, some part is. Indeed, much of the current American economic expansion is best understood in the context of favorable expectations, interacting with production and finance to expand rather than implode economic processes. The American economic stability of the past five years has helped engender increasing confidence of future stability. This, in turn, has dramatically upgraded the stock market's valuation of our economy's existing productive infrastructure, adding about $6 trillion of capital gains to household net worth from early 1995 through the second quarter of this year. While the vast majority of these gains augmented retirement and other savings programs, enough spilled over into consumer spending to significantly lower the proportion of household income that consumers, especially upper income consumers, believed it necessary to save. In addition, the longer the elevated level of stock prices was sustained, the more consumers likely viewed their capital gains as permanent increments to their net worth, and, hence, as spendable. The recent windfall financed not only higher personal consumption expenditures but home purchases as well. It is difficult to explain the recent record level of home sales without reference to earlier stock market gains. The rise in stock prices also meant a fall in the equity cost of capital that doubtless raised the pace of new capital investment. Investment in new facilities had already been given a major boost by the acceleration in technological developments, which evidently increased the potential for profit in recent years. The sharp surge in capital outlays during the past five years apparently reflected the availability of higher rates of return on a broad spectrum of potential investments owing to an acceleration in technological advances, especially in computer and telecommunications applications. This is the apparent root of the recent evident quickened pace of productivity advance. While the recent technological advances have patently added new and increasingly flexible capacity, the ability of these technologies to improve the efficiency of productive processes (an issue I will elaborate on shortly) has significantly reduced labor requirements per unit of output. This, no doubt, was one factor contributing to a dramatic increase in corporate downsizing and reported widespread layoffs in the early 1990s. The unemployment rate also began to fall as the pace of new hires to man the new facilities exceeded the pace of layoffs from the old. Parenthetically, the perception of increased churning of our workforce in the 1990s has understandably increased the sense of accelerated job-skill obsolescence among a significant segment of our workforce, especially among those most closely wedded to older technologies. The pressures are reflected in a major increase in on-the-job training and a dramatic expansion of college enrolment, especially at community colleges. As a result, the average age of full-time college students has risen dramatically in recent years as large numbers of experienced workers return to school for skill upgrading. But the sense of increasing skill obsolescence has also led to an apparent willingness on the part of employees to forgo wage and benefit increases for increased job security. Thus, despite the incredible tightness of labor markets, increases in compensation per hour have continued to be relatively modest. Coupled with the quickened pace of productivity growth, wage and benefit moderation has kept growth in unit labor costs subdued in the current expansion. This has both damped inflation and allowed profit margins to reach high levels. That, in turn, apparently was the driving force beginning in early 1995 in security analysts' significant upward revision of their company-by-company long-term earnings projections. These upward revisions, coupled with falling interest rates, point to two key underlying forces that impelled investors to produce one of history's most notable bull stock markets. But they are not the only forces. In addition, the sequence of greater capital investment, productivity growth, and falling inflation fostered an ever more benevolent sense of long-term stable growth. People were more confident about the future. The consequence was a dramatic shrinkage in the so-called equity premium over the past two years to near historic lows earlier this summer. The equity premium is the charge for the additional risks that markets require to hold stocks rather than riskless debt instruments. When perceived risks of the future are low, equity premiums are low and stock prices are even more elevated than would be indicated solely from higher expected long-term earnings growth and low riskless rates of interest. Thus, one key to the question of whether there is a new economy is whether current expectations of future stability, which are distinctly more positive than say a decade ago, are justified by actual changes in the economy. For if expectations of greater stability are borne out, risk and equity premiums will remain low. In that case, the cost of capital will also remain low, leading, at least for a time, to higher investment and faster economic growth. Two considerations are therefore critical to higher asset values and higher economic growth. The first is whether the apparent upward shift in technological advance will persist. The second is the extent of confidence in the stability of the future that consumers and investors will be able to sustain. With regard to the first: How fast can technology advance, augmenting the pool of investment opportunities that have elevated rates of return, which engender still further increases in expected long-term earnings? Technological breakthroughs, as history so amply demonstrates, are frustratingly difficult to discern much in advance. The particular synergies between new and older technologies are generally too complex to anticipate. An innovation's full potential may be realized only after extensive improvements or after complementary innovations in other fields of science. According to Charles Townes, a Nobel Prize winner for his work on the laser, the attorneys for Bell Labs initially, in the late 1960s, refused to patent the laser because they believed it had no applications in the field of telecommunications. Only in the 1980s, after extensive improvements in fiber-optics technology, did the laser's importance for telecommunications become apparent. The future of technology advance may be difficult to predict, but for the period ahead there is the possibility that already proven technologies may not as yet have been fully exploited. Company after company reports that, when confronted with cost increases in a competitive environment that precludes price increases, they are able to offset those costs, seemingly at will, by installing the newer technologies. Such stories seem odd. If cost improvements were available at will earlier, why weren't the investments made earlier? This implies suboptimal business behavior, contrary to what universities teach in Economics 101. But in the real world, companies rarely fully maximize profits. They concentrate on only those segments of their businesses that appear to offer the largest rewards and are rarely able to operate at the most efficient frontier on all fronts simultaneously. When costs rise, the attention of management presumably becomes focused more sharply on investments to limit the effects of rising costs. But if cost-cutting at will is, in fact, currently available, it suggests that a backlog of unexploited capital projects has been built up in recent years, which, if true, implies the potential for continued gains in productivity close to the elevated rates of the last couple of years. Even if this is indeed the case, and only anecdotal evidence supports it, security analysts' recent projected per share earnings growth of more than 13 percent annually over the next three to five years is unlikely to materialize. It would imply an ever-increasing share of profit in the national income from a level that is already high by historic standards. Such conditions have led in the past to labor market pressures that thwarted further profit growth. The second consideration with respect to how high asset values can rise is: How far can risk and equity premiums fall? A key factor is that price inflation has receded to quite low levels. The rising level of confidence in recent years concerning future outcomes has doubtless been related to the fall in the rate of inflation that has, of course, also been a critical factor in the fall in interest rates and, importantly, the fall in equity premiums as well. Presumably, the onset of deflation, should it occur, would increase uncertainty as much as a re-emergence of inflation concerns. Thus, arguably, at near price stability, perceived risk from business-cycle developments would be at its lowest, and one must presume that would be the case for equity premiums as well. In any event, there is a limit on how far investors can rationally favorably discount the future and therefore how low equity premiums can go. Current claims on a source of income available 20 or 30 years in the future still have current value. But should claims on the hereafter? An implication of high equity market values, relative to income and production, is an increased potential for instability. As I argued earlier, part of capital gains increases consumption and incomes. Since equity values are demonstrably more variable than incomes, when equity market values become large relative to incomes and GDP, their fluctuations can be expected to effect GDP more than when equity market values are low. Clearly, the history of large swings in investor confidence and equity premiums for rational and other reasons counsels caution in the current context. We have relearned in recent weeks that just as a bull stock market feels unending and secure as an economy and stock market move forward, so it can feel when markets contract that recovery is inconceivable. Both, of course, are wrong. But because of the difficulty imagining a turnabout when such emotions take hold, periods of euphoria or distress tend to feed on themselves. Indeed, if this were not the case, the types of psychologically driven ebbs and flows of economic activity we have observed would be unlikely to exist. Perhaps, as some argue, history will be less of a guide than it has been in the past. Some of the future is always without historical precedent. New records are always being made. Having said all that, however, my experience of observing the American economy day by day over the past half century suggests that most, perhaps substantially most, of the future can be expected to rest on a continuum from the past. Human nature, as I indicated earlier, appears immutable over the generations and inextricably ties our future to our past. Nonetheless, as I indicated earlier, I would not deny that there doubtless has been in recent years an underlying improvement in the functioning of America's markets and in the pace of development of cutting edge technologies beyond previous expectations. Most impressive is the marked increase in the effectiveness in the 1990s of our capital stock, that is, our productive facilities, the issue to which I alluded earlier. While gross investment has been high, it has been, in recent years, composed to a significant extent of short-lived assets that depreciate rapidly. Thus, the growth of the net capital stock, despite its recent acceleration, remains well below the peak rates posted during the past half century. Despite the broadening in recent decades of international capital flows, empirical evidence suggests that domestic investment still depends to a critical extent on domestic saving, especially at the margin. Many have argued persuasively, myself included, that we save too little. The relatively low propensity to save on the part of the American public has put a large premium on the effective use of scarce capital, and on the winnowing out of the potentially least productive and, hence, the least profitable of investment opportunities. That is one of the reasons that our financial system, whose job it is to ensure the productive use of physical capital, has been such a crucial part of our overall economy, especially over the past two decades. It is the signals reflected in financial asset prices, interest rates, and risk spreads that have altered the structure of our output in recent decades towards a different view of what consumers judge as value. This has imparted a significant derived value to a financial system that can do that effectively and, despite recent retrenchments, to the stock market value of those individual institutions that make up that system. Clearly, our high financial returns on investment are a symptom that our physical capital is being allocated to produce products and services that consumers particularly value. A machining facility that turns out an inferior product or a toll road that leads to nowhere will not find favor with the public, will earn subnormal or negative profits, and in most instances will exhibit an inability over the life of the asset to recover the cash plus cost of capital invested in it. Thus, while adequate national saving is a necessary condition for capital investment and rising productivity and standards of living, it is by no means a sufficient condition. The former Soviet Union, for example, had too much investment, and without the discipline of market prices, they grossly misplaced it. The preferences of central planners wasted valuable resources by mandating investment in sectors of the economy where the output wasn't wanted by consumers -- particularly in heavy manufacturing industries. It is thus no surprise that the Soviet Union's capital/output ratios were higher than those of contemporaneous free market economies of the West. This phenomenon of overinvestment is observable even among more sophisticated free market economies. In Japan, the saving rate and gross investment have been far higher than ours, but their per capita growth potential appears to be falling relative to ours. It is arguable that their hobbled financial system is, at least in part, a contributor to their economy's subnormal performance. We should not become complacent, however. To be sure, the sharp increases in the stock market have boosted household net worth. But while capital gains increase the value of existing assets, they do not directly create the resources needed for investment in new physical facilities. Only saving out of income can do that. In summary, whether over the past five to seven years, what has been, without question, one of the best economic performances in our history is a harbinger of a new economy or just a hyped-up version of the old, will be answered only with the inexorable passage of time. And I suspect our grandchildren, and theirs, will be periodically debating whether they are in a new economy.	---[PAGE_BREAK]--- Mr. Greenspan considers whether there has been a profound and fundamental alteration in the way the economy works in the United States Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Haas Annual Business Faculty Research Dialogue, University of California, Berkeley, California on 4/9/98. # Question: Is There a New Economy? The question posed for this lecture of whether there is a new economy reaches beyond the obvious: Our economy, of course, is changing everyday, and in that sense it is always "new". The deeper question is whether there has been a profound and fundamental alteration in the way our economy works that creates discontinuity from the past and promises a significantly higher path of growth than we have experienced in recent decades. The question has arisen because the economic performance of the United States in the past five years has in certain respects been unprecedented. Contrary to conventional wisdom and the detailed historic economic modelling on which it is based, it is most unusual for inflation to be falling this far into a business expansion. Many of the imbalances observed during the few times in the past that a business expansion has lasted more than seven years are largely absent today. To be sure, labor markets are unusually tight, and we should remain concerned that pressures in these markets could spill over to costs and prices. But, to date, they have not. Moreover, it is just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress. Developments overseas have contributed to holding down prices and aggregate demand in the United States in the face of strong domestic spending. As dislocations abroad mount, feeding back on our financial markets, restraint is likely to intensify. In the spring and early summer, the Federal Open Market Committee was concerned that a rise in inflation was the primary threat to the continued expansion of the economy. By the time of the Committee's August meeting, the risks had become balanced, and the Committee will need to consider carefully the potential ramifications of ongoing developments since that meeting. Some of those who advocate a "new economy" attribute it generally to technological innovations and breakthroughs in globalization that raise productivity and proffer new capacity on demand and that have, accordingly, removed pricing power from the world's producers on a more lasting basis. There is, clearly, an element of truth in this proposition. In the United States, for example, a technologically driven decline is evident in the average lead times on the purchase of new capital equipment that has kept capacity utilization at moderate levels and virtually eliminated most of the goods shortages and bottlenecks that were prevalent in earlier periods of sustained strong economic growth. But, although there doubtless have been profound changes in the way we organize our capital facilities, engage in just-in-time inventory regimes, and intertwine our newly sophisticated risk-sensitive financial system into this process, there is one important caveat to the notion that we live in a new economy, and that is human psychology. ---[PAGE_BREAK]--- The same enthusiasms and fears that gripped our forebears, are, in every way, visible in the generations now actively participating in the American economy. Human actions are always rooted in a forecast of the consequences of those actions. When the future becomes sufficiently clouded, people eschew actions and disengage from previous commitments. To be sure, the degree of risk aversion differs from person to person, but judging the way prices behave in today's markets compared with those of a century or more ago, one is hard pressed to find significant differences. The way we evaluate assets, and the way changes in those values affect our economy, do not appear to be coming out of a set of rules that is different from the one that governed the actions of our forebears. Hence, as the first cut at the question "Is there a new economy?" the answer in a more profound sense is no. As in the past, our advanced economy is primarily driven by how human psychology moulds the value system that drives a competitive market economy. And that process is inextricably linked to human nature, which appears essentially immutable and, thus, anchors the future to the past. But having said that, important technological changes have been emerging in recent years that are altering, in ways with few precedents, the manner in which we organize production, trade across countries, and deliver value to consumers. To explore the significance of those changes and their relevance to the possibility of a "new economy", we need to first detail some key features of our system. The American economy, like all advanced capitalist economies, is continually in the process of what Joseph Schumpeter, a number of decades ago, called "creative destruction". Capital equipment, production processes, financial and labor market infrastructure, and the whole panoply of private institutions that make up a market economy are always in a state of flux -- in almost all cases evolving into more efficient regimes. The capital stock -- the plant and equipment that facilitates our production of goods and services -- can be viewed, with only a little exaggeration, as continuously being torn down and rebuilt. Our capital stock and the level of skills of our workforce are effectively being upgraded as competition presses business managements to find increasingly innovative and efficient ways to meet the ever-rising demands of consumers for quantity, quality, and variety. Supply and demand have been interacting over the generations in a competitive environment to propel standards of living higher. Indeed, this is the process that, in fits and starts, has characterized our and other market economies since the beginning of the Industrial Revolution. Earlier, standards of living barely changed from one generation to the next. This is the tautological sense in which every evolving market economy, our own included, is always, in some sense, "new", as we struggle to increase standards of living. In the early part of the 19th century, the United States, as a developing country, borrowed much technology and savings from Europe to get a toehold on the growth ladder. But over the past century, America has moved to the cutting edge of technology. There is no question that events are continually altering the shape and nature of our economic processes, especially the extent to which technological breakthroughs have ---[PAGE_BREAK]--- advanced and perhaps, most recently, even accelerated the pace of conceptualization of our gross domestic product. We have dramatically reduced the size of our radios, for example, by substituting transistors for vacuum tubes. Thin fiber-optic cable has replaced huge tonnages of copper wire. New architectural, engineering, and materials technologies have enabled the construction of buildings enclosing the same space but with far less physical material than was required, say, 50 or 100 years ago. Most recently, mobile phones have been markedly downsized as they have been improved. As a consequence, the physical weight of our GDP is growing only very gradually. The exploitation of new concepts accounts for virtually all of the inflation-adjusted growth in output. The cause of this dramatic shift toward product downsizing during the past half century can only be surmised. Perhaps the physical limitations of accumulating goods and moving them in an ever more crowded geographical environment resulted in cost pressures to economize on size and space. Similarly, perhaps it was the prospect of increasing costs of processing ever larger quantities of physical resources that shifted producers toward downsized alternatives. Remember, it was less than three decades ago that the Club of Rome issued its dire warnings about the prospects of running out of the physical resources that allegedly were necessary to support our standards of living. Finally, as we moved the technological frontier forward and pressed for information processing to speed up, for example, the laws of physics required the relevant microchips to become ever more compact. But what was always true in the past, and will remain so in the future, is that the output of a free market economy and the notion of wealth creation will reflect the value preferences of people. Indeed, the very concept of wealth has no meaning other than as a reflection of human value preferences. There is no intrinsic value in wheat, a machine, or a software program. It is only as these products satisfy human needs currently, or are perceived to be able do so in the future, that they are valued. And it is such value preferences, as they express themselves in the market's key signals -- product and asset prices -- that inform producers of what is considered valuable and, together with the state of technology, what could be profitably produced. To get back to basics, the value of any physical production facility depends on the perceived value of the goods and services that the facility is projected to produce. More formally, the current value of the facility can be viewed as the sum of the discounted value of all future outputs, net of costs. An identical physical facility with the same capacity to produce can have different values in the marketplace at different times, depending on the degree to which the investing public feels confident about the ability of the firm to perceive and respond to the future environments in which the plant will be turning out goods and services. The value of a steel mill, which has an unchanging ability to turn out sheet steel, for example, can vary widely in the marketplace depending on the level of interest rates, the overall rate of inflation, and a number of other factors that have nothing to do with the engineering aspects of the production of steel. What matters is how investors view the markets into which the steel from the mill is expected to be sold over the years ahead. When that degree of confidence in judging the future is high, discounted future values also are high -- and so are the prices of equities, which, of course, are the claims on our productive assets. The forces that shape the degree of confidence are largely endogenous to an economic process that is generally self-correcting as consumers and investors interact with a continually changing market reality. I do not claim that all market behavior is a rational response ---[PAGE_BREAK]--- to changes in the real world. But most of it must be. For, were it otherwise, the relatively stable economic environments that have been evident among the major industrial countries over the generations would not be possible. Certainly, the degree of confidence that future outcomes are perceivable and projectable, and hence valued, depends in large part on the underlying political stability of any country with a market-oriented economy. Unless market participants are assured that their future commitments and contracts are protected by a rule of law, such commitments will not be made; productive efforts will be focused to address only the immediate short-term imperatives of survival; and efforts to build an infrastructure to provide for future needs will be stunted. A society that protects claims to long-lived productive assets thereby surely encourages their development. That spurs levels of production to go beyond the needs of the moment, the needs of immediate consumption, because claims on future production values will be discounted far less than in an environment of political instability and, for example, a weak law of contracts. At that point, the makings of a sophisticated economy based on longer-term commitments are in place. It will be an economy that saves and invests -- that is, commits to the future -- and, hence, one that will grow. But every competitive market economy, even one solidly based on a rule of law, is always in a state of flux, and its perceived productiveness is always subject to degrees of uncertainty that are inevitably associated with endeavors to anticipate future outcomes. Thus, while the general state of confidence and consumers' and investors' willingness to commit to long-term investment is buttressed by the perceptions of the stability of the society and economy, history demonstrates that that degree of confidence is subject to wide variations. Most of those variations are the result of the sheer difficulty in making judgments and, therefore, commitments about, and to, the future. On occasion, this very difficulty leads to less-disciplined evaluations, which foster price volatility and, in some cases, what we term market bubbles -- that is, asset values inflated more on the expectation that others will pay higher prices than on a knowledgeable judgment of true value. The behavior of market economies across the globe in recent years, especially in Asia and the United States, has underscored how large a role expectations have come to play in real economic development. Economists use the term "time preference" to identify the broader tradeoff that individuals are willing to make, even without concern for risk, between current consumption and claims to future consumption. Measurable discount factors are intended to capture in addition the various types of uncertainties that inevitably cloud the future. Dramatic changes in the latter underscore how human evaluation, interacting with the more palpable changes in real output, can have profound effects on an economy, as the experiences in Asia have so amply demonstrated during the past year. Vicious cycles have arisen across South-East Asia with virtually no notice. At one point, an economy would appear to be struggling, but no more than had been the case many times in the past. The next moment, market prices and the economy appeared in free fall. Our experiences with these vicious cycles in Asia emphasize the key role in a market economy of a critical human attribute: confidence or trust in the functioning of a market system. Implicitly, we engage in a division of labor because we trust that others will produce and be willing to trade the goods and services we do not produce ourselves. ---[PAGE_BREAK]--- We take for granted that contracts will be fulfilled in the normal course of business, relying on the rule of law, especially the law of contracts. But if trust evaporated and every contract had to be adjudicated, the division of labor would collapse. A key characteristic, perhaps the fundamental cause of a vicious cycle, is the loss of trust. We did not foresee such a breakdown in Asia. I suspect that the very nature of the process may make it virtually impossible to anticipate. It is like water pressing against a dam. Everything appears normal until a crack brings a deluge. The immediate cause of the breakdown was an evident pulling back from future commitments, arguably, the result of the emergence among international lenders of widening doubt that the dramatic growth evident among the Asian "tigers" could be sustained. The emergence of excess worldwide capacity in semiconductors, a valued export for the tigers, may have been among the precipitating events. In any case, the initial rise in market uncertainty led to a sharp rise in discounts on future claims to income and, accordingly, falling prices of real estate and equities. The process became self-feeding as disengagement from future commitments led to still greater disruption and uncertainty, rising risk premiums and discount factors, and a sharp fall in production. While the reverse phenomenon, a virtuous cycle, is not fully symmetrical, some part is. Indeed, much of the current American economic expansion is best understood in the context of favorable expectations, interacting with production and finance to expand rather than implode economic processes. The American economic stability of the past five years has helped engender increasing confidence of future stability. This, in turn, has dramatically upgraded the stock market's valuation of our economy's existing productive infrastructure, adding about $\$ 6$ trillion of capital gains to household net worth from early 1995 through the second quarter of this year. While the vast majority of these gains augmented retirement and other savings programs, enough spilled over into consumer spending to significantly lower the proportion of household income that consumers, especially upper income consumers, believed it necessary to save. In addition, the longer the elevated level of stock prices was sustained, the more consumers likely viewed their capital gains as permanent increments to their net worth, and, hence, as spendable. The recent windfall financed not only higher personal consumption expenditures but home purchases as well. It is difficult to explain the recent record level of home sales without reference to earlier stock market gains. The rise in stock prices also meant a fall in the equity cost of capital that doubtless raised the pace of new capital investment. Investment in new facilities had already been given a major boost by the acceleration in technological developments, which evidently increased the potential for profit in recent years. The sharp surge in capital outlays during the past five years apparently reflected the availability of higher rates of return on a broad spectrum of potential investments owing to an acceleration in technological advances, especially in computer and telecommunications applications. ---[PAGE_BREAK]--- This is the apparent root of the recent evident quickened pace of productivity advance. While the recent technological advances have patently added new and increasingly flexible capacity, the ability of these technologies to improve the efficiency of productive processes (an issue I will elaborate on shortly) has significantly reduced labor requirements per unit of output. This, no doubt, was one factor contributing to a dramatic increase in corporate downsizing and reported widespread layoffs in the early 1990s. The unemployment rate also began to fall as the pace of new hires to man the new facilities exceeded the pace of layoffs from the old. Parenthetically, the perception of increased churning of our workforce in the 1990s has understandably increased the sense of accelerated job-skill obsolescence among a significant segment of our workforce, especially among those most closely wedded to older technologies. The pressures are reflected in a major increase in on-the-job training and a dramatic expansion of college enrolment, especially at community colleges. As a result, the average age of full-time college students has risen dramatically in recent years as large numbers of experienced workers return to school for skill upgrading. But the sense of increasing skill obsolescence has also led to an apparent willingness on the part of employees to forgo wage and benefit increases for increased job security. Thus, despite the incredible tightness of labor markets, increases in compensation per hour have continued to be relatively modest. Coupled with the quickened pace of productivity growth, wage and benefit moderation has kept growth in unit labor costs subdued in the current expansion. This has both damped inflation and allowed profit margins to reach high levels. That, in turn, apparently was the driving force beginning in early 1995 in security analysts' significant upward revision of their company-by-company long-term earnings projections. These upward revisions, coupled with falling interest rates, point to two key underlying forces that impelled investors to produce one of history's most notable bull stock markets. But they are not the only forces. In addition, the sequence of greater capital investment, productivity growth, and falling inflation fostered an ever more benevolent sense of long-term stable growth. People were more confident about the future. The consequence was a dramatic shrinkage in the so-called equity premium over the past two years to near historic lows earlier this summer. The equity premium is the charge for the additional risks that markets require to hold stocks rather than riskless debt instruments. When perceived risks of the future are low, equity premiums are low and stock prices are even more elevated than would be indicated solely from higher expected long-term earnings growth and low riskless rates of interest. Thus, one key to the question of whether there is a new economy is whether current expectations of future stability, which are distinctly more positive than say a decade ago, are justified by actual changes in the economy. For if expectations of greater stability are borne out, risk and equity premiums will remain low. In that case, the cost of capital will also remain low, leading, at least for a time, to higher investment and faster economic growth. Two considerations are therefore critical to higher asset values and higher economic growth. The first is whether the apparent upward shift in technological advance will persist. The second is the extent of confidence in the stability of the future that consumers and investors will be able to sustain. ---[PAGE_BREAK]--- With regard to the first: How fast can technology advance, augmenting the pool of investment opportunities that have elevated rates of return, which engender still further increases in expected long-term earnings? Technological breakthroughs, as history so amply demonstrates, are frustratingly difficult to discern much in advance. The particular synergies between new and older technologies are generally too complex to anticipate. An innovation's full potential may be realized only after extensive improvements or after complementary innovations in other fields of science. According to Charles Townes, a Nobel Prize winner for his work on the laser, the attorneys for Bell Labs initially, in the late 1960s, refused to patent the laser because they believed it had no applications in the field of telecommunications. Only in the 1980s, after extensive improvements in fiber-optics technology, did the laser's importance for telecommunications become apparent. The future of technology advance may be difficult to predict, but for the period ahead there is the possibility that already proven technologies may not as yet have been fully exploited. Company after company reports that, when confronted with cost increases in a competitive environment that precludes price increases, they are able to offset those costs, seemingly at will, by installing the newer technologies. Such stories seem odd. If cost improvements were available at will earlier, why weren't the investments made earlier? This implies suboptimal business behavior, contrary to what universities teach in Economics 101. But in the real world, companies rarely fully maximize profits. They concentrate on only those segments of their businesses that appear to offer the largest rewards and are rarely able to operate at the most efficient frontier on all fronts simultaneously. When costs rise, the attention of management presumably becomes focused more sharply on investments to limit the effects of rising costs. But if cost-cutting at will is, in fact, currently available, it suggests that a backlog of unexploited capital projects has been built up in recent years, which, if true, implies the potential for continued gains in productivity close to the elevated rates of the last couple of years. Even if this is indeed the case, and only anecdotal evidence supports it, security analysts' recent projected per share earnings growth of more than 13 percent annually over the next three to five years is unlikely to materialize. It would imply an ever-increasing share of profit in the national income from a level that is already high by historic standards. Such conditions have led in the past to labor market pressures that thwarted further profit growth. The second consideration with respect to how high asset values can rise is: How far can risk and equity premiums fall? A key factor is that price inflation has receded to quite low levels. The rising level of confidence in recent years concerning future outcomes has doubtless been related to the fall in the rate of inflation that has, of course, also been a critical factor in the fall in interest rates and, importantly, the fall in equity premiums as well. Presumably, the onset of deflation, should it occur, would increase uncertainty as much as a re-emergence of inflation concerns. Thus, arguably, at near price stability, perceived risk from business-cycle developments would be at its lowest, and one must presume that would be the case for equity premiums as well. In any event, there is a limit on how far investors can rationally favorably discount the future and therefore how low equity premiums can go. Current claims on a source of income available 20 or 30 years in the future still have current value. But should claims on the hereafter? ---[PAGE_BREAK]--- An implication of high equity market values, relative to income and production, is an increased potential for instability. As I argued earlier, part of capital gains increases consumption and incomes. Since equity values are demonstrably more variable than incomes, when equity market values become large relative to incomes and GDP, their fluctuations can be expected to effect GDP more than when equity market values are low. Clearly, the history of large swings in investor confidence and equity premiums for rational and other reasons counsels caution in the current context. We have relearned in recent weeks that just as a bull stock market feels unending and secure as an economy and stock market move forward, so it can feel when markets contract that recovery is inconceivable. Both, of course, are wrong. But because of the difficulty imagining a turnabout when such emotions take hold, periods of euphoria or distress tend to feed on themselves. Indeed, if this were not the case, the types of psychologically driven ebbs and flows of economic activity we have observed would be unlikely to exist. Perhaps, as some argue, history will be less of a guide than it has been in the past. Some of the future is always without historical precedent. New records are always being made. Having said all that, however, my experience of observing the American economy day by day over the past half century suggests that most, perhaps substantially most, of the future can be expected to rest on a continuum from the past. Human nature, as I indicated earlier, appears immutable over the generations and inextricably ties our future to our past. Nonetheless, as I indicated earlier, I would not deny that there doubtless has been in recent years an underlying improvement in the functioning of America's markets and in the pace of development of cutting edge technologies beyond previous expectations. Most impressive is the marked increase in the effectiveness in the 1990s of our capital stock, that is, our productive facilities, the issue to which I alluded earlier. While gross investment has been high, it has been, in recent years, composed to a significant extent of short-lived assets that depreciate rapidly. Thus, the growth of the net capital stock, despite its recent acceleration, remains well below the peak rates posted during the past half century. Despite the broadening in recent decades of international capital flows, empirical evidence suggests that domestic investment still depends to a critical extent on domestic saving, especially at the margin. Many have argued persuasively, myself included, that we save too little. The relatively low propensity to save on the part of the American public has put a large premium on the effective use of scarce capital, and on the winnowing out of the potentially least productive and, hence, the least profitable of investment opportunities. That is one of the reasons that our financial system, whose job it is to ensure the productive use of physical capital, has been such a crucial part of our overall economy, especially over the past two decades. It is the signals reflected in financial asset prices, interest rates, and risk spreads that have altered the structure of our output in recent decades towards a different view of what consumers judge as value. This has imparted a significant derived value to a financial system that can do that effectively and, despite recent retrenchments, to the stock market value of those individual institutions that make up that system. Clearly, our high financial returns on investment are a symptom that our physical capital is being allocated to produce products and services that consumers particularly value. A machining facility that turns out an inferior product or a toll road that leads to nowhere will not ---[PAGE_BREAK]--- find favor with the public, will earn subnormal or negative profits, and in most instances will exhibit an inability over the life of the asset to recover the cash plus cost of capital invested in it. Thus, while adequate national saving is a necessary condition for capital investment and rising productivity and standards of living, it is by no means a sufficient condition. The former Soviet Union, for example, had too much investment, and without the discipline of market prices, they grossly misplaced it. The preferences of central planners wasted valuable resources by mandating investment in sectors of the economy where the output wasn't wanted by consumers -- particularly in heavy manufacturing industries. It is thus no surprise that the Soviet Union's capital/output ratios were higher than those of contemporaneous free market economies of the West. This phenomenon of overinvestment is observable even among more sophisticated free market economies. In Japan, the saving rate and gross investment have been far higher than ours, but their per capita growth potential appears to be falling relative to ours. It is arguable that their hobbled financial system is, at least in part, a contributor to their economy's subnormal performance. We should not become complacent, however. To be sure, the sharp increases in the stock market have boosted household net worth. But while capital gains increase the value of existing assets, they do not directly create the resources needed for investment in new physical facilities. Only saving out of income can do that. In summary, whether over the past five to seven years, what has been, without question, one of the best economic performances in our history is a harbinger of a new economy or just a hyped-up version of the old, will be answered only with the inexorable passage of time. And I suspect our grandchildren, and theirs, will be periodically debating whether they are in a new economy.	Alan Greenspan	United States	https://www.bis.org/review/r980911c.pdf	Mr. Greenspan considers whether there has been a profound and fundamental alteration in the way the economy works in the United States Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, at the Haas Annual Business Faculty Research Dialogue, University of California, Berkeley, California on 4/9/98. The question posed for this lecture of whether there is a new economy reaches beyond the obvious: Our economy, of course, is changing everyday, and in that sense it is always "new". The deeper question is whether there has been a profound and fundamental alteration in the way our economy works that creates discontinuity from the past and promises a significantly higher path of growth than we have experienced in recent decades. The question has arisen because the economic performance of the United States in the past five years has in certain respects been unprecedented. Contrary to conventional wisdom and the detailed historic economic modelling on which it is based, it is most unusual for inflation to be falling this far into a business expansion. Many of the imbalances observed during the few times in the past that a business expansion has lasted more than seven years are largely absent today. To be sure, labor markets are unusually tight, and we should remain concerned that pressures in these markets could spill over to costs and prices. But, to date, they have not. Moreover, it is just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress. Developments overseas have contributed to holding down prices and aggregate demand in the United States in the face of strong domestic spending. As dislocations abroad mount, feeding back on our financial markets, restraint is likely to intensify. In the spring and early summer, the Federal Open Market Committee was concerned that a rise in inflation was the primary threat to the continued expansion of the economy. By the time of the Committee's August meeting, the risks had become balanced, and the Committee will need to consider carefully the potential ramifications of ongoing developments since that meeting. Some of those who advocate a "new economy" attribute it generally to technological innovations and breakthroughs in globalization that raise productivity and proffer new capacity on demand and that have, accordingly, removed pricing power from the world's producers on a more lasting basis. There is, clearly, an element of truth in this proposition. In the United States, for example, a technologically driven decline is evident in the average lead times on the purchase of new capital equipment that has kept capacity utilization at moderate levels and virtually eliminated most of the goods shortages and bottlenecks that were prevalent in earlier periods of sustained strong economic growth. But, although there doubtless have been profound changes in the way we organize our capital facilities, engage in just-in-time inventory regimes, and intertwine our newly sophisticated risk-sensitive financial system into this process, there is one important caveat to the notion that we live in a new economy, and that is human psychology. The same enthusiasms and fears that gripped our forebears, are, in every way, visible in the generations now actively participating in the American economy. Human actions are always rooted in a forecast of the consequences of those actions. When the future becomes sufficiently clouded, people eschew actions and disengage from previous commitments. To be sure, the degree of risk aversion differs from person to person, but judging the way prices behave in today's markets compared with those of a century or more ago, one is hard pressed to find significant differences. The way we evaluate assets, and the way changes in those values affect our economy, do not appear to be coming out of a set of rules that is different from the one that governed the actions of our forebears. Hence, as the first cut at the question "Is there a new economy?" the answer in a more profound sense is no. As in the past, our advanced economy is primarily driven by how human psychology moulds the value system that drives a competitive market economy. And that process is inextricably linked to human nature, which appears essentially immutable and, thus, anchors the future to the past. But having said that, important technological changes have been emerging in recent years that are altering, in ways with few precedents, the manner in which we organize production, trade across countries, and deliver value to consumers. To explore the significance of those changes and their relevance to the possibility of a "new economy", we need to first detail some key features of our system. The American economy, like all advanced capitalist economies, is continually in the process of what Joseph Schumpeter, a number of decades ago, called "creative destruction". Capital equipment, production processes, financial and labor market infrastructure, and the whole panoply of private institutions that make up a market economy are always in a state of flux -- in almost all cases evolving into more efficient regimes. The capital stock -- the plant and equipment that facilitates our production of goods and services -- can be viewed, with only a little exaggeration, as continuously being torn down and rebuilt. Our capital stock and the level of skills of our workforce are effectively being upgraded as competition presses business managements to find increasingly innovative and efficient ways to meet the ever-rising demands of consumers for quantity, quality, and variety. Supply and demand have been interacting over the generations in a competitive environment to propel standards of living higher. Indeed, this is the process that, in fits and starts, has characterized our and other market economies since the beginning of the Industrial Revolution. Earlier, standards of living barely changed from one generation to the next. This is the tautological sense in which every evolving market economy, our own included, is always, in some sense, "new", as we struggle to increase standards of living. In the early part of the 19th century, the United States, as a developing country, borrowed much technology and savings from Europe to get a toehold on the growth ladder. But over the past century, America has moved to the cutting edge of technology. There is no question that events are continually altering the shape and nature of our economic processes, especially the extent to which technological breakthroughs have advanced and perhaps, most recently, even accelerated the pace of conceptualization of our gross domestic product. We have dramatically reduced the size of our radios, for example, by substituting transistors for vacuum tubes. Thin fiber-optic cable has replaced huge tonnages of copper wire. New architectural, engineering, and materials technologies have enabled the construction of buildings enclosing the same space but with far less physical material than was required, say, 50 or 100 years ago. Most recently, mobile phones have been markedly downsized as they have been improved. As a consequence, the physical weight of our GDP is growing only very gradually. The exploitation of new concepts accounts for virtually all of the inflation-adjusted growth in output. The cause of this dramatic shift toward product downsizing during the past half century can only be surmised. Perhaps the physical limitations of accumulating goods and moving them in an ever more crowded geographical environment resulted in cost pressures to economize on size and space. Similarly, perhaps it was the prospect of increasing costs of processing ever larger quantities of physical resources that shifted producers toward downsized alternatives. Remember, it was less than three decades ago that the Club of Rome issued its dire warnings about the prospects of running out of the physical resources that allegedly were necessary to support our standards of living. Finally, as we moved the technological frontier forward and pressed for information processing to speed up, for example, the laws of physics required the relevant microchips to become ever more compact. But what was always true in the past, and will remain so in the future, is that the output of a free market economy and the notion of wealth creation will reflect the value preferences of people. Indeed, the very concept of wealth has no meaning other than as a reflection of human value preferences. There is no intrinsic value in wheat, a machine, or a software program. It is only as these products satisfy human needs currently, or are perceived to be able do so in the future, that they are valued. And it is such value preferences, as they express themselves in the market's key signals -- product and asset prices -- that inform producers of what is considered valuable and, together with the state of technology, what could be profitably produced. To get back to basics, the value of any physical production facility depends on the perceived value of the goods and services that the facility is projected to produce. More formally, the current value of the facility can be viewed as the sum of the discounted value of all future outputs, net of costs. An identical physical facility with the same capacity to produce can have different values in the marketplace at different times, depending on the degree to which the investing public feels confident about the ability of the firm to perceive and respond to the future environments in which the plant will be turning out goods and services. The value of a steel mill, which has an unchanging ability to turn out sheet steel, for example, can vary widely in the marketplace depending on the level of interest rates, the overall rate of inflation, and a number of other factors that have nothing to do with the engineering aspects of the production of steel. What matters is how investors view the markets into which the steel from the mill is expected to be sold over the years ahead. When that degree of confidence in judging the future is high, discounted future values also are high -- and so are the prices of equities, which, of course, are the claims on our productive assets. The forces that shape the degree of confidence are largely endogenous to an economic process that is generally self-correcting as consumers and investors interact with a continually changing market reality. I do not claim that all market behavior is a rational response to changes in the real world. But most of it must be. For, were it otherwise, the relatively stable economic environments that have been evident among the major industrial countries over the generations would not be possible. Certainly, the degree of confidence that future outcomes are perceivable and projectable, and hence valued, depends in large part on the underlying political stability of any country with a market-oriented economy. Unless market participants are assured that their future commitments and contracts are protected by a rule of law, such commitments will not be made; productive efforts will be focused to address only the immediate short-term imperatives of survival; and efforts to build an infrastructure to provide for future needs will be stunted. A society that protects claims to long-lived productive assets thereby surely encourages their development. That spurs levels of production to go beyond the needs of the moment, the needs of immediate consumption, because claims on future production values will be discounted far less than in an environment of political instability and, for example, a weak law of contracts. At that point, the makings of a sophisticated economy based on longer-term commitments are in place. It will be an economy that saves and invests -- that is, commits to the future -- and, hence, one that will grow. But every competitive market economy, even one solidly based on a rule of law, is always in a state of flux, and its perceived productiveness is always subject to degrees of uncertainty that are inevitably associated with endeavors to anticipate future outcomes. Thus, while the general state of confidence and consumers' and investors' willingness to commit to long-term investment is buttressed by the perceptions of the stability of the society and economy, history demonstrates that that degree of confidence is subject to wide variations. Most of those variations are the result of the sheer difficulty in making judgments and, therefore, commitments about, and to, the future. On occasion, this very difficulty leads to less-disciplined evaluations, which foster price volatility and, in some cases, what we term market bubbles -- that is, asset values inflated more on the expectation that others will pay higher prices than on a knowledgeable judgment of true value. The behavior of market economies across the globe in recent years, especially in Asia and the United States, has underscored how large a role expectations have come to play in real economic development. Economists use the term "time preference" to identify the broader tradeoff that individuals are willing to make, even without concern for risk, between current consumption and claims to future consumption. Measurable discount factors are intended to capture in addition the various types of uncertainties that inevitably cloud the future. Dramatic changes in the latter underscore how human evaluation, interacting with the more palpable changes in real output, can have profound effects on an economy, as the experiences in Asia have so amply demonstrated during the past year. Vicious cycles have arisen across South-East Asia with virtually no notice. At one point, an economy would appear to be struggling, but no more than had been the case many times in the past. The next moment, market prices and the economy appeared in free fall. Our experiences with these vicious cycles in Asia emphasize the key role in a market economy of a critical human attribute: confidence or trust in the functioning of a market system. Implicitly, we engage in a division of labor because we trust that others will produce and be willing to trade the goods and services we do not produce ourselves. We take for granted that contracts will be fulfilled in the normal course of business, relying on the rule of law, especially the law of contracts. But if trust evaporated and every contract had to be adjudicated, the division of labor would collapse. A key characteristic, perhaps the fundamental cause of a vicious cycle, is the loss of trust. We did not foresee such a breakdown in Asia. I suspect that the very nature of the process may make it virtually impossible to anticipate. It is like water pressing against a dam. Everything appears normal until a crack brings a deluge. The immediate cause of the breakdown was an evident pulling back from future commitments, arguably, the result of the emergence among international lenders of widening doubt that the dramatic growth evident among the Asian "tigers" could be sustained. The emergence of excess worldwide capacity in semiconductors, a valued export for the tigers, may have been among the precipitating events. In any case, the initial rise in market uncertainty led to a sharp rise in discounts on future claims to income and, accordingly, falling prices of real estate and equities. The process became self-feeding as disengagement from future commitments led to still greater disruption and uncertainty, rising risk premiums and discount factors, and a sharp fall in production. While the reverse phenomenon, a virtuous cycle, is not fully symmetrical, some part is. Indeed, much of the current American economic expansion is best understood in the context of favorable expectations, interacting with production and finance to expand rather than implode economic processes. The American economic stability of the past five years has helped engender increasing confidence of future stability. This, in turn, has dramatically upgraded the stock market's valuation of our economy's existing productive infrastructure, adding about $\$ 6$ trillion of capital gains to household net worth from early 1995 through the second quarter of this year. While the vast majority of these gains augmented retirement and other savings programs, enough spilled over into consumer spending to significantly lower the proportion of household income that consumers, especially upper income consumers, believed it necessary to save. In addition, the longer the elevated level of stock prices was sustained, the more consumers likely viewed their capital gains as permanent increments to their net worth, and, hence, as spendable. The recent windfall financed not only higher personal consumption expenditures but home purchases as well. It is difficult to explain the recent record level of home sales without reference to earlier stock market gains. The rise in stock prices also meant a fall in the equity cost of capital that doubtless raised the pace of new capital investment. Investment in new facilities had already been given a major boost by the acceleration in technological developments, which evidently increased the potential for profit in recent years. The sharp surge in capital outlays during the past five years apparently reflected the availability of higher rates of return on a broad spectrum of potential investments owing to an acceleration in technological advances, especially in computer and telecommunications applications. This is the apparent root of the recent evident quickened pace of productivity advance. While the recent technological advances have patently added new and increasingly flexible capacity, the ability of these technologies to improve the efficiency of productive processes (an issue I will elaborate on shortly) has significantly reduced labor requirements per unit of output. This, no doubt, was one factor contributing to a dramatic increase in corporate downsizing and reported widespread layoffs in the early 1990s. The unemployment rate also began to fall as the pace of new hires to man the new facilities exceeded the pace of layoffs from the old. Parenthetically, the perception of increased churning of our workforce in the 1990s has understandably increased the sense of accelerated job-skill obsolescence among a significant segment of our workforce, especially among those most closely wedded to older technologies. The pressures are reflected in a major increase in on-the-job training and a dramatic expansion of college enrolment, especially at community colleges. As a result, the average age of full-time college students has risen dramatically in recent years as large numbers of experienced workers return to school for skill upgrading. But the sense of increasing skill obsolescence has also led to an apparent willingness on the part of employees to forgo wage and benefit increases for increased job security. Thus, despite the incredible tightness of labor markets, increases in compensation per hour have continued to be relatively modest. Coupled with the quickened pace of productivity growth, wage and benefit moderation has kept growth in unit labor costs subdued in the current expansion. This has both damped inflation and allowed profit margins to reach high levels. That, in turn, apparently was the driving force beginning in early 1995 in security analysts' significant upward revision of their company-by-company long-term earnings projections. These upward revisions, coupled with falling interest rates, point to two key underlying forces that impelled investors to produce one of history's most notable bull stock markets. But they are not the only forces. In addition, the sequence of greater capital investment, productivity growth, and falling inflation fostered an ever more benevolent sense of long-term stable growth. People were more confident about the future. The consequence was a dramatic shrinkage in the so-called equity premium over the past two years to near historic lows earlier this summer. The equity premium is the charge for the additional risks that markets require to hold stocks rather than riskless debt instruments. When perceived risks of the future are low, equity premiums are low and stock prices are even more elevated than would be indicated solely from higher expected long-term earnings growth and low riskless rates of interest. Thus, one key to the question of whether there is a new economy is whether current expectations of future stability, which are distinctly more positive than say a decade ago, are justified by actual changes in the economy. For if expectations of greater stability are borne out, risk and equity premiums will remain low. In that case, the cost of capital will also remain low, leading, at least for a time, to higher investment and faster economic growth. Two considerations are therefore critical to higher asset values and higher economic growth. The first is whether the apparent upward shift in technological advance will persist. The second is the extent of confidence in the stability of the future that consumers and investors will be able to sustain. With regard to the first: How fast can technology advance, augmenting the pool of investment opportunities that have elevated rates of return, which engender still further increases in expected long-term earnings? Technological breakthroughs, as history so amply demonstrates, are frustratingly difficult to discern much in advance. The particular synergies between new and older technologies are generally too complex to anticipate. An innovation's full potential may be realized only after extensive improvements or after complementary innovations in other fields of science. According to Charles Townes, a Nobel Prize winner for his work on the laser, the attorneys for Bell Labs initially, in the late 1960s, refused to patent the laser because they believed it had no applications in the field of telecommunications. Only in the 1980s, after extensive improvements in fiber-optics technology, did the laser's importance for telecommunications become apparent. The future of technology advance may be difficult to predict, but for the period ahead there is the possibility that already proven technologies may not as yet have been fully exploited. Company after company reports that, when confronted with cost increases in a competitive environment that precludes price increases, they are able to offset those costs, seemingly at will, by installing the newer technologies. Such stories seem odd. If cost improvements were available at will earlier, why weren't the investments made earlier? This implies suboptimal business behavior, contrary to what universities teach in Economics 101. But in the real world, companies rarely fully maximize profits. They concentrate on only those segments of their businesses that appear to offer the largest rewards and are rarely able to operate at the most efficient frontier on all fronts simultaneously. When costs rise, the attention of management presumably becomes focused more sharply on investments to limit the effects of rising costs. But if cost-cutting at will is, in fact, currently available, it suggests that a backlog of unexploited capital projects has been built up in recent years, which, if true, implies the potential for continued gains in productivity close to the elevated rates of the last couple of years. Even if this is indeed the case, and only anecdotal evidence supports it, security analysts' recent projected per share earnings growth of more than 13 percent annually over the next three to five years is unlikely to materialize. It would imply an ever-increasing share of profit in the national income from a level that is already high by historic standards. Such conditions have led in the past to labor market pressures that thwarted further profit growth. The second consideration with respect to how high asset values can rise is: How far can risk and equity premiums fall? A key factor is that price inflation has receded to quite low levels. The rising level of confidence in recent years concerning future outcomes has doubtless been related to the fall in the rate of inflation that has, of course, also been a critical factor in the fall in interest rates and, importantly, the fall in equity premiums as well. Presumably, the onset of deflation, should it occur, would increase uncertainty as much as a re-emergence of inflation concerns. Thus, arguably, at near price stability, perceived risk from business-cycle developments would be at its lowest, and one must presume that would be the case for equity premiums as well. In any event, there is a limit on how far investors can rationally favorably discount the future and therefore how low equity premiums can go. Current claims on a source of income available 20 or 30 years in the future still have current value. But should claims on the hereafter? An implication of high equity market values, relative to income and production, is an increased potential for instability. As I argued earlier, part of capital gains increases consumption and incomes. Since equity values are demonstrably more variable than incomes, when equity market values become large relative to incomes and GDP, their fluctuations can be expected to effect GDP more than when equity market values are low. Clearly, the history of large swings in investor confidence and equity premiums for rational and other reasons counsels caution in the current context. We have relearned in recent weeks that just as a bull stock market feels unending and secure as an economy and stock market move forward, so it can feel when markets contract that recovery is inconceivable. Both, of course, are wrong. But because of the difficulty imagining a turnabout when such emotions take hold, periods of euphoria or distress tend to feed on themselves. Indeed, if this were not the case, the types of psychologically driven ebbs and flows of economic activity we have observed would be unlikely to exist. Perhaps, as some argue, history will be less of a guide than it has been in the past. Some of the future is always without historical precedent. New records are always being made. Having said all that, however, my experience of observing the American economy day by day over the past half century suggests that most, perhaps substantially most, of the future can be expected to rest on a continuum from the past. Human nature, as I indicated earlier, appears immutable over the generations and inextricably ties our future to our past. Nonetheless, as I indicated earlier, I would not deny that there doubtless has been in recent years an underlying improvement in the functioning of America's markets and in the pace of development of cutting edge technologies beyond previous expectations. Most impressive is the marked increase in the effectiveness in the 1990s of our capital stock, that is, our productive facilities, the issue to which I alluded earlier. While gross investment has been high, it has been, in recent years, composed to a significant extent of short-lived assets that depreciate rapidly. Thus, the growth of the net capital stock, despite its recent acceleration, remains well below the peak rates posted during the past half century. Despite the broadening in recent decades of international capital flows, empirical evidence suggests that domestic investment still depends to a critical extent on domestic saving, especially at the margin. Many have argued persuasively, myself included, that we save too little. The relatively low propensity to save on the part of the American public has put a large premium on the effective use of scarce capital, and on the winnowing out of the potentially least productive and, hence, the least profitable of investment opportunities. That is one of the reasons that our financial system, whose job it is to ensure the productive use of physical capital, has been such a crucial part of our overall economy, especially over the past two decades. It is the signals reflected in financial asset prices, interest rates, and risk spreads that have altered the structure of our output in recent decades towards a different view of what consumers judge as value. This has imparted a significant derived value to a financial system that can do that effectively and, despite recent retrenchments, to the stock market value of those individual institutions that make up that system. Clearly, our high financial returns on investment are a symptom that our physical capital is being allocated to produce products and services that consumers particularly value. A machining facility that turns out an inferior product or a toll road that leads to nowhere will not find favor with the public, will earn subnormal or negative profits, and in most instances will exhibit an inability over the life of the asset to recover the cash plus cost of capital invested in it. Thus, while adequate national saving is a necessary condition for capital investment and rising productivity and standards of living, it is by no means a sufficient condition. The former Soviet Union, for example, had too much investment, and without the discipline of market prices, they grossly misplaced it. The preferences of central planners wasted valuable resources by mandating investment in sectors of the economy where the output wasn't wanted by consumers -- particularly in heavy manufacturing industries. It is thus no surprise that the Soviet Union's capital/output ratios were higher than those of contemporaneous free market economies of the West. This phenomenon of overinvestment is observable even among more sophisticated free market economies. In Japan, the saving rate and gross investment have been far higher than ours, but their per capita growth potential appears to be falling relative to ours. It is arguable that their hobbled financial system is, at least in part, a contributor to their economy's subnormal performance. We should not become complacent, however. To be sure, the sharp increases in the stock market have boosted household net worth. But while capital gains increase the value of existing assets, they do not directly create the resources needed for investment in new physical facilities. Only saving out of income can do that. In summary, whether over the past five to seven years, what has been, without question, one of the best economic performances in our history is a harbinger of a new economy or just a hyped-up version of the old, will be answered only with the inexorable passage of time. And I suspect our grandchildren, and theirs, will be periodically debating whether they are in a new economy.
1998-09-11T00:00:00	Mr. Duisenberg's opening statement at the meeting of the Governing Council of the European Central (Central Bank Articles and Speeches, 11 Sep 98)	Bank Introductory statement by the President of the European Central Bank, Dr. W. F. Duisenberg, at the press conference held in Frankfurt on 11/9/98.	Mr. Duisenberg's opening statement at the meeting of the Governing Council Introductory statement by the President of the European of the European Central Bank Central Bank, Dr. W. F. Duisenberg, at the press conference held in Frankfurt on 11/9/98. Ladies and gentlemen, the Vice-President and I are here today to report not only on the outcome of today's meeting of the Governing Council of the European Central Bank, but also - as you are already aware - on the outcome of the meetings of the Governing Council and the General Council that took place on 1 September 1998. It was in view of the short time span between the two sets of meetings that we decided that it would be more efficient to hold only one press conference to provide you with a summary of our deliberations. It is my intention to continue this practice for the remaining meetings of this year. In this regard, the Governing Council will meet, not only as scheduled on 13 October, 3 November and 1 December 1998, but there will also be an additional meeting on Tuesday, 22 December 1998. By this time, the bulk of nearly five years of preparatory work - including the "EMI years" - will be behind us and I envisage that the Governing Council's final meeting before the start of Stage Three of Economic and Monetary Union (EMU) will be devoted to fine-tuning its last-minute preparations. You will recall that monetary policy decisions remain a national competence until 31 December 1998. Looking ahead to next year, the Governing Council will hold fortnightly meetings and I intend to hold a press conference, normally, once a month. For the first quarter of 1999, I envisage holding a press conference immediately after the first meeting of each month. Further details of the meetings schedule are provided in the separate press release that will be issued to you this evening. Let me, however, return to the present. The Governing Council and the General Council devoted part of their September meetings to an extended exchange of views on recent economic, monetary and financial developments. In particular, much attention was paid to the global economic and financial environment of the future euro area, which has clearly worsened. Two major factors are currently affecting capital markets. First, the "flight into quality". Second and related - the tendency to switch from equities to bonds. As evidenced once again over the past few days by large swings in investor sentiment, the monetary policy environment has become more uncertain. One focal aspect of the discussion has been a close monitoring of the financial crisis in Russia. As we all know, the Russian crisis has added to concerns regarding the state of the world economy at a time when the crisis in Asia is still ongoing and growth in Japan is negative. These concerns have been fuelled by renewed strains in international financial markets as well as sharp fluctuations and downward corrections in major stock markets. There is no doubt that these developments will have a dampening effect on the world economy. However, their precise impact is difficult to measure at the current juncture. On the one hand, economic and model-based analysis still suggests only moderate effects on prices and output in the euro area. This is due to the fact that, first, most of the crisis regions are quite small in economic terms, i.e. when compared with world GDP or their contribution to world trade. Second, trade links between these countries and the euro area are also of limited size. Third, the euro area itself is a very large economy, which is only directly exposed to variations in global trade to a certain degree. However, on the other hand, this analysis should not mislead us. We are perfectly aware that the risks associated with current global developments go beyond those effects which we can measure directly. In this respect one may think of indirect influences resulting from changes in confidence, saving and expenditure within the euro area. We have to take these risks seriously and analyse the situation soberly, but we should also not dramatise. Let me now turn to the latest available data. These seem to indicate that economic expansion within the euro area has remained broadly on track, despite the worsening of the external environment. Domestic demand remains strong, while the contribution to growth from net exports has declined. Both private consumption and investment provided an important stimulus to the growth rate in the first quarter of this year. More up-to-date indicators point towards continued expansion in the second quarter, albeit at a possibly more moderate pace than in the first quarter. The outlook on consumption is supported by higher real earnings growth and declining unemployment, and is reflected in consumer confidence. The evidence for the corporate sector is perhaps more mixed. As compared to the first quarter of 1998, industrial production figures show a somewhat slower rate of increase in the period from April to May, but capacity utilisation has continued to increase and this, combined with low interest rates, should underpin investment. European Commission survey data, such as confidence indicators and the assessment of order books, bear witness to relatively high levels, both with respect to their longterm averages and recent peaks. This can also be taken as a favourable indicator for continued growth in the short term, although some indicators have not improved further since the spring. Unemployment has also been declining, but at a modest pace, and from a high level. In discussing the cyclical uncertainties, one should not forget that work on badly needed structural reforms has not so far made much progress. Considering recent price developments, HICP inflation for the euro area as a whole remained stable at 1.4% between May and July. Both domestic and external factors still appear to be favourable, suggesting that euro area inflation may be expected to remain subdued in the future. An important external factor underlying the favourable prospects for inflation is the sharp decline in oil and commodity prices, which is partly associated with developments in Asia. Moreover, domestic sources of inflation, such as those arising from the labour market situation and capacity utilisation, are also relatively moderate at the present juncture. In my opinion, taking a euro area wide perspective, these views are also broadly compatible with current monetary and financial developments. In this connection, please take note that we should soon have new information on monetary developments on the basis of the new statistical reporting framework for money and banking. The environment of significant volatility in international financial markets, particularly stock markets, appears to account for much of the recent decline in long-term interest rates in the euro area to historically low levels, as investors have sought to protect themselves against heightened global risk. Nonetheless, it is notable that the euro area yield curve shifted downwards at all maturities, which to some extent would tend to indicate a further decline in long-term inflation expectations for the euro area as a whole. As we approach the start of Stage Three, we shall need to continue to monitor closely economic, monetary and financial developments within the euro area and in the world economy. This will allow us eventually to set the interest rate for the euro area as a whole. At the same time, we shall also need to monitor fiscal intentions in the euro area Member States, as they will become more transparent over the autumn. If governments merely adhere to previous deficit targets for 1999, the structural position of budgets in quite a number of countries would effectively deteriorate. This would entail that they would move farther away from, rather than approach, the requirements of the Stability and Growth Pact, which calls for the achievement of a budget close to balance or even in surplus. In addition to the review of economic developments, a number of organisational issues were settled. (i) The General Council adopted its Rules of Procedure, which will be published in the Official Journal of the European Communities. You will recall that I informed you that the Governing Council's Rules of Procedure were adopted in July. (ii) The General Council also decided that the non-euro area national central banks shall pay up 5% of their subscriptions to the capital of the European Central Bank (ECB). However, the four national central banks concerned will not be asked actually to pay in their share as the amount due is less than they can expect to receive as their share in the proceeds of the liquidation of the European Monetary Institute (EMI). Further details on the actual amounts involved are provided in the separate handout that will be issued to you this evening. (iii) For its part, the Governing Council completed the list of committees which will assist in the work of the European System of Central Banks (ESCB). In addition to the eleven ESCB Committees agreed upon at the meeting in July, the Governing Council decided to establish an International Relations Committee and a Budget Committee. The latter was set up in order to provide transparency to the shareholders of the ECB - the national central banks - on matters relating to the budget of the ECB. (iv) Finally, the Governing Council endorsed the draft Headquarters Agreement between the German Federal Government and the ECB, which will be signed here in Frankfurt on 18 September 1998. A number of decisions were also taken with regard to various aspects of the preparatory work for Stage Three. (a) Exchange rate policy co-operation between the euro area and other EU countries The General Council endorsed the text of an Agreement between the ECB and the non-euro area national central banks, laying down the operating procedures for an exchange rate mechanism in Stage Three (the so-called ERM II). You will recall that the European Council in Amsterdam in June last year agreed to set up an exchange rate mechanism in Stage Three to replace the present European Monetary System (EMS). For this reason, the EMI had, on behalf of the ECB, prepared a draft Central Bank Agreement to replace the current exchange rate mechanism (ERM I, if you like) by a new one in Stage Three. It is this Agreement which has now been signed by the President of the ECB and the Governors of the four non-euro area national central banks. The signature by the latter implies their agreement to the operating procedures. It does not, however, imply their participation in ERM II. Further details on the conventions and procedures for ERM II are provided in the separate press release that is being issued to you this evening. The Agreement itself will be published in the Official Journal of the European Communities. (b) Monetary policy issues The Governing Council agreed on several issues relating to the monetary policy framework in Stage Three. At the centre of this framework is the report entitled "The single monetary policy in Stage Three: General documentation on ESCB monetary policy instruments and procedures", which contains a detailed description of the monetary policy instruments and procedures to be applied by the ESCB in Stage Three. The report expands on and updates the material included in an earlier version of the report that was published by the EMI in September 1997. I should like to limit my remarks in this regard to the announcement that a copy of this comprehensive report will be released very shortly, at which time a separate press release explaining the nature and purpose of the documentation will be issued. The Governing Council also agreed upon a guideline for the management of the foreign exchange assets by the national central banks and for the Member States' transactions with their foreign exchange working balances. These are now being formalised in official legal documentation. (c) Statistics The Governing Council endorsed the statistical framework on the basis of a number of reports that had been prepared by the EMI - many of which had been published in the past - thereby confirming the ECB's statistical requirements for Stage Three. I should perhaps point out that the reporting framework for the money and banking statistics of the ECB will appear in the "General Documentation" that will be released next Wednesday. (d) Euro banknotes With regard to the euro banknotes, the Governing Council confirmed (in line with previous recommendations by the EMI) that seven banknote denominations would be issued: 5, 10, 20, 50, 100, 200 and 500. Furthermore, it decided that there would not be any national features on the euro banknotes. As you know, the euro banknotes will be put into circulation on 1 January 2002. Thus there are fewer than 800 working days to go before their launch. The Governing Council took note that the technical preparations for the euro banknotes are proceeding according to schedule. The origination phase (i.e. the process of converting the designs into proof-prints) has now been successfully concluded and a zero-production run will be conducted in the autumn before mass production starts in early 1999. (e) Payment systems The Governing Council endorsed a list of eligible securities settlement systems following an assessment of such systems against standards that had previously been laid down for their use in the credit operations of the ESCB. The list, which indicates those securities settlement systems that will be used by the ESCB and the conditions for their use, will be set out in the "General Documentation", to which I have already referred. In addition, the Governing Council approved a report on the "Assessment of EU securities settlement systems against the standards for their use in ESCB credit operations". It is intended to release this report during the next couple of weeks.	---[PAGE_BREAK]--- # Mr. Duisenberg's opening statement at the meeting of the Governing Council of the European Central Bank Introductory statement by the President of the European Central Bank, Dr. W. F. Duisenberg, at the press conference held in Frankfurt on 11/9/98. Ladies and gentlemen, the Vice-President and I are here today to report not only on the outcome of today's meeting of the Governing Council of the European Central Bank, but also - as you are already aware - on the outcome of the meetings of the Governing Council and the General Council that took place on 1 September 1998. It was in view of the short time span between the two sets of meetings that we decided that it would be more efficient to hold only one press conference to provide you with a summary of our deliberations. It is my intention to continue this practice for the remaining meetings of this year. In this regard, the Governing Council will meet, not only as scheduled on 13 October, 3 November and 1 December 1998, but there will also be an additional meeting on Tuesday, 22 December 1998. By this time, the bulk of nearly five years of preparatory work - including the "EMI years" - will be behind us and I envisage that the Governing Council's final meeting before the start of Stage Three of Economic and Monetary Union (EMU) will be devoted to fine-tuning its last-minute preparations. You will recall that monetary policy decisions remain a national competence until 31 December 1998. Looking ahead to next year, the Governing Council will hold fortnightly meetings and I intend to hold a press conference, normally, once a month. For the first quarter of 1999, I envisage holding a press conference immediately after the first meeting of each month. Further details of the meetings schedule are provided in the separate press release that will be issued to you this evening. Let me, however, return to the present. The Governing Council and the General Council devoted part of their September meetings to an extended exchange of views on recent economic, monetary and financial developments. In particular, much attention was paid to the global economic and financial environment of the future euro area, which has clearly worsened. Two major factors are currently affecting capital markets. First, the "flight into quality". Second and related - the tendency to switch from equities to bonds. As evidenced once again over the past few days by large swings in investor sentiment, the monetary policy environment has become more uncertain. One focal aspect of the discussion has been a close monitoring of the financial crisis in Russia. As we all know, the Russian crisis has added to concerns regarding the state of the world economy at a time when the crisis in Asia is still ongoing and growth in Japan is negative. These concerns have been fuelled by renewed strains in international financial markets as well as sharp fluctuations and downward corrections in major stock markets. There is no doubt that these developments will have a dampening effect on the world economy. However, their precise impact is difficult to measure at the current juncture. On the one hand, economic and model-based analysis still suggests only moderate effects on prices and output in the euro area. This is due to the fact that, first, most of the crisis regions are quite small in economic terms, i.e. when compared with world GDP or their contribution to world trade. Second, trade links between these countries and the euro area are also of limited size. Third, the euro area itself is a very large economy, which is only directly exposed to variations in global trade to a certain degree. However, on the other hand, this analysis should not mislead us. We are perfectly aware that the risks associated with current global developments go beyond those effects which we can measure directly. In this respect one may think of indirect influences resulting from changes in confidence, saving and expenditure ---[PAGE_BREAK]--- within the euro area. We have to take these risks seriously and analyse the situation soberly, but we should also not dramatise. Let me now turn to the latest available data. These seem to indicate that economic expansion within the euro area has remained broadly on track, despite the worsening of the external environment. Domestic demand remains strong, while the contribution to growth from net exports has declined. Both private consumption and investment provided an important stimulus to the growth rate in the first quarter of this year. More up-to-date indicators point towards continued expansion in the second quarter, albeit at a possibly more moderate pace than in the first quarter. The outlook on consumption is supported by higher real earnings growth and declining unemployment, and is reflected in consumer confidence. The evidence for the corporate sector is perhaps more mixed. As compared to the first quarter of 1998, industrial production figures show a somewhat slower rate of increase in the period from April to May, but capacity utilisation has continued to increase and this, combined with low interest rates, should underpin investment. European Commission survey data, such as confidence indicators and the assessment of order books, bear witness to relatively high levels, both with respect to their longterm averages and recent peaks. This can also be taken as a favourable indicator for continued growth in the short term, although some indicators have not improved further since the spring. Unemployment has also been declining, but at a modest pace, and from a high level. In discussing the cyclical uncertainties, one should not forget that work on badly needed structural reforms has not so far made much progress. Considering recent price developments, HICP inflation for the euro area as a whole remained stable at $1.4 \%$ between May and July. Both domestic and external factors still appear to be favourable, suggesting that euro area inflation may be expected to remain subdued in the future. An important external factor underlying the favourable prospects for inflation is the sharp decline in oil and commodity prices, which is partly associated with developments in Asia. Moreover, domestic sources of inflation, such as those arising from the labour market situation and capacity utilisation, are also relatively moderate at the present juncture. In my opinion, taking a euro area wide perspective, these views are also broadly compatible with current monetary and financial developments. In this connection, please take note that we should soon have new information on monetary developments on the basis of the new statistical reporting framework for money and banking. The environment of significant volatility in international financial markets, particularly stock markets, appears to account for much of the recent decline in long-term interest rates in the euro area to historically low levels, as investors have sought to protect themselves against heightened global risk. Nonetheless, it is notable that the euro area yield curve shifted downwards at all maturities, which to some extent would tend to indicate a further decline in long-term inflation expectations for the euro area as a whole. As we approach the start of Stage Three, we shall need to continue to monitor closely economic, monetary and financial developments within the euro area and in the world economy. This will allow us eventually to set the interest rate for the euro area as a whole. At the same time, we shall also need to monitor fiscal intentions in the euro area Member States, as they will become more transparent over the autumn. If governments merely adhere to previous deficit targets for 1999, the structural position of budgets in quite a number of countries would effectively deteriorate. This would entail that they would move farther away from, rather than ---[PAGE_BREAK]--- approach, the requirements of the Stability and Growth Pact, which calls for the achievement of a budget close to balance or even in surplus. In addition to the review of economic developments, a number of organisational issues were settled. (i) The General Council adopted its Rules of Procedure, which will be published in the Official Journal of the European Communities. You will recall that I informed you that the Governing Council's Rules of Procedure were adopted in July. (ii) The General Council also decided that the non-euro area national central banks shall pay up $5 \%$ of their subscriptions to the capital of the European Central Bank (ECB). However, the four national central banks concerned will not be asked actually to pay in their share as the amount due is less than they can expect to receive as their share in the proceeds of the liquidation of the European Monetary Institute (EMI). Further details on the actual amounts involved are provided in the separate handout that will be issued to you this evening. (iii) For its part, the Governing Council completed the list of committees which will assist in the work of the European System of Central Banks (ESCB). In addition to the eleven ESCB Committees agreed upon at the meeting in July, the Governing Council decided to establish an International Relations Committee and a Budget Committee. The latter was set up in order to provide transparency to the shareholders of the ECB - the national central banks - on matters relating to the budget of the ECB. (iv) Finally, the Governing Council endorsed the draft Headquarters Agreement between the German Federal Government and the ECB, which will be signed here in Frankfurt on 18 September 1998. A number of decisions were also taken with regard to various aspects of the preparatory work for Stage Three. # (a) Exchange rate policy co-operation between the euro area and other EU countries The General Council endorsed the text of an Agreement between the ECB and the non-euro area national central banks, laying down the operating procedures for an exchange rate mechanism in Stage Three (the so-called ERM II). You will recall that the European Council in Amsterdam in June last year agreed to set up an exchange rate mechanism in Stage Three to replace the present European Monetary System (EMS). For this reason, the EMI had, on behalf of the ECB, prepared a draft Central Bank Agreement to replace the current exchange rate mechanism (ERM I, if you like) by a new one in Stage Three. It is this Agreement which has now been signed by the President of the ECB and the Governors of the four non-euro area national central banks. The signature by the latter implies their agreement to the operating procedures. It does not, however, imply their participation in ERM II. Further details on the conventions and procedures for ERM II are provided in the separate press release that is being issued to you this evening. The Agreement itself will be published in the Official Journal of the European Communities. (b) Monetary policy issues ---[PAGE_BREAK]--- The Governing Council agreed on several issues relating to the monetary policy framework in Stage Three. At the centre of this framework is the report entitled "The single monetary policy in Stage Three: General documentation on ESCB monetary policy instruments and procedures", which contains a detailed description of the monetary policy instruments and procedures to be applied by the ESCB in Stage Three. The report expands on and updates the material included in an earlier version of the report that was published by the EMI in September 1997. I should like to limit my remarks in this regard to the announcement that a copy of this comprehensive report will be released very shortly, at which time a separate press release explaining the nature and purpose of the documentation will be issued. The Governing Council also agreed upon a guideline for the management of the foreign exchange assets by the national central banks and for the Member States' transactions with their foreign exchange working balances. These are now being formalised in official legal documentation. # (c) Statistics The Governing Council endorsed the statistical framework on the basis of a number of reports that had been prepared by the EMI - many of which had been published in the past - thereby confirming the ECB's statistical requirements for Stage Three. I should perhaps point out that the reporting framework for the money and banking statistics of the ECB will appear in the "General Documentation" that will be released next Wednesday. ## (d) Euro banknotes With regard to the euro banknotes, the Governing Council confirmed (in line with previous recommendations by the EMI) that seven banknote denominations would be issued: 5, 10, 20, 50, 100, 200 and 500. Furthermore, it decided that there would not be any national features on the euro banknotes. As you know, the euro banknotes will be put into circulation on 1 January 2002. Thus there are fewer than 800 working days to go before their launch. The Governing Council took note that the technical preparations for the euro banknotes are proceeding according to schedule. The origination phase (i.e. the process of converting the designs into proof-prints) has now been successfully concluded and a zero-production run will be conducted in the autumn before mass production starts in early 1999. ## (e) Payment systems The Governing Council endorsed a list of eligible securities settlement systems following an assessment of such systems against standards that had previously been laid down for their use in the credit operations of the ESCB. The list, which indicates those securities settlement systems that will be used by the ESCB and the conditions for their use, will be set out in the "General Documentation", to which I have already referred. In addition, the Governing Council approved a report on the "Assessment of EU securities settlement systems against the standards for their use in ESCB credit operations". It is intended to release this report during the next couple of weeks.	Willem F Duisenberg	Euro area	https://www.bis.org/review/r980918c.pdf	of the European Central Bank Introductory statement by the President of the European Central Bank, Dr. W. F. Duisenberg, at the press conference held in Frankfurt on 11/9/98. Ladies and gentlemen, the Vice-President and I are here today to report not only on the outcome of today's meeting of the Governing Council of the European Central Bank, but also - as you are already aware - on the outcome of the meetings of the Governing Council and the General Council that took place on 1 September 1998. It was in view of the short time span between the two sets of meetings that we decided that it would be more efficient to hold only one press conference to provide you with a summary of our deliberations. It is my intention to continue this practice for the remaining meetings of this year. In this regard, the Governing Council will meet, not only as scheduled on 13 October, 3 November and 1 December 1998, but there will also be an additional meeting on Tuesday, 22 December 1998. By this time, the bulk of nearly five years of preparatory work - including the "EMI years" - will be behind us and I envisage that the Governing Council's final meeting before the start of Stage Three of Economic and Monetary Union (EMU) will be devoted to fine-tuning its last-minute preparations. You will recall that monetary policy decisions remain a national competence until 31 December 1998. Looking ahead to next year, the Governing Council will hold fortnightly meetings and I intend to hold a press conference, normally, once a month. For the first quarter of 1999, I envisage holding a press conference immediately after the first meeting of each month. Further details of the meetings schedule are provided in the separate press release that will be issued to you this evening. Let me, however, return to the present. The Governing Council and the General Council devoted part of their September meetings to an extended exchange of views on recent economic, monetary and financial developments. In particular, much attention was paid to the global economic and financial environment of the future euro area, which has clearly worsened. Two major factors are currently affecting capital markets. First, the "flight into quality". Second and related - the tendency to switch from equities to bonds. As evidenced once again over the past few days by large swings in investor sentiment, the monetary policy environment has become more uncertain. One focal aspect of the discussion has been a close monitoring of the financial crisis in Russia. As we all know, the Russian crisis has added to concerns regarding the state of the world economy at a time when the crisis in Asia is still ongoing and growth in Japan is negative. These concerns have been fuelled by renewed strains in international financial markets as well as sharp fluctuations and downward corrections in major stock markets. There is no doubt that these developments will have a dampening effect on the world economy. However, their precise impact is difficult to measure at the current juncture. On the one hand, economic and model-based analysis still suggests only moderate effects on prices and output in the euro area. This is due to the fact that, first, most of the crisis regions are quite small in economic terms, i.e. when compared with world GDP or their contribution to world trade. Second, trade links between these countries and the euro area are also of limited size. Third, the euro area itself is a very large economy, which is only directly exposed to variations in global trade to a certain degree. However, on the other hand, this analysis should not mislead us. We are perfectly aware that the risks associated with current global developments go beyond those effects which we can measure directly. In this respect one may think of indirect influences resulting from changes in confidence, saving and expenditure within the euro area. We have to take these risks seriously and analyse the situation soberly, but we should also not dramatise. Let me now turn to the latest available data. These seem to indicate that economic expansion within the euro area has remained broadly on track, despite the worsening of the external environment. Domestic demand remains strong, while the contribution to growth from net exports has declined. Both private consumption and investment provided an important stimulus to the growth rate in the first quarter of this year. More up-to-date indicators point towards continued expansion in the second quarter, albeit at a possibly more moderate pace than in the first quarter. The outlook on consumption is supported by higher real earnings growth and declining unemployment, and is reflected in consumer confidence. The evidence for the corporate sector is perhaps more mixed. As compared to the first quarter of 1998, industrial production figures show a somewhat slower rate of increase in the period from April to May, but capacity utilisation has continued to increase and this, combined with low interest rates, should underpin investment. European Commission survey data, such as confidence indicators and the assessment of order books, bear witness to relatively high levels, both with respect to their longterm averages and recent peaks. This can also be taken as a favourable indicator for continued growth in the short term, although some indicators have not improved further since the spring. Unemployment has also been declining, but at a modest pace, and from a high level. In discussing the cyclical uncertainties, one should not forget that work on badly needed structural reforms has not so far made much progress. Considering recent price developments, HICP inflation for the euro area as a whole remained stable at $1.4 \%$ between May and July. Both domestic and external factors still appear to be favourable, suggesting that euro area inflation may be expected to remain subdued in the future. An important external factor underlying the favourable prospects for inflation is the sharp decline in oil and commodity prices, which is partly associated with developments in Asia. Moreover, domestic sources of inflation, such as those arising from the labour market situation and capacity utilisation, are also relatively moderate at the present juncture. In my opinion, taking a euro area wide perspective, these views are also broadly compatible with current monetary and financial developments. In this connection, please take note that we should soon have new information on monetary developments on the basis of the new statistical reporting framework for money and banking. The environment of significant volatility in international financial markets, particularly stock markets, appears to account for much of the recent decline in long-term interest rates in the euro area to historically low levels, as investors have sought to protect themselves against heightened global risk. Nonetheless, it is notable that the euro area yield curve shifted downwards at all maturities, which to some extent would tend to indicate a further decline in long-term inflation expectations for the euro area as a whole. As we approach the start of Stage Three, we shall need to continue to monitor closely economic, monetary and financial developments within the euro area and in the world economy. This will allow us eventually to set the interest rate for the euro area as a whole. At the same time, we shall also need to monitor fiscal intentions in the euro area Member States, as they will become more transparent over the autumn. If governments merely adhere to previous deficit targets for 1999, the structural position of budgets in quite a number of countries would effectively deteriorate. This would entail that they would move farther away from, rather than approach, the requirements of the Stability and Growth Pact, which calls for the achievement of a budget close to balance or even in surplus. In addition to the review of economic developments, a number of organisational issues were settled. (i) The General Council adopted its Rules of Procedure, which will be published in the Official Journal of the European Communities. You will recall that I informed you that the Governing Council's Rules of Procedure were adopted in July. (ii) The General Council also decided that the non-euro area national central banks shall pay up $5 \%$ of their subscriptions to the capital of the European Central Bank (ECB). However, the four national central banks concerned will not be asked actually to pay in their share as the amount due is less than they can expect to receive as their share in the proceeds of the liquidation of the European Monetary Institute (EMI). Further details on the actual amounts involved are provided in the separate handout that will be issued to you this evening. (iii) For its part, the Governing Council completed the list of committees which will assist in the work of the European System of Central Banks (ESCB). In addition to the eleven ESCB Committees agreed upon at the meeting in July, the Governing Council decided to establish an International Relations Committee and a Budget Committee. The latter was set up in order to provide transparency to the shareholders of the ECB - the national central banks - on matters relating to the budget of the ECB. (iv) Finally, the Governing Council endorsed the draft Headquarters Agreement between the German Federal Government and the ECB, which will be signed here in Frankfurt on 18 September 1998. A number of decisions were also taken with regard to various aspects of the preparatory work for Stage Three. The General Council endorsed the text of an Agreement between the ECB and the non-euro area national central banks, laying down the operating procedures for an exchange rate mechanism in Stage Three (the so-called ERM II). You will recall that the European Council in Amsterdam in June last year agreed to set up an exchange rate mechanism in Stage Three to replace the present European Monetary System (EMS). For this reason, the EMI had, on behalf of the ECB, prepared a draft Central Bank Agreement to replace the current exchange rate mechanism (ERM I, if you like) by a new one in Stage Three. It is this Agreement which has now been signed by the President of the ECB and the Governors of the four non-euro area national central banks. The signature by the latter implies their agreement to the operating procedures. It does not, however, imply their participation in ERM II. Further details on the conventions and procedures for ERM II are provided in the separate press release that is being issued to you this evening. The Agreement itself will be published in the Official Journal of the European Communities. (b) Monetary policy issues The Governing Council agreed on several issues relating to the monetary policy framework in Stage Three. At the centre of this framework is the report entitled "The single monetary policy in Stage Three: General documentation on ESCB monetary policy instruments and procedures", which contains a detailed description of the monetary policy instruments and procedures to be applied by the ESCB in Stage Three. The report expands on and updates the material included in an earlier version of the report that was published by the EMI in September 1997. I should like to limit my remarks in this regard to the announcement that a copy of this comprehensive report will be released very shortly, at which time a separate press release explaining the nature and purpose of the documentation will be issued. The Governing Council also agreed upon a guideline for the management of the foreign exchange assets by the national central banks and for the Member States' transactions with their foreign exchange working balances. These are now being formalised in official legal documentation. The Governing Council endorsed the statistical framework on the basis of a number of reports that had been prepared by the EMI - many of which had been published in the past - thereby confirming the ECB's statistical requirements for Stage Three. I should perhaps point out that the reporting framework for the money and banking statistics of the ECB will appear in the "General Documentation" that will be released next Wednesday. With regard to the euro banknotes, the Governing Council confirmed (in line with previous recommendations by the EMI) that seven banknote denominations would be issued: 5, 10, 20, 50, 100, 200 and 500. Furthermore, it decided that there would not be any national features on the euro banknotes. As you know, the euro banknotes will be put into circulation on 1 January 2002. Thus there are fewer than 800 working days to go before their launch. The Governing Council took note that the technical preparations for the euro banknotes are proceeding according to schedule. The origination phase (i.e. the process of converting the designs into proof-prints) has now been successfully concluded and a zero-production run will be conducted in the autumn before mass production starts in early 1999. The Governing Council endorsed a list of eligible securities settlement systems following an assessment of such systems against standards that had previously been laid down for their use in the credit operations of the ESCB. The list, which indicates those securities settlement systems that will be used by the ESCB and the conditions for their use, will be set out in the "General Documentation", to which I have already referred. In addition, the Governing Council approved a report on the "Assessment of EU securities settlement systems against the standards for their use in ESCB credit operations". It is intended to release this report during the next couple of weeks.
1998-09-15T00:00:00	Mr. Gramlich reviews the benefits and problems of world capital flows (Central Bank Articles and Speeches, 15 Sep 98)	Remarks by Mr. Edward M. Gramlich, a member of the Board of Governors of the US Federal Reserve System, on 'World Capital Flows' at the Carnegie Bosch Institute, University Center at Carnegie Mellon, Pittsburgh, Pennsylvania on 15/9/98.	Mr. Gramlich reviews the benefits and problems of world capital flows Remarks by Mr. Edward M. Gramlich, a member of the Board of Governors of the US Federal Reserve System, on "World Capital Flows" at the Carnegie Bosch Institute, University Center at Carnegie Mellon, Pittsburgh, Pennsylvania on 15/9/98. For many years it has been clear that free trade is generally more efficient economically than protection. There are still huge political fights within countries about trade policies, and there may be occasions when countries are better off deviating from free trade, but free trade normally wins the economic high ground in most policy arguments. But that is not true, or not as true, for international capital flows. Large increases in world debt levels combined with inadequate management of foreign currency risks have led to a collapse of banking systems in country after country, massive changes in exchange rates, and a recession or depression in much of the world economy. In view of these provocations, many observers are now re-examining their preconceptions that free international capital flows are optimal. Particular countries such as Malaysia are clamping on exchange controls, free trade economists such as Paul Krugman are suggesting currency controls as a least bad option, a good many others are recommending distortionary taxes on some capital flows, and almost everybody is at least re-examining their preconceptions. But before this process goes too far, I would like to enter a contrary plea. There are clear problems with the present system of international lending and borrowing. But there are clear and important benefits as well. We know what the problems are. Let's fix them as soon as possible, and try to preserve the important benefits of international capital flows. The Benefits of World Capital Flows Let me start with the benefits of world capital flows. Much of this is standard neoclassical economics, but it bears repeating in these troubled times. Countries' saving and investment propensities can differ markedly around the world. If economies were closed to capital flows, domestic interest rates would equilibrate saving and investment in each country. These interest rates would vary widely, which means that capital would have a different marginal value in each country. Suppose now the world were to be opened up to capital flows. Capital would flow out of those countries with low interest rates, where investment prospects are scarce compared to domestic saving, and towards countries where interest rates are high, where investment prospects are abundant relative to domestic saving. Countries that import capital would benefit from a greater stock of high productivity investments. Countries that export capital would put their saving to better use. Both countries would gain, and the world economy would also gain because scarce saving is better allocated to capital markets around the world. This all may sound a bit academic, but the process has been very important in the world's economic development. Countries undergoing development can sometimes squeeze the requisite saving out of their poor economies, as the United Kingdom did in the 19th century and Japan did in the 20th century. Or they can import capital to supplement domestic saving, as the United States, Canada, and Australia did in the 19th century and several countries in Eastern Europe and Asia have done in the 20th century. This imported capital has been very important in the world's development process, and it has often brought with it other benefits, such as the international spreading of technological improvements. Without world capital flows, the general level of development in the world would be far less. Problems If that's the story, what's the problem? Why do world capital markets seem to be causing such anguish, in country after country? Why are countries turning away from open capital markets? It turns out that there is some fine print that goes with the neoclassical model, and the world economy has had some trouble with the fine print. Here are some of the ways. • Exchange rate volatility. Countries trade in different currencies, and exchange rates are necessary to make the conversions. But in addition to being the devices for converting currencies, exchange rates play another important role in the world economy - they also represent the mechanisms for bringing countries price structures in line in international trade. Suppose one country's prices are too high for it to compete in world trade, either because it has suffered an adverse trade shock, has had too much inflation, has too rigid labor contracts, or for some other reason. The country can suffer a painful recession to get its prices back in line. Or it can let its currency depreciate. Depreciations are not absolutely necessary, as is asserted by advocates of fixed exchange rates. But depreciations, or currency fluctuations in general, are often far less costly ways to make international adjustments. The next time you hear someone complain about exchange rate changes, ask them what else they had in mind to restore international equilibrium. While exchange rate changes have this potentially stabilizing effect, they can also be destabilizing. When exchange rates are allowed to fluctuate, they are set in currency markets according to the demands and supplies of forward-looking traders, and they can be very volatile, often overshooting long-term values. This volatility can destabilize trade and impart significant uncertainty to international lending. Borrowers may borrow in international markets expecting to repay at one exchange rate, and when the bill comes due, the exchange rate may differ, by a lot. Lenders and borrowers can both hedge, but hedging is costly, and institutions providing this hedge can go broke. • Financial institutions. Financial institutions engage in what is known as maturity transformation. They take deposits from you and me, which deposits can be redeemed any time we take out our check book, and make long-term loans to mortgage borrowers and businesses. There are fantastic efficiencies in this process - consumers can get higher returns on their saving, and business can borrow and invest in productive equipment. Indeed, banks and other financial institutions play the same role in allocating domestic saving to its best uses that the international capital market plays for international capital. But as with capital flows, there are risks. If the banks' loans go bad, the institution is in trouble and may not be able to redeem deposits. Within a country's borders there are often institutions such as deposit insurance to protect savers, but internationally the risks can be greater. Given that banks are involved in the domestic saving, investment process, it is not surprising that they have become heavily involved in the international saving, investment process. In general this process too has led to worldwide efficiencies, but here too there are risks. In Japan, for example, the banks have been hurt by a massive decline in real estate and other values, which have put many nonperforming loans on their books. In Korea and Indonesia, the banks were hurt by the foreign currency exposure of their borrowers. • Incentive effects. Incentive effects are always important in economics, generally complicating the analysis of policy measures. Nowhere is this as true as with international capital flows. One incentive problem involves what is known as moral hazard. Suppose national governments do intervene to protect the safety and soundness of banks. That intervention might seem sensible, but it could inspire more risky lending by the banks, to let the government pick up the tab if things go bad. A second problem involves unilateral default on loan payments or currency obligations. Defaults would appear to benefit debtors, but in the long run these debtors will have trouble getting new credit. Or contagion effects. Even if one borrower is perfectly sound, if other borrowers like it go under, lenders will be reluctant to lend to similarly classified borrowers. Discussions of international capital flows abound with these incentive effects. • Transparency. A last issue involves transparency. For the international capital market to work well, lenders must know the risks and rewards. They must know the aggregate debt of a country, the exchange rate risks they are taking, and the on and off-balance sheet liabilities of all relevant banks. When they do not have a good picture of these risks, they can get into serious trouble. While the world financial crisis has hit with uneven force in various countries, and while local situations have differed, the interaction between these four elements has almost always been critical. Sometimes big changes in exchange rates precipitated a crisis, sometimes big changes in asset values put the banks in trouble, sometimes moral hazard issues generated unsound loans, and almost everywhere there was a lack of transparency. Once a crisis got going, unilateral defaults and contagion effects spread it to other countries. The result was a broadscale financial collapse, which then fed over to the real sector and caused bankruptcies, credit restraints, and recessions. These real income losses in turn magnified the financial problems. Solutions Are there any solutions to this mess? Many are calling for an end to open capital markets, as if the benefits are not worth the costs. Others are calling for distortionary taxes, to protect countries from too much openness. Should we go part or all of the way back to closed economies? I remain an optimist and I think not. There may be occasional instances where some restrictions are necessary to control extreme capital flows not justified by economic fundamentals. Moreover, the world capital system clearly is in need of repair. But I hope we can repair it and get back to a world where saving in whatever country goes to the country that needs it most, and that can pay the most to the saver. And to a world where international capital flows are an important vehicle for world economic development. Let me discuss some remedies that should help in that process. • Financial institutions. Two types of corrections are necessary. A first is tantamount to preventive medicine - what should be done when institutions are not in crisis? The basic need here is for better bank supervision. Supervision must be improved to insure that proper risk management techniques are put in place and followed. Previous practices where banks, or those to whom banks made loans, loaded up on short-term hard currency denominated liabilities must be curbed. Market discipline can also be used to control risk, by exposing financial institutions to as much market discipline as possible and by limiting moral hazard problems. But even with all the preventive medicine in the world, the patient sometimes gets sick, and banks in Japan and a number of other countries surely are. What is to be done then? Examination of a number of historical episodes suggests that there are three important elements to dealing with a banking collapse. First, the bank regulators must go through the balance sheets, determine the problem loans, take them off the banks' balance sheets, sell them, and have the public take whatever losses were entailed. Second, the troubled institutions must be closed down with the management replaced and shareholders suffering losses. Third, the healthy institutions must then be recapitalized, preferably by new equity sales in capital markets. The sooner these steps are taken, the better. The longer they are not taken, the longer troubled banks will continue incurring losses, engaging in risky practices, threatening the safe institutions, generating contagion effects, and not performing the banks' all-important maturity transformation function. Indeed, here is a way foreign capital flows can be part of the solution to the problem, because new foreign-owned banks that can perform this maturity transformation function can be invited to participate in credit-starved economies. • Maturity transformation. While financial institutions perform maturity transformation, there is no reason to unduly burden the system. Countries have often gotten into trouble when they have done too much maturity transformation - that is, borrowed from abroad at short maturities to finance long-term investment. Steps could be taken to limit such borrowing, either nationally or through bank supervision. Some economists have used this idea to propose taxes on short-term borrowing, though the tax rates necessary to do the job could be very high and it might be more effective to use orthodox principles of bank supervision. • Transparency. A further set of corrective mechanisms involves greater transparency. It must be clearer to lenders and borrowers alike what risks they are taking. This requires better reporting by financial institutions, and it also requires better aggregate statistics on the uncommitted foreign reserve balances of individual countries. Transparency alone cannot do the job of good bank regulation, but it is hard to imagine a solution to the international lending problems of the day without more transparent accounting. • The IMF. Last but not least I discuss the IMF. Frankly, my own feeling is that if an institution like the IMF did not exist, we would want to invent something like it. Here is an international institution that, at least in principle, can supervise the finances of different countries without the accusations of big brother that would come about if the United States alone tried to put itself in this role. Moreover, it can organize other lending countries to bring support to countries in need of liquidity assistance, as opposed to having the bill fall entirely on the United States. Supporting the existence of something like the IMF does not suggest agreement with its exact structure or with all of its policies. The present crisis indicates that international preventive medicine provisions are weak. It may be difficult for the IMF to perform this warning system role, but there is clearly a need for better warnings about the risks of lending to certain countries, to prevent currency vulnerabilities from building up as much as they did. The IMF's "one size fits all" recommendations of fiscal austerity should also be re-examined, because in many Asian countries expansionary fiscal policies were clearly called for indeed, still are called for - while the IMF initially recommended the reverse. But the two biggest criticisms of the IMF involve the moral hazard issue and exchange rate flexibility. On moral hazard, the criticism is more or less inevitable. Any time there is any governmental attempt to increase safety and soundness, moral hazard questions can be raised. In the case of the IMF, if it is there to bail out countries in a liquidity crisis, countries will be more likely to end up in liquidity crises. The answer, it seems to me, is for the IMF to attach tight conditions on its lending, so that countries will certainly not look forward to getting into debtor status. In terms of underlying structural change, this is one of the few leverage points the international lending community has on borrowing countries, and it is important for the IMF to use its tool well. On exchange rate flexibility, the problem with the critics is that they are not saying the same thing. Some say the IMF is too quick to let the exchange rate fall, some say it is not quick enough. Both cannot be right at the same time. As a general rule, the exchange rate flexibility issue is a hard one and it is hard to make broad recommendations. Sometimes a country's cost structure is clearly out of line, or its inflation rate is clearly too high, and exchange rate flexibility seems to be the least costly way to bring prices and wages back into line. But exchange rate flexibility will cause capital losses and will raise the cost and risk of future capital transactions. That does not mean that the exchange rate must be preserved at all costs, but it does mean that capital flows themselves put some constraints on the normal international adjustment mechanisms. Given all this, it is hard for me to take a firm policy on exchange flexibility, and I have some sympathy for the apparent open-mindedness of the IMF on the issue. Will these solutions be enough? Who knows. But I think we all have a stake in making the world capital system work better. Before we initiate more artificial restrictions on capital flows, we should try to improve the system to take advantage of its very large benefits.	---[PAGE_BREAK]--- # Mr. Gramlich reviews the benefits and problems of world capital flows Remarks by Mr. Edward M. Gramlich, a member of the Board of Governors of the US Federal Reserve System, on "World Capital Flows" at the Carnegie Bosch Institute, University Center at Carnegie Mellon, Pittsburgh, Pennsylvania on 15/9/98. For many years it has been clear that free trade is generally more efficient economically than protection. There are still huge political fights within countries about trade policies, and there may be occasions when countries are better off deviating from free trade, but free trade normally wins the economic high ground in most policy arguments. But that is not true, or not as true, for international capital flows. Large increases in world debt levels combined with inadequate management of foreign currency risks have led to a collapse of banking systems in country after country, massive changes in exchange rates, and a recession or depression in much of the world economy. In view of these provocations, many observers are now re-examining their preconceptions that free international capital flows are optimal. Particular countries such as Malaysia are clamping on exchange controls, free trade economists such as Paul Krugman are suggesting currency controls as a least bad option, a good many others are recommending distortionary taxes on some capital flows, and almost everybody is at least re-examining their preconceptions. But before this process goes too far, I would like to enter a contrary plea. There are clear problems with the present system of international lending and borrowing. But there are clear and important benefits as well. We know what the problems are. Let's fix them as soon as possible, and try to preserve the important benefits of international capital flows. ## The Benefits of World Capital Flows Let me start with the benefits of world capital flows. Much of this is standard neoclassical economics, but it bears repeating in these troubled times. Countries' saving and investment propensities can differ markedly around the world. If economies were closed to capital flows, domestic interest rates would equilibrate saving and investment in each country. These interest rates would vary widely, which means that capital would have a different marginal value in each country. Suppose now the world were to be opened up to capital flows. Capital would flow out of those countries with low interest rates, where investment prospects are scarce compared to domestic saving, and towards countries where interest rates are high, where investment prospects are abundant relative to domestic saving. Countries that import capital would benefit from a greater stock of high productivity investments. Countries that export capital would put their saving to better use. Both countries would gain, and the world economy would also gain because scarce saving is better allocated to capital markets around the world. This all may sound a bit academic, but the process has been very important in the world's economic development. Countries undergoing development can sometimes squeeze the requisite saving out of their poor economies, as the United Kingdom did in the 19th century and Japan did in the 20th century. Or they can import capital to supplement domestic saving, as the United States, Canada, and Australia did in the 19th century and several countries in Eastern Europe and Asia have done in the 20th century. This imported capital has been very important in the world's development process, and it has often brought with it other benefits, such as the international spreading of technological improvements. Without world capital flows, the general level of development in the world would be far less. Problems ---[PAGE_BREAK]--- If that's the story, what's the problem? Why do world capital markets seem to be causing such anguish, in country after country? Why are countries turning away from open capital markets? It turns out that there is some fine print that goes with the neoclassical model, and the world economy has had some trouble with the fine print. Here are some of the ways. - Exchange rate volatility. Countries trade in different currencies, and exchange rates are necessary to make the conversions. But in addition to being the devices for converting currencies, exchange rates play another important role in the world economy - they also represent the mechanisms for bringing countries price structures in line in international trade. Suppose one country's prices are too high for it to compete in world trade, either because it has suffered an adverse trade shock, has had too much inflation, has too rigid labor contracts, or for some other reason. The country can suffer a painful recession to get its prices back in line. Or it can let its currency depreciate. Depreciations are not absolutely necessary, as is asserted by advocates of fixed exchange rates. But depreciations, or currency fluctuations in general, are often far less costly ways to make international adjustments. The next time you hear someone complain about exchange rate changes, ask them what else they had in mind to restore international equilibrium. While exchange rate changes have this potentially stabilizing effect, they can also be destabilizing. When exchange rates are allowed to fluctuate, they are set in currency markets according to the demands and supplies of forward-looking traders, and they can be very volatile, often overshooting long-term values. This volatility can destabilize trade and impart significant uncertainty to international lending. Borrowers may borrow in international markets expecting to repay at one exchange rate, and when the bill comes due, the exchange rate may differ, by a lot. Lenders and borrowers can both hedge, but hedging is costly, and institutions providing this hedge can go broke. - Financial institutions. Financial institutions engage in what is known as maturity transformation. They take deposits from you and me, which deposits can be redeemed any time we take out our check book, and make long-term loans to mortgage borrowers and businesses. There are fantastic efficiencies in this process - consumers can get higher returns on their saving, and business can borrow and invest in productive equipment. Indeed, banks and other financial institutions play the same role in allocating domestic saving to its best uses that the international capital market plays for international capital. But as with capital flows, there are risks. If the banks' loans go bad, the institution is in trouble and may not be able to redeem deposits. Within a country's borders there are often institutions such as deposit insurance to protect savers, but internationally the risks can be greater. Given that banks are involved in the domestic saving, investment process, it is not surprising that they have become heavily involved in the international saving, investment process. In general this process too has led to worldwide efficiencies, but here too there are risks. In Japan, for example, the banks have been hurt by a massive decline in real estate and other values, which have put many nonperforming loans on their books. In Korea and Indonesia, the banks were hurt by the foreign currency exposure of their borrowers. ---[PAGE_BREAK]--- - Incentive effects. Incentive effects are always important in economics, generally complicating the analysis of policy measures. Nowhere is this as true as with international capital flows. One incentive problem involves what is known as moral hazard. Suppose national governments do intervene to protect the safety and soundness of banks. That intervention might seem sensible, but it could inspire more risky lending by the banks, to let the government pick up the tab if things go bad. A second problem involves unilateral default on loan payments or currency obligations. Defaults would appear to benefit debtors, but in the long run these debtors will have trouble getting new credit. Or contagion effects. Even if one borrower is perfectly sound, if other borrowers like it go under, lenders will be reluctant to lend to similarly classified borrowers. Discussions of international capital flows abound with these incentive effects. - Transparency. A last issue involves transparency. For the international capital market to work well, lenders must know the risks and rewards. They must know the aggregate debt of a country, the exchange rate risks they are taking, and the on and off-balance sheet liabilities of all relevant banks. When they do not have a good picture of these risks, they can get into serious trouble. While the world financial crisis has hit with uneven force in various countries, and while local situations have differed, the interaction between these four elements has almost always been critical. Sometimes big changes in exchange rates precipitated a crisis, sometimes big changes in asset values put the banks in trouble, sometimes moral hazard issues generated unsound loans, and almost everywhere there was a lack of transparency. Once a crisis got going, unilateral defaults and contagion effects spread it to other countries. The result was a broadscale financial collapse, which then fed over to the real sector and caused bankruptcies, credit restraints, and recessions. These real income losses in turn magnified the financial problems. # Solutions Are there any solutions to this mess? Many are calling for an end to open capital markets, as if the benefits are not worth the costs. Others are calling for distortionary taxes, to protect countries from too much openness. Should we go part or all of the way back to closed economies? I remain an optimist and I think not. There may be occasional instances where some restrictions are necessary to control extreme capital flows not justified by economic fundamentals. Moreover, the world capital system clearly is in need of repair. But I hope we can repair it and get back to a world where saving in whatever country goes to the country that needs it most, and that can pay the most to the saver. And to a world where international capital flows are an important vehicle for world economic development. Let me discuss some remedies that should help in that process. - Financial institutions. Two types of corrections are necessary. A first is tantamount to preventive medicine - what should be done when institutions are not in crisis? The basic need here is for better bank supervision. Supervision must be improved to insure that proper risk management techniques are put in place and followed. Previous practices where banks, or those to whom banks made loans, loaded up on short-term hard currency denominated liabilities must be curbed. Market discipline can also be used to control risk, by exposing ---[PAGE_BREAK]--- financial institutions to as much market discipline as possible and by limiting moral hazard problems. But even with all the preventive medicine in the world, the patient sometimes gets sick, and banks in Japan and a number of other countries surely are. What is to be done then? Examination of a number of historical episodes suggests that there are three important elements to dealing with a banking collapse. First, the bank regulators must go through the balance sheets, determine the problem loans, take them off the banks' balance sheets, sell them, and have the public take whatever losses were entailed. Second, the troubled institutions must be closed down with the management replaced and shareholders suffering losses. Third, the healthy institutions must then be recapitalized, preferably by new equity sales in capital markets. The sooner these steps are taken, the better. The longer they are not taken, the longer troubled banks will continue incurring losses, engaging in risky practices, threatening the safe institutions, generating contagion effects, and not performing the banks' all-important maturity transformation function. Indeed, here is a way foreign capital flows can be part of the solution to the problem, because new foreign-owned banks that can perform this maturity transformation function can be invited to participate in credit-starved economies. - Maturity transformation. While financial institutions perform maturity transformation, there is no reason to unduly burden the system. Countries have often gotten into trouble when they have done too much maturity transformation - that is, borrowed from abroad at short maturities to finance long-term investment. Steps could be taken to limit such borrowing, either nationally or through bank supervision. Some economists have used this idea to propose taxes on short-term borrowing, though the tax rates necessary to do the job could be very high and it might be more effective to use orthodox principles of bank supervision. - Transparency. A further set of corrective mechanisms involves greater transparency. It must be clearer to lenders and borrowers alike what risks they are taking. This requires better reporting by financial institutions, and it also requires better aggregate statistics on the uncommitted foreign reserve balances of individual countries. Transparency alone cannot do the job of good bank regulation, but it is hard to imagine a solution to the international lending problems of the day without more transparent accounting. - The IMF. Last but not least I discuss the IMF. Frankly, my own feeling is that if an institution like the IMF did not exist, we would want to invent something like it. Here is an international institution that, at least in principle, can supervise the finances of different countries without the accusations of big brother that would come about if the United States alone tried to put itself in this role. Moreover, it can organize other lending countries to bring support to countries in need of liquidity assistance, as opposed to having the bill fall entirely on the United States. Supporting the existence of something like the IMF does not suggest agreement with its exact structure or with all of its policies. The present crisis indicates that international preventive medicine provisions are weak. It may be difficult for the ---[PAGE_BREAK]--- IMF to perform this warning system role, but there is clearly a need for better warnings about the risks of lending to certain countries, to prevent currency vulnerabilities from building up as much as they did. The IMF's "one size fits all" recommendations of fiscal austerity should also be re-examined, because in many Asian countries expansionary fiscal policies were clearly called for indeed, still are called for - while the IMF initially recommended the reverse. But the two biggest criticisms of the IMF involve the moral hazard issue and exchange rate flexibility. On moral hazard, the criticism is more or less inevitable. Any time there is any governmental attempt to increase safety and soundness, moral hazard questions can be raised. In the case of the IMF, if it is there to bail out countries in a liquidity crisis, countries will be more likely to end up in liquidity crises. The answer, it seems to me, is for the IMF to attach tight conditions on its lending, so that countries will certainly not look forward to getting into debtor status. In terms of underlying structural change, this is one of the few leverage points the international lending community has on borrowing countries, and it is important for the IMF to use its tool well. On exchange rate flexibility, the problem with the critics is that they are not saying the same thing. Some say the IMF is too quick to let the exchange rate fall, some say it is not quick enough. Both cannot be right at the same time. As a general rule, the exchange rate flexibility issue is a hard one and it is hard to make broad recommendations. Sometimes a country's cost structure is clearly out of line, or its inflation rate is clearly too high, and exchange rate flexibility seems to be the least costly way to bring prices and wages back into line. But exchange rate flexibility will cause capital losses and will raise the cost and risk of future capital transactions. That does not mean that the exchange rate must be preserved at all costs, but it does mean that capital flows themselves put some constraints on the normal international adjustment mechanisms. Given all this, it is hard for me to take a firm policy on exchange flexibility, and I have some sympathy for the apparent open-mindedness of the IMF on the issue. Will these solutions be enough? Who knows. But I think we all have a stake in making the world capital system work better. Before we initiate more artificial restrictions on capital flows, we should try to improve the system to take advantage of its very large benefits.	Edward M Gramlich	United States	https://www.bis.org/review/r980918a.pdf	Remarks by Mr. Edward M. Gramlich, a member of the Board of Governors of the US Federal Reserve System, on "World Capital Flows" at the Carnegie Bosch Institute, University Center at Carnegie Mellon, Pittsburgh, Pennsylvania on 15/9/98. For many years it has been clear that free trade is generally more efficient economically than protection. There are still huge political fights within countries about trade policies, and there may be occasions when countries are better off deviating from free trade, but free trade normally wins the economic high ground in most policy arguments. But that is not true, or not as true, for international capital flows. Large increases in world debt levels combined with inadequate management of foreign currency risks have led to a collapse of banking systems in country after country, massive changes in exchange rates, and a recession or depression in much of the world economy. In view of these provocations, many observers are now re-examining their preconceptions that free international capital flows are optimal. Particular countries such as Malaysia are clamping on exchange controls, free trade economists such as Paul Krugman are suggesting currency controls as a least bad option, a good many others are recommending distortionary taxes on some capital flows, and almost everybody is at least re-examining their preconceptions. But before this process goes too far, I would like to enter a contrary plea. There are clear problems with the present system of international lending and borrowing. But there are clear and important benefits as well. We know what the problems are. Let's fix them as soon as possible, and try to preserve the important benefits of international capital flows. Let me start with the benefits of world capital flows. Much of this is standard neoclassical economics, but it bears repeating in these troubled times. Countries' saving and investment propensities can differ markedly around the world. If economies were closed to capital flows, domestic interest rates would equilibrate saving and investment in each country. These interest rates would vary widely, which means that capital would have a different marginal value in each country. Suppose now the world were to be opened up to capital flows. Capital would flow out of those countries with low interest rates, where investment prospects are scarce compared to domestic saving, and towards countries where interest rates are high, where investment prospects are abundant relative to domestic saving. Countries that import capital would benefit from a greater stock of high productivity investments. Countries that export capital would put their saving to better use. Both countries would gain, and the world economy would also gain because scarce saving is better allocated to capital markets around the world. This all may sound a bit academic, but the process has been very important in the world's economic development. Countries undergoing development can sometimes squeeze the requisite saving out of their poor economies, as the United Kingdom did in the 19th century and Japan did in the 20th century. Or they can import capital to supplement domestic saving, as the United States, Canada, and Australia did in the 19th century and several countries in Eastern Europe and Asia have done in the 20th century. This imported capital has been very important in the world's development process, and it has often brought with it other benefits, such as the international spreading of technological improvements. Without world capital flows, the general level of development in the world would be far less. Problems If that's the story, what's the problem? Why do world capital markets seem to be causing such anguish, in country after country? Why are countries turning away from open capital markets? It turns out that there is some fine print that goes with the neoclassical model, and the world economy has had some trouble with the fine print. Here are some of the ways. Exchange rate volatility. Countries trade in different currencies, and exchange rates are necessary to make the conversions. But in addition to being the devices for converting currencies, exchange rates play another important role in the world economy - they also represent the mechanisms for bringing countries price structures in line in international trade. Suppose one country's prices are too high for it to compete in world trade, either because it has suffered an adverse trade shock, has had too much inflation, has too rigid labor contracts, or for some other reason. The country can suffer a painful recession to get its prices back in line. Or it can let its currency depreciate. Depreciations are not absolutely necessary, as is asserted by advocates of fixed exchange rates. But depreciations, or currency fluctuations in general, are often far less costly ways to make international adjustments. The next time you hear someone complain about exchange rate changes, ask them what else they had in mind to restore international equilibrium. While exchange rate changes have this potentially stabilizing effect, they can also be destabilizing. When exchange rates are allowed to fluctuate, they are set in currency markets according to the demands and supplies of forward-looking traders, and they can be very volatile, often overshooting long-term values. This volatility can destabilize trade and impart significant uncertainty to international lending. Borrowers may borrow in international markets expecting to repay at one exchange rate, and when the bill comes due, the exchange rate may differ, by a lot. Lenders and borrowers can both hedge, but hedging is costly, and institutions providing this hedge can go broke. Financial institutions. Financial institutions engage in what is known as maturity transformation. They take deposits from you and me, which deposits can be redeemed any time we take out our check book, and make long-term loans to mortgage borrowers and businesses. There are fantastic efficiencies in this process - consumers can get higher returns on their saving, and business can borrow and invest in productive equipment. Indeed, banks and other financial institutions play the same role in allocating domestic saving to its best uses that the international capital market plays for international capital. But as with capital flows, there are risks. If the banks' loans go bad, the institution is in trouble and may not be able to redeem deposits. Within a country's borders there are often institutions such as deposit insurance to protect savers, but internationally the risks can be greater. Given that banks are involved in the domestic saving, investment process, it is not surprising that they have become heavily involved in the international saving, investment process. In general this process too has led to worldwide efficiencies, but here too there are risks. In Japan, for example, the banks have been hurt by a massive decline in real estate and other values, which have put many nonperforming loans on their books. In Korea and Indonesia, the banks were hurt by the foreign currency exposure of their borrowers. Incentive effects. Incentive effects are always important in economics, generally complicating the analysis of policy measures. Nowhere is this as true as with international capital flows. One incentive problem involves what is known as moral hazard. Suppose national governments do intervene to protect the safety and soundness of banks. That intervention might seem sensible, but it could inspire more risky lending by the banks, to let the government pick up the tab if things go bad. A second problem involves unilateral default on loan payments or currency obligations. Defaults would appear to benefit debtors, but in the long run these debtors will have trouble getting new credit. Or contagion effects. Even if one borrower is perfectly sound, if other borrowers like it go under, lenders will be reluctant to lend to similarly classified borrowers. Discussions of international capital flows abound with these incentive effects. Transparency. A last issue involves transparency. For the international capital market to work well, lenders must know the risks and rewards. They must know the aggregate debt of a country, the exchange rate risks they are taking, and the on and off-balance sheet liabilities of all relevant banks. When they do not have a good picture of these risks, they can get into serious trouble. While the world financial crisis has hit with uneven force in various countries, and while local situations have differed, the interaction between these four elements has almost always been critical. Sometimes big changes in exchange rates precipitated a crisis, sometimes big changes in asset values put the banks in trouble, sometimes moral hazard issues generated unsound loans, and almost everywhere there was a lack of transparency. Once a crisis got going, unilateral defaults and contagion effects spread it to other countries. The result was a broadscale financial collapse, which then fed over to the real sector and caused bankruptcies, credit restraints, and recessions. These real income losses in turn magnified the financial problems. Are there any solutions to this mess? Many are calling for an end to open capital markets, as if the benefits are not worth the costs. Others are calling for distortionary taxes, to protect countries from too much openness. Should we go part or all of the way back to closed economies? I remain an optimist and I think not. There may be occasional instances where some restrictions are necessary to control extreme capital flows not justified by economic fundamentals. Moreover, the world capital system clearly is in need of repair. But I hope we can repair it and get back to a world where saving in whatever country goes to the country that needs it most, and that can pay the most to the saver. And to a world where international capital flows are an important vehicle for world economic development. Let me discuss some remedies that should help in that process. Financial institutions. Two types of corrections are necessary. A first is tantamount to preventive medicine - what should be done when institutions are not in crisis? The basic need here is for better bank supervision. Supervision must be improved to insure that proper risk management techniques are put in place and followed. Previous practices where banks, or those to whom banks made loans, loaded up on short-term hard currency denominated liabilities must be curbed. Market discipline can also be used to control risk, by exposing financial institutions to as much market discipline as possible and by limiting moral hazard problems. But even with all the preventive medicine in the world, the patient sometimes gets sick, and banks in Japan and a number of other countries surely are. What is to be done then? Examination of a number of historical episodes suggests that there are three important elements to dealing with a banking collapse. First, the bank regulators must go through the balance sheets, determine the problem loans, take them off the banks' balance sheets, sell them, and have the public take whatever losses were entailed. Second, the troubled institutions must be closed down with the management replaced and shareholders suffering losses. Third, the healthy institutions must then be recapitalized, preferably by new equity sales in capital markets. The sooner these steps are taken, the better. The longer they are not taken, the longer troubled banks will continue incurring losses, engaging in risky practices, threatening the safe institutions, generating contagion effects, and not performing the banks' all-important maturity transformation function. Indeed, here is a way foreign capital flows can be part of the solution to the problem, because new foreign-owned banks that can perform this maturity transformation function can be invited to participate in credit-starved economies. Maturity transformation. While financial institutions perform maturity transformation, there is no reason to unduly burden the system. Countries have often gotten into trouble when they have done too much maturity transformation - that is, borrowed from abroad at short maturities to finance long-term investment. Steps could be taken to limit such borrowing, either nationally or through bank supervision. Some economists have used this idea to propose taxes on short-term borrowing, though the tax rates necessary to do the job could be very high and it might be more effective to use orthodox principles of bank supervision. Transparency. A further set of corrective mechanisms involves greater transparency. It must be clearer to lenders and borrowers alike what risks they are taking. This requires better reporting by financial institutions, and it also requires better aggregate statistics on the uncommitted foreign reserve balances of individual countries. Transparency alone cannot do the job of good bank regulation, but it is hard to imagine a solution to the international lending problems of the day without more transparent accounting. The IMF. Last but not least I discuss the IMF. Frankly, my own feeling is that if an institution like the IMF did not exist, we would want to invent something like it. Here is an international institution that, at least in principle, can supervise the finances of different countries without the accusations of big brother that would come about if the United States alone tried to put itself in this role. Moreover, it can organize other lending countries to bring support to countries in need of liquidity assistance, as opposed to having the bill fall entirely on the United States. Supporting the existence of something like the IMF does not suggest agreement with its exact structure or with all of its policies. The present crisis indicates that international preventive medicine provisions are weak. It may be difficult for the IMF to perform this warning system role, but there is clearly a need for better warnings about the risks of lending to certain countries, to prevent currency vulnerabilities from building up as much as they did. The IMF's "one size fits all" recommendations of fiscal austerity should also be re-examined, because in many Asian countries expansionary fiscal policies were clearly called for indeed, still are called for - while the IMF initially recommended the reverse. But the two biggest criticisms of the IMF involve the moral hazard issue and exchange rate flexibility. On moral hazard, the criticism is more or less inevitable. Any time there is any governmental attempt to increase safety and soundness, moral hazard questions can be raised. In the case of the IMF, if it is there to bail out countries in a liquidity crisis, countries will be more likely to end up in liquidity crises. The answer, it seems to me, is for the IMF to attach tight conditions on its lending, so that countries will certainly not look forward to getting into debtor status. In terms of underlying structural change, this is one of the few leverage points the international lending community has on borrowing countries, and it is important for the IMF to use its tool well. On exchange rate flexibility, the problem with the critics is that they are not saying the same thing. Some say the IMF is too quick to let the exchange rate fall, some say it is not quick enough. Both cannot be right at the same time. As a general rule, the exchange rate flexibility issue is a hard one and it is hard to make broad recommendations. Sometimes a country's cost structure is clearly out of line, or its inflation rate is clearly too high, and exchange rate flexibility seems to be the least costly way to bring prices and wages back into line. But exchange rate flexibility will cause capital losses and will raise the cost and risk of future capital transactions. That does not mean that the exchange rate must be preserved at all costs, but it does mean that capital flows themselves put some constraints on the normal international adjustment mechanisms. Given all this, it is hard for me to take a firm policy on exchange flexibility, and I have some sympathy for the apparent open-mindedness of the IMF on the issue. Will these solutions be enough? Who knows. But I think we all have a stake in making the world capital system work better. Before we initiate more artificial restrictions on capital flows, we should try to improve the system to take advantage of its very large benefits.
1998-09-16T00:00:00	Mr. Greenspan's testimony on the international economic and financial system (Central Bank Articles and Speeches, 16 Sep 98)	Testimony of the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on Banking and Financial Services of the US House of Representatives on 16/9/98.	Mr. Greenspan's testimony on the international economic and financial Testimony of the Chairman of the Board of Governors of the US Federal Reserve system System, Mr. Alan Greenspan, before the Committee on Banking and Financial Services of the US House of Representatives on 16/9/98. As I testified before this Committee in the midst of the Mexican financial crisis in early 1995, major advances in technology have engendered a highly efficient and increasingly sophisticated international financial system. The system has fostered impressive growth in world trade and in standards of living for the vast majority of nations who have chosen to participate in it. But that same efficient financial system, as I also pointed out in that earlier testimony, has the capability to rapidly transmit the consequences of errors of judgment in private investments and public policies to all corners of the world at historically unprecedented speed. Thus, problems that appeared first in Thailand more than a year ago quickly spread to other East Asian economies that are relatively new participants in the international financial system, and subsequently to Russia and to some degree to eastern Europe and Latin America. Even long-time participants in the international financial community, such as Australia, New Zealand, and Canada, have experienced the peripheral gusts of the financial turmoil. Japan, still trying to come to grips with the bursting of its equity and real estate bubbles of the late 1980s, has experienced further setbacks as its major Asian customers have been forced to retrench. Reciprocally, its banking system problems and weakened economy have exacerbated the difficulties of its Asian neighbors. The relative stability of China and India, countries whose restrictions on international financial flows have insulated them to some extent from the current maelstrom, has led some to conclude that the relatively free flow of capital is detrimental to economic growth and standards of living. Such conclusions, in my judgment, are decidedly mistaken. The most affected emerging East Asian economies, despite the sharp contraction in their economic output during the past year, have retraced, on average, only one-sixth of their per capita growth over the past ten years. Even currently, their average per capita incomes are more than 21⁄2 times the levels of India and China despite the unquestioned gains both have made in recent years as they too have moved partially to join the international financial community. Moreover, outside of Asia, several East European countries have made significant progress towards the adoption and implementation of market systems and have increasingly integrated their financial systems into the broader world context to the evident benefit of their populations. Latin American nations, though currently under pressure, have largely succeeded in opening up their economies to international financial flows, and more rapidly rising living standards have been the result. It is clear, nonetheless, that participation in the international financial system with all its benefits carries with it an obligation to maintain a level of stability and a set of strong and transparent institutions and rules if an economy is to participate safely and effectively in markets that have become highly sensitive to misallocation of capital and other policy errors. When domestic financial systems fail for lack of adequate institutional infrastructures, the solution is not to turn back to a less turbulent, but also less prosperous, past regime of capital controls, but to strengthen the domestic institutions that are the prerequisite for engaging in today's international financial system. Blocking the exodus or repatriation of capital, as some of the newer participants in the international financial system appear inclined to do after they get into trouble, is, of course, the equivalent of the economy receiving a subsidized injection of funds. If liquidity is tight, the immediate effect of controls can be relief from the strain of meeting obligations and a temporary sense of well-being. This is an illusion however. The obvious consequence of confiscating part, or all, of foreign investors' capital and/or income, is to ensure a sharp reduction in the availability of new foreign investment in the future. The presumption that controls can be imposed temporarily, while an economy stabilizes, and then removed, gives insufficient recognition to the imbalances in an economy that emerge when controls are introduced. Removing controls subsequently creates its own set of problems, which most governments, inclined to impose controls in the first place, are therefore loathe to do. Indeed, controls are often employed to avoid required -- but frequently politically difficult -- economic adjustments. There are many examples in history of controls imposed and removed, but rarely without great difficulty and cost. To be sure, any economy can operate with its borders closed to foreign investment. But the evidence is persuasive that an economy deprived of the benefits of new technologies, and inhospitable to risk capital, will be mired at a suboptimal standard of living and slow growth rate associated with out-of-date technologies. It is often stipulated that while controls on direct foreign investment and its associated technology transfer are growth inhibiting, controls on short-term inflows do not adversely affect economic welfare. Arguably, however, the free flow of short-term capital facilitates the servicing of direct investments as well as the financing of trade. Indeed, it is often difficult to determine whether certain capital flows are direct investments or short term in nature. Chile is often cited as an example of the successful use of controls on short-term capital inflows. But in response to the most recent international financial turmoil, Chile has chosen to lower its barriers in order to encourage more inflows. Those economies at the cutting edge of technology clearly do not need foreign direct investment to sustain living standards and economic growth. The economy of the United States in the 1950s, for example, needed little foreign investment and yet was far more dominant in the world then, than it is today. That was a major change from our experiences of the latter half of the nineteenth century, when the vast amount of investment and technology from abroad played a significant role in propelling the US economy to world-class status. Even today, though we lead the world in many of the critical technologies, we still need to borrow a substantial share of the mobile pool of world savings to finance our level of domestic investment. Were we unable to do so, our standard of living would surely suffer. But the inflow of foreign capital would be much reduced if there were uncertainties about whether the capital could be freely repatriated. While historically there could be considerable risk in American investments -- for example, some nineteenth century investments in American railroads entailed large losses -- the freedom of repatriation and the sanctity of private contracts were, with rare exceptions, secure. Our experiences, and those of others, raise the question of the sustainability of free international capital flows when the conditions fostering and protecting them are impaired or absent. Specifically, an economy whose private and/or public sectors have become heavy net debtors in foreign currency is at risk of default, especially when its exchange rate unexpectedly moves adversely. Clearly, should default become widespread among a number of economies, the flow of international capital to other economies perceived as potentially in similar circumstances will slow and in certain instances reverse. The withdrawal of the ongoing benefits of free flowing capital, as recent history has so amply demonstrated, often can be abrupt and disruptive. The key question is obviously how do private sector entities and governments and, by extension, economies as a whole allow themselves through currency mismatches to reach the edge of insolvency? Indeed, where was the appropriate due diligence on the part of foreign investors? Investors will, on occasion, make misjudgments, and borrowers will, at times, misread their capabilities to service debt. When market prices and interest rates adjust promptly to evidence of such mistakes, the consequences of the mistakes are generally contained and, thus, rarely cumulate to pose significant systemic risk. There was some evidence of that process working in the latter part of the nineteenth century and early twentieth century when international capital flows were largely uninhibited. Losses, however, in an environment where gold standard rules were tight and liquidity constrained, were quickly reflected in rapid increases in interest rates and the cost of capital generally. This tended to delimit the misuse of capital and its consequences. Imbalances were generally aborted before they got out of hand. But following World War I such tight restraints on economies were seen as too inflexible to meet the economic policy goals of the twentieth century. From the 1930s through the 1960s and beyond, capital controls in many countries, including most industrial countries, inhibited international capital flows and to some extent the associated financial instability -- presumably, however, at the cost of significant shortfalls in economic growth. There were innumerable episodes, of course, where individual economies experienced severe exchange rate crises. Contagion, however, was generally limited by the existence of restrictions on capital movements that were at least marginally effective. In the 1970s and 1980s, recognition of the inefficiencies associated with controls, along with newer technologies and the deregulation they fostered, gradually restored the free flow of international capital prevalent a century earlier. In the late twentieth century, however, fiat currency regimes have replaced the rigid automaticity of the gold standard in its heyday. More elastic currencies and markets, arguably, are now less sensitive to and, hence, slower to contain the misallocation of capital. Market contagion across national borders has consequently been more prevalent and faster in today's international financial markets than appears to have been the case a century ago under comparable circumstances. As I pointed out before this Committee almost a year ago, a good part of the capital that flowed into East Asia in recent years (largely in the 1990s) probably reflected the large surge in equity prices in most industrial economies, especially in the United States. The sharp rise induced a major portfolio adjustment out of then perceived fully priced investments in western industry into the perceived bargain priced, but rapidly growing, enterprises and economies of Asia. The tendency to downplay the risks of lending in emerging markets, reinforced by the propensity of governments explicitly or implicitly to guarantee such investments in a number of cases, doubtless led to an excess of lending that would not have been supported in an earlier age. As I also pointed out in previous testimony, standards of due diligence on the part of both lenders and borrowers turned somewhat lax in the face of all the largess generated by abundant capital gains and all the optimism about the prospects for growth in the Asian region. The consequent emergence of heavy losses and near insolvency of a number of borrowing banks and nonfinancial businesses engendered a rush by foreign capital to the exits and induced severe contractions in economies with which borrowers and policymakers were unprepared and unable to cope. At that point the damage to confidence and the host economies had already been done. Endeavors now to block repatriation of foreign funds, while offering temporary cash flow relief, have significant long-term costs and clearly should be avoided, if at all possible. I recognize that if problems are allowed to fester beyond the point of retrieval, no market-oriented solution appears possible. Short-term patchwork solutions to achieve stability are presumed the only feasible alternatives. When that point is reached, an economy is seen as no longer having the capability of interacting normally with the international financial system, and is inclined to withdraw behind a wall of insulation. It must be remembered, however, that the financial disequilibria that caused the initial problems would not have been addressed. Unless they are, those problems will reemerge. As I implied earlier with respect to the nineteenth century American experience, there are certain conditions precedent to establishing a viable environment for international capital investment, one not subject to periodic systemic crises. Some mechanism must be in place to enhance due diligence on the part of lenders, but especially of borrowers individually and collectively. Losses of lenders do on occasion evoke systemic risks, but it is the failure of borrowers to maintain viable balance sheets and an ability to service their debts that creates the major risks to international stability. The banking systems in many emerging East Asian economies effectively collapsed in the aftermath of inappropriate borrowing, and large unhedged exposures, in foreign currencies. Much will be required to bolster the fragile market mechanisms of many, but certainly not all, economies that have recently begun to participate in the international financial system. Doubtless at the head of the list is reinforcing the capabilities of banking supervision in emerging market economies. Conditions that should be met before engaging in international borrowing need to be promulgated and better monitored by domestic regulatory authorities. Market pricing and counterparty surveillance can be expected to do most of the job of sustaining safety and soundness. The experience of recent years in East Asia, however, has clearly been less than reassuring. To be sure, lack of transparency and timely data inhibited the more sophisticated risk evaluation systems from signaling danger. But that lack itself ought to have set off alarms. As one might readily expect, today's risk evaluation systems are being improved as a consequence of recent failures. Just as importantly, if not more so, unless weak banking systems are deterred from engaging in the type of near reckless major international borrowing that some systems in East Asia engaged in during the first part of the 1990s, the overall system will continue at risk. A better regime of bank supervision among those economies with access to the international financial system needs to be fashioned.1 In addition, the resolution of defaults and workout procedures require significant improvements in the legal infrastructures in many nations seeking to participate in the international financial system.2 None of these critical improvements can be implemented quickly. Transition support by the international financial community to those in difficulty will, doubtless, be required. Such assistance has become especially important since it is evident from the recent unprecedented swings in currency exchange rates for some of the emerging market economies that the international financial system has become increasingly more sensitive than in the past to shortcomings in domestic banks and other financial institutions. The major advances in technologically sophisticated financial products in recent years have imparted a discipline on market participants not seen in nearly a century. Whatever international financial assistance is provided must be carefully shaped not to undermine that discipline. As a consequence, any temporary financial assistance must be carefully tailored to be conditional and not encourage undue moral hazard. It can be hoped that despite the severe trauma that most of the newer participants in the international financial system are currently experiencing, or perhaps because of it, improvements will emerge to the benefit, not only of the emerging market economies but, of the long-term participants of the system as well. 1 Parenthetically, a century ago, banks were rarely subsidized and, hence, were required by the market to hold far more capital than they do now. In today's environment, bank supervision and deposit insurance have displaced the need for high capital-asset ratios in industrial countries. Many of the new participants in the international financial system have had neither elevated capital, nor adequate supervision. This shortfall is now generally recognized and being addressed. 2 There are, of course, other reforms that I believe need to be addressed. These were outlined in my earlier testimonies before this Committee.	---[PAGE_BREAK]--- # Mr. Greenspan's testimony on the international economic and financial system Testimony of the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on Banking and Financial Services of the US House of Representatives on 16/9/98. As I testified before this Committee in the midst of the Mexican financial crisis in early 1995, major advances in technology have engendered a highly efficient and increasingly sophisticated international financial system. The system has fostered impressive growth in world trade and in standards of living for the vast majority of nations who have chosen to participate in it. But that same efficient financial system, as I also pointed out in that earlier testimony, has the capability to rapidly transmit the consequences of errors of judgment in private investments and public policies to all corners of the world at historically unprecedented speed. Thus, problems that appeared first in Thailand more than a year ago quickly spread to other East Asian economies that are relatively new participants in the international financial system, and subsequently to Russia and to some degree to eastern Europe and Latin America. Even long-time participants in the international financial community, such as Australia, New Zealand, and Canada, have experienced the peripheral gusts of the financial turmoil. Japan, still trying to come to grips with the bursting of its equity and real estate bubbles of the late 1980s, has experienced further setbacks as its major Asian customers have been forced to retrench. Reciprocally, its banking system problems and weakened economy have exacerbated the difficulties of its Asian neighbors. The relative stability of China and India, countries whose restrictions on international financial flows have insulated them to some extent from the current maelstrom, has led some to conclude that the relatively free flow of capital is detrimental to economic growth and standards of living. Such conclusions, in my judgment, are decidedly mistaken. The most affected emerging East Asian economies, despite the sharp contraction in their economic output during the past year, have retraced, on average, only one-sixth of their per capita growth over the past ten years. Even currently, their average per capita incomes are more than $21 / 2$ times the levels of India and China despite the unquestioned gains both have made in recent years as they too have moved partially to join the international financial community. Moreover, outside of Asia, several East European countries have made significant progress towards the adoption and implementation of market systems and have increasingly integrated their financial systems into the broader world context to the evident benefit of their populations. Latin American nations, though currently under pressure, have largely succeeded in opening up their economies to international financial flows, and more rapidly rising living standards have been the result. It is clear, nonetheless, that participation in the international financial system with all its benefits carries with it an obligation to maintain a level of stability and a set of strong and transparent institutions and rules if an economy is to participate safely and effectively in markets that have become highly sensitive to misallocation of capital and other policy errors. When domestic financial systems fail for lack of adequate institutional infrastructures, the solution is not to turn back to a less turbulent, but also less prosperous, past ---[PAGE_BREAK]--- regime of capital controls, but to strengthen the domestic institutions that are the prerequisite for engaging in today's international financial system. Blocking the exodus or repatriation of capital, as some of the newer participants in the international financial system appear inclined to do after they get into trouble, is, of course, the equivalent of the economy receiving a subsidized injection of funds. If liquidity is tight, the immediate effect of controls can be relief from the strain of meeting obligations and a temporary sense of well-being. This is an illusion however. The obvious consequence of confiscating part, or all, of foreign investors' capital and/or income, is to ensure a sharp reduction in the availability of new foreign investment in the future. The presumption that controls can be imposed temporarily, while an economy stabilizes, and then removed, gives insufficient recognition to the imbalances in an economy that emerge when controls are introduced. Removing controls subsequently creates its own set of problems, which most governments, inclined to impose controls in the first place, are therefore loathe to do. Indeed, controls are often employed to avoid required -- but frequently politically difficult -- economic adjustments. There are many examples in history of controls imposed and removed, but rarely without great difficulty and cost. To be sure, any economy can operate with its borders closed to foreign investment. But the evidence is persuasive that an economy deprived of the benefits of new technologies, and inhospitable to risk capital, will be mired at a suboptimal standard of living and slow growth rate associated with out-of-date technologies. It is often stipulated that while controls on direct foreign investment and its associated technology transfer are growth inhibiting, controls on short-term inflows do not adversely affect economic welfare. Arguably, however, the free flow of short-term capital facilitates the servicing of direct investments as well as the financing of trade. Indeed, it is often difficult to determine whether certain capital flows are direct investments or short term in nature. Chile is often cited as an example of the successful use of controls on short-term capital inflows. But in response to the most recent international financial turmoil, Chile has chosen to lower its barriers in order to encourage more inflows. Those economies at the cutting edge of technology clearly do not need foreign direct investment to sustain living standards and economic growth. The economy of the United States in the 1950s, for example, needed little foreign investment and yet was far more dominant in the world then, than it is today. That was a major change from our experiences of the latter half of the nineteenth century, when the vast amount of investment and technology from abroad played a significant role in propelling the US economy to world-class status. Even today, though we lead the world in many of the critical technologies, we still need to borrow a substantial share of the mobile pool of world savings to finance our level of domestic investment. Were we unable to do so, our standard of living would surely suffer. But the inflow of foreign capital would be much reduced if there were uncertainties about whether the capital could be freely repatriated. While historically there could be considerable risk in American investments -- for example, some nineteenth century investments in American railroads entailed large losses -- the freedom of repatriation and the sanctity of private contracts were, with rare exceptions, secure. ---[PAGE_BREAK]--- Our experiences, and those of others, raise the question of the sustainability of free international capital flows when the conditions fostering and protecting them are impaired or absent. Specifically, an economy whose private and/or public sectors have become heavy net debtors in foreign currency is at risk of default, especially when its exchange rate unexpectedly moves adversely. Clearly, should default become widespread among a number of economies, the flow of international capital to other economies perceived as potentially in similar circumstances will slow and in certain instances reverse. The withdrawal of the ongoing benefits of free flowing capital, as recent history has so amply demonstrated, often can be abrupt and disruptive. The key question is obviously how do private sector entities and governments and, by extension, economies as a whole allow themselves through currency mismatches to reach the edge of insolvency? Indeed, where was the appropriate due diligence on the part of foreign investors? Investors will, on occasion, make misjudgments, and borrowers will, at times, misread their capabilities to service debt. When market prices and interest rates adjust promptly to evidence of such mistakes, the consequences of the mistakes are generally contained and, thus, rarely cumulate to pose significant systemic risk. There was some evidence of that process working in the latter part of the nineteenth century and early twentieth century when international capital flows were largely uninhibited. Losses, however, in an environment where gold standard rules were tight and liquidity constrained, were quickly reflected in rapid increases in interest rates and the cost of capital generally. This tended to delimit the misuse of capital and its consequences. Imbalances were generally aborted before they got out of hand. But following World War I such tight restraints on economies were seen as too inflexible to meet the economic policy goals of the twentieth century. From the 1930s through the 1960s and beyond, capital controls in many countries, including most industrial countries, inhibited international capital flows and to some extent the associated financial instability -- presumably, however, at the cost of significant shortfalls in economic growth. There were innumerable episodes, of course, where individual economies experienced severe exchange rate crises. Contagion, however, was generally limited by the existence of restrictions on capital movements that were at least marginally effective. In the 1970s and 1980s, recognition of the inefficiencies associated with controls, along with newer technologies and the deregulation they fostered, gradually restored the free flow of international capital prevalent a century earlier. In the late twentieth century, however, fiat currency regimes have replaced the rigid automaticity of the gold standard in its heyday. More elastic currencies and markets, arguably, are now less sensitive to and, hence, slower to contain the misallocation of capital. Market contagion across national borders has consequently been more prevalent and faster in today's international financial markets than appears to have been the case a century ago under comparable circumstances. As I pointed out before this Committee almost a year ago, a good part of the capital that flowed into East Asia in recent years (largely in the 1990s) probably reflected the ---[PAGE_BREAK]--- large surge in equity prices in most industrial economies, especially in the United States. The sharp rise induced a major portfolio adjustment out of then perceived fully priced investments in western industry into the perceived bargain priced, but rapidly growing, enterprises and economies of Asia. The tendency to downplay the risks of lending in emerging markets, reinforced by the propensity of governments explicitly or implicitly to guarantee such investments in a number of cases, doubtless led to an excess of lending that would not have been supported in an earlier age. As I also pointed out in previous testimony, standards of due diligence on the part of both lenders and borrowers turned somewhat lax in the face of all the largess generated by abundant capital gains and all the optimism about the prospects for growth in the Asian region. The consequent emergence of heavy losses and near insolvency of a number of borrowing banks and nonfinancial businesses engendered a rush by foreign capital to the exits and induced severe contractions in economies with which borrowers and policymakers were unprepared and unable to cope. At that point the damage to confidence and the host economies had already been done. Endeavors now to block repatriation of foreign funds, while offering temporary cash flow relief, have significant long-term costs and clearly should be avoided, if at all possible. I recognize that if problems are allowed to fester beyond the point of retrieval, no market-oriented solution appears possible. Short-term patchwork solutions to achieve stability are presumed the only feasible alternatives. When that point is reached, an economy is seen as no longer having the capability of interacting normally with the international financial system, and is inclined to withdraw behind a wall of insulation. It must be remembered, however, that the financial disequilibria that caused the initial problems would not have been addressed. Unless they are, those problems will reemerge. As I implied earlier with respect to the nineteenth century American experience, there are certain conditions precedent to establishing a viable environment for international capital investment, one not subject to periodic systemic crises. Some mechanism must be in place to enhance due diligence on the part of lenders, but especially of borrowers individually and collectively. Losses of lenders do on occasion evoke systemic risks, but it is the failure of borrowers to maintain viable balance sheets and an ability to service their debts that creates the major risks to international stability. The banking systems in many emerging East Asian economies effectively collapsed in the aftermath of inappropriate borrowing, and large unhedged exposures, in foreign currencies. Much will be required to bolster the fragile market mechanisms of many, but certainly not all, economies that have recently begun to participate in the international financial system. Doubtless at the head of the list is reinforcing the capabilities of banking supervision in emerging market economies. Conditions that should be met before engaging in international borrowing need to be promulgated and better monitored by domestic regulatory authorities. Market pricing and counterparty surveillance can be expected to do most of the job of sustaining safety and soundness. The experience of recent years in East Asia, however, has clearly been less than reassuring. To be sure, lack of transparency and timely data inhibited the more sophisticated risk evaluation systems from signaling danger. But that lack itself ought to have set off alarms. As one might readily expect, today's risk evaluation systems are being improved as a consequence of recent failures. ---[PAGE_BREAK]--- Just as importantly, if not more so, unless weak banking systems are deterred from engaging in the type of near reckless major international borrowing that some systems in East Asia engaged in during the first part of the 1990s, the overall system will continue at risk. A better regime of bank supervision among those economies with access to the international financial system needs to be fashioned. ${ }^{1}$ In addition, the resolution of defaults and workout procedures require significant improvements in the legal infrastructures in many nations seeking to participate in the international financial system. ${ }^{2}$ None of these critical improvements can be implemented quickly. Transition support by the international financial community to those in difficulty will, doubtless, be required. Such assistance has become especially important since it is evident from the recent unprecedented swings in currency exchange rates for some of the emerging market economies that the international financial system has become increasingly more sensitive than in the past to shortcomings in domestic banks and other financial institutions. The major advances in technologically sophisticated financial products in recent years have imparted a discipline on market participants not seen in nearly a century. Whatever international financial assistance is provided must be carefully shaped not to undermine that discipline. As a consequence, any temporary financial assistance must be carefully tailored to be conditional and not encourage undue moral hazard. It can be hoped that despite the severe trauma that most of the newer participants in the international financial system are currently experiencing, or perhaps because of it, improvements will emerge to the benefit, not only of the emerging market economies but, of the long-term participants of the system as well. [^0] [^0]: 1 Parenthetically, a century ago, banks were rarely subsidized and, hence, were required by the market to hold far more capital than they do now. In today's environment, bank supervision and deposit insurance have displaced the need for high capital-asset ratios in industrial countries. Many of the new participants in the international financial system have had neither elevated capital, nor adequate supervision. This shortfall is now generally recognized and being addressed. 2 There are, of course, other reforms that I believe need to be addressed. These were outlined in my earlier testimonies before this Committee.	Alan Greenspan	United States	https://www.bis.org/review/r980918d.pdf	system Testimony of the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan, before the Committee on Banking and Financial Services of the US House of Representatives on 16/9/98. As I testified before this Committee in the midst of the Mexican financial crisis in early 1995, major advances in technology have engendered a highly efficient and increasingly sophisticated international financial system. The system has fostered impressive growth in world trade and in standards of living for the vast majority of nations who have chosen to participate in it. But that same efficient financial system, as I also pointed out in that earlier testimony, has the capability to rapidly transmit the consequences of errors of judgment in private investments and public policies to all corners of the world at historically unprecedented speed. Thus, problems that appeared first in Thailand more than a year ago quickly spread to other East Asian economies that are relatively new participants in the international financial system, and subsequently to Russia and to some degree to eastern Europe and Latin America. Even long-time participants in the international financial community, such as Australia, New Zealand, and Canada, have experienced the peripheral gusts of the financial turmoil. Japan, still trying to come to grips with the bursting of its equity and real estate bubbles of the late 1980s, has experienced further setbacks as its major Asian customers have been forced to retrench. Reciprocally, its banking system problems and weakened economy have exacerbated the difficulties of its Asian neighbors. The relative stability of China and India, countries whose restrictions on international financial flows have insulated them to some extent from the current maelstrom, has led some to conclude that the relatively free flow of capital is detrimental to economic growth and standards of living. Such conclusions, in my judgment, are decidedly mistaken. The most affected emerging East Asian economies, despite the sharp contraction in their economic output during the past year, have retraced, on average, only one-sixth of their per capita growth over the past ten years. Even currently, their average per capita incomes are more than $21 / 2$ times the levels of India and China despite the unquestioned gains both have made in recent years as they too have moved partially to join the international financial community. Moreover, outside of Asia, several East European countries have made significant progress towards the adoption and implementation of market systems and have increasingly integrated their financial systems into the broader world context to the evident benefit of their populations. Latin American nations, though currently under pressure, have largely succeeded in opening up their economies to international financial flows, and more rapidly rising living standards have been the result. It is clear, nonetheless, that participation in the international financial system with all its benefits carries with it an obligation to maintain a level of stability and a set of strong and transparent institutions and rules if an economy is to participate safely and effectively in markets that have become highly sensitive to misallocation of capital and other policy errors. When domestic financial systems fail for lack of adequate institutional infrastructures, the solution is not to turn back to a less turbulent, but also less prosperous, past regime of capital controls, but to strengthen the domestic institutions that are the prerequisite for engaging in today's international financial system. Blocking the exodus or repatriation of capital, as some of the newer participants in the international financial system appear inclined to do after they get into trouble, is, of course, the equivalent of the economy receiving a subsidized injection of funds. If liquidity is tight, the immediate effect of controls can be relief from the strain of meeting obligations and a temporary sense of well-being. This is an illusion however. The obvious consequence of confiscating part, or all, of foreign investors' capital and/or income, is to ensure a sharp reduction in the availability of new foreign investment in the future. The presumption that controls can be imposed temporarily, while an economy stabilizes, and then removed, gives insufficient recognition to the imbalances in an economy that emerge when controls are introduced. Removing controls subsequently creates its own set of problems, which most governments, inclined to impose controls in the first place, are therefore loathe to do. Indeed, controls are often employed to avoid required -- but frequently politically difficult -- economic adjustments. There are many examples in history of controls imposed and removed, but rarely without great difficulty and cost. To be sure, any economy can operate with its borders closed to foreign investment. But the evidence is persuasive that an economy deprived of the benefits of new technologies, and inhospitable to risk capital, will be mired at a suboptimal standard of living and slow growth rate associated with out-of-date technologies. It is often stipulated that while controls on direct foreign investment and its associated technology transfer are growth inhibiting, controls on short-term inflows do not adversely affect economic welfare. Arguably, however, the free flow of short-term capital facilitates the servicing of direct investments as well as the financing of trade. Indeed, it is often difficult to determine whether certain capital flows are direct investments or short term in nature. Chile is often cited as an example of the successful use of controls on short-term capital inflows. But in response to the most recent international financial turmoil, Chile has chosen to lower its barriers in order to encourage more inflows. Those economies at the cutting edge of technology clearly do not need foreign direct investment to sustain living standards and economic growth. The economy of the United States in the 1950s, for example, needed little foreign investment and yet was far more dominant in the world then, than it is today. That was a major change from our experiences of the latter half of the nineteenth century, when the vast amount of investment and technology from abroad played a significant role in propelling the US economy to world-class status. Even today, though we lead the world in many of the critical technologies, we still need to borrow a substantial share of the mobile pool of world savings to finance our level of domestic investment. Were we unable to do so, our standard of living would surely suffer. But the inflow of foreign capital would be much reduced if there were uncertainties about whether the capital could be freely repatriated. While historically there could be considerable risk in American investments -- for example, some nineteenth century investments in American railroads entailed large losses -- the freedom of repatriation and the sanctity of private contracts were, with rare exceptions, secure. Our experiences, and those of others, raise the question of the sustainability of free international capital flows when the conditions fostering and protecting them are impaired or absent. Specifically, an economy whose private and/or public sectors have become heavy net debtors in foreign currency is at risk of default, especially when its exchange rate unexpectedly moves adversely. Clearly, should default become widespread among a number of economies, the flow of international capital to other economies perceived as potentially in similar circumstances will slow and in certain instances reverse. The withdrawal of the ongoing benefits of free flowing capital, as recent history has so amply demonstrated, often can be abrupt and disruptive. The key question is obviously how do private sector entities and governments and, by extension, economies as a whole allow themselves through currency mismatches to reach the edge of insolvency? Indeed, where was the appropriate due diligence on the part of foreign investors? Investors will, on occasion, make misjudgments, and borrowers will, at times, misread their capabilities to service debt. When market prices and interest rates adjust promptly to evidence of such mistakes, the consequences of the mistakes are generally contained and, thus, rarely cumulate to pose significant systemic risk. There was some evidence of that process working in the latter part of the nineteenth century and early twentieth century when international capital flows were largely uninhibited. Losses, however, in an environment where gold standard rules were tight and liquidity constrained, were quickly reflected in rapid increases in interest rates and the cost of capital generally. This tended to delimit the misuse of capital and its consequences. Imbalances were generally aborted before they got out of hand. But following World War I such tight restraints on economies were seen as too inflexible to meet the economic policy goals of the twentieth century. From the 1930s through the 1960s and beyond, capital controls in many countries, including most industrial countries, inhibited international capital flows and to some extent the associated financial instability -- presumably, however, at the cost of significant shortfalls in economic growth. There were innumerable episodes, of course, where individual economies experienced severe exchange rate crises. Contagion, however, was generally limited by the existence of restrictions on capital movements that were at least marginally effective. In the 1970s and 1980s, recognition of the inefficiencies associated with controls, along with newer technologies and the deregulation they fostered, gradually restored the free flow of international capital prevalent a century earlier. In the late twentieth century, however, fiat currency regimes have replaced the rigid automaticity of the gold standard in its heyday. More elastic currencies and markets, arguably, are now less sensitive to and, hence, slower to contain the misallocation of capital. Market contagion across national borders has consequently been more prevalent and faster in today's international financial markets than appears to have been the case a century ago under comparable circumstances. As I pointed out before this Committee almost a year ago, a good part of the capital that flowed into East Asia in recent years (largely in the 1990s) probably reflected the large surge in equity prices in most industrial economies, especially in the United States. The sharp rise induced a major portfolio adjustment out of then perceived fully priced investments in western industry into the perceived bargain priced, but rapidly growing, enterprises and economies of Asia. The tendency to downplay the risks of lending in emerging markets, reinforced by the propensity of governments explicitly or implicitly to guarantee such investments in a number of cases, doubtless led to an excess of lending that would not have been supported in an earlier age. As I also pointed out in previous testimony, standards of due diligence on the part of both lenders and borrowers turned somewhat lax in the face of all the largess generated by abundant capital gains and all the optimism about the prospects for growth in the Asian region. The consequent emergence of heavy losses and near insolvency of a number of borrowing banks and nonfinancial businesses engendered a rush by foreign capital to the exits and induced severe contractions in economies with which borrowers and policymakers were unprepared and unable to cope. At that point the damage to confidence and the host economies had already been done. Endeavors now to block repatriation of foreign funds, while offering temporary cash flow relief, have significant long-term costs and clearly should be avoided, if at all possible. I recognize that if problems are allowed to fester beyond the point of retrieval, no market-oriented solution appears possible. Short-term patchwork solutions to achieve stability are presumed the only feasible alternatives. When that point is reached, an economy is seen as no longer having the capability of interacting normally with the international financial system, and is inclined to withdraw behind a wall of insulation. It must be remembered, however, that the financial disequilibria that caused the initial problems would not have been addressed. Unless they are, those problems will reemerge. As I implied earlier with respect to the nineteenth century American experience, there are certain conditions precedent to establishing a viable environment for international capital investment, one not subject to periodic systemic crises. Some mechanism must be in place to enhance due diligence on the part of lenders, but especially of borrowers individually and collectively. Losses of lenders do on occasion evoke systemic risks, but it is the failure of borrowers to maintain viable balance sheets and an ability to service their debts that creates the major risks to international stability. The banking systems in many emerging East Asian economies effectively collapsed in the aftermath of inappropriate borrowing, and large unhedged exposures, in foreign currencies. Much will be required to bolster the fragile market mechanisms of many, but certainly not all, economies that have recently begun to participate in the international financial system. Doubtless at the head of the list is reinforcing the capabilities of banking supervision in emerging market economies. Conditions that should be met before engaging in international borrowing need to be promulgated and better monitored by domestic regulatory authorities. Market pricing and counterparty surveillance can be expected to do most of the job of sustaining safety and soundness. The experience of recent years in East Asia, however, has clearly been less than reassuring. To be sure, lack of transparency and timely data inhibited the more sophisticated risk evaluation systems from signaling danger. But that lack itself ought to have set off alarms. As one might readily expect, today's risk evaluation systems are being improved as a consequence of recent failures. Just as importantly, if not more so, unless weak banking systems are deterred from engaging in the type of near reckless major international borrowing that some systems in East Asia engaged in during the first part of the 1990s, the overall system will continue at risk. A better regime of bank supervision among those economies with access to the international financial system needs to be fashioned. None of these critical improvements can be implemented quickly. Transition support by the international financial community to those in difficulty will, doubtless, be required. Such assistance has become especially important since it is evident from the recent unprecedented swings in currency exchange rates for some of the emerging market economies that the international financial system has become increasingly more sensitive than in the past to shortcomings in domestic banks and other financial institutions. The major advances in technologically sophisticated financial products in recent years have imparted a discipline on market participants not seen in nearly a century. Whatever international financial assistance is provided must be carefully shaped not to undermine that discipline. As a consequence, any temporary financial assistance must be carefully tailored to be conditional and not encourage undue moral hazard. It can be hoped that despite the severe trauma that most of the newer participants in the international financial system are currently experiencing, or perhaps because of it, improvements will emerge to the benefit, not only of the emerging market economies but, of the long-term participants of the system as well. There are, of course, other reforms that I believe need to be addressed. These were outlined in my earlier testimonies before this Committee.
1998-09-17T00:00:00	Mr. Kelley reports on the Year 2000 progress of the banking and financial services sector in the United States (Central Bank Articles and Speeches, 17 Sep 98)	Testimony of Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, on the Year 2000 progress of the banking and financial services sector, before the Committee on Banking and Financial Services of the US House of Representatives on 17/9/98.	Mr. Kelley reports on the Year 2000 progress of the banking and financial Testimony of Mr. Edward W. Kelley, Jr., a member of the services sector in the United States Board of Governors of the US Federal Reserve System, on the Year 2000 progress of the banking and financial services sector, before the Committee on Banking and Financial Services of the US House of Representatives on 17/9/98. Thank you for again inviting me to appear before this Committee to discuss the Year 2000 issue. This problem poses a major challenge to public policy: the stakes are enormous, nothing less than the preservation of a safe and sound financial system that can continue to operate in an orderly manner when the clock rolls over at midnight on New Year's Eve and the millennium arrives. The Year 2000 problem will touch much more than just our financial systems and could temporarily have adverse effects on the performance of the overall US economy as well as the economies of many, or all, nations if not corrected. As I said last April in testimony before the Senate Committee on Commerce, Science, and Transportation, some of the more adverse scenarios are not without a certain plausibility, if this challenge were being ignored. But it is not being ignored. While it is impossible today to precisely forecast the impact of this event, and the range of possibilities runs from minimal to extremely serious, an enormous amount of work is being done in anticipation of the rollover of the millennium, and I am optimistic that this work will pay off. In that spirit, let me update you on what the Federal Reserve has done to address the Year 2000 issue. Since I last testified here in November 1997, the Federal Reserve has met the goals that we set for ourselves. We have: • renovated our mission-critical applications and nearly completed our internal testing; • opened our mission-critical systems to customers for testing; • progressed significantly in our contingency planning efforts; • implemented a policy concerning changes to our information systems; and concluded our initial review of all banks subject to our supervisory authority. • While these accomplishments are indicative of our significant progress in addressing the Year 2000 issue, much work remains. In the testing area, we are finalizing plans for concurrent testing of multiple mission-critical applications by customers. We are coordinating with the Clearing House for Interbank Payment Systems (CHIPS) and the Society for Worldwide Interbank Financial Telecommunications (SWIFT) to provide a common test day for customers of Fedwire and these two systems. We have a System-wide project underway to enhance our contingency plans to address failures external to the Federal Reserve. We are conducting a second round of supervisory reviews of banks subject to our supervisory authority and also actively coordinating with various domestic and international Year 2000 organizations. This morning I would like to discuss these achievements and the important aspects of the job that remain ahead of us. Federal Reserve Readiness The Federal Reserve has completed the renovation of its mission-critical systems, and we are nearing the conclusion of our internal Year 2000 testing efforts. Internal testing includes both individual applications and application interfaces, such as the exchange of data between Fedwire and our Integrated Accounting System. Testing is conducted through a combination of two elements: one is future-dating our computer systems to verify the readiness of our information technology, and the other is testing critical future date processing within our business applications. Communications network components are also being tested and certified in special test lab environments at the Federal Reserve Automation Services and the Board of Governors. The Reserve Banks and the Board have implemented test century date change (CDC) local area networks to verify the readiness of vendor provided products and internal applications that operate in network-based computing environments. With the exception of a few systems that will be replaced by March 1999, we will complete the testing activities and implement our mission-critical applications in production by year-end 1998. On June 29, 1998, we made our future-dated test environment available to customers for Year 2000 testing; the crucial testing period will extend through 1999. Depository institutions which are Federal Reserve customers, and thus rely on our payment applications such as Fedwire, Fed ACH, and check processing systems, can test century rollover and leap year transactions six days a week. On six weekends this fall, depository institutions will be able to test Year 2000 test dates with several applications simultaneously. We are providing assistance to our customers who test with us, and have provided them, through a series of Century Date Change bulletins, with technical information and guidelines concerning the testing activity. By the end of August, almost 400 customers, including the US Treasury, had conducted CDC testing with the Federal Reserve, and the number scheduling tests is increasing rapidly. These tests encompass ten of our mission-critical applications. To ensure that the nation's larger banks are taking advantage of this testing opportunity, we intend to contact any that have not availed themselves of this service. Several foreign banking organizations have begun to test large dollar payment systems with the Federal Reserve and CHIPS. Most large foreign banks will participate in the September 26, 1998, coordinated test in which Fedwire, CHIPS, and SWIFT are participating. Like most information technology environments, ours are composed primarily of vendor hardware and software products. To assess the Year 2000 readiness of these environments, as well as our building systems such as vault and climate control systems, we have created an automated inventory of the vendor products that we use and are tracking the Year 2000 compliance status of those products. Although the Federal Reserve has made progress in independently testing vendor products, we will continue these efforts. In prior testimony, I have noted the critical dependence of banks on telecommunication services and the need to ensure the readiness of telecommunication service providers. To foster a better understanding of the importance of information sharing by the telecommunications industry, I wrote to Federal Communications Commissioner Powell about this issue. Commissioner Powell has been responsive and has provided us and others with information regarding the FCC's oversight and plans. The Federal Reserve is also participating in the Telecommunications Sector Group of the President's Council on Year 2000 Conversion. In addition, the Federal Reserve is monitoring telecommunication carriers to assess whether those used by the Federal Reserve will be Year 2000 compliant. We are pleased with the responsiveness of the telecommunications industry: plans for industry testing are well under way, with participation from the major service providers, as well as their suppliers. Contingency Planning As the nation's central bank, the Federal Reserve is actively engaged in contingency planning for both operational disruptions and systemic risks. An internal CDC Council consisting of senior managers is coordinating contingency planning across the Federal Reserve's various functions and is fostering a cohesive approach to internal readiness and interaction with the financial community. In general, the banking industry's focus has also progressed from the renovation of systems to business continuity and contingency planning. Contingency planning for the Federal Reserve includes payments systems, currency availability and distribution, information processing, the discount window, and the supervision function. We will also play an important role in coordinating with the financial community concerning issues such as systemic risk and cross-border payments. Operational Contingency The Federal Reserve's plans for operational continuity build on existing contingency plans. As you know, we have long maintained comprehensive contingency plans that are routinely tested and have been implemented during natural disasters and other disruptions. These plans cover our internal systems, as well as the services we provide to depository institutions. In June 1998, each of the Federal Reserve's business offices completed assessments of the adequacy of existing contingency scenarios to address CDC risks. Federal Reserve CDC contingency workgroups are identifying problems external to the Federal Reserve that may arise when the date changes to 2000, such as those affecting telecommunications providers, large financial institutions, utility companies, other key financial market participants, and difficulties abroad that affect US markets or institutions. The workgroups are developing corresponding recommendations to mitigate those problems. The Federal Reserve plans to finalize contingency plans reflecting these recommendations by November 30, 1998. We will continue to refine our CDC contingency plans as necessary throughout 1999. In fourth quarter 1998, we will focus our efforts on how to test our contingency plans to ensure their operational effectiveness at the century rollover. Change Management As a part of our operational readiness planning, the Federal Reserve is developing procedures to manage the risks posed by changes to information systems in 1999 and the first quarter of 2000. After the scheduled completion of testing and implementation of our critical applications, changes to Federal Reserve policies, rules, regulations, and services that generate changes to critical information systems create the risk that those systems may no longer be CDC compliant. Consequently, we have established guidelines to significantly limit policy and operational changes, as well as internal hardware and software changes, during late 1999 and early 2000 in order to minimize the risks and complexities of problem resolution associated with the introduction of new processing components. By limiting changes to our systems, we will not only provide a stable internal processing environment entering the Year 2000, but we will also minimize changes that our customers could be required to make to their applications that interface with our software. In addition, we intend to aggressively coordinate with other institutions that typically generate policy and operational changes in the financial industry. We intend to publish our guidelines to assist other organizations facing similar issues and I would urge that Congress, as well as other federal agencies, consider adoption of such change management policies as we move into 1999. Currency As I noted earlier, cash availability and processing is an issue we have considered in the contingency planning process. We have regularly met the public's heightened demand for US currency in peak seasons or in extraordinary situations, such as natural disasters. We recently submitted our fiscal year 1999 currency printing order to the Department of the Treasury's Bureau of Engraving and Printing and we increased the size of next year's print order due to Year 2000 considerations. With this order, we will substantially increase the amount of currency either in circulation or in Federal Reserve vaults over current levels by late 1999. We believe this increase in the level of currency should be ample to meet the public's demand for extra cash during the period surrounding the century rollover. This is a precautionary step on our part -- we believe it is prudent to print more currency than we think will be required than to risk not printing enough. While we do not anticipate any extraordinary demand for cash, we believe it is important that the public have complete confidence that sufficient supplies of currency will be available. In effect, the Federal Reserve is accelerating the timing of currency printing; we are planning for a possible short-lived increased demand for cash and will be able to reduce future print orders to lower-than-normal levels. As we monitor the public's demand for currency, we can introduce other measures to further increase cash levels. First, the recent currency order with the Bureau of Printing and Engraving is for the federal fiscal year 1999, so that there will be time to print additional notes in the last three months of 1999. Second, we can change the print order to increase production of higher denomination notes. Third, we can increase staff in Reserve Bank cash operation functions to improve the turnaround time required to process cash deposits and move currency back into circulation. Finally, as a last resort, we can hold off the destruction of old or worn currency. Liquidity Another contingency planning issue for the Federal Reserve is liquidity. Despite their best efforts, some depository institutions could encounter problems in the rollover in maintaining reliable computer systems, and these problems may or may not affect their funding positions. To the extent necessary, the Federal Reserve is prepared to lend, in appropriate circumstances and with adequate collateral, to depository institutions when market sources of funding are not reasonably available. The terms and conditions of such lending may depend upon the circumstances causing the liquidity shortfall. Financial Sector Initiatives The Federal Reserve and private industry have intensified cooperative efforts to address contingency planning. The Year 2000 Contingency Planning Working Group of the New York Clearing House (NYCH), the Securities Industry Association (SIA), and the Federal Reserve are developing coordinated contingency plans for the Year 2000 and will act as liaison with other industry groups addressing contingency planning on behalf of banks, securities firms, exchanges, clearance and settlement organizations, regulators, and international markets. Among other things, the Working Group is considering plans for the establishment of Year 2000 communications centers throughout the country, and perhaps internationally. Primarily, such centers would facilitate the exchange of up-to-date information on developing problems and issues among participants and enhance the development of consensus, when necessary, to coordinate timely responses to problems. The Federal Reserve is assisting in the government's coordination of the Year 2000 effort within the financial industry by participating in the Financial Institutions Sector Group of the President's Council on Year 2000 Conversion. A senior Board official who chairs this Sector Group has been working with representatives of government financial organizations, including the federal banking agencies, the Department of the Treasury, the Securities and Exchange Commission, and other agencies responsible for various financial intermediaries, to assess the Year 2000 readiness of the financial industry and formulate strategies for addressing interagency Year 2000 issues. Bank Supervision I would now like to turn to our industry oversight activities. The Federal Reserve met its goal, set in May 1997, of conducting a Year 2000 supervisory review of all banks subject to our supervisory authority by June 1998. This public commitment and visible effort did much to stimulate industry action on the Year 2000 issue. We have also established ties and are providing significant support to numerous public and private groups, both domestic and international, that are addressing the Year 2000 readiness of their respective constituencies. As part of our outreach program, we continually emphasize the critical significance of ensuring that computer systems and applications are Year 2000 compliant and the complexity of the managerial and technological challenges that the required effort presents for all enterprises. For entities such as financial institutions that rely heavily on computers to provide financial services to customers, achieving Year 2000 compliance in mission-critical systems is essential for maintaining the quality and continuity of customer services. While bank supervisors can provide guidance, encouragement, and strong formal and informal supervisory incentives to the banking industry to address this challenge, it is important to recognize that we cannot be ultimately responsible for ensuring or guaranteeing the Year 2000 readiness and viability of the banking organizations we supervise. Rather, the boards of directors and senior management of banks and other financial institutions must be responsible for ensuring that the institutions they manage are able to provide high quality and continuous services from the first day in January of the Year 2000. As we have emphasized continually during the past sixteen months, this critical obligation must be among the very highest of priorities for bank management and boards of directors. Policy Guidance and Supervisory Reviews The Federal Reserve continues to work closely with the other banking agencies that comprise the Federal Financial Institutions Examination Council (FFIEC) to address the banking industry's Year 2000 readiness. A series of seven advisory statements has been issued since I was last here in November 1997, including statements on the nature of Year 2000 business risk, the importance of service provider readiness, the means to address customer risk, the need to respond to customer inquiries, the critical importance of testing, the urgency of effective contingency planning, and the need to address the readiness of fiduciary activities. As a result of these advisory statements, the extent of the industry's Year 2000 efforts has significantly intensified. These statements can be found in their entirety at http://www.federalreserve.gov/Y2K. Compliance with these statements is assessed during the conduct of supervisory reviews. Through June 30, the Federal Reserve had conducted reviews of approximately 1,600 organizations. Information and data collected during these reviews has proven to be reliable, consistent with our overall supervisory experience which is heavily dependent on an extensive on-site examination program. These reviews have resulted in a significant focus of attention on the subject matter within the industry and identified several issues warranting additional attention by the supervisors, particularly the need for the supplemental guidance on testing and contingency planning. It is critical that banks avail themselves of every opportunity to test mission-critical systems internally and with their counterparties, and recurring testing may be warranted as additional systems are renovated to assure that those systems already tested are not adversely affected. Based on the reviews completed by the Federal Reserve, the vast majority of banking organizations are making satisfactory progress in their Year 2000 planning and readiness efforts. About four percent are rated "needs improvement" and fewer than one percent are rated "unsatisfactory". In these cases, the Federal Reserve has initiated intensive supervisory followup. Working closely with state banking departments, the Federal Reserve is making a concerted effort to focus additional attention on those particular banking organizations that are deemed deficient in their Year 2000 planning and progress. Deficient organizations have been informed of their status through supervisory review comments, meetings with senior management or the board of directors, and deficiency notification letters calling for submission of detailed plans and formal responses to the deficiencies noted. Such organizations are then subject to increased monitoring and supervisory follow-up including more frequent reviews. Restrictions on expansionary activities by Year 2000 deficient organizations have also been put into place. As a result of these letters, organizations once deemed deficient have taken significant steps to enhance their Year 2000 programs and over half have been upgraded to satisfactory. The Federal Reserve has commenced Phase II of its supervision program which covers the nine months from July 1998 through March 1999. During this second phase, we will conduct another round of supervisory reviews focused on Year 2000 testing and contingency planning. In addition, we have committed to conducting another review of the information systems service providers and will distribute the results to the serviced banks. Assessment of Review Results Based on these reviews and other interactions with the industry, it appears that financial institution progress in renovating mission-critical systems has advanced notably since the Federal Reserve and the other banking agencies escalated efforts to focus the industry's attention on ensuring Year 2000 readiness. Banking organizations are making substantial headway toward Year 2000 readiness and, with some exceptions, are on track to meet FFIEC guidelines. Specifically, the FFIEC guidelines call for the completion of internal testing of mission critical systems by year-end 1998. Most large organizations are nearing completion of the renovation of their mission-critical systems and are vigorously testing those that have been renovated. Smaller organizations are working closely with their service providers in an effort to confirm that the efforts under way will assure the readiness and reliability of the services and products on which they depend. Information Systems Service Providers The banking agencies are examining the Year 2000 readiness of certain information systems service providers and software vendors that provide services and products to a large number of banking organizations. These examinations are often conducted on an interagency basis. The Federal Reserve has participated in reviews of sixteen national service providers and twelve national software vendors. In addition, the banking agencies are examining selected regional service providers and software vendors. These examinations assess the overall Year 2000 program management of the firms and confirm their plans to support products for Year 2000 readiness. To help banking organizations assess the Year 2000 readiness and dependability of their service providers and to encourage examined service providers to cooperate fully with the industry's efforts, the banking agencies are distributing the results of Year 2000 reviews of service providers and software vendors to the serviced banks. The information in the reports is not a certification of the readiness of the service provider, and it is still incumbent on each bank to work closely with its service providers to prepare for the century date change. Service providers and software vendors serving the banking industry are keenly aware of the industry's reliance on their products and services, and most consider their Year 2000 readiness to be their highest priority in order for them to remain competitive in an aggressive industry. Credit Quality FFIEC guidelines call for banks to have a plan to assess customer Year 2000 readiness by June 30, 1998, and to complete an assessment of their customers' Year 2000 readiness by September 30, 1998, in order to better understand the risks faced by the bank if customers are unable to meet their obligations on a timely basis. Even though our Phase I Year 2000 examinations were conducted before the June 30, 1998, milestone, our examiners noted that most organizations either had begun planning or had initiated their customer assessment programs. We have seen no signs that credit quality has deteriorated as a result of Year 2000 readiness considerations, although it is still early. Results from a Federal Reserve Senior Loan Officer Opinion Survey on Bank Lending Practices (May 1998) indicated that respondents generally include Year 2000 preparedness in their underwriting and loan review standards. Another survey of Senior Loan Officers is to be conducted in November in order to obtain a more timely picture of any deterioration in credit quality related to the Year 2000. Efforts have also been made to prompt the nation's largest banks that syndicate large loans to address the Year 2000 readiness of their borrowers. Through the Shared National Credit Program, banks that syndicate credits over $20 million are asked to provide the banking agencies with information pertaining to the banks' efforts to assess the readiness of the borrowers. This initiative has helped large lenders understand that they need to consider their customers' readiness in their risk management programs. Additional Outreach Initiatives The Federal Reserve is participating in numerous outreach initiatives with the banking industry, trade associations, regulatory authorities, and other groups that are hosting conferences, seminars, and training opportunities focusing on the Year 2000 and helping participants understand better the issues that need to be addressed. Partly in response to the requirements of the Examination Parity and Year 2000 Readiness for Financial Institutions Act, which calls for the banking agencies to conduct seminars for bankers on the Year 2000, the federal banking agencies have been working with state banking departments as well as national and local bankers' associations to develop coordinated and comprehensive efforts at improving the local and regional programs intended to focus attention on the Year 2000. In the first six months of 1998, the Federal Reserve has participated in over 230 outreach initiatives reaching over 14,000 bankers. Another 100 outreach initiatives are scheduled for the third quarter of 1998. In addition, our public web site provides extensive information on our Year 2000 supervision program and on other resources available to the industry to help prepare for the millennium. International Coordination International cooperation on Year 2000 has intensified over the past several months because of the efforts of the public sector Joint Year 2000 Council (Joint Council) and the private sector Global 2000 Coordinating Group (G-2000). As you recall from your hearings on international issues in June, Mr. Ernest Patrikas, then Chairman of the Joint Council and a senior official of the Federal Reserve Bank of New York, testified on the global efforts of the Joint Council to enhance international initiatives by financial regulators. His successor as Chairman of the Joint Council, Federal Reserve Governor Roger Ferguson, is continuing those efforts and is working closely with an external consultative committee composed of representatives from international financial services providers, international financial market associations, financial rating agencies, and a number of other international industry associations. The Joint Council is working to foster better awareness and understanding of Year 2000 issues on the part of regulators around the world; for example, the Joint Council is sponsoring a series of regional seminars for banking, insurance, and securities supervisors. The G-2000 includes more than forty financial institutions from over twenty countries that are addressing country assessments, testing, and contingency planning, as well as other issues. The group has developed a standard framework for assessing individual country preparations for the century date change and also will address the Year 2000 readiness of financial institutions, service providers, and the countries' infrastructures. This framework is being used to collect information and assess the readiness of about twenty major countries by the end of this year, with others scheduled for in-depth reviews in 1999. The Basle Committee on Banking Supervision continues to be active on Year 2000 issues, both within the Joint Council and separately, as part of its normal supervisory activities. Year 2000 will be a major issue to be discussed at the International Conference of Bank Supervisors in October. The Basle Committee is also planning a follow-up survey on Year 2000 progress. Closing Remarks Financial institutions have made significant progress in renovating their systems to prepare for the Year 2000 and much has been accomplished to ensure the continuation of reliable services to the banking public at the century rollover. We are committed to a rigorous program of industry testing and contingency planning and, through our supervisory initiatives, to identifying those organizations that most need to apply additional attention to Year 2000 readiness. The Federal Reserve has renovated its mission-critical applications, and we are nearing the completion of our internal testing activities. To manage the risks posed by subsequent changes to these systems, the Federal Reserve has instituted guidelines to significantly limit policy, operational, hardware, and software changes during late 1999 and early 2000. Going forward, we will continue our industry and international coordination efforts, including participation in the President's Council on Year 2000 Conversion, the Joint Year 2000 Council, and trade associations, to assist the industry in preparing for the Year 2000. In closing, I would like to thank the Committee for its extensive efforts to focus the industry's attention on this significant matter. Awareness of the extent and importance of this challenge is a critical first step in meeting it, and the Committee's participation has been most helpful.	---[PAGE_BREAK]--- # Mr. Kelley reports on the Year 2000 progress of the banking and financial services sector in the United States Testimony of Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, on the Year 2000 progress of the banking and financial services sector, before the Committee on Banking and Financial Services of the US House of Representatives on 17/9/98. Thank you for again inviting me to appear before this Committee to discuss the Year 2000 issue. This problem poses a major challenge to public policy: the stakes are enormous, nothing less than the preservation of a safe and sound financial system that can continue to operate in an orderly manner when the clock rolls over at midnight on New Year's Eve and the millennium arrives. The Year 2000 problem will touch much more than just our financial systems and could temporarily have adverse effects on the performance of the overall US economy as well as the economies of many, or all, nations if not corrected. As I said last April in testimony before the Senate Committee on Commerce, Science, and Transportation, some of the more adverse scenarios are not without a certain plausibility, if this challenge were being ignored. But it is not being ignored. While it is impossible today to precisely forecast the impact of this event, and the range of possibilities runs from minimal to extremely serious, an enormous amount of work is being done in anticipation of the rollover of the millennium, and I am optimistic that this work will pay off. In that spirit, let me update you on what the Federal Reserve has done to address the Year 2000 issue. Since I last testified here in November 1997, the Federal Reserve has met the goals that we set for ourselves. We have: - renovated our mission-critical applications and nearly completed our internal testing; - opened our mission-critical systems to customers for testing; - progressed significantly in our contingency planning efforts; - implemented a policy concerning changes to our information systems; and - concluded our initial review of all banks subject to our supervisory authority. While these accomplishments are indicative of our significant progress in addressing the Year 2000 issue, much work remains. In the testing area, we are finalizing plans for concurrent testing of multiple mission-critical applications by customers. We are coordinating with the Clearing House for Interbank Payment Systems (CHIPS) and the Society for Worldwide Interbank Financial Telecommunications (SWIFT) to provide a common test day for customers of Fedwire and these two systems. We have a System-wide project underway to enhance our contingency plans to address failures external to the Federal Reserve. We are conducting a second round of supervisory reviews of banks subject to our supervisory authority and also actively coordinating with various domestic and international Year 2000 organizations. This morning I would like to discuss these achievements and the important aspects of the job that remain ahead of us. ---[PAGE_BREAK]--- # Federal Reserve Readiness The Federal Reserve has completed the renovation of its mission-critical systems, and we are nearing the conclusion of our internal Year 2000 testing efforts. Internal testing includes both individual applications and application interfaces, such as the exchange of data between Fedwire and our Integrated Accounting System. Testing is conducted through a combination of two elements: one is future-dating our computer systems to verify the readiness of our information technology, and the other is testing critical future date processing within our business applications. Communications network components are also being tested and certified in special test lab environments at the Federal Reserve Automation Services and the Board of Governors. The Reserve Banks and the Board have implemented test century date change (CDC) local area networks to verify the readiness of vendor provided products and internal applications that operate in network-based computing environments. With the exception of a few systems that will be replaced by March 1999, we will complete the testing activities and implement our mission-critical applications in production by year-end 1998. On June 29, 1998, we made our future-dated test environment available to customers for Year 2000 testing; the crucial testing period will extend through 1999. Depository institutions which are Federal Reserve customers, and thus rely on our payment applications such as Fedwire, Fed ACH, and check processing systems, can test century rollover and leap year transactions six days a week. On six weekends this fall, depository institutions will be able to test Year 2000 test dates with several applications simultaneously. We are providing assistance to our customers who test with us, and have provided them, through a series of Century Date Change bulletins, with technical information and guidelines concerning the testing activity. By the end of August, almost 400 customers, including the US Treasury, had conducted CDC testing with the Federal Reserve, and the number scheduling tests is increasing rapidly. These tests encompass ten of our mission-critical applications. To ensure that the nation's larger banks are taking advantage of this testing opportunity, we intend to contact any that have not availed themselves of this service. Several foreign banking organizations have begun to test large dollar payment systems with the Federal Reserve and CHIPS. Most large foreign banks will participate in the September 26, 1998, coordinated test in which Fedwire, CHIPS, and SWIFT are participating. Like most information technology environments, ours are composed primarily of vendor hardware and software products. To assess the Year 2000 readiness of these environments, as well as our building systems such as vault and climate control systems, we have created an automated inventory of the vendor products that we use and are tracking the Year 2000 compliance status of those products. Although the Federal Reserve has made progress in independently testing vendor products, we will continue these efforts. In prior testimony, I have noted the critical dependence of banks on telecommunication services and the need to ensure the readiness of telecommunication service providers. To foster a better understanding of the importance of information sharing by the telecommunications industry, I wrote to Federal Communications Commissioner Powell about this issue. Commissioner Powell has been responsive and has provided us and others with information regarding the FCC's oversight and plans. The Federal Reserve is also participating in the Telecommunications Sector Group of the President's Council on Year 2000 Conversion. In addition, the Federal Reserve is monitoring telecommunication carriers to assess whether those used by the Federal Reserve will be Year 2000 compliant. We are pleased with the ---[PAGE_BREAK]--- responsiveness of the telecommunications industry: plans for industry testing are well under way, with participation from the major service providers, as well as their suppliers. # Contingency Planning As the nation's central bank, the Federal Reserve is actively engaged in contingency planning for both operational disruptions and systemic risks. An internal CDC Council consisting of senior managers is coordinating contingency planning across the Federal Reserve's various functions and is fostering a cohesive approach to internal readiness and interaction with the financial community. In general, the banking industry's focus has also progressed from the renovation of systems to business continuity and contingency planning. Contingency planning for the Federal Reserve includes payments systems, currency availability and distribution, information processing, the discount window, and the supervision function. We will also play an important role in coordinating with the financial community concerning issues such as systemic risk and cross-border payments. ## Operational Contingency The Federal Reserve's plans for operational continuity build on existing contingency plans. As you know, we have long maintained comprehensive contingency plans that are routinely tested and have been implemented during natural disasters and other disruptions. These plans cover our internal systems, as well as the services we provide to depository institutions. In June 1998, each of the Federal Reserve's business offices completed assessments of the adequacy of existing contingency scenarios to address CDC risks. Federal Reserve CDC contingency workgroups are identifying problems external to the Federal Reserve that may arise when the date changes to 2000, such as those affecting telecommunications providers, large financial institutions, utility companies, other key financial market participants, and difficulties abroad that affect US markets or institutions. The workgroups are developing corresponding recommendations to mitigate those problems. The Federal Reserve plans to finalize contingency plans reflecting these recommendations by November 30, 1998. We will continue to refine our CDC contingency plans as necessary throughout 1999. In fourth quarter 1998, we will focus our efforts on how to test our contingency plans to ensure their operational effectiveness at the century rollover. ## Change Management As a part of our operational readiness planning, the Federal Reserve is developing procedures to manage the risks posed by changes to information systems in 1999 and the first quarter of 2000. After the scheduled completion of testing and implementation of our critical applications, changes to Federal Reserve policies, rules, regulations, and services that generate changes to critical information systems create the risk that those systems may no longer be CDC compliant. Consequently, we have established guidelines to significantly limit policy and operational changes, as well as internal hardware and software changes, during late 1999 and early 2000 in order to minimize the risks and complexities of problem resolution associated with the introduction of new processing components. By limiting changes to our systems, we will not only provide a stable internal processing environment entering the Year 2000, but we will also minimize changes that our customers could be required to make to their applications that interface with our software. In ---[PAGE_BREAK]--- addition, we intend to aggressively coordinate with other institutions that typically generate policy and operational changes in the financial industry. We intend to publish our guidelines to assist other organizations facing similar issues and I would urge that Congress, as well as other federal agencies, consider adoption of such change management policies as we move into 1999. # Currency As I noted earlier, cash availability and processing is an issue we have considered in the contingency planning process. We have regularly met the public's heightened demand for US currency in peak seasons or in extraordinary situations, such as natural disasters. We recently submitted our fiscal year 1999 currency printing order to the Department of the Treasury's Bureau of Engraving and Printing and we increased the size of next year's print order due to Year 2000 considerations. With this order, we will substantially increase the amount of currency either in circulation or in Federal Reserve vaults over current levels by late 1999. We believe this increase in the level of currency should be ample to meet the public's demand for extra cash during the period surrounding the century rollover. This is a precautionary step on our part -- we believe it is prudent to print more currency than we think will be required than to risk not printing enough. While we do not anticipate any extraordinary demand for cash, we believe it is important that the public have complete confidence that sufficient supplies of currency will be available. In effect, the Federal Reserve is accelerating the timing of currency printing; we are planning for a possible short-lived increased demand for cash and will be able to reduce future print orders to lower-than-normal levels. As we monitor the public's demand for currency, we can introduce other measures to further increase cash levels. First, the recent currency order with the Bureau of Printing and Engraving is for the federal fiscal year 1999, so that there will be time to print additional notes in the last three months of 1999. Second, we can change the print order to increase production of higher denomination notes. Third, we can increase staff in Reserve Bank cash operation functions to improve the turnaround time required to process cash deposits and move currency back into circulation. Finally, as a last resort, we can hold off the destruction of old or worn currency. ## Liquidity Another contingency planning issue for the Federal Reserve is liquidity. Despite their best efforts, some depository institutions could encounter problems in the rollover in maintaining reliable computer systems, and these problems may or may not affect their funding positions. To the extent necessary, the Federal Reserve is prepared to lend, in appropriate circumstances and with adequate collateral, to depository institutions when market sources of funding are not reasonably available. The terms and conditions of such lending may depend upon the circumstances causing the liquidity shortfall. ## Financial Sector Initiatives The Federal Reserve and private industry have intensified cooperative efforts to address contingency planning. The Year 2000 Contingency Planning Working Group of the New York Clearing House (NYCH), the Securities Industry Association (SIA), and the Federal Reserve are developing coordinated contingency plans for the Year 2000 and will act as liaison with other industry groups addressing contingency planning on behalf of banks, securities firms, exchanges, clearance and settlement organizations, regulators, and international markets. Among ---[PAGE_BREAK]--- other things, the Working Group is considering plans for the establishment of Year 2000 communications centers throughout the country, and perhaps internationally. Primarily, such centers would facilitate the exchange of up-to-date information on developing problems and issues among participants and enhance the development of consensus, when necessary, to coordinate timely responses to problems. The Federal Reserve is assisting in the government's coordination of the Year 2000 effort within the financial industry by participating in the Financial Institutions Sector Group of the President's Council on Year 2000 Conversion. A senior Board official who chairs this Sector Group has been working with representatives of government financial organizations, including the federal banking agencies, the Department of the Treasury, the Securities and Exchange Commission, and other agencies responsible for various financial intermediaries, to assess the Year 2000 readiness of the financial industry and formulate strategies for addressing interagency Year 2000 issues. # Bank Supervision I would now like to turn to our industry oversight activities. The Federal Reserve met its goal, set in May 1997, of conducting a Year 2000 supervisory review of all banks subject to our supervisory authority by June 1998. This public commitment and visible effort did much to stimulate industry action on the Year 2000 issue. We have also established ties and are providing significant support to numerous public and private groups, both domestic and international, that are addressing the Year 2000 readiness of their respective constituencies. As part of our outreach program, we continually emphasize the critical significance of ensuring that computer systems and applications are Year 2000 compliant and the complexity of the managerial and technological challenges that the required effort presents for all enterprises. For entities such as financial institutions that rely heavily on computers to provide financial services to customers, achieving Year 2000 compliance in mission-critical systems is essential for maintaining the quality and continuity of customer services. While bank supervisors can provide guidance, encouragement, and strong formal and informal supervisory incentives to the banking industry to address this challenge, it is important to recognize that we cannot be ultimately responsible for ensuring or guaranteeing the Year 2000 readiness and viability of the banking organizations we supervise. Rather, the boards of directors and senior management of banks and other financial institutions must be responsible for ensuring that the institutions they manage are able to provide high quality and continuous services from the first day in January of the Year 2000. As we have emphasized continually during the past sixteen months, this critical obligation must be among the very highest of priorities for bank management and boards of directors. ## Policy Guidance and Supervisory Reviews The Federal Reserve continues to work closely with the other banking agencies that comprise the Federal Financial Institutions Examination Council (FFIEC) to address the banking industry's Year 2000 readiness. A series of seven advisory statements has been issued since I was last here in November 1997, including statements on the nature of Year 2000 business risk, the importance of service provider readiness, the means to address customer risk, the need to respond to customer inquiries, the critical importance of testing, the urgency of effective contingency planning, and the need to address the readiness of fiduciary activities. As a ---[PAGE_BREAK]--- result of these advisory statements, the extent of the industry's Year 2000 efforts has significantly intensified. These statements can be found in their entirety at http://www.federalreserve.gov/Y2K. Compliance with these statements is assessed during the conduct of supervisory reviews. Through June 30, the Federal Reserve had conducted reviews of approximately 1,600 organizations. Information and data collected during these reviews has proven to be reliable, consistent with our overall supervisory experience which is heavily dependent on an extensive on-site examination program. These reviews have resulted in a significant focus of attention on the subject matter within the industry and identified several issues warranting additional attention by the supervisors, particularly the need for the supplemental guidance on testing and contingency planning. It is critical that banks avail themselves of every opportunity to test mission-critical systems internally and with their counterparties, and recurring testing may be warranted as additional systems are renovated to assure that those systems already tested are not adversely affected. Based on the reviews completed by the Federal Reserve, the vast majority of banking organizations are making satisfactory progress in their Year 2000 planning and readiness efforts. About four percent are rated "needs improvement" and fewer than one percent are rated "unsatisfactory". In these cases, the Federal Reserve has initiated intensive supervisory followup. Working closely with state banking departments, the Federal Reserve is making a concerted effort to focus additional attention on those particular banking organizations that are deemed deficient in their Year 2000 planning and progress. Deficient organizations have been informed of their status through supervisory review comments, meetings with senior management or the board of directors, and deficiency notification letters calling for submission of detailed plans and formal responses to the deficiencies noted. Such organizations are then subject to increased monitoring and supervisory follow-up including more frequent reviews. Restrictions on expansionary activities by Year 2000 deficient organizations have also been put into place. As a result of these letters, organizations once deemed deficient have taken significant steps to enhance their Year 2000 programs and over half have been upgraded to satisfactory. The Federal Reserve has commenced Phase II of its supervision program which covers the nine months from July 1998 through March 1999. During this second phase, we will conduct another round of supervisory reviews focused on Year 2000 testing and contingency planning. In addition, we have committed to conducting another review of the information systems service providers and will distribute the results to the serviced banks. # Assessment of Review Results Based on these reviews and other interactions with the industry, it appears that financial institution progress in renovating mission-critical systems has advanced notably since the Federal Reserve and the other banking agencies escalated efforts to focus the industry's attention on ensuring Year 2000 readiness. Banking organizations are making substantial headway toward Year 2000 readiness and, with some exceptions, are on track to meet FFIEC guidelines. Specifically, the FFIEC guidelines call for the completion of internal testing of mission critical systems by year-end 1998. Most large organizations are nearing completion of ---[PAGE_BREAK]--- the renovation of their mission-critical systems and are vigorously testing those that have been renovated. Smaller organizations are working closely with their service providers in an effort to confirm that the efforts under way will assure the readiness and reliability of the services and products on which they depend. # Information Systems Service Providers The banking agencies are examining the Year 2000 readiness of certain information systems service providers and software vendors that provide services and products to a large number of banking organizations. These examinations are often conducted on an interagency basis. The Federal Reserve has participated in reviews of sixteen national service providers and twelve national software vendors. In addition, the banking agencies are examining selected regional service providers and software vendors. These examinations assess the overall Year 2000 program management of the firms and confirm their plans to support products for Year 2000 readiness. To help banking organizations assess the Year 2000 readiness and dependability of their service providers and to encourage examined service providers to cooperate fully with the industry's efforts, the banking agencies are distributing the results of Year 2000 reviews of service providers and software vendors to the serviced banks. The information in the reports is not a certification of the readiness of the service provider, and it is still incumbent on each bank to work closely with its service providers to prepare for the century date change. Service providers and software vendors serving the banking industry are keenly aware of the industry's reliance on their products and services, and most consider their Year 2000 readiness to be their highest priority in order for them to remain competitive in an aggressive industry. ## Credit Quality FFIEC guidelines call for banks to have a plan to assess customer Year 2000 readiness by June 30, 1998, and to complete an assessment of their customers' Year 2000 readiness by September 30, 1998, in order to better understand the risks faced by the bank if customers are unable to meet their obligations on a timely basis. Even though our Phase I Year 2000 examinations were conducted before the June 30, 1998, milestone, our examiners noted that most organizations either had begun planning or had initiated their customer assessment programs. We have seen no signs that credit quality has deteriorated as a result of Year 2000 readiness considerations, although it is still early. Results from a Federal Reserve Senior Loan Officer Opinion Survey on Bank Lending Practices (May 1998) indicated that respondents generally include Year 2000 preparedness in their underwriting and loan review standards. Another survey of Senior Loan Officers is to be conducted in November in order to obtain a more timely picture of any deterioration in credit quality related to the Year 2000. Efforts have also been made to prompt the nation's largest banks that syndicate large loans to address the Year 2000 readiness of their borrowers. Through the Shared National Credit Program, banks that syndicate credits over $\$ 20$ million are asked to provide the banking agencies with information pertaining to the banks' efforts to assess the readiness of the borrowers. This initiative has helped large lenders understand that they need to consider their customers' readiness in their risk management programs. ---[PAGE_BREAK]--- # Additional Outreach Initiatives The Federal Reserve is participating in numerous outreach initiatives with the banking industry, trade associations, regulatory authorities, and other groups that are hosting conferences, seminars, and training opportunities focusing on the Year 2000 and helping participants understand better the issues that need to be addressed. Partly in response to the requirements of the Examination Parity and Year 2000 Readiness for Financial Institutions Act, which calls for the banking agencies to conduct seminars for bankers on the Year 2000, the federal banking agencies have been working with state banking departments as well as national and local bankers' associations to develop coordinated and comprehensive efforts at improving the local and regional programs intended to focus attention on the Year 2000. In the first six months of 1998, the Federal Reserve has participated in over 230 outreach initiatives reaching over 14,000 bankers. Another 100 outreach initiatives are scheduled for the third quarter of 1998. In addition, our public web site provides extensive information on our Year 2000 supervision program and on other resources available to the industry to help prepare for the millennium. ## International Coordination International cooperation on Year 2000 has intensified over the past several months because of the efforts of the public sector Joint Year 2000 Council (Joint Council) and the private sector Global 2000 Coordinating Group (G-2000). As you recall from your hearings on international issues in June, Mr. Ernest Patrikas, then Chairman of the Joint Council and a senior official of the Federal Reserve Bank of New York, testified on the global efforts of the Joint Council to enhance international initiatives by financial regulators. His successor as Chairman of the Joint Council, Federal Reserve Governor Roger Ferguson, is continuing those efforts and is working closely with an external consultative committee composed of representatives from international financial services providers, international financial market associations, financial rating agencies, and a number of other international industry associations. The Joint Council is working to foster better awareness and understanding of Year 2000 issues on the part of regulators around the world; for example, the Joint Council is sponsoring a series of regional seminars for banking, insurance, and securities supervisors. The G-2000 includes more than forty financial institutions from over twenty countries that are addressing country assessments, testing, and contingency planning, as well as other issues. The group has developed a standard framework for assessing individual country preparations for the century date change and also will address the Year 2000 readiness of financial institutions, service providers, and the countries' infrastructures. This framework is being used to collect information and assess the readiness of about twenty major countries by the end of this year, with others scheduled for in-depth reviews in 1999. The Basle Committee on Banking Supervision continues to be active on Year 2000 issues, both within the Joint Council and separately, as part of its normal supervisory activities. Year 2000 will be a major issue to be discussed at the International Conference of Bank Supervisors in October. The Basle Committee is also planning a follow-up survey on Year 2000 progress. ## Closing Remarks Financial institutions have made significant progress in renovating their systems to prepare for the Year 2000 and much has been accomplished to ensure the continuation of ---[PAGE_BREAK]--- reliable services to the banking public at the century rollover. We are committed to a rigorous program of industry testing and contingency planning and, through our supervisory initiatives, to identifying those organizations that most need to apply additional attention to Year 2000 readiness. The Federal Reserve has renovated its mission-critical applications, and we are nearing the completion of our internal testing activities. To manage the risks posed by subsequent changes to these systems, the Federal Reserve has instituted guidelines to significantly limit policy, operational, hardware, and software changes during late 1999 and early 2000. Going forward, we will continue our industry and international coordination efforts, including participation in the President's Council on Year 2000 Conversion, the Joint Year 2000 Council, and trade associations, to assist the industry in preparing for the Year 2000. In closing, I would like to thank the Committee for its extensive efforts to focus the industry's attention on this significant matter. Awareness of the extent and importance of this challenge is a critical first step in meeting it, and the Committee's participation has been most helpful.	Edward W Kelley, Jr	United States	https://www.bis.org/review/r980928a.pdf	services sector in the United States Testimony of Mr. Edward W. Kelley, Jr., a member of the Board of Governors of the US Federal Reserve System, on the Year 2000 progress of the banking and financial services sector, before the Committee on Banking and Financial Services of the US House of Representatives on 17/9/98. Thank you for again inviting me to appear before this Committee to discuss the Year 2000 issue. This problem poses a major challenge to public policy: the stakes are enormous, nothing less than the preservation of a safe and sound financial system that can continue to operate in an orderly manner when the clock rolls over at midnight on New Year's Eve and the millennium arrives. The Year 2000 problem will touch much more than just our financial systems and could temporarily have adverse effects on the performance of the overall US economy as well as the economies of many, or all, nations if not corrected. As I said last April in testimony before the Senate Committee on Commerce, Science, and Transportation, some of the more adverse scenarios are not without a certain plausibility, if this challenge were being ignored. But it is not being ignored. While it is impossible today to precisely forecast the impact of this event, and the range of possibilities runs from minimal to extremely serious, an enormous amount of work is being done in anticipation of the rollover of the millennium, and I am optimistic that this work will pay off. In that spirit, let me update you on what the Federal Reserve has done to address the Year 2000 issue. Since I last testified here in November 1997, the Federal Reserve has met the goals that we set for ourselves. We have: renovated our mission-critical applications and nearly completed our internal testing;. opened our mission-critical systems to customers for testing;. progressed significantly in our contingency planning efforts;. implemented a policy concerning changes to our information systems; and. concluded our initial review of all banks subject to our supervisory authority. While these accomplishments are indicative of our significant progress in addressing the Year 2000 issue, much work remains. In the testing area, we are finalizing plans for concurrent testing of multiple mission-critical applications by customers. We are coordinating with the Clearing House for Interbank Payment Systems (CHIPS) and the Society for Worldwide Interbank Financial Telecommunications (SWIFT) to provide a common test day for customers of Fedwire and these two systems. We have a System-wide project underway to enhance our contingency plans to address failures external to the Federal Reserve. We are conducting a second round of supervisory reviews of banks subject to our supervisory authority and also actively coordinating with various domestic and international Year 2000 organizations. This morning I would like to discuss these achievements and the important aspects of the job that remain ahead of us. The Federal Reserve has completed the renovation of its mission-critical systems, and we are nearing the conclusion of our internal Year 2000 testing efforts. Internal testing includes both individual applications and application interfaces, such as the exchange of data between Fedwire and our Integrated Accounting System. Testing is conducted through a combination of two elements: one is future-dating our computer systems to verify the readiness of our information technology, and the other is testing critical future date processing within our business applications. Communications network components are also being tested and certified in special test lab environments at the Federal Reserve Automation Services and the Board of Governors. The Reserve Banks and the Board have implemented test century date change (CDC) local area networks to verify the readiness of vendor provided products and internal applications that operate in network-based computing environments. With the exception of a few systems that will be replaced by March 1999, we will complete the testing activities and implement our mission-critical applications in production by year-end 1998. On June 29, 1998, we made our future-dated test environment available to customers for Year 2000 testing; the crucial testing period will extend through 1999. Depository institutions which are Federal Reserve customers, and thus rely on our payment applications such as Fedwire, Fed ACH, and check processing systems, can test century rollover and leap year transactions six days a week. On six weekends this fall, depository institutions will be able to test Year 2000 test dates with several applications simultaneously. We are providing assistance to our customers who test with us, and have provided them, through a series of Century Date Change bulletins, with technical information and guidelines concerning the testing activity. By the end of August, almost 400 customers, including the US Treasury, had conducted CDC testing with the Federal Reserve, and the number scheduling tests is increasing rapidly. These tests encompass ten of our mission-critical applications. To ensure that the nation's larger banks are taking advantage of this testing opportunity, we intend to contact any that have not availed themselves of this service. Several foreign banking organizations have begun to test large dollar payment systems with the Federal Reserve and CHIPS. Most large foreign banks will participate in the September 26, 1998, coordinated test in which Fedwire, CHIPS, and SWIFT are participating. Like most information technology environments, ours are composed primarily of vendor hardware and software products. To assess the Year 2000 readiness of these environments, as well as our building systems such as vault and climate control systems, we have created an automated inventory of the vendor products that we use and are tracking the Year 2000 compliance status of those products. Although the Federal Reserve has made progress in independently testing vendor products, we will continue these efforts. In prior testimony, I have noted the critical dependence of banks on telecommunication services and the need to ensure the readiness of telecommunication service providers. To foster a better understanding of the importance of information sharing by the telecommunications industry, I wrote to Federal Communications Commissioner Powell about this issue. Commissioner Powell has been responsive and has provided us and others with information regarding the FCC's oversight and plans. The Federal Reserve is also participating in the Telecommunications Sector Group of the President's Council on Year 2000 Conversion. In addition, the Federal Reserve is monitoring telecommunication carriers to assess whether those used by the Federal Reserve will be Year 2000 compliant. We are pleased with the responsiveness of the telecommunications industry: plans for industry testing are well under way, with participation from the major service providers, as well as their suppliers. As the nation's central bank, the Federal Reserve is actively engaged in contingency planning for both operational disruptions and systemic risks. An internal CDC Council consisting of senior managers is coordinating contingency planning across the Federal Reserve's various functions and is fostering a cohesive approach to internal readiness and interaction with the financial community. In general, the banking industry's focus has also progressed from the renovation of systems to business continuity and contingency planning. Contingency planning for the Federal Reserve includes payments systems, currency availability and distribution, information processing, the discount window, and the supervision function. We will also play an important role in coordinating with the financial community concerning issues such as systemic risk and cross-border payments. The Federal Reserve's plans for operational continuity build on existing contingency plans. As you know, we have long maintained comprehensive contingency plans that are routinely tested and have been implemented during natural disasters and other disruptions. These plans cover our internal systems, as well as the services we provide to depository institutions. In June 1998, each of the Federal Reserve's business offices completed assessments of the adequacy of existing contingency scenarios to address CDC risks. Federal Reserve CDC contingency workgroups are identifying problems external to the Federal Reserve that may arise when the date changes to 2000, such as those affecting telecommunications providers, large financial institutions, utility companies, other key financial market participants, and difficulties abroad that affect US markets or institutions. The workgroups are developing corresponding recommendations to mitigate those problems. The Federal Reserve plans to finalize contingency plans reflecting these recommendations by November 30, 1998. We will continue to refine our CDC contingency plans as necessary throughout 1999. In fourth quarter 1998, we will focus our efforts on how to test our contingency plans to ensure their operational effectiveness at the century rollover. As a part of our operational readiness planning, the Federal Reserve is developing procedures to manage the risks posed by changes to information systems in 1999 and the first quarter of 2000. After the scheduled completion of testing and implementation of our critical applications, changes to Federal Reserve policies, rules, regulations, and services that generate changes to critical information systems create the risk that those systems may no longer be CDC compliant. Consequently, we have established guidelines to significantly limit policy and operational changes, as well as internal hardware and software changes, during late 1999 and early 2000 in order to minimize the risks and complexities of problem resolution associated with the introduction of new processing components. By limiting changes to our systems, we will not only provide a stable internal processing environment entering the Year 2000, but we will also minimize changes that our customers could be required to make to their applications that interface with our software. In addition, we intend to aggressively coordinate with other institutions that typically generate policy and operational changes in the financial industry. We intend to publish our guidelines to assist other organizations facing similar issues and I would urge that Congress, as well as other federal agencies, consider adoption of such change management policies as we move into 1999. As I noted earlier, cash availability and processing is an issue we have considered in the contingency planning process. We have regularly met the public's heightened demand for US currency in peak seasons or in extraordinary situations, such as natural disasters. We recently submitted our fiscal year 1999 currency printing order to the Department of the Treasury's Bureau of Engraving and Printing and we increased the size of next year's print order due to Year 2000 considerations. With this order, we will substantially increase the amount of currency either in circulation or in Federal Reserve vaults over current levels by late 1999. We believe this increase in the level of currency should be ample to meet the public's demand for extra cash during the period surrounding the century rollover. This is a precautionary step on our part -- we believe it is prudent to print more currency than we think will be required than to risk not printing enough. While we do not anticipate any extraordinary demand for cash, we believe it is important that the public have complete confidence that sufficient supplies of currency will be available. In effect, the Federal Reserve is accelerating the timing of currency printing; we are planning for a possible short-lived increased demand for cash and will be able to reduce future print orders to lower-than-normal levels. As we monitor the public's demand for currency, we can introduce other measures to further increase cash levels. First, the recent currency order with the Bureau of Printing and Engraving is for the federal fiscal year 1999, so that there will be time to print additional notes in the last three months of 1999. Second, we can change the print order to increase production of higher denomination notes. Third, we can increase staff in Reserve Bank cash operation functions to improve the turnaround time required to process cash deposits and move currency back into circulation. Finally, as a last resort, we can hold off the destruction of old or worn currency. Another contingency planning issue for the Federal Reserve is liquidity. Despite their best efforts, some depository institutions could encounter problems in the rollover in maintaining reliable computer systems, and these problems may or may not affect their funding positions. To the extent necessary, the Federal Reserve is prepared to lend, in appropriate circumstances and with adequate collateral, to depository institutions when market sources of funding are not reasonably available. The terms and conditions of such lending may depend upon the circumstances causing the liquidity shortfall. The Federal Reserve and private industry have intensified cooperative efforts to address contingency planning. The Year 2000 Contingency Planning Working Group of the New York Clearing House (NYCH), the Securities Industry Association (SIA), and the Federal Reserve are developing coordinated contingency plans for the Year 2000 and will act as liaison with other industry groups addressing contingency planning on behalf of banks, securities firms, exchanges, clearance and settlement organizations, regulators, and international markets. Among other things, the Working Group is considering plans for the establishment of Year 2000 communications centers throughout the country, and perhaps internationally. Primarily, such centers would facilitate the exchange of up-to-date information on developing problems and issues among participants and enhance the development of consensus, when necessary, to coordinate timely responses to problems. The Federal Reserve is assisting in the government's coordination of the Year 2000 effort within the financial industry by participating in the Financial Institutions Sector Group of the President's Council on Year 2000 Conversion. A senior Board official who chairs this Sector Group has been working with representatives of government financial organizations, including the federal banking agencies, the Department of the Treasury, the Securities and Exchange Commission, and other agencies responsible for various financial intermediaries, to assess the Year 2000 readiness of the financial industry and formulate strategies for addressing interagency Year 2000 issues. I would now like to turn to our industry oversight activities. The Federal Reserve met its goal, set in May 1997, of conducting a Year 2000 supervisory review of all banks subject to our supervisory authority by June 1998. This public commitment and visible effort did much to stimulate industry action on the Year 2000 issue. We have also established ties and are providing significant support to numerous public and private groups, both domestic and international, that are addressing the Year 2000 readiness of their respective constituencies. As part of our outreach program, we continually emphasize the critical significance of ensuring that computer systems and applications are Year 2000 compliant and the complexity of the managerial and technological challenges that the required effort presents for all enterprises. For entities such as financial institutions that rely heavily on computers to provide financial services to customers, achieving Year 2000 compliance in mission-critical systems is essential for maintaining the quality and continuity of customer services. While bank supervisors can provide guidance, encouragement, and strong formal and informal supervisory incentives to the banking industry to address this challenge, it is important to recognize that we cannot be ultimately responsible for ensuring or guaranteeing the Year 2000 readiness and viability of the banking organizations we supervise. Rather, the boards of directors and senior management of banks and other financial institutions must be responsible for ensuring that the institutions they manage are able to provide high quality and continuous services from the first day in January of the Year 2000. As we have emphasized continually during the past sixteen months, this critical obligation must be among the very highest of priorities for bank management and boards of directors. The Federal Reserve continues to work closely with the other banking agencies that comprise the Federal Financial Institutions Examination Council (FFIEC) to address the banking industry's Year 2000 readiness. A series of seven advisory statements has been issued since I was last here in November 1997, including statements on the nature of Year 2000 business risk, the importance of service provider readiness, the means to address customer risk, the need to respond to customer inquiries, the critical importance of testing, the urgency of effective contingency planning, and the need to address the readiness of fiduciary activities. As a result of these advisory statements, the extent of the industry's Year 2000 efforts has significantly intensified. These statements can be found in their entirety at http://www.federalreserve.gov/Y2K. Compliance with these statements is assessed during the conduct of supervisory reviews. Through June 30, the Federal Reserve had conducted reviews of approximately 1,600 organizations. Information and data collected during these reviews has proven to be reliable, consistent with our overall supervisory experience which is heavily dependent on an extensive on-site examination program. These reviews have resulted in a significant focus of attention on the subject matter within the industry and identified several issues warranting additional attention by the supervisors, particularly the need for the supplemental guidance on testing and contingency planning. It is critical that banks avail themselves of every opportunity to test mission-critical systems internally and with their counterparties, and recurring testing may be warranted as additional systems are renovated to assure that those systems already tested are not adversely affected. Based on the reviews completed by the Federal Reserve, the vast majority of banking organizations are making satisfactory progress in their Year 2000 planning and readiness efforts. About four percent are rated "needs improvement" and fewer than one percent are rated "unsatisfactory". In these cases, the Federal Reserve has initiated intensive supervisory followup. Working closely with state banking departments, the Federal Reserve is making a concerted effort to focus additional attention on those particular banking organizations that are deemed deficient in their Year 2000 planning and progress. Deficient organizations have been informed of their status through supervisory review comments, meetings with senior management or the board of directors, and deficiency notification letters calling for submission of detailed plans and formal responses to the deficiencies noted. Such organizations are then subject to increased monitoring and supervisory follow-up including more frequent reviews. Restrictions on expansionary activities by Year 2000 deficient organizations have also been put into place. As a result of these letters, organizations once deemed deficient have taken significant steps to enhance their Year 2000 programs and over half have been upgraded to satisfactory. The Federal Reserve has commenced Phase II of its supervision program which covers the nine months from July 1998 through March 1999. During this second phase, we will conduct another round of supervisory reviews focused on Year 2000 testing and contingency planning. In addition, we have committed to conducting another review of the information systems service providers and will distribute the results to the serviced banks. Based on these reviews and other interactions with the industry, it appears that financial institution progress in renovating mission-critical systems has advanced notably since the Federal Reserve and the other banking agencies escalated efforts to focus the industry's attention on ensuring Year 2000 readiness. Banking organizations are making substantial headway toward Year 2000 readiness and, with some exceptions, are on track to meet FFIEC guidelines. Specifically, the FFIEC guidelines call for the completion of internal testing of mission critical systems by year-end 1998. Most large organizations are nearing completion of the renovation of their mission-critical systems and are vigorously testing those that have been renovated. Smaller organizations are working closely with their service providers in an effort to confirm that the efforts under way will assure the readiness and reliability of the services and products on which they depend. The banking agencies are examining the Year 2000 readiness of certain information systems service providers and software vendors that provide services and products to a large number of banking organizations. These examinations are often conducted on an interagency basis. The Federal Reserve has participated in reviews of sixteen national service providers and twelve national software vendors. In addition, the banking agencies are examining selected regional service providers and software vendors. These examinations assess the overall Year 2000 program management of the firms and confirm their plans to support products for Year 2000 readiness. To help banking organizations assess the Year 2000 readiness and dependability of their service providers and to encourage examined service providers to cooperate fully with the industry's efforts, the banking agencies are distributing the results of Year 2000 reviews of service providers and software vendors to the serviced banks. The information in the reports is not a certification of the readiness of the service provider, and it is still incumbent on each bank to work closely with its service providers to prepare for the century date change. Service providers and software vendors serving the banking industry are keenly aware of the industry's reliance on their products and services, and most consider their Year 2000 readiness to be their highest priority in order for them to remain competitive in an aggressive industry. FFIEC guidelines call for banks to have a plan to assess customer Year 2000 readiness by June 30, 1998, and to complete an assessment of their customers' Year 2000 readiness by September 30, 1998, in order to better understand the risks faced by the bank if customers are unable to meet their obligations on a timely basis. Even though our Phase I Year 2000 examinations were conducted before the June 30, 1998, milestone, our examiners noted that most organizations either had begun planning or had initiated their customer assessment programs. We have seen no signs that credit quality has deteriorated as a result of Year 2000 readiness considerations, although it is still early. Results from a Federal Reserve Senior Loan Officer Opinion Survey on Bank Lending Practices (May 1998) indicated that respondents generally include Year 2000 preparedness in their underwriting and loan review standards. Another survey of Senior Loan Officers is to be conducted in November in order to obtain a more timely picture of any deterioration in credit quality related to the Year 2000. Efforts have also been made to prompt the nation's largest banks that syndicate large loans to address the Year 2000 readiness of their borrowers. Through the Shared National Credit Program, banks that syndicate credits over $\$ 20$ million are asked to provide the banking agencies with information pertaining to the banks' efforts to assess the readiness of the borrowers. This initiative has helped large lenders understand that they need to consider their customers' readiness in their risk management programs. The Federal Reserve is participating in numerous outreach initiatives with the banking industry, trade associations, regulatory authorities, and other groups that are hosting conferences, seminars, and training opportunities focusing on the Year 2000 and helping participants understand better the issues that need to be addressed. Partly in response to the requirements of the Examination Parity and Year 2000 Readiness for Financial Institutions Act, which calls for the banking agencies to conduct seminars for bankers on the Year 2000, the federal banking agencies have been working with state banking departments as well as national and local bankers' associations to develop coordinated and comprehensive efforts at improving the local and regional programs intended to focus attention on the Year 2000. In the first six months of 1998, the Federal Reserve has participated in over 230 outreach initiatives reaching over 14,000 bankers. Another 100 outreach initiatives are scheduled for the third quarter of 1998. In addition, our public web site provides extensive information on our Year 2000 supervision program and on other resources available to the industry to help prepare for the millennium. International cooperation on Year 2000 has intensified over the past several months because of the efforts of the public sector Joint Year 2000 Council (Joint Council) and the private sector Global 2000 Coordinating Group (G-2000). As you recall from your hearings on international issues in June, Mr. Ernest Patrikas, then Chairman of the Joint Council and a senior official of the Federal Reserve Bank of New York, testified on the global efforts of the Joint Council to enhance international initiatives by financial regulators. His successor as Chairman of the Joint Council, Federal Reserve Governor Roger Ferguson, is continuing those efforts and is working closely with an external consultative committee composed of representatives from international financial services providers, international financial market associations, financial rating agencies, and a number of other international industry associations. The Joint Council is working to foster better awareness and understanding of Year 2000 issues on the part of regulators around the world; for example, the Joint Council is sponsoring a series of regional seminars for banking, insurance, and securities supervisors. The G-2000 includes more than forty financial institutions from over twenty countries that are addressing country assessments, testing, and contingency planning, as well as other issues. The group has developed a standard framework for assessing individual country preparations for the century date change and also will address the Year 2000 readiness of financial institutions, service providers, and the countries' infrastructures. This framework is being used to collect information and assess the readiness of about twenty major countries by the end of this year, with others scheduled for in-depth reviews in 1999. The Basle Committee on Banking Supervision continues to be active on Year 2000 issues, both within the Joint Council and separately, as part of its normal supervisory activities. Year 2000 will be a major issue to be discussed at the International Conference of Bank Supervisors in October. The Basle Committee is also planning a follow-up survey on Year 2000 progress. Financial institutions have made significant progress in renovating their systems to prepare for the Year 2000 and much has been accomplished to ensure the continuation of reliable services to the banking public at the century rollover. We are committed to a rigorous program of industry testing and contingency planning and, through our supervisory initiatives, to identifying those organizations that most need to apply additional attention to Year 2000 readiness. The Federal Reserve has renovated its mission-critical applications, and we are nearing the completion of our internal testing activities. To manage the risks posed by subsequent changes to these systems, the Federal Reserve has instituted guidelines to significantly limit policy, operational, hardware, and software changes during late 1999 and early 2000. Going forward, we will continue our industry and international coordination efforts, including participation in the President's Council on Year 2000 Conversion, the Joint Year 2000 Council, and trade associations, to assist the industry in preparing for the Year 2000. In closing, I would like to thank the Committee for its extensive efforts to focus the industry's attention on this significant matter. Awareness of the extent and importance of this challenge is a critical first step in meeting it, and the Committee's participation has been most helpful.
1998-09-17T00:00:00	Mr. Ferguson discusses the state of the US economy: near-term challenges and long-term changes (Central Bank Articles and Speeches, 17 Sep 98)	Remarks by Mr. Roger W. Ferguson, Jr., a member of the Board of Governors of the US Federal Reserve System, at the Federal Reserve Bank of Kansas City on 17/9/98.	Mr. Ferguson discusses the state of the US economy: near-term challenges Remarks by Mr. Roger W. Ferguson, Jr., a member of the Board of and long-term changes Governors of the US Federal Reserve System, at the Federal Reserve Bank of Kansas City on 17/9/98. It is a pleasure to be here today to discuss the state of the economy, not least because -- despite some turbulence of late in financial markets -- there is still good news to report. We are now in the eighth year of economic expansion. Production, employment, and incomes have all been rising briskly, and the unemployment rate has declined to its lowest level since 1970. And at the same time, inflation has remained remarkably subdued. But the prudent central banker cannot afford to focus exclusively on the good performance of the past. He must constantly look as well to the future. In that spirit, today I shall not only discuss our current economic situation, but I shall also comment on several areas that I believe deserve particular attention in the period ahead. Some of these areas involve potential risks to our fine economic performance, and some involve potentially important structural changes to our economy. Before I begin, let me remind you that these views are personal and do not necessarily reflect the views of other members of the Federal Open Market Committee or the Board of Governors. Recent Economic Performance As you know, the United States has been experiencing a period of exceptionally strong economic growth. Real GDP rose nearly 4 percent over 1996 and again last year, the fastest rates of increase, two years in a row, in fifteen years. And activity maintained a rapid pace of expansion over the first half of this year as well, although growth apparently did step down some in the spring. This recent performance is especially impressive because it occurred in the face of a substantial reduction in export demand associated with the crisis in Asia. This powerful economic growth has benefited American businesses through soaring profits. It also has benefited our governments -- federal, state, and local -- through tax revenues that have come in above earlier expectations. And it has benefited American workers, through higher incomes and lower unemployment rates than almost anyone predicted. Our tight labor markets have had the tremendous dividend of giving job experience to people who otherwise would be on the margins of the economy -- experience that will serve these people well for many years to come. Tight labor markets are welcome, even to central bankers, where they can be sustained without producing cost and price pressures that will undermine prosperity. The driving force behind this sustained growth has been domestic demand, as reflected in enormous increases in both consumption and investment spending. Consumption spending has been fueled by rapid growth of employment and incomes. With some 6 million people added to payrolls over the past two years, and with compensation gains well in excess of inflation, consumers have had the means to boost their spending appreciably. And the more than doubling in the value of the stock market since late 1994 -- only a small fraction of which has been reversed in recent weeks, I might add -- has made people more comfortable about spending out of current income -- and probably out of accumulated assets, too. It should be no surprise that surveys that measure consumer confidence have recorded historic highs, nor that the personal saving rate has declined considerably. The same factors, along with the lowest mortgage rates in some time, have powered home sales to record levels. Favorable financial conditions, along with exceptionally large price declines for computer equipment, have made it relatively cheap for firms to invest in new plant and equipment. And with sales in a solid uptrend, this has produced a remarkable boom in capital spending. Business fixed investment was up nearly 10 percent last year, and it rose at a still faster pace in the first half of this year. Even more strikingly, investment has averaged 10 percent annual growth over the past five years, making this the most rapid sustained expansion of investment in thirty years. As I shall discuss shortly, this investment may provide reason for some to be optimistic about productivity growth in the period ahead. But, without doubt, it has played an important role in helping to boost aggregate demand in recent quarters. One important question looking forward is whether the recent rapid growth in demand can be sustained. I am not a forecaster, but it is important to know what the consensus among forecasters has been, and most have been expecting growth to slow from its recent pace. One reason forecasters have expected growth to slow is that production for inventories had been rising at an extremely rapid pace that was unlikely to be maintained. And indeed, inventory investment did drop down a good bit in the second quarter, contributing importantly to that quarter's more modest GDP growth. Still, most analysts believe that the rate of stockbuilding -at least outside the motor vehicle sector -- probably remained unsustainable and can be expected to slow further. A second reason forecasters have expected a slowdown is that the impetus to consumer spending from annual gains of 25 to 30 percent in share values seemed unlikely to be sustained. This may seem obvious after last month's drop in stock prices, but looking back to earlier in the year even the most optimistic forecasters were expecting stock market increases well short of the rates seen in 1996 and 1997. The impetus to spending from such modest increases in household wealth would be considerably smaller than was generated by last year's outstanding run-up in share prices. And of course, last month's decline may provide further reason to expect consumption growth to slow. International Risks A third important reason forecasters have expected slower growth ahead is the continuing troubles overseas. The problems faced by our Asian trading partners, including the persistent weakness of the Japanese economy, and the accompanying strength of the dollar, already have led to a sharp reduction in the demand for our exports. Indeed, in the first half of this year, the quantity of exports declined two quarters in a row for the first time since the mid-1980s, with shipments to Korea and Japan down sharply. Declines in exports of machinery, industrial supplies, and agricultural equipment were especially noteworthy. When we include the effect of rising imports as well, net exports subtracted more than 2 percentage points from GDP growth over this period, and our trade deficit on goods and services widened to about $175 billion at an annual rate in the second quarter. I should emphasize that not all of the effects on our economy of the Asian crisis have been adverse. Low prices this year of energy and other internationally traded commodities, including many agricultural commodities such as soybeans and wheat, have benefited much of our nation -- although certainly not our oil industry or our farmers. Those low prices reflect, in part, a decline in the demand from Asia. To put it another way, those nations exporting oil and other commodities have borne some of the brunt of the sagging Asian economies. Furthermore, the favorable financial conditions in this country may have been aided by a "flight to safety" that helped hold down our long-term interest rates and stimulate interest-sensitive sectors like housing. Thus, the seemingly fortuitous timing of extremely robust domestic demand that has offset the reduction in our export demand has not been entirely coincidental. As with any financial crisis, it is extremely difficult to predict what the future will bring for the troubled Asian countries. I remain guardedly optimistic that conditions will begin to stabilize in the coming months, and that export demand will start to firm at least a little next year. But that is by no means a certainty. One particular risk is that the problems that have thus far been most severe in Asia may become more severe in other regions of the world. We have already seen this in Russia, and financial difficulties in other countries as distinct as South Africa and Brazil emphasize the worries and uncertainties on this score. For a variety of reasons, there could be a more "contagion" to other countries. First, investors' appetite for international risks has gone down following the Asian crises. This has led to trouble for countries that are running current account deficits and so are dependent on foreign capital. While most of Russia's problems are home grown, for example, more cautious investors probably contributed to precipitating that country's crisis. Indeed, over the last month it has become apparent that even US financial markets are not immune to perceptions that risk has increased. Second, as some emerging-market countries with fixed exchange rates respond to market pressures by relaxing their exchange-rate arrangements, those remaining countries attempting to peg their exchange rates may come under increasing speculative pressures. Third, countries that have close economic ties to the hardest-hit Asian nations certainly are feeling the repercussions of a reduction in demand for their exports, and a greater economic slowdown in Asia could trigger financial problems in those countries, too. And finally, as I noted earlier, countries that are heavy exporters of oil and other primary commodities have been hard-hit by low prices. In short, international problems in Asia and elsewhere are proving to be more profound and sustained than many, myself included, were guessing and hoping would be the case. Obviously, the effect of this drag on our ongoing economic expansion is an area that deserves close scrutiny in the months ahead. Inflation Developments But as I noted, the flip side of reduced export demand and a strong dollar is that the international situation is helping to hold down inflation here at home. This helps to explain the remarkable fact that our strong economic growth and low unemployment rates have coincided with exceptionally favorable news on the inflation front. I cannot overemphasize the importance of this story: rising inflation has sown the seeds of almost every cyclical downturn of the last half century. The consumer price index increased less than 2 percent over the past year. The last time consumer inflation was this low was in 1986 when, as in the present instance, consumers benefited from declining prices of energy products. But even when we exclude volatile food and energy items and focus on the so-called "core" CPI, inflation has been running not much above 2 percent, the lowest rate in more than three decades. And a broader measure of prices, the GDP price index, has increased only one percent over the past year, held down by rapid declines in the prices businesses pay for computers and communication equipment. This inflation performance has been better than most analysts had expected. But we should not exaggerate the extent of the surprise. True, most economists believe that the current unemployment rate of 41⁄2 percent is below the level consistent with stable inflation, and indeed may already be exerting upward pressure on labor costs. But almost all sensible economists have long realized that unemployment is not the only influence on inflation. As I have emphasized, the strong dollar has led to falling prices for our imports, and low oil prices have led to low prices for gasoline and other energy products. Low oil prices also have helped hold down prices for petroleum-derived products like fertilizers and plastics, and they have reduced price pressures more generally by reducing firms' utility and transportation costs. Furthermore, structural changes in the health care system have reduced the growth of firms' health care costs. These factors have all contributed to our benign inflation performance. We will need to be vigilant because, just as these factors have worked to the benefit of low inflation recently, any or all of them may turn around and exert upward pressure on inflation in the future. Changes in the Labor Market One of the complexities in the inflation outlook involves changes that appear to be occurring in labor market practices. The extraordinary rise in labor demand and the accompanying tight labor markets have led to labor shortages in some parts of the country. Shortages have been reported for a variety of jobs, with the supply of computer professionals especially tight. To some extent, firms have been responding to these labor shortages by raising wages. And indeed, compensation increases have been growing in size for the past two to three years. But firms also have responded to tight labor markets in ways other than simply granting larger base wage increases. Firms have been making increasing use of various forms of targeted pay, such as hiring and retention bonuses, as a way to attract and retain certain key employees without granting a general wage increase. These targeted bonuses seem to be most prevalent for information processing workers, but I sense that they are reasonably widespread beyond that area as well. And these bonuses are often quite sizable. It is not uncommon to hear of hiring bonuses of five to ten percent of base salary, or higher. Firms are changing their compensation practices in other ways, too. Businesses increasingly are relying less on base wage and salary increases, and are substituting some form of variable pay that is tied directly to performance, such as annual bonuses and profit sharing plans, or even stock options that extend well beyond senior management. These changing labor market practices have implications for the functioning of the economy that are both interesting and, potentially, quite important. For one thing, many targeted bonuses may not be adequately captured by our aggregate wage statistics, so if these bonuses are becoming more prevalent, labor costs may be rising somewhat faster than the published data would indicate. Second, these practices may lead to changes in the cyclicality of firms' compensation costs. On the one hand, if firms now are able to use targeted bonuses to certain workers in place of generalized wage increases, this could hold down compensation costs in tight labor markets, thereby making these costs less cyclical. On the other hand, increasing use of variable pay will tend to make compensation more cyclical than it otherwise would have been. Under a profit sharing system, for example, firms make larger compensation payments to their employees when times are good than they do when business is slack. If the latter effect were to dominate, and compensation were to become more cyclical, it would raise interesting questions about how this change might affect firms' pricing behavior. To some extent, of course, firms probably smooth through the cyclical ups and downs in their costs when making price decisions in any case. But such smoothing probably is not perfect, and increases in fixed pay probably would exert some upward pressure on prices. Increased use of profit-sharing bonuses, however, would presumably lead firms to boost their employees' compensation precisely when they can most afford to do so. And, conversely, when profits are being squeezed, the resulting decline in bonus payments would help ease the firm's cost pressures. Thus, there may be reason to believe that increases in variable compensation payments might not lead to the same price pressures as would increases in fixed compensation payments. In other words, increased cyclicality of compensation gains might not imply any change in the cyclicality of price increases. Finally, the spread of variable pay could lead to changes in employment patterns. Pay that is more variable is more tied to profitability. As profitability declines, so will compensation, and it is possible that employment may not drop as much as it would in a world in which compensation is less closely tied to profits. In any event, it will be fascinating to watch these labor market developments unfold, and to try to sort out the implications for the macroeconomy. Of course, companies are not moving toward variable compensation schemes to alter the macro-dynamics of the economy. Firms are moving to variable compensation schemes because they hope these changes will enhance their profitability, in part by raising worker productivity. By giving workers a larger and more direct stake in the fortunes of the company, firms are providing incentives for their employees to work more efficiently and to suggest productivity-enhancing changes to the way products are made and business is conducted. It is hard to know how successful these efforts will ultimately prove to be. Many business people are convinced that variable compensation plans have paid off in terms of higher productivity. Many others are less confident, and say that they hope the changes are boosting productivity, but that it is very hard to pinpoint the sources of productivity improvements. This discussion points to one final aspect of our economic outlook that deserves mention, namely, productivity growth. In the long run, nothing is as important for our economic welfare as productivity growth, for this is what determines the pace of increase in living standards. And the recent productivity data have been impressive: output per hour worked rose 13⁄4 percent in 1997 after an advance of more than 2 percent the year before. The big question is whether this rapid productivity growth is temporary or is permanent -- that is, whether productivity has merely displayed its normal short-run response to a step-up in the growth of activity, or whether the faster pace can be sustained for some time even as output growth moderates. The only correct answer, of course, is that we don't know yet. I can cite a few reasons to be very cautiously optimistic that productivity may be on a more favorable uptrend than it was in the 1980s. One reason is the changing incentives within the firm owing to variable pay that I just discussed, which at least some firms strongly believe has aided their productivity performance. A second reason for optimism is the investment boom that I discussed earlier. Economic history teaches us fairly convincingly that growth in the amount of capital per worker is an important determinant of gains in output per worker. Furthermore, some analysts have argued that the computerization of our economy is only now beginning to bear fruit, and that we may expect impressive productivity advances as people learn to use the new technology effectively. The economist Paul David notes that it took several decades following the initial development of the electric motor for companies to reorganize their production techniques to use the new invention efficiently. By analogy, David's argument hints that the largest benefits of computerization may be yet to come. This analogy is intriguing, but counterarguments certainly can be made as well. One reason it took electric power so long to yield benefits is that it took many years for the new technology to gain widespread use, in part because of the huge expenditures required to reconfigure manufacturing plants to use electric power. By contrast, the transition from older office equipment to mainframe computers, and then to desktop machines, often entails much smaller adjustment costs and so has been comparatively rapid. Furthermore, it is easy to forget that, while computers account for a large share of investment, they account for only a small share of the overall capital stock, in part reflecting their rapid rate of depreciation. Thus, unless computers earn a considerably higher return than other investments that firms might make, the small share imposes some limits on the contribution computers could make to overall productivity growth. So, while we can be hopeful that the recent productivity increases may represent a faster long-term trend, we should not count our chickens too soon. But you certainly can add productivity to the list of items I will be following closely in the period ahead. Conclusion With strong output growth, low unemployment, low inflation, and rapid productivity growth, these have certainly been good times to be a central banker. But this does not mean that they are not interesting times, as a glance at the financial pages will drive home. Although our economy is basically very strong, we also face near-term and longer-term challenges, and I hope I have given you a sense of some of the issues that will be on my mind as I try to gauge our nation's economic performance in the period ahead.	---[PAGE_BREAK]--- # Mr. Ferguson discusses the state of the US economy: near-term challenges and long-term changes Remarks by Mr. Roger W. Ferguson, Jr., a member of the Board of Governors of the US Federal Reserve System, at the Federal Reserve Bank of Kansas City on 17/9/98. It is a pleasure to be here today to discuss the state of the economy, not least because -- despite some turbulence of late in financial markets -- there is still good news to report. We are now in the eighth year of economic expansion. Production, employment, and incomes have all been rising briskly, and the unemployment rate has declined to its lowest level since 1970. And at the same time, inflation has remained remarkably subdued. But the prudent central banker cannot afford to focus exclusively on the good performance of the past. He must constantly look as well to the future. In that spirit, today I shall not only discuss our current economic situation, but I shall also comment on several areas that I believe deserve particular attention in the period ahead. Some of these areas involve potential risks to our fine economic performance, and some involve potentially important structural changes to our economy. Before I begin, let me remind you that these views are personal and do not necessarily reflect the views of other members of the Federal Open Market Committee or the Board of Governors. ## Recent Economic Performance As you know, the United States has been experiencing a period of exceptionally strong economic growth. Real GDP rose nearly 4 percent over 1996 and again last year, the fastest rates of increase, two years in a row, in fifteen years. And activity maintained a rapid pace of expansion over the first half of this year as well, although growth apparently did step down some in the spring. This recent performance is especially impressive because it occurred in the face of a substantial reduction in export demand associated with the crisis in Asia. This powerful economic growth has benefited American businesses through soaring profits. It also has benefited our governments -- federal, state, and local -- through tax revenues that have come in above earlier expectations. And it has benefited American workers, through higher incomes and lower unemployment rates than almost anyone predicted. Our tight labor markets have had the tremendous dividend of giving job experience to people who otherwise would be on the margins of the economy -- experience that will serve these people well for many years to come. Tight labor markets are welcome, even to central bankers, where they can be sustained without producing cost and price pressures that will undermine prosperity. The driving force behind this sustained growth has been domestic demand, as reflected in enormous increases in both consumption and investment spending. Consumption spending has been fueled by rapid growth of employment and incomes. With some 6 million people added to payrolls over the past two years, and with compensation gains well in excess of inflation, consumers have had the means to boost their spending appreciably. And the more than doubling in the value of the stock market since late 1994 -- only a small fraction of which has been reversed in recent weeks, I might add -- has made people more comfortable about spending out of current income -- and probably out of accumulated assets, too. It should be no surprise that surveys that measure consumer confidence have recorded historic highs, nor that the personal ---[PAGE_BREAK]--- saving rate has declined considerably. The same factors, along with the lowest mortgage rates in some time, have powered home sales to record levels. Favorable financial conditions, along with exceptionally large price declines for computer equipment, have made it relatively cheap for firms to invest in new plant and equipment. And with sales in a solid uptrend, this has produced a remarkable boom in capital spending. Business fixed investment was up nearly 10 percent last year, and it rose at a still faster pace in the first half of this year. Even more strikingly, investment has averaged 10 percent annual growth over the past five years, making this the most rapid sustained expansion of investment in thirty years. As I shall discuss shortly, this investment may provide reason for some to be optimistic about productivity growth in the period ahead. But, without doubt, it has played an important role in helping to boost aggregate demand in recent quarters. One important question looking forward is whether the recent rapid growth in demand can be sustained. I am not a forecaster, but it is important to know what the consensus among forecasters has been, and most have been expecting growth to slow from its recent pace. One reason forecasters have expected growth to slow is that production for inventories had been rising at an extremely rapid pace that was unlikely to be maintained. And indeed, inventory investment did drop down a good bit in the second quarter, contributing importantly to that quarter's more modest GDP growth. Still, most analysts believe that the rate of stockbuilding -at least outside the motor vehicle sector -- probably remained unsustainable and can be expected to slow further. A second reason forecasters have expected a slowdown is that the impetus to consumer spending from annual gains of 25 to 30 percent in share values seemed unlikely to be sustained. This may seem obvious after last month's drop in stock prices, but looking back to earlier in the year even the most optimistic forecasters were expecting stock market increases well short of the rates seen in 1996 and 1997. The impetus to spending from such modest increases in household wealth would be considerably smaller than was generated by last year's outstanding run-up in share prices. And of course, last month's decline may provide further reason to expect consumption growth to slow. # International Risks A third important reason forecasters have expected slower growth ahead is the continuing troubles overseas. The problems faced by our Asian trading partners, including the persistent weakness of the Japanese economy, and the accompanying strength of the dollar, already have led to a sharp reduction in the demand for our exports. Indeed, in the first half of this year, the quantity of exports declined two quarters in a row for the first time since the mid-1980s, with shipments to Korea and Japan down sharply. Declines in exports of machinery, industrial supplies, and agricultural equipment were especially noteworthy. When we include the effect of rising imports as well, net exports subtracted more than 2 percentage points from GDP growth over this period, and our trade deficit on goods and services widened to about $\$ 175$ billion at an annual rate in the second quarter. I should emphasize that not all of the effects on our economy of the Asian crisis have been adverse. Low prices this year of energy and other internationally traded commodities, including many agricultural commodities such as soybeans and wheat, have benefited much of our nation -- although certainly not our oil industry or our farmers. Those low prices reflect, in part, a decline in the demand from Asia. To put it another way, those nations exporting oil and ---[PAGE_BREAK]--- other commodities have borne some of the brunt of the sagging Asian economies. Furthermore, the favorable financial conditions in this country may have been aided by a "flight to safety" that helped hold down our long-term interest rates and stimulate interest-sensitive sectors like housing. Thus, the seemingly fortuitous timing of extremely robust domestic demand that has offset the reduction in our export demand has not been entirely coincidental. As with any financial crisis, it is extremely difficult to predict what the future will bring for the troubled Asian countries. I remain guardedly optimistic that conditions will begin to stabilize in the coming months, and that export demand will start to firm at least a little next year. But that is by no means a certainty. One particular risk is that the problems that have thus far been most severe in Asia may become more severe in other regions of the world. We have already seen this in Russia, and financial difficulties in other countries as distinct as South Africa and Brazil emphasize the worries and uncertainties on this score. For a variety of reasons, there could be a more "contagion" to other countries. First, investors' appetite for international risks has gone down following the Asian crises. This has led to trouble for countries that are running current account deficits and so are dependent on foreign capital. While most of Russia's problems are home grown, for example, more cautious investors probably contributed to precipitating that country's crisis. Indeed, over the last month it has become apparent that even US financial markets are not immune to perceptions that risk has increased. Second, as some emerging-market countries with fixed exchange rates respond to market pressures by relaxing their exchange-rate arrangements, those remaining countries attempting to peg their exchange rates may come under increasing speculative pressures. Third, countries that have close economic ties to the hardest-hit Asian nations certainly are feeling the repercussions of a reduction in demand for their exports, and a greater economic slowdown in Asia could trigger financial problems in those countries, too. And finally, as I noted earlier, countries that are heavy exporters of oil and other primary commodities have been hard-hit by low prices. In short, international problems in Asia and elsewhere are proving to be more profound and sustained than many, myself included, were guessing and hoping would be the case. Obviously, the effect of this drag on our ongoing economic expansion is an area that deserves close scrutiny in the months ahead. # Inflation Developments But as I noted, the flip side of reduced export demand and a strong dollar is that the international situation is helping to hold down inflation here at home. This helps to explain the remarkable fact that our strong economic growth and low unemployment rates have coincided with exceptionally favorable news on the inflation front. I cannot overemphasize the importance of this story: rising inflation has sown the seeds of almost every cyclical downturn of the last half century. The consumer price index increased less than 2 percent over the past year. The last time consumer inflation was this low was in 1986 when, as in the present instance, consumers benefited from declining prices of energy products. But even when we exclude volatile food and energy items and focus on the so-called "core" CPI, inflation has been running not much above 2 percent, the lowest rate in more than three decades. And a broader measure of prices, the GDP price index, has increased only one percent over the past year, held down by rapid declines in the prices businesses pay for computers and communication equipment. ---[PAGE_BREAK]--- This inflation performance has been better than most analysts had expected. But we should not exaggerate the extent of the surprise. True, most economists believe that the current unemployment rate of $41 / 2$ percent is below the level consistent with stable inflation, and indeed may already be exerting upward pressure on labor costs. But almost all sensible economists have long realized that unemployment is not the only influence on inflation. As I have emphasized, the strong dollar has led to falling prices for our imports, and low oil prices have led to low prices for gasoline and other energy products. Low oil prices also have helped hold down prices for petroleum-derived products like fertilizers and plastics, and they have reduced price pressures more generally by reducing firms' utility and transportation costs. Furthermore, structural changes in the health care system have reduced the growth of firms' health care costs. These factors have all contributed to our benign inflation performance. We will need to be vigilant because, just as these factors have worked to the benefit of low inflation recently, any or all of them may turn around and exert upward pressure on inflation in the future. # Changes in the Labor Market One of the complexities in the inflation outlook involves changes that appear to be occurring in labor market practices. The extraordinary rise in labor demand and the accompanying tight labor markets have led to labor shortages in some parts of the country. Shortages have been reported for a variety of jobs, with the supply of computer professionals especially tight. To some extent, firms have been responding to these labor shortages by raising wages. And indeed, compensation increases have been growing in size for the past two to three years. But firms also have responded to tight labor markets in ways other than simply granting larger base wage increases. Firms have been making increasing use of various forms of targeted pay, such as hiring and retention bonuses, as a way to attract and retain certain key employees without granting a general wage increase. These targeted bonuses seem to be most prevalent for information processing workers, but I sense that they are reasonably widespread beyond that area as well. And these bonuses are often quite sizable. It is not uncommon to hear of hiring bonuses of five to ten percent of base salary, or higher. Firms are changing their compensation practices in other ways, too. Businesses increasingly are relying less on base wage and salary increases, and are substituting some form of variable pay that is tied directly to performance, such as annual bonuses and profit sharing plans, or even stock options that extend well beyond senior management. These changing labor market practices have implications for the functioning of the economy that are both interesting and, potentially, quite important. For one thing, many targeted bonuses may not be adequately captured by our aggregate wage statistics, so if these bonuses are becoming more prevalent, labor costs may be rising somewhat faster than the published data would indicate. Second, these practices may lead to changes in the cyclicality of firms' compensation costs. On the one hand, if firms now are able to use targeted bonuses to certain workers in place of generalized wage increases, this could hold down compensation costs in tight labor markets, thereby making these costs less cyclical. On the other hand, increasing use of variable pay will tend to make compensation more cyclical than it otherwise would have been. Under a profit sharing system, for example, firms make larger compensation payments to their employees when times are good than they do when business is slack. ---[PAGE_BREAK]--- If the latter effect were to dominate, and compensation were to become more cyclical, it would raise interesting questions about how this change might affect firms' pricing behavior. To some extent, of course, firms probably smooth through the cyclical ups and downs in their costs when making price decisions in any case. But such smoothing probably is not perfect, and increases in fixed pay probably would exert some upward pressure on prices. Increased use of profit-sharing bonuses, however, would presumably lead firms to boost their employees' compensation precisely when they can most afford to do so. And, conversely, when profits are being squeezed, the resulting decline in bonus payments would help ease the firm's cost pressures. Thus, there may be reason to believe that increases in variable compensation payments might not lead to the same price pressures as would increases in fixed compensation payments. In other words, increased cyclicality of compensation gains might not imply any change in the cyclicality of price increases. Finally, the spread of variable pay could lead to changes in employment patterns. Pay that is more variable is more tied to profitability. As profitability declines, so will compensation, and it is possible that employment may not drop as much as it would in a world in which compensation is less closely tied to profits. In any event, it will be fascinating to watch these labor market developments unfold, and to try to sort out the implications for the macroeconomy. Of course, companies are not moving toward variable compensation schemes to alter the macro-dynamics of the economy. Firms are moving to variable compensation schemes because they hope these changes will enhance their profitability, in part by raising worker productivity. By giving workers a larger and more direct stake in the fortunes of the company, firms are providing incentives for their employees to work more efficiently and to suggest productivity-enhancing changes to the way products are made and business is conducted. It is hard to know how successful these efforts will ultimately prove to be. Many business people are convinced that variable compensation plans have paid off in terms of higher productivity. Many others are less confident, and say that they hope the changes are boosting productivity, but that it is very hard to pinpoint the sources of productivity improvements. This discussion points to one final aspect of our economic outlook that deserves mention, namely, productivity growth. In the long run, nothing is as important for our economic welfare as productivity growth, for this is what determines the pace of increase in living standards. And the recent productivity data have been impressive: output per hour worked rose $13 / 4$ percent in 1997 after an advance of more than 2 percent the year before. The big question is whether this rapid productivity growth is temporary or is permanent -- that is, whether productivity has merely displayed its normal short-run response to a step-up in the growth of activity, or whether the faster pace can be sustained for some time even as output growth moderates. The only correct answer, of course, is that we don't know yet. I can cite a few reasons to be very cautiously optimistic that productivity may be on a more favorable uptrend than it was in the 1980s. One reason is the changing incentives within the firm owing to variable pay that I just discussed, which at least some firms strongly believe has aided their productivity performance. A second reason for optimism is the investment boom that I discussed earlier. Economic history teaches us fairly convincingly that growth in the amount of capital per worker is an important determinant of gains in output per worker. ---[PAGE_BREAK]--- Furthermore, some analysts have argued that the computerization of our economy is only now beginning to bear fruit, and that we may expect impressive productivity advances as people learn to use the new technology effectively. The economist Paul David notes that it took several decades following the initial development of the electric motor for companies to reorganize their production techniques to use the new invention efficiently. By analogy, David's argument hints that the largest benefits of computerization may be yet to come. This analogy is intriguing, but counterarguments certainly can be made as well. One reason it took electric power so long to yield benefits is that it took many years for the new technology to gain widespread use, in part because of the huge expenditures required to reconfigure manufacturing plants to use electric power. By contrast, the transition from older office equipment to mainframe computers, and then to desktop machines, often entails much smaller adjustment costs and so has been comparatively rapid. Furthermore, it is easy to forget that, while computers account for a large share of investment, they account for only a small share of the overall capital stock, in part reflecting their rapid rate of depreciation. Thus, unless computers earn a considerably higher return than other investments that firms might make, the small share imposes some limits on the contribution computers could make to overall productivity growth. So, while we can be hopeful that the recent productivity increases may represent a faster long-term trend, we should not count our chickens too soon. But you certainly can add productivity to the list of items I will be following closely in the period ahead. # Conclusion With strong output growth, low unemployment, low inflation, and rapid productivity growth, these have certainly been good times to be a central banker. But this does not mean that they are not interesting times, as a glance at the financial pages will drive home. Although our economy is basically very strong, we also face near-term and longer-term challenges, and I hope I have given you a sense of some of the issues that will be on my mind as I try to gauge our nation's economic performance in the period ahead.	Roger W Ferguson	United States	https://www.bis.org/review/r980928c.pdf	and long-term changes Remarks by Mr. Roger W. Ferguson, Jr., a member of the Board of Governors of the US Federal Reserve System, at the Federal Reserve Bank of Kansas City on 17/9/98. It is a pleasure to be here today to discuss the state of the economy, not least because -- despite some turbulence of late in financial markets -- there is still good news to report. We are now in the eighth year of economic expansion. Production, employment, and incomes have all been rising briskly, and the unemployment rate has declined to its lowest level since 1970. And at the same time, inflation has remained remarkably subdued. But the prudent central banker cannot afford to focus exclusively on the good performance of the past. He must constantly look as well to the future. In that spirit, today I shall not only discuss our current economic situation, but I shall also comment on several areas that I believe deserve particular attention in the period ahead. Some of these areas involve potential risks to our fine economic performance, and some involve potentially important structural changes to our economy. Before I begin, let me remind you that these views are personal and do not necessarily reflect the views of other members of the Federal Open Market Committee or the Board of Governors. As you know, the United States has been experiencing a period of exceptionally strong economic growth. Real GDP rose nearly 4 percent over 1996 and again last year, the fastest rates of increase, two years in a row, in fifteen years. And activity maintained a rapid pace of expansion over the first half of this year as well, although growth apparently did step down some in the spring. This recent performance is especially impressive because it occurred in the face of a substantial reduction in export demand associated with the crisis in Asia. This powerful economic growth has benefited American businesses through soaring profits. It also has benefited our governments -- federal, state, and local -- through tax revenues that have come in above earlier expectations. And it has benefited American workers, through higher incomes and lower unemployment rates than almost anyone predicted. Our tight labor markets have had the tremendous dividend of giving job experience to people who otherwise would be on the margins of the economy -- experience that will serve these people well for many years to come. Tight labor markets are welcome, even to central bankers, where they can be sustained without producing cost and price pressures that will undermine prosperity. The driving force behind this sustained growth has been domestic demand, as reflected in enormous increases in both consumption and investment spending. Consumption spending has been fueled by rapid growth of employment and incomes. With some 6 million people added to payrolls over the past two years, and with compensation gains well in excess of inflation, consumers have had the means to boost their spending appreciably. And the more than doubling in the value of the stock market since late 1994 -- only a small fraction of which has been reversed in recent weeks, I might add -- has made people more comfortable about spending out of current income -- and probably out of accumulated assets, too. It should be no surprise that surveys that measure consumer confidence have recorded historic highs, nor that the personal saving rate has declined considerably. The same factors, along with the lowest mortgage rates in some time, have powered home sales to record levels. Favorable financial conditions, along with exceptionally large price declines for computer equipment, have made it relatively cheap for firms to invest in new plant and equipment. And with sales in a solid uptrend, this has produced a remarkable boom in capital spending. Business fixed investment was up nearly 10 percent last year, and it rose at a still faster pace in the first half of this year. Even more strikingly, investment has averaged 10 percent annual growth over the past five years, making this the most rapid sustained expansion of investment in thirty years. As I shall discuss shortly, this investment may provide reason for some to be optimistic about productivity growth in the period ahead. But, without doubt, it has played an important role in helping to boost aggregate demand in recent quarters. One important question looking forward is whether the recent rapid growth in demand can be sustained. I am not a forecaster, but it is important to know what the consensus among forecasters has been, and most have been expecting growth to slow from its recent pace. One reason forecasters have expected growth to slow is that production for inventories had been rising at an extremely rapid pace that was unlikely to be maintained. And indeed, inventory investment did drop down a good bit in the second quarter, contributing importantly to that quarter's more modest GDP growth. Still, most analysts believe that the rate of stockbuilding -at least outside the motor vehicle sector -- probably remained unsustainable and can be expected to slow further. A second reason forecasters have expected a slowdown is that the impetus to consumer spending from annual gains of 25 to 30 percent in share values seemed unlikely to be sustained. This may seem obvious after last month's drop in stock prices, but looking back to earlier in the year even the most optimistic forecasters were expecting stock market increases well short of the rates seen in 1996 and 1997. The impetus to spending from such modest increases in household wealth would be considerably smaller than was generated by last year's outstanding run-up in share prices. And of course, last month's decline may provide further reason to expect consumption growth to slow. A third important reason forecasters have expected slower growth ahead is the continuing troubles overseas. The problems faced by our Asian trading partners, including the persistent weakness of the Japanese economy, and the accompanying strength of the dollar, already have led to a sharp reduction in the demand for our exports. Indeed, in the first half of this year, the quantity of exports declined two quarters in a row for the first time since the mid-1980s, with shipments to Korea and Japan down sharply. Declines in exports of machinery, industrial supplies, and agricultural equipment were especially noteworthy. When we include the effect of rising imports as well, net exports subtracted more than 2 percentage points from GDP growth over this period, and our trade deficit on goods and services widened to about $\$ 175$ billion at an annual rate in the second quarter. I should emphasize that not all of the effects on our economy of the Asian crisis have been adverse. Low prices this year of energy and other internationally traded commodities, including many agricultural commodities such as soybeans and wheat, have benefited much of our nation -- although certainly not our oil industry or our farmers. Those low prices reflect, in part, a decline in the demand from Asia. To put it another way, those nations exporting oil and other commodities have borne some of the brunt of the sagging Asian economies. Furthermore, the favorable financial conditions in this country may have been aided by a "flight to safety" that helped hold down our long-term interest rates and stimulate interest-sensitive sectors like housing. Thus, the seemingly fortuitous timing of extremely robust domestic demand that has offset the reduction in our export demand has not been entirely coincidental. As with any financial crisis, it is extremely difficult to predict what the future will bring for the troubled Asian countries. I remain guardedly optimistic that conditions will begin to stabilize in the coming months, and that export demand will start to firm at least a little next year. But that is by no means a certainty. One particular risk is that the problems that have thus far been most severe in Asia may become more severe in other regions of the world. We have already seen this in Russia, and financial difficulties in other countries as distinct as South Africa and Brazil emphasize the worries and uncertainties on this score. For a variety of reasons, there could be a more "contagion" to other countries. First, investors' appetite for international risks has gone down following the Asian crises. This has led to trouble for countries that are running current account deficits and so are dependent on foreign capital. While most of Russia's problems are home grown, for example, more cautious investors probably contributed to precipitating that country's crisis. Indeed, over the last month it has become apparent that even US financial markets are not immune to perceptions that risk has increased. Second, as some emerging-market countries with fixed exchange rates respond to market pressures by relaxing their exchange-rate arrangements, those remaining countries attempting to peg their exchange rates may come under increasing speculative pressures. Third, countries that have close economic ties to the hardest-hit Asian nations certainly are feeling the repercussions of a reduction in demand for their exports, and a greater economic slowdown in Asia could trigger financial problems in those countries, too. And finally, as I noted earlier, countries that are heavy exporters of oil and other primary commodities have been hard-hit by low prices. In short, international problems in Asia and elsewhere are proving to be more profound and sustained than many, myself included, were guessing and hoping would be the case. Obviously, the effect of this drag on our ongoing economic expansion is an area that deserves close scrutiny in the months ahead. But as I noted, the flip side of reduced export demand and a strong dollar is that the international situation is helping to hold down inflation here at home. This helps to explain the remarkable fact that our strong economic growth and low unemployment rates have coincided with exceptionally favorable news on the inflation front. I cannot overemphasize the importance of this story: rising inflation has sown the seeds of almost every cyclical downturn of the last half century. The consumer price index increased less than 2 percent over the past year. The last time consumer inflation was this low was in 1986 when, as in the present instance, consumers benefited from declining prices of energy products. But even when we exclude volatile food and energy items and focus on the so-called "core" CPI, inflation has been running not much above 2 percent, the lowest rate in more than three decades. And a broader measure of prices, the GDP price index, has increased only one percent over the past year, held down by rapid declines in the prices businesses pay for computers and communication equipment. This inflation performance has been better than most analysts had expected. But we should not exaggerate the extent of the surprise. True, most economists believe that the current unemployment rate of $41 / 2$ percent is below the level consistent with stable inflation, and indeed may already be exerting upward pressure on labor costs. But almost all sensible economists have long realized that unemployment is not the only influence on inflation. As I have emphasized, the strong dollar has led to falling prices for our imports, and low oil prices have led to low prices for gasoline and other energy products. Low oil prices also have helped hold down prices for petroleum-derived products like fertilizers and plastics, and they have reduced price pressures more generally by reducing firms' utility and transportation costs. Furthermore, structural changes in the health care system have reduced the growth of firms' health care costs. These factors have all contributed to our benign inflation performance. We will need to be vigilant because, just as these factors have worked to the benefit of low inflation recently, any or all of them may turn around and exert upward pressure on inflation in the future. One of the complexities in the inflation outlook involves changes that appear to be occurring in labor market practices. The extraordinary rise in labor demand and the accompanying tight labor markets have led to labor shortages in some parts of the country. Shortages have been reported for a variety of jobs, with the supply of computer professionals especially tight. To some extent, firms have been responding to these labor shortages by raising wages. And indeed, compensation increases have been growing in size for the past two to three years. But firms also have responded to tight labor markets in ways other than simply granting larger base wage increases. Firms have been making increasing use of various forms of targeted pay, such as hiring and retention bonuses, as a way to attract and retain certain key employees without granting a general wage increase. These targeted bonuses seem to be most prevalent for information processing workers, but I sense that they are reasonably widespread beyond that area as well. And these bonuses are often quite sizable. It is not uncommon to hear of hiring bonuses of five to ten percent of base salary, or higher. Firms are changing their compensation practices in other ways, too. Businesses increasingly are relying less on base wage and salary increases, and are substituting some form of variable pay that is tied directly to performance, such as annual bonuses and profit sharing plans, or even stock options that extend well beyond senior management. These changing labor market practices have implications for the functioning of the economy that are both interesting and, potentially, quite important. For one thing, many targeted bonuses may not be adequately captured by our aggregate wage statistics, so if these bonuses are becoming more prevalent, labor costs may be rising somewhat faster than the published data would indicate. Second, these practices may lead to changes in the cyclicality of firms' compensation costs. On the one hand, if firms now are able to use targeted bonuses to certain workers in place of generalized wage increases, this could hold down compensation costs in tight labor markets, thereby making these costs less cyclical. On the other hand, increasing use of variable pay will tend to make compensation more cyclical than it otherwise would have been. Under a profit sharing system, for example, firms make larger compensation payments to their employees when times are good than they do when business is slack. If the latter effect were to dominate, and compensation were to become more cyclical, it would raise interesting questions about how this change might affect firms' pricing behavior. To some extent, of course, firms probably smooth through the cyclical ups and downs in their costs when making price decisions in any case. But such smoothing probably is not perfect, and increases in fixed pay probably would exert some upward pressure on prices. Increased use of profit-sharing bonuses, however, would presumably lead firms to boost their employees' compensation precisely when they can most afford to do so. And, conversely, when profits are being squeezed, the resulting decline in bonus payments would help ease the firm's cost pressures. Thus, there may be reason to believe that increases in variable compensation payments might not lead to the same price pressures as would increases in fixed compensation payments. In other words, increased cyclicality of compensation gains might not imply any change in the cyclicality of price increases. Finally, the spread of variable pay could lead to changes in employment patterns. Pay that is more variable is more tied to profitability. As profitability declines, so will compensation, and it is possible that employment may not drop as much as it would in a world in which compensation is less closely tied to profits. In any event, it will be fascinating to watch these labor market developments unfold, and to try to sort out the implications for the macroeconomy. Of course, companies are not moving toward variable compensation schemes to alter the macro-dynamics of the economy. Firms are moving to variable compensation schemes because they hope these changes will enhance their profitability, in part by raising worker productivity. By giving workers a larger and more direct stake in the fortunes of the company, firms are providing incentives for their employees to work more efficiently and to suggest productivity-enhancing changes to the way products are made and business is conducted. It is hard to know how successful these efforts will ultimately prove to be. Many business people are convinced that variable compensation plans have paid off in terms of higher productivity. Many others are less confident, and say that they hope the changes are boosting productivity, but that it is very hard to pinpoint the sources of productivity improvements. This discussion points to one final aspect of our economic outlook that deserves mention, namely, productivity growth. In the long run, nothing is as important for our economic welfare as productivity growth, for this is what determines the pace of increase in living standards. And the recent productivity data have been impressive: output per hour worked rose $13 / 4$ percent in 1997 after an advance of more than 2 percent the year before. The big question is whether this rapid productivity growth is temporary or is permanent -- that is, whether productivity has merely displayed its normal short-run response to a step-up in the growth of activity, or whether the faster pace can be sustained for some time even as output growth moderates. The only correct answer, of course, is that we don't know yet. I can cite a few reasons to be very cautiously optimistic that productivity may be on a more favorable uptrend than it was in the 1980s. One reason is the changing incentives within the firm owing to variable pay that I just discussed, which at least some firms strongly believe has aided their productivity performance. A second reason for optimism is the investment boom that I discussed earlier. Economic history teaches us fairly convincingly that growth in the amount of capital per worker is an important determinant of gains in output per worker. Furthermore, some analysts have argued that the computerization of our economy is only now beginning to bear fruit, and that we may expect impressive productivity advances as people learn to use the new technology effectively. The economist Paul David notes that it took several decades following the initial development of the electric motor for companies to reorganize their production techniques to use the new invention efficiently. By analogy, David's argument hints that the largest benefits of computerization may be yet to come. This analogy is intriguing, but counterarguments certainly can be made as well. One reason it took electric power so long to yield benefits is that it took many years for the new technology to gain widespread use, in part because of the huge expenditures required to reconfigure manufacturing plants to use electric power. By contrast, the transition from older office equipment to mainframe computers, and then to desktop machines, often entails much smaller adjustment costs and so has been comparatively rapid. Furthermore, it is easy to forget that, while computers account for a large share of investment, they account for only a small share of the overall capital stock, in part reflecting their rapid rate of depreciation. Thus, unless computers earn a considerably higher return than other investments that firms might make, the small share imposes some limits on the contribution computers could make to overall productivity growth. So, while we can be hopeful that the recent productivity increases may represent a faster long-term trend, we should not count our chickens too soon. But you certainly can add productivity to the list of items I will be following closely in the period ahead. With strong output growth, low unemployment, low inflation, and rapid productivity growth, these have certainly been good times to be a central banker. But this does not mean that they are not interesting times, as a glance at the financial pages will drive home. Although our economy is basically very strong, we also face near-term and longer-term challenges, and I hope I have given you a sense of some of the issues that will be on my mind as I try to gauge our nation's economic performance in the period ahead.

Subsets and Splits

No community queries yet

The top public SQL queries from the community will appear here once available.