Statement by Wayne D. Angell and Edward W. Kelley, Jr., Members, Board of Governors of the Federal Reserve System.

Statement by Wayne D. Angell and Edward W. Kelley, Jr., Members, Board of Governors of the Federal Reserve System, before the Subcommittee on Domestic Monetary Policy of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, July 18, 1991 It is a pleasure for Governor Kelley and me to visit with this subcommittee today to discuss and review the Federal Reserve System's expenses and budget. Today as we look at the Federal Reserve System's budget for 1991, Governor Kelley will discuss the Board's budget and major initiatives, and my comments will focus on the Reserve Bank budgets as well as major System initiatives.

The Board has recently made available to the public and to this subcommittee copies of our publication Annual Report: Budget Review, 1990-91, presenting detailed information about spending plans for 1991. The attached tables have been updated for 1990 actual experience, and, therefore, some variations exist from data in that document.

While the Federal Reserve has always been concerned with controlling costs, the Monetary Control Act of 1980 has provided an additional incentive. As a matter of law, services provided to depository institutions must meet a clear market test. Specifically, all expenses (including overhead and the imputed cost of capital and taxes) for providing "priced" services are covered by charges to users. The markets in which we operate in providing these correspondent banking services are highly competitive, thereby providing a strong and direct incentive to maintain our efficiency. Given these internal and external restraints on costs, the Federal Reserve System's expenses are projected to increase by an average annual rate of 5.3 percent from 1986 through the 1991 budget. This increase includes expenses for supervision and regulation initiatives that account for 0.4 percentage point of the increase, Expedited Funds Availability legislation requirements (0.3 percentage point), contingency planning initiatives (0.2 percentage point), and several major initiatives for the U.S. Treasury (0.4 percentage point). I would add that it is difficult to judge the degree of discipline in an organization's budget solely on the growth rate of expenses. In the Federal Reserve we recognize the responsibilities given to us by the Congress, and we discharge them in a manner that reflects a high concern for quality and effectiveness as well as efficiency.

For 1991, the Federal Reserve System has budgeted operating expenses of $1.6 billion, an increase of 5.9 percent over the 1990 budget. The last year for comparison of actual expenses is 1990 over 1989. This comparison shows expenses up only 4.5 percent, reflecting a 0.8 percent underspending of the 1990 budget. Before getting to the substance of our 1991 plans, I would remind the subcommittee of two aspects of Federal Reserve System operations that affect our budget in unusual ways. First, 40 percent of System expenses arise from the services I just mentioned that are provided to depository institutions at fees adequate to cover all costs, including some imputed costs. Since additional costs of these services are more than recovered by additional revenues, any increases in costs result in increased earnings returned to the U.S. Treasury. Second, many fiscal agency operations are provided to the Treasury Department and other agencies on a reimbursable basis. Altogether, 58 percent of our total expenses are either recovered through pricing or are reimbursable. On a net basis, the cost to the public of the Federal Reserve System's operations is $675 million of the total $1.6 billion budgeted for 1991. (Of course, this amount does not include the earnings on the System's portfolio of assets, derived directly from monetary policy and currency issuance activities, from which the System turned over $23 billion to the Treasury in 1990.)

HISTORICAL OVERVIEW

It may be helpful to put the budget for 1991 in perspective by sketching the most recent ten-year history of System expenses. Between 1980 and 1990, Federal Reserve System expenses increased at an average annual rate of 5.9 percent; System employment decreased at an average annual rate of 0.1 percent; and volume in measured operations increased 26 percent over the ten-year period. Unit cost did increase in some services in the early eighties as Federal Reserve Bank volumes fell after the implementation of pricing under the Monetary Control Act. However, after the transition to pricing was completed in 1983, the composite unit cost for all functions (unadjusted for inflation) has actually declined 0.3 percent on an annual basis, even while improvements have been made in the quality of services.

For priced services, a decline in unit cost has been particularly noticeable in the electronic payment areas. Automated clearinghouse (ACH) unit cost has decreased 6.9 percent per year (1980-90) and funds transfer unit cost has decreased 1.0 percent per year during the same time period; since 1985, the decreases per year have been 12.3 percent for ACH, and 2.9 percent for funds. Volume growth has averaged more than 9 percent per year for funds transfers and more than 24 percent per year for automated clearinghouse transactions (1980-90). In our large check processing operation, on the other hand, when there has been a significant effort to improve the quality of service through increased availability and improved deposit deadlines, there has been an average increase in unit cost of 2.0 percent per year since 1983. However, in the most recent year-over-year comparison (1990 over 1989) unit cost for check processing dropped 1.2 percent, chiefly because the expensive implementation of the Expedited Funds Availability legislation (EFA) was basically completed in 1989.

For our nonpriced cash operations-involving the distribution of currency and coin-unit costs have also been declining. Since 1983 the decline has averaged about 2.6 percent per year, with volumes increasing 5.2 percent per year. However, in our fiscal agency operations, also nonpriced, there has been an increase in unit costs of 2.9 percent per year since 1983, reflecting new operations and services for the Treasury. In this area the Federal Reserve System has managed several initiatives for the Treasury to improve long-term efficiency in Treasury securities and savings bonds and improve the quality of service to the public. Through 1990 the Federal Reserve has added 322 staff members and spent a cumulative $65 million on these Treasury initiatives.

It is difficult to measure productivity improvements in the supervision and regulation area, but these activities have required significant increases in resources over the last ten years. Between 1980 and 1990, the number of staff members for supervision and regulation increased 629 and annual expenditures increased $125.8 million. These resources have been employed to strengthen the ability of the Reserve Banks to identify and address problems in the banking organizations under their jurisdiction. Obviously, the Reserve Banks have had to deal with greatly increasing work loads in the last several years as reflected in the record number of bank failures and problem banks as well as in the increasingly complex issues they have had to face in reviewing and processing regulatory applications and in developing supervisory policies to deal with new and changing banking risks.

In presenting our spending plans for 1991, I would like to mention that both the Reserve Bank budgets and the Board's budget must be approved by the Board of Governors. Reserve Bank budgets are first approved by the Banks' Boards of Directors and then reviewed by the Committee on Federal Reserve Bank Activities before submission to the Board of Governors. Governor Kelley oversees the Board's budget, and I will turn to him for that discussion.

INTRODUCTION

I appreciate this opportunity to discuss the operating and capital budgets of the Board of Governors of the Federal Reserve System. This material was included in the Annual Report: Budget Review 1990-91 furnished you in February, so I will not repeat the detailed data or analysis.

The 1991 operating budget of the Board of Governors totals $110.8 million. The growth in Board expenses between 1990 and 1991, at 7.6 percent, is slightly higher than the 7.5 percent increase from 1989 to 1990. The 1991 increase results from actions to further strengthen our supervision and regulation function, to fund the higher level of salaries needed to remain competitive with changes in the marketplace, and to meet a higher level of expenses for health insurance, Medicare, and the Board's Thrift Plan.

The budget authorized 1,557 positions for the Board's operations. The number of positions increased by a net of 3 as requirements in the supervision and regulation function and in the system policy direction and oversight function were largely met by offsetting reductions in staff in the support functions. From 1984 to 1986 our position level declined by about 80, even though we were increasing resources devoted to the supervision and regulation function. Since then the number of positions has remained substantially constant even as further increases were reallocated to the supervision and regulation function.

The foregoing figures do not include $1.8 million and nineteen positions budgeted for the Office of the Inspector General, which I will cover at the end of this statement.

I will now discuss the budget as it relates to the Board's four major operational areas.

MONETARY AND ECONOMIC POLICY

This function is expected to cost $54.2 million in 1991, an increase of $3.0 million, or 5.8 percent, over 1990. Most of this change is caused by factors such as the increase in pay and benefits and the 1991 component of the automation plan supporting this function. There are no new positions in this function in spite of the continuing growth in the work load.

The budget provides resources to maintain the quality of economic analysis and continues major resource commitments to implement the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), to help develop the National Information Center (NIC), and to support analysis of changes in the country's financial industry.

The growth of expenses in this budget area is constrained because earlier investments in distributed processing systems have produced reductions in the cost of data previously provided the large mainframe computer and has further limited cost growth by improving the productivity of existing staff.

SUPERVISION AND REGULATION

The 1991 budget funds considerable growth in this operational area. The budget of $32.8 million is $3.7 million, or 12.7 percent, greater than expenses for 1990. Eight new positions are added, primarily related to policy development and implementation, supervision of large bank holding companies, and increased emphasis upon compliance with consumer protection statutes. Most of the positions are a result of underlying problems and new developments in the financial sector of the economy and ongoing work related to FIRREA.

Besides the direct costs associated with the new positions, the budget continues to support development of the NIC. This comprehensive database will be the only source of consolidated structure and financial data for depository institutions; it will greatly enhance supervision and regulation in an era of evolving structure in the banking and financial sector. Development of the NIC will avoid redundant costs, improve data integrity, and lead to more timely and meaningful analysis of applications, merger requests, and other actions in a rapidly changing environment.

The office automation networks supporting is functional area will be substantially upgraded during 1991. Besides acquiring new mirocomputers, more advanced networking equipment will be installed.

SERVICES TO FINANCIAL INSTITUTIONS THE PUBLIC

The budget includes $2.9 million for this operational area- $107,000, or 3.9 percent more than in 1990. This area is composed almost entirely of oversight of the payments system function of the Federal Reserve System.

A major factor in the higher level of costs is the continued emphasis on reducing risk in the payments system and ensuring that it responds in an efficient and timely manner to changes in the financial system. The budget includes two new positions to develop policies and procedures to reduce risks in both national and international payment and settlement systems.

The completion in 1990 of a large software development project to manage currency orders and cash shipments produces significant cost savings and thereby limits the overall increase in the 1991 budgets for the Board and the Reserve Banks.

SYSTEM POLICY DIRECTION AND OVERSIGHT

System Policy Direction and Oversight includes resources for the supervision of System and Board programs. This functional area has been partially redefined, and our trend data have been adjusted to reflect the new treatment of the budget for the Office of the Inspector General that began in the 1990 budget.

The $20.3 million budgeted for this function is $1.0 million, or 5.4 percent more than 1990 outlays.

There are no major mission increases in this functional area. Staffing increases for the Reserve Bank examination function are continued with the addition of an electronic data processing (EDP) auditor to help ensure that internal controls over major Reserve Bank automation systems are adequate. The budget funds replacement of older microcomputer equipment in the Division of Reserve Bank Operations and Payment Systems and some initiatives in support of the division's local area network.

INCREASES BY OBJECT OF EXPENSE

The most significant increase in the 1991 budget is associated with salaries, not an unexpected outcome since 77 percent of the Board's budget is made up of personnel costs. The salary increment in this budget, $5.1 million, is significantly less than it was in 1990, when major actions were budgeted to fully implement the new compensation program. This program has succeeded in reducing the number of vacancies with the concomitant effect of increasing the salary budget.

A change in the Board's matching contribution for the Thrift Plan and a higher wage base subject to social security taxes are the principal factors resulting in the increase for retirement costs.

Our insurance costs rose sharply because of two factors. The most important factor is health insurance for which costs are rising sharply for the third consecutive year. Insurance costs also increased as a result of the recent legislation that raised the salary base subject to the employer's matching contribution to Medicare.

CAPITAL OUTLAYS 

The capital budget of 5,131,700 is $1.0 million more than 1990 expenditures. The budget funds requirements in the areas of automation and telecommunication, facilities improvements, and equipment replacements.

A major element of the capital budget is $1,000,000 for the replacement of obsolescent analog telephone switching equipment with a digital, private branch exchange.

Continued investment in our office automation systems is in line with our long-range automation-telecommunication plan. Productivity gains from such investments have been critical in the past in limiting requirements for additional staff to meet the Board's increasing work load. Several facilities improvements such as major roof repairs will require a total of 1,080,000.

SUMMARY

The 1991 operating budget contains sufficient funding to meet the Board's major objectives in each functional area, including the following: (1) expanding our oversight of the nation's financial institutions; (2) implementing risk-based capital standards; (3) supporting the FIRREA; (4) enhancing payments system operations while reducing payments system risk; (5) continuing investments in productivity initiatives, including office automation and the records management project; (6) continuing the development of the National Information Center to provide relevant banking structure data; and (7) maintaining a safe and effective working environment. Three new positions were added in response to continued growth in the work load as a result of problems in the financial industry, continuing implementation of FIRREA, and changes occurring in the payments system mechanism.

BUDGET OF THE INSPECTOR GENERAL

The Office of the Inspector General was created by the Board in July 1987. In 1989 its reporting relationships, duties, and responsibilities were brought into conformance with the Inspector General Act Amendments of 1988. To ensure the independence of the Office of the Inspector General (OIG), its budget is presented to the Board and reported on separately from the regular operating budget. That is, its funds are not commingled with Board operating funds.

The 1991 budget for the OIG is $1.8 million. This amount is $432,200, or 32.2 percent more than 1990 expenses. The increased level of resources is necessary to phase in broader audit and investigation coverage of the Board's mission areas and to provide resources to review new and existing laws and regulations for their impact on the economy and efficiency of Board programs and operations.

The $432,200 increment is largely tied to the full-year cost of four positions added late in 1990 and increases resulting from the Boardwide compensation program. The travel budget projects an increase of $55,000 associated with auditing functions delegated by the Board to Reserve Banks. The Office's 1991 budget provides for no increase in positions, leaving the position count at nineteen.

I will be happy to address any questions that you may have after Governor Angell concludes our joint testimony.

RESERVE BANK BUDGETS

The Reserve Bank 1991 expense increase-both priced and nonpriced-was budgeted at 5.8 percent more than the 1990 budget. The actual increase in expenses from 1989 to 1990 was only 4.2 percent since actual 1990 expenses were lower than budgeted. Nine major initiatives account for almost a third of the budgeted increase in Reserve Bank expenses.

The fiscal agency initiatives are expected to increase expenses by $4.9 million, with $4.2 million due to the nationwide implementation of the Regional Delivery System (RDS). This system, which provides for centralized issuance of U.S. savings bonds, is one of many services that e provide the U.S. government-directly to the Treasury Department-as its fiscal agent. This project will not be fully implemented until 1993 and will require a total staff increase of 350 by at time. A staff increase of 141 is expected in 1991. Other fiscal agency initiatives include expenses for processing savings bonds on high speed check processing equipment (EZ Clear) and centralized processing of payroll deductions for savings bonds (Masterfile). Expenses for these fiscal initiatives are fully reimbursable.

The supervision and regulation initiatives result from needs in several Reserve Districts for additional staff members to handle increases in work loads because of the greater complexity of examinations, more holding company examinations, increased examination of foreign banks, and more problem institutions. The expense impact is expected to be $4.0 million.

Of the "support" initiatives, the largest-$8.2 million-is for facility improvements. Approxiately $5.5 million of this increase is for increased real estate taxes on recently completed Federal Reserve buildings. The remaining increase involves efforts to provide space for efficient operations at Cleveland, St. Louis, Kansas City, and the New York Reserve Bank's East Rutherford Operations Center.

Reserve Bank operations in today's environment require more reliable and secure computer systems, more office automation, more communication networks, and more efficient high-speed sorters and counters for checks and currency. The initiatives identified as contingency and automation initiatives, check operational improvements, and currency initiatives all result from these requirements.

The remaining initiatives include $4.5 million for the Reserve Banks' share of the matching contribution for the thrift plan and the two initiatives that have the effect of reducing costs through improved operational efficiency.

Besides these major initiatives, it may be helpful to look at 1991 budgeted expenses on the basis of our four service lines.

Expenses for Services to Financial Institutions and the Public, which include all of the priced and some of the nonpriced services, are budgeted at $992.1 million and account for two-thirds of total expenses. Expenses are increasing $53.2 million, or 5.7 percent more than 1990. Staffing is budgeted at 9,227, an increase of thirteen, which is 0.01 percent more than the 1990 level. Expenses of priced services are budgeted at $646.6 million, an increase of 3.8 percent; these services, incidentally, are expected to generate revenues of about $780 million. Nonpriced services are budgeted at $345.5 million, an increase of 9.3 percent.

Commercial check processing is by far the largest component in this service line ($492.0 million); it accounts for 49.6 percent of these expenses and employs 5,686 people. The anticipated increase in expenses is $18.9 million or 4.0 percent, while employment is expected to decline 35 or 0.6 percent. These levels represent anticipated stable operations, with both check volume and unit costs expected to increase 1.3 percent.

Our other large operations in this service line are currency ($166.7 million and 1,532 people), automated clearinghouse ($83.4 million and 370 people), and funds transfer ($70.0 million and 155 people). The currency service anticipates sizable volume and staff increases in the San Francisco District but with essentially stable operations elsewhere (expenses up 6.8 percent; staff up nineteen). Automated clearinghouse (expenses up 5.7 percent; staff up five) and funds transfer (expenses up 9.9 percent; staff up one) both anticipate some increased costs for automation type projects concerned with improving efficiency and security of data.

Expenses for Supervision and Regulation, budgeted at $234.2 million for 1991, are expected to increase $22.3 million, or 10.5 percent over 1990. This service line has been the fastest growing of the service lines and now constitutes 15.6 percent of total System expenses, compared with 13.6 percent in 1985. The budgeted staff level is 2,305, an increase of 88 or 4.0 percent over 1990.

The expense increase is centered on the provision for the additional employees and compensation levels for the ongoing staff members as well as travel, training, and automation. The additional demands on the Federal Reserve's examination staff have necessitated increases in personnel. These increased demands on staff members include expanded bank examination programs, improved supervision of foreign banking agencies in the United States, the broadening level of detail covered in the examination process, compliance with the FIRREA and the Bank Secrecy Act, intensified surveillance of problem financial institutions, and increased focus on the requirements of the Community Reinvestment Act.

Expenses for Services to the U.S. Treasury and Other Government Agencies are budgeted at $167.2 million, an increase of $10.3 million or 6.6 percent over 1990. These expenses continue at about I I percent of total expenses in 199 1. Staffing levels are budgeted to increase by 96 or 5.3 percent. The major initiative driving the increases in both expenses and staff is the nationwide expansion of the Regional Delivery System (RDS) discussed earlier, which consolidates the issuance of U.S. savings bonds at one office in each District. RDS volume is expected to increase by 5.4 million bonds in 1991. Expenses in 1991 for the conduct of Monetary and Economic Policy at the Federal Reserve Banks total $107.5 million and account for about 7 percent of the total budget. An increase of $8.5 million and 8.6 percent is anticipated in 1991. Employment budgeted at 786 reflects an increase of 14 over the actual level in 1990 but in fact brings the staff level only to the level approved in the 1990 budget-approved staffing for 1990 was not attainable because of attrition and the lag in finding qualified replacements. Besides providing for the staff additions, the expense increase represents salary administration actions and increased equipment and data-processing costs associated with automation initiatives.

Reserve Bank expenses on an object of expense basis also might be useful to the subcommittee.

Operating expenses for Personnel comprise officer and employee salaries, other compensation to personnel, and retirement and other benefits. Total personnel costs account for 64.5 percent of Reserve Bank expenses and are expected to increase 8.0 percent in 1991.

Salaries and other personnel expenses account for about 52 percent of 1991 budgeted expenses and are expected to be $49.3 million, or 6.7 percent above 1990 expenses. Salaries alone are budgeted to increase $52.6 million, or 7.3 percent, and will be partially offset by a decline in other personnel expenses of $3.2 million or 25.2 percent. The decrease in other personnel expenses results from a declining use of personnel agencies. Merit pay increases of $37.1 million, or 5.1 percent, are the primary reason for salary expense growth. Also contributing to additional salary expenses are staffing level increases, promotions, reclassifications, and structure adjustments. These increases are partially offset by position vacancies and reduced overtime.

Expenses for retirement and other benefits, which account for 12.3 percent of Reserve Bank budgets, are anticipated to increase $22.1 million, or 13.5 percent, in 1991. This increase is the result of continued escalation in hospital and medical costs, a rise in the social security tax, and an increase in the thrift plan match in 1991.

Nonpersonnel expenses account for 35.5 percent of Reserve Bank expenses and are projected to increase 4.5 percent in 1991.

Equipment expenses are expected to increase 7.2 percent and to account for 11.6 percent of total expenses in 1991. Most of the increase is in depreciation expenses resulting from acquisitions to expand data processing and data communications capabilities because of increased work loads.

Shipping costs primarily for check operations) account for 5.8 percent of the 1991 budget and are projected to increase 4.1 percent in 1991. The increase is primarily the result of a substantial increase in postal rates in early 1991, an increase for the interdistrict transportation system (ITS), and increases from rebidding local transportation contracts.

Building expenses, which account for 9.1 percent of total expenses, are expected to increase 10.4 percent in 1991 because of higher real estate taxes in several Districts and the full-year effect of recently completed capital projects.

The plans of the Reserve Banks for Capital spending in 1991 show that outlays for buildings and for data processing and data communications equipment continue to dominate Reserve Bank capital budgets. By their nature, capital outlays vary greatly from year to year.

SPECIAL BUDGET EMPHASIS

The Board of Governors has continued approval in 1991 of two research and development projects intended to provide long-range benefits to the Federal Reserve and the banking industry. Because the spending on such projects is relatively high and short term, the Federal Reserve accounts for them separately from its operating expenses, although they are included in the total system budget. The budget for these "Special Projects" in 1991 is $7.6 million, compared with $5.2 million in 1990 and $7.5 million in 1989.

Since 1985, the Federal Reserve has been working on a project-digital imaging of checks-that could improve the efficiency of the check collection system through transition from paper delivery to electronic delivery. The System has been testing digital image technologies to produce high-quality images of check documents in a sustained high-speed check processing environment. The primary applications chosen for the testing were truncation of government checks and the processing of return items. Both of these check processes provide rigorous tests for image technology because they require the storage of large amounts of data and require a high level of quality in the retrieved image. The focus of this project during 1991 will be on the systems development of a high-speed government check archival system, of personal computer systems for potential applications such as return-item processing, and of low-speed systems that will be efficient in very low-volume applications in the near term. The 1991 budget for this project is $3.7 million.

The second Special Project is the development of currency authentication systems. Our effort is to improve capabilities for detection of counterfeit notes in the processing of incoming currency deposits, and thereby promote the integrity of U.S. currency in circulation. The 1991 budget for this project is $3.9 million.

Before concluding my comments, I would like to add that the Federal Reserve knows a rigorous budget process is only one part of financial management. We are equally concerned about other areas of financial integrity. The structure of the Federal Reserve System provides for appropriate segregation of responsibilities; strong accounting control over assets, liabilities, revenues, and expenses; and an organizational structure that establishes responsibilities for audit and oversight of the objectives and goals of the Federal Reserve System.

This was the subject of our report to the subcommittee earlier this year in which we described and documented procedures and systems employed in supervising and controlling the Federal Reserve Banks. In brief summary, it is the policy of the Federal Reserve that the Board and each Reserve Bank maintain a system of internal controls that is designed to ensure that objectives of each are achieved and that they each operate in compliance with all prescribed rules, regulations, and policies. The management of each is responsible for maintaining adequate internal financial, custody, and data security controls over all aspects of their respective operations.

To ensure that these controls are operating in an effective manner at the Federal Reserve Banks, we have put the following procedures in place: (1) an internal audit function at each Reserve Bank is responsible for assessing practices and procedures for soundness and conformity with regulations in accordance with professional auditing standards; (2) the Board of Governors examiners conduct financial, operational, and procedural reviews at each of the Banks; (3) a certified public accountant firm reviews the procedures and practices of the Board's examination program; and (4) the Board's specialists review the effectiveness of each Reserve Bank's internal audit function. We believe that these measures offer excellent protection against financial impropriety.

Governor Kelley and I thank you for this opportunity to address the subcommittee on the Federal Reserve System budget. The existing budget processes are working well in controlling costs while at the same time encouraging quality improvements. We welcome your comments and would be pleased to address any questions you may have on our budget.

1. The attachments to this statement are available on request from Publications Services, Board of Governors of the Federal Reserve System, Washington, D.C. 20551.