Statements to Congress.

Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Subcommittee on Foreign Operations of the Committee on Appropriations, US. Senate, March 3, 1998

The global financial system has been evolving rapidly in recent years. New technology has radically reduced the costs of borrowing and lending across traditional national borders, facilitating the development of new instruments and drawing in new players. Information is transmitted instantaneously around the world, and huge shifts in the supply and demand for funds naturally follow, resulting in a massive increase in capital flows.

This burgeoning global system has been demonstrated to be a highly efficient structure that has significantly facilitated cross-border trade in goods and services and, accordingly, has made a substantial contribution to standards of living worldwide. Its efficiency exposes and punishes underlying economic imprudence swiftly and decisively. Regrettably, it also appears to have facilitated the transmission of financial disturbances far more effectively than ever before.

Three years ago, the Mexican crisis was the first such episode associated with our new high tech international financial system. The current Asian crisis is the second.

We do not as yet fully understand the new system's dynamics. We are learning fast and need to update and modify our institutions and practices to reduce the risks inherent in the new regime. Meanwhile, we have to confront the current crisis with the institutions and techniques we have.

Many argue that the current crisis should be allowed to run its course without support from the International Monetary Fund (IMF) or the bilateral financial backing of other nations. They assert that allowing this crisis to play out, while doubtless having additional negative effects on growth in Asia, and engendering greater spillovers onto the rest of the world, is not likely to have a large or lasting impact on the United States and the world economy.

They may well be correct in their judgment. There is, however, a small but not negligible probability that the upset in East Asia could have unexpectedly large negative effects on Japan, Latin America, and eastern and central Europe that, in turn, could have repercussions elsewhere, including the United States. Thus, while the probability of such an outcome may be small, its consequences, in my judgment, should not be left solely to chance. We have observed that global financial markets, as currently organized, do not always achieve an appropriate equilibrium, or at least require time to stabilize.

Opponents of IMF support for member countries facing international financial difficulties also argue that such substantial financial backing, by cushioning the losses of imprudent investors, could encourage excessive risk-taking. There doubtless is some truth in that, though arguably it has been the expectation of governments' support of their financial systems that has been the more obvious culprit, at least in the Asian case. In any event, any expectations of broad bailouts have turned out to have been disappointed. Many if not most investors in Asian economies have to date suffered substantial losses. Asian equity losses, excluding Japanese companies, since June 1997, worldwide, are estimated to have exceeded $700 billion, at the end of January, of which more than $30 billion had been lost by U.S. investors. Substantial further losses have been recorded in bonds and real estate.

Moreover, the policy conditionality, associated principally with IMF lending, which dictates economic and financial discipline and structural change, helps to mitigate some of the inappropriate risk-taking. Such conditionality is also critical to the success of the overall stabilization effort. At the root of the problems is poor public policy that has resulted in misguided investments and very weak financial sectors. Convincing a sovereign nation to alter destructive policies that impair its own performance and threaten contagion to its neighbors is best handled by an international financial institution, such as the IMF. What we have in place today to respond to crises should be supported even as we work to improve those mechanisms and institutions.

Some observers have also expressed concern about whether we can be confident that IMF programs for countries, in particular the countries of East Asia, are likely to alter their economies significantly and permanently. My sense is that one consequence of this Asian crisis is an increasing awareness in the region that market capitalism, as practiced in the West, especially in the United States, is the superior model; that is, it provides greater promise of producing rising standards of living and continuous growth.

Although East Asian economies have exhibited considerable adherence to many aspects of free market capitalism, there has nonetheless been a pronounced tendency toward government-directed investment, using the banking system to finance that investment. Given a record of real growth rates of close to 10 percent per annum over an extended period of time, it is not surprising that it has been difficult to convince anyone that the economic system practiced in East Asia could not continue to produce positive results indefinitely. After the breakdown, an increasing awareness, bordering in some cases on shock, that their economic model was incomplete, or worse, has arguably emerged in the region.

As a consequence, many of the leaders of these countries and their economic advisers are endeavoring to move their economies much more rapidly toward the type of economic system that we have in the United States. The IMF, whatever one might say about its policy advice in the past, is trying to play a critical role in this process, providing advice and incentives that promote sound money and long-term stability. The IMF's current approach in Asia is fully supportive of the views of those in the West who understand the importance of greater reliance on market forces, reduced government controls, scaling back of government-directed investment, and embracing greater transparency--the publication of all the data that are relevant to the activities of the central bank, the government, financial institutions, and companies.

It is a reasonable question to ask how long this conversion to embracing market capitalism in all its details will last in countries once temporary IMF support is no longer necessary. We are, after all, dealing with sovereign nations with long traditions not always consonant with market capitalism. There can be no guarantees, but my sense is that there is a growing understanding and appreciation of the benefits of market capitalism as we practice it--that what is being prescribed in IMF programs fosters their own interests.

The just-inaugurated president of Korea, from what I can judge, is unquestionably aware of the faults of the Korean system that contributed to his country's crisis; he appears to be very strenuously endeavoring to move his economy and society in the direction of freer markets and a more flexible economy. In these efforts, he and other leaders in the region with similar views have the support of many younger people, a large proportion educated in the West, who see the advantages of market capitalism and who will soon assume the mantle of leadership.

Accordingly, I fully back the Administration's request to augment the financial resources of the IMF by approving as quickly as possible U.S. participation in the New Arrangements to Borrow and an increase in the U.S. quota in the IMF. Hopefully, neither will turn out to be needed, and no funds will be drawn. But it is better to have it available if that turns out not to be the case and quick response to a pending crisis is essential.

Statement by Laurence H. Meyer, Member, Board of Governors of the Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, US. Senate, March 3, 1998

I welcome the opportunity to testify on behalf of the Federal Reserve Board on proposals in S. 1405 to allow the payment of interest on demand deposits and on the required reserve balances of depositories at the Federal Reserve. The Federal Reserve strongly supports these measures. We have commented favorably on such proposals on a number of previous occasions over the years, and the reasons for those positions still hold today. We also believe the legislation should include a provision to allow the Federal Reserve to pay interest on excess reserves.

These legislative proposals are important for economic efficiency: Unnecessary restrictions on the payment of interest on demand deposits and reserve balances distort market prices and lead to economically wasteful efforts to circumvent them.

Because of recent financial market innovations, the proposals are also important for monetary policy. Balances that depository institutions must hold at Federal Reserve Banks to meet reserve requirements pay no interest. Reserve requirements are now 10 percent of all transaction deposits above a threshold level. Requirements may be satisfied either with vault cash or with balances held in accounts at Federal Reserve Banks. Depositories have naturally always attempted to reduce such non-interest-bearing balances to the minimum. For more than two decades, some commercial banks have done so in part by sweeping the reservable transaction deposits of businesses into nonreservable instruments. These business sweeps not only avoid reserve requirements but also allow firms to earn interest on instruments that are, effectively, equivalent to demand deposits.

In recent years, developments in computer technology have allowed depositories to begin sweeping consumer transaction deposits into nonreservable accounts. In consequence, the balances that depositories hold at Reserve Banks to meet reserve requirements have fallen to quite low levels. These consumer sweep programs are expected to spread further, threatening to lower required reserve balances to levels that may begin to impair the implementation of monetary policy. Should this occur, the Federal Reserve would need to adapt its monetary policy instruments, which could involve disruptions and costs to private parties as well as to the Federal Reserve. However, if interest were allowed to be paid on required reserve balances and on demand deposits, changes in the procedures used for implementing monetary policy might not be needed.

The prohibition of the payment of interest on demand deposits was enacted in the depression atmosphere of the mid-1930s. At that time, the Congress was concerned that large money center banks might have earlier been bidding deposits away from country banks to make loans to stock market speculators, in the process depriving rural areas of financing. It is unclear whether the rationale for this prohibition was ever valid, and it is certainly no longer applicable today. Funds flow freely around the country, and among banks of all sizes, to find the most profitable lending opportunities, using a wide variety of market mechanisms, including the federal funds market. The absence of interest on demand deposits is no bar to the movement of funds from depositories with surpluses--whatever their size or location--to the markets where the funding can be profitably employed. In fact, small firms in rural areas are able to bypass their local banks and invest in money market mutual funds with transaction capabilities. Indeed, smaller banks complain that they are unable to compete for the deposits of businesses precisely because of their inability to offer interest on demand deposits.

The prohibition of interest on demand deposits distorts the pricing of transaction deposits and associated bank services. In order to compete for the liquid assets of businesses, banks set up complicated procedures to pay implicit interest on what are called compensating balance accounts. These accounts, which represent a sizable fraction of demand deposits, earn credits that can be used to pay for a firm's use of other bank services. Banks also spend resources--and charge fees--for sweeping the excess demand deposits of businesses into money market investments on a nightly basis. To be sure, the progress of computer technology has reduced the cost of such systems over time. However, the expenses are not trivial, particularly when substantial efforts are needed to upgrade such automation systems or to integrate the diverse systems of merging banks. Such expenses waste the economy's resources--they would be unnecessary if interest were paid on both demand deposits and the reserve balances that must be held against them.

The prohibition of interest on demand deposits also distorts the pricing of other bank products. Because banks cannot attract demand deposits through the payment of explicit interest, they often try to attract these deposits, aside from compensating balances, through the provision of services at little or no cost. When services are offered below cost, they tend to be overused--an additional waste of resources attributable partly to the prohibition of interest on demand deposits.

However, the potential gains in economic efficiency cannot be fully realized by paying interest on demand deposits alone. As has been demonstrated in the case of the consumer checking accounts, on which interest is paid, the absence of interest on the reserve balances that must be held against such transaction deposits has in itself provided strong enough incentive for banks to start sweep programs. The costs that banks incur to design and maintain the automation systems needed to implement such sweep programs are another instance of economic waste. The payment of interest on required reserve balances could remove the incentives to engage in such reserve avoidance practices.

In light of depositories' use of resources to try to circumvent reserve requirements, the reason for having such requirements might be questioned. Indeed, reserve requirements have been eliminated in a number of other industrialized countries. Let me review with you for a few moments the historical and current purposes served by reserve requirements.

Although the English word "reserves" might imply an emergency store of liquidity, required reserves cannot actually be used for this purpose because they represent a small and fixed fraction of a bank's transaction deposits. Reserve requirements have at times been employed as a means of controlling the growth of money. In the early 1980s, for example, the Federal Reserve used a reserve quantity procedure to control the growth of MI. For the most part, however, the Federal Reserve has looked to the price of reserves--the federal funds rate--rather than the quantity of reserves, as its key focus in implementing monetary policy.

Although reserve requirements no longer serve the primary purpose of monetary control, they continue to play an important role in the implementation of monetary policy in the United States. They do so by helping to keep the federal funds rate close to the target rate set by the Federal Open Market Committee. They perform this function in two ways: First, they provide a predictable demand for the total reserves that the Federal Reserve needs to supply through open market operations in order to achieve a given federal funds rate target. Second, because required reserve balances must be maintained only on an average basis over a two-week period, depositories have some scope to adjust the daily balances they hold in a manner that helps stabilize the federal funds rate. For instance, if the funds rate were higher than usual on a particular day, depositories could choose to hold lower reserve balances, and their reduced demand would help to damp the upward pressure on the funds rate. Later in the two-week period, they could make up the shortfall in their average holdings of reserve balances.

Depositories hold balances in their accounts at Federal Reserve Banks for reasons other than satisfying their two-week average requirements. Some balances are needed as a precaution against the chance that payment orders late in the day might leave a depository with an overdraft on its account, and the Federal Reserve strongly discourages overdrafts. On days when payment flows are particularly heavy and uncertain, or when the distribution of reserves is substantially displaced from normal, depositories tend to hold balances for precautionary purposes well above required levels.

Unlike the two-week average demands, these daily precautionary demands cannot help smooth the funds rate from one day to the next. They are also difficult to predict, making it harder for the Federal Reserve to determine the appropriate daily quantity of reserves to supply to the market. In the absence of reserve requirements, or if reserve requirements were very low, the daily demand for balances at Reserve Banks would be dominated by these precautionary demands, and as a result, the federal funds rate could often diverge markedly from its intended level.

An example of the volatility that can arise in the federal funds market because of a low level of required reserve balances occurred in early 1991. The Federal Reserve had reduced certain reserve requirements in late 1990 as a means of easing funding costs to banks during the credit crunch period. The cut in requirements reduced required balances at Reserve Banks for many depositories to below the balances needed for precautionary purposes, and the federal funds rate consequently became very volatile. On a typical day in that period, the funds rate strayed over a range of about 8 percentage points and missed the target for the average of daily rates by 1/2 percentage point. After a couple of months, stability returned to the federal funds market because depositories made improvements in their reserve management and because strong growth in deposits again boosted the level of required reserve balances above precautionary demands for many institutions.

Since that time, depositories have become much more adept at managing their reserve positions, and their need for precautionary balances on a typical day has declined considerably. In fact, they are now managing to operate with lower aggregate required balances at Reserve Banks than they had in early 1991, and the federal funds rate is nevertheless much more stable. A number of measures taken by the Federal Reserve have helped to foster stability, including improvements in the timeliness of account information provided to depositories, more frequent open market operations geared to daily payment needs, and improved procedures for estimating reserve demand. Another measure now being considered by the Federal Reserve Board is a shift to lagged reserve requirements, which would also contribute to some reduction in uncertainty about reserve demand.

The additional improvements in reserve management in recent years have been needed because required reserve balances have dropped substantially--from about $28 billion in late 1993 to about $9 billion in late 1997. This decline has not occurred because of further cuts in required reserve ratios by the Federal Reserve but because of the new retail sweep programs implemented by depositories. These programs use computerized systems to sweep consumer transaction deposits, which are subject to reserve requirements, into personal savings accounts, which are not. The spread of such retail sweep programs has not yet fully run its course, and considerable uncertainty shrouds its eventual outcome. We expect that the effects of future declines in required reserve balances on the volatility of the federal funds rate will not necessarily proceed gradually; the rather modest effects on volatility seen so far may not preclude a more outsized reaction as reserve balances fall even lower.

Heightened volatility in the federal funds rate is of concern for a number of reasons. To be sure, the transmission of volatility in the funds rate to volatility in longer-term rates is likely to be muted because of the averaging out of upticks and downticks in the overnight rate. However, even in the absence of much transmission to longer-term rates, increased volatility in the federal funds rate would affect other overnight interest rates, raising funding risks for most large banks, securities dealers, and other money market participants. Suppliers of funds to the overnight markets, including many small banks and thrift institutions, would face greater uncertainty about the returns they would earn. Market participants concerned about unexpected losses would incur additional costs in managing their funding to limit the heightened risks.

Countries that have eliminated reserve requirements do not generally experience a great deal of volatility in overnight interest rates because they are able to use alternative procedures for the implementation of monetary policy. One type of procedure, for instance, establishes a ceiling and a floor to contain movements of the overnight interest rate. The ceiling is set by a penalty interest rate on loans provided freely by the central bank through what is called a Lombard facility. The floor is established, in effect, by the payment of interest on excess reserves because no bank would lend to a private party at an interest rate below the rate it could earn on a risk-free deposit at the central bank. For the Federal Reserve to be able to set a similar interest rate floor, it would need authority to pay interest on excess reserves. As regards a ceiling on the funds rate, a change in the Federal Reserve's approach to the discount window would be necessary because we have no penalty interest rate and instead subject borrowing applications to an administrative review. Alternative means of establishing a ceiling could be considered.

If interest were allowed to be paid on both demand deposits and required reserve balances, adjustments in the procedures for implementing monetary policy might not be needed. Such interest payments would likely boost the level of transaction deposits substantially, as some business and household sweep programs were unwound, and as banks became more able to compete for the liquid funds of businesses. The increased transaction deposits could ensure that required reserve balances would remain above the level of daily precautionary needs for many institutions, thus helping to stabilize the federal funds rate, while also improving economic efficiency as previously noted.

The magnitude of the prospective responses to these measures is uncertain, however. Some corporations may not find the interest paid on demand deposits high enough to induce them to shift out of other liquid instruments. Also, some banks may retain consumer sweep programs in order to seek higher investment returns than the Federal Reserve would pay on reserve balances. If interest were allowed on required reserve balances, the Federal Reserve would likely pay a rate close to the rate available on an overnight repurchase agreement. Higher yields are, of course, available on investments of greater risk and longer maturities.

Because of the uncertainties involved, the Federal Reserve needs to be able to pay interest on excess reserves as well as on required reserve balances, and at differential rates to be set by the Federal Reserve. The ability to pay interest on excess reserves would provide an additional tool that could be used for monetary policy implementation, but one that might not need to be used, if interest on required reserve balances and demand deposits resulted in a sufficient boost to the level of those balances. Even if not used immediately, it is important that the Federal Reserve have the full range of tools available to other central banks, given the inventiveness of our financial markets and the need for the Federal Reserve to be prepared for potential developments that may not be immediately visible.

The payment of interest on reserve balances would tend to reduce the revenues received by the Treasury from the Federal Reserve, while the payment of interest on demand deposits would increase those revenues. Treasury revenues would be directly reduced by the payment of interest on existing reserve balances. However, there would be some offset to this direct revenue loss. The level of reserve balances would rise because of the interest payments, and the Federal Reserve would therefore be able to increase its holdings of government securities. The Federal Reserve, on average, would earn a higher yield on those securities than the rate it would pay on required reserve balances. On net, Treasury revenues are still likely to fall with the payment of interest on required reserve balances, but the recent declines in such balances have reduced that revenue loss to a historic low, roughly $100 million annually starting next year, according to a recent estimate by the Congressional Budget Office. Similarly, interest payments on demand deposits would increase the level of demand deposits, as well as the reserve balances held against them on which the Federal Reserve would also earn a positive interest rate spread. The size of this further offset to the Treasury's revenue loss on required reserve balances is subject to considerable uncertainty.

In the long run, the benefits of the proposed legislation will likely be distributed rather widely among bank customers. The biggest winners should be small businesses that currently earn no interest on their checking accounts. They will gain from the interest earned and from being able to relax procedures used to hold to a minimum the size of their checking account deposits. Larger firms will benefit as well, in part by saving on some sweep fees.

For banks, interest on demand deposits will increase costs, at least in the short run. Larger banks and securities firms may also lose some of the fees they currently earn on sweeps of business demand deposits. The higher costs to banks will be partially offset by interest on reserve balances, and over time, these measures should help the banking sector attract liquid funds in competition with nonbank institutions and direct market investments by businesses. Small banks, in particular, should be able to bid for business demand deposits on a more level playing field vis-a-vis both nonbank competition and large bank sweep programs. Moreover, large and small banks will be strengthened by fairer prices on the services they offer and by the elimination of unnecessary costs associated with sweeps and other procedures currently used to try to minimize the level of reserves.

In the early 1980s, the Congress decided to deregulate interest rates on all household deposits and to allow money market deposit accounts for businesses. It is now time to extend the benefits of deposit interest rate deregulation to the ordinary checking accounts of businesses. Eliminating price distortions on demand deposits and on required and excess reserve balances would spare the economy wasteful expenditure, increase the efficiency of our financial markets, and facilitate the conduct of monetary policy.

Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on the Budget, US. House of Representatives, March 4, 1998

Just last week I presented the Federal Reserve's semiannual report on economic conditions and the conduct of monetary policy. This morning, I will briefly review some aspects of that outlook before I turn to a more detailed discussion of coming budgetary challenges.

The exemplary performance of the U.S. economy in 1997 will be hard to match. Last year's combination of robust expansion of activity, healthy creation of new jobs, and a decline in inflation generated widespread benefits for our citizens. Many of those benefits have the promise to be long-lived: Our nation has been experiencing a higher growth rate of productivity--output per hour worked--in recent years, which is the ultimate source of rising standards of living.

There can be no doubt that domestic demand retained some of its considerable momentum going into this year. Production and employment have been on a strong uptrend in recent months. Confident households, enjoying gains in income and wealth and benefiting from the reductions in intermediate- and longer-term interest rates to date, should continue to increase their spending. Firms should find financing available on relatively attractive terms to fund profitable opportunities to enhance efficiency by investing in new capital equipment. By itself, this strength in spending would seem to presage intensifying pressures in labor markets and on prices. Yet, the outlook for total spending on goods and services produced in the United States is less assured of late because of storm clouds massing over the Western Pacific and heading our way.

With the crisis curtailing the financing available in foreign currencies, many Asian economies have had no choice but to cut back their imports sharply from the United States and elsewhere, a situation made worse by disruptions to their financial systems and economies more generally. American exports should be held down further by the appreciation of the dollar, which will make the prices of competing goods produced abroad more attractive, just as foreign-produced goods will be relatively more attractive to buyers here at home. As a result, we can expect a worsening net export position to exert a discernible drag on total output in the United States and the dollar prices of our non-oil imports to extend their recent declines. These lower import prices are apparently already making domestic producers hesitant to raise their own prices for fear of losing market share, further contributing to the restraint on overall prices.

The key question going forward is whether the restraint building from the turmoil in Asia will be sufficient to check inflationary tendencies that might otherwise result from continued strength of domestic spending and tightening labor markets. The depth of the adjustment abroad will depend on the extent of weakness in the financial sectors of Asian economies and the speed with which structural inefficiencies in the financial and nonfinancial sectors of those economies are corrected. If, as we suspect, the restraint coming from Asia is sufficient to bring the demand for American labor back into line with the growth of the working-age population desirous of working, labor markets will remain unusually tight, but any intensification of inflation should be delayed, very gradual, and readily reversible. However, we cannot rule out two other, more worrisome possibilities. On the one hand, should the momentum to domestic spending not be offset significantly by Asian or other developments, the U.S. economy would be on a track along which spending could press too strongly against available resources to be consistent with contained inflation. On the other, we also need to be alert to the possibility that the forces from Asia might damp activity and prices by more than is desirable by exerting a particularly forceful drag on the volume of net exports and the prices of imports.

The robust economy has facilitated the efforts of the Congress and the Administration to restore balance in the unified federal budget. The deficit dropped to its lowest level in more than two decades in fiscal 1997, and both the Administration and the Congressional Budget Office (CBO) now expect the budget to remain essentially in balance over the next few years before moving to moderate surpluses by the middle of the next decade. I should caution, though, that while receipt growth remained robust through January, the prospects for fiscal 1998 as a whole remain uncertain until we have a tally of the final payments that will be included in April's tax returns.

As I have indicated to the Congress on numerous occasions, putting the unified budget into significant surplus would be the surest and most direct way of increasing national saving. In turn, higher national saving, by promoting lower real long-term interest rates, helps spur spending to outfit American firms and their workers with the modern equipment they need to compete successfully on world markets. We have seen a partial down payment of the benefits of better budget balance already: It seems reasonable to assume that the decline in longer-term Treasury yields last year owed, in part, to reduced competition--current and prospective--from the federal government for scarce private saving.

But much hard work remains to be done to ensure that these projected surpluses actually materialize and that the appropriate budgetary strategy is in place to deal with the effects on federal entitlement spending of the looming shift in the nation's retirement demographics. The baseline projections from the Office of Management and Budget (OMB) and the CBO provide a good starting point for assessing the budget outlook over the medium term: They are based on sensible economic and technical assumptions and thus offer a reasonable indication of how the budget is likely to evolve if economic conditions remain favorable and current budgetary policies remain in place. However, the experience of the past few years amply demonstrates that such forecasts are subject to considerable error. For evidence on that score, we need only look back to last winter. Even with fiscal 1997 already well under way, both the CBO and the OMB were overestimating that year's deficit by about $100 billion.

In retrospect, much of the error in last winter's deficit estimates fell on the inflow side, largely reflecting a surge in tax receipts that far exceeded estimates. This "tax surprise", which helped lift the receipts share of gross domestic product to a historical high, was not a new phenomenon. In the early 1990s, growth of receipts consistently fell short of expectations based on the trends in aggregate income and the tax laws then in place. Even after the fact, our knowledge about the sources of such surprises has not always been definitive. As a result, we must remain cautious about extrapolating recent favorable tax inflows into the future. We cannot rule out the possibility that the next few years will see a more rapid dissipation of the strength in receipts than either the OMB and the CBO have assumed, implying renewed deficits. Indeed, all else equal, had the 1997 surprise fallen on the other side--downward instead of upward--we would be confronted by nontrivial budget deficits at least through the beginning of the coming decade.

Moreover, the baseline projections assume that discretionary spending will be held to the statutory caps, which allow almost no growth in nominal outlays through fiscal 2002. Given the declining support for further reductions in defense spending, keeping overall discretionary spending within the caps is likely to require sizable, as yet unspecified, real declines in nondefense programs from current levels. Not surprisingly, many observers are skeptical that the caps will hold, and battles over appropriations in coming years may well expose deep divisions that could make the realization of the budget projections less likely. In addition, although last year's legislation cut Medicare spending substantially, experience has highlighted the difficulty of controlling this program, raising the possibility that the savings will not be so great as anticipated--especially if resistance develops among beneficiaries or providers.

These uncertainties underscore the need for caution as you move ahead on your work on the 1999 budget. There is no guarantee that projected surpluses over the next few years will actually materialize. However, we can be more certain that, absent action, the budgetary position will erode after the next decade as the baby boom generation moves into retirement, putting massive strains on the social security and Medicare programs. Without question, the task of stemming that erosion will become increasingly difficult the longer it is postponed. Indeed, especially in light of these inexorable demographic trends, I have always emphasized that we should be aiming for budgetary surpluses and using the proceeds to retire outstanding federal debt. In that regard, one measure of how much progress has been made in dealing with the nation's fiscal affairs is that serious discussion of such paydowns has begun to surface. Working down the stock of the federal debt would put further downward pressure on long-term interest rates, which would enhance private capital investment, labor productivity, and economic growth, preparing us to better confront the looming changes in retirement demographics.

Over the decades, our budgetary processes have been biased toward deficit spending. Indeed, those processes are strewn with initiatives that were viewed as having only a small projected budgetary cost at inception but which produced a sizable drain on the Treasury's coffers over time. As you are well aware, programs can be easy to initiate or expand but extraordinarily difficult to trim or shut down once a constituency develops that has a stake in maintaining them. Thus far, the President and the Congress have been quite successful, contrary to expectations, in placing, and especially holding, caps on discretionary spending. More recently, they have started to confront the budget implications of the surge in retirements that will occur early in the next century. But the good news of late on the budget has unleashed an outpouring of proposals that, if adopted, do not bode well for the maintenance of fiscal discipline. Although many of the individual budget proposals may have merit, they must be considered only in the context of a responsible budget strategy for the longer run.

In closing, I want to commend Chairman Kasich and the members of the committee for your insistence on fiscal responsibility and persistent efforts to bring the budget under control. The shrinking budget deficit and the prospect of surplus stand as testimony to your endeavors. But we must remember that projections of surpluses are based on an extrapolation of steady economic growth and subdued inflation in coming years. Achieving such a performance in these uncertain times, with the U.S. economy now subject to a fine balance of powerful forces of expansion and restraint, will provide policymakers with a considerable challenge. And, on your part, not succumbing to the temptation to commit prematurely future surpluses that exist only on paper, while, in addition, addressing the adverse effects of ongoing demographic changes to the budget over the longer run, will not be easy. However, if we meet these challenges, the increase in national saving and investment will almost surely pay off handsomely in the form of a more rapidly expanding standard of living for all Americans.

Statement by Laurence H. Meyer, Member, Board of Governors of the Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, US. Senate, March 10, 1998

The Board of Governors appreciates this opportunity to comment further on S. 1405, the Financial Regulatory Relief and Economic Efficiency Act of 1997. The members of this committee, and in particular Senators Shelby and Mack, are to be commended for the leadership role you have taken over the past several years in reducing unnecessary burdens on our nation's banking system. This committee has recognized that unnecessary regulatory burdens hinder the ability of banking organizations to compete effectively in the broader financial services marketplace and, ultimately, adversely affect the availability and prices to consumers of banking services and credit products.

This bill represents a further effort by this committee to eliminate unnecessary regulatory burdens. The Board believes that a number of sections of this bill accomplish that purpose, and it recommends their adoption. Several other provisions, however, appear inadvertently to have gone beyond the goal of regulatory relief and may result in changes to the law that were neither intended nor desired. In this testimony, I would like to highlight some of the provisions that the Board supports and some of the areas with which the Board has concerns. (Attached to this statement is an appendix containing several technical suggestions and comments on other provisions of the bill that are not discussed directly in my testimony.)'

THE COMMITTEE'S PAST SUCCESSES

This committee has twice approved comprehensive legislation to ease regulatory burdens for financial institutions. As the Board stated at the time the committee was considering these prior legislative initiatives, the banking industry badly needed the type of regulatory burden relief embodied in the Community Development and Regulatory Improvement Act of 1994 (1994 Act) and in the Economic Growth and Paperwork Reduction Act of 1996 (1996 Act).

Before the passage of these two acts, the aggregate regulatory burden on our nation's banking organizations had become substantial. The Board supported the efforts of the committee and voiced its concern that obsolete and dysfunctional regulations were handicapping the ability of U.S. banking institutions to operate in increasingly competitive financial markets, both domestic and global. Taking heed of the calls for regulatory reform from the Board and others, this committee fashioned important legislation to revise anachronistic banking statutes that were imposing costs without providing commensurate benefits to the safety and soundness of financial institutions, consumer protection, or credit availability.

In the 1994 Act, the committee alleviated the paperwork burden for banking organizations seeking to gain federal approval to engage in certain transactions, enhanced the efficiency of the regulatory process by eliminating applications and other filing requirements, and streamlined examination and audit procedures. Two years later, with the support of the Board, the committee passed the 1996 Act, which, among other steps, permitted well-capitalized and well-managed institutions to commence previously approved nonbanking activities without filing an application. In the 1996 Act, the committee also passed important reforms to consumer protection statutes that alleviated the burdens imposed by these statutory provisions on financial institutions without undercutting the goals of the consumer protection laws.

OUR EFFORTS AT THE BOARD

The Board has long recognized that regulatory burdens on our nation's financial institutions must be reduced. Consistent with the mandate of the Congress and this committee, the Board has sought to ensure that regulatory requirements are imposed only when they are needed to accomplish the statutory responsibilities of the Board. For example, within the past two years, the Board has substantially revised its Regulation Y (which primarily governs bank holding companies) and has proposed comprehensive revisions to its Regulation H (which governs membership of state banks in the Federal Reserve System) and its Regulation K (which governs international banking operations). These changes will make the Board's regulations simpler, less burdensome, and more transparent while still providing banking organizations with powerful incentives to maintain strong capital positions, preserve solid management, and serve the needs of their communities.

The efforts of the Board, coupled with the mandates of this committee, have had a bottom-line, practical effect: Fewer applications need to be filed with the Board; and banking organizations have saved substantial regulatory, legal, compliance, and other costs. In short, these changes have enhanced the competitiveness of banking organizations that are regulated by the Board and have benefited the customers of these financial institutions.

The Provisions of This Bill

S. 1405 contains some important additional reform provisions. As I stated before the committee last week, the Board strongly supports the provision in section 101 of this bill that would permit the Federal Reserve to pay interest on reserve balances that depository institutions are required to maintain at Federal Reserve Banks. Because required reserve balances do not earn interest, banks and other depository institutions employ sweeps and other costly procedures to reduce such balances to a minimum. These reserve avoidance techniques represent a waste of resources for the economy and could also potentially complicate the implementation of monetary policy. Allowing the Board to pay interest on required reserve balances would not only eliminate economic inefficiencies but also alleviate risks that could affect the future implementation of monetary policy. In addition, as I mentioned last week, the Board would support allowing the Federal Reserve the option to make payment of interest on "excess" reserves, which could be a useful tool for monetary policy.

The Board also strongly endorses the provision in section 102 that would permit all depository institutions to pay interest on demand deposits, including deposits made by businesses. As I explained more fully last week, the prohibition of interest on the demand accounts of businesses is an anachronism that no longer serves any public policy purpose. On the other hand, this prohibition imposes a burden both on banks and on those holding demand deposits, especially small businesses, which frequently do not have the resources to implement sophisticated cash management programs. Repeal of the prohibition would remove an unnecessary regulatory burden, enhance the competitiveness of depository institutions, and benefit bank depositors.

There are other parts of this bill, as well, that would relieve regulatory burden without giving rise to safety and soundness, supervisory, consumer protection, or other policy concerns. For example, section 203 would eliminate the outdated and largely redundant requirement in section 11 (m) of the Federal Reserve Act, which currently sets a rigid ceiling on the percentage of bank capital and surplus that may be represented by loans collateralized by securities. Current national and state bank lending limits address concerns regarding concentrations of credit more comprehensively than section 11 (m) but do so without the unnecessary constraining effects of this section of the Federal Reserve Act.

In another area, the alternative consumer credit disclosure mechanisms permitted by sections 401 and 402 will be less burdensome to creditors and just as helpful to consumers as the disclosure requirements embodied in current law. The Congress has already eliminated the requirement that creditors disclose a historical table for closed-end variable rate loans. Taking similar action with respect to open-end variable rate home-secured loans, and permitting creditors to make alternative disclosures to meet their obligations with regard to credit advertising under the Truth in Lending Act, would reduce regulatory burdens without sacrificing consumer protections.

The Board supports other sections of the bill as well. Section 304, which would eliminate the banking agency report on differences in capital and accounting standards, is a provision that would terminate a reporting requirement that is no longer necessary in light of the considerable progress the agencies have made (at this committee's direction in the 1994 Act) in conforming their capital and accounting standards. Section 109 would provide a uniform limit on loans by banks to their executive officers, thereby diminishing confusion among regulated institutions and reducing regulatory burden across institutions with different regulators. Section 306, which would eliminate the Thrift Depositor Protection Oversight Board, would save the government money by terminating an administrative board whose primary function, oversight of the Resolution Trust Corporation (RTC), ceased when the RTC closed in 1995. Moreover, as discussed in the appendix, section 502 would make an important change in the health benefits available to Federal Deposit Insurance Corporation and Board retirees.

A few other provisions of this bill, however, appear to go beyond the committee's goal of regulatory relief or represent such fundamental changes in the federal regulatory system as to warrant a fuller debate in the context of broad financial modernization legislation. The Board is concerned that these provisions, as currently drafted, may result in changes to the law that the committee did not intend and will have effects that the committee may not desire. Some of these changes may give certain entities unfair competitive advantages; other provisions appear to extend taxpayer subsidies in a manner that would not seem warranted.

Nonbank Banks

Several provisions of S. 1405 would eliminate a number of important limitations that have been applied to nonbank banks. For example, section 208 would greatly enhance the ability of nonbank banks to expand their banking operations by allowing them to acquire any undercapitalized bank. Section 116 would allow nonbank banks to permit their affiliates to incur overdrafts at the nonbank bank and would allow nonbank banks to incur overdrafts at the Federal Reserve on behalf of affiliates. This section also would remove restrictions in current law on the crossmarketing of products by nonbank banks and their commercial affiliates. Section 205 would allow nonbank banks to offer business credit cards even where these business loans are funded by insured demand deposits. Finally, section 117 would liberalize the divestiture requirements that apply when companies violate the nonbank bank operating limitations.

Eliminating restrictions on nonbank banks, at first glance, may have intuitive appeal. However, there are important reasons why the Board is concerned about these provisions. Nonbank banks--which, despite their popular name, are federally insured, national or state-chartered banks--came into existence by exploiting a loophole in the law. By means of this loophole, industrial, commercial, and other companies were able to acquire insured banks and to mix banking and commerce in a manner that was then, and remains today, statutorily prohibited for banking organizations. These companies also have avoided the comprehensive framework of prudential standards and supervisory examination and review under the Bank Holding Company Act that governs all other corporate owners of insured banks.

In 1987, in the Competitive Equality Banking Act (CEBA), the Congress closed the nonbank bank loophole. At that time, the Congress chose not to require the fifty-seven companies operating nonbank banks to divest these institutions. Instead, the Congress permitted the companies owning these banks to retain their ownership as long as they complied with a carefully crafted set of limitations on the activities of nonbank banks and their parents. In a unique statutory explanation of legislative purpose, the Congress stated in the CEBA that these limitations were necessary to prevent the owners of nonbank banks from competing unfairly with bank holding companies and independent banks. In addition, the Congress found that the restrictions were needed to address potential adverse effects, including conflicts of interest, that could result from the ownership of these insured banks by companies that, unlike bank holding companies, are not subject to federal supervision or regulation or to the federal proscription against mixing banking and commerce.

Fewer than twenty-five nonbank banks currently claim the grandfather rights accorded in the CEBA. The Board is concerned that removal of the limitations and restrictions that apply to nonbank banks would enhance advantages that this relative handful of organizations already possess over other owners of banks and would give rise to the potential adverse effects about which the Congress has in the past expressed concern. In addition, removal of these limitations would permit the increased combination of banking and commerce for a select group of commercial companies, creating potential disadvantages and inequities for all other companies, including banks and bank holding companies.

As this committee is aware, there is significant debate in the context of broader efforts to modernize our financial laws regarding whether it is prudent to remove the existing separations between banking and commerce. Because reform of the nonbank bank provisions raises fundamental questions regarding the mixing of banking and commerce, the Board believes that reform of the provisions governing nonbank banks should be considered within the framework of broad financial modernization rather than in the context of efforts to reduce regulatory burden.

Thrift Powers

S. 1405, as drafted, also would appear to expand the mixing of commerce and banking by owners of savings associations. In particular, section 107, which appears to have been intended to allow a savings and loan holding company (SLHC) to acquire a noncontrolling interest in a savings association, would also permit multiple SLHCs, with the approval of the Office of Thrift Supervision, to acquire more than 5 percent of the shares of any company, including any commercial firm. This would seem to expand the ability of multiple SLHCs to mix banking and commerce to an unlimited degree, a result that the sponsors of this bill may not have intended. The Board supports clarifying the language in the bill to ensure that the powers of multiple SLHCs are not unintentionally broadened and advocates retaining the current proscription against allowing multiple SLHCs to acquire a significant interest in a commercial company.

Daylight Overdrafts 

Section 118 would require the Federal Reserve to make intraday credit, in the form of daylight overdrafts, available to the Federal Home Loan Banks. As it did in the last Congress, the Board strongly opposes this proposal, which would provide special treatment to the Federal Home Loan Banks over other government-sponsored enterprises (GSEs) and other lending institutions as well as over all depository institutions with access to central bank credit.

Section 118 would represent the first time that the Congress has mandated the availability and price of central bank credit. As such, this bill would serve as precedent for other GSEs to meet intraday liquidity needs with Federal Reserve credit at an administered interest rate instead of with the proceeds of obligations issued in the markets at competitive rates as contemplated by their statutory funding schemes.

In addition, section 118 would serve as a precedent for regularly extending Federal Reserve credit to institutions that are not subject to reserve requirements and therefore would grant the Federal Home Loan Banks access to that credit on terms more attractive than those available to depository institutions. For these reasons, the Board opposes extending the availability of routine daylight overdrafts to the Federal Home Loan Banks.

Price Discounts

Section 204 is intended to allow banks to discount the price of products and services that are offered in bundles to consumers. Current law prohibits banks from offering price discounts in most situations, even though this is a common practice in other industries and even though consumers benefit from receiving a price discount on the purchase of a combination of products and services.

In the past several years, the Board has utilized authority granted to it by the Congress to craft a number of exceptions to current law that allow banks to offer price discounts on bundled products. For example, the Board has allowed banks to offer discounts to customers that maintain a certain level of deposits at the bank so long as both the deposit accounts and the other bundled products are also separately available to the public. This type of price discounting both saves money for consumers who desire the bundled products and allows consumers who are not interested in purchasing the entire bundle of discounted services to purchase individual products or services separately at competitive prices.

Section 204, as currently drafted, would appear to go further than is necessary to allow this type of price discounting. The Board would support efforts to allow banks to offer price discounts to customers that choose to acquire multiple products or services from banks and their affiliates where the bundled products and services are also made available separately to customers at competitive prices.

Affiliations with Government-Sponsored Enterprises

A provision in section 113 would remove the current restriction on bank affiliations with GSEs. As worded, the section would appear to permit a bank or bank holding company to acquire control of any GSE and to permit any GSE to acquire an insured bank. This broad change, involving all GSEs, raises significant policy issues that the Board believes go beyond the scope of regulatory burden relief For example, this change raises the questions: Is it desirable to allow a banking organization to exercise control over a GSE? Would a banking organization that affiliates with a GSE gain competitive advantages over its peers from the special tax and quasi-governmental status of the GSE? Would the secondary markets that rely on GSEs be affected if a single banking organization acquires control of a GSE? Conversely, is it appropriate to allow any GSE to acquire control of an insured bank?

These and other questions are raised by a statutory change that would affect all GSEs, but the Board understands that the provision in section 113 is intended to address an existing relationship involving a banking organization's ownership of shares of a single GSE. This situation may be better addressed with a narrower provision that does not raise concerns regarding control of GSEs more broadly.

CLOSING THOUGHTS

The Board applauds the efforts of the committee to continue to eliminate unnecessary government-imposed burdens. The committee's past successes in regulatory reform and relieving regulatory burdens on banking organizations, coupled with the efforts of the bank regulatory agencies, necessarily make the committee's task today a difficult one. The committee's substantial previous efforts have left fewer areas in banking law that require reexamination outside the context of comprehensive financial modernization. As a consequence, in some areas, S. 1405 attempts to resolve issues that are better addressed in broader legislation that would reform the financial services industry.

The Board has long endorsed financial modernization strategies that ensure regulatory equity for all participants in the financial services industry, that minimize the chances that federal safety net subsidies will be expanded into new activities and beyond the confines of insured depository institutions, and that guarantee adequate federal supervision of financial organizations. The Board would be pleased to work with the committee and its able staff to reach these goals.

(1.) The attachment to this statement is available from Publications Services, Mail Stop 127, Board of Governors of the Federal Reserve System, Washington, DC 20551, or the Board's World Wide Web site, http://www.bog.frb.fed.us/