Statements to Congress.

Statements to Congress

Statement by Martha R. Seger, Member, Board of Governors of the Federal Reserve System, before the Subcommittee on Consumer and Regulatory Affairs of the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, June 7, 1989.

Thank you for the opportunity to provide the views of the Board of Governors of the Federal Reserve System on legislation relating to the Community Reinvestment Act (CRA), the Government Check Cashing Act of 1989, and the Basic Banking Services Access Act of 1989.

The CRA revisions in S. 909 would require that the numerical ratings and a written assessment of an institution's CRA performance be made available to the public. In addition, S. 906 would require depository institutions to cash government checks at cost for noncustomers provided that such persons have registered with the institution. S. 907 adds the requirement that depository institutions offer, for minimal fees, "basic financial services accounts" that have low minimum balance requirements and that they permit at least ten withdrawals per month.

COMMUNITY REINVESTMENT ACT

To preface our discussion of the legislation pertaining to the CRA, I would like to underscore our belief that the purpose of the CRA can best be accomplished in an arena that is, as much as possible, open to public view and input. Recent actions by the Board in concert with other regulators have echoed a theme that seems to be at the heart of the proposals before you today--that people who are well informed about the activities of their local financial institutions are better equipped to participate effectively in the CRA process. We are also committed to widening the channels of communication among banks, their communities, and regulators, but we believe this should be done without making the regulatory mechanisms and procedures for the CRA more complicated, costly, or apt to impose delays on those institutions with good records of performance.

I will begin by describing briefly the three-faceted program that we have established to carry out our mandate in enforcing the CRA. First, the Federal Reserve's specialized consumer compliance examiners conduct examinations of CRA performance about every 18 months for most state member banks, and more often for those with identified weaknesses in their record. The examination takes a comprehensive look at the bank's activities to address credit needs in its market, including those of low-and moderate-income areas, as well as the kinds of relationships it is forging with specific segments of the community. Second, through the community affairs office at each of the Reserve Banks, we provide information about community development strategies and techniques to banks, bank holding companies, and others. One of our primary goals is to become familiar with the credit needs within the Federal Reserve Districts, and then help banks construct programs that respond to those needs. Third, we consider the CRA record of banks in connection with applications received under the Bank Holding Company and Bank Merger Acts; CRA performance is taken into account along with legal, financial, managerial, and competitive factors.

Our commitment to enhancing the role the public plays in the CRA process has been a long-standing one. For more than 10 years, we have endeavored to ensure that CRA examinations are not conducted in a regulatory vacuum--Federal Reserve examiners routinely interview business people, government officials, and housing and other community group leaders in the bank's community to learn about the local economic environment and the perceptions these individuals hold of their local financial institutions. We require institutions to keep a file of letters commenting on their CRA performance from members of the community; examiners review those letters, as well as the institutions' responses to them. Careful attention is also given to public comments on CRA performance, or protests, received in connection with an application. Yet our experience with the CRA leads us to believe that more can be done to open up the process--and that is precisely the direction in which we are moving.

In March of this year the Board, together with the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Federal Home Loan Bank Board, adopted a CRA Policy Statement to provide guidance to institutions and to community groups and to clarify a number of issues that have arisen in enforcing the CRA. For example, institutions are now required by regulation to prepare, annually update, and make available for public review a CRA statement listing the loan products they are willing to extend. The new Policy Statement urges each institution to significantly expand its statement to paint a picture of the institution's overall approach to CRA, describing strategies for marketing and advertising, credit needs assessment and new product development, past accomplishments, and future plans. Naturally, the size, resources, and location of an institution will influence the CRA statement's degree of detail and its scope. While an expanded statement laying out the details of its CRA efforts may be extremely useful to a large bank in a major city, it may simply not be necessary for a small bank in a rural setting to go into similar detail.

A major thrust of the policy statement is to shift the "CRA spotlight" away from the applications process--with the pressures imposed by our timetable guidelines for completing the process--and to build stronger, enduring mechanisms for outreach and service by institutions to their communities. We think that the expanded CRA statement is an ideal vehicle for doing that by focusing the attention of an institution's management, and of the public at large, on the institution's record on an ongoing basis, and on any areas needing improvement. At the same time, we have strongly encouraged community organizations to take advantage of the expanded CRA statements as a starting point for discussion, bringing their concerns to the attention of an institution's management--to the greatest possible extent--in the framework of a continuing dialogue, rather than in a protest situation.

A second important policy direction emphasized in the new policy statement should be borne in mind in considering proposed legislation. That is, that institutions desiring to expand their operations should have appropriate CRA policies in place, and working well, before filing an application. That means that while commitments by applicants for future actions may be used to address specific problems in an otherwise satisfactory record, making commitments to improve in the future should not be seen by applicants as a way to compensate for a seriously deficient past record of performance.

This approach was demonstrated earlier this year in the Board's denial of an application by Continental Illinois Bancorp, Inc., of Chicago, Illinois, to acquire an Arizona bank. In its order, the Board described, and took a positive view of, a plan developed by Continental to correct shortcomings in its CRA performance, which was in the initial stages of implementation. Yet the prior record failed to demonstrate, in the words of the Board's order, "a basic level of compliance on which the commitments can be evaluated." The Board's handling of the Continental case should not be interpreted as evidence of any lessened willingness to work with institutions directly, or through their primary regulators, to improve their record. While there were reasons for the Board's denial besides CRA factors, the case does give a clear signal that, with respect to the CRA, institutions should "put their houses in order" before considering expansion. It also highlights the importance of an established record of performance under the CRA.

S. 909

In light of these developments, let me now turn our attention to S. 909, which would amend the Community Reinvestment Act to require the regulatory agencies to prepare written evaluations of institutions' performance under the act, and to make those evaluations public. We support the concept at the core of Senator Metzenbaum's proposal; in fact, you may recall that Governor Johnson endorsed the idea of regularly publishing an assessment of each institution's CRA record by our examiners in testimony before this committee last September.

But one point is especially worthy of emphasis with regard to the nature of the written evaluations for public release that we support. Though the public evaluations we support would summarize the examiner's conclusions, together with supporting information related to the CRA assessment factors, these evaluations would not be the same as the examination reports themselves. Neither would they divulge material contained in the examination report that is important for supervisory purposes, but must be treated confidentially--such as information about the financial condition of the institution and any sensitive information about its employees, customers, or members of the community. We believe that the relevant provisions of S. 909 should be written to recognize the distinction between the examination report that is given to the bank and the summary assessment that we believe can usefully be made public.

The objective of that proposal was to tell people at the community level in a concise, straightforward, and timely way how well their local institutions are doing under the CRA. Doing so should facilitate exactly what we are endeavoring to do through the Policy Statement just described--promote the early start of a constructive dialogue about CRA achievements and goals. Those concerned about affordable housing, minority businesses, inner city reinvestment, and many other areas will benefit from knowing how these factors have been weighed in assessing the record, and what areas for improvement have been identified.

We do, however, have serious concerns about two aspects of the proposal. First, the written evaluations of each institution's performance would be required to emphasize three specific types of credit--loans for low- and moderate-income housing, small businesses, and small farms. We believe that this requirement is inconsistent with the intent of the act itself, which does not impose any specific lending requirements. Rather, institutions have a responsibility to help meet local credit needs, using their own expertise and resources.

Because needs vary widely from community to community, we would be remiss in rigidly focusing on these three credit categories in making our evaluations. CRA examiners aim to take a broad picture, instead of a snapshot, of all activities by an institution that foster community revitalization--principally direct loans of all kinds, but also, for instance, participation in the secondary market, purchase of state or municipal bonds, and investment in or technical assistance to community development projects. Examiners do look at the amounts and distribution of credit extended for housing, small businesses, and small farms, not with the intent of making a quantitative analysis of an institution's lending, but to gain a full, balanced view of its service to the community.

Secondly, the bill would mandate public disclosure of the numeric ratings assigned during examinations. Historically, CRA ratings, like commercial examination ratings, have been treated with strict confidentiality, as required by procedures adhered to by all regulators. The ratings were designed as a kind of supervisory shorthand to help us monitor those institutions needing closer attention; the numeric rating is in no way a self-explanatory indicator of performance. Moreover, a rating assigned at a particular date in the past can be misleading, given that CRA performance should be seen as a process developing over time, rather than a static state of affairs. At the very least, release of the rating number would divert attention from the substance of examination findings. Of even greater concern is the potential for the undermining of public confidence in the safety of deposits in an institution if an adverse CRA rating were to be misunderstood as a reflection on the institution's financial soundness. Much more can be achieved by making public only the narrative evaluation, as suggested by Governor Johnson last September.

CRA AMENDMENT TO H.R. 176

Your letter asked that we address other CRA changes proposed in an amendment to H.R. 176 late last year. This proposal comprises a broad spectrum of measures pertaining to CRA examinations, assessment factors for CRA performance, and the treatment of CRA issues in the applications process. Here again, we believe that the aspect of the proposal dealing with a public CRA assessment has merit. Our overriding concern, however, is that many of its provisions unnecessarily encumber existing administrative procedures for CRA enforcement.

First, the bill requires in Section 804(b) that the agencies give public notice before commencing CRA examinations. Presumably this would be done through newspaper advertisements, since it must be given "in a manner reasonably designed to reach members of the community served by the institution under examination"--although the use of lobby notices in the institution, or publications currently disseminated by each Reserve Bank that list pending applications might also be envisioned.

To gauge the implications of this proposal, Reserve Banks surveyed local newspapers to estimate the costs involved in running the 26,500 notices that we estimate would be required every two years for the examinations by all the federal regulators, assuming every institution is examined at least every two years. The total bill would be about $1.24 million biannually, taking into account price differences in urban and rural areas. Time involved in identifying suitable newspapers and making publication arrangements could add considerably to the price tag.

As stated in the proposed statutory language, the reason for the provision is to allow any person to submit comments on an institution's record in connection with CRA examinations. Actually, this has long been our practice. In the Federal Financial Institutions Examination Council's A Citizen's Guide to CRA, for example, community members are encouraged to discuss their concerns with the institution's regulatory authority, particularly through the public file, the maintenance of which is one of the CRA's statutory requirements. As indicated in the Guide, persons who request to speak to a Federal Reserve examiner in letters to the public file will be contacted during the next scheduled examination.

In reality, we go far beyond this provision, since we welcome comments about any institution's performance at any time, not just in connection with examinations, and we take them very seriously. We also seek out public input each time we conduct a CRA examination through the community contact interviews I mentioned earlier. In 1988, Federal Reserve examiners alone interviewed some 925 consumer advocacy groups, housing coalitions, local business and trade associations, as well as local government officials, and factored their comments into their assessments of CRA performance. Given the totality of these efforts, we do not believe this additional expense for soliciting public comments in the examination process is necessary.

The bill's Section 804(e) calls upon the agencies to prepare and make public their assessments of each institution's performance under the CRA. This concept has our support, for the reasons already discussed in connection with Senator Metzenbaum's proposal. There is, however, a need to clarify that the assessment would be separate and distinct from the examination report and the numeric rating.

Provisions of the bill's Section 805 regarding the consideration of CRA performance in the application process are troubling to us. We note that it would require the agencies to rely on the "most recent assessment of such record" in considering an applicant institution's performance. Experience has shown us that the most recent assessment may not always be the only, or most reliable, indicator of current performance, especially when the examination report is outdated, or when an institution has undergone a major internal change, such as turnover in management. In such instances, the flexibility to look beyond the latest examination report for up-to-date information accurately reflecting present performance is essential.

Section 805(e) sets out timing requirements for agencies to complete their assessments of CRA records in the framework of applications that we think are unnecessary and unwise. You may be aware that under Regulation Y, the Board has imposed on itself a 60-day guideline for processing applications. The vast majority of domestic bank and bank holding company applications are processed well within the 60-day goal; in both 1987 and 1988, the average processing time for more than 4,000 domestic cases, including those with CRA issues, was 39 days.

Under the Board's Rules of Procedure, the presence of a CRA protest or an adverse assessment by any agency makes the case a matter for Board attention--though it may be returned to the Reserve Bank after Board staff review. It also can make the process more complex, requiring a thorough, and frequently time-consuming, analysis of the issues. In many instances, it is necessary for us to seek out additional information from the applicant, or its primary regulator, to fully address these issues. This is why we are not always able to meet the 60-day target, although delays have generally not been inordinate; in 1987, average processing time for the 37 CRA-protested cases was 73 days and in 1988, for 32 cases, it was 87 days.

At the outset, we would question whether imposing statutory timeframes on applications processing would achieve the desired end. They would seem to hamper, rather than help, our efforts to give appropriate attention to convenience and needs considerations in applications, especially when an applicant's performance has been marginal, or when the applicant is not readily able to provide detailed information about its record.

Apart from our general concern about these requirements of the bill, other aspects of the bill's timing provisions are unclear. CRA is only one of many issues considered as part of these applications. The Board also considers legal, financial, managerial, and competitive issues, as well. The draft seems to speak only of those cases in which CRA issues are brought forward through a protest. In fact, CRA issues may also be uncovered by Federal Reserve Bank or Board review, when any of the banks that are parties to an application have been assigned adverse CRA examination ratings by any of the agencies' examiners. In addition, the draft appears to require that the CRA assessment in an application be completed by a certain time in the application process, whether or not the analysis of any other issues the case might raise have been completed and the overall case is ready for final decision.

Let me mention briefly our policy regarding extensions of the comment period since misperceptions about our policy may have sparked interest in the statutory timeframes. We believe that it is incumbent on persons desiring to comment on an applicant's CRA record to do so within a 30-day period; otherwise, we may be unable to give their comments the attention they deserve, and still carry out our responsibility to process applications in a timely manner. In a very few circumstances we do find that an extension of the comment period is warranted--when the application has not been promptly made available for inspection by the parties, for example, or in the rare event when there has been inadequate public notice of the application. But we do not think it is appropriate to extend the comment period--and possibly delay the Board's decision on the case--simply because the commenter wants more time to pursue negotiations with an institution under the pressure of a pending application. The agencies' recent Policy Statement stresses this point.

In summary, the amendment to H.R. 176, in our view, poses a number of problems. Most importantly, it would make more rigid and cumbersome procedures, which for the most part are already in place for enforcing the CRA, without presenting any really new approaches to make the process work better. We stand ready to answer any questions you may have, and to continue working with the committee in this key policy area.

CHECK CASHING AND BASIC BANKING

Let me turn now to the government check cashing and basic banking bills that are under consideration. These bills result from concerns that are similar to those that motivate the Community Reinvestment Act. Not only are some people questioning whether banks are meeting the credit needs of their communities, but others have also raised concerns that low- and moderate-income persons may not have ready access to banking services. In particular, the focus has been on the need to cash government checks and to have an account for making a limited number of payments to third parties.

The Board is quite familiar with these concerns. Since 1977, we have sponsored four surveys that determined, among other things, the number of families that do not have depository accounts. While the General Accounting Office (GAO) has reported a higher number, our research suggests that the overall percentage of families without accounts has remained fairly constant at about 8 to 12 percent between 1977 and 1986. This research has also indicated that roughly 30 percent of the families whose income falls in the lowest quintile do not hold accounts. Although the percentages for this latter group have fluctuated, the numbers were more or less the same in 1986 as in 1977. Thus, while many low-income families do not have accounts, the fact that the percentage has remained relatively constant suggests that the increase in fees and minimum balance requirements in recent years has not caused a significant decline in account holding. There are probably more fundamental reasons for much of the lack of account ownership. For example, the convenience of check cashing alternatives, the fact that these families may have few bills to pay, and the difficulties in managing an account with limited resources may explain, to a large degree, why some low-income families do not have an account relationship. Also, it may be that some people simply do not trust banks and prefer not to deal with them.

Nevertheless, we share the belief that banking services should be widely available to all. Several years earlier, the Board adopted a Joint Policy Statement on Basic Financial Services with the other federal financial regulatory agencies and with the state financial institution regulatory associations. The Policy Statement encouraged financial institutions to recognize the need of consumers for a safe and accessible place to keep money, the need to obtain cash (including cashing government checks), and the need to make payments to third parties. The Policy Statement encouraged institutions to continue to develop account products that are responsive to these needs.

In the Policy Statement, the Board supported a voluntary rather than a mandated approach so that institutions could have flexibility in developing account products that meet the particular needs of their customers. That remains our preference, and we oppose legislation to require institutions to offer specific banking services.

First, it is not clear that these services are so widely unavailable at present that legislation is warranted. Over the past several years, a number of surveys have been conducted to assess the availability of basic banking and check cashing services. While results vary, there is evidence that a widespread problem does not exist. For example, in its recent report to the Congress on government check cashing, the GAO reported that, as of 1985, 86 percent of banks and 55 percent of thrift institutions cashed U.S. Treasury checks for noncustomers. The American Bankers Association reports that more than half of all banks, and more than 70 percent of large banks, offer basic banking accounts and that the number of institutions offering such accounts has increased dramatically over the years. Following a survey of virtually all financial institutions in New York State, the New York State Banking Department found that low-cost banking services are widely available and that the vast majority of low- and moderate-income persons have ready access to such accounts. In a 1987 report, the GAO found that 74 percent of financial institutions provide low-cost accounts to senior citizens.

These surveys suggest that check cashing services are often available to noncustomers who choose to use them and that a substantial and increasing number of financial institutions voluntarily offer basic banking accounts. Consequently, the Board does not believe that enough of a problem has been demonstrated to justify sweeping legislation.

The Board has several other concerns with this legislation. First, as a general matter, we question whether it is wise for the government to mandate the services that financial institutions must provide. This is particularly so when the legislation involves setting the fees for such services. If there are problems in the way government funds are delivered to recipients, then it seems that the government should itself assume more responsibility for addressing the difficulty. For example, it might be useful to explore the possibility of using federal post offices to provide check cashing services to holders of government checks since they offer other financial services such as money orders. Electronic delivery of government benefits is another avenue that could be vigorously pursued. Successful electronic benefits delivery systems are currently operating, including programs in New York City and St. Paul, Minnesota. The advantages of these systems--for beneficiaries, government agencies, and financial institutions--are numerous. They include eliminating problems with delayed, lost, or stolen checks, providing quicker resolution of problems concerning payments, and lowering costs to all parties.

A more specific concern involves the mechanism for setting fees for the services. The bills require the Board to study financial institutions' "actual" costs and to set the fees permitted to be charged for these services to recover these costs. Besides the many difficulties of trying to determine such costs, any fees set by the Board would almost certainly be an average and, as such, could never reflect the actual differences among institutions. As a result of a federally established fee, some institutions would fail to recover their costs, while other institutions could exceed them under the national fee standard. Finally, it appears inequitable that financial institutions would be required to offer these services at cost while other entities, such as check cashers, could continue to offer them at a profit.

The Board is also concerned that financial institutions would increasingly fall victim to fraud if check cashing legislation is enacted. Checks can easily be stolen, and identification cards can easily be forged. Giving the Board the authority to suspend the check cashing requirement for certain classes of checks, as the bill does, is small comfort. It would take a relatively long period of time for the Board to learn of any patterns of fraud and, by then, significant losses may already have been suffered. Also, while fraud levels may now be low for U.S. government checks, this may not continue to be the case after legislation. Institutions can now keep fraud losses low by establishing procedures, based on their own experiences, that are adequate to address their own risks. Mandatory standards may eliminate their ability to continue using methods that have been successful for them and may leave them far more vulnerable.

The Joint Policy Statement I mentioned had the benefit of putting the federal government behind providing basic services, while leaving the implementation to the creativity of individual institutions. Conversely, a single federally mandated banking service may stifle innovation and experimentation. Several different account products have evolved as a result of voluntary efforts by financial institutions. Some, for example, involve savings accounts with money orders used for third-party payments. Others, based on a "pay-as-you-go" idea, have fees for each check, rather than the monthly maintenance fee contemplated by the legislation. Either of these could be better and more economical for the person who writes fewer than ten checks a month. The basic banking bill will likely result in the standardization of accounts, and it runs the risk of thwarting the continued development of different services, such as these, to address varying and changing needs of low-income and elderly individuals. Institutions may have much less incentive to offer additional, and potentially cheaper, basic banking accounts once they offer the standard service required by law.

Other innovative arrangements are being investigated that would eliminate many of the problems with delivering government benefits by paper checks. The Board strongly supports the facilitation of electronic alternatives for the delivery of government payments (known as "electronic benefits transfer" or EBT). These arrangements are probably a better long-term solution to the problems that motivate the check-cashing legislation.

Since the Board testified on similar legislation last fall, interest in electronic benefits transfer has increased. Several meetings have been held among representatives of government agencies, financial institutions, and consumer groups to discuss the feasibility of such arrangements. In addition, several programs are now operating and others are about to be initiated. The Board agrees with the GAO's conclusion that electronic delivery provides several advantages over a paper-based government benefits system. Consequently, we are very encouraged about the increased momentum in EBT activity over the last several months. We urge the Congress to foster these efforts, rather than imposing burdensome new requirements on financial institutions.

Finally, in our experience, well-intentioned legislation and regulations, particularly as they pyramid on one another, can cumulatively be overwhelming--especially for small institutions. This bears particular note when it is not clear that a compelling need for the legislation has been demonstrated. The Board believes that voluntary efforts by financial institutions will continue to be successful in meeting many of the concerns that have been expressed without the burden and cost that rules and regulations inevitably impose. Alternatives such as EBT, in particular, merit future exploration. For all the foregoing reasons, the Board opposes the basic banking and check-cashing bills now being considered by the Senate.

Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Subcommittee on Securities of the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, June 14, 1989.

I am pleased to appear today to discuss the internationalization of securities markets. This subcommittee is to be commended for holding timely hearings on this important matter. Our markets and financial system are evolving at a brisk clip, in ways that were not fully envisioned only a few short years earlier.

These developments hold a good deal of promise for the diversity of financial markets and instruments available to our investors. At the same time, they are enhancing the avenues of credit available to borrowers and the convenience and efficiency of financial services. However, these changes also are adding immensely to the complexity of our financial system and accordingly are posing new risks. With the memory of October 1987 still fresh in our minds, it is important that we stand back and review this process--not only to take stock of what has happened but to understand better the economic causes of the globalization of securities markets and to identify potential accompanying risks and ways to limit such risks. We also must be mindful that our domestic financial institutions have much to contribute to this process--and the considerable economic benefits that it produces--and we must seek to ensure that their competitive position is not inappropriately hindered.

In my remarks today, I would like to put trends in developments in global securities markets in some perspective and to draw implications for financial risks. I shall touch on the efforts under way to coordinate policies internationally and the question of legislation. In this way, I hope to address those issues suggested in your letter of invitation that seem to be most relevant to the Federal Reserve's concerns.

RECENT TRENDS

International transactions in securities have soared from levels earlier in this decade. This is true both of foreign purchases and sales of U.S. securities and, to a somewhat lesser degree, U.S. transactions in foreign securities. Transactions volume has been most dramatic in foreign purchases and sales of U.S. Treasury notes and bonds, which surpassed $3 trillion on a gross basis last year--from $100 billion to $200 billion earlier in the decade. Foreign purchases and sales of U.S. corporate stocks and bonds also have been running dramatically above levels earlier in the decade, although they are off from peak levels of a couple years earlier.

Similarly, U.S. residents have become much more active transactors in foreign bonds and stocks. Purchases and sales of foreign bonds and U.S. residents exceeded $400 billion, gross, last year--up about tenfold from the beginning of the decade. Meanwhile, U.S. transactions in foreign stocks recently have climbed into the $200 billion annual area on a gross basis--after some retrenchment in the wake of the October 1987 collapse--which also is up about tenfold from the early part of this decade.

Clearly, this surge in cross-border financial transactions has accompanied a large advance in cross-border trade of goods and services. In the 1980s, growth of world output devoted to trade has continued to surpass growth of total output, although by a smaller margin than in the 1970s. Thus, the share of output going to trade has continued to rise. For the United States, the import share of our final purchases has moved higher in the 1980s, but there has been no discernible improvement in the export share of our output during this period of large external deficits.

In financial markets, securities and open market paper have tended to play a more important role in the financing of such international transactions in recent years, and net securities purchases have represented the largest source of capital inflow into the United States to finance our large external deficits. Investors have become more familiar with foreign securities issuers through the greater availability of foreign products in local markets and through better information on foreign issuers made possible by vast improvements in information, aided by the revolution in electronic information processing and telecommunications. Moreover, the expansion of securities firms and banks into foreign markets, including their research function, adds to the information available to home-country investors about foreign investment opportunities.

At the same time, issuers, seeking to minimize their funding costs, have increasingly over time tested external capital markets, most visibly the Euromarket. Furthermore, the growing sophistication of currency and interest rate swap markets has enhanced this process by enabling borrowers to issue instruments in fixed or floating form in the currency most desired by investors and to swap into the currency or form preferred by the borrower.

An increasing array of securities--most notably government bonds and corporate stocks--is being traded in secondary markets outside the traditional market of the issuer. Many of these securities are being traded at some point on the globe virtually around the clock, alongside foreign exchange, and this has been a factor behind the surge in transactions volume already noted. In many cases, financial futures and options contracts can be traded during these same hours, which facilitates a shifting of risk and an enhancement of market liquidity.

UNDERLYING ECONOMIC FORCES

Behind these trends in international trade and securities transactions is a process that I have described elsewhere as the "downsizing of economic output." The creation of economic value has shifted increasingly toward conceptual and intangible values with decidedly less reliance on physical volumes. A half century earlier, for example, our radios and calculators were bulky. Today, owing to modern electronics, they are tiny and light and capable of performing more functions. Thin fiber optics are replacing vast tonnages of copper and with higher fidelity in transmission. Financial transactions historically buttressed with reams of paper are being progressively reduced to electronic charges. Such advances not only reduce the amount of human effort required in making and completing financial transactions but facilitate more accuracy and promptness in execution.

The considerable increase in the economic well-being of most nations in recent decades has come about without much change in the bulk or weight of the gross national product. In fact, if all the weight of materials--the tons of grain, cotton, ore, coal, steel, cement, and so forth--we produce were added up, their aggregate volume per capita might not be much greater today than it was, say, 50 or 75 years earlier. This would mean that increases in the conceptual components of GNP--that is, those reflecting advances in knowledge and ideas--would explain by far the major part of the rise in real GNP in the United States, and presumably the industrial world as a whole.

In part, this downsizing has reflected the economic need to conserve increasingly precious space. Also, it has been a response to the need to reduce the costs of moving goods and services to their most highly valued use--thereby conserving on energy, labor, and other valuable resources. Further contributing to this process have been quantum advances in technology, spurred by economic forces. In recent years, the explosive growth in information-gathering and processing techniques has greatly extended our analytical capabilities of substituting ideas for physical volume. Since irreversible conceptual gains are propelling the downsizing process, these trends almost surely will continue into the twenty-first century and beyond. The purpose of production of economic value will not change. It serves human needs and values. But the form of output will be increasingly less tangible.

In the years ahead, telecommunications and advanced computing will take on an even greater role. They create value by facilitating the transfer of ideas--that is, they create value by changing the location of intellectual property--much like the American railroads in an earlier time created value by transferring physical goods to geographic locations where they were of greater worth. In today's environment, economic value is increasingly created by moving the conceptual part of GNP--not coal or ore but data, analysis, and insights--from one location to another through increasingly sophisticated electronic means.

Downsizing is having a profound impact on international trade and on the policies of the world's economies. International trade in construction gravel and fiberglass insulation, for example, is limited by weight and bulk. High value computer-related products, on the other hand, are major and increasingly important components of world trade. Obviously, the less the bulk, and the lower the weight, the easier it is to move goods.

It is not surprising, therefore, to find that after having adjusted for average export price changes, pounds shipped per real dollar of exports have fallen an average of almost 3 1/2 percent per year since 1970. Pounds shipped per real dollar of U.S. imports declined even more, an average of 4 3/4 percent per year. Reflecting the downsizing of tradable goods, the share of U.S. foreign trade carried by air has doubled since 1970. On a global basis, the real value of trade has grown at an annual rate of 5 percent over the past two decades, significantly outstripping the growth in world domestic demand. In tonnage terms, of course, the increase has been far less.

CONSEQUENCES FOR FINANCIAL MARKETS

Clearly, as cross-border trade grows, gross surpluses and deficits on current account similarly can be expected to grow. That is, owing to the forces that are acting to boost the share of output going to trade, net cross-border financial claims relative to GNP can be expected to rise.

Moreover, new technology--especially computer and telecommunications technology--is boosting gross financial transactions at an ever faster pace than the net transactions required to finance current account deficits. Rapidly expanding data processing and virtually instantaneous information transmission capacity are facilitating in ways that were not feasible in earlier times the development of a broad spectrum of complex financial instruments that can be tailored to the hedging, funding, and investment needs of a growing array of market participants. Some of this has involved an unbundling of financial risk to meet the increasingly specialized risk avoidance requirements of market participants. Exchange rate and interest rate swaps, together with financial futures and options, have become important means by which currency and interest rate risks get shifted to those most willing to take it on. The proliferation of financial instruments, in turn, implies an increasing number of arbitrage opportunities, which tend to further boost gross financial transactions volume in relation to output.

Portfolio considerations also are playing an important role in the globalization of securities markets. As the welfare of people in the United States and abroad becomes more dependent on the performance of external economies and exchange market developments, it is natural for both individual investors and institutions that directly or indirectly manage the assets of individuals to acquire or raise the weight of foreign securities in investment portfolios. Such diversification provides investors a means of protecting against depreciation of the local currency on foreign exchange markets and domestic economic disturbances affecting asset values on local markets. Clearly, as international trade continues to expand more rapidly than global output and domestic economies become even more closely linked to those abroad, the objective of diversifying international securities portfolios will become increasingly important. Moreover, since the U.S. dollar is still the key international currency, such diversification has been, and may continue to be, disproportionately into the dollar.

In summary, therefore, it would seem reasonable to assume that cross-border trading in securities will continue to expand rapidly for the foreseeable future. This implies that investors will wish to be able to adjust their holdings of foreign securities during times that coincide with their regular domestic trading hours. As a consequence, we can expect to see the move to around-the-clock trading extending to more securities.

Already, we have virtually around-the-clock trading in various U.S. Treasury securities through global securities firms with offices in the Far East and Europe as well as in the United States. Global markets for the securities of other governments are not at this time as developed as those for our Treasury securities; however, the potential exists for active around-the-clock markets in other government bonds, especially those of Japan and Germany. Such trading in securities creates a demand for hedging instruments--especially financial futures and options--and thus we are likely to see more such instruments that also trade outside regular domestic market hours.

In the corporate securities area, cross-border trading of shares of large multinational firms has become prominent, with considerable scope for adjusting positions outside the regular hours of the primary exchange on which the shares are listed. In many cases, these shares are listed on foreign exchanges--for example, foreign American Depository Receipts (ADRs) are listed on the New York Stock Exchange--or are tracked on a real-time basis, such as NASDAQ shares displayed on the terminals of International Stock Exchange members in London. In other cases, a fairly well-developed, over-the-counter market has emerged.

While international securities activity has grown rapidly in recent years, trading systems have been undergoing changes--generally to reflect advanced computer and telecommunications technology. For example, the International Stock Exchange in London moved to a terminal-based trading system at the time of the Big Bang in 1986 and the Paris Bourse has nearly completed its conversion to an electronic trading system.

Electronic trading system technology has considerable potential for around-the-clock trading. The GLOBEX system being developed by the Chicago Mercantile Exchange and the Chicago Board of Trade's Aurora system are good examples. These exchanges have recently announced that they will combine their systems, and after-hours trading of some futures contracts could begin trading on the joint system this fall. Already, the futures exchanges of Paris and Sydney have negotiated to put their products on the GLOBEX system for after-hours trading, and others have expressed interest. This type of system could be adapted for trading other financial instruments.

As international securities trading has surged--growing more rapidly than trade and output--demands for clearing services across a wide range of financial instruments have soared, placing pressures on clearing and settlement systems. Some of these pressures arise from the greater interdependence among clearing and settlement systems. Investors today engage in a complex chain of financial transactions, often involving positions in both national and international markets, and difficulties in the clearing and settlement process in one of these markets can affect their ability to discharge obligations in others. We got a sense of such clearing and settlement problems in October 1987, when the options clearing system was weakened by large losses in the options market and other difficulties emerged from inadequate coordination of "pays and collects" in the futures markets. A deficient clearing system in Hong Kong not only contributed to paralysis in that marketplace but cast a cloud over other markets as well.

The process of unbundling financial risk is a factor boosting the volume of financial transactions and hence increasing strains on clearing and settlement systems. Through the use of futures and options, price or interest rate risk can, in effect, be unbundled and new synthetic instruments created by shifting risk to other parties, actions that raise clearing and settlement volume. Alternately, elements of risk can be transferred through interest rate and currency swaps; in these cases, such shifting can lead to hedging needs or to arbitrage opportunities that result in additional transactions in markets for securities and their derivatives and to enlarged clearing and settlement volume, with attendant risks to clearing and settlement systems.

Another important dimension to securities market risk resulting from growing internationalization is the emergence of large multinational securities firms that increasingly act as underwriters, dealers, and brokers in securities markets around the globe. A loss by one or more of these firms could impair that firm's functioning in other markets, thereby potentially transmitting a disturbance to those other markets. Such a disturbance could have ripple effects as creditors and counterparties seek to reduce their exposure to these firms and as confidence erodes in the clearing and settlement systems in which these firms are participants. Difficulties could also extend to commercial banks thought to have large credit exposure to such securities firms.

We observed the potential for such a problem emerge in October 1987, when it became evident to the markets that certain firms committed to the underwriting of British Petroleum shares in the United Kingdom stood to lose substantial sums. It is reported that for a brief period participants in the U.S. securities markets were cautious about dealing with these firms, a situation that could have gotten decidedly worse if the underwriting environment had not stabilized.

If risks associated with cross-market and cross-border securities activities are to be contained, then it is critical that large investment firms have sound internal risk monitoring and control procedures in place. Moreover, there is no substitute for strong capital positions to act as a buffer for losses.

It is worth noting that computer and telecommunications technology, while an important factor contributing to the globalization of securities markets and to certain financial system risks, can be used and is being used to limit risk. Information systems increasingly are permitting securities firms to monitor their global positions on a timely basis, and virtually around-the-clock trading in some securities enables them to shed unwanted risk promptly. Such technology also permits clearing systems to monitor member positions in their own markets on a timely basis and to share member position information with other clearing systems, thereby enhancing control of overall risk to clearing and settlement systems.

The trend toward globalization of securities firms and markets--including the move toward around-the-clock trading in a growing array of securities--not only provides investors with 24-hour capability to adjust positions but also provides the investor or brokerage firm with more choice of where an order will be placed. Factors such as relative costs of trading in different markets, liquidity, and the timing of clearing and settlement systems thus may affect decisions about where to place orders.

Such opportunities for choice lead to more discipline being exerted on exchanges to control costs and enhance liquidity. To the degree that investors are concerned about the soundness and timeliness of clearing and settlement systems, discipline is imposed on the exchanges to strengthen their clearing mechanisms. However, to the degree that some markets seek to lower costs and add to volume at the expense of capital positions of securities firms or clearing system safeguards, risks may be posed for other markets and for the global financial system more broadly. In other words, in an interdependent global marketplace, externalities are significant, and weaknesses in one financial center can pose serious problems for other centers.

IMPLICATIONS FOR COORDINATION

The Brady Commission and others have characterized our domestic markets for stocks, index futures, and options as, in effect, functioning as one economic market. It is certainly clear that the market for some securities and their derivatives has, in effect, already become a unified global market, and others are rapidly moving in this direction. Such international developments obviously require a considerable degree of international coordination just as we have learned that domestic markets for securities and their derivatives require a high level of coordination.

Both the private and public sectors have important roles to play in the coordination of securities market policies. Among the areas needing attention are capital of dealers and underwriters, clearing, settlement and payment systems, circuit breakers, disclosure to investors, and accounting standards followed by securities issuers and intermediaries. In addition, coordination of insider trading rules and enforcement of securities market laws are issues of significance in the area of securities market regulation and oversight. To an important degree, more standardization in areas such as clearing and settlement and capital standards holds the promise of enhancing efficiency while at the same time strengthening market structures. Moreover, coordination of policies in these areas will act to reduce the scope for so-called regulatory arbitrage--that is, artificial reasons for investors or securities houses to favor one national market over others.

At the present time, a considerable amount of effort is being expended to coordinate within and across borders in these various areas. In some cases, this involves regulatory authorities; in some other cases, it involves the private sector; and in still others, it involves a combination of both. For example, there are a number of bilateral discussions between the Securities and Exchange Commission and securities market regulators in other countries on issues relating to the exchange of information and enforcement of securities market laws. Also, central banks have, within the context of their responsibilities for national payment systems, been addressing risks associated with securities clearing and settlement and are working to coordinate policies on payment system netting arrangements.

The International Organization of Securities Commissions, a group of national securities authorities, has established various working groups seeking to coordinate, among other things, accounting standards and capital requirements of securities firms. The Group of 30, composed of private-sector representatives from the securities and banking industries, recently advanced a constructive set of guidelines for securities clearing and settlement and now is in the process of seeking implementation. The Organization for Economic Cooperation and Development has established a group of securities market experts focusing explicitly on the issue of systemic risk in global securities markets.

It is important to realize that the contributions that the private and public sectors can make differ, depending on the issue. On matters such as clearing and settlement, the private sector has much to offer given its expertise and considerable self-interest in developing a sound global securities clearing and settlement system. Other areas, such as insider trading and enforcement, clearly require coordination among regulators.

Also, some matters are going to be resolved most effectively through bilateral approaches while others lend themselves to multilateral solutions. The nature and regulation of securities markets have been sufficiently diverse that a multilateral regulatory approach along the lines of the Basle agreement on capital guidelines for commercial banks may be difficult, given the entire scope of matters requiring coordination. In any event, it is important that regulatory authorities continue to monitor overall progress in this area and seek to identify and address elements of weakness.

At the present time, it appears that progress is being made in key areas needing attention. Given the diversity of traditional national standards, it may well take longer to reach agreements than we are accustomed to in our domestic financial system. It is also likely that as these coordination efforts get further along, necessary legislative changes will become more evident.

LEGISLATIVE ISSUES

This subcommittee has heard a great deal of testimony in recent months about steps that have been taken by our national exchanges and clearinghouses to strengthen existing systems and to improve coordination among markets and market participants. As these hearings proceed, you, no doubt, will hear many more ideas and concerns about the future direction of these markets.

It is encouraging that so many resources in the public and private sectors are being focused on these issues. It also is encouraging that so much can be, and is being, done within the existing legislative and regulatory framework that oversees our financial system. With a notable exception, we at the Federal Reserve Board do not at this time see a need for major legislative changes of our securities laws and regulatory structure.

In the previous Congress, the Senate had passed a bill that would have broadened the powers of banking organizations in the securities market area. We supported that bill on the grounds that our banking organizations have a lot to contribute to the development of a stronger and more efficient securities market, both domestically and globally. The formula embodied in the Senate bill last year would enable our banks to become more competitive in these markets but in a manner that would not jeopardize the safety of the commercial bank entities or the federal safety net applied to the commercial banking system. We trust the Congress will return to this matter promptly.

In closing, the stability of our financial markets must, of course, at root, rest on the performance of the world economy. Thus, at the very top of our consideration in maintaining a sound financial structure is the pursuit of sound economic policies, both domestically, and to the extent relevant, on a coordinated international basis. At the same time, we must seek to strengthen that financial structure through appropriate market reforms, recognizing that even a system with formidable safeguards will be unable to insure against a disruption resulting from a massive speculative imbalance. Through the cooperative efforts of the private and public sectors, we can go a considerable distance in improving the safety and soundness of our financial market systems, but we cannot realistically expect to eliminate all risks to these systems.

Statement by William Taylor, Director, Division of Banking Supervision and Regulation, Board of Governors of the Federal Reserve System, before the Subcommittee on International Development, Finance, Trade and Monetary Policy of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, June 27, 1989.

I am pleased to have this opportunity to appear before this committee to discuss bank supervisory policies regarding U.S. bank lending to developing countries. Before I focus on the regulatory and accounting issues concerning developing country debt, especially as they relate to Secretary Brady's proposal, I would like to begin by summarizing the condition of the banking system within the context of bank claims on developing countries.

THE BANKING SYSTEM AND DEVELOPING COUNTRY DEBT

The U.S. banking system is less vulnerable to potential debt-servicing difficulties of developing countries than it was when these problems first surfaced in the early 1980s. However, the vulnerability of some of the largest U.S. banks to these problems is still of significant concern. Several considerations support this judgement.

First, through a variety of transactions, U.S. banks are adjusting their portfolio of claims on developing countries while decreasing their overall exposure levels. In 1988, twenty-two of the largest U.S. banks reduced their net exposure to problem debtor countries approximately $9 billion to a level of about $65 billion. Much of this reduction was achieved through mechanisms that also reduced the countries' external debt-service requirements.

Second, bank capital has been strengthened as both bankers and banking supervisors have recognized the need to increase the capital cushion available to absorb potential losses. Between December 1982 and December 1988, primary capital for twenty-two of the largest U.S. banks increased from $40 billion to $74 billion. When measured against declining levels of exposure to countries with debt-servicing problems, this increase in capital is substantial. Exposure relative to primary capital for nine money center banks has declined from 233 percent in 1982 to 106 percent at year-end 1988. For thirteen large regional banks, exposure to these countries has declined from 154 percent to 55 percent during the same period.

Third, earnings of large U.S. multinational banks are generally at higher levels and are somewhat more diversified than in the past. Higher earning levels lead to stronger capitalized organizations, and more diverse earnings help to act as a cushion if a major borrower or borrowing sector experiences debt-servicing difficulties.

Finally, U.S. banks have set aside large amounts in their general loan-loss reserves for their exposure to developing countries. These reserves help to cushion a bank's balance sheet from losses on these loans.

In summary, the improved condition of the U.S. banking system through increases in capital and reserves has reduced the vulnerability of the U.S. banking system to debt-servicing difficulties of developing countries. However, the substantial exposure levels of the largest U.S. banks require that these banks continue to build their reserves and capital in an orderly manner. At the same time, it seems to be in the interests of the banks to support borrowing countries so that they may reform their economies to restore economic growth, thereby enhancing their credit-worthiness.

ACCOUNTING AND REGULATORY POLICIES AFFECTING DEBT RESTRUCTURING 

Bank regulatory and accounting policies pertaining to developing country loans of U.S. banks are designed to maintain the safety and soundness of the financial system. These policies are consistent with those regulations governing other aspects of the banking business.

Current regulatory policies provide considerable flexibility for U.S. banks to engage in transactions to adjust or reduce their exposure to developing countries. Such transactions have had the effect of reducing the debt-servicing obligations of developing countries and have included debt exchanges, debt-for-equity swaps, and discounted buybacks of debt. Bank regulatory policy is not a barrier to further bank participation in debt-reduction transactions as envisioned by Secretary Brady's proposals.

Accounting rules for loans of U.S. banks to developing countries, like requirements for other debts, provide for disclosure of information to enable investors to judge the financial condition of a bank and the financial impact of management's decisions in a meaningful and consistent manner. Banks are required by the Securities and Exchange Commission to disclose information on significant sovereign debt restructurings, including the amount of exposure, changes in exposure, and the impact of restructurings on earnings. Considerable information is also required to be provided directly to bank regulatory authorities. Failure to provide meaningful financial information inhibits effective banking supervision and can undermine depositor and investor confidence.

Generally accepted accounting practices require banks that intend to swap or sell a claim on a developing country (or any other credit) to value that credit at current market value and to estblish sufficient reserves to cover any anticipated losses associated with that transaction. For those loans or portions of loans that are expected to be held as a long-term investment, the carrying value less any related reserve must reflect a realistic assessment of the ultimate value likely to be collected. Consequently, depending upon management's intentional of either remaining or exiting from the business of lending to developing countries, the carrying value of developing country credits and reserve levels varies from bank to bank.

I would like to comment briefly on the International Lending Supervision Act of 1983 (ILSA). In passing ILSA, the Congress carefully balanced the interest of debtor countries in maintaining access to private credit markets against the requirements for maintaining a safe and sound banking system. Based on these considerations, the Congress required that banks set aside specific allocated transfer risk reserves (ATRR) against credits that have been impaired by a protracted inability of foreign borrowers to make payments on their external indebtedness. The law and the implementing regulations essentially require an ATRR against credits to countries that are not servicing their debts and are not moving toward implementing sound economic policies that can restore growth and enhance creditworthiness. Such reserves are not required against credits to countries that are maintaining debt service and are working with the international institutions to develop and implement sound economic policies.

I believe that this distinction based upon the overall performance of borrowers is valid, and it is crucial that it be preserved. Much headway already undertaken to resolve the developing country debt crisis could be lost by requiring an ATRR against credits to countries that are following responsible economic and debt-servicing policies.

Those who argue for expansion of the allocated reserves usually do so in the belief that the establishment of a specific reserve by a bank, which is the functional equivalent of a charge-off, can benefit a borrowing country. It should be clearly understood that a mandated charge-off of a loan, while tax-deductible, does not necessarily diminish a bank's incentive to collect in full on the credit; nor does it encourage the bank to sell or redeem the credit at a discount. In fact, unlike U.S. banks, most banks from countries with large tax-deductible reserves have not actively participated in voluntary debt reduction transactions such as secondary market sales or exchanges of debt for equity investments.

To date the allocated reserves required pursuant to ILSA have been applied to twelve countries. These countries generally are the weakest economic performers and have essentially no access to international credit from private markets. Many of these countries have taken unilateral decisions to reduce or suspend debt service to banks. In most cases a further deterioration in economic activity and living standards has followed such actions by these countries.

Rather than unduly expand the scope of the allocated reserve, U.S. banking supervisors have required banks with significant exposures to troubled sovereign borrowers to strengthen their general loan--loss reserves and capital. As previously mentioned, U.S. banks have set aside large amounts in their general loan--loss reserves for exposures to developing countries. Many regional U.S. banks have adopted a strategy of exiting from this business by selling their loans in the secondary market. To absorb the related losses, they have established commensurately high reserve levels. Most money center banks, with a longer history of involvement in these countries and multinational corporate clientele requiring ongoing banking services, have a more optimistic view of this business. These banks apparently intend to hold the bulk of their credits as long-term investments. To the extent that these banks are swapping or reducing debt, their strong local presence in the debtor countries has enabled them to realize prices well above those prevailing in the secondary market.

The adequacy of these general reserves is also judged within the context of an organization's overall capital structure and financial condition. Banking regulators examine an institution's financial condition, its management and asset quality, and the current financial and economic conditions in assessing the adequacy of bank capital. This capital must support several risks other than developing country lending. To assure the adequacy of bank capital, those institutions with significant exposure to developing countries must continue to augment their capital and reserves in an orderly fashion. In particular, it is necessary for these banks to review reserve levels frequently and systematically in light of changing circumstances.

The proposals set forth by Secretary Brady provide an opportunity for reinvigorating developing country debt strategy. However, I do not believe that bank supervisory policies can, or should, be used as incentives or disincentives to influence further the implementation of these proposals. The decisions of both foreign and domestic banks on debt restructurings will inevitably be determined by whether a particular restructuring provides the best means for realizing the maximum possible value on their loans. While the implementation of Secretary Brady's proposals will require the recognition of some losses on the part of the banks, if properly implemented, it should improve the quality of the remaining credits and prevent further deterioration.

In this regard, while several positive steps have been taken recently, progress has not been as great as expected when the Federal Reserve testified on this issue before the House Banking Committee at the beginning of this year. What concerns me as a bank regulator is that without further cooperation between borrowers and lenders, credit quality will continue to deteriorate as more countries become unable or unwilling to service their bank debts. In such an event, further significant increases in reserves will clearly be required. Time is running short and uncertainties appear to be increasing. In this environment, it is expected that banks with large exposures will further strengthen their capital and reserve levels.