Statements to the Congress.

Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Banking and Financial Services, US. House of Representatives, September 21, 1995

I am pleased to be able to appear here today to offer my thoughts on the proposed legislation to recapitalize the Savings Association Insurance Fund (SAIF), to merge SAIF and the Bank Insurance Fund (BIF), and to merge the thrift and the commercial bank charters.

As I suggested to this subcommittee at the beginning of August, two insurance funds with sharply different premiums cannot be sustained. Such a structure is inherently unstable. Competitive depository institutions cannot differentiate themselves by the quality of the deposit insurance that is offered because it is the same insurance regardless of whether it is from BIF or SAIF. In either case, it is government-mandated and government-sponsored deposit insurance. For identical insurance, it is rational that depository institutions seek the one available at the lowest cost. If a substantial difference in deposit premiums exists between SAIF and BIF, the institutions paying the higher premium will pursue insurance offered by the other insurance fund unless there is some other reason to remain with their current fund. In the process, the disadvantaged fund becomes increasingly vulnerable to insolvency as its premium base declines. The only winners created by the looming deposit premium difference between SAIF and BIF deposits will be those depositories able to "game" the system and leave SAIF first. The solution to this problem is to end this game and merge SAIF and BIF.

A prerequisite to the merger of BIF and SAIF is to put SAIF on a sound basis. There seems to be a general agreement to accomplish this recapitalization by a special one-time assessment on those deposits currently insured by SAIF. The merging of a recapitalized SAIF with a sound BIF would then consolidate The Financing Corporation (FICO) bond obligation of SAIF into the new insurance fund and effectively obligate past BIF members to participate on a pro rata basis.

Discussions about merging BIF with a recapitalized SAIF and sharing the FICO interest obligation among the members of both deposit insurance funds raise the question of retaining separate bank and thrift charters. If a persuasive public policy case could be demonstrated to maintain two charters, a merged BIF and SAIF would have to adjust to this structure. However, not only has the policy necessity for residential mortgage specialization at thrift institutions been diminished, but also such narrow portfolio focus has induced excessive portfolio risk.

As I indicated to this subcommittee last month, while thrift institutions were dominant and innovative mortgage lenders in the post-world War Il years, by the 1970s, market forces and technology began to erode the original mortgage financing purpose of specialized thrift institutions and, hence, of their charter. Equally important, events over the past decade have been associated with market forces and innovations that have reduced the relative yield on the standard residential mortgage, while at the same time other market forces have made deposit rates increasingly competitive. In such an environment, significant questions are raised about the risk profile and economic viability of any institution that by law or regulation is required to place most of its assets in mortgage instruments and fund them in the deposit market.

Two conclusions are clear. First, the nexus between thrift institutions and housing largely has been broken without any evident detriment to the availability of housing finance. Second, a public policy that induces - let alone requires - thrift institutions to specialize in mortgage finance threatens the continued viability of many of these entities - particularly those without wide and deep deposit franchises, tight cost controls, and the ability, when necessary, effectively to originate and sell standard mortgages that cannot profitably be held long-term. A broader charter for thrift institutions - such as a commercial bank charter that lets them hold a wider range of assets - thus would seem to be good public policy, and the bill before you confronts the challenge of creating one charter.

The specific details of a charter consolidation must blend economic, market, and legal ingredients. The specific blend is less important than making measurable progress in developing a set of insured depository institutions subject to as identical a set of rules and incentives as possible. For thrift institutions, this means a trade-off between current permissible activities and greater portfolio flexibility and viability. For banks, the historical inequity created by competition from insured depository institutions with wider permissible activities and opportunities would be reduced, if not eliminated. For public policy, the potential greater diversification of thrift portfolios could strengthen and make more flexible that class of depository institution. With a legislative thrust to shift thrift institutions to more bank-like operations, it seems prudent and reasonable that thrift institutions be supervised and regulated as banks. To facilitate such supervision and regulation, the bill before you creatively establishes a mutual commercial bank category, to ease the shift from thrift to bank status for many institutions, and permits states to continue their thrift charter but treats such entities as if they were commercial banks for federal purposes.

A common charter will not accomplish its objective without elimination of tax rules that not only induce mortgage specialization but also penalize thrift institutions that try to adopt more diversified portfolios. The special bad debt reserve treatment that provides tax benefits - and, hence, subsidy - to mortgage lending by thrift institutions no longer serves a perceivable public policy function and, hence, should be removed going forward. Moreover, the tax recovery of the reserve buildup from this past tax subsidy should be eliminated. In reality, this reserve was always a subsidy and never really a true bad debt reserve. The possibility of any significant recapture of lost tax revenue to the U.S. Treasury has been hypothetical at best because of the tax-induced high marginal cost to thrift institutions of reducing their mortgage portfolios and, as a result, triggering the so-called bad debt recapture. Indeed, without a fresh start, the current bad debt recapture provisions would be a significant barrier for entities that wish to diversify. A penalty should not be charged institutions striving to respond rationally to market realities and to legislation designed to induce portfolio diversification.

The Board realizes that legislation will require compromises and skillful craftsmanship. But we should not lose sight of first principles. A deposit insurance system that focuses the attention of banks and thrift institutions on the relative status of their funds, and a system that rewards those who can jump ship first, is, to say the least, counterproductive. What is needed is a deposit insurance system whose status is unquestioned so that the depositories can appropriately focus their attention on the extension and management of credit in our economy. A merger of BIF with a recapitalized SAIF accomplishes that objective and provides the Congress with the opportunity to strengthen and rationalize our depository institutions. Congressional action to provide a more bank-like thrift charter and bank-like taxation would be consistent with market trends and stronger depositories and should not reduce mortgage credit flows. There are several variations of the bill structure and timing implementations that would effectively resolve the current difficulties affecting our deposit insurance system. The bill before you is one of them. It would strengthen our deposit insurance system and create a framework for the evolution of thrift institutions.

Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, U& Senate, September 22, 1995

I am pleased to appear here today. In July, the Federal Reserve submitted its semiannual report on monetary policy to the Congress.(1) That report covered in detail the Federal Reserve's assessment of economic conditions and the forecasts of the governors and the Reserve Bank presidents for economic growth and inflation. This morning, I would like to offer my views on recent developments.

As I reported earlier to the House Banking Committee, a moderation in economic activity in 1995 was inevitable after the frenetic pace of late 1994. It was also necessary if we were to avoid the creation of major inflationary instabilities. By the end of 1994, pressures on resources were contributing to sizable increases in delivery lead times for raw materials and intermediate goods and steep markups in their prices; overtime in manufacturing was extensive. Fortunately, economic growth has slowed appreciably this year, inflation risks have receded, and, as a consequence, the threat of severe recession has declined.

I also noted that one could not expect the transition to a more sustainable growth path to be entirely smooth. Rough patches were also encountered in past economic expansions, typically because businesses did not fully anticipate the changes in demand for output. The slowing in real gross domestic product growth at the beginning of this year was precipitated by a weakening in consumer spending and housing construction, partly as a consequence of higher interest rates, and by the damper on net exports from the economic crisis in Mexico. But the risk of a more serious slowdown thereafter was exacerbated by the failure of inventory investment to match the slackening in spending. Indeed, although stocks in the aggregate remained modest, a few major industries, such as motor vehicles and home goods, found themselves with substantial excesses. Attempts to control inventories triggered cutbacks in orders and output that, in turn, depressed employment and income in the spring.

At midyear, the uncertainties about the dimension of the inventory adjustment, and thus about the prospects for real GDP over the near term, were considerable. Nonetheless, it seemed that the point of maximum risk of undue weakness had been passed and that moderate growth was likely to resume in the second half of the year. As events unfolded, revised data indicated that overall activity in the second quarter was not quite so weak as suggested by the initial estimates, largely because final sales were stronger. Moreover, the available statistical indicators for the current quarter are consistent with a firmer pace of economic growth. In the labor market, for example, payrolls have posted moderate increases, on average, over the past couple of months, and the unemployment rate has edged back down to 5.6 percent.

Industrial production also turned up in August, after a sustained period of weakness that extended back to last winter. The surge in output should probably be discounted somewhat, given that this summer's unseasonably hot weather provided a transitory boost to the output of electricity. Moreover, in a number of industries in which efforts to pare stocks are continuing, inventory-sales ratios remained on the high side in July. Even so, the production data suggest that, on balance, manufacturers were confident enough about their sales prospects - and, in the main, comfortable enough with their inventory positions - to expand production once again.

The underlying trends in final sales are favorable overall, in part because of the considerable decline in long-term interest rates and the sharp increase in stock prices this year. Retail sales have been rising moderately, on average, since the spring, and home sales and starts have posted hefty gains. As for business investment, new orders for capital goods have fallen of late, but backlogs remain sizable. It thus appears that purchases of equipment will continue to grow, though perhaps at a slower pace than in the recent past. In addition, rising building permits point to further expansion in nonresidential construction.

Meanwhile, the inflation picture is looking more favorable than it did in early 1995. Core inflation - as proxied by the twelve-month change in the consumer price index (CPI) excluding food and energy - has moved back down to around 3 percent, after a bulge earlier in the year, and there appears little reason to expect much change in inflation trends in the near term. Increases in labor costs have remained modest even though unemployment has fallen to levels that history suggests might be associated with some acceleration in compensation. In addition, the deceleration in manufacturing activity this year has helped to ease pressures on capacity and to stabilize, and in many areas reduce, lead times on deliveries. And with supply and demand in global commodity markets in better balance, prices of materials and supplies are no longer rising rapidly. In light of these developments, the firming in monetary policy in 1994 and early 1995 appears to have been sufficient to head off a ratcheting up of inflation. As I have often stated, containing inflation, and over time eliminating it, is the main contribution the Federal Reserve can make to enhancing the nation's long-run economic performance.

On the whole, the near-term prospects for the US. economy have improved in recent months, in part because the strong increases in financial market values this year are likely to provide substantial support to household and business spending. But the outlook is not without concern. Firms' desired inventory levels are extremely difficult to gauge, and the remaining adjustment process could play out more negatively than we anticipate. Moreover, although the economies of our key trading partners are recovering somewhat, they are still expanding only moderately, on average, and, as a consequence, the external sector is unlikely to contribute positively to real gross domestic product growth in the United States.

Some observers have expressed fears that current efforts to eliminate the federal budget deficit will prove a hindrance to the economy. I do not share those fears. Long-term interest rates have fallen a great deal this year, in part because of the growing probability that a credible, multiyear deficit reduction plan will be adopted. The declines in rates are already helping to stimulate private, interest-sensitive spending - providing, in effect, a shock absorber for the economy. Clearly, the Federal Reserve, in appraising evolving developments, will continue to take the likely effects of fiscal policy into account. But I have no doubt that the net result of moving the budget into balance will be a more efficient, more productive US. economy in the long run.

I continue to be impressed by the growing public recognition of the importance of deficit reduction - and the commitment on the part of the President and the Congress to bring the budget back into balance in the reasonably near future. The challenge is enormous: The budget deliberations will be contentious, and the deadlines now are extraordinarily tight. But these pressures must not be allowed to prevent us from taking concrete action to implement a program of credible multiyear deficit reduction. Failure to take such action would signal that the United States is not capable of putting its fiscal house in order, with adverse and serious consequences for financial markets and long-term economic growth.

(1.) See "Monetary Policy Report to the Congress," Federal Reserve Bulletin, vol. 81 (August 1995), pp. 757-74.