Testimony of Federal Reserve Officials.

Testimony by Laurence H. Meyer, Member, Board of Governors of the Federal Reserve System, before the US. Securities and Exchange Commission Hearing Held at Pace University, New York, New York, September 13, 2000

Thank you for the opportunity to speak at today's heating on the rules governing auditor independence that have been proposed by the Securities and Exchange Commission (SEC).

A principal concern of the Federal Reserve is the efficiency and stability of financial markets. By extension, we take a keen interest in issues that underpin the functioning of these markets, such as the reliability of the information that supports them. The auditor's opinion distinguishes financial reporting from other, potentially self-serving, information circulating in the marketplace. The willingness of investors, creditors, and other stakeholders to trust the public accountant's opinion is an important facet of market efficiency.

The Board has long believed that high-quality accounting standards and disclosure requirements are essential for the efficient, rational allocation of capital. We also recognize that independence enhances both the setting of accounting standards and the enforcement of conformance with those standards. The SEC and the accounting profession have important roles in maintaining and promoting independence. Steps they have taken over the years to foster independence and objectivity in the formulation of accounting standards have improved financial reporting. We note, however, that high-quality accounting standards potentially can be nullified by a perception that auditors lack independence and objectivity in their enforcement role.

Accountants have recognized this possibility since the earliest years of their profession. The ethics rules of their professional societies regulate commercial dealings between external auditors and clients to protect the integrity of financial reporting and to promote investor confidence in the auditor's opinion. Achieving and maintaining independence is difficult because independence is an intangible quality, an attitude, a state of mind. An outsider can infer auditors' attitudes only by their outward dealings with clients. Judgment by inference is particularly characteristic of our era of global markets and widely dispersed ownership.

As a result, the auditing profession has focused intently on appearance as a means of demonstrating independence. That is, the profession's own rules emphasize the tangible, measurable aspects of the auditor--client relationship to assure the public of its independence. Some indicia of independent appearance are clear-cut. For example, long-standing rules prohibit direct ownership in a client by an audit partner. These rules are obvious and require little explanation or interpretation. Other aspects of the auditor-client relationship are more difficult to regulate, but no less important. For example, the auditing profession prohibits its members from acting in a management capacity for a client. The line between what may appear to be unacceptable "managerial" actions and what may be acceptable "advisory" actions can be a fine one, subject to a great deal of interpretation.

For nearly as long as there have been public accountants, state and federal legislators have also grappled with laws to protect auditor independence. It must be difficult to balance the public interest in maintaining independent, objective external audits with the legitimate commercial aspirations of accounting professionals. Nonetheless, all recognize that significant erosion

of the public's confidence regarding auditor independence could have severe consequences for investors, creditors, and those seeking capital.

EXTERNAL AUDITS

As the regulator of state member banks, bank holding companies, and (recently) financial holding companies, the Federal Reserve is very interested in the external audits of institutions it supervises. Banks with total assets of $500 million or more are required by statute to have an external audit. Recognizing the value of external audits, the federal banking agencies also encourage smaller institutions to engage public accountants. External audits can give supervisors greater assurance of the integrity of the financial information we receive. In addition, we believe that banking organizations benefit from an outside opinion on the quality of their financial reports and internal controls.

The benefit derived from an external audit, however, is contingent upon the auditor's competence and independence. For institutions that we supervise, our examiners assess these two qualities. Of course, banking supervisors have broad powers that allow us to remove an audit firm if there is evidence of nonfeasance, misfeasance, or malfeasance. As I said earlier, however, independence is intangible. Therefore, it is difficult for outsiders, including examiners, to judge the objectivity of external auditors toward their clients. Despite that difficulty, we must be watchful because a lack of objectivity can compromise the external audit as a useful tool for enhancing banking safety and soundness.

The large financial institutions we supervise are required to furnish us not only with audited financial statements but also with an external auditor's opinion of management's report on the effectiveness of internal controls over financial reporting. These reports are an important source of information about these institutions. The auditor's attestation is key to our reliance on these reports. When auditors lack objectivity, this process for informing supervisors about the condition of banks' internal controls can break down.

Our ability to supervise institutions is improved by competent and objective external audits. If our examiners are comfortable with a particular audit, they may focus on how management is dealing with problems found by the external auditor. This situation is far more efficient than replicating the work and second-guessing the conclusions drawn from the evidence. According to their assessment of the external audit, our examiners can reallocate supervisory resources to other areas of risk in the banking organization. The Federal Reserve benefits by gaining a better picture of an institution's risk profile for a given level of supervisory resources. Financial institutions also gain from a reduction in overall examination burden. We hope that accounting professionals also benefit from the interaction between the external auditor and the examiner.

The Federal Reserve hopes to expand the private sector's role in regulating the risk and solvency of banking organizations. The effectiveness of market discipline is highly dependent upon the quality of information available to market participants. Biased, unreliable information would distort the allocation of capital to banks and thereby frustrate the discipline we seek to promote.

OUTSOURCING OF INTERNAL AUDIT

Now I would like to focus on the SEC's proposal to limit internal audit outsourcing by external auditors. The Federal Reserve has a long-standing supervisory interest in banks' risk management, including internal controls and their effect on safety and soundness. We have been wary of the outsourcing of internal audit functions since the trend began. Our concerns are twofold: the potential for blurting the accountability of bank directors and managers for internal controls and the diminished effectiveness of the internal auditor's ability to monitor controls.

In 1997, the federal banking agencies issued an interagency policy statement that serves as a framework for banking organizations to structure and maintain the internal audit function and manage outsourcing arrangements. With respect to outsourcing, the policy seeks foremost to warn managers and directors that outsourcing the review function of an internal auditor does not in any way transfer responsibility for maintaining adequate internal controls. Institutions may delegate the technical work, but not the management oversight or accountability. The policy also makes the important recommendation that banks promote and maintain independence in the design of their own management structures over the internal audit function. The most effective internal audit function has the impartiality and standing within an organization to report its findings and views candidly to directors and the highest levels of management.

The policy does not prohibit all outsourcing because we appreciate that efficiencies can be gained and specialized talent brought to bear. Care needs to be exercised, however, in structuring the arrangements so as not to weaken overall the processes for identifying and fixing internal control deficiencies. The banking agencies considered prohibiting banks' external auditors from acting as outsourcing vendors because of a concern about the effect of such arrangements on external-auditor independence.

As we finalized our guidance, we decided we could work for the time being within the existing auditor independence rules and that a prohibition by the banking agencies was inappropriate for several reasons. First, the banking agencies were reluctant to set a standard different from that of other industries, which, of course, are exempt from our safety and soundness policies. Second, we believed that the issue was more properly regulated by the SEC, which has broader jurisdiction over the auditor-client relationship. Lastly, given the early stage of the outsourcing trend, we decided to take a flexible approach to outsourcing; the policy could be amended to address safety and soundness concerns if they became apparent. With regard to the last issue, the agencies decided it was sufficient for examiners to monitor arrangements among supervised institutions and evaluate auditor independence case by case. Nevertheless, our examiners have been encouraging individual organizations to consider using firms other than their external auditor.

We have been vigilant in monitoring these outsourcing arrangements because we view the internal audit function as an integral part of bank management. In arrangements in which much of the internal audit is outsourced to the external auditor, the public accountant can be disturbingly close to being a part of the management team. Questions, therefore, arise about his or her independence. One of the corollary benefits we see to an external audit is that the auditor can give an independent assessment of the quality of a bank's own processes for identifying and rectifying internal control deficiencies. We feel that this "check and balance" is diminished when the external auditor acts largely as the bank's internal auditor.

The SEC is looking at internal audit outsourcing through the lens of external auditor independence. We share the SEC's concern. However, we also have a broader issue about the safety and soundness aspects of outsourcing risk-management activities, regardless of who is engaged to perform the task. Contracting a large part of the internal audit work to a third party can be cumbersome, and banks operate in a rapidly changing environment. Furthermore, we see the internal audit function as a core part of banks' risk-management processes. As is true of other aspects of risk management, the internal audit function is an inextricable part of the senior management team's responsibilities.

The SEC's proposal would not eliminate outsourcing or prohibit public accountants from selling internal audit services. Instead, it would generally exclude an auditor from performing both external and internal audits for the same client. Combining the internal and external audits may have some efficiencies because the work can serve a dual purpose of inspecting the system of internal control and expressing an opinion about the financial statements. These efficiencies, however, may come at the cost of the external auditor's appearance of independence. Our view is that auditor independence is more valuable than these asserted efficiencies. We are pleased to see the SEC address this issue on a cross-industry basis. From the perspective of a banking supervisor, we support the SEC's proposal to limit the external auditor's role in the internal audit function of its clients.

Testimony by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Education and the Workforce, US. House of Representatives, September 21, 2000

I am pleased to be here this morning to discuss improving mathematics and science education in our elementary and secondary schools. In this regard, I am conveying my own views, not necessarily those of the Federal Reserve.

We are in a period--especially in this country--of rapid innovation that is yielding dramatic changes in the way goods and services are produced and in the ways that they are delivered to final users. These innovations are markedly elevating the skill levels that will be needed if our increasingly sophisticated capital stock is to function effectively in the years ahead. Such considerations are an important element in the ongoing dialogue that our nation's leaders in business, labor, education, and public policy must have if we, together, are to be successful in meeting the rising demand for skilled workers. Success in this area will, in turn, allow us to realize the potential that advances in science and technology have to enhance living standards for a large majority of Americans.

The pressures we face today are not unlike those of a century ago, when our education system successfully responded to the multiplying needs brought about by a marked acceleration in technological innovation. As those advances put new demands on workers interacting with an increasingly more complex stock of productive capital, high-school education proliferated--enabling students to read manuals, manipulate numbers, and understand formulae. Students were thus accorded the skills necessary to staff the newly developing assembly lines in factories and the rapidly expanding transportation systems whose mechanical and automotive jobs required a widening array of cognitive skills. For those who sought education beyond high school, land grant colleges sprang up, as states reacted to the increased skills required by industry and especially agriculture, the dominant occupation a century ago.

By today's standard, the required share of "intellectual workers" in our labor force was then still small. But the technological innovations of the latter part of the nineteenth century began to bring an increasing conceptualization of our gross domestic product--that is, a greater emphasis on value added stemming from new ideas and concepts as distinct from material inputs and demanding physical labor. The proportion of our workforce that created value through intellectual endeavors, rather than predominantly through manual labor, began a century-long climb. In 1900, only one out of every ten workers was in a professional, technical, or managerial occupation. By 1970, that proportion had doubled, and today those types of jobs account for nearly one-third of our workforce.

Moreover, this simple statistic undoubtedly understates the ongoing increase in the analytic content of work, because there also seems to have been a marked increase in the need for conceptual skills in jobs that a decade or so ago would have been easily characterized as fully manual labor. Indeed, the proliferation of information technologies throughout the economy in recent years has likely accelerated this shift in the skill requirements of many occupations away from routine work and toward nonroutine interactive and analytical tasks.

Another signal of the ongoing rise in demand for conceptual skills in recent years has been the increase in relative wages for college-educated workers. During the 1980s and much of the 1990s as demand for skilled workers outpaced the supply, the gap between the wages of the college educated and those with a high-school diploma or less widened considerably. More recently, as labor markets tightened, that gap has leveled off. Real wage gains have picked up for workers with less than a college education. But evidence of a high skills premium for workers with college degrees remains--not just for high-tech workers but across a broad range of occupations.

Innovation boosts output per hour and the freed pool of workers seek to exploit other opportunities. Their success is evidenced by the dramatic decline in the unemployment rate since 1992. The capital invested in any endeavor needs human interaction in order to function. But the new jobs that have been created by the surge in innovation require that the workers who fill them use more of their intellectual potential. This process of stretching toward our human intellectual capacity is not likely to end anytime soon. Indeed, the dramatic increase in the demand for on-the-job technical training and the major expansion of the role of our community colleges in teaching the skills required to address our newer technologies are persuasive evidence that the pressures for increased learning are ongoing.

At the same time that we have been witnessing these substantial increases in the demand for human input, we see little evidence that the general level of human intelligence has changed much--indeed, has changed at all--over the centuries. Fortunately, human beings exhibit a pronounced ability to stretch their intellectual capabilities when called upon. Hence, while the intellectual output of humans may appear to have an upper limit, that limit seems to be sufficiently flexible to assuage most concerns. Nonetheless, in today's economy, it is becoming evident that a significant upgrading or activation of underutilized intellectual skills will be necessary to effectively engage the newer technologies.

Expanding the number of individuals prepared to use a greater proportion of their intellectual capacity means, among other things, that our elementary and secondary students must broaden their skills in mathematics and related sciences. In my experience, competency in mathematics--both in numerical manipulation and in understanding its conceptual foundations--enhances a person's ability to handle the more ambiguous and qualitative relationships that dominate our day-to-day decisionmaking. The study of science, of course, also advances problem-solving skills.

Early success in problem solving clearly enhances the self-esteem of young people and encourages them to engage in ever more complex reasoning. We all tend to gravitate toward those activities that we do best. This is a self-reinforcing process in which early success promotes further effort in a self-perpetuating direction. This is true of playing Little League baseball or the piano, as well as doing math.

If we are to improve the scientific reasoning skills of our young people, we need to encourage a deeper interaction with numbers and their manipulation to a point at which students are confident and proud of their level of skills--in many instances an outcome they may not have anticipated. One is led to wonder whether the early sharpening of intellectual rigor that occurs when young students struggle to negotiate the complexities of doing multiplication and division the old-fashioned way is not without enduring value. A superficial understanding that does not stretch a child's intellectual capacity, in my experience, cannot galvanize an enhanced reality-based sense of self-esteem.

In this regard, it is discouraging that so many students who clearly demonstrate impressive verbal or other conceptual skills find mathematical procedures intimidating. According to a recent survey of student attitudes toward math conducted by the Department of Education, less than half of the high-school seniors surveyed said that they like mathematics, a proportion similar to the proportion who felt that they were good at it. Even more disturbing, these proportions were lower than those in the surveys conducted in 1990. Some research indicates that such "math anxiety" has a negative effect on mathematics performance and that strategies for increasing students' confidence in their mathematical abilities are likely to have additional benefits in terms of achievement.(1) If we can enhance their self-esteem and provide them with a strong curriculum and effective teaching, students may well find themselves rising to a level of analytic capability beyond their previous vision.

There is clearly work to be done, for, as you know, the international comparisons of student achievement in mathematics and science that were conducted in 1995 suggested that our fourth graders were among the highest rated around the world but that our eighth and twelfth graders fell short of their peers in other countries. These comparisons heightened the debate about the quality of education that students are exposed to between the fourth and twelfth grades and raised concerns about prospects for a continuing shortfall of American-educated skilled technicians.

To be sure, substantial reforms in math and science education had been under way for some time prior to the 1995 study and have continued since. It is encouraging that the latest results on trends in academic progress from the National Assessment of Educational Progress show some improvement in both subjects. Perhaps that improvement will show up in a narrowing of the gap between our students and those abroad when the results of a follow-up survey of international comparisons are released later this year. Nonetheless, with the conceptual demands on our workers continuing to rise, substantial further progress needs to be made in raising the analytic competency of our graduating high-school seniors.

Addressing this issue is crucial for the future of our nation. It is obviously just a matter of time before the bulk of our workforce will require a much higher level of problem-solving skills than is currently evident. And while we have been fortunate to attract so many skilled young people to our shores, we must nonetheless strive to increase math and science achievement so that our students can take advantage of the considerable opportunities that will exist in tomorrow's labor market. In that way, we can realize the potential of technological change for bringing substantial and lasting benefits to our economy.

As a final point, I would stress that, even with the increasing intellectual specialization so necessary if we are to move to an ever-higher degree of specialization in our overall economy, we also need to ensure that all students have a broad knowledge of the world at large. Major technological advances are becoming increasingly interdisciplinary. Many academics argue, I believe rightly, that significant exposure to a liberal education--music, literature, and the arts--broadens intellectual awareness, enhancing the ability to reach across disciplines to forge new ideas. Thus, while we must strengthen math and science education to address the requirements of the newer technologies we see on the horizon, we should not lose sight of the advantages of a liberal education.

I do not doubt that many of our most innovative and successful dot-com entrepreneurs are exceptionally, but narrowly, technically focused and educated. But if technology is to fit into a broader society of complex democratic institutions such as ours, it is important that all participants have an adequate awareness of its structure and values. For it is the latter that we as a people endeavor to achieve. Our technologies are only a means to that end.

(1.) Hsui-Zu Ho and others, "The Affective and Cognitive Dimensions of Math Anxiety: A Cross-National Study," Journal for Research in Mathematics Education (May 2000). This article cites a long literature on "math anxiety" among U.S. students and reports that it also has an adverse effect on students in China and Taiwan.