Testimony of Federal Reserve Officials.

Testimony of Roger W. Ferguson, Jr., Vice Chairman, Board of Governors of the Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, June 13, 2001

Chairman Sarbanes, Senator Gramm, and members of the Committee, I am pleased to appear before you today as President Bush's nominee to serve on the Board of Governors of the Federal Reserve System. I am honored that the President has nominated me to serve a full term as a member of the Board.

As a Governor, I am particularly mindful that the policy decisions of the Federal Reserve influence the economic well-being of all Americans. It has been my privilege to serve our fellow citizens in this capacity since 1997, giving this role my undivided attention, and I hope to be able to continue in that service.

During my tenure we have faced a rapidly changing environment in many of our areas of responsibility, and I would like to review briefly some of those developments and our responses to them.

The Congress has given the Federal Reserve three monetary policy objectives: maximum employment, stable prices, and moderate long-term interest rates. We have viewed these objectives as congruent with a goal of maximum sustainable growth, which can occur only in the context of long-mn price stability. Fostering financial conditions in which Americans can realize the full productive potential of our economy has presented a number of challenges in recent years. The most important developments have been a step-up in the advance of technology--both in terms of the production of new goods and the more effective harnessing of past innovations--and a rapid accumulation of physical capital. These developments have made workers increasingly more productive. But faster productivity growth fed back on the demand for goods and services in ways that complicated the calibration of monetary policy. Faster growth in productivity, and the reactions of businesses and households to this acceleration of productivity, have combined with other forces--particularly those associated with the growing interconnectedness of the global economy--to require substantial adjustments in the Federal Reserve's policy interest rate in recent years. But those adjustments in our policy instrument have been in the service of our objective of promoting maximum sustainable growth.

Making monetary policy has been only part of the challenge. During my tenure at the Federal Reserve we have also worked diligently to communicate to the public what we are doing with policy and why. Transparency in policymaking is a key part of the democratic process, as well as being helpful in fostering efficient decisionmaking in the private sector. Becoming more transparent has been a goal of the central bank in recent years, keeping in mind that we must balance the need to be open and accountable with the need to maintain an effective process of decisionmaking by the Federal Open Market Committee. Transparency requires that we periodically review our procedures, as we did in 1999, to ensure that they appropriately balance these considerations. I do not know what future changes, if any, might be called for in how we communicate, but I am confident that the Federal Reserve will continue to look for ways to communicate clearly our policies and our supporting rationales.

While macroeconomic conditions are of overriding importance, the role of the Federal Reserve is broader than monetary policy. Financial stability is an essential precondition for maintaining a strong economy, and the Federal Reserve has important supervisory and regulatory responsibilities for our nation's banking system. The Federal Reserve, and other regulators, must continue to foster a competitive environment that will benefit the users of financial services, while also promoting safety and soundness. I believe that we must achieve these goals with a minimum of regulatory burden and without leaving the impression that any institution is too big to fail. To minimize regulatory burden and achieve our other objectives, we should encourage what to my mind are the best regulators, namely market discipline and management accountability. Of late, our challenge has been to meet these goals as we implement the financial modernization law. In my opinion, the Congress wisely removed several antiquated barriers to a modern financial structure in the United States, and now we need to design regulatory and supervisory policies that reflect the will of the Congress and deal effectively with a changing financial services industry.

Technology and deregulation, forces for change that I have just mentioned, have encouraged consolidation in the financial sector. With central bank and treasury officials from twelve other major industrial economies, I have reviewed the likely effect of the global trend toward consolidation and its implication for central banks and regulators. Because financial systems will continue to consolidate, as the forces that motivate that evolution are unabated, the regulatory community needs to monitor developments closely. But our study also found that existing policies appear adequate to allow regulators to maintain safe and sound financial industries now and in the intermediate term and for monetary policy to work through many of the same mechanisms as in the past.

More than the structure of the financial services industry has changed of late. That sector has found uses for consumer information and created an array of financial products and services unimagined even a few years ago. These developments, in turn, raise some new concerns, and have re-ignited some existing ones, among consumers and legislators. The Congress grappled with one of these issues, privacy, in the financial modernization law. Concerns about abusive lending practices have also re-emerged of late. In all areas, but particularly in areas as sensitive as these, regulators should faithfully administer consumer protection laws as written. Any necessary regulations should adequately inform consumers and protect them against abusive practices while also not discouraging legitimate extensions of credit, especially to those who might previously have been denied access to such credit. Financial literacy will certainly play an important role in avoiding the growth of abusive or deceptive financial practices and in allowing consumers to protect their interests. I believe that legislation, careful regulation, and education are all components of the response to these emerging consumer concerns. I also hope, however, that businesses recognize that it is in their long-term interest to maintain the confidence of consumers by avoiding deceptive and abusive practices and by respecting the privacy of their customers.

Finally, our payment system affects every consumer and business. This system too has been, and will continue to be, changed greatly by emerging technologies. From the time of its very founding, the Federal Reserve has had the responsibility to foster an efficient, safe, and accessible payment system. During much of 1998 and 1999, our primary objective in this regard was to help banks and other participants in the payment system maintain smooth operations as the century date change passed. Domestically, we achieved this goal by working directly with the banking sector. Internationally, I was privileged to work through multilateral groups to raise the awareness of the international regulatory community of the nature of the Y2K challenge. Now, we can take a longer-term perspective and consider how we might facilitate innovation in the payment system.

As an overseer and regulator, the Federal Reserve needs to approach payment system innovations with an open mind and a willingness to adapt. In a dynamic economy, markets need to play a key role in guiding the development of infrastructure. This means that innovation and competition will be central to the future development of the payment system--as they are in other areas of the economy. Regulators should strive to remove barriers to innovations when we can do so without sacrificing important public policies. We should take every opportunity to foster competition and maintain the integrity of the payment system, but public policy should not be built on a single vision or prediction of the future. Ultimately, consumers and businesses as well as service providers will determine the range of payment services that best meet their needs.

Mr. Chairman and members of the Committee, during my years on the Board of Governors, I have done my best to contribute positively to all aspects of the Federal Reserve's many responsibilities. I look forward to the opportunity to continue to work with you and serve the nation as a member of the Board of Governors. Thank you for your attention and for considering my nomination. I would be pleased to respond to questions.

Testimony of Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, June 20, 2001

Mr. Chairman and members of the Committee, I am pleased to be here this morning to discuss the condition of the U.S. banking system. In my presentation today, I would like to raise just a few issues. I have attached an appendix in which the Federal Reserve Board staff provides far more detail relevant to the purpose of these hearings.(1)

There are, I believe, two salient points to be made about the current state of the banking system. First, many of the traditional quantitative and qualitative indicators suggest that bank asset quality is deteriorating and that supervisors therefore need to be more sensitive to problems at individual banks, both currently and in the months ahead. Some of the credits that were made in earlier periods of optimism--especially syndicated loans--are now under pressure and scrutiny. The softening economy and/or special circumstances have especially affected borrowers in the retail, manufacturing, health care, and telecommunications industries. California utilities, as you know, have also been under particular pressure. All of these, and no doubt other problem areas that are not now foreseeable, require that both bank management and supervisors remain particularly alert to developments.

Second, we are fortunate that our banking system entered this period of weak economic performance in a strong position. After rebuilding capital and liquidity in the early 1990s, followed by several years of post-World War II record profits and very strong loan growth, our banks now have prudent capital and reserve positions. In addition, asset quality was quite good by historical standards before the deterioration began. Moreover, in the last decade, as I will discuss more fully in a moment, banks have improved their risk management and control systems, which we believe may have both strengthened the resultant asset quality and shortened banks' response time to changing economic events. This potential for an improved reaction to cyclical weakness, and better risk management, is being tested by the events of recent quarters and may well be tested further in coming quarters.

We can generalize from these recent events to understand a bit better some relevant patterns in banking, patterns that appear to be changing for the better. The recent weakening in loan quality bears some characteristics typical of traditional relationships of loans to the business cycle--the pro-cyclicality of bank lending practices. The rapid increase in loans, though typical of a normal expansion of the economy, was unusual in that it was associated with more than a decade of uninterrupted economic growth. As our economy expanded, business and household financing needs increased, and projections of future outcomes turned increasingly optimistic. In such a context, loan officers, whose experience counsels that the vast majority of bad loans are made in the latter stages of a business expansion, have had the choice of (1) restraining lending, and presumably losing market share, or (2) hoping for repayment of new loans before conditions turn adverse. Given the limited ability to foresee turning points, the competitive pressures led, as has usually been the case, to a deterioration of underlying loan quality as the peak in the economy approached. Supervisors have had comparable problems. In a rising economy buffeted by competitive banking markets, it is difficult to evaluate the embedded risks in new loans or to be sure that adequate capital is being held. Even if correctly diagnosed, making that supervisory case to bank management can be difficult because, regrettably, incentives for loan officers and managers traditionally have rewarded loan growth, market share, and the profits that derive from booking interest income with, in retrospect, inadequate provisions for possible default. Moreover, credit-risk specialists at banks historically have had difficulty making their case about risk because of their inability to measure and quantify it. At the same time, with debt service current and market-risk premiums cyclically low, coupled with the same inability to quantify and measure risk, supervisory criticisms of standards traditionally have been difficult to justify.

When the economy begins to slow and the quality of some booked loans deteriorates, as in the current cycle, loan standards belatedly tighten. New loan applications that earlier would have been judged creditworthy, especially since the applications are now being based on a more cautious economic outlook, are nonetheless rejected, when in retrospect it will doubtless be those loans that would have been the most profitable to the bank.

Such policies are demonstrably not in the best interests of banks' shareholders or the economy. They lead to an unnecessary degree of cyclical volatility in earnings and, as such, to a reduced long-term capitalized value of the bank. More importantly, such policies contribute to increased economic instability. The last few years have had some of the traditional characteristics I have just described: the substantial easing of terms as the economy improved, the rapid expansion of the loan book, the deterioration of loan quality as the economy slowed, and the cumulative tightening of loan standards. But this interval has had some interesting characteristics not observed in earlier expansions. First, in the mid-1990s, examiners began to focus on banks' risk-management systems and processes; at the same time, supervisors' observations about softening loan standards came both unusually early in the expansion and were taken more seriously than had often been the case. The turmoil in financial markets in 1998, associated with both the East Asian crisis and the Russian default, also focused bankers' attention on loan quality during the continued expansion in this country. And there was a further induced tightening of standards last year in response to early indications of deteriorating loan quality, months before aggregate growth slowed.

All of this might have been the result of idiosyncratic events from which generalizations should not be made. Perhaps. But at the same time another, more profound development of critical importance had begun: the creation at the larger, more sophisticated banks of an operational loan process with a more or less formal procedure for recognizing, pricing, and managing risk. In these emerging systems, loans are classified by risk, internal profit centers are charged for equity allocations by risk category, and risk adjustments are explicitly made. In short, the formal measurement and quantification of risk has begun to occur and to be integrated into the loan-making process. This is a sea change--or at least the beginning of one. Formal risk-management systems are designed to reduce the potential for the unintended acceptance of risk and hence should reduce the pro-cyclical behavior that has characterized banking history. But, again, the process has just begun.

The federal banking agencies are trying to generalize and institutionalize this process in the current efforts to reform the Basel Capital Accord. When operational, near the middle of this decade, the revised accord, Basel II, promises to promote not only better risk management over a wider group of banks but also less intrusive supervision once the risk-management system is validated. It also promises less variability in loan policies over the cycle because of both bank and supervisory focus on formal techniques for managing risk.

In recent years, we have incorporated innovative ideas and accommodated significant change in banking and supervision. Institutions have more ways than ever to compete in providing financial services. Financial innovation has improved the measurement and management of risk and holds substantial promise for much greater gains ahead. Building on bank practice, we are in the process of improving both lending and supervisory policies that we trust will foster better risk management; but these policies could also reduce the pro-cyclical pattern of easing and tightening of bank lending and accordingly increase bank shareholder values and economic stability. It is not an easy road, but it seems that we are well along it.

(1.) The attachment to this statement is available, on request, from Publications Services, Mail Stop 127, Board of Governors of the Federal Reserve System, Washington, DC 20551.