The Federal Reserve voice - active or passive?
Let me build on a bit of history and personal experience. You will see that they will tie in with my theme of whether or not the Fed is active or passive in today's society - and whether or not it should be.
The Federal Reserve System was born out of the panic of 1907, when Congress determined that it was going to provide emergency liquidity to the banking system. Twelve banks were chartered, and the Federal Reserve Board was put in place in 1914.
The member banks set reserve requirements. They said that liquidity for the system required each bank to keep a certain amount of its deposits in the central bank. In a liquidity crisis, those reserves would be used to forestall a run on a bank. This was before deposit insurance.
Five or six years later, there were huge amounts of these reserves in the system. Banks in reserve cities, for example, were keeping as much as 20 percent of their deposits in this reserve pool. And the Fed could by law invest that money only in U.S. Treasury securities.
So an informal committee met once a month or so in New York and directed the New York Federal Reserve Bank to buy or sell Treasury securities for the accounts of the 12 individual banks. Gradually, the committee began to notice that after the orders coming out of these meetings were executed, the level of interest rates changed, and so did the whole government bond market. And because of the effect on the government bond market, there were implications for all the capital markets.
Suddenly, like a cartoon in which a light bulb goes on, somebody said: "Hey, this is another way that we can influence the economy." Thus began what is called open market operations as an instrument of monetary policy. The committee that makes these decisions today is called the Open Market Committee.
Let me now move from history to personal experience. The Open Market Committee consists in 1989 of the seven governors of the Federal Reserve Board and five of the 12 district bank presidents. The president of the New York bank is always a member because the New York bank is charged with the open market operations both in Treasury securities and in foreign exchange.
The committee meets every six weeks. Before each meeting, an enormous amount of data is gathered from all of the district banks and from the staff of 140 economists in Washington. Using various computer models, the data is analyzed and compiled in a report that is distributed to all members of the committee. Basically, these reports present the staff's opinion of what is going on in the economy and projections for the next 12 to 24 months.
At the committee meeting, each member sitting around the table is asked his opinion of the economy, the staff reports, and the projections. Then there is a strategic coffee break. Everybody has now heard how everybody else thinks, and each one begins to test his or her own ideas against what he or she heard around the table. So the 15 or 20 minutes in which the committee members are drinking coffee and eating donuts in the corridor outside is the period in which a consensus begins to develop.
After the coffee break, the chairman speaks first. He may start by saying: "Well, it looks to me like what is going on here is as follows." And in a few sentences, he will capsulize what he's heard. Then he might say: "In view of that, I think we might proceed along these lines." He then describes his impression of where the committee wants to go, and generally he is fairly accurate. Not because everybody automatically agrees, but because in what he has described there is enough for everybody to feel a part of it.
There is rarely a unanimous vote. But it's usually a fairly lopsided vote. However, the prose in the instructions to the New York bank needs to be so precise in terms of its meaning that we may discuss for a half an hour what specific words to use.
It's a very exciting atmosphere. Given tremendous staff input, you feel you have all the information you need in order to make a decision. And yet the implications of any decision are so awesome that you don't act casually. You really think before you express your position and cast your vote.
While in today's environment the role of the Federal Reserve as a regulator, a source of temporary liquidity, and a lender of last resort in emergencies remains important, the focus of media attention is fixed on its role in the economy through its administration of monetary policy. If the country goes into recession, it is assumed that the Federal Reserve has kept money too tight for too long. If we have inflation, it is assumed that the Fed has made money too easy for too long. As these words are written, we have had 76 months of growth (the longest such stretch in peacetime in 130 years) and only moderate inflation. Having said that, I want to emphasize that we believe rather strongly that even at current rates inflation is too high. Certainly one policy that the Federal Reserve will follow is to try to contain inflation in the short run and ratchet it down to much lower levels over time.
Public policy issues
The Fed is clearly going to play a role in a number of public policy issues now on the plate in Washington. Let me review some of them.
The thrift industry crisis - This is an unholy mess, one that should never have reached the point where it is. As recently as three years ago, it might have been fixed for $30 billion. Congress authorized $10 billion, and it was like throwing pebbles in the ocean.
The President's plan offers a very forthright way of dealing with the crisis. It revamps the regulatory structure and it puts significant capital requirements on the thrifts. It also brings them under the same kind of constraints that are imposed on commercial banks.
The original Senate-passed bill was essentially consistent with the President's proposals. The House has amended the basic bill many times. The most significant change at this moment is the proposal to finance the Resolution Trust Company on the budget with a legislative exception from Gramm-Rudman-Hollings. That approach risks a Presidential veto that could prolong the process of getting a solution and run the risk of further erosion of public confidence in the thrifts.
The Fed is in a difficult position here. As the lender of last resort, we have set up procedures under which we step in if the Federal Home Loan Banks, FSLIC, and the Treasury cannot handle a sustained run on a major thrift or group of thrifts. But does it make sense from a policy point of view for us to be funding defunct organizations as opposed to our traditional role of providing emergency liquidity to sound institutions? We are taking an aggressive stance behind the scenes in trying to work out these issues because we have to protect the integrity of the whole financial system as well as of the Federal Reserve System.
Highly leveraged financing - We're concerned about this from the standpoint of the safety and soundness of the banking system, because a lot of these financings have debt service requirements with very thin coverage from a cash flow point of view.
How is the Fed dealing with this? We do not believe in the allocation of credit or its rationing. Therefore, we oppose legislation that hinders the financing of LBOs or takeovers. We think that's an improper interference with the operation of the marketplace.
We think a better way to deal with any problems arising is through close supervision of participating banks. We tell our examiners to look for the following: Is the bank approaching this kind of lending intelligently? Does it have sound credit policies and procedures? Is it following them? Are bank executives doing right kind of analysis of each one of these credit applications? Have they put limits on their exposure to individual companies, to industries, and to how much of this kind of exposure they will allow in the overall loan portfolio? And, most important, is the board of directors of the bank aware of what's going on in this area and have the directors agreed to it?
When examiners find financings on the books in which the cash flow isn't sufficient, they classify the loan. We think that's a better way to approach the situation than a legislative or regulatory absolute.
Credit policy and procedures are always a matter of concern. If all the projections are right, things will work out. But if we have a sudden downturn in the economy or upturn in interest rates, some banks are going to have problems.
Deregulation - The recast of Glass/Steagall didn't get through Congress last year. I believe the Proxmire-sponsored Senate bill would have passed in the House overwhelmingly. It passed in the Senate without significant opposition.
The bill failed in the House because it never got to the floor. It was held up by the leadership. It's now unlikely that Congress will revisit that issue in the near future. Congress is politically sensitive to the scandals in Wall Street, the fraud and mismanagement in a lot of failed S&Ls, and the failure of 200 commercial banks last year. It may feel that this is the time to pause in further financial deregulation and take a closer look.
In fact, I am concerned that Congress is disillusioned with deregulation. And that, I believe, is a shame. American banks are not competitive in world markets largely because they are competing in many cases with so-called universal banks that can do more things than American banks are allowed to do.
Europe 1992 - By 1992, many European nations are scheduled to be integrated into one economy. No more trade barriers. No more regulatory barriers. If a German bank wants to go to London or Paris, it can do anything there that it could do in Germany. The effect will be to reduce regulation to the lowest common denominator in order to be competitive. That will produce an open, relatively unrestrained market, but a very attractive one.
Now, the question is: Who are they going to let participate from outside and under what terms? The Europeans have proposed that European banks from the integrated market should be allowed, on a reciprocal basis, to go into any country around the world and do anything in that country that they can do in the European market. But banks coming in from let's say the U.S. or Japan can only do in the European market the things that they can do at home.
Because both we and the Japanese have narrow restrictions on what our banks can do, we would be at a tremendous disadvantage in adhering to those restrictions in that huge market of 320 million people. The U.S. favors national treatment. This country has allowed banks to come in from anywhere as long as they are willing to operate here by our rules. We contend that U.S. banks should be able to go into other countries and operate according to what the rules are in that country. At the moment, there is some indication that the European Community may be willing to compromise in the direction of reciprocal national treatment.
LDC debt - This is still a gigantic problem. The major banks with the huge exposures are still reserved at about only 30 to 35 percent. The political pressures, particularly in Latin American countries, are building to the point where there could be some explosions - witness the demonstrations earlier this year in Venezuela.
The nearest term risk is the coming Peronista government in Argentina. If Argentina should decide to abrogate its international debt, other nations may climb on the bandwagon. That could result in rather serious repercussions in world financial markets.
Before that happens, some fundamental long-term restructuring has to be undertaken in order to give third-world economies resources to grow. Until they attain more vigorous growth, there is no way to pay down their debt.
The Brady initiatives are most welcome, and the Federal Reserve is supportive of their basic thrust. The question is how to obtain new money to fund growth and encourage structural reform in these economies while reducing the debt burden without destabilizing the banking system. Mexico may offer a good model, but only a limited number of debtor countries have the same prospects of success as Mexico.
The banking structure - A number of issues are involved here. The Fed is strongly in favor of interstate banking. We believe that the only way our banks can be competitive in world markets is to grow on a strong capital base. We're the only country in the world that has built geographic barriers around banks, thus seriously limiting their ability to grow and operate with maximum efficiency. Therefore, the current rapid breakdown of these barriers is welcome.
But there are some interesting public policy issues. If a bank holding company has banks in 10 states, is it going to have to operate under 10 different sets of rules? What is the right of an individual state to regulate banking subsidiaries of an interstate holding company within its borders? Will Congress override states' rights and say interstate bank holding companies will operate under a separate, federally supervised set of rules? These state versus federal jurisdiction issues are among the most difficult for Congress.
Also, what of the purchase of solvent thrifts by banks? This is very important if we're going to rationalize the banking structure. The Federal Reserve supports provisions in the thrift legislation under consideration that would allow commercial bank holding companies to buy healthy thrifts in addition to failing thrifts.
Financial services holding companies will probably emerge in the mid 1990s when Congress returns to structural issues. That means a financial holding company could hold a bank, a securities company, a real estate development company, a real estate brokerage company, an insurance company, and so on - as long as the bank is insulated from financing or passing capital to the nonbank affiliates.
This, in turn, raises the question of the barrier between commerce and banking. Will we allow commercial firms to own banks, bank holding companies, or financial services holding companies? The issue will be widely debated, but commercial companies already own thrifts and nonbank banks. Thus the traditional barriers are already partially breached.
How would you evaluate the Fed's role? Active or passive? At times, I would like to see it more publicly active. In this LDC problem, for example, and also in some of the specifics of the thrift problem. Because these are major issues.
To date, we've been satisfied in many cases to work through other agencies. We consult with them almost continuously on some of these issues. But we are an independent agency. There is no legal reason why we can't make our own views known if they are different from those that are surfacing elsewhere. So in my enthusiasm, I sometimes urge a more visible role.
On the LDC debt, for example, I think we are still playing around with surface issues and not getting down to the fundamentals of how to restructure the debt sufficiently to encourage the return of capital that has fled. Latin America alone, according to some estimates, has lost $110 billion in flight capital. If just half of that came back because of an improved financial environment, there would be a tremendous stimulus to those economies.
When I say that I personally would like to see the central bank take a more visibly active role on these issues, I am perceived to be a little irreverent in regard to the traditions and the culture of the organization. Perhaps I will change over time, but at the moment my freshman enthusiasm has the upper hand.
PHOTO : A tin gondola, circa 1890
PHOTO : Submarine: S.S.N. 25, made of tin and powered by flywheel, Japan, circa 1955
PHOTO : Part of the "Soldiers of the Queen" series, lead cast, U.S.A., 1981
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|Author:||LaWare, John P.|
|Date:||Nov 1, 1989|
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