Statement by E. Gerald Corrigan, President, Federal Reserve Bank of New York, before the Subcommittee on Securities of the Committee on Banking, Housing and Urban Affairs, U.S. Senate, January 23, 1992.
I am pleased to have the opportunity to appear before you this morning to discuss the joint report on improvements in the government securities market and the related subject of the official oversight and regulation of that most important market. Although my opening statement is brief and relates primarily to the specific activities of the Federal Reserve Bank of New York in regard to the overall effort, allow me at the outset to make a brief comment on the joint report as a whole.
As you know, in many appearances before this committee on the subject of banking reform, I have made the call for what I have termed progressive but cautious" reform of our banking system. Although the context is different, I believe the totality of the changes outlined in the joint report are fully in keeping with the philosophy of progressive but cautious change. Because the report does reflect a careful blending of these considerations, I strongly support its overall thrust.
Having said that, it is obviously true that there are any number of specific areas in which reasonable men and women can debate about whether more or less could be done. From my perspective, the balance reflected in the report is about as close to the optimal that we could reasonably hope or expect.
The American public and the world at large have an enormous stake riding on the efficient workings of this crucial market. Therefore, as we seek out opportunities to enhance the workings of the market we must be sure that we do not push for changes that might inadvertently impair the efficiency of Treasury debt management procedures, the conduct of monetary policy, or the secondary market for these securities. As we gain experience with the changes that are contemplated in the report, still further enhancements may be warranted, but for now I believe that the menu of initiatives contained in the report is at the outer edge of what we can prudently absorb in the period ahead.
With those general observations in mind, let me turn to the specific aspects of the report that relate directly to the responsibilities of the Federal Reserve Bank of New York. There are three such major areas: first, the changes in the Bank's "Administration of Relationships with Primary Dealers;" second, the Bank's role in the development, testing, and implementation of new automated systems for Treasury auctions and Federal Reserve open market operations; and third, the Bank's expanded role with regard to day-to-day surveillance of the government securities market.
ADMINISTRATION OF RELATIONSHIPS WITH PRIMARY DEALERS
Attached to this statement is a paper issued yesterday by the Federal Reserve Bank of New York outlining revised procedures for the administration of the Bank's relationships with primary dealers. 1 Although that document itself represents a careful balancing of many considerations and viewpoints, it is based on several key and interrelated considerations including the following.
First, although change was needed, the complete dismantling of the primary dealer system-including the responsibility of dealers to make markets for Federal Reserve open market operations and to participate meaningfully in Treasury auctions-would not have been a prudent step.
Second, it was important to provide for a more open" system of primary dealers, in part because the existing approach has been viewed as conferring on dealer firms special status that carries with it elements of "franchise" value, and in part because of fairness and equity considerations. This provision has been accomplished by the elumination of the so-called 1 percent market share requirement and the use of straightforward and objective capital standards for eligibility as a primary dealer. Taken together, these changes will substantially increase the potential number of firms that can become primary dealers.
Third, it was important that the Federal Reserve Bank of New York make absolutely clear to the marketplace that the Federal Reserve Bank of New York does not regulate the primary dealer firms, in part because of "moral hazard" considerations and in part because of legal and regulatory realities. For this reason we are disbanding the Bank's dealer surveillance unit.
Fourth, for obvious reasons, it was necessary to clarify the reasons and the conditions under which the Federal Reserve Bank of New York would alter its relationship with a primary dealer firm. Under the new administrative procedures, the three independent sets of circumstances under which that might occur are the following:
A dealer firm's status will be altered if the firm fails to meet its responsibilities to make reasonable markets for Federal Reserve open market operations or if it fails to participate meaningfully in Treasury auctions or if it fails to meet its responsibilities to provide the Federal Reserve with meaningful market intelligence over time. To the extent that a firm's dealer status is altered for any or all of the above reasons, that action by the Federal Reserve will reflect considerations relating to the business relationship alone and will carry no implication about creditworthiness, financial strength, or managerial competence of the firm.
A dealer firm's status will be altered if the dealer falls below the relevant capital standards and does not, in the eyes of its primary federal regulator, have a credible plan to restore such capital in a reasonable period of time.
A dealer firm's status will be altered if the firm is convicted of a felony under U.S. law or pleads guilty or nolo contendre to a felony under U.S. law for activities directly or indirectly related to its business relationship with the Federal Reserve. This provision should create powerful incentives for a firm-when faced with wrongdoing by individual employees-to take immediate and strong actions to root out the source of the problem to minimize the risk to that firm.
Although major elements of the changes in the administration of the relationships with primary dealers will begin to take place immediately, the full benefits of these changes will occur only as the automation of Treasury auctions and Federal Reserve open market operations take place and as the other changes contemplated by the Joint Report take hold. Over time, however, the automation efforts may prove particularly important. These initiatives are described below.
AUTOMATION EFFORTS BY THE FEDERAL RESERVE BANK OF NEW YORK
The design work for the automation of Treasury auctions based on existing auction techniques has been under way for some time and should be completed late this year. The software for the automation of the auctions is not particularly difficult to develop. The difficult aspects of this task relate more to its communications system-particularly as the number and nature of prospective direct participants in the auctions change. But, what makes this automation effort especially difficult is the need to build into the computer systems and the communications systems a very high level of operational integrity, as well as multiple levels of backup for various contingencies.
If the Treasury were to decide to move to a different auction technique, the strategy would be to enhance the system presently being developed to accommodate both types of auctions. Although important elements of the work being done for the current auction procedures can be used with a new auction technique, the enhancement of the system being developed to accommodate the new procedures will take some time after the requirements have been defined. This enhancement will not, however, delay the planned implementation of automated procedures for the current auction by the end of this year.
The full automation of Federal Reserve open market operations is even a more complex and time-consuming task, especially because it is impossible to prejudge with any precision the number, location, financial, and legal characteristics of potential counterparties for such operations. Moreover, the operating systems and communication systems associated with this effort must be integrated with several other highly complex automated systems, including the Federal Reserve's existing money and securities transfer systems. Because of this integration an extraordinarily high level of reliability and integrity will be needed. To illustrate the concerns I have in mind, just imagine, for a moment, what might have occurred on the morning of October 20, 1987, had the Federal Reserve been unable-because of technical problems with such a system-to furnish substantial liquidity through open market operations as a part of the effort to stabilize financial markets in the wake of the stock market crash.
I raise this point because I believe that it is very important that the committee recognize that tasks of this nature must be approached with care. Moreover, the front-end or design-development stages of such projects cannot easily be expedited by simply throwing more people at the problem. The analogy may be a bit overdone, but I think it is fair to suggest that to believe that this kind of task can be significantly accelerated by throwing more people at the task is akin to suggesting that open heart surgery can be accelerated by throwing more doctors into the operating room. At the margin, it may help; but, if overdone, I pity the patient.
To put it briefly, I can assure this committee that we will do everything possible to complete these tasks as quickly as possible but will not, in the name of saving a few weeks or months, take unacceptable risks that might impair the ultimate efficiency, flexibility, integrity, and reliability of these systems.
THE ROLE OF THE FEDERAL RESERVE BANK OF NEW YORK IN THE MARKET SURVEILLANCE PROCESS
Little needs to be added to what is contained in the Joint Report as it pertains to the expanded role of the Federal Reserve Bank of New York-in cooperation with the other agencies-with regard to day-to-day surveillance of the government securities market except (1) to emphasize that market surveillance is quite distinct from dealer surveillance, which we are discontinuing; and (2) to emphasize that it will take some time to fully put in place some of the new or altered statistical reporting arrangements that might be agreed upon by the interagency surveillance working group over the period immediately ahead.