Statements to Congress.
Statement by Wayne D. Angell, Member, Board of Governors of the Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, September 10, 1990. I am pleased to be here on behalf of the Federal Reserve Board to discuss regulatory accounting standards and capital requirements for depository institutions. Both of these standards play particularly important roles in the supervisory process. Accounting standards, by promoting consistent and accurate financial reports, enhance the ability of supervisors to monitor developments at depository institutions and to identify situations of deteriorating financial conditions that require immediate corrective actions. Capital standards are perhaps even more critical. A strong capital position enables an organization to withstand an unexpected setback and return to financial health, and when that does not prove possible, helps to limit potential losses to the government deposit insurance fund.
The importance of accounting and capital standards, of course, was recognized by the Congress when it enacted the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA). FIRREA directed the depository institution supervisory agencies to develop uniform accounting standards for all federally insured depository insitutions, and mandated that capital standards for thrift institutions be no less stringent than those for commercial banks. Furthermore, the Congress asked the agencies to submit reports discussing any differences among their accounting and capital standards by August 9, 1990. The Federal Reserve's report was submitted on that date.
Today, I do not want to repeat all of the details set forth in that report. Rather, I would like to address some important policy issues regarding the accounting and capital standards employed by the Federal Reserve and the other banking agencies. I particularly want to focus upon those issues raised in your letter of invitation, Mr. Chairman, including market value accounting and our view on how the banking agencies might proceed to assess interest rate risk for examination and capital adequacy purposes.
The Role of Accounting Standards
The Federal Reserve has long viewed accounting standards as a necessary step to efficient market discipline and bank supervision. Accounting standards provide the foundation for credible financial statements and other financial reports. Accurate information reported in a timely manner provides a basis for the decisions of market participants. The effectiveness of market discipline, to a very considerable degree, rests on the quality and timeliness of reported financial information.
Financial statements and regulatory financial reports perform a critical role for depository institution supervisors. The supervisory agencies have in place monitoring systems that enable them to follow, on an off-site basis, financial developments at depository institutions. When reported financial information indicates that a deterioration in financial condition has occurred, these systems can signal the need for on-site examinations and any other appropriate actions. The better the quality of financial information, the greater the ability to monitor and supervise effectively.
Financial statements provide information needed to evaluate an enterprise's financial condition and performance. Generally accepted accounting principles (GAAP) must be followed in the preparation of financial statements filed with the Securities and Exchange Commission or that otherwise are audited by Certified Public Accountants (CPAs). The regulatory financial statements for federally insured commercial banks and savings banks are the reports of condition and income, commonly referred to as call reports. The call reports, the form and content of which, by law, are developed by the Federal Financial Institutions Examination Council (FFIEC), are currently required to be filed in a manner generally consistent with GAAP. In those few instances in which the call report specifies reporting requirements that differ from GAAP, these requirements are intended to be more conservative than GAAP.
Call reports include balance sheets, income statements, and supporting schedules providing information on types of loans, securities, and deposits, and the extent of off-balance-sheet activities. Other supporting schedules also provide information on past due and nonaccrual loans and leases, loan losses and recoveries, and changes in the allowance for loan and lease losses. Certain information on the maturity or repricing frequency of securities, loans, and time certificates of deposit is also presented. Furthermore, the call report provides information necessary for the calculation of capital ratios.
FIRREA Mandate for Uniform Accounting Standards
As you know, section 1215 of FIRREA provides that each federal bank and thrift regulatory agency "establish uniform accounting standards to be used for determining the capital ratios of all federally insured depository institutions and for other regulatory purposes." As I have explained, the banking agencies, under the auspices of the FFIEC, have in place uniform call reports for all commercial banks and savings banks supervised by the Federal Deposit Insurance Corporation (FDIC). The banking agencies base their capital adequacy and other regulatory and supervisory computations on the call report. Thus, for the Federal Reserve Board, the Office of the Comptroller of the Currency (OCC), and the FDIC, uniform "accounting standards" for capital and other regulatory purposes are in place.
On the other hand, the Office of Thrift Supervision (OTS) utilizes the Thrift Financial Report (TFR), which differs from the bank call report in scope, detail, and definition of terms. Furthermore, the TFR is based entirely on GAAP for thrift institutions, which is somewhat different from GAAP for banks. Some of the reporting differences between banks and thrift institutions were appropriate given the different type of assets that thrift institutions typically held. However, FDIC-insured mutual savings banks file the same call report as commercial banks, and the FDIC has been able to accommodate the differences between these two types of institutions while still preserving comparability and definitional consistency.
Table 1 in the appendix summarizes the primary areas of difference that exist between the reporting standards of the federal banking agencies and the OST.(1) Some of these differences, such as those involving loan-loss reserves for real estate loans and the valuation of foreclosed real estate, arise from differences between GAAP for banks and GAAP for savings and loan associations. Other differences arise in those areas in which bank reporting standards are intended to be more conservative than GAAP, such as in the areas of asset sales with recourse, futures contracts, excess servicing, and in-substance defeasance of debt. These areas of difference are discussed in more detail in our report to the Congress.
The Federal Reserve Board and the other banking agencies have held preliminary discussions with the OTS to study ways in which a more uniform reporting scheme can be developed for all banking and thrift institutions. The Federal Reserve Board is prepared to work constructively to resolve differences between the call report and the thrift financial report. Also, the Financial Accounting Standards Board (FASB) and the American Institute of CPAs have been asked by the FDIC to consider eliminating the differences in GAAP as applied to banks and thrift institutions. More uniform reporting by all institutions is a goal of the Federal Reserve Board.
Market Value Accounting
A major issue relating to accounting standards is the appropriateness of market value accounting. Under market value accounting, an institution's assets, liabilities, and off-balance-sheet items would be reported in financial statements at their market values. Alternatively, market values could be disclosed in supplemental schedules without affecting the balance sheet and income statement.
The problems in our financial system over the past several years have focused attention on the differences that often exist between accounting and economic measures of the financial condition and performance of banking and thrift institutions. Market value accounting has been proposed by some as a way to narrow these differences between accounting and economic measures. It is argued that the use of market value accounting might lead to more effective regulation and supervision of financial institutions and to the closure of problem institutions long before they would become insolvent on the basis of financial statements prepared under GAAP.
While market value accounting has theoretical appeal, several concerns have been expressed regarding this accounting model that should be considered. One major potential problem is that market values do not exist for a large portion of a financial institution's assets and liabilities and standards have not been developed for the estimation of reliable market values for these items. In addition, the overall cost and reporting burden associated with market value accounting could be considerable, including the cost of verifying market value quotations and estimates during audits and supervisory examinations. Furthermore, market value accounting could result in more volatility in the reported financial condition and earnings of financial institutions.
Clearly, information about the economic value of financial institutions is beneficial for supervisory purposes. However, the Federal Reserve believes that the preceding issues should be thoroughly studied before dramatic moves toward market value accounting are made. In particular, the Federal Reserve is concerned that, without the development of standards for the estimation of market values, financial statements prepared on a market value accounting basis would not be reliable or verifiable by audits and examinations. The federal banking agencies are reviewing the use of market values in connection with the federal deposit insurance study mandated by the FIRREA. At the same time, the FASB is studying the need for greater use of market values in GAAP as part of a project to develop new comprehensive standards for all financial instruments. These studies should provide additional information regarding the appropriateness of market value accounting for purposes of bank regulation and financial reporting.
It is also important to emphasize that much can be done to reduce the differences between accounting and economic measures of financial condition and performance without adopting market value accounting. This is accomplished when declines in economic value that result from credit problems are accurately reflected in loan-loss reserves and capital positions in a timely manner.
Chairman Greenspan addressed the need to accurately measure capital positions in his testimony before this committee on July 12, 1990, when he discussed his proposal for prompt corrective action. In this regard, a key part of this proposal is the conduct of on-site examinations--focusing on the quality of asset portfolios and off-balance-sheet commitments--at least annually, when it is not already in practice. This rigorous review helps ensure that the loan-loss reserves are consistent with the quality of the portfolio. When they are not, the examiner requires that additional reserves be created with an associated reduction in the earnings and equity capital of the bank. This process leads to a timely review of the adequacy of loan-loss reserves and an accurate measurement of capital positions. When the resultant capital position of the bank is not adequate and credible capital raising commitments are not met, the regulatory agency should promptly require such responses as lowered dividends, slower asset growth, divestiture of affiliates, and other corrective measures while an institution's capital position is still positive. Such a policy not only deters banks from riskier lending practices, it also minimizes the ultimate resolution costs.
While the adjustment of recorded asset values for inherent credit losses could be accomplished through market or economic value accounting, it can also be accomplished under existing GAAP. Timely, thorough on-site examinations focusing on asset quality, together with rigorous application of GAAP, result in loan-loss reserves that accurately reflect the estimated credit losses inherent in loan portfolios and in accurate reported capital positions. This process narrows differences between accounting and economic measures of depository institutions' financial condition and performance, while avoiding many of the potential problems associated with market value accounting. While not provided for in current GAAP, if further guidance were provided to determine an appropriate method for deriving the present value of asset and liability cash flows, even more accurate measures of market or economic value could be estimated.
The Importance of Capital Standards
For several years, the Federal Reserve and the other banking agencies have been working to strengthen bank capital positions. The Federal Reserve has long viewed adequate capital as essential to protecting the soundness of individual banks and our banking system as a whole. While some have set forth arguments about the competitive disadvantages of stronger capital requirements, we must not ignore the long-term benefits of strong capital positions. Well-capitalized banks are the ones best positioned to be successful in the establishment of long-term relationships, to be the most attractive counter-parties for a large number of financial transactions and guarantees, and to expand their business activities to meet new opportunities and changing circumstances. Indeed, many successful U.S. and foreign institutions would today meet substantially increased risk-based capital standards. In addition, although there has been uncertainty lately in the current market, the evidence of recent years suggests that U.S. banks have raised sizable amounts of equity. The dollar volume of new stock issues by banking organizations has grown at a greater rate since the late 1970s than the total dollar volume of new issues of all domestic corporate firms.
I would like to elaborate on some of the important benefits that would result from stronger capital requirements. First, a stronger capital position would strengthen the incentives of bank owners and managers to evaluate more prudently the risks and benefits of portfolio choices because a substantial amount of their money would be at risk. In effect, the moral hazard risk of deposit insurance would be reduced. Second, stronger capital levels would create a larger buffer between the mistakes of bank owners and managers and the need to draw on the deposit insurance fund. For too many institutions, that buffer has been too low in recent years. The key to creating incentives to behave as the market would dictate, and at the same time creating these buffers or shock absorbers, is to require that those who would profit from an institution's success have the appropriate amount of their own capital at risk. Third, requiring stronger capital positions would impose on bank managers an additional market test, in that they must convince investors that the expected returns justify the commitment of risk capital. Those banks unable to do so would not be able to receive the additional funds necessary for expansion. Fourth, strongly capitalized financial institutions are in a better position to take advantage of opportunities that may arise. Furthermore, it would not be necessary to apply as rigorous supervisory attention to such institutions. Thus, it is important that regulators make sure that financial institutions are operating not from a minimal capital base, but from a strong capital base.
The three federal bank regulatory agencies have a long-established history of cooperation in setting minimum capital standards. Throughout most of the 1980s, the banking agencies required banks to meet minimum ratios of capital-to-total assets or leverage ratios. In 1989, the federal banking agencies also adopted a risk-based capital standard. Furthermore, the Federal Reserve System has adopted new leverage guidelines that will supplement the risk-based capital framework. However, the primary supervisory emphasis has shifted to the risk-based capital requirement. Prudent banking organizations would continue to operate with a cushion above the minimum leverage and risk-based capital ratios.
The risk-based capital framework adopted by all three of the federal bank supervisory agencies, in 1989, is based upon the international Capital Accord developed by the Basle Committee on Banking Supervision and endorsed by the central bank governors of the G-10 countries. Under this framework, total capital comprises tier 1 (or equity capital) and tier 2 (or supplemental) capital instruments. The risk-based capital standards establish for all commercial banking organizations a minimum ratio of total capital to risk-weighted assets of 7.25 percent for year-end 1990. This minimum standard increases to 8.0 percent as of year-end 1992. Besides identical ratios, the risk-based framework includes a common definition of regulatory capital as well as a uniform system of risk weights and categories.
The principal objectives of risk-based capital are to make regulatory capital requirements more sensitive to differences in risk profiles of banks, to factor off-balance-sheet exposures more explicitly into the assessment of capital adequacy, and minimize disincentives to holding liquid, low-risk assets.
The banking agencies are also engaged in implementing new minimum leverage ratios that will be based upon a definition of capital consistent with the tier 1 capital definition that is used in the risk-based capital guidelines. The Federal Reserve has issued a new supplementary leverage standard that will require a minimum ratio of capital to assets of 3.0 percent for the safest institutions. These minimum risk-based and leverage ratio requirements will enable us to remove the current capital-to-assets standards at year-end 1990. Similar leverage guidelines are being developed by the OCC and the FDIC, as explained in detail in the Federal Reserve's report to the Congress on capital and accounting standards used by the regulatory agencies.
The objective of the new leverage ratio is to ensure that banking organizations that hold substantial amounts of low credit risk assets must still maintain a minimum amount of capital. A financial institution operating at or near the established minimum level must have well-diversified risk, including no undue interest rate risk exposure, excellent asset quality, high liquidity, good earnings, and, in general, be considered a strong banking organization. Institutions without these characteristics, including institutions with supervisory, financial, or operational weaknesses, are expected to operate well above the minimum standard. Also, insitutions experiencing or anticipating significant growth are expected to maintain above average capital ratios.
It should be stressed that the banking agencies have generally viewed their capital ratios as minimums. Furthermore, most banking organizations would wish to operate well above these levels. Over the years, the Federal Reserve has encouraged banks to continue to strengthen their capital positions. We have done this primarily through the bank examination process, and by requiring strong capital positions of those institutions undertaking expansion.
Differences in Capital Standards
As you are aware, we have submitted a report to this committee detailing the capital and accounting standards used by the federal banking and thrift agencies. The differences in the capital standards of the banking agencies and the OTS are discussed in detail in our report. A summary of the primary areas of difference is presented in the appendix. The staffs of the banking agencies and the OTS meet regularly to identify and address differences in their capital standards and work toward consistency.
Assessment of Capital Adequacy
While current capital standards generally provide a cushion against losses from operations or a weak loan portfolio, they do not address all risks of an institution. For example, the bank risk-based capital guidelines, at present, do not yet address noncredit factors, such as interest rate risk and foreign exchange positions.
Interest rate risk is defined as the sensitivity of an institution's earnings and capital to changes in interest rates. This sensitivity may result from differences in the maturity or repricing of an institution's assets, liabilities, and off-balance-sheet instruments. This type of mismatch occurs, for example, when an institution funds a long-term, fixed-rate loan with a short-term or variable-rate deposit. When significant interest rate exposure exists, a relatively small adverse change in interest rates may result in a substantial reduction in an institution's earnings and capital.
Interest rate risk has been evaluated in connection with the overall determination of an organization's capital adequacy and financial condition during on-site examinations. Since a conclusive assessment of capital adequacy can be made only after consideration of all the quantitative factors that determine the need for capital, we think it is clear that the time has now come to place greater emphasis on the quantitative measurement of interest rate risk and to more explicitly factor interest rate risk into the assessment of capital adequacy.
To this end, the Federal Reserve is working with the other U.S. banking agencies and regulatory authorities on the Basle Supervisors' Committee to develop methods to measure and address interest rate and other noncredit risks. These methods are necessary to enhance the basic risk-based capital framework.
In considering how best to factor interest rate risk into capital adequacy calculations, we are guided by the following principles:
1. The system should provide incentives to reduce risk or a means to ensure that those risks that are assumed are backed by sufficient capital to fully protect the deposit insurance system and investors.
2. The system should assess the impact on the firm of interest rate volatility and hedging activities, including proper risk weighting of hedging instruments.
3. The system should be straightforward so that it can be widely understood and utilized by bank directors and management.
4. The system or the data required to implement it should not place excessive burdens or costs upon the institution.
5. The system should strengthen U.S. banking organizations so as to enhance their international competitiveness.
Although domestic and international work has been under way for some time, we have not yet achieved a consensus on how to measure interest rate risk or assess an appropriate capital requirement. However, it is necessary to find a measure that produces an acceptable interest rate risk measurement tool.
While the Board has not officially approved a particular approach to interest rate risk measurement, there are a number of possible approaches that the Board is likely to consider. One alternative might be to require that all institutions, regardless of size, provide detailed information on the maturity and repricing of their assets, liabilities, and off-balance-sheet exposures. This information would then be used to calculate an institution's interest rate exposure and the corresponding capital requirement. One drawback, however, is that this approach could impose substantial reporting burdens on institutions with minimal interest rate risk.
Another alternative that the supervisory agencies might explore to deal with interest rate risk involves a two-phased approach. Under this approach, institutions would be screened by the use of a rather rough measure of interest rate risk, derived from minimally enhanced data that is, for the most part, already available in the call report. For institutions that undertake interest rate risks outside of established parameters, more detailed reporting would be required and could be the basis for a more precise calculation of an additional capital requirement.
We would certainly work to ensure that any approach that is finally adopted would be compatible with the rate risk measurement mechanism that might be developed internationally under the auspices of the Basle Supervisor's Committee. The approach that is finally adopted should be designed to afford regulators considerable comfort that institutions with undue interest rate risk have been appropriately identified, that a reasonable amount of additional capital for that added risk is being held, and that additional supervisory action could be taken as warranted. In addition, institutions that undertake interest risk outside of the established parameters would be expected to have the management expertise, together with strong reporting and control systems that would enable them to undertake such risks on a knowledgeable basis. Moreover, the interest rate data that banks provide would be verified regularly through the examination process.
One area that must also be addressed involves the accounting treatment for off-balance-sheet instruments. To better factor these instruments into the assessment of interest rate risk, more work will have to be done by the FASB to improve the accounting standards for these diverse instruments and to provide more specific criteria for hedge accounting.
In summary, the Federal Reserve believes that both accounting and capital standards play an important role in the supervisory process. Besides providing important information to market participants, accurate and timely financial reports enhance the supervisor's ability to monitor an institution's financial condition and to take prompt corrective action.
Stronger capital positions and prompt corrective action by supervisors will help reduce excessive risktaking by insured institutions. The requirement for depository institutions to maintain strong capital positions sufficient to cover on-and off-balance-sheet risks will promote the safety and stability of our banking system and protect the interest of the U.S. taxpayers. The Federal Reserve will continue to work with the other supervisory agencies to develop uniform capital and accounting standards that achieve these important objectives.
Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, September 13, 1990. I am pleased to appear before this committee to discuss deposit insurance reform. Your letter of invitation contained a list of important issues and questions that I will try to address. Our recent experience with thrift institutions underlines the pressing need for deposit insurance reform. Indeed, the Congress recognized that last year's landmark Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) was only a first step when it mandated a Treasury study of deposit insurance issues. This study, in which the Federal Reserve is an active participant, will be published late this year or early next. By holding hearings considerably before that research is complete, I hope that the Congress will be able to focus on the needed legislation immediately after the release of the Treasury study.
Your letter of invitation suggested that the topic of these hearings would be solely deposit insurance reform. While this subject is complex, the Board believes that the issue is intimately related to the need for legislation to also modernize our banking system in other ways. The Congress and the Board repeatedly are reminded of the erosion of the competitiveness of our banking system both domestically and internationally. The Board believes that addressing this problem should be joined with deposit insurance reform, and my statement will intertwine both topics.
The fundamental problems with our current deposit insurance program are clearly understood and are, I believe, subject to little debate among those with drastically different prescriptions for reform. The safety net--deposit insurance, as well as the discount window--has so lowered the risks perceived by depositors as to make them relatively indifferent to the soundness of the depository recipients of their funds, except in unusual circumstances. With depositors exercising insufficient discipline through the risk premium they demand on the interest rate they receive on their deposits, the incentive of some banks' owners to control risktaking has been dulled. Profits associated with risktaking accrue to owners, while losses in excess of bank capital that would otherwise fall on depositors are absorbed by the Federal Deposit Insurance Corporation (FDIC).
Weak depositor discipline and this moral hazard of deposit insurance have two important implications. First, the implicit deposit insurance subsidy has encouraged banks to enhance their profitability by increasing their reliance on deposits rather than capital to fund their assets. In effect, the deposit insurance funds have been increasingly substituted for private capital as the cushion between the asset portfolios of insured institutions and their liabilities to depositors. A hundred years ago, the average equity capital to assets ratio of U.S. banks was almost 25 percent, approximately four times the current level. Much of the decline over the past century no doubt reflects the growing efficiency of our financial system. But it is difficult to believe that many of the banks operating over recent decades would have been able to expand their assets so much, with so little additional investment by their owners, were it not for the depositors' perception that, despite the relatively small capital buffer, their risks were minimal. Regulatory efforts over the past ten to fifteen years have stabilized and partially reversed the sharp decline in ratios of bank equity capital to assets. This reversal has occurred despite the sizable write-off of loans and the substantial buildup in loan-loss reserves in the past three years or so. But the capital ratios of many banks are still too low.
Second, government assurances of the liquidity and availability of deposits have enabled some banks with declining capital ratios to fund riskier asset portfolios at a lower cost and on a much larger scale, with governmental regulations and supervision, rather than market processes, as the major constraint on risktaking. As a result, more resources have been allocated to finance risky projects than would have been dictated by economic efficiency.
In brief, the subsidy implicit in our current deposit insurance system has stimulated the growth of banks and thrift institutions. In the process the safety net has distorted market signals to depositors and bankers about the economics of the underlying transactions. This distortion has led depositors to be less cautious in choosing among institutions and has induced some owners and their managers to take excessive risk. In turn, the expanded lending to risky ventures has required increased effort and resources by supervisors and regulators to monitor and modify behavior.
But, in reviewing the list of deficiencies of the deposit insurance system, we should not lose sight of the contribution that both deposit insurance and the discount window have made to macroeconomic stability. The existence and use of the safety net have shielded the broader financial system and the real economy from instabilities in banking markets. More specifically, it has protected the economy from the risk of deposit runs, especially the risk of such runs spreading from bank to bank, disrupting credit and payment flows and the level of trade and commerce. Confidence in the stability of the banking and payments system has been the major reason why the United States has not suffered a financial panic or systemic bank run in the last half century.
There are thus important reasons to take care as we modify our deposit insurance system. Reform is required. So is caution. The ideal is an institutional framework that, to the extent possible, induces banks both to hold more capital and to be managed as if there were no safety net, while at the same time shielding unsophisticated depositors and minimizing disruptions to credit and payment flows.
If we were starting from scratch, the Board believes it would be difficult to make the case that deposit insurance coverage should be as high as its current $100,000 level. However, whatever the merits of the 1980 increase in the deposit insurance level from $40,000 to $100,000, it is clear that the higher level of depositor protection has been in place long enough to be fully capitalized in the market value of depository institutions and incorporated into the financial decisions of millions of households. The associated scale and cost of funding have been incorporated into a wide variety of bank and thrift decisions, including portfolio choices, staffing, branch structure, and marketing strategy. Consequently, a return to lower deposit insurance coverage--like any tightening of the safety net--would reduce insured depository market values and involve significant transition costs. It is one thing initially to offer and then to maintain a smaller degree of insurance coverage, and quite another to reimpose on the existing system a lower level of insurance, with its associated readjustment and unwinding costs. This is why the granting of subsidies by the Congress should be considered so carefully: They not only distort the allocation of resources but also are extremely difficult to eliminate, imposing substantial transition costs on the direct and indirect beneficiaries. For such reasons, the Board has concluded that, should the Congress decide to lower deposit insurance limits, a meaningful transition period would be needed.
Another relevant factor that should be considered in evaluating the $100,000 insurance limit is the distribution of deposit holders by size of account. Unfortunately, data to analyze this issue by individual account holder do not exist. However, we have been able to use data collected on an individual household basis in our 1983 Survey of Consumer Finances to estimate the distribution of account holders. While these data are seven years old, they are the best available until results from our 1989 Survey of Consumer Finances become available this fall. I have attached as an appendix to this statement summary tables and descriptive text of the 1983 survey results.(1) Briefly, the survey suggests that between 1.0 and 1.5 percent of U.S. households held, in 1983, deposit balances in excess of $100,000. The demographic characteristics of these account holders suggest that they are mainly older, retired citizens with most of their financial assets in insured accounts. These characteristics of heads of households owning deposits are remarkably stable as the size of deposits declines to $50,000.
A decision by the Congress to leave the $100,000 limit unchanged, however, should not preclude other reforms that would reduce current inequities in, and abuses of, the deposit insurance system, often thwarting its purpose. Serious study should be devoted to the cost and effectiveness of policing the $100,000 limit so that multiple accounts are not used to obtain more protection for individual depositors than the Congress intends. We at the Federal Reserve believe that it is administratively feasible--but not costless--to establish controls on the number and dollar value of insured accounts per individual at one depository institution, at all institutions in the same holding company, and perhaps even across depositories of different ownership. But we are concerned about the cost and administrative complexity of such schemes and would urge the careful weighing of benefits and costs before adopting any specific plan.
The same study could consider the desirability of limiting pass-through deposit insurance--under which up to $100,000 of insurance protection is now explicitly extended to each of the multiple beneficiaries of some large otherwise uninsured deposits. Brokered accounts of less than $100,000 also have been used to abuse deposit insurance protection, particularly by undercapitalized institutions. However, we must be careful to remember that the use of brokered deposits by healthy firms can be the economy's most efficient way of allocating funds to their most productive use. The study should keep in mind these considerations, as well as the power that the Congress has already provided the agencies to constrain misuse of brokered accounts.
No matter what the Congress decides on deposit insurance limits, we must be cautious of our treatment of uninsured depositors. Such depositors should be expected to assess the quality of their bank deposits just as they are expected to evaluate any other financial asset they purchase. Earlier I noted that our goal should be for banks to operate as much as possible as if there were no safety net. In fact, runs of uninsured deposits from banks under stress have become commonplace.
So far, the pressure transmitted from such episodes to other banks whose strength may be in doubt has been minimal. Nevertheless, the clear response pattern of uninsured depositors to protect themselves by withdrawing their deposits from a bank under pressure raises the very real risk that in a stressful environment the flight to quality could precipitate wider financial market and payments distortions. These systemic effects could easily feed back to the real economy, no matter how open the discount window and how expansive open market operations. Thus, while deposits in excess of insurance limits should not be protected by the safety net at any bank, reforms designed to rely mainly on increased market discipline by uninsured depositors raise serious stability concerns.
An example of one such approach is depositor coinsurance or a deductible under which a depositor at a failed institution receives most, but not all, of his or her deposit in excess of a reduced (or the current) insurance limit. This option has some attractions, coupling depositor market discipline with relatively modest possible losses to depositors. The Board believes, however, that an explicit policy that requires imposition of uninsured depositor loss--no matter how small--is likely to increase the risk of depositor runs and to exacerbate the depositor response to rumors.
Another option to rely more on private-market incentives is the use of private deposit insurance as a supplement or replacement for FDIC insurance. This use would require, of course, that all relevant supervisory information--much of which is now held confidential--be shared with private insurers who would be obligated to use that information only to evaluate the risk of depositor insurance and not for the purposes of adjusting any of their own portfolio options. In addition, it is clearly unreasonable to impose on private insurers any responsibilities for macro-stability in their commercial underwriting of deposit insurance. Private insurers' withdrawal of coverage in a weakening economy or their unwillingness to forebear in such circumstances would be understandable but counterproductive. The inability of private insurers to meet their obligations after an underwriting error would be disruptive at best and involve taxpayer responsibility at worst. Private insurance and public responsibility unfortunately are not always compatible. We have similar concerns with mutual assurance among groups of banks who would seek to evaluate each other's risk exposure and to discipline overly risky entities by expulsion from their mutual guarantee syndicate. In addition, a system of mutual guarantees by banks could raise serious anticompetitive issues.
There has also been support for the increased use of subordinated debentures in the capital structure of banking organizations. Intriguing attractions of this option are the thoughts that nonrunnable, but serially maturing, debt would provide both enhanced market discipline and a periodic market evaluation of the bank. The Board continues to support the use of subordinated debt for these reasons, as well as the fact that it provides supplementary capital to act as an additional buffer to the FDIC over and above that provided by the owners' equity capital. But, in our view, subordinated debentures can only be supporting players and not be awarded the central role in reform. This is a limited source of capital and one that may prove difficult and expensive to obtain when advertised as having constrained returns whose holders are expected to absorb losses for the FDIC. Adding features to make it more attractive adds complications that perhaps are best met directly by additional pure equity and other reforms.
A promising approach that seeks to simulate market discipline with minimal stability implications is the application of risk-based deposit insurance premiums by the FDIC. The idea is to make the price of insurance a function of the bank's risk, reducing the subsidy to risktaking and spreading the cost of insurance more fairly across depository institutions. In principle, this approach has many attractive characteristics, and could be designed to augment risk-based capital. For example, banks with high risk-based capital ratios might be charged lower insurance premiums. But the range of premiums necessary to induce genuine behavioral changes in portfolio management might well be many multiples of the existing premium, thereby raising practical concerns about its application. Risk-based premiums also would have to be designed with some degree of complexity if they are to be fair and if unintended incentives are to be avoided. In any event, the potential additional benefits on top of an internationally negotiated risk-based capital system, while positive, require further evaluation.
Another approach that has induced increasing interest is the insured narrow bank. Such an institution would invest only in high quality, short-maturity, liquid investments, recovering its costs for checking accounts and wire transfers from user fees. The narrow bank would thus require drastic institutional changes, especially for thousands of our smaller banks and for virtually all households using checking accounts. Movement from the present structure for delivery of many bank services would be difficult and costly, placing U.S. banks at a disadvantage internationally. In addition, this approach might shift and possibly focus systemic risk on larger banks. Banking organizations would have to locate their business and household credit operations in nonbank affiliates funded by uninsured deposits and borrowings raised in money and capital markets. Only larger organizations could fund in this way, and these units, unless financed longer term than banks today, would, even with the likely higher capital ratio imposed on them by the market, be subject to the same risks of creditor runs that face uninsured banks, with all of the associated systemic implications. If this were the case, we might end up with the same set of challenges we face today, refocused on a different set of institutions. We at the Board believe that while the notion of a narrow bank to insulate the insurance fund is intriguing, in our judgment further study of these systemic and operational implications is required.
If, in fact, proposals that rely on uninsured depositor discipline, private insurance, subordinated debentures, risk-based premiums, and structural changes in the delivery of bank services raise significant difficulties, reform should then look to other ways to curb banks' risk appetites, and to limit the likelihood that the deposit insurance fund, and possibly the taxpayer, will be called on to protect depositors. The Board believes that the most promising approach is to reform both bank capital and supervisory policies. This would build upon the groundwork laid in the FIRREA, in which the Congress recognized as key components of a sound banking system the essentiality of strong capital plus effective supervisory controls. Both would be designed to reduce the value of the insurance subsidy. Neither would rule out either concurrent or subsequent additions to deposit insurance reform, such as the changes discussed previously, other proposals, or new approaches that may emerge in the years ahead. In fact, higher capital, by reducing the need for, and thereby the value of, deposit insurance would make subsequent reform easier. There would be less at stake for the participants in the system.
At the end of this year, the phase-in to the International Capital Standards under the Basle Accord will begin. This risk-based capital approach provides a framework for incorporating portfolio and off-balance-sheet risk into capital calculations. Most U.S. banks have already made the adjustment required for the fully phased-in standard that will be effective at the end of 1992. However, the prospect of an increasingly competitive environment suggests that the minimum level of capital called for by the 1992 requirements may not be adequate, especially for institutions that want to take on additional activities. As a result of the safety net, too many banking organizations, in our judgment, have traveled too far down the road of operating with modest capital levels. It may well be necessary to retrace our steps and begin purposefully to move to capital requirements that would, over time, be more consistent with what the market would require if the safety net were more modest. The argument for more capital is strengthened by the necessity to provide banking organizations with a wider range of service options in an increasingly competitive world. Indeed, projections of the competitive pressures only intensify the view that if our financial institutions are to be among the strongest in the world, let alone avoid an extension of the taxpayers' obligation to even more institutions, we must increase capital requirements. Our international agreements under the Basle Accord permit us to do so.
There are three objectives of a higher capital requirement. First, higher capital would strengthen the incentives of bank owners and managers to evaluate more prudently the risks and benefits of portfolio choices because more of their money would be at risk. In effect, the moral hazard risk of deposit insurance would be reduced. Second, higher capital levels would create a larger buffer between the mistakes of bank owners and managers and the need to draw on the deposit insurance fund. For too many institutions, that buffer has been too low in recent years. The key to creating incentives to behave as the market would dictate, and at the same time creating these buffers or shock absorbers, is to require that those who would profit from an institution's success have the appropriate amount of their own capital at risk. Third, requiring higher capital imposes on bank managers an additional market test. They must convince investors that the expected returns justify the commitment of risk capital. Those banks unable to do so would not be able to expand.
We are in the process in the Federal Reserve System of developing more specific capital proposals, including appropriate transition arrangements designed to minimize disruptions. However, at the outset I would like to anticipate several criticisms. For many banks, raising significant new capital will be neither easy nor cheap. Maintaining return on equity will be more difficult, and those foreign banks that only adhere to the Basle minimums may be put in a somewhat better competitive position relative to some U.S. banks. Higher capital requirements also will tend to accelerate the move toward bank consolidation and slow growth in bank assets. However, these concerns must be balanced against the increasing need for reform now, the difficulties with all the other options, and both the desire of, and necessity for, banking organizations to broaden their scope of activities to operate successfully.
More generally, many of the arguments about the competitive disadvantages of higher capital requirements are shortsighted. Well-capitalized banks are the ones best positioned to be successful in the establishment of long-term relationships, to be the most attractive counterparties for a large number of financial transactions and guarantees, and to expand their business activities to meet new opportunities and changing circumstances. Indeed, many successful U.S. and foreign institutions would today meet substantially increased risk-based capital standards. In addition, the evidence of recent years suggests that U.S. banks can raise sizable equity. The dollar volume of new stock issues by banking organizations has grown since the late 1970s at a greater rate than the total dollar volume of new issues by all domestic corporate firms.
Higher capital standards should go a long way toward inducing marketlike behavior by banks. However, the Board believes that, so long as a significant safety net exists, additional inducements will be needed through an intensification of supervisory efforts to deter banks from maintaining return on equity by acquiring riskier assets. When it is not already the practice, full in-bank supervisory reviews--focusing on asset portfolios and off-balance-sheet commitments--should occur at least annually, and the results of such examinations should promptly be shared with the board of directors of the bank and used to evaluate the adequacy of the bank's capital. The examiner should be convinced after a rigorous and deliberate review that the loan-loss reserves are consistent with the quality of the portfolio. If they are not, the examiner should insist that additional reserves be created with an associated reduction in the earnings or equity capital of the bank.
This method of adjusting and measuring capital by reliance on examiner loan evaluations does not depend on market value accounting to adjust the quality of the assets. Some day, perhaps, we may be able to apply generally accepted precepts of market value accounting to both the assets and liabilities of a financial going concern with a wide spectrum of financial assets and liabilities. But the Board is not comfortable with the process as it has developed so far, either regarding the ability of market value accounting to reflect market values accurately over reasonable periods or to avoid being overly sensitive to shortrun events. For most banks, loans are the predominant asset, an asset that the examiners should evaluate in each of the proposed annual in-bank supervisory reviews. We at the Federal Reserve believe that the examiners' classification of loan quality should, as I noted, be fully reflected in the banks' loan-loss reserves by a diversion of earnings or a reduction in capital. If the resultant capital is not consistent with minimum capital standards, the board of directors and the bank's regulators should begin the process of requiring the bank either to reduce those assets or to rebuild equity capital.
If credible capital raising commitments are not forthcoming, and if those commitments are not promptly met, the authorities should pursue such responses as lowered dividends, slower asset growth, or perhaps even asset contraction, restrictions on the use of insured brokered deposits, if any, and divestiture of affiliates with the resources used to recapitalize the bank. What is important is that the supervisory responses occur promptly and firmly and that they be anticipated by the bank. This progressive discipline or prompt corrective action of a bank with inadequate capital builds on our current bank supervisory procedures and is designed to simulate market pressures from risktaking--to link more closely excessive risktaking with its costs--without creating market disruptions. It is also intended to help preserve the franchise value of a going concern by acting early and quickly to restore a depository to financial health. In this way, the precipitous drop in value that normally occurs when a firm is placed in conservatorship or receivership would, for the large majority of cases, be avoided.
While some flexibility is certainly required in this approach, the Board believes that there must be a prescribed set of responses and a presumption that these responses will be applied unless the regulator determines that the circumstances do not warrant them. Even though prompt corrective action implies some limit on the discretion of supervisors to delay for reasons that they perceive to be in the public interest, the Board is of the opinion that it would be a mistake to eliminate completely the discretion of the regulator.
Accordingly, the Board believes that a system that combined a statutorily prescribed course of action with an allowance for regulatory flexibility would result in meaningful prompt resolution. For example, if a depository institution failed to meet minimum capital requirements established by its primary regulatory agency, the agency might be required by statute to take certain remedial action unless it determined on the basis of particular circumstances that such action was not required. The presumption would thus be shifted toward supervisory action, and delay would require an affirmative act by the regulatory agency.
The prescribed remedial action required in a given case would be dependent upon the adequacy of the institution's capital. As the capital fell below established levels, the supervisor could be required, for example, to order the institution to formulate a capital plan, limit its growth, limit or eliminate dividends, or divest certain nonbank affiliates. In the event of seriously depleted capital, the supervisor could require a merger, sale, conservatorship, or liquidation.
In adopting such a statutory framework, the Congress should consider designing the system so that forced mergers, divestitures, and, when necessary, conservatorships could be required while there is still positive equity capital in the depository institution. While existing stockholders should be given a reasonable period of time to correct deteriorating capital positions, the Congress should specifically provide the bank regulators with the clear authority, and therefore explicit support, to act well before technical insolvency to minimize the ultimate resolution costs. The presence of positive equity capital, even if at low levels, when combined with any tier 2 capital, would limit reorganization and liquidation costs.
In the Board's view, most of the remedial actions discussed above can be taken, and have been taken, by bank regulators under the current legal framework. Under current law, however, the actions to be taken are discretionary and dependent upon a showing of unsafe or unsound conditions or a violation of law, and implementation of a supervisory remedial action can be extended over a protracted period of time when the depository institution contests the regulator's determination. In cases in which an institution's capital is deteriorating, the progressive discipline framework described above would establish a systematic program of progressive action based on the capital of the institution, instead of requiring the regulator to determine on a case-by-case basis, as a precondition to remedial action, that an unsafe or unsound practice exists. This program would introduce a greater level of consistency of treatment into the supervisory process, place investors and managers on notice regarding the expected supervisory response to falling capital levels, and reduce the likelihood of protracted administrative actions challenging the regulator's actions.
The Board is in the process of developing the parameters, processes, and procedures for prompt corrective action. One of the principles guiding our efforts is the need to balance rules with discretion. In addition, as is the case for higher capital standards, the Board is mindful of the need for an appropriate transition period before fully implementing such a change in supervisory policy.
Higher capital and prompt corrective action would increase the cost and reduce the availability of credit from insured institutions to riskier borrowers. In effect, our proposal would reduce the incentive that some banks currently have to overinvest in risky credits at loan rates that do not fully reflect the risks involved. This implies that the organizers of speculative and riskier ventures will have to restructure their borrowing plans, including possibly paying more for their credit, or seek financing from noninsured entities. Some borrowers may find their proposals no longer viable. However, it is just such financing by some insured institutions that has caused so many of the current difficulties, and it is one of the objectives of our proposals to cause depositories to reconsider the economics of such credits. As insured institutions reevaluate the risk-return tradeoff, they are likely to be more interested in credit extensions to less risky borrowers, increasing the economic efficiency of our resource allocation.
Despite their tendency to raise the average level of bank asset quality, higher capital requirements and prompt corrective action will not eliminate bank failures. An insurance fund will still be needed, but we believe that, with a fund of reasonable size, the risk to taxpayers should be reduced substantially. As I have noted, higher capital requirements and prompt corrective action imply greater caution in bank asset choices and a higher cushion for the FDIC to absorb bank losses. In addition, an enhanced supervisory approach will not permit deteriorating positions to accumulate.
But until these procedures have been adopted and the banking system has adjusted to them, circumstances could put the existing insurance fund under severe pressure. As Chairman Seidman has indicated, the fund is already operating under stress, as its reserves have declined in recent years and now stand, as a percentage of insured deposits, at their lowest level in history. At the same time, there remain all too many problems in the banking system, problems that have been growing of late as many banks, including many larger banks, have been experiencing a deterioration in the quality of their loan portfolios, particularly real estate loans. It thus seems clear that the insurance fund likely will remain under stress for some time to come. Moreover, pressures would intensify if real estate market conditions were to weaken further or a recession were to develop in the general economy.
It should, however, be clearly underlined that the size or adequacy of the insurance fund does not change the quality of the deposit insurance guarantee made by the federal government; it does allocate the cost of meeting any guarantee between the banking industry that pays the insurance premiums and the taxpayers as a whole. It should, in our view, be the policy of the government to minimize the risk to taxpayers of the deposit insurance guarantee, and we believe that our proposal does that. While some increase in insurance premiums is in all likelihood necessary, we must be concerned that attempts to accomplish this end by substantially higher insurance premiums may well end up--especially if accompanied by higher capital requirements--simply making deposits so unattractive that banks are unable to compete. Avoiding taxpayer costs and maintaining a competitive banking system are just two more reasons why basic deposit insurance reform is so urgent.
Among the deposit insurance reforms that might be considered on the basis of both strengthening the insurance fund and fairness to smaller and regional banks is the assessment of insurance premiums on the foreign branch deposits of U.S. banks. A substantial proportion of the deposits of the largest U.S. banks are booked at branches outside the United States, including offshore centers in the Caribbean. Assessing such deposits could yield significant revenue for the FDIC.
However, assessing deposit insurance premiums on foreign deposits would involve some costs. Such deposits may be quite sensitive to a small decline in their yields. Thus imposing premiums could lead to deposit withdrawals and funding problems at some U.S. banking organizations and possibly inhibit the ability of these organizations to raise capital.
Even if no adjustment is made in the insurance assessment on foreign deposits, held almost solely by large banks, other deposit insurance reforms should be equally applicable to banks of all sizes. No observer is comfortable with the inequities and adverse incentives of an explicit or implicit program that penalizes depositors, creditors, and owners of smaller banks more than those of larger ones. The Board believes that no bank should assume that its scale insulates it from market discipline, nor should any depositor with deposits in excess of the insurance limit at the largest of U.S. banks assume that he or she faces no loss should their bank fail.
Nevertheless, it is clear that there may be some banks, at some particular times, whose collapse and liquidation would be excessively disruptive to the financial system. But it is only under the very special conditions, which should be relatively rare, of significant and unavoidable risk to the financial system that our policies for resolving failed or failing institutions should be relaxed. The benefits from the avoidance of a contagious loss of confidence in the financial system accrue to us all. But included in the cost of such action is the loss of market discipline that would result if large banks and their customers presume a kind of exemption from loss of their funds. The Board's policies of prompt corrective action and higher capital are designed to minimize these costs. Under these policies, the presumption should always be that prompt and predictable supervisory action will be taken. For no banks is ever too large or too small to escape the application of the same prompt corrective action standards applied to other banks. Any bank can be required to rebuild its capital to adequate levels and, if it does not, be required to contract its assets, divest affiliates, cut its dividends, change its management, sell or close offices, and the resultant smaller entity can be merged or sold to another institution with the resources to recapitalize it. If this is not possible, the entity can be placed in conservatorship until it is.
It is, by the way, the largest U.S. banks that would be required under our proposals to raise that most additional capital, both absolutely and proportionally. Most banks with assets of less than $1 billion already meet capital requirements considerably above the fully phased-in Basle Capital Accord minimums. In addition, it bears emphasizing that no deposit insurance reform that truly reduces the subsidy existing in the current system will be costless for banks. The issue really is one of achieving maximum benefit from reform at minimum cost. We believe that our proposals achieve this goal.
It is worth noting that in many foreign countries large banks are considered so important to their economy that it is widely anticipated that authorities in these countries would support these banks during financial crises. In some countries, notably France and Italy, some large banks are owned by the government, another factor that arguably leads market participants to doubt that these banks could fail. Thus the commitment of foreign authorities presumably extends beyond the rather limited levels explicitly incorporated into their deposit insurance systems and may potentially create the same types of problems that the United States faces with institutions deemed "too big to fail."
Virtually all of the major industrial countries have instituted a system of explicit deposit insurance. The character of these systems, however, varies widely, and most of them are more modest in scope than the U.S. system. In many cases, especially in Europe, deposit insurance is not a funded system, but rather an agreement among banks intended to make money available to protect the small depositors at failed banks. Except in Germany and Italy, the ceiling on insured deposits is substantially lower than in the United States. Membership in the insurance system is also voluntary in several countries. Though most banks in these countries join the system, deposit insurance is not viewed as the primary means of support for large banks. As Europe 1992 is implemented, and full cross-border banking becomes a European reality, it is quite likely that the European Community will find itself under pressure to make its deposit insurance system more explicit and more uniform.
I noted earlier that one response of some U.S. banks to the more intense competitive environment has been to draw down their capital buffer. These and other institutions cannot rebuild, strengthen, and maintain the appropriate level of capital unless they are able to adapt to the changing competitive and technological environment. The ability to adapt is crucially dependent on broadening the permissible range of activities for banking organizations. At the same time, we should be sensitive to the implications of the potential extension of the safety net--directly or indirectly--under those markets that banking organizations are authorized to enter.
The Board has for some time held the view that strong insulating fire walls would both protect banks (and taxpayers) from the risk of new activities and limit the extension of the safety net subsidy that would place independent competitors at a disadvantage. However, recent events, including the rapid spread of market pressures to separately regulated and well-capitalized units of Drexel when their holding company was unable to meet its maturing commercial paper obligations, have raised serious questions about the ability of fire walls to insulate one unit of either a holding company or a bank from funding problems of an affiliate or subsidiary. Partially as a result, the Board is in the process of reevaluating both the efficacy and desirability of substantial fire walls between a bank and some of its affiliates or subsidiaries. It is clear that high and thick fire walls reduce synergies and raise costs for financial institutions, a significant problem in increasingly competitive financial markets. If they raise costs and may not be effective, we must question why we are imposing these kinds of fire walls at all. Moreover, higher capital standards and prompt corrective action at the bank go a long way to limit the transference of the bank safety net subsidies to bank affiliates or subsudiaries that fire walls are designed to constrain. And, as such, they should greatly limit the risk of distorted market signals and excessive risktaking over an expanded range of markets, as well as the unfair competition, that might otherwise accompany wider activities by banking organizations.
It may be more realistic to apply more limited fire walls to the new activities. I have in mind here restrictions such as sections 23A and 23B of the Federal Reserve Act, which already limit the financial transactions between a bank and its affiliates, requiring collateral, arms-length transactions, and--except when Treasury securities are used as collateral--quantitative limits based on the bank's capital. Such limitations could also be applied to transactions between a bank and certain bank subsidiaries.
Even with these, or tighter fire walls, the potential for problems in one unit of a firm to affect other units raises the question of the implications of a piecemeal regulatory structure, with no means for ensuring that the activities of the organization as a whole do not impose undue risk on the insured entity and hence either the financial system or the safety net. We believe that, to protect the insured entity, the financial system, and the safety net, some agency should be responsible for oversight of the entire organization.
Authorization to use their expertise over a wider range of markets might well be limited only to those organizations in which the bank or the holding company meets a new higher capital standard. Consequently, the Congress might wish to authorize bank supervisors to grant certain of these activities only to those entities that exceed such a standard. Those institutions that consistently exceed the capital standard perhaps could receive more flexibility in supervisory treatment. For example, a notice requirement could be substituted for formal applications for activities permitted by law and regulation, provided that such acquisition leave the bank or other appropriate entity's capital in excess of the higher standards. Other reductions in regulatory burden for highly capitalized banks or banking organizations might also be appropriate. Such organizations would, however, still be subject to the same thorough annual examinations.
As you know, the Board has long supported repeal of the provisions of the Glass-Steagall Act that separate commercial and investment banking. We still strongly advocate such repeal because we believe that technology and globalization have continued to blur the distinctions among credit markets and have eroded the franchise value of the classic bank intermediation process. Outdated constraints will only endanger the profitability of banking organizations and their contribution to the American economy. Beyond investment banking, the Board believes that highly capitalized banking firms should be authorized to engage in a wider range of financial activities as a part of the modernization of our financial structure and the maintenance of strong, profitable financial institutions that can compete in world markets. A banking system that cannot adapt to the changing competitive and technological environment will no longer be able to attract and maintain the higher capital level that some of our institutions need to operate without excessive reliance on the safety net.
Firms primarily engaged in the financial activities authorized to banking organizations should likewise be permitted to operate an insured bank. The Congress, of course, will have to give careful consideration to how to handle the activities some of these entities are already engaged in that would not be permitted to banking organizations. More generally, as we expand the range of activities available to banks and their subsidiaries or affiliates, competitive equity suggests the desirability of functional regulation. Under such an approach, each area of activity should be subject to the same regulatory constraints as equivalent or very similar functions at nonbank firms.
As the Congress considers modernization of our banking structure to meet the needs of the twenty-first century, it should not only widen the permissible activities of well-capitalized banking organizations but also eliminate outdated statutes that only increase costs. The McFadden Act forces state member banks and national banks to deliver interstate services only through separately capitalized bank holding company subsidiaries (where permitted by state law) rather than through branches. Such a system reduces the ability of many smaller banks to diversify geographically and raises costs for all banking organizations that operate in more than one state, a curious requirement as we search for ways to make banks more competitive and profitable. The McFadden Act ought to be amended to permit interstate branching by banks.
In summary, events have made it clear that we ought not to permit banks, because of their access to the safety net, to take excessive risk with inadequate capital. Even if we were to ignore the potential taxpayer costs, we ought not to permit a system that is so inconsistent with efficient market behavior. In the process of reform, however, we should be certain we consider carefully the implications for macroeconomic stability. The Board believes that higher capital and prompt corrective action by supervisors to resolve problems will go a long way to eliminate excessive risktaking by insured institutions and would not preclude additional deposit insurance reform, now or later. Moreover, we believe that with such an approach the Congress should feel comfortable with authorizing banking organizations to expand the scope of their financial activities. Indeed, we believe that permitting wider activities is necessary to ensure that such organizations can remain competitive both here and abroad. Increased activities are also required to sustain the profitability needed if banking firms are to attract capital. To limit the risk of safety net transference, some new activities might be made available by banking regulators only to banks with impressive capital positions. We believe that whatever the regulatory form and structure under which new activities are permitted, one agency should have oversight responsibility sufficient to protect the bank from excessive risks taken in other parts of its broader organization. It is also our view that, with these suggested reforms, reliance on stringent fire walls would not be necessary. And the McFadden Act should be amended to permit banks to deliver their services at the lowest possible costs and to more easily diversify their geographic risks. The Board has shared its views with the Treasury as part of our continuing consultations on these matters, especially in the context of their FIRREA-mandated study.
Finally, in considering all proposals, we should remind ourselves that our objective is a strong and stable financial system that can deliver the best services at the lowest cost and compete around the world without taxpayer support. This objective requires the modernization of our financial system and the weaning of some institutions from the unintended benefits that accompany the safety net. Higher capital requirements may well mean a relatively leaner and more efficient banking system, and they will certainly mean one with reduced inclinations toward risk. However, the Board believes that our proposed reforms--including the authorization of wider activities by banking organizations--will go a long way toward ensuring a safer and more efficient financial system and lay the groundwork for other modifications in the safety net in the years ahead.
Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Joint Economic Committee, U.S. Congress, September 19, 1990. It is a pleasure to be here today to discuss the state of the economy and the appropriate course for policy in the current situation.
When I presented the Federal Reserve's semi-annual report on monetary policy to the Congress in July, I noted that the pace of economic activity had slowed considerably this year. Real gross national product rose at only a 1 1/2 percent annual rate, on average, in the first half, and the available indicators suggest that real growth remained slow during the summer. Private employment has been flat over the past two months, and the unemployment rate, which had fluctuated narrowly for several quarters, has edged up since midyear.
Despite the general sluggishness in business activity this year, the underlying trend in inflation has not improved. In fact, the core rate of inflation in consumer prices may have crept higher. Moreover, the chance of a significant break soon in the inflation trend would seem to have diminished in view of the additional pressures from oil prices.
In my July testimony, I noted that the Board members and Reserve Bank presidents expected the economy to expand at a moderate pace over the ensuing year and a half, while prices were anticipated to rise less rapidly than they had earlier this year. Most private forecasters shared that assessment. Regrettably, events in the Middle East have introduced new and substantial risks to the outlook. The higher oil prices already have added to overall price pressures and may have begun to restrain real activity. Besides the effects of the higher oil prices per se, just the enormous uncertainty about how and when the tensions in the Persian Gulf will be resolved undoubtedly is affecting the economy in a negative way.
If we knew how oil prices were going to move in coming months, it would be feasible--at least in principle--to trace out the effects of the 1990 "oil shock" on the U.S. economy. Economic theory supplies an analytical framework, and empirical analyses of past experience provide rough indications of the likely direction and size of the impacts.
Admittedly, even the most sophisticated econometric models are simplified, almost crude, representations of economic reality. They vary in their readings of history and cannot capture completely the scope and complexity of the economy's interrelationships or changes in its structure over time. Moreover, they cannot take into account the political and military unknowns in the current situation. Nonetheless, such models can be employed to identify the directions, and rough orders of magnitude, of the average effects of changes in oil prices. This is certainly a useful first step in policy analysis.
Suppose, for example, that crude oil prices were to average something under $30 per barrel over the next year--roughly in line with what is suggested by current transactions in the spot and futures markets. This would be approximately $10 per barrel above their July level. Representative models suggest that such a $10 per barrel increase in the price of oil would add 1 1/2 to 2 percent to the level of overall consumer prices over the next year. Much of the increase in the overall price level reflects the pass-through of higher costs of crude oil into prices of domestically consumed petroleum products. These direct effects typically appear relatively quickly; indeed, such effects already were evident in yesterday's report on the consumer price index for August and undoubtedly will remain sizable in the September figures as well. Other, less direct, effects will build over time. Prices for competing energy products will be bid up, and those of goods and services that use energy as an input will rise more rapidly than they otherwise would have. A sustained higher oil price also would tend to feed through--with some lag--to wages, as workers seek to offset losses in their real income.
The effects on economic activity work through several channels and are more difficult to sort out. The range of empirical estimates is doubtless wider than for prices, but a representative figure is that a sustained increase of $10 per barrel of oil would reduce the level of real GNP roughly 1 percent within a year. Much of this loss in output arises because--to the extent that the United States is a net importer of oil--a hike in oil prices drains away purchasing power from American energy users to foreign oil producers. Indeed, with imports of petroleum and products currently averaging about 8 1/2 million barrels per day, a $10 per barrel rise in the oil price adds roughly $30 billion to our annual import bill.
Specifically, the higher consumer prices that result from the oil shock cut into the real disposable income of households, which in turn can be expected to reduce their spending. The weaker path for consumption subsequently can be presumed to spill over to business investment as many firms--their profit margins already squeezed by higher energy costs--lower capital spending in response to the reduced demand for their output.
Over time, the oil-producing countries may increase their purchases of U.S.-produced goods and services. In the current situation, the recent fall in the dollar may also provide some stimulus to our exports and restrain our imports. But, in total, the increment to U.S. GNP from higher net exports probably will be smaller than the drop in domestic demand--particularly in the short run. In addition, the weaker dollar adds upward pressure to U.S. import prices and hence raises further concern about inflation and instability.
Domestic energy producers, like their foreign counterparts, benefit from higher oil prices. At least to some extent, they likely will increase spending on exploration and drilling, or other types of investment. Nonetheless, this offset, too, probably will be relatively small in the near term, as producers--not knowing whether the higher oil price will be sustained--are likely to be reluctant to undertake major projects.
Turning from the abstract to the current reality, hard data on the output of goods and services in the period since the invasion of Kuwait are limited, and it is difficult to distinguish the effects of higher oil prices from developments that would have occured anyway. Clearly, growth is, at best, sluggish. Nonetheless, judging from both hard data and more anecdotal reports, we are not--at least as yet--witnessing a cumulative unwinding of economic activity.
Outlays on new cars and light trucks should be sensitive to the uncertainty shock that the Persian Gulf crisis has imparted, yet they have softened only moderately from the pace of earlier in the summer. In addition, the advance estimates for August suggest that retail sales of other items were about the same in real terms as in the proceeding few months. Nonetheless, prospects for consumer demand are highly uncertain, especially in light of the sharp deterioration in consumer sentiment recorded in a variety of surveys since the Middle East crisis began. For example, the indexes compiled by the Survey Research Center at the University of Michigan and by the Conference Board both plummeted in August to their lowest levels since 1983.
As yet, there is no statistical evidence on how prospects for business investment may have changed as a consequence of the oil shock. But the available anecdotal information clearly has taken on a more pessimistic tone over the past several weeks. Notably, the latest information provided to the Federal Reserve Banks by business and other contacts suggests a greater caution on the part of firms in the acquisition of capital goods, in some cases because of increased uncertainty. The reports from the District Banks are summarized in the so-called Beige Book, which will be released later today.
It would be surprising if the recent developments did not give rise to some pullback by consumers and businesses. But the paucity of hard data makes it difficult to assess the extent of any cutbacks in spending or production that may be under way. It is also difficult to put the information in perspective. For example, the sharp drop in consumer attitudes may be largely a reflexive response to bad news, rather than an objective assessment of the outlook for income and employment. If so, attitudes, and spending in turn, may improve, once the initial shock effect wears off. On the other hand, the surveys may be signalling a more basic weakness in demand that will not be eased by the mere passage of time. The prospects for weakness cascading throughout the economy do not as yet appear compelling, in part because of the tight rein that businesses have been keeping on inventories. Nonetheless, we must remain alert to the possibility of such a development.
Whether an efficacious policy response to current developments would seek higher, lower, or unchanged interest rates will depend on the specifics of the situation, which are shifting day by day. In framing policy, however, we must not lose sight of the fact that there is no policy initiative that can in the end prevent the transfer of wealth, and cut in our standard of living, that stems from higher prices for imported oil. In addition, we must take into account the policy problems that already were present before the oil shock. For example, as I reported to the Congress in July, we made an adjustment to policy at that time in response to evidence, including Federal Reserve surveys, that banks--along with other lenders--had tightened credit. Data since that time have validated the earlier assessment, and, of course, we shall continue to evaluate all of the evidence relating to credit conditions.
Another key issue one must address is how much of any change in short-term rates would carry over to the crucially important long-term rates, given the concern in financial markets about prospects for inflation and about future economic developments. It is lower long-term rates, rather than short rates, that can do the most to foster the investment activity that is critical for the future health of the economy. Specifically, lower mortgage rates clearly would be useful in containing the current erosion of real estate markets. Policy actions that are not perceived to be consistent with a stable, noninflationary economic environment could easily be counterproductive over the long haul.
It is the responsibility of monetary policy to look through the uncertainty of the near term and to provide the stable financial environment that is consistent with our longer-run objectives. We shall want, for example, to make sure that money and credit remain on appropriate growth tracks, with due allowance for the special influences affecting the demand for money and its velocity; among those influences are the credit developments to which I referred a moment ago. Indeed, one could argue that the restrained stance of monetary policy over the past few years may have reduced the odds of the oil shock igniting a more general acceleration of prices and a sharp escalation of bond yields.
In any event, the surest way to bring down real long-term interest rates is to reduce the federal budget deficit. As you know, some have expressed concern in recent weeks that a large cut in the FY 1991 budget--coming on top of the oil shock--would risk tipping the economy into recession. Such fears are understandable; however, they must be balanced against the benefits that will flow from reducing the federal government's claim on the nation's limited pool of saving. Because the government has been borrowing so much and for so long, it is well past time to scale back its draw on credit markets and to free up more resources for enhancing investment and production by the private sector.
The participants in the Budget Summit are endeavoring to craft a package of sizable deficit reductions. If they succeed and the Congress does enact a credible, long-term, enforceable budget agreement, I would expect long-term interest rates to decline.
In that context, I would presume that the Federal Reserve would move toward ease to accommodate those changes in the capital markets. What adjustment might be necessary, and how it might be timed, cannot be spelled out before the fact. The actions required will depend on current economic conditions, the nature and magnitude of the fiscal package, and the likely timing of its effects.
In the final analysis, no one can guarantee that real growth will proceed smoothly, without a hitch on a quarter-to-quarter basis. I can only offer the assurance that the Federal Reserve will seek, as we have in the past, to foster economic stability and sustainable growth, in the context of continued progress over time toward price stability.
(1)The attachments to this statement are available on request form Publications Services, mail stop 138, Board of Governors of the Federal Reserve System, Washington, D.C. 200551
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|Title Annotation:||policy statements made by members of the Federal Reserve System|
|Publication:||Federal Reserve Bulletin|
|Date:||Nov 1, 1990|
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