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Statements to the Congress.

Statement by Susan M. Phillips, Member, Board of Governors of the Federal Reserve System, before the Subcommittee on Capital Markets, Securities and Government Sponsored Enterprises of the Committee on Banking and Financial Services, US. House of Representatives, October 1, 1997

I welcome this opportunity to discuss the Federal Reserve Board's views on proposed accounting standards for derivatives and risk-management activities issued by the Financial Accounting Standards Board (FASB).

In approaching this complex matter, it should be acknowledged up front that most responsible observers and market participants share an interest in improved accounting standards and disclosure of information that is useful and relevant to the broad range of users of financial statements. Thus, the desirability of meaningful disclosure is not the issue. All would agree, I think, that enhanced financial disclosure and market transparency can lead to more efficient financial markets, more accurate pricing of risks, and more effective market discipline.

With respect to financial disclosures, the interests of most firm managers, investors, and other market participants are essentially the same. Market participants can benefit from enhanced disclosure by being in a better position to understand the financial condition of their counterparties and competitors. Investors have an obvious interest in being able to make meaningful assessments of a firm's performance, underlying trends, and income-producing potential. Sound, well-managed firms can benefit if better disclosure enables them to obtain funds at risk premiums that accurately reflect their lower risk profiles. Inadequate financial disclosures, on the other hand, could penalize well-managed firms if market participants are unable to assess their fundamental financial strength.

While most market participants favor sound accounting standards and meaningful disclosure, a key question is how to ensure that accounting practices and techniques reflect, and are consistent with, how a business is run, that is, its overall business strategy. Indeed, accounting methodology should measure the results of a business purpose or strategy and not be an end in itself. For example, in the case of a company that actively trades financial instruments or other products to profit from short-term price movements, such as a securities firm, reporting trading positions at fair values appropriately measures the success or failure of that business strategy, and market participants expect this reporting treatment. However, for many other types of businesses, such as a manufacturer or a lender that funds loans with liabilities of equal maturity, market value accounting in the primary financial statements may not accurately reflect business strategies or appropriately measure the firm's underlying performance and condition. In these cases, although information about fair value can be useful in supplemental disclosures, it is questionable whether there is widespread demand for market value accounting to become the basis for the preparation of the primary financial statements.

Although the needs of financial statement users may vary, a critical function of financial statements is to reflect in a meaningful way underlying trends in the financial performance and condition of the firm. The application of market value accounting to business strategies when it is not appropriate, and particularly when applied on a piecemeal basis, may lead to increased volatility or fluctuation in reported results and actually obscure underlying trends or developments affecting a firm's condition and performance. Requiring companies to adopt market value accounting when it is not consistent with their business strategies can cause them to incur significant costs to provide information that may not reflect in a meaningful way their underlying circumstances or trends in their performance. Moreover, from the standpoint of financial statement analysts and other users, having to make adjustments to remove the effects of this accounting volatility from income statements and balance sheets--volatility that is not consistent with firm's risk positions--can also impose significant costs without offsetting benefits.

These problems can be minimized by placing market values in meaningful supplemental disclosures rather than by forcing their use in the primary financial statements. Such an approach would give analysts the information they need, without imposing the broader costs of having to reverse or back out the effects of artificial volatility from the primary financial statements. Of course, financial statements and supplemental disclosures must be accurate and not misrepresent a firm's financial circumstances--a problem that can be minimized when financial reports are subject to thorough review by management and external auditors.

FEDERAL RESERVE'S EXPERIENCE

The Federal Reserve Board has a long-standing interest in the quality of financial reporting. This arises from our role as the nation's central bank and as the supervisor of bank holding companies, state member banks, and the U.S. operations of foreign banking organizations. The Federal Reserve and other bank supervisors are responsible for assessing the safety and soundness of the institutions they regulate. In this regard, the Federal Reserve relies on off-site monitoring, on-site supervision, capital and other regulatory requirements, and policies that encourage sound risk-management practices. We believe that market discipline--supported by appropriate accounting standards and public disclosure--complements these supervisory efforts by fostering healthy financial institutions and efficient capital markets.

In the course of supervising financial institutions, the Federal Reserve has developed considerable familiarity with financial instruments, both derivative and nonderivative, that are characterized by a wide range of complexity and risk. We have learned that in supervising trading and derivatives activities it is the underlying characteristics of a financial instrument--and how it contributes to the overall risk profile of the firm--that are important, not the instrument's name. Two instruments that differ in name only may have entirely different treatment under existing legal and accounting frameworks, even though the economic risks (including market, credit, liquidity, operational, and reputational risks) they embody are identical. Financial engineering can certainly create derivative instruments that combine risks in complex ways. But the same engineers can create cash instruments that appear simple and traditional but may have greater risk than many instruments labeled "derivative." Indeed, placing financial instruments in regulatory or accounting pigeonholes without regard to their true risks and economic functions can create disincentives for prudent risk management.

The Federal Reserve is increasingly emphasizing the need for institutions to manage the aggregate or portfolio risks of banking and de-emphasizing a focus on specific instruments. Risk should be measured and managed comprehensively. That is, an institution should manage the dynamics of its portfolio rather than manage specific instruments. A focus on individual transactions can ignore the interaction of the specified instrument with other instruments. Although portfolio theory is widely appreciated by bankers and regulators, putting its principles into practice in banking has not been easy. For example, past banking crises have, in part, reflected a failure by some institutions to recognize and limit concentrations of risk within their portfolios.

The Federal Reserve is increasingly recognizing the need for supervisory and regulatory policies to be more "incentive-compatible," in that they encourage sound risk management within an institution. Furthermore, supervisory and regulatory policies are placing increasing emphasis on minimizing burden by using internal risk-measurement systems and by reinforcing supervisory objectives through market forces. We believe that market discipline--supported by appropriate accounting standards and public disclosure--complements our supervisory efforts by fostering strong financial institutions and efficient capital markets. We believe this approach is more constructive than rote adherence to rules and regulations that may not be consistent with the firm's own risk-management systems.

Consistent with these policies, the Federal Reserve and other banking supervisors have explored regulatory approaches that encourage more use of market-value-based measures in risk-management approaches. For example, beginning next year, internationally active banks meeting certain criteria for risk management will calculate the amount of capital necessary to support the market risk of their trading activities using their own internal value-at-risk (VaR) measures. A significant effort that could increase supervisory reliance on market discipline in the future is the Federal Reserve's so-called "pre-commitment" approach to determining capital for market risk. It seeks to provide banks with stronger regulatory and market incentives to improve all aspects of market risk management. Other initiatives have improved the focus of our supervision policies and examination practices on institutions' risk profiles and risk-management activities in ways that emphasize sound practices and strong internal controls.

Moreover, the Federal Reserve has called for improved U.S. accounting and disclosure standards and has had a key role in sponsoring major international initiatives to encourage improved disclosures by the largest banks and securities firms of their trading and derivatives activities. For example, our 1995 and 1996 analyses of the derivatives disclosure by the top ten U.S. dealer banks were used as models for the joint reports by the Basle Committee on Banking Supervision and the International Organization of Securities Commissions, which covered a sample of the largest banks and securities firms in the G-10 countries. These studies revealed major differences in disclosure among the participating countries and highlighted the greater level of disclosure by U.S. dealer banks. In addition, a representative of the Federal Reserve chaired an international working group of the Euro-currency Standing Committee that recommended in 1994 improvements to disclosure by financial intermediaries of the credit and market risks of their trading activities. .The Federal Reserve and the other federal banking agencies also developed improvements in derivatives disclosure standards for regulatory reports that are similar to disclosure requirements issued at the same time by FASB in Statement No. 119, "Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments."

SPECIFIC ISSUES RAISED BY THE DERIVATIVES PROPOSAL

We share several objectives with the FASB for improving financial reporting. For example, we both support the fundamental objectives of promoting clear and understandable financial reports that increase the transparency of companies' activities. We also share the view that accounting and disclosure standards that faithfully represent financial condition and performance can improve investor and counterparty decisions, thus improving market discipline on banking organizations and other companies. Further, we also agree that current accounting and disclosure standards for derivatives--as well as for other financial instruments--should be improved.

We recognize the difficult task that FASB has in developing a standard that is acceptable to its many constituents. In this regard, we understand that FASB has considered and rejected a number of approaches to hedge accounting for derivatives because particular problems were identified with each approach. We also believe that the approach of reporting all financial instruments at fair value in the primary set of financial instruments, while having some theoretical appeal at least for some types of firms, is not an appropriate solution in the near term. In this regard, fair value estimation techniques are not yet sufficiently robust for exclusive reliance in financial statements. For example, difficult valuation issues arise for highly illiquid instruments for which fair value is based on models rather than observed prices, core deposits with varying durations, and the liabilities of a firm whose credit quality has weakened. Furthermore, fair value estimates can be highly subjective, and little guidance is available for measuring fair values in the financial statements. Another difficult issue relates to whether fair value is the most relevant measurement for commercial banks and other firms that are in the business of holding illiquid loans and other assets for the long term. The success or failure of such a strategy is not measured by evaluating such loans on the basis of a price that indicates value in the context of immediate delivery. In this regard, an appropriate value for many bank loans and off-balance-sheet commitments--the one that reflects the nature of a bank's business--is the original acquisition price adjusted for the expectation of performance at maturity.

Given the many difficulties of FASB's task, it is not surprising that their proposal raises a number of complex issues. For example, the proposal is likely to lead to increased volatility in income and stockholders equity by companies that manage risk with derivatives. This volatility could be artificial because of the piecemeal approach of marking certain risk positions to fair value but not all positions contributing to the risk. As a result, there could be accounting volatility that bears little relation to an institution's overall risk position. Supervisors and analysts will have to strip out the artificially created volatility to assess the true performance of the firm. On the other hand, companies that do not manage their risks, or manage their risks solely through cash instruments that are not covered by the standard, would not reflect similar volatility.

A simple example might illustrate this concern. Assume a company's activities consist solely of lending long term at fixed rates and funding these loans with variable-rate deposits. I think we can all agree that this company has a significant exposure to interest rate risk. If the company does not manage its risk with derivatives, it would not be affected by the derivatives accounting proposal and would not report any volatility from fair value changes in its financial statements. If, however, the company has a strategy to use derivatives to reduce its interest rate risk and move it closer to a match-funded position, the company may report greater volatility in income and stockholders' equity--a result not consistent with its reduced risk exposure. For example, if the company specified under the framework set forth in the FASB proposal that the derivatives are "cash flow" hedges of variable rate liabilities, the company would have volatility in equity or earnings based on the specifically linked effectiveness tests set forth by the proposal. Thus, the firm in using derivatives reduces its economic volatility, yet increases its accounting volatility.

More important, by taking a transaction level approach to hedging, the proposal would not describe well the efforts of more sophisticated market participants to hedge their risks on a comprehensive, portfolio basis. Thus, these firms would effectively be required to keep different sets of books, and their financial reporting may not be consistent with the derivatives' intended use. This leads me to conclude that the proposal could discourage or constrain prudent risk-management practices that rely on derivatives. Furthermore, it may not improve transparency of financial information.

The proposal also introduces into the financial statements an untested method for reporting loans, deposits, and other assets and liabilities being hedged. These assets and liabilities would be valued at a "hybrid" historical cost and fair value amount on the balance sheet when they are hedged with derivatives that are designated as fair value hedges. For example, generally, the historical cost values of these assets and liabilities would be adjusted for changes in fair value related to the risk being hedged. However, certain other changes in fair value would not be recognized (such as those that arise from other risks, that are the results of an ineffective hedge, or that do not offset a gain or loss on the hedging instrument). These hybrid amounts could differ significantly from--and potentially exceed--fair values. They may also be difficult to verify by auditors and examiners, thus reducing the reliability of amounts reported in the financial statements.

The proposed approach is complex, which may increase related developmental systems costs. In this regard, the proposal may cause significant systems changes for institutions that hedge with derivatives. At the same time institutions are making these systems changes, they need to upgrade their systems to address Year 2000 issues. The cost of systems changes arising from the derivatives proposal should be evaluated along with other costs and benefits arising from the proposal. This is particularly important because the derivatives proposal is intended by the FASB to be an interim treatment and its long-term goal is to measure all financial instruments at fair value. Indeed, the FASB already has under way a project that is evaluating issues related to that goal.

LOOKING FORWARD

Because of our concerns about FASB's derivatives proposal, we have assessed various alternative approaches to accounting and disclosure for derivatives and financial instruments. In this regard, we have discussed this issue with other banking regulators in this country and overseas, accounting professionals, and others. We also considered FASB's long-term objectives of accounting for all financial instruments at fair value and recognize the difficult challenge of trying to address derivatives even on an interim basis. It is unlikely that any one solution will please everyone.

While we have heard a number of different views, several themes emerged from our discussions. One is that there is a need for accounting and disclosure standards that faithfully represent risk profiles and thus encourage better risk management, result in transparent financial reports that enhance market discipline, and minimize the costs of systems changes and reporting burden. Second, derivatives accounting and disclosure standards can be improved to the extent that they better reflect portfolio hedging strategies. Third, many major market participants believe that existing derivatives accounting practices can be improved by focusing on the best of current accounting practices, rather than developing significantly novel and untested approaches. Lastly, many believe that existing disclosure requirements for fair values could be improved. We encourage the FASB to carefully consider these ideas as they move forward in their derivatives accounting project.

One approach to accounting and disclosures for derivatives and financial instruments that takes into account these commonly expressed themes has received broad support from banking supervisors both domestically and internationally, as well as from some other major constituents. The Federal Reserve recently offered this idea to the FASB as one possible approach for addressing financial reporting issues raised by derivatives. Likewise, the Basle Committee on Banking Supervision suggested this approach when commenting to the International Accounting Standards Committee (IASC) on its project on financial instruments. In addition, the European Commission provided comments to the IASC that offered a substantially similar approach.

Under this approach, FASB would (1) enhance the current historical cost-based financial reporting framework by issuing a derivatives accounting standard that is based on the best current accounting practice for derivatives, and (2) supplement the historical cost-based statements with expanded disclosures of financial statements based on fair values, including the fair values of derivatives and other financial instruments. Such disclosures should be limited for the time being to larger market participants and be coupled with enhanced accounting guidance on the estimation of fair values. This framework is intended to be a broad template that would be consistent with management and market participant needs for better information from companies, such as financial firms with extensive trading operations. Additional work would be needed by the various groups that set accounting standards, in consultation with interested constituents, to provide a basis for implementing more specific standards. We believe that this framework could more faithfully represent risk profiles and thus encourage better risk management, as well as increase transparency of financial reports to improve market discipline Furthermore, we believe the supplemental comprehensive fair value financial statement disclosures would be a useful adjunct to the accounting paradigm we currently have, and the two bases of accounting could act as a check and balance for each other.

In addition, this approach would minimize reporting burden by utilizing the best of current accounting practices and existing disclosure standards. In this regard, companies are now required to disclose in footnotes the fair value of all of their financial instruments and to report "comprehensive income," which takes into account changes in fair value of certain (but not all) financial instruments that are not currently reflected in net income. The approach could provide a framework for FASB to explore ways to improve these disclosure requirements. Although the Federal Reserve has suggested this alternative approach to the FASB, there may also be other acceptable ways of addressing the many concerns expressed by commenters to the FASB proposal. For example, FASB could in the near term focus on improvements to existing derivatives accounting practices under the historical cost framework and leave improvements in fair value information to its longer-term project on financial instruments. Alternatively, FASB could defer the effective date of the proposed standard to provide more time for institutions to address implementation issues and make systems changes.

In the end, it is the responsibility of the FASB, SEC, and IASC to find the best practicable solutions for accounting and disclosures for derivatives and other financial instruments. These organizations are given the difficult charge of determining the best accounting and disclosure principles, evaluating all of the factors, and considering the views of all constituents. We look forward to working with these organizations in their efforts to improve these standards. We are glad to be able to participate in the public comment process and look forward to doing so in the future.

Statement by Theodore E. Allison, Assistant to the Board for Federal Reserve System Affairs, Board of Governors of the Federal Reserve System, before the Subcommittee on Domestic and International Monetary Policy of the Committee on Banking and Financial Services, US. House of Representatives, October 1, 1997

Thank you for the opportunity to report on the Federal Reserve's plans for dealing with some new design $50 notes that were imperfectly printed. My statement will address three matters: our view of the quality and quantity of $50 notes currently being produced by the Bureau of Engraving and Printing, the options we are looking into for handling the imperfect notes, and steps we are taking jointly with the Bureau of Engraving and Printing to better ensure that we are both satisfied with notes produced by the Bureau in the future.

BACKGROUND

Before turning to those matters, I want to emphasize that the Federal Reserve takes very seriously its stewardship of the nation's currency. Our objective is to issue notes--new and previously circulated--that meet high standards of quality and security. Indeed, we believe that high quality reinforces security. In general, security features in currency notes are most effective in deterring counterfeiting, and therefore in inspiring confidence in genuine notes, when circulating notes are of consistently high quality and when the public is well informed about the characteristics of genuine notes. In the present circumstances, as a new series of notes is being introduced containing security features that are new to the public, and as we seek to inform the public about the new features, new-design notes put into circulation should be held to a particularly high standard of quality.

Despite an admirable history of producing, and delivering to the Federal Reserve, notes of consistently acceptable visual quality, earlier this year the Bureau of Engraving and Printing produced some $50 notes that the Federal Reserve believes fall short of the required standard of quality for notes containing new security features. Specifically, a portion of new-design $50 notes produced before September 8, 1997, have an apparent absence of ink in one or more of the concentric fine lines surrounding the portrait of President Grant. The educational information prepared for the public identifies these concentric fine lines as one of several new security features that should be present, in the form intended, in a genuine note. Consequently, we do not plan to issue those notes.

CURRENT PRODUCTION AT THE BUREAU OF ENGRAVING AND PRINTING

Since September 8, 1997, the Bureau of Engraving and Printing has used both improved printing plates and an improved examination system for $50 notes, with good results. Based on an inspection of notes at all of the thirteen Federal Reserve offices to which new $50 notes of the type produced since September 8 had been shipped, the Federal Reserve is satisfied that those notes are suitable for circulation.

Moreover, the Bureau is producing the higher quality $50s in quantities that will enable all Federal Reserve Banks and branches to have an adequate inventory of those notes by next week. Consequently, the production of the imperfectly printed notes has not materially interfered with the planned introduction of new-design $50 notes. Nor, I might add, has it had any significant impact on the Federal Reserve's note-issuing operations.(1)

DISPOSITION OF THE INVENTORY OF IMPERFECTLY PRINTED NOTES

Disposition of the notes that the Federal Reserve considers unissuable will, of course, entail some cost. A total of 217.6 million $50 notes was produced before September 8, some portion of which appear not to be of issuable quality. Of these, 59.5 million were shipped to Federal Reserve Banks and branches, and 158.1 million are being held at the Bureau of Engraving and Printing. The unissuable notes occur more or less randomly throughout the 217 million notes.

If all 217 million notes were destroyed and replaced with additional newly printed notes, the cost to the Federal Reserve would be about $7.6 million--roughly $360 thousand to destroy the notes now being held at the Reserve Banks and the Bureau of Engraving and Printing and to ship replacement notes to the Reserve Banks and $7.2 million to produce replacement notes. If that were to happen, the $7.6 million cost would be reflected in a correspondingly lower payment of Federal Reserve earnings to the Treasury.

Blanket destruction and replacement may not be the only option, however. The Federal Reserve is looking into the feasibility of obtaining the equipment needed to examine these notes, one by one on our high-speed note processing machines and to recover the notes of issuable quality. We believe that it should be possible to do that. Whether it would be feasible will depend on the costs involved and the quantity of issuable-quality notes that would be recovered. At this time, we do not have good estimates of either of those magnitudes but we hope to have them before the end of this year.

Consequently, $7.6 million should be viewed as an upper limit on the cost of this matter, with the possibility that the actual cost will be lower.

STEPS TO ENSURE THE PRODUCTION OF MUTUALLY ACCEPTABLE NOTES IN THE FUTURE

In order to ensure that the Federal Reserve and the Bureau of Engraving and Printing not find themselves in the future in the position of having notes produced and shipped that are not of mutually acceptable quality, we have taken several important steps.

The Federal Reserve and the Bureau of Engraving and Printing have jointly established print-quality standards for a new electronic examination system now being used at the Bureau to inspect all $50 and $100 notes and to review those standards regularly. This examination system promises to provide a more consistent level of printing quality calibrated more closely to the Federal Reserve's needs.

In addition, the Federal Reserve has agreed to work with the Bureau before and during production of new-design $20 notes, as well as the other lower denominations, to establish mutually acceptable quality standards and to monitor production.

These steps should help to safeguard the security and efficiency of our currency system.

(1.) The impact of the $50-note printing imperfections has been moderate mainly because the total volume of $50 notes in circulation is relatively low. They account for only about 5 percent of all Federal Reserve notes in circulation and only about 3 percent of Reserve Bank receipts from, and payments to, depository institutions. Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on the Budget, US. House of Representatives, October 8, 1997

After decades of budgetary imprudence, there has been a growing recognition of our fiscal problems in recent years and an increased willingness of Presidents and Congresses to address them. The capping of discretionary programs and the first steps to deal with entitlement programs are encouraging, as, unquestionably, is the slower pace at which we are creating new entitlement programs. But it is important to place this improvement in the context of the decades-long deterioration in our fiscal position; we have stopped the erosion for now, but we have made only a downpayment on the longer-range problem confronting us.

Moreover, much of the fiscal improvement of recent years is less the result of a return to the prudent attitudes and actions of earlier generations than the emergence of benevolent forces largely external to the fiscal process. The end of the Cold War has yielded a substantial peace dividend, and the best economic performance in decades has augmented tax revenues far beyond expectations while restraining countercyclically sensitive outlays.

The payout of the peace dividend is coming to an end. Defense outlays have fallen from 6.2 percent of gross domestic product in 1985 to 3.4 percent this year. Further cuts may be difficult to achieve, for even if we are fortunate enough to enjoy a relatively tranquil world, spending will tend to be buoyed by the need to replace technologically obsolescent equipment as well as by the usual political pressures.

The long-term outlook for the U.S. economy presents us with, perhaps, even greater uncertainties. There can be little doubt that the U.S. economy in the past several years has performed far better than the history of business expansions would have led us to expect. Labor markets have tightened considerably without inflation emerging as it has in the past. Encouraged by these results, financial markets seem to have priced in an optimistic outlook, characterized by a significant reduction in risk and an increasingly benevolent inflation process.

For example, in equity markets, continual upward revisions of longer-term corporate earnings expectations have driven price-earnings ratios to levels not often observed at this stage of an economic expansion.

Contributing to the expected increases in profits is a perceived marked increase in the prospective rate of return on new business ventures. This is evidenced by the sharp increase in capital investment since early 1993, especially in high tech equipment, which has persisted and even accelerated in recent quarters.

Underlying this apparent bulge in expected profitability and rates of return, as I suggested in my July Humphrey-Hawkins testimony, may be a maturing of major technologies in recent years. The synergies of lasers and fiber optics have spurred large increases in communications investments. The continued extra-ordinary spread of computer-related applications as costs of manipulating data and other information fall, has also been a major factor in increased investment outlays. The combination of advancing telecommunications and computer technologies have induced large investment outlays to support the Internet and utilize it to realize efficiencies in purchasing, production, and marketing.

This dramatic change in technology, as I pointed out in earlier testimony, has markedly shortened the lead times in bringing new production facilities on line to meet increased demand and has accordingly significantly reduced longer-term bottlenecks and materials shortages, phenomena often leading to inflation in the past.

Indeed, this faster response of facility capacity, coupled with dramatic declines in transportation costs owing to a downsizing of products, has led to speculation that we are operating with a new "paradigm," where price pressures need rarely ever arise because low-cost capacity, both here and abroad, can be brought on sufficiently rapidly when demand accelerates.

Before we go too far in this direction, however, we need to recall that it was just three years ago that we were confronted with bottlenecks in the industrial sector. Though less extensive than in years past at similarly high levels of capacity utilization, they were nonetheless putting visible upward pressures on prices at early stages of the production chain. Further strides toward greater flexibility of facilities have occurred since 1994, but this is clearly an evolutionary, not a revolutionary, process. At least for the foreseeable future, it will still take time to bring many types of new facilities into the production process, and productive capacity will still impose limits on meeting large unexpected increases in demand in a short period.

More relevant, by far, however, is that technology and management changes have had only a limited effect on the ability of labor supply to respond to changes in demand. To be sure, individual firms have acquired additional flexibility through increased use of outsourcing and temporary workers. In addition, smaller work teams may be able to adapt more readily to variations in order flows. While these techniques put the right workers at the right spots to reduce bottlenecks, they do not increase the aggregate supply of labor. That supply is sensitive to changes in demand but to a far more limited extent than facilities. New plants can almost always be built. But labor capacity for an individual country is constrained by the size of the working-age population, which, except for immigration, is basically determined several decades in the past. Its lead time reflects biology, not technology.

Of course, the demand for capital facilities and labor are not entirely independent. Within limits, labor and capital are substitutes, and slack in one market can offset tightness in another. For example, additional work shifts often can expand output without significant addition to facilities. Similarly, more labor-saving equipment can permit production to be increased with the same level of employment, an outcome that we would observe as increased labor productivity. As I will be discussing in a moment, we are seeing some favorable signs in this regard, but they are only suggestive, and the potential for increased productivity to enhance the effective supply of labor is limited.

The fact is, that despite large additions to the capital stock in recent years, the supply of labor has kept pace with the demand for goods and services and the labor to produce them only by reducing the margin of slack in labor markets.

Of the more than 2 million net new hires at an annual rate from early 1994 through the third quarter of this year, little more than half came from an expansion in the population aged sixteen to sixty-four who wanted a job, and more than a third of those were net new immigrants. The remaining 1 million per year increase in employment was pulled from those who had been reported as unemployed (nearly 700,000 annually) and those who wanted, but had not actively sought, a job (more than 300,000 annually). The latter, of course, are not in the official unemployment count.

The key point is that continuously digging ever deeper into the available working-age population is not a sustainable trajectory for job creation. The unemployment rate has a downside limit, if for no other reason than unemployment, in part, reflects voluntary periods of job search and other frictional unemployment and includes people whose skills are not well adapted to work today and would be very costly to employ.

In addition, there is a limit on how many of the millions who wanted a job but were not actively seeking one could be readily absorbed into jobs--in particular, the large number whose availability is limited by their enrollment in school and those who may lack the necessary skills or may face other barriers to taking jobs. The number of people saying they would like a job, but have not been engaged in active job search, declined dramatically in 1996. But, despite increasingly favorable labor markets, few more of these 5 million individuals have been added to payrolls in 1997. This group of potential workers, on balance, is at its lowest level relative to the working-age population since at least 1970. As a source of new workers we may have reached about as far as is feasible into this group of the population.

Presumably, some of the early retirees, students, or homemakers who do not now profess to want to work could be lured to the job market. Rewards sufficient to make jobs attractive, however, could conceivably also engender upward pressures on labor costs that would trigger renewed price pressures, undermining the expansion.

Thus, there would seem to be emerging constraints on potential labor input. If the recent 2 million plus annual pace of job creation were to continue, the pressures on wages and other costs of hiring large numbers of such individuals could escalate more rapidly. To be sure, job growth slowed significantly in August and September, but it did not slow enough to close, from the demand side alone, the gap of the demand for labor over the supply from increases in the working-age population.

Thus, the performance of the labor markets this year suggests that the economy has been on an unsustainable track. That the marked rate of absorption of potential workers since 1994 has not induced a more dramatic increase in employee compensation per hour and price inflation has come as a major surprise to most analysts.

The strengthened exchange value of the dollar, which has helped contain price increases, is certainly one factor in explaining business reluctance to grant wage increases. Another explanation I have offered in the past is that the acceleration in technology and capital investment, in part by engendering important changes in the types of facilities with which people work on a day-by-day basis, has also induced a discernible increase in fear of job skill obsolescence and, hence, an increasing willingness to seek job security in lieu of wage gains. Certainly, the dramatic rise in recent years of on-the-job training and a substantial increase in people returning to school--especially those aged twenty-five to thirty-four, mainly at the college level--suggests significant concerns about skills.

But the force of insecurity may be fading. Public opinion polls, which recorded a marked increase in fear of job loss from 1991 to 1995, a period of tightening labor markets, now indicate a partial reversal of that uptrend.

To be sure, there is still little evidence of wage acceleration. To believe, however, that wage pressures will not intensify as the group of people who are not working, but who would like to, rapidly diminishes strains credibility. The law of supply and demand has not been repealed. If labor demand continues to outpace sustainable increases in supply, the question is surely when, not whether, labor costs will escalate more rapidly.

Of course, a falloff in the current pace of demand for goods and services could close the gap and avoid the emergence of inflationary pressures. So could a sharp improvement in productivity growth, which would reduce the pace of new hiring required to produce a given rate of growth of real output.

Productivity growth in manufacturing, as best we can measure it, apparently did pick up some in the third quarter, and the broader measures of productivity growth have exhibited a modest quickening this year. Certainly, the persistence, even acceleration, of commitments to invest in new facilities suggests that the actual profitability of recent past investments, and by extension increased productivity, has already been achieved to some degree rather than being merely prospective.

However, to reduce the recent 2 million plus annual rate of job gains to the 1 million rate consistent with long-term population growth would require, all else equal, a full percentage point increase in the rate of productivity growth. While not inconceivable, such a rapid change is rare in the annals of business history, especially for a mature industrial society of our breadth and scope.

Clearly, impressive new technologies have imparted a sense of change in which previous economic relationships are seen as being less reliable now. Improvements in productivity are possible if worker skills increase, but gains come slowly through experience, education, and on-the-job training. They are also possible as capital substitutes for labor, but that is limited by the state of current technology. Very significant advances in productivity require technological breakthroughs that alter fundamentally the efficiency with which we use our labor and capital resources. But at the cutting edge of technology, where the United States finds itself, major improvements cannot be produced on demand. New ideas that matter are hard won.

Short of a marked slowing in the demand for goods and services and, hence, labor--or a degree of acceleration of productivity growth that appears unlikely--the imbalance between the growth in labor demand and the expansion of potential labor supply of recent years must eventually erode the current state of inflation quiescence and, with it, the solid growth of real activity.

In this context, the economic outlook sketched out for the United States by both the Office of Management and Budget (OMB) and the Congressional Budget Office (CBO) is realistic, even in some sense conservative. But you should recognize the range of possible long-term outcomes, both significantly better or worse, has risen markedly in the past year.

An acceleration of productivity growth, should it materialize, would put the economy on a higher trend growth path than they have projected. The development of inflationary pressures, on the other hand, would doubtless create an environment of slower growth in real output than that projected by OMB or CBO. A re-emergence of inflation is, without question, the greatest threat to sustaining what has been a balanced economic expansion virtually without parallel in recent decades. In this regard, we at the Federal Reserve recognize that how we handle monetary policy will be a significant factor influencing the path of economic growth and, hence, fiscal outcomes.

Given the wider range of possible outcomes that we face for long-term economic growth, the corresponding ranges of possible budget outcomes over the next five to ten years has also widened appreciably.

In addition to the uncertainties associated with economic outcomes, questions may be raised about other assumptions behind both projected receipts and outlays. With regard to the former, it is difficult to believe that our much higher-than-expected income tax receipts of late are unrelated to the huge increase in capital gains, which since 1995 have totaled the equivalent of one-third of national income. Aside from the question of whether stock prices will rise or fall, it clearly would be unrealistic to look for a continuation of stock market gains of anything like the magnitude of those recorded in the past couple of years.

On the outlay side, the recently enacted budget agreement relies importantly on significant, but as-yet-unspecified, restraints on discretionary spending to be made in the years 2001, 2002, and thereafter. Supporters of each program expect the restraints to fall elsewhere. Inevitably, the eventual publication of the detail will expose deep political divisions, which could make the realization of the budget projections less likely. In addition, while the budget agreement included significant cuts in Medicare spending, past experience has shown us how difficult Medicare is to control, raising the possibility that savings will never be realized. More generally, I wonder whether there is enough funding slack to accommodate contingencies, or the inevitable new, but as yet unidentified, spending programs.

Budget forecasts are understandably subject to fairly large errors. Seemingly small changes in receipts and outlays are magnified in the budget deficit. For example, during the 1990s, the average absolute error in the projections of February for receipts and outlays in the fiscal years starting the subsequent October has been greater than 4 percent. A 4 percent error in both outlays and receipts in opposite directions amounts to more than $125 billion annually. Indeed, the uncertainty of budget forecasts is no better illustrated than by an admittedly extreme case. During the past two and a half years the projection of the fiscal balance, excluding new initiatives, for the year 2002 has changed by about $250 billion. While all this fortunately has been in the direction of smaller deficits, the degree of uncertainty suggests that the error could just as easily be on the other side.

With this high level of uncertainty in projecting budget totals and associated deficits, the Congress needs to evaluate the consequences to long-term economic growth of errors in fiscal policy. A base issue in such an evaluation is whether we are better off to be targeting a large deficit, balance, or a chronic surplus in our unified budget.

There is nothing special about budget balance per se, except that it is far superior to deficits. I have always emphasized the value of a budgetary surplus in increasing national savings, especially when U.S. private domestic savings is low, as it is today.

Higher national savings lead in the long run to higher investment and living standards. They also foster low inflation. Low inflation itself may be responsible, in part, for higher productivity growth and larger gains in standards of living.

If economic growth and rising living standards, fostered by investment and price stability, are our goal, fiscal policy in my judgment will need to be biased toward surpluses in the years immediately ahead. This is especially so given the inexorable demographic trends that threaten huge increases in outlays beyond 2010. We should view the recent budget agreement, even if receipts and outlays evolve as expected, as only an important downpayment on the larger steps we need to take to solve the harder problem-putting our entitlement programs on a sound financial footing for the twenty-first century.

Moreover, it is hoped that targeted surpluses could help to offset the inbuilt political bias in favor of budget deficits. I have been in too many budget meetings in the past three decades not to have learned that the ideal fiscal initiative from a political perspective is one that creates visible benefits for one group of constituents without a perceived cost to anybody else, a form of political single-entry bookkeeping.

To be sure, in recent years we have been showing some real restraint in our approach to fiscal policy. Yet, despite terminating a number of programs, the ratio of federal nondefense, noninterest, spending to GDP still stands at nearly 14 percent, double what it was in the 1950s. This may be one reason why inflation premiums, embodied in long-term interest rates, are still significant. There is, thus, doubtless a lot of catching up to do.

The current initiatives toward welfare, social security, and Medicare reform are clearly steps in the right direction, but far more is required. Let us not squander years of efforts to balance the budget and the benefits of ideal economic conditions by failing to address our long-term imbalances.

A critical imbalance is the one faced by social security. Its fund's reported imbalance stems primarily from the fact that, until very recently, the payments into the social security trust accounts by the average employee, plus employer contributions and interest earned, were inadequate, at retirement, to fund the total of retirement benefits. This has started to change. Under the most recent revisions to the law, and presumably conservative economic and demographic assumptions, today's younger workers will be paying social security taxes over their working years that appear sufficient to fund their benefits during retirement. However, the huge liability for current retirees, as well as for much of the work force closer to retirement, leaves the system, as a whole, badly underfunded. The official unfunded liability for the Old Age, Survivors and Disability funds, which takes into account expected future tax payments and benefits out to the year 2070, has reached a staggering $3 trillion.

This issue of funding underscores the critical elements in the forthcoming debate on social security reform because it focuses on the core of any retirement system, private or public. Simply put, enough must be set aside over a lifetime of work to fund the excess of consumption over claims on production a retiree may enjoy. At the most rudimentary level, one could envision households saving by actually storing goods purchased during their working years for consumption during retirement. Even better, the resources that would have otherwise gone into the stored goods could be diverted to the production of new capital assets, which would, cumulatively, over a working lifetime, produce an even greater quantity of goods and services to be consumed in retirement. In the latter case, we would be getting more output per worker, our traditional measure of productivity, and a factor that is central in all calculations of long-term social security trust fund financing.

Hence, the bottom line in all retirement programs is physical resource availability. The finance of any system is merely to facilitate the underlying system of allocating real resources that fund retirement consumption of goods and services. Unless social security savings are increased by higher taxes (with negative consequences for growth) or lowered benefits, domestic savings must be augmented by greater private saving or surpluses in the rest of the government budget to help ensure that there is enough savings to finance adequate productive capacity down the road to meet the consumption needs of both retirees and active workers.

The basic premise of our current largely pay-as-you-go social security system is that future productivity growth will be sufficient to supply promised retirement benefits for current workers. However, even supposing some acceleration in long-term productivity growth from recent experience, at existing rates of domestic saving and capital investment this is becoming increasingly dubious.

Accordingly, short of a far more general reform of the system, there are a number of initiatives, at a minimum, that should be addressed. As I argued at length in the Social Security Commission deliberations of 1983, with only marginal effect, some delaying of the age of eligibility for retirement benefits will become increasingly pressing. For example, adjusting the full-benefits retirement age to keep pace with increases in life expectancy in a way that would keep the ratio of retirement years to expected life span approximately constant would help to significantly narrow the funding gap. Such an initiative will become easier to implement as fewer and fewer of our older citizens retire from physically arduous work. Hopefully, other modifications to social security, such as improved cost-of-living indexing, will be instituted.

There are a number of thoughtful reform initiatives that, through the process of privatization, could increase domestic saving rates. These are clearly worthy of intensive evaluation. Perhaps the strongest argument for privatization is that replacing the current underfunded system with a fully funded one could boost domestic saving. But, we must remember it is because privatization plans might increase savings that makes them potentially valuable, not their particular form of financing. As I have argued elsewhere, unless national savings is increased, shifting social security trust funds to private securities, while increasing government retirement system income, will lower retirement incomes in the private sector to an offsetting degree. This would not be an improvement to our overall retirement system.

The types of changes that will be required to restore fiscal balance to our social security accounts, in the broader scheme of things, are significant but manageable. More important, most entail changes that are less unsettling if they are enacted soon, even if their effects are significantly delayed, rather than waiting five or ten years or longer for legislation.

Minimizing the potential disruptions associated with the inevitable changes to social security is made all the more essential because of the pressing financial problems in the Medicare system, social security's companion program for retirees. Medicare, as you are well aware, is in an even more precarious position than social security. The financing of Medicare faces some of the same problems associated with demographics and productivity as social security but faces different, and currently greater, pressures owing to the behavior of medical costs and utilization rates. Reform of the Medicare system will require more immediate and potentially more dramatic changes than those necessary to reform social security.

We owe it to those who will retire after the turn of the century to be given sufficient advance notice to make what alterations in retirement planning may be required. The longer we wait to make what are surely inevitable adjustments, the more difficult they will become. If we procrastinate too long, the adjustments could be truly wrenching. Our senior citizens, both current and future, deserve better.

Statement by Susan M Phillips, Member, Board of Governors of the Federal Reserve System, before the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Banking and Financial Services, US. House of Representatives, October 8, 1997

I am pleased to be here today to discuss the Federal Reserve's efforts in recent years to strengthen its supervisory processes and also to share with you the Board's views about what challenges lie ahead, for both the banking system and the supervisory process. As you know, the U.S. economy and its banking system have enjoyed half a decade of improving strength in which U.S. banks have become better capitalized and more profitable than they have been in generations. Moreover; in the past thirteen months not a single insured bank has failed, and the Bank Insurance Fund is now capitalized at a level requiring most banks to pay only nominal fees for their insurance. While we can take comfort and, to some degree, satisfaction in these events, experience has demonstrated that at times like these--if we are not vigilant--risks can occur that set the stage for future problems.

As I begin my remarks, I would like to point out that no system of supervision or regulation can provide total assurance that banking problems will not occur or that banks will not fail. Nor should it. Our goal as regulators is to identify weak banking practices early so that small or emerging problems can be addressed before they become large and costly--to either the insurance fund or the financial system as a whole. We believe that progress made in recent years to focus our examinations on the areas of highest risk at banking organizations places us in a better position to identify problems early, control systemic risk, and maintain financial stability. That goal and the need to adapt the supervisory process to the potentially rapidly changing conditions in banking and financial markets underlie our decision to pursue a more risk-focused supervisory approach.

We are well under way in implementing this new supervisory framework, and initial indications about that process from both the Federal Reserve's supervisory staff and the banking industry, itself, have been favorable. The risk-focused approach reflects our supervisory response to the effects that technology and financial innovation have had on the pace of change in banking organizations, the nature of U.S. and world financial markets, and the techniques employed for managing and controlling risk. As banking practices and markets continue to evolve, our emphasis on risk-focused supervision will be even more necessary in the years to come.

THE FEDERAL RESERVE'S OVERSIGHT ROLE

As the primary federal supervisor of U.S. bank holding companies, state member banks, and most U.S. offices of foreign banks, the Federal Reserve has sought to apply effective supervision and contain excessive risks to the federal safety net, while also ensuring that banks adequately serve their communities and accommodate economic growth. As the nation's central bank, the Federal Reserve brings a different, important perspective to the supervisory process through its attention to the broad and long-term consequences of supervisory actions on the financial system and the economy. Significantly, the practical, hands-on involvement that the Federal Reserve gains through its supervisory function supports and complements our other central bank responsibilities, including fostering a safe and efficient payment system and ensuring the stability of the financial system.

Past studies of bank failures have cited a number of contributing factors, including, but certainly not limited to, inadequate supervisory staffing and antiquated examination procedures. Over the years, as it has supervised and regulated banking organizations, the Federal Reserve has emphasized periodic, on-site examinations that entail substantive loan portfolio reviews and significant transaction testing to identify emerging problems. In that connection, the Federal Reserve has sought to maintain a sufficient number and quality of supervisory personnel to conduct examinations with appropriate frequency and depth. That approach appears to have provided us with some consistent success.

As conditions within the industry have substantially improved, the Board has been mindful of the cost of conducting its supervisory activities and has worked to contain those costs in the face of increased responsibilities. Throughout this period we have recognized the need to maintain stability in our work force and have sought to avoid excessive buildups or periods of disruptive retrenchment. That approach has enabled us to maintain what we believe has been an adequate and consistent level of oversight of banking organizations under our supervision during both good times and bad.

DEVELOPMENTS DRIVING CHANGE

During the past decade, the U.S. banking system has experienced a great deal of turmoil, stress, and change. Ten years ago, many of the country's largest banks announced huge loan-loss provisions, beginning the process of reducing the industry's overhang of doubtful developing country loans. At the same time, many of these institutions and smaller regional banks were struggling with oil and agriculture sector difficulties or accumulating commercial real estate problems. These and other difficulties took a heavy toll. By the end of the 1980s, more than 200 banks were failing annually, and there were more than 1,000 other problem banks.

This experience provided important lessons and forced supervisors and bankers, alike, to reconsider the way they approached their jobs. For their part, bankers recognized the need to build their capital and reserves, strengthen their internal controls, and improve practices for identifying, underwriting, and managing risk. Supervisors were also reminded of the need to remain vigilant and of the high costs that bank failures can bring, not only to the insurance fund but to local communities as well. The FDIC Improvement Act of 1991 emphasized that point, requiring frequent examinations and prompt regulatory actions when serious problems emerge.

Beyond these largely domestic, institutional events, banks and businesses throughout the world were dealing in the 1980s and 1990s with new technologies that were leading to a multitude of new and increasingly complex financial products that changed the nature of banking and financial markets. These technologies have brought many benefits that facilitate more efficient markets and, in turn, greater international trade and economic growth.

They may also, however, have raised macrostability concerns by concentrating the growing volume and complexity of certain activities within a small number of truly global institutions. It is essential that these largest firms adequately manage the related risks of these activities and that they remain adequately supervised. For it is these institutions that have the potential to disrupt worldwide payment systems and contribute most to systemic risk. In addition to the formal supervisory oversight exerted by regulators, concerns may be eased somewhat by the strong counterparty discipline being brought to bear worldwide on banks and other financial institutions dealing in these new products. The scrutiny among counter-parties in the global market place has contributed to improvements in capital positions and in overall risk-management practices.

In many ways, U.S. banks have been in the vanguard in applying technological advances to their products, distribution systems, and management processes, with such applications and innovations as automated teller machines, home banking, securitizations, and credit derivatives. Such efforts, combined with greater attention to pricing their services and measuring their risks, have had material effects on the increased strength and profitability that our banks have seen.

Within the United States, our banking system has also experienced a dramatic consolidation in the number of banking institutions, with the number of independent commercial banking organizations declining from 12,400 in 1980 to 7,400 in June of this year.(1) That structural change has also contributed to industry earnings by providing banks with greater opportunities to reduce costs.

The challenge going forward for many of these institutions may be in managing the growth and the continuing process of industry consolidation. This challenge may be greatest as banking organizations expand, particularly through acquisitions, into more diverse or nontraditional banking activities. That growth into a wider array of activities is especially important if banks are to meet the wide-ranging needs of their business and household customers while competing effectively with other regulated and unregulated firms. However, the managerial implications of rapid growth and growth into new activities should not be overlooked, by either the institutions or their supervisors.

SUPERVISORY CHALLENGES AHEAD

There is also no shortage of tasks facing the Federal Reserve as a bank supervisor, despite the virtually unprecedented strong condition of the U.S. banking system today. We, too, must deal with the evolving financial markets and advances in technology. At the same time, we must ensure that our own supervisory practices, tools, and standards take advantage of technological improvements and financial techniques so that our oversight is not only effective but also as unobtrusive and appropriate as possible. These tasks are wide ranging, extending from our own re-engineering of the supervisory process to the way supervisors approach issues such as measuring capital adequacy and how we seek convergence on bank supervisory standards worldwide.

Risk-Focused Examinations

Constructing a sound supervisory process while minimizing regulatory burden has been a long-standing and ongoing effort at the Federal Reserve and an objective we have sought to advance with our emphasis on risk-focused examinations. Particularly in the past decade, we have found that the increased range of products and the greater depth and liquidity of financial markets permit banking organizations to change their risk profiles more rapidly than ever before. That possibility requires that we strike an appropriate balance between evaluating the condition of an institution at a point in time and evaluating the soundness of the bank's processes for managing risk. Recognition of the need for that balance is at the heart of the risk-focused examination approach.

The risk-focused approach, by definition, entails a more formal risk assessment planning phase that identifies those areas and activities that warrant the most extensive review. This preplanning process is supported by technology, for example, to download certain information about a bank's loan portfolio to our own computer systems and target areas of the portfolio for review.

Once on site, examiners analyze the bank's loans and other assets to ascertain the organization's current condition, and also to evaluate its internal control process and its own ability to identify and resolve problems. As a result, the Federal Reserve is placing greater reliance than before on a bank's internal auditors and on the accuracy and adequacy of its information systems. The review of the information flow extends from top to bottom, and with the expectation that bank senior management and boards of directors are actively involved in monitoring the bank's activities and providing sufficient guidance regarding risk assumption.

As in the past, performance of substantive checks on the reliability of a bank's controls remains today a cornerstone of the examination process, albeit in a more automated and advanced form. For example, automated loan sampling is performed for the purpose of generating statistically valid conclusions about the accuracy of a bank's internal loan review process. To the extent we can validate the integrity of a bank's internal controls more efficiently, we can place more confidence in them at an earlier stage and can also take greater comfort that management is getting an accurate indication of the bank's condition. Toward that end, Board staff is working to refine loan-sampling procedures that should further boost examiner productivity and accomplish other supervisory goals. Moreover, as examiners are able to complete loan reviews more quickly, they will have more time to review other high-priority aspects of the institution's operations.

A significant benefit of the risk-focused approach is its emphasis on ensuring that the bank's internal oversight processes are sound and that communication between the bank and senior examiners is ongoing between examinations. That approach is generally supported by institutions we supervise and provides a more comprehensive oversight process that complements our annual or eighteen-month examinations. Such an approach strengthens our ability to respond promptly if conditions deteriorate.

Another benefit of the risk-focused approach has been a greater amount of planning, analysis, and information gathering at Reserve Banks before the on-site portion of the examination. Far from reducing our hands-on knowledge of the institution, this approach has ensured that when we are on site, we are reviewing and analyzing the right areas, talking to the right people, and making better use of our time and that of the bank's management and employees. In addition to improving productivity, it has also reduced our travel costs and improved employee morale.

Examination staff at the Reserve Banks indicate that this process may be reducing on-site examination time 15 percent to 30 percent in many cases and overall examination time of Federal Reserve personnel perhaps 10 percent. While those results are tentative, partial, and unscientific, they are certainly encouraging in terms of resource implications.

Complementing the risk-focused approach to supervision are enhancements to the tools we use to grade a bank's condition and management. Since 1995, we have asked Federal Reserve examiners to provide a specific supervisory rating for a bank's risk-management process. More recently, the CAMEL rating system, too, has been revised by the banking agencies to place more emphasis on the adequacy of a bank's risk-management practices and was expanded to include a specific "S" rating for an institution's sensitivity to market risk. As you may know, the Federal Reserve has also, for some time, used a rating scheme that focuses heavily on managerial procedures and controls in its oversight of U.S. branches and agencies of foreign banks.

How effective is the risk-focused process? Because economic and industry conditions have been generally favorable for the past several years, there has not been a sufficiently stressful economic downturn to test fully bank risk-management systems or supervisory practices. The market volatility beginning in 1994 did, however, provide some tests for the risk-management systems of the larger banks with active trading desks. Nevertheless, there are many indications that bank and supervisory practices are materially better than they were in the 1980s and early 1990s.

For example, the risk-focused approach is helping to identify certain deficiencies before they show up in a bank's financial condition. These are evidenced by instances where ratings for the quality of bank management are lower than those for capital, asset quality, or earnings. Because managerial weaknesses eventually show up in a bank's financial condition, it is important to identify and resolve those weaknesses early. In that regard, the risk-focused approach endeavors to prevent problems from developing to the point that they cause unnecessary losses that impair the institution's capital and require resolution under the Prompt Corrective Action mandate.

One example of how the risk-focused approach is helping to identify and address deficiencies is our supervisory experience with the U.S. branches of foreign banks. Subsequent to the enactment of the Foreign Bank Supervision Enhancement Act of 1991, which gave the Federal Reserve greater supervisory authority over foreign branches, our examinations uncovered a number of entities with internal control and audit weaknesses. This result was not completely unexpected, as these foreign banking organizations were not previously subject to the same level of oversight as our domestic organizations.

Recognizing the seriousness of these weaknesses and their potential for causing problems in the future, the Federal Reserve has taken a number of steps to ensure that practices are materially upgraded at foreign branches and that any weaknesses continue to be uncovered. In addition to identifying and addressing internal control and audit weaknesses through examinations and supervisory follow-up, these efforts include ensuring that the foreign bank provides the necessary managerial support to its U.S. branches, including adequate systems of controls and audit. To place even more emphasis on internal controls and audit systems, the foreign branch rating system was revised in 1994. Furthermore, in 1996 additional steps were taken to ensure that internal control weaknesses are corrected and will not cause financial harm by adopting requirements for audit procedures in situations where significant control weaknesses are detected.

These efforts to detect problems at their early stages and resolve them appear to be having positive effects. After having peaked in 1993, there has been a steady decline in the number of U.S. branches and agencies with an overall examination rating of fair or lower and a rating of fair or lower in an examination component substantively affected by internal control and audit weaknesses. We believe that our continued efforts in this area will lead to further improvements in the internal control and audit practices of foreign banking organizations

Implementing the risk-focused approach has not been an easy task. It has required a significant revision of our broad and specialized training programs, including expansion of capital markets, information technology, and global trading activities as well as courses devoted exclusively to internal controls. These education programs will, of course, need to be continually updated as industry activities and conditions evolve.

With the greater discretion provided to examiners to focus on areas of highest risk, ensuring the consistency and quality of examinations has increased in importance. Fortunately, new training courses and improved examination platforms, tools, and programs that guide examiners through the appropriate selection of examination procedures will help. In addition, our ability to evaluate more thoroughly the quality of an examination has improved with the greater depth of analysis provided in supporting examination materials such as the written risk assessments and analysis of exam findings. Those materials are allowing us to perform comparative reviews of examinations across institutions of similar size, risk profile, and complexity to ensure quality and consistency.

So far we have been able to evaluate the effectiveness of our examination programs by identifying whether problems are identified early and resolved in a timely fashion, by evaluating whether examination reports and findings provide clear feedback to management and identify areas of highest risk, and by monitoring the extent to which our examinations are complying with statutory mandates for the frequency of examinations. Based on those criteria, I believe our examination program has been generally successful.

Application of Technology to Supervisory Process

The Federal Reserve has also done much to increase its own use of technology in an effort to improve examiner productivity, enhance analyses, and reduce burden on banks. Much of this effort has been conducted on an interagency basis, particularly in cooperation with the Federal Deposit Insurance Corporation (FDIC) and state banking departments with whom we share supervision of state-chartered banks. Specific results include the development of a personal computer, laptop workstation that provides examiners with a decision tree framework to assist them through the necessary procedures. The workstation also helps them document their work and prepare exam reports more efficiently. In addition, a software program has also been developed for receiving and analyzing loan portfolio data transmitted electronically from financial institutions. This process not only saves time but also improves the examiner's understanding of the risks presented by individual portfolios.

The Federal Reserve is also developing an electronic examination tool for large domestic and foreign banking organizations that enhances our ability to share examination analysis and findings and other pertinent supervisory information among our Reserve Banks and with other supervisory authorities. This platform should substantively improve our ability to provide comprehensive oversight to those firms that are most prominent in the payment system and global financial markets.

In addition to examination tools, the Federal Reserve has for many years maintained a comprehensive source of banking structure, financial, and examination data in its National Information Center. By year-end, we will have completed significant enhancements to the tools that provide examiners and analysts at the federal and state banking agencies access to those data.

The Year 2000

One of the clearest reminders that managing technology is a challenge of its own is the need for banks to resolve the "Year 2000" problem. U.S. banks appear to be taking this matter seriously and are generally well under way toward identifying their individual needs and developing action plans. The Federal Reserve and the other federal bank supervisors are reviewing the relevant efforts of every insured depository institution to determine whether adequate progress on this issue is being made. This process should be complete by the middle of next year so that any detected deficiencies may be addressed in time. Meeting the demands of this review and ensuring proper remedies both before and after the year 2000 will be a significant and costly task to both the industry and the banking agencies.

However, even within the context of banking, the scope of the Year 2000 problem extends far beyond U.S. banks to foreign banks, bank borrowers, depositors, vendors, and other counterparties. Through the Bank for International Settlements and other international forums, the Federal Reserve and other U.S. banking agencies have emphasized the need for all institutions to recognize this issue and to address it actively. Importantly, century date compliance is gaining more attention internationally, and the Basle Supervisors Committee is taking steps to address this matter.

Banks and others need to address year 2000 system alterations, not only because of the potential effects on overall markets but also as a threat to individual firm viability. At a minimum, banks should be concerned about their ability to provide uninterrupted service to their customers into the next millennium. If nothing else, it is simply good business.

Efforts to Accommodate Industry Growth and Innovation

Another goal of the Federal Reserve's supervisory approach is to remove unnecessary barriers that might hinder the industry's ability to grow, innovate, and remain competitive. Recently, the Board refined its application process to ensure that well-run, well-capitalized banking organizations may apply to acquire banks and nonbanks in a more streamlined fashion and commence certain types of new activities without prior approval. The Board also significantly revised various rules for section 20 companies and scaled back or removed many redundant firewalls. While these refinements require some changes to the supervisory process, we firmly believe that removing barriers to these lower-risk activities is essential to maintaining the industry's health and competitiveness and its ability to serve its customers and the community.

Supervising Nationwide and International Institutions

The consolidation and transformation of the U.S. banking system resulting from evolving market, statutory, and regulatory changes are also requiring the Federal Reserve to adapt to new conditions. As previously noted, we are working closely with the FDIC and state banking agencies to deal with the challenges presented by interstate banking and branching to ensure that the dual banking system remains viable in future years.

To address that goal, the FDIC, the Federal Reserve, and the state banking departments began on October 1 a common risk-focused process for the examination of state-chartered community banks. Another initiative has been the State/Federal Supervisory Protocol, which commits the various banking agencies to work toward a "seamless" and minimally burdensome oversight process. In short, it sets forth a process in which state banking supervisors will accept the supervisory reports of other agencies for banks operating in their states through branches but headquartered elsewhere. The fact that the plan has been accepted by all involved parties is encouraging. We now need to ensure that it is implemented as intended as banks make use of their broader branching powers.

Similar coordination efforts are necessary and under way in an international context. Through the Bank for International Settlements, for example, the Federal Reserve and the other U.S. banking agencies participate with supervisors from other G-10 countries to develop not only prudential capital and other regulatory standards but also to promote sound practices over a broad range of banking issues.

In this regard, the Basle Committee on Banking Supervision, with the approval of the central bank Governors of the G-10 countries, recently issued three documents: one dealing with the management of interest rate risk by banks, one dealing with the Year 2000 problems, and another identifying twenty-five "core principles" of effective supervision that is directed at bank supervisors worldwide. The Basle Committee is also working to improve international risk-disclosure practices of banks and has created the new market risk capital standard that is based on banks' internal value-at-risk models. That standard goes into effect in January of next year.

Beyond the work of the Basle Committee and the banking agencies, we are also meeting with the Securities and Exchange Commission and international securities and insurance regulators to identify common issues and to bring about greater convergence in our respective regulatory frameworks. That effort also has links to the committee's efforts and should prove helpful in strengthening the oversight and regulation of financial institutions throughout the world that provide a broad range of financial products. Successful groundwork from this effort could also have implications for moving forward domestically in an era of financial reform.

Guidance as well as supervisory and regulatory standards such as these--whether developed in a domestic or international context--are soon incorporated into examination procedures and help examiners in their reviews of many of the more complex activities of global banking organizations. These global institutions are perhaps the most challenging to supervise. Because it is not feasible for supervisors to review all locations of a global banking organization, emphasis is placed on the integrity of risk management and internal control systems, coordination with international supervisors, strong capital standards, and improved disclosures.

Staffing the Supervisory Process

A final supervisory challenge relates to the Federal Reserve's need to continue attracting, training, and retaining expert staff. Retaining sufficient numbers of individuals with the expertise to evaluate fully the risks in a rapidly changing banking industry is a major priority for the Federal Reserve and figures prominently in the bank supervision function's strategic plan. Particularly challenging is attracting and retaining specialists in the areas of capital markets and information technology in which we have experienced increased turnover. We will continue efforts to attract and retain both specialists and generalists who are qualified to address issues as the industry evolves.

As I have outlined in my testimony, the Federal Reserve's supervisory strategy is to maintain staff members that can adequately evaluate the general soundness of banking activities by placing strong emphasis on the bank's management processes, systems, and controls. I believe such an approach will serve us well as the industry continues to evolve either by expanding the scope of its activities or through broader structural changes from financial modernization legislation. Nevertheless, developing the supervisory techniques and attracting and training the personnel to do the job will pose a continuing challenge in the years ahead.

CONCLUSION

The history of banking and of bank supervision shows a long and rather close relationship between the health of the banking system and the economy, a connection reflecting the role of banks in the credit intermediation process. We can expect that relationship to continue and for bank earnings and asset quality to fluctuate as economic conditions change. As supervisors, we must prepare for such developments.

In many ways, however, the banking and financial system have changed dramatically in the past decade in terms of both structure and diversity of activities. Risk-management practices have also advanced, helped by technological and financial innovations. I believe that both bank supervisors and the banking industry have learned important lessons from the experience of the past ten years specifically about the need to actively monitor, manage, and control risks.

Nevertheless, conditions can always change, and the risk-focused approach will be continually challenged to anticipate and avoid new kinds of problems. We must recognize that a risk-focused approach to supervision is a developing process and however successful it may be, there will again be bank failures. Indeed, having no bank failures may suggest inadequate risk-taking by banks and less economic growth. Through our supervisory process, the Federal Reserve seeks to maintain the proper balance--permitting banks maximum freedom, while still protecting the safety net and maintaining financial stability. Devoting adequate attention to banking practices and conditions and responding promptly as events unfold is the key. We intend to do that now and in the years ahead.

(1.) "Independent commercial banking organizations" is defined as the sum of all bank holding companies and independent banks. Multibank holding companies are, therefore, considered as a single organization.

Statement by Theodore E. Allison, Assistant to the Board for Federal Reserve System Affairs, Board of Governors of the Federal Reserve System, before the Subcommittee on Domestic and International Monetary Policy of the Committee on Banking and Financial Services, US. House of Representatives, October 21, 1997

Thank you for the opportunity to comment on H.R.2637, the United States $1 Coin Act of 1997. Under H.R.2637, the dollar coin would be made gold in color and would be given a distinctive rim; it would retain the dimensions of the Susan B. Anthony dollar coin; and the dollar note would remain in circulation. The Federal Reserve believes that H.R.2637 achieves a good balance among the issues involved in the dollar-coin-versus-dollar-note debate and supports its passage.

For most of this decade, there has been a public discussion of the merits of replacing the dollar note with a dollar coin, with no consensus having developed in favor of doing so. Out of this discussion, however, a few conclusions can be drawn:

* The design of the Susan B. Anthony coin is widely disliked on grounds that it is easily confused with the quarter.

* The public appears to prefer to use dollar notes for most purposes because dollar coins can be confused with the quarter and also because they are thought to be too heavy.

* Many firms prefer dollar coins for certain kinds of transactions because coins are easier to handle in large quantities (especially important for transit systems), they reduce transaction time at the cash register (important for small retailers), or they work more efficiently in vending machines.

In the meantime, there has been an ongoing demand for Susan B. Anthony coins, with the result that the combined inventory at the Mint and the Federal Reserve, which now stands at about 133 million coins, will be depleted during the first half of the year 2000 assuming continuation of the current rate of withdrawals from Federal Reserve Banks, which is averaging about 4.2 million coins per month. Thus, it is likely that the Treasury Department will need to produce more dollar coins of some kind within the next several years. Even if the rate of withdrawals were to decline moderately in the next few years, as it has over the past several, the existing stock of dollar coins would likely be exhausted within a period that makes it advisable to plan now for that event.(1)

Public reaction to the design of the Susan B. Anthony dollar has been negative from the beginning. In 1978, even before the coin was issued, research conducted for the Federal Reserve by the University of Michigan School of Business Administration, using focus group interviews with both consumers and retailers, revealed considerable reservations in both groups about the Anthony design. The main concern was the perceived similarity to the quarter and, as a consequence, the risk of making a mistake in handling change. Through the years since, potential confusion with the quarter has dominated the public's perception of the dollar coin. Thus, it would not seem considerate-either of the public who dislike the Anthony dollar or of the merchants who need a viable dollar coin--if the impending depletion of Anthony dollars were addressed by manufacturing more of those coins.

Nor would it seem appropriate to introduce a new dollar coin with dimensions markedly different from those of the Anthony dollar because that would require that nearly all vending machines be mechanically refitted at considerable cost to the vending machine industry and its customers.

Moreover, a decision to withdraw the dollar note in connection with issuance of a redesigned dollar coin would be contrary to the preference of most Americans, who apparently do not wish at this time to give up the note.

Enactment of H.R.2637 would address all of these issues in a way that should be consistent with the needs of most of the affected public: The gold color and distinctive rim of the newly designed coin should make the public more approving than it now is of the Susan B. Anthony dollar. That, in turn, should benefit vending machine operators and other merchants who wish to see greater use of a dollar coin. Maintaining the Anthony dollar's dimensions in the new coin should minimize the introduction costs that vending machine operators would face. And retention of the dollar note would be consistent with the apparent wishes of most individuals at this time.

Finally, I should observe that the Treasury of the United States--and thereby taxpayers--would benefit financially if, and to the extent that, the availability of a more acceptable dollar coin either caused dollar coins to substitute for dollar notes in circulation more than would be the case without it or caused the total circulation of dollar notes and dollar coins to increase further than would have been the case otherwise.(2) Although this effect may not be large, it should be positive.

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

(2.) The impact of substituting dollar coins for dollar notes on the Treasury's financial position has been outlined in previous Board statements to the Congress. See, for example, "Statement by Edward W. Kelley, Jr., Member, Board of Governors of the Federal Reserve System, to the Subcommittee on Domestic and International Monetary Policy of the Committee on Banking and Financial Services, U.S. House of Representatives, May 3, 1995," Federal Reserve Bulletin, vol. 81 July 1995), pp. 676-78.

Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Joint Economic Committee, U.S. Congress, October 29, 1997

We meet against the background of considerable turbulence in world financial markets, and I shall address the bulk of my remarks to those circumstances.

We need to assess these developments against the backdrop of a continuing unpressive performance of the American economy in recent months. Growth appears to have remained robust and inflation low, and even falling, despite an ever-tightening labor market. Our economy has enjoyed a lengthy period of good economic growth, linked, not coincidentally, to damped inflation. The Federal Reserve is dedicated to contributing as best it can to prolonging this performance, and we will be watching economic and financial market developments closely and evaluating their implications.

Even after the sharp rebound around the world in the past twenty-four hours, declines in stock markets in the United States and elsewhere have left investors less wealthy than they were a week ago and businesses facing higher equity cost of capital. Yet, provided the decline in financial markets does not cumulate, it is quite conceivable that a few years hence we will look back at this episode, as we now look back at the 1987 crash, as a salutary event in terms of its implications for the macroeconomy.

The 1987 crash occurred at a time when the American economy was operating with a significant degree of inflationary excess that the fall in market values arguably neutralized. Today's economy, as I have been suggesting of late, has been drawing down unused labor resources at an unsustainable pace, spurred, in part, by a substantial wealth effect on demand. The market's net retrenchment of recent days will tend to damp that impetus, a development that should help to prolong our six-and-a-half-year business expansion.

As I have testified previously, much of the stock price gain since early 1995 seems to have reflected upward revisions of long-term earnings expectations, which were implying a continuing indefinite rise in profit margins from already high levels. I suspect we are experiencing some scaling back of the projected gains in foreign affiliate earnings, and investors probably are also revisiting expectations of domestic earnings growth. Still, the foundation for good business performance remains solid. Indeed, data on our national economy in recent months are beginning to support the notion that productivity growth, the basis for increases in earnings, is beginning to pick up.

I also suspect that earnings expectations and equity prices in the United States were primed to adjust. The currency crises in Southeast Asia and the declines in equity prices there and elsewhere do have some direct effects on U.S. corporate earnings, but not enough to explain the recent behavior of our financial markets. If it was not developments in Southeast Asia, something else would have been the proximate cause for a re-evaluation.

While productivity growth does appear to have picked up in the past six months, as I have pointed out in the past, it likely is overly optimistic to assume that the dimension of any acceleration in productivity will be great enough and persistent enough to close, by itself; the gap between an excess of long-term demand for labor and its supply. It will take some time to judge the extent of a lasting improvement.

Regrettably, over the past year the argument for the so-called new paradigm has slowly shifted from the not unreasonable notion that productivity is in the process of accelerating, to a less than credible view, often implied rather than stated, that we need no longer be concerned about the risk that inflation can rise again. The Federal Reserve cannot afford to take such a complacent view of our price prospects. There is much that is encouraging in the recent performance of the American economy, but, as I have often mentioned before, fundamental change comes slowly, and we need to evaluate the prospective balance of supply and demand for various productive resources in deciding policy.

Recent developments in equity markets have high-lighted growing interactions among national financial markets. The underlying technology-based structure of the international financial system has enabled us to improve materially the efficiency of the flows of capital and payment systems. That improvement, however, has also enhanced the ability of the financial system to transmit problems in one part of the globe to another quite rapidly. The recent turmoil is a case in point. I believe there is much to be learned from the recent experience in Asia that can be applied to better the workings of the international financial system and its support of international trade that has done so much to enhance living standards worldwide.

While each of the Asian economies differs in many important respects, the sources of their spectacular growth in recent years, in some cases decades, and the problems that have recently emerged are relevant to a greater or lesser extent to nearly all of them.

After the early post-World War II period, policies generally fostering low levels of inflation and openness of their economies coupled with high savings and investment rates contributed to a sustained period of rapid growth, in some cases starting in the 1960s and 1970s. By the 1980s most economies in the region were expanding vigorously. Foreign net capital inflows grew but until recent years were relatively modest. The World Bank estimates that net inflows of long-term debt, foreign direct investment, and equity purchases to the Asia Pacific region were only about $25 billion in 1990 but exploded to more than $110 billion by 1996.

A major impetus behind this rapid expansion was the global stock market boom of the 1990s. As that boom progressed, investors in many industrial countries found themselves more heavily concentrated in the recently higher valued securities of companies in the developed world, whose rates of return, in many instances, had fallen to levels perceived as uncompetitive with the earnings potential in emerging economies, especially in Asia. The resultant diversification induced a sharp increase of capital flows into those economies. To a large extent, they came from investors in the United States and Western Europe. A substantial amount came from Japan, as well, owing more to a search for higher yields than to rising stock prices and capital gains in that country. The rising yen through mid-1995 also encouraged a substantial increase in direct investment inflows from Japan. In retrospect, it is clear that more investment monies flowed into these economies than could be profitably employed at modest risk.

I suspect that it was inevitable in those conditions of low inflation, rapid growth, and ample liquidity that much investment moved into the real estate sector, with an emphasis by both the public and private sectors on conspicuous construction projects. This is an experience, of course, not unknown in the United States on occasion. These real estate assets, in turn, ended up as collateral for a significant proportion of the assets of domestic financial systems. In many instances, those financial systems were less than robust, beset with problems of lax lending standards, weak supervisory regimes, and inadequate capital.

Moreover, in most cases, the currencies of these economies were closely tied to the U.S. dollar, and the dollar's substantial recovery since mid-1995, especially relative to the yen, made their exports less competitive. In addition, in some cases, the glut of semiconductors in 1996 suppressed export growth, exerting further pressures on highly leveraged businesses.

However, overall GDP growth rates generally edged off only slightly, and imports, fostered by rising real exchange rates, continued to expand, contributing to what became unsustainable current account deficits in a number of these economies. Moreover, with exchange rates seeming to be solidly tied to the dollar, and with dollar and yen interest rates lower than domestic currency rates, a significant part of the enlarged capital inflows, into these economies, in particular short-term flows, was denominated by the ultimate borrowers in foreign currencies. This put additional pressure on companies to earn foreign exchange through exports.

The pressures on fixed exchange rate regimes mounted, as foreign investors slowed the pace of new capital inflows and domestic businesses sought increasingly to convert domestic currencies into foreign currencies or, equivalently, slowed the conversion of export earnings into domestic currencies. The shifts in perceived future investment risks led to sharp declines in stock market, across Asia, often on top of earlier declines or lackluster performances.

To date, the direct impact of these developments on the American economy has been modest, but it can be expected not to be negligible. U.S. exports to Thailand, the Philippines, Indonesia, and Malaysia (the four countries initially affected) were about 4 percent of total U.S. exports in 1996. However, an additional 12 percent went to Hong Kong, Korea, Singapore, and Taiwan (economies that have been affected more recently). Thus, depending on the extent of the inevitable slowdown in growth in this area of the world, the growth of our exports will tend to be muted. Our direct foreign investment in, and foreign affiliate earnings reported from, the economies in this region as a whole have been a smaller share of the respective totals than their share of our exports. The share is, nonetheless, large enough to expect some drop-off in those earnings in the period ahead. In addition, there may be indirect effects on the U.S. real economy from countries such as Japan that compete even more extensively with the economies in the Asian region.

Particularly troublesome over the past several months has been the so-called contagion effect of weakness in one economy spreading to others as investors perceive, rightly or wrongly, similar vulnerabilities. Even economies, such as Hong Kong, with formidable stocks of international reserves, balanced external accounts, and relatively robust financial systems, have experienced severe pressures in recent days. One can debate whether the recent turbulence in Latin American asset values reflects contagion effects from Asia, the influence of developments in U.S. financial markets, or homegrown causes. Whatever the answer, and the answer may be all of the above, this phenomenon illustrates the interdependencies in today's world economy and financial system.

Perhaps it was inevitable that the impressive and rapid growth experienced by the economies in the Asian region would run into a temporary slowdown or pause. But there is no reason that above-average growth in countries that are still in a position to gain from catching up with the prevailing technology cannot persist for a very long time. Nevertheless, rapidly developing, free market economies periodically can be expected to run into difficulties because investment mistakes are inevitable in any dynamic economy. Private capital flows may temporarily turn adverse. In these circumstances, companies should be allowed to default, private investors should take their losses, and government policies should be directed toward laying the macroeconomic and structural foundations for renewed expansion; new growth opportunities must be allowed to emerge. Similarly, in providing any international financial assistance, we need to be mindful of the desirability of minimizing the impression that international authorities stand ready to guarantee the liabilities of failed domestic businesses. To do otherwise could lead to distorted investments and could ultimately unbalance the world financial system.

The recent experience in Asia underscores the importance of financially sound domestic banking and other associated financial institutions. While the current turmoil has significant interaction with the international financial system, the recent crises would arguably have been better contained if long-maturity property loans had not accentuated the usual mismatch between maturities of assets and liabilities of domestic financial systems that were far from robust to begin with. Our unlamented savings and loan crises come to mind.

These are trying days for economic policymakers in Asia. They must fend off domestic pressures that seek disengagement from the world trading and financial system. The authorities in these countries are working hard, in some cases with substantial assistance from the International Monetary Fund, the World Bank, and the Asian Development Bank, to stabilize their financial systems and economies.

The financial disturbances that have afflicted a number of currencies in Asia do not at this point, as I indicated earlier, threaten prosperity in this country, but we need to work closely with their leaders and the international financial community to ensure that their situations stabilize. It is in the interest of the United States and other nations around the world to encourage appropriate policy adjustments, and where required, provide temporary financial assistance.
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Publication:Federal Reserve Bulletin
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Date:Dec 1, 1997
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