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Statements to the Congress.

Statement by Laurence H. Meyer, 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, July 16, 1998

The Board of Governors appreciates this opportunity to comment on the discussion draft regulatory relief bill. The Board welcomes this legislation and supports its purpose of revising outdated banking statutes that are imposing costs without providing commensurate benefits to the safety and soundness of depository institutions, enhancing consumer protection, or expanding credit availability. As the members of this subcommittee are aware, unnecessary regulatory burdens hinder the ability of banking organizations to compete effectively in the broader financial services marketplace and, ultimately, adversely affect the availability and prices of banking services and credit products to consumers.

In my testimony today, I would like to highlight those provisions of this legislation that the Board supports and believes are particularly significant in reducing burden and promoting efficient regulation. For example, the Board strongly endorses the measures in this bill that would immediately allow banks to pay interest on demand deposits and the Federal Reserve System to pay interest on the required and excess reserve balances held by depository institutions at the Federal Reserve Banks. The Board also strongly supports the protections embodied in title V of this bill, the Bank Examination Report Privilege Act, which promote effective bank supervision by enhancing the cooperative exchange of information between supervised financial institutions and their regulators. (Attached to this statement is an appendix containing an expanded discussion of the provisions governing interest on reserves and interest on demand deposits.)(1)

Although there is much in the draft bill that the Board favors, there are a few provisions with which the Board has concerns. I would like to point out some of these provisions, but I do not wish these objections to detract from the central message of my testimony--that the nation's banking system needs reform of the type embodied in this legislation.

PAST EFFORTS TO ALLEVIATE BURDEN

By way of background, it is important to note that the legislation being considered by the subcommittee today builds on the accomplishments of two prior reform measures that many members of this subcommittee worked hard to enact. The Community Development and Regulatory Improvement Act of 1994 (1994 Act) and the Economic Growth and Paperwork Reduction Act of 1996 (1996 Act) were useful measures that achieved meaningful reductions in regulatory burden.

In the 1994 Act, the Congress alleviated the paperwork burden for banking organizations seeking to gain federal approval to form new holding companies and to engage in certain nonbanking transactions, enhanced the efficiency of the regulatory process by eliminating unnecessary applications and filing requirements, and streamlined the examination and audit procedures of the federal banking agencies. Two years later, the Congress passed the 1996 Act, which permitted well-capitalized and well-managed institutions to commence previously approved nonbanking activities without filing an application. In the 1996 Act, the Congress also passed important reforms to consumer protection statutes that alleviated the burdens imposed by these statutory provisions on financial institutions without undercutting the goals of the consumer protection laws.

The Board supported these prior reform efforts, which--coupled with the Board's independent initiatives to make our regulations simpler, less burdensome, and more transparent--have had a bottom-line, practical effect: Fewer applications need to be filed with the Board, and banking organizations have saved substantial regulatory, legal, compliance, and other costs. In short, these statutory and regulatory changes have enhanced the competitiveness of banking organizations and have benefited the customers of these financial institutions. Nonetheless, as the authors of this bill have recognized, more can and should be done.

THE PROVISIONS OF THIS BILL

The draft bill contains important additional reform provisions that would further eliminate obsolete and unnecessary regulations. The Board applauds many of the measures contained in this bill, which we believe would eliminate restrictions that no longer serve a useful purpose and would thereby enhance the ability of U.S. banking institutions to operate efficiently and effectively in increasingly competitive financial markets.

Interest on Demand Deposits and Reserve Balances

The Board strongly endorses section 101 of the draft bill, which would permit the Federal Reserve to pay interest on required and excess reserve balances that depository institutions maintain at Federal Reserve Banks. Because required reserve balances do not currently earn interest, banks and other depository institutions employ costly procedures to reduce such balances to a minimum. The costs of designing and maintaining the systems that facilitate these reserve avoidance techniques represent a significant waste of resources for the economy. In addition, because some small banks do not have the volume of deposits needed to justify these costs, the current system of reserve avoidance techniques tends to place smaller institutions at a competitive disadvantage.

The reserve avoidance measures utilized by depository institutions currently also could complicate the implementation of monetary policy. Declines in required reserve balances through avoidance schemes could lead to increased volatility in the federal funds rate. The draft bill's authorization of interest payments on excess reserves would be a useful addition to the tools that the Federal Reserve possesses to deal with such contingencies.

If increased volatility in the federal funds rate did become a persistent feature of the money market, it would affect other overnight interest rates, raising funding risks for large banks, securities dealers, and other money market participants. Suppliers of funds to the overnight markets, including many small banks and thrift institutions, also would face greater uncertainty about the returns they would earn. Accordingly, allowing the Board to pay interest on required reserve balances would not only eliminate economic inefficiencies but also alleviate risks that could affect monetary policy and the smooth functioning of the money markets.

The Board also strongly supports section 102 of the bill, which would permit payment of interest on demand deposits held by businesses. The current prohibition of interest on the demand accounts of businesses is an anachronism that no longer serves any public policy purpose. This prohibition was enacted in the 1930s, at a time when the Congress was concerned that large money center banks might bid deposits away from country banks to make loans to stock market speculators. Regardless of whether this rationale for the prohibition was ever valid, it is certainly not applicable today: Funds flow freely around the country and among banks of all sizes. The absence of interest on demand deposits is no bar to the movement of money from depositories with surpluses--whatever their size or location--to the markets where funds can be profitably employed.

Moreover, although the prohibition has no current policy purpose, it imposes a significant burden both on banks and on those holding demand deposits, especially small banks and small businesses. Smaller banks complain that they are unable to compete for the deposits of businesses precisely because of their inability to offer interest on demand deposit accounts. Small banks, unlike their larger counterparts, lack the systems to offer compensating balance schemes and sweep accounts that allow these banks to offer businesses credit for, or interest on, excess demand balances. Small businesses, which often earn no interest on their demand deposits because they do not have account balances large enough to justify the fees charged for sweep programs, stand to gain the most from eliminating the prohibition of interest on demand deposits.

For these reasons, the Board strongly supports the immediate repeal of the prohibition of interest on demand deposits, as accomplished in section 102 the bill. Section 102 also presents an alternative that would ultimately allow payment of interest on demand deposits and, during a transition period, would authorize a fully reservable, twenty-four-transaction money market deposit account (MMDA). Although some transition period in the implementation of direct payments on demand deposits would not be objectionable, a relatively short period would be appropriate, rather than the six-year delay proposed in the alternative. The twenty-four-transaction MMDA under the alternative would be fully reservable and therefore would not contribute to further declines in required reserve balances and the complications that might entail for the implementation of monetary policy. With a relatively short transition period, the alternative would be acceptable to the Board in preference to the status quo.

The draft bill's alternative language also includes a provision granting the Federal Reserve increased flexibility in setting reserve requirements. At present, we have no intention of either increasing or decreasing reserve requirement ratios within the limits that we are already allowed by law. However, it is impossible to know in advance the contingencies that the Federal Reserve may have to address, and the added flexibility in setting reserve requirement ratios might be a useful tool at some time in the future.

Bank Examination Report Privilege

The Board endorses title V of the bill, the Bank Examination Report Privilege Act (BERPA). BERPA would take three steps to promote effective supervision of banking organizations by helping to preserve candor in communications between such institutions and their examiners. First, BERPA would clarify that a supervised institution may voluntarily disclose information that is protected by the institution's own privileges, such as the attorney-client privilege, to a federal banking agency without waiving those privileges as to third parties. Some courts have ruled that disclosure of information to examiners waives an institution's privileges in private civil litigation, and, as a result, some institutions have attempted to withhold information from their supervisors. By ensuring that privileges are not waived when data are given to examiners, BERPA would overcome the present reluctance of many institutions to disclose information for fear of losing common-law privileges.

Second, BERPA would establish uniform procedures that govern how a third party may seek to obtain confidential supervisory information from a banking agency. BERPA would require third parties to request such information directly from the federal banking agencies, under regulations and procedures adopted by the agencies. Third parties may turn to the courts only after having exhausted their administrative remedies. Finally, BERPA would define what constitutes confidential supervisory information and would strengthen the protection afforded to such information.

By protecting disclosures by depository institutions to their examiners and by safeguarding supervisory information, BERPA would prevent unwarranted disclosures that would have a chilling effect on the examinations process. Taken together, these measures would enhance the ability of the federal banking agencies to assess and to protect the safety and soundness of depository institutions.

Elimination of Duplicative Approval Requirements

Section 310 of the draft bill would provide an opportunity to eliminate needlessly duplicative filing and approval requirements for bank holding companies seeking to acquire a depository institution and merge it with an existing subsidiary. Currently, a bank holding company must obtain two sets of identical approvals before engaging in such a transaction. The bank holding company first must file an application and obtain prior approval under the Bank Holding Company Act to acquire the depository institution, and then the holding company must file another application and obtain a second approval under the Bank Merger Act to merge the acquired institution, which is by now already a subsidiary of the holding company, with one of its other subsidiaries.

The dual approval requirement is needlessly redundant. Under the Bank Holding Company Act, the Board is required to consider the financial, managerial, and competitive effects of the entire merger transaction, including any part of the transaction that involves the purchase of nonbanking assets. By contrast, under the Bank Merger Act, the appropriate federal banking agency reviews only that portion of the transaction that concerns the surviving bank. Accordingly, the Bank Merger Act review is subsumed in the larger Bank Holding Company Act review process. In addition, the statutory factors that the appropriate federal banking agencies are required to consider under the Bank Holding Company and the Bank Merger Acts are identical, and, frequently, the agencies undertake the two statutory reviews simultaneously. For these reasons, the Bank Merger Act review rarely, if ever, raises any issues that have not been fully vetted in the Bank Holding Company Act applications process.

Section 310 would provide the option for eliminating the duplicative review process by permitting bank holding companies that have already obtained approval to acquire an institution under the Bank Holding Company Act, then to merge that institution with an existing subsidiary without obtaining a second approval under the Bank Merger Act. To ensure that any special issues that may be raised by a specific bank merger may be reviewed by the relevant bank supervisor, section 310 would, nevertheless, require that the federal banking agency responsible for supervising the bank resulting from the merger receive advance notice of the proposed merger. Importantly, section 310 also would allow that agency to require a full application under the Bank Merger Act if that agency determines that special concerns or circumstances warrant such review of a transaction.

Other Burden Reduction Provisions

There are other parts of this draft bill, as well, that would relieve regulatory burden without giving rise to safety and soundness, supervisory, consumer protection, or other policy concerns. For example, section 312 would eliminate the outdated and largely redundant requirement in section 11(m) of the Federal Reserve Act, which currently sets a rigid ceiling on the percentage of bank capital and surplus that may be represented by loans collateralized by securities. Current supervisory policy, as well as national and state bank lending limits, addresses concerns regarding concentrations of credit more comprehensively than section 11(m) but does so without the unnecessary constraining effects of this section of the Federal Reserve Act.

Section 313 would eliminate section 3(f) of the Bank Holding Company Act, which applies certain restrictions that govern the nonbanking activities of bank holding companies to the activities conducted directly by savings banks under state law. Since the enactment of section 3(f), the courts have found that the insurance and other nonbanking prohibitions of the Bank Holding Company Act do not apply to the direct activities of banks. Eliminating section 3(f) would put savings banks that are subsidiaries of bank holding companies on equal competitive footing with their state bank counterparts, allowing savings banks and their subsidiaries to engage in those activities that are permissible for state banks under state law.

In another area, the alternative consumer credit disclosure mechanisms permitted by sections 401 and 402 will be less burdensome to creditors and just as helpful to consumers as the disclosure requirements embodied in current law. The Congress has already eliminated the requirement that creditors disclose a historical table for closed-end variable rate loans. Taking similar action with respect to open-end variable rate home-secured loans, and permitting creditors to make alternative disclosures to meet their obligations with regard to credit advertising under the Truth in Lending Act, would reduce regulatory burdens without sacrificing consumer protections.

AREAS OF CONCERN

Although the Board supports most of the provisions in the draft bill, there are a few sections of the legislation that cause us concern as they are drafted. These provisions, as currently drafted, may give certain entities unfair competitive advantages, may result in changes to the law that the subcommittee did not intend, may harm the safety and soundness of depository institutions, or are unnecessary.

Nonbank Banks

Two provisions of the draft bill would eliminate limitations that have been applied to nonbank banks. Section 221 would allow nonbank banks to offer business credit cards, even when these business loans are funded by insured demand deposits. Section 222 would liberalize the divestiture requirements that apply when companies violate the nonbank bank operating limitations. Eliminating these restrictions on nonbank banks, at first glance, may have intuitive appeal. However, there are important reasons why the Board is concerned about these provisions.

Nonbank banks--which, despite their popular name, are federally insured, national or state-chartered banks---came into existence by exploiting a loophole in the law. By means of this loophole, industrial, commercial, and other companies were able to acquire insured banks and to mix banking and commerce in a manner that was then, and remains today, statutorily prohibited for banking organizations. In 1987, in the Competitive Equality Banking Act (CEBA), the Congress closed the nonbank-bank loophole. At that time, the Congress chose not to require the fifty-seven companies operating nonbank banks to divest these institutions. Instead, the Congress permitted the companies owning these banks to retain their ownership so long as they complied with a carefully crafted set of limitations on the activities of nonbank banks and their parents. In a unique statutory explanation of legislative purpose, the Congress stated in CEBA that these limitations were necessary to prevent the owners of nonbank banks from competing unfairly with bank holding companies and independent banks.

Fewer than twenty-five nonbank banks currently claim the grandfather rights accorded in CEBA. The Board is concerned that removal of the limitations and restrictions that apply to nonbank banks would enhance advantages that this relative handful of organizations already possess over other owners of banks and would give rise to the potential adverse effects about which the Congress has in the past expressed concern. In addition, removal of limitations would permit the increased combination of banking and commerce for a select group of commercial companies, a mixture that the House recently considered and decided not to permit in the context of a broader effort to modernize our financial laws.

Financing Corporation Payments

The Board also has some concerns about section 103 of the draft bill, which authorizes the use of "excess net income" of a deposit insurance fund to pay interest on Financing Corporation (FICO) bonds and to reduce FICO interest assessments of the fund's members. The proposal would divert resources from the "deposit insurance purposes" of the funds to other, non-insurance purposes--a diversion that would create a troubling precedent that could be difficult to resist in the future.

More fundamentally, it is not clear if the provision would ensure that the deposit insurance funds have an adequate level of reserves. There is no "correct" level of reserves and no level that can be deemed "excess." There are always unforeseen problems--most recently, Asian instabilities and potential "year 2000" problems. Nor can we simply assume the indefinite continuation of the current economic expansion. As a result, the Board believes that it would be more prudent not to divert "excess" reserves but, instead, to allow bank insurance fund reserves to grow to provide greater protection against future unforeseen problems in the banking system.

Extensions of Credit to Executive Officers

Section 311 of the draft bill would allow a member bank to extend credit to the bank's executive officers (1) in the form of a home equity credit line of up to $100,000, so long as the credit line is secured by the officer's primary residence, and (2) in an unlimited amount, so long as the loan is overcollateralized by readily marketable assets. The Board believes the provision regarding the home equity line should be clarified to indicate that the amount of the credit line may not exceed the value of the real estate held as collateral. In addition, the Board believes that the provision allowing unlimited extensions of credit secured by readily marketable assets goes too far: Loans to executive officers and to other insiders should be carefully circumscribed and subject to quantitative limits. The Board and the Federal Deposit Insurance Corporation, which we understand recommended these provisions, are working together to suggest a clarification of this section of the bill and to address these issues.

Call Report Simplification

Finally, the subcommittee specifically requested comment on section 302 of the draft bill, which restates section 307 of the Riegle Community Development and Regulatory Improvement Act (Riegle Act). The Board and the other banking agencies, working through the Federal Financial Institutions Examination Council, have made substantial progress in implementing the mandate of section 307 of the Riegle Act.

Thus far, the federal banking agencies have eliminated approximately 80 Call Report data items; placed revised Call Report instructions and forms on the Internet; adopted Generally Accepted Accounting Principles as the reporting basis for all Call Reports; produced a draft core report; condensed four sets of Call Report instructions into one; provided an index for Call Report instructions; implemented an electronic filing requirement for all institutions submitting Call Reports; placed much of the Call Report data on the Internet; and reported to the Congress on recommendations to enhance efficiency for filers and users. The agencies are currently surveying depository institutions to identify additional Call Report items that could be eliminated, while retaining items that are essential for safety and soundness and other public policy purposes. The significant progress that has been made by the agencies to date and the agencies' ongoing efforts suggest that this section of the draft bill is not necessary.

CLOSING THOUGHTS

The Board applauds the efforts of the subcommittee to continue to eliminate unnecessary government-imposed burdens. The subcommittee has fashioned legislation that, in the main, builds upon past successes in regulatory reform and relieves regulatory burdens on banking organizations. In some areas, however, the draft bill may not achieve meaningful reform but instead would lead to competitive inequities or raise safety and soundness and other concerns.

The Board has long endorsed regulatory relief and financial modernization strategies that ensure regulatory equity for all participants in the financial services industry, that minimize the chances that federal safety net subsidies will be expanded into new activities and beyond the confines of insured depository institutions, that guarantee adequate federal supervision of financial organizations, and that ensure the continued safety and soundness of financial organizations. The Board would be pleased to work with the subcommittee and its able staff to reach these goals in this and future legislative efforts.

(1.) The attachments to this statement are available from Publications Services, Mail Stop 127, Board of Governors of the Federal Reserve System, Washington, DC 20551, and on the Board's site on the World Wide Web (http://www.federalreserve.gov).

Statement by Edward M. Gramlich, Member, Board of Governors of the Federal Reserve System, before the Subcommittee on Financial Institutions and Regulatory Relief and the Subcommittee on Housing Opportunity and Community Development of the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, July 17, 1998

(Governor Gramlich presented identical testimony before the Subcommittee on Financial Institutions and Consumer Credit and the Subcommittee on Housing and Community Opportunity of the Committee on Banking and Financial Services, U.S. House of Representatives, July 22, 1998.)

Despite a number of congressional actions designed to give mortgage borrowers greater information and protection, today's mortgage lending process can still be characterized as confusing, costly, and far less than optimal. Hence the Federal Reserve Board and the Department of Housing and Urban Development (HUD) were eager to respond to the Congress's request to make recommendations for improvement. At the outset, I should say we have enjoyed our cooperative working relationship with HUD.

We have spent two years considering possible reforms in the Truth in Lending Act (TILA) and the Real Estate Settlement Procedures Act (RESPA), two related but distinct statutes. We have concluded that meaningful TILA-RESPA reform can be achieved only through new legislation. Recommendations for such legislation are contained in the joint report we are delivering to the Congress.

The report identifies four key policy questions. After giving some background, my testimony today covers those four questions.

THE TRUTH IN LENDING ACT

TILA is intended to promote the informed use of consumer credit, primarily through disclosure, though with some substantive restrictions. It requires creditors to highlight the cost of credit as a dollar amount (the finance charge) and as an annual percentage rate (the APR). TILA requires additional disclosures for a loan secured by a consumer's home and permits consumers to rescind certain transactions that involve their principal dwelling. The Board's Regulation Z implements the act, and an official staff commentary interprets the regulation.

The disclosure rules that creditors must follow vary depending on the type of credit being offered. For example, there are separate rules for closed-end (installment) loans such as automobile or home mortgage loans, and for open-end (revolving) credit plans such as credit cards or home-equity lines of credit. Additional rules govern reverse mortgages and mortgages on which borrowers pay rates and fees above a certain amount.

THE REAL ESTATE SETTLEMENT PROCEDURES ACT

RESPA seeks to protect consumers from unnecessarily high real estate settlement costs, by providing them with information about the costs required to close a mortgage transaction and by prohibiting certain business practices. The two key RESPA cost disclosures are the good faith estimate of settlement costs and the settlement statement. The good faith estimate provides consumers with an itemized estimate of the costs they are expected to pay at closing. The settlement statement records the actual costs paid, such as fees for survey, appraisal, credit report, title examination and insurance, loan points, mortgage broker's fees, and amounts to be held in reserve accounts. RESPA also imposes other disclosure requirements in the mortgage-servicing process, including initial and annual escrow account statements and notice of the transfer of loan servicing. RESPA is implemented by HUD's Regulation X.

RESPA prohibits kickbacks, referral fees, and unearned fees because these practices were found to unnecessarily increase the cost of settlement services to consumers. RESPA also limits the amounts creditors can collect for escrow accounts, prohibits sellers's requiring a purchaser-borrower to obtain title insurance from a particular title company, and provides rights for consumers when loan servicing is transferred.

THE AGENCIES' ACTIONS REGARDING REFORM

The Board and HUD have worked steadily since 1996 to respond to the congressional mandate to reform and simplify TILA and RESPA disclosures. Initially the agencies considered whether congressional goals could be achieved by changing administrative rules, but ultimately we decided that significant harmonizing of TILA and RESPA could come about only through legislation.

In April 1997, the Board published a notice seeking comments on possible statutory changes. Generally, creditors supported reform to TILA and RESPA to improve clarity and certainty for compliance. Consumer advocates supported changes that would result in more user friendly disclosures provided early enough to allow shopping among creditors, and that were more accurate to avoid unexpected charges at the loan closing.

The Board and HUD have also hosted public meetings. In July 1997, the agencies jointly sponsored a forum to give interested parties an opportunity to present their views on the issues of simplifying and reforming TILA and RESPA. Some speakers discussed extensive reforms to the entire disclosure scheme for real-estate-secured lending, while others cautioned the Board and HUD against mere tinkering with the current law.

The forum followed heatings that the Board had held in June 1997, in Los Angeles, Atlanta, and Washington, D.C., on home-equity lending and the so-called high cost loans covered by the Home Ownership and Equity Protection Act of 1994 (HOEPA). Although the focus of the hearings was HOEPA, there was also discussion of TILA's finance charge and the APR. The agencies also have met extensively with representatives of consumer groups and the industries involved in the mortgage-lending process, including member organizations of the Mortgage Reform Working Group, a private-sector group formed in 1997 to deliberate on possible reforms to TILA and RESPA.

The Board also commissioned consumer surveys and focus groups. The studies provided insight into information consumers use to shop for credit and on consumers' understanding of the APR and other cost disclosures. And at several of its meetings in recent years, the Board's Consumer Advisory Council has considered efforts to reform and simplify TILA and RESPA.

FOUR MAJOR POLICY QUESTIONS DISCUSSED IN REPORT ON TILA-RESPA REFORM

The issues involved in mortgage loan reform are highly complex. To facilitate the Congress's study of the central issues of reform, our report focuses on four broad policy questions concerning closed-end home-secured loans: the effectiveness of the finance charge and the APR (a TILA question), the reliability of settlement cost disclosures (a RESPA question), the timing of disclosures (both), and substantive protections to target abusive lending practices (both).

1. Should the finance charge and APR disclosures be eliminated, or should they be modified and retained?

The Board and HUD recommend that the APR and finance charge concepts be retained, and that the definition of the finance charge (which affects the APR) be expanded to include all costs the consumer is required to pay in order to close the loan. The agencies also recommend that the interest rate on the note and a more informative explanation of the APR be added as disclosures so that consumers can better understand the distinction between the two rates.

Most of the attention given to TILA reform has focused on two issues: Should the APR be retained as a measure of the overall cost of credit, and should the definition of a finance charge be revised to include more (or fewer) costs. The same cost items are included in both concepts, but the finance charge is expressed as the full dollar cost of borrowing over all years, while the APR is that dollar cost expressed as an annualized percentage rate, comparable to an interest rate.

In principle, TILA defines the finance charge very broadly, as any charge payable directly or indirectly by the consumer and imposed directly or indirectly by the creditor as an incident to or a condition of the extension of credit. Under this definition, the finance charge should include interest, points, and transaction fees.

But in practice the finance charge and the corresponding APR have never disclosed the full cost of credit. Because of legislated exceptions, TILA does not include a number of charges in the finance charge, most notably many closing costs associated with real-estate-secured loans, such as fees for appraisals and title insurance.

While some favor dropping the APR altogether, the Board believes in improving it. It is familiar to consumers, even though they may not frilly understand it. It is simple and potentially comparable to the straight mortgage rate. It is easier for consumers to evaluate competing products with a single figure than by using a number of different costs such as interest, points, and closing costs. If more costs were included in the finance charge and reflected in the APR, the APR would become an even better measuring rod. Also, including the interest rate on the TILA disclosure with the APR could help consumers better understand the difference between the two (currently the interest rate is not disclosed). A chart showing the treatment of various items under TILA and our proposed standard is given in attachment A.(1)

The key to improving the usefulness of the APR is in revising the definition of the finance charge. TILA's current "some fees in, some fees out" approach produces a finance charge and APR that for consumers is incomplete as a measure of the cost of credit and for creditors is unnecessarily complicated. Indeed, the Congress recognized the need for possible changes and asked the Board to study the feasibility of a more inclusive finance charge.

The Board and the HUD believe that the finance charge should be defined as the costs the consumer is required to pay to get credit. Under this approach, many fees now excluded from the finance charge would be included. But this test would still exclude costs that are paid in comparable cash transactions (such as property taxes) and costs for optional services (such as credit life insurance). We believe that such a required-to-pay definition would provide both consumers and creditors with the most consistent basis for comparison shopping.

2. Should creditors be required to provide firmer quotes for closing costs disclosed under RESPA?

The Board and HUD recommend that creditors be required to give consumers more reliable closing cost information to promote shopping and competition. Creditors should be given a choice between guaranteeing settlement costs and providing a good faith estimate that is accurate within a specified tolerance. HUD testimony discusses additional HUD recommendations.

RESPA requires creditors to list all costs they anticipate the consumer will have to pay to close a loan. A good faith estimate is provided at or soon after application, and a settlement statement containing the actual costs is provided at closing.

The Board and HUD believe that an essential element of mortgage reform is to create incentives for creditors to provide firmer cost disclosures to consumers. The agencies are concerned, for example, that some costs in the good faith estimate are significantly lower than those actually charged at closing and that other costs are left off the good faith estimate altogether. To the extent that discrepancies exist, the good faith estimate is unreliable as a shopping tool. Requiring firmer figures for RESPA's early closing cost disclosures would also improve the finance charge and APR disclosures under TILA because many of the costs that go into those disclosures would be more accurate.

The Board and HUD have considered a number of ways for ensuring that closing costs are estimated more accurately. We agree that it would be appropriate to provide an incentive to creditors, such as giving an exemption for creditors and service providers to RESPA's section 8, which prohibits certain fees and may be thought to prevent volume-based discounts. The agencies recommend a dual disclosure system in which creditors could choose between guaranteeing the closing costs, hence entitling the creditor to an exemption under section 8, and providing estimated closing costs that are accurate within a prescribed tolerance. This system would provide an incentive to creditors and others to guarantee costs without forcing them to guarantee. We believe the dual approach also offers an opportunity for the market to test whether guaranteed cost arrangements offer economical and efficient means for consumers to obtain mortgage loans.

3. Should the timing rules for providing cost disclosures to consumers be changed--and should creditors be required to provide disclosures before imposing substantial fees?

The Board and HUD recommend that consumers be given cost disclosures for home-secured loans as early as possible in the shopping process. The Board recommends that disclosures be provided not later than three days after application. HUD recommends even earlier disclosure, along with a limitation on application fees.

The Board and HUD also recommend that three days prior to closing, creditors should be required to redisclose significant changes in the APR or other material disclosures and provide an accurate copy of the settlement statement. For nonpurchase home-secured transactions in which the right of rescission currently applies, the Board recommends that consumers also receive a notice of a pre-closing right to a refund at that time, to replace the existing rescission period in most instances.

Currently in home-secured transactions, consumers receive RESPA or TILA disclosures at several different times. Generic information, such as consumer education booklets, are provided at or before application. Certain loan-specific disclosures are given at or several days after application, others are given at or several days before the time of closing. (The chart in attachment B identifies the timing requirements under the two statutes.)

The Congress has asked the Board and HUD to simplify and improve the timing of the disclosures under the two laws. The disclosure process would be simplified for creditors if the timing requirements for providing disclosures could be made more consistent. It would be further improved if the disclosures were given when they could be of most help to consumers. Another consideration is the extent to which shopping may be impeded by the payment of fees before consumers receive cost disclosures about their mortgage loan.

The Board and HUD agree that consumers should be given cost disclosures as early as possible in the shopping process. The agencies differ somewhat in their approaches on this issue, but in either case consumers would get better information sooner than at present.

The Board recommends that the initial cost disclosures be provided no later than three days after application. HUD recommends even earlier disclosure. The Board and HUD believe that rapid advances in technology (such as automated underwriting) will permit creditors to disclose firm costs at earlier stages of the loan origination process, and the Board believes that the marketplace may lead creditors to the standard contemplated by HUD. However, the Board believes that while some creditors can provide closing costs at first contact with consumers, others cannot. Even fewer creditors can fully underwrite the loan to determine the interest rate and points within a few days. The Board believes its more flexible approach strikes the appropriate balance of encouraging greater certainty in cost figures at an early stage without mandating a standard that is currently impossible for many creditors.

The Board recognizes that the ability to comparison shop will be curtailed for many consumers if they must pay more than a nominal amount to obtain disclosures, regardless of when the disclosures are provided. But unlike HUD, the Board does not support a limitation on fees, which could constrict the supply of credit. The Board believes that creditors will keep fees reasonable as they realize savings from the increased use of technology and as competition in mortgage lending increases.

With regard to subsequent disclosures, the Board and the HUD both recommend that three days before closing creditors be required to redisclose significant changes in the APR or other material disclosures and to provide an accurate copy of the settlement statement. Consumers would receive final cost disclosures three days before closing (rather than at closing, the current practice), which will allow them to study the disclosures in an unpressured environment. Redisclosure at closing would be required if there were material changes from the disclosures provided three days before closing.

TILA now provides that, in certain transactions secured by a consumer's principal home, the consumer has three business days after becoming obligated on the debt to rescind the transaction. This right of rescission was created to allow consumers time to reexamine their credit contracts and cost disclosures and to reconsider whether they want to place their home at risk by offering it as security for the credit.

For transactions subject to this right of rescission, the Board also recommends that the disclosures given three days before closing also include a notice of the right not to complete the transaction and receive a refund. As an incentive to provide accurate disclosures in these transactions, the Board recommends that creditors be allowed to fund the loan at closing (assuming the consumer chooses to complete the transaction), when such a notice has been provided and when there are no material changes in the disclosures. If the consumer chooses not to complete the loan transaction, the creditor would be required to refund all fees, as is currently the case. If at closing there are material changes, closing can still occur but consumers would still have the three-day right to rescind, which they would be free to waive.

4. Should additional substantive consumer protections be added to the statutes?

The Board and HUD recommend that substantive protections be adopted that will target abusive lending practices without unduly interfering with the flow of credit or narrowing consumers' options in legitimate transactions. The agencies recommend restrictions against balloon payments and the advance collection of lump-sum premiums for credit insurance for loans covered by HOEPA. The Board and HUD also recommend requiring certain minimum standards for notice procedures creditors must follow in all home foreclosures. HUD testimony discusses additional HUD recommendations.

TILA was amended by HOEPA to address abusive practices. HOEPA applies to home-secured loans with rates or fees above a specified amount. The rate test for a HOEPA-covered loan is met if the APR at the time of closing exceeds by more than 10 percentage points the yield on Treasury securities of comparable maturity. The dollar test is met if the total points and fees exceed 8 percent of the loan amount or a certain dollar figure, whichever is greater. (The dollar figure is adjusted annually; for 1998 it is $435.) Home-purchase loans, reverse mortgages, and open-end lines of credit are exempt.

While HOEPA was an important step in curtailing abusive practices, unfortunately they persist. The report discusses various ways to deal with abusive lending practices. For example, the report discusses the problem of loan "flipping," in which loans are refinanced repeatedly and consumers' equity is stripped by excessive fees added to the loan amount. These loans are made to appear attractive by monthly payments that are kept low, but they are often accompanied by a large balloon payment that the consumer must then refinance.

The report discusses possible ways to control flipping, including additional limitations on balloon payments and the ability to finance closing costs for loans subject to the HOEPA. The report also discusses a number of approaches to avoid unwarranted foreclosures on consumers' homes, including counseling and uniform notice requirements that inform consumers about the foreclosure process and what steps must be taken--and by when--to forestall foreclosure. While it is difficult to control abusive lending practices, the Board and HUD believe that protections against these practices should be a part of any legislation enacted to simplify and reform TILA and RESPA. The Board and HUD further believe that any new rules should be part of a multifaceted approach that also includes counseling, education, and voluntary industry action.

The Board believes that certain protections, narrowly drawn, clearly address some abusive practices. These fit the criteria of being narrowly tailored rules that will not unduly restrict credit and limit choice.

The Board and HUD join in two recommendations to protect consumers who obtain HOEPA-covered loans; one addresses balloon payments, and the other addresses single-premium credit insurance.

Currently, balloon payments are prohibited for HOEPA-covered loans with maturities of less than five years. This prohibition is an important first step to curb the flipping that occurred before HOEPA was enacted. While most creditors believe low monthly payments and a balloon payment can be a useful tool in some cases and should be permitted, the current less-than-five-year rule can still be criticized because it allows creditors to flip mortgages with balloon loans that mature in five years. For HOEPA loans, consumers may be just as unlikely to repay or refinance the loan at better rates after five years than they are after two or three years. Hence the Board believes that HOEPA balloon notes should be further restricted either by lengthening the prohibition period, applying stronger prohibitions to a subset of HOEPA loans, or prohibiting HOEPA balloon notes altogether.

The Board and HUD also recommend limiting creditors' ability to collect up front certain credit insurance premiums on HOEPA-covered loans. Currently, TILA has some limitations regarding the sale of credit insurance (for life, disability, and unemployment). It permits creditors to exclude the cost of premiums for optional insurance from the disclosed finance charge and APR if it is truly optional and if the premium amount is disclosed.

Consumer advocates express concern about high-pressure sales tactics used on consumers to purchase high-priced credit insurance. The insurance is sometimes sold with a single premium collected up front. If for some reason the mortgage loan is closed prematurely, it is often difficult for consumers to get back the unused portion of their premium.

Regulation of insurance, including the allowable premium rates, has historically been a matter for state law. The Board and HUD believe, however, that some abusive practices could be eliminated by prohibiting the advance collection of premiums on HOEPA-covered loans, so that consumers would pay for insurance periodically--and only for the time the loan is actually outstanding. This means that termination of the loan automatically would cancel both the coverage and any liability for future payments.

The final recommendation addressing abusive lending practices concerns notices that should be provided to consumers in general (HOEPA and non-HOEPA) before foreclosure. The Board and HUD believe that consumers who have been victims of abusive practices must be provided adequate opportunity to assert their rights in order to avoid unwarranted foreclosures.

For the most part, the procedures that a creditor must follow for foreclosure are governed by state law, local practice, and the terms of the relevant contract documents. These procedures include the amount or type of notice that consumers are entitled to regarding impending foreclosure. Some states require creditors to provide actual notices to consumers, but in other states notice by publication is deemed sufficient. In some states a judicial process is followed; the creditor must file a lawsuit and obtain a judgment in order to obtain permission to sell the property. Other states allow the use of a non-judicial process, in which the creditor merely notifies the borrower that the home will be advertised and sold, thereby placing the burden on the homeowner to take legal action to prevent the sale. In some cases consumers do not receive adequate information about the foreclosure and options that are available to them.

Requiring a minimum standard for the type of notice creditors must provide to consumers before foreclosure raises issues concerning preemption of state law. However, to avoid unannounced foreclosures on consumers' homes, the Board and HUD recommend that before any foreclosure sale, creditors must first provide a written explanation of any rights the consumer may have to cure the delinquency or redeem the property. Consumers should also be notified of steps they must take to exercise their rights, the process that will be followed in any foreclosure, and information about the availability of third-party credit counseling.

This concludes my discussion of the four key questions in reforming TILA-RESPA. We look forward to working further with HUD and the Congress to make the recommended changes.

(1.) The attachments to this statement are available from Publications Services, Mail Stop 127, Board of Governors of the Federal Reserve System, Washington, DC 20551, and on the Board's site on the World Wide Web (http://www.federalreserve.gov).

Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, July 21, 1998

(Chairman Greenspan presented identical testimony before the Subcommittee on Domestic and International Monetary Policy of the Committee on Banking and Financial Services, U.S. House of Representatives, July 22, 1998.)

I appreciate this opportunity to present the Federal Reserve's midyear report on monetary policy.(1)

Overall, the performance of the U.S. economy continues to be impressive. Over the first part of the year, we experienced further gains in output and employment, subdued prices, and moderate long-term interest rates. Important crosscurrents, however, have been impacting the economy. With labor markets very tight and domestic final demand retaining considerable momentum, the risks of a pickup in inflation remain significant. But inventory investment, which was quite rapid late last year and early this year, appears to have slowed, perhaps appreciably. Moreover, the economic and financial troubles in Asian economies are now demonstrably restraining demands for U.S. goods and services--and those troubles could intensify and spread further. Weighing these forces, the Federal Open Market Committee (FOMC) chose to keep the stance of policy unchanged over the first half of 1998. However, should pressures on labor resources begin to show through more impressively in cost increases, policy action may need to counter any associated tendency for prices to accelerate before it undermines this extraordinary expansion.

RECENT DEVELOPMENTS

When I appeared before your subcommittee in February, I noted that a key question for monetary policy was whether the consequences of the turmoil in Asia would be sufficient to check inflationary tendencies that might otherwise result from the strength of domestic spending and tightening labor markets. After the economy's surge in 1996 and, especially, last year, resource utilization, particularly that of the labor force, had risen to a very high level. Although some signs pointed to stepped-up increases in productivity, the speed at which the demand for goods and services had been growing clearly exceeded the rate of expansion of the economy's long-run potential to produce. Maintenance of such a pace would put even greater pressures on the economy's resources, threatening the balance and longevity of the expansion.

However, it appeared likely that the difficulties being encountered by Asian economies, by cutting into U.S. exports, would be a potentially important factor slowing the growth of aggregate demand in the United States. But uncertainties about the timing and dimensions of that development were considerable given the difficulties in assessing the extent of the problems in East Asia.

In the event, the contraction of output and incomes in a number of Asian economies has turned out to be more substantial than most had anticipated. Moreover, financial markets in Asia and in emerging market economies generally have remained unsettled, portending further difficult adjustments. The contraction in Asian economies, along with the rise in the foreign exchange value of the dollar over 1997, prompted a sharp deterioration in the U.S. balance of trade in the first quarter. Nonetheless, the American economy proved to be unexpectedly robust in that period. The growth of real gross domestic product not only failed to slow, it climbed further, to about a 5 1/2 percent annual rate in the first quarter, according to the current national income accounts. Domestic private demand for goods and services--including personal consumption expenditures, business investment, and residential expenditures--was exceptionally strong.

Evidently, optimism about jobs, incomes, and profits, high and rising wealth-to-income ratios, low financing costs, and falling prices for high tech goods fed the appetites of households and businesses for consumer durables and capital equipment. In addition, inventory investment contributed significantly to growth in the first quarter; indeed, the growth of stocks of materials and goods outpaced that of overall output by a wide margin during the first quarter, adding 1 3/4 percentage points to the annualized growth rate of GDP. Although accumulation of some products likely was unintended, surveys indicate that much of the stockbuilding probably reflected firms' confidence in the prospects for continued growth.

As evidence piled up that the economy continued to run hot during the winter, the Federal Reserve's concerns about inflationary pressures mounted. Domestic demand clearly had more underlying momentum than we had anticipated, supported in part by financial conditions that were quite accommodative. Credit remained extremely easy for most borrowers to obtain; intermediate- and long-term interest rates were at relatively low levels; equity prices soared higher, despite some disappointing earnings reports; and growth in the monetary aggregates was rapid. Indeed, the crises in Asia, by lowering longer-term U.S. interest rates--through stronger preferences for dollar investments and expectations of slower growth ahead--and by reducing commodity prices, probably added to the positive forces boosting domestic spending in the first half, especially in the interest-sensitive housing sector. The robust expansion of demand tightened labor markets further, giving additional impetus to the upward trend in labor costs. Inflation was low--though, given the lags with which monetary policy affects the economy and prices, we had to be mainly concerned not with conditions at the moment but with those likely to prevail many months ahead. In these circumstances, the Federal Open Market Committee elected in March to move to a state of heightened alert against inflation but left the stance of policy unchanged.

Although national income and product data for the second quarter have not yet been published, growth of U.S. output appears to have slowed sharply. The auto strike has brought General Motor's production essentially to a halt, probably reducing real GDP in the second quarter about 1/2 percentage point at an annual rate. The limited available information on inventory investment suggests that stockbuilding dropped markedly from its unsustainable pace of the first quarter. In addition to the slower pace of inventory building, Asian economies have continued to deteriorate, further retarding our exports in recent months.

Indeed, readings on the elements that make up the real GDP have led many analysts to anticipate a decline in that measure in the second quarter, after the first-quarter surge. Given the upcoming revisions to the national income accounts, such assessments would have to be regarded as conjectural. It is worth noting in any case that other indicators of output, including worker hours and manufacturing production, show a somewhat steadier, though slowing, path over the first half of the year. And underlying trends in domestic final demand have remained strong, imparting impetus to the continuing economic expansion.

During the first half of the year, measures of resource utilization diverged. Pressures on manufacturing facilities appeared to be easing. Plant capacity was growing rapidly as a result of vigorous investment. And growth of industrial output was dropping off from its brisk pace of 1997, importantly reflecting the deceleration in world demand for manufactured goods that resulted from the Asian economic difficulties.

But labor markets, in contrast, became increasingly taut during the first half. Total payroll jobs rose about one-and-one-half million over the first six months of the year. The civilian unemployment rate dropped to a bit below 4 1/2 percent in the second quarter, its lowest level in three decades. Firms resorted to a variety of tactics to attract and retain workers, such as paying various types of monetary bonuses and raising basic wage rates. But, at least through the first quarter, the effects of a rising wage bill on production costs were moderated by strong gains in productivity.

Indeed, inflation stayed remarkably damped during the first quarter. The consumer price index as well as broader measures of prices indicates that inflation moved down further, even as the economy strengthened. Although declining oil prices contributed to this development, pricing leverage in the goods-producing sector more generally was held in check by reduced demand from Asia that, among other things, has led to a softening of commodity prices, a strong dollar that has contributed to bargain prices on many imports, and rising industrial capacity. Service price inflation, less influenced by international events, has remained steady at about a 3 percent rate since before the beginning of the crisis.

Some elements in the goods price mix clearly were transitory. Indeed, the more recent price data suggest that overall consumer price inflation moved up in the second quarter. But, even so, the increase remained moderate.

In any event, it would be a mistake for monetary policy makers to focus on any single index in gauging inflation pressures in the economy. Although much public attention is directed to the consumer price index (CPI), the Federal Reserve monitors a wide variety of aggregate price measures. Each is designed for a particular purpose and has its own strengths and weaknesses. Price pressures appear especially absent in some of the measures in the national income accounts, which are available through the first quarter. The chain-weight price index for personal consumption expenditures excluding food and energy, for example, rose 1.5 percent over the year ending in the first quarter, considerably less than the 2.3 percent rise in the core CPI over the same period. An even broader price measure, that for overall GDP, rose 1.4 percent. These indexes, while certainly subject to many of the measurement difficulties the Bureau of Labor Statistics has been grappling with in the CPI, have the advantages that their chain-weighting avoids some aspects of so-called substitution bias and that already published data can be revised to incorporate new information and measurement techniques. Taken together, while the various price indexes show some differences, the basic message is that inflation to date has remained low.

ECONOMIC FUNDAMENTALS: THE VIRTUOUS CYCLE

So far this year, our economy has continued to enjoy a virtuous cycle. Evidence of accelerated productivity has been bolstering expectations of future corporate earnings, thereby fueling still further increases in equity values, and the improvements in productivity have been helping to reduce inflation. In the context of subdued price increases and generally supportive credit conditions, rising equity values have provided impetus to spending and, in turn, the expansion of output, employment, and productivity-enhancing capital investment.

The essential precondition for the emergence, and persistence, of this virtuous cycle is arguably the decline in the rate of inflation to near price stability. In recent years, continued low product price inflation and expectations that it will persist have promoted stability in financial markets and fostered perceptions that the degree of risk in the financial outlook has been moving ever lower. These perceptions, in turn, have reduced the extra compensation that investors require for making loans to, or taking ownership positions in, private firms. With risks in the domestic economy judged to be low, credit and equity capital have been readily available for many businesses, fostering strong investment. And low mortgage interest rates have allowed many households to purchase homes and to refinance outstanding debt. The reduction in debt-servicing costs has contributed to an apparent stabilization of the financial strains on the household sector that seemed to emerge a couple of years ago and has buoyed consumer demand.

To a considerable extent, investors seem to be expecting that low inflation and stronger productivity growth will allow the extraordinary growth of profits to be extended into the distant future. Indeed, expectations of earnings growth over the longer term have been undergoing continual upward revision by security analysts since early 1995. These rising expectations have, in turn, driven stock prices sharply higher and credit spreads lower, perhaps in both cases to levels that will be difficult to sustain unless the virtuous cycle continues. In any event, primarily because of the rise in stock prices, about $12 1/2 trillion has been added to the value of household assets since the end of 1994. Probably only a few percent of these largely unrealized capital gains have been transformed into the purchase of goods and services in consumer markets. But that increment to spending, combined with the sharp increase in equipment investment, which has stemmed from the low cost of both equity and debt relative to expected profits on capital, has been instrumental in propelling the economy forward.

The consequences for the American worker have been dramatic and, for the most part, highly favorable. A great many chronically underemployed people have been given the opportunity to work, and many others have been able to upgrade their skills as a result of work experience, extensive increases in on-the-job training, or increased enrollment in technical programs in community colleges and elsewhere. In addition, former welfare recipients appear to have been absorbed into the work force in significant numbers.

Government finances have been enhanced as well. Widespread improvement has been evident in the financial positions of state and local governments. In the federal sector, the taxes paid on huge realized capital gains and other incomes related to stock market advances, coupled with taxes on markedly higher corporate profits, have joined with restraint on spending to produce a unified budget surplus for the first time in nearly three decades. The important steps taken by the Congress and the Administration to put federal finances on a sounder footing have added to national saving, relieving pressures on credit markets. The paydown of debt associated with the federal surplus has helped to hold down longer-term interest rates, which in turn has encouraged capital formation and reduced debt burdens. Maintaining this disciplined budget stance would be most helpful in supporting a continuation of our current robust economic performance in the years ahead.

The fact that economic performance has strengthened as inflation subsided should not have been surprising, given that risk premiums and economic disincentives to invest in productive capital diminish as the economy approaches price stability. But the extent to which strong growth and high labor force utilization have been joined with low inflation over an extended period is, nevertheless, exceptional. So far, at least, the adverse wage-price interactions that played so central a role in pressuring inflation higher in many past business expansions--eventually bringing those expansions to an end--have not played a significant role in the current expansion.

For one thing, increases in hourly compensation have been slower to pick up than in most other recent expansions, although, to be sure, wages have started to accelerate in the past couple of years as the labor market has become progressively tighter. In the first few years of the expansion, the subdued rate of rise in hourly compensation seemed to be, in part, a reflection of greater concerns among workers about job security. We now seem to have moved beyond that phase of especially acute concern, though the flux of technology may still be leaving many workers with fears of job skill obsolescence and a willingness to trade wage gains for job security. In the past couple of years, of course, workers have not had to press especially hard for nominal pay gains to realize sizable increases in their real wages. In contrast to the pattern that developed in several previous business expansions, when workers required substantial increases in pay just to cover increases in the cost of living, consumer prices have been generally well-behaved in the current expansion.

A couple of years ago--almost at the same time that increases in total hourly compensation began trending up in nominal terms--evidence of a long-awaited pickup in the growth of labor productivity began to show through more strongly in the data; and this accelerated increase in output per hour has enabled firms to raise workers' real wages while holding the line on price increases. Gains in productivity usually vary with the strength of the economy, and the favorable results that we have observed during the past two years or so, when the economy has been growing more rapidly, almost certainly overstate the degree of structural improvement. But evidence continues to mount that the trend of productivity has accelerated, even if the extent of that pickup is as yet unclear. Signs of major technological improvements are all around us, and the benefits are evident not only in high tech industries but also in production processes that have long been part of our industrial economy.

Those technological innovations and the rapidly declining cost of capital equipment that embodies them in turn seem to be a major factor behind the recent enlarged gains in productivity. Evidently, plant managers who were involved in planning capital investments anticipated that a significant increase in the real rates of return on facilities could be achieved by exploiting emerging new technologies. If that had been a mistake on their part, one would have expected capital investment to run up briefly and then start down again when the lower-than-anticipated rates of return developed. But we have instead seen sustained gains in investment, indicating that hoped-for rates of return apparently have been realized.

Notwithstanding a reasonably optimistic interpretation of the recent productivity numbers, it would not be prudent to assume that even strongly rising productivity, by itself, can ensure a noninflationary future. Certainly wage increases, per se, are not inflationary, unless they exceed productivity growth, thereby creating pressure for inflationary price increases that can eventually undermine economic growth and employment. Because the level of productivity is tied to an important degree to the stock of capital, which turns over only gradually, increases in the trend growth of productivity probably also occur rather gradually. By contrast, the potential for abrupt acceleration of nominal hourly compensation is surely greater.

As I have noted in previous appearances before the Congress, economic growth at rates experienced on average over the past several years would eventually run into constraints as the reservoir of unemployed people available to work is drawn down. The annual increase in the working-age population (from 16 to 64 years of age), including immigrants, has been approximately 1 percent a year in recent years. Yet employment, measured by the count of persons who are working rather than by the count of jobs, has been rising 2 percent a year since 1995, despite the acceleration in the growth of output per hour. The gap between employment growth and population growth, amounting to about 1.1 million persons a year on average since the end of 1995, has been made up, in part, by a decline in the number of individuals who are counted as unemployed--those persons who are actively seeking work--of approximately 650,000 a year, on average, over the past two and one-half years. The remainder of the gap has reflected a rise in labor force participation that can be traced largely to a decline of almost 300,000 a year in the number of individuals (aged 16 to 64) wanting a job but not actively seeking one. Presumably, many of the persons who once were in this group have more recently become active and successful job seekers as the economy has strengthened, thereby preventing a still sharper drop in the official unemployment rate. In June, the number of persons aged 16 to 64 who wanted to work but who did not have jobs was 10.6 million on a seasonally adjusted basis, roughly 6 percent of the working-age population. Despite an uptick in joblessness in June, this percentage is only fractionally above the record low reached in May for these data, which can be calculated back to 1970.

Nonetheless, a strong signal of inflation pressures building because of compensation increases markedly in excess of productivity gains has not yet clearly emerged in this expansion. Among nonfinancial corporations (our most recent source of data on consolidated income statements), trends in costs seem to have accelerated from their lows, but the rates of increase in both unit labor costs and total unit costs are still quite low.

Still, the gap between the growth in employment and that of the working-age population will inevitably close. What is crucial to sustaining this unprecedented period of prosperity is that it close reasonably promptly, given already stretched labor resources, and that labor markets find a balance consistent with sustained growth marked by compensation gains in line with productivity advances. Whether these adjustments will occur without monetary policy action remains an open question.

FOREIGN DEVELOPMENTS

While the United States has been benefiting from a virtuous economic cycle, a number of other economies unfortunately have been spiraling in quite the opposite direction. The United States, Canada, and Western Europe have been enjoying solid economic growth, with relatively low inflation and declining unemployment, but the economic performance in many developing and transition nations and Japan has been deteriorating. How quickly the latter erosion is arrested and reversed will be a key factor in shaping U.S. economic and financial trends in the period ahead. With all that is at stake, it would be difficult to overstate how crucial it is that the authorities in the relevant economies promptly implement effective policies to correct the structural problems underlying recent weaknesses and to promote sustainable economic growth before patterns of reinforcing contraction become difficult to contain.

Conditions in Asia are of particular concern. Aggregate output of the Asian developing economies has plunged, with particularly steep declines in Korea, Malaysia, Thailand, and Indonesia. Even the economies of the stalwart tigers--Hong Kong, Singapore, and Taiwan--have softened. Economic growth in China has also slowed, largely because of the currency depreciations among its neighbors and the sharp declines in their demand for imports.

Russia has also experienced some spillover from the Asian difficulties, but Russia's problems are mostly homegrown. Large fiscal deficits stem from high effective marginal tax rates that encourage avoidance and do not raise adequate revenue. This and the recent declines in prices of oil and other commodities have rendered Russian financial markets and the ruble vulnerable, particularly in an environment of heightened concern about all emerging markets. The Russian government has recently promulgated a set of new policy measures in connection with an expanded International Monetary Fund support package in an effort to address these problems.

In Latin America, conditions vary: Economies that are heavily dependent on exports of oil and other commodities have suffered as prices of those items have fallen, and several countries in that region have received more intensive scrutiny in international capital markets, but, on the whole, Latin American economies continue to perform reasonably well.

Disappointingly, economic activity in Japan--a crucial engine of Asian economic growth--has turned down after a long period of subpar growth. Gross domestic product fell at a 5 1/4 percent annual rate in the first quarter. More recently, confidence of households and businesses has continued to erode, the sharp contraction elsewhere in Asia has fed back onto Japan, and the dwindling domestic demand for goods and services in that country has been further constrained by a mounting credit crunch. Nonperforming loans have risen sharply as real estate values fell after the bursting of the asset bubble in 1991. Problems in the banking sector, exacerbated by the broader Asian financial crisis, have led to market concerns about the adequacy of the capital of many Japanese banks and have engendered a premium in the market for Japanese banks' borrowing. This resulting squeeze to profit margins has led to a reluctance to lend in dollars or yen. In response to the weakening economy and deteriorating banking situation, the Japanese yen has tended to weaken significantly, in often-volatile markets, against the dollar and major European currencies.

As you know, we have sought to be helpful in the Japanese government's efforts to stabilize their economy and financial system, reflecting our awareness of the important role that Japanese financial and economic performance plays in the world economy, including that of the United States. We have consulted with the relevant Japanese authorities on methods for resolving difficulties in their banking system and have urged them to take effective measures to stimulate their economy. I believe that the Japanese authorities recognize the urgency of the situation.

That a number of foreign economies are currently experiencing difficulties is not surprising. Although many had previously realized a substantial measure of success in developing their economies, a number had leaned heavily on command-type systems rather than relying primarily on market mechanisms. This characteristic has been evident not only in their industrial sectors but in banking where government intervention is typically heavy, where long-standing personal and corporate relationships are the predominant factor in financing arrangements, and where market-based credit assessments are the exception rather than the rule. Recent events confirm that these sorts of structures are ill suited to today's dynamic global economy, in which national economies must be capable of adapting flexibly and rapidly to changing conditions.

Responses in countries currently experiencing difficulties have varied considerably. Some have reacted quickly and, in general terms, appropriately. But in others, a variety of political considerations appear to have militated against prompt and effective action.

As a consequence, the risks of further adverse developments in these economies remain substantial. And given the pervasive interconnections of virtually all economies and financial systems in the world today, the associated uncertainties for the United States and other developed economies remain substantial as well.

In the current circumstances, we need to be aware that monetary policy tightening actions in the United States could have outsized effects on very sensitive financial markets in Asia, a development that could have substantial adverse repercussions on U.S. financial markets and, over time, on our own economy. But while we must take account of such foreign interactions, we must be careful that our responses ultimately are consistent with a monetary policy aimed at optimal performance of the U.S. economy. Our objectives relate to domestic economic performance, and price stability and maximum sustainable economic growth here at home would best serve the long-run interests of troubled financial markets and economies abroad.

THE ECONOMIC OUTLOOK

The Federal Open Market Committee believes that the conditions for continued growth with low inflation are in place here in the United States. As I noted previously, an important issue for policy is how the imbalance of recent years between the demand for labor and the growth of the working-age population is resolved. In that regard, we see a slowing in the growth of aggregate demand as a necessary element in the mix.

At this time, some of the key factors that have supported strong final demand by domestic purchasers remain favorable. Although real short-term interest rates have risen as the federal funds rate has been held unchanged while inflation expectations have declined, the financial conditions that have fostered the strength in demand are still in place. With their incomes and wealth having been on a strong upward track, American consumers remain quite upbeat. For businesses, decreasing costs of and high rates of return on investment, as well as the scarcity of labor, could keep capital spending elevated. These factors suggest some risk that the labor market could get even tighter. And even if it does not, under prevailing tight labor markets increasingly confident workers might place gradually escalating pressures on wages and costs, which would eventually feed through to prices.

But a number of factors likely will serve to damp growth in aggregate demand, helping to foster a reasonably smooth transition to a more sustainable rate of growth and reasonable balance in labor markets. We have yet to see the full effects of the crisis in East Asia on U.S. employment and income. Residential and business fixed investment already have reached such high levels that further gains approaching those experienced recently would imply very rapid growth of the stocks of housing and plant and equipment relative to income trends. Moreover, business investment will be damped if recent indications of a narrowing in domestic operating profit margins prompt a reassessment of the expected rates of return on investment in plant and equipment. Reduced prospects for the return to capital would not only affect investment directly but could also affect consumption if stock prices adjust to a less optimistic view of earnings prospects.

Of course, the demand for labor that is consistent with a particular rate of output growth also could be lowered if productivity growth were to increase more. And, on the supply side of the labor market, faster growth of the labor force could emerge as the result of increased immigration or delayed retirements. Nonetheless, it appears most probable that the necessary slower absorption of labor into employment will reflect, in part, a deceleration of output growth, as a consequence of evolving market forces. Failing that, firming actions on the part of the Federal Reserve may be necessary to ensure a track of expansion that is capable of being sustained.

Thus, members of the Board of Governors and presidents of the Federal Reserve Banks anticipate a slowing in the rate of economic growth. The central tendency of their forecasts is that real GDP will rise 3 percent to 3 1/4 percent over 1998 as a whole and 2 percent to 2 1/2 percent in 1999. With the rise in the demand for workers coming into line with that of the labor force, the unemployment rate is expected to change little from its current level, finishing next year in the neighborhood of 4 1/2 percent to 4 3/4 percent.

Inflation performance will be affected by developments abroad as well as those here at home. The extent and pace of recovery of Asian economies currently experiencing a severe downturn will have important implications for prices of energy and other commodities, the strength of the dollar, and competitive conditions on world product markets. Should the situation abroad remain unsettled, these factors would probably continue to contribute to good price performance in the United States in the period ahead. But it is important to recognize that the damping influence of these factors on inflation is mostly temporary. At some point, the dollar will stop rising, foreign demand will begin to recover, and oil and other commodity prices will stop falling and could even back up some. Indeed, a brisk snap-back in foreign economic activity, should that occur, would add, at least temporarily, to price pressures in the United States.

On a more fundamental level, it is the balance of supply and demand in labor and product markets in the United States that will have the greatest effect on inflation rates here. As I noted previously, wage and benefit costs have been remarkably subdued in the current expansion. Nonetheless, an accelerating trend in wages has been apparent for some time.

In addition, a gradual upward tilt in benefit costs has become evident of late. A variety of factors-including the strength of the economy and rising equity values, which have reduced the need for payments into unemployment trust funds and pension plans, and the restructuring of the health care sector--have been working to keep benefit costs in check in this expansion. But, in the medical area at least, the most recent developments suggest that the favorable trend may have run its course. The slowing of price increases for medical services seems to have come to a halt, at least for a time, and, with the cost-saving shift to managed care having been largely completed, the potential for businesses to achieve further savings in that regard appears to be rather limited at this point. There have been a few striking instances this past year of employers boosting outlays for health benefits by substantial amounts.

Given that compensation costs are likely to accelerate at least a little further, productivity trends and profit margins will be key to determining price performance in the period ahead. Whether the recent strong performance of productivity can be extended remains to be seen. It does seem likely that productivity calculated for the entire economy using GDP data weakened in the second quarter. This development clearly owed, at least in some degree, to the deceleration of output in that period. In manufacturing, where our data are better measured, productivity appears still to have registered a solid increase. We will be closely monitoring a variety of indicators to assess how productivity is performing in the months ahead.

Monetary policymakers see the most likely outcome as modestly higher inflation rates in the next one and one-half years. The central tendency of monetary policymakers' CPI inflation forecasts is for an increase of 1 3/4 percent to 2 percent during 1998 and 2 percent to 2 1/2 percent next year. As noted, the ebbing of the special factors reducing inflation over the past year or so, such as the decline in oil prices, will account for some of this uptick. But the Federal Open Market Committee will need to remain particularly alert to the possibility that more fundamental imbalances are increasing inflationary pressures. The Committee would need to resist vigorously any tendency for an upward trend, which could become embedded in the inflationary process.

The Committee recognizes that significant risks attend the outlook: One is that the impending constraint from domestic labor markets could bind more abruptly than it has to date, intensifying inflation pressures. The other is the potential for further adverse developments abroad, which could reduce the demand for U.S. goods and services more sharply than anticipated and which would thereby ease pressures on labor markets. While we expect that the situation will develop relatively smoothly, the Committee believes that, given the current tightness in labor markets, the potential for accelerating inflation is probably greater than the risk of protracted, excessive weakness in the economy. In any case, it will need to continue to monitor evolving circumstances closely and adjust the stance of monetary policy, as appropriate, in order to help establish conditions consistent with progress toward the Federal Reserve's goals of price stability and maximum sustainable economic growth.

RANGES FOR MONEY AND CREDIT GROWTH

Indeed, recognition of the benefits of low inflation and our commitment to the Federal Reserve's statutory objective of price stability were once again dominant in the Committee's semiannual review of the ranges for the monetary and debt aggregates. The FOMC noted that the behavior of the monetary aggregates had been somewhat more predictable over the past few years than it had been earlier in the 1990s. The rapid growth of M2 and M3 over the first half of the year, which lifted those measures above the upper ends of the target ranges established in February, was consistent with the unexpectedly strong advance in aggregate demand. However, movements in velocity remain difficult to predict.

The FOMC will continue to interpret the monetary ranges as benchmarks for the achievement of price stability under conditions of historically normal velocity behavior. Consistent with that interpretation, the Committee decided to retain the current ranges for the monetary aggregates for 1998, as well as the range for debt, and to carry them over on a provisional basis to next year. Although near-term prospects for velocity behavior are uncertain, the Committee recognizes that monetary growth does appear to provide some information about trends in the economy and inflation. Therefore, we will be carefully evaluating the aggregates, relative both to forecasts and to their ranges, in the context of other readings on other variables in our efforts to promote optimum macroeconomic conditions.

CONCLUDING COMMENTS

As I have stated in previous testimony, the recent economic performance, with its combination of strong growth and low inflation, is as impressive as any I have witnessed in my near half-century of daily observation of the American economy. Although the reasons for this development are complex, our success can be attributed in part to sound economic policy. The Congress and the Administration have successfully balanced the budget and, indeed, achieved a near-term surplus, a development that tends to boost national saving and investment. The Federal Reserve has pursued monetary conditions consistent with maximum sustainable long-run growth by seeking price stability. These policies have helped bring about a healthy macroeconomic environment for productivity-boosting investment and innovation, factors that have lifted living standards for most Americans. The task before us is to maintain disciplined economic policies and thereby contribute to maintaining and extending these gains in the years ahead.

(1.) See "Monetary Policy Report to the Congress," Federal Reserve Bulletin, vol. 84 (August 1998), pp. 585-603.

Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Banking and Financial Services, U.S. House of Representatives, July 24, 1998

(Chairman Greenspan presented similar testimony before the Committee on Agriculture, Nutrition, and Forestry, U.S. Senate, July 30, 1998.)

I am pleased to be here today to present the Federal Reserve Board's views on the regulation of over-the-counter (OTC) derivatives. Under Secretary Hawke has already addressed the specific questions raised in your letter of invitation. The Board generally agrees with the Treasury Department's views on these issues. In particular, the Board supports a standstill of attempts by the Commodity Futures Trading Commission (CFTC) to impose new regulations on OTC derivatives as a minimalist approach to our longstanding concerns about CFTC assertions of authority in this area.(1) In my testimony I shall step back from these issues of immediate concern and address the fundamental underlying issue, that is, whether it is appropriate to apply the Commodity Exchange Act (CEA) to over-the-counter derivatives (and, indeed, to financial derivatives generally) in order to achieve the CEA's objectives--deterring market manipulation and protecting investors.

THE CEA AND ITS OBJECTIVES

The Commodity Exchange Act of 1936 and its predecessor the Grain Futures Act of 1922 were a response to the perceived problems of manipulation of grain markets that were particularly evident in the latter part of the nineteenth and early part of the twentieth centuries. For example, endeavors to corner markets in wheat, while rarely successful, often led to temporary, but sharp, increases in prices that engendered very large losses to those short sellers of futures contracts who had no alternative but to buy and deliver grain under their contractual obligations. Because quantities of grain following a harvest are generally known and limited, it is possible, at least in principle, to corner a market.

It is not possible to corner a market for financial futures when the underlying asset or its equivalent is in essentially unlimited supply. Financial derivative contracts are fundamentally different from agricultural futures owing to the nature of the underlying asset from which the derivative contract is "derived." Supplies of foreign exchange, government securities, and certain other financial instruments are being continuously replenished, and large inventories held throughout the world are immediately available to be offered in markets if traders endeavor to create an artificial shortage. Thus, unlike commodities whose supply is limited to a particular growing season and finite carryover, the markets for financial instruments and their derivatives are deep and, as a consequence, are extremely difficult to manipulate. The type of regulation that is applied to crop futures appears wholly out of place and inappropriate for financial futures, whether traded on organized exchanges or over the counter, and accordingly, the Federal Reserve Board sees no need for it.

The early legislation on the trading of commodity futures was primarily designed to discourage forms of speculation that were seen as exacerbating price volatility and hurting farmers. In addition, it included provisions designed primarily to protect small investors in commodity futures, whose participation had been increasing and was viewed as beneficial. The Commodity Futures Trading Commission Act of 1974 (1974 Act) did not make any fundamental changes in the objectives of derivatives regulation. However, it expanded the scope of the CEA quite significantly. In addition to creating the CFTC as an independent agency and giving the CFTC exclusive jurisdiction over commodity futures and options, the 1974 Act expanded the CEA's definition of a "commodity" beyond a specific list of agricultural commodities to include "all other goods and articles, except onions .... and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in."

Given this broadened definition of a commodity and an equally broad interpretation of what constitutes a futures contract, a wide range of off-exchange transactions would have been brought potentially within the scope of the CEA. The Treasury Department was particularly concerned about the prospect that the foreign exchange markets might be found to fall within the act's scope. Aside from the difficulty of manipulating these markets, the Treasury argued that participants in OTC markets, primarily banks and other financial institutions, and large corporations, did not need the consumer protections of the Commodity Exchange Act. Consequently, Treasury proposed and the Congress included a provision in the 1974 Act, the "Treasury Amendment," which excluded off-exchange derivative transactions in foreign currency (as well as government securities and certain other financial instruments) from the newly expanded CEA. What the Treasury did not envision, and the Treasury Amendment did not protect, was the subsequent development and spectacular growth of a much wider range of OTC derivative contracts-swaps on interest rates, exchange rates, and prices of commodities and securities.

POTENTIAL APPLICATION OF THE CEA TO OTC DERIVATIVES

The vast majority of privately negotiated OTC contracts are settled in cash rather than through delivery. Cash settlement typically is based on a rate or price in a highly liquid market with a very large or virtually unlimited deliverable supply, for example, LIBOR or the spot dollar-yen exchange rate. To be sure, there are a limited number of OTC derivative contracts that apply to nonfinancial underlying assets. There is a significant business in oil-based derivatives, for example. But unlike farm crops, especially near the end of a crop season, private counterparties in oil contracts have virtually no ability to restrict the worldwide supply of this commodity. (Even OPEC has been less than successful over the years.) Nor can private counterparties restrict supplies of gold, another commodity whose derivatives are often traded over the counter, where central banks stand ready to lease gold in increasing quantities should the price rise.

To be sure, a few, albeit growing, types of OTC contracts such as equity swaps and some credit derivatives have a limited deliverable supply. However, unlike crop futures, where failure to deliver has additional significant penalties, costs of failure to deliver in OTC derivatives are almost always limited to actual damages. There is no reason to believe either equity swaps or credit derivatives can influence the price of the underlying assets any more than conventional securities trading does. Thus, manipulators attempting to corner a market, even if successful, would have great difficulty in inducing sellers in privately negotiated transactions to pay significantly higher prices to offset their contracts or to purchase the underlying assets.

Finally, the prices established in privately negotiated transactions are not widely disseminated or used directly or indiscriminately as the basis for pricing other transactions. Counterparties in the OTC markets can easily recognize the risks to which they would be exposed by failing to make their own independent valuations of their transactions, whose economic and credit terms may differ in significant respects. Moreover, they usually have access to other, often more reliable or more relevant sources of information. Hence, any price distortions in particular transactions could not affect other buyers or sellers of the underlying asset.

Professional counterparties to privately negotiated contracts also have demonstrated their ability to protect themselves from losses from fraud and counterparty insolvencies. They have managed credit risks quite effectively through careful evaluation of counterparties, the setting of internal credit limits, and judicious use of netting and collateral agreements. In particular, they have insisted that dealers have financial strength sufficient to warrant a credit rating of A or higher. This, in turn, provides substantial protection against losses from fraud. Dealers are established institutions with substantial assets and significant investments in their reputations. When they have been seen to engage in deceptive practices, the professional counterparties that have been victimized have been able to obtain redress under laws applicable to contracts generally. Moreover, the threat of legal damage awards provides dealers with strong incentives to avoid misconduct.

A far more powerful incentive, however, is the fear of loss of the dealer' s good reputation, without which it cannot compete effectively, regardless of its financial strength or financial engineering capabilities. In these respects, derivatives dealers bear no resemblance to the "bucket shops" whose activities apparently motivate the exchange trading requirement.

I do not mean to suggest that counterparties will not in the future suffer significant losses on their OTC derivatives transactions. Since 1994 the effectiveness of their risk-management skills has not been tested by widespread major declines in underlying asset prices. I have no doubt derivatives losses will mushroom at the next significant downturn as will losses on holdings of other risk assets, both on and off exchange. Nonetheless, I see no reason to question the underlying stability of the OTC markets, or the overall effectiveness of private market discipline, or the prudential supervision of the derivatives activities of banks and other regulated participants. The huge increase in the volume of OTC transactions reflects the judgments of counterparties that these instruments provide extensive protection against undue asset concentration risk. They are clearly perceived to add significant value to our financial structure, both here in the United States and internationally.

Accordingly the Federal Reserve Board sees no reason why these markets should be encumbered with a regulatory structure devised for a wholly different type of market process in which supplies of underlying assets are driven by the vagaries of weather and seasons. Inappropriate regulation distorts the efficiency of our market system and as a consequence impedes growth and improvement in standards of living.

APPLICATION OF THE CEA TO CENTRALIZED MARKETS FOR DERIVATIVES

Recently, some participants in the OTC markets have shown interest in utilizing centralized mechanisms for clearing or executing OTC derivatives transactions. For example, the London Clearing House plans to introduce clearing of interest rate swaps and forward rate agreements in the second half of 1999, and the Electronic Broking Service, a brokerage system for foreign exchange contracts, reportedly is planning to begin brokering forward rate agreements. The latter service may not be offered in the United States, however, because of the threat of application of the CEA.

Even some who argue that privately negotiated and bilaterally settled derivatives transactions should be excluded from the CEA, nonetheless believe that such transactions should be subject to the CEA if they are centrally executed or cleared, for fear that such facilities can foster price manipulation. Leaving aside our concern about the regulatory regime of financial futures generally, the Federal Reserve Board is particularly concerned that the vast majority of the instruments currently traded in the OTC markets not be subject to the CEA, even if they become sufficiently standardized to be centrally executed or cleared. To be sure, OTC contracts between counterparties would then have many similarities to exchange-traded contracts. But they would still retain distinct characteristics that would leave them economically far short of standardization. For example, participants in trade execution systems may seek to retain counterparty credit limits, and participants in clearing systems likely will resist constraints on their ability to customize the economic terms of contracts. To force full standardization would reduce the economic value of a bilateral contract to both parties and to the marketplace as a whole. The 1992 Act as we read it authorized exemption of all OTC derivatives transactions between professional counterparties from the CEA, whether or not they are centrally executed or cleared. Even with centralized execution or clearing, the most relevant attributes of these markets would not resemble those of the agricultural futures markets and hence would not be susceptible to manipulation.

HARMONIZING REGULATION OF THE OTC MARKETS AND FUTURES EXCHANGES

Beyond question, the centralized execution and clearing of what to date have been privately negotiated and bilaterally cleared transactions would narrow the existing differences between exchange-traded and OTC derivatives transactions. However, that is not a reason to extend the CEA to cover OTC transactions. As we have argued, doing so is unnecessary to achieve the public policy objectives of the CEA. Moreover, as the economic differences between OTC and exchange-traded contracts are narrowing, it is becoming more apparent that OTC market participants share this conclusion; their decision to trade outside the regulated environment implies they do not see the benefits of the CEA as outweighing its costs. Instead, the Federal Reserve believes that the fact that OTC markets function so effectively without the benefits of the CEA provides a strong argument for development of a less burdensome regulatory regime for financial derivatives traded on futures exchanges. To reiterate, the existing regulatory framework for futures trading was designed in the 1920s and 1930s for the trading of grain futures by the general public. Like OTC derivatives, exchange-traded financial derivatives generally are not as susceptible to manipulation and are traded predominantly by professional counterparties.

Indeed, the Congress has rejected the notion of a "one-size-fits-all" approach to regulation of exchange trading. The exemptive authority that the Congress gave the CFTC in 1992 permitted it to create a less restrictive regulatory regime for professional trading of financial futures. However, the pilot program proposed by the CFTC evidently has not met the competitive and business requirements of the futures exchanges--no contracts are currently trading under the program. Last year, the Agriculture Committees of the House and the Senate both attempted to craft legislation that would spur development of such a new regulatory framework but were unable to achieve consensus on the best approach. In any event, if progress toward a more appropriate regime is not forthcoming soon, the Congress should seriously consider passage of legislation that would mandate progress.

CONCLUSION

In conclusion, the Board continues to believe that, aside from safety and soundness regulation of derivatives dealers under the banking or securities laws, regulation of derivatives transactions that are privately negotiated by professionals is unnecessary. Moreover, the Board questions whether the CEA as currently implemented is an appropriate framework for professional trading of financial futures on exchanges. The key elements of the CEA were put in place in the 1920s and 1930s to regulate the trading of agricultural futures by the general public. The vast majority of financial futures traded simply are not as susceptible to manipulation as agricultural and other commodity futures where supplies are more limited. And participants in financial futures markets are predominantly professionals that simply do not require the customer protections that may be needed by the general public. Regulation that serves no useful purpose hinders the efficiency of markets to enlarge standards of living. In choosing a particular regulatory regime it is important to remember that no system will fully eliminate inappropriate or illegal activities. Banking examiners, for example, find it difficult to unearth fraud and embezzlement in their early stages. Securities regulators have difficulty ferreting out malfeasance. Even trading on exchanges does not in itself eliminate all endeavors at manipulation, as the Hunt brothers' 1979-80 fiasco in silver demonstrated. The primary source of regulatory effectiveness has always been private traders being knowledgeable of their counterparties. Government regulation can only act as a backup. It should be careful to create net benefits to markets.

(1.) It also supports the legislation to amend the banking and insolvency laws that has been recommended by the President's Working Group on Financial Markets. This legislation would shore up the infrastructure of U.S. markets and enhance their competitiveness. The legislation recognizes that the traditional insolvency process can create serious risks to counterparties to financial transactions because of the price volatility of financial assets.
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Title Annotation:Federal Reserve Board
Publication:Federal Reserve Bulletin
Date:Sep 1, 1998
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