Statements to the Congress.
I am pleased to appear before this committee to discuss the President's Working Group on Financial Markets' Report on Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management. Under Secretary Gensler has made a comprehensive presentation of the report's conclusions and recommendations. Chairman Greenspan participated actively in the Working Group's discussions and supports the contents of the report. My remarks this morning will be limited to highlighting a few key conclusions and recommendations.
LEVERAGE AND MARKET DISCIPLINE
As the title of its report indicates, the Working Group has concluded that the central public policy issue raised by the Long-Term Capital Management (LTCM) episode is excessive leverage. Leverage plays a positive role in our financial system, resulting in greater market liquidity, lower credit costs, and a more efficient allocation of resources in our economy. But leverage poses risks to firms and their creditors, and the LTCM episode demonstrated that a single firm could become both so large and so highly leveraged that failure of its business strategies could pose risks to the financial system as well.
While LTCM is a hedge fund, excessive leverage is neither characteristic of, nor necessarily limited to, hedge funds. Available data indicate that no other hedge fund was or is as large as LTCM, and no other large hedge fund was or is so highly leveraged. Indeed, a large majority of hedge funds are not significantly leveraged, having balance sheet leverage ratios of less than 2 to 1. Many financial institutions, including some banks and securities firms, are far larger than LTCM and are significantly leveraged. Whether any of these larger financial institutions was or is as highly leveraged as LTCM cannot be established definitively. Leverage is best defined as the ratio of economic risk relative to capital, but defined this way, it is very difficult to measure. The fact that no other large U.S. financial institution saw its capital significantly impaired indicates that none was so vulnerable as LTCM to the extraordinary market conditions that emerged last August.
In our market-based economy, the discipline provided by creditors and counterparties is the primary mechanism that regulates firms' leverage. If a firm seeks to achieve greater leverage, its creditors and counterparties will ordinarily respond by increasing the cost or reducing the availability of credit to the firm. The rising cost or reduced availability of funds provides a powerful economic incentive for firms to restrain their risk-taking. In our system, government oversight of leverage is the exception, not the rule. Even when government oversight has been deemed appropriate, as is the case of banks and brokerdealers, it is intended to supplement and reinforce market discipline, not to replace it.
However, in the case of LTCM, market discipline seems largely to have broken down. LTCM received very generous credit terms, even though it took an exceptional degree of risk. Furthermore, this breakdown in market discipline reflected weaknesses in risk-management practices by LTCM's counterparties that were also evident, albeit to a lesser degree, in their dealings with other highly leveraged firms.
If market discipline is to be effective, counterparties of a firm must obtain sufficient information to make reliable assessments of its risk profile, both at the inception of the credit relationship and throughout its duration. Furthermore, they must have in place mechanisms that place limits on the credit risk exposures that become more stringent as the firm's riskiness increases and its creditworthiness declines. In the case of LTCM, however, few, if any, of its counterparties really seem to have understood its risk profile, especially its very large positions in certain illiquid markets. And many of its counterparties did not effectively limit their risk exposures to LTCM. In part, they simply did not anticipate the extraordinary market conditions last August. But a combination of the aggressive pursuit of earnings in a highly competitive environment and excessive confidence in LTCM's management appears to have led some counterparties to suspend or ignore fundamental riskmanagement principles.
The Working Group's recommendations are intended to make market discipline more effective by (1) improving risk-management practices, and (2) increasing the availability of information on the risk profiles of hedge funds and their creditors. The Working Group has not recommended steps, such as direct government regulation of hedge funds, that would risk significantly weakening market discipline by creating or exacerbating moral hazard.
ENHANCING RISK MANAGEMENT
Primary responsibility for addressing the weaknesses in risk-management practices that were evident in the LTCM episode rests with the private financial institutions--a relatively small number of U.S. and foreign banks and broker-dealers, most of which were LTCM's counterparties--whose credit and clearing services are critical to the establishment of leveraged trading positions. Addressing the weaknesses is in their self-interest, as their experience with LTCM demonstrated. And as the world leaders in risk management, these firms have the capabilities as well as the incentives to address the weaknesses. Nonetheless, prudential supervisors and regulators have a responsibility to help to ensure that the processes that banks and securities firms utilize to manage risk are commensurate with the size and complexity of their portfolios and responsive to changes in financial market conditions.
Since the LTCM episode, both private financial institutions and prudential supervisors and regulators have taken steps to strengthen risk-management practices. Banks and securities firms have demanded more information and tightened their credit terms, especially vis-a-vis highly leveraged institutions. Supervisors and regulators have sought to lock in this progress by issuing guidance on sound practices. As banking supervisors testified in March before two of this committee's subcommittees, the Basle Committee on Banking Supervision, the Federal Reserve, and the Office of the Comptroller of the Currency have all issued such guidance recently. The International Organization of Securities Commissions is well along in developing appropriate guidance for securities firms.
That said, further improvements in riskmanagement practices can and should be made. And as was demonstrated so clearly by the Group of Thirty's 1993 work on risk management, shared private-sector initiatives can be extremely effective in fostering progress. One such initiative has already been completed. The International Swaps and Derivatives Association has issued a review of collateral management practices that draws lessons from collateral managers' experiences during the LTCM episode and other recent periods of market volatility. The practitioners found that collateralization proved to be a highly successful tool for mitigating credit risk during such periods. However, echoing concerns expressed by bank supervisors, they warned that collateralization should be regarded as a complement to, not a replacement for, other credit risk safeguards. In particular, they emphasized that it does not obviate careful credit analysis of the counterparty. The review set out recommendations for improving collateral management practices and an action plan for facilitating their implementation.
A broader and more ambitious initiative also is well under way. In January, twelve major internationally active banks and securities firms formed the Counterparty Risk Management Policy Group. As the co-chairmen of the group testified in March before this Committee's Capital Markets Subcommittee, the objective is to develop flexible standards for strengthened risk-management practices in providing credit-based services to major counterparties, including, but not limited to, hedge funds. The group has established three working parties to address issues relating to risk management, reporting, and risk reduction through cooperative initiatives. The group hopes to complete its work and publish its findings in mid-June.
Such private-sector initiatives can fulfill their considerable promise only if their words are translated into actions. Here again, the private market participants should have primary responsibility. But supervisors and regulators undoubtedly will study these reports carefully and, when appropriate, incorporate their findings in supervisory guidance, as they did with the findings of the Group of Thirty's earlier report.
IMPROVING INFORMATION ON RISK PROFILES
Improving the quality of information on the risk profiles of hedge funds and certain other highly leveraged institutions is particularly challenging because the liquidity of markets permits them to alter their risk profiles significantly within days or even hours. In this instance, too, the Working Group's recommendations call for actions by both the private sector and public authorities. One of the most difficult and important issues to be addressed by the Counterparty Risk Management Policy Group involves the exchange of information between creditors and counterparties. The challenge is to develop meaningful measures of risk that could be exchanged frequently without revealing proprietary information on strategies or positions. The revelation of proprietary information not only would jeopardize market participants' profits but could also significantly impair market liquidity and widen liquidity premiums for the assets traded.
The need for timely information on rapidly changing risk profiles means that counterparties cannot expect to rely on public disclosure mechanisms to meet their requirements. Nonetheless, new public disclosure requirements for both hedge funds and public companies could also contribute to the goal of strengthening market discipline.
With respect to hedge funds, the Working Group has recommended that more frequent and more meaningful information be made public. Some hedge funds are already required to report certain financial information to the Commodity Futures Trading Commission. However, the information is only reported annually, does not include comprehensive and meaningful measures of risk, and cannot be made available to the public. Quarterly release to the public of enhanced information on a broader group of hedge funds (not limited to those that trade futures) would help inform public opinion about the role of hedge funds in our financial system. Equally important, by making clear that public disclosure is the sole objective of any reporting requirements, any false impression that the regulatory agency operating the reporting system is conducting prudential oversight of hedge funds would be discouraged. Such a false impression can be dangerous because it weakens private market discipline without any hope that government oversight is making up for what is lost.
In the case of public companies, including financial institutions, the Working Group recommends that they publicly disclose additional information about their material financial exposures to significantly leveraged institutions. The information to be disclosed would be total exposures (aggregating across all relevant transactions), disaggregated by sector (for example, commercial banks, securities firms, hedge funds, and so on). The goal is to enhance market discipline on creditors of significantly leveraged institutions, which, in turn, would enhance creditor discipline on the leveraged institutions themselves. The precise nature of any new disclosure requirements will be determined by the Securities and Exchange Commission (SEC), taking into account public comments through the normal rule-making process. Both fellow regulators and market participants will need to support and assist the SEC in developing requirements that are both meaningful and cost effective.
To sum up, then, the Working Group has concluded that the central public policy issue raised by the LTCM episode is how to constrain leverage more effectively. In our market-based economy, we have always relied on market discipline as the primary mechanism for constraining leverage. Although market discipline seems to have largely broken down in the case of LTCM, the Working Group believes that the best approach to addressing concerns about excessive leverage is to make market discipline more effective. Primary responsibility for increasing the effectiveness of market discipline necessarily rests with market participants. Nonetheless, prudential supervisors and regulators of the banks and brokerdealers that are critical sources of credit to leveraged institutions should seek to ensure that the necessary improvements in risk-management practices are implemented. The Working Group believes that further progress in this area can and should be made and, through its constituent agencies, will be monitoring the credit-risk-management policies of large commercial banks and securities firms and assessing their effectiveness.
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, U. S. House of Representatives, May 12, 1999
The Board of Governors appreciates this opportunity to comment on H.R. 1585, the "Depository Institution Regulatory Streamlining Act of 1999," introduced by Representative Roukema. 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.
MEASURES THE BOARD SUPPORTS
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. The Board strongly supports allowing the Federal Reserve System to pay interest on required and excess reserve balances held by depository institutions at the Federal Reserve Banks, and it supports allowing banks to pay interest on demand deposits. (Attached to this statement is an appendix containing an expanded discussion of these topics.)(1) 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.
While the Board also applauds many of the other measures contained in this bill, which eliminate restrictions that no longer serve a useful purpose and thereby enhance the ability of U.S. banking institutions to operate efficiently and effectively in increasingly competitive financial markets, there are a few provisions with which the Board has concerns. While I will discuss them, I do not wish these objections to detract from my central message--that the nation's banking system would benefit from the type of reform embodied in this legislation.
Interest on Reserves and Interest on Demand Deposits
The Board strongly supports provisions in section 101 of H.R. 1585, which would permit the Federal Reserve to pay interest on both 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 cost of designing and maintaining the systems that facilitate these reserve avoidance techniques represents a significant waste of resources for the economy. In addition, because some small banks do not have a sufficient volume of deposits to justify these costs, current reserve avoidance techniques tend to place smaller institutions at a competitive disadvantage.
The reserve avoidance measures utilized by depository institutions could also eventually complicate the implementation of monetary policy. Declines in required reserve balances through avoidance schemes could lead to increased volatility in the federal funds rate. Since last July, when I spoke to this subcommittee on the same topic, required reserve balances have fallen further and some episodes of heightened volatility in federal funds rates have occurred, although they were associated in part with stresses on global financial markets. Allowing the payment of interest on required reserve balances would reduce current incentives for reserve avoidance and would likely induce a rebuilding of reserve balances over time. If volatility in the federal funds rate nevertheless did become a persistent concern, the Federal Reserve at present has a limited set of tools to address such a situation; authorizing interest payments on excess reserve balances would be a useful addition to the Federal Reserve's monetary policy tools for this purpose. Several other major central banks, including the European Central Bank and the Bank of Canada, already have the power to pay interest on excess reserve balances.
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, would also 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.
Because the level of required reserve balances has fallen substantially in recent years, because of the implementation of additional reserve avoidance measures by depository institutions, estimates of the revenue losses to the Treasury associated with paying interest on required reserve balances have dropped to a relatively low level. After having taken account of the increases in revenue from a related measure, the payment of interest on demand deposits, the Congressional Budget Office recently estimated that the net federal budget costs of similar legislation pending in the Senate would be about $130 million per year over the next five years.
The Board strongly supports allowing the immediate payment of interest on demand deposits held by businesses. The current prohibition against paying interest on such deposits 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 had earlier bid deposits away from country banks to make loans to stock market speculators. This rationale for the prohibition 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 immediate repeal of the prohibition of interest on demand deposits. In contrast, section 102 of H.R. 1585 would allow payment of interest on demand deposits to begin on October 1, 2004. During a transition period lasting until that time, the bill would authorize a twenty-four-transaction-per-month money market deposit account (MMDA). Demand deposits could be swept into this new MMDA in order to earn interest. The twenty-four-transaction MMDA 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.
While a relatively short transition period before the implementation of direct payments on demand deposits would not be objectionable, delaying direct interest payments on demand deposits for any extended period, such as the five years or so proposed in the bill, is not advisable. Such a long delay would be associated with further wasteful sweep activities and would disadvantage small banks and their business customers relative to the larger organizations already using sweep programs that can be modified to incorporate a new MMDA product.
Finally, the committee has asked the Board to comment specifically on the impact on the banking industry of repealing the prohibition on paying interest on business checking accounts. For banks, interest on demand deposits will increase costs, at least in the short run. Larger banks (and securities firms) may also lose some of the fees they currently earn on sweeps of business demand deposits. The higher costs to banks will be partially offset by interest on reserve balances, and, over time, these measures should help the banking sector attract liquid funds in competition with nonbank institutions and direct market investments by businesses. Small banks, in particular, should be able to bid for business demand deposits on a more level playing field vis-a-vis both nonbank competition and large bank sweep programs. Moreover, large and small banks will be strengthened by fairer prices on the services they offer and by the elimination of unnecessary costs associated with sweeps and other procedures currently used to try to minimize the level of reserves.
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 depository institutions 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 is 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 that third parties 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. In this regard, the measure would also require that federal courts afford to confidential supervisory information of state and foreign bank supervisory authorities the same status with regard to privilege as is afforded to the confidential supervisory information of the federal banking agencies.
By protecting disclosures by depository institutions to their examiners and by safeguarding supervisory information based on such disclosures, 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.
The banking agencies may have some further suggestions for refining the language of sections 501 and 502, and we would be pleased to work with the subcommittee on those suggestions.
Other Burden Reduction Provisions
There are other parts of this 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 311 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 312 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.
Section 303 of the bill authorizes the banking agencies to act jointly to allow up to 100 percent of the fair market value of an institution's purchased mortgage servicing rights to be included in its tier 1 capital. Currently, only 90 percent of the value of such assets can be included. Developments since the Congress enacted current law in 1991 have greatly reduced the concerns that prompted the existing capital "haircut." Accordingly, the Board believes the change envisioned in section 303 would reduce regulatory burden without compromising safety and soundness. The Board also suggests changing all the section's references concerning "purchased mortgage servicing rights" to "mortgage servicing assets" to reflect current accounting terminology.
In another area, the alternative consumer credit disclosure mechanism permitted by section 401 will be less burdensome to creditors, and just as helpful to consumers, as the disclosure requirement 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 would reduce regulatory burdens without sacrificing consumer protections.
AREAS OF CONCERN
Although the Board supports most of the provisions in the bill, there are a few sections of the legislation that cause us concern. These provisions may give certain entities unfair competitive advantages, may harm the safety and soundness of depository institutions, or are unnecessary.
Two sections of the bill would eliminate limitations that have been applied to nonbank banks. Section 223 would allow nonbank banks, and FDIC-insured credit card banks, to offer business credit cards, even when these business loans are funded by insured demand deposits. Section 222 would remove the activity limitations and cross-marketing restrictions that currently apply to nonbank banks. It would also liberalize the divestiture requirements that apply when companies violate the nonbank bank operating limitations and allow nonbank banks to acquire assets from credit card banks. Eliminating these restrictions on nonbank banks, at first glance, may have intuitive appeal. However, there are important reasons for the Board's concern 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 that the fifty-seven companies operating nonbank banks 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 fifteen 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 Banking Committee recently considered and decided not to permit in the context of a broader effort to modernize our financial laws.
The Board continues to believe that the questions of whether and to what extent it is appropriate to enhance the position of nonbank banks are questions most fairly determined in connection with broad financial modernization legislation. In that broader context, it may be possible to relieve some of the restraints placed on the handful of existing nonbank banks without seriously disadvantaging the majority of banking organizations that do not have the privileges enjoyed by nonbank banks.
Call Report Simplification
Section 302 of the bill largely 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 (FFIEC), have made substantial progress in implementing the mandate of section 307 of the Riegle Act and the Board believes that this section of the bill is unnecessary.
Thus far, in response to section 307, the federal banking agencies have eliminated approximately 100 Call Report data items; placed revised instructions and forms on the Internet for the Call Report, the Bank Holding Company (BHC) Reports, and the Thrift Financial Report (TFR); adopted generally accepted accounting principles (GAAP) as the reporting basis for all Call Reports (and consistent with the reporting basis for the BHC reports and the TFR); produced a draft core report that is consistent with the TFR report and resolves most of the definitional differences between the reports; 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 (consistent with existing mandatory electronic filing for the TFR and optional electronic filing for the BHC reports); placed much of the Call Report data and some of the BHC data on the Internet; and reported to the Congress on recommendations to enhance efficiency for filers and users.
The agencies surveyed users of the information 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 FFIEC's Reports Task force is analyzing the results of the survey of Call Report users throughout each of the agencies to identify all of the current purposes served by the information. After the surveys are analyzed, the Task Force will recommend ways to further streamline the reporting requirements and continue to refine a set of common, or "core," reporting items. The agencies have not determined an implementation date, given year 2000 concerns for the banking industry and the regulatory agencies, and given that banking institutions have requested a minimum lead time of one year to implement a "core" report. However, we believe 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.
The legislation being considered by the subcommittee today builds on two prior reform measures, the Community Development and Regulatory Improvement Act of 1994 and the Economic Growth and Regulatory Paperwork Reduction Act of 1996, that the Board supported. Those were useful measures that achieved meaningful reductions in regulatory burden. ` Those bills--coupled with the Board's independent initiatives to make our regulations simpler, less burdensome, and more transparent--have had a practical, bottom-line effect: Fewer applications need to be filed with the Board, and banking organizations have saved substantial regulatory, legal, compliance, and other costs. Those statutory and regulatory changes have enhanced the competitiveness of banking organizations and have benefited the customers of these financial institutions. Nonetheless, more can and should be done.
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 a few areas, however, the 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 promote regulatory equity for all participants in the financial services industry, minimize the chances that federal safety net subsidies will be expanded into new activities and beyond the confines of insured depository institutions, guarantee adequate federal supervision of financial organizations, and 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 through legislation.
Statement by Patrick M. Parkinson, Associate Director, Division of Research and Statistics, Board of Governors of the Federal Reserve System, before the Subcommittee on Risk Management, Research, and Specialty Crops of the Committee on Agriculture, U.S. House of Representatives, May 18, 1999
I am pleased to be here today to present the Federal Reserve Board's views on whether it is necessary to modernize the Commodity Exchange Act (CEA). The Board believes that modernization of the act is essential. The reauthorization of the Commodity Futures Trading Commission (CFTC) offers the best opportunity to make the necessary changes. If this opportunity is lost, the Board is concerned that market participants will abandon hope for regulatory reform in the United States and take critical steps to shift their activity to jurisdictions that provide more appropriate legal and regulatory frameworks.
THE NEED FOR MODERNIZATION OF THE CEA
The key elements of the CEA were put in place in the 1920s and 1930s to regulate the trading on exchanges of grain futures by the general public, including retail investors. The public policy objectives were, and are, clear: to deter market manipulation and to protect investors.
The objective of the Grain Futures Act of 1922 was to reduce or eliminate "sudden or unreasonable fluctuations" in the prices of grain on futures exchanges. The framers of the act believed that such price fluctuations reflected the susceptibility of grain futures to manipulation. During the latter part of the nineteenth century and the early part of the twentieth century, attempts to corner the markets for wheat and other grains, while rarely successful, often led to temporary, but sharp, increases in prices that engendered large losses to short sellers of futures contracts who had no alternative but to buy and deliver grain under their contractual obligations. Because quantities of grain after a harvest are generally known and limited, it is possible, at least in principle, to corner a grain market. Furthermore, because grain futures prices were widely disseminated and widely used as the basis for pricing grain transactions off the exchanges, price fluctuations from attempts at manipulation had broad ramifications for the agricultural sector and, given the relative size of the agricultural sector at the time, for the economy as a whole.
The Commodity Exchange Act of 1936 introduced provisions to protect retail investors in agricultural futures. Retail participation in these markets had been increasing and was viewed as beneficial, but retail investors may lack the knowledge and sophistication to protect themselves effectively against fraud of' to manage counterparty credit exposures effectively. Safeguards against fraud and counterparty losses were intended to foster their participation in these markets.
Although the objectives of the CEA have not changed since the 1930s, what are now called the derivatives markets have undergone profound changes. On the futures exchanges themselves, financial contracts now account for about 70 percent of the activity, and retail participation in most financial contracts is negligible. Outside the exchanges, enormous markets have developed in which banks, corporations, and other institutions privately negotiate customized derivatives contracts, the vast majority of which are based on interest rates or exchange rates.
The Board believes that the application of the CEA to the trading of financial derivatives by professional counterparties is unnecessary. Prices of financial derivatives are not susceptible to, that is, easily influenced by, manipulation. Some financial derivatives, for example, Eurodollar futures or interest rate swaps, are virtually impossible to manipulate because they are settled in cash, and the cash settlement is based on a rate or price in a highly liquid market with a very large or virtually unlimited deliverable supply. For other financial derivatives--for example, futures contracts for government securities--manipulation of prices is possible, but it is by no means easy. Large inventories of the instruments are immediately available to be offered in markets if traders endeavor to create an artificial shortage. Furthermore, the issuers of the instruments can add to the supply if circumstances warrant. This contrasts sharply with supplies of agricultural commodities, for which supply is limited to a particular growing season and finite carryover.
In addition, professional counterparties simply do not require the kind of investor protections that the CEA provides. Such counterparties typically are quite adept at managing credit risks and are more likely to base their investment decisions on independent judgment. And, if they believe they have been defrauded, they are quite capable of seeking restitution through the legal system. Nor is there any obvious public policy reason to foster direct retail participation in financial derivatives markets.
Most professional counterparties in financial derivatives markets view the regulatory protections imposed by the CEA as unnecessary and burdensome. Although to date there is no clear-cut evidence of a significant migration of activity to other jurisdictions, should the next CFTC reauthorization not provide for modernization of the regulation of financial derivatives, this could change--perhaps quickly. Rapid advances in technology are making electronic trading systems increasingly attractive, both as an alternative to open outcry trading on exchanges and as an alternative to the use of telephones and voice brokers in the over-the-counter (OTC) markets. Such electronic trading systems might develop in the United States, but if the United States continues to impose what market participants perceive as unnecessary regulatory burdens, such systems could instead develop abroad. In particular, much of the existing activity in financial derivatives consists of transactions between large global financial institutions, all of which already have substantial operations in London. Regulatory burdens on financial derivatives transactions in the United Kingdom (UK) are generally perceived to be significantly lighter than those currently imposed by the CEA, yet participants have considerable confidence in the integrity of the UK markets. If unnecessary regulatory burdens in the United States prompt global institutions to join, or even develop, a London-based electronic trading system for financial derivatives, the United States would suffer a serious and perhaps irreversible blow to its international competitiveness in financial services.
MODERNIZING THE CEA: OTC DERIVATIVES
In the Board's view, then, significant changes in the CEA are appropriate, and the time to make those changes is in the next CFTC reauthorization. In the case of privately negotiated derivatives transactions between institutions, the Board has supported exclusion of such transactions from coverage under the CEA in the past and continues to do so. In these markets, private market discipline appears to achieve the public policy objectives of the CEA quite effectively and efficiently. Counterparties to these transactions have limited their activity to Contracts that are very difficult to manipulate. A global survey conducted by central banks and coordinated by the Bank for International Settlements revealed that, as of June 1998, 97 percent of OTC derivatives were interest rate or foreign exchange contracts. The vast majority of these OTC contracts are settled in cash rather than through delivery. Cash settlement is typically based on a rate or price in a highly liquid market with a very large or virtually unlimited deliverable supply--for example, LIBOR (London interbank offered rate) or the spot dollar-yen exchange rate.
To be sure, some types of OTC contracts that have a limited deliverable supply, such as equity swaps and some credit derivatives, are growing in importance. However, unlike agricultural futures, for which failure to deliver has additional significant penalties, costs of failure to deliver in OTC derivatives are almost always limited to actual damages. Thus, manipulators attempting to corner a market, even if successful, would have great difficulty 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 used directly or indiscriminately as the basis for pricing other transactions. Counterparties in the OTC markets can be expected to 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 on valuations. Hence, any price distortions in particular transactions would not affect other buyers or sellers of the underlying asset.
Professional counterparties to privately negotiated contracts have also demonstrated their ability to protect themselves from losses from counterparty insolvencies and from fraud. In general, they have managed credit risks 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 engaged 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.
The effectiveness of these incentives was confirmed in a 1995 survey of end-users of OTC derivatives that was conducted by the General Accounting Office. When asked if they were satisfied with derivatives dealers' sales practices, 85 percent of users of plain vanilla derivatives and 79 percent of users of more complex derivatives indicated satisfaction. The great majority of the remainder responded neutrally rather than indicating that they were dissatisfied.
MODERNIZING THE CEA: CENTRALIZED EXECUTION OR CLEARING OF FINANCIAL 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 several entities are developing electronic trading systems for interest rate and foreign exchange contracts. Such mechanisms could well reduce risk and increase transparency in derivatives markets. However, their development in the United States is being impeded by the specter that the CEA might be held to apply to transactions executed or settled through such mechanisms. Application of the act not only is perceived as entailing unnecessary regulatory burdens, but also, because of the exchange trading requirement of the act, it raises questions about the legal enforceability of the contracts traded or cleared.
Provided that participation is limited to professional counterparties acting as principals, the Board believes financial derivatives executed or cleared through such centralized mechanisms should nonetheless be excluded from the CEA. The use of such mechanisms would not make these transactions any more susceptible to manipulation than when the transactions are bilaterally executed and cleared. Nor would their use impair the demonstrated ability of professional counterparties to protect themselves from losses from fraud.
Because clearing concentrates and often mutualizes counterparty risks, some type of government oversight of clearing systems may be appropriate. However, it is not obvious that regulation of such clearing facilities under the CEA would always be the best approach. For example, the Board sees no reason why a clearing agency regulated by the Securities and Exchange Commission should not be allowed to clear OTC derivatives transactions, especially if it already clears the instruments underlying the derivatives. Likewise, if a clearing facility were established in the United States for privately negotiated interest rate or exchange rate contracts between dealers, most of which were banks, oversight by one of the federal banking agencies would seem most appropriate.
MODERNIZING THE CEA: 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 act. 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 act as outweighing its costs.
Instead, the Federal Reserve believes that the futures exchanges should be allowed to compete in offering such services to professional counterparties, free from the constraints and burdens of the CEA. The conclusion that centralized mechanisms for professional trading of financial derivatives do not require regulation under the act is valid even if those centralized mechanisms are operated by entities that also operate traditional futures exchanges.
If an exchange chooses to clear professional transactions in financial derivatives through the same clearinghouse that clears its traditional CEA-regulated contracts, then the clearing should be regulated by the CFTC. But exchanges should be allowed to choose to establish a separate clearing system for such transactions that would be overseen by another regulator. In general, with respect to such transactions, the exchanges should have the same options and be subject to the same constraints as competing service providers.
To sum up, the Commodity Exchange Act was designed in the 1920s and 1930s to regulate the trading of grain and other agricultural futures by the general public, including retail investors. Since then, what are now called the derivatives markets have undergone profound changes. Both on futures exchanges and in the OTC markets, financial derivatives now account for the great bulk of the activity. Counterparties to financial derivatives transactions are predominantly institutions and other professional counterparties; retail participation in most of these markets is negligible. Financial derivatives are not susceptible to manipulation, and professional counterparties do not need the protections that retail investors do.
The Board believes that privately negotiated derivatives transactions between professional counterparties should be excluded from the act. Furthermore, the exclusion should apply to centrally executed or cleared transactions, provided that any clearing system is subject to official oversight. Futures exchanges should be allowed to compete as operators of such trading or clearing systems, free from the burdens and constraints of the act.
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, May 20, 1999
We at the Federal Reserve are in broad agreement with the approach outlined by Secretary Rubin and expect to continue to work closely with the Treasury in this area.
As I have indicated previously before this committee, dramatic advances in computer and telecommunications technologies in recent years have enabled a broad unbundling of risks through innovative financial engineering. The financial instruments of a bygone era, common stocks and debt obligations, have been augmented by a vast array of complex hybrid financial products that has led to a far more efficient financial system. These same new technologies and financial products, however, have challenged the ability of inward-looking and protectionist economies to maintain effective barriers, which, along with the superior performance of their more open trading partners, has led, over the past decade, to a major dismantling of impediments to the free flow of trade and capital. The new international financial system that has evolved as a consequence has been, despite recent setbacks, a major factor in the marked increase in living standards for those economies that have chosen to participate in it.
Notwithstanding the demonstrable advantages of the new international financial system, the Mexican financial breakdown in late 1994 and, of course, the most recent episodes in East Asia and elsewhere have raised questions about the inherent stability of this new system.
These newly open markets were exposed to a huge expansion in capital inflows that their economic and financial systems were not ready to absorb. These flows, in turn, were engendered by the increasing diversification out of industrial country investment portfolios, augmented by huge capital gains through 1997. Net private capital inflows into emerging markets roughly quadrupled between 1990 and the onset of the Asian crisis. Such diversification was particularly directed at those economies in Asia that had been growing so vigorously through the 1970s, 1980s, and into the 1990s--the so-called "Asian tigers." In the event, these economies were ill prepared to absorb such volumes of funds. There were simply not enough productive investment opportunities to yield the returns that investors in the West were seeking. It was perhaps inevitable then that the excess cash found its way in too many instances into ill-conceived and unwisely financed real estate ventures.
What appeared to be a successful locking of currencies onto the dollar over a period of years in East Asia, led, perhaps inevitably, to large borrowings of cheaper dollars to lend, unhedged, at elevated domestic interest rates that reflected unheeded devaluation risk premiums. When the amount of such unhedged dollar borrowings finally became excessive, as was almost inevitable, the exchange rate broke.
Although it might seem that the consequences were easily discernible, they were not. Problems with imprudently financed real estate investments emerge with chronic frequency around the globe without triggering the size of the collapse experienced in East Asia in 1997. The size of the crisis became evident only when the normal buffers that any economy builds up to absorb shocks were, in the case of the East Asian economies, so readily breached under pressure.
It has taken the long-standing participants in the international financial community many decades to build sophisticated financial and legal infrastructures that buffer shocks. Those infrastructures discourage speculative attacks against a well-entrenched currency because financial systems are robust and are able to withstand the consequences of vigorous policy responses to such attacks. For the newer participants in global finance, their institutions, until recently, had not been tested against the rigors of major league pitching, to use a baseball analogy.
The heightened sensitivity of exchange rates of emerging economies under stress would be of less concern if banks and other financial institutions in those economies were strong and well capitalized. Developed countries' banks are highly leveraged but subject to sufficiently effective supervision both by counterparties and regulatory authorities so that, in most countries, banking problems do not escalate into international financial crises. Most banks in emerging-market economies are also highly leveraged, but their supervision often has not proved adequate to forestall failures and a general financial crisis. The failure of some banks is highly contagious to other banks and businesses that deal with them, as the Asian crisis has so effectively demonstrated.
This weakness in banking supervision in emerging market economies was not a major problem for the rest of the world before those economies' growing participation in the international financial system over the past decade or so. Exposure of an economy to short-term capital inflows, before its financial system is sufficiently sturdy to handle a large unanticipated withdrawal, is a highly risky venture.
It thus seems clear that some set of suggested standards that countries should strive to meet would help the new highly sensitive international financial system function effectively. There are many ways to promote such standards without developing an inappropriately exclusive and restrictive club of participants.
For example, in any set of standards there should surely be an enhanced level of transparency in the way domestic finance operates and is supervised. This is essential if investors are to make more knowledgeable commitments and supervisors are to judge the soundness of such commitments by their financial institutions. A better understanding of financial regimes as yet unseasoned in the vicissitudes of our international financial system also will enable counterparties to more appropriately evaluate the credit standing of institutions investing in such financial systems. There should be no mechanism, however, to insulate investors from making foolish decisions, but some of the ill-advised investing of recent years can be avoided in the future if investors, their supervisors, and counterparties are more appropriately forewarned.
To be sure, counterparties often exchange otherwise confidential information as a condition of a transaction. But broader dissemination of detailed disclosures by governments, financial institutions, and firms is required if the greater risks inherent in our vastly expanded global financial structure are to be contained. A market system can approach an appropriate equilibrium only if the signals to which individual market participants respond are accurate and adequate to the needs of the adjustment process. Product and asset prices, interest rates, debt by maturity, and detailed accounts of central banks and private enterprises are among the signals so essential to the effective functioning of a global economy. I find it difficult to believe, for example, that the crises that arose in Thailand and Korea would have been nearly so virulent had their central banks published data before the crises on net reserves instead of the not very informative gross reserve positions only. Some inappropriate capital inflows would almost surely have been withheld, and policymakers would have been forced to make difficult choices more promptly if earlier evidence of difficulty had emerged.
As a consequence, the Group of Ten and the International Monetary Fund (IMF) initiated an effort to establish standards for disclosure of on- and off-balance-sheet foreign currency activities of the public sector by countries that participate, or aspire to participate, in international capital markets. The focus of this work was the authorities' foreign currency liquidity position, which consists of foreign exchange resources that can be easily mobilized, adjusted for potential drains on those resources. This work was part of a larger effort to enhance disclosure of a broader set of economic and financial data under the IMF Special Data Dissemination Standard.
Such transparency suggests a second standard worth considering. Countries that lack the seasoning of a long history of dealing in international finance should manage their external assets and liabilities in such a way that they are always able to live without new foreign borrowing for up to, for example, one year. That is, usable foreign exchange reserves should exceed scheduled amortizations of foreign currency debts (assuming no rollovers) during the following year. This rule could be readily augmented to meet the additional test that the average maturity of a country's external liabilities should exceed a certain threshold, such as three years. This could be accomplished directly or through the myriad innovations to augment maturities through rollover options. The constraint on the average maturity ensures a degree of private sector "burden sharing" in times of crisis because in the event of a crisis the market value of longer maturities would doubtless fall sharply. Clearly few, if any, locked-in holders of long-term investments could escape without significant loss. Short-term foreign creditors, on the other hand, are able to exit without significant loss as their instruments mature. If the preponderance of a country's liabilities are short term, the entire burden of a crisis would fall on the emerging market economy in the form of a run on reserves.
Some emerging-market countries may argue that they have difficulty selling long-term maturities. If that is indeed the case, their economies are being exposed to too high a risk generally. For too long, too many emerging-market economies have managed their external liabilities so as to minimize their current borrowing cost. This shortsighted approach ignores the insurance embedded in long-term debt, insurance that is almost always well worth the price.
Adherence to such a rule is no guarantee that all financial crises can be avoided. If the confidence of domestic residents is undermined, they can generate demands for foreign exchange that would not be captured in this analysis. But controlling the structure of external assets and liabilities nonetheless could make a significant contribution to stability.
Considerable progress has been made in recent years in developing sophisticated financial instruments. These developments create added complexity that all financial market participants, including policymakers from emerging-market economies, must manage. However, they also create opportunities that emerging-market economies should seek to exploit. In doing so there are lessons they can learn from advances in risk-management strategies developed by major financial institutions.
To the extent that policymakers are unable to anticipate or evaluate the types of complex risks that the newer financial technologies are producing, the answer, as it always has been, is less leverage, that is, less debt, more equity, and, hence, a larger buffer against adversity and contagion.
A third standard could be a legal infrastructure that enables the inevitable bankruptcies that will occur in today's complex world to be adjudicated in a manner that minimizes the disruption and contagion that can surface if ready resolutions to default are not available.
A fourth standard is the obvious necessity of sound monetary and fiscal policies whose absence was so often the cause of earlier international financial crises. With increased emphasis on private international capital flows, especially interbank flows, private misjudgments within flawed economic structures have been the major contributors to recent problems. But inappropriate macropolicies also have been a factor for some emerging-market economies in the current crisis.
There are, of course, numerous other elements of sound international finance that are worthy of detailed consideration, but the aforementioned would constitute a good start. Even so, improvements in transparency, commercial and legal structures, as well as supervision cannot be implemented quickly. Such improvements and the transition to a more effective and stable international financial system will take time. The current crisis, accordingly, has had to be addressed with ad hoc remedies. It is essential, however, that those remedies not conflict with a broader vision of how our new international financial system will function as we enter the next century.
(1.) The attachment to this statement is 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://federalreserve.gov).
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|Title Annotation:||Patrick M. Parkinson, Laurence H. Meyer, and Alan Greenspan appear before the House Committee on Banking and Financial Services|
|Publication:||Federal Reserve Bulletin|
|Date:||Jul 1, 1999|
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