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Statements to the Congress.

Statement by Laurence H. Meyer, Member, Board of Governors of the Federal Reserve System, before the Committee on Banking and Financial Services, U.S. House of Representatives, May 3, 2000

The Board of Governors appreciates this opportunity to comment on issues related to H.R. 4209, the Bank Reserves Modernization Act of 2000. The Board strongly supports the proposal in the bill to allow the payment of interest on the balances that depository institutions maintain in their accounts at Federal Reserve Banks. We have commented favorably on such proposals on a number of previous occasions over the years, and the reasons for that position still hold today.

Historically, the issue of permitting interest to be paid on reserve balances has been linked to the repeal of the prohibition against paying interest on demand deposits. The Board is pleased that the House of Representatives has passed legislation that would ultimately permit the payment by financial institutions of interest on their customers' demand deposits. Assuming it becomes law, that legislation eventually will contribute considerably to the improved efficiency of our financial sector. Authorizing the Federal Reserve to pay interest on reserve balances held by depository institutions at Reserve Banks would also be important for increasing the economic efficiency of our banking sector.

To help clarify this point, let me first give you some background information on reserve requirements. The Federal Reserve currently requires that depository institutions maintain required reserves equal to 10 percent of their transactions deposits above certain minimum levels. Reserve requirements may be satisfied either with vault cash or with balances held in accounts at Federal Reserve Banks. Excess reserves are reserve balances that depositories hold in Reserve Banks in excess of the balances needed to meet reserve requirements. Depository institutions may also arrange with their Reserve Banks to hold additional balances, called required clearing balances, which I will explain later. Depository institutions earn no interest on their vault cash, required reserve balances, or excess reserve balances.

Paying interest on vault cash is not authorized in the proposed legislation, and it is not advisable because banks hold vault cash mainly for other business purposes, not to meet reserve requirements. Also, questions of equity would arise because it would be administratively impossible for the Federal Reserve to pay interest on the currency holdings of the general public.

However, paying interest on required reserve balances could eliminate some expenditures by the banking sector that are wasteful from the point of view of the overall economy. Depository institutions currently expend considerable resources to minimize their required reserve balances by developing and operating various programs, such as business and retail sweep programs, in order to minimize the balances recorded in their transaction accounts. From society's point of view, these expenditures produce no net benefits, and paying interest on required reserve balances would reduce the incentives for depository institutions to engage in these practices.

Depository institutions have always attempted to reduce to a minimum the non-interest-bearing balances held at Federal Reserve Banks to meet reserve requirements. For more than two decades, some commercial banks have done so in part by sweeping the reservable transaction deposits of businesses into nonreservable instruments. These business sweeps not only have avoided reserve requirements but also have allowed businesses to earn interest on instruments that are effectively equivalent to demand deposits. In recent years, developments in information systems have allowed depository institutions to begin sweeping consumer transaction deposits into nonreservable accounts. These retail sweep programs use computerized systems to transfer consumer transaction deposits, which are subject to reserve requirements, into personal savings accounts, which are not. Largely because of such programs, required reserve balances have dropped from about $28 billion in late 1993 to around $6 billion today, and the spread of such programs has not yet fully run its course.

The payment of interest on required reserve balances would remove the incentives to engage in such reserve avoidance practices. If the bill becomes law, the Federal Reserve would likely pay an interest rate on required reserve balances close to the rate on other risk-free money market instruments, such as repurchase agreements. This rate is usually a little less than the interest rate on federal funds transactions, which are uncollateralized overnight loans of reserves in the interbank market.

In light of the resources used by depository institutions to try to circumvent reserve requirements, some might question the reason for having such requirements. Indeed, reserve requirements have been eliminated in some other industrialized countries. Let me review the historical and current purposes served by reserve requirements.

Although the word "reserves" might imply an emergency store of liquidity, required reserves cannot actually be used for this purpose because they represent a small and fixed fraction of a bank's transaction deposits. I should also note that reserve requirements are quite different from capital requirements. Capital is a buffer against losses, and capital requirements are an important aspect of the prudential supervision and regulation of banks. Reserve requirements, by contrast, have no role in banking supervision and prudential regulation.

Reserve requirements are a monetary policy tool. In the past, they have been employed to assist in controlling the growth of the money stock. In the early 1980s, for example, the Federal Reserve used a reserve quantity procedure to control the growth of the monetary aggregate M1. Indeed, the current structure of reserve requirements, with relatively high required reserve ratios on transaction deposits, which are included in M1, and zero or relatively low ratios on nontransaction deposits, which are not, was originally designed to aid the control of M1. For the most part, however, the Federal Reserve has looked to the price of reserves--the federal funds rate--rather than the quantity of reserves, as its key focus in implementing monetary policy.

While reserve requirements no longer serve the purpose of monetary control, required reserves continue to play a valuable role in the implementation of monetary policy in the United States. They do so because reserve requirements induce a predictable demand for balances at Reserve Banks on a two-week average basis. As you know, depository institutions trade reserve balances among themselves every day at the interest rate called the federal funds rate. The Federal Open Market Committee sets a target for the federal funds rate that the Open Market Desk attempts to maintain. The predictability of the overall demand for reserves is important in helping the Desk determine the amount of reserves to supply through open market operations in order to achieve a given federal funds rate target. Because required reserve balances must be maintained only on an average basis over a two-week period, depositories have some scope to adjust the daily balances they hold for this purpose, and this process helps stabilize the federal funds rate. For instance, if the funds rate were higher than usual on a particular day, some depository institutions could choose to hold lower reserve balances that day, and their reduced demand would help to damp the upward pressure on the funds rate. Later in the two-week period, when the funds rate might be lower, those institutions could choose to hold more reserves and make up the shortfall in their average holdings of reserve balances. This action would also help smooth out the funds rate over the two-week period.

The Federal Reserve permits depository institutions to hold additional deposits in the form of required clearing balances, which are not included in total reserves. Under the Federal Reserve's required clearing balance program, depository institutions may hold credit-earning balances, not for meeting reserve requirements but for assisting with clearing needs. The credits offset charges for Federal Reserve services, like check-clearing, used by the depository. This program helps to restrain volatility in the federal funds rate in a manner similar to reserve requirements because the clearing balance requirement is on a two-week average basis and because it is identified ahead of time. The volume of required clearing balances is limited, however, because the credits accumulate only to the level of charges that a depository institution incurs for Federal Reserve services. Under H.R. 4209, explicit interest could be paid on such balances. Thus, this constraint on the level of required clearing balances would be eliminated, a result that would potentially boost their benefit for the implementation of monetary policy.

In addition to required reserve and required clearing balances, depository institutions also hold excess reserve balances in their accounts at Federal Reserve Banks. Their motive in holding excess reserves is mainly as a precaution against the chance that unpredictable payments out of their accounts late in the day might cause shortages of reserves to satisfy reserve requirements or might cause overnight overdrafts on their accounts. The Federal Reserve strongly discourages overnight overdrafts.

If required reserve and required clearing balances dropped to very low levels, there would be increased risks of overnight overdrafts on the accounts of depositories in Reserve Banks. The remaining balances of depositories at Reserve Banks would be largely excess reserves held as a precaution against such overdrafts. It would be especially difficult to predict the level of balances depositories would need for this purpose from one day to the next. For example, on days when payment flows were particularly heavy and uncertain, or when the distribution of reserves around the banking system were substantially different than normal, depositories would need a higher-than-usual level of precautionary balances to avoid the risk of overdrafts. The uncertainties would make it harder for the Federal Reserve to determine the appropriate daily quantity of reserves to supply to the market. Thus, in such a scenario, the federal funds rate could become more volatile and often diverge markedly from its intended level.

Moderate levels of volatility are not a concern for monetary policy, in part because the Federal Reserve now announces the target federal funds rate, eliminating the possibility that fluctuations in the actual funds rate in the market would give misleading signals about monetary policy. A significant increase in volatility in the federal funds rate, however, would be of concern because it would affect other overnight interest rates, raising funding risks for most large banks, securities dealers, and other money market participants. Suppliers of funds to the overnight markets, including many small banks and thrift institutions, would face greater uncertainty about the returns they would earn, and market participants would incur additional costs in managing their funding to limit their exposure to the heightened risks.

An example of significantly heightened volatility occurred in early 1991, just after the Federal Reserve reduced reserve requirements in order to ease funding costs to banks during the credit crunch period. Because of the cut in reserve requirements, many depository institutions found that their required reserve balances fell below the level of balances they needed to hold as a precaution against overdrafts because of unpredictable payment flows; as a consequence, the federal funds rate became quite volatile for a while, with daily trading ranges averaging around 8 percentage points, compared with about 1 1/2 percentage points in normal times.

Since, then, depository institutions have become much more adept at managing their reserve positions, in part by making greater use of required clearing balances, and as a result, their needs for day-to-day precautionary balances have declined considerably. Several measures taken by the Federal Reserve also have helped to foster stability in the funds market, including improvements in the timeliness of account information provided to depository institutions, more frequent open market operations, which are increasingly geared to daily payment needs rather than two-week-average requirements, a shift to lagged reserve requirements, which gives depositories and the Federal Reserve advance information on the demand for reserves, and improved procedures for estimating reserve demand. As a result of these steps taken by depository institutions and the Federal Reserve, the average level of volatility in the federal funds rate has not moved up, despite much lower levels of required reserve balances than in the 1991 episode. However, the limited effects on volatility of the spread of retail sweep programs to date may not preclude a more outsized reaction if reserve balances fall even lower. We expect required reserve balances to fall from their current level of around $6 billion to perhaps $4 billion, thereby increasing the risk of heightened volatility in the funds rate.

As I previously mentioned, some industrial countries have managed to implement monetary policy successfully without reserve requirements. Those countries have avoided substantial volatility in overnight interest rates by using alternative procedures for the implementation of monetary policy. One approach, for instance, establishes a ceiling and a floor to contain movements of the overnight interest rate. The ceiling is set by the central bank's lending rate in what is called a Lombard facility; loans are provided freely to qualified banks but at an interest rate above the expected level of overnight market interest rates. Adopting a Lombard facility in the United States would involve changes in our discount window operations. For such a facility to function effectively as a ceiling for overnight interest rates, depository institutions would need to exhibit a greater willingness to make use of discount window loans than they have in the past. In some countries, a floor for overnight interest rates is established by the rate of interest a central bank pays on excess reserve balances; banks would not generally lend to other banks at an interest rate below the rate they could earn on a risk-free deposit at the central bank. For the Federal Reserve to be able to set a similar interest rate floor, it would need expanded legislative authority, for example, to pay interest on excess reserves. Under H.R. 4209, interest on excess reserves would be allowed.

If interest were permitted to be paid on required reserve balances, adjustments in the procedures for implementing monetary policy and in the behavior of depository institutions might not be needed. Interest on required reserves would reduce banks' costs of offering transaction deposits and thus could boost their levels substantially, as some sweep programs were unwound. The unwinding would be larger if interest could also be paid on demand deposits, as eventually would be permitted by the legislation already passed by the House. The increased transaction deposits likely would bring required reserve balances above the level of daily precautionary needs for many institutions, thus helping to stabilize the federal funds rate, while also improving economic efficiency as previously noted.

The magnitude of the responses to these measures, however, is uncertain. Some corporations may not find the interest paid on demand deposits high enough to induce them to shift a substantial volume of funds out of other liquid instruments. Also, some banks may retain consumer sweep programs in order to seek higher investment returns than the Federal Reserve would pay on riskless reserve balances.

Because of the uncertainties involved, it is best for the Federal Reserve to be able to pay interest on any balances that depositories hold at Reserve Banks, not just on required reserve balances, and at differential rates to be set by the Federal Reserve, as the bill would allow. The ability to pay explicit interest on balances other than required reserve balances would provide additional tools that could be helpful for monetary policy implementation if interest on required reserve balances resulted in an insufficient boost to the level of those balances. In any case, it is important that the Federal Reserve have a full monetary toolkit, given the inventiveness of financial market participants and the need for the Federal Reserve to be prepared for potential developments that may not be immediately visible.

H.R. 4209 also includes a technical provision related to pass-through reserves. This provision would extend to banks that are members of the Federal Reserve System a privilege that was granted to nonmember institutions at the time of the Depository Institutions Deregulation and Monetary Control Act of 1980. It would allow member banks to count as reserves their deposits in affiliated or correspondent banks that are in turn "passed through" by those banks to Federal Reserve Banks as required reserve balances. The provision would remove a constraint on some banks' reserve management and would cause no difficulties for the Federal Reserve in implementing monetary policy. The Board supports it.

The payment of interest on required reserve balances would reduce the revenues received by the Treasury from the Federal Reserve. The extent of the revenue loss, however, has fallen considerably on balance over the past ten to twenty years because of reductions in the level of such balances as banks have increasingly implemented reserve avoidance techniques and because of the generally lower level of interest rates as inflation has declined. Paying interest on required clearing balances would merely involve a switch to explicit interest from the implicit interest of earnings credits. It might, if anything, have a slight positive effect on the Treasury budget to the extent that the level of such balances increased with explicit interest, and the Federal Reserve was able to earn a higher return on investing the additional funds than it paid out in interest. Regarding interest on excess reserve balances, the Federal Reserve does not see an immediate need to use this additional tool for monetary policy. If it were used, Treasury revenues could be reduced, but probably only slightly, because of the small amount of excess reserve balances, which have averaged a little more than $1 billion in recent years, and the likelihood that the Federal Reserve would pay a rate well below the federal funds rate on them. Also, if the demand for excess reserves increased, any "spread" that the Federal Reserve earned on the higher excess reserves would be returned to the Treasury, further limiting the budgetary cost.

The committee has requested the Board's view on the possibility of transferring some of the capital surplus of the Federal Reserve Banks to the Treasury in order to cover the budgetary costs of paying interest on required reserve balances. Let me take a moment to explain the role of the surplus account of the Reserve Banks.

The Federal Reserve System derives the bulk of its revenues from interest earnings on Treasury securities that it has obtained through open market operations. The System returns a very high proportion of its earnings every year to the Treasury. In 1999, it turned over $25 billion, or about 97 percent of its earnings. In most years, the System retains a small percentage of those earnings in its surplus account. The surplus account is a capital account on the Federal Reserve Banks' balance sheets. Since 1964, the Federal Reserve has followed the practice of allowing the surplus to rise to match increases in the paid-in capital of member banks. Each member bank is required by law to subscribe to the capital stock of its Reserve Bank in an amount equal to 6 percent of its own capital and surplus. The Board requires that half of that subscribed capital be paid in.

The Federal Reserve's surplus account is currently about $6 1/2 billion, while its total capital amounts to $14 billion. As required by the omnibus appropriations legislation that passed at the end of the last congressional session, the Federal Reserve will transfer $3.752 billion from its surplus account to the Treasury; that transfer is scheduled for May 10. After the transfer, the surplus will be $2.7 billion and total capital will be about $10.3 billion. Total assets of the Federal Reserve are around $600 billion.

The surplus account has helped to provide extra backing for the issue of Federal Reserve notes. The Federal Reserve is required by law to hold certain specified assets, including Treasury securities, as collateral against the issuance of currency. The Federal Reserve buys Treasury securities, its main asset, in the open market as the counterpart to the surplus on its books. The extra margin of collateral for currency made possible because of the surplus was important in the past because certain types of discount window loans could not be used as collateral. However, legislation signed into law last year expanded the assets of the Federal Reserve that could be used to back the issuance of currency to include all discount window loans. As a result, the importance of the surplus in providing a margin of excess currency collateral has greatly diminished.

Traditionally, the Federal Reserve and virtually all other central banks have maintained an appreciable level of capital. For the Federal Reserve, some of that capital has been contributed by member commercial banks and some from earnings retained in the surplus account. Maintaining a surplus account may help support the perception of the central bank as a stable and independent institution by ensuring that its assets remain comfortably in excess of its liabilities. However, the need for capital in this case is limited by the modest variability of the Federal Reserve's profits, the safety of its primary asset, Treasury securities, and the substantial regular flow of earnings from its portfolio of securities.

Indeed, in the abstract, a central bank with the nation's currency franchise does not need to hold capital. In the private sector, a firm's capital helps to protect creditors from credit losses. Creditors of central banks, however, are at no risk of a loss because the central bank can always create additional currency to meet any obligation denominated in that currency.

Whatever the benefits of the surplus account, it should be emphasized that its maintenance is costless to the Treasury and to taxpayers. The Treasury has to issue more debt because of the surplus, but an exactly equivalent amount of Treasury debt is held by the Federal Reserve. The amount of Treasury debt held by the private sector is not affected by the existence or the level of the surplus. The Treasury pays interest on the portion of its debt held by the Federal Reserve, but those interest/payments are then returned to the Treasury by the Federal Reserve on a weekly basis.

For similar reasons, transfers of Federal Reserve surplus to the Treasury provide no true budgetary savings. Let me give you an example that illustrates this principle. First, imagine that the Congress wished to enact some new spending program that would cost $500 million. In the absence of any new revenues or reductions in outlays on other programs, the Treasury would need to issue $500 million of debt to the public to fund the expenditure. The annual interest cost on that debt, at a 6 percent interest rate, would be $30 million a year. Now suppose that, instead, the Congress decided to "finance" the spending program by transferring $500 million from Federal Reserve surplus to the Treasury. To obtain the funds to transfer to Treasury while maintaining the stance of monetary policy, the Federal Reserve would need to sell $500 million of Treasury securities from its portfolio to the public. The public would wind up holding $500 million of additional Treasury debt, and the government would increase its net interest cost by $30 million a year--exactly the same outcome as if the Treasury just sold the debt directly to the public. Thus, financing an additional $500 million outlay through a surplus transfer is exactly equivalent to borrowing from the public. For reasons illustrated by this example, the Federal Reserve has consistently stated that transfers of Federal Reserve surplus do not provide true budgetary revenues and indeed that mandating such transfers undermines the integrity of the federal budgetary process. The fact that budgetary rules count transfers of Federal Reserve surplus as revenues for the purpose of calculating the budget deficit is an anomaly of federal budget accounting.

Over the years, the Congress generally has concurred with this view, with a few exceptions. Congressional budget resolutions in 1996, 1997, and again this year noted that transfers of surplus have no real budgetary or economic effects. The 1996 and 1997 resolutions directed the Congressional Budget Office not to score any savings from legislation requiring transfers from the surplus account to the Treasury. The most recent budget resolution contains a provision to ensure that transfers of Federal Reserve surplus "shall not be used to offset increased onbudget spending when such transfers produce no real budgetary or economic effects." The Manager's statement explaining this provision states: "It has long been the view of the Committee on the Budget that transfers of Federal Reserve surpluses to the Treasury are not valid offsets for increased spending."

In summary, the Federal Reserve strongly supports legislation to authorize the payment of interest on reserves. Such authorization, however, would have a budgetary cost. The transfer of Federal Reserve surplus would technically increase reported budget receipts, because of a unified budget convention, but would not represent a true source of revenue to offset this cost.

Statement by Stephen R. Malphrus, Staff Director for Management, Board of Governors of the Federal Reserve System, before the Subcommittee on Financial Institutions, Committee on Banking, Housing, and Urban Affairs, U.S. Senate, May 18, 2000

Chairman Bennett and members of the subcommittee, I am pleased to have this opportunity to participate in today's panel on our recent experience with the so-called "I love you," or "Love Bug," computer virus. First, Mr. Chairman, I had the pleasure of working with you when I served as Chair of the Financial Sector Group of the President's Council on Year 2000 Conversion. I am grateful for the leadership and support you provided to the work of the Financial Sector Group and the President's Council. Clearly the public-private sector partnership you helped forge was key to our nation's successful conversion to the new century.

As you know, the Love Bug virus was launched from the Far East, and it attacked computers around the world running Microsoft Outlook for Windows. To review what we know, the Love Bug virus, or in the taxonomy of computer science, the "worm," entered computers through e-mail messages. Once a message was opened, the virus was able to reproduce itself by finding address lists stored by the computer's owner and then sending itself to the addressees. If an addressee opened the attachment, a similar replication occurred, enabling the virus to spread rapidly. We understand that the virus was designed to steal Internet passwords. The virus was able to modify operating system files as well as certain sound and picture files residing in the infected computers. It had the effect of degrading network performance by inundating e-mail server systems and some web pages. Variants of the virus in some cases had a major impact on the data and program files of some computer networks, although we did not experience that in the Federal Reserve.

Like many organizations, the Federal Reserve System received hundreds of Love Bug e-mail messages. However, the virus had no impact on our critical business functions or information systems. Indeed, the delivery of key financial and central bank services by the Federal Reserve was unaffected. In the weeks after May 4, we contacted industry trade organizations as well as a number of the institutions we supervise, and they reported the virus did not impair critical retail or wholesale banking services. Indeed with the help of various public- and private-sector information-sharing programs, the virus was quickly detected, isolated, and immunized through a variety of standard operating procedures that have been implemented by the Federal Reserve and financial institutions.


Because the virus started in the Far East, it was identified before most U.S. public and private institutions opened for business. The Federal Reserve became aware of the virus on the morning of Thursday, May 4, through reports from Microsoft. By approximately 8:30 a.m., major news wire services also contained fairly accurate details about how to identify the virus, although the type of damage inflicted on computer hardware and files and the manner in which the virus spread were still unclear. Throughout the day, we also received reports from the FBI's National Infrastructure Protection Center (NIPC),(1) from InfraGard,(2) and from antivirus software vendors.

Financial institutions that have foreign offices, particularly those with operations in Asia, had the earliest warning and were able to take steps to inform employees worldwide and to shield their e-mail systems, in many cases before opening for business. As a precaution, many institutions shut down external, and in some instances internal, e-mail systems. These institutions also quickly alerted industry trade organizations and business partners about what they knew of the virus. The global nature of commerce helped many financial institutions learn about the virus before many of the monitoring services issued an alert.

At the Federal Reserve, we immediately began to implement our standard virus incident response procedures. The fact that our employees were already trained to recognize and report suspicious e-mail messages, such as those that typically are virus carriers, was a tremendous asset in limiting the spread of the virus internally--only a handful of messages were opened. As a preventive measure, at about 9:30 a.m., we shut down our e-mail systems to incoming mail from the Internet, and subsequently through our intranet, until we received and installed an antivirus patch, or antidote, from our software vendors. (An antidote cannot be produced until the particular virus is analyzed, and systems are at risk until an antidote is installed.)

In accordance with Federal Reserve System policy, line management responsible for information security convened Systemwide conference calls to discuss the virus and to coordinate actions to contain it. During the day, CERT(3) and other virus-response centers provided information about how the virus spread and measures to contain the virus. We began installing antivirus patches in the afternoon, and, as an example, the Board of Governors re-opened its e-mail systems to outside mail by 5:00 p.m. Financial institutions reported they were able to reopen e-mail systems at various times during the day, and most e-mail systems were open by the beginning of business the following morning.


When the Love Bug struck, the Federal Reserve had state-of-the-art procedures and controls in place for responding to and managing cyber-related incidents, including computer viruses. The procedures were effective in managing this incident and limiting the spread of the Love Bug virus.

Besides training our employees in how to identify and deal with suspicious messages, the Federal Reserve has implemented several layers of security protections. These include incident response teams and virus-detection software that screens e-mail messages and mailboxes for viruses; and, on some systems, we are operating "integrity checking tools" that detect changes in operating systems and software. We have an ongoing communications program with senior executives regarding the operational risks associated with information systems. Effective lines of communication are also in place linking information technology (IT) professionals across the Federal Reserve System to each other and with our vendors and organizations, such as the FBI and CERT.


Other than impeding office communications and diminishing productivity because of the temporary halt in receiving and sending e-mail messages, the virus had minimal impact on the Federal Reserve's business operations and no impact on our critical financial and central bank services. Our electronic payment services are protected from e-mail viruses because they do not operate on the automation systems that support our Internet and electronic mail services. Our payment systems operate on proprietary software systems and use a closed network rather than the public Internet. Fedwire--our large-value funds transfer application--and our other key payment systems are accessible only through dedicated devices and require specific hardware, software, and communications facilities to process transactions. Moreover, all of these communication systems are fully encrypted. If for some reason the Love Bug virus was able to operate on a device linked to one of our payment system applications, the device might, at worst, be temporarily disabled. An infected terminal, however, could be recovered by using contingency procedures.

The Federal Reserve did experience some negative effects from the Love Bug attack. While our e-mail systems were disconnected, we used fax machines and telephones to complete routine communications. This proved to be inconvenient for some employees. In addition, our IT staff had to devote time to communicating with employees and business partners about appropriate screening and containment measures and to perform work to apply software patches to immunize our e-mail systems and recover machines that had been infected by the virus. In short, a virus of this nature can be disruptive to an organization's electronic communications and knowledge-sharing activities.

The financial institutions we supervise reported a similar experience. Word about the virus spread around the globe almost as quickly as the virus did, and companies were able to alert employees and to shield e-mail systems early in the business day. Even when e-mail systems became infected, the virus was not able to spread to critical banking systems. Financial institutions conducted business as usual, and ATMs and other retail and wholesale payment and settlement systems were unaffected.

Although there were some minor disruptions in commerce, we have not identified any measurable effect on the economy--in large part because commercial transactions are not generally conducted using e-mail-based information systems. Various news services have estimated the cost of the virus--in terms of lowered productivity and labor costs to manage the virus and recover from damage--in the range of $5 billion to $15 billion worldwide. At this time, however, we view those numbers as "guesstimates."(4)


Although the Federal Reserve's detection and response procedures were adequate and worked well, we see the incident as an opportunity to identify lessons learned so that we can continue to improve our virus response processes. Our information-security program is based on a process of continuous improvement and a post-incident review is standard practice in the Federal Reserve. We want to ensure that we operate in the most secure environment possible and that we are prepared to respond to cyber-related incidents in a consistent, coordinated manner.

With respect to the financial institutions we supervise, the Federal Reserve is integrating our information technology examination program into safety and soundness assessments to ensure that the inherent business risks created by technology are properly managed. One benefit of Y2K is that senior executives and boards of directors of financial institutions have a better understanding of the linkage between operations risk and credit, market, liquidity, reputational, legal, and other forms of risk. This will serve the industry well in addressing new operational risks posed by rogue software, such as viruses.

In addition, we are committed to participating in initiatives that promote information-system security and that assist in the rapid identification and analysis of new viruses and other forms of cyber attacks. The Federal Reserve is an active participant in numerous public- and private-sector activities to protect the critical infrastructure. For example, we receive information from the NIPC, and we will also be participating in the financial services information sharing and assessment center. We also plan to work more closely with our antivirus software vendors to convey the urgency of producing antidotes to new viruses in an even more timely manner.

Our financial institutions report a renewed commitment to training, particularly institutions in which virus-screening capabilities are somewhat limited because of lesser reliance on e-mail systems. Moreover, to avoid having to shut down e-mail systems even briefly, some larger institutions plan to investigate more robust filters that can be deployed in the period after the spread of a virus and before their antivirus software vendors produce an antidote patch. As a result of the Love Bug virus, there is an increased awareness in the financial sector that today's most commonly used desktop products (web browsers, e-mail, and the like) are generally not designed to resist future virus strains. Financial institutions also believe that the software industry needs to take additional steps to ensure that their products are appropriately secure. It is essential that desktop products used to support critical business functions are secure and engender confidence in their use. In the future, we anticipate that desktop products will increasingly be employed to deliver retail financial services over the Internet.


Computer viruses and other malicious attacks by software hackers present an ongoing threat. Although the Love Bug virus was limited in the damage that it caused, future viruses may be more difficult to contain. Because viruses put us into a defensive mode, good information security processes and controls are critical--and those employed by the Federal Reserve were effective in detecting and responding to the Love Bug virus.

In my opinion, if electronic commerce is to flourish, there must be a high degree of confidence by all parties to transactions that the systems and networks are as secure as possible. There is a need to focus on measures that can be implemented to contain viruses while antidotes are being developed. These include measures to share information more effectively, to analyze new viruses quickly, to distribute fixes more efficiently, and to recognize new, innovative viruses as they occur. Finally, public- and private-sector information-security initiatives, including early warning, analysis, information, and containment, should be supported and broadened.

Up to this point, much of the focus on new threats to computer systems has focused on national security and criminal aspects of the problem. From my perspective, the discussion should be expanded to include the broader risks presented by the growth of electronic commerce. One of the reasons our nation's Year 2000 efforts were so successful was that leaders in the public and private sectors recognized that technology issues presented significant business risks, and they worked together to meet the challenge. The work of the Department of the Treasury in supporting the goals of Presidential Decision Directive 63 is a good step in helping the financial sector to address new forms of operations risk. Finally, in my view, the model implemented to address Y2K could be helpful in strengthening programs to address the risks to the public infrastructure on which the financial services industry relies: telecommunications, power, water, transportation, and public safety.

(1.) ANSIR (Awareness of National Security Issues and Response) is the NIPC center that provides automated, unclassified advisory, alert, and warning information to private-sector security professionals concerning physical and cyber threats.

(2.) InfraGard is an FBI initiative to provide a private- and public-sector information-sharing mechanism in support of critical infrastructure protection. The FBI plans to open InfraGard chapters in all fifty-six FBI field districts.

(3.) The CERT (Computer Emergency Response Team) coordination center was chartered in 1988 by the U.S. Department of Defense to work with the Internet community to respond to computer security problems, raise awareness of computer security issues, and prevent security breaches. CERT/CC is part of the Networked Systems Survivability Program in the Software Engineering Institute, a federally funded research and development center at Carnegie Mellon University.

(4.) See, for example, David Noack, "`Love Bug' Damage Worldwide: $10 Billion," (May 8, 2000); Kathleen Ohlson, Computer World, "Love Virus Costs Approaching $7 Billion" (May 9, 2000); Jesse J. Holland, Associated Press writer, "Computer Virus Hits Fed Agencies" (May 11, 2000).

Statement by Edward M. Gramlich, Member, Board of Governors of the Federal Reserve System, before the Committee on Banking and Financial Services, U.S. House of Representatives, May 24, 2000

Much recent attention has been focused on predatory lending, amid distressing reports of abusive practices connected with home-secured loans. These practices may involve, among other things, excessive fees and interest rates, unnecessary insurance, and fraud. Borrowers saddled with unaffordable payments can lose their homes. Excessive up-front fees combined with frequent refinancings (often referred to as "loan flipping") may also strip the equity from consumers' homes. These are matters of serious concern, and the committee should be commended for examining them.

There is some debate about what constitutes abusive or predatory lending. A narrow definition of predatory lending focuses on specific practices that take advantage of consumers and that are unfair, deceptive, or fraudulent. Other observers view predatory lending more broadly, focusing on high-cost loans as such. Most predatory lending seems to occur in the subprime mortgage market, a market that has grown recently. In this market, the premiums paid by borrowers typically range from about 1 percentage point to about 6 percentage points more than the rate charged for prime mortgage loans, depending on the credit risk involved. Some consumer advocates have stated that many subprime loans are predatory because, in their view, subprime borrowers pay rates and fees that exceed the amounts necessary to account for any additional credit risks. Thus, even though most consumer advocates applaud the growth of subprime lending--because it expands the availability of credit to those with less-than-perfect credit records--they are concerned about whether, in practice, some subprime lenders or their brokers are taking unfair advantage of many of these consumers.

The information we have about predatory lending is essentially anecdotal. Even apart from the conceptual differences I mentioned, there is no ready method for measuring the amount of predatory lending or determining how prevalent a problem it represents. Yet, even without precise data, there are enough anecdotes to suggest that a problem exists. We also know that attempts to deal with predatory lending are hampered by two broad phenomena:

* Predatory lending often involves the abuse of credit provisions that can be of value to many borrowers.

* Predatory lending seems to occur most commonly in the unregulated sector of the loan market by lending institutions that are not forced to undergo periodic compliance exams.


No law administered by the Board contains a statutory or regulatory definition of predatory lending. The Truth in Lending Act (TILA) is intended to promote the informed use of consumer credit, primarily through disclosure of the costs and terms of loans, although it also contains some substantive restrictions.

TILA requires all creditors to calculate and disclose credit costs in a uniform manner. Lenders must disclose information on payment schedules, prepayment penalties, and the total cost of credit expressed as a dollar amount and as an annual percentage rate (APR). TILA mandates additional disclosures for loans secured by a consumer's home and provides for a "cooling off period," during which consumers may rescind certain transactions that involve their principal dwelling.


In response to reports of abusive lending practices whereby unscrupulous lenders made unaffordable home-secured loans to "house-rich but cash-poor borrowers," the Congress amended TILA by enacting the Home Ownership and Equity Protection Act of 1994 (HOEPA). HOEPA identifies a class of high-cost mortgage loans and protects borrowers from loan agreements that are likely to result in default and the loss of their homes. The act does not prohibit creditors from making such loans but defines a class of transactions through rate and fee triggers. The particular triggers of HOEPA are an APR 10 percentage points above the yield on a Treasury security of comparable maturity or closing fees exceeding 8 percent of the loan amount. For covered transactions, additional disclosures are required and certain loan terms are prohibited, such as balloon payments for short-term loans and non-amortizing payment schedules.

The disclosures required by HOEPA include a warning that the lender has a mortgage on the borrower's home and that the borrower could lose the home through a default. The disclosures also must provide cost information such as the APR and the monthly payment. These disclosures must be given to consumers at least three days in advance of the loan closing. When combined with TILA's three-day right of rescission after the closing, the disclosures ensure that a consumer has a minimum of six days to consider the relevant information before finally deciding to enter into a transaction. If a creditor fails to provide material disclosures or includes prohibited terms in the loan agreement, the borrower may have up to three years to rescind the transaction. Violations of HOEPA may result in creditors' being liable for actual and statutory damages. Consumers may also recover all finance charges and fees paid on a loan. HOEPA also includes special liability rules that generally make the purchasers or assignees of these loans subject to all claims and defenses that could be asserted against the original creditor.


Since HOEPA's enactment, the volume of home equity lending has increased significantly. This overall growth in home equity lending has featured a sharp boost in the subprime mortgage market. The Department of Housing and Urban Development (HUD) reports that the number of subprime loans used to purchase homes has increased from a mere 16,000 in 1993 to more than 220,000 in 1998. The number of subprime home equity loans has increased from 80,000 in 1993 to 790,000 in 1998.

The result of this growth has been a massive increase in the availability of credit to borrowers having less-than-perfect credit histories and to other consumers who do not meet the underwriting standards of prime lenders. These are mainly lower-income or minority borrowers, or those residing in lower-income or minority neighborhoods.

Because consumers who obtain subprime mortgage loans have fewer credit options than other borrowers, or because they perceive that they have fewer options, they may be more vulnerable to unscrupulous lenders or brokers. With the increase in the number of subprime loans and the fact that a large share of these loans are made by nondepository financial institutions that are not facing periodic compliance examinations, consumer advocates have been concerned for some time about the potential for a corresponding increase in the number of predatory loans. But some industry representatives have noted that the trend toward securitizing subprime mortgages has served to standardize creditor practices and to limit the opportunity for widespread abuse.

Although HOEPA's purpose is to regulate abusive lending practices, coverage by the act depends on price triggers rather than on a definition or finding of "predatory lending." This means that HOEPA's price triggers bring some subprime loans not associated with unfair or abusive lending within the act's coverage and that abusive practices may occur in transactions that fall below the HOEPA triggers.


In July 1998, the Board and the Department of Housing and Urban Development submitted a report to the Congress on the issue of how TILA and the Real Estate Settlement Procedures Act (RESPA), an act requiring certain disclosures and prohibitions, might be reformed. Although improved disclosures would help many consumers shop for loans that best fit their needs, the two agencies found that these disclosures alone were unlikely to protect vulnerable or unknowing consumers from unscrupulous creditors. Accordingly, the 1998 report included a detailed analysis of the problem of abusive practices in mortgage lending, with several recommendations for possible legislation. A copy of the report is attached.(1)

As described in the 1998 report, abusive practices in home equity lending take many forms but principally fall within two categories. One category includes the use of blatantly fraudulent or deceptive techniques that may also involve other unlawful acts, including violations of HOEPA. These practices occur even though they are illegal. For example, loan applicants' incomes and ability to make scheduled loan payments may be falsified, consumers' signatures may be forged or obtained on blank documents, or borrowers may be charged fees that are not tied to any service rendered.

The other category of abuses involves various techniques used to manipulate borrowers, coupled with practices that may ordinarily be acceptable but can be used or combined in abusive ways. Consumers may be talked into accepting high-cost loans without knowing that they may qualify for lower-cost alternatives. A broker or creditor may pressure consumers to enter into transactions that they do not fully understand or that are not beneficial. If there is sufficient equity in the property, homeowners may be charged excessive up-front fees, which are added to the loan amount. Because of the equity built up, such loans may be based on the collateral value alone, without consideration of the borrowers' ability to repay. And some loan terms that work well for some borrowers in some circumstances may harm borrowers who are not fully aware of the consequences. For example, a consumer may not understand that a loan with affordable monthly payments will not amortize the principal or that the consumer may have to refinance a balloon payment at additional cost.


The 1998 report suggested some new substantive protections to deal with predatory lending, some involving legislative action. The report noted that any regulatory scheme involves tradeoffs. Government-imposed rules dictating when and on what terms consumers can obtain credit sometimes raise issues of fairness and economic efficiency. Overly broad rules could unnecessarily burden the entire home equity credit industry in an effort to regulate a minority of unethical or dishonest players. Any legislation should focus on abusive practices without interfering with legitimate credit transactions.

The desirability of rules that narrow a consumer's options depends on the circumstances or the perspective of the particular consumer. We should try to preserve consumers' ability to choose loan products that meet their particular needs. For example, mortgages with a balloon payment feature often are attractive to borrowers because they allow distressed borrowers or young borrowers who have low cash incomes to buy homes and match payments with their rising income stream. But sometimes balloon payments can ruin borrowers who do not have a rising stream of income and who are unduly influenced by the lower short-term cost of a balloon note.

Given the wide range of practices that are included in the notion of what is "predatory," a multifaceted approach is likely to be the most effective. We should certainly look at ways to strengthen enforcement of current laws that are being ignored. Nonregulatory strategies should also be encouraged and implemented, including voluntary industry action, community outreach efforts, and consumer education and counseling.

The 1998 report identified two specific changes to protect consumers who obtain HOEPA-covered loans. One addresses balloon payments; the other addresses single-premium credit insurance.

Currently, balloon payments are prohibited for HOEPA-covered loans having 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 with balloon payments can sometimes be useful credit arrangements 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-covered loans, consumers may be just as unlikely to repay or refinance the loan at better rates after five years as they are after two or three years. Hence the Board and HUD proposed that balloon notes covered by HOEPA might be further restricted, for example, either by applying stronger prohibitions to a subset of these loans or by prohibiting balloon notes for these loans altogether.

The Board and HUD also recommended limiting creditors' ability to collect certain credit insurance premiums on HOEPA-covered loans up-front. Consumer advocates express concern about high-pressure sales tactics sometimes used to sell high-priced credit insurance that does not allow for a discount for advance payments. The insurance is sometimes sold with a single premium collected up-front. If for some reason the mortgage loan is paid off early, it is often difficult for consumers to obtain a refund of the unused portion of their premium.

Regulation of insurance, including the setting of allowable premium rates, has historically been a matter for state law. Yet 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 would automatically cancel both the coverage and any liability for future payments.

The Board and HUD also recommended reforms concerning the type of notice that should be provided with consumer loans in general, both HOEPA and non-HOEPA, before foreclosure. Consumers victimized by abusive practices must be provided adequate opportunity to assert their rights 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. Some states require creditors to provide actual notices of foreclosure proceedings 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 to obtain permission to sell the property. Other states allow a nonjudicial 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 the 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. Nevertheless, to avoid unannounced foreclosures on consumers' homes, the Board and HUD recommended that before any foreclosure sale, creditors should be required to 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 the steps they must take to exercise their rights and the process that will be followed in any foreclosure, and should be given information about the availability of third-party credit counseling.


As I mentioned earlier, a multifaceted approach, including both regulatory and nonregulatory strategies, is likely to be the most effective. Efforts on all or most of these fronts are under way. For example, several bills taking different approaches to addressing predatory lending have been introduced in the Congress. Several states have enacted or are considering legislation.

Various federal task forces have been formed. The Board has convened a nine-agency working group, including the five federal agencies that supervise depository institutions, two agencies that regulate housing (HUD and the Office of Federal Housing Enterprises Oversight), and two that regulate or prosecute deceptive trade practices in general (the Department of Justice and the Federal Trade Commission). The latter four agencies cover lending institutions outside the normal compliance network. The aims of the group are to tighten enforcement of existing statutes and to establish a coordinated approach to predatory practices. Even though insured depository institutions typically have not been associated with making predatory loans, concerns have been raised about financial institutions that invest in these loans.

The Board is required to hold periodic hearings on the effectiveness of HOEPA in curbing abusive lending. The Board did so in 1997, slightly less than two years after the act became effective. Those hearings formed the basis of the 1998 analysis of abusive lending contained in the Board-HUD joint report to the Congress. The Board plans to hold another round of public headings on HOEPA later this year, with the Board's Consumer Advisory Council taking an active role in developing the specific questions for discussion.

At those hearings, consideration will be given to broadening HOEPA's coverage by, for example, lowering the HOEPA rate triggers or including additional costs in the points and fee triggers. In addition, the Board will explore whether its regulatory authority under HOEPA to prohibit practices that harm consumers can, as a practical matter, curb predatory loans. Frankly, the value of rules prohibiting such practices is uncertain, given the nature of predatory practices. Some occur even though they are already illegal, and others are harmful only in certain circumstances. The best solution in many cases may simply be stricter enforcement of current laws.

Nonregulatory strategies are also being pursued. Trade associations for subprime lenders and mortgage brokers have been actively engaged in developing self-regulatory guidelines. Secondary market participants such as Fannie Mae and Freddie Mac are developing their own strategies for ensuring that they do not finance predatory loans and are making efforts to develop consumers' awareness of legitimate credit options.

There is one final, but important, factor. Whether the concern is high-cost loans generally or specific predatory practices, credit markets operate more efficiently when consumers are well informed. Community outreach efforts, consumer education, and, when appropriate, counseling would increase consumers' understanding of their credit options. Such efforts can, and should, be supported by both government and industry, working in conjunction with consumer and community organizations. For example, the Federal Reserve's community affairs program has been actively working with community organizations, holding conferences and workshops, and publishing articles that identify specific abuses and strategies for avoiding them.

(1.) The attachment is available on the Board's web site ( and on request from Publications Services, Mail Stop 127, Board of Governors of the Federal Reserve System, Washington, DC 20551.
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Publication:Federal Reserve Bulletin
Date:Jul 1, 2000
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