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Statements to the Congress.

Statement by E. Gerald Corrigan, President, Federal Reserve Bank of New York, before the Subcommittee on Telecommunications and Finance of the Committee on Energy and Commerce, U.S. House of Representatives, September 4, 1991

I appreciate the opportunity to provide the subcommittee with my views concerning the recent disclosures by Salomon Brothers Inc. and the implications of those disclosures for the government securities market. These disclosures are clearly serious matters that must be addressed to ensure that confidence in the U.S. government securities market is maintained at the highest levels. My statement touches on three topics: first, the role of the Federal Reserve Bank of New York as it relates to the government securities market; second, the Bank's understanding of the circumstances surrounding Salomon Brothers' disclosures over the period August 9 to August 19, including the steps the firm has taken or is planning to take to protect against similar problems in the future; and third, my thoughts on a prudent course for the near term.


As the subcommittee knows, the market for U.S. government securities is the world's largest, most efficient, and most important securities market. Given the sheer size of the federal government debt that needs to be financed, we all have a big stake in ensuring that the debt is financed at the lowest possible cost and that the liquidity and efficiency of this market is preserved.

The market consists of several broad categories of private and public participants. First, there is the U.S. government itself as issuer of the securities. Second, there are Federal Reserve Banks operating as the Treasury Department's fiscal agent. Third, there is the Federal Reserve Bank of New York, acting on behalf of the Federal Open Market Committee, in entering the market for day-to-day purchases and sales of government securities as the chief instrument for the implementation of monetary policy. Further, the New York Bank also acts in the market as agent for foreign central banks and other official institutions. Fourth, there are government securities dealers and banks that act as intermediaries between the Treasury and others in the distribution and trading of government securities. Finally, there is the multitude of individual and institutional holders of the Treasury's securities.

For descriptive purposes, it may be useful to think of the operation of the market in two separate but closely related classes of activities. First, there are those activities that center on the issuance of new debt (or the rollover of existing debt) by the Treasury. This function is performed under rules established by the Treasury, including the so-called 35 percent rule. Primary dealers (whose characteristics are described below) are the major takers of new debt issued by the Treasury either for the dealer's own account or for the accounts of their clients or customers. Entities that are not primary dealers may also submit competitive bids on their own, but many choose to make such bids through primary dealers. Finally, any entity or individual may submit noncompetitive bids in an amount up to $1 million. Such bids are accepted by the Treasury at the average price that results from the competitive bidding process.

The second class of activity relates to investing and trading in the vast stock of Treasury debt that makes up the market as a whole. At this level, the scope of the market widens appreciably and ultimately encompasses the millions of individuals and institutions on a global basis that are active in the market for U.S. government securities. This vast secondary market in government securities functions with elements of liquidity, efficiency, and resiliency that are unique, on a global scale, to that market. In part, this is made possible by the Treasury-Federal Reserve bookentry system for the electronic custody and transfer of these securities.

As noted above, among the private participants in the market are the so-called primary dealers in U.S. government securities with whom the Federal Reserve Bank of New York conducts its open market operations. The primary dealers are the main market makers for government debt. They maintain two-way markets for government securities and participate directly and actively in the Treasury's auctions. Today, there are about forty primary dealers-about half are banks or securities affiliates of banks and half are diversified or specialized securities firms. All Federal Reserve transactions in the market, whether for its own account or for the accounts of other official institutions, are conducted with the primary dealers. During 1990, the aggregate volume of such transactions conducted by the Federal Reserve with primary dealers was close to $525 billion.

The mere fact that the Federal Reserve Bank of New York must conduct transactions with private-sector counter-parties implies, of necessity, that the Bank incurs the same elements of counterparty credit, delivery, and settlement risk that any private-sector market participant also incurs. For this reason, the Bank has established criteria for selecting those firms with whom the Bank does business. (The criteria for primary dealers are described in Attachment A. 1) It should also be noted that in several other major industrial countries there are broadly similar arrangements between central banks and a designated group of firms with whom those other central banks conduct their business.

It is important to note that the role of the Federal Reserve Bank of New York in its business relationship with the primary dealers takes place in a framework in which the Federal Reserve has no express statutory authority to regulate or supervise the primary dealers. Indeed, the Government Securities Act of 1986 established a formal supervisory and regulatory framework for the government securities market for the first time, with the Treasury as rulemaker and the Securities and Exchange Commission and banking supervisors as responsible for enforcement. While the Federal Reserve Bank of New York does not have statutory rulemaking or enforcement authority in this area, we recognize that our public nature carries with it certain implicit responsibilities to work closely with those having such authority to preserve and enhance the health and vitality of this market. We also recognize that the smooth functioning of the market for U.S. government securities-given its role as the anchor for other markets-has obvious implications for the smooth functioning of other money and capital markets here and abroad.

The number of primary dealers has varied over the years as the U.S. Treasury market has grown. From eighteen in the early 1960s, the number increased to twenty-three in 1971 and to thirty-six in 1981. Today there are about forty primary dealers, after having peaked at forty-six in 1988. These firms are expected to facilitate the Federal Reserve's Open Market Operations, to make markets in the full range of U.S. government securities for customers in good times and bad, and to be consistent and meaningful participants in Treasury auctions of new securities. Firms choose to take on these responsibilities as primary dealers for a variety of reasons, including the desire to have an active role in the largest market worldwide. Firms also choose to withdraw for business considerations such as the belief that they may achieve better returns on their capital from other lines of business. For example, during 1990, two firms were added to the list while five firms were deleted.

From time to time, the Federal Reserve Bank of New York has carefully considered possible changes in its approach to the selection of those entities with whom it will do business. Those deliberations always collide head-on with two realities that seem to limit practical alternatives to current arrangements. First, the fact that we must deal with private-sector counterparties necessarily implies that some will be chosen and some will not. Second, the fact that some will be chosen and others not necessarily implies that whether they are called primary dealers or not, the unique relationship between the Federal Reserve Bank of New York and those entities with whom the Bank does business will remain. Recent events have obviously called into even sharper focus these difficult questions.

While the primary dealer system is, in the first instance, based on business counterparty relationships, our interests in the health and well-being of the market extend beyond that narrow framework. The breadth, depth, and liquidity of this market are essential characteristics that the Federal Reserve relies on for the implementation of monetary policy, the Treasury relies on for financing the federal government, and investors rely on in committing their funds.


On Friday, August 9, 1991, top officials at Salomon Brothers telephoned the Federal Reserve Bank Bank of New York and almost simultaneously faxed to the Bank a copy of the firm's August 9 press release. Before that phone call, the Federal Reserve Bank of New York had no knowledge of the wrongdoing then or subsequently disclosed by Salomon. However, in the normal review of the bids for the February five-year note auction, an employee of the Federal Reserve Bank of New York had noted that another dealer firm had submitted a bid, which, if added to the bid submitted by Salomon Brothers for an affiliate of that same second dealer firm, would have placed that entity's consolidated bid over the Treasury's 35 percent limit for a single entity. The Federal Reserve Bank of New York notified the Treasury of this finding, and the Treasury subsequently wrote to Salomon's customer-with a copy to Salomon-informing it that all of its affiliates would be considered a single entity for purposes of the administration of the auction rules.

The circumstances surrounding these events strongly suggest that it was the receipt by Salomon of the copy of the Treasury letter to that second firm that prompted a senior official of Salomon to disclose to his superiors the fact of the unauthorized bid in the February auction. Despite this disclosure within the firm, the fact of the unauthorized bid was not disclosed to the Federal Reserve Bank of New York or any other official entity until the telephone call of August 9, 1991.

While not directly the subject of Salomon Brothers' August 9 press release, there was also a considerable amount of discussion between officials of the Federal Reserve Bank of New York and Salomon Brothers in the period after the Treasury's May auction of two-year notes. In that timeframe, there was no evidence that Salomon had breached the Treasury's 35 percent rule in the May auction. There was, however, concern in the marketplace and in official circles that the auction results may have created something of a "squeeze" in the market for that particular issue. Those concerns prompted the Securities and Exchange Commission, in consultation with the Treasury and the Federal Reserve, to commence an in-depth review and investigation into the May two-year note auction and its market aftermath. Given the amount of attention and discussions that surrounded the May auction, the disclosures made by Salomon during the course of the Friday, August 9 telephone call were particularly unsettling, especially as it pertained to top management's knowledge since late April of the unauthorized customer bid in the February auction.

On the basis of the disclosures made by Salomon Brothers on Friday, August 9, the Federal Reserve Bank of New York informed Salomon Brothers by letter on Tuesday, August 13 that it wanted a written explanation of the circumstances surrounding the disclosures made on August 9 and a full report on managerial and other changes that would be taken to prevent a recurrence of these irregularities in the future.

Early in the evening of Tuesday, August 13 the Federal Reserve Bank of New York received another call from top management at Salomon. At that time, further disclosures of irregularities were made. These irregularities were the subject of the press statement issued by Salomon Brothers late in the day of Wednesday, August 14.

On the basis of the August 14 disclosures, there were further discussions between top officials of Salomon Brothers and the Federal Reserve Bank of New York on the evening of Thursday, August 15 and on the morning of Friday, August 16. During the discussion on Friday, August 16, it became clear that the top two officials of the firm intended to resign and that Mr. Buffett would take on the position of interim chairman over the weekend. In the face of these important changes in top management at the firm and the strong commitments made by the incoming chairman, the Federal Reserve Bank of New York deemed it appropriate to provide the firm with a limited amount of additional time to respond to the questions raised in the Bank's letter of August 13.

Over the entire period from the late morning call of Friday, August 9 to the Federal Reserve Bank of New York through the conversations between the Federal Reserve Bank of New York and the firm on the morning of Friday, August 16, the Bank kept the Federal Reserve Board, the Treasury, and the Securities and Exchange Commission informed as to the nature of these conversations. Over this same interval, officials of the Federal Reserve worked closely with the Securities and Exchange Commission and law enforcement entities in the sharing of information and in the shaping of concepts and approaches to the investigations then under way. All such discussion occurred in the context of full cooperation and strong working relationships between the three official entities and the Justice Department.

Over the course of Sunday, August 18, the Federal Reserve Bank of New York was in constant contact with the Treasury Department, the Board of Governors of the Federal Reserve System, and Salomon Brothers. The Bank was fully aware of the decisions taken by the Treasury in regard to the extent of Salomon's ability to participate-either for its own account or for the account of customers-in Treasury auctions, and it regarded all such decisions as appropriate. Indeed, the Bank shared the view that the decision to permit Salomon to continue to participate in auctions for its own account was appropriate in light of the further management changes announced on Sunday, August 18, as well as the further assurances received as to the future course of conduct by the firm. Throughout all of these discussions, however, the Federal Reserve Bank of New York was mindful that the nature and extent of its future business relationship with the firm were under review, and the Bank made that quite clear to all, including the new management of the firm.

In looking at the acknowledgements by the firm since the first statement on August 9 regarding wrongdoings in the auctions of December 1990 and February 1991-especially in light of the fact that the latter was known by the top management of the firm in late April-one can only be shocked and dismayed by this sequence of events. Having said that, it will take some time for the various criminal and civil proceedings to sort themselves out in a setting in which due process must be allowed to run its course. Similarly, some breathing room is needed for the new management of the firm to be able to respond in detail as to what steps the firm, its lawyers, its accountants, and its advisers have taken, or are planning to take, to prevent and detect similar activities in the future. Finally, we, along with other authorities, will rigorously evaluate these changes. In the meantime, one cannot help but be impressed with the sweeping management changes that have already been made and with the strength of the new management's commitment to proper behavior and strengthened management and control systems.


At this point in time, while awaiting the results of current investigations by several agencies, it seems premature to come forward with any broad-based plans for regulatory changes or legislative proposals with respect to the government securities market. In coming weeks, we will be coordinating closely with officials and staff of the Treasury Department, the Securities and Exchange Commission, and, of course, the Board of Governors of the Federal Reserve System. The agencies together will be looking at this situation with an eye toward developing a coherent approach that deals with the abuses that have come to light and does so in a manner that recognizes the need to proceed very carefully in respect to this highly important market. We would aim to have recommendations within ninety days-although on certain more limited points it may be possible to move sooner. With a carefully thought-out and implemented approach, we believe that it will be feasible to maintain the integrity and efficiency of this vital market.
COPYRIGHT 1991 Board of Governors of the Federal Reserve System
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Title Annotation:statement by E. Gerald Corrigan
Publication:Federal Reserve Bulletin
Article Type:Transcript
Date:Nov 1, 1991
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