Statements to the Congress.
Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, July 12, 1990. I am pleased to appear before this committee to discuss reform of the deposit insurance system and expanded activities for banking organizations. Like each of you, my colleagues and I have spent considerable time discussing and debating the issues. We are reminded almost daily of the potential for public cost of the deposit insurance obligation, made so painfully apparent by the failures and difficulties of so many thrift institutions. Similarly, both the Congress and the Board are reminded repeatedly of the erosion of the competitiveness of our banking system both domestically and internationally. The time has come when these issues must be addressed.
The hearings you are conducting, Mr. Chairman, will establish a record preliminary to the publication early next year of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA)-mandated Treasury study of the issues. The Board is participating in this study and has conveyed to the Treasury the views expressed in this statement. By holding hearings at this early date, I hope that the Congress will be able to focus on the needed legislation immediately after the release of the Treasury study. Basic reforms are required both of the safety net and of the range of activities permitted banking organizations.
The fundamental problems with deposit insurance that must be addressed are clearly understood and are, I believe, subject to little debate among those with drastically different prescriptions for reform. The safety net--deposit insurance, as well as the discount window--has so lowered the risks perceived by depositors as to make them relatively indifferent to the soundness of the depository recipients of their funds, except in unusual circumstances. With depositors exercising insufficient discipline through the cost of deposits, the incentive of some banks' owners to control risk-taking has been dulled. Profits associated with risk-taking accrue to owners, while losses in excess of bank capital that would otherwise fall on depositors are absorbed by the Federal Deposit Insurance Corporation (FDIC).
Weak depositor discipline and this moral hazard of deposit insurance have two important implications. First, the implicit deposit insurance subsidy has encouraged banks to enhance their profitability by increasing their reliance on deposits rather than capital to fund their assets. In effect, the deposit insurance funds have been increasingly substituted for private capital as the cushion between the asset portfolios of insured institutions and their liabilities to depositors. A hundred years ago, the average equity-capital-to-asset ratio of U.S. banks was almost 25 percent, approximately four times the current level. Much of the decline over the past century, no doubt, reflects the growing efficiency of our financial system. But it is difficult to believe that many of the banks operating over recent decades would have been able to expand their assets so much, with so little additional investment by their owners, were it not for the depositors' perception that, despite the relatively small capital buffer, their risks were minimal. Regulatory efforts over the past ten to fifteen years have stabilized and partially reversed the sharp decline in bank equity capital-asset ratios. This trend has occurred despite the sizable write-off of loans and the substantial build-up in loan-loss reserves in the past three years or so. But the capital ratios of many banks are still too low.
Second, government assurances of the liquidity and availability of deposits have enabled some banks with declining capital ratios to fund a riskier asset portfolio at a lower cost and on a much larger scale, with governmental regulations and supervision, rather than market processes, the major constraint on risk-taking. As a result, more resources have been allocated to finance risky projects than would have been dictated by economic efficiency.
In brief, the subsidy implicit in our current deposit insurance system has stimulated the growth of banks and thrift institutions. In the process, the safety net has distorted market signals to depositors and bankers about the economics of the underlying transactions. This distortion has led depositors to be less cautious in choosing among institutions and has induced some owners and their managers to take excessive risk. In turn, the expanded lending to risky ventures has required increased effort and resources by supervisors and regulators to monitor and modify behavior.
But in reviewing the list of deficiencies of the deposit insurance system, we should not lose sight of the contribution that both deposit insurance and the discount window have made to macroeconomic stability. The existence and use of the safety net have shielded the broader financial system and the real economy from instabilities in banking markets. More specifically, they have protected the economy from the risk of deposit runs, especially the risk of such runs spreading from bank to bank, disrupting credit and payment flows and the level of trade and commerce. Confidence in the stability of the banking and payments system has been the major reason why the United States has not suffered a financial panic or systemic bank run in the last half century.
There are thus important reasons to take care as we modify our deposit insurance system. Reform is required. So is caution. The ideal is an institutional framework that, to the extent possible, induces banks both to hold more capital and to be managed as if there were no safety net, while at the same time shielding unsophisticated depositors and minimizing disruptions to credit and payment flows.
If we were starting from scratch, the Board believes it would be difficult to make the case that deposit insurance coverage should be as high as its current $100,000 level. However, whatever the merits of the 1980 increase in the deposit insurance level from $40,000 to $100,000, it is clear that the higher level of depositor protection has been in place long enough to be fully capitalized in the market value of depository institutions. The associated scale and cost of funding have been incorporated into a wide variety of bank and thrift decisions, including portfolio choices, staffing, branch structure, and marketing strategy. Consequently, a return to lower deposit insurance coverage--like any tightening of the safety net--would reduce insured depository market values and involve significant transition costs. It is one thing initially to offer and then maintain a smaller degree of insurance coverage and quite another to reimpose on the existing system a lower level of insurance, with its associated readjustment and unwinding costs. This is why the granting of subsidies by the Congress should be considered so carefully: They not only distort the allocation of resources but also are extremely difficult to eliminate, imposing substantial transition costs on the direct and indirect beneficiaries. For such reasons, the Board has concluded that, should the Congress decide to lower deposit insurance limits, a meaningful transition period would be needed.
A decision by the Congress to leave the $100,000 limit unchanged, however, should not preclude other reforms that would reduce current inequities in, and abuses of, the deposit insurance system. Serious study should be devoted to the cost and effectiveness of policing the $100,000 limit so that multiple accounts are not used to obtain more protection for individual depositors than the Congress intends. The same study could consider the desirability of limiting pass-through deposit insurance--under which up to $100,000 insurance protection is now explicitly extended to each of the multiple beneficiaries of some large and otherwise uninsured deposits. Both have been used at times to thwart or abuse the purpose of deposit insurance protection.
No matter what the Congress decides on deposit insurance limits, we must be cautious of our treatment of uninsured depositors. Such depositors should be expected to assess the quality of their bank deposits just as they are expected to evaluate any other financial asset they purchase. Earlier I noted that our goal should be for banks to operate as much as possible as if there were no safety net. In fact, runs of uninsured deposits from banks under stress have become commonplace.
So far, the pressure transmitted from such episodes to other banks whose strength may be in doubt has been minimal. Nevertheless, the clear response pattern of uninsured depositors to protect themselves by withdrawing their deposits from a bank under pressure raises the very real risk that in a stressful environment the flight to quality could precipitate wider financial market and payments distortions. These systemic effects could easily feed back to the real economy, no matter how open the discount window and how expansive open market operations. Thus, while deposits in excess of insurance limits should not be protected by the safety net at any bank, reforms designed to rely mainly on increased market discipline by uninsured depositors raise serious stability concerns. Public policy, therefore, should rely on other means as the primary mechanism to induce prudent bank policies.
A promising approach that seeks to simulate market discipline with minimal stability implications is the application of risk-based deposit insurance premiums. The idea is to make the price of insurance a function of the bank's risk, reducing the subsidy to risk-taking and spreading the cost of insurance more fairly across depository institutions. In principle, this approach has many attractive characteristics and could be designed to augment risk-based capital. For example, banks with high risk-based capital ratios might be charged lower insurance premiums. But the range of premiums necessary to induce genuine behavioral changes in portfolio management might well be many multiples of the existing premium, thereby raising practical concerns about its application. Risk-based premiums also would have to be designed with some degree of complexity if they are to be fair and if unintended incentives are to be avoided. In any event, the potential additional benefits on top of an internationally negotiated risk-based capital system, while positive, require further evaluation.
Another approach that has induced increasing interest is the insured narrow bank. Such an institution would invest only in high quality, short-maturity, liquid investments, recovering its costs for checking accounts and wire transfers from user fees. The narrow bank would thus require drastic institutional changes, especially for thousands of our smaller banks and for virtually all households using checking accounts, Movement from the present structure for delivery of many bank services would be difficult and costly, placing U.S. banks at a disadvantage internationally. In addition, this approach might shift and possibly focus systemic risk on larger banks. Banking organizations would have to locate their business and household credit operations in nonbank affiliates funded by uninsured deposits and borrowings raised in money and capital markets. Only larger organizations could fund in this way, and these units, unless financed longer term than banks today, would be subject to the same risks of creditor runs that face uninsured banks, with all of the associated systemic implications. If this were the case, we might end up with the same set of challenges we face today, refocused on a different set of institutions. We at the Board believe that while the notion of a narrow bank to insulate the insurance fund is intriguing, in our judgment further study of these systemic and operational implications is required.
If, in fact, proposals that rely on uninsured depositor discipline, risk-based premiums, and structural changes in the delivery of bank services raise significant difficulties, reform should then look to other ways to curb banks' risk appetites, and to limit the likelihood that the deposit insurance fund, and possibly the taxpayer, will be called on to protect depositors. The Board believes that the most promising approach is to reform both bank capital and supervisory policies. Both policies would be designed to reduce the value of the insurance subsidy. Neither policy would rule out either concurrent or subsequent additions to deposit insurance reform, such as the changes discussed previously, other proposals, such as increased reliance on subordinated debt, or new approaches that may emerge in the years ahead. In fact, higher capital, by reducing the need for, and thereby the value of, deposit insurance would make subsequent reform easier. There would be less at stake for the participants in the system.
At the end of this year, the phase-in to the International Capital Standards under the Basle Accord will begin. This risk-based capital approach provides a framework for incorporating portfolio and off-balance-sheet risk into capital calculations. Most U.S. banks have already made the adjustment required for the fully phased-in 1992 standard. However, the prospective increasingly competitive environment suggests that the minimum level of capital called for by the 1992 requirements may not be adequate, especially for institutions that want to take on additional activities. As a result of the safety net, too many banking organizations, in our judgment, have traveled too far down the road of operating with modest capital levels. It may well be necessary to retrace our steps and begin purposefully to move to capital requirements that would, over time, be more consistent with what the market would require if the safety net were more modest. The argument for more capital is strengthened by the necessity to provide banking organizations with a wider range of service options in an increasingly competitive world. Indeed, projections of the competitive pressures only intensify the view that if our financial institutions are to be among the strongest in the world, let alone avoid an extension of the taxpayers' obligation to even more institutions, we must increase capital requirements. Our international agreements under the Basle Accord permit us to do so.
There are three objectives of a higher capital requirement. First, higher capital would strengthen the incentives of bank owners and managers to evaluate more prudently the risks and benefits of portfolio choices because more of their money would be at risk. In effect, the moral hazard risk of deposit insurance would be reduced. Second, higher capital levels would create a larger buffer between the mistakes of bank owners and managers and the need to draw on the deposit insurance fund. For too many institutions, that buffer has been too low in recent years. The key to creating incentives to behave as the market would dictate, and at the same time creating these buffers or shock absorbers, is to require that those who would profit from an institution's success have the appropriate amount of their own capital at risk. Third, requiring higher capital imposes on bank managers an additional market test. They must convince investors that the expected returns justify the commitment of risk capital. Those banks unable to do so would not be able to expand.
We in the Federal Reserve System are in the process of developing more specific capital proposals, including appropriate transition arrangements designed to minimize disruptions. However, at the outset I would like to anticipate several criticisms. For many banks, raising significant new capital will be neither easy nor cheap. Maintaining return on equity will be more difficult, and those foreign banks that only adhere to the Basle minimums may be put in a somewhat better competitive position relative to some U.S. banks. Higher capital requirements also will tend to accelerate the move toward bank consolidation and slow bank asset growth. However, these concerns must be balanced against the increasing need for reform now, the difficulties with all the other options, and both the desire of, and necessity for, banking organizations to broaden their scope of activities to operate successfully.
More generally, many of the arguments about the competitive disadvantages of higher capital requirements are shortsighted. Well-capitalized banks are the ones best positioned to be successful in the establishment of long-term relationships, to be the most attractive counterparties for a large number of financial transactions and guarantees, and to expand their business activities to meet new opportunities and changing circumstances. Indeed, many successful U.S. and foreign institutions would today meet substantially increased risk-based capital standards. In addition, the evidence of recent years suggests that U.S. banks can raise sizable equity. The dollar volume of new stock issues by banking organizations has grown at a greater rate since the late 1970s than the total dollar volume of new issues by all domestic corporate firms.
Higher capital standards should go a long way toward inducing market-like behavior by banks. However, the Board believes that, so long as a significant safety net exists, additional inducements will be needed through an intensification of supervisory efforts to deter banks from maintaining return on equity by acquiring riskier assets. When it is not already the practice, full in-bank supervisory reviews--focusing on asset portfolios and off-balance-sheet commitments--should occur at least annually, and the results of such examinations should promptly be shared with the board of directors of the bank and used to evaluate the adequacy of the bank's capital. The examiner should be convinced, after a rigorous and deliberate review, that the loan-loss reserves are consistent with the quality of the portfolio. If they are not, the examiner should insist that additional reserves be created with an associated reduction in the earnings or equity capital of the bank. If the resultant capital is not consistent with minimum capital standards, the board of directors and the bank's regulators should begin the process of requiring the bank either to reduce those assets or to rebuild equity capital.
If credible commitments to raise capital are not forthcoming, and if those commitments are not promptly met, the authorities should explore such responses as lowered dividends, slower asset growth or perhaps even asset contraction, restrictions on the use of insured brokered deposits, if any, and divestiture of affiliates with the resources used to recapitalize the bank. What is important is that the supervisory responses occur promptly and firmly and that they be anticipated by the bank. This progressive discipline or prompt corrective action of a bank with inadequate capital builds on our current bank supervisory procedures and is designed to simulate market pressures from risk-taking--to link excessive risk-taking more closely with its costs--without creating market disruptions. Some flexibility is certainly required, but the Board has in mind a set of credible responses in principle and a presumption that these responses will be applied in the absence of compelling reasons not to do so.
Such an approach--higher capital and prompt corrective action--would increase the cost and reduce the availability of credit from insured institutions to riskier borrowers. In effect, our proposal would reduce the incentive some banks currently have to overinvest in risky credits at loan rates that do not fully reflect the risks involved. This reduction implies that the organizers of speculative and riskier ventures will have to restructure their borrowing plans, including possibly paying more for their credit, or seek financing from noninsured entities. Some borrowers may find their proposals no longer viable. However, it is just such financing by some insured institutions that has caused so many of the current difficulties, and it is one of the objectives of our proposals to cause depositories to reconsider the economics of such credits. As insured institutions reevaluate the risk-return tradeoff, they are likely to be more interested in credit extensions to less risky borrowers, increasing the economic efficiency of our resource allocation.
Despite their tendency to raise the average level of bank asset quality, higher capital requirements and prompt corrective action will not eliminate bank failures. An insurance fund will still be needed, but we believe that, with a fund of reasonable size, the risk to taxpayers should be reduced substantially. As I have noted, higher capital requirements and prompt corrective action imply greater caution in bank asset choices and a higher cushion to the FDIC to absorb bank losses. In addition, an enhanced supervisory approach will not permit deteriorating positions to accumulate. Moreover, the Board believes that forced mergers, divestitures, and, when necessary, conservatorships should occur while there is still positive (albeit low) capital in the bank to limit reorganization or liquidation costs. Existing stockholders should be given adequate time to correct deteriorating positions--including providing new capital--but the Congress should specifically provide the bank regulators with the clear authority, and, therefore, explicit support, to act well before technical insolvency to minimize the ultimate resolution costs.
These reforms should be equally applicable to banks of all sizes. No observer is comfortable with the inequities and adverse incentives of an explicit or implicit program that penalizes depositors, creditors, and owners of smaller banks more than those of larger ones. The Board believes no bank should assume that its scale insulates it from market discipline. Nevertheless, it is clear that there may be some banks at some particular times whose collapse and liquidation would be excessively disruptive to the financial system. But no bank is ever too large or too small to escape the application of the same prompt corrective action standards applied to other banks. Any bank can be required to rebuild its capital to adequate levels and, if it does not, be required to contract its assets, divest affiliates, cut its dividends, change its management, sell or close offices, and the resultant smaller entity can be merged or sold to another institution with the resources to recapitalize it. If this is not possible, the entity can be placed in conservatorship and liquidated.
I noted earlier that one response of some banks to the more intense competitive environment has been to draw down their capital buffer. These banks and other institutions cannot rebuild, strengthen, and maintain the appropriate level of capital unless they are able to adapt to the changing competitive and technological environment. The ability to adapt is crucially dependent on broadening the permissible range of activities for banking organizations. At the same time, we should be sensitive to the implications of the potential extension of the safety net--directly or indirectly--under those markets that banking organizations are authorized to enter.
The Board has for some time held the view that strong insulating fire walls would both protect banks (and taxpayers) from the risk of new activities and limit the extension of the safety net subsidy that would place independent competitors at a disadvantage. However, recent events, including the rapid spread of market pressures to separately regulated and well-capitalized units of Drexel when their holding company was unable to meet its maturing commercial paper obligations, have raised serious questions about the ability of fire walls to insulate one unit of a holding company from funding problems of another. Partially as a result, the Board is in the process of reevaluating both the efficacy and desirability of substantial fire walls between a bank and some of its affiliates. It is clear that high and thick fire walls reduce synergies and raise costs for financial institutions, a significant problem in increasingly competitive financial markets. If they raise costs and may not be effective, we must question why we are imposing these kinds of fire walls at all. Moreover, higher capital standards and prompt corrective action go a long way to limit the transference of the bank safety net subsidies to bank affiliates that fire walls are designed to constrain. And, as such, they should greatly limit the risk of distorted market signals and excessive risk-taking over an expanded range of markets, as well as the unfair competition, that might otherwise accompany wider bank activities.
Indeed, authorization to use their expertise over a wider range of markets might well be limited only to those banking organizations that meet a new higher capital standard. Consequently, the Congress might wish to authorize bank supervisors to grant certain of these activities only to those entities that exceed such a standard. Those institutions that consistently exceed the capital standard perhaps could receive more flexibility in supervisory treatment. For example, a notice requirement could be substituted for formal applications for activities permitted by law and regulation, provided that such acquisitions leave a banking organization's capital in excess of the higher standards. Other reductions in regulatory burden for highly capitalized banking organizations might also be appropriate. Such organizations would, however, still be subject to the same through annual examinations.
As you know, the Board has long supported repeal of the provisions of the Glass-Steagall Act that separate commercial and investment banking. We still strongly advocate such repeal because we believe that technology and globalization have continued to blur the distinctions among credit markets, and have eroded the franchise value of the classic bank intermediation process. Outdated constraints will only endanger the profitability of banking organizations and their contribution to the American economy. Beyond investment banking, the Board believes that highly capitalized banking firms should be authorized to engage in a wider range of financial activities as a part of the modernization of our financial structure and the maintenance of strong, profitable financial institutions that can compete in world markets. A banking system that cannot adapt to the changing competitive and technological environment will no longer be able to attract and maintain the higher capital level that some of our institution need to operate without excessive reliance on the safety net.
Firms primarily engaged in the financial activities authorized to banking organizations should likewise be permitted to operate an insured bank. The Congress, of course, will have to give careful consideration to how to handle the activities some of these entities are already engaged in that would not be permitted to banking organizations. More generally, as we expand the range of activities available to banking organizations, competitive equity suggests the desirability of functional regulation. Under such an approach, each area of activity should be subject to the same regulatory constraints as equivalent or very similar functions at nonbank firms. But independent of regulatory or organizational structure, all of us should understand that the market, the stockholders, and the management will think of the bank and any associated units--affiliates or subsidiaries--not as a confederation of businesses, but as an integrated organization. Recognition of this reality suggests that it is perhaps inefficient, at best, and under conditions of financial distress, ineffective, to try to make integrated businesses behave as if they were a collection of independent firms.
As a result, it may be more realistic, as I suggested earlier, to apply more limited fire walls to the new activities. I have in mind here restrictions such as sections 23A and 23B of the Federal Reserve Act, which already limit the financial transactions between a bank and its affiliates, requiring collateral, arms-length transactions, and--except when Treasury securities are used as collateral--quantitative limits based on the bank's capital. Moreover, recognition of the integrated nature of the operations of the insured unit with the rest of the organization raises the question of the implications of a piecemeal regulatory structure, with no means for ensuring that the activities of the organization as a whole do not impose undue risk on either the financial system or the safety net. We believe that some agency should be responsible for oversight of the entire organization, especially if expanded activities and less rigorous fire walls are adopted.
As the Congress considers modernization of our banking structure to meet the needs of the twenty-first century, it should not only widen the permissible activities of well-capitalized banking organizations, but also eliminate outdated statutes that only increase costs. The McFadden Act forces state member and national banks to deliver interstate services only through separately capitalized bank holding company subsidiaries (when permitted by state law) rather than through branches. Such a system reduces the ability of many smaller banks to diversify geographically and raises costs for all banking organizations that operate in more than one state, a curious requirement as we search for ways to make banks more competitive and profitable. The McFadden Act ought to be amended to permit interstate branching by banks.
In summary, events have made it clear that we ought not to permit banks, because of their access to the safety net, to take excessive risk with inadequate capital. Even if we were to ignore the potential taxpayer costs, we ought not to permit a system that is so inconsistent with efficient market behavior. In the process of reform, however, we should be certain that we consider carefully the implications for macroeconomic stability. The Board believes that higher capital and prompt corrective action by supervisors to resolve problems will go a long way to eliminate excessive risk-taking by insured institutions, and would not preclude additional deposit insurance reform, now or later. Moreover, we believe that with such an approach the Congress should feel comfortable with authorizing banking organizations to expand the scope of their financial activities. Indeed, we believe that permitting wider activities is necessary to ensure that such organizations can remain competitive both here and abroad. Increased activities are also required to sustain the profitability needed if banking firms are to attract capital. To limit the risks of safety net transference, some new activities might be made available by banking regulators only to banks with impressive capital positions. We believe that whatever the regulatory form and structure under which new activities are permitted, one agency should have oversight responsibility for the banking organization as a whole. It is also our view that, with these suggested reforms, reliance on stringent fire walls would not be necessary. And the McFadden Act should be amended to permit banks to deliver their services at the lowest possible costs and to more easily diversify their geographic risks. The Board has shared its views with the Treasury as part of our continuing consultations on these matters, especially in the context of their FIRREA-mandated study.
Finally, in considering all proposals, we should remind ourselves that our objective is a strong and stable financial system that can deliver the best services at the lowest cost and complete around the world without taxpayer support. This requires the modernization of our financial system and the weaning of some institutions from the unintended benefits that accompany the safety net. Higher capital requirements may well mean a relatively leaner and more efficient banking system, and they will certainly mean one with reduced inclinations toward risk. However, the Board believes our proposed reforms--including the authorization of wider activities by banking organizations--will go a long way toward ensuring a safer and more efficient financial system and lay the groundwork for other modifications in the safety net in the years ahead.
Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, July 18, 1990. I am pleased to be here today to testify in connection with our semiannual Monetary Policy Report to the Congress.(1) In my prepared remarks this morning I shall discuss, as is customary on such occasions, current and prospective economic conditions and the Federal Reserve's objectives for money and credit growth over the period ahead. Two areas of particular note at present, with potential implications for the conduct of monetary policy, are the ongoing restructuring of credit flows in the U.S. economy and the prospects for a significant cut in the federal budget deficit. I shall pay special attention to these topics in my statement.
Economic and Financial Developments Thus Far in 1990
When I came before this committee in February, I characterized the economy as poised for continued moderate expansion in 1990, and, in large measure, developments so far this year appear to have borne that statement out. Real gross national product grew at a 2 percent annual rate in the first quarter, and indicators of economic activity for the second quarter suggest a further rise, though perhaps at a somewhat slower rate. Within this whole, however, the various sectors have moved along at different paces.
On the distinctly positive side, exports have shown solid gains, buoyed by expanding markets abroad. The impetus from international trade has been important in the pickup in industrial production this year.
In contrast, the news coming from the household sector in recent months has had a softer cast to it. Consumers appear to have pulled back a bit, as the slower overall pace of expansion and the more pronounced weakness in certain parts of the country--especially the Northeast--seem to have taken some toll on confidence in the economic outlook. Moreover, having accumulated large stocks of automobiles and other consumer durables earlier in the expansion, consumers could be more selective about when to purchase replacements. Sales of new homes also have weakened, deterring building activity.
There are other pluses and minuses, as well, in the economic picture--by sector and by region. But, on balance, the economy still appears to be growing, and the likelihood of a near-term recession seems low, in part because businesses have been working hard to keep their inventories in line with sales trends.
Although output overall grew rather modestly over the first half, the unemployment rate remained at its lowest level in almost twenty years. Over the past year, as employment has decelerated, so too has the labor force, in part reflecting a surprising decline in labor force participation rates for young people. Some flattening in the aggregate participation rate would be consistent with evidence that many individuals now perceive job opportunities as less abundant. Differences from past cyclical experiences, however, suggest that other factors also must be at work--if, in fact, the current pattern represents something more than noise in the data. This development certainly bears watching, for it may have implications for potential output growth.
Be that as it may, with hiring proceeding at a less rapid pace, the rate of increase in wages appears to have leveled out from its earlier upward trend. The core rate of inflation in consumer prices, proxied by abstracting from movements in food and energy prices, picked up sharply in the first quarter, but has moderated in recent months. This moderation has been concentrated in the prices of goods, perhaps reflecting the ebbing of capacity pressures in several industries, while service price inflation has shown little sign of abating.
In 1990, Federal Reserve policy has continued to be directed at sustaining the economic expansion while making progress toward price stability. Ultimately, the two go hand in hand: A stable price level sets the stage for the economy to operate at its peak efficiency, while high inflation inevitably sows the seeds of recession and wrenching readjustment. In the short run, however, the risks of inflation, on the one hand, and of an economic downturn, on the other, must be weighed in the policymaking process. The Federal Reserve saw those risks as about evenly balanced over the first half of the year and made no adjustments in monetary policy.
Throughout this period, which has been marked by dramatic changes in the flow of funds through depository institutions, the Federal Reserve has been paying particularly close attention to conditions in credit markets. Evidence of a tightening of terms and reduced availability of credit has gradually accumulated, to the point where it became apparent in recent days that some action by the monetary authority was warranted. Several indicators have been pointing in this direction, including the behavior of the monetary aggregates. Growth in M2, for example, which stalled out in the spring, has failed to strengthen materially, suggesting that the degree of financial restraint in train might be greater than anticipated or than appropriate to the evolving economic situation. This restraint is a function of developments in the credit markets, independent of monetary policy. The recent decline in the federal funds rate to 8 percent, as a consequence of our action to reduce slightly the pressures in reserve markets, represents an effort to offset the effects of greater stringency in credit markets.
Other market interest rates generally rose early in 1990, as it became apparent that the economy was not as weak as many had thought. Long-term yields were most affected, increasing a full percentage point by early May. Subsequently, however, signs of a softening of activity prompted a reversal of much of that runup. Rates on long-term securities remain about 1/2 percentage point above their year-end levels, but money market quotes are now little changed on balance. Throughout this period, rates on Treasury bills have remained somewhat higher than usual relative to those on private instruments, probably in part reflecting the large amount of bill issuance necessary to fund working capital for the Resolution Trust Corporation (RTC).
The runup in market interest rates early in the year was one factor behind the sharp slowing in money growth over the first half of 1990. M2, which had been running close to the top of its target range in February, posted no net increase between March and June. This weakness, which moved the aggregate close to the bottom of its range, was too abrupt to be accounted for fully by the rise in market rates, however. Another of the factors at work was the restructuring of financial flows. One aspect of this restructuring was the closing of insolvent thrift institutions by the RTC and the sale of their deposit bases. Although the RTC's activities do not directly affect M2, the availability of huge blocks of deposits to the remaining thrift institutions and banks lessened their need to raise rates to draw in funds. In combination with the more cautious attitude that depositories have exhibited toward expanding their balance sheets, the deposit transfers contributed to an unusual degree of inertia in the pricing of retail deposits. Households responded to the relatively low returns on deposits by looking elsewhere, as suggested by heavy flows into stock and bond mutual funds and sizable noncompetitive tenders at Treasury auctions. Nevertheless, while the movements in yield spreads can account for a good share of the slump in M2 growth, a portion of it still requires explanation.
The cause for the meager growth this year in the broader monetary aggregate, M3, is clearer: The RTC closed down a very large number of savings and loan associations, taking many of those institutions' assets onto the government's balance sheet and thereby effectively reducing the overall funding needs of the depository system. In addition, increased loan losses and the phasing-in of tighter capital requirements circumscribed the expansion of credit at many other thrift institutions and banks. With depository credit growth limited, M3--which contains much of the associated funding--essentially stalled. By June, M3 growth was well below the 2 1/2 percent lower bound of the target range the FOMC had set in February.
That range had itself been reduced a full percentage point from the target provisionally set last July in recognition of the potential effects of the ongoing contraction of the thrift industry. Lacking historical experience with a financial restructuring like the current one, however, it was unclear exactly how the flows would end up being redirected through the financial system and, in particular, how much of the thrift lending would be picked up by commercial banks. While the economy more broadly is about where we expected it to be, the configuration of the financial system is somewhat different, leading to less M3 growth than had been anticipated.
The weakness in the monetary aggregates, in part, signals a change in the behavior of depository institutions, with potential for affecting overall credit provision. The conservative pricing of retail and wholesale deposits represents one aspect of their efforts to widen profit margins. In light of concerns about their capital positions, banks and thrift institutions also have reined in lending activity and imposed stiffer terms on loans.
The change in credit supply conditions may have significant implications for borrowing, spending, and policy. I would not call this change a "credit crunch," as those words connote a contraction of lending on a major scale, with many borrowers effectively shut out of credit markets, regardless of their qualifications. We are not seeing symptoms of that kind of widespread, classic crunch, as in the past when deposit rate ceilings or usury ceilings limited the market's ability to adjust and forced cutoffs of credit. But I can well appreciate that my view on this topic may be perceived as a semantic nicety by a borrower who today is suddenly unable to get a loan on the terms formerly available. To the borrower, it makes little difference why the lender is pulling back or how pervasive the change in credit conditions is.
From a policymaker's perspective, however, it is essential to sort the issues out. This means discerning the breadth and depth of the shift in credit conditions, its causes, its effects, and the extent to which it may ultimately be a desirable development. Clearly, the verdict is not yet in on the current episode; in economics we are seldom able to make a definitive diagnosis until well after the fact, but to do our job we must hazard some answers.
First, what do we observe? The evidence on this score continues to grow; numerous reports indicate that depository institutions and other lenders have become more selective in extending credit. In addition, Federal Reserve surveys of large banks support this sense that terms have been tightened in particular parts of the country and on certain types of loans. Especially hard-hit have been financings for mergers and leverage buyouts, commercial real estate, and construction and development. There also is evidence that small and medium-sized companies, as well as the poorer quality credits among the larger firms, have faced some tightening of credit availability. The change in credit conditions has taken various forms, including tougher standards for credit approval, higher collateral requirements, and increases in interest rates; and, in some cases, loans have been simply unavailable. Even investment-grade corporations appear to be facing slightly higher costs in accessing bank credit facilities. At the same time, a huge widening of spreads on less-than-investment-grade bonds has effectively shut down that market to most new issues.
But on several other types of credit, changes in price and nonprice terms appear to have been relatively minor. For example, the rates on residential mortgages, consumer loans, and the debt of investment-grade corporations have remained about in their usual alignment with other market interest rates. Because these credits may trade on securities markets and thereby access a broad range of investors, the interest of banks and thrift institutions in holding the obligations in portfolio has little, if any, effect on the cost to borrowers. These obligations account for a major share of the credit extended in the economy, and hence the slowing of depository credit and the sluggish behavior of the monetary aggregates--while indicative of some tightening of credit--likely overstate the impact of the depositories' behavior on economic activity.
No doubt a sizable portion of lenders' increased reluctance to commit funds for certain purposes reflects a natural and healthy reaction to a slowdown in growth as the economy moves closer to capacity constraints. Prospects for continued strong production and sales increases fade, and the odds rise that some borrowers will prove unable to meet their obligations. In other words, part of the ongoing shift in credit conditions is what amounts to a regular cyclical event. But there is more to it than that. Through one avenue or another, the change in credit standards has its roots in part in the excesses of the 1980s. The weaker credits extended during that decade have come home to roost, and in so doing have impinged to varying degrees on the current availability of credit.
Perhaps the clearest example is the real estate sector and its principal lender, the thrift industry. Those savings and loan associations that were the freest with their funds exist no longer, having been closed by the RTC, and the remaining savings and loan associations face tighter regulations constraining their lending. The resulting void has been filled quite effectively for home mortgage borrowers, with highly developed secondary markets drawing funds in from elsewhere. For these borrowers, the shrinkage of the thrift industry does not represent a significant decline in intermediation services. But many other clients of thrift institutions, whose debt is less easily securitized, have been hard-pressed to find alternative sources of funds. Moreover, lax lending standards by both thrift institutions and banks contributed to overbuilding in commercial real estate, which has added to problems for lenders to this industry.
Rising capital requirements for banks and thrift institutions have interacted with large losses on soured loans and the financial market's distaste for providing additional capital to the institutions taking these losses. This interaction has resulted in strong incentives for depository institutions to conserve capital. Their efforts to build larger capital cushions, in turn, have been manifest in a somewhat more cautious approach to lending, as well as a stepped-up effort to sell off assets by, for example, securitizing loans. Partly as a result of tighter credit conditions, the growth of credit, as measured by the change in the debt of domestic nonfinancial sectors, has come down into closer alignment with the expansion of nominal GNP. This process, which reflects a somewhat more cautious approach on the part of borrowers as well, is not an aberrant restrictive phase in the life of the financial system, but rather a return to what had been the norm before the 1980s.
To be sure, when you go from excess credit creation to normal, it can feel like a tightening. And in that sense credit conditions have tightened. Many of the loans made during the 1980s should not, by historical standards of creditworthiness, have been made. As standards reverted closer to normal, those weaker borrowers have been finding it far more difficult to access credit.
In addition, however, depository institutions appear more recently to be lending with greater caution in general. As a result, even creditworthy borrowers may have to look harder for a loan, put up more collateral, or pay a somewhat higher spread. For the nation as a whole, the tightening of credit standards will leave the financial system on a sounder footing and contribute to economic stability in the long run. Nevertheless, in the here and now, the tightening is beginning to have very real, unwelcome effects. Diminished credit availability can constrain firms' spending, for example, limiting more of them to internally generated funds. It is difficult to discern the dividing line between lending standards that are still healthy and those that are so restrictive as to be inconsistent with the borrower's status and the best interests of the lender in the long run. In recent weeks, however, we may have slipped over that line. Such developments can, and do, occur independently of central bank actions and can have important influences on spending and output. Thus the Federal Reserve must remain alert to the possibility that an adjustment to its posture in reserve markets might be needed to maintain stable overall financial conditions.
As best we can judge, the change in credit conditions currently is exerting a slight additional degree of restraint on the economy. The process of credit restraint may not have reached completion, and some of its effects may not yet have been felt; hence it will require continued scrutiny. However, the tightening should eventually unwind as displaced borrowers find alternative sources of funds and as the banking system rebuilds its capital.
This restraint has implications for monetary policy at present, and the ongoing restructuring of the financial system has implications for the conduct of policy over the foreseeable future. It is clear that the financial restructuring will affect the channels through which policy actions are transmitted ultimately to economic growth and inflation; some will be diminished and others augmented. In these circumstances, the Federal Reserve has emphasized a flexible approach to policymaking, which includes attention to a wide range of economic and financial indicators.
Ranges for Money and Debt Growth in 1990 and 1991
At its meeting earlier this month, the FOMC reaffirmed the 1990 range of 3 percent to 7 percent that it had set for the growth of M2. With the thrift industry likely to continue to shrink at a good clip and commercial banks expanding more circumspectly, depository institutions are not expected to be bidding aggressively for funds. As a result, although banks may replace more of their managed liabilities with retail deposits, M2 could well remain in the lower half of its target range through year-end. In view of changing credit flows, a slow rate of expansion in M2 seems consistent with continued moderate growth in output, but any pronounced weakness in the aggregate that drops it below its current range might represent greater monetary restraint than is desirable this year.
Looking ahead to 1991, the Committee lowered the M2 range 1/2 percentage point on a provisional basis. We believe that this range is consistent with the continuation of measured restraint on aggregate demand--a necessity in the containment, and ultimate elimination, of inflation. Such restraint need not be a barrier to sustained growth. Indeed, it is a crucial requirement. As I suggested earlier, one thing that surely would jeopardize the current expansion would be for inflation to move upward, rather than downward, from the recent plateau.
FOMC members and other Reserve Bank Presidents generally foresee the policy embodied in the money ranges as leading to both sustained growth and diminished inflation in the period ahead. For 1990, their expectations center on an inflation rate in the 4 1/2 percent to 5 percent range, with real GNP growth of about 1 1/2 percent to 2 percent. But with this year's slow growth helping to relieve pressures on resources, expectations for 1991 incorporate both somewhat lower inflation and somewhat higher real growth, at a rate closer to that of growth in potential output.
The path of M3 consistent with these projections has been heavily affected by the changes in financial intermediation in recent quarters. Taking into account the current lending posture of the commercial banks and remaining thrift institutions, we now expect the closures of insolvent thrift institutions to show through in very subdued growth in M3. Accordingly, the FOMC voted to lower the 1990 range for growth of this aggregate to 1 percent to 5 percent. This action does not signal a tighter policy stance, but rather our recognition that financial markets have been adjusting to the RTC's activities in a somewhat different manner than we had anticipated, making the lower M3 target appropriate. In view of the considerable uncertainties about both the scale of RTC activities next year and the speed with which the banking industry will approach a more comfortable capital position, the new 1990 range was carried forward unchanged into 1991 on a tentative basis.
Overall debt growth during the rest of this year is expected to remain around the midpoint of its reaffirmed 5 percent to 9 percent monitoring range. The nonfederal sectors now appear to be increasing their debt about in line with nominal income growth, with the rapid pace of mortgage borrowing in recent years slowing into the single digits and corporate leveraging activity slackening. Growth of total debt in 1990 is likely to exceed that of nominal GNP, however, as the federal government's borrowing to fund RTC activities is expected to boost the total by roughly 3/4 percentage point.
For 1991, the FOMC has provisionally reduced the monitoring range for domestic nonfinancial sector debt to 4 1/2 percent to 8 1/2 percent. Debt growth in this range should be adequate to support continued economic expansion, while avoiding the excessive leveraging that characterized much of the 1980s.
A number of uncertainties come into play in the process of judging the outlook for the economy over the next year and a half. Of particular concern in the context of monetary policy are the likely extent and persistence of the tightening of credit terms, the prospective path of potential output growth--especially in view of the recent slowing in the labor force--and the outlook for fiscal policy. It is the last of these that is the focus of the remainder of my comments today.
Fiscal and Monetary Policy Interaction
The determination displayed by the Congress and the Administration in their efforts to come to an agreement on cutting the deficit has been enormously heartening to all who are concerned about the long-run health of the U.S. economy. As a nation, we have been saving too little and borrowing too much; significant progress on the federal deficit would be an important step in rectifying this situation. As you know, I favor not only eliminating the deficit, but also ultimately bringing the government's accounts into surplus over time to compensate for the private sector's tendency to save relatively little. In the long run, the nation's saving and investment behavior is crucial in determining its productivity and hence its standard of living.
Major, substantive, credible cuts in the budget deficit would present the Federal Reserve with a situation that would call for a careful reconsideration of its policy stance. What adjustment might be necessary, and how it might be timed, cannot be spelled out before the fact. The actions required will depend on the constellation of other influences on the economy, the nature and magnitude of the fiscal policy package, and the likely timing of its effects. I can only offer the assurance that the Federal Reserve will act, as it has in the past, to endeavor to keep the economic expansion on track.
Concerns that the Federal Reserve would be unable to offset undesirable macroeconomic effects of a budget pact are, I believe, largely unfounded. It is true that, in general, monetary policy cannot be calibrated extremely finely in response to economic developments, as we are all subject to imperfect data and an imperfect understanding of the myriad economic interrelationships of the real world. However, some doubts seem to focus on whether the various lags involved permit monetary policy to catch up to a change in the fiscal stance. I am less concerned on this point. We can decide that a policy adjustment is appropriate and implement it fully, all in the same morning if need be, and the effects of the change will show through to interest rates and financial asset prices almost immediately. Granted, the impact on economic growth and inflation will be spread out over several quarters, but this is true of changes in fiscal policy as well.
In the final analysis, no one can guarantee that growth in the economy will proceed smoothly, without a hitch on a quarter-to-quarter basis. Nevertheless, a major cut in the budget is unquestionably the right thing to do. Because the federal government has been borrowing too much for too long, it is well past time to reduce the government's draw on credit markets and to free up more resources for enhancing investment and production by the private sector. In this way, fiscal policy, by augmenting national saving, will be doing its part to promote maximum sustainable economic growth. With monetary policy similarly keeping sight of its long-run goal of price stability, the two together will have set a favorable backdrop for vibrant and enduring economic growth.
(1)See "Monetary Policy Report to the Congress," Federal Reserve Bulletin, vol. 76 (September 1990), pp. 711-25.
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|Title Annotation:||policy statements by members of the Federal Reserve Board|
|Publication:||Federal Reserve Bulletin|
|Date:||Sep 1, 1990|
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