Mr. Greenspan presents the views of the Federal Reserve Board on the
supervision of US banks if they are authorized to widen their activities Testimony of
Chairman of th Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan,
before the Subcommittee on Capital Markets, Securities and Government-Sponsored Enterprises
of the Committee on Banking and Financial Services of the US House of Representatives on
19/3/97.
Mr. Chairman, members of the Subcommittee, thank you for inviting me to
present the views of the Federal Reserve Board on the supervision of our nation's banking
organizations should they be authorized by the Congress to engage in a wider range of activities.
As you know, the Board has supported financial modernization for many years and hopes that
the Congress will act to facilitate reforms that, by enhancing competition within the financial
services industry, would benefit the consumers of financial products in the United States.
Financial modernization may well mean that future banking organizations will be
sufficiently different from today as to require perhaps substantial changes in the supervisory
process for the entire organization. Just how much modification may be needed will depend on
the kinds of reforms the Congress adopts. In evaluating those modifications, I would like to
underline the significant supervisory role required by the Federal Reserve to carry out its central
bank responsibilities. I also would like briefly to discuss the continued importance of umbrella
supervision and the implications of a wider role for bank subsidiaries in the modernization
process.
Supervision and Central Banking
There are compelling reasons why the central bank of the United States -- the
Federal Reserve -- should continue to be involved in the supervision of banks. The supervisory
activities of the Federal Reserve, for example, have benefited from its economic stabilization
responsibilities and its recognition that safety and soundness goals for banks must be evaluated
jointly with its responsibilities for the stability and growth of the economy. The Board believes
that these joint responsibilities make for better supervisory and monetary policies than would
result from either a supervisor divorced from economic responsibilities or a macroeconomic
policymaker with no practical experience in the review of individual bank operations.
To carry out its responsibilities, the Federal Reserve has been required to develop
extensive, detailed knowledge of the intricacies of the U.S., and indeed the world, financial
system. That expertise is the result of dealing constantly over many decades with changing
financial markets and institutions and their relationships with each other and with the economy,
and from exercising supervisory responsibilities. It comes as well from ongoing interactions with
central banks and financial institutions abroad. These international contacts are critical because
today crises can spread more rapidly than in earlier times -- in large part reflecting new
technologies -- and require a coordinated international response.
Crisis Management and Systemic Risk
Second only to its macrostability responsibilities is the central bank's
responsibility to use its authority and expertise to forestall financial crises (including systemic
disturbances in the banking system) and to manage such crises once they occur. In a crisis, the
Federal Reserve, to be sure, could always flood the market with liquidity through open market
operations and discount window loans; at times it has stood ready to do so, and it does not need
supervisory and regulatory responsibilities to exercise that power. But while sometimes
necessary in times of crises, such an approach may be costly and distortive to economic
incentives and long-term growth, as well as an insufficient remedy. Supervisory and regulatory
responsibilities give the Federal Reserve both the insight and the authority to use techniques that
are less blunt and more precisely calibrated to the problem at hand. Such tools improve our
ability to manage crises and, more importantly, to avoid them. The use of such techniques
requires both the authority that comes with supervision and regulation and the understanding of
the linkages among supervision and regulation, prudential standards, risk taking, relationships
among banks and other financial market participants, and macroeconomic stability.
Our financial system -- market oriented and characterized by innovation and rapid
change -- imparts significant benefits to our economy. But one of the consequences of such a
dynamic system is that it is subject to episodes of stress. In the 1980s and early 1990s we faced a
series of international debt crises, a major stock market crash, the collapse of the most important
player in the junk bond market, the virtual failure of the S&L industry, and extensive losses at
many banking institutions. More recently, we faced another Mexican crisis and, while in the
event less disruptive, the failure of a large British merchant bank. In such situations the Federal
Reserve stands ready to provide liquidity, if necessary, and monitors continuously the condition
of depository institutions to contain the secondary consequences of any problem. The objectives
of the central bank in crisis management are to contain financial losses and prevent a contagious
loss of confidence so that difficulties at one institution do not spread more widely to others. The
focus of its concern is not to avoid the failure of entities that have made poor decisions or have
had bad luck, but rather to see that such failures -- or threats of failures -- do not have broad and
serious impacts on financial markets and the national, and indeed the global, economy.
The Federal Reserve's ability to respond expeditiously to any particular incident
does not necessitate comprehensive information on each banking institution. But it does require
that the Federal Reserve have in-depth knowledge of how institutions of various sizes and other
characteristics are likely to behave, and what resources are available to them in the event of
severe financial stress. Even for those events that might, but do not, precipitate financial crises,
the authorities turn first to the Federal Reserve, not only because, as former Chairman Volcker
noted last month, we have the money, but also because we have the expertise and the experience.
We currently gain the necessary insight by having a broad sample of banks subject to our
supervision and through our authority over bank holding companies.
Payment and Settlement Systems
Virtually all of the U.S. dollar transactions made worldwide -- for securities
transfers, foreign exchange and other international capital flows, and for payment for goods and
services -- are settled in the United States banking system. A small number of transactions that
comprise the vast proportion of the total value of transactions are transferred over large-dollar
payment systems. Banks use two of these systems -- Fedwire, operated by the Federal Reserve,
and CHIPS, operated by the New York Clearing House -- currently to transfer $1.6 trillion and
$1.3 trillion a day, respectively. CHIPS settles its members' net positions on Fedwire.
These interbank transfers, for banks' own accounts and for those of their
customers, occur and are settled over a network and structure that is the backbone of the U.S.
financial system. Indeed, it is arguably the linchpin of the international system of payments that
relies on the dollar as the major international currency for trade and finance. Disruptions and
disturbances in the U.S. payment system thus can easily have global implications. Fedwire,
CHIPS, and the specialized depositories and clearinghouses for securities and other financial
instruments, are crucial to the integrity and stability not only of our financial markets and
economy, but those of the world. Similarly, adverse developments in transfers in London,
Tokyo, Singapore, and a host of other centers could rapidly be transferred here, given the
financial interrelationships among the individual trading nations.
In all these payment and settlement systems, commercial banks play a central
role, both as participants and providers of credit to nonbank participants. Day-in and day-out, the
settlement of payment obligations and securities trades requires significant amounts of bank
credit. In periods of stress, such credit demands surge just at the time when some banks are least
willing or able to meet them. These demands, if unmet, could produce gridlock in payment and
settlement systems, halting activity in financial markets. Indeed, it is in the cauldron of the
payments and settlement systems, where decisions involving large sums must be made quickly,
that all of the risks and uncertainties associated with problems at a single participant become
focussed as participants seek to protect themselves from uncertainty. Better solvent than sorry,
they might well decide, and refuse to honor a payment request. Observing that, others might
follow suit. And that is how crises often begin.
Limiting, if not avoiding, such disruptions and ensuring the continued operation
of the payment system requires broad and indepth knowledge of banking and markets, as well as
detailed knowledge and authority with respect to the payment and settlement arrangements and
their linkages to banking operations. This type of understanding and authority -- as well as
knowledge about the behavior of key participants -- cannot be created on an ad hoc basis. It
requires broad and sustained involvement in both the payment infrastructure and the operation of
the banking system. Supervisory authority over the major bank participants is a necessary
element.
Monetary Policy
While financial crises and payment systems disruptions arise only sporadically,
the Federal Reserve conducts monetary policy on an ongoing basis. In this area, too, the Federal
Reserve's role in supervision and regulation provides an important perspective to the policy
process. Monetary policy works through financial institutions and markets to affect the
economy, and depository institutions are a key element in those markets. Indeed, banks and
thrifts are more important in this regard than might be suggested by a simple arithmetic
calculation of their share of total credit flows. While diverse securities markets handle the lion's
share of credit flows these days, banks are the backup source of liquidity to many of the
securities firms and large borrowers participating in these markets. Moreover, banks at all times
are the most important source of credit to most small and intermediate-sized firms that do not
have ready access to securities markets. These firms are the catalyst for U.S. economic growth
and the prime source of new employment opportunities for our citizens. The Federal Reserve
must make its monetary policy with a view to how banks are responding to the economic
environment. This was especially important during the "credit crunch" of 1990. Our supervisory
responsibilities give us important qualitative and quantitative information that not only helps us
in the design of monetary policy, but provides important feedback on how our policy stance is
affecting bank actions.
The macroeconomic stabilization responsibilities of the Federal Reserve make us
particularly sensitive to how regulatory and supervisory postures can influence bank behavior
and hence how banks respond to monetary policy actions. For example, capital, liquidity, loan
loss reserve, and asset quality evaluation policies of supervisors will directly influence the
manner and speed with which monetary policy actions work. In the development of interagency
rules and policies, the Federal Reserve brings to the table its unique concerns about the impact of
these rules on credit availability, potential responses to changes in interest rates, and the
consequences for the economy. We believe that, as a result, supervisory policy is improved.
Federal Reserve's Supervisory Role
For all of these reasons, the Board believes the Federal Reserve needs to retain a
significant supervisory role in the banking system. Just exactly how that is achieved depends
critically on the types of reforms the Congress enacts and the direction the banking industry
takes in structuring and conducting its activities. In the Board's view, its current authority is
adequate for the current structure. For today's financial system, we are able to meet our
obligations by the intelligence we gain from, and the authorities we have over the modest
number of large banks we directly supervise and the holding companies of these and other large
banks over which we have a direct umbrella supervisory role. Our information is importantly
supplemented by our supervision of a number of other banks of all sizes, namely state member
banks. Currently, the latter group gives us a good representative sample of organizations of all
sizes outside the largest entities.
The large entities are essential if we are to address the Federal Reserve's crisis
management and systemic risk responsibilities, deal with international financial issues involving
foreign central banks, manage risk exposures in payment systems, and retain our practical
knowledge and skill base in rapidly changing financial markets. Large bank holding companies
are typically at the forefront in financial innovation and in developing sophisticated techniques
for managing risks. It is crucial that the Federal Reserve stay informed of these events and
understand directly how they work in practice. Directly supervising both these large
organizations and a sample of others is also critical to our ability to conduct monetary policy by
permitting us to gain first-hand on-the-spot intelligence on how changes in financial markets
-including those induced by monetary policy -- are affecting money and credit flows.
If in the future the holding company becomes a less clear window into the
banking system, the Board believes that the Congress would need to change the supervisory
structure if the central bank is to carry out the responsibilities I have discussed today.
Umbrella Supervision
The Congress, in its review of financial modernization, must consider legal entity
supervision alone versus legal entity supervision supplemented by umbrella supervision. The
Board believes that umbrella supervision is a realistic necessity for the protection of our
financial system and to limit any misuse of the sovereign credit, that is, the government's
guarantees that support the banking system through the safety net.
The bank holding company organization increasingly is being managed so as to
take advantage of the synergies between its component parts in order to deliver better products
to the market and higher returns to stockholders. Such synergies cannot occur if the model of the
holding company is one in which the parent is just, in effect, a portfolio investor in its
subsidiary. Indeed, virtually all of the large holding companies now operate as integrated units
and are managed as such, especially in their management of risk.
One could argue that regulators should be interested only in the entities they
regulate and, hence, review the risk evaluation process only as it relates to their regulated entity.
Presumably each regulator of each entity -- the bank regulators, the SEC, the state insurance and
any state finance company authorities -- would look only at how the risk management process
affected their units. It is our belief that this simply will not be adequate. Risks managed on a
consolidated basis cannot be reviewed on an individual legal entity basis by different
supervisors.
The latter logic motivated the congressional decision just five years ago to require
that foreign banks could enter the United States if, and only if, they were subject to consolidated
supervision. This decision, which is consistent with the international standards for consolidated
supervision of banking organizations, was a good decision then. It is a good decision today,
especially for those banking organizations whose disruption could cause major financial
disturbances in United States and foreign markets. For foreign and for U.S. banking
organizations, retreat from consolidated supervision would, the Board believes, be a significant
step backward.
We have to be careful, however, that consolidated umbrella supervision does not
inadvertently so hamper the decisionmaking process of banking organizations as to render them
ineffectual. The Federal Reserve Board is accordingly in the process of reviewing its supervisory
structure and other procedures in order to reflect a market-directed shift from conventional
balance sheet auditing to evaluation of the internal risk management process. Although focussed
on the key risk management processes, it would sharply reduce routine supervisory umbrella
presence in holding companies. As the Committee knows, the Board has recently published for
comment proposals to expedite the applications process, and the legislation Congress enacted
last year eased such procedures as well. Nonetheless, the Board requests even greater
modification to its existing statutory mandate so that the required applications process could be
sharply cut back, particularly in the area of nonbank financial services.
In the Board's view, those entities interested in banks are really interested in
access to the safety net, since it is far easier to engage in the nonsafety net activities of banks
without acquiring a bank. If an organization chooses to deliver some of its services with the aid
of the sovereign credit by acquiring a bank, it should not be excused from efforts of the
government to look out for the stability of the overall financial system. For bank holding
companies, this implies umbrella supervision. Although that process will increasingly be
designed to reduce supervisory presence and be as nonintrusive as possible, umbrella supervision
should not be eliminated, but recognized for what it is: the cost of obtaining a subsidy.
Nonetheless, we would hope that should the Congress authorize wider activities
for financial services holding companies that it recognize that a bank which is a minor part of
such an organization (and its associated safety net) can be protected through adequate bank
capital requirements and the application of Sections 23A and 23B of the Federal Reserve Act.
The case is weak, in our judgment, for umbrella supervision of a holding company in which the
bank is not the dominant unit and is not large enough to induce systemic problems should it fail.
Subsidiaries, Subsidies, and Safety Nets
The members of this Subcommittee are, I think, aware of the Board's concerns
that the safety net constructed for banks inherently contains a subsidy, that conducting new
activities in subsidiaries of banks will inadvertently extend that subsidy, and that extension of
any subsidy is undesirable. The Subcommittee recently heard testimony that there is no net
subsidy and, therefore, the authorization of nonbank activities in bank subsidiaries would neither
inadvertently extend this undesirable side effect of the safety net nor reduce the importance of
the holding company as a consequence of the increased incentives to shift activities from the
holding company to the bank.
Mr. Chairman, I would like briefly to comment on these latter views.
Subsidy values -- net or gross -- vary from bank to bank; riskier banks clearly get
a larger subsidy from the safety net than safer banks. In addition, the value of the subsidy varies
over time; in good times, markets incorporate a low risk premium and when markets turn weak,
financial asset holders demand to be compensated by higher yields for holding claims on riskier
entities. It is at this time that subsidy values are the most noticeable. What was it worth in the
late 1980s and early 1990s for a bank with a troubled loan portfolio to have deposit liabilities
guaranteed by the FDIC, to be assured that it could turn illiquid to liquid assets at once through
the Federal Reserve discount window, and to tell its customers that payment transfers would be
settled on a riskless Federal Reserve Bank? For many, it was worth not basis points but
percentage points. For some, it meant the difference between survival and failure.
It is argued by some that the cost of regulation exceeds the subsidy. I have no
doubt that the costs of regulation are large, too large in my judgment. But no bank has turned in
its charter in order to operate without the cost of banking regulation, which would require that it
operate also without deposit insurance or access to the discount window or payments system. To
do so would require both higher deposit costs and higher capital. Indeed, it is a measure of the
size of banks' net subsidy that most nonbank financial institutions are required by the market to
operate with significantly higher capital-to-asset ratios than banks. Most finance companies, for
example, with credit ratings and debenture interest costs equal to banks are forced by today's
market to hold six or seven percentage points higher capital-to-asset ratios than those of banks.
It is instructive that there are no private deposit insurers competing with the
FDIC. For the same product offered by the FDIC, private insurers would have to charge
premiums far higher than those of government insurance, and still not be able to match the
certainty of payments in the event of default, the hallmark of a government insurer backed by
the sovereign credit of the United States.
The Federal Reserve has a similar status with respect to the availability of the
discount window and riskless final settlement during a period of national economic stress.
Providing such services is out of the reach of all private institutions. The markets place
substantial values on these safety net subsidies, clearly in excess of the cost of regulation. To
repeat, were it otherwise, some banks would be dropping their charters if there were not a net
subsidy.
In fact it is apparently the lower funding costs at banks that benefit directly from
the subsidy of the safety net that has created the tendency for banking organizations to return to
the bank and its subsidiaries many activities that are authorized to banks. These activities
previously had been conducted in nonbank affiliates for reasons such as geographic and other
inflexibilities, which have gradually eased. Indeed, over the last decade the share of consolidated
assets of bank holding companies associated with nonbank affiliates -- other than Section 20
securities affiliates -- has declined almost half to just 5.2 percent. This tendency reflects the fact
that asset growth that earlier had been associated with nonbank affiliates of bank holding
companies -- consumer and commercial finance, leasing, and mortgage banking -- has most
recently occurred largely in the bank or in a subsidiary of the bank. To be sure, as Chairman
Helfer indicated to the Subcommittee earlier this month, many banking organizations still retain
nonbank subsidiaries. Our discussions with bank holding companies, however, suggest that in
some cases, these affiliates were acquired in the past and have established names and an
interstate network whose value would be reduced if subsumed within a bank. There are also
often adverse tax implications for the shift. And, finally, some of these activities may not be
asset intensive and hence may not benefit significantly from bank funding.
Clearly, the authorization of new activities in bank subsidiaries that are not now
permitted either to banks or their affiliates would tend to accelerate the trend to reduce holding
company activity, even if these activities were also permitted to holding company subsidiaries.
The subsidy inherent in the safety net would assure that result, extending the spread of the safety
net and requiring that the Federal Reserve's authority and ability to meet its responsibilities be
shifted to a different paradigm.
Such a result is reason enough for our concern about the spreading of the safety
net subsidy. But we should also be concerned because of the distortions subsidies bring to the
financial system more generally. After all, the broad premise underlying financial
modernization -- with its removal of legislative and regulatory restrictions -- is that free and
often intense competition will create the most efficient and customer-oriented business system.
This principle has proved itself, generation by generation, with ever higher
standards of living.
In financial, as well as most other, markets the principle is rooted in another
premise -- that the interaction of private competitive forces will, with rare exceptions, create a
stable error self-correcting system. This premise is very seriously called into question if
government subsidies are supplied at key balancing points. By their nature, subsidies distort the
establishment of competitive market prices, and create incentives that misalign private risks with
private gains. Such distortions undermine the error self-correcting mechanisms that support
strong financial markets.
We must be very careful that in the name of free market efficiency we do not
countenance greater powers and profits subsidized directly or indirectly by government.
Conclusion
Mr. Chairman, in conclusion, the Board believes that as the Congress moves
toward financial modernization the newly created structure of financial organizations should
limit, in so far as possible, the real and perceived transfer of the subsidy inherent in the safety
net to nonbank activities. To maintain a level playing field for all competitors, nonbank
activities must be financed at market, not subsidized, rates.
The Board also believes that financial modernization should not undermine the
ability and authority of the central bank of the United States to manage crises, assure an efficient
and safe payment system, and conduct monetary policy. We believe all of these require that the
Federal Reserve retain a significant and important role as a bank supervisor. In today's structure,
we have adequate authority and coverage to meet our responsibilities. But should erosion occur,
as would likely be the case if new activities are authorized in bank subsidiaries, the Congress
would have to consider what changes would be required in the Board's supervisory authority to
assure that it continues to be able to meet its central bank responsibilities.