laurence h meyer : federal deposit insurance reform testimony of mr laurence h meyer, member of the board of governors of the us federal reserve system, before the subcommittee on financial institutions and consumer credit of the committee on financial services, us house of representatives, 26 july 2001. * * * it is a pleasure, mr chairman, to appear before this subcommittee to present the views of the board of governors of the federal reserve system on deposit insurance reform as proposed by the federal deposit insurance corporation ( fdic ) this past spring. at this point, the federal reserve board ’ s views are necessarily general because the fdic ’ s recommendations were purposefully quite broad. that said, on behalf of the board i want to compliment the fdic for an excellent report that highlights the issues and develops an integrated framework for addressing them. we urge the congress to use that framework for promptly developing a detailed legislative proposal that addresses the most important deficiencies in our current deposit insurance system. i hope my comments this morning will be helpful in doing so. benefits and costs of deposit insurance as background to our suggestions, the board believes it is important first to understand the benefits and costs of deposit insurance. deposit insurance has played a key – at times even critical – role in achieving the stability in banking and financial markets that has characterized the past almost seventy years. deposit insurance, combined with other components of our banking safety net – the federal reserve ’ s discount window and payment system guarantees – and with enhanced macroeconomic stability resulting from monetary and fiscal policies, has meant that periods of financial stress are no longer characterized by depositor runs on banks and thrifts. quite the opposite : asset holders now seek out deposits as safe havens when they have strong doubts about other financial assets. looking beyond the contribution of deposit insurance to overall financial stability, we should not minimize the security it has brought to millions of households and small businesses. deposit insurance has provided a safe and secure place for those households and small businesses with relatively modest amounts of financial assets to hold their transaction and other balances. these benefits of deposit insurance, as significant as they are, have not come without cost. the very same process that has ended deposit runs has made insured depositors largely indifferent to the risks taken by their banks because their funds are not at risk if their institution is unable to meet its obligations. as a result, the market discipline to control risks that insured depositors would otherwise have imposed on banks and thrifts has been weakened. relieved of that discipline

of credit to sound borrowers, even when secured by what had been seen as good collateral, has been a source of instability and constraint on credit flows. central banks can address such a shortage because they can remain unaffected by panicky flights to liquidity and safety. their willingness to extend collateralized lending in size against a broad range of assets can replace flows of private credit that are normally uncollateralized. another aspect of our efforts to affect financial conditions has been the extension of our open market operations to large - scale purchases of agency mortgage - backed securities ( mbs ), agency debt, and longer - term treasury debt. we initially announced our intention to undertake large - scale asset purchases last november, when the federal funds rate began to approach its zero lower bound and we needed to begin applying stimulus through other channels as the economic contraction deepened. these purchases are intended to reduce intermediate - and longer - term interest rates on mortgages and other credit to households and businesses ; those rates influence decisions about investments in long - lived assets like houses, consumer durable goods, and business capital. in ordinary circumstances, the typically quite modest volume of central bank purchases and sales of such assets has only small and temporary effects on their yields. however, the extremely large volume of purchases now underway does appear to have substantially lowered yields. the decline in yields reflects " preferred habitat " behavior, meaning that there is not perfect arbitrage between the yields on longer - term assets and current and expected short - term interest rates. these preferences are likely to be especially strong in current circumstances, so that longterm asset prices rise and yields fall as the federal reserve acquires a significant portion of the outstanding stock of securities held by the public. against this general background, let me address some questions about our operations. have they been effective? yes, i believe they have helped ease financial conditions, though they can't address all the problems in financial markets. and the situation in financial markets and the economy would have been far worse if the federal reserve hadn't taken the actions we did in supplying liquidity as well as lowering our federal funds rate target. clearly, sharp decreases in the federal funds rate target have shown up directly in other short - term interest rates. our commercial paper facilities helped stabilize money market mutual funds and have steadied the commercial paper market and lowered rates for highquality issuers. and the announcements of our purchases of mbs and treasury bonds have reduced mortgage and other long - term interest rates