The Federal Reserve System (Federal Reserve or System), our nation’s central bank, is unique among governmental entities in many respects, particularly in its finances. Unlike many government agencies whose operations are funded through the Congressional appropriations process, the Federal Reserve deducts operations and other expenses from its revenues and transfers the remaining amount to the U.S. Department of the Treasury (Treasury). Although the primary mission of the Federal Reserve is to support a stable economy, not to make a profit or maximize its transfer to Treasury, System revenues contribute to total U.S. revenues; thus, deductions from System revenues represent a cost to U.S. taxpayers. In today’s constrained budget environment, Congress seeks to be well informed on all activities that affect the government’s finances. For this reason, Members of Congress have requested our assistance in providing information about the revenues and costs of the Federal Reserve, factors that could affect Federal Reserve finances, and about the mechanisms used to control costs and conduct strategic planning. The Federal Reserve was created by the Federal Reserve Act of 1913 “. . . to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.” The Federal Reserve’s basic structure includes a federal agency in Washington, D.C.—the Board of Governors of the Federal Reserve System (Board), whose seven members are appointed by the president and confirmed by the Senate. Figure 1.1 shows the organizational structure of the Board. The structure also includes 12 federally chartered corporations, located in various regions of the country (Federal Reserve districts), known as Federal Reserve Banks (Reserve Banks). Figure 1.2 shows the boundaries of the Federal Reserve districts. The Federal Reserve is unusual in many respects compared to other entities established to carry out public purposes. It is a federal system that is part public and part private; although the Board is a government agency, the Reserve Banks are not. Also, the Federal Reserve does not follow the familiar federal structure of a “top-down” hierarchy, with all policymaking powers centralized in Washington, D.C. Instead, the Board and the Reserve Banks have shared responsibilities and policymaking authority in many areas of operation. The Federal Reserve’s part-public, part-private composition evolved from efforts to ensure our central bank’s balanced consideration of public and private interests at national and regional levels. A related feature is the Federal Reserve’s structural independence from political influence and direct taxpayer support. The Federal Reserve’s budget is not subject to the approval of Congress or the administration, and the central bank receives no government appropriations. The Reserve Banks are structured as self-supporting corporations, and the Board is financed by a levy on the Reserve Banks. The Reserve Banks are federally chartered corporations wholly owned by private-sector commercial banks (which, as members of the Federal Reserve, are known as member banks.) In terms of assets and personnel, most of the Federal Reserve is in the Reserve Banks: virtually all of the Federal Reserve’s assets, liabilities, revenues, and expenses are carried on the books of the Reserve Banks, and 94 percent of the over 25,000 employees of the Federal Reserve are employed by the Reserve Banks. As of December 31, 1994, the assets of the Reserve Banks were $437.0 billion, and their liabilities and equity were $429.5 and $7.4 billion, respectively. Although the Reserve Banks are privately owned corporations, they differ from most such entities in important ways. The ownership of all stock of the Reserve Banks confers on member banks only some of the typical attributes of control and financial interest. For example, member banks receive dividends on Federal Reserve stock, but these dividends are set by law at 6 percent of paid-in capital. Member banks may not sell the stock or pledge the stock as collateral for loans. Also, member banks elect six directors of the Reserve Banks’ boards of directors; the Board appoints three directors and designates one of these as chairman and another as deputy chairman of the board. Finally, the Reserve Banks have been considered instrumentalities of the federal government in at least one context. Although the Federal Reserve must report to Congress annually on its operations, decisions of System policymakers generally are not subject to ratification by the president or any presidential appointees in the executive branch or by Congress. The Federal Reserve Act not only gives the board of directors at each of the Reserve Banks powers of supervision and control over the Reserve Bank, but it also grants the Board of Governors the power to exercise general supervision over the Reserve Banks. For example, the board of directors at each Reserve Bank appoint and determine the compensation of the top official of each Reserve Bank; however, the Board of Governors is authorized to approve or disapprove these decisions. The Federal Reserve Act does not specifically define the general supervisory responsibilities of the Board of Governors. To help systemwide planning and decisionmaking in a system of shared responsibilities, the Board and the Reserve Banks participate in systemwide conferences. In 1994, the conference structure consisted of three major conferences: the Conference of Presidents (COP), the Conference of First Vice Presidents (COFVP), and the Conference of General Auditors, as described in table 1.1. Each of these conferences is supported by committees, subcommittees, and task forces, involving many Federal Reserve officials and staff. In 1995, a new management structure for financial services took over many of the duties of the COFVP that were related to priced services. The new committee was established to streamline the Federal Reserve’s decisionmaking process and to make the Reserve Bank first vice presidents more accountable for strategic planning of major business lines throughout the entire System. This new structure and details on the Federal Reserve’s decisionmaking authority are discussed further in chapter 5. Many, but not all, of the responsibilities of the Federal Reserve are shared by the Board and the Reserve Banks. This is perhaps best explained in the context of a discussion of the basic mission of the Federal Reserve. The mission of the Federal Reserve today, which is critical to the nation’s economy, can be generally described in terms of four major functions or responsibilities: conducting monetary policy; maintaining the stability of the financial system and containing systemic risk that may arise in financial markets; providing services to financial institutions and other governmental agencies; and supervising and regulating banks and bank-holding companies. Table 1.2 briefly describes the basic responsibilities of the Federal Reserve and explains how these responsibilities are shared by components of the System. The budgetary controls and oversight structures internal to the Federal Reserve reflect the fact that each of the Reserve Banks has its own management structure in addition to being supervised by the Board. Concerning budget controls—the primary control over spending—the Reserve Banks and the Board have similar, but separate, processes, and the Board approves all final budgets. The Federal Reserve’s internal oversight structure includes general auditors at each of the Reserve Banks and the Office of the Inspector General (OIG) at the Board. The OIG is authorized to audit activities for which the Board has primary responsibility. In addition, some Board divisions, such as the Division of Reserve Bank Operations and Payment Systems (DRBOPS), Division of Human Resources Management (DHRM), and Division of Banking Supervision and Regulation (DBS&R), conduct operations reviews using the Board’s delegated authority to supervise the Reserve Banks. DRBOPS also conducts financial examinations, operational audits, and annual performance evaluations of the Reserve Banks. The budgetary controls and oversight structures of the Federal Reserve are discussed further in chapter 5. The Reserve Banks use accrual accounting to track expenses. For this reason, the Reserve Banks’ operating expenses reflect only the depreciation costs of capital acquisitions. Each major unit of the Reserve Banks has an operations budget and a capital asset budget, and each is controlled by the same process. Each year, the Federal Reserve deducts operations and other expenses from current revenue and transfers the remaining amount to Treasury. For example, in 1994, the Federal Reserve deducted about $3.5 billion from the current revenue of about $24 billion and returned about $20.5 billion to Treasury. The amount returned to Treasury has varied during the period of 1988 to 1994, as shown in table 1.3. The return of these remaining revenues to Treasury is in accordance with a policy established by the Board of Governors, and is not required by statute. The amount that the Federal Reserve transfers to Treasury each year is a function of the amount of System revenues and deductions, which are affected by a variety of factors. The Federal Reserve has three major sources of recurring revenue: interest on U.S. securities held primarily to collateralize currency (currency-related securities), other interest earned, and fee income. Table 1.4 briefly identifies the sources of revenue and briefly describes the primary factors that determine the amounts received from each source. As detailed in this table, only in the case of priced services and net payments for fiscal agent services can the Federal Reserve set fees in response to fluctuations in the costs it incurs. Most Federal Reserve revenue comes from interest earned on U.S. government securities that are held by Reserve Banks and used to back, or collateralize, Federal Reserve notes. The Federal Reserve Act introduced Federal Reserve notes—the “paper money” that we use today. Before being issued to the public, Federal Reserve notes must be secured by legally authorized collateral—gold certificates, special drawing rights (SDR), and U.S. Treasury and federal agency securities purchased through open-market operations. About $381.5 billion in Federal Reserve notes were in circulation as of December 31, 1994, and as shown in table 1.4, the assets that collateralized those notes accounted for about 87 percent of the Federal Reserve assets at that time. Those assets represented mainly U.S. Treasury and federal agency securities. Throughout the 1988 to 1994 period, interest received on such currency-related securities ranged from 79 to 87 percent of all System revenues. Interest on noncurrency-related U.S. securities refers to interest earned on securities purchased to implement monetary policy. The Federal Reserve influences the economy mainly through a system of managed reserves.The Monetary Control Act of 1980 requires all depository institutions to hold reserve balances in accounts with the Reserve Bank for their Federal Reserve districts or other designated institutions or, as permitted by Board regulations, in the form of cash in their vaults. The Federal Reserve sets reserve requirements for depository institutions and determines the total of reserves for the banking system. By purchasing securities in the market, the Federal Reserve expands reserves when it wants to lower interest rates and encourage more credit in the economy. Conversely, by selling securities, the Federal Reserve reduces reserves when it wants to raise interest rates and restrict the amount of credit. The Federal Reserve’s control over bank reserves enables it to play a major role in protecting the economy against systemic risk—that is, excessive disruption from financial market disturbances. In the event of a financial crisis, such as a plunge in stock prices, the Federal Reserve may increase the liquidity of markets by temporarily supplying extra reserves to the banking system through open-market operations. Interest on foreign securities was an additional source of revenue. In 1994, the Federal Reserve held $20.5 billion in foreign securities. The Federal Reserve also has a reciprocal swap network with different central banks, which is not included on the balance sheet. The Federal Reserve earns interest on foreign-denominated assets, but also faces risks in that it can gain or lose on trades. The Federal Reserve earns interest on loans provided to depository institutions through its discount window. Through the discount window, commercial banks and other depository institutions may borrow reserves from the Federal Reserve. These institutions are expected to draw on all other reasonably available sources of funds before coming to the discount window. The loans are made at a rate of interest—the discount rate—set by the Reserve Banks and approved by the Board. The Monetary Control Act requires the Federal Reserve to charge depository institutions for its services to financial institutions, setting fees in such a way that, over the long run, the revenues from these services will recover the costs of providing them. The act also requires all depository institutions to meet the Federal Reserve’s reserve requirements and grants these same institutions access to System services at market prices as well as access to short-term or discount loans. In addition to the services mentioned in table 1.2, the Federal Reserve provides securities safekeeping and transfer and noncash collection services. Services to financial institutions and Treasury constitute a large portion of the Federal Reserve expenses. From current revenues, the Federal Reserve deducts the cost of operating the 12 Reserve Banks and the Board and other expenses before transferring the remaining revenues to Treasury. Generally, these deductions can be categorized as expenses; other deductions; and losses, gains, and other adjustments. Table 1.5 briefly describes these deductions. For purposes of this report, operating expenses of the Federal Reserve include the cost of operating the Reserve Banks and the Board. As shown in table 1.6, the Federal Reserve makes other adjustments to current revenue. For example, gains and losses resulting from sales of U.S. Treasury and agency securities or changes in value of foreign exchange or assets denominated in foreign currencies are accounted for in adjustments to current revenue. Other gains or losses, such as those realized as the result of changes to accounting rules, are also accounted for in this way. In 1993, the Federal Reserve experienced a significant one-time deduction to revenues, primarily the result of the initial accrual of postretirement employee benefits required by a change in accounting rules. In recent years, adjustments have been volatile because of gains or losses on assets denominated in foreign currencies, both from actual transactions and from revaluation to dollars of assets held in portfolio. Our objectives were to (1) analyze trends in the cost of Federal Reserve operations during 1988 to 1994 and the System’s management processes for controlling spending and overseeing operations, (2) identify opportunities to increase the System’s efficiency without adversely affecting its effectiveness, (3) identify ongoing and future developments that could significantly affect the Federal Reserve’s mission and finances, and (4) assess the System’s strategic management processes and identify actions the Federal Reserve could take to successfully meet future challenges and ensure the efficiency and effectiveness of its operations. To analyze trends in the Federal Reserve’s spending during 1988 to 1994, we developed a 7-year trend analysis on the expenses of the Federal Reserve. In addition, we examined the Reserve Banks’ and the Board’s cost-accounting systems to identify trends in the Federal Reserve’s operating expenses by mission-related activity (such as services to financial institutions and Treasury) and types of expense (such as salaries, benefits, and travel). However, we did not audit these numbers and did not verify their accuracy. We reviewed a variety of financial-accounting, cost-accounting, staffing, and budgetary reports prepared by the Board and the individual Reserve Banks. To analyze the Federal Reserve’s spending trends, we compared the System’s levels of spending to inflation and levels of discretionary spending of the federal government during the same period. Due to the limitations of our audit authority, we did not analyze direct costs relating to the buying, selling, and holding of securities and foreign currency or other valuables in connection with the implementation of monetary policy. To identify opportunities that exist to increase the System’s efficiency without adversely affecting its effectiveness, we concentrated our work on personnel compensation, travel, and procurement and contracting. More specifically, we reviewed Board and Reserve Bank personnel compensation data and policies, travel policies, and samples of travel vouchers; compared personnel compensation policies and regulations to those of developed and mailed a standardized data collection instrument, or questionnaire, to obtain pay and benefits information from the human resource officers at the eight Reserve Banks where we did not do detailed audit work in these areas; contacted questionnaire respondents by telephone to further clarify did an in-depth review of the procurement process at the San Francisco Reserve Bank, focusing on items with a cost of more than $25,000; and interviewed officials at three Reserve Banks who were responsible for procurement, reviewed procurement guidance, traced purchases through the payment process, and reviewed selected contracts. To identify ongoing and future developments that could significantly affect the Federal Reserve’s mission and finances, we analyzed studies, data, and other information and interviewed knowledgeable officials of the Federal Reserve on issues related to check clearing, currency processing, and bank supervision and interviewed officials and analyzed supporting documentation from the Federal Reserve Bank of Kansas City to determine how the automation consolidation project, the Federal Reserve Automation Services (FRAS), had affected its check-clearing priced service. DBS&R. We did our work in accordance with generally accepted government auditing standards at the Board of Governors in Washington, D.C., and at the Federal Reserve Banks in Chicago; Dallas; Kansas City, MO; New York; Richmond; and San Francisco from January 1994 through September 1995. We obtained written comments on a draft of this report from the Federal Reserve Board of Governors. The comments are discussed at the ends of chapters 3 and 5 and reprinted in appendix V. Staff of the Federal Reserve Board provided additional technical comments on the draft report, which were incorporated as appropriate. In the 7-year period from 1988 to 1994, as many commercial banks restructured to reduce operating costs and increase revenues and Congress and the Executive Branch acted to constrain discretionary federal spending, the cost to operate the Federal Reserve has increased steadily and substantially—from $1.36 billion in 1988 to $2.00 billion in 1994, or 48 percent. This percentage increase exceeded the 25-percent inflation that occurred during the same period, was also greater than the 17-percent increase in overall federal discretionary spending, and was almost the same as the 51-percent increase in federal nondefense spending. The growth in Federal Reserve expenses was caused by significant increases that occurred in expenses for bank supervision and regulation, personnel compensation, and extensive automation modernization and consolidation. Since the early 1980s, federal budgeting has been dominated by concern about the budget deficit. In the mid-1980s, the deficit was greater than $200 billion; in the early 1990s, the deficit approached $300 billion. By 1985, the high deficit prompted the enactment of the Gramm-Rudman-Hollings Act (GRH), which established deficit targets for each year through fiscal year 1991, when the budget was to be balanced. GRH was amended in 1987. In 1990, Congress revised the GRH process with the Budget Enforcement Act of 1990 (BEA). Rather than focusing on fixed deficit targets, BEA was designed to limit legislative actions by limiting appropriations and restricting the creation or expansion of any entitlement program or tax cut. BEA categorizes all federal spending as either discretionary (funded through annual appropriation acts) or direct (entitlements or spending that results from laws other than appropriation acts). BEA set discretionary spending limits—called caps—to control the aggregate amount that can be appropriated and expended for all discretionary programs in a fiscal year. Thus, all discretionary programs compete with each other within the caps. Direct spending programs are controlled by BEA’s pay-as-you-go (PAYGO) rules. The main PAYGO requirement is that legislation enacted during a session of Congress which increases direct spending or decreases revenues, must be offset by revenue increases or a cut in another direct spending program. If the legislative action increases the deficit for a fiscal year, a sequestration from certain direct spending accounts occurs. In addition to these budgetary control mechanisms, the administration and Congress are attempting to make the federal government smaller and more cost efficient by reforming or “reinventing” its agencies and work processes. For example, the National Performance Review (NPR), under the direction of the Vice President, is an administration initiative that seeks to propose recommendations on how the federal government could work better and cost less. Throughout the 1980s and into the 1990s, many U.S. banks also made strategic decisions to restructure their activities, cut operating costs, and generally develop more efficient operations. The U.S. banking system underwent this transition in response to intense domestic and international competition, technological and financial innovations, and changing market conditions. For several reasons, the Federal Reserve is not subject to the same cost-reduction pressures that are affecting both public agencies and private sector firms. The Federal Reserve, for example, is not subject to BEA, primarily because it operates without congressional appropriations and funds its operations and pays other expenses from the current revenue of the Reserve Banks. Also, unlike private firms, the Federal Reserve does not have a profit incentive to lower costs and increase efficiency. From 1988 to 1994, as shown in figure 2.1, Federal Reserve operating expenses increased from $1.36 billion to $2.00 billion. This was an increase of about twice the amount of inflation and about 3 times the increase in overall federal discretionary spending that occurred in that period. During this same period, Federal Reserve operating expenses increased at about the same rate as the percentage increase for nondefense federal discretionary spending. The Federal Reserve uses cost-accounting systems that allocate operating budget expenditures to both mission-related categories and expense categories. For budgeting purposes and accounting, expenditures of the Federal Reserve are accounted for in five major mission-related areas of the System: monetary policy, supervision and regulation, services to financial institutions and the public, services to Treasury and other government agencies, and System policy and oversight. Costs of support and overhead, including Board expenditures for System policy direction and oversight, are allocated to each Federal Reserve mission activity. The costs are distributed to the Federal Reserve mission activities in accordance with predetermined ratios derived by estimated usage. The Federal Reserve also categorizes operating expenses by expense categories. These categories include personnel compensation, equipment and software, buildings, travel, shipping, materials and supplies, and communication. As shown in table 2.1, although spending in all five of the Federal Reserve’s mission-related activities increased during 1988 to 1994, the supervision and regulation area experienced the highest spending growth. The rate of spending increases in mission-related activities ranged from 34 percent (services to financial institutions and the public) to 102 percent (supervision and regulation). The growth in the supervision and regulation area resulted from staff increases in the area. Services to financial institutions and the public, services to government agencies, and bank supervision and regulation accounted for almost 90 percent of the Federal Reserve’s costs. Within the services to financial institutions activity, expenses for priced services increased substantially less than those for nonpriced services. Priced services expenses increased the least of any mission-related activity. According to Federal Reserve officials, growth in supervision and regulation expenditures was driven primarily by staff increases. These staff increases resulted from the implementation of the regulatory requirements mandated by banking reform laws, such as the Federal Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) and the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991. The supervision and regulation area increased its staff over 42 percent during 1988 to 1994 from 2,456 to 3,498. During the same period, both the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) had increased the size of their bank supervision and regulation staff by about 24 percent and 45 percent, respectively. As shown in table 2.1, costs related to priced services rose by the smallest rate of growth during 1988 to 1994. The Federal Reserve has a significant incentive to restrain priced services costs because under the Monetary Control Act, fees for services are to be based on the recovery of expenses, and the System competes with the private sector in providing services to financial institutions. The Monetary Control Act requires the Federal Reserve to charge financial institutions for priced services, such as check processing, and to recover its costs. In addition, the Federal Reserve competes with private check clearinghouses and automated clearinghouse (ACH) networks in processing checks and conducting ACH transactions. As shown in table 2.2, the three Federal Reserve expense categories with the largest growth rates were equipment and software (85 percent), travel (66 percent), and personnel compensation (53 percent) during 1988 to 1994. The percentage growth in Federal Reserve expenses for personnel compensation, equipment and software, building, and travel all exceeded the amount of inflation (25 percent). The most significant expense category during the period of 1988 to 1994 was personnel compensation, which accounted, in 1994, for nearly two-thirds of the Federal Reserve’s operating budget and over 70 percent of the total growth in the System’s operating budget. (See fig. 2.2.) Personnel compensation expenses increased from $858 million in 1988 to $1.3 billion in 1994—an increase of $456 million, or about 53 percent. Thus, any increase in personnel compensation costs would have a disproportionate impact on the overall increase in Federal Reserve spending. As shown in table 2.2, the overall increase in Federal Reserve operating expenses from 1988 to 1994 was about $646 million; personnel compensation accounted for about $456 million, or 71 percent, of this increase. Figure 2.3 shows the contributions (by percentage) of each major expense category to this $646 million increase. Increases in staffing levels and in the overall cost of benefits as well as the changes in the workforce composition of the Federal Reserve contributed to the rising cost of System personnel compensation in the 1988 to 1994 period. The percentage increases for the Federal Reserve’s staffing levels and its overall cost of benefits exceeded the comparable percentages for the federal government (see table 2.3). Salary growth in the Federal Reserve and the federal government was comparable during the period. More specifically, System benefits have been adjusted to account for the Federal Reserve’s decision to start, in 1987, to amortize the overfunded portion of its pension plan. The effect of this action has been to reduce the Federal Reserve’s expenses. In addition, the Federal Reserve started in 1993 to accrue the cost of health benefits for its retired employees. The federal government’s employee pension program is prefunded, but it and postretirement health benefits have an unfunded liability. While the federal government’s overall staffing level declined by 2 percent, the overall staffing level of the Federal Reserve increased from 24,829 to 25,744, or by about 4 percent. This percentage increase is about the same as employment growth in the federal government outside the Department of Defense. Viewed in terms of mission-related activities, the level of staffing shifted considerably from 1988 to 1994, as shown in table 2.4. The largest increase in staffing occurred in supervision and regulation, whose staff tend to be white-collar employees, primarily bank examiners. The second-largest increase occurred in support, due primarily to new, automated data-processing professionals, also white-collar staff. The largest decrease in staffing occurred in services to financial institutions, which is an area of activity with a larger proportion of blue-collar workers who handle functions in check and currency processing. Federal Reserve salary costs, which amounted to a total of about $1 billion in 1994, constituted 79 percent of System personnel compensation costs in 1994. During 1988 to 1994, the Federal Reserve salary costs increased by 44 percent compared to an increase of 33 percent for the federal government. Adjusting for the Federal Reserve’s increase in staffing, we compared the salary costs of the System and the federal government on a per employee basis for the period of 1988 to 1994. The results showed that the 39-percent increase in the per employee cost of Federal Reserve salaries was slightly higher than the 36-percent increase in the per capita salary cost in the federal government. The growth in the Federal Reserve’s overall salary costs can be attributed to the increase in new professional positions created by the Federal Reserve during 1988 to 1994. During 1988 to 1994, the cost of benefits represented an increasingly larger share of the Federal Reserve’s personnel compensation costs—16 percent in 1988 and 21 percent in 1994. During this same period, the cost of Federal Reserve benefits increased by 98 percent compared to an increase of 59 percent for the federal government. Again, adjusting for the Federal Reserve’s increase in staffing, we compared the benefit costs of the System and the federal government on a per employee basis for the period of 1988 to 1994. The results showed that the increase in the per employee cost of Federal Reserve benefits (96 percent) was higher than the increase for the federal government (62 percent). The difference in the growth of Federal Reserve and federal government benefits can be attributed to (1) higher costs for benefits offered to existing staff and (2) the additional cost of benefits for new positions created by the Federal Reserve in the period. Although travel and equipment and software expenses constituted a small portion of the System’s operating expenses, during 1988 to 1994, these expenses had the highest growth rates in operating expenses. As previously mentioned, equipment and software and travel expenses increased by 85 percent and 66 percent, respectively. The growth in the equipment and software expenses primarily resulted from the depreciation/amortization expenses in equipment, including computers and software. The cost of the Federal Reserve’s travel expenses increased significantly more than the federal government’s travel expenses during 1988 to 1994. The Federal Reserve’s travel expenses increased by 66 percent compared to 26 percent for the federal government. This may be due, in part, to differences in the travel policies of the Federal Reserve and the federal government. During 1988 to 1994, the Reserve Banks spent about $1.7 billion on capital acquisitions. Costs for capital expenditures are allocated to a budget separate from the Reserve Banks’ operating budget. During 1994, the Reserve Banks spent approximately $270 million to acquire capital assets, such as computer equipment and software for the Federal Reserve’s automation and consolidation project, which is known as FRAS. The Reserve Banks’ 1994 capital expenditures represented a 60-percent increase from the 1988 expenditures. However, unlike operating expenses, which increased steadily every year, the growth in the capital expenditures was somewhat sporadic, increasing in some years and decreasing in other years. We did not compare the Reserve Banks’ capital acquisitions to the federal government’s capital acquisitions because of the differences in the way capital spending is tracked. As previously mentioned, the large growth in the Reserve Bank’s capital expenditures was partially the result of FRAS. Three automation consolidation centers will consolidate most of the independent mainframe operations of the 12 Reserve Banks, providing consolidated mainframe and contingency support for, among other things, the Federal Reserve’s mission-critical payments system. The three FRAS centers are at the Dallas and Richmond Reserve Banks and the East Rutherford Operations Center of the New York Federal Reserve. As of December 31, 1994, the total capital acquisition cost, primarily for computer and software, was $242 million. While many commercial banks were downsizing their organizations and the federal government was constraining spending, the Federal Reserve’s costs were steadily increasing. During 1988 to 1994, the cost of operating the Reserve Banks and the Board increased by 48 percent—nearly twice the amount of inflation. The growth in the Federal Reserve’s operating budget was primarily produced by cost increases in the supervision and regulation area and in the expense categories of personnel compensation, travel, and equipment. Although the Federal Reserve’s expenditures increased in all five mission-related areas, supervision and regulation experienced the most growth during 1988 to 1994. The priced services area—where the Monetary Control Act requires the Federal Reserve to recover costs and the Federal Reserve competes with the private sector in providing services to financial institutions—had the lowest cost growth. Thus, where the System had significant incentives to constrain costs, it appeared to have done so. Personnel compensation costs, accounting for nearly two-thirds of the operating budget, grew by 53 percent during 1988 to 1994. Also, personnel compensation costs represented over 70 percent of the growth in the Federal Reserve’s operating budget. The growth in Federal Reserve benefits and the increase of professional employment at the Reserve Banks contributed to the rise in the Federal Reserve personnel compensation costs. The results of our review of many policies and practices of the Board and Reserve Banks indicated that opportunities exist to reduce the Federal Reserve’s spending. Federal Reserve personnel compensation (pay and benefits) varied within the Federal Reserve and included benefits that were relatively generous compared to those of government agencies with similar responsibilities. We also found that improvements and greater uniformity in Reserve Bank policies and practices relating to travel reimbursements, contracting and procurement, and construction planning could reduce operating and capital spending costs and reduce the Reserve Banks’ risk of potential conflict of interest and favoritism. For example, we found that the Federal Reserve overlooked opportunities to reduce costs in planning and managing the design of the new Dallas Reserve Bank building. Finally, we found that a reduction in annual Federal Reserve transfer to its surplus account, while not representing a direct reduction in Federal Reserve expenditures, would have a positive budgetary impact in the year that any such reductions occurred. The boards of directors of the 12 Reserve Banks supervise and control the Reserve Banks, subject to the general supervision of the Board of Governors. The Board employs individuals who are necessary to conduct the business of the Board. It also sets employee salaries and benefits; approves compensation paid by Reserve Banks to their employees; and establishes regulations, policies, and practices covering employee benefits. The Reserve Banks and Board have established differing employee pay levels and benefits. Except for the salaries of the Chairman and members of the Board, Federal Reserve salaries are not limited by ceilings established by the civil service pay system. Salaries at some other federal financial regulators, notably OCC and FDIC, also have not been limited by civil service pay rules. Two important objectives of the Federal Reserve’s compensation system are to (1) attract, retain, and motivate qualified employees at all levels of responsibility and (2) be externally competitive with local and/or regional labor markets. To accomplish these objectives, the Board and 12 Reserve Banks conduct individual salary surveys of private and public institutions with related job positions in local labor markets. The Board and Reserve Banks also survey other organizations periodically as they make benefit decisions. While we sought to understand the nature and scope of the Federal Reserve’s surveys, we did not verify or analyze the data and methodology used in these surveys. To determine whether opportunities exist to reduce the Federal Reserve’s costs of operation, we reviewed personnel pay and benefits at the Reserve Banks and Board. We compared the general procedures for setting Reserve Board and Banks’ salaries to those of the federal government. We compared the specific benefits offered Board and Reserve Bank employees to those of federal financial regulatory agencies with responsibilities analogous to some responsibilities of the Federal Reserve. The federal agencies whose salaries and benefits served as comparisons were FDIC, OCC, and the Securities and Exchange Commission (SEC). OCC and FDIC generally are not subject to civil service limitations in providing salaries and benefits to their employees, while SEC is subject to such limitations. We did not attempt to analyze differences in employee responsibilities when we compared Federal Reserve salary levels and benefits to those of FDIC, OCC, and SEC. The Federal Reserve attempts to offer salaries competitive with private sector organizations. The Federal Reserve is not constrained by maximum limits when setting its salaries for most positions. (The notable exceptions are the salaries for the Governors of the Board, including the Chairman.)In addition, both Board and Reserve Bank salaries are based on independent salary surveys of organizations that have similar local labor forces. As a result, the Federal Reserve offers salaries that are competitive with private sector organizations in a given locality. In contrast, most civil service salaries are subject to maximum levels, the highest of which is level IV of the executive pay schedule, which was $115,700 in 1994. In 1990, Congress passed the Federal Employees Pay Comparability Act (FEPCA), which provided for a comprehensive, long-term pay reform program designed to ultimately make federal salaries more competitive with the private sector. Under FEPCA, locality pay adjustments were to be phased in over a 9-year period beginning in 1994. The goal was to reduce pay disparities between federal white-collar workers and nonfederal workers to no more than 5 percent by the year 2002. However, budget constraints have already resulted in reductions of scheduled locality pay adjustments for federal workers for 1995 and 1996. Thus, in contrast to the Federal Reserve, civil service agencies, including SEC, have been unable to offer their employees salaries comparable to those in local labor markets. Other federal financial regulators do not face these constraints. FDIC employees received salaries with geographic differentials that amounted to up to 31 percent more than civil service basic pay levels. OCC’s salary structure, which had a maximum base salary of $166,400, also provided employees with geographic pay differentials of up to 34 percent of OCC’s base salary levels. FDIC and OCC salaries are, with some exceptions, not limited to ceilings established by the civil service pay system; notable exceptions are the salaries of members of FDIC’s board of directors and the salary of the Comptroller of the Currency. One interesting result of the statutory limits on the Governors’ salaries, coupled with the ability of the Federal Reserve to set competitive salaries for other positions, is that a substantial number of Federal Reserve employees are paid more than the Chairman of the Board. Specifically, 120 top-level Federal Reserve officials, including all Reserve Bank presidents, earned more in 1994 than the Chairman. In 1994, the annual salaries of Reserve Bank presidents ranged from $159,600 to $229,600, while the Board Chairman’s salary was $133,600 (the maximum allowed), and each of the other Board members’ salary was $123,100. Appendix III provides the titles and the number of Federal Reserve employees who earn more than the Board Chairman and also shows the 1994 salaries for the presidents of the 12 Reserve Banks. Although employee benefits at the Board and Reserve Banks differed in many respects, some Federal Reserve benefits were systemwide and available at the same levels to all Federal Reserve employees. Systemwide benefits included retirement plans, the thrift savings plan, business travel/accident insurance, life and survivor insurance, and a long-term disability income plan. Other benefits not offered on a systemwide basis included mass transit subsidies and leave granted for marriage, bereavement, family care, and floating holidays. From our review of the Federal Reserve’s personnel policies and practices, we found that a few Federal Reserve benefits were more generous than those available to OCC and FDIC and many were more generous than civil service benefits, such as those available to SEC. Also, the Federal Reserve provided additional benefits to some high-level officials, including home security systems, bodyguards, and home-to-work transportation in Federal Reserve-owned vehicles. All 12 Reserve Banks offered their employees comprehensive health insurance packages. Although the Board paid the same health care premiums as other federal agencies (payments that ranged from about 60 to 75 percent) the percentage of premiums paid by Reserve Banks differed. Most Reserve Banks paid 75 to 90 percent of health insurance premiums. Appendix III shows the percentage of health insurance premiums paid by the Reserve Banks, the Board, FDIC, OCC, and SEC. The total health care cost paid by the Board and the Reserve Banks in 1994 was $7.5 million and $64.9 million, respectively. Recognizing that health care costs are escalating, Reserve Banks are attempting to reduce health plan costs. Federal Reserve health care benefits were managed on a decentralized basis, with each Bank negotiating its own health care coverage. One Reserve Bank eliminated its preferred provider option previously available to employees, replaced it with a managed care network, and reduced the number of available health maintenance organizations. Federal Reserve officials estimated that health care costs would have been about $900,000 more for 1993 without these changes. Another Reserve Bank reduced the number of health care plans available to employees to two effective in April 1994; officials estimated resulting savings of about $2.3 million over the following 3 years. Although the Reserve Banks have individually made efforts to reduce health care costs, the Reserve Banks have not worked together to determine whether their combined bargaining powers would further reduce these expenses. The number of days allowed for annual and sick leave differed significantly among the Reserve Banks and between the Reserve Banks and the Board. The Board, along with FDIC, OCC, and SEC, followed the civil service guidelines, which provide between 13 and 26 days for annual leave and 13 days for sick leave each year. The number of annual leave days available to Reserve Bank employees ranged from 10 to a maximum of 23 to 32 days per year, depending on length of service. Thus, relatively junior Reserve Bank employees were granted fewer annual leave days than civil service permits, but more senior employees could accrue more annual leave days each year than civil service permits. However, some Reserve Banks offered additional paid leave for certain purposes, such as bereavement or marriage, which was in addition to annual leave. Among the Reserve Banks, the number of sick days employees accrue varied considerably. Six Reserve Banks offered fewer sick leave days annually than civil service employment (ranging from 8-1/4 to 12 days), while two others offered sick leave in the range of 15 to 18 days. Other Reserve Banks appeared to offer more generous sick leave policies. Tables III.7 and III.9 in appendix III show the leave benefits available at the Reserve Banks, the Board, FDIC, OCC, and SEC. Federal Reserve Board and Bank employees do not participate in the retirement programs that cover most federal civilian employees. Separate retirement programs apply to Board and Reserve Bank employees. Before 1983, Board employees, along with federal employees in general, were not covered by the Social Security program. Board employees were under the Federal Reserve Board Retirement System (FRBRS), and other federal employees were under the Civil Service Retirement System (CSRS). Even though they were separate, the two systems’ provisions were virtually identical. In contrast, Reserve Bank employees were not considered to be employed by the federal government. They were covered by Social Security and a separate retirement system designed to complement their Social Security benefits. The Social Security Amendments of 1983 required all federal employees, including Board employees, first hired after December 1983 to participate in Social Security. Accordingly, new retirement systems had to be developed to recognize the availability of Social Security benefits for the covered employees. The Federal Employees’ Retirement System (FERS) was developed to cover federal employees in general. However, rather than develop a new retirement system for future Board employees, the Federal Reserve decided that they would be covered by the retirement system already in place for Reserve Bank employees. In addition to the pension benefits available from the FRBRS and Reserve Bank retirement systems, Board and Reserve Bank employees can earn additional retirement income through participation in a thrift plan sponsored by the Federal Reserve. The thrift plan includes two components—a savings account and a deferred compensation account. Employees may contribute to either or both accounts. Employee contributions to the savings account are made with after-tax dollars, and contributions to the deferred compensation account are made with pretax dollars. For each dollar an employee contributes to the thrift plan, up to 6 percent of salary, the Federal Reserve matches 80 percent of the employee’s contributions. Thus, the maximum employer contribution to any employee’s thrift plan is 4.8 percent of salary. Employees may contribute additional amounts to the thrift plan with no matching contributions by the Federal Reserve. Even though the pension benefits available to other federal employees in CSRS and Board employees in FRBRS are the same, Board employees have the distinct advantage of being eligible to participate in the thrift plan and receive matching contributions from the Federal Reserve. Employees in CSRS may contribute to a thrift plan, but receive no contributions from their employing agencies. The Reserve Bank pension plan differs from the FERS pension plan that applies to federal employees in general. Some of the features of the Reserve Bank plan are less generous than the counterpart features of FERS. For example, Reserve Bank plan’s benefits are based on employees’ average salaries earned during their 5 highest-paid years, while FERS’ benefits are based on employees’ average salaries earned during their 3 highest-paid years. Also, Reserve Bank employees must be at least age 60 with 30 years of service to retire with unreduced retirement benefits, while FERS provides unreduced benefits as early as age 55 with 30 years of service. However, these FERS advantages are more than offset by a number of significant features of the Reserve Bank plan that are superior to FERS. Some of the features where the Reserve Bank plan is more generous than FERS are as follows: The Reserve Bank plan is free to employees; FERS requires employees to contribute .8 percent of their salaries toward plan costs. The Reserve Bank plan’s benefit calculation formula provides considerably greater benefits than the FERS formula. In the Reserve Bank plan, benefits are equal to 1.3 percent of average salary up to the Social Security integration level and 1.8 percent of average salary over the integration level multiplied by total years of service. (The integration level is the average of the maximum amounts of salary covered by Social Security from 1959 through the year of retirement. For employees retiring in 1995, the integration level was $24,312). In the FERS plan, the formula for each year of service is 1.1 percent of average salary for retirees who are at least age 62 with 20 years of service. For retirees who are younger than age 62, the FERS benefit formula is 1 percent of average salary for each year of service. The Reserve Bank plan allows employees as young as age 50 to voluntarily retire early with reduced benefits. FERS does not have a similar provision. Under FERS, employees cannot voluntarily retire before age 55 unless they or their agencies are facing involuntary employee separations. FERS also includes a thrift plan to which covered employees and their agencies can contribute to increase retirement income. The FERS thrift plan is designed somewhat differently from the Federal Reserve thrift plan; overall, it provides slightly greater benefits to participating employees. Unlike the Federal Reserve thrift plan, all employees in FERS receive agency contributions equal to 1 percent of their salaries regardless of whether the employees make any contributions. The agencies then match, dollar-for-dollar, employee pretax contributions of up to 3 percent of salary and 50 cents on the dollar for the next 2 percent of salary that employees contribute to the thrift plan. Thus, compared to the maximum 4.8 percent of salary the Federal Reserve will contribute to an employee’s thrift plan, employing agencies will contribute as much as 5 percent of employees’ salaries to the FERS thrift plan. Also, to receive the maximum employer contribution of 4.8 percent of salary, Board and Reserve Bank employees must contribute 6 percent of their salaries. Employees in FERS can receive employer contributions of 5 percent of salary by contributing 5 percent of their salaries to the FERS thrift plan. As shown in table 3.1, the Federal Reserve offered a few benefits to its employees that are generally not offered to civil service employees. These benefits included separate dental insurance, subsidized employee cafeterias, premium conversion accounts, flexible spending accounts, matching contributions for savings accounts, and mass transit subsidies. In addition, some banks offered marriage, bereavement, parental care, and floating holiday leave as leave categories separate and distinct from the usual annual and sick leave offered. Appendix III provides a full description of these selected Federal Reserve benefits and their availability at FDIC, OCC, and SEC. To determine whether opportunities existed to reduce the Federal Reserve’s operational costs, we also reviewed travel reimbursement policies within the Federal Reserve. Each year, the Board and the Reserve Banks spend millions of dollars for employee travel. In 1994, for example, the total of travel expenditures for the Federal Reserve was $42 million. According to Board officials, Board personnel are authorized to use government rates for lodging and airfare. Some Reserve Bank officials we interviewed stated that Reserve Bank employees are ineligible for government rates for lodging and airfare because the Reserve Banks are not federal agencies. However, one Bank official disagreed, stating that Reserve Bank employees can request government rates for lodging, but cannot insist on receiving government rates. Under regulations comparable to those for other federal employees, Board employees are reimbursed for lodging and meal expenses on a per diem basis. However, members of the Board are permitted to receive reimbursement for domestic lodging and meals on either an actual expense or per diem basis, when deemed appropriate. The Board’s general policy directive for Reserve Bank travel expenditures allows for variations in Reserve Bank reimbursement procedures. These differences can result in additional expenditures. One Reserve Bank we reviewed had maximum lodging reimbursement rates, while another Reserve Bank had recommended reimbursement rates. However, two Reserve Banks reimbursed at cost without maximum or recommended rates. As a result of these policy differences, two travelers’ overnight lodging allowances for the same city could vary widely, depending on each traveler’s Reserve Bank. In addition to the differences noted in lodging costs, Reserve Banks reimbursed employees for meals using varying schedules and rates. Two Reserve Banks reimbursed travelers for meals on the basis of a schedule that divided the day into four quarters, while another Reserve Bank used a more narrowly defined schedule that aligned with typical meal times. Additionally, another Reserve Bank reimbursed travelers for meals depending on whether they were traveling to a Federal Reserve System entity versus other locations. Of the Reserve Banks we reviewed, two also allowed employees to choose actual cost reimbursement rather than a flat per diem rate. As a result of these policy differences, the total meal reimbursement for a 3-day trip to the Board in Washington, D.C., could range from $76 to $105. We believe making travel policies uniform within the Federal Reserve could provide an opportunity to reduce Federal Reserve expenses, particularly if caps on reimbursements were set below current levels. In addition, more uniform policies could result in some administrative costs reductions, particularly if common travel policies would enable travel expenses to be managed on a more centralized basis, thus reducing the need for staff time devoted to travel administration at each Reserve Bank. To determine whether opportunities existed to reduce the Federal Reserve’s operational costs, we also reviewed procurement and contracting practices at several Reserve Banks. Unlike personnel costs that remain relatively stable, expenses associated with capital acquisitions can vary significantly from year-to-year, offering additional opportunities for controlling and reducing procurement costs. The 12 Reserve Banks spent more than $560 million in 1994 to acquire buildings, equipment, supplies, and services. Nearly half of the total ($267 million) was used to buy capital items (buildings and equipment) and fund building projects. As discussed in chapter 1, only depreciation costs of capital assets are accounted for in annual operating budgets. Because the Board and Reserve Banks spend millions each year for goods and services, certain controls should be in place to ensure that those dollars are spent wisely. For example, the Reserve Banks should have an effective procurement and control process in place to ensure that they receive goods and services at the most reasonable cost. Moreover, to prevent fraud and abuse, the procurement practices should also preclude potential conflicts of interest between the Reserve Banks and contractors. The Board and the Reserve Banks used different procurement guidelines. Although not specifically directed to do so by the Federal Reserve Act, a spokesman for the Board told us that the Board follows the spirit of the federal government contracting rules, which are contained in the Federal Acquisition Regulations (FAR). Reserve Banks are not required to follow these rules. However, each Reserve Bank is required to follow general procurement guidance, called Uniform Acquisition Guidelines (UAG), which were adopted by the Reserve Banks in 1985. The UAGs were developed by the Reserve Banks in conference committees. They were designed to provide minimum requirements for Reserve Bank procurement activities. By providing opportunities for all interested bidders to become a selected source, the guidelines attempt to ensure that Reserve Banks treat sources fairly and impartially. By fostering competition in the procurement process, Reserve Banks will also have a greater opportunity to realize cost savings through lower competitive pricing. Despite the UAGs, we observed the following: Practices at individual Reserve Banks differed significantly and some practices favored certain sources over others. For instance, some Reserve Banks did not allow an equal opportunity for new bidders to bid for large procurements and limited bidders lists to sources with which the Reserve Banks had traditionally done business. This practice existed even though other equally qualified sources were both available and interested. Furthermore, some Reserve Banks retained incumbent contractors for certain services for years without recompeting the award, thus precluding other firms from competing for those services. At one of the four Reserve Banks we visited, the records indicated that the cafeteria contract was last competed over 9 years ago. At another Reserve Bank we visited, personnel could not locate documentation of their last cafeteria contract negotiations, which they believed occurred in the late 1980s. By limiting the ability of other sources to compete for a contract, Reserve Banks tend to reduce competition, thereby missing opportunities to reduce procurement costs. Proper controls over conflict of interest were not followed at certain Reserve Banks. For instance, the UAGs prohibit disclosure of specific information contained in bids or proposals to anyone except Reserve Bank personnel before awarding the contract. However, two of the four Reserve Banks we visited transferred almost all functions leading up to the award of major building contracts to architecture and engineering (A&E) firms. A&E firms receive and evaluate bids and recommend the source that should receive the award. In contrast, at the other two Reserve Banks we visited, only Reserve Bank personnel were allowed to receive and evaluate the bids or proposals and choose the successful source. The building department’s vice president at one of the four Reserve Banks told us that the larger the role the A&E firm plays, the greater the potential for favoritism and conflict of interest. Practices at certain Reserve Banks lacked independent checks and reconciliations. Although each Reserve Bank should have controls for independent checks and reconciliations of voucher payments, at two of the four Reserve Banks we visited, only the building department was responsible for authorizing progress payments made to construction contractors. At both Reserve Banks, officials responsible for the payment function, where the reconciliation should take place, did not track payment amounts against the total available contract dollars. Instead, when vouchers were received that showed the approval of the building department, the vouchers were paid. Noteworthy practices used by certain Banks were not disseminated among the Reserve Banks. Several Reserve Banks had procedural strengths or notable practices that were missing in others. Building department officials at one of the four Reserve Banks requested and analyzed various elements of cost included in construction proposals, which enabled them to evaluate the proposed prices. They had found that challenging the bids/proposals from construction contractors resulted in improved understanding of what is required, as well as better quality and lower prices. However, we found no evidence that information about these “best practices” was being disseminated within the Federal Reserve. Specifics on these practices are described in appendix IV. To determine whether opportunities exist to reduce the Federal Reserve’s operational costs, we also reviewed decisions related to the construction of the Dallas Reserve Bank facility. Even though the cost of the Dallas building project was $8 million less than the initially approved budget and construction was completed ahead of schedule, opportunities existed for the Federal Reserve to reduce costs. In two areas, we found that the Reserve Bank could have cut costs approved by the Board. First, the Dallas Reserve Bank building was larger than the plan initially specified; second, the Reserve Bank purchased more land than necessary. Since the building contained enough square footage to meet the projected space-study needs through 2017, the purchase of additional acreage for expansion purposes had questionable value. By July 1988, the Dallas Reserve Bank had outgrown its original building. The building could not house all employees, no longer complied with the evolving building codes, and contained many space deficiencies. Faced with these problems, Dallas Reserve Bank officials commissioned a study, to identify alternatives that would resolve the space problems. As a result of that study, in November 1988, the Dallas Reserve Bank recommended that the Board: approve a space plan for a building with 540,334 net usable square feet, which would satisfy the Reserve Bank’s projected needs through 2017; locate the new building on land within the Central Business District (CBD), which would provide the most effective and appropriate solution for satisfying the Reserve Bank’s space needs over the long term; approve a target budget of $171.8 million for the construction of a new building on a new site; and authorize the Reserve Bank to proceed with a site selection and conceptual design for a new building. In January 1989, the Board approved the Dallas Reserve Bank’s proposal to construct a new building at a new location within the Dallas CBD. The Board-approved plan had a target budget of $171.8 million and a target completion date of August 1992. In July 1990, the Board authorized the Dallas Reserve Bank’s proposal to follow an expedited (or “fast track”) construction plan. This approach allowed the Reserve Bank to begin construction with incomplete construction drawings and without finalized subcontract agreements. Additionally, the Board lowered the final budget for the land purchase and new building design and construction to $164.5 million. The expedited construction plan also allowed occupancy 3 months ahead of schedule. The proposal submitted by the Dallas Reserve Bank to the Board called for the construction of a 540,334 square foot building. The building requirements for the Reserve Bank’s new facility were based on the Board’s projected space requirements. The Board requires that new building projects allow for 15 years of personnel growth and 25 years of vault and other space growth. The Dallas Reserve Bank hired a consultant to determine the projected space needs on the basis of the Board criteria. The space study found that 540,334 square feet would allow for 15 years of personnel growth through 2007 and that 580,093 square feet would allow for 25 years of equipment growth though 2017. The completed building contains 595,385 square feet, which is 55,051 square feet more (about 10 percent) than the initially approved square footage. In addition, the new building’s square footage was more than the 580,093 square feet the bank is projected to need in 2017. The two areas most overbuilt, in terms of total square feet and percent authorized, were the data services and lobby areas. In the data services area, 70,167 square feet were authorized by the Board. However, in the completed building, the final square footage for data services was 90,860, or 29 percent more than was authorized. The building’s two lobby entrances called for 7,800 in total square feet, while the actual square footage on completion was 27,369, or an increase of 250 percent. According to a Reserve Bank official, the architect’s plan provided for more space than was approved by the Board. However, the additional space did not cause concern since the design and construction costs for the plan were less than the budgeted amount approved by the Board. The Dallas Reserve Bank purchased, with the Board’s approval, 8.02 acres of land for $27.7 million, or $79.30 per square foot. They needed 6.02 acres for new building construction and purchased the additional 2 acres for future building expansion or sale. Since the building design exceeded projected space needs through 2017, the need for additional land was redundant. According to a senior official at the Dallas Reserve Bank, the Bank could have purchased only the 6.2 acres for approximately $20.7 million and foregone the additional 2 acres for a total savings to the Federal Reserve of $7 million. Downward adjustments to the surplus account, or its elimination, would have a positive budgetary impact by increasing the amounts returned to Treasury in the years that they occur. The current formula for calculating the amounts to be contributed to surplus accounts is as follows. Each Reserve Bank’s capital stock is by law equal to 6 percent of the paid-in capital and surplus of its member banks. Annually, as banks’ paid-in capital and surplus grow or shrink, member banks are required to adjust the amount of their Federal Reserve Bank stock to equal 6 percent of their paid-in capital and surplus. The Reserve Banks then contribute, out of Federal Reserve earnings, amounts to their surplus accounts so that the surplus balances are equal to the amount of paid-in capital. During 1988 to 1994, the total of the surplus accounts systemwide increased 79 percent, from $2.1 billion in 1988 to $3.7 billion in 1994. The Federal Reserve has stated in its publications that the purpose of the surplus accounts is to ensure that adequate capital is available to absorb possible losses. In its monetary policy, lender of last resort, and payment system activities, the Federal Reserve is exposed to risks that could potentially generate large losses. However, because the Federal Reserve’s interest income so far exceeds its expenses, we believe it is highly unlikely the Federal Reserve will ever incur sufficient annual losses such that it would be required to use any funds in the surplus account. In the years 1914 and 1915, the first 2 years of its operations, the Federal Reserve experienced net losses. However, every year since then, for 79 years, the Federal Reserve has recorded substantial net profits. The profits for 1994 were $20 billion and expenses, including losses, were about $3 billion. We could find no criteria to use in assessing the amount held in surplus. According to Federal Reserve officials, the methodology for deciding that amount has changed and is somewhat arbitrary. Currently, and in the past, the levels of the surplus account have been discretionary because the requirement to have the surplus account equal to paid-in capital has been a matter of Federal Reserve policy; it was not required by law. However, in a provision of the Omnibus Budget Reconciliation Act of 1993, Congress required the Federal Reserve, in fiscal years 1997 and 1998 only, to calculate the surplus account using the current formula and then to reduce the account by $106 million in fiscal year 1997 and $107 million in fiscal year 1998. Although the law did not specifically state the purpose of those transfers, its effect was to reduce the federal government’s projected deficit in those years. Considering that this provision only applies to fiscal years 1997 and 1998 and the general lack of criteria for assessing surplus amounts, Congress may wish to determine whether these surplus accounts are necessary and, if so, set permanently in law an appropriate amount for these accounts. Because the Federal Reserve’s spending represents a cost to U.S. taxpayers, the Federal Reserve should operate as efficiently as possible. Our review indicates opportunities exist to reduce Federal Reserve spending. Federal Reserve expenditures for personnel benefits varied among Reserve Banks and some benefits were generous compared to those of federal agencies with similar responsibilities. Also, we believe that opportunities exist for reductions in discretionary spending for health care and travel costs through the systemwide management of these areas. Although several Reserve Banks have undertaken efforts to reduce their health care costs, we believe that centralized management of the Federal Reserve’s health care plans could further reduce health care costs. Furthermore, we believe travel expenses could be reduced by adopting the most cost-effective “best practices” in travel reimbursement policies. Although instituting uniform, cost-conscious practices at all Reserve Banks may appear contrary to the tradition of independently managed Reserve Banks, the Reserve Banks have adopted uniform policies and procedures in many areas of operation. Our review of contracting and procurement practices at some Reserve Banks also indicate opportunities to reduce discretionary spending for goods and services. We believe that the Federal Reserve could better ensure the purchase of goods and services at reasonable cost through increased compliance with UAG as well as systemwide adoption of “best practices” in procurement and contracting. Moreover, in its planning and management of the Dallas Reserve Bank construction project, the Reserve Bank overlooked opportunities to reduce spending that the Board had approved. Downward adjustments to the surplus account, or its elimination, would have a positive budgetary impact by increasing the Federal Reserve’s annual transfer to Treasury in the years that any such reductions occur.Federal Reserve deductions would have to exceed the billions of dollars transferred to Treasury annually before the Federal Reserve’s use of the account would be necessary. Since the chances of an occurrence of such an event are extremely remote, we believe that capping, reducing, or even eliminating the surplus account represents an opportunity to decrease deductions to the amount transferred to Treasury each year. We recommend that the Board of Governors review pay and benefits levels at the Board and the Federal Reserve Banks to determine if current levels can continue to be justified in today’s environment of increased governmental and private-sector cost containment; assess whether managing the Federal Reserve’s health care coverage on a systemwide basis could reduce health care costs; review travel policies at the 12 Reserve Banks and change those policies review contracting and procurement practices at the 12 Reserve Banks to ensure that these practices are in compliance with the system acquisition guidelines and result in cost-effective contracts; ensure that the “best practices” in contracting and procurement at the 12 Reserve Banks are regularly identified, disseminated, and adopted by the Reserve Banks; and review policies regarding the size of the surplus account and determine if opportunities exist to decrease the amount held in the account. Congress should consider the results of the Board’s review and decide if there is a continued need for the Federal Reserve’s surplus account and, if so, what the appropriate amount of the account should be. In written comments on a draft of this report, the Federal Reserve’s Board of Governors did not agree with our recommendations that they review pay and benefits levels and consider reducing or eliminating the surplus account. The Board stated that the Federal Reserve strives to provide salaries and benefits competitive with local private sector markets and that its current pay and benefits levels are necessary to attract and retain skilled employees. The Board agreed that the appropriate level of the surplus account is open to debate, but it did not agree to consider reducing or eliminating the surplus account. The Board stated that reducing the surplus account would have no real economic impact and cited the possibility that, without the surplus account, temporary short-term losses could lead to a perceived impairment of its capital that could raise investors’ concerns about the System’s ability to conduct sound monetary policy. The Board agreed with our recommendations concerning the Federal Reserve’s policies and practices regarding travel, contracting, and procurement. The Board also agreed with our recommendation concerning the management of health care benefits. Because personnel costs accounted for almost 70 percent of the Federal Reserve’s total operating costs and increased by over 50 percent in the 1988 to 1994 period, we believe these costs should be one of the first areas to be examined for potential savings. We acknowledge that certain benefit levels may be necessary for the Federal Reserve to attract and retain a skilled workforce. However, we do not believe the Board has made a convincing case that these benefits need not be reexamined with a view toward greater cost containment. In addition to the private sector, the Federal Reserve also competes with public sector employers, and its benefits are clearly more generous than those of the federal government overall. In some cases, the Federal Reserve’s benefits are more generous than those of the other financial industry regulators who are the major employer-competitors in areas such as bank supervision. Moreover, we note that less than half of the Federal Reserve’s total workforce is highly skilled professional staff, such as lawyers, economists, and financial analysts. We maintain, and the Board agreed, that reducing or eliminating the surplus account, by transferring these funds to Treasury, would increase overall government receipts and reduce the unified budget deficit in the year that any such transfer occurred. We also agree with the Board that reducing or eliminating the surplus account would be offset by a reduction in subsequent years of interest payments to Treasury that the Federal Reserve would have otherwise earned by investing these funds in government securities. However, we believe Congress has a legitimate interest in deciding whether it would be more appropriate to have these funds returned immediately, either to reduce the outstanding public debt or for other purposes, rather than to receive them over a longer period of time. To allow for the possibility that a small, temporary loss could raise investor concerns about the Federal Reserve’s ability to conduct sound monetary policy, we suggested that Congress may wish to set an appropriate level for the surplus account as an alternative to its elimination. The Federal Reserve System faces major challenges in its mission and lines of business, particularly in services to depository institutions and government agencies and in bank supervision. These challenges include (1) increased competition from the private sector and increasing difficulties in recovering costs in priced services, (2) increasingly widespread use of electronic transactions in the financial services industry, and (3) the continuing rapid consolidation of the banking industry, which could affect both the need for, and the distribution of, bank examination staff. Because these areas account for the largest part of the Federal Reserve’s expenses and staffing, addressing these challenges effectively will likely result in major changes in how the Federal Reserve operates. As the Federal Reserve undertakes to meet these challenges, it is also likely to find that its current structure, established in 1913 when the nation’s financial industry was much less complicated, is increasingly inappropriate for the fast-paced, global financial world of today and the next century. However, if major changes to the Federal Reserve’s structure are to be made to promote increased efficiency and competitiveness, such changes will need to be carefully weighed against any potential effects on the independence of our nation’s central bank. The overwhelming majority of the workload and expenses incurred at the Reserve Banks is related to three lines of business—services to depository institutions, services to government agencies, and bank supervision and regulation. These lines of business account for over 90 percent of all Federal Reserve Bank expenses, as shown in table 4.1. Except for bank supervision, most of this workload is production-oriented, whether paper driven, such as processing currency for banks and clearing checks, or electronic in nature, such as running the automated clearinghouse and funds transfer systems. In these areas, employees often work in shifts, under fairly rigid deadlines and production expectations. These three lines of business are precisely the areas subject to an increasing variety of external and internal environmental pressures and challenges. In providing services to depository institutions, the Federal Reserve faces its most immediate and significant challenges to its mission. The Monetary Control Act of 1980 requires that the Federal Reserve base its fees for certain services—check processing, automated clearinghouse (ACH) transactions, Fedwire, securities transfers, etc—on, among other things, the costs of providing such services. At the same time, the Federal Reserve is required to promote the accessibility and efficiency of the nation’s payments system, a role that may make it difficult for the Federal Reserve to raise prices sufficiently to recover its costs. Because services to depository institutions represent over 61 percent of all Federal Reserve Bank expenses and employ the largest part of Reserve Bank staffing, these changes are likely to have a dramatic effect on the size of the Reserve Banks’ expenses, workload, and staffing needs. The Federal Reserve faces intense competition in check clearing. In 1993, for the first time in a number of years, the actual volume of checks handled by the Federal Reserve declined, albeit by a modest 0.2 percent. The Federal Reserve reported that the total volume of commercial checks for 1994 declined by almost 15 percent from 1993 levels. The implementation of same-day settlement rules by the Federal Reserve, beginning on January 3, 1994, is partly responsible for this declining trend. Federal Reserve officials told us they expect further declines in the years ahead. A significant factor in the Federal Reserve’s loss of volume and market share in check clearing is the growth of private clearinghouses. The nation’s check-clearing volume is still growing slowly, but on a per capita basis, the volume is stagnant. At the same time, private clearinghouses competing with the Federal Reserve have grown. The California Bankers Clearing House, the Chicago Clearing House, and the Clearing House Association of the Southwest reported increases in the numbers of member banks in 1994. The California Bankers Clearing House also reported that it is delivering checks to 200 nonmember banks for same-day settlement and, in the process, saving its member banks $3.2 million a year in fees these banks would have had to pay the Federal Reserve for these services. Other factors promise even further reductions in check-clearing volume for the Federal Reserve. These factors include electronic check presentment, in which only the essential check data are recorded and transmitted to the payor bank so that payment or return decisions can be accelerated; check imaging, which involves the use of digitized images of entire checks to perform processing operations; banking consolidation and increased interstate banking, resulting in the increase of “on us” checks, which will not need to go through a clearinghouse, and electronic banking, which is now being offered by some banks, could, in the long term, make paper checks an anachronism. In combination, these factors indicate a continued and perhaps accelerating decline in the Federal Reserve’s check-clearing business. About 22 percent of all Reserve Bank employees were involved in check clearing in 1994. As volume declines, the Federal Reserve will need to prepare for reductions in staff required for cost-competitive services. In other priced services, the Federal Reserve is also likely to face increased competition. The market share of private ACH providers, such as the New York Automated Clearinghouse, the Arizona Clearinghouse Association, and VISA will likely increase. Even in book-entry securities transfer services, an area where the Federal Reserve currently faces only nominal competition, the Federal Reserve is anticipating that future developments could lead to increased competition. The Federal Reserve is facing increased difficulty in recovering its costs for priced services. As shown in table 4.2, costs have outpaced revenues since 1990 in three of the Federal Reserve’s priced services. Some of the difficulties in recovering costs stem from higher than anticipated automation consolidation costs associated with the Federal Reserve Automation Services (FRAS). (See chs. 2 and 5 for details on the FRAS project.) These costs have been a particular problem in check clearing. In recent times, the Federal Reserve has been able to mitigate the effects of these trends in several ways: The Federal Reserve has simply deferred certain automation consolidation costs to future years. The Federal Reserve has reduced its targeted return on equity. In 1993 and 1994, the target rate of return was about 5 percent, which was historically a low rate of return, primarily because of losses that bank-holding companies experienced in 1989 and 1991. Past overfunding of the Federal Reserve’s pension plans has enabled the Federal Reserve to offset some additional costs of providing priced services by allocating a portion of the overfunding to priced services, resulting in a decrease in expenses for those services. In 1993, for example, the amount of the overfunded plan allocated to priced services was $36.7 million. Even so, the impact of the overfunded pension plan was not sufficient to enable the Federal Reserve to meet its targeted return on equity in 1994. The overfunding will be completely amortized in the year 2002. These conditions are all temporary. The Federal Reserve will be faced with increasing pressures on its pricing policies. For example, with regard to the return on equity, median rates of return on equity among large bank-holding companies are now in the 15- to 16-percent range, so the target rate of the Federal Reserve may have to move toward that number. Meeting a 15-percent target rate of return on equity would require the Federal Reserve to increase its revenue by about $50 million, which amounts to about a 7-percent across-the-board price increase. Several changes in services to Department of the Treasury and other government agencies, and depository institutions, could have a significant impact on Federal Reserve costs as well as on staffing levels and alignment. These changes include consolidation of U.S. savings bonds operations, increased government use of electronic benefit transactions, and changes in the U.S. currency. Treasury, which directs the U.S. government’s savings bonds program, ordered the Federal Reserve to consolidate its savings bonds operations to five locations. This consolidation has resulted in the need to relocate staff at Reserve Banks that were losing savings bonds operations. Most of the savings bonds employees at nonconsolidation Reserve Bank locations have been relocated to other departments at their respective Reserve Banks. However, one Reserve Bank could not relocate all of its savings bonds employees to other departments and was forced to lay off some of those employees. An increased use of electronic payments in services provided to Treasury and other government agencies may also result in realignments or reductions in staff at Reserve Banks. The National Performance Review’s (NPR) recommendation that the U.S. Department of Agriculture distribute food stamp benefits through Electronic Benefits Transfer (EBT) may result in the realignment of Reserve Bank staff. EBT uses an automated financial transaction process and card access technologies to electronically deliver federal and state benefits to recipients via point-of-sale (POS) terminals and Automated Teller Machines (ATM). Currently, the Federal Reserve receives the paper coupons deposited by merchants at their financial institutions, confirms the totals, checks for counterfeit coupons, destroys the coupons, credits the sending institution’s account, and debits the U.S. Treasury account for the value of the food coupons. Under the EBT system, funds would be transferred electronically from the U.S. Treasury’s bank account to the retailer’s depository account via the automated clearinghouse (ACH). Recently, Texas converted its food-stamp operations to an EBT arrangement. This necessitated the Dallas Federal Reserve Bank’s eliminating 22 positions in its food-stamp processing area. Introduction of a 1-dollar coin, which is currently being considered by Congress, could result in dramatic staffing reductions in Reserve Banks’ currency processing operations. Many nations use a coin for monetary transactions at, and in many cases well above, the level for which the United States uses a paper dollar. Although the Susan B. Anthony 1-dollar coin was not accepted by the public when it was introduced in 1979, a switch to a 1-dollar coin, particularly if the paper dollar were withdrawn from circulation, could nevertheless reduce Federal Reserve expenses and result in savings to the taxpayers. One-dollar paper notes make up approximately 40 percent of the currency processed by Federal Reserve Banks. Officials told us that if the 1-dollar coin were introduced and the 1-dollar bill were removed from circulation, substantial reductions in currency processing staff would need to be made, perhaps resulting in the elimination of the second shift processing at many Reserve Banks. The continuingly intense banking industry consolidation would likely affect the locations and need for Federal Reserve bank examination staff. As banks merge or are acquired, the Federal Reserve will face the need to reexamine its current distribution of examination staff. Some Reserve Banks may see a need for increased staffing; others may find that they must radically reduce their examination staffs. As an example, figure 4.1 shows the percentage changes in the number of state-member banks by Federal Reserve district for the period of 1990 to 1995. Less certain are the potential effects of any bank regulatory consolidation Congress may enact. Differing consolidation proposals have been made to consolidate federal financial institutions’ regulatory responsibilities. Some proposals would provide for the complete consolidation of all regulation into a single federal regulator. Other proposals envision retaining or even increasing the responsibilities of the Federal Reserve in bank supervision. Some proposed changes to the banking regulatory structure have raised policy issues about the Federal Reserve’s role in bank regulation. The Federal Reserve has raised strong objections to a new regulatory system in which its role in direct bank supervision would be eliminated or substantially reduced. Federal Reserve officials argue that the System’s ability to conduct monetary policy and operate the payments system and the discount window would be greatly impaired by the removal of its responsibilities for regulating and supervising bank-holding companies and state-member banks. Likewise, those who support maintaining the Federal Reserve’s involvement in bank regulation argue that if the Federal Reserve is to be responsible for forestalling financial crises and effective as the “lender of last resort,” the Federal Reserve must have direct experience with at least a portion of the depository institutions. On the other hand, others argue that the Federal Reserve can obtain information needed for monetary control through other means, such as reports from other agencies or Board representation on other agencies. Because supervision and regulation activities account for approximately 20 percent of Federal Reserve Bank operating expenses, a reduction in the central bank’s direct role in bank supervision and regulation could have a significant impact on the Reserve Banks. Conversely, if the Federal Reserve were given responsibility for some or all of the largest banks, the percentage of the banking system assets for which the Federal Reserve would be the primary regulator could increase. While assigning large banking organizations to the Federal Reserve would address concerns about systemic risk, this could change the geographic distribution of Federal Reserve supervisory responsibilities. Such a redistribution would, of course, affect expenditures at individual Reserve Banks. The Federal Reserve’s revenues, and hence its return to the taxpayers, would be enhanced by charging fees for bank examinations. Federal bank regulators differ in their policies regarding the assessment of fees for bank examinations. The Office of the Comptroller of the Currency (OCC) charges national banks for examinations that it conducts. In contrast, state-chartered banks, which are supervised by either the Federal Reserve or the Federal Deposit Insurance Corporation (FDIC) in conjunction with state-banking agencies, are charged fees by those state-banking agencies but not by their federal regulator. Thus, the costs of the Federal Reserve’s bank examinations—$368 million in 1994—are borne by the taxpayers, while for national banks, the costs of examinations are borne by the banks that are examined. The Federal Reserve Act authorizes the Federal Reserve to charge fees for bank examinations, but the Federal Reserve has not done so, either for the state-member banks it examines or the bank-holding company examinations it conducts. Similarly, FDIC is authorized to charge for bank examinations but does not do so. The administration’s fiscal year 1996 budget includes provisions for both FDIC and the Federal Reserve to charge for bank examinations. The Federal Reserve is concerned that if it instituted charges for its bank examinations it could create incentives for state-member banks, who are already charged for state examinations, to either change their charters to national charters or resign membership in the Federal Reserve (opting to be supervised by FDIC as state-nonmember banks), to avoid paying fees for both state and federal examinations. Such incentives, the Federal Reserve believes, would have major disruptive effects on the dual banking system. We believe any disruption would be small. At the end of 1994, there were 3,078 national banks with 56 percent of total bank assets, 6,398 state-chartered nonmember banks with 23 percent of total bank assets, and only 974 state-chartered member banks with 21 percent of total bank assets. Thus, the number of banks that would be affected is relatively small. If the FDIC also adopted examination fees, incentives for banks to become state-nonmember banks to avoid such fees would be eliminated. With respect to double-charges for bank examinations, we believe an equitable fee-sharing arrangement with state agencies that is based on the division of supervisory responsibility seems possible. Moreover, charging for bank-holding company examinations would not present such possible disruptions because the Federal Reserve is their federal regulator, regardless of whether the subsidiary banks are chartered by OCC or the states. Charging holding company examination fees might also encourage greater efficiency in supervising banking organizations. Addressing the challenges discussed above will likely result in dramatic changes in staffing and how work is done at the Reserve Banks. In addition, continuing pressures to contain costs, in part fueled by the increasing competition from the private sector in priced services, may result in changes in how Federal Reserve programs are managed. Taken together, such changes will likely call into question the continuing appropriateness of the Federal Reserve’s current structure. Changes that can affect many of the Federal Reserve’s lines of business—particularly those concentrated at the Reserve Banks, such as check clearing, currency processing, and bank supervision—may result in substantial reductions in staffing at the Reserve Banks in the years ahead. These trends are already beginning to occur. Overall staffing at the Reserve Banks has declined modestly by 1.4 percent from the first quarter of 1994 to the first quarter of 1995. And staffing in the line of business, services to financial institutions and the public, which includes priced services, declined somewhat more—by 2.2 percent. Some Reserve Banks have offered “early out” retirements to some employees to encourage reductions during 1988 to 1994. As Reserve Banks contract in size, the continuing justification for the overhead structure, replicated at 12 Reserve Banks, will be called into question. Federal Reserve overhead expenses rose from $355 million in 1988 to $564 million in 1994, an increase of about 59 percent. This is one of the greatest increases among the Federal Reserve’s lines of business for this period. As the Federal Reserve faces the challenges we have just described, it will have significant opportunities to reduce staffing and, therefore, costs, particularly at the Reserve Banks. As this occurs, the Federal Reserve should plan to reduce overhead expenses comparably. Increased competition from the private sector and the continuing need to make governmental functions as cost efficient as possible will likely require that the Federal Reserve achieve significantly greater efficiencies in its operations—for example, in personnel pay and benefits, travel costs, procurement, and other areas. Systemwide management of many Federal Reserve activities has the potential to reduce costs to taxpayers, the government, and financial institutions. The Federal Reserve has often chosen in the past to manage programs on a systemwide basis for reasons of efficiency and to ensure effective operations of Reserve Bank programs. For example, some Federal Reserve benefits are established systemwide and are available at the same levels to all employees, regardless of where they work. In this regard, the Board of Governors sets benefits for all Federal Reserve employees. These systemwide benefits include retirement plans, thrift savings plans, business travel/accident insurance, life and survivor insurance, and a long-term disability income plan. Benefits that are not established systemwide include health benefits and various types of leave, such as marriage leave and bereavement leave (see app. III). For large System projects, the Federal Reserve has often taken a systemwide approach to procurement and management. When the Federal Reserve determined the need for a new generation of currency processing equipment, a single contract was used to purchase all 132 machines from a single vendor. According to the Board’s Division of Reserve Bank Operations and Payment Systems’ (DRBOPS) Cash Manager, this helped ensure a better price compared to prices resulting from the Reserve Banks’ purchasing the machines individually. When the Federal Reserve determined the need for the Federal Reserve’s data processing and communications to have improved reliability, risk management, and security, among other things, Reserve Bank and Board decisionmakers chose to centralize those operations at three centers rather than continue separate operations at each of the Reserve Banks. Finally, when the Office of the Inspector General (OIG) criticized the individual ethics programs at the Reserve Banks, the Federal Reserve responded by establishing uniform ethics standards (the Uniform Code of Conduct) and standardizing financial disclosure and other ethics-related forms throughout the Federal Reserve. We have also identified several opportunities for the Federal Reserve to better control costs and increase efficiencies through increased systemwide management. These include the Federal Reserve’s taking the following steps: review benefits programs at the 12 Reserve Banks to reduce or eliminate benefits that are not necessary to attract and retain a quality workforce; manage other benefits—such as health plans—on a cost-effective systemwide basis, utilizing the combined bargaining power of the 12 Reserve Banks; standardize travel policies and procedures to eliminate anomalies among the Reserve Banks that may result in unnecessary expenditures; and review contracting and procurement practices at the 12 Reserve Banks to (1) eliminate practices that could result in excessive costs and (2) promote and publicize “best practices” that are identified. As more centralized management is instituted, the continuing need for separate management structures at the 12 Reserve Banks may increasingly be called into question. For example, increasingly uniform Reserve Bank personnel policies would reduce the need for 12 separate Reserve Bank personnel departments. Similarly, if travel policies are made more consistent, travel may be able to be managed more efficiently on a systemwide basis. The structure of the Federal Reserve was shaped when the U.S. economy was much more regional in nature. For example, during congressional debate on establishing the Reserve Banks, a Member of Congress said that the numbers and locations of the Reserve Banks should be such that “. . . no bank be more than an overnight’s train ride from its Reserve Bank.” Today, the increased use of electronic funds and securities transfers make the geographical location of Reserve Banks irrelevant for many functions. Demographics that shaped decisions about the location of Reserve Banks have also changed profoundly. Except for minor boundary changes, the geographical structure of the Federal Reserve has remained unchanged since 1914, while the nation’s population has shifted dramatically. Although population statistics are an inexact proxy for all matters considered in the original decisionmaking, they have rough parallels in bank assets, check-clearing volume, currency needs, and other factors that have an impact on the Federal Reserve’s lines of business. Since 1914, population growth and shifts have resulted in increasing disparities in population in the 12 Reserve districts, which were fairly similar in size in 1914. For example, the San Francisco Reserve Bank in 1914 served 6 percent of the nation’s population; the St. Louis Reserve Bank served almost 10 percent. As of 1990, the San Francisco Bank served almost 20 percent of the population, while the St. Louis Bank served just 5 percent. Overall, in 1914, the populations served by the Reserve Banks represented a range of 5 to 14 percent of the nation’s population. By 1990, the range had spread to 3 to 19 percent of the nation’s population, as shown in table 4.3. Further changes in the nation’s population, coupled with reduced staffing at the Reserve Banks and increasing systemwide management of the Federal Reserve, call into question the continuing need for 12 Reserve Banks. In addition, an examination of the continuing need for maintaining 25 branch banks may be appropriate. Although the Board has authority to open or close branch banks, it has not done so frequently. Twenty-four of the current 25 branch banks were established by 1927. Since then, the Board has opened only one additional branch bank—the Miami branch of the Atlanta Federal Reserve Bank in 1975. The Board has only closed one branch bank in the Federal Reserve’s history; the Spokane branch of the San Francisco Reserve Bank was closed in 1938. Considering the substantial changes in the nation and its financial system since most of the branches were established, an overall review of the branch bank structure would seem appropriate. The Federal Reserve’s structure, established in 1913, was the end result of many compromises designed to promote Federal Reserve accountability to the public, and, at the same time, to maintain Federal Reserve independence from the nation’s political processes. The importance of the banking industry was acknowledged by establishing member banks as owners of Reserve Bank stock. At the same time, representation from the public was ensured through the membership of the Reserve Banks’ Boards of Directors, which are chosen to include a diverse representation from agriculture, commerce, industry, services, labor, and consumers across each Reserve Bank’s district. The importance of money centers, such as New York and San Francisco, was geographically balanced through the creation of 12 Reserve Banks—the maximum allowed under the Federal Reserve Act—thus ensuring that both rural and urban interests would be represented in the work and the deliberations of our central bank. In the same way, the power of the Board was tempered by establishing the Reserve Banks as independent entities subject only to the “general supervision” of the Board. Finally, while the Federal Reserve was created by an act of Congress and is required to report periodically to Congress, its actions do not need to be ratified by Congress or the president and, as explained in previous chapters, it is funded independently from the congressional appropriations process. In many ways, these compromises have served the nation well and have created additional benefits for the Federal Reserve perhaps not fully envisioned when the Federal Reserve Act was passed. Federal Reserve officials believed that the broad geographic diversity represented by the Reserve Banks aids in the conduct of monetary policy by ensuring that various regional perspectives on the nation’s economy are heard. A total of 281 individuals, many of whom are prominent leaders of industry, the financial services community, labor groups, and consumer interests, serve as directors of the Reserve Banks and their branches. These directors provide both a sounding board for Federal Reserve policies as well as an established “community of interest” to support the Federal Reserve when challenges to its independence arise, as they have from time to time in the past. Federal Reserve officials also feel that this community of directors provides a very useful network of relationships for the nation’s economy during times of financial crisis. We are not in a position to fully evaluate the merits of these benefits for the Federal Reserve or the nation. If, because of the major challenges facing the Federal Reserve, changes to the Federal Reserve’s structure are contemplated, these issues would need to be carefully evaluated when doing so. As to the benefit of having diversity of economic information for monetary policy purposes, in today’s information age, it is likely that sufficient quality economic information could be gathered in some manner, even if the number of Reserve Banks were reduced. As to the benefits of its directors’ network of support, the effects of a reduction in the numbers of Reserve Banks or a diminution of their responsibilities is less clear. If some Reserve Banks were to become, in effect, merely payments system processing centers, for example, the ability of these banks to attract prominent directors might be jeopardized. Any actual or perceived effects this might have on the independence of the Federal Reserve would need to be weighed carefully against any potential improvements in efficiency and cost savings that such changes would yield. In this and previous chapters we have discussed a number of changes facing the Federal Reserve. These are summarized below in table 4.4. Taken together, these changes will likely result in substantial reductions in staffing at the Reserve Banks, which will likely call into question the continued appropriateness of the Federal Reserve’s current structure. We believe that responding to these challenges and making any accompanying structural changes that may become desirable can best be effectively accomplished through strategic management and planning by both the Reserve Banks and the Board working together for the System. In chapter 5, we focus on strategic planning and how the Federal Reserve can take steps to proactively manage for these current and future challenges. If the Federal Reserve is to effectively meet the challenges it faces and streamline operations, the Board and the Reserve Banks must work together to strategically plan for the future. Our prior work in public- and private-sector management reform showed that organizations that have been successful in improving their efficiency have done so by effectively implementing initiatives to focus on their primary missions and business lines, realign their structures to fit their mission, and apply technology to their work processes. Without strong external pressure to minimize overall costs, the Federal Reserve must create the necessary self-discipline for the institution to adequately control its costs and respond effectively to future challenges. However, we found weaknesses in the planning, budgeting, and internal oversight processes that are key mechanisms for helping accomplish these goals. A fundamental review of the Federal Reserve’s missions, structure, and use of technology would present the Federal Reserve with profound cultural challenges; however, the Federal Reserve has begun to show that it can address operational issues strategically and work in a systemwide manner when necessary. As the Federal Reserve enters the next century, it is vital that both the Reserve Board and the Banks continue to foster a systemwide focus so that the Federal Reserve can fulfill its mission in an efficient and effective manner. On the basis of our earlier work in public- and private-sector management reform, we found that leading organizations were able to effectively adapt to changes and challenges in their environment by planning strategically for the future. These organizations had the management processes in place—strategic planning, budgeting, and performance measurement—that supported their top leadership in setting strategic direction and establishing organizationwide priorities. Through strategic planning, organizations were able to better identify emerging issues and challenges and posture themselves to address these changes proactively. Successful organizations also integrated their planning processes with budgeting and performance management. With sound budgeting processes, these organizations were better able to weigh the priorities of the moment against those of the future. These organizations were also able to identify mistakes and make the appropriate adjustments by linking their budgeting processes to performance management. Our work has also shown that public and private sector organizations that were able to achieve significant cost reductions while improving performance and service delivery did so by fundamentally rethinking their mission, strategic goals, lines of business (products and services), and customer needs. As a result of these reassessments, organizations sometimes found it necessary to redefine all or part of their missions, set new strategic goals, and modify their lines of business. In redefining their missions and strategic goals, organizations sometimes found that a fundamental rethinking and radical redesign of their key business and work processes was needed. Known as business process reengineering, this fundamental rethinking seeks to achieve dramatic improvements in critical performance measures. In reviewing their core management and business processes, these leading organizations identified those that were highest in cost, were most customer sensitive, and presented the most significant opportunities and risks for improvement. They then considered the full range of information technology alternatives and information needs to determine how information technology could simplify and reduce the time and cost of carrying out these work processes. After considering the range of needs and available alternatives, these organizations radically redesigned these work processes to better carry out their core missions. As discussed in chapter 4, the Federal Reserve faces major challenges to its business lines, particularly in the delivery of priced services to financial institutions. To effectively address these challenges, the Board and Reserve Banks need to work together to strategically plan for the future. We found that the Federal Reserve had a range of strategic plans and strategic planning initiatives in place or under development. For example, Board divisions and Reserve Banks had strategic planning processes that supported the formulation of strategic plans. According to Federal Reserve planning documents, the strategic planning process is to be linked to the Federal Reserve’s budgeting and resource allocation process. In addition to these strategic plans, strategic plans at the System-level had been adopted, or were being developed, for Financial Services and Information Technology. However, the Federal Reserve did not have a process for integrating these individual planning processes and providing a systemwide focus for assumptions involving the future environment and relationships among functions. As a result, the Federal Reserve may not be making the best use of its many strategic planning processes to prepare for the future and undertake the bold thinking that is needed to address current and future challenges. Strategic planning within the Federal Reserve is carried out by the Chairman, the Board, and the Reserve Banks. As the chief executive officer of the Board, the Chairman is responsible for, among other things, providing (1) overall leadership and organizational direction to help establish major policy goals of the Federal Reserve and (2) administrative direction to the other Governors, the Board staff, and Reserve Banks. In his leadership capacity, the Chairman is involved in key decisions relating to major organizational structure changes that are designed to achieve strategic goals. The Chairman also conveys his views on the future direction, goals, and objectives of Federal Reserve policy through participation in meetings with the chairmen of Reserve Banks’ boards of directors and various Federal Reserve conferences. The Board, which sets policy for the Federal Reserve, also has a role in strategic planning. The Board carries out its work through regular meetings and is assisted by standing committees and ad hoc committees. The standing committees perform a range of functions. The committees help formulate policy, review annual budgets for the relevant Board staff units, and monitor the performance of Board staff units or Reserve Banks against the approved budget. One of the standing committees, the Committee on Reserve Bank Activities, is responsible for overseeing the administrative operations of the Federal Reserve. Its purview includes general supervision over Reserve Bank operations, budgets, and planning activities and oversight of DRBOPS. Each of the Reserve Banks has a strategic planning process that establishes goals and direction for the Reserve Bank. Because of the independent structure of the Reserve Banks and shared supervisory authority within the Federal Reserve, the Reserve Banks have established a conference structure, composed of the Conference of Presidents (COP) and the Conference of First Vice Presidents (COFVP), to help develop systemwide consensus on issues and proposals that affect all Reserve Banks. COP, representing the Reserve Bank presidents, focuses on issues related to discounts and credits, management systems, strategic planning, personnel, legislation and regulations, supervision, and research. COFVP, representing the Reserve Bank first vice presidents, focuses on operational issues affecting the Reserve Banks. The conferences are supported by committees and subcommittees that administer the bulk of the conferences’ work and often initiate projects. The organizational structures of COP and COFVP are shown in figures 5.1 and 5.2. In late 1994, a new management structure was installed to streamline the decisionmaking process and increase the accountability of Reserve Bank first vice presidents for strategic planning of financial services—which are priced services and other services, such as cash operations—provided to financial institutions. Under the new structure, the Financial Services Policy Committee, which is composed of two presidents and three first vice presidents, is responsible for the overall direction of financial services and related support functions. Furthermore, the committee serves as the vehicle for conveying major issues to the Board for discussion and actions. The new structure has dramatically altered the responsibilities of COFVP. COFVP maintains responsibility over the budget process. The Financial Services Management Committee is composed of six first vice presidents—the chairperson, four product group directors, and the director of automation services. The management committee is responsible for developing and implementing business plans for the financial services and monitoring budgets and projects. The Financial Services Operations Council is responsible for coordination and provides advice to the management committee. The product offices are responsible for planning the future direction of each service area and receive support from their respective advisory groups. To carry out the Board’s supervisory role, DRBOPS staff serve as liaisons to the various groups in the new structure. Figure 5.3 illustrates the new structure for financial services management. Although the Federal Reserve has a range of strategic planning processes or programs in place or under development, we found these processes were not designed to address, on behalf of the Federal Reserve, the critical challenges raised by an increasing need to constrain costs, likely changes for System business lines, or the possible implications of those changes on the Federal Reserve’s structure. In reviewing the Federal Reserve’s strategic plans and strategic programs under development, we found that they were generally focused on the strategic goals and objectives of individual divisions, Reserve Banks, or functions. While we believe these plans serve an important purpose in defining the direction of these Federal Reserve entities, we believe that the emerging issues and challenges facing the Federal Reserve will necessitate bold strategic planning focused on the System as a whole. For example, the Federal Reserve may find the System’s long-term interest better served, both from a cost-reduction and performance perspective, by a review of (1) the System’s mission and business lines; (2) the need for all Reserve Banks to perform many of the same functions; and (3) the potential for further consolidation or centralization of certain missions and functions. Determining the future direction of the Federal Reserve and what is best for the System overall, will require the Chairman, the Board, and the Reserve Banks to make hard decisions that will raise further issues and concerns regarding their impact on the Federal Reserve’s system of shared leadership and control. The Federal Reserve recently took action toward achieving greater integration of its strategic planning processes. Recognizing the need for a more systemwide focus, the Board, in mid-1995, chartered the establishment of a new planning entity known as the Federal Reserve System Strategic Planning Coordination Group (SPCG). In assembling SPCG, the Federal Reserve put together an organizationally diverse group whose membership includes the Chairman of the Board (who serves as an ex officio member) and representatives of the Board, and the Reserve Banks, and all major functional and support areas. SPCG is to provide a common framework for the development and refinement of the many individual strategic plans and action plans within the Federal Reserve. According to Federal Reserve planning documents, several Board members and Reserve Bank presidents believed that the discrete strategic planning processes within the Federal Reserve would benefit from greater coherence, especially in terms of assumptions about the future environment and interrelationships among functions. While we believe the establishment of SPCG is a positive step for the Federal Reserve, we are concerned that SPCG’s scope of responsibility and authority may be too limited. Specifically, SPCG was tasked to develop for senior management (governors, presidents, first vice presidents, and certain Board division directors) a document setting forth a common view of the mission, vision, values, and priorities of the Federal Reserve; view of, and assumptions about, the future environment in which the Federal Reserve will operate; understanding of the strengths and opportunities, as well as the weaknesses and vulnerabilities, of the Federal Reserve; and recognition of major challenges or redirections facing the Federal Reserve. In describing the scope of SPCG’s work, the Board also identified the following four important issues that the group might address. How can the Federal Reserve Board and Reserve Banks work better as a System rather than as 13 separate entities? How can the Board and Reserve Banks achieve better coordination across functional areas within units and within the Federal Reserve? How can the Board and Reserve Banks achieve better coordination across units within functional areas? Are there changes or innovations in the structure or governance of the Federal Reserve that would make it work better? If the Federal Reserve is to more fully use SPCG, it may need to (1) broaden the group’s responsibilities to specifically include a fundamental review of Federal Reserve operations focusing on the primary mission, business lines, and structure that would best support the Federal Reserve’s overall mandate in an environment of an increasingly constrained federal budget and (2) better empower the group to have an impact by changing expectations throughout the Federal Reserve about the nature of the changes that could result from the group’s work. The SPCG Chairman and Vice Chairman have stated that SPCG is not intended to develop new specific action plans or objectives or to override plans or objectives already in place, for either functional areas or organizational units. Rather, the results of the planning coordination process would be the common framework for developing and refining constituent strategic plans and action plans. Minutes of a September 1995 SPCG meeting indicated the group’s concern about its limited authority. The minutes identified several important questions as being planned to be addressed by the group. Two of these questions were (1) how the group could guide organizational decisionmaking, help set priorities for the Federal Reserve, and drive the System’s budget processes and (2) how the group could strike an appropriate balance between a system framework and the system strength derived from district/functional autonomy. Beginning in the latter 1980s, information technology within the Federal Reserve underwent a profound change. Between 1988 through 1994, the Federal Reserve spent hundreds of millions of dollars on information technology. By late 1995, according to Federal Reserve planning documents, most mission-critical applications had been or were being completely rewritten; a new network, FEDNET, had been built and was being deployed; and the FRAS organization, established to consolidate the mainframe processing function, had assumed responsibility for most mainframe processing. While we did not do an in-depth review of FRAS, we believe that such an approach makes sense. However, Reserve Banks have remaining concerns about the spillover implications of a systemwide approach to mainframe processing consolidation for the System’s future. Because of the size of the information technology investment and the potential that such technology holds for providing higher quality services at a faster and lower cost, it is critical that the Federal Reserve ensures that its strategic information technology planning is an integral part of the Federal Reserve’s strategic planning process and business planning and that assumptions about the future environment are fully considered. In the 1980s, several Reserve Banks, primarily seeking cost efficiencies, proposed that their Reserve Banks consolidate mainframe processing. On the basis of this effort, the Board later established a committee to study the feasibility of consolidation for the Federal Reserve as a whole. This committee proposed that the Federal Reserve replace the independent mainframe operations of the 12 Reserve Banks and consolidate these operations into 3 automation centers. This proposal also included a unique organizational structure for overseeing mainframe computer operations, placing the responsibility for the consolidated operations under a Senior Automation Executive located within the Richmond Reserve District as a separate organizational entity called FRAS. In 1990, the Board and the Reserve Banks adopted this proposal, setting a new precedent for a systemwide approach to an important operational function. The Federal Reserve’s approach to implementing FRAS represented a major departure from the decentralized approach traditionally used by the Federal Reserve to carry out its operational functions. The objectives of automation consolidation, in descending order of importance, were to improve reliability and disaster recovery, increase control of payment system risk in a national banking environment, improve security of the total automation environment, enhance responsiveness to changing business requirements, and improve efficiency. The Federal Reserve anticipates that FRAS will be responsible for operating mission-critical systems, such as Fedwire (which handles more than $1 trillion in transactions each business day from almost every U.S. financial institution) and key information systems, such as the Federal Reserve’s bank statistics database and payroll system. The systemwide approach to automation consolidation prompted concerns about the control of automation resources and the impact of this approach on the Reserve Bank autonomy and the future of the Federal Reserve. These concerns were twofold: (1) that the consolidation of this activity would lead to the consolidation of other activities and (2) that the Reserve Banks would lose control of the automation resources. The Reserve Banks worried whether they would continue to manage the automation resources or whether the Board’s staff would become more involved in the planning and day-to-day management of automation resources. Concerns were also expressed that, as consolidation progresses, a few “significant” Reserve Banks would emerge. The emergence of such Reserve Banks could cause other Reserve Banks to have a harder time recruiting prestigious directors, thereby diminishing the regional character and local support of the Federal Reserve. As originally conceived, FRAS was to be a system to provide cheaper mainframe processing support for the delivery of services to Treasury and the financial institutions. However, as is often the case with major information technology projects, the scope of the project grew to include applications not originally envisioned in the original plans for FRAS. Planning for FRAS could have taken into greater account the needs of the Reserve Banks. Some Reserve Bank officials told us that the growth in scope of FRAS, particularly to include check processing, had made it difficult for them to comply with the requirement in the Monetary Control Act that service fees should recover the costs of priced services. As the Federal Reserve proceeds in the implementation of FRAS, it needs to better identify the Federal Reserve’s overall mission needs, the needs of the Reserve Banks, and those work processes that hold the most promise for improved service delivery through information technology. While we did not do an in-depth review of FRAS, it appears that the design of FRAS assumes the retention of all key missions and business lines. Furthermore, we did not observe an identification of those work processes that could be reengineered and that hold the most promise and risk for the application of information technology. If the Federal Reserve revises its assumptions about the future environment and the Federal Reserve’s core missions and business lines, it must ensure that these decisions are well integrated with its information technology strategic planning. The Federal Reserve is currently working on a strategic plan for Federal Reserve information technology. The plan seeks to lay out a planning horizon for the Federal Reserve through the year 2000. As of February 1996, the strategic plan was still in draft. In reviewing the draft plan, we observed that it lays out the strategic goals and strategies by mission. The draft plan also assumed the retention of all missions, business lines, and operating structures. As the Federal Reserve refines its information technology strategic plan, it is vital that the Federal Reserve continually checks its key strategic assumptions and makes sure that the information technology strategic goals keep pace with key strategic decisions. An effective budget process should support top management in constraining costs, weighing current priorities against future priorities, and allocating resources according to organizational priorities. For an institution such as the Federal Reserve, it is especially important that there be a rigorous budget formulation and execution process in place to constrain cost and foster the internal self-discipline necessary to periodically reassess its strategic goals and priorities. The Federal Reserve’s budget process seeks to ensure that overall Federal Reserve objectives are accomplished efficiently and effectively. In reviewing the budgeting process for both the Board and Reserve Banks, we found that the Federal Reserve had a budgeting process that imposed some discipline in that there was no material overspending of approved budgets. However, we found the Federal Reserve’s budget process had a weakness in that it used a current services approach that assumed existing functions would be retained and that assumed continued incremental budgetary growth. Such an approach, we believe, did not adequately support top management in constraining costs and imposing the internal self-discipline necessary for the Federal Reserve to respond effectively to future priorities. In reviewing the budgeting process for 1988 to 1994, we found the operating budgets of the Board and the Reserve Banks were formulated on the basis of the assumption that existing units would generally continue to perform their required functions and their budgets would increase from year-to-year to account for expected increases in inflation and salaries. With no formal constraints on overall spending, the extent of increases in unit budgets was left ultimately to the discretion of the Board. The formulation of the Board’s budget was overseen by the administrative governor under authority delegated by the Chairman of the Board and managed by the Board’s Office of the Controller. The process began in the spring of each year with the development of a budget guideline and extends through November. In the spring, each Board division developed a strategic plan, which identified and prioritized objectives, and a proposed budget. Next, the Board Governor (or Governors) with administrative responsibility for the division reviewed the plans and commented on the merit of the proposed budget. The divisions had the opportunity to revise their strategic plans on the basis of those comments. The Program Analysis and Budgets section of the Controller’s Office then developed a proposed budget guideline, or acceptable percentage increases in Board expenses for the upcoming year. According to officials we interviewed, the percentage increases were based on such factors as inflation and the expected cost of programs and initiatives identified in strategic planning sessions. The proposed percentage increases were first reviewed by the administrative Governor and the Board Chairman; if they were satisfied, the Board received the proposal for approval during the summer. Each Board division used the approved percentage increase to prepare a revised budget proposal that they submitted to the Controller in the fall. After reviewing the budget proposals and making any necessary adjustments, the Controller coordinated meetings to discuss the budget proposal with each division and the appropriate administrative Governor(s). On the basis of these meetings, the Controller could make additional adjustments before consolidating the division budgets. The consolidated budget was then given to the Administrative Governor for review and presentation to the Board Chairman. After all appropriate adjustments had been made, the Administrative Governor presented the consolidated budget to the full Board for approval at a public meeting shortly before the new budget year, which began in January. Percentage increases and proposed Reserve Bank budgets were formulated and approved in a process separate from formulation and approval of the Board’s increases and budget. The Reserve Banks’ process generally took 6 months, culminating in the Board’s approval of the proposed increase in late spring of the year before the subject budget year. During 1988 to 1994, the Federal Reserve’s conferences—COP and COFVP—along with their supporting committees, subcommittees, and task forces, provided a systemwide mechanism for the development and sequential review at many System levels of budgetary proposals and objectives that affect all Reserve Banks. Various data were considered in developing the percentage increase proposal, including volume and cost projections for priced services, Federal Reserve project cost projections, and information on Reserve Bank initiatives affecting expenses. Shortly after the Board’s approval of the allowed increase in Reserve Bank budgets, each Reserve Bank developed budget documents and materials, including a proposed budget. These proposals were initially reviewed by COFVP and then forwarded to COP for review. The COP’s budget recommendations were then reviewed and approved, in turn, by DRBOPS, the Board’s Reserve Bank Activities Committee and, finally, by the full Board shortly before the start of the budget year. The budgets for the Reserve Banks and the Board were monitored throughout the year. For example, the Board’s actual expenditures were compared to the budget plan throughout the year to ensure compliance with approved budget and program plans. The Office of the Controller had lead responsibility for monitoring the Board’s budget. The Controller submitted quarterly reports to the Board that compared each division’s performance with its expenses and conducted midyear reviews with each division to control costs and provide a baseline for analyzing the upcoming year’s budget request. Generally, if the Reserve Banks and the Board did not deviate from their respective budgets by more than 1 percent, they were allowed to reprogram funds from one spending category to another without seeking Board approval. Reserve Bank budgets were also monitored throughout the year—both at the Board and Reserve Banks. These budgets were monitored mainly through the Reserve Bank’s cost-accounting system by the individual Reserve Bank controller and staff of DRBOPS. The cost-accounting system facilitated the comparison of the financial and operating performance at Reserve Banks individually and as a whole. In exercising its statutory authority to generally supervise the Reserve Banks, the Board required the Reserve Banks to submit budgets annually and to seek approval, on an ad hoc basis, for large purchases (capital acquisitions). In addition to the budget approval process, the Board established various levels of approvals for Reserve Bank operations for expenditures related to buildings, equipment acquisitions, and price changes for Reserve Bank services. Over certain dollar amounts, these proposed expenditures must be approved by the Board. For proposals that fell below the specified threshold, the Board delegated its approval authority to DRBOPS or the Reserve Banks. In addition, DRBOPS may forward Reserve Bank proposals that may have systemwide policy implications to the Board. According to a DRBOPS official, proposals approved at the Reserve Bank-level are routinely forwarded to the Board as an information item. In reviewing the execution of the Federal Reserve’s budget between 1988 and 1994, we observed that the budget processes of the Board and the Reserve Banks resulted in budgets that increased each year. However, amounts finally approved were generally lower than those initially requested. As a whole, we found that Reserve Banks and the Federal Reserve sometimes exceeded the initially approved operating budgets, but generally by amounts that were less than 1 percent of the approved operating budget. Concerning the Federal Reserve’s capital budget, we found that in every year except 1992, the Federal Reserve spent less than was budgeted. In most years, the underspending was primarily related to data processing and data communications equipment. However, in 1992, the Federal Reserve overspent its data processing and data communications budget by almost $52 million. In that year, the Federal Reserve’s initial capital budget did not call for purchasing any computer equipment for FRAS. However, in 1992, the Federal Reserve began FRAS-related acquisition and development; by year-end, the Federal Reserve had spent nearly $96 million to purchase computer equipment. Internal oversight processes, such as performance measurement, internal audit, and financial audits, can and should play key roles in assisting management in achieving its strategic vision for the organization. The Federal Reserve had many oversight mechanisms in place. However, we found that these mechanisms either did not support performance evaluation from a systemwide perspective or were becoming increasingly inappropriate in the changing environment. As a result, the Federal Reserve may not be making the most use of its resources devoted to Federal Reserve oversight. The Board and Reserve Banks had a variety of mechanisms to oversee many activities. Oversight of Board programs and operations is provided by the Board’s OIG. The various oversight mechanisms of the Federal Reserve are summarized in table 5.1. Through involving key stakeholders in developing performance measurement systems keyed to organizational goals, performance measurement can be used to assess how all parts of the organization are contributing to overall effectiveness in achieving the organization’s key goals. In conducting our work, we noted that the evaluation and assessment of Reserve Bank performance had received considerable attention from both Reserve Bank management and the Board. DRBOPS conducted annual assessments of Reserve Bank operations in various areas. Reserve Bank management tracked performance on a variety of measures on an ongoing basis. And other oversight mechanisms—internal and external financial examinations, operations reviews, and OIG evaluations—provided other information on performance. However, many of these current performance measures were too narrowly focused on such Bank-specific measures as the numbers of checks processed or the amount of fees collected for ACH processing. In the context of the Federal Reserve’s new efforts on systemwide planning for the Board and the Reserve Banks together, the Federal Reserve would appear to lack major systemwide benchmarks to measure how effectively the Federal Reserve—as a whole—is meeting its new challenges. Concerning systemwide goals and objectives, it may now be appropriate for the Federal Reserve to redesign its key performance indicators to more accurately reflect overall organizational goals and objectives. As a part of this new strategy, outcome-linked performance measures should be developed, for both the Board and Reserve Banks, that show how organizational components can best contribute to overall organizational effectiveness. Even given the numbers of oversight mechanisms available to the Federal Reserve, we identified specific problems—the coverage of audit and evaluations, the potential for the lack of independence, and possible audit reporting problems—that all could be improved with certain changes in Federal Reserve oversight. These problems stemmed in part from the unique structure of the Federal Reserve and the authority provided to those entities supporting the Board. For example, the Inspector General is authorized to review only the activities of the Board while DRBOPS is responsible for overseeing the Reserve Banks and for developing policies. As the Federal Reserve increases systemwide projects and consolidations, the need for stronger, comprehensive Federal Reserve oversight is likely to increase. With improved oversight, the Federal Reserve can better identify areas where efficiencies can be achieved, particularly areas with reengineering potential, and ensure that organizational results are both outcome-linked and responsive to multiple organizational priorities that may cut across various parts of an organization. The lack of a systemwide perspective has affected the audit and evaluation coverage within the Federal Reserve. Until recently, the Federal Reserve’s oversight mechanisms did not include an independent audit of the combined financial statements of the Reserve Banks. DRBOPS, which lacks clear independence, conducted individual financial examinations of each Reserve Bank on behalf of the Board. In November 1994, the Board awarded a contract to have an independent public accounting firm audit the combined financial statements of the Federal Reserve Banks for the years 1995 through 1999. We believe this would be helpful toward improving financial auditing within the Reserve. However, we also believe that a permanent policy to require an annual independent financial audit of the combined Reserve Banks’ financial statements is needed. We recommended that this be done in some of our previous work.Government experience has shown that emphasis on financial management and oversight can change with agency leadership. Therefore, legislating an annual audit requirement, as was done by the Government Management Reform Act of 1994, which expanded the Chief Financial Officer Act’s requirements to the 24 largest executive agencies to obtain annual financial statement audits, would ensure that emphasis on financial management is continued. We also noted in our review that some areas were the subject of possibly redundant audit attention. For example, at the time of our review, we observed separate evaluations of various aspects of work on the Federal Reserve Automation Services project at the Richmond Reserve Bank being conducted by the Richmond General Auditor, the OIG, and DRBOPS staff. While we did not do an in-depth analysis of areas of overlap in these audits, we nevertheless found possible areas of overlap. At the same time, in our review of a sample of contracting and procurement practices at selected Reserve Banks, we found potential for possible conflicts of interest within the bid selection processes and some lax practices in ensuring that correct payments were being made on contracts. Yet despite the fact that contracting received some audit attention at the Reserve Banks we visited, these problems were not identified. The use of the existing oversight structure to conduct systemwide audits may not be appropriate because the general auditors do not report to a systemwide board of directors. At the time of our review, one General Auditor was serving as the head of the systemwide audit of the ISS-3000 currency processing equipment. The General Auditor was to report the audit findings to that Reserve Bank’s Audit Committee even though this review was conducted for the Federal Reserve as a whole. In our view, the findings of an audit of a major systemwide project should be reported directly to the Board, which has direct fiscal responsibility for the project. We believe that the Federal Reserve could alleviate some, if not all, of these problems by providing a more focused and efficient approach to Federal Reserve oversight. The Federal Reserve could accomplish this by taking steps to better ensure the independence of its internal audit function and to expand the scope of the OIG’s authority to include responsibility for auditing the Reserve Banks and systemwide projects. As Reserve Banks are moving toward more systemwide projects and more centralized decisionmaking, the Federal Reserve’s fragmented oversight structure is increasingly inappropriate to provide adequate oversight of centralized Reserve Bank operations. If the OIG’s authority was expanded, the problems of redundant audits would be addressed. The expansion of the OIG’s authority would necessitate both an increase in staff and spending for the OIG. However, it may be possible to simultaneously reduce staffing in other oversight mechanisms. We believe that the Federal Reserve, to effectively plan for the future, needs to conduct a fundamental assessment of its operations focusing on its missions, strategic goals, and structure. Such an assessment should also include a review of the Federal Reserve strategic management processes. We believe that the Federal Reserve faces some difficult constraints in conducting such an effort. For example, the Board will need to work with the Reserve Banks to rethink their mutual roles in the shared leadership of the system. Furthermore, they will face profound challenges in planning and confronting possible changes. Planning deliberations related to redefining core missions and business lines and realigning the Federal Reserve’s structure and governance would require strategic planners to “think beyond” the statutory powers of the Board and Reserve Banks. The essential missions as well as the locations of the Federal Reserve’s Reserve Banks are set by law, and the autonomy of the Reserve Banks generally necessitates consensus-oriented decisionmaking in systemwide planning. For example, the Federal Reserve is required by law to develop and implement monetary policy, supervise and regulate banks, regulate and provide payments system services, and provide fiscal agency services to government agencies upon request. In rethinking its mission and business lines, the Federal Reserve may face conflicts and difficult policy choices, which may require that it consult with Congress for help in resolving them. For example, the Federal Reserve is required to base check-clearing fees on the recovery of its costs; at the same time, it must also function as the “clearer of last resort” and promote the safety and soundness of financial institutions. In addition, neither the Board nor the Reserve Banks is authorized to change the numbers or locations of Reserve Banks or essential elements of Federal Reserve governance. Changes that might be considered in the context of a fundamental assessment of Federal Reserve operations could require legislative action to accomplish. Because it lacks the cost minimization pressures common to most public and private entities, the Federal Reserve must work extra hard to overcome internal pressures for budgetary increases. As discussed in chapter 1, the Board is a government agency and provides Congress with an annual report of the Federal Reserve’s operations; however, the Federal Reserve is not subject to the congressional appropriations process that serves as a constraint on spending by federal entities. Furthermore, because the Federal Reserve Act sets dividends to member banks at 6 percent and prohibits them from selling their shares, shareholders, who are member banks, do not have the usual financial incentives to encourage cost-efficient operations. Additionally, the amount of interest the Federal Reserve receives on securities acquired through the issue of Federal Reserve notes is so great that it tends to mask the net decline of all other revenue sources that occurred over the 1988 to 1994 period. Therefore, it is especially important for the Federal Reserve to have management processes that support top management in constraining costs and that instill a high level of internal self-discipline that would allow the Federal Reserve to overcome institutional resistance to major management reform. However, despite its unique structure, the Federal Reserve has begun to show that it can address operational issues strategically and work in a systemwide manner when necessary, as evidenced by the recent establishment of a new Financial Services Committee to examine priced services and by the consolidation of its data-processing facilities. The Board and the Reserve Banks must work together to meet the emerging challenges and to ensure that the nation’s central bank keeps pace with the changing environment and remains a strong and competitive institution. In analyzing opportunities to reduce the cost of Federal Reserve operations to the taxpayer, any potential adverse impact on the independence of monetary policy or on the Federal Reserve’s ability to meet its key responsibilities should be considered carefully. However, we see no inherent conflict between the Federal Reserve’s independence or effectiveness and efforts to improve efficiency. Many of the functions performed by the Federal Reserve have little direct relation to monetary policy, and the Board, working with the Reserve Banks, has the authority and ability to take many cost-saving actions without jeopardizing its mission effectiveness. However, any decision to close Reserve Banks or establish a separate corporation for priced services would require congressional approval. Thus, we make recommendations to the Board and suggest several matters for congressional consideration. We recommend that the Board of Governors undertake a fundamental review of Federal Reserve operations focusing on the primary mission, business lines, and structure that would best support its overall mandate. Such an organizational review should include an assessment of the following: the Federal Reserve’s role in providing financial services to banks and government agencies and an analysis of the costs and benefits to the Federal Reserve and the taxpayers of various options for delivering such services (such options could include discontinuing delivery of certain priced services to financial institutions, privatizing the delivery of other services by establishing a private corporation for delivering such services, or retaining responsibility for being the primary service provider); cost-saving opportunities that could result from streamlining the Federal Reserve’s existing management structures and consolidating Federal Reserve operations, including possible mergers among the 12 Reserve Banks and 25 branches; and the potential for technology to support streamlined work processes in the Reserve Banks and to reduce costs and improve quality. In addition, we recommend that the Board strengthen its existing control and oversight mechanisms by, among other things, (1) reviewing the appropriateness of current budget assumptions, which assume steady annual growth; (2) taking steps to better ensure the independence of the Federal Reserve’s internal audit function and to expand the scope of its OIG’s authority; and (3) ensuring that an independent financial audit of the Reserve Banks’ combined financial statements is conducted every year. Congress should consider the results of the Federal Reserve’s assessments and determine whether it would be desirable to merge or close any of the 12 Reserve Banks or 25 branches and which of the various options for delivering priced services to financial institutions are in the best interests of public policy and represent the best balance between achieving cost savings and serving the nation’s financial interests. requiring an annual independent audit of the Reserve Banks’ combined requiring the Federal Reserve to charge for bank examinations; and establishing a statutory requirement that the Federal Reserve annually transfer its remaining revenues to the Treasury. The Federal Reserve’s Board of Governors did not agree with any of our recommendations to the Board or with our suggestions to Congress. The Board did not agree to undertake a fundamental review of the Federal Reserve System’s operations, because it believes such reviews are an ongoing and integral part of the Board’s oversight of the System. The Board stated that the Federal Reserve’s role in providing financial services to depository institutions is constantly being tested in the marketplace, and the Board noted that the System is consolidating the management of some financial services. The Board stated its belief that most savings from such consolidation efforts would be possible in electronic payment functions, such as Fedwire, with lesser savings possible in paper-based financial services, such as check clearing. The Board also did not agree to consider alternatives to the current way the System provides priced services. Concerning merging or closing any of its 12 Reserve Banks or 25 branches, the Board stated that, while the Federal Reserve’s structure would likely be different if established today, any such realignments or relocations would have to yield substantial long-term savings to offset the transition costs. Concerning the potential for technology to support streamlined work processes in the Reserve Banks, the Board stated that the Federal Reserve routinely assesses technologies for their ability to reduce costs and improve the quality of its services. Concerning our recommendations to improve the Federal Reserve’s control and oversight mechanisms, the Board did not agree with our characterization of the System’s budget process as one that assumed continuous growth. The Board also did not agree that the independence of its internal oversight would be strengthened by expanding the authority of the Board’s OIG to the Reserve Banks. The Board believed that the current audit process ensured adequate independence and that expanding the OIG’s authority could integrally involve the inspector general in the Board’s oversight process and raise questions about the inspector general’s “arm’s length” ability to audit such processes. The Board did not comment on our recommendation to institutionalize an annual external audit of the combined financial statements of the Reserve Banks. Finally, the Board did not agree with our suggestion that Congress may want to consider requiring the Federal Reserve to charge for bank examinations. The Board noted that, currently, the states charge examination fees that, on average, are approximately half of those charged by OCC for national bank examinations. The Board believed that if the Federal Reserve and FDIC were to charge for their examinations of state-chartered banks, such fees could tip the scales toward national charters and call into question the long-term viability of a valuable dual banking system. We continue to believe that the major technological and marketplace developments that are currently affecting the financial services industry have profound implications for the activities and operations of the Federal Reserve and require the System to have a strong, systemwide strategic management process. We acknowledge that the Federal Reserve has a range of strategic planning processes and programs in place or under development. And we recognize and commend the Federal Reserve’s efforts to provide a more systemwide focus for its strategic planning efforts through the recent creation of the Federal Reserve System Strategic Planning Coordination Group. However, we are concerned that these strategic planning efforts are not sufficiently integrated and thus may be too limited and insufficient to effectively address the major challenges the Federal Reserve is facing, given the potential implications of these developments for the Federal Reserve’s business lines and organizational structure. Leading private and public institutions have found that truly significant savings often come only when, as a part of a comprehensive strategic planning process, they have rethought their basic missions and lines of business and reengineered their work processes to streamline operations. The Federal Reserve’s plans to consolidate some of its operations in financial services, while commendable, fall far short of the broad rethinking that we believe is necessary if the Federal Reserve is to be as efficient and cost effective as it can be in fulfilling its critical role as our nation’s central bank. As a part of this broad rethinking, we also believe the Federal Reserve should consider consolidating some Reserve Banks and branches. We agree with the Board that such consolidation would result in transition costs but we believe that these costs could be offset by longer-term savings. We also note that consolidating banks and branches is not without precedent among central banks. For example, before the reunification of the former East and West Germany, the German central bank, the Deutsche Bundesbank (which was established by the Allies after World War II and modeled on the Federal Reserve System), had a presence in the form of Landesbanks in each of the 11 West German states. If it chose to keep intact the same structure after reunification, the Bundesbank was faced with the possibility of establishing five additional Landesbanks, one in each of the states of the former East Germany. Instead, the German government reduced the total number of Landesbanks serving the reunified 16 states to 9 Landesbanks and significantly reduced the number of central bank branches as well. The chief reasons given for these consolidation efforts were to promote efficiency and cost savings. Between January 1, 1995, and January 1, 1996, the Bundesbank reported that it was able to reduce its staff by 6 percent. Our recommendation that the Federal Reserve consider alternatives to the current way it delivers priced services to depository institutions is another example of the broad rethinking of mission and lines of business that we believe the Federal Reserve should undertake. When institutions carefully reexamine their missions and lines of business, they often determine that some lines of business are no longer profitable or no longer fit with the strategic direction they wish to take. For example, observers in the private sector have questioned whether it is appropriate for the Federal Reserve to continue to be both a provider and regulator of priced services, particularly in light of the growth of private-sector service providers. Some top officials within the Federal Reserve have, in the past, also suggested alternative ways to provide these services, such as by establishing a separate corporation. Regarding the use of technology to streamline work processes, our reviews of leading organizations that have sought to improve performance through strategic information management and technology have shown that accomplishing order-of-magnitude improvements in performance nearly always requires streamlining or redesigning critical work processes.Consequently, we believe information systems initiatives must be focused on process improvement. Using business process reengineering to drive information systems initiatives can lead to these order-of-magnitude savings, rather than the marginal efficiency gains normally associated with initiatives that use technology to do the same work, the same way, only faster. We acknowledged in several sections in this report that the Federal Reserve’s automation consolidation efforts (under the FRAS system) were designed to promote more efficient operations and to ensure increased security in the nation’s payments system. However, we are concerned that the Federal Reserve’s automation consolidation efforts may not have involved sufficient reengineering of existing work processes. Because of the size of the information technology investment and the potential that such technology holds for providing higher quality services faster and at lower cost, we believe that it is critical that the Federal Reserve ensures that its strategic information technology planning is an integral part of its strategic and business planning processes. We continue to believe that the concerns we raised about the Federal Reserve’s oversight and control mechanisms are valid. Although the Federal Reserve does not view its budget process as having a built-in assumption of annual growth, we note that, for each year from 1988 to 1994 and for each Reserve Bank, annual budget targets have been expressed as percentage increases from the previous year’s budgets. The budget did not reflect a decrease in budget authority in any year for any Reserve Bank despite the fact that during this period many Reserve Banks consolidated their savings bonds programs and mainframe computer operations. With regard to expanding the OIG’s authority to directly audit the Reserve Banks, we believe the inspector general can perform these functions while also retaining the ability to provide arm’s length reviews of the Board’s oversight processes. In an increasingly consolidated Federal Reserve System, retaining the Reserve Banks’ general auditors to do systemwide reviews seems increasingly inappropriate. And reliance on DRBOPS to do such reviews leads to questions about the independent nature of such reviews, particularly since this division also sets policy for the Reserve Banks and has approval authority over certain Reserve Bank purchases and decisions. Such problems and questions could be resolved by expanding the OIG’s authority and by taking steps to better ensure the independence of the Federal Reserve’s internal audit function. In addition, centralizing reviews of Reserve Bank programs would make more apparent any overlapping and redundant reviews and would more clearly highlight areas receiving insufficient audit attention. Finally, we found no reason to suggest that having the Federal Reserve charge for its bank examinations would threaten our valuable dual banking system. Currently, the Federal Reserve is the only one of five federal regulators of depository institutions where taxpayers, and not the industry, bear the cost of supervision. As we noted in this report, the Federal Reserve supervises less than 1,000 state-member banks, or about 9 percent of all banks, and evidence from recent mergers indicates that state charters are being considered more desirable than national charters. The Federal Reserve could also take steps through arrangements with state banking regulators to reduce any undue competitive effects of charging for bank examinations. In addition, our recommendation is not meant to be limited to charging state-member banks. The Federal Reserve’s response does not address charging for its other examinations—those for foreign banks and bank-holding companies—where the possibility of charter switching is not an issue.

Summary: Pursuant to a congressional request, GAO reviewed the operations of the Federal Reserve System, focusing on: (1) its finances and levels of spending; (2) areas where spending could be reduced; and (3) actions the Federal Reserve could take to meet future challenges in systemwide management. GAO found that: (1) Federal Reserve operating expenses increased from $1.36 billion in 1988 to $2 billion in 1994; (2) the most significant operating cost increases were for bank supervision and regulation, personnel pay and benefits, and extensive modernization and consolidation of information systems; (3) operating costs vary among reserve banks because the Federal Reserve has not established consistent policies; (4) the Federal Reserve could reduce its personnel benefits and travel-related reimbursements, and realign its contracting and procurement practices; (5) a reduction or elimination of the Federal Reserve surplus account, which increased from $2.1 billion in 1988 to $3.7 billion in 1994, would increase federal budgetary receipts in the year that the reduction or elimination occurs; (6) major developments such as increased competition from private-sector suppliers, use of electronic banking, and consolidation of the banking industry, are likely to affect the Federal Reserve's operations, future role, and management structures; and (7) the Federal Reserve must eliminate the weaknesses in its planning, budgeting, oversight, and audit processes that impede its cost control efforts.