2006 Annual Report
By President & CEO Michael H. Moskow Since joining the Chicago Fed in 1994, I have witnessed significant changes in our financial and economic system, as well as in the way the Federal Reserve carries out its responsibilities. One thing of which I am certain is that the financial system, and the Fed's role in supporting it, will continue to evolve. With that in mind, I would like to offer my perspectives on some of the major developments in monetary policy, the nation's payments system, and bank supervision and regulation over the last 13 years. Some of the more significant developments include the acceleration in productivity in the late 1990s, the risk of deflation in 2003, transformations in the banking industry, and the growth and rapid acceptance of electronic payments. Much of what we have learned from these and other events can and should shape our monetary, supervisory, and regulatory policies going forward. These lessons also will help position the Fed to anticipate and effectively respond to whatever challenges lie ahead. MONETARY POLICYAt the time of my arrival at the Federal Reserve Bank of Chicago in September of 1994, the U.S. economy was well into two very important transitions. The first was the shift from a high or moderate-inflation economy to one with relatively low and stable inflation. Core PCE inflation, which measures the percent change in the price index for Personal Consumption Expenditures, excluding food and energy, had fallen from staggering double-digit rates in the late 1970s and early 1980s to just 21/2 percent in 1994. The second transition, referred to by economists as "The Great Moderation," had begun in the mid-1980s, but we were just beginning to recognize it in 1994. This period was the evolution to a low-volatility economy, in which fluctuations in real economic activity were much smaller than they had been in the 30 years prior to the mid-1980s. In many important ways, these two transitions made the policymaking environment easier during my years at the helm of the Chicago Fed. While some challenges remained in the pursuit of price stability when I started, the inflation issues the Federal Open Market Committee (FOMC) has faced since then have been less severe than those confronted by the Paul Volcker-led Fed in 1979. In addition, since 1994 the FOMC has faced relatively smaller cyclical fluctuations in growth than it had in the past. But the FOMC during the last 13 years still has had to react to a number of important and difficult challenges: the Asian financial crisis, the Russian debt default, unusual asset price movements (such as equities in the late 1990s and housing in the mid-2000s), Y2K, 9/11, the acceleration in productivity, and the risk of deflation. All of these issues generated policy questions that did not fit neatly into any familiar textbook framework. Instead, they required new approaches and new ways of thinking. It is useful to consider two of these experiences in more detail — the acceleration in productivity growth and the risk of deflation. They exemplify how, when making difficult decisions in unusual circumstances, it is important to follow sound policy-making principles, including:
By following these principles, the FOMC made decisions over the past 13 years that played a meaningful role in helping maintain a low-inflation, low-volatility economy. THE PRODUCTIVITY ACCELERATION
In determining the appropriate stance for monetary policy, the FOMC was well aware of the risks of making a mistake. If we set policy based on the assumption that the productivity surge was permanent, and it turned out to be transitory, we risked providing too much liquidity and generating inflationary pressures. If we instead set policy thinking the increase was temporary, and it turned out to be permanent, we would not have provided adequate liquidity to fund productive investments and hence would have stifled non-inflationary growth. So it was important to make the best assessment possible. As we now know, the higher rate of growth was long-lasting. Much has been written about the Fed's — and particularly former Chairman Alan Greenspan's — insights into recognizing the permanent nature of the productivity pickup. An important part of the analysis was looking beyond the top-line growth numbers. Much of the surge in economic activity was coming in high-technology areas. By studying what was happening in these sectors, our best assessment was that the gains would be long-lived. Furthermore, we were observing very benign inflation numbers, a sign that productive resources were not being strained. In response, we raised the nominal federal funds rate target only 50 basis points between January, 1996 and June, 1998 — much less than if we had simply stuck to the previous benchmarks regarding long-run sustainable growth and unemployment. The lessons of economic theory also shaped our decision-making. Regardless of which productivity scenario may have been correct, theory indicated higher real interest rates were warranted. If the productivity increases were transitory, higher real rates were needed to contain inflationary pressures. This would require raising nominal rates. If the gains were permanent, the return to investment would be higher, and thus higher real rates were necessary to equilibrate saving and investment. In this latter case, some of the increase in real rates would occur through a drop in the inflation premium built into nominal interest rates. And, as it turned out, though we increased the nominal funds rate only slightly, the real federal funds rate rose about 1 1/4 percentage points between early 1996 and mid-1998, largely because inflation declined. Overall, monetary policy was relatively successful over this period. Real GDP growth averaged about 4 percent in the second half of the 1990s, a full percentage point faster than over the previous 25 years. In addition, core PCE inflation ended the decade at 1 1/2 percent, a rate I view as being consistent with price stability. THE RISK OF DEFLATION Looking at broader economic data helped put the issue into perspective. The term "deflation" naturally made people focus on the serious downward-price spiral that occurred in the U.S. during the Great Depression. But the performance of the U.S. economy during the 19th century, as well as a number of international experiences, reminded us that solid economic expansion and deflation can co-exist. Once again, economic theory offered an explanation: If productivity growth remains healthy, investment projects can earn large positive real rates of return even if prices are falling, and hence there is no threat of a default cycle. However, economic theory also reminded us that deflation could pose a special problem for monetary policy. Nominal interest rates cannot go below zero because no one will lend funds without receiving some positive return. If the economy is weak, then businesses may not be able to generate large real returns to investment. And the lower the inflation rate, the smaller the inflation premium built into nominal interest rates. So deflation raises the likelihood that nominal short-term interest rates could fall to zero during some period when the central bank would like to lower interest rates to stimulate a sluggish economy. Given the weakness in the real economy in late 2002 and early 2003, the FOMC took seriously the issue of nominal interest rates falling to zero. In fact, Fed researchers investigated various alternative means for providing monetary stimulus in the event that short-term interest rates hit zero. Our response to the deflation, or "unwelcomed disinflation," threat was to lower the nominal federal funds target to 1 percent, a very low level by historical standards. As we moved into the second half of 2003, output growth recovered smartly, labor markets firmed, and inflation moved up from its very low levels without the Fed having to undertake any unusual alternative financial market interventions. However, we took one important additional step: Starting in August, 2003, we communicated our willingness to keep the funds rate low for a "considerable period" and continued using that phrase in FOMC statements for the next several meetings. This communication, and our later statement that the FOMC could "be patient in removing its policy accommodation," may have produced some added stimulus to the economy by helping keep medium-term interest rates lower than they otherwise would have been. The 2003 deflation risk served another important role: It sharpened our thinking about the conduct of monetary policy when the economy is operating in the neighborhood of price stability. We were not worrying about deflation as part of policy discussions when I joined the Fed, but given the defeat of high inflation, it is now an important consideration in the discussion of how best to pursue monetary policy. BANK SUPERVISION AND REGULATIONThe structure of the banking industry and approaches to bank supervision have changed dramatically during my tenure at the Chicago Fed. Banks have become larger and more complex, and banking risks have become more diverse and dynamic. Bank risk management has become more complicated and sophisticated, and so bank supervision, like monetary policy, has required new approaches and new ways of thinking to remain effective.
INDUSTRY STRUCTURE With the advances in information technology (particularly computer systems), credit databases, and risk-management techniques, these geographic legal limitations became highly restrictive in the 1970s and 1980s. Policy makers increasingly realized that broader geographic expansion could create potential efficiency gains for banks and consumers. As a result, the restrictions began to be lifted, first within state boundaries as branching laws were liberalized, then across state borders via regional compacts between states. Finally, shortly after I joined the Fed, the Riegle-Neal Interstate Banking and Branching Efficiency Act was passed, beginning a process of much broader interstate expansion. Thus, geographic deregulation initiated a significant shift in the landscape of U.S. banking. The chart above shows the change in the number of banks in the U.S. over the last 13 years, while the chart on the next page shows the change in the number of bank branches. Nationally, the number of banks decreased nearly 29%. Most closed as the result of unassisted mergers and acquisitions rather than failures. This stands in stark contrast to the late 1980s, when failures averaged about 400 per year. Distributed by size, a large majority of the decline occurred among community banks (banks with less than $1 billion in assets). In the Seventh Federal Reserve District, the trend has been somewhat similar, though the declines in Illinois, Indiana, and Wisconsin have slightly exceeded the national trends. This is, in part, because each of these states was relatively late in relaxing its geographic restrictions. While the number of banks in most areas declined over this time period, the number of branches serving bank customers significantly increased, by over 16% nationally. This contrast has been most obvious in Illinois, where the number of banks has declined by more than 32%, but the number of branches has increased by more than 43%. Many students of the industry predicted these changes, as Illinois had one of the most restrictive state banking laws regulating geographic expansion. Of course, the passage of Riegle-Neal and the liberalization of state branching laws were not the only major developments affecting the structure of the banking industry. The Gramm-Leach-Bliley Act of 1999 removed most of the long-standing restrictions against affiliations between commercial banks and investment banks imposed by the Glass-Steagall Act in 1933. The act allowed for the creation of financial holding companies, which are now permitted to engage in a full range of financial activities, such as securities underwriting and dealing, insurance underwriting and selling, and merchant banking, through holding-company affiliates of commercial banks. This is as long as the commercial banks are sufficiently capitalized and meet other qualifications. Though the individual affiliate activities are regulated by the appropriate functional regulator (such as the SEC, state insurance authorities, and the federal banking agencies), the Federal Reserve serves as the "umbrella supervisor" for the financial holding company.
CHALLENGES FOR COMMUNITY
BANKING Essentially, two different banking models have evolved in the U.S. Larger banks emphasize a low-margin, commodity-based production process using state-of-the-art information technologies, including scoring models and standardized processes. The emphasis is on the processing of easily quantifiable "hard information," so the most viable competitors in this market will be the banks that do this most efficiently. Community banks take a different approach that stresses relationship banking. This is typically a higher-cost, higher-margin process that emphasizes the relationship with customers and the processing of less-quantifiable "soft information," such as management quality and strength of character. The most viable organizations in this model are the banks that can most efficiently extract and interpret this soft information. Looking at the production process in this manner explains why some have questioned the viability of community banks. As technology has improved, more information can be collected and processed in a hard-information, commodity-like manner. For example, scoring models are now relatively common for small business loans, a category once thought to be the model for relationship banking. Similarly, research has shown that proximity to the customer is becoming less important than it had been in the past. This allows banks based outside of the local market to better compete in markets once dominated by local community banks. Nevertheless, community banks continue to play an integral role in financial markets. They comprise over 90% of the total number of banks, a number essentially unchanged since 1985. While their total deposit and asset shares declined somewhat during the recent consolidation trend, community banks continue to have a relatively stable share of business real estate lending and a disproportionate share of small business loans and agricultural loans. Community banks appear to be able to compete in the new deregulated environment using the "relationship" model; however, it clearly is more difficult than it was in the past. The efficient community bank, which is capable of providing value by processing soft information, simply has to work harder to succeed given the removal of protective entry barriers and the corresponding increase in competition. RISK MANAGEMENT Risk management at banking organizations has evolved significantly and rapidly, becoming a core function at banks. Market developments have largely driven these changes, but bank supervisors have also played an important role. For example, until the early 1990s, credit risk was generally managed on a loan-by-loan basis, and banks kept most loans on their books until maturity. Now banks can actively manage the credit risk of their loan portfolios as a whole, continually adjusting it through a wide array of techniques, such as loan trading, securitization, and the use of credit derivatives. The management of market (interest rate) risk shows similar trends. Banks used to manage market risk through simple position limits and rather basic duration "gap" analysis, slotting assets and liabilities into various re-pricing categories. Financial engineering and advances in information technology now allow banks of all sizes to manage market risk more effectively using a variety of concepts and techniques. With operational risk, banks are not as far along the learning curve. They have always had tools to reduce operational risk, such as business-line controls, audit programs, and insurance protection. However, in light of the growing number and complexity of operational risks, banks are now beginning to manage these risks in a more systematic way. Further, many banking organizations are developing "enterprise" risk management programs to ensure that they have a holistic view of risks across divisions and risk categories. Responding to the increasingly complex and dynamic nature of risk and the changes in industry structure, banking supervisors began developing a new supervisory framework in the mid-1990s. Historically, bank examinations were largely standardized. They relied heavily on historical data and involved extensive account verification and review of individual loan files on site — what is known in the industry as "transaction testing." In contrast, the new risk-focused supervisory framework involves directing examination resources toward the areas of greatest risk at each bank. As a result, off-site risk assessment and examination planning are critical. Risk-focused supervision also is more forwardlooking than the old approach, focusing on the management practices and controls banks use (such as board oversight, policies and procedures, and management information systems) to deal with current and future risks. Transaction testing has assumed a lesser role, though it is still important in determining the effectiveness of policies and the integrity of banks' internal credit ratings. |
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