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Annual Report, 2006
2006 Annual Report
Letter from the President

Real gross domestic product, or real — our broadest measure of economic output — increased at an annual rate of 3.1 percent in 2006. However, over the past few quarters, growth has been averaging close to 2 percent. At the Federal Reserve Bank of Chicago, our estimate of the economy's potential growth rate — that is, the rate of growth it can sustain over time given its labor and capital resources — is just a bit under 3 percent. As such, by this standard, economic growth over the last few quarters has been somewhat below potential. However, even though overall growth has been below our estimate of potential, labor markets have continued to tighten; the unemployment rate fell from 5 percent in late 2005 to an average of about 4 1/2 percent in early 2007.


Such tightening resource pressures, as well as high energy and commodity prices, likely contributed to faster increases in prices. As a result, inflation ran too high. The Fed's preferred measure of inflation is the price index for personal consumption expenditures excluding food and energy, also known as core PCE. Over the four quarters of 2006, core PCE prices increased 2.2 percent, about the same pace as in 2005. By contrast, I prefer that, over time, inflation run between 1 and 2 percent — the range I consider to be most compatible with the Fed’s goal of price stability.


Given the relatively high level of resource utilization in the first half of 2006, the Federal Open Market Committee (FOMC) continued removing policy accommodation at a measured pace. The FOMC raised the target federal funds rate from 4 1/4 percent at the beginning of the year to 5 1/4 percent after its June meeting. With the pace of growth moderating in the second half of the year, but with inflation still running too high, the FOMC left the stance of policy unchanged through the rest of 2006 and the beginning of 2007.


For the balance of 2007, economic growth likely will average modestly below potential, but I expect that growth will return to near potential in 2008. The below-potential growth this year would be consistent with slight increases in the unemployment rate and other measures of resource slack, but the magnitude of the increases would likely be small.


Core inflation should gradually come down, moving closer to the levels I view as being consistent with price stability. Still, there is a risk that inflation could remain stubbornly high for a couple reasons. First, the economy appears to be operating in the neighborhood of its potential level of output. The unemployment rate is low, growth in compensation per hour has moved up some over the past year, and productivity growth has slowed. Together, these have resulted in an acceleration in unit labor costs. Second, inflation has run at or above 2 percent for the past three years. With inflation at such a high level for such a long period of time, we have to recognize the risk that inflation expectations could become stuck in a range that would not be conducive to price stability. To date, inflation expectations appear to be contained, but that is not something we can take for granted. The longer inflation runs above levels consistent with effective price stability, the greater the danger that expectations of future inflation will settle in above those levels as well.


Taking all of these factors into account, my assessment is that the risk of inflation remaining too high in 2007 is greater than the risk of growth falling too low. Of course, whether policy will need to be adjusted and the degree of any adjustment will depend on the incoming data and how that data influences our forecast of the economy.


After 13 years as president of the Federal Reserve Bank of Chicago, I will retire on August 31, 2007. In this year's annual report, I reflect upon my tenure at the Bank, and in particular, on my impressions of the most important developments in the Federal Reserve's core responsibilities of monetary policy, bank supervision and regulation, and the payments system.


In addition, I would be remiss if I did not say how tremendously rewarding my work at the Chicago Fed has been, primarily because of the opportunity over the years to work with such dedicated and talented staff members and directors.

Of special note are the seven individuals who served as chairman of our Board of Directors during my years at the Chicago Fed: Richard Cline; Robert Healey (deceased); Lester McKeever, Jr.; Arthur Martinez; Robert Darnall; James Farrell and Miles White. Each has made significant contributions to the Chicago Fed and the FederaI Reserve System.


I would also like to thank the many directors who served the Chicago Fed and its Detroit Branch during my tenure (listed on page 17) as well as the three individuals who completed their service as directors last year. They are:

  • James Farrell, former chairman of Glenview, Ill.-based Illinois Tool Works. Jim served as chairman of the board from 2004 to 2005.
  • William A. Osborn, the chairman and CEO of Northern Trust Corporation and the Northern Trust Company.
  • Mindy C. Meads, currently the president and chief merchandising officer of Aeropostale, Inc., and formerly the president and CEO of Lands' End Inc.

I am very grateful for their counsel and help in running our operation efficiently and productively. On a related note, I would like to recognize the following people who joined our board this year. They are:

  • William C. Foote, chairman and CEO of Chicago-based USG Corporation.
  • Dennis J. Kuester, chairman and CEO, Marshall & Ilsley Corporation, Milwaukee, Wisconsin.
  • Ann D. Murtlow, president and CEO, Indianapolis Power & Light Company, Indianapolis, Indiana, and vice president, AES Corporation.

In closing, I would like to emphasize how much I have enjoyed serving the Federal Reserve Bank of Chicago and the residents of the Seventh Federal Reserve District. I am proud of our accomplishments and value the relationships that I have been able to form with people throughout Chicago and the Midwest. I also am proud of the tremendous strides we have made in fulfilling our varied responsibilities. With the continued dedication of our staff and directors, I am confident that the Bank will remain in very strong condition in the years ahead.

Michael H. Moskow
President and Chief Executive Officer
May 15, 2007

Stability in Times of Change, A Personal Reflection on Thirteen Years in Office

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.


At 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:

  • Looking at a wide range of data and information, instead of one or two summary indicators.
  • Using cogent economic theory to shape analysis.
  • Respecting the risks of undesirable outcomes for growth or inflation, even in environments that appear benign.
  • Remaining flexible to new approaches and ways of thinking in responding to developments and changes in the economy.

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.


Productivity — the amount of output the economy can produce with an hour's worth of work — is the fundamental determinant of our standard of living. That is because new technologies that generate productivity growth provide strong incentives for firms to invest and because, over time, increases in productivity eventually translate into increases in workers' wages, salaries, and benefits. After two decades of sluggish increases, productivity growth picked up sharply in the second half of the 1990s, and as a result, output surged. Notwithstanding, it was difficult to judge whether the increase in productivity growth was permanent or temporary.


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 other experience I want to discuss occurred in 2003. Growth in real activity was sluggish, the pace of job growth was subdued, and according to the data we had in hand at the time, core inflation had fallen to below 1 percent. There was a concern that the inflation rate would actually fall below zero, resulting in deflation — a decline in the overall price level. The concern no longer seemed so far-fetched, considering that Japan was at the time in the midst of a prolonged deflation spell. Some commentators even discussed a deflationary spiral, in which the increased real value of debt obligations would lead to a self-reinforcing cycle of defaults, wealth erosion, and a marked contraction in economic activity.


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.


The 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.

Total number of banks in U.S., 7th District and 7th District States
Total number of banks in U.S., 7th District and 7th District States

The U.S. has historically been unique in the structure of its banking industry. By almost any measure — number of banks, banks per capita, or banks per square mile — the U.S. has been more "banked" than any other country in the world. This has been the result, in part, of the geography and demographics of the U.S., characterized by many lightly populated rural areas, each having at least one bank. Another major force was the set of restrictions imposed on geographic expansion. Since the 1920s, the expansion of banking and branching had been left to the states to determine, and a number of them, particularly in the Midwest, opted to restrict expansion significantly. This resulted in the proliferation of single-office banks providing banking services in local communities.


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.


Total number of bank branches in U.S., 7th District and 7th District States
Total number of bank branches in U.S., 7th District and 7th District States

With these changes in the banking landscape, some have questioned the future viability of community banks. The concern is that the very nature of the industry has changed so significantly that small community banks will no longer be able to compete with large money-center or regional banks.


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.


Whether in community banks, regional institutions, or large, complex financial institutions, the changes in the banking industry have coincided with significant changes in the banking industry's risk profile. Traditional credit and interest rate risks, and, increasingly, operational and compliance risks, have been rapidly evolving. Accordingly, banks have worked to improve their risk management capabilities. In response, the Federal Reserve's supervision programs have developed to become more risk focused and institution specific.


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.



There have been many important milestones in the movement from paper checks to electronic payments in the past 13 years. This is particularly notable since payment habits typically change slowly, especially when existing instruments perform well and remain highly convenient. But ultimately, changing cost structures affect what payment networks offer and what the public uses. This evolution has again required new approaches by the Federal Reserve in its role in the payment system.


U.S. payments volume in billions of payments per year
U.S. payments volume in billions of payments per year

As in many other industrialized countries, the U.S. continues to shift to electronic payments. For society, the benefits of the shift should be substantial, since the marginal cost of adding one more transaction into an electronic payment network is almost always considerably less than it would be in a paper-based network. However, the shift is not easy because the methods of handling paper have been refined over centuries, and the fixed costs of automating transactions are seldom minor. Therefore, when a tipping point eventually is reached, the switch-over period from paper to electronic can be rapid.


Estimated total paper check usage in the U.S. finally began to decline shortly after I began at the Chicago Fed. By 2003, estimated electronic payment transactions in the United States exceeded check payments.


The downward trajectory for checks reflects the introduction and expansion of a number of technologies. One example is debit cards. While debit cards were introduced initially in the 1970s to dispense cash from ATM machines, debit transactions at the checkout register have soared over the last ten years, displacing a considerable number of checks. Another example is check truncation, which involves converting checks into substitute checks or electronic signals at lock boxes (for the payment of bills), at the point of service, or in the back office.


The explosive growth of the Internet since 1994, and its important role in changing the character of both banking and commerce, also has been an important factor. Households increasingly choose to purchase goods and services online using existing card and automated clearinghouse (ACH) networks.1 New payment processors such as PayPal entered the marketplace to service the ballooning online auction business. After a faltering start, online banking finally took hold and began to reduce dramatically the number of checks written by households. Beyond households, however, business-to-business transactions were much slower to transition to electronic platforms, largely because of the greater information needs of firms and the inherent difficulties in integrating payments with enterprise resource-planning systems.


To gain widespread acceptance, successful payment innovations have to benefit a host of parties, such as payment processors, banks, households, and businesses. When payment networks grow sufficiently, scale economies lower operating costs, and the technology suddenly becomes profitable in new venues. Merchants become more willing to accept plastic in lieu of cash or checks in part because of falling real costs of placing PIN pads at the checkout. These developments engendered a cultural shift, which transformed many previously cash-only locations. As a result, many new vendors began to accept plastic, most notably taxicabs, coffee shops, doctor's offices, fast-food restaurants, grocery stores, utilities, and mass transit facilities.


As the use of checks declined, the Federal Reserve closed more than half of its 45 check-processing sites, including offices in Milwaukee, Indianapolis, and Peoria, Ill. in the Seventh District. We also consolidated other payment services, such as ACH and FedWire.2 To lower operational costs, the Chicago Fed moved its check-processing operation from its downtown headquarters to a more strategic location near Midway Airport. We established a payments team to produce high-quality research, foster dialogue with the payments industry, and provide valuable insights on System payment initiatives. Finally, the Customer Relations and Support Office was established and headquartered at the Chicago Fed to strengthen Federal Reserve System contacts with commercial banks and to develop modern software, such as FedLine Advantage, for banks to access various Federal Reserve financial services.


Along similar lines, the Federal Reserve took the initiative to improve the efficiency of check processing by proposing and supporting the passage of the Check Clearing for the 21st Century Act, or Check 21, which allows for the substitution of image-replacement documents in the clearing and settlement of checks. The law went into effect on October 28, 2004. Check 21 is designed to foster innovation in the payments system and enhance its efficiency by reducing some of the legal impediments to check truncation. The law facilitates check truncation by creating a new negotiable instrument called a substitute check, which permits banks to truncate original checks, process check information electronically, and deliver substitute checks to banks that want to continue receiving paper checks. A substitute check is the legal equivalent of the original check and includes all of the information contained on the original check. The law does not require banks to accept checks in electronic form, nor does it require banks to create substitute checks, but it is an important step toward greater use of electronic payments.


In comparison to the switch-over from check to electronic payments, the substitution of electronic payments for cash appears to be more challenging and is moving slowly. General-purpose stored-value card trials in the U.S. at the Atlanta Olympics in 1996 and in Manhattan a year later did very little to convince consumers and merchants of their value. Rather, stored-value products have been successful only in relatively limited situations: gift cards, payroll cards, various government benefits, mass transportation, and on university campuses.


Cash itself has undergone several facelifts in the last decade or so. Along with the Federal Reserve, the U.S. Treasury continued to improve the counterfeiting deterrence capabilities of U.S. bank notes. The list of improvements includes adding color to some notes, an enlarged off-center portrait, a watermark, fine-line printing patterns, and color-shifting ink. The counterfeiting threat has global implications because, in value terms at least, half of U.S. banknotes continue to be held outside the United States, particularly as a store of value in several economies with underdeveloped banking systems.


Moving forward, the Federal Reserve must continue to play an important role in fostering a smoothly functioning payments system that is safe, efficient, and accessible. Within that framework, continuing to support the shift from paper to electronic payments is good public policy.


I have discussed a number of unique challenges in the macroeconomy and banking and financial systems the Fed faced since 1994. Using these experiences as a guide, I believe we can reasonably anticipate a number of developments in the future.


Macroeconomic and financial challenges will undoubtedly continue to emerge. Some of these challenges will be similar to events the U.S. economy has experienced in the past. Others will be new and unique. Many of these new challenges likely will stem from the increasing technological sophistication and complexity of the real economy and of the financial system; others will come from the progressive influence of globalization on trade and international financial flows. All will continue to test the best thinking of the Federal Reserve.


For policy to respond successfully to them, we will need to keep in mind the principles of sound policy-making I previously discussed: Study a wide range of data. Analyze problems using cogent economic theory. Respect the risks of undesirable outcomes for growth and inflation. And remain flexible in thinking about changes in the economy and the ways policy should react to them.

The Federal Reserve also has the responsibility of explaining our actions to the public. Over the past decade, we have seen a move from central bank secrecy to central bank transparency, a change that reflects a growing appreciation of the enhanced policy credibility and reduced economic uncertainty that accompany public understanding of the goals and rationales underlying monetary policy decisions. I consider this movement toward greater transparency a very positive development and expect it to continue.


The structure of the U.S. banking industry is likely to continue to evolve toward one in which a small number of large, complex banking organizations compete globally with the world's largest financial institutions while a large number of smaller institutions focus on local communities or somewhat larger regional areas. Banks will continue to expand their product lines across the spectrum of financial activities, and other financial institutions will increasingly offer traditional banking services. Technological advances will facilitate increasingly sophisticated banking products and services. At the same time, the implementation of the Basel II Capital Accord in the U.S. will spur further development of risk management practices of financial institutions.


The evolution of the banking industry will require the Federal Reserve to continue to improve its supervision techniques, tailoring them to the needs and challenges posed by the different types of banking institutions. At the core of our supervisory responsibilities will be the Federal Reserve's ability to identify and understand the swiftly changing risks and risk management practices of banking organizations. To carry out their supervisory tasks, the Reserve Banks must continue to improve their capacity to evaluate the quality of these risk management practices. To obtain a complete picture of industry risks and risk management practices, we will need to continue to share insights across Districts and with other regulators, both domestic and foreign.


The migration of U.S. retail payments to electronics will continue to accelerate. Payment system developments will require the Fed to continue to adapt to lower demand for paperbased processing services and higher demand for electronic payment services.


To accomplish this, Reserve Banks are unlikely to remain full-service providers of retail payment services indefinitely. The Reserve Banks will continue encouraging greater use of electronics in the check-collection process as well as offering an array of products and services to take advantage of the opportunities provided by the Check 21 Act. At the same time, there will be an ongoing focus on customers, service levels, and fees, and on cost efficiency in both retail services and Reserve Bank support functions.


The Reserve Banks also will continue to contribute to the formulation of payment system policy, particularly with respect to payment system risk issues. In doing so, they will further strengthen their outreach to financial markets, both domestic and abroad, by enhancing the Fed's role in promoting financial stability, effective crisis management, and the formulation of standards. Ultimately, the Federal Reserve's role in helping to shape the development of our nation's payment system will continue to be informed by its unique role as a public policy-making institution and payments provider.


I would note that, in many ways, the Federal Reserve System has already made great strides to prepare for these future challenges in the economy, banking and payments system. Across its responsibilities, the Federal Reserve has adopted industry best practices, managed its responsibilities holistically, and worked to retain and build upon its distinctive strengths. These attributes are likely to sustain the central bank in the years to come.


The Federal Reserve will continue to adopt and incorporate best practices from the industry and elsewhere to ensure the highest levels of integrity and excellence. In 2006, the Federal Reserve voluntarily chose to meet the rigorous requirements of Section 404 of the Sarbanes-Oxley Act of 2002 (SOX). Like publicly held organizations, through SOX, the Fed strengthened its focus on its system of internal controls over financial reporting and the effective management of risks. For similar reasons, the Federal Reserve System has bolstered its governance structure through service agreements between Reserve Banks, performance metrics, and other mechanisms that enhance the clarity of authority and accountability.

Across the System, Federal Reserve Banks increasingly strive to provide a common face to customers and stakeholders. Responding to changes in the payments system, the System consolidated a number of business and support functions such as payments processing locations (notably in the paper check infrastructure), statistical reporting functions, marketing and some sales activities, and information technology support and infrastructure. The System also further coordinated its activities in supervising financial institutions. At the same time, we improved the coordination and collaboration between Reserve Banks, the Board of Governors, and other entities. These moves improve the efficiency and effectiveness of our payments products and central bank responsibilities, and ensure we deliver more seamless interaction and services to customers and stakeholders.


In the midst of tremendous change in the economy and banking and financial systems, the Federal Reserve has been vigilant to retain and build upon a unique attribute and strength — its regional structure and character. Given population shifts in the U.S. since 1913, we would probably implement the geographic structure of Reserve Banks differently if we were to create the Federal Reserve System from scratch today. However, this structure makes our central bank a uniquely American institution, reflecting the importance that we as a society place on local representation, independence, and transparency. It also contributes greatly to the monetary policy-making process.


The 12 regional banks, and their independent Boards of Directors, give the Fed ready access to information from all parts of the country and all sectors of the economy. And the fact that all District Bank presidents serve on the FOMC — and have access to high-quality research performed by their own independent staffs — assures that a variety of voices are heard in the policy-making function. While it is perhaps most notable in the core responsibility of monetary policy, the presence of the Federal Reserve's regional character helps to inform nearly all aspects of our responsibilities as a central bank, allowing us to bring new insights and ideas to bear on unforeseen problems.


Given these attributes, I remain confident in the ability of the Federal Reserve Banks and the Federal ReservSysemark tem to adapt in the face of challenges that lie ahead. In my experience, a hall of the Federal Reserve has been and will continue to be the level of commitment and talent associated with the people who make up the institution. At the risk of making a bold prediction, that will never change. As long as we retain these qualities, the System will remain the world's preeminent central bank.


Federal Reserve Bank of Chicago Research Department Vice Presidents Spencer Krane, Douglas Evanoff and Richard Porter contributed to the development of this essay, as did Supervision & Regulation Senior Vice President Cathy Lemieux and Senior Examiner Steven Van Bever as well as Enterprise Risk Management Assistant Vice President Nate Wuerffel.


1 An ACH network is an electronic clearing and settlement system for exchanging electronic transactions among participating depository institutions. Such electronic transactions are substitutes for paper checks and are typically used to make recurring payments such as payroll or loan payments. The Federal Reserve Banks operate an ACH, as do some private sector firms.

2 Fedwire is an electronic funds transfer network operated by the Federal Reserve. Fedwire is usually used to transfer large amounts of funds and U.S. government securities from one institution's account at the Federal Reserve to another institution's account. It is also used by the U.S. Department of the Treasury and other federal agencies to collect and disburse funds.

Chicago Fed Highlights of 2006

Economic Research and Programs 

  • Chicago Fed economists provided support throughout the year to the president and board members to help them carry out their monetary policy responsibilities.
  • Research Department members prepared eight special policy briefings, including presentations on topics such as the long-run trends in housing markets and inflation dynamics.
  • Twenty-seven working papers were produced, and 25 previously written papers were accepted for publication in top-tier scholarly journals.
  • The Research and Consumer and Community Affairs (CCA) areas held 41 conferences.
  • Research reports were presented in Economic Perspectives, Ag Letter, Profitwise News and Views, and Fed Letter, including 12 special issues of Fed Letter.
  • Department economists gave 49 paper presentations to academic audiences and presented 129 speeches and lectures to a variety of audiences.
  • Policy conferences and forums were held on financial access for immigrants, rural economic development, community development finance, access to financial services, and foreclosure prevention.

Financial Institution Supervision and Regulation 

  • Supervision and Regulation continued to focus on improving core supervisory functions by promoting staff development and a collaborative work culture as well as improving risk assessment and operational processes.
  • The department's primary 2006 focus was on enhancing the quality of risk resolution work.
  • More than 1100 examinations, inspections and off-site reviews were conducted.
  • The department focused strategic efforts on streamlining processes for low-risk organizations and activities and making improvements in examination processes.
  • New procedures were implemented for examining banks with low-risk information technology operations.

Financial Services 

  • Check processing successfully met all cost, productivity and sales targets and played a leadership role in supporting, selling and implementing Check 21 products.
  • Cash Services successfully met all unit cost, productivity and quality targets.
  • 2006 marked the first full year in the new Detroit Cash facility, featuring multiple machine rooms, state-of-the-art technology, increased capacity, and a strengthened control environment.
  • The Des Moines check-processing operation remains among the top in the Federal Reserve System.
  • The Midway check-processing center improved its efficiency, increasing both productivity and quality.
  • Cash and check continued to maintain internal quality controls throughout the year.

Customer Relations and Support Office (CRSO) 

  • The CRSO successfully completed the migration of FedLine Advantage and converted the more than 8,600 remaining customers off of the DOS-based FedLine platform.
  • National Marketing and Sales continued strong performance and played a critical role in achieving outstanding results in 2006.
  • The CRSO developed a new customized Check 21 Value Calculator and online resource center for customers and issued the first quarterly National Customer Satisfaction Survey.

Other Activities

  • A new Financial Markets Group was created to study financial markets and the clearing and settlement operations that support these markets, with particular focus on Chicago derivatives exchanges and clearinghouses.
  • Money Smart Weeks held in Chicago, Michigan, Indiana and Wisconsin involved more than 500 partner organizations and featured more than 1300 events providing financial education to consumers throughout the Seventh Federal Reserve District.
  • Executives from around the Federal Reserve System gathered in Chicago twice during the year for the Senior Leadership Conference, featuring thought-provoking activities and presentations.
  • The process began to identify the successor to Chicago Fed President Michael H. Moskow, who will retire at the end of August of 2007.
  • The bank better managed operational risks and controls.
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