Regional President Speech

FRB. Kansas City. Addresses. Hoenig 2 Regulatory Consolidation and the Federal Reserve System's Supervisory Needs Remarks by Thomas M. Hoenig President of the Federal Reserve Bank of Kansas City before the Kansas Bankers Association January 14, 1994 The Department of the Treasury presented a plan in November to establish a Federal Banking Commission, which would supervise all federally insured banks and thrift institutions, as well as their holding companies and affiliates. This proposal is the latest in a long line of plans for regulatory consolidation --a topic which many now refer to as the perennial issue. This frequent attention shows that simplifying the regulatory structure is an attractive idea, and one I strongly support in concept. On the other hand, the lack of previous legislative action on this topic seems to show that there are no simple and well-accepted solutions. Under the Treasury proposal, a new Federal Banking Commission would take over all supervisory functions currently exercised by the Comptroller of the Currency, the FDIC, the Office of Thrift Supervision, and the Federal Reserve. This Commission would be headed by a five-member board, which would include three members appointed by the President, plus the Secretary of the Treasury and a member of the Federal Reserve Board. One of the three appointed members would be designated as chairman and would serve a four-year term corresponding closely to that of the President. The Treasury proposal would allow the FDIC to continue with its deposit insurance responsibilities, but the FDIC would no longer supervise state nonmember banks. Similarly, the Federal Reserve would retain its monetary policy duties, but would be stripped of its supervisory authority over state member banks and all bank holding companies --a loss which I believe would severely compromise the Federal Reserve's ability to serve the public and our financial system effectively. 2 In my remarks today, I first wish to discuss why the Federal Reserve will need a key supervisory role in any successful restructuring. I believe our responsibilities as a central bank are closely intertwined with our supervisory commitment, and I want to elaborate on why supervision is essential to fulfilling our basic objectives and functions. The second part of my discussion will focus on factors that should be given careful consideration in evaluating proposals for consolidation. The right approach to consolidation is of great importance if banks are to have a clear path to the future. If we do not take the right approach, we may find ourselves in the same position as Yogi Berra when he explained why the Yankees failed to win a World Series, "We lost because we made the wrong mistakes." WHY THE FEDERAL RESERVE MUST HAVE A SIGNIFICANT SUPERVISORY ROLE Since its inception, the Federal Reserve has been asked to play a key role in both stabilizing U.S. financial markets and supervising the banking system. The history leading up to the Federal Reserve Act of 1913 clearly demonstrates that Congress established the Federal Reserve to address the periodic financial crises that had disrupted the U.S. economy. The Senate Report on the Federal Reserve Act, in fact, stated that the main purpose of the legislation was "to give stability to the commerce and industry 3 of the United States" and "to prevent financial panics or financial stringencies . " This assigned task is obviously a very broad one --- one that encompasses much more than monetary policy or other Federal Reserve functions. In order to give the Federal Reserve the ability to perform this task, Congress provided for an independent agency, organized under a regional structure, with meaningful bank supervisory and "lender of last resort" powers. Thus, from the start, the Federal Reserve's monetary and financial stabilization objectives have been recognized as being closely related to the oversight of the banking industry. A number of recent market disruptions and other events have added further import to this responsibility: (1) the 1987 stock market crash, (2) regional economic downturns over the last decade and resulting bank and thrift problems, (3) the collapse of Drexel and its junk bond operations, (4) the credit crunch, and (5) the failure of state and private deposit insurance systems in Ohio, Maryland, and Rhode Island. In each of these cases, the Federal Reserve was a vital factor in maintaining public confidence. During the 1987 stock market crash, for example, a close working relationship with major banking organizations was an essential ingredient. This relationship helped to keep both customary and emergency channels of liquidity open to the securities market, thus preventing individual market breakdowns and, most notably, any escalating panic. 4 The 1980s collapse in energy and agricultural prices provided me, and perhaps some of you, with a firsthand look at the importance of the Federal Reserve's link to the banking industry. Through a careful blending of monetary policy actions, supervisory oversight and examiner assistance, and emergency discount window lending, the Federal Reserve played a key role in stabilizing weak spots in our District economy, providing time in which to manage risks and prevent further deterioration in the regional credit base. Without such action, I think most of us would concede that the downturn could have been more severe. Similarly, the Federal Reserve's supervisory duties provided an early insight into the tightening of bank lending and supervisory practices that led to the credit crunch, indicating the need to adjust monetary and supervisory policy before conditions deteriorated further. Could the Federal Reserve have successfully responded to these situations with only secondhand knowledge of the banking industry? Perhaps, in some way, but the nature of our response might not have generated timely market confidence and a greater certainty of action. Overall, these experiences provide strong evidence that the Federal Reserve's supervisory responsibilities cannot be easily separated from the basic functions and objectives of a central bank. Moreover, these events indicate the importance of an organization with the authority, capability, and an established reputation for dealing with potential crises. 5 . FEDERAL RESERVE FUNCTIONS AND THEIR LINKAGE TO BANK SUPERVISION AND FINANCIAL STABILITY In fulfilling its financial stabilization responsibilities, the Federal Reserve performs various key functions that I believe rely on close supervisory insight into the banking industry. This insight, for instance, has been a vital factor in monetary policy actions, discount window lending, control of payments system risk, and monitoring of international relationships. Monetary Policy -- The Federal Reserve's monetary and supervisory responsibilities have been linked together since the System was created. In the words of Paul Volcker, former chairman of the Federal Reserve Board, "The Federal Reserve was founded out of an instinct that monetary and banking disturbances were interrelated." This relationship clearly remains today. While monetary policy is commonly viewed as controlling the money supply and influencing the level of prices, interest rates, and flow of credit, more is involved. Open market operations influence the reserve base of our banking system. Banks, as the primary holder of reserves and a chief source of deposits and credit, are the main vehicle for implementing monetary policy. Thus, the Federal Reserve must pay close attention to the linkages in this system. The Federal Reserve must have an accurate feel for the liquidity in the banking system, the condition of individual banks 6 and their sensitivity to market disturbances, as well as other factors affecting banks' ability to withstand financial stress. Without this knowledge, the Federal Reserve would run a greater risk of pursuing monetary policy inconsistent with the realities of the financial system or inadequate in addressing a banking or financial disturbance. This supervisory and monetary policy linkage, moreover, appears to be growing in importance. Rapid technological innovation and the new competitive environment in the financial system are changing the types of financial services offered to the public and the way the public uses deposits and other financial products. These shifts are altering many of the historical relationships between measures of the money supply and the general economy. Bank supervision is providing insight into these changes, their effects on risk in banking and finance, and their implications for monetary policy. Discount Window Lending -- Another Federal Reserve function, discount window lending, is a key means for injecting the liquidity that financial institutions may need to maintain their operations and withstand a crisis. To perform this function, the Federal Reserve must be able to identify the weak spots in the banking system and the sensitivity of banks to financial strains. This requires detailed knowledge of the condition and liquidity needs of individual banks, and our success in this area relies on 7 relationships with the banking industry that go well beyond what can be generated from secondhand information. I believe this liquidity role is becoming necessarily mors significant with recent banking and legislative changes. The Federal Deposit Insurance Corporation Improvement Act of 1991, for instance, limits the FDIC's ability to take actions that would protect uninsured depositors. With this change, depositor runs on problem or "suspected problem" institutions may become more likely, much as occurred with Continental Illinois National Bank in 1984. Moreover, banking developments such as instantaneous wire transfers and other electronic transactions may further complicate discount window lending by giving the Federal Reserve almost no time to react. If critical and timely lending decisions are to be made, I see no other alternative than for the Federal Reserve to have firsthand supervisory information and a close relationship with much of the banking industry. Payments System Risk -- Through its check clearing, wire transfers, automated transactions, and other payments functions, the Federal Reserve has been assigned major responsibility for the smooth functioning of the payments system. Although the operation of the payments system is often taken for granted, I regard this system as one of the most critical links in our entire economy. The financial transactions which support virtually all of our business and consumption activity would not be possible without public confidence in the payments system. Serious disruptions to this 8 system would, accordingly, have an immediate and dramatic effect on the overall economy and the stability of the financial system. To maintain the soundness of the payments system, the Federal Reserve must know the current condition of the institutions using it and be able to monitor and analyze transactions posing a risk to the system. While some of this information can be obtained from other agencies, having people experienced in supervision enables the Federal Reserve to more accurately assess potential threats to the payments system. Through supervision, the Federal Reserve also has a better opportunity to stay abreast of changes in technology and payment practices that could affect the condition of this system. International Relationships -- Another vital function of the Federal Reserve is to cooperate with other central banks in maintaining the integrity of the international financial system. This includes monitoring the condition of banks with international operations, helping to maintain a safe and stable global payments system, and sharing responsibility for international monetary conditions. Congress recognized these reponsibilities by passing the Foreign Bank Supervision Enhancement Act of 1991, which gives the Federal Reserve either direct or backup supervisory and enforcement authority over all forms of foreign bank entry into the United States. Other legislation has also given the Federal Reserve similar authority over most forms of expansion by U.S. banks abroad. 9 Summary -- I believe the primary functions of the Federal Reserve go hand-in-hand with supervision of the banking industry. These functions have given the Federal Reserve expertise in a wide variety of areas -- an expertise which provides the background to incorporate a broad range of issues into policy decisions and to deal with crisis situations as they arise. To continue to perform these functions well, the Federal Reserve will need more than a backup supervisory role or secondhand information provided by another agency. Moreover, as a central bank, we have relied on highly trained and experienced examiners to carry out our various functions -­ whether judging the condition of our financial markets and ensuring their stability, shaping sound banking and discount window practices, or providing assistance in problem situations. With the changes in banking today, it would be difficult to maintain such examiner expertise in only a standby supervisory capacity and yet be ready to act when a critical need arises. These views are not unique to the Federal Reserve. I would note that many industrialized countries have found it advisable to give their central banks a meaningful role in supervision, and recent international banking developments appear to be increasing this role rather than decreasing it. In several major countries, the central bank is the primary or sole supervisor, while in many others, the central bank has joint responsibility for bank supervision and writing banking regulations. I believe this type of role is more important in the United States because of our key 10 position on the international level and because the large number of banks in this country make it extremely difficult for an organization without supervisory duties to gain a good understanding of industry developments. WHAT ARE THE MAJOR ISSUES IN REGULATORY CONSOLIDATION? Apart from the factors I have mentioned that emphasize why the Federal Reserve must have a significant supervisory role, I believe there are other factors to be considered in regulatory consolidation. Much debate went into the legislation that created the existing regulatory structure and a number of important principles were established in this process. If we are to maintain the strengths of this system while streamlining its structure, we will need to think carefully about many fundamental questions. What degree of independence should be given to a consolidated agency or agencies? -- Under our current system, the agencies have had some degree of political independence. The presence of four federal bank and thrift agencies and 50 state agencies has made it nearly impossible to control the entire supervisory process for partisan political purposes. Moreover, through law or by practice, several of the agencies have operated with a certain level of independence. For example, independence was an extremely critical issue in the debate leading up to the Federal Reserve Act, and System officials have consequently been provided considerable 11 independence in pursuing monetary operations and other functions, subject, of course, to the general oversight of Congress. In a highly visible, consolidated supervisory environment, this type of independence would be most important. Our banking system and its supervision have been fundamental to the long-run health of the economy, and a consolidated agency would need to be able to pursue policies that reflect the best interests of the public and the financial industry. As a result, I believe any consolidation must be accompanied by a reasonable level of independence in decision making and funding. Should consolidation preserve the dual banking system? - - Our dual banking system has provided an opportunity for substantial innovation in banking and banking regulation, and I believe dual banking has yielded a richer experience than might have occurred under a more narrowly focused system. The states have initiated many important changes, paving the way for multibank holding companies, interstate banking, broader branching authority, and such products as NOW accounts and adjustable rate mortgages. State banking and its separate regulatory structure have also helped to ensure a less concentrated banking and supervisory framework, in which a variety of viewpoints on banking issues can be presented and discussed. While dual banking may have complicated the decision-making process, I think it has been extremely worthwhile from the standpoint of bringing all the issues and trade-offs into 12 the open and developing policies in the best interest of all parties. I believe a single federal regulator could prove to be a serious threat to dual banking. Such a regulator would have a natural tendency to regulate state banks in the same manner as national banks, with only a limited interest in preserving their statutory differences. Over time, this lack of support at the federal level could lead to a dual banking system in name alone -­ a prospect that has been a major concern of state banks and state agencies in past consolidation proposals. Therefore, I think we should take a careful look at the dual banking system and consider which ways are most likely to streamline the supervision of state- chartered banks while sustaining them as a viable alternative. Should cost savings be a major factor in. the decision to consolidate? -- One of the most common reasons suggested for consolidation is efficiency. I believe any savings, though, are likely to prove illusive. The major supervisory expense -- field examiners and related costs -- would remain about the same with or without consolidation, since essentially the same number of examinations would have to be performed. Also, the federal agencies already rely on a number of joint programs and cooperative efforts to help control costs. Under the Treasury proposal, the FDIC and the Federal Reserve would still have to maintain a backup examination staff to perform their assigned functions. 13 Potential cost savings might be more likely realized under regulatory streamlining that stops short of placing everything under a single federal agency. This would be particularly true of alternatives that could be accomplished through the existing agency structure, since such steps would avoid the substantial transition costs associated with creating a new Federal Banking Commission. Also, given the history of some federal bureaucracies, a single, all-powerful banking commission may not have a strong inclination to reduce staff, cut other costs, or take innovative approaches. As a result, we should be wary of basing the case for a single agency on cost savings, and any savings should be regarded as secondary to creating a system that can best meet the needs of the public and the financial system. Will consolidation significantly lower the regulatory burden? -- Another common claim is that consolidation, as described by Senate Banking Committee Chairman Riegle, "can go a great distance toward relieving the regulatory burdens many bankers are feeling." From a banker's perspective, this claim may have much appeal -­ simplifying the regulatory system would help reduce the number of agencies over a banking organization. However, there are a number of different ways this streamlining could be accomplished short of creating a new superagency. In addition, the federal banking agencies have already done much to reduce the burden of multiple authorities. For instance, all insured banks now operate under nearly identical 14 examination rating systems, reporting requirements, capital standards, and other major regulations, including consumer laws. As a result, any real progress in relieving the regulatory burden will almost certainly have to come from reform of banking laws rather than regulatory restructuring. I also believe bankers would have a much greater fear of regulatory burden if they were to be subject to a single, monolithic federal regulator -- particularly one unchecked by the viewpoints and perspectives of other agencies and with little incentive to be innovative and responsive to banking industry needs. In discussing a proposal for a single agency in 1962, the president of the American Bankers Association expressed a similar view when he stated, "The power to supervise is the power to control." Would credit availability improve with consolidation? - - Some proponents of regulatory consolidation have also argued that the elimination of supervisory overlap would improve credit availability and make banking a more vital industry. Where supervision is duplicative, I tend to agree. However, I also believe that a single supervisory agency would be more risk averse and less innovative, which would almost certainly result in fewer incentives to lend. To me, this suggests that credit availability and banking competitiveness will not be improved unless we can find an approach that eliminates much of the regulatory overlap, but still maintains a supervisory choice at the federal level. 15 AN ALTERNATIVE PROPOSAL Overall, I believe many sound arguments can be made for simplifying our regulatory system. At the same time, I greatly fear the consequences if this restructuring weakens our dual banking system and fails to maintain a meaningful supervisory role for the Federal Reserve System. For these reasons, I strongly support restructuring along the lines recently suggested by Federal Reserve Governor John LaWare. Under his proposal, banking regulation would be realigned along holding company lines. The OCC or a Federal Banking Commission would be responsible for any organization whose lead institution was a national bank, while the Federal Reserve would be over any organization headed by a state-chartered bank. An exception to this format would be made for organizations of particular importance to our financial stability. In such cases, the Federal Reserve would supervise the parent organization and its nonbank operations, while the banking subsidiaries would be supervised by the regulator for the lead bank. This proposal, while not as simple as some, would achieve virtually all of the basic goals of consolidation without destroying the dual banking system and without leaving our economy more vulnerable to a financial crisis. For bankers, moreover, the LaWare proposal would allow them to report to a single agency, while still preserving their choice of regulators. Conclusion In closing, I wish to repeat some remarks on supervisory consolidation made by Gerald Corrigan, former president of the Federal Reserve Bank of New York. I believe these remarks are especially relevant today because they reflect the views of a person who had a vital role in steering the banking industry through the problems of the 1980s and early 1990s. Therefore, the real issue with regard to the role of the Fed in the supervisory arena needs to be put squarely on the table. Namely, in times of disruption or crisis, do we want (and does the world at large want) the central bank of the most important country in the world to have neither the authority nor the expertise to help manage and contain such financial disruptions? If it ever comes to a vote, those who would vote in favor of stripping the Fed of those necessary responsibilities may sleep better at night but I will not.

Thomas M. Hoenig (1994, January 13). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19940114_thomas_m_hoenig

@misc{wtfs_regional_speeche_19940114_thomas_m_hoenig,
  author = {Thomas M. Hoenig},
  title = {Regional President Speech},
  year = {1994},
  month = {Jan},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19940114_thomas_m_hoenig},
  note = {Retrieved via When the Fed Speaks corpus}
}