The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
For release on delivery
10:00 A.M., E.S.T.
February 6, 1992
Statement by
David W. Mullins, Jr.
Vice Chairman, Board of Governors
of the Federal Reserve System
Before the
Committee on Banking, Finance and Urban Affairs
and the Subcommittee on Domestic Monetary Policy
U.S. House of Representatives
February 6, 1992
Hr. Chairman, members of the Committee, thank you
for this opportunity to present the Federal Reserve Board’s
views on reforms to the regulation of the government
securities market.
Just two weeks ago, staff of the Federal
Reserve, the Treasury Department» and the Securities and
Exchange Commission (SEC) released results of their
exhaustive examination of this market.
My prepared remarks
will touch Upon some of the main conclusions of this report
from the particular perspective of the Board of Governors of
the Federal Reserve System.
Our perspective differs
somewhat from the other agencies contributing to the report
due to differences in legislative mandates.
The Board of
Governors has little direct regulatory authority for the
U.S. government securities market.
While the Board has general oversight
responsibility for all Federal Reserve District Banks, it is
the District Banks that act as fiscal agents of the
Treasury, thus sharing with the Treasury operating
responsibility for the market.
In addition, it is the
District Banks that routinely examine those financial
institutions for which the Federal Reserve System has
primary oversight responsibility, virtually all of which
hold and some of which actively trade government securities.
It is the SEC’s charge to enforce the securities laws that
seek to foster a high degree of fairness in the marketplace.
With neither the direct responsibilities of funding the
government nor substantial regulatory oversight, the Board
of Governors can view this market from a somewhat different
vantage point--a policy perspective that allows us to
examine these issues in an economy-wide context.
When we look to the government securities market,
we see a market that works as well as any on earth.
U.S.
government debt is an ideal trading vehicle, since it is all
closely substitutable and has none of the default risk or
idiosyncratic problems of private issues.
As a result,
-
2
-
market participants, in the aggregate, willingly commit
substantial amounts of risk capital and exchange a large
volume of securities each day.
Positions are large yet
trading skills are so sharply refined that bid/ask spreads
are razor thin, a small fraction of the size of spreads in
major equity markets.
This market generates widespread macroeconomic
benefits.
The government securities market efficiently
absorbs the large quantity of new issues required to finance
the deficit.
With real-time quotes on a range of
instruments, this market serves as the foundation for
private market rates and a haven for ready liquidity.
Further, this deep and liquid market gives the Federal
Reserve a powerful, reliable mechanism to implement monetary
policy.
Nonetheless, the admission of wrongdoing by Salomon
Brothers, episodes of price distortions, and other evidence
uncovered in our joint study all suggest that this market
has faults.
It can be improved.
The proposals contained in
the joint report, along with other reforms announced
earlier, constitute a careful, comprehensive modernization
of the mechanisms and practices in the government securities
market.
Implementing these proposals represents a
formidable, though feasible, task in our view.
Over the longer term, the most effective force in
enhancing market efficiency and reducing the potential for
manipulative abuses is the force of competition.
And the
effect of these proposals is to open up the government
securities market to broad-based participation.
Automating
Treasury auctions; facilitating direct bidding by customers,
including non-primary dealers; implementing a single-price,
open auction technique; and reducing the barriers to primary
dealer membership all will serve, in time, to broaden
participation in the primary market and in the secondary
market for newly issued securities.
More depth and breadth
-
3-
in this end of the market should increase efficiency, reduce
Treasury financing costs, and lessen the potential for
manipulative trading abuses.
In addition, the competitive
force of broader participation will be reinforced by
proposals targeted at manipulative abuse: tighter
enforcement of auction rules and enhanced market
surveillance by the Federal Reserve Bank of New York to
identify potential manipulative episodes that could trigger
SEC investigation and Treasury supply management to reopen
offerings.
Taken together, these actions should serve to deter
manipulative practices and quickly detect abuses should they
occur.
Moreover, they are relatively low-cost, market-based
responses that should achieve these benefits without
impairing the efficiency and liquidity of this vital market.
There are, of course, many other alternatives which
could be considered to combat the potential for abuses in
this market.
However, the government securities market is
too important a national resource and works too well to be
put at risk by regulatory change for the sake of change.
From the Board of Governors’ perspective, a compelling case
must be established that the benefits outweigh the costs.
In our view, such a compelling cost-benefit
analysis has not been made with respect to proposals to
establish a broad-based apparatus of reporting requirements
in this market, either directly or through audit trails or
transparency requirements.
While increased reporting would
deter manipulation and facilitate the investigation of
abuses, such systems would impose substantial potential
costs on this market.
The reporting burden would fall on
all traders--the good and the bad--boosting the cost of
every trade.
While the direct costs of additional record
keeping might be kept manageable, an indirect cost looms
larger.
Rather than risk the divulging of their finances
and trading strategies, participants might withdraw from
-4this market, thereby raising the cost of Treasury finance.
And, of course, the stakes are high. * A tiny increase in
Treasury rates aggregates into a very substantial increase
in cost to U.S. taxpayers.
Because it might be difficult to resist
implementing, even backup authority risks sending a chilling
message about the U.S. market to all participants choosing a
trading arena in the global marketplace.
Moreover, in view
of the extensive nature of the other changes proposed in
this report, one might question the capacity of this market
to absorb, at an acceptable cost, this additional change-the imposition of broad-based reporting requirements for
this market.
The agencies agree that large position
reporting requirements should not be implemented at this
time.
Rather than risk slipping into this fundamental
change through backup authority, the Board of Governors
feels it would be a wiser course of action to return to
Congress for enabling legislation in the future should such
authority appear necessary.
This Committee's important mandate is to ensure
that a legislative framework is in place that provides for
the adequate supervision of the government securities
activities of banks.
In the Board's opinion, the current
supervisory structure secures a full measure of prudential
oversight of the activities of commercial banks and bankrelated dealers in government securities.
The Federal
Reserve System's share of responsibility for that
supervision and oversight has three components.
First, under the Government Securities Act of 1986
("GSA"), government securities brokers and dealers that are
financial institutions are subject to oversight by their
primary federal supervisory agency.
In this capacity, the
Federal Reserve's watch extends to State member banks of the
Federal Reserve System, foreign banks, State branches and
agencies of foreign banks, and commercial lending companies
-5-
owned or controlled by foreign banks.
As a part of their
annual examinations, Federal Reserve examiners review dealer
compliance with all aspects of GSA-mandated rules adopted by
the Treasury Department.
Specifically included are rules
designed for protection of investor securities and funds,
recordkeeping, registration of associated persons, and rules
governing custodial holdings of government securities--the
latter of which are applicable to all depository
institutions.
Second, the Federal Reserve examines the trading
and investment practices of nonbank subsidiaries of bank
holding companies that deal in or underwrite securities-including government securities--to ensure that they are
being prudently managed and do not pose an undue risk to
bank affiliates.
These subsidiaries are registered with the
SEC and are examined by a self-regulatory organization
("SRO"), such as the NASD, for compliance with all
rules applicable to broker-dealers.
Federal Reserve
inspection procedures are designed to prevent, to the extent
possible, duplication of the procedures of the various SROs.
For the so-called "Section 20 subsidiaries," which have been
authorized to underwrite and deal in bank-ineligible
securities, the Federal Reserve also examines for compliance
with its "firewall" provisions, which importantly insulate
affiliated depositories and the federal safety net from the
risks inherent in the securities business.
Moreover,
section 20 inspections check compliance with the Board’s
revenue test, verifying that Section 20 subsidiaries do not
become principally engaged in the distribution of securities
in violation of the Glass-Steagall Act.
Moreover, all
inspections of nonbank subsidiaries include an evaluation of
their financial impact, if any, on the parent bank holding
company.
Third, the Federal Reserve supervises State member
banks’ investment activities, which in virtually all
-
6-
instances include investments in government securities.
Despite the diminished concerns about credit quality
afforded by a portfolio of government securities, examiners
still must scrutinize those holdings.
For example, a
portfolio's liquidity and interest rate risk must be
evaluated to determine whether the investments are
consistent with the institution's financial position and
management’s expertise.
Indeed only last month, the Federal
Reserve and other depository institution regulatory agencies
issued a revised supervisory policy statement that describes
securities trading practices that are inappropriate to be
conducted in an investment portfolio.
Returning to the broader issue of the health of the
government securities market, it is the Board of Governors’
judgment that the reforms outlined in the interagency
report--changes in auction mechanisms, active and rigorous
monitoring of market rates, and the clear willingness to use
relative supplies to punish manipulative behavior--will work
to prevent a replay of last year’s events.
These are
fundamental changes in market mechanisms that promise to
open up this market to broad-based participation while, at
the same time, enhancing regulatory surveillance and
remedial capabilities.
These
responses are measured,
targeted and commensurate to the problem at hand, and, in
our view, obviate the need to punish many with reporting
burdens because of the actions of a few.
This strategy also
offers flexibility to deal with future problems as they
arise.
It is perhaps ironic that the most serious abuses in
the history of this market--the Salomon Brothers episode-have served as the catalyst for changes that promise
substantial long-term benefits.
Taken together, these
proposals and those already implemented constitute a
thorough, thoughtful, and feasible renovation of the
government securities market and will result in a healthier,
more efficient market for our U.S. government securities.
@FedFRASER