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For release on de li v e r y 9:30 a . m . , E . D . T . September 26, 1991 Statement of David W. Mullins. Jr. Vice Chairman Board of Governors of the Federal Reserve System before the Subcommittee on Oversight of the Committee on Ways and Means U.S. House of Representatives September 26, 1991 Mr. Chairman, Congressman Schulze, members of the Committee, I am pleased to be here today to testify in connection with the regulation of the government securities market. Mr. Sternlight’s statement has detailed both the role of the Federal Reserve Bank of New York in this market, including its relationship with the primary dealers, and the circumstances surrounding the disclosures by Salomon Brothers. The Board of Governors of the Federal Reserve System was actively involved in the consultations among regulators during this episode. In my prepared remarks, I shall first delineate the role of the Board of Governors in this market and then turn to the potential implications of this episode for regulatory and legislative initiatives. The Board of Governors considers the U.S. government securities market the most important securities market in the world. reasons. It is important for at least three First, market conditions there determine the cost to the taxpayer of financing U.S. government operations. Second, this market serves as the foundation for other money and capital markets here and abroad, and as a prime source of liquidity for financial institutions. Finally, and for us perhaps most importantly, the U.S. government securities market is the market through which the Federal Reserve implements monetary policy, and thus this market must be an efficient and reliable transmitter of our monetary policy actions. Nonetheless, the Board of Governors has little direct regulatory authority for the U.S. securities market. government In this market, the Reserve Banks operate as fiscal agents of the U.S. Treasury and the New York Reserve Bank also serves as the operating arm of the Federal Open Market Committee. The Board, though, retains general oversight responsibility for all Federal Reserve District Bank activities. Moreover, the Board of Governors bears the responsibility for determining overall policy for the Federal Reserve System with respect to this market and other matters. For example, by statute the Board consults with the Treasury and the Securities and Exchange Commission on issues related to administration of the Government Securities Act. Because of these responsibilities and the importance of this market, the Board is committed to participating actively in the process of ensuring and enhancing the efficiency and integrity of this market. The market under consideration here is at the center of the nation’s financial system. breadth are unparalleled. Its depth and And it is because of the importance of the market for U.S. government securities that the events of recent months are of such concern. The price distortions in certain securities, the admissions of wrongdoing by Salomon Brothers, and the allegations of further misconduct have raised troubling questions about the government securities market. While it has been extraordinarily resilient and has continued to function well over this period, this episode underscores the importance of ensuring the integrity of this market. Of course, we must not overlook the fact that existing enforcement mechanisms appear to have been instrumental in this unfolding episode. included surveillance activities, These mechanisms inquiries, and other enforcement activities by the Federal Reserve Bank of New York, the Treasury, the SEC, and the Justice Department. Although senior Salomon Brothers officials were aware of rule violations months before, the firm finally admitted wrongdoing only under the pressure of these advancing enforcement processes. And of course, these enforcement processes continue to move forward as we meet here today. It is already apparent to all observers that the consequences of willful violations in this area are quite severe indeed. While this has been a troubling episode, it is not apparent that sweeping changes in regulation are warranted. It is clear that tightening up on enforcement would be efficacious in detecting and deterring future offenses. For example, the Federal Reserve has begun contacting customers bidding through dealers to confirm the accuracy of those bids. In addition, the Federal Reserve regularly receives information on dealer positions in when-issued securities. These reports were not actively monitored from an - 4 - enforcement perspective, because they were not designed for that purpose. Nonetheless, closer attention to them may be helpful in raising questions about situations with possible enforcement implications, and we will explore the redesign of this report to enhance its potential usefulness in the enforcement process. The Federal Reserve is committed to ensuring active monitoring of all incoming data and prompt referral of anomalous findings to appropriate regulatory authorities. We are working with other government agencies to assure an effective system of surveillance is in place. And yet this episode has raised concerns that go beyond the straightforward process of detecting and punishing wrongdoing. With the revelations by Salomon Brothers, the price distortions in certain recent issues, and allegations of other misconduct, some have felt that the fairness of the market has been called into question. Others have raised concerns about the efficiency of market mechanisms and the efficacy of the current regulatory structure. The continued smooth functioning of this market demonstrates that there appears to have been no economically meaningful loss of confidence in this market as yet. Nonetheless, these concerns need to be addressed; reduced confidence in the fairness and efficiency of the government securities market could potentially impair liquidity and raise the cost of Treasury financing. Of course, Treasury’s costs also will rise if regulators and legislators overreact by instituting unnecessarily burdensome and restrictive rules that discourage bidding for Treasury securities. The integrity of this marketplace must be ensured through means that do not unduly restrict demand or impose unreasonable costs on bidders. In response to these concerns, a wide variety of proposals have been advanced for changes in regulation or market structure. I believe this broad-based reassessment is appropriate and healthy. This episode has presented us with an opportunity to undertake a thorough analysis of the structure of this market and its regulations. I also believe that the assessment of these important issues should not be done in haste. changes be considered in a piecemeal manner. too complex and highly interrelated, yet completed, Nor should The issues are investigations are not and the data needed to make informed judgments are still being gathered. The consequences of mistakes are too severe for us to rush to judgment on fundamental issues of market structure and regulation. What is needed is a rigorous, comprehensive, and coordinated review of the government securities market--its structure, practices, and regulation. The objective should be to find ways to ensure and enhance the efficiency and integrity of this market. Accordingly, the Department of the Treasury, the Federal Reserve, and the SEC have agreed to undertake an intensive study, culminating in recommendations for any changes needed to ensure and enhance the efficiency and integrity of this market. A key question to be addressed in the course of such a review is whether current laws, regulations, procedures, and enforcement mechanisms foster the efficiency and liquidity of this market, as well as provide adequate protection against the potential for manipulative practices. A wide range of issues is on the table, pertaining to both the primary and secondary markets for Treasury securities. A promising approach is to explore ways to make access to the primary market easier and more efficient. Broader based participation in auctions should reduce the vulnerability to collusion, and result in a deeper, more efficient market. For example, an electronic bidding process in the primary market promises to provide easier access, thereby broadening the market. Moreover, a computerized auction process will greatly enhance the efficiency of market surveillance and monitoring efforts and allow rapid and easy detection of many potential abuses. Consequently, the Federal Reserve and the Treasury have accelerated their effort to automate major aspects of the auction process. We also need to analyze alternative auction techniques. While it is not clear at this stage that different ways of conducting auctions would attract a sizable number of additional bidders and reduce the costs to the Treasury, this is a potentially fruitful area for examination. Broader participation in auctions and more efficient surveillance mechanisms may render collusion impractical and obviate the need for cumbersome, restrictive regulations that risk raising the cost of Treasury financing. In thinking about such issues, the Board begins from the premise that it is absolutely essential that the extraordinary liquidity and efficiency of the government securities market not be impaired. This liquidity is important to the smooth functioning of the financial system, it facilitates the implementation of monetary policy through open market operations, and it allows the Treasury to issue federal debt at the lowest possible cost to the taxpayers. With well over $2 trillion in Treasury debt held by the public, the stakes are high and the consequences of mistakes are severe. Should either concerns about market integrity or inappropriate regulation raise the interest rate on Treasury debt even one one-hundredth of a percentage point, this would aggregate into more than $200 million in increased interest cost every year which would have to be borne by U.S. taxpayers. Time is needed for a careful, analytical approach to the issues of market structure and regulation. In sum, Mr. Chairman, recent events have raised troubling questions about the U.S. government securities market. These concerns must be addressed. A thorough and - 8 - thoughtful investigation is the first step in this process. Ultimately, a careful and wide-ranging examination of the government securities market, with the goal of enhancing its efficiency and its fairness, will be an important input to our consideration of the appropriate changes in this market. Though I am deeply concerned about recent revelations and await the results of ongoing investigations, I do not believe that the government securities market is broken in any fundamental sense. improved, end. I do, however, believe it can be and the Board of Governors is committed to this
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