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A World of Choices  Are We Better Off with International Trade?  Federal Reserve Bank of Chicago 1998 Annual Report  Our Mission The Federal Reser ve Bank of Chicago is one of 12 regional Reser ve Banks across the United States that, together with the Board of Governors in Washington, D.C., ser ve as the nation’s central bank. The role of the Federal Reserve System, since its establishment by an act of Congress passed in 1913, has been to foster a strong economy, suppor ted by a stable financial system. To this end, the Federal Reserve Bank of Chicago par ticipates in the formulation and implementation of national monetar y policy, super vises and regulates state-member banks, bank holding companies and foreign bank branches, and provides financial services to depository institutions and the U.S. government. Through its head office in Chicago, branch in Detroit, regional offices in Des Moines, Indianapolis and Milwaukee, and facility in Peoria, the Federal Reser ve Bank of Chicago serves the Seventh Federal Reserve District, which includes major portions of Illinois, Indiana, Michigan and Wisconsin, plus all of Iowa.  Our Vision Fur ther the public interest by fostering a sound economy and stable financial system Provide products and services of unmatched value to those we ser ve Set the standard for excellence in the Federal Reserve System Work together, value diversity, communicate openly, be creative and fair Live by our core values of integrity, respect, responsibility and excellence  Contents President’s Message 1 Are We Better Of f with International Trade? 4 1998 Highlights 16 Directors 20 Advisor y Councils 22 Of ficers 24 Executive Changes 26 Operations Volumes 27 Financial Statements 30 Notes to Financial Statements 33  PresidentÕs Message  M ost Americans would agree that if a factory cannot turn a profit without pouring toxic waste into a community’s water supply, that factor y should be shut down—even if that means the loss of hundreds of jobs. When it comes to matters of public health, the interests of the many outweigh those of the few. Regarding the economic health of our nation, however, the American public seems to place the interests of a few above the interests of the majority. Economists concur that international trade and open markets are directly responsible for greater consumer choice and a higher overall standard of living for the American public. And yet 58 percent of those surveyed in a NBC/Wall Street  Journal poll taken at the end of 1998 said that foreign trade had been bad for America. Why? Because open markets lead to cheaper imports that, in turn, can cost some individuals their jobs. How ironic that public resistance to open markets is rising just as our economy is in the longest peace-time expansion in our history and employment is at record levels. Earlier this decade, I served as deputy U.S. trade representative. Opening markets and expanding international trade was my chief concern as I negotiated trade pacts with the countries of Europe and East Asia, including Japan and China. As confident as I am that more open trade is crucial to the economic health of America as we enter the next centur y, I am well aware it is not an easy matter to change public opinion on open markets. One trade-related plant closure can dramatically worsen public attitudes toward foreign competition, especially when the closure puts hundreds of people out of work. It is more difficult to convince the public that lower prices, higher-quality products, and resulting higher standards of living are also linked to free trade. This annual repor t focuses on the important and complex issue of international trade, examining the costs and benefits of open markets. Our economic well being is increasingly influenced by our ability to reach untapped markets: Nearly four-fifths of world consumption currently occurs outside the U.S. With this new century of increased globalization soon upon us, now is the time to address concerns over the economic and social risks associated with bringing down barriers to trade.  1  The great strength of the U.S. Constitution, so emulated worldwide, is the careful balancing of the rights of the few with the interests of the many. As the U.S. enters the next century we have the tremendous opportunity to extend these principles to our trade policy. Some short-term job displacement no more justifies holding back our entire economy than it does the operation of a factor y that puts our environment at risk. But we must meet the needs of those who are directly affected by foreign competition. We have an obligation to develop programs that help those facing job cuts because of open markets. Only by reducing hardship today can we reduce future backlashes against free trade. The per formance of the U.S. economy in 1998 was extraordinary despite turbulence in foreign markets. Real GDP growth came in at a robust 4.3 percent on a fourth-quarter to fourth-quarter basis. Inflation as measured by the Consumer Price Index slowed to 1.5 percent in 1998. For the first time in 30 years inflation was below 2 percent for two consecutive years. The unemployment rate averaged 4.5 percent for the year, the lowest level since 1969. In 1999 we expect that real GDP growth will continue at a solid but more sustainable rate, and that inflation and unemployment will continue to be favorable. On a personal note, I’d like to extend my heartfelt appreciation for the hard work of our dedicated staff, whose accomplishments are highlighted on pages 16 and 17. The achievements of the Federal Reserve Bank of Chicago also reflect the outstanding leadership and counsel of our directors in Chicago and Detroit. Thank you all. A special note of gratitude goes to directors Donald Schneider and Arnold Schultz, who completed their service with the Chicago board in 1998. I would also like to welcome James Keyes and Alan Tubbs, who joined the board at the star t of 1999. One of the highlights of our achievements this year was ensuring the readiness of our important internal computer applications for Y2K. I am confident that the success of the Federal Reser ve and the banking industry this past year will be echoed in 1999 by enhanced consumer confidence in industry preparedness as we approach the millennium.  Michael H. Moskow President and Chief Executive Officer March 26, 1999  2  Pictured in the Federal Reserve Bank of ChicagoÕs new conference center, which opened in May of 1998, are (left to right) Deputy Chairman Arthur Martinez, President Michael Moskow, Chairman Lester McKeever, and First Vice President William Conrad.  3  Are We Better Off with International Trade?  What’s Trade Got to Do with It? Are we better off with international trade? Most economists would say yes, pointing out that international trade and open markets provide more choices at lower prices for consumers. From the morning when we eat strawberries from Mexico to the evening when we watch a program on a TV made in Korea, we benefit from increased choices at lower prices. But what are the costs? The choices we make can mean lost jobs and reduced incomes for some. Are the general benefits to the population at large wor th the sometimes painful costs for some of us?  4  T  he general consensus that open markets provide benefits is rooted in  economic theor y, specifically the natural ef ficiency of specialization. Economic theory on the principles of international trade can be traced to 1776, when Adam Smith discussed the importance of specialization in The Wealth of Nations. British economist David Ricardo built on Smith’s ideas by extending the concept of specialization to trade among nations—the notion of comparative advantage. The principle of comparative advantage, which applies to both individuals and firms, states that nations should focus on goods and services that they are best at producing and trade for other goods. Such trade is efficient even if the home countr y can produce all goods more efficiently than its trading partners can. Why? If a nation spends its time producing all goods, rather than those it is best at producing, the result would be fewer and/or lower-quality goods and ser vices. The surest way to achieve the highest efficiency and quality for all goods and ser vices produced by all nations is for each country to exploit its comparative advantages. Increasing Productivity Some of the advantages of open markets are as obvious and familiar as the TV in our living room or the fruit on our cereal. Open markets provide more choices for consumers—ever ything from Italian suits to Japanese cars to Brazilian coffee. Perhaps even more importantly, open markets mean lower prices. If countries focus on their comparative advantage, they do a better job of allocating resources. The cost savings achieved by each nation’s producers are passed on to consumers in the form of lower prices. The more efficient allocation of resources fostered by  Opening Markets: The Fruit of our Labor Strawberries from Mexico, apples from Canada, bananas from Costa Rica and Equador, and grapes from Chile. Many types of fruit flow into the U.S. from a variety of nations. In fact, in 1998 the U.S. imported 8.1 million tons of fruit. And the U.S. exported almost as much, shipping 6.8 million tons in 1998. For example, the U.S. sends grapefruit to Japan and France, peaches and pears to Canada and Mexico, apples to Taiwan, and raisins to the United Kingdom.  open markets also results in higher quality goods and services. Only the best products at the lowest prices can sur vive the global winnowing process. Consumers literally have their pick of the best the world has to of fer. The result is a higher standard of living for the population at large. Open markets also raise our standard of living in a more subtle way by boosting productivity growth. This is important because productivity is the key ingredient in raising our standard of living. Open markets foster higher productivity growth by creating stronger incentives for innovation and efficiency. Competition from abroad compels domestic producers to develop more efficient production methods. A case in point is the U.S. auto industry, which was roused from its sleepy complacency during the 1970s by sudden, sharp competition from Japan. The exchange of information and ideas across borders, such as the adoption by U.S. companies of the Japanese “just-in-time” inventory method, accelerates continual change and improvement. Long-term economic vitality depends on this process of change, described by economist Joseph Schumpeter as “creative destruction,” in which competition weeds out inefficient companies and creates oppor tunities for firms with new ideas, lower prices, and better products.  5  Costs of Open Markets While the benefits of open markets are substantial, they come with costs. The distribution of these costs and benefits is often uneven, helping some industries and benefiting some individuals while harming others—especially in the shor t run. Export-oriented industries, of course, are helped by open markets. So are the workers employed by these industries. According to the 1998 Economic Report of the  President, jobs in export-oriented industries pay between 5 and 10 percent more than other jobs in the U.S. economy. Other industries are hit hard by foreign competition; some do not survive. Among the U.S. industries hurt by foreign competition was the consumer electronics industry during the 1970s. Open markets also can have a disproportionate effect on cer tain regions or economic sectors. The downturn in the Midwest in the early 1980s, caused in part by intense foreign competition, resulted in one-fifth of the region’s manufacturing workers losing their jobs.  The Steel Story The Asian financial crisis resulted in lower prices for imported steel, helping to keep inflation down in the U.S. At the same time, low prices have hurt domestic steel manufacturers. In fact, several nations have been accused of “dumping” steel on U.S. markets. Selling exports below costs has the potential to distort the efficient allocation of resources as much as erecting barriers to trade.  6  The ef fect of job losses can be devastating, regardless of the reason. Workers who are displaced by trade may suffer greater hardship than workers who lose their jobs for other reasons because there is a greater likelihood that an entire industry may be affected, rather than a specific firm. However, the extent of U.S. job losses due to international trade is open to debate. For example, analysis in the 1998 Economic Repor t of the President indicates that open markets were not the cause of a large percentage of U.S. job displacement in manufacturing during the 1980s. Most of the job losses in manufacturing during this period occurred because of technological change, according to the Report. Another indication of the ef fect of open markets is provided by the U.S. Labor Department, which recently reported that 210,000 workers have lost their jobs as a result of the North American Free Trade Agreement (NAFTA) since it became effective in 1994. However, this figure is dwarfed by the 15.3 million total jobs created by the U.S. economy from 1994 to 1998. Formulating Trade Policy How can the U.S. resolve the difficult tradeoffs between the benefits and costs of open markets in determining future trade policy? Determining trade policy is complicated by the variation in the benefits of open markets for the overall world economy versus individual nations. Open markets provide overall benefits for the world economy. In this way, it is in the best interests of all nations to promote open markets. However, in some cases, it may not be beneficial for a countr y to open its markets to another country that retains trade barriers. If each country in a region acts on its own—on a unilateral basis—it may be optimal for each country to retain trade barriers. It may take a binding, multi-lateral trade agreement, such as those negotiated under the auspices of the World Trade Organization (WTO), to create a situation in which all countries in a region are better off by jointly removing trade barriers. One key to formulating effective policy will be to separate the rhetoric from the reality of trade. Often the trade debate has centered on the net effect on jobs, a focus that is reflected in the public’s attitude. In a NBC/Wall Street Journal poll taken in late 1998, 58 percent of those surveyed said foreign trade has been bad for America because cheap impor ts have hurt wages and cost jobs. Yet the key advantages of open markets are fostering lower prices and higher-quality goods and facilitating the efficient allocation of resources. The amorphous nature of these benefits makes them less compelling. The immediate and ver y real pain resulting from a shuttered factory has a much more visceral ef fect. But the advantages of open markets are vitally important in raising our standard of living. The ongoing challenge facing policymakers is to balance these important benefits to the population at large with the undeniable costs to some industries and workers.  7  Regional Impact  Have Open Markets Helped the Midwest? Having U.S. borders open to trade and investment has helped the Midwest regain the economic prowess lost during the downturns of the early 1980s. Midwestern manufacturing has revived in recent years, leading to higher relative standards of living and low unemployment.  8  T  he Midwest’s revival is partly due to an influx of direct foreign investment to  the U.S., which totaled roughly $300 billion in the 1980s and early 1990s. Roughly one-third of that investment was directed at manufacturing-related industries, par ticularly the auto industr y, a Midwestern stronghold. Productivity-enhancing management practices frequently accompanied the investment. These include procedures such as lean manufacturing and just-in-time inventory practices. Auto and truck manufacturers successfully adopted many of these techniques, finding the Midwest’s transportation infrastructure and dense concentration of suppliers and service providers ver y suitable for these new modes of operation. Open markets for the sale of Midwestern goods abroad have also contributed to the region’s revival. Since 1990, manufacturing goods exports have increased significantly in the Midwest compared with the rest of the countr y. Cer tain types of agricultural expor ts are also up, including processed food products derived from the region’s staple crops of corn and soybeans. Total expor ts from the Midwestern states of Iowa, Illinois, Indiana, Wisconsin and Michigan have increased more than 80 percent since 1990. Since trade has been beneficial to the region, why do some Midwesterners oppose efforts to open up markets to greater trade? One reason may be a misunderstanding of the reasons behind the industrial upheavals that have dislocated workers and their families. Trade is often an over-emphasized factor in understanding economic upheavals. Over the course of the 20th century, trade has not been a major factor in changing the concentration of manufacturing in the Midwest. Rather, these changes resulted from a variety of other factors. One is the advent of the interstate highway system, which opened new labor markets in other regions and helped disperse manufacturing throughout the U.S.  Domestic or Imported? Manufacturing Increasingly Complex Price stickers on new cars illustrate the complex nature of manufacturing, with many autos manufactured in one country using parts produced in another. For example, final assembly of the auto pictured here was in central Illinois, while 23% of the parts came from Japan. It is increasingly difficult to differentiate an export from an import.  9  The Realities of Trade  Who are our Biggest Trading Partners? The answer might surprise you. TV pundits or politicians debating trade policy might lead one to guess Japan or possibly Mexico. But our biggest trading partner of goods is up north—Canada. The United States sends more goods there—and receives more in return—than to any other individual nation.  Classroom to the World: The Export of Education Exports are much more than tangible items such as washing machines or automobiles. Many are services as opposed to goods. One example of a service export is a college education. When a foreigner is educated in the U.S., that’s considered an export. Other common services frequently exported are travel-related, or in the financial or legal fields. Overall, the U.S. runs a trade surplus in services, exporting more than it imports.  10  M ost equate trade with the exchange of goods. But roughly 28 percent of our exports and 16 percent of our imports are services. If trade in goods and ser vices is combined, the 15 countries that make up the European Union rank ahead of Canada as the largest U.S. trading partner. While we run a deficit in the trade of goods, we have a relatively large surplus in the trade of ser vices. Traded services include travel, education, or financial ser vices. If consumed by foreigners, these ser vices are considered an export. For example, a Thai student studying at the University of Iowa is buying education. Thus, it’s an expor t. Of all ser vice exports, those related Imports  to travel make up about 35 percent. Other private services— including  Exports  educational, legal and financial services—make up another 58 percent.  Where U.S. imports came from and where U.S. exports were sent in 1998  What goods do we export? Much of what we export is capital  (all figures are a percentage of either total imports or exports of goods) ○  ○  ○  ○  ○  ○  ○  ○  19.1% 19.3 10.4 9.4 5.6 13.3 7.8 15.1 ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  Canada European Union Mexico Asia (NICs*) Central/South America Japan China All other nations  equipment such as machines and the components to make those 22.9% 21.9 11.6 9.3 9.3 8.5 2.1 14.4  machines. In fact, capital equipment and components of capital equip-  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ment, autos, consumer goods, and other manufactured goods make up more than 70 percent of our goods expor ts. Nearly 30 percent of our exports is industrial supplies or foods, feeds and beverages. And even for many of the products in those categories, substantial manufacturing or processing is involved. The flip side is ver y similar: Slightly more than two-thirds of what we import is capital equipment and components, autos and con-  * Hong Kong, Korea, Singapore and Taiwan  sumer goods. The remainder includes industrial supplies or foods, feeds Imports  and beverages.  Exports  What goods the U.S. imported or exported in 1998  Overall, we import more than we export. We hit a record high in  (all figures are a percentage of total U.S. imports or exports) ○  ○  ○  ○  ○  ○  29.6% 21.9 23.6 16.5 4.5 3.9 ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  Capital goods Industrial supplies Consumer goods Autos, etc. Foods, feeds, beverages Other goods  the overall trade deficit in 1998, importing $1.1 trillion in goods and  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  43.8% 21.7 11.6 10.6 6.8 5.4  services and exporting $931 billion. In services alone, we ran a surplus,  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  exporting $260 billion compared with the $181 billion we imported. Relative to the size of the total U.S. economy, international trade accounts for a modest but increasing share. The nominal value of exports of goods and services is equivalent to about 11 percent of gross domestic product (GDP), while impor ts are about 13 percent of GDP. That compares with 5.5 percent and 5.4 percent respectively in 1970. As for foreign direct investment, the countries that have invested most in the U.S. are the United Kingdom and Japan, followed by the  What services the U.S. imported or exported in 1998  Imports  Exports  Netherlands, Germany, and Canada. Most of that investment falls in the  (all figures are a percentage of total U.S. imports or exports) ○  ○  ○  ○  ○  ○  ○  29.5% 6.1 16.6 10.3 6.8 1.6 29.2 ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  Travel Royalties and license fees Other transportation Passenger fares Military/Defense U.S. government miscellaneous Other private services  category of manufacturing, followed by wholesale trade and insurance. 27.3% 13.4 9.9 7.7 6.5 0.3 35.0  The benefits of foreign investment extend beyond the money spent.  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  New ideas and manufacturing techniques often accompany those funds. Most U.S direct investment abroad is in the United Kingdom, followed by Canada and Germany. Overall, U.S. companies invest far more at home than they do abroad. The vast majority of our trade is “inter-regional,” among businesses located in the U.S. And most foreign investment by American  Source: U.S. Department of Commerce  companies is in developed nations. In fact, most of our trade is with developed nations.  11  Un d e rst anding t h e De fic it  Why Does the U.S. Have a Trade Deficit? Simply put, the amount of foreign goods and services purchased by the U.S. is greater than the amount of U.S. goods and services purchased by people abroad. This allows Americans to consume more goods and services than they produce. If Americans buy more than they sell, they must borrow from foreigners to finance the purchases. In other words, foreigners are lending to or investing in the United States.  Global Trade: A Toy Story Most toys imported into the U.S. are duty-free. American kids enjoy a wide variety of high-quality toys made in other countries or with parts manufactured abroad. The U.S. imports many more toys than it exports. U.S. toy manufacturers see great potential for expanding U.S. exports, since more than 96 percent of the world’s children live outside the U.S. With the help of regional free trade agreements, toy industry officials look forward to expanded trade and reduced customs tariffs worldwide.  12  A  trade deficit is not inherently undesirable. A variety of economic, social,  and demographic factors determines the relationship between a country’s goods and services trade and capital flows. For a trade-deficit (net capital inflow) country such as the U.S., the most important issue is not the existence of a deficit. Rather, it’s how the impor ted capital that finances the deficit is used. When there is a trade deficit, there must be an offsetting capital inflow into the U.S. This means that in the current environment Americans are borrowing from abroad to finance some of their foreign purchases. If the borrowed capital is used to improve productivity and increase output, it can be paid back, and at the same time the nation’s real income will have increased. It results in not only an increase in current consumption of imports but also an increase in the standard of living for future generations. However, if the borrowed capital is used for non-productive endeavors, at some future date the nation may need to reduce consumption to ser vice and pay back the debt. That leads to a lower standard of living than other wise would have been the case. The recent increase in the trade deficit is par tly the result of the financial crisis abroad and partly the result of strong U.S. economic growth. The financial crisis in Southeast Asia has withered economic growth in the region, reducing its demand for our exports. Strong U.S. economic growth has increased the demand for impor ts from all markets. In addition, the appreciation of the dollar relative to our Asian trading par tners’ currencies made their products cheaper for Americans to buy. Both factors resulted in more imports to the U.S. At the same time, weak economic conditions abroad reduced foreign demand for U.S. exports, and the stronger dollar made it relatively more expensive for foreigners to buy U.S. goods and services. Current conditions have been beneficial in some ways for the U.S. Lower import prices have helped consumers, and have tended to hold down price increases for domestic goods. But lower import prices have made it more dif ficult for some import-competing domestic industries, such as steel and textiles. And other industries, including agriculture and some capital equipment producers, have faced a decline in exports. 1998 U.S. Trade Deficit  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  Exports: $931.3 billion  ○  ○  Imports: $1,099.9 billion  ○  Deficit: $168.6 billion Triggered by the impact of the global financial crisis, the U.S. trade deficit on goods and services increased from $110 billion in 1997 to a record $169 billion in 1998.  13  Policy Options  What About Those Left Behind? A  merican trade is booming. Last year the U.S. exported $931 billion in  goods and services, about 50 percent more than just five years ago. Despite the Asian financial crisis, exports now sustain an estimated 12 million American jobs, including one in five in manufacturing industries. Yet many polls indicate that Americans are unsure about the wisdom of maintaining open markets. This may be due to the fact that the benefits are sometimes diffuse and difficult to identify. In addition, open markets have costs. Some workers’ jobs are eliminated because of foreign competition. For many Americans, the key question is: What about those left behind? Policymakers can address the inherent complexities of open markets in two ways: working to ensure the maximum benefits and helping to of fset the inevitable costs. The most impor tant step in maximizing the global benefits of open markets is for each nation to resist the temptation to shift to a more protectionist policy. Such policies insulate specific industries against competition, distort resource allocation, discourage innovation, and result in higher prices for consumers. Tariffs are the best-known type of barrier, but non-tariff barriers are an increasingly impor tant and visible form of trade restriction. This is due in part to the large reductions in tariffs during the post-War period. Technical trade barriers, such as duplicative regulations and unnecessary paperwork, are a notable example of a non-tariff barrier. The growing impor tance of ser vices in international trade has highlighted non-tariff barriers, such as the lack of a worldwide standard for intellectual  14  property rights, such as patents and copyrights. And even as GATT negotiations have steadily lowered formal barriers, some countries have created hostile environments for outside competitors with informal systems that erode the viability of formal agreements. The World Trade Organization (WTO) provides a mechanism for resolving disputes and preventing an escalating series of sanctions. Building on the progress in mediating disputes will aid the effort to create a global level playing field. Reaping the maximum gains of open markets is important, but for many Americans the key question is how to address the inevitable costs. In cases where foreign competition shutters a domestic manufacturing plant, thousands might be out of work. How do policymakers reconcile this difficult tradeoff? Perhaps the most effective—and difficult—strategy is making high-quality education and training more readily available. Education and training is essential  The Textile Trade: Low-tech No Longer  because the Americans most at risk from foreign competition are low-skilled workers  Once dominant in the textile industry, the U.S. began to feel the pinch of foreign competition in the post-World War II period, losing market share to nations with lower wage costs. But the U.S. is fighting back. Once low-tech and labor intensive, the textile industry is now almost fully automated, particularly in the U.S., Western Europe, and Japan. U.S. firms for years have been investing steadily in capital equipment and computers to improve productivity and efficiency. This is important because all quotas in global trade in textiles are scheduled to be eliminated by 2005.  high-skill goods and services, such workers are hit especially hard as there are  who tend to be less productive. In countries such as the U.S., which specialize in fewer job opportunities for them. Education and training that upgrade skills would improve productivity and better equip workers for higher-paying, more competitive jobs in a global economy. An impor tant starting point is ensuring high-quality elementary and secondary education. Those already in the workforce need new training methods that better meet the needs of employees and employers. Another option is to do more to provide immediate, shor t-term relief for workers displaced by foreign trade. The Trade Adjustment Assistance (TAA) program, in place since 1962, already extends unemployment insurance payments to tradedisplaced workers after the six-month limit on regular unemployment benefits expires. The program also provides job search assistance, worker retraining, and relocation expenses. Under legislation implementing NAFTA, TAA benefits are extended to workers displaced by a company moving production to Canada or Mexico. There are a number of proposals to supplement or replace these existing programs. Brookings Institution economists Bob Litan and Gary Burtless described one such proposal at a recent Chicago Fed conference on global trade. The unemployment insurance program proposed by Litan and Burtless would compensate trade-displaced workers who accept a lower-paying job by providing them with a percentage of their monthly wage loss. The additional payments would be provided only when a displaced worker started on a new job, creating both assistance and an incentive to take a new position as quickly as possible. (See the book Globaphobia: Confronting Fears about  Open Trade by Gary Burtless, Robert Lawrence, Rober t Litan, and Robert Shapiro for more information on the proposal.) Ultimately, the answer in developing effective trade policy lies in striking a balance between efficiency and equity, preser ving the important advantages of efficient resource allocation, while maintaining a sense of fairness in the distribution of the benefits. Determining the appropriate balance is important because of the potential payoff—easing the pain for those left behind in the global economy and increasing the standard of living for the population at large.  15  A Review of the YearÕs Activities and Accomplishments  Highlights of 1998 Second Quarter (April-June)  • The Bank began building renovations to consolidate its statistical repor ting functions at one central location at the Chicago Office, a target that was achieved in October. • Generally regarded as the leading conference of its kind, the 34th annual Conference on Bank Structure and Competition focused on payments systems in the global economy. • The Bank held the first meeting of the Community Bank Council, established to promote communication between the Chicago Fed and community banks. • The Chicago Fed opened its new Conference Center, which during the year accommodated nearly 600 events for employees and visitors. • The Bank finished the process of ensuring that mission-critical applications that provide electronic services to external customers are ready for the Year 2000. • A newly designed $20 bill was unveiled with a variety of new security features. • The Bank committed itself to 72 action steps aimed at improving performance by taking advantage of the organization’s diversity.  • The Seventh District Cash Department was rated the Federal Reserve System’s best operation in the first quarter, a distinction it earned for the entire year. • The Bank began a successful year resulting in achievement of its top-priority objectives and expenses well below budget. • The Chicago Fed launched an initiative to develop strategies for moving to the next generation of electronic payments. • The Illinois Check Territory set out to improve operations and meet demanding revenue targets, goals that were ultimately accomplished. • The Bank embarked upon a variety of diversityrelated initiatives, including mandatory diversityawareness sessions for all employees. • Credit risk, Year 2000 risk, event risk and fair lending are targeted as Super vision and Regulation’s top priorities during 1998 exams. • Supervision and Regulation launched a successful year in which more than 880 inspections, examinations, and risk assessments were carried out. • The Bank began an effort requiring all employees to create personal development plans. • The Des Moines Office celebrated 25 years of service.  ○  ○  ○  ○  ○  ○  First Quarter (January-March)  ○  16  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  Fourth Quarter (October-December)  Third Quarter (July-September)  • Banks began to test their electronic connections with the Chicago Fed for any of the financial ser vices provided them. • The Bank was selected to coordinate the new System Leadership Conference, a forum designed to help develop Federal Reserve System leaders. • Consumer & Community Affairs coordinated a public hearing in August on the then-proposed merger of First Chicago NBD and Banc One. • Roughly 60,000 people visited the Bank’s booth in August at the Iowa State Fair. • Foreign graduate students attending the University of Illinois at Urbana-Champaign toured the Bank, counting them in the nearly 12,000 visitors who toured the Chicago Fed during the year. • Economist Daniel Aaronson explored the effect of neighborhoods on children’s educational outcomes in a research paper, one of 20 papers from Economic Research throughout the year accepted for or published in leading scholarly journals. • Economic Research staff analyzed the competitive considerations of the First Chicago NBD-Banc One merger, one of a record 315 cases reviewed in 1998. • The Check Department began using imaging technology at its Chicago and Detroit offices to process checks for its commercial customers. The ser vice was previously available at just the Des Moines and Milwaukee offices. ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  • The System’s Business Development Of fice, housed in Chicago, developed a new Web site for all Reserve Banks focusing on the System’s financial products and services. • The Bank successfully ended the year having fully recovered the costs of providing priced financial services, including the cost of taxes and capital and the average level of profit it would incur if it were a private firm. • Super vision and Regulation finished processing the last of its 650 total applications, one of the highest volumes in the System. • Research Statistics enjoyed a productive year, having met 100 percent of its report deadlines to the Board of Governors and 99 percent of its report deadlines to the New York Fed. • The Bank finished cer tifying all its businesscritical computer applications for Y2K readiness, and most are now in production. • The Research Department hosted an October conference with the International Monetary Fund on the Asian financial crisis. • The Detroit Branch was recognized for its quality management and per formance excellence by the Michigan Quality Leadership Award program. • The Peoria Of fice hit a new high in December by increasing check volumes to an annual daily average of 850,000 checks. • The Bank played a leadership role throughout the year in 23 System committees. • The Bank closed 1998 having processed 20 percent of the System’s ACH volume, as well as the largest commercial ACH volume in the System. • The System’s new “Sell Direct” program located at the Chicago Fed ended the year having processed 16,220 transactions.  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  ○  TREASURY DIRECT SELL DIRECT  17  Y2k Making Headway on Y2K  The Federal Reser ve Bank of Chicago accomplished a great deal in 1998 to prepare for the Year 2000. The Bank’s highest-priority objective in 1999 will be to complete preparation of its internal systems and to help prepare the U.S. financial system for Y2K. testing and have helped banks assess their Year 2000 readiness. Banks should have completed testing by June 30, 1999, and should have substantially completed implementation of renovated mission-critical systems and contingency planning activities.  The Federal Reserve System is committed to maintaining the stability of the U.S. financial system during the date-change period. Americans have worked together to meet important challenges in the past. Fed of ficials are confident the financial system will be ready and that the public will keep the Year 2000 in perspective, realizing it is one more challenge that will be met. Public confidence about the Year 2000 will be strengthened by regular communication from banks, banking super visors and trade groups. All of these institutions and organizations should be active communicators. The Fed understands the public’s need for accurate information and has been communicating about Y2K efforts in a wide variety of ways. The Fed will continue to communicate about the readiness of the banking industr y as 1999 progresses. Following are some questions and answers related to Federal Reser ve Year 2000 preparations:  2) How many banks have tested so far?  Roughly 825 banks had conducted tests with the Chicago Fed as of March 31, 1999, and roughly 7,900 had tested with Federal Reser ve Banks across the countr y. All in all, testing has gone well, and banks are making good progress. Banks that have not yet completed testing are encouraged to do so as soon as possible. The Chicago Fed is available and ready to meet their needs. 3) How are preparations going from a supervisory standpoint?  The Chicago Fed’s examinations during 1998 indicate that institutions are progressing well in their Year 2000 compliance programs. The super visor y agencies have established critical project milestones that institutions must meet. For example, missioncritical system testing must be complete by June 30, 1999. Besides testing, institutions are required to assess Year 2000-related business risks and establish outreach programs to discuss their preparedness with customers. Contingency plans also must be developed to address potential system failures and liquidity management issues. The examination process is focusing on institutions’ progress in all of these areas. However, the ultimate responsibility for Year 2000 readiness lies with individual banks. The Chicago Fed can monitor their progress, but individual banks are responsible for being ready.  1) How is the Chicago Fed helping financial institutions to which it provides financial services?  The Federal Reser ve is doing everything it can to be sure that various methods of payment will continue to work. Banks can test their electronic connections with the Chicago Fed for any of the financial services provided them. Available six days a week, this testing is carried out in an environment that simulates many future dates, but most impor tantly concentrates on the century date change and leap year dates in the Year 2000. The testing confirms the ability of banks to interact electronically with the Federal Reserve in a future-dated environment. A variety of outreach seminars, bulletins and newsletters promoted the  18  during natural disasters and other disruptions. The Bank is building on the plans already in place. Many of these contingency plans will be tested and refined in 1999. The Chicago Fed is developing alternate manual operating procedures for automated business applications where possible, and has a number of other contingency plans in place for a wide variety of other possible problems.  4) How is the Federal Reserve preparing for demands for currency?  The Fed expects the U.S. financial system to be ready for the Year 2000. Most people should find their money is safe where it is. Some people might decide to hold extra cash during the Year 2000 rollover, but few individuals are expected to hold significantly more than they typically do. As a precaution, the Fed will increase the currency in circulation and in Federal Reserve or commercial banks’ vaults to about $700 billion in 1999. That provides a cushion of about $200 billion to meet any increased demand—about $50 billion more than the previous cushion. The Fed will also be taking steps to ensure that depository institutions will be able to obtain currency on a timely basis to meet the demands of their customers. If necessar y, Federal Reserve Banks will extend their hours to fill banks’ currency orders or take other operational steps to ensure that banks can obtain cash quickly. The Fed will continue to assess public needs, and if necessary, make adjustments in the currency printing order for the fourth quarter.  9) What is the Fed doing to assess worldwide readiness?  Although the Federal Reserve can’t be responsible for Year 2000 preparations among foreign nations and institutions, it’s working to better understand their level of readiness. The Federal Reserve’s direct supervisory authority is limited to offices of those foreign banks operating in the U.S., but it will receive information on foreign bank Year 2000 readiness from international super visory bodies and private sector forums. The Fed will also be working with foreign bank super visors and other U.S. supervisors to improve the flow and quality of information on foreign Year 2000 readiness. 10) What will be the impact of the Year 2000 problem on the U.S. economy?  5) What else is important for consumers to know?  The Year 2000 date change does not affect deposit insurance coverage. Deposits at an FDIC-insured bank or savings institution will continue to be protected up to $100,000 against loss due to the failure of the institution. Banks and savings associations are required to keep backup records for account transactions so they can recover account information in case of an emergency.  The Fed is cautiously optimistic there will be no significant disruptions to the economy as a result of the Year 2000 problem. A recession seems unlikely, but a positive outcome continues to depend on diligent preparation and progress. The economic stakes are very large and the spectrum of possible outcomes ver y broad, ranging from minimal to ver y serious. It is impossible to know exactly what will happen, but a reasonable scenario is that the net effect of spending to correct the problem could shave one-tenth or two-tenths of a percent off the growth of U.S. labor productivity and could reduce GDP by one-tenth of a percentage point per year over 1999 and 2000.  6) What are the Fed’s internal preparations for the Year 2000?  Much of the Bank’s internal preparation has involved making sure all computer systems and applications are ready. The Bank’s most impor tant systems were ready for Year 2000 at the end of 1998, and all remaining systems were ready by March 31, 1999. A comprehensive eight-phase process was used to make sure computer hardware and operating systems—as well as systems with embedded chips—were ready. That was followed by testing the processing capabilities of specific business applications in a simulated future-date environment.  11) What about the role of monetary policy?  Monetary policy can do nothing to head off Year 2000 disruptions, but the Fed will be prepared to lend to financial institutions under appropriate circumstances or to provide needed reserves to the banking system. In the unlikely event that serious Year 2000 disruptions resulted in significant longer-term effects on aggregate demand, the Federal Reserve would have an important role to play in countering the downturn.  7) What will be the Bank’s internal focus for the rest of the year?  The rest of the year will be devoted to certifying the readiness of new internal software or software that is changed, as well as to contingency planning.  For more information Visit the Fed’s Year 2000 web site at http://www.frbsf.org/ fiser vices/cdc/index.html for information on a variety of Year 2000 topics. For information on what banks must do to satisfy the regulator y requirements for the Year 2000, visit the FFIEC’s Web site at http://www.ffiec.gov/y2k/default.htm.  8) What type of contingency planning is underway?  It focuses on the Chicago Fed’s internal readiness and its ability to interact with depository institutions. It’s important to remember that the Chicago Fed already has extensive contingency plans that have been routinely tested, and occasionally implemented,  These questions and answers have been designated as a Year 2000 Readiness Disclosure.  19  Directors  Board of Directors Federal Reserve Bank of Chicago Chairman Lester H. McKeever, Jr. Managing Partner Washington, Pittman & McKeever Chicago, Illinois Deputy Chairman Arthur C. Mar tinez Chairman and Chief Executive Officer Sears, Roebuck, and Co. Hoffman Estates, Illinois Robert J. Darnall President and Chief Executive Officer Ispat North America Chicago, Illinois Jack B. Evans President The Hall-Perrine Foundation Cedar Rapids, Iowa  Migdalia Rivera* Chicago, Illinois Donald J. Schneider President Schneider National, Inc. Green Bay, Wisconsin Arnold C. Schultz Chairman and President GNB Bancorporation and Chairman and Chief Executive Of ficer The Grundy National Bank Grundy Center, Iowa  Two new directors joined the board in 1999. They are (left) James H. Keyes, chairman and chief executive officer of Johnson Controls, Inc. in Milwaukee, Wisconsin, and Alan R. Tubbs, president of Maquoketa State Bank and Ohnward Bancshares in Maquoketa, Iowa. They replace Donald Schneider and Arnold Schultz, who ser ved the maximum two terms as directors.  Rober t R. Yohanan Managing Director and Chief Executive Of ficer First Bank and Trust of Evanston Evanston, Illinois  *Inactive  Verne G. Istock Chairman BANK ONE Corporation Chicago, Illinois  1998 Board of Directors, Federal Reserve Bank of Chicago, from left to right: Donald Schneider, Jack Evans, Verne Istock, Lester McKeever, Arthur Martinez, Arnold Schultz, Robert Yohanan, Robert Darnall.  20  Board of Directors Detroit Branch Chair Florine Mark President and Chief Executive Officer The WW Group, Inc. Farmington Hills, Michigan Richard M. Bell President and Chief Executive Officer The First National Bank of Three Rivers Three Rivers, Michigan Irma B. Elder President Troy Motors, Inc. Troy, Michigan Timothy D. Leuliette President and Chief Operating Officer Penske Corporation Detroit, Michigan  Denise Ilitch Vice Chair woman Little Caesars Enterprises, and President Olympia Development, Inc. Detroit, Michigan Stephen R. Polk Chairman and Chief Executive Of ficer R. L. Polk & Company Southfield, Michigan David J. Wagner Chairman, President and Chief Executive Officer Old Kent Financial Corporation Grand Rapids, Michigan  1998 Board of Directors, Detroit Branch, from left to right: Timothy Leuliette, David Wagner, Denise Ilitch, Florine Mark, Stephen Polk, Irma Elder, Richard Bell.  21  Advisory Councils  Federal Advisory Council Seventh District Representative Norman R. Bobins President and Chief Executive Officer LaSalle National Corporation and LaSalle National Bank Chicago, Illinois  Advisory Council on Agriculture, Labor, and Small Business Henr y Carstens Brillion, Wisconsin Wisconsin Agri-Ser vice Association Alan Garner Mason, Michigan Michigan Farm Bureau Brad Glenn Stanford, Illinois Illinois Soybean Association Brent Halling Perr y, Iowa Iowa Pork Producers Association John Howell Bryant, Indiana Indiana State Poultry Association Charles Shaw Hope, Indiana Milk Promotion Services of Indiana John Whipple Shenandoah, Iowa Iowa Corn Growers Association Carl Camden Troy, Michigan Kelly Services, Inc. Member-at-Large John Challenger Chicago, Illinois Challenger, Gray & Christmas, Inc. Member-at-Large Linda Ewing Detroit, Michigan International Union, UAW David Newby Milwaukee, Wisconsin Wisconsin State AFL-CIO Steve Redfield Chicago, Illinois STRIVE/Chicago Employment Council Member-at-Large James Rohan Chicago, Illinois Sullivan, Cotter and Associates Member-at-Large Ronald Willis Chicago, Illinois Chicago Federation of Labor Lloyd Falconer Seward, Illinois National Federation of Independent Business, (NFIB)  Harold F. Force Columbus, Indiana Indiana Chamber of Commerce  Iowa J. Michael Earley Bankers Trust Company Des Moines, Iowa  Diane McCluskey Independent Bankers’ Bank of Illinois Springfield, Illinois  Dwight Seegmiller Hills Bank & Trust Company Hills, Iowa  John McEvoy Metro Bank East Moline, Illinois  Paul Swenson Iowa Trust & Savings Bank Oskaloosa, Iowa  Michael King First National Bank of Decatur Decatur, Illinois  Richard A. Waller Security National Bank Sioux City, Iowa  Sue Ling Gin Chicago, Illinois Flying Food Fare, Inc. Member-at-Large  Michigan Charles B. Cook Marshall Savings Bank, FSB Marshall, Michigan  Manuel T. Gonzalez Indianapolis, Indiana United States Hispanic Chamber of Commerce  William C. Nill First State Bank of East Detroit St. Clair Shores, Michigan  Richard T. Koenings Elm Grove, Wisconsin Independent Business Association  Robert E. Churchill Citizens National Bank of Cheboygan Cheboygan, Michigan  Myrna Ordower Chicago, Illinois National Association of Women Business Owners (NAWBO)  Wisconsin Helge S. Christensen Bankers’ Bank Madison, Wisconsin  James Michael Schultz Effingham, Illinois Illinois State Chamber of Commerce  Richard A. Hansen Johnson International, Inc. Johnson Bank Racine, Wisconsin  Billie Jo Wanink Royal Oak, Michigan National Association of Women Business Owners (NAWBO)  Bradley O. Yocum State Bank of Howards Grove Howards Grove, Wisconsin  Alan C. Young, CPA Detroit, Michigan Booker T. Washington Business Association  Customer Advisory Groups Central Illinois Dale Baraks Southeast National Bank of Moline Moline, Illinois  Community Bank Council Illinois Douglas C. Mills First Busey Corporation Urbana, Illinois  Gar y Elliott The Havana National Bank Havana, Illinois  John Rodda Capstone Bank Watseka, Illinois  Richard Giebelhausen Herget National Bank of Pekin Pekin, Illinois  Thelma J. Smith Illinois Ser vice Federal Savings and Loan Association Chicago, Illinois  William Glaze First Bank of Illinois Collinsville, Illinois  Indiana Calvin Bellamy Bank Calumet Hammond, Indiana  Wilbur R. Lancaster Magna Bank of Illinois Decatur, Illinois  John W. Corey Lafayette Savings Bank, FSB Lafayette, Indiana  Randall Ross First Mid-Illinois Bank & Trust, N.A. Mattoon, Illinois  James L. Saner, Sr. Peoples Trust Company Brookville, Indiana  Donald Schlor ff Busey Bank Urbana, Illinois  Cathy E. McHenr y Fairmount State Bank Fairmount, Indiana  22  Chicago Metropolitan Diane Anderson Financial Federal Trust & Savings Bank Olympia Fields, Illinois  John Collins Great Lakes Credit Union Great Lakes, Illinois John Bailey Baxter Credit Union Deer field, Illinois Thomas Darovic Superior Bank, FSB Oak Brook Terrace, Illinois Richard Brattland AMCORE Financial, Inc. Rockford, Illinois Edward Fur ticella Peoples Bank SB Munster, Indiana Denise Currier First of America Chicago, Illinois James Constantine Sears, Roebuck and Co. Hof fman Estates, Illinois Arlene Kowalczyk Downers Grove National Bank Downers Grove, Illinois Barbara Yeates Cole Taylor Bank Chicago, Illinois Deborah Schneider First Midwest, N.A. Joliet, Illinois Charles Sanger Bank Calumet Hammond, Indiana Indiana H. Matthew Ayers State Bank of Lizton Lizton, Indiana  Steven Bailey Decatur Bank and Trust Decatur, Indiana Lynn Bierlein Salin Bancshares, Inc. Indianapolis, Indiana Debora L. Cox Irwin Union Bank & Trust Columbus, Indiana Rober t E. Fall NBD Indianapolis, NA Indianapolis, Indiana  Steven D. Flowers Bank One Indianapolis, NA Indianapolis, Indiana  Steve Tscherter Lincoln Savings Bank Reinbeck, Iowa  Patricia Lunog Alliance Banking Company New Buffalo, Michigan  Chanda L. Booms Signature Bank Bad Axe, Michigan  Pamela S. Gossett DeMotte State Bank DeMotte, Indiana  Northern Michigan Barbara Gurn The Empire National Bank of Traverse City Traverse City, Michigan  D. Scott Hines The First National Bank Three Rivers, Michigan  Cynthia Bourjally Madison National Bank Madison Heights, Michigan  Linda Pitsch ChoiceOne Bank Sparta, Michigan  Richard Bauer Fidelity Bank Birmingham, Michigan  Linda Comps-Klinge State Bank of Caledonia Caledonia, Michigan  Stephen M. Mazurek Bank of Lenawee Adrian, Michigan  Kathleen Alford The Empire National Bank of Traverse City Traverse City, Michigan  Jaylen T. Johnson Southern Michigan Bank & Trust Coldwater, Michigan  Paul Fuller Republic Bank Ann Arbor, Michigan  John R. Kluck First National Bank of Gaylord Gaylord, Michigan  Robert Branch Ionia County National Bank Ionia, Michigan  Dee Ann Hammel First Federal Savings Bank Huntington, Indiana Stan V. Hart Terre Haute First National Bank Terre Haute, Indiana H. Dean Hawkins First State Bank Morgantown, Indiana Paul Hoover First Merchants Bank, NA Muncie, Indiana Sherri Jones Phillips Electronics Federal Credit Union Fort Wayne, Indiana Sharon A. Mar x National City Bank Indianapolis, Indiana Carl A. Minick Fort Wayne National Bank Fort Wayne, Indiana Robert J. Ralston Lafayettte Bank & Trust Company Lafayette, Indiana Iowa Daniel G. Augustine Security National Bank Sioux City, Iowa  Monte Berg John Deere Community Credit Union Waterloo, Iowa Linda Donner First American Bank Fort Dodge, Iowa Dale C. Froehlich Community State Bank Ankeny, Iowa Nelson Klavitter Dubuque Bank & Trust Dubuque, Iowa Bill Logan State Central Bank Keokuk, Iowa Victor Quinn Quad City Bank & Trust Bettendor f, Iowa Marti T. Rodamaker First Citizens National Bank Mason City, Iowa Steve Ollenberg Principal Bank Des Moines, Iowa Robert A. Steen Bridge Community Bank Mechanicsville, Iowa  Brian Bromley The Empire National Bank of Traverse City Traverse City, Michigan  Wendell Stoeffler Ionia County National Bank Ionia, Michigan  William Kirsten First National Bank of Gaylord Gaylord, Michigan  Carole Sanocki Ionia County National Bank Ionia, Michigan  Kathleen Taskey First National Bank of Gaylord Gaylord, Michigan  Chantele M. Neal Hillsdale County National Bank Hillsdale, Michigan  Michael Thompson First Community Bank Harbor Springs, Michigan  Debra S. Smith Hillsdale County National Bank Hillsdale, Michigan  Marilyne Joy Charlevoix State Bank Charlevoix, Michigan  Joan Hef felbower Hastings City Bank Hastings, Michigan  Patrick Duffy Commercial Bank Alma, Michigan Janet Davison Commercial Bank Alma, Michigan  Jerry Van Blarcom Southern Michigan Bank & Trust Coldwater, Michigan  Victoria Sager Central State Bank Beulah, Michigan  Emily Stafford Hastings City Bank Hastings, Michigan  Nikki Bright State Savings Bank of Frankfort Frankfort, Michigan  Detroit Metropolitan Michael McMinn Metrobank Farmington Hills, Michigan  Susan A. Eno Citizens National Bank of Cheboygan Cheboygan, Michigan  Marianne Hellebuyck Metrobank Farmington Hills, Michigan  Mary Ann Breuer Isabella Bank & Trust Mt. Pleasant, Michigan  Laird Kellie Lapeer County Bank & Trust Co. Lapeer, Michigan  Dennis P. Angner Isabella Bank & Trust Mt. Pleasant, Michigan  Kathleen Rhoades Citizens State Bank New Baltimore, Michigan  Leo D. Marciniak Huron Community Bank East Tawas, Michigan  Bonnie Vanderbossche Citizens State Bank New Baltimore, Michigan  Western Michigan Robert De Jonge Grand Bank Grand Rapids, Michigan  Joseph Hallman Citizens State Bank New Baltimore, Michigan  23  Richard Roty Republic Bank Ann Arbor, Michigan Catherine Joslin The State Bank Fenton, Michigan Ronald Justice The State Bank Fenton, Michigan Wisconsin Paul Adamski Pineries Bank Stevens Point, Wisconsin  Terry Anderegg Mutual Savings Bank Milwaukee, Wisconsin Steven Bell Community State Bank Union Grove, Wisconsin Jesse L. Calkins Blackhawk State Bank Beloit, Wisconsin Robert W. Fouch Wisconsin Corporate Credit Union Hales Corners, Wisconsin Timothy R. Kent Firstar Bank Milwaukee, Wisconsin Guy Ringle M&I Data Center Milwaukee, Wisconsin Mara Todorvic Bank One Data Services Milwaukee, Wisconsin Ronald L. Slater Bankers Bank Madison, Wisconsin Thomas Smith Heritage Bank and Trust Racine, Wisconsin Leonard Steele Associated Data Services Green Bay, Wisconsin Werner Kant Educators Credit Union Racine, Wisconsin  Officers  Michael H. Moskow President and Chief Executive Officer  Supervision and Regulation*  John J. Wixted, Jr. Senior Vice President  William C. Conrad First Vice President and Chief Operating Officer  Administration James A. Bluemle Vice President and Division Leader  CENTRAL BANK ACTIVITIES Economic Research and Programs  William C. Hunter Senior Vice President and Director of Research  Macroeconomic Policy Research Charles L. Evans Vice President and Economic Advisor  Jean L. Valerius Vice President and Senior Policy Advisor  Anne Marie L. Gonczy Assistant Vice President and Economic Advisor  Financial Markets Regulation and Payments Issues Douglas D. Evanoff Vice President and Economic Advisor  Microeconomic Policy Research Daniel G. Sullivan Vice President and Economic Advisor  Elijah Brewer III Assistant Vice President and Economic Advisor  Paula R. Worthington Research Officer and Economic Advisor  James T. Moser Research Officer and Economic Advisor  Regional Economic Programs William A. Testa Vice President and Economic Advisor  Sheryn E. Bormann Director Michael R. Jarrell Director Bank and Bank Holding Company Supervision Barbara D. Benson Vice President and Division Leader  Global Supervision James W. Nelson Vice President and Division Leader  Adrian B. D’Silva Director Philip G. Jackson Director Mark H. Kawa Director Catharine M. Lemieux Director William H. Lossie, Jr. Director  Robert A. Bechaz Regional Director – Illinois  Anne M. Phillips Director  Richard C. Cahill Regional Director – Indiana/ Michigan  Barbara A. Werner Director  Frederick L. Miller Regional Director – Wisconsin  Loretta C. Ardaugh Statistical Repor ts Officer  Paulette M. Myrie-Hodge Regional Director — Illinois  A. Raymond Bacon Special Exams Director  Jeffrey A. Jensen Regional Director – Iowa  Statistics Angela D. Robinson Vice President and Director of Research Statistics  Kevin P. Murray Regional Director — Iowa  Information Technology and Staff Development David E. Ritter Vice President and Division Leader  Joseph J. Turk Director, Supervisor y Resource Group  Gregor y J. Bartnicki Director  Compliance and Community Reinvestment Act Douglas J. Kasl Vice President and Division Leader  Catherine M. Bourke Director  Richard D. Chelsvig Regional Director – Wisconsin Ellen J. Holmgren Regional Director – Indiana/ Michigan  Margaret M. Beutel Director  Kathrine L. Kielma Director Karen M. Whalen-Ward Director – Cultural Transformation  * Includes directors as well as officers  Federal Reserve Bank of Chicago Management Committee, from left to right: William Conrad, Michael Moskow, Deirdre Grant, William Barouski, William Gram, Thomas Ciesielski, Carl Vander Wilt, David Allardice, Glenn Hansen, William Hunter, Charles Furbee, John Wixted, Richard Anstee, Nancy Goodman.  24  SERVICES TO DEPOSITORY INSTITUTIONS Business Development  Richard P. Anstee Senior Vice President Business Development Office Valerie J. Van Meter Vice President Strategic Marketing and Customer Service Kathleen H. Williams Vice President  Rosemarie A. Gould Administrative Officer Retail Payment Services  Charles W. Furbee Senior Vice President Automated Clearing House and Customer Support Jerome F. John Vice President  Cynthia L. Rasche Assistant Vice President Marketing and Business Development Katherine McDonald Retail Payments Officer Check Services Yvonne H. Montgomery Vice President  Tyler K. Smith Assistant Vice President Regional Offices Des Moines Office L. Edward Ketchmark Assistant Vice President  Indianapolis Office Donna M. Yates Assistant Vice President Milwaukee Office Michael J. Hoppe Operations Officer Peoria Facility Mary H. Sherburne Assistant Vice President  Robert W. Lapinski Corporate Communications Officer and Assistant Vice President  Branch Operations and Cash Operations  David R. Allardice Senior Vice President and Branch Manager  Facilities Management and Protection Wayne R. Baxter Vice President  Cash Operations Jerome D. Nicolas Vice President  General Services Kristi L. Zimmermann Assistant Vice President  Guadalupe Garcia Assistant Vice President Detroit Branch Brian D. Egan Vice President  Culture Transformation  Deirdre A. Grant Cultural Transformation Leader and Equal Employment Oppor tunity Officer  Valerie Van Meter Vice President Patrick A. Garrean Assistant Vice President  Human Resource Services  Joseph R. O’Connor Assistant Vice President  Thomas G. Ciesielski Vice President  F. Alan Wells Assistant Vice President  Margaret K. Koenigs Assistant Vice President  Linda S. McDonald Operations Officer  Richard F. Opalinski Assistant Vice President  Electronic and Fiscal Services  Information Technology Services William A. Barouski Senior Vice President  Thomas G. Ciesielski Vice President James M. Rudny Assistant Vice President  Information Management Frank McKenna Vice President  R. Steve Crain Assistant Vice President  SUPPORT FUNCTIONS Community and Internal Services  Brenda D. Ladipo Assistant Vice President  Nancy M. Goodman Senior Vice President  Lysette R. Bailey Training and Information Security Officer  Consumer and Community Affairs Alicia Williams Vice President Corporate Communications James R. Holland Corporate Communications Officer and Assistant Vice President  Legal Services Yurii Skorin Vice President and Associate General Counsel  Elizabeth A. Knospe Assistant Vice President and Assistant General Counsel Anna M. Voytovich Assistant Vice President and Assistant General Counsel Management Services, Accounting, Loans and Payment System Risk  Carl E. Vander Wilt Senior Vice President and Chief Financial Officer Loans, Accounting, and Payment System Risk Gerard J. Nick Vice President  William J. O’Connor Assistant Vice President Ellen J. Bromagen Assistant Vice President Robert A. Lyon Loans Officer Financial and Management Services Jeffrey S. Anderson Assistant Vice President  Jeffrey B. Marcus Assistant Vice President  Ira R. Zilist Information Technology Officer  Office of the General Auditor  Technology Services Thomas M. Matsumoto Assistant Vice President  Robert M. Casey Assistant General Auditor  Contingency Services and Century Date Change Anthony J. Tempelman Assistant Vice President  25  Legal Department and Office of the Secretary William H. Gram Senior Vice President, General Counsel and Secretar y  Glenn C. Hansen General Auditor  Joseph B. Green Audit Officer  As of December 31, 1998  1998 Executive Changes  Directors  Advisory Councils  Members of the Federal Reser ve Bank of Chicago’s board of directors are selected to represent a cross section of the Seventh District economy, including consumers, industr y, agriculture, the ser vice sector, labor, and commercial banks of various sizes.  The Federal Advisor y Council, which meets quarterly to discuss business and financial conditions with the Board of Governors in Washington, D.C., is comprised of one banker from each of the 12 Federal Reserve Districts. Each year the Chicago Reserve Bank’s board of directors selects a representative to this group. Norman R. Bobins was appointed to serve a second one-year term beginning January 1, 1999.  The board consists of nine members. Member banks elect three bankers and three nonbankers. The Board of Governors appoints three additional nonbankers and designates the Reserve Bank chair and deputy chair from among its three appointees.  The Community Bank Council was established in 1998. Members of the Advisory Council on Agriculture, Labor and Small Business, who are selected from nominations by Seventh District organizations, served the second year of their terms in 1998. The councils provide a vital communication link between the Bank and these important sectors.  The Detroit Branch has a seven-member board of directors. The Board of Governors appoints three nonbankers and the Chicago Reser ve Bank board appoints four additional directors. The Branch board selects its own chair each year. All Reserve Bank and Branch directors serve threeyear terms, with a two-term maximum.  Officers  The Bank’s board of directors acted on the following promotions during 1998:  Director appointments and elections at the Chicago Reserve Bank and its Detroit Branch effective in 1998 were:  • William A. Barouski to senior vice president, Information Technology Ser vices.  • Lester H. McKeever, Jr. reappointed to a second three-year term and redesignated Chairman.  • Brian D. Egan to vice president, Detroit Branch.  • Arthur C. Mar tinez redesignated Deputy Chairman.  • Douglas D. Evanoff to vice president, Economic Research.  • Jack B. Evans, President of The Hall-Perrine Foundation, Cedar Rapids, Iowa, and Rober t R. Yohanan, Managing Director and Chief Executive Officer of First Bank & Trust, Evanston, Illinois, appointed to three-year terms as directors replacing Thomas C. Dorr and Stefan S. Anderson.  • Charles L. Evans to vice president, Economic Research.  • Florine Mark redesignated Branch Chair.  • Angela D. Robinson to vice president and director of research statistics, Statistics  • Frank S. McKenna to vice president, Information Technology Ser vices. • Jerome D. Nicolas to vice president, Cash.  • Timothy D. Leuliette reappointed as Branch director. • David J. Wagner, Chairman, President, and Chief Executive Officer of Old Kent Financial Corporation and Chairman of Old Kent Bank, Grand Rapids, Michigan, appointed to threeyear term as Branch director, replacing Charles R. Weeks.  • Daniel G. Sullivan to vice president, Economic Research.  At year-end 1998 the following appointments and elections to terms beginning in 1999 were announced:  • Ellen Bromagen to assistant vice president, Accounting.  • William A. Testa to vice president, Economic Research. • Kathleen H. Williams to vice president, Strategic Marketing and Customer Service. • Cynthia L. Rasche to assistant vice president, Retail Operations.  • Lester H. McKeever, Jr. was redesignated to a third term as Chairman.  New officers appointed by the board in 1998 were:  • Arthur C. Mar tinez was reappointed to a second threeyear term and redesignated Deputy Chairman.  • Lysette R. Bailey to training and information security officer, Information Technology Ser vices.  • James H. Keyes, Chairman and Chief Executive Officer, Johnson Controls, Inc., Milwaukee, Wisconsin, was elected to a three-year term, replacing Donald Schneider.  • Deirdre A. Grant to cultural transformation leader and EEO officer, Cultural Transformation.  • Alan R. Tubbs, President, Maquoketa State Bank and Ohnward Bancshares, Maquoketa, Iowa, was elected to a three-year term replacing Arnold C. Schultz.  • Michael J. Hoppe to operations officer, Milwaukee Office.  • Florine Mark was redesignated Branch Chair.  • Linda S. McDonald to operations officer, Detroit Branch.  • Stephen R. Polk and Richard M. Bell were reappointed to a second three-year term as Branch directors.  • Ira R. Zilist to information technology officer, Information Technology Ser vices.  • Katherine McDonald to retail payments officer, Retail Payment Services.  George Coe retired after 37 years of service to the Federal Reser ve System.  26  Operations Volumes  Dollar Amount 1998  Number of Items  1997  1998  1997  Check & Electronic Payments Checks, NOWs, & share drafts processed  1.5 trillion  1.3 trillion  2.0 billion  1.9 billion  Fine sort & packaged checks handled  46.7 billion  64.1 billion  76.0 million  120.3 million  U.S. government checks processed  43.7 billion  41.4 billion  41.8 million  40.7 million  2.5 trillion  2.2 trillion  744.3 million  687.1 million  46.8 trillion  37.0 trillion  20.5 million  16.8 million  –  650.2 million  524.3 million  Automated Clearing House (ACH) items processed Transfer of funds Electronic cash letters processed  –  Cash Operations Currency received and counted Unfit currency destroyed Coin received and counted  39.4 billion  39.3 billion  2.8 billion  2.8 billion  6.6 billion  10.8 billion  629.6 million  831.2 million  858.3 million 759.8 million  8.4 billion  5.0 billion  Securities Services for Depository Institutions Safekeeping balance December 31: Definitive securities  20.7 billion  12.7 billion  273.4 billion  282.5 billion  Purchase & Sale  3.4 billion  3.1 billion  Book-entr y government securities  7.4 trillion  7.2 trillion  2.5 billion  4.0 billion  33.3 million  37.4 million  0.8 thousand  3.2 thousand  2.5 million  3.8 million  9.2 thousand  11.7 thousand  11.0 billion  46.8 billion  Food stamps redeemed  832.3 million  1.5 billion  Sell Direct transactions processed  510.6 million 132.3 million  Book-entr y securities  14.4 thousand – 7.0 thousand  23.5 thousand – 11.1 thousand  876.1 thousand 979.4 thousand  Loans to Depository Institutions Total loans made during year  0.8 thousand  1.6 thousand  Services to U.S. Treasury and Government Agencies Redemptions of definitive government securities Government coupons paid Federal tax deposits processed  27  703.0 thousand 773.2 thousand 166.3 million 16.2 thousand  291.3 million 4.2 thousand  1998 Financial Statements  Management Asser tion March 5, 1999 To the Board of Directors of The Federal Reserve Bank of Chicago: The management of the Federal Reserve Bank of Chicago (FRBC) is responsible for the preparation and fair presentation of the Statement of Financial Condition, Statement of Income, and Statement of Changes in Capital as of December 31, 1998 (the “Financial Statements”). The Financial Statements have been prepared in conformity with the accounting principles, policies, and practices established by the Board of Governors of the Federal Reserve System and as set for th in the Financial Accounting Manual for the Federal Reserve Banks, and as such, include amounts, some of which are based on judgments and estimates of management. The management of the FRBC is responsible for maintaining an effective process of internal controls over financial repor ting including the safeguarding of assets as they relate to the Financial Statements. Such internal controls are designed to provide reasonable assurance to management and to the Board of Directors regarding the preparation of reliable Financial Statements. This process of internal controls contains self-monitoring mechanisms, including, but not limited to, divisions of responsibility and a code of conduct. Once identified, any material deficiencies in the process of internal controls are reported to management, and appropriate corrective measures are implemented. Even an effective process of internal controls, no matter how well designed, has inherent limitations, including the possibility of human error, and therefore can provide only reasonable assurance with respect to the preparation of reliable Financial Statements. The management of the FRBC assessed its process of internal controls over financial reporting including the safeguarding of assets reflected in the Financial Statements, based upon the criteria established in the “Internal Control – Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, the management of the FRBC believes that the FRBC maintained an effective process of internal controls over financial repor ting including the safeguarding of assets as they relate to the Financial Statements.  Federal Reserve Bank of Chicago  Federal Reserve Bank of Chicago  Michael Moskow President and Chief Executive Officer  William Conrad First Vice President and Chief Operating Officer  Repor t of Independent Accountants To the Board of Directors of The Federal Reserve Bank of Chicago: We have examined management’s assertion that the Federal Reserve Bank of Chicago (“FRB Chicago”) maintained effective internal control over financial reporting and the safeguarding of assets as they relate to the Financial Statements as of December 31, 1998, included in the accompanying Management’s Assertion. Our examination was made in accordance with standards established by the American Institute of Cer tified Public Accountants, and accordingly, included obtaining an understanding of the internal control over financial reporting, testing, and evaluating the design and operating effectiveness of the internal control, and such other procedures as we considered necessary in the circumstances. We believe that our examination provides a reasonable basis for our opinion. Because of inherent limitations in any internal control, misstatements due to error or fraud may occur and not be detected. Also, projections of any evaluation of the internal control over financial repor ting to future periods are subject to the risk that the internal control may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assertion that the FRB Chicago maintained effective internal control over financial repor ting and over the safeguarding of assets as they relate to the Financial Statements as of December 31, 1998, is fairly stated, in all material respects, based upon criteria described in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission.  Chicago, Illinois March 5, 1999  28  1998 Financial Statements  PricewaterhouseCoopers LLP 203 North LaSalle Street Chicago, IL 60601-1210 Telephone: 312-701-5500 Facsimile: 312-701-6533  Repor t of Independent Accountants  To the Board of Governors of the Federal Reserve System and the Board of Directors of the Federal Reserve Bank of Chicago We have audited the accompanying statements of condition of The Federal Reserve Bank of Chicago (the “Bank”) as of December 31, 1998 and 1997, and the related statements of income and changes in capital for the years then ended. These financial statements are the responsibility of the Bank’s management. Our responsibility is to express an opinion on the financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and per form the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Note 3, the financial statements were prepared in conformity with the accounting principles, policies, and practices established by the Board of Governors of The Federal Reserve System. These principles, policies, and practices, which were designed to meet the specialized accounting and repor ting needs of The Federal Reserve System, are set forth in the “Financial Accounting Manual for Federal Reserve Banks” and constitute a comprehensive basis of accounting other than the generally accepted accounting principles. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Bank as of December 31, 1998 and 1997, and results of its operations for the years then ended, on the basis of accounting described in Note 3.  Chicago, Illinois March 5, 1999  29  1998 Financial Statements  Statement of Condition (in millions) As of December 31,  1998  1997  Assets Gold Cer tificates .................................................................................................................  $  998  $  1,069  Special Drawing Rights Certificates ......................................................................................  900  900  Coin ...................................................................................................................................  35  52  Items in Process of Collection ..............................................................................................  794  773  Loans to Depositor y Institutions ...........................................................................................  3  13  U.S. Government and Federal Agency Securities, Net .............................................................  43,841  46,293  Investments Denominated in Foreign Currencies ...................................................................  1,911  1,989  Accrued Interest Receivable .................................................................................................  414  438  Interdistrict Settlement Account ...........................................................................................  1,838  Bank Premises and Equipment, Net .....................................................................................  141  143  Other Assets ......................................................................................................................  28  87  Total Assets ...........................................................................................................................  $ 50,903  $ 51,757  $ 44,608  $ 40,531  Depository Institutions ....................................................................................................  4,282  3,570  Other Deposits ................................................................................................................  78  82  Deferred Credit Items ..........................................................................................................  609  679  Surplus Transfer Due U.S. Treasur y ......................................................................................  56  59  Interdistrict Settlement Account ...........................................................................................  –  5,705  Accrued Benefit Cost ...........................................................................................................  79  76  Other Liabilities...................................................................................................................  25  26  Total Liabilities .......................................................................................................................  $ 49,737  $ 50,728  Capital Paid-in .....................................................................................................................  583  527  Surplus ..............................................................................................................................  583  502  –  Liabilities and Capital  Liabilities: Federal Reserve Notes Outstanding, Net .............................................................................. Deposits:  Capital:  Total Capital ...........................................................................................................................  $  Total Liabilities and Capital ......................................................................................................  $ 50,903  The accompanying notes are an integral part of these financial statements.  30  1,166  $  1,029  $ 51,757  1998 Financial Statements  Statement of Income (in millions) For the years ended December 31,  1998  1997  Interest Income: Interest on U.S. Government Securities ................................................................................  2,625  $ 2,696  Interest on Foreign Currencies .............................................................................................  43  44  Interest on Loans to Depository Institutions ..........................................................................  1  2  2,669  $ 2,742  Income from Ser vices .........................................................................................................  95  95  Reimbursable Services to Government Agencies ...................................................................  22  17  Foreign Currency Gains (losses), Net ....................................................................................  181  (303)  Government Securities Gains, Net ........................................................................................  4  Total Interest Income ...........................................................................................................  $  $  Other Operating Income (Loss):  Other Income ...................................................................................................................... Total Other Operating Income (Loss) .....................................................................................  1  5 $  307  4 $  (186)  Operating Expenses: Salaries and Other Benefits .................................................................................................  129  127  Occupancy Expense ............................................................................................................  18  20  Equipment Expense .............................................................................................................  19  18  Cost of Unreimbursed Treasur y Ser vices ..............................................................................  1  4  Assessments by Board of Governors ....................................................................................  53  58  Other Expenses ..................................................................................................................  97  96  Total Operating Expenses ....................................................................................................  $  317  Net Income Prior to Distribution ...........................................................................................  $  2,659  $  323  $ 2,233  Distribution of Net Income: Dividends Paid to Member Banks .........................................................................................  $  33  Transferred to (from) Surplus ...............................................................................................  81  Payments to U.S. Treasur y as Interest on Federal Reserve Notes ...........................................  770  Payments to U.S. Treasur y as Required by Statute ................................................................ Total Distribution .................................................................................................................  The accompanying notes are an integral part of these financial statements.  31  $  $  32 (10) –  1,775  2,211  2,659  $ 2,233  1998 Financial Statements  Statement of Changes in Capital (in millions) For the years ended Dec. 31, 1998 and Dec. 31, 1997  Capital Paid-in  Balance at January 1, 1997 (10.7 million shares) ..............................................  $  537  Surplus Total Capital $ 524  $ 1,061  Net Income Transferred (from) Surplus ..........................................................  (10)  (10)  Statutor y Surplus Transfer to the U.S. Treasur y ..............................................  (12)  (12)  Net Change in Capital Stock (Redeemed) (0.2 million shares) .........................  $  (10)  $  Balance at December 31, 1997 (10.5 million shares) ........................................  $  527  $ 502  $ 1,029  81  81  –  56  Net Income Transferred to Surplus ................................................................ Net Change in Capital Stock Issued (1.2 million shares) ................................. Balance at December 31, 1998 (11.7 million shares) ........................................  The accompanying notes are an integral part of these financial statements.  32  56 $  583  –  $ 583  $  (10)  $ 1,166  Notes to Financial Statements  1. Organization The Federal Reserve Bank of Chicago (“Bank”) is part of the Federal Reser ve System (“System”) created by Congress under the Federal Reserve Act of 1913 (“Federal Reser ve Act”), which established the central bank of the United States. The System consists of the Board of Governors of the Federal Reserve System (“Board of Governors”) and twelve Federal Reser ve Banks (“Reserve Banks”). The Reser ve Banks are chartered by the federal government and possess a unique set of governmental, corporate, and central bank characteristics. Other major elements of the System are the Federal Open Market Committee (“FOMC”), and the Federal Advisory Council. The FOMC is composed of members of the Board of Governors, the president of the Federal Reserve Bank of New York (“FRBNY”) and, on a rotating basis, four other Reserve Bank presidents.  government’s bank; providing short-term loans to depository institutions; serving the consumer and the community by providing educational materials and information regarding consumer laws; supervising bank holding companies and state member banks; and administering other regulations of the Board of Governors. The Board of Governors’ operating costs are funded through assessments on the Reserve Banks. The FOMC establishes policy regarding open market operations, oversees these operations, and issues authorizations and directives to the FRBNY for its execution of transactions. Authorized transaction types include direct purchase and sale of securities, matched sale-purchase transactions, the purchase of securities under agreements to resell, and the lending of U.S. government securities. Additionally, the FRBNY is authorized by the FOMC to hold balances of and to execute spot and for ward foreign exchange and securities contracts in four teen foreign currencies, maintain reciprocal currency arrangements (“F/X swaps”) with various central banks, and “warehouse” foreign currencies for the U.S. Treasur y and Exchange Stabilization Fund (“ESF”) through the Reser ve Banks.  Structure The Bank and its branch in Detroit, Michigan serve the Seventh Federal Reser ve District, which includes Iowa and por tions of Illinois, Indiana, Michigan, and Wisconsin. In accordance with the Federal Reserve Act, super vision and control of the Bank is exercised by a Board of Directors. Banks that are members of the System include all national banks and any state char tered bank that applies and is approved for membership in the System.  3. Significant Accounting Policies Accounting principles for entities with the unique powers and responsibilities of the nation’s central bank have not been formulated by the Financial Accounting Standards Board. The Board of Governors has developed specialized accounting principles and practices that it believes are appropriate for the significantly different nature and function of a central bank as compared to the private sector. These accounting principles and practices are documented in the “Financial Accounting Manual for Federal Reserve Banks” (“Financial Accounting Manual”), which is issued by the Board of Governors. All Reserve Banks are required to adopt and apply accounting policies and practices that are consistent with the Financial Accounting Manual. The financial statements have been prepared in accordance with the Financial Accounting Manual. Differences exist between the accounting principles and practices of the System and generally accepted accounting principles (“GAAP”). The primary dif ferences are the presentation of all security holdings at amortized cost, rather than at the fair value presentation requirements of GAAP, and the accounting for matched sale-purchase transactions as separate sales and purchases, rather than secured borrowings with pledged collateral, as is required by GAAP. In addition, the Bank has elected not to present a Statement of Cash Flows or a Statement of Comprehensive Income.  Board of Directors The Federal Reser ve Act specifies the composition of the board of directors for each of the Reserve Banks. Each board is composed of nine members serving three-year terms: three directors, including those designated as Chairman and Deputy Chairman, are appointed by the Board of Governors, and six directors are elected by member banks. Of the six elected by member banks, three represent the public and three represent member banks. Member banks are divided into three classes according to size. Member banks in each class elect one director representing member banks and one representing the public. In any election of directors, each member bank receives one vote, regardless of the number of shares of Reser ve Bank stock it holds. 2. Operations and Services The System per forms a variety of ser vices and operations. Functions include: formulating and conducting monetary policy; participating actively in the payments mechanism, including large-dollar transfers of funds, automated clearinghouse operations and check processing; distribution of coin and currency; fiscal agency functions for the U.S. Treasury and certain federal agencies; serving as the federal  33  Notes to Financial Statements reser ves and may be transferred from one national monetar y authority to another. Under the law providing for United States par ticipation in the SDR system, the Secretar y of the U.S. Treasury is authorized to issue SDR certificates, somewhat like gold certificates, to the Reserve Banks. At such time, equivalent amounts in dollars are credited to the account established for the U.S. Treasury, and the Reserve Banks’ SDR certificate accounts are increased. The Reser ve Banks are required to purchase SDRs, at the direction of the U.S. Treasury, for the purpose of financing SDR cer tificate acquisitions or for financing exchange stabilization operations. The Board of Governors allocates each SDR transaction among Reserve Banks based upon Federal Reserve notes outstanding in each District at the end of the preceding year.  3. Significant Accounting Policies, continued  The Statement of Cash Flows has not been included as the liquidity and cash position of the Bank are not of primary concern to the users of these financial statements. The Statement of Comprehensive Income, which comprises net income plus or minus cer tain adjustments, such as the fair value adjustment for securities, has not been included because as stated above the securities are recorded at amortized cost and there are no other adjustments in the determination of Comprehensive Income applicable to the Bank. Other information regarding the Bank’s activities is provided in, or may be derived from, the Statements of Condition, Income, and Changes in Capital. Therefore, a Statement of Cash Flows or a Statement of Comprehensive Income would not provide any additional useful information. There are no other significant differences between the policies outlined in the Financial Accounting Manual and GAAP. The preparation of the financial statements in conformity with the Financial Accounting Manual requires management to make cer tain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the reporting period. Actual results could differ from those estimates. Unique accounts and significant accounting policies are explained below.  c. Loans to Depository Institutions The Depository Institutions Deregulation and Monetar y Control Act of 1980 provides that all depository institutions that maintain reser vable transaction accounts or nonpersonal time deposits, as defined in Regulation D issued by the Board of Governors, have borrowing privileges at the discretion of the Reser ve Banks. Borrowers execute certain lending agreements and deposit sufficient collateral before credit is extended. Loans are evaluated for collectibility, and currently all are considered collectible and fully collateralized. If any loans were deemed to be uncollectible, an appropriate reser ve would be established. Interest is recorded on the accrual basis and is charged at the applicable discount rate established at least every four teen days by the Board of Directors of the Reserve Banks, subject to review by the Board of Governors. However, Reserve Banks retain the option to impose a surcharge above the basic rate in certain circumstances.  a. Gold Certificates The Secretar y of the Treasur y is authorized to issue gold cer tificates to the Reserve Banks to monetize gold held by the U.S. Treasury. Payment for the gold certificates by the Reser ve Banks is made by crediting equivalent amounts in dollars into the account established for the U.S. Treasury. These gold certificates held by the Reserve Banks are required to be backed by the gold of the U.S. Treasur y. The U.S. Treasury may reacquire the gold cer tificates at any time and the Reser ve Banks must deliver them to the U.S. Treasur y. At such time, the U.S. Treasury’s account is charged and the Reser ve Banks’ gold cer tificate accounts are lowered. The value of gold for purposes of backing the gold certificates is set by law at $42 2/9 a fine troy ounce. The Board of Governors allocates the gold certificates among Reserve Banks once a year based upon Federal Reserve notes outstanding in each District at the end of the preceding year.  d. U.S. Government and Federal Agency Securities and Investments Denominated in Foreign Currencies The FOMC has designated the FRBNY to execute open market transactions on its behalf and to hold the resulting securities in the portfolio known as the System Open Market Account (“SOMA”). In addition to authorizing and directing operations in the domestic securities market, the FOMC authorizes and directs the FRBNY to execute operations in foreign markets for major currencies in order to counter disorderly conditions in exchange markets or other needs specified by the FOMC in carrying out the System’s central bank responsibilities. Purchases of securities under agreements to resell and matched sale-purchase transactions are accounted for as separate sale and purchase transactions. Purchases under agreements to resell are transactions in which the FRBNY purchases a security and sells it back at the rate specified at the commencement of the transaction. Matched  b. Special Drawing Rights Cer tificates Special drawing rights (“SDRs”) are issued by the International Monetary Fund (“Fund”) to its members in proportion to each member’s quota in the Fund at the time of issuance. SDRs ser ve as a supplement to international monetary  34  Notes to Financial Statements In connection with its foreign currency activities, the FRBNY, on behalf of the Reser ve Banks, may enter into contracts which contain var ying degrees of of f-balance sheet market risk, because they represent contractual commitments involving future settlement, and counter-par ty credit risk. The FRBNY controls credit risk by obtaining credit approvals, establishing transaction limits, and performing daily monitoring procedures. While the application of current market prices to the securities currently held in the SOMA por tfolio and investments denominated in foreign currencies may result in values substantially above or below their carrying values, these unrealized changes in value would have no direct effect on the quantity of reser ves available to the banking system or on the prospects for future Reser ve Bank earnings or capital. Both the domestic and foreign components of the SOMA por tfolio from time to time involve transactions that can result in gains or losses when holdings are sold prior to maturity. However, decisions regarding the securities and foreign currencies transactions, including their purchase and sale, are motivated by monetary policy objectives rather than profit. Accordingly, earnings and any gains or losses resulting from the sale of such currencies and securities are incidental to the open market operations and do not motivate its activities or policy decisions. U.S. government and federal agency securities and investments denominated in foreign currencies comprising the SOMA are recorded at cost, on a settlement-date basis, and adjusted for amor tization of premiums or accretion of discounts on a straight-line basis. Interest income is accrued on a straight-line basis and is reported as “Interest on U.S. government securities” or “Interest on foreign currencies,” as appropriate. Income earned on securities lending transactions is reported as a component of “Other income.” Gains and losses resulting from sales of securities are determined by specific issues based on average cost. Gains and losses on the sales of U.S. government and federal agency securities are repor ted as “Government securities gains, net”. Foreign currency denominated assets are revalued monthly at current market exchange rates in order to repor t these assets in U.S. dollars. Realized and unrealized gains and losses on investments denominated in foreign currencies are reported as “Foreign currency gains (losses), net”. Foreign currencies held through F/X swaps, when initiated by the counter party, and warehousing arrangements are revalued monthly, with the unrealized gain or loss repor ted by the FRBNY as a component of “Other assets” or “Other liabilities,” as appropriate. Balances of U.S. government and federal agencies securities bought outright, investments denominated in foreign currency, interest income, amortization of premiums  3. Significant Accounting Policies, continued d. U.S. Government and Federal…, continued  sale-purchase transactions are transactions in which the FRBNY sells a security and buys it back at the rate specified at the commencement of the transaction. Reserve Banks are authorized by the FOMC to lend U.S. government securities held in the SOMA to U.S. government securities dealers and to banks participating in U.S. government securities clearing arrangements, in order to facilitate the effective functioning of the domestic securities market. These securities-lending transactions are fully collateralized by other U.S. government securities. FOMC policy requires the lending Reserve Bank to take possession of collateral in amounts in excess of the market values of the securities loaned. The market values of the collateral and the securities loaned are monitored by the lending Reserve Bank on a daily basis, with additional collateral obtained as necessary. The securities loaned continue to be accounted for in the SOMA. Foreign exchange contracts are contractual agreements between two parties to exchange specified currencies, at a specified price, on a specified date. Spot foreign contracts normally settle two days after the trade date, whereas the settlement date on forward contracts is negotiated between the contracting par ties, but will extend beyond two days from the trade date. The FRBNY generally enters into spot contracts, with any for ward contracts generally limited to the second leg of a swap/warehousing transaction. The FRBNY, on behalf of the Reserve Banks, maintains renewable, short-term F/X swap arrangements with authorized foreign central banks. The parties agree to exchange their currencies up to a pre-arranged maximum amount and for an agreed upon period of time (up to twelve months), at an agreed upon interest rate. These arrangements give the FOMC temporary access to foreign currencies that it may need for intervention operations to support the dollar and give the partner foreign central bank temporary access to dollars it may need to support its own currency. Drawings under the F/X swap arrangements can be initiated by either the FRBNY or the par tner foreign central bank, and must be agreed to by the drawee. The F/X swaps are structured so that the party initiating the transaction (the drawer) bears the exchange rate risk upon maturity. The FRBNY will generally invest the foreign currency received under an F/X swap in interest-bearing instruments. Warehousing is an arrangement under which the FOMC agrees to exchange, at the request of the Treasur y, U.S. dollars for foreign currencies held by the Treasury or ESF over a limited period of time. The purpose of the warehousing facility is to supplement the U.S. dollar resources of the Treasur y and ESF for financing purchases of foreign currencies and related international operations.  35  Notes to Financial Statements notes outstanding. The collateral value is equal to the book value of the collateral tendered, with the exception of securities, whose collateral value is equal to the par value of the securities tendered. The Board of Governors may, at any time, call upon a Reserve Bank for additional security to adequately collateralize the Federal Reser ve notes. To satisfy its obligation to provide sufficient collateral for its outstanding Federal Reser ve notes, the Reserve Banks have entered into an agreement that provides that cer tain assets of the Reserve Banks are jointly pledged as collateral for the Federal Reser ve notes of all Reserve Banks. In the event that this collateral is insufficient, the Federal Reser ve Act provides that Federal Reser ve notes become a first and paramount lien on all the assets of the Reser ve Banks. Finally, as obligations of the United States, Federal Reserve notes are backed by the full faith and credit of the United States government. The “Federal Reserve notes outstanding, net” account represents Federal Reserve notes reduced by cash held in the vaults of the Bank of $9,506 million, and $6,589 million at December 31, 1998 and 1997, respectively.  3. Significant Accounting Policies, continued d. U.S. Government and Federal…, continued  and discounts on securities bought outright, gains and losses on sales of securities, and realized and unrealized gains and losses on investments denominated in foreign currencies, excluding those held under an F/X swap arrangement, are allocated to each Reserve Bank. Securities purchased under agreements to resell and the related premiums, discounts and income, and unrealized gains and losses on the revaluation of foreign currency holdings under F/X swaps and warehousing arrangements are allocated to the FRBNY and not to other Reserve Banks. Income from securities lending transactions is recognized only by the lending Reserve Bank.  e. Bank Premises and Equipment Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is calculated on a straight-line basis over estimated useful lives of assets ranging from 2 to 50 years. New assets, major alterations, renovations and improvements are capitalized at cost as additions to the asset accounts. Maintenance, repairs and minor replacements are charged to operations in the year incurred.  h. Capital Paid-in The Federal Reserve Act requires that each member bank subscribe to the capital stock of the Reserve Bank in an amount equal to 6% of the capital and surplus of the member bank. As a member bank’s capital and surplus changes, its holdings of the Reserve Bank’s stock must be adjusted. Member banks are those state-chartered banks that apply and are approved for membership in the System and all national banks. Currently, only one-half of the subscription is paid-in and the remainder is subject to call. These shares are nonvoting with a par value of $100. They may not be transferred or hypothecated. By law, each member bank is entitled to receive an annual dividend of 6% on the paid-in capital stock. This cumulative dividend is paid semiannually. A member bank is liable for Reserve Bank liabilities up to twice the par value of stock subscribed by it.  f. Interdistrict Settlement Account At the close of business each day, all Reserve Banks and branches assemble the payments due to or from other Reser ve Banks and branches as a result of transactions involving accounts residing in other Districts that occurred during the day’s operations. Such transactions may include funds settlement, check clearing and automated clearinghouse (“ACH”) operations, and allocations of shared expenses. The cumulative net amount due to or from other Reser ve Banks is repor ted as the “Interdistrict settlement account.” g. Federal Reser ve Notes Federal Reserve notes are the circulating currency of the United States. These notes are issued through the various Federal Reserve agents to the Reser ve Banks upon deposit with such Agents of certain classes of collateral security, typically U.S. government securities. These notes are identified as issued to a specific Reser ve Bank. The Federal Reser ve Act provides that the collateral security tendered by the Reserve Bank to the Federal Reserve Agent must be equal to the sum of the notes applied for by such Reserve Bank. In accordance with the Federal Reser ve Act, gold certificates, special drawing rights certificates, U.S. government and agency securities, loans allowed under Section 13, and investments denominated in foreign currencies are pledged as collateral for net Federal Reserve  i.  Surplus  The Board of Governors requires Reserve Banks to maintain a surplus equal to the amount of capital paid-in as of December 31. This amount is intended to provide additional capital and reduce the possibility that the Reserve Banks would be required to call on member banks for additional capital. Reserve Banks are required by the Board of Governors to transfer to the U.S. Treasur y excess earnings, after providing for the costs of operations, payment of dividends, and reser vation of an amount necessary to equate surplus with capital paid-in. Payments made after September 30, 1998 represent payment of interest on Federal Reserve notes outstanding.  36  Notes to Financial Statements The Bank’s allocated share of securities held in the SOMA at December 31, that were bought outright, were as follows (in millions):  3. Significant Accounting Policies, continued i.  Surplus, continued  1998  The Omnibus Budget Reconciliation Act of 1993 (Public Law 103-66, Section 3002) codified the existing Board surplus policies as statutory surplus transfers, rather than as payments of interest on Federal Reserve notes, for federal government fiscal years 1998 and 1997 (which began on October 1, 1997 and 1996, respectively). In addition, the legislation directed the Reser ve Banks to transfer to the U.S. Treasur y additional surplus funds of $107 million and $106 million during fiscal years 1998 and 1997, respectively. Reserve Banks were not permitted to replenish surplus for these amounts during this time. The Reser ve Banks made these transfers on October 1, 1997 and October 1, 1996, respectively. The Bank’s share of the 1997 transfer is reported as “Statutory surplus transfer to the U.S. Treasur y.” In the event of losses, payments to the U.S. Treasury are suspended until such losses are recovered through subsequent earnings. Weekly payments to the U.S. Treasury vary significantly.  1997  Par value: Federal Agency  $  U.S. Government: Bills Notes Bonds Total Par Value  32  $  73  18,699 18,038 6,670  21,026 18,582 6,337  $ 43,439  $ 46,018  Unamor tized Premiums  709  661  Unaccreted Discounts  (307)  (386)  Total allocated to Bank  $ 43,841  $ 46,293  Total SOMA securities bought outright were $456,667 million and $434,001 million at December 31, 1998 and 1997, respectively. The maturities of U.S. government and federal agency securities bought outright, which were allocated to the Bank at December 31, 1998, were as follows (in millions): Par Value  j.  Cost of Unreimbursed Treasury Services The Bank is required by the Federal Reserve Act to ser ve as fiscal agent and depositor y of the United States. By statute, the Depar tment of the Treasur y is permitted, but not required, to pay for these ser vices. The costs of providing fiscal agency and depository services to the Treasur y Department that have been billed but will not be paid are repor ted as the “Cost of unreimbursed Treasur y ser vices.”  Maturities of Securities Held  U.S. Government Securities  Within 15 days 16 days to 90 days  k. Taxes The Reser ve Banks are exempt from federal, state, and local taxes, except for taxes on real proper ty, which are reported as a component of “Occupancy expense.”  $  111  Federal Agency Obligations $  –  Total $  111  9,517  2  9,519  91 days to 1 year  13,789  7  13,796  Over 1 year to 5 years  10,348  10,342  6  Over 5 years to 10 years  4,303  17  4,320  Over 10 years  5,345  –  5,345  32  $ 43,439  Total  $ 43,407  $  At December 31, 1998, and 1997, matched salepurchase transactions involving U.S. government securities with par values of $20,927 million and $17,027 million, respectively, were outstanding, of which $2,009 million and $1,816 million respectively, were allocated to the Bank. Matched sale-purchase transactions are generally overnight arrangements.  4. U.S. Government and Federal Agency Securities Securities bought outright and held under agreements to resell are held in the SOMA at the FRBNY. An undivided interest in SOMA activity, with the exception of securities held under agreements to resell and the related premiums, discounts and income, is allocated to each Reser ve Bank on a percentage basis derived from an annual settlement of interdistrict clearings. The settlement, per formed in April of each year, equalizes Reser ve Bank gold certificate holdings to Federal Reser ve notes outstanding. The Bank’s allocated share of SOMA balances was approximately 9.600% and 10.666% at December 31, 1998 and 1997, respectively.  5. Investments Denominated in Foreign Currencies The FRBNY, on behalf of the Reser ve Banks, holds foreign currency deposits with foreign central banks and the Bank for International Settlements and invests in foreign government debt instruments. Foreign government debt instruments held include both securities bought outright and securities held under agreements to resell. These investments are guaranteed as to principal and interest by the foreign governments.  37  Notes to Financial Statements 6. Bank Premises and Equipment A summar y of bank premises and equipment at December 31 is as follows (in millions):  5. Investments Denominated…, continued  Each Reserve Bank is allocated a share of foreigncurrency-denominated assets, the related interest income, and realized and unrealized foreign currency gains and losses, with the exception of unrealized gains and losses on F/X swaps and warehousing transactions. This allocation is based on the ratio of each Reserve Bank’s capital and surplus to aggregate capital and surplus at the preceding December 31. The Bank’s allocated share of investments denominated in foreign currencies was approximately 9.660% and 11.667% at December 31, 1998 and 1997, respectively. The Bank’s allocated share of investments denominated in foreign currencies, valued at current exchange rates at December 31, were as follows (in millions): 1998  1998 Bank premises and equipment: Land  $  Government debt instruments including agreements to resell  1,010  Building machinery & equipment  229  Government debt instruments including agreements to resell Accrued interest $  17  1  1  Furniture and equipment  100  93  $  $  141  (96) $  599  572  9  10 $  44 $  Bank premises and equipment Accumulated depreciation  $  3 (1)  $  3 (1)  Capitalized leases, net  $  2  $  2  1999  $  2  2000  2  2001  2  2002  2  2003  2  Thereafter  5 $  $ 1,819  Over 5 years to 10 years  1997  The Bank leases unused space to outside tenants. Those leases have terms ranging from 1 to 13 years. Rental income from such leases was $2 million for each of the years ended December 31, 1998 and 1997. Future minimum lease payments under agreements in existence at December 31, 1998, were (in millions):  1,989  Maturities of Investments Denominated in Foreign Currencies 48  143  375 67  Over 1 year to 5 years  239  Depreciation expense was $15 million for each of the years ended December 31, 1998 and 1997. Bank premises and equipment at December 31 include the following amounts for leases that have been capitalized (in millions):  Total investments denominated in foreign currencies were $19,769 million and $17,046 million at December 31, 1998 and 1997, respectively, which include $15 million and $3 million in unearned interest for 1998 and 1997 respectively, collected on cer tain foreign currency holdings that are allocated solely to the FRBNY. The maturities of investments denominated in foreign currencies which were allocated to the Bank at December 31, 1998, were as follows (in millions):  Total  250 (109)  Bank premises and equipment, net $  965  64  1,911  6 122  1998  Foreign currency deposits  Within 1 year  $  18  Japanese Yen:  Total  6 125  Construction in progress  Accumulated depreciation  1997 $  $  Buildings  German Marks: Foreign currency deposits  1997  15  7. Commitments and Contingencies At December 31, 1998, the Bank was obligated under noncancelable leases for premises and equipment with terms ranging from 1 to approximately 8 years. These leases provide for increased rentals based upon increases in real estate taxes, operating costs or selected price indices.  1,911  At December 31, 1998 and 1997, there were no open foreign exchange contracts or outstanding F/X swaps. At December 31, 1998 and 1997, the warehousing facility was $5,000 million, with zero outstanding.  38  Notes to Financial Statements 8. Retirement and Thrift Plans Retirement Plans The Bank currently offers two defined benefit retirement plans to its employees, based on length of service and level of compensation. Substantially all of the Bank’s employees participate in the Retirement Plan for Employees of the Federal Reser ve System (“System Plan”) and the Benefit Equalization Retirement Plan (“BEP”). The System Plan is a multi-employer plan with contributions fully funded by par ticipating employers. No separate accounting is maintained of assets contributed by the par ticipating employers. The Bank’s projected benefit obligation and net pension costs for the BEP at December 31, 1998 and 1997, and for the years then ended, are not material.  7. Commitments and Contingencies, continued  Rental expense under operating leases for cer tain operating facilities, warehouses, and data processing and office equipment (including taxes, insurance and maintenance when included in rent), net of sublease rentals, was $2.3 million and $2.2 million for the years ended December 31, 1998 and 1997, respectively. Certain of the Bank’s leases have options to renew. Future minimum rental payments under noncancelable operating leases and capital leases, net of sublease rentals, with terms of one year or more, at December 31, 1998, were (in thousands): Operating  Capital  1999  $ 1,303  2000  1,073  175  2001  847  175  2002  561  175  2003  375  29  Thereafter  $  998 $  175  Thrift plan Employees of the Bank may also par ticipate in the defined contribution Thrift Plan for Employees of the Federal Reser ve System (“Thrift Plan”). The Bank’s Thrift Plan contributions totaled $4.0 million and $3.9 million for the years ended December 31, 1998 and 1997, respectively, and are reported as a component of “Salaries and other benefits.”  –  5,157  $  729  Amount representing interest Present value of net minimum lease payments  $  (115) 614  9. Postretirement Benefits Other Than Pensions and Postemployment Benefits Postretirement benefits other than pensions In addition to the Bank’s retirement plans, employees who have met certain age and length of service requirements are eligible for both medical benefits and life insurance coverage during retirement. The Bank funds benefits payable under the medical and life insurance plans as due and, accordingly, has no plan assets. Net postretirement benefit cost is actuarially determined using a Januar y 1 measurement date. Following is a reconciliation of beginning and ending balances of the benefit obligation (in millions):  At December 31, 1998, the Bank had no other material commitments or long-term obligations in excess of one year outstanding. Under the Insurance Agreement of the Federal Reserve Banks dated as of June 7, 1994, each of the Reserve Banks has agreed to bear, on a per incident basis, a pro rata share of losses in excess of 1% of the capital of the claiming Reser ve Bank, up to 50% of the total capital and surplus of all Reserve Banks. Losses are borne in the ratio that a Reserve Bank’s capital bears to the total capital of all Reserve Banks at the beginning of the calendar year in which the loss is shared. No claims were outstanding under such agreement at December 31, 1998 or 1997. The Bank is involved in cer tain legal actions and claims arising in the ordinary course of business. Although it is difficult to predict the ultimate outcome of these actions, in management’s opinion, based on discussions with counsel, the aforementioned litigation and claims will be resolved without material adverse effect on the financial position or results of operations of the Bank.  1998 Accumulated postretirement benefit obligation at Januar y 1  63.3  $  60.9  Service cost-benefits earned during the period  1.4  Interest cost of accumulated benefit obligation  4.5  4.3  Actuarial loss (gain)  8.4  (0.3)  1.3  Contributions by plan participants  0.3  0.3  Benefits paid  (3.3)  (3.2)  Accumulated postretirement benefit obligation at Dec. 31  39  $  1997  $  74.6  $  63.3  Notes to Financial Statements The following is a summary of the components of net periodic postretirement benefit cost for the years ended December 31 (in millions):  9. Postretirement Benefits…, continued  Following is a reconciliation of the beginning and ending balance of the plan assets, the unfunded postretirement benefit obligation, and the accrued postretirement benefit cost (in millions): 1998 Fair value of plan assets at January 1  1998 Service cost-benefits earned during the period  0.0  Amortization of prior service cost  Contributions by the employer  3.0  2.9  Contributions by plan participants  0.3  0.3  Net periodic postretirement benefit cost  (3.3)  (3.2)  $  Benefits paid  0.0  $  Fair value of plan assets at December 31  $  0.0  $  0.0  Unfunded postretirement benefit obligation  $  74.6  $  63.3  Unrecognized prior service cost  8.9  9.9  Unrecognized net actuarial (loss)  (12.8)  (4.4)  Accrued postretirement benefit cost  $  70.7  $  Discount rate  6.25%  7.00%  For measurement purposes, an 8.5% annual rate of increase in the cost of covered health care benefits was assumed for 1999. Ultimately, the health care cost trend rate is expected to decrease gradually to 4.75% by 2006, and remain at that level thereafter. Assumed health care cost trend rates have a significant effect on the amounts reported for health care plans. A one percentage point change in assumed health care cost trend rates would have the following effects for the year ended December 31, 1998 (in millions): 1 Percentage 1 Percentage Point Increase Point Decrease  Effect on aggregate of ser vice and interest cost components of net periodic postretirement benefit cost Effect on accumulated postretirement benefit obligation  $  1.0 11.8  $  $  1.3  4.4  4.3  (0.9)  (0.9)  4.9  $  4.7  Postemployment benefits: The Bank offers benefits to former or inactive employees. Postemployment benefit costs are actuarially determined and include the cost of medical and dental insurance, survivor income, and disability benefits. Costs were projected using the same discount rate and health care trend rates as were used for projecting postretirement costs. The accrued postemployment benefit costs recognized by the Bank at December 31, 1998 and 1997, were $8.5 million and $7.4 million, respectively. This cost is included as a component of “Accrued benefit cost.” Net periodic postemployment benefit costs included in 1998 and 1997 operating expenses were $1.9 million and $1.6 million, respectively.  Accrued postretirement benefit cost is repor ted as a component of “Accrued benefit cost.” The weighted-average assumption used in developing the postretirement benefit obligation as of December 31 is as follows: 1997  $  1.4  Net periodic postretirement benefit cost is reported as a component of “Salaries and other benefits.”  68.8  1998  $  Interest cost of accumulated benefit obligation  1997  1997  (1.1) (12.2)  40  Head Office 230 South LaSalle Street P.O. Box 834 Chicago, Illinois 60690-0834 312-322-5322 Detroit Branch 160 West For t Street P.O. Box 1059 Detroit, Michigan 48231-1059 313-961-6880 Des Moines Office 2200 Rittenhouse Street Suite 150 Des Moines, Iowa 50321 515-256-6100 Indianapolis Office 8311 North Perimeter Road Indianapolis, Indiana 46241 317-244-7744 Milwaukee Office 304 East State Street P.O. Box 361 Milwaukee, Wisconsin 53201-0361 414-276-2323 Peoria Facility 6100 West Dirksen Parkway Peoria, Illinois 61607 309-633-5000  For additional copies of this annual repor t contact the Public Information Center, Federal Reser ve Bank of Chicago, at 312-322-5111 or access the Bank’s Internet home page at http://www.frbchi.org.  WWW. FRBCHI.ORG