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THE FEDERAL RESERVE BANK OF ST. LOUIS ANNUAL REPORT 2002 ALTHOUGH OUR FINANCIAL SYSTEM Past performance is no guarantee of future results. HAS WEATHERED THESE STORMS— — The steps we took to protect our credit and WE’D BE WISE TO KEEP IN MIND THE payment mechanisms during the latest wave of criOFT-STATED WARNING: ses may not apply in the future. 2 William Poole President and CEO Charles W. Mueller Chairman 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS A MESSAGE FROM OUR PRESIDENT THE ST. LOUIS FED TRADITION- can recur, even in a country ALLY ANCHORS ITS ANNUAL start thinking about these problems and solutions now__ before REPORT WITH AN ESSAY ON A some vulnerability surfaces out record of stability like ours. TOPIC THAT’S IMPORTANT TO of the blue and bites us. A few THOSE WHO CARE ABOUT OUR of the threats to our financial spurs discussion about the NATION’S ECONOMY. This year system are very well-known, vital need for vigilance on the is no exception. The subject is financial stability__ always worth such as the funding shortages subject of financial stability. facing Social Security and talking about but particularly Medicare. Others are beginning Elsewhere in this report, we summarize our year__ a timely now, what with the to catch the public’s eye, such good one for the St. Louis Fed, shocks that we’ve endured of as the troubling dominance of in almost all regards. This book late: terrorist attacks, war, the home mortgage market by also contains a new section, accounting scandals and vola- Fannie Mae and Freddie Mac. called “By the Numbers.” tile markets, to name a few. If either of these giants were Through important, unusual or Although our financial sys- to stumble, the entire housing just interesting numbers, we tem has weathered these storms__ and many more before market would fall into disarray. will tell you a bit more about Other possible threats may be who we are at the St. Louis Fed them__ we’d be wise to keep in harder to get a handle on, but and what we do. I hope you mind the oft-stated warning: we must still try. enjoy it. Past performance is no guaran- tee of future results. The steps tectors of our financial system we took to protect our credit will always prevail, this essay and payment mechanisms dur- will provide a reminder of when ing the latest wave of crises the United States had a reputa- may not apply in the future. tion for financial instability. Different problems require dif- Looking today at Japan, one ferent solutions. We should can see that such instability that has a long-term track We hope that this essay For those who think the pro- William Poole 3 2002 MARKED THE THIRD Yet, three consecutive years of turbulence CONSECUTIVE YEAR OF FINANCIAL have not damaged the roots of the U.S. TURBULENCE IN THE UNITED STATES. financial system—the banking sector. 4 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS FINANCIAL STABILITY WELL-ROOTED IN U.S. 2002 MARKED THE THIRD Yet, three consecutive years CONSECUTIVE YEAR OF of turbulence have not damaged around the globe, our financial FINANCIAL TURBULENCE IN system has stood immune and THE UNITED STATES. In early the roots of the U.S. financial system__ the banking sector. 2000, investors lost faith in Commercial banks and thrifts Why? technology stocks and later in other stocks, ushering in what have proven financially robust__ indeed, quite profitable__ during THE SEEDS OF STABILITY has turned out to be a long this period. Creditworthy bear market in equities. In households and businesses FINANCIAL STABILITY RARELY March 2001, the economy continue to enjoy uninterrupted COMES UP IN DAILY CONVER- entered its first recession in a access to credit, while the pay- SATION PRECISELY BECAUSE decade. Then, in September ments system functions as THE U.S. FINANCIAL SYSTEM 2001, terrorists attacked New smoothly as ever. Steady per- HAS PROVEN SO STABLE York City and Washington, D.C. formance is important because SINCE THE 1930s. Stability After these shocks, one might access to credit and to a func- implies widespread reliance on have expected a calmer 2002. tioning payments system are Instead, last year brought new the twin hallmarks of financial the financial system and its parts to function smoothly__ as, challenges in the form of sensa- stability. for example, when we expect a tional accounting and invest- 24-hour ATM machine to dis- ment-banking scandals, large turbulence did spread to the pense cash on demand, when corporate bankruptcies, and banking system in the 19th we assume a gas pump will historically high levels of stock- and early 20th centuries in the accept a debit card without fail, and bond-market volatility. United States and sometimes when we anticipate that online Although financial market still does in other economies stable for decades. 5 lenders will refinance mortgag- and payments-systems policies system was perhaps most es without a hassle or when we to calm financial markets after notable among advanced econ- trust our money to an unfamiliar a shock. Finally, the Fed moni- omies for its instability bank without a second thought. tors many U.S. financial institu- as late as the 1930s. Caveat tions to make sure that they emptor was the operative rule term has a more precise mean- are run in a safe-and-sound because banks failed as fre- ing: Financial stability refers manner. All of these responsi- quently as any other kind of To the Federal Reserve, the to the smooth, uninterrupted operation of both credit and payment mechanisms. In practice, financial stability means that all credit-worthy borrowers can obtain funds at reasonable business. System-wide col- Financial stability means that all creditworthy borrowers can obtain funds at reason- lapses, albeit temporary, were not unknown. Business and financial cycles did not originate in the United States, of course. Adam rates and that all monetary able rates and that all Smith, the Scotsman who is payments and securities trans- monetary payments and now known as the father of actions will settle accurately securities transactions modern economics, long ago and promptly. Because extending credit and executing pay6 ments are two core commercial will settle accurately and promptly. distilled the essential dynamics of a modern economy as an inevitable, recurring sequence of “overtrading,” followed by banking functions, it should come as no surprise that the bilities interact to stabilize the “negligence and profusion,” Fed’s mandate to promote banking system, thereby pre- culminating in “revulsion and financial stability is carried serving its ability to extend discredit.”2 What was unusual out largely through policies credit and to serve as the back- about the U.S. financial system designed to preserve the health bone of the payments system.1 is how long it took to temper of individual banks and the integrity of interbank networks. the “overtrading-negligenceUPROOTING STABILITY The Fed plays an important role in maintaining both econo- revulsion” cycle. England experienced only one banking crisis after 1866__ when the Bank of mic and financial stability. Using HISTORICALLY, FINANCIAL INSTABILITY__ A TEMPORARY monetary policy, the Fed exerts BUT POTENTIALLY SEVERE cessfully as a lender of last a stabilizing influence on the resort. Meanwhile, serious economy as a whole, working DISRUPTION OF CREDIT AND PAYMENT MECHANISMS__ HAS primarily through interest-rate OCCURRED FROM TIME TO United States in 1873, 1884, channels that influence borrow- TIME DESPITE THE BEST 1890, 1893, 1907, 1914, and ing and lending decisions. The EFFORTS OF MARKET PARTICI- most tragically, 1930-33.3 Fed also relies on lender-of- PANTS AND POLICY-MAKERS. Crashes of the stock market last-resort (discount window) To be sure, the U.S. financial England first intervened suc- banking disruptions struck the continued on Page 8 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS The Fed and Financial Stability 7 The 12 Federal Reserve banks serve as the banking system’s lender of last resort. CASUAL OBSERVERS MAY THINK THE FEDERAL RESERVE’S sudden spikes in the demand for liquidity, such as occurred ROLE IN THE ECONOMY IS EXCLUSIVELY TO PROMOTE in the aftermath of Sept. 11. This episode showed clearly MACROECONOMIC STABILITY— —INCLUDING PRICE STABILITY, that, when commercial banks and thrifts have emergency MAXIMUM SUSTAINABLE ECONOMIC GROWTH AND LOW access to liquidity at the central bank’s discount window, LONG-TERM INTEREST RATES. While certainly an important disruptions to the credit and payment mechanisms can be and challenging task, the Fed’s mandate actually is broader avoided even under the direst circumstances. The Federal and includes the goal of promoting financial stability of the Reserve also serves as lead supervisor for thousands of banking system. This dual mandate makes sense because financial holding companies, bank holding companies and macroeconomic and financial stability are mutually reinforc- many state-chartered banks in the United States. This front- ing——for better and for worse. line contact with financial institutions equips the Fed to play a role in financial policy-making and provides a source of The 12 Federal Reserve banks serve as the banking sys- tem’s lender of last resort, the safety valve that depressurizes timely information for monetary policy deliberations. continued from Page 6 and collapses of major financial Instability in 1920s, 1930s Slashed Number of Banks in U.S. institutions were even more frequent. These episodes contrib- Number of Banks in the United States uted to a widespread belief that the U.S. financial system__ 35,000 and particularly the banking system__ was inherently unstable. 25,000 30,000 20,000 The remarkable 19th- and 15,000 early 20th-century instability of 10,000 the U.S. banking system was, in 5,000 many ways, homegrown. 0 Because the U.S. Constitution prohibited states from taxing 1865 1875 1885 1895 1905 1915 1925 1935 1945 1955 1965 1975 1985 1995 BEFORE THE GREAT DEPRESSION, the number of banks steadily rose. States had allowed relatively free entry into banking then. Restrictions on geographic expansion meant that the expanding national economy required more banks. But in the 1920s, the numbers began to fall. Many agricultural areas, along with the banks that served them, were hit hard by falling agriculture prices and overall deflation. Some people thought that the failure of hundreds of banks each year during the 1920s without a nationwide financial crisis meant that our system was immune to collapse. The 1930s showed otherwise. The number of bank failures increased during the early 1930s until deposit insurance and the other New Deal reforms “froze” into place the system that existed as of 1934. The total number of banks began to fall again about 1985 because of failures and mergers. interstate commerce or printing money, they turned in large part to taxes on state-chartered banks to cover their expendi8 The Great Depression tures.4 Many of the restrictions on geographical and product expansion in banking date from this period. To maximize tax revenues from banks, states DATA SOURCES: 1865-1933: White, Eugene. The Regulation and Reform of the American Banking System, 1900-1929. Princeton, N.J.: Princeton University Press, 1983. 1934-2001: Federal Deposit Insurance Corp., Historical Statistics on Banking, Washington, D.C., 2003. restricted competition. As a result, the United States ended up with a very large number of small, undiversified institutions that were vulnerable to local economic as businesses and households as a means to keep small well as national financial from making payments. banks competitive with larger shocks. Depositors, aware of banks that could offer greater this vulnerability, rationally economic instability to create a safety. Many states responded responded to such shocks by self-reinforcing downward spiral. with programs for local banks. “running” their banks. Bank Before 1914, no central bank Typically, the insurance was panics, in turn, depressed the existed in the United States to voluntary, and its price did not real economy by reducing the help break the vicious cycle. A rise much with bank risk. These available supply of credit to demand for the government to design flaws ultimately bank- business firms and preventing provide deposit insurance arose rupted the states’ reserve funds Financial instability amplified 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS and, more importantly, kept the ity to contain the banking panic. Deal financial reforms, the cir- state-run programs from exert- This financial, economic and cumstantial evidence suggests ing a stabilizing influence on the social catastrophe convinced a that these reforms have contri- financial system.5 sufficient majority of business buted to our success in avoid- What forced fundamental and political leaders of the day ing bouts of financial instability change on the U.S. financial sys- that the hitherto lightly regulated during the past seven decades. tem, of course, was the Great financial system was inherently Depression. Between 1930 and and intolerably unstable. fered no instances of general- The United States has suf- 1933, roughly 9,000 U.S. banks failed__ some 30 percent of the ized financial instability since ROOT-AND-BRANCH the 1930s despite the fact that nation’s total. Today, many REFORM shocks to financial markets economists believe that the col- have been no less frequent than lapse of the banking system THE NEW DEAL WAS A MAS- in earlier eras. A partial list of transformed a garden-variety SIVE POLICY RESPONSE TO shocks since the Depression recession into an economic THE ECONOMIC CALAMITY. includes World War II and the calamity. Bank failures In the financial sector, the Korean War, the Cuban missile destroyed deposits in droves response took the form of strict crisis, the Penn Central com- (or froze them as the failed bank chartering requirements, mercial-paper crisis, two OPEC banks were resolved), causing narrowly drawn activity restric- oil shocks, the 1974 and 1987 the available money supply to tions across all types of finan- stock market crashes, and the drop by one-third. Bank fail- cial institutions, price controls regionally devastating energy ures also destroyed valuable (such as interest-rate ceilings), and real estate lending cycles lending relationships, further federal deposit insurance, new of the 1980s, culminating in the contributing to the depth and government financial institu- failure of thousands of bank and length of the Depression. tions (such as the Recon- thrift institutions. Most recently, Between 1929 and 1933, the struction Finance Corp. and the corporate accounting scandals, unemployment rate soared to Federal National Mortgage large corporate bankruptcies 25 percent from 3 percent, not Association, or “Fannie Mae”) and stock market volatility have falling back into the single dig- and a restructured Federal shaken investor and consumer its until the 1940s. Sadly, the Federal Reserve__ created in Reserve System. Although confidence. Yet, none of these many warned of the inhibiting events produced economy-wide 1914 in part to ensure that effects of government interven- financial instability. Why? financial shocks would not spark financial instability__ tion, the risk of not attempting root-and-branch reform of the made things worse in the early financial system appeared even the keystone of the New Deal reforms__ largely explains the 1930s by tightening monetary greater. And while a revisionist disappearance of financial policy to defend the gold stan- school of thought today ques- instability. When designing the dard rather than injecting liquid- tions the wisdom of many New Federal deposit insurance__ continued on Page 13 9 CROSS SECTION of U.S. Financial Crises and Reforms The National Banking Acts of 1863 and 1864. Created a national bank charter and the Office of the Comptroller of the Currency to regulate nationally chartered banks. These acts tried unsuccessfully to drive state-chartered banks out of business. The McFadden Act of 1927. In effect, barred interstate banking and branching by requiring national banks to follow the same laws that applied to state banks. The Bank Holding Company Acts of 1956 and 1970. Defined and created regulation for bank holding companies, an organizational form with little economic rationale other than to arbitrage regulation. The Federal Reserve was given authority to regulate bank holding companies, regardless of the charter(s) held by banks owned by the holding companies. Major banking disruptions. The Great Depression1929-1939. Nearly 30 percent of banks fail. Unemployment hits 25 percent. 10 1970: Penn Central commercialpaper crisis, which threatened to draw the Fed (via the discount window) into a non-banking financial crisis. The Fed refused a request by the Nixon administration to lend money to a non-bank. Early 1930s: Fed tightens monetary policy to defend gold standard rather than injecting liquidity to contain banking panic. The Federal Reserve Act of 1913 was signed by President Woodrow Wilson. Created the Federal Reserve System. This was the first central bank in the United States, although its structure and functioning were quite decentralized. The Banking Acts of 1933 (Glass-Steagall) and 1935 (part of FDR’s New Deal reforms, which stretched out throughout the 1930s). Created federal deposit insurance for commercial banks (FDIC) and savings institutions (FSLIC). Separated commercial banking from investment banking and insurance underwriting. Restructured the Federal Reserve System, focusing more authority in Washington. Created the Federal Open Market Committee (FOMC). Created a true central bank with a unified decision-making structure. When Franklin National Bank of Long Island, N.Y., failed in October 1974, it was the largest bank failure to date. Franklin had $5 billion in assets. Federal Reserve discount-window lending to Franklin peaked at $1.8 billion just six days before the bank’s failure. Noting “the severe deterioration of confidence at home and abroad that would have resulted from an abrupt failure,” the Fed was inadvertently laying the groundwork for a “too-big-to-fail” policy, which later would hamper efforts to instill market discipline in banking. 1973-74: Worst bear market since the Great Depression. The S&L crisis of the late 1970s and 1980s. By the time all the doors were closed and depositors paid off, the crisis cost U.S. taxpayers at least $150 billion. The Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980. Abolished Regulation Q, which put ceilings on deposit interest rates. Broadened access by banks to the Federal Reserve’s discount window and extended reserve requirements to all depository institutions. The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989. Tightened regulation of commercial banks and savings institutions. Appropriated funds and created governmentsponsored entities to administer the resolution (bailout) of the savings and loans’ insolvent deposit-insurance corporation (FSLIC). Moved deposit insurance of savings institutions to the FDIC. The Federal Deposit Insurance Corp. Improvement Act (FDICIA) of 1991. Made changes to the FDIC and to the deposit insurance provided to depository institutions. Addressed the “too-big-tofail” problem by specifying how systemically important depository institutions could be treated when insolvent. The Financial Modernization Act (Gramm-Leach-Bliley) of 1999. Repealed much, but not all, of the Glass-Steagall Act that had separated commercial banking from investment banking and insurance underwriting. Created the financial holding company designation to permit financial organizations to engage in different financial activities within the same corporate entity. Reaffirmed the role of the Federal Reserve as the lead (or “umbrella”) supervisor of complex financial institutions (both bank holding companies and financial holding companies). Preserved the role of functional supervisors at the subsidiary level to oversee each line of financial business separately. 11 2000: Stock market meltdown begins. 1984: “Too big to fail” is inadvertently acknowledged as policy by the Comptroller of the Currency when it says Continental Illinois and 10 other major banks cannot be allowed to fail for fear of bringing the entire financial system down. The Riegle-Neal Interstate Bank Branching Act of 1994. Permitted interstate branching by all commercial banks. States subsequently passed laws to permit state-chartered banks to branch across state lines. 1998: Long-Term Capital Management, a hedge fund, collapses, pushing the world’s financial system to the brink of collapse. Sept. 11, 2001: Terrorists attack New York City and Washington, D.C. New York Stock Exchange closes for four days, the longest interruption of trading since 1914. Federal Reserve undertakes extraordinary measures to protect the payments system. Financial stability is maintained. Potential Sources of Financial Instability in the 21st Century 12 “Financial crises have appeared at roughly 10-year intervals for the last 400 years or so.” IS A RETURN TO FINANCIAL INSTABILITY LIKELY? In 1984, Charles Kindleberger, an eminent economic historian, suggested that financial turbulence was unavoidable: “Financial crises have appeared at roughly 10-year intervals for the last 400 • Deterioration in the financial condition of households, posing a risk that consumer spending could slow sharply. • Heightened risk aversion among investors in financial markets, depressing asset prices. years or so.” The years after 1984 have witnessed, if • High levels of volatility in major equity and credit markets. anything, even more financial crises around the world. Yet, • Bank losses——both financial losses on loans and losses of 6 the United States has successfully avoided disruptions of credit and payments mechanisms. Will our record hold? What threats to financial stability exist today? reputation from questionable business practices. • Diminished access to international capital markets by borrowers in emerging markets. To answer these questions, it pays to think about the type The March 2003 report also pointed to the huge size and ambigu- of economic or financial crisis that could cause an outbreak of ous legal status of Fannie Mae and Freddie Mac, two government financial instability. The International Monetary Fund provides sponsored enterprises (GSEs), as discussed elsewhere in this essay. a quarterly update on trouble spots in the global economy and in Any one or a combination of these risk factors could strike an the financial systems of major countries.7 The report summariz- undercapitalized, poorly regulated banking system and precipitate ing risks to global economic and financial stability entering 2003 financial instability somewhere in the world during 2003. But given pointed to a long list of problems: the resilience of our banking system in the last three years, it • An excessive amount of corporate leverage and excess appears unlikely that financial instability will visit the United States production capacity in some sectors. any time soon. 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS continued from Page 9 policy-makers and, ironically, the interest rate risk exposure program, Congress sought to test the robustness of the post- of the industry and ate away avoid the problems that brought Depression financial system. capital during the period of down the state systems. For Specifically, the flat-rate premium structure__a design flaw higher and more volatile inter- in the state-run systems as well__ promoted imprudent risk- 1970s and early 1980s. example, Congress insisted that all national banks and est rates in the late 1960s, members of the Federal Reserve System accept coverage__ taking, thereby contributing to thereby preventing larger, and the savings and loan debacle of developing crisis by deregulating thrift asset portfolios__ a typically stronger, banks from the 1980s. With flat-rate premi- sensible move for a strongly opting out. The nationwide ums, troubled thrifts could take capitalized industry, but an ill- scope of the program reduced on risky activities, knowing that advised policy for a weakly capi- the likelihood that a geographic deposit insurance would cost talized one. With little of their or industry shock would bank- no more than before and that own wealth to lose, some rupt the reserve fund. In the the government would bear undercapitalized thrift owners worst case, the federal treasury most of any resulting losses. gladly took on risky invest- could be called upon to bolster These perverse incentives ments. Congress also raised the fund. These improvements resulted in billions of dollars of the deposit insurance ceiling, over the state-run programs loans to support projects of thereby shielding thrifts from kept financial turbulence from dubious value and, ultimately, market discipline because a provoking banking panics. No longer did a financial shock__ in thousands of failures with greater portion of their funding enormous cost to taxpayers. became insensitive to risk. such as the failure of a major financial institution__ spell Underfunded thrift supervisors, ums were not the only cause who operated under intense trouble for a small depositor. of the thrift debacle. Policy- political and lobbying pressure, Nationwide bank panics induced incentives to take on sanctioned the use of account- became the stuff of newsreels, interest-rate risk, inadequate ing gimmicks to give thrifts not CNN. supervision of risk-taking and more leeway to avoid recogniz- poorly designed legislative ing losses, presumably so that To be sure, flat-rate premi- well.8 Congress responded to the OTHER WEAKNESSES responses contributed as they could grow out of their SURFACE New Deal programs that were problems. In many cases, how- aimed at stabilizing the mort- ever, these gimmicks simply ALTHOUGH FEDERAL DEPOSIT gage market encouraged thrifts gave thrift managers more time INSURANCE DID MUCH TO to lengthen the maturity of to experiment with new, even STABILIZE THE U.S. BANKING their assets, while deposit riskier investments, thereby SYSTEM, IT CONTAINED insurance allowed thrifts to compounding the cost of the STRUCTURAL FLAWS that shorten their liabilities. The eventual cleanup. Despite an would later come back to haunt resulting mismatch increased ultimate loss to taxpayers of 13 roughly $150 billion, the federal deposit insurance system__ and replace thrift institutions as against mistakes and unfore- the primary conduits for chan- seen portfolio losses. Finally, what is more important, the banking system__ did not break. neling funds to households bank supervisors must receive desiring mortgages. adequate funding and remain Through it all, the public never lost confidence in depository shielded from political pressures. A NEW SEASON institutions because the insur- The Federal Deposit Insurance Corp. Improvement ance was fully backed by the Act of 1991 (FDICIA) constituted federal government. Because REFORMS HELPED US SUR- a significant step in the right the credit and payment mecha- VIVE THE THRIFT DEBACLE, direction. The act beefed up nisms remained intact, the THE HIGH PRICE PAID TO PRO- supervision by mandating safety- thrift crisis did not degenerate TECT THE FINANCIAL SYSTEM, and-soundness exams at least into a vicious cycle of financial IN TERMS OF TAXPAYER every 18 months, prompt cor- and economic instability. The FUNDS AND RESOURCE rective action, risk-based role of federal insurance can- MISALLOCATION, DICTATED A deposit insurance premiums not be overemphasized: In the RE-EVALUATION. This re-evalu- and least-cost failure resolution. mid-1980s and early 1990s, ation pointed to five important Frequent exams improved the state-insured depository insti- lessons. First, it became clear flow of information between tutions in Maryland, Ohio and 14 EVEN THOUGH THE NEW DEAL that mechanisms should be in bankers and supervisors so Rhode Island were destroyed place to encourage faithful and that emerging problems could by panicked deposit with- timely disclosure of financial be addressed quickly and deci- drawals. Such panics could condition. Second, a new sively. Prompt corrective have become national rather method was needed for pricing action, which mandates specific than localized phenomena if deposit insurance, whereby the supervisory responses to dete- no federal deposit insurance explicit price of deposit insur- riorating bank capital, guaran- system had existed. ance plus the implicit price teed that emerging problems No doubt, other factors help imposed by bank supervisors account for the financial stability would mimic the private sec- would be addressed quickly and decisively__ thereby keep- of the 1980s and 1990s. Unlike tor’s risk-sensitive approach to ing supervision insulated from the early 1930s, monetary policy pricing. Third, wherever possi- politically motivated tampering. during and after the S&L crisis ble, market discipline must Risk-based premiums, which took explicit account of the reinforce pressure from currently range from 0 to 27 condition of the banking sys- deposit-insurance premiums cents annually per $100 of tem. Government-sponsored enterprises__ Fannie Mae, and bank supervisors to contain deposits, increased the cost of risk. Fourth, financial firms deposit insurance coverage as Freddie Mac and the Federal Home Loan Banks __ stepped in must maintain adequate capital bank risk rises, thereby making to promote market discipline deposit insurance more like pri- with commercial banks to and to provide a cushion vate insurance. Finally, least- 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS cost resolution, which forces was unlikely; so, the potential now face greater default risk the FDIC to clean up failures in damage one bank’s failure might than before FDICIA, which is the least costly way for the cause for other banks also the intent of the law. Genuine deposit insurance fund, shifted diminished. As a consequence risk exposure ensures that more of the losses to uninsured of implied federal protection, market discipline will reinforce depositors. Greater loss expo- supervisory efforts to maintain sure increases investors' incen- To be sure, regulatory tive to demand higher interest rates from riskier institutions__ resolve has yet to be the safety and soundness of large banks. Why the banking sector has an illustration of market disci- tested in a crisis; so, we fared so well during the recent pline. The consensus view so do not know if the claim economic slowdown can be far seems to be that FDICIA by regulators that no explained in part by the retool- has reduced the chances of bank is too big to fail is, another thrift-type deposit- indeed, true. insurance meltdown. ing of policy following the thrift crisis, along with: • other changes in regulation FDICIA brought one more important change __ it scaled that permitted greater bank of course, market pressure on diversification across product back the so-called “too big to all large banks to contain risk lines and geographic markets, fail” protection for large banks. was reduced. In May 1984, concerns about “systemic risk” (another term fail protection by requiring the for financial instability) led reg- consent of the Secretary of the • technological advances in ulators to shield all creditors of Treasury, along with two-thirds risk management, such as Continental Illinois from losses majorities of the Board of asset securitization, and when the bank became insol- Governors of the Federal vent. That September, the Reserve and the directors of Comptroller of the Currency the FDIC, before an institution formalized the policy in con- could be given an exemption whole, return on assets remains gressional testimony by from normal procedures for comfortably above the traditional announcing that the 11 largest resolution. To be sure, regula- 1 percent benchmark for strong national banks were too big to tory resolve has yet to be tested earnings. Bank failures num- fail. The equity markets imme- in a crisis; so, we do not know bered more than 100 every year diately priced a reduction in if the claim by regulators that between 1985 and 1991, but risk into the publicly traded no bank is too big to fail is, since 1995, they have not securities of all large banking indeed, true. The consensus exceeded 11 in any year. The organizations. That is, market view among market partici- average commercial bank’s participants came to believe pants appears to be that unin- equity capital ratio stood at 6.4 that the failure of a large bank sured creditors of large banks percent of assets at the end of • the strengthening of capital FDICIA curbed too-big-to- requirements under the Basel Capital Accord, • better risk management by banks. For the banking sector as a 15 1990, but had risen to 9.2 per- THREATS ON THE system. As important, they are cent of assets by the end of HORIZON not federally insured and do not have access to the Federal One other stabilizing aspect of the supervisory framework is worth mentioning. The Federal LONG AND PAINFUL EXPERI- Reserve discount window. Two of these entities __ Reserve’s role as supervisor of ENCE THAT THE BEST SAFE- Fannie Mae and Freddie Mac __ all financial holding companies, GUARD AGAINST FINANCIAL merit special attention because bank holding companies and INSTABILITY IS A CAREFULLY of their size and dominance in some state-chartered banks DESIGNED PRIVATE-PUBLIC the housing finance market in contributes to financial stability PARTNERSHIP. Yet, as a result the United States. These two in two ways. First and foremost, of rapid financial innovation as housing GSEs are so massive the Fed’s supervisory role yields well as profit-driven incentives in size and are growing so fast critical feedback about ongoing to avoid regulation, a thriving set that any significant disruption at developments in the financial of non-bank financial entities one or both of the enterprises sector and in the non-financial has emerged in the United necessarily would impact a economy. This feedback puts 16 WE HAVE LEARNED FROM States and many other nations. large number of other financial the Fed in a better position to These lightly regulated entities institutions and non-financial carry out its function as lender are not allowed to offer deposits, entities.9 The securities issued of last resort. Second, and but compete with banks on and guaranteed by the housing somewhat under-appreciated, other fronts. Prominent non- GSEs are widely held in the the Fed’s status as being “inde- bank financial entities today United States and abroad, nota- pendent inside the government” include investment banks, bly by commercial banks.10 puts some distance between mutual funds, finance com- U.S. households depend on the political process and bank panies, the “financial con- Fannie and Freddie to obtain supervision. The Fed shares glomerates” permitted by the capital-market rates for home supervisory responsibility at the Gramm-Leach-Bliley Act of 1999 mortgage borrowing. A large federal level with the Office of and financially oriented govern- number of players in the inter- the Comptroller and the FDIC; ment sponsored enterprises est-rate derivatives market each state also has a supervi- (GSEs). Because these institu- (including commercial banks) sion department. tions have grown rapidly, they count one or both enterprises have become important players among their most important helps guarantee that competi- in the financial system. Yet, counterparties. Illiquidity tion among state and federal because we do not have many caused by concerns about enter- regulators, which can do much centuries of experience with prise viability, not to mention to improve efficiency and non-bank financial institutions outright default, could reduce regulatory burden, does as we do for banks, we do not disrupt commercial banks’ not compromise the integrity of really know what risks they liquidity management and other the supervisory process. potentially pose to the financial The Fed’s independence continued on Page 18 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS Fannie and Freddie Troubling Dominance Their direct debt—over $1.5 trillion—is about 40 percent as much as the publicly held debt of the Treasury. FANNIE MAE (FORMERLY KNOWN AS THE FEDERAL NATIONAL tions of the two enterprises (i.e., excluding mortgage-backed MORTGAGE ASSOCIATION, OR FNMA) AND FREDDIE MAC securities) presently exceed $1.5 trillion, roughly 40 percent (FORMERLY KNOWN AS THE FEDERAL HOME LOAN MORTGAGE as much as the publicly held debt of the U.S. Treasury. CORP., OR FHLMC) TOGETHER OWN OR GUARANTEE ABOUT Mortgage-backed securities issued and guaranteed by Fannie 45 PERCENT OF ALL RESIDENTIAL MORTGAGE DEBT, UP FROM and Freddie of about the same amount are held by investors ABOUT 25 PERCENT IN 1990. of many types. U.S. commercial banks held about $900 billion 11 In their primary market niche of so-called “conforming mortgages”— —prime quality fixed-rate sin- of housing-GSE securities (13 percent of banks’ total assets) gle-family mortgages——Fannie and Freddie enjoy a market share on Sept. 30, 2002, up from about $400 billion at the end of of about 75 percent, up from about 50 percent a decade ago. 1993 (11 percent of total assets). Meanwhile, community The U.S. housing market has been strong throughout the 1990s banks alone (those banks with less than $500 million of assets) and into the 2000s, in part due to the ability of these housing held $130 billion of housing-GSE securities on Sept. 30, 2002 GSEs to provide uninterrupted access by households to the com- (16 percent of total assets), a bit more than at the end of petitive interest rates available in international capital markets. 1993 (15 percent of total assets).12 To manage interest-rate risk, Fannie and Freddie together have become the largest As the secondary mortgage market has grown, so have the direct debt obligations of Fannie and Freddie. Direct debt obliga- end-users of interest-rate derivatives in the world. 17 continued from Page 16 financial institutions and mar- The fact that we have kets in unpredictable ways. Nevertheless, OFHEO con- cluded that the chance of such a systemic disruption could not The collapse of the hedge fund avoided Long-Term Capital Management instability for 70 years research is warranted. For, (LTCM) in 1998 illustrates how is, unfortunately, no though a Fannie or Freddie disruptive a single large play- guarantee that we will insolvency is unlikely, the rami- er’s demise can be, especially financial be as lucky during the in the global derivatives mar- next seven decades. kets. Federal Reserve intervention, which encouraged a capi- be ruled out and that further fications for financial markets and some financial institutions should insolvency occur__ particularly if it occurred tal infusion and an orderly wind-ing-up of LTCM’s business, cial stability posed by the housing prevented much greater GSEs has not gone unnoticed. uncovering an accounting fraud__ would be profound, to financial turbulence. The housing GSEs’ federal regu- say the least. A more likely lator, the Office of Federal event is not outright insolvency with an ambiguous status in the Housing Enterprise Oversight of one or both of the enterpris- market. Participants in capital 18 (OFHEO), recently published an es, but some disruption to the markets clearly perceive a sig- extensive study analyzing the liquidity of the markets in which nificant credit-quality benefit systemic-risk implications posed attached to GSE status, as by Fannie Mae and Freddie their fixed-income securities trade__ the agency market or reflected in the very tight Mac.13 The report concluded the mortgage-backed security interest-rate spreads that GSE that the immediate risks of (MBS) market. Such a “liquidity obligations enjoy over Treasury financial-solvency issues at either Fannie or Freddie__ and event” could stress the banking ing more and more on agency upon the federal government hence, the risk they pose for financial stability__ were quite to provide financial support small because these enterprises ary liquidity reserves. beyond a trivial line of credit. are very strong financially and If market participants were to are well-regulated by OFHEO. AS UNPREDICTABLE abruptly downgrade the credit The agency also believes it like- AS THE WEATHER quality of GSE-issued or GSE- ly that other financial institu- guaranteed securities, the tions, such as large banks, SUDDEN SHOCKS__ INCLUD- resulting repricing and loss of could quickly fill any void creat- ING DRAMATIC REVALUATIONS wealth by securities holders ed by the pullback of Fannie or OF CURRENCIES, STOCK MAR- could unleash substantial Fred-die from the mortgage portfolio reallocations and market due to financial prob- KET CORRECTIONS OR TERRORIST EVENTS__ are facts of widespread market volatility. lems they might encounter. life in modern economies. Housing GSEs also operate securities. Yet, the housing GSEs have no legal right to call The potential threat to finan- abruptly, say, as a result of system because banks are relysecurities and MBS as second- 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS ing of Japan’s “bubble economy” of the 1980s has crippled its Financial Stability Pays Off banking sector. Indeed, Japan 120 100 80 120 100 80 60 60 Recessions represented by shaded stripes 40 40 Industry Production 1997=100 20 20 has avoided profound financial instability only by massive ad hoc government interventions that well may bring long-lasting negative consequences, such as an unsustainable amount 10 10 of government debt issued to support the banks. Moreover, 4 4 20 30 40 50 60 70 80 90 00 10 The United States has enjoyed financial stability since the 1930s. This has helped make recessions less frequent and of shorter duration. In addition, the growth of industrial production (a proxy for real GDP) has been noticeably smoother since the 1930s, in part because the financial system has functioned smoothly. many less-developed economies have succumbed to macroeconomic and financial instability of the type that bedeviled the U.S. economy during the 19th and early 20th centuries. SOURCE: Federal Reserve Board As we move into the 21st century, we must build on our Economic disturbances such as nomic and financial stability, successes and learn from our recessions and lending cycles and other financial regulations__ own and other countries’ mis- appear to be unavoidable as has short-circuited this damag- takes. In practice, this means well. Without prudent policy, ing feedback loop since the paying careful attention to the these shocks and disturbances, 1930s. To be sure, private- incentives created by our bank- if severe or concentrated sector risk management prac- ing policies. The fact that we enough in time, could translate tices have improved, but it is no have avoided financial instability into a financial crisis that criti- accident that the New Deal for 70 years is, unfortunately, cally damages the banking sec- financial reforms described in no guarantee that we will be tor. This, in turn, could severely this essay have coincided with as lucky during the next seven disrupt credit and payment mechanisms__ that is, create the longest uninterrupted decades. In addition to contin- stretch of financial stability uous updating of financial financial instability. in U.S. history. supervisory practice and regula- vention into the financial sector of the U.S. economy__ federal financial instability have tion, constant vigilance by government regulators__ the occurred in the United States public’s watchdogs__ will be deposit insurance, the Federal since the 1930s, we know its required. Reserve System’s multifaceted reappearance is not outside the role as promoter of macroeco- realm of possibility. The burst- Extensive government inter- Even though no bouts of 19 ENDNOTES 1 The Federal Reserve served as a stabiliz- 10 Direct debt obligations of Fannie, Freddie ing force on several fronts in the unsettled or the Federal Home Loan Bank System post-Sept. 11 environment. The Federal are termed “agency securities.” Securitized Reserve Bank of St. Louis 2001 Annual pools of mortgages guaranteed against Report described in detail the Fed’s contri- default by Fannie or Freddie are termed butions to maintaining financial stability. http://www.stlouisfed.org/publications/ ar/2001/default.html. 2 Smith, Adam. An Inquiry into the Nature and the Causes of the Wealth of Nations. New York: Modern Library, 1776 (1937 edition), p. 700. 3 Gorton, Gary. “Banking Panics.” The “mortgage-backed securities,” or MBS. 11 Falcon Jr., Armando. Statement before the Bond Market Association, New York, Feb. 4, 2003. http://www.ofheo.gov/ docs/speeches/bmspeech2403.pdf. 12 Banks increasingly view securities issued by the housing GSEs as near-perfect substitutes for Treasury securities to serve as New Palgrave Dictionary of Money and secondary liquidity reserves. The share of Finance, p. 147. New York: The Stockton banks’ total securities holdings accounted Press, 1992. for by housing-GSE securities increased 4 Sylla, Richard; Legler, John B.; and Wallis, from 49 to 72 percent between the end John J. “Banks and State Public Finance of 1993 and late 2002. Substitution of in the New Republic: The United States, GSE for Treasury securities raises banks’ 1790-1860.” Journal of Economic History, interest earnings slightly, at the risk of 1987, Vol. 47, pp. 391-403. some illiquidity if GSE securities markets 5 For a brief history of the state-chartered deposit insurance systems, see Mark D. Vaughan and David C. Wheelock, were to become unsettled and illiquid for some reason. 13 Office of Federal Housing Enterprise “Deposit Insurance Reform…Is It Déjà Vu 20 Oversight. “Systemic Risk: Fannie Mae, All over Again?” Federal Reserve Bank of Freddie Mac and the Role of OFHEO,” St. Louis, The Regional Economist, a report transmitted to the Congress October 2002, pp. 5-9. pursuant to 12 U.S.C. 4513, Sec. 1313 (e), 6 Kindleberger, Charles P. “Financial Crises.” A Financial History of Western Europe, p. 269. London: George Allen & Unwin, 1984. 7 International Monetary Fund. Global Financial Stability Report: Market Developments and Issues. Washington, D.C.: IMF, December 2002 and March 2003. www.imf.org/external/ pubs/ft/GFSR. 8 For an overview of the thrift crisis, see David H. Pyle, “The U.S. Savings and Loan Crisis,” in Handbooks in Operations Research and Management Science, Vol. 9, edited by R.A. Jarrow, et al., Amsterdam, North Holland, 1995. 9 The third housing GSE is the Federal Home Loan Bank System. Because its structure and operations are quite different, we do not discuss it here. February 2003, http://www.ofheo.gov/ docs/reports/sysrisk.pdf. THE FEDERAL RESERVE BANK OF ST. LOUIS ANNUAL REPORT 2002 THE YEAR IN REVIEW t 2002 WAS A YEAR OF WHICH Looking at the most basic barometer of success, ALL OF US AT THE ST. LOUIS FED our expenses came in under budget and our financial CAN BE TRULY PROUD. services local net revenue exceeded expectations. 2 Mary Karr Karl Ashman LeGrande Rives Dave Sapenaro Julie Stackhouse William Poole MANAGEMENT COMMITTEE Robert Rasche Hank Bourgaux 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS A MESSAGE FROM MANAGEMENT 2002 WAS A YEAR OF WHICH one of our main businesses. of a move that will improve the ALL OF US AT THE ST. LOUIS At the same time, we’ve been nation’s economy in the long run. FED CAN BE TRULY PROUD. We accomplished our goals__ encouraging check writers to Despite the sobering news switch to electronic forms of of staff reductions, we must and, in many cases, did more than we set out to do __ in help- payment. Why? Electronic recognize the many successes we’ve had over the past year. ing the Federal Reserve System payments make for a moreefficient payments system__ fulfill its primary responsibili- one of our primary responsibili- variety of ways: from the num- ties: setting and carrying out ties. Because the public has bers on the ledger sheets to monetary policy, regulating and now begun a fundamental shift the number of outreach efforts, supervising member financial to electronic payments, we from the quality of our financial institutions, and providing need fewer locations and peo- services to the valuable financial services to banks and ple to process checks. System- research and advice that we to the federal government. wide, 1,300 positions will be provide to our nation’s mone- eliminated; in the Eighth District, tary policy-makers. However, the Federal These can be measured in a Looking at the most basic ing paper payments to electron- about 170 jobs will be cut by year-end 2004__ more than barometer of success, our ics will result in consolidated 10 percent of our staff__ as expenses last year came in operations and a significant the Little Rock and Louisville under budget and our financial change in the way we operate. branches stop processing services local net revenue Recently, the Federal Reserve checks. Never before has the exceeded expectations. Not System announced that it Fed reduced staff to this extent, many businesses can say that would eliminate jobs because and we’re saddened that we’ll for 2002. of the decline in the nation’s lose such dedicated employees. In the financial services check usage. For decades, Yet we know these reductions arena, we’re working hard to processing checks has been are an unavoidable consequence keep up with our customers’ Reserve’s success in convert- 3 to create common practices, the Treasury an additional to produce economies of scale $3 million. and to reduce expenses. For In bank supervision, our staff example, our electronic access carried out 91 on-site safety support was shifted in 2002 to and soundness examinations the Minneapolis Fed. We also and inspections last year and pursued joint ventures with continued to use off-site moni- other Feds; the business devel- toring capabilities to improve opment departments of the our own productivity and to be St. Louis and Cleveland Feds were recently merged __ a first for less intrusive in our examina- demands. For example, we’ve the System __to save money and were processed faster than modernized all check-related provide better service to cus- ever. The department’s newly systems as the Fed has moved tomers across the two districts. established Center for Online Bill Poole reads the news before starting another day at the helm of the St. Louis Fed. to a single system for the entire Our previous experience and tions. Reports on examinations Learning is the System’s leader nation; the Eighth District was in web-based training for exam- the first Reserve bank in the 4 expertise in financial services have been carried over into the iners. The center’s online System to complete this effort. Our cash operations __ count- jobs we perform for the U.S. courses save time and money Treasury. For the last two for all involved and allow train- ing, sorting and storing currency, years, the St. Louis Fed has had ees to learn at their own pace. along with replacing the wornout bills __ have also become oversight responsibility for the work done by other Federal Research Department continue more efficient. As a result, we Reserve banks for the Treasury. to provide valuable policy advice, ended 2002 as No. 2 in pro- In addition, our District provided which is shared with the Federal ductivity among the 12 Fed some of these Treasury services. Open Market Committee when districts in cash operations. For example, we handled more it meets to set monetary policy. The Federal Reserve System than $2 trillion in transactions The economists also share their has also recognized our track for the Treasury last year, mainly record in processing food coupons at our Memphis Branch __ in federal tax payments and research and expertise with broader District audiences __ investments of available Treasury everyone from students to Memphis now has responsibility funds in banks around the teachers to business execu- for processing food coupons country. With our help, these tives to government officials. for the western half of the United investments earned $280 mil- In the past year, the economists States. lion in interest for the U.S. have seen more of their work Even as we picked up addi- Treasury in 2002. We also published and have increased tional System responsibilities, helped in 2002 to devise a the number of speeches they we gave up some financial ser- new investment program that give to outside audiences. vices work to other Feds in the pilot phase alone netted They also regularly criss-cross The economists in our 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS Meanwhile, our economic edu- been trained and certified as a cation department is at the federal law enforcement officer. forefront in the Fed in training Next year at this time, we teachers and laymen about the hope that we can report a simi- economy, having doubled its lar level of success. And we goal in attendance at such wish the same for you. events last year. As good stewards of our limLeGrande Rives answers questions at one of the employee town halls last year. ited resources, we are always trying to do more with less. William Poole One of our new initiatives in President and Chief Executive Officer tuents and customers, swap 2002 for saving money was ED__ Electronic Distribution. ideas and gather information on Instead of printing and mailing local and regional economies. regulatory and financial ser-vic- the district to meet our consti- es information to banks, W. LeGrande Rives who are reaching out to the we now send them via e-mail First Vice President public with expertise and ser- and the Internet. This move and Chief Operating Officer vices. Our Community Affairs reduced our mailing costs by staff travels the District and more than half. It’s not just the economists beyond, bringing together bank- Another major savings will ers and those who need credit come in the future as a result to help redevelop their commu- of our decision not to build a nities. The office also shines new headquarters building. the spotlight on issues that Instead, we will renovate the deserve attention, issues such building that we’ve called home as predatory lending and finan- for more than 75 years. This cial literacy. Of particular note decision will require some cre- is the conference we sponsored ativity on the architects’ part— — in fall 2002 on the subject of to give us the added security revitalizing distressed urban precautions necessitated by areas. Instead of holding such Sept. 11 in our current location. an affair in a destination city at But we won’t sacrifice on a fancy hotel, the office took employee security, as we’ve the bold move of holding the already demonstrated. In the conference in East St. Louis, Ill., past year, we’ve added protec- the exact location that needs tion officers at all four offices, and deserves our attention. and each of them has now 5 WHAT FOLLOWS IS A COLLECTION You don’t have to be an accountant— OF NUMBERS THAT SPEAK ON MANY or auditor—to understand why these numbers DIFFERENT LEVELS ABOUT THE ST. LOUIS are meaningful to us. FED’S WORK AND ABOUT THE PEOPLE... 106,549 102,843 $37,611,399,000 1,323 6 1,165,805,000 102,843 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS THE ST. LOUIS FED BY THE NUMBERS AT ANY BANK, SUCCESS IS ■ 171 citations in professional journals and elsewhere to the work of Research Division economists. MEASURED THROUGH NUMBERS. But not all the important numbers can be found in accountants’ financial state- ■ 396 loans to depository institutions for a total dollar value of $974 million. ments. What follows is a collection of numbers that speak on many different levels about the ■ 46,120,000 Treasury checks processed, an increase of 64 percent from the previous year. St. Louis Fed’s work and about the people involved with the Bank, whether they are custom- ■ 4 ers, employees or outside parties who are just curious about the Federal Reserve System. You don’t have to be an accountant — or auditor— to understand — — why these numbers are mean- 28 percent of all the notes sent to the Bank are destroyed because they are worn out. is average number of suspected counterfeit bills found a day in money turned over to the St. Louis office by banks for processing and storing. The bills are turned over to the Secret Service. ingful to us. ■ 1,994 depository institutions — — banks, savings & loans, credit unions and holding companies— are located in the Eighth — District. These include 75 Fed-supervised state member banks and 624 Fed-supervised holding companies. Last year, four banks and 16 holding companies were started in the District, and there were two failures (one bank and one credit union, neither supervised by the Fed). Unless otherwise noted, all numbers are for the year 2002 or are as of Dec. 31, 2002. 1,323 employees in four locations: the home office in St. Louis and the branches in Little Rock, Louisville and Memphis. Of these, 76 were part-time. Total turnover was 8.25 percent. 7 $37,611,399,000 the total dollar value of all currency handled by the St. Louis Fed and paid out. In all, almost 2.4 billion notes were processed. When the cash is received from banks, lightning-quick machines count, validate and bundle notes at the rate of 88,500 an hour. ■ Approximately $1.6 trillion in federal taxes on businesses processed through the Treasury Tax & Loan program for the U.S. Treasury. ■ $280 million in interest earned for the U.S. Treasury through TT&L investments at qualified financial institutions. ■ 216,487,000 8 postal money orders processed. ■ 5,500 calls a month handled by Treasury Relations and Systems Support staff members. They deal with more than 10,000 financial institutions nationwide. ■ 25 workshops on risk management were facilitated by the Bank’s Risk Management Consulting department. ■ 34,189 statistical reports from financial institutions and other respondents were processed. 102,843 cans of food donated by St. Louis employees to charity. The annual food drive is now providing half of the food collected by Operation Food Search, the area’s largest food bank. 5,435,469 hits to the newly designed web site from the time it went live in the middle of August until the end of the year. 1,165,805,000 commercial checks processed (down 0.7 percent from 2001), with a total dollar value of $696 billion (up 12 percent). 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS I N C O M E $1.040 b i l l i o n $897 million interest on federal securities $53 million services $42 million foreign currency gains $38 million reimbursable services to government agencies E X P E N S E S $163 m i l l i o n $84 million salaries and benefits 106,549 subscriptions $42 million other (includes everything from software to travel to some pension costs) to our periodicals. In addition to these publications sent out in the mail, we have 3,617 online subscriptions from people who want to do their reading on the computer. depository institutions had a total balance of $478,795,726 in Fed accounts at year’s end. The money represents required reserves and discretionary funds needed for settling transactions. ■ 26,949,000 food coupons destroyed. That’s 28 percent more than the previous year, thanks, in large part, to consolidation of this work in Memphis and Richmond, Va. ■ 1,603 people who attended 29 economic education events held across the District. These included seven high-school students from St. Louis who made it to the Fed Challenge’s “final four” in Washington, the highest level attained by any team from our district, and 35 teachers who participated in the weeklong Money and Banking course during the summer for college credit. The Bank had net income of $877 million, with $816 million of that profit turned over to the U.S. Treasury, $11 million paid out to member banks and $50 million kept as surplus. 8 million hits ■ 520 $19 million upkeep of the Board of Governors for the year to the FRED (Federal Reserve Economic Data) database, the Internet’s most popular noncommercial web site for U.S. economic data. The Research Division implemented a new, enhanced version of FRED in 2002. Hits rose 23 percent from 2001. 9 THANK YOU RETIRING BOARD MEMBERS We would like to express our deepest gratitude to those members 10 of our Eighth District boards of directors who retired in 2002. Our appreciation and best wishes go out to: Joseph E. Gliessner Jr. from the St. Louis Board, Cynthia J. Brinkley from the Little Rock Board and Mike P. Sturdivant Jr. from the Memphis Board. 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS LITTLEDIRECTORS ROCK BOARD OF LEFT OF COLUMN A. Rogers Yarnell II David R. Estes President Yarnell Ice Cream Co. Inc. Searcy, Arkansas President and CEO First State Bank Lonoke, Arkansas 11 RIGHT OF COLUMN Vick M. Crawley Chairman Plant Manager Baxter Healthcare Corporation Mountain Home, Arkansas Lawrence A. Davis Jr. Raymond E. Skelton Chancellor University of Arkansas at Pine Bluff Pine Bluff, Arkansas Regional President U.S. Bank North Little Rock, Arkansas NOT PICTURED Everett Tucker III Scott T. Ford Chairman Moses Tucker Real Estate Inc. Little Rock, Arkansas President and CEO ALLTEL Corporation Little Rock, Arkansas LOUISVILLE BOARD OF DIRECTORS LEFT OF COLUMN David H. Brooks Marjorie Z. Soyugenc Thomas W. Smith Chairman and CEO Stock Yards Bank & Trust Co. Louisville, Kentucky Executive Director and CEO Welborn Foundation Evansville, Indiana President Thomas W. Smith & Associates Inc. Danville, Kentucky 12 RIGHT OF COLUMN Norman E. Pfau Jr. Chairman President and CEO Geo. Pfau’s Sons Company Inc. Jeffersonville, Indiana Maria Gerwing Hampton Cornelius A. Martin Frank J. Nichols President The Housing Partnership Inc. Louisville, Kentucky President and CEO Martin Management Group Bowling Green, Kentucky Chairman, President and CEO Community Financial Services Inc. Benton, Kentucky 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS MEMPHIS BOARD OF DIRECTORS LEFT OF COLUMN Russell Gwatney Meredith B. Allen James A. England President Gwatney Companies Memphis, Tennessee Vice President, Marketing Staple Cotton Cooperative Association Greenwood, Mississippi Chairman, President and CEO Decatur County Bank Decaturville, Tennessee 13 RIGHT OF COLUMN Gregory M. Duckett Chairman Senior Vice President and Corporate Counsel Baptist Memorial Health Care Corporation Memphis, Tennessee Tom A. Wright Walter L. Morris Jr. E.C. Neelly III Chairman, President and CEO Enterprise National Bank Memphis, Tennessee President H&M Lumber Co. Inc. West Helena, Arkansas Management Consultant First American National Bank Iuka, Mississippi ST. LOUIS BOARD OF DIRECTORS LEFT OF COLUMN Lewis F. Mallory Jr. Bert Greenwalt J. Stephen Barger Chairman and CEO National Bank of Commerce Starkville, Mississippi Partner Greenwalt Company Hazen, Arkansas Executive SecretaryTreasurer Kentucky State District Council of Carpenters Frankfort, Kentucky Charles W. Mueller Chairman Chairman and CEO Ameren Corporation St Louis, Missouri 14 RIGHT OF COLUMN Gayle P.W. Jackson Lunsford W. Bridges Robert L. Johnson Bradley W. Small Managing Director FondElec Clean Energy Group Inc. St. Louis, Missouri President and CEO Metropolitan National Bank Little Rock, Arkansas Chairman and CEO Johnson Bryce Inc. Memphis, Tennessee President and CEO The Farmers and Merchants National Bank Nashville, Illinois NOT PICTURED Walter L. Metcalfe Jr. Deputy Chairman Chairman Bryan Cave LLP St. Louis, Missouri 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS FINANCIAL STATEMENTS THE FEDERAL RESERVE BANK OF ST. LOUIS FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2001 AND 2002 THE FIRM ENGAGED BY THE BOARD OF GOVERNORS FOR THE AUDITS OF THE INDIVIDUAL AND COMBINED FINANCIAL STATEMENTS OF THE RESERVE BANKS FOR 2002 WAS PRICEWATERHOUSECOOPERS LLP (PWC). FEES FOR THESE SERVICES TOTALED $1.0 MILLION. IN ORDER TO ENSURE AUDITOR INDEPENDENCE, THE BOARD OF GOVERNORS REQUIRES THAT PWC BE INDEPENDENT IN ALL MATTERS RELATING TO THE AUDIT. SPECIFICALLY, PWC MAY NOT PERFORM SERVICES FOR THE RESERVE BANKS OR OTHERS THAT WOULD PLACE IT IN A POSITION OF AUDITING ITS OWN WORK, MAKING MANAGEMENT DECISIONS ON BEHALF OF THE RESERVE BANKS, OR IN ANY OTHER WAY IMPAIRING ITS AUDIT INDEPENDENCE. IN 2002, THE BANK DID NOT ENGAGE PWC FOR ADVISORY SERVICES. 15 March 3, 2003 To the Board of Directors: The management of the Federal Reserve Bank of St. Louis (“FRBSTL”) 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, 2002 (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 forth in the Financial Accounting Manual for the Federal Reserve Banks (“Manual”), and as such, include amounts, some of which are based on judgments and estimates of management. To our knowledge, the Financial Statements are, in all material respects, fairly presented in conformity with the accounting principles, policies and practices documented in the Manual and include all disclosures necessary for such fair presentation. The management of the FRBSTL is responsible for maintaining an effective process of internal controls over financial reporting 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 16 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 FRBSTL 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, we believe that the FRBSTL maintained an effective process of internal controls over financial reporting including the safeguarding of assets as they relate to the Financial Statements. Federal Reserve Bank of St. Louis William Poole, President and Chief Executive Officer W. LeGrande Rives, First Vice President and Chief Operating Officer Marilyn K. Corona, Principal Financial Officer 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of the Federal Reserve Bank of St. Louis: We have examined management’s assertion that the Federal Reserve Bank of St. Louis (“FRB”) maintained effective internal control over financial reporting and the safeguarding of assets as they relate to the financial statements as of December 31, 2002, based on criteria described in “Internal Control— Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission included in the accompanying Management’s Assertion. FRB’s management is responsible for maintaining effective internal control over financial reporting and the safeguarding of assets as they relate to the financial statements. Our responsibility is to express an opinion on the assertion based on our examination. Our examination was conducted in accordance with attestation standards established by the American Institute of Certified 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 performing 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 reporting 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 maintained effective internal control over financial reporting and over the safeguarding of assets as they relate to the financial statements as of December 31, 2002, is fairly stated, in all material respects, based on criteria described in “Internal Control—Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. March 3, 2003 St. Louis, Missouri 17 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Governors of The Federal Reserve System and the Board of Directors of The Federal Reserve Bank of St. Louis: We have audited the accompanying statements of condition of The Federal Reserve Bank of St. Louis (the “Bank”) as of December 31, 2002 and 2001, and the related statements of income and changes in capital for the years then ended, which have been prepared in conformity with the accounting principles, policies, and practices established by the Board of Governors of The Federal Reserve System. 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 auditing standards generally accepted in the United States of America. Those standards require that we plan and perform 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. 18 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 reporting 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 accounting principles generally accepted in the United States of America. 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, 2002 and 2001, and results of its operations for the years then ended, in conformity with the basis of accounting described in Note 3. March 3, 2003 St. Louis, Missouri 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS FEDERAL RESERVE BANK OF ST. LOUIS | STATEMENTS OF CONDITION (IN MILLIONS) As of December 31, 2002 2001 ASSETS Gold certificates $ 346 $ 343 Special drawing rights certificates 71 71 Coin 59 58 Items in process of collection 695 215 Loans to depository institutions 11 3 U.S. government and federal agency securities, net 22,726 20,245 Investments denominated in foreign currencies 343 291 Accrued interest receivable 194 206 Interdistrict settlement account – 721 Bank premises and equipment, net 66 67 Other assets 26 19 TOTAL ASSETS $ 24,537 $ 22,239 LIABILITIES AND CAPITAL Liabilities: Federal Reserve notes outstanding, net $ 18,914 $ 21,435 Securities sold under agreements to repurchase 750 — Deposits: Depository institutions 480 344 Other deposits 5 1 Deferred credit items 345 79 Interest on Federal Reserve notes due U.S. Treasury 30 22 Interdistrict settlement account 3,554 — Accrued benefit costs 57 55 Other liabilities 4 5 TOTAL LIABILITIES Capital: Capital paid-in Surplus TOTAL CAPITAL TOTAL LIABILITIES AND CAPITAL 24,139 21,941 199 199 149 149 398 298 $ 24,537 $22,239 The accompanying notes are an integral part of these financial statements. FEDERAL RESERVE BANK OF ST. LOUIS | STATEMENTS OF INCOME (IN MILLIONS) For the years ended December 31, 2002 2001 Interest income: Interest on U.S. government and federal agency securities $ 897 $ 1,082 Interest on investments denominated in foreign currencies 5 7 TOTAL INTEREST INCOME 902 Other operating income: Income from services 53 Reimbursable services to government agencies 38 Foreign currency gains (losses), net 42 U.S. government securities gains, net 3 Other income 2 TOTAL OTHER OPERATING INCOME 138 Operating expenses: Salaries and other benefits 84 Occupancy expense 8 Equipment expense 10 Assessments by Board of Governors 19 Other expenses 42 TOTAL OPERATING EXPENSES $ 163 $ 1,089 54 26 (30) 12 3 65 80 8 10 18 35 151 19 Net income prior to distribution $ 877 $ Distribution of net income: Dividends paid to member banks $ 11 $ Transferred to surplus 50 Payments to U.S. Treasury as interest on Federal Reserve notes 816 TOTAL DISTRIBUTION $ 877 $ 1,003 9 11 983 1,003 The accompanying notes are an integral part of these financial statements. FEDERAL RESERVE BANK OF ST. LOUIS | STATEMENTS OF CHANGES IN CAPITAL for the years ended December 31, 2002 and December 31, 2001 (IN MILLIONS) Capital Paid-in Surplus Total Capital Balance at January 1, 2001 (2.8 million shares) $ 138 $ 138 $ 276 Net income transferred to surplus 11 11 Net change in capital stock issued (0.2 million shares) 11 11 Balance at December 31, 2001 (3.0 million shares) $ 149 $ 149 $ Net income transferred to surplus 50 Net change in capital stock issued (1.0 million shares) 50 Balance at December 31, 2002 (4.0 million shares) $ 199 $ 199 $ 298 50 50 398 The accompanying notes are an integral part of these financial statements. 20 FEDERAL RESERVE BANK OF ST. LOUIS | NOTES TO FINANCIAL STATEMENTS 1. STRUCTURE The Federal Reserve Bank of St. Louis (“Bank”) is part of the Federal Reserve System (“System”) created by Congress under the Federal Reserve Act of 1913 (“Federal Reserve 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 Reserve Banks (“Reserve Banks”). The Reserve Banks are chartered by the federal government and possess a unique set of governmental, corporate, and central bank characteristics. The Bank and its branches in Little Rock, Louisville and Memphis, serve the Eighth Federal Reserve District, which includes Arkansas, and portions of Illinois, Indiana, Kentucky, Mississippi, Missouri and Tennessee. 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. Banks that are members of the System include all national banks and any state chartered bank that applies and is approved for membership in the System. Board of Directors In accordance with the Federal Reserve Act, supervision and control of the Bank are exercised by a Board of Directors. The Federal Reserve 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 Reserve Bank stock it holds. 2. OPERATIONS AND SERVICES The System performs a variety of services and operations. Functions include: formulating and conducting monetary policy; participating actively in the payments mechanism, including large-dollar transfers of funds, automated clearinghouse (“ACH”) operations and check processing; distributing coin and currency; performing fiscal agency functions for the U.S. Treasury and certain federal agencies; serving as the federal 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 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS 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 agreement to resell, the sale of securities under agreement to repurchase, and the lending of U.S. government securities. The FRBNY is also authorized by the FOMC to hold balances of and to execute spot and forward foreign exchange (“F/X”) and securities contracts in nine foreign currencies, maintain reciprocal currency arrangements (“F/X swaps”) with various central banks, and “warehouse” foreign currencies for the U.S. Treasury and Exchange Stabilization Fund (“ESF”) through the Reserve Banks. 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 accounting principles generally accepted in the United States of America (“GAAP”). The primary differences 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 generally required by GAAP. In addition, the Bank has elected not to present a Statement of Cash Flows. 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. 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 would not provide any additional useful information. There are no other significant differences between the policies outlined in the Financial Accounting Manual and GAAP. Effective January 2001, the System implemented procedures to eliminate the sharing of costs by Reserve Banks for certain services a Reserve Bank may provide on behalf of the System. Major services provided for the System by the Bank, for which the costs will not be redistributed to the other Reserve Banks, include operation of the Treasury Relations and Support Office and Treasury Relations and Systems Support Department, which provide services to the U.S. Treasury. These services include: relationship management, strategic consulting, and oversight for fiscal and payments related projects for the Federal Reserve System; and operational support for the Treasury’s tax collection, cash management and collateral monitoring. The preparation of the financial statements in conformity with the Financial Accounting Manual requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities, 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. a. Gold Certificates The Secretary of the Treasury is authorized to issue gold certificates to the Reserve Banks to monetize gold held by the U.S. Treasury. Payment for the gold certificates by the Reserve 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. Treasury. The U.S. Treasury may reacquire the gold certificates at any time and the Reserve Banks must deliver them to the U.S. Treasury. At such time, the U.S. Treasury’s account is charged and the Reserve Banks’ gold certificate 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 average Federal Reserve notes outstanding in each District. b. Special Drawing Rights Certificates 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 serve as a supplement to international monetary reserves and may be transferred from one national monetary authority to another. Under the law providing for United States participation in the SDR system, the Secretary 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 Reserve Banks are required to purchase SDRs, at the direction of the U.S. Treasury, for the purpose of financing SDR certificate acquisitions or for financing exchange stabilization operations. At the time SDR transactions occur, the Board of Governors allocates SDR certificate transactions among Reserve Banks based upon Federal Reserve notes outstanding in each District at the end of the preceding year. There were no SDR transactions in 2002. c. Loans to Depository Institutions The Depository Institutions Deregulation and Monetary Control Act of 1980 provides that all depository institutions that maintain reservable 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 Reserve 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 loans were ever deemed to be uncollectible, an appropriate reserve would be established. Interest is accrued using the applicable discount rate established at least every fourteen days by the Boards of Directors of the Reserve Banks, subject to review by the Board of Governors. Reserve Banks retain the option to impose a surcharge above the basic rate in certain circumstances. 21 22 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 to meet other needs specified by the FOMC in carrying out the System’s central bank responsibilities. Such authorizations are reviewed and approved annually by the FOMC. In December 2002, the FRBNY replaced matched sale-purchase (“MSP”) transactions with securities sold under agreements to repurchase. MSP transactions, accounted for as separate sale and 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. Securities sold under agreements to repurchase are treated as secured borrowing transactions with the associated interest expense recognized over the life of the transaction. The FRBNY has sole authorization 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 on behalf of the System, 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 FRBNY to take possession of collateral in excess of the market values of the securities loaned. The market values of the collateral and the securities loaned are monitored by FRBNY on a daily basis, with additional collateral obtained as necessary. The securities loaned continue to be accounted for in the SOMA. F/X 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 parties, but will extend beyond two days from the trade date. The FRBNY generally enters into spot contracts, with any forward 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 two 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 partner 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 Treasury, 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 Treasury and ESF for financing purchases of foreign currencies and related international operations. In connection with its foreign currency activities, the FRBNY, on behalf of the Reserve Banks, may enter into contracts which contain varying degrees of off-balance sheet market risk, because they represent contractual commitments involving future settlement and counter-party 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 portfolio 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 reserves available to the banking system or on the prospects for future Reserve Bank earnings or capital. Both the domestic and foreign components of the SOMA portfolio from time to time involve transactions that can result in gains or losses when holdings are sold prior to maturity. Decisions regarding the securities and foreign currencies transactions, including their purchase and sale, are motivated by monetary policy objectives rather than profit. Accordingly, market values, 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 amortization of premiums or accretion of discounts on a straightline basis. Interest income is accrued on a straight-line basis and is reported as “Interest on U.S. government and federal agency securities” or “Interest on investments denominated in 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 reported as “U.S. government securities gains, net.” Foreign-currency-denominated assets are revalued daily at current foreign currency market exchange rates in order to report 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 daily, with the unrealized gain or loss reported by the FRBNY as a component of “Other assets” or “Other liabilities,” as appropriate. Balances of U.S. government and federal agency securities bought outright, securities sold under agreements to repurchase, securities loaned, investments denominated in foreign currency, interest income and expense, securities lending fee income, amortization of premiums 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. Income from securities lending transactions undertaken by the FRBNY are also allocated to each Reserve Bank. Securities purchased under agreements to resell 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. e. Bank Premises, Equipment, and Software 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 improve- 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS ments are capitalized at cost as additions to the asset accounts. Maintenance, repairs and minor replacements are charged to operations in the year incurred. Costs incurred for software, either developed internally or acquired for internal use, during the application development stage are capitalized based on the cost of direct services and materials associated with designing, coding, installing, or testing software. f. Interdistrict Settlement Account At the close of business each day, all Reserve Banks and branches assemble the payments due to or from other Reserve 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 ACH operations, and allocations of shared expenses. The cumulative net amount due to or from other Reserve Banks is reported as the “Interdistrict settlement account.” g. Federal Reserve Notes Federal Reserve notes are the circulating currency of the United States. These notes are issued through the various Federal Reserve agents (the Chairman of the Board of Directors of each Reserve Bank) to the Reserve 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 Reserve Bank. The Federal Reserve 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 Reserve Act, gold certificates, special drawing rights certificates, U.S. government and federal agency securities, securities purchased under agreements to resell, loans to depository institutions, and investments denominated in foreign currencies are pledged as collateral for net Federal Reserve 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, and securities purchased under agreements to resell, which are valued at the contract amount. The par value of securities pledged for securities sold under agreements to repurchase is similarly deducted. The Board of Governors may, at any time, call upon a Reserve Bank for additional security to adequately collateralize the Federal Reserve notes. The Reserve Banks have entered into an agreement which provides for certain assets of the Reserve Banks to be jointly pledged as collateral for the Federal Reserve notes of all Reserve Banks in order to satisfy their obligation of providing sufficient collateral for outstanding Federal Reserve notes. In the event that this collateral is insufficient, the Federal Reserve Act provides that Federal Reserve notes become a first and paramount lien on all the assets of the Reserve 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 the Bank’s Federal Reserve notes outstanding, reduced by its currency holdings of $3.088 million and $2.586 million at December 31, 2002 and December 31, 2001, respectively. 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 percent 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 percent 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. 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. Pursuant to Section 16 of the Federal Reserve Act, Reserve Banks are required by the Board of Governors to transfer to the U.S. Treasury excess earnings, after providing for the costs of operations, payment of dividends, and reservation of an amount necessary to equate surplus with capital paid-in. In the event of losses or a substantial increase in capital, payments to the U.S. Treasury are suspended until such losses are recovered through subsequent earnings. Weekly payments to the U.S. Treasury may vary significantly. j. Income and Costs related to Treasury Services The Bank is required by the Federal Reserve Act to serve as fiscal agent and depository of the United States. By statute, the Department of the Treasury is permitted, but not required, to pay for these services. k. Taxes The Reserve Banks are exempt from federal, state, and local taxes, except for taxes on real property, which are reported as a component of “Occupancy expense.” 4. U.S. GOVERNMENT AND FEDERAL AGENCY SECURITIES Securities bought outright are held in the SOMA at the FRBNY. An undivided interest in SOMA activity and the related premiums, discounts and income, with the exception of securities purchased under agreements to resell, is allocated to each Reserve Bank on a percentage basis derived from an annual settlement of interdistrict clearings. The settlement, performed in April of each year, equalizes Reserve Bank gold certificate holdings to Federal Reserve notes outstanding. The Bank’s allocated share of SOMA balances was approximately 3.556 percent and 3.604 percent at December 31, 2002 and 2001, respectively. 23 The Bank’s allocated share of securities held in the SOMA at December 31, that were bought outright, was as follows (in millions): 2002 2001 PAR VALUE: U.S. government: Bills $ 8,060 $ 6,563 Notes 10,592 9,585 Bonds 3,728 3,736 TOTAL PAR VALUE Unamortized premiums Unaccreted discounts TOTAL ALLOCATED TO BANK 22,380 383 (37) 19,884 407 (46) $ 22,726 $ 20,245 Total SOMA securities bought outright were $639,125 million and $561,701 million at December 31, 2002 and 2001, respectively. The maturity distribution of U.S. government and federal agency securities bought outright, which were allocated to the Bank at December 31, 2002, was as follows (in millions): PAR VALUE U.S. Government Federal Agency Securities Obligations MATURITIES OF SECURITIES HELD Within 15 days $ 16 days to 90 days 91 days to 1 year Over 1 year to 5 years Over 5 years to 10 years Over 10 years TOTAL 976 $ 5,483 5,044 6,143 1,895 2,839 $ 22,380 — $ — — — — — Total 976 5,483 5,044 6,143 1,895 2,839 — $ $22,380 As mentioned in footnote 3, in December 2002, the FRBNY replaced MSP transactions with securities sold under agreements to 24 repurchase. At December 31, 2002, securities sold under agreements to repurchase with a contract amount of $21,091 million and a par value of $21,098 million were outstanding, of which $750 million and $750 million, respectively, were allocated to the Bank. At December 31, 2001, MSP transactions involving U.S. government securities with a par value of $23,188 million were outstanding, of which $836 million was allocated to the Bank. Securities sold under agreements to repurchase and MSP transactions are generally overnight arrangements. At December 31, 2002 and 2001, U.S. government securities with par values of $1,841 million and $7,345 million, respectively, were loaned from the SOMA, of which $65 million and $265 million were allocated to the Bank. 5. INVESTMENTS DENOMINATED IN FOREIGN CURRENCIES The FRBNY, on behalf of the Reserve 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 purchased under agreements to resell. These investments are guaranteed as to principal and interest by the foreign governments. Each Reserve Bank is allocated a share of foreign-currency-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 2.030 percent and 2.001 percent at December 31, 2002 and 2001, respectively. The Bank’s allocated share of investments denominated in foreign currencies, valued at current foreign currency market exchange rates at December 31, was as follows (in millions): 2002 2001 European Union Euro: Foreign currency deposits $ 113 $ 92 Government debt instruments including 67 54 Agreement to resell Japanese Yen: Foreign currency deposits 36 38 Government debt instruments including 125 106 Agreement to resell Accrued interest 2 1 TOTAL $ 343 $ 291 Total investments denominated in foreign currencies were $16,913 million and $14,559 million at December 31, 2002 and 2001, respectively. 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS The maturity distribution of investments denominated in foreign currencies which were allocated to the Bank at December 31, 2002, was as follows (in millions): MATURITIES OF INVESTMENTS DENOMINATED IN FOREIGN CURRENCIES Within 1 year $ Over 1 year to 5 years Over 5 years to 10 years Over 10 years TOTAL $ 317 18 8 – 343 At December 31, 2002 and 2001, there were no open foreign exchange contracts or outstanding F/X swaps. At December 31, 2002 and 2001, the warehousing facility was $5,000 million, with zero balance outstanding. 6. BANK PREMISES AND EQUIPMENT A summary of bank premises and equipment at December 31 is as follows (in millions): 2002 2001 BANK PREMISES AND EQUIPMENT: Land $ 4 $ 4 Buildings 50 46 Building machinery and equipment 18 16 Construction in progress — 1 Furniture and equipment 57 56 Accumulated depreciation BANK PREMISES AND EQUIPMENT, NET $ 129 (63) 66 $ 123 (56) 67 Depreciation expense was $8.9 million and $8.6 million for the years ended December 31, 2002 and 2001, respectively. Future minimum payments under agreements in existence at December 31, 2002 were immaterial. 7. COMMITMENTS AND CONTINGENCIES At December 31, 2002, the Bank was obligated under noncancelable leases for premises and equipment with terms ranging from 1 to approximately 4 years. These leases provide for increased rentals based upon increases in real estate taxes, operating costs or selected price indices. Rental expense under operating leases for certain operating facilities, warehouses, and data processing and office equipment (including taxes, insurance and maintenance when included in rent), net of sublease rentals, was $1 million for each of the years ended December 31, 2002 and 2001. 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, 2002, were (in thousands): OPERATING 2003 $ 240 2004 64 2005 64 2006 48 2007 – Thereafter – $ 416 At December 31, 2002, other commitments and long-term obligations in excess of one year were $0. Under the Insurance Agreement of the Federal Reserve Banks dated as of March 2, 1999, each of the Reserve Banks has agreed to bear, on a per incident basis, a pro rata share of losses in excess of one percent of the capital paid-in of the claiming Reserve Bank, up to 50 percent of the total capital paid-in of all Reserve Banks. Losses are borne in the ratio that a Reserve Bank’s capital paid-in bears to the total capital paid-in 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, 2002 or 2001. The Bank is involved in certain 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. 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 Reserve 25 System (“System Plan”) and the Benefit Equalization Retirement Plan (“BEP”) and certain Bank officers participate in a Supplemental Employee Retirement Plan (“SERP”). The System Plan is a multi-employer plan with contributions fully funded by participating employers. No separate accounting is maintained of assets contributed by the participating employers. The Bank’s projected benefit obligation and net pension costs for the BEP at December 31, 2002 and 2001 and the SERP at December 31, 2002, and for the years then ended, are not material. Thrift Plan Employees of the Bank may also participate in the defined contribution Thrift Plan for Employees of the Federal Reserve System (“Thrift Plan”). The Bank’s Thrift Plan contributions totaled $3 million and $2 million for the years ended December 31, 2002 and 2001, respectively, and are reported as a component of “Salaries and other benefits.” 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 costs are actuarially determined using a January 1 measurement date. Following is a reconciliation of beginning and ending balances of the benefit obligation (in millions): 2001 Accumulated postretirement benefit obligation at January 1 $ Service cost-benefits earned during the period Interest cost of accumulated benefit obligation Actuarial loss (gain) Contributions by plan participants Benefits paid Plan Amendment/Settlement 45.4 $ 0.8 2.9 (1.1) 0.1 (2.5) 0.2 42.9 1.0 3.5 9.5 0.1 (2.2) (9.4) ACCUMULATED POSTRETIREMENT BENEFIT OBLIGATION AT DECEMBER 31 $ 26 2002 45.8 $ 45.4 Following is a reconciliation of the beginning and ending balance of the plan assets, the unfunded postretirement benefit obligation, and the accrued postretirement benefit costs (in millions): 2002 2001 Fair value of plan assets at January 1 $ Contributions by the employer Contributions by plan participants Benefits paid FAIR VALUE OF PLAN ASSETS AT DECEMBER 31 $ Unfunded postretirement benefit obligation Unrecognized prior service cost Unrecognized net actuarial loss $ ACCRUED POSTRETIREMENT BENEFIT COSTS $ — $ 2.4 0.1 (2.5) — $ 45.8 $ 9.0 (3.5) — 2.2 0.1 (2.3) — 45.4 10.0 (4.6) 51.3 $ 50.8 Accrued postretirement benefit costs are reported as a component of “Accrued benefit costs.” At December 31, 2002 and 2001, the weighted average discount rate assumptions used in developing the benefit obligation were 6.75 percent and 7.0 percent, respectively. For measurement purposes, a 9.0 percent annual rate of increase in the cost of covered health care benefits was assumed for 2003. Ultimately, the health care cost trend rate is expected to decrease gradually to 5.0 percent by 2008, 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, 2002 (in millions): One Percentage One Percentage Point Increase Point Decrease Effect on aggregate of service and interest cost components of net periodic postretirement benefit costs $ 0.2 $ 0.2 Effect on accumulated postretirement benefit obligation 4.0 4.5 2002 ANNUAL REPORT THE FEDERAL RESERVE BANK OF ST. LOUIS The following is a summary of the components of net periodic postretirement benefit costs for the years ended December 31 (in millions): 2002 2001 Service cost-benefits earned during the period $ Interest cost of accumulated benefit obligation Amortization of prior service cost 0.8 $ 2.9 (0.8) 1.1 3.5 (0.1) NET PERIODIC POSTRETIREMENT BENEFIT COSTS 2.9 $ 4.5 $ Net periodic postretirement benefit costs are reported as a component of “Salaries and other benefits.” 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, 2002 and 2001, were $5 million and $4 million, respectively. This cost is included as a component of “Accrued benefit costs.” Net periodic postemployment benefit costs included in 2002 and 2001 operating expenses were $1 million for each year. 10. SUBSEQUENT EVENT In January 2003, the System decided to restructure its check collection operations. The restructuring plans include streamlining the check management structure, reducing staff, decreasing the number of check-processing locations, and increasing processing capacity in other locations. The restructuring, which is expected to begin in 2003 and conclude by the end of 2004, will result in the Bank discontinuing its check operations at the Little Rock and Louisville offices, increasing its check processing capacity at the Memphis office, and consolidating its check adjustment function at the St. Louis or Memphis office. 27 ADVISORY COUNCILS AND BANK OFFICERS FEDERAL ADVISORY COUNCIL MEMBER David W. Kemper Chairman, President and CEO Commerce Bancshares Inc. St. Louis, Missouri DISTRICT ADVISORY COUNCIL MEMBERS Agricultural Robert A. Cunningham Valley Farms Bigbee Valley, Mississippi John W. Block Jr. Vice President Vicki L. Kosydor Assistant Vice President Mark D. Vaughan Supervisory Officer Timothy A. Bosch Vice President Patricia A. Marshall Assistant Vice President, Assistant Counsel and Assistant Secretary Howard J. Wall Research Officer Timothy C. Brown Vice President Ronald L. Byrne Vice President Marilyn K. Corona Vice President Cletus C. Coughlin Vice President Robert Seidenstricker Hazen, Arkansas Judith A. Courtney Vice President Joseph H. Spalding Lebanon, Kentucky William T. Gavin Vice President Small Business R. Alton Gilbert Vice President William D. Crawley President Southern Sales & Service Memphis, Tennessee Chris Krehmeyer Executive Director Beyond Housing St. Louis, Missouri 28 Dennis Ott President/Owner Dennis Ott and Company Inc. Clarksville, Indiana BANK OFFICERS St. Louis Office William Poole President and Chief Executive Officer W. LeGrande Rives First Vice President and Chief Operating Officer Karl W. Ashman Senior Vice President Henry Bourgaux Senior Vice President Mary H. Karr Senior Vice President, General Counsel and Secretary Robert H. Rasche Senior Vice President and Director of Research John M. Mitchell Assistant Vice President John W. Mitchell Assistant Vice President Kathleen O’Neill Paese Assistant Vice President Todd J. Purdy Assistant Vice President Philip G. Schlueter Assistant Vice President Frances E. Sibley Assistant Vice President Glenda J. Wilson Community Affairs Officer Little Rock Office Robert A. Hopkins Vice President and Branch Manager William D. Little Assistant Vice President Matthew W. Torbett Operations Officer Louisville Office Harold E. Slingerland Assistant Vice President Thomas A. Boone Vice President and Branch Manager Diane A. Smith Assistant Vice President V. Gerard Mattingly Assistant Vice President Kim D. Nelson Vice President Leisa J. Spalding Assistant Vice President and Assistant General Auditor James E. Stephens Operations Officer Michael D. Renfro Vice President and General Auditor Jeffrey L. Wann Assistant Vice President Memphis Office Jean M. Lovati Vice President Michael J. Mueller Vice President Steven N. Silvey Vice President Randall C. Sumner Vice President and Assistant Secretary Daniel L. Thornton Vice President Carl K. Anderson Assistant Vice President Barkley E. Bailey Assistant Vice President Dennis W. Blase Assistant Vice President Daniel P. Brennan Assistant Vice President James B. Bullard Assistant Vice President Susan K. Curry Assistant Vice President Hillary B. Debenport Assistant Vice President David A. Sapenaro Senior Vice President Michael W. DeClue Assistant Vice President Julie L. Stackhouse Senior Vice President Elizabeth A. Hayes Assistant Vice President Richard G. Anderson Vice President Edward A. Hopkins Assistant Vice President John P. Baumgartner Vice President Gary J. Juelich Assistant Vice President David C. Wheelock Assistant Vice President Martha Perine Beard Vice President and Branch Manager Sharon N. Williamson Assistant Vice President J. Allen Brown Assistant Vice President Diane B. Camerlo Assistant Counsel Michael J. Dueker Research Officer Joseph C. Elstner Public Affairs Officer Kathy A. Freeman Financial Management Officer Paul M. Helmich Operations Officer Joel H. James Bank Relations Officer Visweswara R. Kaza Operations Officer Raymond McIntyre Facilities Officer Christopher J. Neely Research Officer Patricia S. Pollard Research Officer Kathy A. Schildknecht Operations Officer Harriet Siering Operations Officer The Federal Reserve Bank of St. Louis is one of 12 regional Reserve banks, which, together with the Board of Governors, make up the nation’s central bank. The Fed carries out U.S. monetary policy, regulates certain depository institutions, provides wholesale-priced services to banks and acts as fiscal agent for the U.S. Treasury. The St. Louis Fed serves the Eighth Federal Reserve District, which includes all of Arkansas, eastern Missouri, southern Indiana, southern Illinois, western Kentucky, western Tennessee and northern Mississippi. Branch offices are located in Little Rock, Louisville and Memphis. FEDERAL RESERVE BANK OF ST. LOUIS 411 Locust Street St. Louis, Missouri 63102 (314) 444-8444 Authors of essay: William Emmons, Mark Vaughan LITTLE ROCK BRANCH 325 West Capitol Avenue Little Rock, Arkansas 72201 (501) 324-8300 Production: Barbara Passiglia, Mark Kunzelmann LOUISVILLE BRANCH 410 South Fifth Street Louisville, Kentucky 40202 (502) 568-9200 Franklin National Bank photograph on Page 10: ©1974 Newsday, Inc. Reprinted with permission. MEMPHIS BRANCH 200 North Main Street Memphis, Tennessee 38102 (901) 523-7171 Editor: Al Stamborski Designers: Joni Williams, Brian Ebert Photographs of boards of directors, chairman, president and management committee: Steve Smith Studios This annual report is also available on the Federal Reserve Bank of St. Louis web site at www.stlouisfed.org. For additional print copies, contact Public Affairs Department Federal Reserve Bank of St. Louis 411 Locust Street St. Louis, Missouri 63102 (314) 444-8809 PA0305 4/03