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FD1 N EW S RELEASE F E D E R A L D E P O S IT IN S U R A N C E C O R P O R A T IO N FOR RELEASE UPON DELIVERY PR-80-78 (8-4-78) \ \ M rcposn '® UKl LOtR c S l'O N Statement on Federal Reserve Membership Act of 1978 (H. R. 12706), and Related Legislative Matters Presented to Committee on Banking, Finance, and Urban Affairs U.S. House of Representatives by Ö George A. LeMaistre, Chairman Federal Deposit Insurance Corporation August 4, 1978 FED ER A L DEPOSIT INSURANCE CORPORATION, 5 5 0 Seventeenth St. N.W., Washington, D.C. 20429 202-389-4221 Mr. Chairman, I appreciate the opportunity to testify before this Committee and present the FDIC's views on the Federal Reserve Membership Act of 1978 (H. R. 12706) introduced by Mr. Stanton and the amendment to this bill that has been proposed by Chairman Reuss. During the course of this statement, I shall also discuss the FDIC’s views on the Federal Reserve Requirements Act of 1978 (H. R. 13476) and the Interest on Reserves Act of 1978 (H. R. 13477), both intro duced at the request of the Federal Reserve System, and the Monetary Policy Data Improvement Act of 1978 (H. R. 13549). For the most part, the proposals contained in these bills grow out of the Federal Reserve's concern with declining membership. There has been a slow but steady erosion of Federal Reserve member ship over the last decade as banks have chosen to leave the System. Recently, this gradual decline accelerated. Since the beginning of 1977, 108 banks have withdrawn from membership. The percentage of total deposits of commercial banks held by Federal Reserve members has decreased from 83 percent in 1965 to nearly 73 percent at the present time. The Federal Reserve System has become increasingly concerned about the attrition of membership and the declining proportion of deposits held by member banks. membership as a solution. For many years it proposed mandatory The proposal never received a serious hearing in the Congress for various reasons, but primarily because of the concern expressed by the States about the impact of mandatory membership on the viability of State banking systems. More Recently, the Federal Reserve modified its proposal to provide for mandatory reserves and membership privileges for nonmembers. 2 Last year, as the problem of membership attrition became more acute, the System proposed payment of interest on required reserves and reductions in the minimum statutory reserve requirement limita tions. Those proposals were coupled with the Consumer Financial Services Act (S. 2055) which would have authorized depository insti tutions to offer NOW accounts. In my testimony before Mr. St Germain's Subcommittee on Financial Institutions Supervision, Regulation, and Insurance last year, I stated that payment of interest on required reserves and reduction of reserve requirements as proposed in S. 2055 would have important implications for the competitive balance between member and nonmember banks, and for the structure of the banking system. I indicated that in my judgment these issues are quite complex and are not related to permitting interest bearing NOW accounts on a national basis. Therefore, I recommended that these issues be dealt with separately and be subjected to careful and reasoned study. These hearings and those scheduled before the Senate Banking Committee provide the opportunity for the thorough consideration I think is essential. Let me begin by stating our view that the legal requirement that Federal Reserve member banks maintain sterile reserves is inequitable to them and inequitable to their customers. In many States, it also places member banks at a competitive disadvantage vis-a-vis nonmember banks. The several bills under discussion propose two solutions: the first is to establish universal reserve requirements for all banks or depository institutions; the second is to pay interest on reserves, to reduce reserve requirements, and to charge banks for Federal Reserve services now provided free to member banks. 3 For reasons I shall discuss, we strongly oppose the establish ment of universal reserve requirements. The alternate proposal, however, is attractive on its face and deserves thoughtful and sympathetic consideration. However, its implementation will not be easy because a redressing of the imbalance between member and non member banks raises many of the difficult issues with which the Congress has been wrestling, without resolution, for a number of years. These include, notably, the issue of changes in the Federal regulatory structure, particularly whether the Federal Reserve should continue to exercise supervisory authority; and the issue of regulatory reform, particularly whether interest rate ceilings and the prohibition of interest on demand deposits should be abolished. In the remainder of this statement I shall explain how we reached these conclusions by discussing how these two proposals for dealing with the attrition of Federal Reserve membership bear on several important public policy considerations: (1) the capability of the Federal Reserve System to conduct monetary policy effectively, (2) the balance between the State and national banking systems, (3) the efficiency and innovative capacity of the banking system, and (4) the viability of the banking system under liquidity pressures. I. Monetary Policy Effectiveness According to the Federal Reserve System, the Federal Reserve Requirements Act of 1978 (H. R. 13476) is intended to provide the basis for more effective monetary control. Furthermore, the Federal Reserve has stated its belief that the decline in the proportion of deposits held by member banks caused by membership attrition adversely affects the precision with which monetary policy can be conducted. The point is that as a larger portion of deposits becomes subject to 4 diverse State reserve requirements the linkage between bank reserves and the money supply becomes less predictable. Of course, estimating the impact on the monetary aggregates of a particular change in reserves becomes more difficult when different banks are subject to different reserve requirements. But this problem would exist even if all banks were subject to universal reserve require ments or if all banks were member banks. Under the present reserve structure of the Federal Reserve, time deposits are subject to differen requirements than demand deposits and different size classes of member banks are subject to varying reserve requirements. Hence, a shift of funds among member banks has precisely the same effect of blurring the precision of monetary policy that disturbs the Federal Reserve when nonmember banks are involved. It should be noted that H. R. 13476 would not alter this appreciably, nor would the Reuss amendment which would maintain the present system of varying the percentage of deposits set aside as reserves based on bank size but which would also remove the Federal Reserve's power to change reserve requirements. There have been several studies of the monetary control issue by economists outside the Federal Reserve. All of those that I am familiar with have concluded that increased Federal Reserve member ship is not important to the effectiveness of monetary policy. There have been two major statistical studies which attempted to ascertain the impact of uniform reserve requirements for nonmember banks on the implementation of monetary policy. The first was conducted by Clark tfarburton for the Commission on Money and Credit. Warburton concluded that nonmember banks are affected by Federal Reserve monetary policy actions in approximately the same way that member banks are. Another investigation was reported by Dennis 5 Starleaf of Iowa State University. M In Starleaf's study the actual money multiplier for the period 1962-1972 was compared with a 1 money multiplier series simulated under the assumption that all banks were subject to the reserve requirements of the Federal Reserve. The simulation indicated that had nonmember banks been subject to such reserve requirements there would have been even greater variations in the money stock. Starleaf thus rejected the argument that uniform Federal Reserve reserve requirements are necessary for the implementation of monetary policy. There have also been a number of articles that attempted to analyze the logical arguments and the statistical data that exist on this issue. The Hunt Commission concluded that "reserve require ments are unnecessary for open market operations to control the monetary base effectively." Carter Golembe, after discussing the difficulties in conducting monetary policy with precision, concluded that, ...so many factors contribute to the lack of precision and certainty that simply changing the proportion of deposits subject to Federal Reserve requirements from almost 80 percent to nearly 100 percent would be of relatively minor importance. In a 1974 study, Professors Ross Robertson and Almarin Phillips investigated the argument that nonmember banks behave in a differ ent manner from member banks and that such behavior thwarts imple mentation of Federal Reserve monetary policy. They concluded that these arguments have no validity: This contention deluded those who are innocent of money matters and even a few who should know better. As has been observed, open market operations are for all practical purposes the instrument of monetary control. Like the rain from heaven that falls on us all, regardless of 6 our merits, open market operations affect member and nonmember banks alike. There is not one shred of evidence to the contrary. A study conducted by Gary Gilbert and Manferd Peterson at the FDIC found results similar to those of Robertson arid Phillips. They concluded that, ...the behavior of nonmember banks under varying degrees of monetary ease or restraint is relatively similar to that of country member banks. To the extent that systematic behavior of the demand deposits components is important for the effective control of the money supply, there is no indica tion from available evidence that the nonmember banking segment has hampered monetary policy. Some economists have stressed the caveat that the Federal Reserve could control monetar y aggregates without member banks or without reserve requirements. For example, in a 1973 article Henry and Mable Wallich stated that, , Since intermediation [the function of gathering funds from various entities and lending them to others] is a constructive activity, there seems to be no reason why Congress should place burdens upon it beyond those that the tax system imposes on any other form of business. The bulk of com mercial banking has been exposed to a special tax, in the form of reserve requirements. It makes no essential difference that the revenues from the tax reach the Treasury via the Federal Reserve. There is no particular reason for this tax, since the Federal Reserve can quite well conduct monetary policy operations without required reserves. The requirement could, then, be phased out to give full effect to the benefits of intermediation. Most economists regard reserve requirements as secondary to open market operations in conducting monetary policy. The Federal Reserve has made minimal use of changes in reserve requirements in recent years, in part owing to its fear of aggravating the membership attrition problem. Nonetheless, the limited use of this monetary tool has not 7 had a noticeable impact on the ability of the Federal Reserve to conduct monetary policy. Furthermore, several studies have shown that open market operations have a timely impact on all commercial bank reserves. These studies indicate that the total impact is felt by banks in some regions within the first 2 weeks following open market operations. In most cases, the impact of open market operations on reserves is transmitted within 6 weeks. Moreover, the length of time for the impact of open market operations to be trans mitted is not related to the region's distance from money market centers. What the Federal Reserve does need to conduct monetary policy effectively is information about monetary aggregates. The Reuss amendment to H. R. 12706 would authorize the Federal Reserve, as it deems necessary for the conduct of monetary policy, to obtain from the appropriate Federal agency summary statistics on assets and liabilities of all depository institutions. H. R. 13476 would require depository institutions to report their deposit liabilities and required reserves directly to the Federal Reserve. We support making such information available to the Federal Reserve and have no objection to the adoption of either proposal. We do not believe, however, that adoption of the Monetary Policy Data Improvement Act of 1978 (H. R. 13549) is necessary. This proposal would require the FDIC to collect data on deposit and cash items each week from a sample of 1,000 nonmember banks, including all those having deposits exceeding $100 million, and transmit that information to the Federal Reserve. 8 Several years ago, the Federal Reserve became concerned about the adequacy of its data on the money supply and established a committee chaired by Professor George L. Bach of Stanford University to recommend changes in money supply statistics. One of the major recommendations of the Bach Committee was that better and more frequent data on nonmember bank deposits were desirable. Following that report the FDIC instituted a weekly survey of a sample of nonmember banks to provide the Federal Reserve with better information on the money supply This collection was initiated with the spring 1976 Call for Report of Condition. A second step, also recommended by the Bach Committee, went into effect in the first week of July 1977. A sample of 580 nonmember banks is reporting deposit and cash items on a regular weekly basis, the same items as all nonmember banks report four times a year. The Federal Reserve has indicated that it expects the data from these two surveys to enable significant improvements in their estimates of the nonmember bank component of the Nation's money supply. The FDIC and the Federal Reserve have agreed to review this program in mid-1979 to determine whether nonmember bank data are necessary for monetary policy purposes and, if they are, whether the sample of nonmember banks is adequate. In the interest of improving the timeliness of the survey data to the Federal Reserve, the FDIC intends to request the 580 banks participating in the program to submit the data directly to the Federal Reserve, rather than through the FDIC regional offices, which is the present procedure. In summary, we believe the need of legal reserve requirements for monetary control purposes is not supported by the weight of available evidence. The evidence to date suggests that monetary 9 policy effectiveness depends on adequate data, proper estimation procedures and appropriate open market operations decisions, and not on reserve requirement jurisdiction. Bank Supervision and the Exercise of Monetary Policy Representatives of the Federal Reserve System have also argued that significant supervisory and regulatory responsibilities are required for the effective conduct of monetary policy. Chairman Miller reiterated in his testimony before this Committee the Federal Reserve’s belief that its activities in the bank supervisory and regulatory area "cannot be readily separated from its job of conducting monetary policy." In the past, representatives of the Federal Reserve have argued as well that an understanding of the nuances of monetary policy and of developments in the economy facilitate bank supervision. Three major arguments have been advanced by those who believe bank supervision and regulation and the conduct of monetary policy should be separated. First, it has been argued that the Federal Reserve's responsibility for bank supervision diverts attention from monetary policy formation and that this diversion may reduce its effectiveness in implementing monetary policy. Former Federal Reserve Governor James Robertson voiced this concern in stating: As a practical matter, I believe it would be seriously detrimental to place in the Board the important additional responsibilities that would accompany unification. There are limits to a man's ability effectively to perform his assigned duties. In our complex society, merely keeping informed of what is going on in the national economy is becoming more and more difficult. Developing and implementing appropriate monetary policy at a given time require consideration and evaluation of the significance of an enormous 10 volume of available data and their interrela tionships. The responsibilities are of such magnitude that the Board should not be also burdened with the performance of bank super visory functions. Supervision is too important a function in itself to be the Federal Reserve's part-time job. This argument has assumed greater importance today than when first made by Governor Robertson because of the Federal Reserve’s mush rooming responsibilities under the civil rights and consumer protec tion laws and because of the ever increasing burdens of holding company supervision and regulation. Second, some observers find the existing concentration of power within the Federal Reserve System disturbing, given the System’s insulation from the political process. They would favor separation of the supervisory and monetary policy functions. Third, it is argued that when the implementation of monetary policy goals and bank supervision are combined, the former will inevitably take precedence leading to inconsistent and inequitable bank supervision. For example, it is argued that the monetary authority would be loath to restrain the aggressive policies of a group of overextended money center institutions when monetary policy goals are aimed at credit expansion. Conversely, it is argued that the Federal Reserve might move to check bank holding company expansion on safety and soundness grounds when its actual reason is to effect a restrictive monetary policy. Events during the period 1971-1975 are cited to support this proposition. Many, including former FDIC Chairman Frank Wille, believe this combina tion of supervision and the implementation of monetary policy goals to be inappropriate, arguing that bank supervision and regulation should be based upon an independent appraisal of the condition of 11 the bank and not upon the monetary goals of the moment. Former FDIC Chairman W ille concisely stated the case as follows: The basic problem, of course, is that where the implementation of monetary policy goals is combined with bank regulation and supervision, the former will always be viewed as more important than the latter and the temptation or threat is ever present to use the powers of regulation and supervision to reward banks for their cooperation or to penalize banks for their lack of cooperation with the Board’s most recent view of its monetary policy goals. Since those goals change with some frequency, the likelihood of a consistent, evenhanded approach to matters of bank regulation and supervision over any length of time is very much in doubt. Whereas prior to 1970, this was a special concern only of large State member banks which the Federal Reserve System actually examined or of member banks forced to the discount window, it is now the concern of every bank in a holding company system. We believe that the first and third of these arguments have merit. Yet, we think that the merits of the Federal Reserve’s contention that it is necessary for it to have supervisory and regulatory responsibilities to conduct monetary policy effectively deserve consideration. The Federal Reserve has stated two reasons. First, the Board of Governors has contended that information gained directly from examination and supervision of banks provides a useful input in the formulation of monetary policy. This argument implies that supervisory responsibilities provide the Board with a tangible feel for events in the banking system. Former Governor Holland argued in testimony before this Committee that "examiner asset evaluations supply firsthand knowledge of the changing quality of credit.... This provides valuable supplements to the meaning of the quantitative statistics on monetary and credit aggregates." 12 We do not disagree that information derived from bank examina tions and supervision might be helpful to the Federal Reserve. However, the Federal Reserve does not need to be engaged actively in supervision to obtain such information. It could be attained easily through conversations with supervisory agencies or through participa tion on their boards. Alternatively, the Board could be given authority to collect information reflecting credit quality by means that do not involve the full panoply of supervisory responsibilities. Second, even if monetary policy benefits from information provided firsthand through direct supervision, which cannot be obtained in other ways, one still must consider whether the value of such information outweighs the very substantial costs in terms of time and resources that are consumed by supervisory and regulatory responsibil ities. Finally, many analysts question whether such information can possibly be relevant given the lags between changes in credit quality and the examination and between events in the economy and changes in credit quality. The second reason given for the Federal Reserve's retention of supervisory and regulatory responsibilities is, in effect, that supervisory and regulatory responsibilities and the conduct of monetary policy are mutually reenforcing. Again, testifying before this Committee, then Governor Holland asserted: Now more than ever, the Federal Reserve's role as monetary policymaker and as lender of last resort interacts with the effects of prevailing bank supervisory and regula tory policies. Each of these policies increasingly influences the effectiveness of the other. To divorce them is to weaken both. 13 Governor Holland argued by way of example that if the bank supervisor alters bank capital or liquidity standards "at an inopportune moment, he can dilute or frustrate for a time the thrust of monetary policy." The difficulty with this position is obvious and it is pointed up in former Chairman Wille's arguments. Sometimes objective super visory standards will and should run counter to the thrust of monetary policy and will, therefore, dilute or tend to frustrate it. This will be the case whether or not supervision is within or outside of the Federal Reserve System unless the Federal Reserve is really arguing that supervision and regulation ought to be used to facilitate the implementation of monetary policy. This, of course, would be objected to by those who believe in consistent and equitable supervision and regulation and by monetarists who would argue that the attempt to use such a tool is wholly inappropriate and ultimately an ineffective way to conduct monetary policy. Thus far, we are not persuaded by the case put forward by the Federal Reserve for the importance of bank supervision and regulation to the effective conduct of monetary policy. Furthermore, we believe some benefits will be gained from the functional separation of super vision and monetary policy. Therefore, it is our opinion that the attrition of members from the Federal Reserve System and, hence, a lessening of its supervisory and regulatory presence has not inter fered with the effective conduct of monetary policy. In summary, based on the available evidence and experience, we tentatively conclude that neither control of reserve require ments in nonmember depository institutions nor supervisory juris diction is critical to the conduct of monetary policy. In fact, 14 membership might not even be necessary for the Federal Reserve to conduct monetary policy effectively. I I Dual Banking System Historically, our Nation’s banking system has developed within the unique Federal character of our State and national governments. Today this is manifested in the ability of both the States and the Federal Government to charter banks and other kinds of depository institutions. The vitality of this dualism is maintained by permit ting banks to convert from one chartering authority to another. While some may disagree, we believe the dual system of State and national banks has been a positive element in the American system of government and has contributed to a more innovative and responsive financial system. Accordingly, maintaining a balance between the State and national banking systems is a desirable public policy. The attrition in Federal Reserve membership gives some pause that this balance is more precarious now than it has been in the past However, despite the decline of Federal Reserve membership, member banks still hold about three-quarters of domestic deposits. Moreover the largest banks which depend on Federal Reserve clearing and money transfer services represent a hard core of membership and deposits not likely to leave the system. Nonetheless, we should not maintain a "balance" for the sake of balance. It is clear that Federal Reserve reserve requirements bear heavily on member banks and result generally in such banks carrying more cash than they otherwise would. In direct competition with the nonmember bank, a member bank might be disadvantaged. For example, how can a member bank offer the same rate for a $100 time deposit as 15 a competing nonmember if the member is able to invest less than its competitor because the law requires it to hold more in cash? Its deposit customers will tend to be offered lower rates, its loan customers will tend to be charged higher rates, or its shareholders will receive lower returns. One solution to the problem of equity that we believe should be resisted is the proposal in H. R. 13476 to impose universal reserve requirements on the transactions balances of nonmember depository institutions. As we explained above, extension of universal reserve requirements to nonmember institutions is not essential to conduct monetary policy effectively. While reserve requirements are primarily responsible for the inequity of Federal Reserve membership, we believe that equity can be achieved in other ways— such as paying interest on reserves, permitting reserves to be held in the form of marketable securities, or reducing reserve requirements— without the necessity of resorting to universal reserves for all institutions. Universal reserve requirements are perceived as a threat to the integrity of State banking systems. If nonmember banks have to main- tain reserves at the Federal Reserve just as member banks must do, but have no access or have limited access to the discount window and other System benefits, why not become members? The assumption is that obligatory universal reserves would not only make nonmember ship unattractive, but many institutions would also be inclined to convert to a national charter. The result would be an imbalance in the dual system in favor of membership and the national banking system. There is little evidence to substantiate the accuracy of such a scenario. The fear may well be a false one. However, the impact 16 of redressing the reserves imbalance on the dual banking system cannot be predicted accurately. It is conceivable that there would be a massive influx into the State member and national systems. If this occurred, many State systems would lose their viability, and the Federal Reserve's and the Comptroller's supervisory authority would have grown substantially without the benefit of Congressional consideration. My point is that the issue of Federal regulatory structure cannot be isolated from this issue of balance. The better of the two proposals— the payment of interest on reserves and lower ing of reserve requirements— avoids some serious shortcomings of the universal reserve requirements proposal, but it holds the potential of an inadvertant resolution of an issue which the Congress has conscientiously debated for many years and which deserves conscious choice for its resolution. Ill• Banking System Efficiency and Innovativeness Market pricing of goods and services is vital to the efficient allocation and use of those goods and services. In the words of Milton Friedman, pricing is highly desirable "...to prevent the waste that arises from the absence of specific charges for them." Generally, market pricing encourages competition to improve the quality of goods and services and to lower their cost. Presently, pricing is absent in at least three areas that bear directly or indirectly upon the legislation under consideration: (1) the absence of interest payment on the required reserves of member banks, (2) the provision of services by the Federal Reserve to member banks, and (3) the prohibition of interest payments on demand deposit balances and deposit interest rate ceilings. I will address each in turn. 17 Interest on Reserves As a matter of principle, whether to pay interest on reserves should not be an issue. Presently, failure to pay interest is tantamount to the imposition of a tax without calling it that. A substantial amount of the revenue foregone by member banks is passed on to the Treasury Department by the Federal Reserve. Some of the revenue is used by the System to offset the cost of providing "free" services to member banks. If it were the national policy to tax banks, it would be preferable to levy the tax directly on all banks and other depository institutions as well. Then all would be treated equally* Concern has been raised about the adverse impact payment of interest on reserves would have on Treasury revenues. This concern has lead to attempts to structure a procedure for paying interest while minimizing the loss in Treasury revenues. However, structur ing a procedure for paying interest bogs down in questions about the appropriate interest rate, concerns about possible windfall gains to to large banks, and controversy over what percentage of the Federal Reserve System's revenues should be available for interest payments, vie submit that none of this is really necessary. It imposes the subjective judgment of men in dealing with the cost of membership when the market system could probably do better. Why not permit member banks to invest their reserves in interest bearing securities? The Federal Reserve could determine what kinds of securities should be eligible for this purpose based on considerations such as risk. This approach would permit each bank to make its own choice and obviate the necessity of having the Federal Reserve establish a rate. Presently, 36 States allow State nonmember banks to hold at least 18 part of their required reserves in the form of U.S. Government securities. To our knowledge, such a change would not have any significant impact on the effective conduct of monetary policy. If either the loss of Treasury revenues or subsidization of small banks were felt to be important problems, we would recommend that the Congress address these problems directly through national tax policy. To the extent that our faith in the efficacy of the market system might be misplaced, we are willing to endorse the provision in Section 3 of H. R. 12706 (Stanton bill) that would require the Board of Governors to prepare a study on permitting member banks to invest their reserves in securities. Pricing of Services Explicitly pricing Federal Reserve services should increase the efficiency of our financial system by allowing various financial institutions to purchase the services they desire from the Federal Reserve or private alternatives. major services are: Among the Federal Reserve System's operation of the payments system, including check processing and transportation and automated clearinghouse services; pickup and delivery of coin and currency? wire transfers; purchase, sale, safekeeping and clearing securities? and operation of the discount window. The Federal Reserve has proposed pricing most of these services except the discount window in a two-phase process. In the first phase, pricing of services would be limited to those connected with the payments mechanism and access would be limited to member banks. This would permit the Federal Reserve time to develop appropriate prices before bringing in all depository institutions. Services would be priced according to geographic region and whether the activity in question is processed through a city bank, country bank, regional check processing center, or interdistrict transfer. Non member institutions would be permitted to deposit intraregional checks and drafts through regional check processing centers. In the second phase, nonmembers could purchase virtually all services the Federal Reserve has to offer, but would continue to clear checks and drafts through reserve accounts of member banks. Charges for services would not be determined on the basis of membership. The Stanton bill would require the Federal Reserve to price each service explicitly, based on all the costs of providing the service including overhead plus a return on capital. The Federal Reserve would be required to offer each service to every depository institution at the same fee. If interest were paid on member bank reserves, by whatever means, pricing of Federal Reserve services would be essential to prevent dis criminatory treatment of nonmember depository institutions. Pricing of services also is sound policy because it would enhance the efficiency of the financial system. This would provide a better opportunity for the correspondent banking system to compete with the Federal Reserve. Such competition, in turn, should encourage the Federal Reserve to eliminate waste, to improve services and to offer new ones. The Federal Reserve has stated its opposition to the Stanton bill which would require the System to price each service on the basis of costs and a return on capital. Governor Coldwell pointed out that private competitors would not be required to price services separately as the Stanton bill would require of the System. This loss 20 of flexibility would place the System at a significant competitive disadvantage. It should be noted, however, that if the Federal Reserve is not subject to pricing guidelines of some sort, it could achieve the same advantage that the Stanton bill would provide to private competitors. Assuming that it is good public policy to maintain a significant presence for the Federal Reserve in the pay ments mechanism, we are sympathetic to its concern about constraints on its flexibility in setting prices. Therefore, we would recommend that the matter of pricing guidelines receive careful study prior to the enactment of legislation on the issue of pricing. Some of the reasons for favoring such an intermediate approach and some of the matters that need to be considered are discussed below. The costs of producing the same service for a variety of customers may differ in various areas of the country because labor and capital costs are not equal. Thus, it may be more efficient to allow the Federal Reserve to charge different prices according to the costs of providing services to different customers. The cost of providing a certain service to nonmember banks and nonbank depository institutions could be below the cost of providing the same service only to member banks. service were utilized. This could result from the way in which a For example, a credit union may not require daily pickup and delivery of coins or currency, or a savings and loan association might not complete security transactions as often as a commercial bank. To allow the Federal Reserve some flexibility in developing and implementing a pricing system, the Federal Reserve could be permitted to price services explicitly by broad service classes. One price schedule might be developed for payments services, another for 21 securities services, and another for transportation. Perhaps a cost- plus pricing system could be developed for the services now provided by the Federal Reserve, and the markup over the cost of providing the service might be limited to a fixed percentage. There seem to be economies of scale associated with at least some services that the Federal Reserve now provides. If these economies are pervasive, the Federal Reserve will be able to offer the relevant ser vice at a lower price than any private competitor. There is nothing undesirable about this, but the result should be determined by experi ence, not fiat. It is not unlikely that the Federal Reserve has a natural monopoly on some services because private competitors could not attract sufficient volume to offer the same services at as low a price. According to materials that former Federal Reserve Chairman Burns submitted to Senator Proxmire on October 4, 1977, in recent years the per unit costs of conventional check processing, return items, transfer of funds, and automated clearinghouse activities have declined as volumes increased. If these trends continue, the private sector might not be able to offer competing services at costs that.are as low as those incurred by the Federal Reserve. On the other hand, the cash services offered by the Federal Reserve do not seem to show declining costs with increasing volumes. In an electronic banking environment, it is not clear that several payments systems can compete efficiently. However, in this regard the private bank wire continues to compete with the Federal Reserve wire, and networks of correspondent banks provide payment services that are preferred by some member banks over Federal Reserve payment services. 22 Interest on Demand Deposits Payment of interest on reserves of member banks potentially could place nonmember banks at a disadvantage because the 40-year old prohibition against the payment of interest on demand deposits does not permit member banks to pay interest on correspondent balances. These balances often serve as reserves for nonmember banks and serve as well for check clearing operations and compensation for other correspondent services. If the principle of explicit pricing is adopted for member banks, then parallel treatment would dictate that banks should have the choice of paying interest on correspondent balances and levying explicit charges for correspondent services. There can be little doubt that this would increase the efficiency of the financial system. As a matter of principle, if the interest prohibition is lifted for correspondent deposits, it should be lifted for all demand deposits I have long supported elimination of the prohibition of interest pay ments on all transactions balances as well as removal of interest rate ceilings on other kinds of deposits. Economists have demonstrated that there is no merit to the contention that competition for demand deposits through the payment of interest led to bank failures during the Depression as some contend. They have also demonstrated, at least to our satisfaction, that competition for deposits through the pricing mechanism would result in a more efficient allocation of resources thaï competition through indirect means involving the implicit payment of interest by building more branches, keeping open longer hours, providii free checking services, offering premiums and free travelers’ checks, a well as a variety of other services. Such competition would lead to substantial benefits for both financial institutions and bank customers 23 Under the present system of implicit interest payments on checking accounts, depositors are denied the opportunity to determine for themselves how they wish to spend their portion of the income the bank earns on their deposits. If interest were paid, a depositor might choose to consume the same services that banks now offer in the course of competing with other institutions for accounts or a depositor might choose to forego such services and spend interest income on different goods and services. This is an important benefit— consumers would decide how to spend their interest income, not the banks. Free- or below-actual-cost checking encourages inefficient use of resources because depositors have little or no incentive to economize on check writing, even though check clearance costs are substantial. Direct charges for checks are likely to prompt depositors to write fewer checks. checks. Such fees should cover a substantial cost of clearing Management’s adoption of pricing policies more nearly in line with the costs of providing services to customers will enhance a financial institution's capability of paying a competitive interest rate on deposit balances without impairing earnings. Payment of competitive interest rates will lower some operating costs by reducing the need for customers to transfer funds from non interest bearing checking accounts to savings accounts. Thus depositors will no longer find it necessary to maintain separate checking and savings accounts. Customers will not need to spend as much time and effort in managing deposit balances, particularly when interest rates are high. Also, existing inequities, whereby some depositors pay less than the cost of servicing their accounts will be eliminated. IV. Banking System Viability and Liquidity Pressures One of the important functions of the Federal Reserve System is to serve as the Nation’s lender of last resort. Through the vehicle of the discount window, the Federal Reserve is able to provide liquidity when it is needed. The discount window acts as a safety valve by permitting the Federal Reserve to cushion the impact of a tight monetary policy on individual institutions. It can also assist member banks in meeting routine but unexpected loan demand or deposit withdrawals, seasonal liquidity requirements, and emergency liquidity needs. expected to be to the market. A member bank's first recourse is If sufficient funds are not available in the market, the Reserve Bank might provide accommodation, but it is understood that it is temporary. Each member bank must eliminate its discount window borrowings within a reasonable period. Reserve Banks also require member banks to pledge collateral, typically of high quality. The Federal Reserve Act authorizes entities other than member banks to use the discount window only under "unusual and exigent" circumstances. As a result, the Federal Reserve indicates, for example, that no nonmember bank has borrowed from the discount window since 1966. While nonmember banks also face unexpected needs for liquidity, they ordinarily cope with them with little difficulty by borrowing from correspondent banks in much the same way that members do from the Federal Reserve. Indeed, even when nonmember banks are in trouble, it is generally possible for them to borrow from corres pondents if they have sufficient and acceptable collateral. To be sure, the lending bank may also impose special conditions on the 25 borrowing, bank. But in that regard, the Federal Reserve also behaves like a careful creditor in accommodating a floundering bank. It makes sure such loans are well collaterized, that its interest in the collat eral is perfected, and that the borrowing bank is solvent. Thus, the fact that nonmembers do not have window accommodation is not seriously disadvantageous in most circumstances. The Federal Reserve believes that the ability of the financial system to handle liquidity "crunches" will weaken if membership attrition continues unabated. It should be understood that the decline in Federal Reserve membership does not impair the ability of the System to cope with the kind of generalized liquidity crisis most of us are concerned about, in which the public demands more cash than the banking system holds. Aggressive open market operations and discount window accommodation to members can provide cash sufficient to meet the public's demand. The decline in membership does impair the ability of the system to minister to a localized liquidity squeeze involving one or a few institutions. In the past, the Federal Reserve has sometimes resorted to conduit loans in such circumstances— that is, loans to a member bank which in turn provide credit to a nonmember institution. We think that the Federal Reserve should accommodate a nonmember bank directly in such special circumstances. Indeed, we are concerned that membership attrition has contributed to a narrow interpretation of the words "unusual and exigent" by the Federal Reserve. If experience is a guide, these words appear to be interpreted by the Board of Governors as requiring a national emergency before a Reserve Bank would be authorized to lend to a nonmember insti tution. The interpretation could be less restrictive, but at the present time it does not appear that the Board of Governors is willing 26 to interpret "unusual and Exigent" circumstance as extending to situations that are unique to an inidividual nonmember institution. The unwillingness of the Federal Reserve to open the discount window to American Bank and Trust of Orangeburg, South Carolina, in September 1974 led the FDIC to take the unusual step of providing short-term liquidity directly to the bank under Section 13(c) of the FDI Act. This was the only time the FDIC ever took such action for temporary liquidity purposes.* Former FDIC Chairman Frank W ille in a letter to Mr. St Germain in January 1975 stated: I believe that the statutory provisions, regulations and policies surrounding direct Federal Reserve loans to nonmember banks need to be reviewed and a procedure adopted whereby the failure of a nonmember bank will not be precipitated by a sudden and purely temporary need for liquidity. W e share Chairman Wille*s concern. We believe that emergency borrowings from the Federal Reserve discount window should be avail able to member and nonmember banks alike upon certification by the FDIC that they are in danger of failing and that such assistance is ♦• necessary for a temporary period until a merger, a receivership sale or some other orderly resolution of the bank’s problems is arranged. The FDIC, in turn, should be authorized to guarantee the repayment of such borrowings*out of the resources of the deposit insurance fund. In connection with this authority, the FDIC should be required by law to keep the Federal Reserve fully informed with up-to-date information as to the financial condition of all banks certified to borrow from the discount window under this provision. *Two weeks later the bank was closed.
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