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Remarks by
John P. LaWare
Member, Board of Governors
of the Federal Reserve System
Forex Club Ireland
Dublin, Ireland
September 5, 1994

It is a genuine honor to have been invited to address this
distinguished group.

Your hospitality outdoes even Ireland's

reputation for warm welcome to visitors.

And this is a special

treat for me inasmuch as my Grandmother LaWare was born Margaret
Quinn in Cashel.

Her mother was a Fitzgerald.

was French from a French Canadian family.

My grandfather

On my mother's side

the stock is all German, and Prussian at that.

So I guess I am a

bit of a mongrel, but at least a good solid quarter of my
bloodline is Irish, and my middle name is Patrick, for my
father's favorite uncle.

This is my first trip to ireland, but

based on these last few days, it surely won't be the last.
I propose, today, to comment on three subjects of current
interest in the United States which, because of their nature, may
have some importance here in Ireland as well as in the assortment
of lesser countries that lie some miles east of here.
I will discuss the current state of the U.S. economy and my
personal expectations for the next year or so.

Then I want to

give you a brief update on the banking industry in the United
States and some recent legislative initiatives.

Finally, a few


words about the current storm raging in my country over
derivatives and their use and abuse.
The economy comes first as I guess it does inevitably for
any central banker.

The good news is that we are experiencing

solid growth across the economy in general with a particularly
good performance being turned in by steel, autos and capital

The bad news is that it may be growing a bit too fast.

That worry has prompted us to snub the brakes a bit by raising
short interest rates five times this year for a total of 1-3/4
percent on the federal funds rate and 1 percent on the Federal
Reserve discount rate.
The conventional estimate is that the capacity of the
economy is growing at about 2.5 percent at an annual rate.


the economy itself has been cooking along for the last two years
at about a 3.5 percent growth rate, well in excess of increases
in potential.

A recovering economy can certainly grow faster

than capacity increases for ten or twelve quarters, but if that
condition goes on much longer than that, shortages begin to
appear, creating just the right environment for price increases.
Price increases inevitably lead to wage demands and then the
inflation pot really begins to bubble.
This recovery from our 1991 slump has been a powerful one.
There has been a genuine boom in capital spending with business
fixed investment growing at an annual rate of 12 percent over the
past two years.

And there is an investment flavor in household

or consumer spending as well.

Construction of new homes is up 9%

percent and motor vehicle sales are up 8% percent.

The effect of this healthy recovery on the labor market has
been dramatic.

From the second quarter of 1992 to the end of

July 1994, nearly 4% million new jobs were created and
unemployment dropped from 7% percent to 6.1 percent —

which we

calculate to be at or near the natural rate of unemployment.
At the same time consumer price inflation has fallen from 6%
percent in 1990 to a bit under 3 percent most recently.

And the

core rate of inflation, that is excluding food and energy, is a
bit under 3 percent for the first time since the mid-1960s.
Another favorable feature of the recovery has been the
strengthening of corporate and household balance sheets.
Tremendous debt had been taken on by individuals and businesses
during the booming '80s and the servicing of that debt had become
a real drag on economic growth.

At the same time, banks were

having loan problems which resulted in hundreds of bank failures
and even threatened the survival of some of the very largest
Household debt service burden peaked in 1989 at 18 percent
of income on an annual basis.

That ratio has now been worked

down to 16 percent through modest growth in incomes and more
restraint in borrowing.

However, in the past several months the

increases in consumer debt have been robust reflecting increased
confidence and the pressing need to satisfy pent up demand,
replace old cars and appliances, and upgrade housing facilities.
On the asset side of the household balance sheet, housing
prices are beginning to rise modestly and the recent interest
rate structure has fostered mortgage refinancing, enabling many
households to convert increased equity in real estate into cash.

The gains in other asset values over the past several years have
fortunately not been seriously offset by the decline in stock and
bond prices in 1994.
While consumer spending over the past two years has
increased at about a 3% percent annual rate, some of the urge to
spend has undoubtedly been dampened by anxiety over job security.
The United States has been experiencing an unprecedented wave of
corporate restructuring —

or re-engineering as it is now called

characterized by very large staff reductions.

Unlike previous

episodes of lay-offs, this one is not confined to production-line

To the contrary, this episode is characterized by a

drive to improve the operating efficiency of corporations by
reducing the number of management layers and broadening the span
of control of managers from five or six direct reports to as many
as eight or nine.

Directors, at the same time have become less

tolerant of lackluster performance by senior managers.

So the

casualties in the job market include chairmen, presidents,
managing directors and chief financial officers in unprecedented
I believe the uncertainty about future job security may well
have dampened to some extent consumer spending that might
otherwise have been recorded.

Indeed, retail sales have been

sluggish in recent months, and I suspect this is particularly
true of purchases which might require long-term commitments to

One indicator of that is the increasing popularity of

leasing autos instead of purchasing.

A two-year lease doesn't

involve tying up a large amount of cash in a down payment, and
you have the option of getting a new car every two years.

One of the most impressive and significant developments in
the U.S. economy has been the surge in investment spending by

Improved balance sheets, better profits and stronger

cash flows have helped to increase equipment purchases at nearly
a 17 percent annual rate over the last two years.

Since much of

this spending is for high technology equipment, it has helped
raise productivity and increased efficiency.

In fact, high tech

office and computer equipment increased at a 60 percent rate last
year and is expected to continue to increase this year although
at a somewhat slower rate.

This capital spending boom also

includes more traditional types of industrial machinery and
equipment as well.

In fact, order backlogs for industrial

machinery continue to grow.
The ability to finance these investments has been helped
materially by the decline in our budget deficit from $300 billion
two years ago to what will probably be about $200 billion this

This, in turn, reduces the crowding out of private sector

enterprises from capital markets to make room for the risk-free
obligations of the government. That makes more capital available
to the private sector.
With the dollar relatively cheap and United States products
more competitive in world markets, in a quality sense, the export
sector of the economy is likely to expand strongly in the next
year or two as the economies of our principal trading partners
move from recession to expansion.

Canada, Japan, the U.K.,

Germany, France and Italy are important markets for U.S. products
and their economic outlook is for better growth ahead albeit at
markedly different rates.

However, our trade deficit in goods

and services won't be reversed in the near term because we have a
tendency to consume more than we produce and growing prosperity
will support consumption of imports at ever higher levels.
To sustain this favorable picture and keep inflation under
some degree of control, the Federal Reserve has been attempting
to anticipate future developments and apply restraint before
inflationary forces take over.

The lag in the effect of monetary

policy changes is thought to be at least 10 to 12 months.
Therefore, current monetary policy moves are taken in light of
our projections of economic conditions in the future.


posture tends to make the Fed very unpopular when we are
tightening because the reasons are not yet apparent in the
current statistics.

To be sure, monetary policy is an art thinly

disguised as a science, and it alone cannot achieve and maintain
economic equilibrium.

Fiscal policy is also an important

element, and in a global economy and global marketplace, events
and conditions elsewhere are increasingly important variables in
the equation.
In my view, not necessarily shared by my colleagues, the
rather robust rate of growth in the first half of 1994 will slow
somewhat in the second half, but for the full year I expect real
GDP growth to be about 3^ percent.

Inflation will remain

constrained during this year at a shade under 3 percent.


guess about 1995 is that the effects of 1994 monetary policy
moves will slow the economy to a growth rate closer to potential
and therefore less inflationary.
1995 of about 2% percent.

That means real GDP growth for

In that scenario, inflation may still

creep up to about 3 percent due to forces already at work.


there is, I think, a good chance that a growth pattern in that
range can be sustained for some time without setting off an
eruption of inflation.
-oLet me switch now to banking.

An important element in any

healthy economy is a sound banking and financial system able and
willing to finance economic expansion.

I will not take your time

to recite yet again the devastating effects of the collapse of
much of the thrift industry in the United States.

It has been an

Augean Stables mess that will cost perhaps $150 billion when all
is said and done.

But, it is substantially behind us now.


behind us are the related troubles in the commercial banks
resulting from bad commercial real estate loans, made in the
euphoric days when no one believed real estate values could do
anything but continue to rise at a brisk pace.

In the feeding

frenzy to get and keep market share in that sure-thing
environment, overconfidence resulted in compromised lending
standards, inadequate equity in projects and overestimated
markets resulting in badly financed gross overbuilding.


now, five years later, is there any sign of real revival in
commercial real estate construction.
Foreclosures, provisions and charge-offs wreaked havoc on
bank operating statements and capital accounts, and just at the
time we were phasing into compliance with the Basle risk-based
capital standards.

Several hundred banks failed and some of the

very largest teetered on the brink of failure before regaining
their balance.

In their efforts to rebuild their balance sheets and
revitalize their income statements, banks significantly tightened
credit standards and loan terms.

The resulting contraction in

bank credit probably contributed to the recession which, in turn,
reduced demand for credit as businesses worked down inventories
and reduced receivable ledgers in the face of shrinking sales.
The banking industry not only survived, but it has roared
back to record profits and the strongest capital positions in
thirty years.

The largest 50 bank holding companies, which

account for roughly two-thirds of the assets of the entire
industry, are a useful proxy for industry-wide performance.


the first half of 1994, these banking organizations had a return
on assets calculated on an annual basis of 111 basis points
compared with 115 basis points in the first half of 1993.
However, a new accounting rule, which caused banks to eliminate
grand-slam netting of nonqualifying derivatives, had the effect
of increasing reported assets.

Adjusting for that accounting

change, the return on assets performance of the top 50 was the
same for both years.
While net interest margins narrowed as the result of higher
interest rates and trading profits contracted, reduced overhead
costs and lower provisions for loan losses more than offset those
negative trends.
Assets and loans both grew at a healthy pace on a year-toyear basis, with assets up 8.6 percent and loans up 6.0 percent.
Very difficult market conditions, rising interest rates, and
market volatility reduced trading revenues and resulted in many
banks substantially decreasing their risk positions, particularly

in derivatives trading.

Better expense control also contributed

heavily to improved earnings.

Overhead expenses relative to

revenue peaked in 1990 at 70 percent.

At present, the ratio is

64 percent and bank managers continue to put heavy emphasis on
further improvement in the future.
about $38 billion for the top 50.
of nonperforming loans.

Loan loss reserves are at
That works out to 177 percent

The ratio has improved dramatically from

1991 when it stood at only 73 percent of nonperformers.
Capital ratios have also improved.

The capital markets have

provided significant amounts of both new equity and debt capital.
These factors, along with strong earnings, have raised the total
risk-based capital of the top 50 to more than 13 percent and the
equity ratio to 7.2 percent.
The return on equity for the first half was 15.5 percent,
down a bit from a year earlier.

As a matter of fact, a number of

banks, believing they have too much capital to generate a return
satisfactory to the markets, have started or announced programs
to repurchase some of their shares.

But, they will remain after

the repurchase well capitalized and have high overall ratings for
safety and soundness.
Again, using the top 50 bank holding companies as a proxy,
one can conclude that the industry is in excellent shape
financially and current survey information and anecdotal
intelligence indicate aggressive competition among banks to
obtain loans.

That obviously bodes well for continued economic

There have been two legislative initiatives over the last
year or so which have potential importance to banking in the

United States, both for U.S. banks and foreign banks operating in
the United States.

The first is a broad act to provide financial

assistance to organizations engaged in direct financing of
community development projects.

Since the purpose of the

legislation was certain to attract wide political support in both
parties, additional features were added which might not fair so
well on their own.

Among those were several modest attempts to

relieve some of the regulatory burden on the banks, including a
mandate to the regulatory agencies to review rules and
regulations and eliminate obsolete or unnecessary ones.


individually, none of the relief measures are revolutionary.


taken in the aggregate, they constitute a significant reduction
of burden.

The bill passed both houses of Congress and may have

already been signed by the President as we speak.
The second initiative, of even more importance to foreign
banks, is a bill to permit interstate branching by banks.


will be the final step in breaking down the artificial barriers
to geographic expansion.

Included in the bill is authorization

for foreign banks to branch interstate as well.

In that case,

the House conferees prevailed over the Senate conferees who had
favored requiring foreign banks who wished to branch interstate
to do so through a U.S. subsidiary bank rather than directly.
That would have placed foreign banks at a distinct competitive
disadvantage and would have been contrary to our established
policy of national treatment.

The bill also proposes a three-

year moratorium on assessing examination fees to foreign banks.
By that time the fee issue for all banks will have been examined
more thoroughly.

It is expected that this revised legislation will pass after
Congress reconvenes this week.

In the unlikely event that it

does not or that the President fails to approve it, the Federal
Reserve will be obligated to begin to collect examination fees
from foreign banks in the near future.
Finally, let me say a few words about derivatives.


explosive expansion of the use of derivative products, both for
hedging and speculating, has created rising concern in the United
The topic is being discussed currently in an overheated
environment created by recent market volatility, a few sizable
accidents and a media reaction which has created an aura of
mystery and danger.

Those factors have stimulated the habitual

reaction of Congress which is to regulate everything that moves.
Some would like us to believe that derivatives are a new
phenomenon —

in fact, so new, so complicated and so dangerous

that no one presently living can possibly understand them, let
alone know how to manage them.

Not so!

Derivatives have been

around for a long time and have been used primarily to contain
risk by providing a way to hedge against price volatility,
primarily in commodities but also in financial instruments.
Futures and options contracts are veterans of tens of generations
of use in the commodities markets; and forwards, short positions,
puts and calls have been factors in financial markets as well.
To be sure, these instruments have not always been used
solely on defense or to minimize risk.

By their very nature,

they can also be used for speculative purposes.

But, then, what

financial instruments cannot be used for speculation?

In the

most simplistic illustration, it can be argued that a person
buying a share of stock, expecting the price of that share to go
up while it is held, is speculating.

If the price goes up, there

is a profit; if it goes down, there is a loss.

And, if the

company invested in fails, the investors loses everything.


size of the bet only makes it more dramatic, but it doesn't
change the fundamental elements of the transaction.
The complexity of certain of the newer, more exotic
derivative instruments may make their operations more difficult
to understand, particularly under varying degrees of volatility
in the markets.

To try to understand these new instruments, very

sophisticated mathematical models have been designed to simulate
the behavior of markets and of market instruments like these
sophisticated derivatives during episodes of volatility which may
be triggered by wide swings in interest rates.
During the recent episodes, some of the models failed to
provide the guide to safe harbor because they assumed narrower
swings in interest rates than actually took place.
Those who invest in hedge funds are generally well-heeled
speculators, willing to take very significant risks in pursuit of
higher than usual profits.

Where the minimum investment is $250

thousand or even as much as $1 million, are we really concerned
that some of the rich high-rollers lose a bundle in the course of
a market adjustment?
over them.

Well, I, for one, have not shed any tears

There is no evidence that uninformed widows and

orphans are playing the derivatives market, unless, of course,
they are very rich widows and orphans who should know what they
are doing.

And, if that's the case, who cares.


Much of the current rhetoric urging legislation to
regulative derivatives and their use focuses on threats to the
safety and soundness of banks.

Some argue that proprietary

trading in derivative instruments is extraordinarily risky and,
therefore, inappropriate for United States banks with insured

But, making term loans to businesses is probably the

riskiest business of banks and we don't give that a second
A simple but useful definition of banking is that the banker
essentially manages financial risks for his depositors.
is to manage risk not avoid it.

His job

It is certainly reasonable to

assume that exotic, or at least exotically named derivatives are
riskier than single-family mortgage loans.

But does it follow

that they are, therefore unmanageable and should be prohibited to
Let's be realistic.

Derivatives are not new.

They are not

And, if managed properly, like any risk, they are

not particularly dangerous.
dangerous vehicle.

A race car is not in and of itself a

It is only dangerous and life threatening in

the hands of an ordinary driver.

And, in that analogy lies the

answer to the question of what to do about derivatives.
I am convinced that with full disclosure by banks of their
derivatives activities and exposure, trained auditors and
examiners will be able to assess the risk inherent in the
activity and then make an informed judgment whether the risk
management process in the bank is adequate to protect against
disastrous loss that would threaten depositors and shareholders.
A good risk management system must include:

A position monitoring and reporting system capable of
keeping management absolutely current with market
developments and the bank's position.
Stop-loss disciplines should be in place to
automatically trigger the close-out of deteriorating
Exposure limits should be in place for each category of
risk undertaken and these should be specifically known
to and approved by the board of directors.
Credit policies and procedures should provide for
adequate assessment of counter-party credit risk.
Authority to make exceptions to position limits and
stop-loss procedures should be vested in senior
management officials who are not responsible for the
profitability of the trading operations.
Market models used for designing investment and trading
strategies should enable management to "stress test"
the bank's position to identify emerging problems in a
changing market.
And, finally, management, both top management and
trading management, should have a thorough
understanding of the instruments and how they are being
used; and trading management should be experienced in
trading in volatile as well as stable markets.
If examiners have enough information disclosed to them to
make an accurate assessment of the degree of risk undertaken by a
bank, they should then be able to judge the ability of a given
institution to handle that risk and take whatever steps needed to

adjust individual institutions to their individual risk
Legislation would inevitably try to set standards or
parameters for the industry which ignore individual differences
among institutions.

On the other hand, with disclosure and

trained examiners, the supervisors will be able to recognize
individual capacities and permit broader range for those who are
qualified and restrict participation for the amateurs.
I am sure you sense my aversion to legislated regulation
when good supervision can do a better job.
In summary, the U.S. economy and its banking system are in
good shape and the central bank is pursuing a monetary policy
aimed at sustaining growth without further inflation.
Thank you for your attention.

I would be delighted to try

to answer any questions you may have.