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RELEASE ON DELIVERY esdav, April 22, 1981 p . m". E . S . T . FINANCIAL INNOVATION AND PUBLIC POLICY Remarks by Lyle E. Gramley Member, Board of Governors of the Federal Reserve System at the Financial Innovation Conference Northwestern University Evanston, Illinois April 22, 1981 It is indeed a pleasure to be with so many old friends to help kick off this conference on financial innovation. I thought it might be of some interest to offer a few comments on the problems and opportunities that financial innovation creates for public policy, and particularly for central banking. I am never entirely sure where to draw the line of dis tinction between financial innovations, the behavioral changes that prompt them, and the results they lead to. of innovation extending over a period of years, tend to get blurred. In a process such distinctions But let me list briefly some of the more important changes in financial behavior over the past quarter century associated with innovation, and then turn to the public policy issues they present. One of the more important areas is the growth of liability management--first at banks and later at other depository in stitutions. Twenty-five years ago, commercial banks hung out a shingle that said, "We accept deposits," and thrift institutions did likewise. Since deposits were largely exogenous to the individual depository institution, liquidity was principally pro vided by holdings of liquid debt instruments issued by someone else--often the Treasury. - 2 - Liability management has changed radically the source of liquidity to individual depository institutions. Now, the principal source is the ability of an institution to sell its own debt instruments. Liability management has also increased enormously the capacity of individual institutions to extend credit to potential borrowers. The counterpart of the spread of liability management has been the explosion in the types of instruments made available for financial investors to hold, and the gradual lifting of restraints on the ability of institutions to pay going rates of interest. New markets have been created and some old ones expanded greatly. The new instruments and markets are so familiar that I need not name them. Let me simply remind you that some of the new assets are excellent substitutes for money; others are not. Some are issued by banks; depository institutions; otherr- by nonbank others by nondepository financial institutions, and still others by nonfinancial firms. vestor has an enormous The in menu of financial assets to choose frotr and a wide array of chefs to prepare the financial repast. - 3 - The third factor--the flip side of the second--is the increase in the sophistication shown by individuals and businesses in their appetites for financial assets. The principal motivating force is clear--the need to earn the highest possible return to protect financial asset holdings against loss of real purchasing power. Management of cash flows has become as important to the financial managers of business firms as their traditional role of arranging credit for the enterprise. A fourth development is the gradual blurring underway in the distinctions among classes of financial institutions and between financial and nonfinancial firms. really only beginning. commercial banks; This development is S&L's still are quite different from bank holding companies engage in only a relatively narrow range of nonbanking activities; is still mainly a brokerage firm; a retailer. Merrill Lynch and Sears Roebuck is largely But Sears has a nationwide EFT system, a stock S&L subsidiary in California, a credit card with over 20 million customers, an on-line POS system, arrangements Cor clearing and settling third-party payments, a full-line insurance subsidiary, a nationwide network of over 1,000 offices, and ready access to the commercial paper market. If interstate branching were permitted for S&L's, Sears would have an opportunity to increase the financial counterpart of its operation enormously. - 4 - Tbe fifth category on my list is the application in financial markets of technological advances in the fields of computation and communication. Automated accounting systems, computer-based cash management models, and wire transfers of funds have, of course, provided the underpinnings for some of the innovations already mentioned. In this area, too, actual developments to date are only a small fraction of their potential. We are, I believe, on the verge of a substantial surge in electronic transfers of funds--stimulated in part by Federal Reserve pricing of check collection services, subsidization of ACH transfers, and efforts by the Fed to promote electronic check collection. Sixth, and finally, there is the internationalization of banking and finance, a trend that has several strands. banks are entering the U.S. similar inroads abroad. Foreign in volume and U.S. banks are making Capital has begun to flow much more freely in international markets--to both public and private borrowers. And as the share of exports and imports has risen in GNP, our banks have increasingly become engaged in the financing of international trade. The single most important element in this innovational process is the increasing lack of correspondence between the geographic location of real economic activity and the financial transactions related to it. - 5 - There are other innovations, such as the creation of futures markets for financial instruments, and the enormous increase in Federal financial intermediation, added to the list. that could be But the six that I have mentioned seem to me to encompass the main areas of current interest and concern for the central bank. Let me turn now to the impact of these innovations on monetary policy. Monetary Policy Twenty-five years ago, monetary restraint worked importantly through reductions in the availability of credit to potential borrowers. When liquid assets were drawn down, banks turned away nonlocal borrowers and nondepositors, halted credit flows to particular industries, and in other ways tightened nonprice credit terms. Outside the banking system, usury ceilings and legislated ceiling rates on VA and FHA loans gave rise to significant reductions in mortgage credit availability. Statutory and constitutional limits of states on interest rates that could be paid blocked the flows of credit to states and political subdivisions. - 6 - Innovations and regulatory changes have, by and large, eliminated the periodic reductions in credit availability that accompanied an increase in monetary restraint. As a result, monetary policy now transmits its effects to the real economy largely through fluctuations in interest rates. Monetary restraint still works, but in different ways and perhaps more gradually. Any given degree of monetary restraint on spending, moreover, now requires a higher level of real interest rates than it did before. I once thought that this shift in the channels of transmission of monetary policy was an unmixed blessing. It seemed to free policymakers of concerns about potential sectoral distortions resulting from monetary restraint. Moreover, it improved the efficiency of money and capital markets, affording savers and investors greater opportunities to lend and borrow at or near market interest rates. I no longer take so sanguine a view. To moderate aggregate demand, interest rates, it turns out, have to rise to much higher levels than almost anyone would have guessed a couple of years ago. This can lead to critical forecast errors by policymakers and others. Failure to take adequate account of this fact appears to have contributed importantly to the premature forecasts of recession that were - 7 - prevalent from mid-1977 to early 1980. rise to levels that bite, moreover, When interest rates do the housing market is hit about as hard as it was in earlier periods of restraint. Although I can't prove it, I would hazard the guess that small businesses, and particularly farmers, fare as badly, or worse, during periods of monetary restraint now than they did 20 years ago. The wider cyclical swings in interest rates we have seen in the past year and a half, of course, reflect the Fed's current operating strategy, as well as this change in the trans mission of monetary policy to the real economy. Taken together, the two developments have caused banks and other lenders to shy away from interest rate risk exposure, a function they once accepted readily. In the process, they have shifted the risk of fluctuating interest rates around in ways that cannot readily be measured, much less understood. The maturing of futures markets for financial assets may help to shift the burden of interest rate risk to those most willing and able to bear it. But those markets are not that well developed yet. So I find myself not infrequently yearning for the good old days of tight money and relatively low interest rates. If I could think of clever ways to reintroduce some sand into the credit-granting machinery, I might well want to do so. tunately, once the genie pops out of the bottle, to put it back in again. Unfor it is not easy - 8 - A second monetary policy problem that innovation has created is the gradual destruction of the simple rules of thumb that once provided useful guidance to the central bank. Since 1974, innovation has contributed to payments practices that have led to both a substantial decline in the amounts of money needed to finance a given level of GNP, and a high degree of short-run instability of money demand. To illustrate: in the second quarter of 1980, the demand for transactions balances appears to have shifted down by perhaps 3 to 3-1/2 percentage points, based on the money demand function in the Board's quarterly econometric model. An even larger shift apparently occurred in the first quarter of this year. In light of what has been happening to the demand for money since 1974, it does not seem to me that a constant growth rate of money is always the ideal monetary policy. I am willing to grant that shifts in money demand over the past seven or eight years have not totally destroyed the usefulness of monetary aggregates as a policy target or guide. But they have certainly made the task of running monetary policy more difficult, and that of explaining what is going on to a skeptical public nearly impossible. - 9 - The problems of interpreting the monetary aggregates will get much worse if, as I suspect, we are on the verge of an explosion in the use of EFT. In a world of mature EFT systems, where transactions costs will be much smaller than they are at present, very few large economic entities will have identifiable transactions balances at the end of a business day. The internationalization of banking and financial markets creates further measurement and interpretational problems for monetary policy. Changes in onshore deposits and domestic private credit flows no longer measure very precisely the amount of money and credit available to finance domestic economic activity. Growth in transactions balances abroad has thus far not been very large, but it may become so in the future, particularly in light of the prospect for same-day settlement through the Clearing House Interbank Payments System (CHIPS) later this year. Since data on the international components of money and credit are less comprehensive and available only with a lag, the potential information gap is serious. - 10 - Developments such as these greatly complicate the life of a central banker. It is not easy to develop new rules of thumb that are robust in a world of rapid innovation, or to estimate new large-scale econometric models that capture the new ways financial variables affect economic activity. policymakers will, Monetary I am afraid, be operating by the seat of their pants for a long time to come. The internationalization of banking and finance has had another effect on monetary policy that deserves mention. The opening up of international capital markets has made the effects of domestic monetary policy register more heavily and more rapidly abroad. The huge amount of dollar indebtedness of L D C 's means that their debt service costs are powerfully affected by changes in U.S. ized countries, interest rates. For the industrial the problem is that exchange rates are heavily affected by relative interest rates in the short run. rise in U.S. interest rates, A sharp therefore, confronts them with the prospect of accepting a depreciation of their currency relative to the dollar, or taking steps to raise their own interest rates. Needless to say, these are not always the options they would choose if they had their druthers. - 11 - Our friends abroad strongly support the Fed's efforts to bring down inflation with monetary restraint. Their expressions of support, however, are sometimes made through clenched teeth. We cannot very well ignore these international side effects of monetary policy. Supervisory and Regulatory Policy Let me turn now to some of the issues that innovational change presents for supervisory and regulatory policy. biggest problem, The it seems to me, is the increased risk of failure in the business of financial intermediation. Risks have increased for a number of reasons. some financial institutions, First, such as the thrifts, have had less ability than others to adjust to rapid change. Many thrifts, as I am sure you know, are facing negative net earnings this year. Second, for those with a high propensity to gamble, fluctuating interest rates offer a great temptation to speculate to increase net interest margins. Moreover, it is difficult for supervisors and examiners to monitor and assess the interest-rate risk exposure of a financial institution. Third, competition among depository institutions has increased tremendously, narrowing profit margins. Fourth, new forms of activity, such as foreign - lending, 12 - increase the prospects for mistaken judgments. Fifth, and perhaps most importantly, liability management has increased the risk exposure of individual institutions. The problem of maintaining an image of soundness has taken on critical importance, as sources of funding can evaporate at a mere hint of difficulty. Reliance on purchased funds has also increased the degree of interdependence among institutions. If an institution A appears to be in a rocky position, excess of caution, large depositors may decide, out of an to remove funds from B or C. This greater interdependence tempts supervisors to adopt bailout policies to ensure that institutions do not fail--for fear that panic may spread. perverse effects. But succumbing to such a temptation has It increases the propensity of financial institutions to take risks and thus makes the safety and sound ness problem still worse. Moreover, with such a safety net, lenders may feel less compelled to restrain credit when the objective of a monetary policy is to limit aggregate demand. There are other areas in which regulatory decisions are being affected importantly by innovation. For example, traditional view that commercial banking is a unique line of the - 13 - commerce is gradually breaking down. Competition between thrifts and banks is now being given some weight in bank holding company and bank merger case analysis, but staff work is under way at the Federal Reserve Board looking toward a more sub stantial overhaul of this concept. Pressure for cross-industry acquisitions between thrifts and banks is likely to increase as these two classes of institutions become more alike. Studies of the pros and cons of such cross-industry acquisitions are currently being prepared for the Congress by the Federal Reserve Board, the Federal Home Loan Bank Board, the Federal Deposit Insurance Corporation, and the Comptroller of the Currency. How those studies will come out I don't know; but I have long felt that acquisitions of thrifts by bank holding companies could provide an important source of capital and management talent to the thrift industry. ful, and more sympathetic, I hope the Congress will take a care look at this issue when those studies are completed. One of the most acute problems for financial regulation is the need to address the growing competition faced by banks and thrifts from nondepository financial institutions. The most immediate concern is the drain of deposits into money market mutual fund shares. But the greater long-run threat to - 14 - depository institutions may come from large financial con glomerates operating on a nationwide scale and increasingly penetrating banking markets. It is hard to see how financial regulatory policy can deal with these institutions as though they were in separate compartments. Moreover, it seems clear that the movement into banking of large financial conglomerates will add powerfully to the pressures already developing for relaxing existing restraints on interstate banking. When facing potentially profound structural changes of this kind, it is perhaps tempting to conclude that the best course of action for financial regulators and the Congress is to remove existing barriers and let freedom reign. isn't the lesson of the postwar After all, period that regulation cannot stem the tide of innovation and its consequences in markets? I read history somewhat differently. The ultimate results of innovation, it seems to me, are only dimly perceived when the innovation occurs. us and often do. Moreover, The side effects can easily escape the transition problems generated by innovation can be extremely painful. These considerations are, I believe, one reason why both the financial regulators and the Congress have perhaps been somewhat more chary about un leashing the forces of innovation than experts in the academic field. - 15 - I would hazard the guess that the structure of financial markets, practices, and institutions will change even more in the next two decades than it has in the past 20 years. The effects of past innovations are still far from complete. Moreover, technological change will continue to provide new applications in the financial world. The tide of innovation sweeping through financial markets cannot be 'mlted; the task we face is to guide it in ways that contribute to a healthier and more efficient financial system. It is a task in which policymakers in Washington, experts in the academic field, and others will need to work closely together. #*#######
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