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One fundamental premise of the Federal Reserve's interpretation of f and response to, any proposed restructuring of
arrangements for the regulation and supervision of banking and
related markets and institutions is that such responsibilities
:annot be insulated from —
f:rom —

or thought of as something separate

the basic responsibilities of a central bank.


banking responsibilities by law and custom, in the United
States as we 1 1 as most other industrialized countries, plainly
encompass concerns about the stability of the financial system
in general, and the banking system in particular.

Crucial points of concern include:

the operation of the domestic and
payments system —


that is the reliability and

safety of arrangements by which hundreds of billions
of funds are transferred among banks and others

ie capital and liquidity of the banking system
chat it can {"') absorb shocks originating


wC :ttside the banking system, and (2) respond
effectively to monetary policy decisions.

The general risk profile of banks, and the consistency
of regulatory and supervisory approaches toward risk
with objectives of monetary policy.



The structure of the banking system and the powers of
banking or other financial organizations as they
bear upon these concerns.

The clear implication is that the Federal Reserve as the
nation's central bank must remain substantively involved
the regulation and supervision of the financial and banking
system because those functions impinge upon its general
These responsibilities are broader than those implied by
any particular operational mode for monetary policy; they go
back to the founding of the Federal Reserve System as an
institution for forestalling and dealing with financial crises.
But it is also true that, taking monetary policy as the point
of departure, that policy will be either complemented or
compromised by regulation and supervision of the banking and
financial system.
In sum, "central banking" concerns about regulation am*
supervision need to be considered together with other valic
concerns of regulatory policy —

competition, simplicity,

adaptability, fairness, and Federal-State relationships -

In any

"reform" of the regulatory system.
This memorandum first develops these basic points about the
interrelationships between central banking and supervisory and
regulatory responsibilities, including the possibility of conflicts
among them.

It then emphasizes that proposals for administrative

reform of supervisory authority need to be viewed in the light

-3of proposed changes in substantive legislation governing powers
of banks and bank holding companies.
A basic continuing responsibility of any central bank —
and the principal reason for the founding the Federal Reserve —
is to assure stable and smoothly functioning financial and
payments systems.

These are prerequisites for, and complementary

- the central bank's responsibility for conducting monetary
policy as it is more narrowly conceived.

Indeed, conceptions

of the appropriate focus for "monetary policy" have changed
historically, variously focusing on control of the money
supply, "defending" a fixed price of gold, or more passively
providing a flow of money and credit responsive to the needs of

what has not changed, and is not likely to change,

is the idea that a central bank must, to the extent possible,
head off and deal with financial disturbances and crises.
To these ends, the Congress has over the last 70 years
authorized the Federal Reserve (1) to be a major participant in
the naticrs payments mechanism, (2) to lend at the discount
window as the ultimate source of liquidity for the economy,
and (3) to regulate and supervise key sectors of the financial
arkets, both domestic and international.

These functions are

addition to, and largely predate, the more purely "monetary"
functions of engaging in open market and foreign exchange
operations and setting reserve requirements; historically,


-4in fact, the "monetary" functions were largely grafted on to
the "supervisory" functions, not the reverse.
In a real sense, the Federal Reserve was founded out of
an instinct that monetary and banking disturbances were interrelated*

The concept is still plainly relevant.

strain, the Federal Reserve is looked to as central
contain the crisis and maintain confidence —
"stability" and "continuity" —

efforts to

to maintain

ever if the involvemer

banking system is only derivative.

imes of

of the

Examples can be focnd in the

Federal Reserve's participation in efforts to deal with the
threat to the commercial paper market in the early 1970 's
from the bankruptcy of Penn Central, or with the pressures on
securities firms (and potentially banks) from the collapse of
silver speculation in early 1980.

These crises had toe seeds,

and more, of requiring a response in terms of monetary policy
itself —

that is, the need to provide more liquidity to the


The point is that monetary policy can potentially

be thrown off course by disturbances or fragilities arising in
the internal structure or performance of financial markets, and
those disturbances may, in some instances, require a monetary
policy response.

The public interest requires not only a

continuing effort to foresee and deal with such weaknesses
before they erupt into crisis, but also effective "crisis
management" fully aware of monetary implications.
Central banking responsibilities for financial stability
are supported by discount window facilities —

historically a


key function of a central bank —

through which the banking

systemf and in a crisis, the economy more generally, can be

But effective use of that critically important

tool of crisis management is itself dependent on intimate
familiarity with the operations of banks, and to a degree
other financial institutions, of the kind that can only be
derived from continuing the operational supervisory responsibilities,
We need to be aware of the ways in which financial markets and
institutions are intertwined, recognizing that problems in
one area typically affect others.

In particular, a "crisis"

in one limited part of the banking system can quickly affect
the strength and well-being of others and the system as a
vhole, both because of direct links through the payments system
and because the system, in the end, rests on intangibles of
It is our view that it would not be workable or reasonable —
it would indeed be dangerous -- to look to the Federal Reserve to
'pick up the pieces" in a financial crisis, without also providing
the Federal Reserve with the tools to do the job and with
adequate "leverage" in shaping the system so as to reduce the
1 kelihood o

crisis actually arising.

However imperfect the

foresight of any institution in the best of circumstances, these
continuing concerns and responsibilities demand a strong place
for the central bank among the institutions shaping financial


-6These concerns have continuing operational implications*
Year in and year out, supervisory and regulatory decisions will
influence the manner in which depository institutions respond
to monetary policy decisions. On those occasion

when the

economic environment may require particularly forceful monetary
policy action, the failure of supervisors and regulators
adequately to have foreseen potential strains on depository
institutions could either constrain the ability of: the central
bank to act vigorously to meet monetary policy objectives or
create a situation in which needed monetary restraint pushes
the stability of the system to and beyond a breaking point.
The administration of the discount window from day-to-day and
operations in the open market, domestically and internationally,
presume a capacity to evaluate the circumstances and soundness
of the institutions with which the Federal Reserve is dealing
or providing credit.
Some have argued these needs of the central bank can be
met by adequate exchange of information.
but strongly, disagree.

We respectfully,

Clearly, close working arrangements

among all agencies with supervisory responsibilities are
helpful and important.

But no one familiar with bureaucratic

processes over the years, in fair weather and foul, and with
the realities of changing personalities and consequent possibilities
for friction, can count on access to examination reports or other
information prepared elsewhere, or on opportunities to express
views formally or informally, to substitute adequately for at

-7least a share of "hands on11 operational and policy responsibility.
Otherwise, the voice of the central bank in regulatory and
supervisory matters can and sometimes will be ignored, the analysis
it performs or is performed for it in these areas will be
superficial, and the able and forceful staff it needs will be

Almost inevitably, the tendency would be to

retreat into a kind of ivory tower, adversely affecting both
monetary and supervisory policy.
Possib..<1ity of Conflicts
Some have argued that conflicts between regulation of
banks and the conduct of monetary policy can arise, and that
when? in specific instances, the conflict becomes acute the
Federal Reserve v?ill in effect tend to override the supervisory
or regulatory concerns, presumably to the detriment either of
safety or soundness or the competitive strength of banking.
Others may argue the reverse, that at times of financial crisis
those concerns may lead to the provision of significant
additional liquidity to the detriment of monetary targets.
1e do not dispute the obvious —

that in particular instances,

differe t responsibilities may lead to legitimate differences
in pcii,.,s of view

The real question is how best to resolve

such differences so that any "trade-offsM are carefully weighed
and decisions made with a balanced view of the public interest.
The nature of the Federal Reserve's responsibilities for
the overall financial health of the economy force it to weigh


-8various trade-offs among various goals.

Specifically, con-

flicts between measures taken to achieve objectives of monetary
policy and those of supervision and regulation have to be reconcilec
more positively, those objectives need to be pursued in
mutually reinforcing manner.

Indeed, regulatory and mone-- ? ry

policy will both be improved by taking advantage of information
obtained in the execution of each.
Conversely, the public interest will not necessarily b .
served by the single-minded pursuit of different * - and possibly
competing —

policy objectives.

To take an extreme case,

imposing highly conservative supervision standards at a time
of strain in pursuit of the safety and soundness of individual
institutions —

one legitimate and continuing objective of

supervision and regulation —

could unwittingly place the

stability of the entire system at risk; such an approach may nc
take account of "trade-offs" that have implications for the
ability of the financial system as a whole to withstand and
manage the strains.

Conversely, our supervisory arrangements

should encpurage continuing concern with the abi *.ity of the
banking system to withstand potential pressure even during long
periods of fair weather, when temptations may develop to cater
to the instincts of the most aggressive banking entrepreneurs.
There can be no absolute protection from these dangers.
But experience here and abroad suggests a strong central
bank, by the very nature of its broad responsibilities and
its relative independence, is in a unique strategic position to

-9take a balanced and long view.

The design of any regulatory

and supervisory system needs to take account of that broad
perspective —

a perspective essentially shared only with the

Treasury or finance ministry.
Some historical perpective on the point is useful.


major concern of the Federal Reserve Board and others during
and after the Great Depression was that bank supervisors
enforcing unduly conservative lending standards were undercutting
the effects ;i expansionary fiscal and monetary objectives.
At other tinus, the opposite concern may develop.

The fact

is such general regulatory policies as capital and liquidity
standards, reserving policiesf interest rate ceilings (when they
were in effect) , and disclosure of financial information have
very great significance for monetary policy and the stability
of the entire financial system.

In specific instances, they

can even be a dominating influence on actual policy results.
A currant example is the situation with respect to loans
to under-developed countries, in which we face complex and
interrelated questions aisout financial and economic stability,
b&nk soundness and public confidence, and appropriate disclosure.
Trie various regulators of depository institutions inevitably
h&^e somewhat different emphases in carrying out their responsibilities, and tnere is considerable merit in bringing these
disparate views to bear on supervisory and regulatory problems.
But in the end, resolution of the issue will have the broadest
implications for monetary policy and our economy, and the



economies of other major countries.

The Federal Reserve cannot

help but be deeply concerned and involved in the decision making.
It is possible —

indeed probable —

that any "reform** to

eliminate or greatly reduce the Federal Reserve's formal
regulatory and supervisory involvement would eventually be
overwhelmed by the need to achieve coordination, and the
regulatory structure would in practi e provide significant
weight to the views of this nation's central bank*

But this

clearly is not the intent of certain proposals, and it would
obviously be totally unsatisfactory to have recognition of
the central bank's legitimate and necessary interests reasserted
only after lurching from crisis to crisis.
Foreign Experience
Although specific arrangements differ, the concerns expressed
in this memorandum are widely recognized in the practices of
other industrialized countries.

Among 22 OECD coutries,* fully

half (including England, Italy, the Netherlands) place both ln&
monetary policy and the main supervisory functions directly »
the central bank.

In several major countries, including France,

Germany, Japan, and Switzerland, supervisory responsibilities
are shared in varying degrees between the central bank and
either a banking commission or the Ministry of Finance.
country —

Canada —

In one

the formal responsibility lies basically

with the finance ministry.

The remaining six small countries

*Excluding Luxemberg, which as part of a monetary union has
no central bank, and the U. S.


have separate (and typically very small) banking commissions;
those commissions usually have formal links with the central
bank, and may rely on the central bank for operational surveillance
as well as for policy input.
our view* much of the discussion involving the
orgai ration of iinancial supervision —
schemes to curtEi

including various

or practically eliminate the Federal

Reserve's regulatory or supervisory role —

is out of focus.

The present sense of disarray among regulatory agencies and
the.r approaches grows in substantial part out of questions of
substance and policy inherent in applying a framework of law
developed many years ago to markets and institutions transformed by
economic and technological change.

These are not, at bottomf

questions of procedure or bureaucratic jurisdiction —


urgently need to be sorted out by the review of substantive
law underway in the Congress.
For instancef cle key concern revolves around the question
of what nonbanking business banks and other depositories
shouiS be permiitr

engage in and the types of organizations

thai saould be permitted to own banks.

Uncertainty in the

induM-rv is rife* ami conflicts in regulatory approach in
interpreting current law are obvious.
The problem has become acute as banks and bank holding
companies have attempted to expand into new businesses such



as securities and insurance brokerage, while nonbank entities
such as insurance companies, securities firms, and retail firms
have made inroads on the banks1 traditional franchise in deposit
taking and the payments system*

A glaring illustration

this process was the success of the money market funds i
competing with the banks8 core business of collecting deposits.
The problem has accelerated with various deregulatory steps,
the vast improvements in communications and data processing
technology and, until recently, with rising inflation and
interest rates.
Exploitation of loopholes in existing law —

law whicn for

many years protected the core of the banking business from
outside competition —

has recently favored "non-bank11 competitors,

while generally restraining banks from diversifying their
business lines.

The problem has been compounded by provisions

of the Bank Holding Company Act in which the Congress placed
on banking organizations a differential burden of demonstrating
net public benefits from proposed new activities and whic
gives procedural advantages to banks' competitors when banks
seek to undertake new activities through the holding company

These problems are rightly of concern to the banks.

But the concerns fundamentally arise from the law, not from
the particular administrators of the law —

although, as a

common phenomenon of human nature, the "messenger" can be
blamed for the message.


Some parts of the banking community have argued that the
Bank Holding Company Act is too restrictive in terms of the
powers permitted to banking organizations.

The Federal Reserve

shares that view, and we have endorsed and supported the
Administrations proposed Financial Institutions Deregulation

That: bill provides for expanded powers for banking

organizations and firmly defines the banking powers of nondepository

It carefully defines M a bank" and thus the

scope of institutions that are subject to the Bank Holding
Company Act.

Moreover, as a natural complement, the proposals

would greatly simplify the regulatory procedures for holding
company initiation of the new activities that are provided
for in the bill.
Passage of the "PIDA" legislation would, in and of itself,
settle many of the substantive issues, provide direct and fresh
indications of Congressional intent as to how the law should
be administered, and bring about great improvement and
simplification in the regulatory process.


it could be expected to clear the atmosphere and eliminate,
or greot: y alleviate*.ra*snyof the pressures by banking trade
associations to seek change through a different regulatory
structure conceived as more sympathetic to their substantive
or procedural concerns.

Indeed, in the absence of fundamental

legislation dealing with both powers and procedures, it is
doubtful that any reshuffling of governmental responsibilities


-14for bank regulation would relieve the legitimate concerns of
commercial banks about their competitive position and hence
their discomfort with the regulatory regime.
The Federal Reserve does not need nor ss-ek sole responsibility
for regulation and supervision of depository institution', but
it must have a continuing substantial involvement in this process.
It must be able to bring to bear effectively its concerns
about the direction of regulation as the financial system
evolves, and needs significant supervisory authority as well.
Such authority will keep the Federal Reserve in touch with
developments at financial institutions and will give weight
to its views in the formation of supervisory policy, which is
at the foundation of a sound financial system.
Consequently, proposals that would simply remove the
most important element for Federal Reserve regulatory and
supervisory influence —
companies —

its responsibility for bank holding

cannot meet the minimum requirements unless "leverage"

is restored in other ways.

One vote on a five-member council

and the right to accompany the examiners of other agencies as
a kind of junior partner as they supervise a limited number
of the nation's largest banks—without regulatory authority


or the power to require corrective measures—is not an adequate

And, to the extent concurrent regulatory or

supervisory authority is provided for a small group of institutions,
problems of a clash in policy and confusion for the supervised
banks would be magnified.
We also recognize that the current regulatory system
has a number of problems of overlapping or divided authority,

:ese problems have been aggravated by differences toward

substantive questions.

In our view, the fresh Congressional

direction on these questions implied by the adoption of FIDA
would eliminate much of the difficulty, and present the
remaining problems in a different, and more manageable, context.
Modifying the Present Framework
In approaching change, the strengths of the present
regulatory system should not be overlooked.

Most broadly, it

has provided some balance among various interests and concerns
within the government in the process of supervision and regulation.
For example, through the Office of the Comptroller of the Currency
there is a Irak to the broad policy concerns of the Secretary
of che Treasury

At the same time, the supervision and regulation

function as a whole, and particularly the portions concerned
with "case work/* are insulated from political pressures and
administrative arrangements encourage a degree of continuity
that would be lost if tied directly to the Executive Branch.


-16The current system also incorporates an important role
and influence for the Federal Reserve in domestic and international banking regulation without concentrating all power
and "case work" in that agency*
There is a significant role for the deposit insurance
agency, while offering some balance to its inherently conservative
mandate to protect the insurance fund

The existing system also

fits reasonably comfortably within the context of the dual banking
system; a more centralized system, impelled to treat banks with
a high degree of uniformity, might inherently tend to erode a
meaningful role for states in regulation and supervision.
These are matters that must be dealt with in any reform,
and it remains to be seen whether it can be done as effectively
in another framework.
The point was made earlier that enactment of FlDA would,
in itself, deal with some of the most important concerns of the
regulated banks and achieve substantial simplicity %n bank holding
company regulation.

A number of other steps could be taken f~

improve the present supervisory and regulatory structure
independent of FIDA.
Those steps include consolidating the responsibility for antitrust analysis of cases involving domestic banking organizations
in the Justice Department.

Another step would be to consolidate

the responsibility for administration of the securities laws
as they affect deposit-taking companies in the Securities and
Exchange Commission.

Authority for margin requirements could


be realigned, if retained at all.

(It might be noted that, when

these steps have been considered in the past, the banking
industry itself usually has urged that the basic authorities
be kept with the bank regulatory agencies.)
Regulatory responsibility for much of the consumer credit
protection legislation (and for relations with the Consumer
Advisory Council, which, in any event, should be preserved)
might also be shitted from the Federal Reserve to an agency
with responsibility for other consumer-related legislation.
However, the current arrangement appears to be working satisfactorily, and this, in itself, is probably not a priority
Improvements toward simplicity and consistency can be made
other areas, potentially more closely related to the essence
of the Federal Reserve's concerns for regulation and supervision,
These steps could be taken whether or not FIDA is passed, but
would make a greater contribution if FIDA were the operative

One possibility would be to shift responsibility for
one;7J2&njk holding companies where no significant non-bank
act .ivities are in tact conducted to the primary banking
regulator; while a heavy case load is present in this area,
the holding companies are essentially nothing more than
financing vehicles for the bank.
Another possibility would be to shift responsibility for
regulation of the banks that are part of holding companies with


-18significant non-banking activities to the Federal Rerserve.
This would create a situation where both the bank and the bank
holding company would be regulated by the same agency ? further
reducing the overlapping jurisdiction now in place.
Regulation of non-banking activities of bank holding
companies and multibank holding companies raises questions of
uniform treatment for activities that extend over state and
national boundaries, and the logic points strongly toward
maintaining regulation and supervision in a single agency.
From the standpoint of the Federal Reserve, this provides a
critical vantage point for maintaining oversight and
surveillance over the evolution and risk characteristics of the
system as a whole.
Under current practice, the Federal Reserve routinely
solicits the recommendation of the OCC f FDIC<? and state supervisory authorities, as relevant, on applications that come
before it under the Bank Holding Company Act,

With rare

exceptions, the final determination by the Federal Reserve
is consistent with those recommendations.

Nonetheless, the

supervisory system could be better integrated if the lav were
amended to provide the presumption that the Federal Reserve
accepts the findings of the primary banking supervisor with
respect to the financial and managerial factors bearing on
the lead bank of the holding company.

December 15,