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For release on delivery February 4, 1980 10:00 AM EST Statement by Paul A* Volcker Chairman, Board of Governors of the Federal Reserve System before the Committee on Banking, Housing, and Urban Affairs United States Senate February 4, 1980 I am grateful for this opportunity to testify once again on certain proposals this Committee is considering to ensure the continued capacity of the Federal Reserve System to conduct effective monetary policy in the years ahead. I am convinced that, after long debate and with a final effort by this Committee, a fully satisfactory legislative solution can be enacted in a matter of weeks —- legislation that would have broad support from the interested constituencies, would fall within acceptable limits of cost to the Treasury, and most important, enable the Federal Reserve to maintain disciplined control of the money supply and meet its other responsibilities for protecting the safety and soundness of the banking system. The need for legislation is strongly reiruxreed by the decision of the Federal Reserve to adopt new operating procedures on October 6. These new procedures —- which are described in a i attaclv -nt to i this testimony — place much greater emphasis on reserves as the instrument for controlling money growth. have worked reasonably well. Thus far, the procedures But their effectiveness will be undercut as the share of money not subject to reserve requirements set by the Federal Reserve increases. Legislation to keep Federal Reserve control over the nation's reserve base from atrophying further is, in that context, an essential element in our antiinflationary program. As we deliberate, the problem of attrition from Federal Reserve membership intensifies. In the three years that Congress has debated this issue, the proportion of bank deposits held by member banks dropped from 73 percent to about 70 percent. That drop occurred despite the fact that many institutions have been willing to defer withdrawal .from membership while awaiting legislation that would result in more equitable conditions. Now, it is evident that patience has run thin. During the fourth quarter of 197 9 and the first few weeks of 1930, 69 banks with about $7 billion in deposits have given notice of withdrawal from membership. The loss of deposits in this short period exceeds that of any full year. The recent withdrawals by two very sizable banks in Pennsylvania, with more than $3 billion in deposits between them, seems to me especially significant. They show that much larger institutions than before are now prepared to take the step. As one banker has put it, the cost of membership is "too high a price to be a member of anything," It is my judgment, and that of many others, that, in the absence of legislative action, the stream of member banks withdrawing will reach flood proportions. Financial innovation, shifting competitive patterns, and stx*ong inflationary pressures with their related high interest rates, all have contributed to an increasing burden of membership. It has become progressively moire costly and more difficult for banks to justify continuing their membership. It was not so long ago that, among medium- sized and larger banks, membership was pretty much taken for granted- Now in more and more areas of the country, that attitude is being reversed; it is continued membership that has to be justified to the stockholders and customers that ultimately shoulder the burden. Even banks conscious of the importance of a strong central bank and reluctant to give up a national charter find that justification increasingly difficult or impossible in the light of the heavy burden involved. A recent survey by Reserve Banks, based entirely on information volunteered by members in the normal course of business, found that 320 member banks were considered certain or probable to withdraw. Another 350 were actively considering withdrawal. These 670 banks — drawal procedures — some of which have alx,,a^y initiated withrepresent more than n) percent of the System's membership and have in excess of $71 billion in deposits. If these banks, in fact, withdraw, deposits of banks holding Federal reserves will decline to 64 percent of the deposits of the banking system. And there is no doubt in my mind that many more banks are considering withdrawal than have come to our attention and that the momentum would build further. I would remind you that loss of members has several adverse effects on monetary control, the soundness of the banking system, and the strength of the Federal Reserve, As attrition causes the total amount of reserves held at Federal Reserve Banks to decline, the "multiplier" relationship between reserves and money increases and tends to become less stable• Consequently, -4- fluctuations in the amount of reserves supplied — and these fluctuations inevitably have a range of uncertainty — can cause magnified and unintended changes in the money supply. As attrition increases the proportion of deposits held by nonmember banks, the possibility of unanticipated (and unpredictable) shifts of deposits between member and nonmember banks increases, destabilizing the relationship between reserves and money. As banks leave membership, they also lose ready access to the Federal Reserve discount window. Operation of the window not only can assist otherwise sound banks to weather unexpected deposit outflows, but also provide an essential safety-valve function for the monetary system as a whole by enabling individual institutions to adjust more smoothly and without disruptions to changing credit conditions. At the same time, the Federal Reserve is losing the intimate supervisory surveillance of individual institutions important to the administration of the discount window and effective discharge of our supervisory and regulatory responsibilities. Finally, the structural consideration so central to the formation of the Federal Reserve System would become relevant again as larger and larger segments of the banking industry come to hold their entire operating and liquidity reserves at other commercial banks rather than maintaining balances with the Federal Reserve Banks. In this setting localized strains may more readily be transmitted to other banks, and individual failures could have more serious repercussions. • 5- Among the relevant criteria for evaluating any proposed legislation are how many banks are covered*, the proportion of deposits held by those banks, and the size of the reserve base itself in relation to deposit totals. We have no formula for deciding precisely how large reserve balances need be f or how they should be distributed,, to ensure effective monetary control and a well-functioning banking system* I am convinced that reserve requirements must be more equitably distributed among the nation's banks., and I also feel quite sure the Federal Reserve can meet its responsibilities with a smaller reserve base than we now have. But I have grave doubts whether coverage and the reserve base could be reduced as drastically as in the bill (H.R. 7) passed by the House without se \ adverse implications for monetary management. Theorists have put forward arguments that under certain operating hypotheses required reserves may not be needed at all, let alone in sizable amounts. The rather abstruse arguments may or may not be valid in certain circumstances. But we at the Federal Reserve are not prepared ~- least of all at this critical juncture for our economy — to commit ourselves to experiments with monetary policy on the basis of untested theorizing about operating without sufficient reserve balances. You will properly hold us accountable for contributing to progress in dealing with inflation and the other economic problems that beset us. part, we must have adguate tools to meet that challenge. For our In our opinionf a reduction in reserve balances held at Federal Reserve Banks (expressed in 1977 terms) to as little as $10 to $15 billion — terms — or about $11.5 to $17 billion in 1979 could prove adequate to conduct monetary policy, provided it is distributed equitably across depository institutions having transactions accounts* But we are not certain of that outcome,, and that level of balances -- some 4 to 6 percent of transactions balances and less than 1.5 percent of total deposits in depository institutions -- might not even adequately support Federal Reserve operational requirements* For that reason we would strongly urge at least standby capacity to obtain somewhat larger balances — up to $20 billion or more in 1977 terms* H.R. 7, in contrast, provides for less than $8 billion of balances (in 1977 terms), distributed among only 450 banks. The monetary policy need for an adequate level of reserve balances creates something of a quandary* Reduction of reserve balances of member banks to that level would not be sufficient to stem attrition in a purely voluntary system, because it plainly would not eliminate the burden of sterile reserves of Fed members* On the other hand, a reduction in reserve require- ments large enough to stop attrition would not provide a satisfactory level of reserve balances from the viewpoint of monetary policy, S. 353 would attempt to resolve this quandary, within the context of a voluntary system, by paying interest on the reserves held after some reduction, S. 85 or H.R. 7 approach the problem by making lower, non-interest bearing reserve requirements mandatory for all depository institutions having transactions types of accounts. However, H.R. 7 provides too small a reserve base covering too few institutions. S. 85 would achieve a much more sizable reserve base than H.R, 7. But it does so at the expense of sizable requirements on time deposits —• requirements high enough to burden significantly covered institutions relative to competing market instruments. The Federal Reserve Modernization Act (S._353) As I just indicated, the amended version of S. 353, proposed by Senator Tower, would deal with attrition from Federal Reserve membership in the context of a fully voluntary system. The bill seeks to eliminate the burden of membership by reducing requirements against most deposits and mandating that all balances held at the Federal Reserve to meet reserve requirements earn interest at rates close to, but still somewhat short of, market z&tes. Access to services would be restricted to members and to other institutions voluntarily maintaining balances in an amount equal to those required of a member of the same deposit size and configuration. Those services would be fully priced. Senator Tower's bill, unlike H.R. 7 and S. 85, provides for reserves on all savings deposits and on all time deposits of less than 18 0 day maturity. Such reserves would be interest bearing, and therefore would not have the same "tax" effect associated with such reserves in a mandatory framework. Thus, there would not be so strong an incentive to shift funds from -8- these types of accounts because of the reserve requirement, a phenomenon that has been of great concern to the Board in the context of mandatory reserves on time and savings accounts. Nevertheless, it seems apparent that members would still feel somewhat burdened relative to other institutions. In that connection, I would point out that, to maintain an adequate reserve base, actual reserve requirements imposed within the framework of S. 353 would need to be in the upper part of the ranges specified in the bill. I have examined this approach with care and have sympathy for its objectives because, as I have indicated to the Committee before, I understand and share the nostalgia for retaining elements of voluntarism in the operations of the Federal Reserve System. But, we simply cannot rely on nostalgia in conducting monetary policy. It is the considered conclusion of the Federal Reserve Board that the voluntary approach cannot practically be made effective within the framework of acceptable revenue loss to the Treasury and other objectives. Indeed, it is our judgment that membership attrition would probably continue, although at a much slower rate. Based on 1977 data, the cost analyses of the basic provisions of S 9 353 that 1 have attached show that the net cost to the Treasury of implementing that bill would fall in the range from $4 50 to $520 million annually. This appears to be far in excess of amounts acceptable to the Administration or many members of the Congress. The bill also encompasses the possibility of a mandatory supplemental deposit on transactions balances in an "emergency." As the Appendix table indicates, with such sup- plementary deposits yielding 1% percentage points less than a market rate (as would be the case under the amendment to S. 353 supplied to the Board by Senator Tower), the net cost would still not be reduced to acceptable levels even if the supplemental provision was to be invoked. The dilemma is that without payment of interest on reserves at or very near market rates., a purely voluntary system cannot stem attrition, but the payment of that interest drives up the cost. Moreover, it seems unlikely that An view of the highly efficient correspondent banking network throughout the country — many nonmember institutions would be prepared to place equivalent balances with the Federal Reserve to obtain access to services, Indeed, under S. 353 the effectiveness of monetary policy, whether viewed in terms of the size of the reserve base or ongoing access to the discount window,might ultimately swing on the extent to which nonmember institutions maintained balances to obtain "Fed" services. In any event, we would be left with the increasingly awkward problem of discriminating between members and nonmembers in the provision of certain services,such as automated clearinghouse payments, which for practical reasons cannot operate efficiently unless open to all depository institutions. Indeed, even now non- members have access to those automated services. -10- Therefore, I must conclude that attention should be directed toward approaches that would apply reserve requirements to depository institutions on a universal and mandatory basis. Such a universal approach has the enormous benefit of equitably applying reserve requirements to comparable accounts at thrifts as well as banksf at members as well as nonmembers. This is particularly important with respect to rapidly growing components of the nation's basic money supply, NOW and ATS accounts, many of which now escape reserve requirements altogether* I can readily sympathize with the desire to maintain a voluntary system wherever possible in the provision of governmental services. But, it would be ironic indeed to insist upon that approach for philosophical reasons in an area control of money — — which is clearly a specified constitutional function of the Federal Government/ even at the expense of impairing the effectiveness with which that function is discharged• It is possible to reconcile the seemingly conflicting objectives of equity for financial institutions, acceptable limits en the loss of Treasury revenues, and the provision of a large enough reserve base to ensure the effective conduct of monetary policy by use of a standby authority for interest- earning supplemental deposits at Reserve Banks along the lines that I suggested to the Committee last fall. Provision of such a supplemental would permit us to attempt to operate with a relatively small reserve base, while providing a "safety net" should experience prove that base inadequate to obtain sufficiently precise control over the money supply. It would entail no added cost to the Treasury and virtually no cost to the banking system* And, from a legislative viewpoint, it could easily be made part of any of the bills before the Congress. The amendment proposed for S. 353 in fact seems to accept the general logic of that approach. However, the pre-conditions for the imposition and retention of the supplement as specified in the amendment appear so restrictive as to impair its value. The amendment stipulates, for example, that the Board must find that the supplemental deposit is the only means to maintain effective control over monetary growth and it requires a unanimous vote of the Board, provisions that might make it impossible to use the authority even if the overwhelming majority of the Board felt it had enormous advantages over any conceivable alternative. The provision in the amendment that stipulates that the authority for the supplemental will expire after four years is perhaps a still more serious flaw. in four years. It may or may not be needed But, if the expiration date came at a time when supplemental deposits were in place, an obvious problem would be created for the authority would not be in use at that time -12- unless it was needed. On the other hand, the fact that it had not been used in four years should not indicate that it would never be necessary. We have no dispute with the point that the authority should not be used lightly and we would be glad to propose procedural safeguards to reinforce that point without vitiating its potential usefulness in a time of need* Provision of Services and Other Issues The amendments to S. 353 offered by Senator Tower to require charges for Reserve Bank services and for float are, in principle, acceptable to the Federal Reserve, and similar provisions are in other bills. We believe that pricing is a natural corollary to open access — but I would also emphasize, however, that open access and pricing are practicable only after reserve requirements are restructured and applied to all depository institutions. Pricing of System services likely will induce major changes in existing banking relationships. It may have differential effects on large and small, or city and rural, institutions. Overly rigid application of the principles, however sound these principles are, could cause disruptions in banking markets. Consequently, I would urge that the pricing provision allow a degree of flexibility in timing and implementation. For instance, -13- it should be clear that the Federal Reserve need not precisely match costs and revenues for every service. I would also urge that the Board be given authority, similar to that provided in H a R. 7, to permit exceptions to full cost coverage where required by the public interest, competitive conditions, or the provision of an adequate level of services nationwide * Indeed, the Board questions whether a charge for the receipt and disbursement of new currency is appropricite at all. The government might normally be expected to provide that service, and in any event, the Treasury already earns some $7 billion per year from the provision of currency through the interest earned on securities held by the Federal Reserve as collateral against that currency The Committee also should note that S. 3 53 does not address the technical problem relating to collateralization of Federal Reserve notes that can arise under legislation that reduces reserve requirements. We are prepared to supply an appropriate amendment that could be attached to S. 353 or to any bill that would deal with the problem* Conclusion 1 am convinced the essential elements of legislation to provide the Federal Reserve with the tools it needs to meet its responsibilities are at hand. The Board of Governors believes these elements should give concrete embodiment to the -14- following principles/ and these principles can be achieved without revenue loss. Reserves should be applied to all transactions accounts. Some relatively low exemption level, or a system of graduated requirements for the smallest institutions can be accommodated within this principle. - When and if reserve requirements are imposed on time deposits, they should be confined to shortterm nonpersonal accounts and be at a relatively low level. To establish comparable competitive conditions, reserve requirements should be equal for all depository institutions offering comparable accounts. - Authority should be provided to ensure that the reserve base is of adequate size for the efficient and effective conduct of monetary policy. Access to Federal Reserve services should be open to all depository institutions with transactions accounts, and the Reserve Banks should, in principle, aim to recover the full cost of those services from pricing — provided all institutions have a com- parable reserve burden. Consistent with the dual banking system, institutions should remain free to choose a State or Federal charter and membership in the Federal Reserve -15- System, with its implications for certain supervisory matters and for the election of Federal Reserve Eank Directors, should remain voluntary. These principles already are incorporated intof or could readily be added to two bills that are before you: H.R. 7. S. 8 5 and Last September I testified at length on specific modifications to improve S. 8 5 or H.R. 7 to bring them more fully into line with the essential objectives, and I have little further to add to the comments I made at that time. In conclusion, let me express again the Board's deep concern that prompt action be taken tc ensure that the Federal Reserve has, and for years to come will continue to have, adequate tools to manage the nation's monetary affairs and to ensure a sound and safe banking system. In light of the many new uncertainties facing our nation both at home and abroad, and the enormous challenge of dealing with inflation, we cannot responsibly permit attrition from membership to grow to the stage where it seriously disrupts monetary management and calls into question the strength and independence of the nation's Central Bank. fear we will soon be perilously close to that point. I have stated are consistent with prompt action. the opportunity before us to slip away. * * * * * * I The principles We must not permit APPENDIX February 1, 1980 Estimates for Monetary Improvement Legislation (1977 Data) Plan Break-points ($ millions) Reserve Ratios (percent) Transactions: Below break-point Above break-point Savings Time (1) Time (2) Actual 1977 S.85 As Amended 5/5 " 3 12 Without Supjglementa^ (High) (To^T 35/0 35/0 3 10 3 3 With Supplementalli/ TLQWT" 35/0 35/0 THTgiT) 3 10 3 3 0 VJ VJ 0 0 17.2 3.5 0 20.7 21.7 0 0 21.7 1.0 0 0 1.0 29.8 2.3 0.1 32.1 9.1 2.3 0.1 11.4 6.8 5.7 26.3 ( 4.8) 15.9 Revenues ($ millions) Cost of reserve requirement changes Interest on reserves Revenues from service charges and floatS/ 428 0 ( 657) 368 , 1 303*/ ( 657) 1,713 109^ ( 657) Net cost after taxes (55 percent rate) ', 99) 456 524 3«6 454 5,398 2,239 0 2,239 0 5,663 8,758 14,421 408 5,663 8,758 14,421 408 Reserve Balances ($ billions)-/ Member o Nonmember Thrift Total 27.3 0 0 27.3 Reserves released Coverage (Reserves at Fed) Commercial banks Members Nonmembers Total Thrifts 5,663 0 5,663 0 _ _°- 5~, 398 0 ( 3111 1,033 1,8251/ 6311/ ( 657) ( 657) Footnotes to Appendix Table a/ All depository institutions must hold supplementary deposits at Federal Reserve Banks of 3 percent of the first $35 million of transactions balances plus 5 percent of transactions balances above $35 million, b/ Nonpersonal time deposits, — I c/ Short-term time deposits. Includes supplementary deposits where applicable. % / e/ Interest on required reserves of 1/2 percent below the portfolio rate. / Interest on required reserves of 1/2 percent below the portfolio rate; interest on supplementary deposits of 1-1/2 percent below portfolio rate. Based on float outstanding of $3.8 billion at year-end 1977. Revenue from service charges assumed to be $410 million.
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