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Presented by Anthony M.
Federal Reserve Bank of Philadelphia
Oesterreichische Nationalbank's 30th Economics Conference
'Competition of Regions and Integration in EMU'
Hofburg Palace, Vienna
June 13, 2002
The role of national central banks in Europe has been a subject of much deliberation, especially since the introduction of the euro. The euro area constitutes a vast geography and much economic diversity - characteristics not unlike the United States. It is an honor to participate in this event, which brings together so many prominent individuals from various nations, to discuss this important and timely topic.
As a former academic with considerable European experience and a current central banker in the U.S. system, I would like to share with you my perspectives on the U.S. experience with our central banking system. I will leave it to my audience to make the parallels and contrasts with the current and still emerging structure in Europe. However, I will try, by topic selection, to spotlight relevant points of comparison.
As you all know, the Federal Reserve System serves as the central bank of the United States --- the epicenter of our financial system. It controls the monetary base of the economy to affect interest rates and inflation; it provides liquidity in times of crisis; and, it ensures the general integrity of our financial system.
The Federal Reserve's decentralized structure has been a positive force in the U.S. economy. I believe it has proved a vital, and indeed very practical, structure for our central bank. Throughout its history, decentralization has provided the local context and contact necessary for effective policymaking.
A key to the success of our decentralized structure is its flexibility. To be sure, there is no single model that works everywhere, or all of the time. In fact, it is just the opposite. The structure of a central bank must fit the economic and political realities of the time, or it will not survive. It must evolve in response to the unique features of the economy it serves. This adaptation is a constant challenge with new twists and turns along the way.
Let me begin with some history. In 1913, the U.S. Congress established the Federal Reserve System to serve as our central bank. The System comprised 12 independently incorporated Reserve Banks spread across the United States, operating under the supervision of a Board of Governors in Washington, D.C.
Why did the central bank come along so late in the economic history of the United States? Moreover, why was it given such a decentralized structure?
The answers to these questions are interconnected. In fact, the United States had made two previous attempts to establish a central bank. The First Bank of the United States was established in 1791, and the Second Bank of the United States was established in 1816. Congress gave each an initial 20-year charter. Yet, neither was able to muster the political support to have its charter renewed. Therefore, the United States spent most of the nineteenth century without a central bank.
By the early twentieth century, a series of financial panics and economic recessions further demonstrated the need for a central bank. It became widely recognized that the nation required a more elastic supply of money and credit to meet the fluctuating demands of the marketplace. It also needed a more efficient infrastructure for transferring funds and making payments in the everyday course of business, particularly by check.
While the need for a central bank was clear, so were the reasons to be wary of one. Many people, particularly small businesspeople and farmers across the South and West, were concerned that a central bank headquartered 'back East,' in either the financial center of New York City or the political center of Washington D.C., would not be responsive to their economic needs.
In some sense, this was a replay of the broader governance issue the United States wrestled with from the beginning of its short national history. The thirteen colonies saw the need to bind together and form a nation, but they were wary of ceding power to a national government. It was out of that tension that the federal government of the United States was forged in my hometown of Philadelphia, Pennsylvania, with the establishment of the U.S. Constitution.
The Constitution provided for the establishment of a federal government that acknowledged and preserved the rights of the states, and a system of checks and balances within the Federal government. In this way, power was not unduly concentrated in any one individual or group.
To galvanize the necessary political support to establish a central bank, President Woodrow Wilson and Congress drew on the now familiar model of a federal structure. That structure, embodied in the Federal Reserve Act of 1913, essentially remains intact today.
Overseeing the System is a seven-member Board of Governors appointed by the President of the United States and confirmed by the United States Senate. The 12 Reserve Banks, spread across the country --- from Boston to San Francisco --- each serve a defined geographic area, or District. Each Reserve Bank is overseen by its own local board of directors, with some elected by the local District banks and some appointed by the Board of Governors in Washington. The Reserve Bank board of directors selects a president, in consultation with the Board of Governors, who serves as CEO and chief operating officer.
Our founders' original vision was that the 'central' in the central bank would be minimized. That is, the Reserve Banks would be relatively autonomous bankers' banks providing a full array of services to the banks operating in their Districts. The Reserve Bank would extend credit directly to District banks with short-term liquidity needs on a collateralized basis through rediscounting. Banks would also maintain reserve accounts at their Federal Reserve Bank and use those accounts to clear checks, move funds and obtain currency for their customers.
Of course, the original vision of self-contained regional banks began to erode almost as quickly as the System was established. Technological change and the dynamics of the marketplace were driving the U.S. economy, particularly its financial and payments systems, into a more fully integrated entity. The Federal Reserve System would have to integrate the activities of its various components as well. Indeed, this is exactly what has happened in the Fed over the course of its history, and what continues to happen today.
This integration has occurred on all levels, from making policy decisions to managing backroom operations. It occurs through all our central bank lines of business --- monetary policy, bank supervision and regulation, and payment system support.
Yet, the integration continues to evolve within the context of the 'federal' structure established almost 90 years ago. I consider this a testament to the Federal Reserve's flexibility, and also to the value of its structure in achieving the Fed's mission.
Let me be specific about how the Fed has evolved its decentralized structure in each area of its operations.
When the Fed was founded, the notion was local economic conditions generated local credit conditions, and regional Reserve Banks would help the regional banks address them. Meanwhile, with the nation on the gold standard, the overall supply of money --- and hence the long run price level --- was out of the central bank's hands.
Today, we think of monetary policy as an independent tool at the central bank's disposal to help stabilize overall economic performance. The establishment of the Federal Open Market Committee was the pivotal event in the evolution of the Fed to an independent, activist, monetary policymaking body with national macroeconomic objectives.
Although not formally established until 1935, the history of the FOMC begins in the 1920s, when regional Banks began looking for a source of revenue to cover their operating costs. As you may know, the Fed does not receive an appropriation from Congress. Instead, it funds itself from the return on its portfolio. In fact, it was with the intention of funding their operations that each of the Fed Banks began to purchase government securities. Eventually, these assets were managed collectively by the Federal Reserve Bank of New York. This portfolio became the System Open Market Account, through which the Fed now conducts open market operations.
Gradually, it was recognized that the Fed's open market securities transactions had a powerful and immediate impact on short-term interest rates, and the supply of money and credit. Over time, open market operations became the central tool for carrying out monetary policy.
Congress created the structure of the FOMC in the midst of the Great Depression. As you all know, the FOMC consists of the seven members of the Board of Governors and the 12 Reserve Bank Presidents. Because the FOMC is a mix of Presidential appointees, the members of the Board of Governors, and Reserve Bank Presidents, who are selected by their respective Boards of Directors, the FOMC is a blend of national and regional input of both public and private interests.
The fundamental insight is, while there can be only one national monetary policy, making the right policy decision is the product of sharing perspectives from different regions of the country.
The Reserve Bank presidents provide both valuable up-to-date intelligence about economic conditions, and the perspective of businesspeople about prospects going forward. They glean these from their meetings with their Bank's board of directors, advisory councils, informal 'town meetings' around their Districts, as well as the contacts they make in the everyday course of operating a Reserve Bank.
Some of this finds its way into our regional reviews, the so-called Beige Book, but even this suffers from time lags and a formulaic approach to gathering intelligence. Our real time grassroots perspective is valuable for helping to overcome the fundamental challenge to monetary policy --- the effects of long and variable lags on its impact.
Beyond this, the Reserve Bank presidents can also bring broader perspectives on monetary policy. On a theoretical level, differences can coexist on the structure of the economy and the role of monetary policy, with well-known examples of the monetarist perspective championed by the St. Louis Fed, and the real business cycle perspective supported by research at the Minneapolis Fed. On a more practical level, differences still exist in the geographic distribution of industries across our nation. The perspective of some regions give particularly useful insight into certain parts of our economy, for example, San Francisco's technology focus and Chicago's heavy industry concentration.
Decisions are usually made by consensus, so unanimous decisions are usually the rule rather than the exception. Nonetheless, we do have a voting procedure. The 12 voting members make the formal decision of the FOMC. All seven Governors vote at all times, while only five of the 12 Presidents vote, on a rotating basis. Philadelphia happens to be a voting member in 2002. In any case, we all participate on equal terms in the discussion and consensus building that leads to the formal policy vote.
Once the FOMC has made its decision on the appropriate target level for the federal funds rate, it is up to the Fed's trading desk located at the Federal Reserve Bank of New York to achieve the objective. To facilitate that process, a policy directive is drafted requesting the appropriate action by the New York Desk to achieve the overnight borrowing rate target.
Time has shown that the structure of the FOMC uses the decentralized Federal Reserve to its best advantage. This structure allows for the generation of well-informed monetary policy decisions at the national level, plus an ability to communicate our decisions and rationale to various parts of our nation. This two-way exchange of information enhances our capability to monitor the economy, and build consensus for the needed policy action.
Monetary policy is the role for which central banks are best known. But, the Fed also plays an integral role in the U.S. payments system. In fact, payments processing is the largest component of Fed operations. Systemwide, the Federal Reserve Banks employ over 23,000 people. Of these, about 12,000 --- roughly half --- are involved in payments.
Over the years, the Fed's decentralized structure has given us an advantage in supporting the payments system. The U.S. has long been a nation of many small banks serving relatively limited geographic areas. Establishing a network for the efficient movement of money among them is one reason the Fed was founded. One of the Fed's first projects was setting up a check clearing system. In that system, each Reserve Bank provided the banks in its district with a local clearinghouse, and access to a national clearing network through its sister Reserve Banks.
As early as 1918, the Reserve Banks also gave the banks in their District convenient access to a national electronic funds transfer network Fedwire. At that time, the transfers were via telegraph connection among the Reserve Banks.
The traditional paper-based means of payment --- cash and check --- still require a decentralized delivery network. However, over time the movements toward electronic payments and mergers in the U.S. banking industry have been driving the Fed towards greater coordination and consolidation of payments services. Accordingly, the Fed has reorganized to provide nationally managed services through the decentralized structure of the regional Reserve Banks.
First, at the strategic level, the Federal Reserve has established the Payments System Policy Advisory Committee (PSPAC). Its mission is to set the direction for Fed payments activities Systemwide. Like the FOMC, the PSPAC is a committee of Fed Governors and Reserve Bank presidents.
Second, at the operational level, the Reserve Banks coordinate their payments operations through national product offices, reporting to the so-called Financial Services Policy Committee. By this means each payments product is centrally managed by one Reserve Bank and delivered as appropriate through the Reserve Bank distribution network.
I have discussed the benefits of the Federal Reserve's decentralized structure on the monetary policy decision process, as well as on its evolving role in the nation's payment system. This structure has also served us well in our third area of responsibility, bank supervision and regulation.
As noted a few moments ago, the U.S. has long been a nation of many small banks, serving local communities in narrow geographic areas and offering relatively limited product lines. This was primarily the result of government regulation. Long-standing state laws prohibited banks from branching across state lines, and frequently other political boundaries as well. Then, in reaction to the Great Depression, the U.S. Congress passed legislation prohibiting commercial banks from engaging in investment banking or insurance activities.
During this period in our history, under delegated authority, local Reserve Banks kept a close watch on the safety and soundness of the local banks under their jurisdiction.
But, recently, in the U.S. and around the globe, a deregulation wave has cut away the thicket of limitations on banks' activities. Now technology and the marketplace are driving banking organizations to expand their geographic reach and diversify their array of product offerings. The result has been the growth of larger and more complex banking organizations with national or international scale and scope.
Through this process of change, the Federal Reserve's role in the regulatory structure has been expanding. Congress first entrusted the Fed with the responsibility of regulating all bank holding companies, and more recently we have been assigned the additional role of 'umbrella supervisor' for newly formed financial holding companies. As such, the Fed aggregates the assessments of other financial service industry regulators to form an enterprise-wide view of risk and protect depository institutions.
To fulfill our responsibilities in this new environment, the Federal Reserve has been transforming its supervision and regulation function. Our focus has shifted from point-in-time financial statement reviews to continuous risk based assessments; from on-site examinations to early warning systems; from strictly financial evaluations to ones that include increased emphasis on community lending and technology. Furthermore, in light of the shift toward broad financial holding companies, we are working in closer cooperation with other banking and financial industry regulators.
In addition, to properly oversee larger, more complex organizations, we have employed new and more sophisticated analytical tools, and have consolidated examination reports from geographically dispersed subsidiaries into overall financial profiles.
Our approach has been the Systemwide coordination of bank supervision to achieve efficiency in staff deployment, yet still gain the benefits of specialized knowledge. Still, we have maintained face-to-face contact with the regulated institutions, as well as the use of on-site examinations. In the end, even with all the changes in the financial services industry, there is no substitute for first-hand knowledge of the organization and its leadership. Our Reserve Bank network allows the Fed to have geographic proximity, which substantially improves our ability to know the institutions we regulate.
Before closing let me say a few words about September 11. The events of that day, and the days and weeks that followed, put many aspects of the U.S. financial system to the test, and demonstrated its resiliency.
At the Fed, our response to those events was a coordinated effort across all its areas of responsibility and across our entire Fed System. We kept the payments system operating, provided access to credit for affected banking institutions, and implemented aggressive monetary expansion. Our ability to feel the pulse of financial activity across the country, operate in multiple locations, and coordinate our efforts to assure financial stability is a testimony to our present organizational design.
Looking ahead, the terrorist attacks on New York and Washington have caused many organizations, public and private, to see new value in a decentralized operational structure. A recent Fed assessment of the lessons from 9/11 reached a conclusion that applies not only to financial institutions in general, but to the Federal Reserve System as well: ' geographic diversity for critical operations and backup facilities should be a key consideration of business-resumption plans.'
Since its creation almost 90 years ago, the Federal Reserve has survived, and succeeded, by evolving. Through Congressional mandates and its own internal restructuring, the Fed has proved an ever-changing entity, decentralized yet coordinated. The trends in the financial sector imply a continuation of the move toward a single national market, with a growing number of national and international players. As a result, further coordination and consolidation of activity is inevitable.
Yet, even as we develop into a more fully integrated organization to better address our central bank responsibilities, we continue to extract value from our decentralized structure.
Today, the regional structure of the Federal Reserve System is one of its greatest strengths. This has proven true both in normal times and times of crisis. While the process of change will continue to challenge the Fed, it is worthwhile to reflect on our strengths and our successes. The System's structure fits both categories.