The issue of the relation between commercial banks and the central
bank is a broad, general one which, if I adhere to it, risks a
lack of focus in my remarks this morning. Nevertheless, I intend
to adhere to it because, as I reflected upon this subject, it
became clear that the relation is an important and far-reaching
one, with potentially significant implications for a country's
My "theme" this morning, in fact, is that a nation's commercial
banks and central bank are reflections of each other. They are likely
to succeed or fail together. While this theme may have some intuitive
appeal in the arena of bank supervision and regulationwhere
there are clearly overlapping if not common interestsit may
be less obvious in other areas of central bank responsibility and
of commercial bank activity. It is, however, my firm conviction
that the conduct of monetary policy (macroeconomic stabilization
responsibilities) and payment system responsibilities are also critical
components of central bank-commercial bank relations.
In market economies, the banking system plays a critical role
in gathering funds from the publicmobilizing savingsand
in channeling these credit resources to their most effective uses.
Economies with minimal or underdeveloped banking systems will
typically find capital formation, productivity and growth inhibited.
An effective banking system can contribute over time to economic
The banking system is also a major processor of paymentsfrequently
the backbone of the payments system of a country. The role of
an efficient, reliable, smoothly functioning payments system,
as a contributor to economic prosperity, often is overlooked or
at least underestimated because it is taken for granted in many
industrial countries. We assume, when depositing funds with currency
or check, that appropriate credit will occur, and the counterparty's
account correctly debited. And we assume the same scenario with
the electronic movement of funds. In countries geographically
vast, for example the United States and Russia, timely movement
of balances and account information is no small accomplishment.
Yet the effective conduct of commerce, at a high and sustainable
level, depends on it. Businesses and consumers need to be confident
that funds are transferred timely and accurately; if not, the
economy has to rely too heavily on cash and/or barter, inherently
less efficient means of payment.
Integral to a smoothly functioning payments system, are intangibles
which, as experience demonstrates, are critical in virtually all
aspects of banking. These intangibles are concepts such as confidence,
trust, integrity and stability. In the United States, consumers
and businesses worry little if at all about the mechanics of payments.
They that know with confidence that the system can and will move
funds and information routinely, within specific deadlines, and
rarely give it a thought. This is what I meant about underestimating
the importance of a payments system.
Similarly, there is a good deal of confidencetrust, if
you willthat the financial institutions doing business today
will be there tomorrow. It has not always been so, but today's
system is reasonably stable.
The Federal Reserve System, through the 12 district Reserve banks,
is a major provider of payments services. The Fed is active in
check clearing, electronic funds transfer, securities transfer,
currency provision and destruction, and the accounting of commercial
bank reserve balances that coincide with payments. Commercial
banks, of course, are also major providers of payments services,
and in general deal with a much broader range of customers than
the central bank. In the United States, the Fed provides payments
services directly only to insured depository institutions.
The Federal Reserve is also a regulator of payments system practices
and provides a safety net under the U.S. payments system, explicitly
with regard to movement of large dollar funds by wire and implicitly
under other payments in times of instability and disruption. It
should be emphasized that large dollar payments systems, where
banks exchange claims on each other, are vulnerable to major disruption
should a participant fail. Such systems handle a large volume
of payments for goods, services and financial transactions, and
failure of a participant could be highly disruptive to the financial
system and, potentially, to the economy. Because of the magnitude
of these consequences, the central bank has a role to play in
assuring the integrity of the system.
To be sure, there is tension from time to time between commercial
banks and the central bank over payments issues, due to the Federal
Reserve's dual role as regulator of, and participant in, the payments
system. We in the Federal Reserve System have dealt with this
tension by establishing a barrier between our regulatory responsibilities
on the one hand, and our participatory activities on the other.
Nevertheless, some tension remains.
I believe most would agree that, both through regulation and
provision of the safety net, the Federal Reserve has contributed
to the reliability of the payments system and has helped to provide
and to strengthen those intangiblestrust, confidence, stabilitywhich
I earlier emphasized. Our direct participation in the provision
of payments services has contributed as well, particularly in
times of stress in the banking system when direct, hands-on experience
is of particular value in resolving problems.
As these comments imply, an effective banking system requires
a high degree of trust and confidence. It is here that a central
bank's supervisory and regulatory responsibilities are particularly
valuable because, if carried out thoroughly and well, they can
provide assurance that banking institutions are conducting their
affairs in a safe and sound manner, and in a manner consistent
with international banking standards. This helps to give customers,
domestic and foreign, confidence that they can count on the performance
of the institutions in question. I am convinced that effective
supervision and regulation is in the interest of commercial bankers.
It helps to make their institution credible, internationally and
domestically, so that they can participate fully in global markets
and with a diverse base of customers.
Supervision alone will not accomplish such participation, however.
A comprehensive financial infrastructure, encompassing the foundations
of law, accounting and regulation, is needed for the success of
a market-based banking system. More specifically, a legal framework
that protects private property rights and that supports debt recovery,
liquidation and bankruptcy is essential. Adoption of accounting
and auditing standards comparable to those accepted internationally,
which will measure the conditions of banks consistently and accurately,
is also critical.
It is instructive to note that over its history the United States
has experimented with both banking structures and approaches to
banking supervision. For example, during the Free Banking Era,
roughly a 25-year experiment in the middle of the 19th century,
US banks were restricted by law and regulation much less than
ever before (or since). Allowing such freedom in banking did not
work well: Many free banks closed, and many of the notes they
issued lost value. Thus, customers of the free banks were losers.
One explanation for this performance is that little government
oversight encouraged dishonest bankers to form so-called "wildcat
banks" whose purpose was to defraud the public.
A more careful reading of the evidence on this period suggests
a different explanation, however. Bank problems, rather than attributable
primarily to fraud, resulted from declines in the prices of bank
assets, leading to impairment of bank capital and to runs on banks
and in some cases to insolvency and/or closure. Many of the banks
opened in the free banking states, although initially reasonably
well capitalized, had asset portfolios that were insufficiently
diversified and insufficiently liquid to weather the economic
shocks of the period. Whatever the cause, it is undeniable that
free banking did not work well.
The Federal Reserve System was established in 1913 after a series
of financial problems and panics which had characterized the second
half of the 19th century and the early years of the 20th. There
were several problems with which banking systems of the time seemed
unable to cope:
- Money and credit did not, at times, grow commensurately with
the needs of the economy. Economic expansion thus was constrained
by financial shortages.
- There were sharp seasonal fluctuations in the cost and availability
of credit, which were disruptive to sectors of the economy.
- There were impediments to the flow of credit to its most
effective uses, thus interfering with the efficient allocation
Not only were financial institutions and their immediate customers
affected by these problems, but also such disruptions frequently
spilled over to adversely affect the level of employment and output
in the economy more generally. Part of the problem, as during
the free banking era, was that bank asset portfolios were insufficiently
diversified, in terms of both type of credit and geographic location
of the borrower, so that, once a "shock" depressed values, the
effects on particular institutions could be very large.
In response to these problems, the new central bank was to prevent
or at least contain banking panics, to provide for growth in money
and credit in line with the needs of the economy, and to smooth
out seasonal fluctuations in credit availability. These objectives
are still with us today, 80 plus years after formation of the
As demonstrated particularly by the Depression of the 1930s,
achievement of the original objectives of the Federal Reserve
Act did not come easily and, indeed, central banking in our country
is still evolving. The difficult experience of the 1930s led to
changes in the Federal Reserve's structure which remain in place
Significantly, legislation of the 1930s also expanded the safety
net underpinning banking, with the establishment of deposit insurance.
Deposit insurance changed the financial landscape profoundly by
making the banking system far more stable and less subject to
runs by nervous depositors. It also altered incentives for bankers,
leading to a tendency to excessive risk taking in their portfolios
and practices, although it took some time for this tendency to
Deposit insurance creates a "moral hazard" problem. When insured,
depositors have little if any incentive to care about the calibre
of the institutions with which they do business. Hence, risk taking
is priced too low, and as a consequence too much risk is assumed.
Some remedies that have been suggested are to limit or eliminate
insurance; to raise bank capital requirements, so owners have
more at stake; and to regulate and supervise bank activities so
as to avoid excessive risk taking.
The rationale for the supervision and regulation of banks by
the Federal Reserve and other regulatory organizations is to offset
the tendency for excessive risk taking as a consequence of deposit
insurance and other elements of the safety net. Deposit insurance
is a valuable subsidy to banks, but the cost is that the institutions
are subject to regulation and supervision of activities, essentially
a quid pro quo.
Thus, despite commitment in the United States to market determined
outcomes, the banking system has been deemed "special," sufficiently
special so that at least some of its creditors (depositors) are
protected by a safety net of deposit insurance. In addition, banks
have access to the Federal Reserve discount window to meet short-term
and seasonal needs for liquidity. All such borrowing from the
Federal Reserve is fully collateralized. The United States has
made the public policy choice to enhance the stability of the
banking system with the safety net; many other countries have
made the same decision. Once such a decision is made, supervision
and regulation of banking logically follow.
The focus of supervision is to assure banks are well managed,
with strong earnings and capital positions, ample liquidity to
satisfy increases in loan demand or deposit withdrawals, and high-quality
assets well diversified by borrower, economic sector and geography.
Banks that fail to display these characteristics are subject to
supervisory actions to strengthen their position.
As would be expected, tension can arise from time to time between
commercial banks and the central bank in the supervision and regulation
area. From one perspective, this is as it should be, for the regulator's
responsibility is not that of advocate of, or spokesperson for,
the industry. Rather, the regulator must keep public policy objectives
at the forefront, objectives which will benefit the economy as
a whole rather than banking or any other specific industry.
Nevertheless, many bankers no doubt see considerable value in
supervision. It acts as an objective outside check on their policies
and practices, "certifying" their soundness and integrity. Further,
it adds to banks' credibility, assuring customers, domestic and
foreign, that the institution meets solid prudential standards.
This assists the bank, and the system as a whole, in attracting
and retaining resources, to the long-range benefit of the economy.
Increasingly, regulations, and in particular requirements for
bank capital, have become standardized internationally under the
auspices of the Bank for International Settlements. The advantages
of such an approach are clear. When banks adhere to such standards,
they and their customers can be reasonably confident of the quality
of the institutions with which they are dealing. Uncertainty is
reduced. Moreover, the playing field for banks competing in the
international arena is leveled.
The third major area of responsibility of the US central bank
is monetary policy. While this function may at first seem far
removed from the banking issues and concerns I have previously
discussed, it is in fact integrated with these other matters.
It is very difficult to have an effective, smoothly functioning,
sound banking system in an unstable macroeconomic environment.
An unstable economy may have several unfavorable consequences.
The health of particular sectors of the economy will ebb and flow,
in the process imposing losses on creditors (banks) and possibly
on their depositors as well. I've commented previously on the
need for diversification of a bank's asset portfolio, but even
extensive diversification may be insufficient if the economy swings
sharply between boom and recession. There is no doubt that bank
balance sheets are healthier in a sound economy. Conversely, there
is no practical way for banks to avoid all the effects of dislocations
in their domestic economy.
Instability marked by rapid inflation undermines the value of
the currency and can contribute to a flight from deposits in the
home currency. Rapid inflation also can make it difficult for
bankers to judge the creditworthiness of various business enterprises,
thus interfering with sound credit extension practices. Inflation
may also spur a return to barter, a highly inefficient transactions
Inflation adversely affects economic performanceresource
allocation, growth, productivitybecause price signals are
distorted. Decision-makers have difficulty distinguishing between
a general rise in the price level and a change in relative prices.
The latter should shift resources to the activity where prices
have risen, while the former has no such implications for resource
A good deal of evidence has now been accumulated which demonstrates
that countries with low inflation generally outperform economies
with high inflation. Similarly, evidence demonstrates that, over
time, the economy of a given country performs better, in terms
of employment, growth, and so on, in periods of low inflation.
There is even a school of thought that says the severity of the
Depression of the 1930s in the United States was in part a consequence
of flight from the dollarbecause of fear that it would depreciate
in value relative to other currenciesrather than a run on
US banks, because of fear of their failure.
It is widely acknowledged that an overly expansive monetary policy
is the root cause of persistent inflation. The central bank may
simply permit money and credit to grow too rapidly. On the other
hand, the central bank may be responding to a variety of pressures:
pressure to finance large fiscal deficits, pressure to achieve
unrealistically low unemployment targets, pressure to provide
short-term support for faltering business enterprises, to name
At least in the United States, and I suspect in many other countries,
banks are central to the transmission of monetary policy to the
economy at large. It is the banking sector that is among the first
to feel the effects of changes in monetary policy, as reserve
conditions are directly and promptly affected by Federal Reserve
Banks, in turn, transmit policy changes to at least some of their
customers. Borrowers with floating rate obligations may be affected
almost immediately, and other customers may well find conditions
changed when they come to roll over loans or to obtain new credit.
While large, international businesses frequently have direct
access to domestic and foreign financial markets at competitive
terms, medium and small-sized businesses tend to rely much more
heavily on banks, and other intermediaries, for financing. It
is such businesses, as well as consumers, that typically are most
significantly affected by policy changes. For even if all borrowers
face the same general change in interest rates, customers of banks
and other intermediaries may experience a change in creditor attitudes
which can magnify the effect of the change in rates, for better
or for worse.
Let me conclude by summarizing the points I have attempted to
make this morning. It is my view that commercial banks and the
central bank of a country are reflections of each other. A healthy,
efficient banking system goes hand-in-hand with a dependable,
independent central bank. The activities of both are inextricably
intertwined, and the institutions undeniably share a commonality
Central bank supervision of commercial banks, helping to assure
maintenance of standards and sound banking practices, contributes
to the health of the industry and to the trust and confidence
upon which banking depends. The safety net contributes to this
objective as well.
Similarly, effective central bank stabilization policy provides
an environment in which banks can thrive; one in which they can
go about the business of meeting the legitimate needs of their
customers without undue concern for capricious fluctuations in
economic conditions or asset values.
Further, as I have noted, a reliable and efficient payments system
in which both commercial banks and the central bank participate
enhances economic activity, encouraging smooth exchange of goods
and services and of financial claims, and efficient allocation