The Region

Interview with Clyde Farnsworth

David Levy | Vice President

Published June 1, 1990  | June 1990 issue

It's said that financial management is one of Clyde Farnsworth's strengths, and that's to the benefit of the Federal Reserve System. For, as director of the Division of Federal Reserve Bank Operations for the Board of Governors in Washington, D.C., Farnsworth has oversight responsibility for the nation's payment system, Federal Reserve services to financial institutions and the Fed's automation and communications system.

Further still, Farnsworth is called on to use that expertise to supervise the financial planning of the Federal Reserve Banks, which includes oversight of annual operating and capital budgets of approximately $1.3 billion.

Of his management style and responsibilities, Farnsworth frankly states: "I require and demand a quality product from the staff, and I expect a quality product from the Reserve Banks."

When Farnsworth joined the Board in 1975, he was no stranger to the Federal Reserve System, having previously served as assistant vice president and economist at the Federal Reserve Bank of Richmond.

Farnsworth, who received a masters degree from East Tennessee State University and a doctorate from the University of Missouri, has also held teaching positions at Virginia Tech and Clemson University.

In the following interview, Farnsworth discusses the Fed's role in the marketplace, the impact of technology on the Fed System, and proposals to consolidate some operations.

Region: Your primary responsibility for the Board of Governors is operations oversight for the Reserve Banks. What does that mean?

Farnsworth: Operations oversight is a very broad term. It covers a wide range of responsibilities. I think the most important have to do with protecting the safety and soundness and integrity of the nation's central bank. Other than that, the responsibilities primarily involve trying to make sure that the System is moving in the right direction, keeping pace with payments system developments, and that the operations of the Federal Reserve are consistent with the direction—or in some cases even leading the direction—of financial institutions in the private sector. Specifically, my division has oversight responsibility for financial services, automation and communications planning, and financial control, including Reserve Bank budgets, accounting and auditing.

Region: Those who have worked with you on various projects have reported that one of your strengths is financial management. Is that correct and if so, how are you able to best apply those skills in the wide range of activities that you oversee?

Farnsworth: I guess one of my strengths would be considered financial management. I don't know whether that's another term for being fiscally conservative, but I think that probably does characterize my style quite a bit. I do pay a great deal of attention to financial management issues. The System has a number of very big, multi-year projects. I think the way we plan and implement those projects has a great deal to do with the eventual success of those projects. In the operations area, most of our services are priced, so we're forced by competition, in essence, to put in new systems as efficiently as we possibly can. So in looking at some of the major long-range projects such as the Systemwide communications network and electronic payments processing systems, it's critical that those System projects are as well-controlled as they are designed, developed and implemented.

Region: You have an excellent vantage point to observe changes in the System. How would you describe the long-term direction of Reserve Bank activities? Do you see shifts or major thrusts?

Farnsworth: I think we are at an advantage in Washington in being able to stand back from direct hands-on operations and look at longer-term trends in the System.

The major priced service in the past has been the paper check. I think that has made up something on the order of 65 to 70 percent, maybe even more, of our total revenue. Our belief is that Federal Reserve check volume will stabilize and possibly decline in the future, and there are a number of reasons for that. One is that we're faced with, to some extent, the Postal Service problem—that is, we're required to take the work of any depository institution that wishes to give us work. We are seeing and will continue to see the more expensive work coming to the Federal Reserve and the easier, higher profit margin work going to the private sector. I think that the Federal Reserve will see less and less of the item processing work. Another reason results directly from consolidation in the banking industry, meaning that more checks will clear internally, that is, on the books of the consolidated bank. As a result, our volume probably will not grow as fast as the total volume of check business.

On the electronic side of the payments processing operation, I think we see some of the same kinds of things as on the paper side—both domestically and internationally. And, Federal Reserve processing volumes are likely to grow less rapidly than they have in the past.

Region: How do you view the movement toward electronics in Fed operations?

Farnsworth: It's clearly more efficient to process payments electronically, and there are a number of other applications for electronics in the System. The Minneapolis Reserve Bank has been one of the primary movers toward electronic check truncation of items, especially in northern Michigan where a pilot is being conducted. We will continue to see more of that kind of thing. We have an interest in moving from paper to electronics because of the efficiency and the overall improvements electronics can bring to the payments mechanism.

Region: Do you see any drawbacks to the continuous "technologizing" of financial services?

Farnsworth: Yes, there are some drawbacks. Technology causes us to look at some things differently than before. We have to look at risk in a different way, and assess risks, both operational and credit, in the payments system. In the electronic world, this can be difficult. The easier risks to handle are those that have to do with protecting the integrity of the electronic system by things like sophisticated message scrambling and authenticating messages. That's the easier side.

The more difficult side has to do with the systemic risk issues, that is, the risk in a private-sector network that one participant's inability to settle at the end of the day will cause other institutions to be unable to settle as well. Funds move very rapidly electronically, and we have to be cognizant of the risks associated with the failure of an institution to be able to cover its payments. And because those payments are so large, the failure of an institution to cover its position can have a mushrooming effect or a domino effect on other institutions. We refer to that as the systemic risk. We're not only concerned about that domestically but internationally as well.

The dollar continues to be the world's basic monetary unit. Transactions in countries all over the world are denominated in dollars. And even though U.S. institutions may not be a principal in the transactions, such transactions can ultimately have an effect on the Federal Reserve and depository institutions in this country because the transactions are being made in dollars rather than in Japanese yen, deutsche marks, French francs or whatever the currency may be.

Region: A Federal Reserve task force has examined the possibility of consolidating some of the System's computer operations. Specifically, it examined the feasibility of reducing the number of mainframes to avoid duplication of efforts and to save money. The preliminary findings are complete, and they generally recommend that consolidation makes sense. Are you in a position to offer any comments?

Farnsworth: I think conceptually anyone who looks at consolidation would have to say that it makes sense. It's not that much more expensive to have a very large mainframe than it is to have a smaller mainframe. And it's not difficult at all to see that three or four mainframe computers can do the job more efficiently than 12 or 13 mainframes. So I think consolidation, at least from the conceptual point of view, makes a great deal of sense.

The other parts of that have to do with the standardization of the Federal Reserve product. All of the Federal Reserve Banks are interested in continuing to tailor services to meet the needs of their own depository institutions. Standardization can take place, however, one step back from that. The depository institution itself probably would not even know where the mainframe resides, nor would it care, as long as it's getting services that it's asking for. The main contact for depository institutions in a consolidated world, we think, will continue to be their local Federal Reserve Bank.

A substantial part of the real savings are derived from development of standard software. Some development, of course, will very likely continue at each bank, but the major development staffs will be concentrated in a smaller number of locations, which should enable the Federal Reserve to save considerably in staff resources.

I personally believe that the quality of services at the Federal Reserve can be made much better by consolidation, but there is a debate in the System. There are others who believe that the quality of the product may suffer. Right now, if the Federal Reserve decides to put a product into service, we generally wait until the twelfth bank is ready. And if that twelfth bank or one of the other banks believes it cannot provide some unique feature, in many cases the entire System will drop that feature.

In a consolidated world of say three or four main processors, I think it's very likely that the overall quality of the product is going to be higher.

Region: The Federal Reserve System was designed over 75 years ago to be decentralized. Fed watchers have observed that a result over the years is a healthy tension between the Board of Governors and the 12 District Banks. Do you agree that a tension exists and that indeed it is healthy?

Farnsworth: There is no question that there is tension from time to time between the Board and the 12 Federal Reserve Banks. Often that's healthy; occasionally it is not healthy. I think each, and I'm speaking of the banks as a group and the Board as an entity, has its strengths and each has its weaknesses. The Reserve Banks are closer to the community and to their depository institutions. From an operational standpoint they're obviously closer to the operations. So they can see some things that a person sitting in Washington cannot see.

On the other hand, the Board's staff and the Board of Governors have a different perspective from the Reserve Banks. We don't have a vested interest in many of the things that a Reserve Bank would, so that allows us to step back and look in a more open way than the Reserve Banks. I think the healthy part of the conflict is confined to the fact that it takes place as a result of honest differences of opinion.

Region: In the last several years, by your direction a number of working groups have been formed to solve banking problems outside the United States. Is that correct?

Farnsworth: I would say the Federal Reserve has been instrumental in bringing banking issues to the attention of foreign central bankers, and I have been fortunate enough to represent the Board of Governors on two or three Bank for International Settlements (BIS) groups, working with representatives of 10 other countries. Two of those groups, in particular, have moved us into areas that are very interesting from a worldwide point of view: a group of computer experts and a group of payments experts. Governor [Wayne] Angell is the chairman of the payments group, and he has done a great deal to move the group forward into looking at some issues that many of the central banks really didn't think were very important three or four years ago. Lately, the work of the payments group has expanded rather dramatically.

As a result of the work of the payments group, a committee of central bank governors was formed to look at risks associated with the systems used to clear or exchange payments, as well as the credit risk exposure that depository institutions face in settling these exchanges of payments. The problems posed in settling foreign exchange transactions illustrates some of these issues. If an institution purchases yen with dollars, the seller of the yen will have to deliver yen to the purchaser, perhaps 18 hours before it receives the dollar payments because of the time difference between Japan and the United States. Clearly, the seller is at risk. This is one of the many problems that the committee and several working groups reporting to it are looking at.

Region: Is much happening in the Far East as far as these new international efforts of cooperation?

Farnsworth: Japan has done a great deal in developing an electronic payments system. They have the most sophisticated electronic payments system in the world. One of the reasons the payments experts began to look at offshore clearing and netting arrangements was because of a system developed by Chase Manhattan's office in Tokyo that does clearing and offshore clearing for the major banks in Tokyo. That clearing takes place at the end of the Tokyo banking day and Chase then moves those funds to Chase New York. Chase New York then does the clearing and settlement, and eventually finality takes place on the books at the Fed approximately 18 hours later. And it's that period of time that creates the international payments risk that we're concerned about. The ultimate risk we think probably will fall on the Fed even though the clearing is for Tokyo banks dealing in dollars. So it's a situation that we think is interesting and challenging, and we're trying to find a solution to the problem.

Region: You hinted at this back in the first question. How would you describe your management style?

Farnsworth: I think it's always hard for a person to describe his own management style. I know some people around here have described my style as one of paying attention to both product and process. I require and demand a quality product from the staff, and I expect a quality product from the Reserve Banks. Fortunately, I get that from my staff and depository institutions get that from the Federal Reserve Banks. The Federal Reserve is very fortunate to have high quality people throughout the organization. Another characteristic of my management style is the fact that I really care a lot about my people. I work very hard to try to develop people, and part of that development involves giving them responsibility. And as long as I get the quality product from the people, I'm willing to give them the responsibility that goes along with that. As I said earlier, in order to run an organization, an organization must plan—and I do believe in planning.

Region: What do you predict will most occupy you and your staff's time in the near future, say the next three years?

Farnsworth: In terms of programs, I think the payments system risk program, because of its importance for the safety and soundness of the banking system, will continue to take a great deal of our time over the next three years. The objectives of this program are to reduce direct Federal Reserve credit exposure and to control systemic risk. Probably the most important result of the program is the internalization of credit risk by users of payment services. The development of policies to reduce those risks is very difficult. The issues are very complex. I've heard many people who have gotten into the payments systems risk work say that it's the most complex work they've ever experienced. And that has included people like Vice Chairman [Manuel] Johnson, who chairs the Federal Reserve's Payments Systems Policy Committee.

I think the work in consolidation—trying to determine what we need to do to develop a good, workable consolidated environment in the System—will take a tremendous amount of effort. And I'm not referring just to the technical side of the business. I'm also referring to the management side. The management issues that we face in consolidation are enormous. How will the Federal Reserve operate three or four stand-alone consolidated sites?—or maybe they don't stand alone. Maybe they're actually operating in a Reserve Bank somewhere. That's not how we're structured to run operations, and we've got to do some very hard thinking on the subject. What are the reporting relationships? Who is ultimately responsible for running those operations? Those are going to be quite difficult issues.

Region: One last open-ended question: Is there anything that we didn't touch on that you'd like included in the interview?

Farnsworth: Yes, I'd like to talk about the System Interchange Program. I think it's one of the best resource development programs that we have going in the System right now. I really believe strongly in System interchange, which is the temporary assignment of Board staff to work in Reserve Banks for a period of time and the assignment of Reserve Bank people to the Board. This is one way to improve understanding and reduce conflicts between the banks and the Board. The people who come in here and work get a very different view of what the Board staff's responsibilities are, what they're doing, why they do certain things and the way they do them. And I think they go back feeling a lot better. Of course, the other side also works the same way.

I spent a few months running the Atlanta branch three or four years ago, and that was a very good experience for me. I say that only because I don't think there's a limit to the level. I think the System Interchange Program can be effective at junior staff level, senior staff level and official level.

Region: Thank you, Mr. Farnsworth.