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Copyright 1999 Federal Document Clearing House, Inc.
Federal Document Clearing House
Congressional Testimony
March 25, 1999, Thursday
SECTION: CAPITOL HILL HEARING TESTIMONY
LENGTH: 3335 words
HEADLINE: TESTIMONY March 25, 1999 EDWARD M. GRAMLICH MEMBER BOARD OF GOVENORS OF THE
FEDERAL RESERVE SYSTEM
SENATE BANKING, HOUSING
& URBAN AFFAIRS
BANKRUPTCY REVISION
BODY:
Testimony of Governor Edward M. Gramlich On H.R. 3150, the
Bankruptcy Reform Act of 1998 Before the Committee on Banking, Housing, and Urban Affairs, U.S.
Senate March 25, 1999 I appreciate this opportunity to appear before the
Committee to present the views of the Board of Governors of the Federal Reserve
System on currency collateral, financial netting, and consumer issues raised by
the Conference Report on H.R. 3150, the
Bankruptcy Reform Act of 1998. The Board strongly supports Section 1013 of the Conference Report
relating to Federal Reserve collateral requirements and urges its inclusion in
this year's legislation. The Board also strongly supports the financial
contract provisions of Title X of the Conference Report. Our testimony also
offers comments on the consumer provisions found in Sections 112, 113, 114, and
1128 of the Conference Report. Currency Collateral Section
16 of the Federal Reserve Act requires the Federal Reserve to collateralize
Federal Reserve notes when they are issued. The list of eligible collateral
includes Treasury and federal agency securities, gold certificates, Special
Drawing Right certificates, and foreign currencies, the items in bold print on
the left side of the balance sheet in appendix A. In addition, the legally
eligible backing for currency includes discount window loans made under Section
13 of the Federal Reserve Act. Over the years sections have been added to the
Act that permit lending by the Federal Reserve to depository institutions under
provisions other than Section 13 and against a broader range of collateral than
is allowed under Section 13.
However, the currency collateralization requirement of Section 16 has not been
similarly amended, thus limiting the types of loans the Federal Reserve can use
to back the currency. (Appendix is available on hard copy only). To date, the
Federal Reserve has always had more than enough collateral to back Federal
Reserve notes. In recent years, however, the margin of excess currency
collateral has been dwindling. The primary reason for the decline in excess
currency collateral has been the development of retail sweep accounts. Retail
sweep accounts are a technique used by banks to increase earnings by reducing
their required reserves. Because of the growth of sweep accounts, required
reserve balances have declined substantially over the past five years. Since
reserve balances, unlike currency, do not have to be collateralized, they serve
as a source of excess collateral for currency. To maintain a balance between
the demand for and the
supply of reserve balances that is consistent with the intended stance of
monetary policy, the Federal Reserve has responded to the declining demand for
reserves by accumulating a smaller volume of Treasury securities than it would
have in the absence of retail sweep accounts. This means that the growth of
retail sweep accounts has effectively diminished the margin of excess currency
collateral. As additional sweep programs are implemented, the margin will tend
to shrink further. One can trace the effects of declining reserve balances on
excess currency collateral in the simplified Federal Reserve balance sheet in
appendix A--excess currency collateral was down to about $20 billion by the end
of 1998, and is likely to drop further. (Appendix is available on hard copy
only). The small margin of available collateral poses a serious potential
problem for the Federal Reserve. Although
discount window borrowing has been very low in recent years, it could increase
substantially in the future. For example, one or more banks could experience
operational problems (perhaps owing to computer failures related to the century
date change) that require a large volume of temporary funding from the discount
window. These banks might not be able to tender the types of collateral that
would qualify for loans under Section 13. Consequently, any such loans would
need to be made under other provisions of the Act, and under current law they
would not be eligible to back currency. If the aggregate need for such loans
exceeded excess currency collateral, the Federal Reserve would be faced with an
unpalatable choice. Were the Federal Reserve to extend the credit, it would not
be able to absorb all of the resulting excess reserves by selling Treasury
securities from its portfolio, because selling the necessary amount would cause
a deficiency in currency collateral. The increase in excess reserves would
reduce short-term interest rates, causing an unintended easing of monetary
policy and perhaps risking inflation. The situation would persist until the
loans were repaid. Were the Federal Reserve instead to refuse to make the
discount loans in order to maintain the stance of monetary policy and continue
to collateralize the currency, the depository institutions seeking credit would
not be able to meet their obligations, with possible adverse implications for
the financial system as well as the individual depository institutions. Thus
the Federal Reserve would need to choose between two of its most fundamental
policy objectives--protecting the value of the currency and preserving
financial stability. The legislation in Section 1013 of the Conference Report
would greatly reduce the likelihood of circumstances that would give rise to
such difficulties. It would authorize the Federal Reserve to collateralize the
currency with all types of discount
window loans, not just those made under Section 13. By permitting all discount
window loans to back the currency, the Federal Reserve would be able to
collateralize currency fully--as the original framers of the Federal Reserve
Act saw fit to require--in virtually all conceivable circumstances while
conducting monetary policy in pursuit of the nation's macroeconomic objectives
and making any and all discount window loans that are appropriate. I might
note that Section 101 of S.576, the Senate regulatory relief bill, would also
reduce the odds that the currency collateral requirement could inappropriately
constrain Federal Reserve operations. If the Federal Reserve were permitted to
pay interest on required reserve balances, as provided for in that proposal,
the incentives that depository institutions face to generate new retail sweep
arrangements would be greatly reduced, and some banks would probably even
dismantle such arrangements. As a result, the level of reserve balances should
rise, providing a modest additional source of funds to purchase collateral to
back the currency. This step by itself would not be adequate to address the
currency collateral issue, but it would help. More importantly, the prevention
of further erosion in required reserve balances, and the possibility that they
would rise, would assist the Federal Reserve in the implementation of monetary
policy by forestalling the possibility that the volatility of overnight
interest rates could rise substantially as a result of low reserve balances.
The Federal Reserve strongly supports this section of S.576. Financial Netting
The Federal Reserve commends the Committee for addressing Title X, Financial
Contract Provisions, of H.R. 3150,
Bankruptcy Reform Act of 1998, which was considered in the last Congress. Title X of H.R. 3150
included a number of proposed
amendments to the Federal Deposit Insurance Act and the
Bankruptcy Code as well as other statutes related to financial transactions. Most of
these amendments incorporated or were based on amendments to these statutes
that were endorsed by the President's Working Group on Financial Markets. As
discussed more fully in appendix B, the Board supports enactment of the
amendments recommended by the Working Group. The importance of improving the
legal regime underpinning financial markets has been recognized by the finance
ministers of the G7 countries. In this regard, the ability to terminate or
close out and net contracts and to realize on collateral pledged in connection
with these contracts is vital. Enactment of the provisions of Title X would
reduce uncertainty in these areas. This reduced uncertainty should foster
market efficiency and limit market disruptions in the event of an insolvency,
limit risk to federally supervised financial market participants, including
insured
depository institutions, and limit systemic risk. (Appendix is available on
hard copy only). Close out refers to the right to terminate a contract upon an
event of default and to compute a termination value due to or due from the
defaulting party, generally based on the market value of the contract at that
time. By providing for termination of contracts on default, nondefaulting
parties can remove uncertainty as to whether the contract will be performed,
fix the value of the contract at that point, and proceed to rehedge themselves
against market risk. The right to terminate or close out contracts is
important to the stability of market participants and reduces the likelihood
that a single insolvency will trigger other insolvencies due to their market
risk. Further, absent termination and close out rights the inability of market
participants to control their market risk is likely to lead them to reduce
their
market risk exposure, potentially drying up market liquidity and preventing the
affected markets from serving their essential risk management, credit
intermediation, and capital raising functions. Netting refers to the right to
set off, or net, claims between parties to arrive at a single obligation
between the parties. Netting can serve to reduce the credit exposure of
counterparties to a failed debtor and thereby to limit systemic risks and to
foster market liquidity. Finally credit exposure under financial market
transactions is frequently collateralized. The right to liquidate collateral
immediately is important for preserving the liquidity of financial market
participants. Recognizing the importance of termination, or close out,
netting, and collateral, in March of 1998 the Secretary of the Treasury, on
behalf of the President's Working Group on Financial Markets, transmitted to
Congress proposed legislation that would amend the banking laws and the
Bankruptcy
Code. As I noted previously, the provisions of Title X, Financial Market
Contracts, of H.R. 3150 were largely based on the provisions that were endorsed
by the Working Group. Additional language in Title X was designed to further
the same ends that the Working Group sought to promote. Other provisions, such
as section 1012 on Asset-Backed Securitizations, which was not included in the
Working Group's recommendations, also may foster the efficiency of the
financial markets by promoting certainty. I understand that there also have
been concerns expressed over this provision. Although we believe that this
provision is beneficial, we think the provisions endorsed by the Working Group
are sufficiently important to be pursued by Congress even if the asset
securitization provision is not included. Consumer Protection The Conference
Report contains a number of provisions relating to consumer protection laws the
Federal Reserve Board administers. Section 113 would
direct the Board to study the adequacy of existing protections that limit
consumers' liability for the unauthorized use of
"dual use" debit cards. Commonly debit cards--such as those used at an automated teller
machine (ATM)--can be used only if the consumer provides a personal
identification number (PIN). However, some debit cards also can be used without
a PIN; consumers sign a sales draft as they would for credit cards. Consumers'
liability under the Truth in Lending Act (TILA) for the unauthorized use of a
credit card is no more than $50; for debit cards, the potential loss under the
Electronic Fund Transfer Act (EFTA) can be much higher. Depending on how
timely the consumer is in reporting the unauthorized use, the consumer's
liability in the latter case may be as much as $500, and
may even be unlimited if the consumer does not notify the institution within 60
days of the sending of a periodic statement listing an unauthorized
transaction. Some observers have expressed concern that consumers using debit
cards in the same way that they use credit cards may not understand the
difference in their potential risk of loss. The Conference Report requires the
Board to study how well existing law protects consumers against unauthorized
use of debit cards, whether the industry has enhanced the level of protection
through voluntary rules, and whether additional amendments to the EFTA or the
Board's regulations are necessary. The Board believes that market discipline
is preferable to government-imposed regulations. As an example of how market
discipline might work, both VISA and MasterCard have already voluntarily
established rules for financial institutions offering non-PIN protected debit
cards that
generally limit a consumer's liability to $50 or less. Though these rules are
not identical to those in the EFTA and the Board's Regulation E, which
implements the EFTA, these voluntary rules bring consumers' liability for these
debit cards more in line with the liability rules for credit cards. The
voluntary rules govern all institutions offering these types of debit cards and
thus diminish consumers' liability substantially. In this case we believe the
private sector has already acted appropriately to address the liability issue.
With regard to the possible need for additional disclosures that explain how
non-PIN protected debit cards differ from other credit cards, the Board is
studying this matter. We have the authority under the EFTA to adopt additional
disclosures, but must weigh the value of additional consumer protection against
the additional compliance costs that would be imposed. Because the industry has
already established voluntary
limits on liability and the Board is currently analyzing the need for
additional disclosures, we believe the study mandated in Section 113(c) of the
Conference Report may be unnecessary. Section 112 of the Conference Report
would require the Board to study the adequacy of information consumers receive
about the deductibility of interest paid on home-secured credit transactions.
The Board is to consider whether additional disclosures are necessary when the
total amount of the home- secured credit extended exceeds the fair market value
of the dwelling. The Truth in Lending Act (TILA) and the Board's Regulation Z,
which implements TILA, currently have limited disclosure requirements about the
effect of the credit transaction on consumers' income tax liability. Creditors
offering home-secured lines of credit must provide generic disclosures when an
application is made, including a statement warning consumers to consult a
tax advisor regarding the deductibility of interest and other charges connected
with the line of credit. Creditors offering purchase-money mortages and other
home-secured installment loans are not required to provide any tax-related
disclosures. The Board recognizes that it is useful for consumers to be aware
of the potential tax implications of home-secured credit transactions. But we
have concerns about the study required by Section 112(a). The tax code is
complex and its applicability to each consumer depends on personal financial
information and additional analysis. Creditors often do not have all the
information that would permit them to provide specific meaningful tax advice to
consumers. We would be concerned that additional disclosures might give
consumers the impression that a creditor has considered their individual
circumstances and made a determination about the income tax consequences. In
the end, the most meaningful disclosure a
creditor could offer might be a generic statement advising the consumer to
consult a tax advisor, or in the case of credit that exceeds a home's fair
market value, a disclosure that the tax laws may not allow a deduction for all
the interest paid on that loan. It will be very difficult to obtain the data
necessary to do the study required by Section 112(a). Findings would likely be
based on consumer surveys that ask consumers to relate their experiences in
deducting interest associated with home-secured credit for income tax purposes.
Taxpayers are notoriously private about their dealings with the Internal
Revenue Service, and surveys about their dealings could result in unreliable
information. The third Board study, required by Section 114(e) of the
Conference Report, addresses the adequacy of the information consumers receive
about
certain borrowing practices that may result in financial problems. The focus of
the study is consumers' practice of making only minimum payments on their
credit card accounts or other revolving credit plans. The Board would be
directed to use the results of the study to determine whether consumers need
additional disclosures regarding minimum payment features beyond the minimum
payment disclosures added by other provisions of the bill. The Board is again
concerned that there would be difficulties in obtaining reliable data. For
example, the Board is asked to consider the extent to which the availability of
low minimum payments causes financial difficulties, and the impact of minimum
payments on default rates. We believe these relationships are difficult,
perhaps impossible, to estimate. The Board would be happy to work with the
Congress to draft a more manageable alternative. Section 114 of the Conference
Report would amend TILA to require creditors offering open-end
credit plans, such as credit cards, to provide additional disclosures about
minimum payments as well as arrangements where consumers may
"skip payments" while interest continues to accrue on the unpaid balance. It would also
require lenders to provide an example of how long it would take to pay off a
$500 balance, if the consumer makes only the minimum payment and does not
obtain additional credit. These disclosures would be provided when the account
is opened, annually, and in the case of the minimum payment disclosure, on each
periodic statement. Regarding these additional disclosures, the Board
recognizes the value of ensuring that consumers better understand the
implications of making minimum payments on open-end credit plans. But the
Congress might ask whether providing similar disclosures repeatedly, as
required by this legislation, may have the unintended effect of creating
"information overload" for consumers receiving these
disclosures. Here is where a study might be helpful. Section 1128 amends TILA
to prohibit creditors from terminating open-end credit accounts solely because
the consumer does not incur a finance charge on the account. (Typically, these
cardholders are
"convenience users" who pay their credit card balances in full each month.) Under the provision,
creditors could terminate an account for inactivity of three months or more,
but consumers who use their cards regularly and pay their balances in full
could not have their accounts terminated for that reason. The Board generally
does not favor federal laws that restrict creditors' ability to determine
whether particular accounts or transactions are economically viable. We believe
competition in the marketplace is the better approach for motivating creditors'
activities, and the credit card market is certainly competitive. Moreover, we
have concerns about the possible consequences of such a
prohibition. We are not aware that the practice of terminating accounts is
prevalent in the industry, but we presume that to the extent creditors do so,
it is because the accounts are considered unprofitable. If creditors cannot
terminate these accounts, they will likely seek to recover their costs by
increasing fees on convenience cardholders, or for all their cardholders. In
addition to these comments, the Board would also like to bring certain
technical comments on the consumer provisions to the Committee's attention.
LOAD-DATE: March 29, 1999