Federal Reserve System: Current and Future Challenges Require Systemwide
Attention (Testimony, 07/26/96, GAO/T-GGD-96-159).

GAO discussed the Federal Reserve System's major operational activities
and expenses. GAO noted that: (1) in 1994, about 70 percent of the
Federal Reserve's operating costs were for payment system and other
financial services to financial institutions and government agencies, 20
percent were for regulatory activities, and 10 percent were for monetary
policy activities; (2) employees' pay and benefits accounted for almost
70 percent of the Reserve's operating expenses; (3) almost 80 percent of
Federal Reserve employees were involved in support activities, overhead,
and financial services, monetary and economic policy activities and
Board of Governors staff accounted for less than 10 percent of the total
staff, and bank supervision and regulation accounted for about 12
percent of Federal Reserve staff; (4) the Federal Reserve must face a
number of challenges such as rising costs, the reduced demand for
financial services and supervisory adjustments because of the banking
industry's consolidation, and the use of banks' external audits to
supplement and guide bank examinations; and (5) the System needs to
streamline its operations and address challenges in cost-effective ways
on a systemwide basis.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  T-GGD-96-159
     TITLE:  Federal Reserve System: Current and Future Challenges 
             Require Systemwide Attention
      DATE:  07/26/96
   SUBJECT:  Federal reserve banks
             Banking regulation
             Monetary policies
             Financial institutions
             Federal agency reorganization
             Cost control
             Overhead costs
             Bank examination
             Administrative costs

             
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Cover
================================================================ COVER


Before the Committee on Banking, Housing, and Urban Affairs, U.S. 
Senate

For Release on Delivery
Expected at
9:15 a.m., EDT,
on Friday,
July 26, 1996

FEDERAL RESERVE SYSTEM - CURRENT
AND FUTURE CHALLENGES REQUIRE
SYSTEMWIDE ATTENTION

Statement of Charles A.  Bowsher
Comptroller General

GAO/T-GGD-96-159

GAO/GGD-96-159T


(233476)


Abbreviations
=============================================================== ABBREV


FEDERAL RESERVE SYSTEM:  CURRENT
AND FUTURE CHALLENGES REQUIRE
SYSTEMWIDE ATTENTION
==================================================== Chapter STATEMENT

Mr.  Chairman and Members of the Committee: 

We are pleased to appear today to discuss our recently issued report
on the Federal Reserve System.\1 The findings and conclusions of this
report are based on the most comprehensive review that we have ever
undertaken of the Federal Reserve's operations.  While we focused our
review on the Federal Reserve's major operational activities and
expenses, we did not review its monetary policy-making and foreign
transactions, because of limitations on our audit authority.\2

As you know, Mr.  Chairman, Congress established the Federal Reserve
in 1913 as our nation's independent central bank.  The Federal
Reserve is unique among federal entities in its mission, structure,
and especially in its financing.  In addition to its well-known role
in conducting monetary policy, the Federal Reserve has several other
important functions, such as managing our nation's payment system,
providing services to financial institutions and government agencies,
and supervising and regulating banks and bank-holding companies.  The
System's structure comprises a 7-member Board of Governors, which is
a federal agency; 12 Federal Reserve Banks, which are federally
chartered private corporations; and 25 branches.  This structure has
remained virtually unchanged since it was established despite the
significant shifts in demographics and economic activity that have
occurred since then.  Unlike federal agencies that are funded by
congressional appropriations, the Federal Reserve is a self-financing
entity that deducts its expenses from its revenues and transfers the
remaining amounts to the U.S.  Treasury.  Because an additional
dollar of Federal Reserve cost is an additional dollar of lost
federal revenue, the costs of operating the Federal Reserve System
are borne by U.S.  taxpayers just like the costs of any federal
agency. 

Over the 1988 to 1994 period, the Federal Reserve's average annual
revenue was $22.0 billion, which greatly exceeded its average annual
expenses and other deductions of $2.5 billion.  Each year the Federal
Reserve returned to the Treasury about $16 billion to $24 billion. 
The largest source of revenue for the Federal Reserve is the interest
earned on the U.S.  securities it holds as backing or "collateral"
for over $380 billion in Federal Reserve notes that circulate as our
nation's paper currency.  This interest income accounted for almost
90 percent of total Federal Reserve revenue in 1994 and virtually
guarantees that the System will earn a substantial "profit" each
year.  Fees that the Federal Reserve is required to charge financial
institutions for providing "priced services," such as check clearing
and electronic funds transfers, account for most of the System's
other revenues. 

The largest deduction that the Federal Reserve makes each year from
its revenues is for the operating expenses of the 12 Reserve Banks
and the Board of Governors.  These operating costs totaled $2.0
billion in 1994, and increased by 48 percent from 1988 to 1994.  This
48-percent cost increase exceeded the 25-percent inflation and the
17-percent increase in total federal discretionary spending that
occurred during this period, and was somewhat less than the
51-percent increase in federal nondefense discretionary spending. 

About 70 percent of the Federal Reserve's operating costs were for
payment system and other financial services provided to banks and
government agencies, about 20 percent were for regulatory activities,
and about 10 percent were for monetary policy activities.  Pay and
benefits for the Federal Reserve's workforce of over 25,000 employees
accounted for almost 70 percent of its operating expenses. 

As shown in table 1, over 10,000 Federal Reserve employees were
involved with providing services to financial institutions and
government agencies, over 5,000 were in support activities, and over
5,000 were in overhead.  Thus, over 20,000 Federal Reserve
employees--almost 80 percent of the System's total staff--were
involved with support activities, overhead, or financial services. 
Monetary and economic policy activities and the Board of Governors
staff accounted for only about 2,300 employees--or less than 10
percent of the System's total staff.  And despite increasing almost
40 percent from 1988 to 1994, only about 3,000 Federal Reserve
employees--or about 12 percent of the total staff--were involved with
bank supervision and regulation in 1994. 



                                Table 1
                
                 Federal Reserve Staffing by Activity,
                                  1994

                                                      1994
                                                  staffing  Percentage
Category                                             level    of total
----------------------------------------------  ----------  ----------
Board of Governors\a                                 1,635          6%

Reserve Banks, by activity
----------------------------------------------------------------------
Monetary and economic policy                           729           3
Services to Treasury and other agencies              1,754           7
Services to financial institutions                   8,302          32
Supervision and regulation                           3,079          12
Support (includes data processing, occupancy,        5,062          20
 printing, supplies, central planning
 services, district projects, etc.)
Overhead (includes administrative services,          5,183          20
 system projects, mail, legal, general books
 and budget, personnel, audit, protection,
 purchasing, motor vehicles, library,
 telephone, etc.)
======================================================================
Total Reserve Bank staffing                         24,109          94
======================================================================
Total                                               25,744        100%
----------------------------------------------------------------------
Note:  Table staffing numbers reflect the average number of persons.\

\a System accounting does not allocate Board staffing by
mission-related activity. 

Source:  Federal Reserve System. 

As its staffing composition clearly indicates, the main workload of
the Federal Reserve is not policymaking or bank supervision.  Rather,
it is oriented toward the production of financial services, whether
paper driven, such as processing currency and clearing checks for
banks, or electronic in nature, such as running an automated clearing
house and funds transfer system.  And it is precisely these major
lines of business where we found that the Federal Reserve faces a
number of growing pressures and challenges. 

For example, as a result of increasing competition from private
sector suppliers and a continued shift to electronic banking, the
Federal Reserve has experienced a decline in the volume of its
check-clearing activity and its market share.  As table 2 shows, the
Federal Reserve's costs have been rising faster than corresponding
revenues in several of its other major service lines as well, and we
found that the System did not meet its cost recovery target for its
priced services overall in 1994.  The major consolidation that is
currently occurring in the banking industry could further reduce the
demand for the Federal Reserve's financial services and significantly
affect the magnitude and distribution of the Federal Reserve's
supervisory activities as well.  In particular, changes in the number
and location of the bank-holding companies the Federal Reserve
examines could require adjustments in the examination staffs of the
various Reserve Banks. 



                                Table 2
                
                   Percentage Changes in Revenue and
                   Expenses for Payments for Federal
                      Reserve Services, 1990-1994

Service                                        Revenue        Expenses
--------------------------------------  --------------  --------------
Check clearing                                    -.2%           13.8%
ACH                                               22.0            41.1
Fedwire                                           12.0            25.8
----------------------------------------------------------------------
Legend:  ACH = automated clearinghouse. 

Source:  Federal Reserve System. 

In addition to reexamining the allocation of its supervisory
resources, the Federal Reserve may also wish to rethink the way it
conducts bank supervision.  Rather than simply increasing the number
of examiners when its responsibilities increase, the Federal Reserve
could look for ways to make more effective use of private sector
resources.  In our recent review of five foreign bank regulatory
structures, we found that all but one of these countries used the
work of banks' external auditors as an important source of
supervisory information.\3 While external audits would not
necessarily replace bank examinations, the work of external auditors
could be used to supplement and guide examinations and could enhance
the efficient use of examination resources.  Achieving some
consolidation of the four federal banking regulators, as we have
recommended, could also achieve greater efficiencies in the use of
supervisory and regulatory resources.\4

Many of the inefficiencies that we found at the Federal Reserve
relate to its decentralized nature, which allows each Reserve Bank to
set many of its own policies, and to the absence of traditional
cost-minimizing forces that are commonplace in entities that are
either purely private or public sector in nature.  We also found that
the Federal Reserve retained a $3.7 billion surplus account that we
believe could be safely reduced or returned to the Treasury.  While
there are many areas that have some cost-saving potential, we believe
that achieving major cost reductions ultimately depends on the
Federal Reserve carefully reexamining its mission, structure, and
work processes. 

The need for increased cost consciousness is heightened when one
considers the degree of budgetary stringency that the federal
government is projected to face in the next few years.  If total
discretionary spending is held to the levels envisioned in this
year's congressional budget resolution, spending will fall by almost
6 percent between 1995 and 2002.  Adjusting for projected inflation,
this means that, in the year 2002, federal agencies as a whole will
have about 22 percent fewer real resources than they had in 1995.  It
will be difficult to exempt the Federal Reserve, one of the larger
federal entities in terms of employment, from bearing its share of
this planned reduction. 

For the Federal Reserve to most effectively meet these challenges and
streamline its operations, we believe the Board of Governors and the
Reserve Banks must work together to strategically plan for the
future.  Our prior reviews of public and private sector organizations
that have successfully faced similar challenges and achieved truly
significant cost savings, indicated that these organizations
effectively implemented initiatives that focused on their primary
missions and business lines, realigned their structures to fit their
missions, and applied modern technology to streamline their work
processes.  If the Federal Reserve is to effectively follow this
strategy, it will need the Board's sustained leadership and the
Reserve Banks' commitment.  The Federal Reserve will also need to
address certain weaknesses that we identified in its existing
oversight and budgetary processes. 

Mr.  Chairman, the Federal Reserve has begun to show that it can
address operational issues strategically and work in a systemwide
manner when necessary.  As the Federal Reserve enters the next
century, we believe that it needs to continue these efforts so that
it can successfully meet the current and future challenges that it
faces and accomplish its vital mission as efficiently and effectively
as possible.  Specifically, we recommend that the Board of Governors
undertake a fundamental review of the Federal Reserve's operations
that focuses on the primary mission, business lines, and structure
that would best support its overall mandate. 

Such a review of the System will present a challenge to the Federal
Reserve because it is always difficult for an organization to ask
basic questions about itself and to think about its future in a
fundamentally new way.  As a result, the Federal Reserve may want to
call in outside experts to help it perform its review, which is an
approach taken by many private sector enterprises. 

Because the Federal Reserve would need congressional approval to act
on some of these matters, we also suggest that Congress consider the
results of the Board's assessments and determine what changes to the
Federal Reserve's operations and structure would be desirable.  While
we believe it is particularly important not to make any changes that
would threaten the independence of our nation's central bank in
setting monetary policy, we also believe that there is no inherent
conflict between this independence and efforts to improve the
efficiency and effectiveness of the Federal Reserve's operations. 


--------------------
\1 \1 Federal Reserve System:  Current and Future Challenges Require
Systemwide Attention (GAO/GGD-96-128, June 17, 1996). 

\2 Under the Federal Banking Agency Audit Act, 31 U.S.C.  section
714(b), our audits of the Federal Reserve Board and Federal Reserve
banks may not include (1) transactions for or with a foreign central
bank or government, or nonprivate international financing
organization; (2) deliberations, decisions, or actions on monetary
policy matters; (3) transactions made under the direction of the
Federal Open Market Committee; or (4) a part of a discussion or
communication among or between members ofthe Board of Governors and
officers and employees of the Federal Reserve System related to items
(1), (2), or (3).  See Federal Reserve System Audits:  Restrictions
on GAO's Access (GAO/T-GGD-94-44), statement of Charles A.  Bowsher. 

\3 Bank Regulatory Structure:  Canada (GAO/GGD-95-223, Sept.  28,
1995); Bank Regulatory Structure:  France (GAO/GGD-95-152, Aug.  31,
1995); Bank Regulatory Structure:  The Federal Republic of Germany
(GAO/GGD-94-134BR, May 9, 1994); Bank Regulatory Structure:  The
United Kingdom (GAO/GGD-95-38, Dec.  29, 1994); and Bank Regulatory
Structure:  Japan, which is currently a draft report. 

\4 Bank Oversight:  Fundamental Principles for Modernizing the U.S. 
Structure (GAO/T-GGD-96-117, May 2, 1996), statement of James L. 
Bothwell. 


------------------------------------------------ Chapter STATEMENT:0.1

Mr.  Chairman, this concludes my prepared statement.  We would be
happy to answer any questions that you or the other Members may have. 


*** End of document. ***