2006 Annual Report

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LESSONS LEARNED AND THE FED OF THE FUTURE

I have discussed a number of unique challenges in the macroeconomy and banking and financial systems the Fed faced since 1994. Using these experiences as a guide, I believe we can reasonably anticipate a number of developments in the future.

CHALLENGES AHEAD
Macroeconomic and financial challenges will undoubtedly continue to emerge. Some of these challenges will be similar to events the U.S. economy has experienced in the past. Others will be new and unique. Many of these new challenges likely will stem from the increasing technological sophistication and complexity of the real economy and of the financial system; others will come from the progressive influence of globalization on trade and international financial flows. All will continue to test the best thinking of the Federal Reserve.

For policy to respond successfully to them, we will need to keep in mind the principles of sound policy-making I previously discussed: Study a wide range of data. Analyze problems using cogent economic theory. Respect the risks of undesirable outcomes for growth and inflation. And remain flexible in thinking about changes in the economy and the ways policy should react to them.

The Federal Reserve also has the responsibility of explaining our actions to the public. Over the past decade, we have seen a move from central bank secrecy to central bank transparency, a change that reflects a growing appreciation of the enhanced policy credibility and reduced economic uncertainty that accompany public understanding of the goals and rationales underlying monetary policy decisions. I consider this movement toward greater transparency a very positive development and expect it to continue.

EVOLUTION OF BANKING INDUSTRY
The structure of the U.S. banking industry is likely to continue to evolve toward one in which a small number of large, complex banking organizations compete globally with the world's largest financial institutions while a large number of smaller institutions focus on local communities or somewhat larger regional areas. Banks will continue to expand their product lines across the spectrum of financial activities, and other financial institutions will increasingly offer traditional banking services. Technological advances will facilitate increasingly sophisticated banking products and services. At the same time, the implementation of the Basel II Capital Accord in the U.S. will spur further development of risk management practices of financial institutions.

The evolution of the banking industry will require the Federal Reserve to continue to improve its supervision techniques, tailoring them to the needs and challenges posed by the different types of banking institutions. At the core of our supervisory responsibilities will be the Federal Reserve's ability to identify and understand the swiftly changing risks and risk management practices of banking organizations. To carry out their supervisory tasks, the Reserve Banks must continue to improve their capacity to evaluate the quality of these risk management practices. To obtain a complete picture of industry risks and risk management practices, we will need to continue to share insights across Districts and with other regulators, both domestic and foreign.

PAYMENT SYSTEM
The migration of U.S. retail payments to electronics will continue to accelerate. Payment system developments will require the Fed to continue to adapt to lower demand for paperbased processing services and higher demand for electronic payment services.

To accomplish this, Reserve Banks are unlikely to remain full-service providers of retail payment services indefinitely. The Reserve Banks will continue encouraging greater use of electronics in the check-collection process as well as offering an array of products and services to take advantage of the opportunities provided by the Check 21 Act. At the same time, there will be an ongoing focus on customers, service levels, and fees, and on cost efficiency in both retail services and Reserve Bank support functions.

The Reserve Banks also will continue to contribute to the formulation of payment system policy, particularly with respect to payment system risk issues. In doing so, they will further strengthen their outreach to financial markets, both domestic and abroad, by enhancing the Fed's role in promoting financial stability, effective crisis management, and the formulation of standards. Ultimately, the Federal Reserve's role in helping to shape the development of our nation's payment system will continue to be informed by its unique role as a public policy-making institution and payments provider.

INCORPORATING BEST PRACTICES
I would note that, in many ways, the Federal Reserve System has already made great strides to prepare for these future challenges in the economy, banking and payments system. Across its responsibilities, the Federal Reserve has adopted industry best practices, managed its responsibilities holistically, and worked to retain and build upon its distinctive strengths. These attributes are likely to sustain the central bank in the years to come.

The Federal Reserve will continue to adopt and incorporate best practices from the industry and elsewhere to ensure the highest levels of integrity and excellence. In 2006, the Federal Reserve voluntarily chose to meet the rigorous requirements of Section 404 of the Sarbanes-Oxley Act of 2002 (SOX). Like publicly held organizations, through SOX, the Fed strengthened its focus on its system of internal controls over financial reporting and the effective management of risks. For similar reasons, the Federal Reserve System has bolstered its governance structure through service agreements between Reserve Banks, performance metrics, and other mechanisms that enhance the clarity of authority and accountability.

Across the System, Federal Reserve Banks increasingly strive to provide a common face to customers and stakeholders. Responding to changes in the payments system, the System consolidated a number of business and support functions such as payments processing locations (notably in the paper check infrastructure), statistical reporting functions, marketing and some sales activities, and information technology support and infrastructure. The System also further coordinated its activities in supervising financial institutions. At the same time, we improved the coordination and collaboration between Reserve Banks, the Board of Governors, and other entities. These moves improve the efficiency and effectiveness of our payments products and central bank responsibilities, and ensure we deliver more seamless interaction and services to customers and stakeholders.

OUR REGIONAL STRUCTURE
In the midst of tremendous change in the economy and banking and financial systems, the Federal Reserve has been vigilant to retain and build upon a unique attribute and strength — its regional structure and character. Given population shifts in the U.S. since 1913, we would probably implement the geographic structure of Reserve Banks differently if we were to create the Federal Reserve System from scratch today. However, this structure makes our central bank a uniquely American institution, reflecting the importance that we as a society place on local representation, independence, and transparency. It also contributes greatly to the monetary policy-making process.

The 12 regional banks, and their independent Boards of Directors, give the Fed ready access to information from all parts of the country and all sectors of the economy. And the fact that all District Bank presidents serve on the FOMC — and have access to high-quality research performed by their own independent staffs — assures that a variety of voices are heard in the policy-making function. While it is perhaps most notable in the core responsibility of monetary policy, the presence of the Federal Reserve's regional character helps to inform nearly all aspects of our responsibilities as a central bank, allowing us to bring new insights and ideas to bear on unforeseen problems.

Given these attributes, I remain confident in the ability of the Federal Reserve Banks and the Federal ReservSysemark tem to adapt in the face of challenges that lie ahead. In my experience, a hall of the Federal Reserve has been and will continue to be the level of commitment and talent associated with the people who make up the institution. At the risk of making a bold prediction, that will never change. As long as we retain these qualities, the System will remain the world's preeminent central bank.

Federal Reserve Bank of Chicago Research Department Vice Presidents Spencer Krane, Douglas Evanoff and Richard Porter contributed to the development of this essay, as did Supervision & Regulation Senior Vice President Cathy Lemieux and Senior Examiner Steven Van Bever as well as Enterprise Risk Management Assistant Vice President Nate Wuerffel.

Notes:
¹ An ACH network is an electronic clearing and settlement system for exchanging electronic transactions among participating depository institutions. Such electronic transactions are substitutes for paper checks and are typically used to make recurring payments such as payroll or loan payments. The Federal Reserve Banks operate an ACH, as do some private sector firms.

² Fedwire is an electronic funds transfer network operated by the Federal Reserve. Fedwire is usually used to transfer large amounts of funds and U.S. government securities from one institution's account at the Federal Reserve to another institution's account. It is also used by the U.S. Department of the Treasury and other federal agencies to collect and disburse funds.

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