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2003 Annual Report
by Cathy E. Minehan, with appreciation to editor Kristin F.
Kanders and graphic designer Fabienne Anselme Madsen
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Over its entire history, the Federal Reserve Bank of Boston
has faced changes in the economy, in the financial services
industry, and in its responsibilities. At times, we’ve
reacted to change; at times, the Bank has served as a catalyst,
as our staff have explored new ways to accomplish the tasks
facing us. The Bank’s mission has remained the same
over the years—to support sound economic growth and
financial stability in New England and the nation. But the
ways in which we fulfill our mission and meet our changing
responsibilities have evolved. Philosophers tell us that change
is the only constant, but its pace is hardly constant. At
present, it seems to be accelerating.
This essay features short segments on some aspects of change
in the Bank in 2003 and beyond. It describes changes affecting
the economy, our building and security measures, payments
operations, educational efforts, and bank supervision. These
are very different areas, but changes in each are driven by
advances in technology, increasing complexity, and a continuing
need to operate more efficiently and effectively
Our Changing Environment
We in Boston have been experiencing the sights and sounds
of the Central Artery/Tunnel Project for over a decade. The
“Big Dig” was one of the largest and most complex
and expensive highway projects in American history, and it
is now in its final stages. Construction projects always cause
some inconvenience, and this one certainly has. But the Big
Dig is providing a once in a lifetime opportunity to improve
the downtown Boston area.
At the Federal Reserve Bank of Boston, we have had a firsthand
view of the construction. For a time, it was literally taking
place in-house, as a part of our building underground was
used for the slurry wall that enabled the tunnel to be built
down Atlantic Avenue. We are now taking advantage of the completion
of this massive project to renovate our five and a half acre
site to make it both more secure and more attractive. Plans
for restoring the front plaza and other areas around the building
have been in development since the late 1990s. After September
11, 2001, enhanced security elements became an additional
consideration.
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When our building was built in the 1970s, it was intended
to be an open, welcoming facility with a public purpose and
public space. We retain our desire to welcome visitors as
well as our tenants and their visitors. But the times require
new methods to improve security. Our Protection Officers are
now fully trained federal law enforcement officers, and we
use the best technology we can find to augment security—all
in an effort to strike the right balance between security
and accessibility.
The Payments Evolution
The long awaited transition to electronic retail payments
is finally here. Instead of pulling out checkbooks, people
today swipe debit and credit cards at the corner store, initiate
purchases online, and sign up for automatic payment plans.
Businesses are finding new ways for electronics to reduce
their payment transaction costs, and lawmakers have eased
the way for check imaging. These changes are having a considerable
effect on Federal Reserve Bank operations, both around the
nation and in Boston.
The reasons for the paper check decline are understandable:
consumers are attracted to the convenience of electronic payments,
and businesses like the economics of converting checks to
electronic transactions. For example, a credit card processor
might convert the checks it receives to automated clearinghouse
(ACH) transactions at its processing site and then, shortly
thereafter, destroy the paper checks and store an electronic
copy for recordkeeping purposes. This process is faster, cheaper,
and safer than traditional paper processing.
Most knowledgeable observers thought about 70 billion checks
were being written in the United States as recently as 2000.
Research conducted by the Federal Reserve put the number closer
to 40 billion; and that is declining, likely by as much as
5 percent a year. In addition, commercial bank mergers have
reduced demand for the Federal Reserve’s services as
a check clearing intermediary, and competition among check
processors has intensified. Reserve Banks will be challenged
to reduce the Federal Reserve System’s check processing
infrastructure while at the same time positioning Bank services
as viable alternatives should depository institutions outsource
their check processing or need Reserve Banks to clear checks
when problems occur.
This year, the Reserve Banks are responding to the current
volume decline by discontinuing check processing at 13 of
45 sites, although check collection services will continue
to be offered nationwide. Check adjustments, the error-resolution
portion of the check business, will be handled in only one
location per Reserve District. For Boston, this means we will
do our error-resolution work at our office in Windsor Locks,
Connecticut. Check processing will continue at both our Boston
and our Windsor Locks sites, although as volumes continue
to decline, we will have to consider all options facing us.
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Technological change has made this consolidation and downsizing
possible. In 2003, we in Boston converted our large processing
offices to new, standard software that will enable the Banks’
central technology operations to manage our check equipment.
All Reserve Banks now provide consistent products and services
across the country; check adjustments processing is integrated
in ways that enable each Bank to help others as necessary;
and digital imaging services for checks are standardized nationwide.
Boston provides image services to commercial customers across
the country and to the U.S. Treasury. These changes meet the
needs of financial institutions that use services from multiple
Reserve Banks. They also help the Banks increase efficiency
and respond more quickly when launching new products.
Modernization of check processing is proving useful in other
ways. The common platform is making it easier for Reserve
Banks to develop standards and services to implement the new
“Check 21” legislation in October 2004. Check
21, short for the “Check Clearing in the 21st Century
Act,” removes the legal barriers to using digital images
of checks as proof of payment. We expect Check 21 to increase
efficiency in the payments system and encourage banks to provide
innovative services to their customers.
At the same time that paper is declining, fully automated
retail payment processes are gaining favor and using Reserve
Bank services. The ACH is increasingly the way electronic
payments are settled. In addition, other new electronic payment
options seem to be developing at a rapid pace, pushed by consumer
and business needs, and by the needs of the U.S. Treasury.
The Reserve Banks are playing a leadership role both in the
networks that support electronic payments and in serving the
Treasury’s needs. Retail payments are evolving. This
is good for the payment system and good for the economy. All
transitions bring challenges; we are ready to meet them.
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New Approaches to Economic and Financial Education
When making decisions about how to save and spend, consumers
face an ever-increasing array of financial products and services.
Access to credit has grown tremendously, bringing new benefits
but also posing new risks. In response, the Federal Reserve
System has been intensifying its educational efforts. When
consumers understand financial alternatives and make smart
decisions, they help themselves and contribute to a stronger
overall economy.
The Federal Reserve Bank of Boston has a long history of
helping consumers understand economic and financial issues.
We provide education about what the nation’s central
bank does and why, as well as insights into the workings of
the economy more generally. In addition, our Community Affairs
function has become increasingly active in promoting financial
literacy, the personal side of economics.
Boston’s educational efforts in economics —both
general and personal—were very much in evidence in 2003.
In the fall, we opened the New
England Economic Adventure, an educational program combining
exhibits, video, and interactive games to show how increases
in productivity have improved living standards. The Adventure
celebrates the resilience of the New England economy by drawing
upon the region’s rich economic history to illustrate
its theme. The experience engages visitors in exploring important
economic concepts in an exciting way. It also includes an
economic education laboratory and a web site with lesson plans
and reference materials to help teachers use the Adventure
to meet their evolving curriculum needs.
Community Affairs also supported a number of initiatives
to educate consumers about such issues as the importance of
saving, the wise use of credit, and the necessity of protecting
personal financial information. The Community Affairs area
dates from 1977 when the Federal Reserve was asked to implement
the Community Reinvestment Act. This Act required supervised
institutions to help meet the credit needs of low and moderate
income communities, and over time they have proven they can
do so. In Boston, commercial banks have stepped up their outreach
to minority borrowers and neighborhoods. They have developed
a variety of products to meet low and moderate income market
needs. Communities report that they are becoming more comfortable
with the financial system, and minority households are increasingly
becoming homeowners. Challenges remain, however, as financial
products become more sophisticated, nonbank providers proliferate,
and predatory lending becomes an increased focus of attention.
In addition, increased immigration has expanded the number
of potential users of financial services who have limited
experience with the U.S. financial system.
In response, Boston’s Community Affairs area and its
counterparts throughout the System have increased their emphasis
on consumer-directed financial education. If borrowers and
consumers of financial services are better informed about
the financial products available to them, they will use these
services and products more wisely. In delivering their message,
both Community Affairs and our economic education staff work
with nonprofit organizations, public schools, and other academic
institutions to share expertise and enhance economic understanding
with all our audiences.
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Managing Risk: Changes in the World of Supervision
and Regulation
The U.S. financial services sector generated about one-third
of all U.S. corporate profits last year and had about one-fifth
of the nation’s market capitalization. Bank capital
ratios were strong, even after the recession and the long,
slow recovery. While not without its problems in the wake
of a significant stock market correction and corporate governance
problems, the banking industry emerged in remarkably strong
shape. One reason for this was an increased focus on risk
management.
Over the past decade, the nation’s banks have been
expanding across the country (and increasingly, the globe),
diversifying income sources, hedging risks more effectively,
and using technology to their advantage. These changes have
come about in part because regulatory barriers to geographic
and product expansion have been removed. The industry has
also refined its methods for quantifying and managing risks
to deal with the changing landscape.
To effectively evaluate risks in the current complex environment
requires an increasing degree of sophistication on the part
of both bankers and bank regulators. Supervision and Regulation
staff at the Federal Reserve Bank of Boston and at other Reserve
Banks are focused on using the best and most appropriate tools
to harness information and understand bank risks.
Modeling and measurement techniques for market risks, such
as fluctuations in the stock market, are well established
and integrated into risk management at most financial firms.
Credit risk models that determine the likelihood and impact
of loan defaults have existed for some time as well, though
many have changed dramatically in recent years. The most recent
risk to be analyzed quantitatively is operational risk. Operational
risk is the risk of loss resulting from inadequate or failed
internal processes, people, and systems or from external events.
Operational losses are often headline events: Employee fraud
topples a respected bank; terrorist activity damages bank
property; a bank settles a major lawsuit regarding its lending
practices.
One of the key questions facing both bankers and regulators
concerning operational risk is how much capital should be
kept as a cushion against very large but unlikely losses.
For most activities, the price charged for the service provided
or effective controls and automation can limit the costs of
operational risk to a financial institution. But some operational
losses are sizable, and banks and regulators have been looking
for ways to translate the costs of those unexpected losses
into capital requirements. U.S. bank regulators had been studying
this issue for some time; now it is being incorporated into
the evolving discussion of a new international capital standard
known as Basel II (Basel I is the existing standard).
During 2003, staff in Boston undertook several specialized
studies to gain a greater understanding of banks’ actual
operational loss experience and capital allocations to address
potential losses. Our analysis helped us conduct and support
supervisory examinations within our District and at some of
the country’s largest and most complex banking organizations.
We have disseminated our analytical findings by publishing
research, and we will work with the industry going forward
to take advantage of data and technology to provide effective
supervision. This is a change for us, and our staff is strengthening
its capacity to meet these new supervision needs. Change brings
challenges, for sure, but meeting this challenge will help
the Bank work toward ensuring that the U.S. financial system
remains strong and stable.
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An Economy Transformed: The "New" New Economy
One of the most remarkable features of the U.S. economy over
the past year has been the continuing surge in productivity.
Indeed, after rising at a pace of 2.5 percent per year through
the late 1990s—after better than 2o years at a percentage
point lower—productivity growth surged even higher in
the new century. Over the four quarters of 2003, productivity
growth averaged better than 5 percent per year—truly
a staggering number for a mature, industrialized economy.
It seems unlikely that such strong productivity growth is
sustainable, but it seems equally unlikely that productivity
will revert to its rate of growth in the early 1990s.
What does seem likely is that the nation’s economy
is reinventing itself in the face of newly emerging telecommunications
technologies and intense global competition. The ongoing introduction
of new technology and the ability of businesses to use technology
to improve efficiency augur well for the long run. In the
short run, however, these changes have challenged everyone
with the temerity to attempt economic forecasting—and
that includes monetary policymakers.
In the first half of 2003, growth stalled and productivity
surged, widening the gap between the current level of activity
and the economy’s full-employment capacity. At the same
time, inflation fell to levels that raised concerns among
some. But real growth rebounded in the second half of the
year, and business investment revived after a three- year
hiatus. Partly as a consequence, inflation appears to have
stabilized in recent months.
Despite the resurgence in demand, however, new hiring remained
weak. Boston Fed economists devoted significant research effort
to making sense of this puzzling confluence of revitalized
demand, stagnant employment, and high productivity growth.
We were not alone in our puzzlement, as evidenced by the numerous
newspaper and business magazine articles that flagged and
then flogged potential explanations for labor market doldrums.
Leading explanations in the press included export of jobs
abroad (“outsourcing”); a severe mismatch between
workers’ skills and skills required for new jobs; rising
labor costs, especially for health insurance and contributions
to retirement funds; mis-measurement of employment trends;
permanent substitution of capital for labor in key industries;
a never-ending ability to find efficiency and process improvements
that enabled companies to meet demand without hiring; and
lingering uncertainty about geopolitical and economic prospects.
While all of these explanations have some basis in fact,
and some are painfully real to businesses and employees in
certain sectors, most fall short of the mark. At present,
we are taking some comfort in the fact that our best explanations—some
combination of uncertainties and the continued ability to
achieve process improvements—are transitory and imply
that labor market weakness is transitory as well. We are heartened
by recent indications that hiring is improving. As a result,
we expect that, as firms become more certain that solid economic
growth is here to stay, hiring will resume, and productivity
growth will recede from its very high levels.
One thing of which we can be confident is that the dynamic
U.S. economy will continue to change. In part, changes will
be impelled by the underlying competitive drive that is a
hallmark of our economy. As the economy transforms itself
yet again, we will be confronted with new and challenging
questions about how best to conduct monetary policy. In recognition
of that likelihood, our 2003 annual economic conference focused
on “behavioral economics.” This strand of economics
questions many of the underpinnings of standard economic theory,
including how consumers and businesses respond to changes
in the economic environment. It is probably a bit early to
expect direct application of the insights from behavioral
economics to monetary policymaking. But we believe that by
expanding the set of viewpoints that we bring to analyzing
the macroeconomy, we stand a better chance of detecting and
making sense of new developments as they inevitably occur.
As we seek to better understand the evolving economy, we
expect to benefit from listening to the public about their
real-world experience of economic change, and we hope to share
with them our insights about its consequences for policymaking.
In so doing, we best position ourselves to push out the frontiers
of research and to contribute creatively and effectively to
the formation of monetary policy.
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