Just like private enterprise, the Fed continues
to evolve, adapting to change and reinventing
itself to stay in step with the times.

Chairman's
Message

Monetary
Policy:
To wring double-digit inflation out of the economy, the Fed increased its emphasis on price stability and communicated its policy decisions more openly.

Bank
Supervision:
To more effectively supervise a changing banking landscape, the Fed shifted from one-size-fits-all to customized bank examinations focused on risk.

Financial
Services:
Through a revamped financial services management structure and consolidated automation systems, the Fed aggressively promotes electronic payments.

Conclusion

Financial Statements

Boards of Directors

Economic Advisory Council

Bank Officers

The last 20 years have been a period of remarkable change for the Federal Reserve System. To some, this may be a revelation. Although most of us are familiar with the reengineering success stories of American business, the tale of how the Federal Reserve has retooled in the face of tremendous market change is subject to little fanfare. That is because, to a great extent, changes at the Fed have been transparent to the public.

Most of what the Fed does -- regulate banks, conduct monetary policy and oversee the payments system -- affects the economy profoundly. Sweeping, unpredictable changes in the Fed's operations could lead to uncertainty in financial markets and produce undesirable effects throughout our economic system. So, while the private sector captures headlines with pronouncements of rapid restructuring and dramatic changes in purpose or tactics, the Fed quietly makes deliberate but incremental moves to adjust to -- or stay ahead of -- the evolving marketplace.

These incremental moves are the subject of this year's annual report. On the following pages, you will see that the Fed acts, within the confines of its structure, in a manner similar to the private sector. It is continually analyzing its own operations and methods, and making adjustments when necessary to keep on top of its game: ensuring a steadily growing economy. In this regard, the Fed must be effective at both anticipating and reacting to changes in the marketplace, while maintaining public confidence in the workings of the economy. It is not an easy task.

Before we begin, however, I'd first like to thank several of my retiring colleagues on the boards of this Bank and its Branches for their years of distinguished service. It has been my privilege to serve this organization with Sandra B. Sanderson from the St. Louis board, Robert D. Nabholtz Jr. and Lee Frazier from Little Rock, John A. Williams and Thomas E. Spragens Jr. from Louisville, and Lewis F. Mallory Jr. from Memphis.

I especially want to thank Tom Melzer for his 12 years as president and chief executive officer of the St. Louis Fed. He ably served this Bank, its region and the nation's economy through his unparalleled leadership, integrity and professionalism. Tom's disarming manner and calm, reasoned approach won him respect throughout the Federal Reserve System and from all who had the opportunity to work with him.

At the same time, we are extremely fortunate that William Poole has recently joined the Bank to replace Tom. Getting his start on the staff of the Federal Reserve Board in 1964, Bill brings his distinguished career as an academic scholar and economist full circle in his new role as president. I am confident Bill will provide strong continuity and innovative evolution to the monetarist tradition that is the hallmark of the St. Louis Fed.

John F. McDonnell
Chairman of the Board

An Increased Emphasis on Price Stability
Success in monetary policy came about because of an increased focus on price stability, sustained over the entire period after 1980. Given their experience with high inflation, many central banks around the world have come to realize that low inflation promotes sustainable economic growth. High and variable inflation, on the other hand, distorts the economy's signals about price movements and puts upward pressure on nominal interest rates, as lenders demand compensation for expected inflation and the risk associated with inflation uncertainty.

How the Federal Reserve implements its low-inflation strategy has changed in response to dramatic changes in financial innovation and deregulation over the past two decades. The Fed's chief policymaking body, the Federal Open Market Committee (FOMC), employs a variety of indicators, including monetary aggregates, reserve aggregates and interest rates, to gauge the impact of its policies on the nation's economy. Given the lag between Fed actions and their effect on inflation, monetary policy must be forward-looking and, thus, is most effective when it is preemptive.

To increase an understanding of the preemptive nature of its policies, the Fed has taken steps to conduct monetary policy more openly. In 1994, the FOMC began announcing its policy decisions immediately after making them; in 1995, it began to announce a target level for the federal funds rate; and in 1997, it began including this target in its policy directive. In addition, the Fed now uses the Internet to disseminate economic information, both policy-related and educational.

Ultimately, efforts to broaden public understanding of the Fed's goals and objectives, along with continued innovation in the strategies that drive monetary policymaking, will play a critical part in prolonging our current monetary policy successes. Making the Fed's strategy clear and its performance measurable are key to establishing credibility for a long-term policy that seeks to foster sustained economic growth and increasing standards of living for all Americans.

The nature of competition in the banking industry also has been altered through an unprecedented number of bank consolidations. Computers and the Internet are removing geographic barriers that have traditionally separated many domestic and international markets. And artificial barriers -- such as the laws that have restricted bank growth across state lines -- are coming down as well.

Supervising banks in this environment is a challenge. The risks inherent in rapidly changing markets are often difficult to pinpoint. When financial markets evolved more slowly, and the composition of a bank's asset and liability structure was relatively static, a periodic snapshot of a bank's condition, obtained through an on-site examination, was an effective means of overseeing an institution's stability.

Today, however, evaluating a bank's condition at a single point in time -- using only traditional accounting techniques and balance sheet analysis -- is no longer effective. For this reason, the Federal Reserve developed a new framework known as risk-based supervision.

Shifting the Focus to Risk
Risk-based supervision presumes that a bank's own management is in the best position to monitor the institution's exposure to risk. To verify management's capability in this regard, the Fed's bank examiners must address several issues: Does the bank's management have the expertise to effectively oversee its business strategy? Does management have the internal controls to adequately monitor the bank's activity? Is there a contingency plan to mitigate loss in a worst-case scenario? Risk-based supervision attempts to identify weak banking practices early on so that emerging problems can be contained and remedied, and losses minimized.

The same advances in technology that have changed banking services and competition have enhanced the Fed's ability to conduct risk-based exams. Risk-based supervision enables examiners to shape each review to fit the institution. The examiner may identify areas requiring analysis during a planning period so that on-site examination resources match the areas requiring review. Further, examination data from each bank can be provided to the examiner electronically so that review areas can be analyzed and targeted before the examiner ever enters the institution. New technology also permits particular areas of the bank -- such as a securities portfolio -- to be assessed entirely off-site.

Once on-site, the examiners continue to evaluate aspects of a bank's operations, like the credit quality of the loan portfolio, as they have traditionally. However, the overall emphasis of the examination is very different. Where the primary means of determining the institution's financial and operating condition used to rely heavily on transaction testing, the assessment is now focused largely on assessing ongoing risk management processes, such as how well these processes address banking risks.

The bottom line is whether the institution's ability to manage risk is commensurate with the level of risk it has taken on in its business practices. This assessment is accomplished in a much less disruptive manner than ever before. Examiners are able to reduce the time they spend reviewing low-risk activities and emphasize instead those areas with higher risk. Examinations no longer employ a one-size-fits-all approach; they are tailored to the institution's business lines, risk profile, operating philosophy and size.

Increasing Cooperation among Regulators
The Fed applies federal banking law to bank holding companies and member state chartered banks -- financial institutions with a wide range of sizes, business activities, sophistication and markets. Complicating this task is the recent passage of interstate branching legislation. The legislation eliminated laws that, for generations, prevented banks from branching across state lines and has prompted bank expansion and reorganizations. As a regulator with supervision responsibility on both sides of the dual (federal and state) banking system, the Fed has led initiatives to broaden cooperative agreements with other regulators. While achieving a more consistent partnership with state authorities and other federal regulators, this cooperation also controls the regulatory burden placed on banking organizations. The goal is to make these supervisory efforts seamless by conducting coordinated examinations with more joint resources and expertise, and providing consistent direction to banking organizations that are overseen by multiple regulators.

The Fed's concern for banking safety and soundness extends beyond its domestic borders, too. As a central bank, the Fed is concerned with systemic risk in banking and economic systems -- that is, the risk that a banking failure or financial crisis will spread through financial markets, causing widespread failures. In this regard, the Fed has worked with international regulators to build strategies that promote sound banking practices worldwide. For example, the Basle Committee on Bank Supervision, an organization of supervisory authorities and central banks from around the world, has adopted the Fed's model for risk-based supervision.

New challenges, as always, are in the offing. Two of note are the current debates in Congress on how to dismantle Depression-era laws that have separated commercial banking from the securities industry, and on the expansion of banking powers so that banks can better compete with the growing number of nonbank financial service providers.

A perennial challenge for bank regulators, however, concerns how to strike the appropriate balance of regulatory oversight without overly interfering with market innovation -- since the former ensures prudent industry practices and the latter serves the public's demand for financial services. The Fed is working continually to achieve this balance by ensuring that its supervisory framework remains flexible, comprehensive and efficient, and that it continues to respond to the realities of an industry in transition.

Our payments system has not always enjoyed this high degree of confidence. In the 19th and early 20th centuries, a series of financial shocks battered the nation's economy.

A particularly severe crisis in 1907 was made worse when the system used to clear and settle check payments broke down. In response, Congress chartered the Federal Reserve System in 1913 and gave the Fed the authority to establish a national check-clearing system to improve the stability of the payments system. Today, the Fed supports confidence in the payments system by guaranteeing the large-dollar payments financial institutions make to each other over the Fed's electronic transfer system, Fedwire^®. And, should a financial crisis arise, the Fed can quickly inject cash into the banking system to maintain liquidity.

The payment services the Fed provides have expanded well beyond its founding check-clearing mandate. The Fed offers a variety of services -- primarily Fedwire funds transfers and securities transfers, check processing and the automated clearinghouse (ACH) transactions -- to financial institutions for clearing and settling of paper and electronic payments. In 1996, the Fed processed $464 trillion worth of payments in these services.

Prior to the passage of the Depository Institutions Deregulation and Monetary Control Act (MCA) in 1980, only banks that were members of the Federal Reserve System had access to these services -- services the Fed provided free of charge. The MCA radically redefined the Fed's relationship with its member banks and its participation in the payments system. The MCA required the Fed to open access to its payment services to all U.S. depository institutions and to charge fees for these services, thereby making the Fed compete with private clearing systems. It must recover, in the long run, all costs associated with providing payments services -- including imputed costs like taxes that would be incurred, the cost of capital, and profits that would be earned -- had the services been provided by the private sector.

Thus, the MCA imposed the same market discipline on Reserve Banks that private-sector firms face. To remain viable providers of financial services, Reserve Banks must meet the market's benchmark for quality and price.

Reorganizing Financial Services
In light of the changes brought about by the MCA and in recognition of the forces, like interstate banking and technological changes, that are reshaping the financial industry, the Fed set out to reinvent its management of financial services. This recognition resulted in the creation of the Financial Services Policy Committee (FSPC). The FSPC sets the strategic direction for Fed financial services nationwide. Under the FSPC umbrella, individual Reserve Banks serve as product and function offices for the entire System (see sidebar above). This restructuring transformed a regional approach to payments system innovation and delivery into one that is truly national.

The FSPC's primary objective is maintaining payments system efficiency, integrity and accessibility. This objective is accomplished by focusing on improvements in the Reserve Banks' automated systems and operating environments. Since the FSPC's debut, the Fed's ability to respond to customer needs in a changing environment has improved in a number of ways. One example is the account structure the Fed implemented in 1998 in response to the Riegle-Neal Interstate Banking and Branching Efficiency Act, which allows state-chartered banks to open out-of-state branches. Anticipating this significant change in the banking landscape, the Reserve Banks developed a single account structure for their customers that accommodates institutions operating in multiple states and Fed Districts. This allowed financial institutions with accounts at multiple Reserve Banks to consolidate them into a single account at their "home" Fed bank.

Promoting Electronic Services
The current management structure provides a vehicle for the Fed to aggressively carry out its long-term strategy: improving the payments system through the use of electronic technology. Several of the Fed's high-priority projects along these lines include:

Automated Clearinghouse -- The Fed's development of the automated clearinghouse (ACH) in the 1970s reflects an early effort to bring electronic technology to retail payments. While acceptance has been slow, businesses and governments are now making greater use of the ACH for recurring payments, like direct deposit of employee paychecks and Social Security payments. Since 1990, ACH transaction volume has increased roughly 16 percent a year, reaching 4.5 billion payments worth over $12 trillion in 1997 (see chart). This trend will no doubt continue as the federal government relies more heavily on the ACH to achieve its 1999 electronic payment mandate.

Electronic Check Presentment -- Although some 80 percent of the value of all U.S. payments move over large-dollar interbank electronic systems like Fedwire, these transactions make up less than 1 percent of the total number of payments each year. The reason for this lopsided bias is that Americans find that checks are a convenient form of payment. We write the lion's share of the world's checks -- some 65 billion per year. And, despite the increased use of electronic forms of retail payment -- such as debit cards and the ACH -- over the last five years, U.S. check use has continued to grow approximately 2 percent a year. This preference comes with a huge economic cost: The processing of paper checks is extremely labor intensive, requiring ground and air transportation and the physical handling of millions of checks each day. To bridge the gap between this high cost and Americans' continuing preference for paper checks, the Fed has focused on promoting electronic check presentment (ECP). ECP allows a bank that's collecting a payment to rush the critical payment information electronically to the paying bank. Whether or not the physical checks are returned to the check writer, the handling and processing costs are reduced. Right now, about 11 percent of all the checks the Fed presents are electronic.

Wire Funds Transfer -- Two important efficiency improvements were made to the Fedwire funds transfer system in 1997: The format was expanded, and the operating hours were extended. The changes affect both domestic and international payments markets. The format was expanded in response to industry interest in having more complete information about all parties to a funds transfer. It brings added efficiency to processing and posting transfers. The expanded format, which is similar to those used by international funds transfer and information services, permits increased communication across global systems. The operating hours for on-line Fedwire funds transfers were extended from 10 to 18 hours a day, enabling banks to move money earlier in the day and correspond more closely with settlements in international financial markets. The extended hours reduce risk by giving banks more time to settle their international transactions in the same business day.

Improving Internal Efficiency
An effective restructuring of the Fed's financial services management could not have been accomplished without a parallel effort in the systems that support these services. In this regard, the Reserve Banks are nearing completion of a five-year restructuring effort of their mainframe computer systems, enabling electronic payments like fund transfers and ACH to be handled at central sites, rather than at each of the 12 Reserve Banks.

Consolidation has allowed the Banks to launch new nationwide services and enhance existing ones at a lower cost. It also has dramatically improved the Reserve Banks' disaster recovery and information security capabilities, increased the Fed's ability to respond quickly to change, and expanded the central bank's management of payments system risk. Moreover, the consolidation effort gave the Fed a headstart on preparing its computers for the Year 2000. The consolidation process, begun five years ago, required new centralized applications for services like Fedwire funds and securities transfers, and ACH. All were designed with Year 2000 compliance in mind.

The financial services industry has already realized dividends from the Fed's increased efficiencies in processing Fedwire and ACH payments. These dividends include improved software to run these systems and a series of price reductions begun in 1995, which will generate a savings of $42 million in fees by year-end 1998 for Fed customers.

The Reserve Banks also have improved the efficiency of the other services they provide to banks and the public. The Fed consolidated the number of processing sites for its noncash collection service for maturing coupons and bonds from 27 to one and for savings bond operations from 24 to five. Along with the Treasury, the Fed also has introduced automated processing to the previously paper-based Treasury auction system, thereby improving the accessibility, integrity and timeliness of the Treasury securities auction process. Finally, the Reserve Banks have consolidated the handling of commercial tenders from 13 to three sites using the automated system. Overall, these changes have improved the reliability and security of many Fed services and have enabled the Reserve Banks to respond more quickly to changes in their own business environments and the demands of their business customers.

As we have seen, the Fed has reinvented itself in the face of tremendous technological and environmental change. Indeed, this practice of reinvention is hardly new to the Fed; it has evolved and adapted to market changes throughout its history. In a sense, the Federal Reserve System was reinvented from the start, the result of a 1913 political compromise that sought to mitigate the political and public distrust for government-run banks, which had brought an end to the country's two previous attempts at central banking. Its balance of public and private missions, centralized and decentralized operations, independence from politics, and accountability to the public is unique in American history.

But structure alone does not guarantee future success. Nor should it. Public expectations are high for an institution whose mission is to enhance the nation's economic well being. And, ultimately, the Fed has embraced an even broader public policy mission than is detailed in this report. Through its economic education programs and its community affairs activities, and as a corporate citizen, the Federal Reserve seeks to foster a more widespread understanding of how to achieve the maximum sustainable growth for our economy.

The future legacy of the Fed rests firmly on its ability to adapt and innovate, while not losing sight of its commitment to the public interest. The Fed must continue to reinvent itself and keep up with the times. At the same time, it must carefully gauge the effect of any reengineering effort, considering the impact on its operations, on the economy and on its ability to fulfill its public policy mission. Simply put, achieving efficiency at the expense of damaging public confidence in the Fed's ability to conduct monetary policy, protect the payments system or regulate banking organizations is not an option.