CLEVELAND — The Federal Reserve’s pending creation of its own real-time payments network has won plaudits from community bankers, but there are questions about how it will work in practice, including its interaction with big banks’ existing system.
Loretta Mester, the president of the Federal Reserve Bank of Cleveland and one of the leading forces in the creation of that network, dismissed worries that the two competing networks could lead to bifurcated payments systems for big and small banks.
“We have payment systems like that now, and I don't see that as being a big risk,” she said in an interview. “What you'll end up seeing is ... some banks will be on both, and others will stick with one. But if we make make sure that the message sending is standardized, they'll be able to switch if they want to switch, so there's going to be room for both systems to be very robust systems.”
Mester discussed this and other topics, including financial stability and the creation of a national digital currency, during a sit-down discussion here. Following is an edited transcript of the conversation. For full audio of the interview,
How important is it that the Fed's faster payments network be able to interface directly with the industry-backed Real Time Payments network? How hard is it to make the two networks interoperable?
LORETTA MESTER: We're evaluating now the specs of our system. Certainly, interoperability is on our radar screen, but we haven't made any determinations about where we want to be on that spectrum yet. And partly it'll be, where does The Clearing House see it? We're working with them to address these kinds of issues that are coming up, but I don't think you have to make a decision now on that, because I think banks are going to be able to be members of both if they prefer.
But if you have two networks without interoperability, could payments become balkanized, with one system for large banks and another for small institutions?
We have payment systems like that now, and I don't see that as being a big risk — everything will be bifurcated. I think what you'll end up seeing is ... some banks will be on both, and others will stick with one. But if we make make sure that the message sending is standardized, they'll be able to switch if they want to switch, so there's going to be room for both systems to be very robust systems.
If ubiquity is the goal for the Fed's system, what happens if The Clearing House’s network gains more ubiquity over the next few years? Might the Fed then change its mind about developing its own system?
We're committed to building the system, and here's why. We do care about ubiquity. Ubiquity means you could have firms sign up, but it's also the terms of the signing up, right? We want to make sure that … our firms have equal access.
But I think the other thing is the resiliency of the system. I think actually having two systems … actually makes [payments] probably more [secure]. Each system is going to be secure, but you never know how things are going to work.
What would you cite as the greatest gains that regulators have made since the financial crisis in ensuring financial stability through the business cycle?
One of the things that I think has been very successful is really looking horizontally across firms, as opposed to just looking in individual firms vertically. This mindset and recognition that it's really the financial system — as well as safety and soundness of individual institutions — that's important for a sound and resilient financial structure. That's been a very valuable and important change in the way we think about financial stability. If you look at the regulatory structure in terms of capital, liquidity, stress testing and living wills or resolution [planning], I think those are much sounder, in terms of the way we go about [determining] what the regulations are, and also making sure that they're applied consistently.
The other piece that I think is very important is a recognition that you want to apply rules and regulations and supervision that's tailored to where the risks lie. ... You've seen that there's been some simplification for the regulatory structure for the largest banks, and at the same time for the community banks — more of a "Do we need to put on that kind of regulatory burden on them?” ... I think that's a good direction to go in. But we have to make sure that we don't take things back to pre-Dodd-Frank days, since there's a lot of value in the Dodd-Frank system.
Fed Vice Chairman for Supervision Randal Quarles said recently that it might make sense for the Fed to choose either the proposed minimum stress capital buffer or the countercyclical capital buffer. Do you think there are any differences between those choices?
I'm on record as saying that I thought we should have raised [the countercyclical capital buffer] by now, precisely because we are seeing some risk in terms of leveraged lending and things in the banking system. This is exactly when you want banks to be building capital so that then they can reduce it. One of the methods that Randy suggested was you could have it so that it's not zero ... but it's at a higher level in normal [times], ... and then that gives you an opportunity to lower it when banks are going into a downturn, because they've built up the capital. So that's one method.
The other way is making it tailored to the risk of the bank and just having that stress buffer, not ... a flat [buffer] across all banks. ... Whatever way we go, I think we should probably think harder about what are the triggers for raising the [CCyB], what are the triggers for lowering it. We recently held a tabletop exercise between the board, [Federal Reserve Board Gov.] Lael Brainard, and some of us in the Reserve banks ... where we actually looked at scenarios on how we react, trying to get at this nexus between monetary policy tools and macroprudential tools. One of the lessons that came out of that were probably the triggers that you would need to raise [the CCyB] may not be the same as to lower it.
There is a lot of discussion about central banks developing their own digital currency. Should the Fed develop a FedCoin?
There's no active group working towards Fed digital currency. Obviously, we are monitoring the private-sector currencies … and also other central banks around the world. Some of them are starting to move in a digital currency, at least some experimentation with it. So we're definitely talking to them so that we understand the issues.
We're in a good situation in the sense that the dollar is the reserve currency of the world. We have a very good payment system here. If you think about some countries ... where the uptake [of digital currency] is higher, it's because they don't have as much confidence in their own sovereign currency. We don't have that issue here. In fact, other countries rely on the dollar as the stable store of value.
If you think about the digital currency they are talking about, ... you'd need right connectivity to everyone. How would you do that? And you'd be then having a lot of information on individual transactions of everyone. And frankly, I don't see a need for that here. And I don't know whether I want to be responsible for that here. We have a good payment system that runs for our banks. They're already connected to it. And that seems to be working.
The Cleveland Fed is a central hub for the Fed's cybersecurity supervision. What are the main trends and challenges you're seeing in cybersecurity preparedness for banks you oversee?
One thing we're seeing is that there's a rise of nation states as opposed to individual hackers or private-sector hackers, and there's more connectivity — connections between the nation-states and the private hackers then we might have seen before. This is what our CAST [Cybersecurity Analytics and Response Team] group is telling us.
The attacks are much more sophisticated. They're using tools like AI and machine learning to increase their ability to hack into and find vulnerabilities, which is relatively recent. And I think that's going to continue to develop. As they get better tools, they're going to be able to find vulnerabilities faster and exploit them more than they were before. And then insider threats, of course, have always been on the radar screen, but [also a] more sophisticated way of using insiders. ... There's a big focus within the Federal Reserve on our own systems to make sure that we have very good controls on access management.
There has been some concern about whether the Fed’s recent intervention in the repo market might set a precedent, leading to the expectation that the Fed would intervene again if the market sees another spike. Does that concern you?
I hope not and I don't think so. When we saw some spikes in repo rates in the middle of September and October, we had already announced in early January that we were going to be running an ample reserves regime ... that means we're going to have enough reserves in the system so that we didn't have to continue to intervene in the markets as we did pre-crisis to hit our [interest rate] target. So if there's enough reserves in the system, then we can basically hit our fed funds rate target without a lot of open market operations or intervening in the markets.
In early September, things were fine. We started getting spikes mid-September and into October. ... What we're in the process of doing is intervening in the market to bring reserve levels up to where they were in the early-September time frame. ... I think by sort of pre-announcing that where we want to get to and then how long we think that'll last, I hope that alleviates this “They're always going to intervene” [sentiment].
It is our responsibility to make sure that the markets are liquid enough that we can hit our target and that the short-term interest rates stay well tied to one another.
