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Business
Review
Federal Reserve Bank o f Philadelphia
M ay.june 1991
ISSN 0007-7011
Business
Review
The BUSINESS REVIEW is published by the
Department of Research six times a year. It is
edited by Patricia Egner. Artwork is designed
and produced by Dianne Hallowell under the
direction of Ronald B. Williams. The views
expressed here are not necessarily those of this
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MAY/JUNE 1991
THE EVOLUTION
OF SHARED ATM NETWORKS
James J. McAndrews
Ever since Philadelphia National Bank
installed the nation's first automated teller
machine in 1969, the number of people
accessing their bank accounts through
ATMs has increased dramatically. The
reason is that most ATMs are now part of
shared networks that, through consoli
dation, have expanded both geographi
cally and in terms of machines. This
greater concentration may provide bank
customers with more convenience, but is
it posing a risk of anticompetitive prac
tices by shared networks?
INTEREST RATE RISK:
WHAT'S A BANK TO DO?
Sherrill Shaffer
Stressed by increased competition and a
volatile economy, many banks are ex
posed to more interest rate risk than is
healthy. To correct the problem, how
ever, a bank must first measure how much
risk it faces. The most reliable technique
is some form of "duration" analysis, which
calculates an account's average time to
repricing using discounted components
of cash flow. But applying duration analy
sis is only half the battle. Once a bank has
determined the amount of interest rate
risk it faces, what should it do then?
FEDERAL RESERVE BANK OF PHILADELPHIA
The Evolution
of Shared ATM Networks
F
J - J I v e r since Philadelphia National Bank in
stalled the nation's first automated teller ma
chine in 1969, the number of consumers access
ing their bank accounts through ATMs has
increased dramatically. One reason for ATMs'
frequent use is that most are part of a shared
network— that is, a network that links together
a number of banks and their customers.
Only a few shared networks existed in the
*James J. Me Andrews is an Economist in the Banking
and Financial Markets Section of the Philadelphia Fed's
Research Department. The author thanks Douglas
Robertson for excellent research assistance.
James J. McAndrews*
1970s, but the number grew quickly right up
until the late 1980s, when consolidation elimi
nated nearly half of them. This consolidation
has allowed the remaining networks to expand
both geographically and in terms of number of
machines, significantly improving the quality
of services provided.
The increasing concentration of ATM trans
actions in the largest networks has raised the
issue of anticompetitive behavior. So far, how
ever, competition among ATM networks con
tinues. Nevertheless, both state and federal
antitrust authorities continually monitor the
practices of ATM networks for evidence of
anticompetitive actions.
3
BUSINESS REVIEW
MAY/JUNE 1991
GLOSSARY
Automated Teller Machine (ATM) - A machine used for banking services, including withdrawals
or deposits, balance inquiries, transfers, and other services. Customers access an ATM by using their
debit cards, and the transactions are processed electronically with the aid of computer information
systems.
Consumer Fees - The fees customers pay to use ATMs. Consumer fees for ATM use are not uniform;
they are determined by the customer's bank, not by the ATM network. Many banks offer certain
checking accounts, often with high minimum balances, that include ATM use at no charge. Many
accounts, however, do charge the customer a fee for each ATM transaction.
Debit Cards - Also known as access cards, debit cards are plastic cards encoded with electromagnetic
identification. The banks issue them to customers upon approval of their applications. Customers
can insert the card in an affiliated network ATM to obtain account information and cash.
Duality - The name given to the interchange agreement between the two national networks, Plus and
Cirrus. Under this agreement, a member of one can accept cardholders from the other at no
additional fee.
Foreign Fees - A transaction fee charged the customer for using another institution's ATM. Typically,
foreign fees are higher than the transaction fee customers pay to use their own bank's ATMs.
Gateway - An electronic channel between two networks.
Interchange Fee - Also known as terminal income, an interchange fee is a fee paid to the owner of an
ATM by a network member whenever that member's cardholders use an ATM. The fee is typically
set by the network and currently ranges from 40 cents to $1.
ATM NETWORKS ENHANCE
CONSUMERS' CONVENIENCE
A network is a common way of delivering a
product or service that increases the product's
value by linking many customers together. For
example, the value of a telephone network to
customers increases with the number of cus
tomers that can be reached via the network.
Similarly, ATM networks link together banks
in various locations, giving the customers of
each institution greater access to their bank
accounts.
ATM networks started as proprietary net
works of single banks, accessible only by a
single bank's customers. Often located within
branches of banks, ATMs served as substitutes
for human tellers. They were intended to
improve service quality in branches, and in this
they were successful. Lines for tellers shrank,
and, in some cases, customers were provided
access to their accounts 24 hours a day.
Soon, banks realized that, by sharing ATMs,
they could spread the costs of the machines and
network facilities over many more customers
and transactions while giving customers en
hanced access to their accounts. As a result,
banks created shared ATM networks (see Glos
sary), usually as joint ventures of banks within
various regions of the country.1 The national
'See Paul Calem, "Joint Ventures: Meeting the Competi
tion in Banking," this Business Review (May 1988). Of the 20
largest regional shared ATM networks today, 13 are jointly
owned by a group of banks and seven are owned by a single
FEDERAL RESERVE BANK OF PHILADELPHIA
The Evolution o f Shared ATM Networks
Janies J. McAndrews
Interchange Transaction - A transaction in a shared ATM network in which a cardholder of one
member bank uses another bank's ATM.
Point-of-Sale (POS) Network - A network of banks, point-of-sale cardholders, and merchants that
permits an immediate electronic funds transfer from the bank account of the cardholder to the account
of the merchant.
Network Switch - The electronic equipment that receives and transmits transactions between the
bank that operates the ATM and the bank that holds the customer's account and issues the card used
in the transaction.
Proprietary ATM Network - An ATM network owned and operated by one depository institution
and accessible only to that institution's customers.
Reciprocal Sharing Agreement - An interconnection agreement between regional ATM networks
that allows the networks to conduct interregional transactions directly rather than route them through
a national network.
Shared ATM Network - An ATM network accessible to multiple depository institutions' customers.
Surcharge - A direct charge to ATM users assessed by the owner of the ATM. Surcharges, which are
charged only rarely, range from 15 cents to $1.
Switch Fee - A fee charged by the network for the use of its switch. Typically, it is paid by the bank
that holds the customer's account. The fee ranges between 2 cents and 25 cents per transaction,
depending on the network and the volume of transactions originated by the member bank.
networks came later, in the early 1980s, and
were designed for "long-distance" ATM trans
actions.
Sharing Provides an Expanded Service. Be
fore shared ATM networks, banks had to build
firm. ATM networks serve either a particular region of the
country— such as the MAC network, which serves the MidAtlantic and Northeast regions—or the entire nation. There
are only three national networks: the two largest networks,
Plus and Cirrus, and one smaller network, the Exchange.
Currently, the vast majority of ATM transactions are carried
out within regional networks. For earlier discussions of
shared ATM networks, see Steven D. Felgran, "Shared ATM
Networks: Market Structure and Public Policy," in New
England Economic Review (January 1984), and Felgran and
R.E. Ferguson, "The Evolution of Retail EFT Networks,"
New England Economic Review (July 1986).
branches in order to enhance their customers'
geographical access to bank accounts. How
ever, branching had only limited success in
expanding customer service. Banks were pro
hibited from branching across state lines, and
many states imposed limits on branching within
their boundaries.2 The advent of shared ATM
networks, however, meant that one bank's cus
tomers could use another bank's ATMs, even if
they were located across state lines. (See Typi
cal ATM Network Transactions, p. 6.)
2In 1987, for example, eight states restricted banks to
having a single office, and 18 other states allowed only
limited branching.
5
BUSINESS REVIEW
MAY/JUNE 1991
Typical ATM Network Transactions
Illustrated here are the possible links between two shared regional networks, "Eastnet" and
"Frontier"; a shared national network, "Union National"; and member banks. Besides transactions fees,
networks charge membership fees on an annual basis, as well as fees based on the number of cards the
member bank issues. The fees used in these examples are actual fees of shared ATM networks.*
A typical shared regional ATM network transaction:
Penelope O'Malley, a customer of First East Bank, wants to withdraw some cash from her account.
She uses the nearest ATM, which happens to be owned by Yankee Bank, and her debit card, issued by
First East, to initiate the transaction. Both First East and Yankee Bank are members of the Eastnet regional
network. The Eastnet regional switch relays the necessary account information and approval to First
East and back to Yankee Bank. The transaction is approved, and Penelope gets her cash.
First East must pay the Eastnet network a switch fee of anywhere between 2 and 10 cents for
processing the transaction. In addition, First East must pay Yankee Bank a 40-cent fee, called the
interchange fee or terminal income, set by the Eastnet network, to compensate Yankee Bank for having
deployed the machine and the cash that Penelope received. First East Bank itself may charge Penelope
a transaction fee, of 25 cents, just for using an ATM. (Some banks do not charge transactions fees to
customers who meet special requirements—for instance, customers who maintain high minimum
balances in their accounts.) If First East charges Penelope a higher fee— say 50 cents— it's because she
used a network ATM not owned by First East; this higher fee is typically called a foreign fee. And, finally,
Penelope may, in rare circumstances, be charged directly by Yankee Bank for using its ATM. Yankee
Bank charges from Penelope's account at First East a fee, called a surcharge, which may be as high as
$1. Banks set the consumer fees independently of the network and other network members; the network
sets the switch fee and the interchange fee.
A typical national ATM network transaction:
Since her bank is a member of the Union National ATM network, Penelope can obtain cash from any
ATM displaying the Union National logo. Suppose she is traveling on the West Coast and wants to
withdraw cash from an ATM owned by Cactus Federal, a member of both the Frontier and Union
National networks. Once again, the necessary account information and approval are relayed between
her bank, First East Bank, and the bank owning the ATM, Cactus Federal. Because these banks have only
the national network in common, the national switch relays messages back and forth through gateways
provided by the regional switches, Eastnet and Frontier. In this case, First East Bank pays a national
switch fee of 5 cents to the national network—plus regional switch fees, which may amount to about 20
cents, both to its regional network, Eastnet, for providing the gateway to the national switch, and to the
receiving regional network, Frontier. First East also pays Cactus Federal an interchange fee, set by the
Union National network, of 50 cents. In effect, then, First East had to pay three switch fees to carry out
Penelope's national network transaction.
T h e fees depend on the transactions volume of a bank's customers. The fees presented here are not meant to reflect
the average cost of an ATM transaction, but to give the reader an idea of the approximate size of the ATM network fee.
6
FEDERAL RESERVE BANK OF PHILADELPHIA
The Evolution of Shared ATM Networks
James J. McAndrews
An interregional transaction if there is a reciprocal sharing agreement:
If Eastnet and Frontier have a considerable amount of traffic between their networks, it may pay them
to establish a reciprocal sharing agreement that allows them to create a channel between themselves and
bypass the national switch in interregional transactions like Penelope's. In this case, First East Bank
would pay a total of only 70 cents (as opposed to 75 cents when using the national network), of which
40 cents would go to Cactus Federal as the interchange fee and the remaining 30 cents would be shared
by Eastnet and Frontier, to compensate them for the switching and for the channel they had to create in
order to carry out the shared transactions.
7
BUSINESS REVIEW
A key legal decision ratifying this practice
was the Marine Midland decision of 1984, in
which a Federal Appeals Court held that an
ATM is not a branch of a bank. By deciding that
network ATMs were not branches of national
banks, the court allowed banks to expand ac
cess to their customers through network ATMs
without being bound by the restrictive prohibi
tions on branching.
A shared ATM network can expand access
to a customer's account in at least two ways.
First, geographically diverse member banks,
having deployed ATMs for their own deposi
tors, offer use of their machines to other banks'
depositors. Second, and perhaps more impor
tant, sharing encourages deployment of ATMs
at new locations.
For example, consider the deployment of an
ATM at a commuter train station. Suppose that
the customers of 10 banks pass through the
station and that any one bank's customers will
generate 1000 transactions per month. Sup
pose further that it requires 3000 transactions a
month for the ATM machine to break even.
Without sharing, no machine will be put in
place. But with a shared network of all 10
banks, there is a strong incentive to place a
machine at such a busy public place because, in
addition to serving its own depositors, the
ATM owner can earn interchange revenue
when other banks' customers use the ATM.
The Expanded Service Represents a Net
work Externality. A network externality is a
boost in the value customers place on a product
or service as its network of users expands. For
example, a new bank and its customers, by
joining a shared ATM network, create a net
work externality for all the existing ATM net
work members by allowing them to access their
accounts at m ore locations. The larger
cardholder base in the expanded network makes
deployment of new ATMs more profitable,
which further enhances the accessibility of ex
isting members' accounts. The larger the net
work, the more convenient are the ATM loca
8
MAY/JUNE 1991
tions, and the more the customer values mem
bership in the network.
Network externalities occur in the provision
of many goods and services. Besides the tele
phone industry, other beneficiaries of network
externalities include credit cards and other
payment systems, fax machine networks, train
systems, and computer software. Each prod
uct increases in value as the network of users
becomes larger.
Because an expanded network increases the
value of the product, its customers are willing
to pay more for it. This greater willingness to
pay for the good or service— combined with
lower per-unit costs that economies of scale
generate for larger networks—creates a sur
plus that will be shared between the producers
and the consumers. Since a growing network
can generate a surplus, producers of goods and
services that create network externalities have
an incentive to expand their network, up to the
point when either the network externality or
the economies of scale disappear and no addi
tional surplus is generated by expansion.
THE GROWTH AND CONSOLIDATION
OF SHARED ATM NETWORKS
As more and more financial institutions rec
ognized the benefits of sharing, the number of
shared regional ATM networks increased rap
idly, peaking in 1986 at almost 200. Since then,
consolidation—mergers and outright purchases
of one network by another—has nearly halved
the number of regional networks, to about 100
(Figure 1).
Meanwhile, the number of ATMs has con
tinually increased, rising from less than 10,000
machines in 1978 to approximately 80,000 in
1990, one for every 3000 people. The steady
increase in the number of transactions and
ATM debit cards in recent years reveals that the
ATM transaction has become a common way
for people to access their bank accounts. It is
estimated that half of all U.S. households use
ATMs at least once a month.3 Furthermore,
FEDERAL RESERVE BANK OF PHILADELPHIA
The Evolution of Shared ATM Networks
James J. McAndrews
tion of network activity
has risen even more than
Shared ATM Networks
we would expect based
Networks
on the consolidation of
networks. Indeed, the
largest netw orks are
transacting an increas
ing share of ATM activ
ity. While in 1982 the
top 20 regional shared
networks accounted for
about 15 percent of all
regional shared network
transactions, today they
account for over 90 per
cent, and the top six ac
count for 60 percent.
The drop in the
num ber of netw orks
Sources: TransData Corporation; Bank Network News; The Nilson Report (various
years).
stems from two factors:
1) the formation of new
although the number of shared ATM networks shared networks has slowed; and 2) mergers
has declined in the past several years, the activ and acquisitions have reduced the number of
ity of existing networks has increased steadily. existing networks.
Reduced Entry. In the early 1980s, all the
Plus and Cirrus, the largest national net
works, began as joint ventures in 1982, some 10 ATM networks were small, and the many new
years after the regional networks. Banks around entrants to the market did not face the prospect
the country recognized that travelers would of formidable competition—in other words,
benefit from being able to access their bank the presence of very large, well-known net
accounts even when away from home. Accord works. As these large networks evolved, they
ingly, the number of transactions in national reduced the incentive for others to form new
networks has grown rapidly in recent years.3 networks. Consequently, while about 20 new
4
(See ATM Transactions and Card Growth, p. 10.) networks entered the market per year in the
Increasing Concentration. The concentra first half of the 1980s, this rate of entry slowed
to about five per year in the last half of the 1980s.
Mergers Concentrate Network Activity.
Some of the increase in the largest networks'
3"Teaching ATMs New Tricks," American Banker, De
relative size is due to internal expansion, but
cember 3,1990.
much of it owes to mergers and acquisitions. In
1989 and 1990, at least 18 shared networks were
4Other national networks that link ATMs, but do not
either acquired by other networks or merged
provide access to customers' bank accounts (in other words,
into a new network. An example is the recent
they are not used with bank access cards), include the Visa
merger of the Honor, Relay, and Avail net
network, which links 17,897 machines, and Express Cash,
which links 16,100 machines. And finally there is the
works into the Southeast Switch network.
Exchange, a third national network, though it is much
Among regional networks, Honor, Relay, and
smaller than either Plus or Cirrus.
FIGURE 1
9
BUSINESS REVIEW
MAY/JUNE 1991
people will be willing
to pay for it— net
ATM Transactions and Card Growth
works have an incen
tive to expand. In
Year
Monthly
Monthly ATM Volume
Debit Cards
doing so, they can
Regional ATM
in Cirrus, Plus, and
(millions)
hope to capture at
Transactions
Exchange
(millions)
(millions)
least some of the sur
plus created through
1978
41.0
0
NA
higher revenue, gen
erated in part because
1979
63.5
0
NA
more transactions are
1980
100.0
0
NA
routed through the
network switch. Fac
NA
1981
135.0
0
ing competition for
1982
167.0
0
60.0
d ep o sito rs, banks
wish to offer their cus
1983
200.0
0.1
74.6
tomers membership
in the best network
1984
261.0
0.5
100.0
available. If one net
1.4
130.0
1985
296.0
work in the region has
many member banks
301.0
2.6
140.0
1986
and many ATM loca
152.0
1987
335.3
3.6
tions while another
n etw ork has few
1988
375.3
7.1
170.9
members and loca
tions, then the bank
183.9
1989
422.2
12.2
that has decided to
191.4
1990
474.9
19.6
offer its custom ers
debit cards would pre
fer membership in the
Sources: Bank Administration Institute; Bank Network News; Cirrus System, Inc.; Plus
System, Inc.; The Nilson Report; TransData Corporation (various years).
first network, other
things equal.
There is a tendency
Avail ranked eighth, ninth, and fourteenth, for a network, if it gains some small advantage
respectively, in transactions volume in 1990. over a rival network, to benefit from a "band
The merged network would have ranked fourth. wagon effect" that increases its size and further
enhances its initial advantages.5 As these large
WHY CONSOLIDATION HAS OCCURRED networks evolve, they create barriers to market
Consolidation has occurred mainly for three entry. By offering their members the benefits of
reasons: 1) the presence of network externali lower switch fees due to economies of scale,
ties; 2) economies of scale; and 3) relaxed bar
riers to interstate banking.
5See Joseph Farrell and Garth Saloner, "Standardization,
Network Externalities Create Incentives for
Compatibility, and Innovation," Rand Journal o f Economics
Larger N etw orks. Because of netw ork 16 (1985) for a model and discussion of the bandwagon
externalities— the wider the network, the more effect.
10
FEDERAL RESERVE BANK OF PHILADELPHIA
The Evolution o f Shared ATM Networks
James J. McAndrews
increased interchange
FIGURE 2
due to greater network
externalities, and name
Interchange Volume of the Top 60 Networks
recognition among con
Percent
sumers, they can stifle
o th er n etw o rk s' a t
tempts to enter the mar
ket.
The im portance of
this incentive to expand
an ATM network can be
measured by the num
ber of "in terch an g e"
transactions, which oc
cur when the customers
of one bank access their
accounts through an
other bank's ATM. As
Note: The figure shows the interchange volume of the top 60 networks as a percent
the num ber of inter
of the total transaction volume of the top 100 networks.
change transactions in
Source: Bank Network News (various years).
creases, the revenues
from the netw ork
"switch fee" rise. The percentage of ATM due to economies of scale has been the Plus
network transactions that are interchange trans network. Having charged a 10-cent switch fee
actions has increased dramatically as ATM since its inception, this national network even
activity has become more concentrated in the tually lowered the fee to 5 cents per transaction
largest networks (Figure 2). The reason is that in 1989 after its transaction volume had grown
the larger networks are able to provide a more sufficiently large.
convenient service that yields more network
Interstate Banking Has Spurred Network
activity.
Consolidation. Today, many states offer some
Large Networks Can Take Advantage of form of interstate banking, and bank holding
Economies of Scale. Every network must have companies have been quick to cross state lines
computer equipment and standards by which by purchasing or organizing a new subsidiary
a transaction is "switched," or processed. These bank.7 But as banking organizations entered a
resources are subject to economies of scale— as new state, they frequently found that a differ
more banks join the network and more transac ent network was prominent. The result was
tions are routed through the switch, the cost per that banks often had to join both networks,
transaction drops. In fact, the switch fees of resulting in duplicate membership fees and
networks have declined as the networks have different formats for transactions—a strong
grown larger, which provides evidence of this incentive for consolidation. The merger of the
effect.6 A clear example of reduced switch fees
6See "The Switch Fee Elevator: 'Going Down /"Bank
Network News, February 10,1990.
7For a review of interstate banking legislation, see Paul
Calem, "Interstate Bank Mergers and Competition in Bank
ing," this Business Review (January 1987).
11
BUSINESS REVIEW
southeastern networks Honor, Relay, and Avail
into the Southeast Switch is a prime example of
this incentive's effects. The southeastern states
have allowed regional bank holding companies
to cross state lines for many years. By merging
the networks, the multistate banking member
can use a standard format and avoid competing
with itself.
WILL NETWORK CONSOLIDATION
CONTINUE?
It is difficult to judge how extensive network
externalities and economies of scale are for
shared ATM networks. In some network in
dustries, such as the telephone industry, con
solidation led to a single monopoly firm. In
others, such as the credit-card industry, mul
tiple firms compete.
National Network Duality. The Plus and
Cirrus networks concluded an agreement of
interconnection, popularly known as "dual
ity," in 1990. Under this agreement, an ATM
owner, by belonging to only one of the two
networks, can service the cardholders of either
network without having to pay additional mem
bership fees. As a result, "long-distance" ATM
service may soon be available through a single
network, since not all ATM owners have yet
taken advantage of duality. This network now
represents a more credible competitive threat
to regional networks, since a bank could drop
membership in, say, a high-fee regional net
work and be a member only of the national
network. Since most ATMs in the country are
owned by banks that are members of either Plus
or Cirrus, the bank would still be able to offer
its customers convenient service. As a result,
depending on the costs of providing quick and
efficient service, the national network could
ultimately displace regional networks.
Regional Networks Continue to Merge.
The merger of regional networks is a continu
ing trend. Increasingly, single networks are
coming to dominate the ATM market in a city
or region. A good example is the MAC net
12
MAY/JUNE 1991
work, the only regional network in the Phila
delphia area.
In addition to consolidation, many regional
networks have made bilateral interconnection
agreements. These agreements allow one
network's customers to use another network's
machines without the customer's bank incur
ring both a national and a regional switch fee.
A recent survey estimates that the number of
transactions conducted under such agreements
grew by 50 percent between 1989 and 1990.8
*
By expanding the size of their effective net
work, the interconnected regionals can more
successfully rebuff competition from another
network. In particular, through either con
solidation or bilateral interconnection, the re
gional networks can give the national network
increased competition, since the interchange
traffic between the regional networks can effec
tively bypass the national switch. These agree
ments are limited to networks that have a
sufficiently large volume of transactions flow
ing between them to support developing both
a channel between the networks and the meth
ods to process the transactions.
PUBLIC POLICY CONCERNS
Weighed against the obvious benefits of
shared ATM networks are concerns about non
competitive behavior by network industries.
While joint ventures among competing firms
often result in superior service to the public,
they always raise questions of collusion in
pricing and of attempts to exclude other com
petition from entering the business. A domi
nant network can extract a large share of the
benefits of network externalities through mo
nopolistic pricing and restrictions on member
ship.
Discriminatory and Exclusive Membership
Practices. One practice considered anticom
8"Network-to-Network Links Build Transactions," Bank
Network News, October 11,1989.
FEDERAL RESERVE BANK OF PHILADELPHIA
The Evolution o f Shared ATM Networks
petitive is discriminatory access to the net
work, such as allowing a small bank to join only
if it pays an exorbitant membership fee unre
lated to the cost of membership; the small bank,
in order to offer its customers the convenience
that other banks offer theirs, would probably be
willing to pay a high fee. Also considered
discriminatory is the fact that most ATM net
works restrict membership to depository fi
nancial institutions, even though money-mar
ket mutual funds and brokerage firms could
offer many of the same services through ATMs.
These other types of firms could conceivably
start their own ATM networks; however, if an
ATM network of depository institutions be
comes the dominant network, then entry would
be difficult owing to the bandwagon effect, and
the other institutions may be denied access to
an important method of delivering services.
Another practice that can be anticompetitive
is exclusionary membership: forbidding a net
work member from simultaneously joining
another network. Before duality, for example,
the Plus network forbade its members from
belonging to Cirrus. Regional ATM networks,
however, allow their members to also join a
national network, which reduces the concern
about this particular anticompetitive practice.
In October 1990, the Plus network proposed
a rule that some regional networks believe may
be anticompetitive.9 It requires that any trans
action carried out between two regional net
works whose only logo in common is Plus (on
both access card and machine) be routed
through the Plus switch. The routing require
ment reduces the regional network's ability to
engage in reciprocal interconnection, discour
aging this type of competition. The rule on
transactions routing is a type of exclusionary
James / . McAndrews
clause in that Plus is requiring the transaction to
be routed through the national switch even if
the two regional networks involved can more
efficiently route the transactions directly. Be
cause of the regional networks' criticism of the
rule, its implementation has been postponed
pending further discussions with the regional
networks.1
0
Anticompetitive Pricing Practices. If one
network charges an extremely low fee for its
services in the short run, it may—thanks to the
bandwagon effect—be able to establish a domi
nant, or even monopolistic, position by attract
ing a large base of members from other net
works. Once it establishes its monopoly by
engaging in predatory pricing, it could then
raise prices to a high, noncompetitive level.
Compared to a competitive network, a mo
nopoly network can set prices to extract a larger
share of its service's benefits. But entry into the
industry would be deterred nonetheless, since
no entrant could offer a prospective member a
large base of other members.
Public Policy in Action. U.S. antitrust laws
provide penalties for networks found to be
engaging in anticompetitive practices. In 1985,
a Justice Department official, in outlining
Justice's views on shared ATM networks, stated
that the agency would not attempt "to apply
limitations to the structural evolution of the
industry."1 However, the official pointed out
1
that anticompetitive practices by networks
would be cause for limitations on their behavior.
The Justice Department and the Conference of
State Attorneys General monitor shared ATM
networks to determine if a particular practice
warrants an antitrust action. To date, there
1 See "Plus Takes a Routing Rule Time-Out,"
0
Network News, January 26,1991.
9See "Plus Establishes a Routing Rule," Bank Network
News, October 26,1990, and "Plus's Routing Rule Faces An
EFT Baptism By Fire," Bank Network News, November 10,
1990.
Bank
H
See "Remarks of Charles F. Rule, Acting Assistant
Attorney General, Antitrust Division, Before the Federal
Bar Association and the American Bar Association," May
23, 1985.
13
BUSINESS REVIEW
have been few instances of regulatory action
against ATM networks. (See The Bandwagon
Effect: Plus, Cirrus, and Entree for a case in which
several states brought suit alleging violations
of the antitrust laws in an allied electronic
funds transfer network.)
Because of the interconnection of the Plus
and Cirrus systems, the Conference of State
Attorneys General has stated it will be closely
monitoring the behavior of these two national
networks for anticompetitive practices.1 The
2
Attorneys General expressed concern that du
ality would stifle technological developments,
reduce ATM deployment, and result in higher
prices. They have decided, however, not to
obstruct the duality agreement on antitrust
grounds.
Meanwhile, the same group is concerned
about national networks engaging in predatory
pricing that encourages banks to bypass re
gional networks. In 1988, an assistant attorney
general of New York State expressed concern
that Visa was engaging in predatory pricing
when it offered to process the transactions of
several southeastern ATM networks for 2 cents
per transaction—a level far lower than the
transactions fees charged at that time.1 (The
3
offer was not accepted.) Significantly, how
ever, a great deal of information is required to
judge whether a particular pricing practice is
anticompetitive.
Additional laws at the state level—called
mandatory-sharing laws—assist in preventing
anticompetitive practices.1 By the mid-1980s,
4
12From a letter by Kenneth O. Eikenberry, Attorney Gen
eral of Washington, to Plus and Cirrus, August 13,1990.
13See "Trustbusters Spear Entree and More," Bank Net
work News, August 11,1989.
14To learn more about the effects of mandatory-sharing
laws, see Elizabeth S. Laderman, "The Public Policy Impli
cations of State Laws Pertaining to Automated Teller Ma
chines," Federal Reserve Bank of San Francisco Economic
Review (Winter 1990).
14
MAY/JUNE 1991
more than 20 states had enacted laws requiring
a shared ATM network to allow membership,
at a reasonable fee, of any financial institution
seeking to join. The mandatory-sharing laws
reduce the network's ability to engage in dis
criminatory membership practices and to charge
excessive fees. Although the laws do not define
a "reasonable" fee, a financial institution could
take the network to court if it had evidence that
the network's fees were unreasonable. The
network, then, must stand ready to justify its
prices in court.
If a monopoly ATM network were to de
velop, we may expect policymakers to create a
regulatory agency that oversees the system's
prices, much like state public utility boards
regulate prices charged by gas and electric
utilities. To date, however, no direct regulation
of prices has been implemented.
CONCLUSION
The billions of transactions carried out each
year by shared ATM networks are indisputable
evidence that these networks have greatly en
hanced the convenience of basic banking ser
vices. The ability of shared networks to offer a
new service— geographically convenient ac
cess to bank accounts at a substantially lower
cost—has spurred the creation and growth of
networks at both the regional and national
levels.
National network duality has led to the pos
sibility of an interconnected national network,
although that has not happened to date; in
many regions of the country, a single network
transacts most ATM activity. Network consoli
dation will likely continue at the regional level
through mergers and interconnection with other
networks.
The consolidation overall has been due to
the incentive producers have to expand the
networks. The wider the network, the more
customers will be willing to pay for it, which in
turn creates a surplus to be shared by network
and consumer alike.
FEDERAL RESERVE BANK OF PHILADELPHIA
The Evolution of Shared ATM Networks
James J. McAndrews
The Bandwagon Effect: Plus, Cirrus, and Entree
Plus began in the 1970s as the proprietary network of Colorado National Bank. Originally, it
positioned itself as a processor of ATM transactions for other banks in the region. Then, in the mid1970s, Colorado National decided to include shared ATMs, creating the Rocky Mountain BankCard
system. By 1979, more than 15 percent of the banks in Colorado, New Mexico, and Wyoming had
joined the network. In 1982, the network saw the need for a national network, and 26 banks from
around the nation incorporated the Plus System, Inc.
Cirrus, too, was formed in 1982, when a group of 12 large banks around the nation also saw a need
for a national ATM network. Both Cirrus and Plus were quickly organized, and both were in
operation by 1983.
In February 1987, Visa acquired an ownership interest in Plus, and in January 1988 MasterCard
acquired Cirrus. In June 1987, Visa and MasterCard, with the assistance of Plus and Cirrus, agreed
to jointly develop a point-of-sale (POS) system called Entree. A POS system is an on-line method for
merchants to receive payment from their customers. A shared POS system, like a shared ATM
system, allows many banks' customers to use the POS machine at the merchant's site. The system
directly debits the customer's bank account and provides payment to the merchant.
By February 1989, more than 170 banks had joined the planned network, representing a potential
card base of 17.8 million. However, few merchants had been introduced to the program.
With the creation of Entree, several states in July 1989 filed suit against Visa and MasterCard,
alleging intent to monopolize the POS market in violation of the Clayton and Sherman antitrust acts.
The State Attorneys General contended that "defendants have obtained dominant control of the
manner, pace and circumstances for introduction of a national EFT-POS system.... This dominant
control also suppresses competition because potential entrants into the national EFT-POS market
confront what is essentially a joint venture of the two bankcard associations, the two largest shared
national ATM networks ... and potentially all of the major banks in the United States."3
The allegation that the Entree plan deterred entry into the POS market is supported by studies of
network industry competition. Researchers have shown that a product preannouncement in an
industry with strong network externalities, such as Entree, can deter entry by preventing an
alternative network from gaining a large enough base of members to make it an attractive alternative.b
Such an announcement can work in this way if it succeeds in convincing enough participants to delay
joining any network other than the preannounced one. In other words, if enough participants
anticipate the bandwagon effect in the preannounced product, they can reduce the possible
bandwagon for competing products.
The suit sought a divestiture of Plus and Cirrus, as well as prohibitions on Visa and MasterCard
from jointly operating Entree or any other POS system. In an out-of-court settlement in May 1990,
Visa and MasterCard agreed not to develop Entree. However, they admitted no wrongdoing and
were not required to divest themselves of Plus and Cirrus.
a"The States of New York, Arizona, California, Connecticut, Louisiana, Maryland, Massachusetts, Minnesota,
Tennessee, Texas, Utah, Washington, West Virginia, and Wisconsin against Visa U.S.A., Inc., and MasterCard
International, Inc.," First Amended Complaint, CV-89-5043 (PNL), United States District Court, Southern District
of New York.
bSee Joseph Farrell and Garth Saloner, "Installed Base and Compatibility: Innovation, Product Preannouncements,
and Predation," American Economic Review 76 (1986).
15
BUSINESS REVIEW
Large networks, however, pose risks of
anticompetitive practices, such as discrimina
tory membership rules and monopolistic pric
ing. Federal antitrust laws and the mandatory
sharing laws in many states are designed to
16
MAY/JUNE 1991
prevent these practices. So far, however, spir
ited competition continues between the na
tional systems and the regionals (due to the
regionals' reciprocal sharing agreements) and
among regional networks.
FEDERAL RESERVE BANK OF PHILADELPHIA
Interest Rate Risk:
What's a Bank to Do?
Sherrill Shaffer*
I n today's competitive environment, banks
and regulators alike must become more famil
iar with ways to measure and control interest
rate risk, despite the complexities involved.
Fluctuations in interest rates can either raise or
lower the net worth of a financial institution
when its assets and liabilities do not respond in
the same direction or by equal amounts. True,
gains and losses may tend to average out over
time if interest rates move in both directions
*Sherrill Shaffer is Assistant Vice President and Chief of
the Banking and Financial Markets Section, Department of
Research, Federal Reserve Bank of Philadelphia.
over the long term; nevertheless, the short
term losses from even temporary adverse con
ditions can be very costly. For example, the rise
in interest rates in the early 1980s was a leading
cause of losses in the savings and loan industry.
To do anything about interest rate risk, a
bank must first measure how much it has.
Unfortunately, traditional measures of such
risk, while convenient, provide only rough
approximations at best. Analysts have known
better measures for years, but banks have been
slow to adopt them because of their complexity
and data requirements. Similarly, regulators to
date have sometimes appeared ambivalent
about encouraging banks in this direction.
17
BUSINESS REVIEW
MAY/JUNE 1991
Once it has adopted a reliable measure of
interest rate risk, a bank must choose how to
respond. Techniques now exist for hedging
against interest rate movements, but those same
techniques can just as easily be used for specu
lative purposes. Moreover, hedging involves
direct costs, as well as the forgone profits that
an unhedged bank would have earned had it
gambled correctly on a change in rates. Gone
are the days, however, when a bank can safely
ignore the issue.
Recent losses and the current economic envi
ronment strongly suggest that many banks are
exposed to more risk than is desirable and that
at least some degree
of hedging is essential.
Interest rates have
fluctuated much more
over the past decade
than in earlier periods,
implying larger potential lo sses for an
unhedged portfolio.
M oreover,
even
though interest rates
are currently lower than in the early 1980s,
banks' operating margins tend to be thinner
and more variable—and hence more vulner
able to losses due to interest rate risk—because
financial markets are more competitive.
three months, three months to one year, and so
on. Within each category, the gap is then
expressed as the dollar amount of assets minus
liabilities. This approach, however, offers no
single summary statistic that expresses the
bank's interest rate risk.
Traditionally, depository institutions have
had longer average maturities on the asset side
than on the liability side. For example, smaller
banks and thrifts, especially, often use deposit
liabilities payable on demand to fund long
term assets such as fixed-rate mortgage loans.
Such banks would have a large negative matu
rity gap in the shorter-maturity brackets (short
term liabilities ex
ceed short-term as
sets) and a large posi
tive gap in the longerm atu rity brack ets
(long-term assets ex
ceed long-term li
abilities). In this situ
ation, a rise in inter
est rates would lead
to a higher cost of
funds before loan rates could adjust, narrowing
the bank's interest rate spread and lowering its
profits.
Even though the maturity gap can suggest
how a bank's condition will respond to a given
change in interest rates, it omits certain impor
tant factors, including cash flow, unequal inter
est rates on assets and liabilities, and initial net
worth. It is therefore more appropriate to view
the maturity gap as an indicator of a bank's
liquidity risk, not its interest rate risk: in the
event of massive withdrawals of deposits, the
rate of withdrawal is limited by the maturity of
the deposit accounts; likewise, the rate at which
assets can be liquidated to meet the withdraw
als is limited by the maturity of loans and other
assets. Liquidity risk is important and plays a
valid role in maturity-gap management. How
ever, we need a better measure of interest rate
risk.
The "right" theory
for the problem
was advanced at least
as far back as 1938.
MEASURING INTEREST RATE RISK
The traditional measure of interest rate risk
is the maturity gap between assets and liabili
ties, which is based on the repricing interval of
each component of the balance sheet—that is,
the period of time over which the interest rate
is required by contract to remain fixed. The
repricing interval of a fixed-rate account equals
its maturity. For adjustable-rate assets or li
abilities, the repricing interval is given by the
date of the next adjustment.
To compute the maturity gap, an analyst
would first group assets and liabilities accord
ing to their repricing intervals, such as less than
18
FEDERAL RESERVE BANK OF PHILADELPHIA
Interest Rate Risk: What's a Bank to Do?
A Conceptual Alternative. The "right"
theory for the problem was advanced at least as
far back as 1938, when Frederick Macaulay
formulated the concept of duration. Duration is
usually presented as an account's weighted
average time to repricing, where the weights
are discounted components of cash flow. Origi
nally, however, the technique was devised to
determine what percentage change in present
value would result from a 1 percent change in
the interest rate.1 In its simplest form, duration
provides the correct answer to this question
only under special conditions. The most re
strictive conditions are that interest rate move
ments be small and that long-term interest rates
be equal to short-term rates at all times. (See A
Simple Example of Duration Analysis, p. 21.)
A bank is perfectly hedged against interest
rate risk when the duration of its assets, weighted
by dollars of assets, equals the duration of its
liabilities, weighted by dollars of liabilities.2 The
difference between these two weighted dura
tions is called the duration gap, distinct from
the maturity gap discussed above. The larger
’Many people are surprised to realize that this response
factor corresponds to units of time: percent, divided by
percent per year, equals years. Excellent introductions to
duration theory are provided by Kaufman (1984), French
(1988), and, on a more academic plane, Grove (1974). To see
that the duration of an asset need not equal its maturity,
consider a two-year loan for $200 at 8 percent repaid in
equal installments of $112.15 each year. The present values
of the cash payments are $103.85 and $96.15, so the duration
of the loan equals (1 x $103.85 + 2 x $96.15)/$200 = 1.48
years. More generally, the formula for duration is [E^, tPt/
(1 + rt)‘]/[E * j Pt/(1 + rt)*], where Pt is the cash flow in period
t, rt is the interest rate in period t (usually assumed in
textbooks to be constant across t), and T is the maturity of the
loan. The box on p. 21 explains in more detail how duration
is calculated.
2This implication of duration theory was first derived by
Samuelson (1945) and Hicks (1946). The property is strictly
true either under simplifying assumptions (if the simple
concept of duration is used) or when an appropriate gener
alization of duration is used, as discussed in Kaufman et al.
(1983). The requirement of weighting is discussed later.
Sherrill Shaffer
the duration gap, the more sensitive the bank's
net worth will be to a given change in interest
rates.
The key element distinguishing duration
from maturity is the cash flow, in terms of both
its timing and its amount. For a zero-coupon
bond or a so-called "bullet" loan, the only
payment comes at maturity; in such cases, the
duration equals the maturity. However, when
interim payments are scheduled, each payment
received can be reinvested while each payment
owed must be funded. Changes in interest
rates that occur before the last payment will
affect the value of all remaining payments and
hence the net worth of the contract or the
portfolio to which it belongs.
Likewise, when loan rates differ from de
posit rates (as they must in order for the bank
to earn a positive spread), the cash-flow amounts
will differ between an asset and an otherwise
identical liability. Duration incorporates this
distinction, whereas the maturity gap does not.
In addition, the initial net worth also affects
an organization's sensitivity to interest rate
changes. When assets do not initially equal
liabilities, then net worth can change with inter
est rates even when the duration of assets
equals that of liabilities. That is, setting the
duration of assets equal to that of liabilities
does not by itself necessarily eliminate interest
rate risk; these durations need to be weighted
by dollars of assets and liabilities to achieve that
goal.
Why have these additional factors not been
universally incorporated into management and
accounting practices more than half a century
after their importance was first recognized?
There are two reasons, one institutional and the
other technical.
Until 1980, not only were interest rates in the
U.S. relatively stable, but federal regulations
also set the maximum interest rate that banks
could pay on deposits. Banks consequently
believed they had little reason to worry about
interest rate risk. However, the success of
19
BUSINESS REVIEW
money market mutual funds during the 1970s
demonstrated that regulatory ceilings on inter
est rates provided false security to banks, as
depositors simply shifted their funds from bank
accounts to more lucrative investments. After
1980, the institutional environment shifted as
regulatory rate ceilings were phased out just as
market interest rates were rising to record
levels.
Even though banks now have a stronger
motive for measuring and managing interest
rate risk than before, several technical factors
make it difficult to apply duration analysis
correctly. First, the detailed information on
cash flows required for duration analysis pre
sents a computational and accounting burden.
Second, the true cash-flow patterns are not well
known for certain types of accounts, such as
demand deposits or passbook savings accounts;
they are likely to vary with the size or timing of
a change in market interest rates, making it all
the harder to quantify the associated interest
rate risk. For example, during the 1970s and
1980s, demand deposits continued to pay zero
interest while nonbank instruments paid in
creasingly high rates; in response, commercial
firms devised new cash-management practices
to economize on their demand balances, which
led to lower, more volatile demand balances
than previously seen. Prepayments similarly
complicate the measurement or prediction of
cash flows on home mortgages.
And finally, a more complex version of du
ration is needed to reflect the fact that long
term interest rates do not always equal short
term rates and indeed may move indepen
dently of each other. For these reasons, many
institutions have thus far chosen either to retain
the simpler, but less accurate, maturity gap
methods, or to rely on computer scenarios
without always acknowledging their linkage to
duration. In the latter case, a better under
standing of duration can safeguard against
misuse of the simulation results.
A Numerical Approach. Some banks simu
20
MAY/JUNE 1991
late the impact of various risk scenarios on their
portfolios, asking, for example, "If interest rates
rise by 2 percentage points, how much will my
net worth fall?" When done properly, this
technique essentially replicates the same bot
tom line as duration theory while bypassing the
more sophisticated mathematical derivations.
Indeed, a computer simulation can be made to
yield a single summary statistic representing
the bank's interest rate risk, which will then
equal its duration gap. A useful way of think
ing about both the level of risk and how to
hedge it, this technique may be thought of as
"brute force" duration analysis. (The box at
right gives a simple example.) However, draw
backs remain.
The major complication is, again, the need
for detailed cash-flow data for assets and li
abilities. When loans are repaid monthly and
interest payments accrue daily, for example,
correct calculations are more difficult than in
the simple example shown in the box. A com
puter scenario is only as useful as it is realistic,
and either oversimplifying the cash flows or
omitting them from the model entirely can lead
to nasty surprises. As it happens, the inclusion
of cash flows is an unavoidable complexity—a
cost of doing business in today's market envi
ronment. One possible response to this cost is
to simplify contractual payment schedules ac
cording to the trade-off between the benefits of
such simplification (easier calculation of port
folio effects) and the costs (lumpier cash flows
and other inconveniences).
Likewise, computers alone cannot solve the
problem of forecasting cash-flow patterns for
some assets and liabilities. Simulations often
rely on historical data to estimate the duration
of savings accounts, mortgages, and other types
of accounts. This backward-looking approach
may give good estimates of cash flow under the
historical pattern of interest rates, but possibly
not if the pattern changes in the future; for that,
a more theoretical approach may provide a
better forecast. Techniques to address these
FEDERAL RESERVE BANK OF PHILADELPHIA
Sherrill Shaffer
Interest Rate Risk: What's a Bank to Do?
A Simple Example of Duration Analysis
To keep calculations as simple and clear as possible, let's look at a balance sheet in which a single-payment twoyear loan of $100 is funded by two successive one-year $100 certificates of deposit. (Note that this assumes no initial
equity or reserves.) We want to do two things: calculate the duration gap for this portfolio and examine the effect
of changing interest rates on the present value of profits (which defines the market value of the portfolio).
Suppose initially that the interest rate is 6 percent for both the loan and the CD. (This means that the bank earns
zero spread and, consequently, no profit—not a realistic scenario, but one easy to follow.) At the end of the first year,
the bank pays $106 on the first CD and takes in $100 for the second CD for a net cash flow of -$6. In two years it pays
out $106 more. The loan is a "bullet loan," requiring no repayment until it matures. At that time the entire loan, plus
interest for two years at 6 percent, will be repaid: $100 x 1.06 x 1.06 = $112.36. So the bank's cash flows, both
undiscounted and discounted at a 6 percent annual rate, can be summarized as follows:
Year
Income
(Discounted)
1
0
(0)
2
$112.36
($100.00)
Total
Expense
(Discounted)
Profit
(Discounted)
$6.00
($5.66)
-$6.00
(-$5.66)
$106.00
($94.34)
$6.36
($5.66)
($100.00)
($100.00)
(0)
The net present value of the portfolio is zero.
Duration for each side of the balance sheet is calculated as the weighted average time to repricing, where the
weight in each period up to repricing is the discounted cash flow as a proportion of total present value. Since the
loan has only a single payment coming at the end, the duration of assets is 1 year x ($0 / $100) + 2 years x ($100 /
$100) = 2 years, the same as its maturity. Likewise, each CD has one payment coming at its maturity, so the duration
of the liability side is 1 year x ($100 / $100) = 1 year.
The duration gap for the entire portfolio is the difference between the asset duration, weighted by the present value
of assets, and the liability duration, weighted by the present value of liabilities: $100 x 2 years - $100 x 1 year = 100
dollar-years. By comparison, the maturity gap is -$100 in the zero-to-one-year range and $100 in the one-to-two-year
range, as seen from the outset.
Like that of the typical small bank, this portfolio has a positive duration gap. Consequently, duration theory tells
us that an increase in interest rates will lower the present value of the portfolio. We can demonstrate this directly.
Suppose there is an immediate, unanticipated increase in the market interest rate to 8 percent. Both the loan and the
deposit are locked into the original 6 percent rate for the first year. But in the second year, the deposit rate adjusts
to 8 percent while the loan rate is still fixed at 6 percent. Discounting at the new market rate of 8 percent, the cash
flows become:
Year
1
2
Income
(Discounted)
0
(0)
$112.36
Total
($96.33)
($96.33)
Expense
(Discounted)
Profit
(Discounted)
$6.00
($5.56)
-$6.00
(-$5.56)
$108.00
($92.59)
$4.36
($3.74)
($98.15)
(-$1.82)
The net present value of the portfolio declines from zero to -$1.82.
We can compare this drop in present value with that predicted by duration theory. As discussed by George
Kaufman (1984), the change in the present value of the portfolio equals the negative of the duration gap, times the
change in interest rates, divided by the original discount factor. In our example, this equals -100 x .02 / 1.062 = -$1.78,
very close to the change of -$1.82 computed directly.
21
BUSINESS REVIEW
thorny questions have been under develop
ment for several years now. For example,
several computer programs designed to model
mortgage prepayments as interest rates change
are now commercially available, and even bet
ter answers can be expected in the future.
Choosing appropriate interest rate scenarios
within which to explore portfolio effects re
mains more art than science. It is not enough to
project a given rise or fall in rates across the
board; the term structure may shift, with long
rates changing either more or less than short
rates, and each variation can have a different
impact on overall net worth. The computer
cannot tell an analyst how to do this. But even
so, the computer-based scenario method can
prove more flexible and require less effort than
the strictly theoretical duration approach.
CONTROLLING INTEREST RATE RISK
Once a bank has measured its interest rate
risk, what action should it take? Some theories
of banking consider it essential that banks ac
cept some degree of interest rate risk, and most
bankers prefer not to hedge completely against
such risk. However, for a bank to profit consis
tently from changes in interest rates requires
the ability to forecast interest rates better than
the rest of the market. Obviously, not everyone
can be better than average all the time.
The experience of the 1980s suggests that
more hedging would be an improvement for
the banking industry, even if a complete hedge
is not best. There are several ways of bringing
a bank's duration gap near zero to construct a
hedge. The various approaches generally in
volve some combination of adjusting the port
folio of assets and lia b ilitie s or using
nontraditional financial instruments.
Adjusting the Portfolio. Possibly the sim
plest, most conventional solution is to adjust
the maturity, repricing, and payment schedules
of assets and liabilities. In its simplest form, this
approach does not require exotic instruments
or strategies; in fact, many banks already use it
22
MAY/JUNE 1991
in a general way.
Consider the example of a small bank or
thrift with long-term fixed-rate mortgages
funded by short-term CDs. The bank may
shorten its asset duration to reduce interest rate
risk by holding adjustable-rate mortgages
(ARMs) instead of fixed-rate ones, thereby
changing the repricing interval of assets. A
drawback here is that the demand for ARMs
may be substantially weaker in some markets
than that for fixed-rate mortgages. Accord
ingly, a bank may not be able to go as far with
this strategy as it would like, and it may also
have to accept a lower expected return or spread.
A second drawback is that an ARM's cash-flow
pattern itself may change following large move
ments in interest rates: if rates fall sharply,
ARMs are frequently refinanced using fixedrate mortgages; and if interest rates rise very
much, ARMs may suffer a higher default rate.
These changes in the cash-flow pattern would
need to be modeled in order to choose the right
amount of ARMs to provide the desired degree
of hedging against interest rate risk. A third
drawback is that most ARMs are sold with a
cap on interest rates, leaving the bank exposed
to risk if market rates rise above the cap.
Other actions that a bank can take to shorten
its average asset duration include holding short
term securities and lending overnight—for ex
ample, in the interbank market. Moreover,
early amortization by means of accelerated or
fixed-amortization payment schedules can re
duce the duration of loans.
Another element of portfolio adjustment
involves matching the amounts of assets and
liabilities within each duration category. For
example, suppose a bank found that its savings
accounts behave like a long-duration deposit,
even though in principle depositors are free to
withdraw at any time. Armed with this infor
mation, the bank could then try to match the
amount of its savings deposits with the amount
of its fixed-rate mortgages, relying on shortduration CDs and other deposits to fund any
FEDERAL RESERVE BANK OF PHILADELPHIA
Interest Rate Risk: What's a Bank to Do?
Sherrill Shaffer
short-duration assets. In this way the overall
weighted duration of liabilities can be brought
close to that of the bank's assets, resulting in a
hedged balance sheet.
As the example suggests, duration matching
is often applied to the balance sheet on an itemby-item basis, where it
can provide only an im
precise hedge. More ex
act hedging is possible if
the approach is applied
instead to the portfolio
as a whole, taking ad
vantage of the fact that a
balance between dura
tions of weighted assets
and weighted liabilities
does not require a per
fect match between any subset of the assets and
liabilities.
However, a portfolio that is perfectly
matched ("immunized") at one set of interest
rates will typically require rebalancing as soon
as rates move. Such rebalancing can involve
transactions costs, as well as more complicated
calculations if individual components of the
balance sheet are not matched. In addition, at
some point greater precision in hedging may
require more exotic instruments or techniques.
Using Nontraditional Financial Instru
ments. Within the past decade, banks have
increasingly turned to such hedging instru
ments as asset-backed securities, futures, op
tions, and swaps.3 Their adoption has been
concentrated among the large banks, however,
and has tended to meet with suspicion from
small bankers (who view them as a costly and
unnecessary complication) and even from regu
lators (who view them as another means by
which banks can take on more risk).
There is some truth in all these views. A
wider range of instruments requires more re
sources to manage, but these instruments, if
managed well, can save resources in the long
run. And indeed, additional instruments can
be used either to reduce or to increase overall
portfolio risk, according to the intention and
expertise of a bank's man
agement and staff. Ex
aminers would need spe
cial training to distin
guish good from bad. But
as with fire, informed use
beats uninform ed ne
glect.
Securitization.
Traditionally, bankers
have viewed the activi
ties of originating and
holding a loan as inseparable. More recently,
however, they have recognized that the activi
ties are truly distinct, such that the originating
institution may differ from the institution that
holds the asset to maturity. A bank may origi
nate a loan, shortly thereafter sell the loan for a
fee to a third party, and subsequently repeat the
process.
When a loan is sold, it may be marketed
alone or as part of a package of loans. A
common approach is to bundle a number of
similar loans, such as auto loans, credit-card
loans, or home mortgages, and sell the package
at a sp ecified y ield — a process called
"securitization," since it converts loans into a
contractual stream of payments resembling a
bond or some other security. The similarity of
loans within a bundle makes assessing its risk
easier, while the multiplicity of loans allows
some diversification of default risk.
Although fee income from the sale has drawn
attention as a motivation for this activity, an
equally important aspect is that the loan's effec
tive maturity to the bank is only the interval
between origination and sale. Therefore,
securitization may substantially reduce the
bank's average asset duration and, in the case
Banks have
increasingly turned
to asset-backed
securities, futures,
options, and swaps.
3A number of these instruments are described by
Grumball (1987).
23
BUSINESS REVIEW
of a typical small bank with long-term mort
gages and short-term deposits, reduce its inter
est rate risk.
The success of this method requires, among
other things, a demand for the securitized as
set. If interest rates rise, a loan with a fixed rate
suddenly below market is no longer an attrac
tive purchase. It could be sold only at a dis
count, forcing the originating bank to realize an
immediate loss.
Recent evidence also suggests that combin
ing traditional banking with securitizing may
tend to raise a bank's costs.4This result could be
viewed as reflecting a cost of managing interest
rate risk: you don't get something for nothing.
Subject to these limitations, securitization of
fers an attractive opportunity for banks to
shorten their asset duration.5 Of course, misuse
is possible. Banks can buy as well as sell
securitized assets, and a bank that buys a pack
age of securitized loans may lengthen its asset
duration, increasing its interest rate risk. For
this reason a bank should make sure that it ends
up on the right side of a deal for its own
portfolio needs; indeed, some banks have suf
fered losses by neglecting this principle.
Swaps. A swap is a contract that trades
payment streams (but not the underlying prin
cipal or associated credit risk) between two
parties. For example, a bank having a fixed-rate
mortgage with 10 years remaining to maturity
may prefer to receive a variable-rate payment
stream in order to shorten its asset duration
and reduce its interest rate risk. Suppose it
finds another institution that has made a vari
able-rate commercial loan of equivalent princi
pal amount with 10 years left to maturity. If that
MAY/JUNE 1991
institution would prefer to receive fixed-rate
payments, the bank can contract to pass through
its mortgage payments to the second institu
tion in return for receiving a pass-through of
the variable-rate commercial loan payments.
The mortgage itself remains on the bank's books,
while the commercial loan stays on the books of
the second institution. Such a contract is known
as a swap.
Interest rate swaps can reduce interest rate
risk either by converting a fixed-rate income
stream to a variable-rate stream, as in the ex
ample, or by converting a variable-rate expense
stream to a fixed-rate stream. Used in the first
way, a swap shortens the duration of assets;
used in the second way, it increases the dura
tion of liabilities. Either or both approaches can
help overcome the typical bank's mismatch
between long-duration assets and short-dura
tion liabilities.6
The arrangement has several shortcomings,
however. First, if the commercial borrower
defaults, then the variable-rate income stream
stops and the bank must turn elsewhere if it
desires to continue trading fixed-rate for float
ing-rate payments. By that time, interest rates
may have changed, making it difficult for the
bank to find another counterparty at the origi
nal terms. This possibility shows that the hedge
is not perfect.
Second, the arrangement seemingly requires
the bank to find an institution with repricing
needs exactly opposite its own. However,
approximate matches can be accommodated
by more complicated contracts involving more
than two assets or parties. A related problem is
that if all banks want to be on the same side of
the deal, there may not be enough counterparties
willing to take the other side.
4See Mester (1990).
5See Nadler (1987) for an argument that even commu
nity banks can benefit from securitization.
24
6Even community banks can benefit from this seemingly
intricate arrangement; see Findlay (1987).
FEDERAL RESERVE BANK OF PHILADELPHIA
Interest Rate Risk: What's a Bank to Do?
Futures. An interest rate futures contract is
an agreement between two parties to buy (or
sell) a fixed-income asset, such as a Treasury
security, for a fixed price at a specified date.
The holder of such a contract earns a positive or
negative profit based on the difference between
the specified delivery price and the price at
which the underlying securities can be sold
after taking delivery.7
Unlike securitization and swaps, which alter
the repricing intervals of a bank's assets and
liabilities, futures can be used to create cash
flows that offset losses on the original portfolio.
For example, a bank that would lose net worth
if interest rates rise can reduce this risk by
selling bond futures, locking in the current
interest rate and, in effect, selling bonds short.8
If interest rates rise before the futures contracts
expire, bond prices will fall and the bank can
close out its futures position at a profit by
buying either the bonds or additional futures at
a lower price. The profits on the futures offset
losses due to declining interest rate spreads on
the rest of the portfolio. If interest rates fall,
losses on the futures are offset by increased
interest rate spreads on the rest of the portfolio.
However, it should be emphasized that fu
tures, like any hedging device, cannot totally
eliminate all risk; some sources of residual risk
remain even after careful application of fu
tures.9
Although any interest-rate futures contract
can provide a hedge against interest rate risk,
futures on U.S. Treasury instruments have spe-
7Morris (1989) provides an excellent introduction to the
potential use of interest rate futures by banks, while
Koppenhaver (1986) describes the role of options on such
futures.
Sherrill Shaffer
cial advantages: (1) there is negligible risk of
default on the underlying instruments; (2) the
relevant markets are highly liquid; and (3) the
yields move more in line with market interest
rates than with factors unique to the instru
ment, making them ideal for hedging diversi
fied portfolios.1
0
WHAT NEXT?
Fundamental changes in the regulatory and
market environment have made interest rate
risk a vital issue. The importance of this risk
underlies the explosive growth of banking's
involvement in so-called derivative instruments
(such as futures and options, which are "de
rived" from other financial contracts) and in
new strategies over the past decade. In the
period from 1980 to 1985, the volume of interest
rate futures held by banks grew tenfold, as did
the volume of loan sales by banks in the period
from 1983 to 1988.1 Interest rate swaps grew
1
from an estimated world market of $3 billion in
1982 to well over $100 billion just three years
later and to over $500 billion by 1987; the
outstanding amount of pass-through securities
backed by residential mortgages reached $769
billion by 1988.1
2
However, even though the aggregate vol
ume has grown dramatically, these new activi
ties have been concentrated in a relatively few
10 For a small, undiversified bank, a futures contract on
the sector most heavily represented in its portfolio may also
be an effective hedge, not only against interest rate risk but
also against price or credit risk, if the futures market is liquid
and default risk on the contract is low. Examples might be
oil futures for Texas banks or commodities futures for
agricultural banks.
n See Parkinson and Spindt (1985), p. 226, and Boemio
and Edwards (1989).
8See Green (1986), p. 86.
9Morris (1989) discusses several types of residual risk.
12See Bank for International Settlements (1986), pp. 3943; Smith et al. (1988); and Boemio and Edwards (1989).
25
MAY/JUNE 1991
BUSINESS REVIEW
large banks. For example, in the second quarter
of 1989, nine money-center banks accounted
for about 40 percent of total loan sales, and 54
banks accounted for more than 90 percent.1
3
Most of the nation's 13,000 banks have re
mained hesitant about plunging in, some on the
premise that the fundamental business of bank
ing hasn't changed and therefore doesn't re
quire new approaches, and others on the premise
that the costs of learning and managing the new
techniques would outweigh any benefit. Such
arguments appear short-sighted in today's com
bination of thinner margins, aggressive compe
tition, and volatile interest rates.
As more banks perceive the need to reduce
their interest rate risk, regulators need to be
trained in evaluating the use of the new tech
niques, since a debate inevitably arises when
managers and regulators disagree on an
institution's position. A recent dispute oc
curred in Kansas, where regulators argued that
Franklin Savings Association was insolvent
even though management (and eventually a
federal court) held that it was solvent once its
sophisticated hedging techniques were prop
erly recognized.1 Traditional accounting rules
4
further cloud the issue: when the balance sheet
is not marked to market, a gain on the portfolio
will not be fully reflected on the books, whereas
a corresponding loss on the hedge may have to
be recorded. Ffowever, the Financial Account
ing Standards Board allows a loss on futures or
other hedging programs to be kept off the
books if it "correlates with and offsets" an
unbooked capital gain.1
5
To avoid such uncertainty and waste, regu
latory guidelines must keep pace with the in
dustry. The Basle accord on banks' risk-based
capital requirements recognized this need by
incorporating a commitment to augment guide
lines over the next few years to account for
interest rate risk. This resolve was reiterated in
a recent Treasury Department proposal to re
form the financial system.1
6
The only alternative would be to ban mod
ern hedging techniques, a move that would
have at least two unfortunate consequences.
First, it would leave the burden of interest rate
risk on the banks and the already strained
federal safety net. Second, it would place U.S.
banks at a further competitive disadvantage
relative not only to major players from other
nations, but also to other U.S. financial institu
tions.
In summary, we can't turn back the clock
now. Regulators and banks alike need to be
come more familiar with measures of interest
rate risk and the ways of hedging it.
13See Mester (1990), p. 5.
15See Milligan (1991), pp. 54-55.
14See Labaton (1990) and Milligan (1991).
16See U.S. Department of the Treasury (1991).
REFERENCES
Bank for International Settlements. Recent Innovations in International Banking. Basle: BIS, 1986.
Boemio, Thomas R., and Gerald A. Edwards, Jr. "Asset Securitization: A Supervisory Perspective," Federal Reserve
Bulletin 75 (October 1989) pp. 659-69.
Findlay, David M. "Swap Applications for Community Banks," Journal of Commercial Bank Lending (December
1987) pp. 9-14.
26
FEDERAL RESERVE BANK OF PHILADELPHIA
Interest Rate Risk: What's a Bank to Do?
Sherrill Shaffer
French, George E. "Measuring the Interest-Rate Exposure of Financial Intermediaries," FDIC Banking Review 1 (Fall
1988) pp. 14-27.
Green, Edward J. "Financial Futures and Price-Level Variability," in Myron L. Kwast, ed., Financial Futures and
Options in the U.S. Economy. Washington: Board of Governors of the Federal Reserve System (1986) pp. 79-89.
Grove, Myron A. "On 'Duration' and the Optimal Maturity Structure of the Balance Sheet," Bell Journal of Economics
5 (Autumn 1974) pp. 696-709.
Grumball, Clive. Managing Interest Rate Risk. New York: Quorum Books, 1987.
Hicks, John R. Value and Capital. Oxford: Clarendon Press, 1946.
Kaufman, George G. "Measuring and Managing Interest Rate Risk: A Primer," Federal Reserve Bank of Chicago
Economic Perspectives (January 1984) pp. 16-29.
Kaufman, George G., Gerald O. Bierwag, and Alden Toevs, eds. Innovations in Bond Portfolio Management: Duration
Analysis and Immunization. Greenwich, CT: JAI Press, 1983.
Koppenhaver, Gary D. "Futures Options and Their Use by Financial Intermediaries," Federal Reserve Bank of
Chicago Economic Perspectives (January 1986) pp. 18-31.
Labaton, Stephen. "The Return of S&L Is Ordered," New York Times, September 6,1990.
Macaulay, Frederick R. Some Theoretical Problems Suggested by the Movements of Interest Rates, Bond Yields, and Stock
Prices in the U.S. Since 1856. New York: National Bureau of Economic Research, 1938.
Mester, Loretta J. "Traditional and Nontraditional Banking: An Information-Theoretic Approach," Federal Reserve
Bank of Philadelphia Working Paper 90-3 (1990).
Milligan, John W. "Abuse of Power: How the Government Railroaded Franklin Savings," Institutional Investor
(January 1991) pp. 50-60.
Morris, Charles S. "Managing Interest Rate Risk with Interest Rate Futures," Federal Reserve Bank of Kansas City
Economic Review (March 1989) pp. 3-20.
Nadler, Paul S. "Implications of Securitization for the Community Bank," Journal of Commercial Bank Fending
(November 1987) pp. 19-25.
Parkinson, Patrick, and Paul Spindt. "The Use of Interest Rate Futures by Commercial Banks," in Myron L. Kwast,
ed., Financial Futures and Options in the U.S. Economy. Washington: Board of Governors of the Federal Reserve
System (1986) pp. 221-48.
Samuelson, Paul A. "The Effect of Interest Rate Increases on the Banking System," American Economic Review 35 (1945)
pp. 16-27.
Smith, Clifford W., Jr., Charles W. Smithson, and Lee Macdonald Wakeman. "The Market for Interest Rate Swaps,"
Financial Management 17 (Winter 1988) pp. 34-44.
U.S. Department of the Treasury. Modernizing the Financial System: Recommendations for Safer, More Competitive Banks.
Washington (February 1991).
27
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