Full text of Economic Commentary (Federal Reserve Bank of Cleveland) : Debt Growth and the Financial System, October 15, 1986

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increased total risk in the overall
financial system.
The rapidly changing financial system has generated new complexities
and interdependencies. This has created
additional uncertainty about the ways
in which default risk can lead to systemic breakdown. The thrift industry
crises in Ohio and in Maryland provide
recent examples of concern." They
serve to illustrate the need to understand fully the changing network
through which default can disrupt the
financial system. With this full understanding, we might expect to adapt our
supervisory and regulatory structure in
ways that reduce systemic risk, possibly through initiatives such as riskbased capital adequacy requirements
and risk-based insurance premiums.
Policy Issues
The recent extraordinary increase in
debt has called attention to the need to
understand better the changing nature
of risk exposures, the growing interdependencies among formerly isolated
risks, and the potential for systemic
failures. Without a better understanding, we might expect that the Federal Reserve will increasingly face situations in
which it must act as a lender of last
resort. In the postwar period, the Federal Reserve, together with the FDIC
and Office of the Comptroller of the Currency, have demonstrated an ability to
deal with and contain isolated instances
of financial distress. There is a reasonable fear, however, that lenders might
begin to expect that government assistance will be so freely available that
they will increase patterns of behavior
that are unsustainable in the aggregate.
The textbook solution to this "moral

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hazard" problem is coinsurance. One
form of coinsurance in banking regulation is to establish capital requirements
for banks. Capital essentially is a cushion that allows a firm to absorb temporary losses, yet remain viable. The greater the capital, the more able banks will
be to withstand losses without government help. By having to absorb more of
their own losses, banks are likely to
apply more prudent standards to asset
and liability management. While banks
have strengthened their capital positions in recent years, the question of
whether current capital requirements
are sufficient remains, especially when
accounting for bank exposures to offbalance-sheet liabilities.
Financial guarantees issued by banks
are, in principle, similar to the obligation of a lender of last resort; that is,
banks act as back-up lenders for the
benefit of third parties. Such activities
have their own potential to create a
moral hazard. To deal with this problem, banks "regulate" their customers.
Banks have contractually established
standards that borrowers must meet,
and internal controls provide for some
degree of supervision of risk. Thus,
while we have seen a political movement toward deregulation of private
financial markets, market forces themselves may also generate private regulatory practices. The issues raised here
concern the appropriate structures of
the regulatory regime. Of particular
importance is the legal definition of a
bank, which determines the scope of
government regulation that is applied.
Financial change has worked to muddle
the traditional distinctions. It seems
certain that financial change will continue to generate new fault lines, making the design of the official regulatory
regime an ongoing issue.

The final issue considered here concerns monetary policy. The view that
the rise in private indebtedness represents an increase in the economy-wide
exposure to debt default, and further,
that this increased exposure to debt
default magnifies the contractionary
dynamics of the business cycle, suggests that the choices for monetary policy could become more difficult with
continued increases in the private debt
ratio. Some economists have argued
that the increased potential for financial instability could lead to a greater
reluctance to tolerate recessions." An
implication of this, in their view, would
be that monetary policy would become
more expansionary than it would otherwise, raising the potential for an inflationary bias to policy.
Concluding Comments
It is obvious that the Federal Reserve
has legitimate reasons to be concerned
about the stability of the financial system and, consequently, about the level,
quality, and distribution of debt in the
economy. While developments in riskmanagement techniques have reduced
risks for one or more of the parties
involved, there remains an open issue
of whether risks have been reduced on
balance for the financial system as a
whole. If there is a consensus about
rapid debt growth, it is that we should
be more aware of the potential risks
that attend excessive and imprudent
debt issuance.'? Although the Federal
Reserve certainly has the ability to
provide massive liquidity to our financial system in a time of extraordinary
distress, we can all agree that an ounce
of prevention would be worth a pound
of cure.

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Federal Reserve Bank of Cleveland

October 15, 1986
ISSN 042R-1276

ECONOMIC
COMMENTARY

Debt Growth and
the Financial
System

Since 1982, the indebtedness of domestic nonfinancial sectors has increased
from around 140 percent of nominal
gross national product (GNP) to 170
percent. This extraordinary growth
contrasts sharply with the pattern of
debt growth over most of the postWorld War II period.
Between 1951 and 1982, for example,
debt growth was remarkably stable,
continuing in direct proportion to nominal GNP. Although debt increased
sharply relative to GNP from 1929 to
1933, this increase largely reflected a
46 percent decline in GNP over the
same period. Meanwhile, some measures of debt were declining in absolute
terms. In fact, domestic nonfinancial
debt (the measure of total debt used in
this article) actually declined 14 percent from 1929 to 1933.
The recent surge in debt has raised
some concerns among economists, particularly about its implications for the
vulnerability of the financial system
and the economy. A viable marketoriented financial system depends on a
heavy preponderance of prudent decisions of private parties over imprudent decisions. Despite recent efforts to
quantify financial risk and to establish
precise rules for managing it, prudent
management of financial risk remains a
matter of judgment. Moreover, recent
financial innovations and regulatory
changes have altered the financial
landscape drastically, making it especially difficult to assess the implications of accelerated debt growth.
This Economic Commentary provides
a perspective for understanding policymakers' concerns about the increasing debt burden, particularly for

The federal government, while running
budget deficits, was nevertheless borrowing a declining share of national
income. Private borrowing, on the other
hand, trended upward relative to national income over most of the period.
Only after 1982, when federal borrowing needs jumped sharply, did total
domestic nonfinancial debt (DNFD) rise
sharply relative to nominal GNP.
Many factors can account for the increasing private demands for debt after
World War ILl Two key factors may
explain part of the pattern of household
debt. One of these factors is demographics, especially an acceleration in
household formation; the other is the
proliferation of bank credit cards,
which is due largely to the convenience
of their use in transactions. Neither of
these factors suggests cause for alarm.
Deductibility of mortgage and consumer
debt interest payments for tax purposes
also helps explain the increasing attractiveness of household debt in the postwar period. Developments in corporate
finance that increased access to credit
markets by previously excluded businesses formed one important element
explaining the increase in business borrowing; tax incentives to leveraging
formed another. These factors, taken
by themselves, suggest a rational basis
for the increasing private debt ratio.
However, some market observers do
not find it comforting that there are
many reasonable explanations for the
perennial increases in private debt relative to income. They point to the deterioration of some common indicators of
financial distress, particularly at a time
when the economy has been expanding.

John Carlson is an economist at the Federal
Reserve Bank of Cleveland. The author would like
to thank Mark Sniderman, E.]. Stevens, and
Walker Todd for their helpful comments.
The views stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

the implications of such a debt burden
for the integrity of the financial system. We examine how this integrity is
essential to the well-being of the economy and analyze the important stabilizing role played by deposit insurance
and the lender-of-last-resort function of
the central bank. We discuss the
nature of the incentives created by the
financial stabilizers, specifically
whether they encourage excessive risktaking. We also consider the possibly
adverse implications of the increasing
complexity and interdependencies arising from the evolution of the financial
system. This concern arises because
recent changes in financial markets
may have generated new ways in
which debt default can spill over into
the banking system. Finally, we
address some of the policy issues
related to these concerns.
Debt and Income
Debt cannot rise without limit in relation to the income needed to cover payments of interest and principal. Largely
for this reason, debt is commonly measured in relation to nominal GNP.
There is, however, no particular basis
in standard economic theory for arguing that the nation's welfare is best
served at any particular value of this
ratio, nor is the recent increase in this
ratio alarming in itself.
The steady proportionality of debt to
income between 1951 and 1982 seems,
in retrospect, to reflect largely a coincidence of diminishing federal needs in
the face of increasing private needs.

1. Although these factors account for the underlying trends in debt growth, there remains something of a puzzle as to why the recent acceleration in debt has been so strong.
2. See Benjamin M. Friedman, Harvard University, "Increasing Indebtedness and Financial
Stability in the United States," draft, July 1986.

by John B. Carlson

3. Some economists would argue that the likelihood of such financial collapse is nil, provided the
central bank supplies sufficient reserves to offset
the lost liquidity. See George]. Benston et aI.,
"Perspectives on Safe and Sound Banking," MIT
Press, Cambridge, Mass. 1986.

For example, since the beginning of the
current business expansion in 1982,
more corporate bonds have been downgraded by rating agencies than upgraded. In addition, there has been an
upward tendency in delinquency rates
on consumer and mortgage debt. This
is unusual during economic expansions
and suggests additional exposure of
households to the risk of default.
A chief concern is that continued increases in the debt ratio ultimately increase the chances that debt service
will become unsustainable in the aggregate. A fundamental risk in debt accumulation is that borrowers and lenders
overestimate the growth potential for
aggregate income. It is feared that they
may not adequately take into account
the potential for sustained periods of
general economic stagnation. Moreover,
we have seen financial strains in several sectors of the economy-agriculture, energy, foreign transactions, and
real estate-in which lenders and borrowers were too optimistic about the
growth potential of these sectors, if not
that of the overall economy.
In addition, some analysts argue that
the upward trend in private debt partly
reflects a number of institutional
biases that encourage more risk-taking
than borrowers would have accepted in
the past. It is feared that these biases
may encourage debt growth beyond
limits that are consistent with the wellbeing of the economy.
Debt and Stability of
the Financial System
Some economists have argued that the
potentially increased exposure of the
debt structure to risk may lead to larger swings in the business cycle." This
view is based on some widely accepted
models of the process underlying financial instability, which emphasize a
mutually deteriorating interaction between situations of financial market
distress and contractions in nonfinancial economic activity. Such a process
could be initiated when sufficient numbers of borrowers fail to meet their
obligations so that their creditors (perhaps borrowers themselves) face severe

4. For a more complete discussion of this issue
see James Thompson, "Equity, Efficiency, and
Mispriced Deposit Guarantees," Economic Com·
mentary, Federal Reserve Bank of Cleveland.july
15, 1986.

restrictions on liquidity or possibly
become insolvent. The loss of liquidity
leads to constraints on aggregate
spending, which in turn reduce the
cash flow of other borrowers. Some of
these borrowers are pushed into
default, causing further weakness in
aggregate demand, and so forth. Typically, this interactive process is dampened either by some offsetting exogenous event, by automatic stabilizers, or
by actions of the Federal Reserve to restore lost liquidity. To the extent that
the overall economy is becoming more
exposed to default risk, we might
expect that the contractionary dynamics would be further intensified.
The ultimate fear is that the process
underlying financial instability could
become open-ended. In such a situation,
large numbers of debtors and creditors,
seeking to regain liquidity, could be
forced to sell assets at "fire sale"
values. This destruction of financial
wealth could undermine the public's
confidence in the financial system's
safety and soundness, leading to general collapse in financial markets and
to persistent stagnation in nonfinancial
economic activity."
Those who express strong concerns
about this kind of systemic risk typically view history as replete with episodes in which highly leveraged speculation climaxed in a crescendo of debt
defaults. Prior to World War II, such
episodes often culminated in bank runs
that led to a cascade of bank failures
and to general collapse in financial
markets. In the United States, for
example, such severe bank panics
occurred in 1837, 1857, 1873, 1884,
1893, 1907, and 1933.
A key catalyst in the process of systemic failure-the bank run-has been
contained by federal deposit insurance
(FDIC and FSLIC), first established by
statute in 1933. Since the end of the
Great Depression, federal deposit insurance has helped maintain unprecedented confidence in the safety and
soundness of the banking system by
sharply reducing the probability of
panic withdrawals of bank deposits
when the public suspects that some
banks are insolvent. In addition, deposit insurance has helped banks to
weather cyclical storms that could have
led to temporary periods of illiquidity;
5. It is interesting to note that FDIC premiums
are not necessarily underpriced, since historically
outlays have roughly equaled revenues (that is,
they have been actuarially fair in the aggregate).
However, FDIC insurance pricing does create a
moral hazard because individual premiums are
not risk-related.

it has, thereby, limited the impact of
defaults by some borrowers and some
banks on the overall credit supply.
Some economists also argue that
postwar financial stability in the commercial banking system also is attributable to prompt backup lending by the
Federal Reserve. Most liquidity provided by the Federal Reserve still is
added through open market operations.
However, in isolated instances, the
Federal Reserve has been able to maintain sufficient liquidity in a community
or region through discount window
operations when traditional lending
facilities have broken down. The
lender-of-Iast-resort function has
limited the number of situations in
which problems of illiquidity lead to
insolvency. By isolating and containing
systemic risks of default, deposit insurance and Federal Reserve lending have
greatly reduced the frequency and
magnitude of financial panics.
Incentive Problems
While the potential stabilizing effects of
federal deposit insurance and Federal
Reserve lending seem evident in principle, there are a number of problems in
practice. Insurance protection, whether
explicit or implicit, alters the benefits
and costs of various activities of the
insured, particularly by softening the
consequences of risky situations. When
it is costly to control, or even monitor,
the actions of the insured, it is sometimes rational for the insured to
become less concerned about risk. This
is known as the moral hazard problem.
When the costs of deposit insurance are
low and the benefits of risky behavior
are high, a moral hazard is created.
The moral hazard problem is inextricably linked to insurance pricing. If
the deposit insurance premium is less
than what is commensurate with the
inherent risk, a subsidy arises, creating
incentives for insured institutions to
hold riskier portfolios than they would
otherwise.' Thus, while deposit insurance may reduce the frequency of bank
runs in response to liquidity crises, it
could, through underpricing, encourage
banks to continue lending in excess of
prudent amounts. Such excessive lending would increase the likelihood of

6. See Hyman P. Minsky, "Money and the Lender
of Last Resort," Challenge, March/April1985, vol.
28, no. 1, pp. 12·18.
7. An excellent summary of these developments
is found in Edward]. Frydl, "The Challenge of
Financial Change," Annual Report 1985, Federal
Reserve Bank of New York.

bank failures in response either to systemic disturbances or to particular
cases of mismanagement. Critics of the
current pricing practices for deposit
insurance argue that some deposit
premiums are, in fact, underpriced.
They point to pending legislation that
seeks to recapitalize FSLIC as evidence
that the existing pricing practice is not
actuarially sound."
Another subsidy can arise from the
deposit insurance system in the failed
bank settlement practices employed by
deposit insurance agencies. In recent
years, the FDIC handled these settlements in a manner in which no uninsured deoositors at large institutions
(more than $1 billion of assets) have
suffered losses, despite the fact that the
FDIC has absorbed significant losses
itself. This practice, it is argued,
creates de facto deposit insurance for
all deposits at large banks, including
those which are legally uninsured. Critics of bank failure settlement practices
argue that de facto insurance for all
deposits erodes market discipline.
Allowing losses to holders of large uninsured deposits is obviously not without its own risks. Large banks typically
have correspondent relationships with
many small banks. Under these arrangements small banks hold deposits at the
respondent bank as clearing balances.
The prospect of bank runs on uninsured deposits could create situations
of illiquidity that would jeopardize the
health of some small, but otherwise
well-managed, correspondent banks.
The lender-of-Iast-resort function of
the Federal Reserve can also be characterized as a form of insurance and thus
may generate its own moral hazard." If
the Federal Reserve were to intervene
too readily to maintain liquidity in the
banking system, banks would have
increased incentives to bias their asset
and liability innovations toward
instruments that could compromise
their own liquidity and solvency. Creating an illiquid system then would
increase the chances that a failure
anywhere in the system would result
in a chain of defaults unless the Federal Reserve quickly isolated the overall
system from the initial failure.

8. See "Unfoldings in Ohio: 1985," Annual Report
1985, Federal Reserve Bank of Cleveland.
9. See Friedman, op. cit.

Some observers have noted that since
the end of World War II the Federal
Reserve has intervened increasingly as
the lender of last resort. Some of these
interventions have been precipitated by
events occurring outside traditional
banking channels. A noteworthy
example was provided by the liquidity
crisis which arose after the bankruptcy
of Penn Central Corporation in 1970.
Penn Central, like many large corporations, had been shifting increasingly
away from bank sources of credit to
direct borrowing in money and capital
markets-especially
the commercial
paper market. Lenders in these
markets have little or no commitment
to maintain continuity of credit supply.
When Penn Central defaulted, the
commercial paper market dried up for
all borrowers (including the most viable
firms), as lenders withdrew their funds
to reassess the risks of holding other
issues of such paper. With the openmarket channel blocked, borrowers
could not roll over their open-market
paper and turned en masse to their
banks. To facilitate bank adjustment to
the sizable increase in loan demand, the
Federal Reserve, as lender of last
resort, provided the banking system
with reserves sufficient to meet the
surge in loans that replaced the commercial paper borrowings.
Financial Change
The increasing use of open-market instruments is only one of many developments in the financial system that have
affected the exposure of the financial
system to debt default.' Other developments altering the risk exposure include
innovation, deregulation, and increasing competition from foreign banks and
other financial intermediaries.
Innovation is the development of new
instruments and risk-management techniques that transform price, credit, and
liquidity risks in a manner that promotes wider use of capital markets.
Some examples are: 1) risk transferring
and techniques such as interest rate
and foreign exchange options, currency
and interest-rate swaps, and other
futures and options markets instruments; 2) liquidity-enhancing innovations such as money-market mutual

10. In recent congressional testimony, Federal
Reserve Chairman Paul A. Volcker stressed the
need for further exploration of the difficult and
complex issues raised by rapid debt growth. See

funds, cash-management techniques,
and, perhaps most importantly, new
financial guarantees that have
improved the liquidity of some capitalmarket instruments.
While new techniques in risk management may reduce risks for one or
more parties, the net effect could be to
generate new forms of risk exposure for
the banking system as a whole. For
example, several of these techniques
involved greater use of standby letters
of credit (SLCs) and other financial
guarantees. An SLC is a contractual
arrangement in which a bank issues,
for a fee, a guarantee that the bank's
customer will meet an underlying obligation to a third party. The bank
suffers a loss only if its customer fails
to perform. Such risk exposure generally is thought to be positively correlated with other bank asset risk, and
SLCs are counted against regulatory
lending limits for banks. Moreover,
SLCs outstanding exceed capital at
many large banks, but these guarantees do not appear on bank balance
sheets. Thus, some analysts fear that,
while bank capital cushions have
increased recently, they have not
increased in direct proportion to the
inherent bank-credit risks assumed.
Another major development affecting
the network of risk exposures is deregulation. While deregulation has benefitted consumers by allowing banks to offer a greater menu of instruments at
more attractive yields, it also has reduced the interest margins and, hence,
the profitability of traditional lines of
bank business. On the other hand,
interest-rate deregulation has helped
stabilize deposit bases. With interestrate ceilings, depositories found it difficult to maintain deposits when market
interest rates exceeded the deposit rate
ceilings. Nevertheless, increased competition from foreign banks and other
financial intermediaries-such
as money
-market-mutual funds and "nonbank"
banks-has made it more costly for
banks to obtain funds. Deregulation of
bank powers has also put additional
competitive pressures on banks. Overall deregulation has led to greater
uncertainty and, therefore, may have

his statement before the Subcommittee
communications, Consumer Protection,
nance of the Committee on Energy and
merce, House of Representatives, April

on Teleand FiCorn23. 1986.