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Federal Reserve Bank of Cleveland

August

1, 1987

ISSN 042R·1276

ECONOMIC
COMMENTARY
Contagion risk in the banking system the sensitivity of a bank to the failure of
another bank - is a source of public policy
concern. It is especially a problem when
the failure of one bank, or a limited
number of banks, causes multiple failures
in the banking system. Significant contagion effects have public policy implications both for the way banks are regulated
and for the solvency of federal deposit
insurance funds.
Research into the problem of contagion
in the banking system has concentrated on
two areas: the payment-system risk associated with daylight overdrafts and the
implications of the exposure of a large
number of U.S. banks to borrowers in a
few foreign countries.' .This analysis considers a third source of contagion risk in
the banking system: the risk associated
with banks holding assets in the form of
claims against other banks (both domestic
and foreign), which we refer to as inter-

bank exposure. 2

Interbank exposure may rise to the level
of contagion risk because the failure of a
bank is translated into losses at those
banks whose asset portfolios include
claims against the failing institution.
These losses could be large enough to
exhaust the claimant bank's capital, causing it to fail. It is not difficult to imagine a
situation in which the failure of one mediurn-to-large bank could result in a chain of
bank failures. In fact, the Federal Deposit
Insurance Corporation (FDIC) used this
very argument to justify the bailout of the
Continental Illinois Bank and Trust Company of Chicago in 1984.3

James B Thomson is an economist at the Federal
Reserve Bank of Cleveland. The author thanks Lynn
Downey for excellent research assistance and T#zlker
Todd for extensive comments and suggestions.
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.

In this Economic Commentary, we present arguments supporting two hypotheses: high levels of interbank exposure
reduce the safety and soundness of the
banking system, and interbank exposure
affects the ability of the FDIC to use
market discipline as a constraint on banks'
risk-taking. In addition, we provide evidence that interbank exposure does not, at
this time, appear to be a problem for banks
in the Fourth Federal Reserve District.

Correspondent Banking and
Interbank Exposure
We define interbank exposure as the assets
one bank has at risk to another bank. In
this study, the interbank-exposure items
include cash items in the process of collection (CIPC), balances due from depository
institutions (BDI), loans to depository
institutions (LDI), acceptances of other
banks (AOB), and federal funds sold and
securities purchased with agreements to
resell (FFS). We selected these items
because they can be constructed from
publicly available data. Recent innovations
in banking may have created new categories of interbank exposure that should be
included in future measures of such
exposure, but those innovations, such as
interest-rate and currency swaps, are
either poorly measured by publicly available data or are not measured at all.

1. See E.J Stevens, "Reducing Risk in Wire Transfer Systems," Economic Review, Federal Reserve
Bank of Cleveland, Quarter 21986, pp.17-22; and
Jack M. Guttentag and Richard]. Herring, "Disaster Myopia in International Banking," Essays in
International Finance, no. 164, Princeton University,
September 1986.

Interbank
Exposure in the
Fourth Federal
Reserve District

by James B. Thomson

Note that CIPC and BDI, which make
up our variable cash and balances due
(CBDI), arise from correspondent banking
relationships. Indeed, it is likely that
correspondent banking is responsible for
the lion's share of the interbank exposure
accounted for by CBDI and for at least
some of the interbank exposure represented by LDI, AOB, and FFS.
Correspondent banking is a market
innovation that arbitrages away much of
the inefficiency of a unit banking system.
In fact, we would argue that the efficiency
gains associated with correspondent
banking may be responsible for the apparent lack of scale economies in banking+
Two types of banks are involved in a
correspondent banking relationship:
correspondent banks (usually small banks)
and respondent banks (usually large
banks). The correspondent bank can
obtain services, such as check clearing and
computer services, from its respondent
bank at a lower cost than by performing
those functions itself. In addition, a
respondent bank can provide its correspondent bank with a source of increased
portfolio diversification through loan
participations.
In return for the services provided by
the respondent bank, the correspondent
keeps non-interest-bearing balances at its
respondent bank as a form of implicit
payment for the services it receives.
Correspondent banks also keep cash balances at respondent banks, which provide
their check -clearing services as a reserve

2. For a discussion of the historical relationship
between interbank exposure and financial distress,
see Walker F. Todd, "The Historical Relationship
Between Rising Interbank Exposure and Financial
Distress," unpublished manuscript, Federal Reserve
Bank of Cleveland, July 1987.
3. See Irvine H. Sprague, Bailout: An Insider's
Account of Bank Failures and Rescues. 1986: Basic
Books, Inc., New York.

account against which they can debit
checks drawn on the correspondent bank
or credit checks payable to the
correspondent.
To the extent that interbank exposure
arises from normal correspondent relationships, the benefits associated with
increased efficiency of the banking system
usually outweigh the risks associated with
interbank ties. Indeed, if properly managed, much of the interbank-exposure
risk
faced by a correspondent bank can be
diversified away by setting up multiple
correspondent banking relationships. This
practice limits the exposure of the correspondent bank to anyone respondent bank,
and it limits the replacement costs of
establishing new correspondent banking
relationships should one of its respondent
banks fail.

Interbank Exposure and Federal
Deposit Insurance
Interbank exposure can increase the risk
exposure of the FDIC in two ways. First, it
reduces the independence of bank failures.
That is, it increases the probability that the
failure of bank A will be accompanied by
the failure of banks B, C, and D. Second, it
reduces the FDIC's ability to close and
dispose of insolvent banks in a manner that
does not protect stockholders and uninsured creditors. High levels of interbank
exposure can force the FDIC to adopt a
policy of full or partial forbearance toward
a failing bank's uninsured creditors and
stockholders.
If bank failures are independent events,
the risk exposure of the FDIC's insurance
fund from any single bank is the expected
value of losses should the bank fail, multiplied by the probability that the bank will
fail. That is, the FDIC's risk exposure to a
bank is a function of the riskiness of the
bank's portfolio. However, if contagion
effects (such as interbank exposure) cause
bank failures to be nonindependent events,

4. See George]. Benston, Gerald A. Hanweck, and
David B. Humphrey, "Scale Economies in Banking:
A Restructuring and Reassessment," Journal of
Money, Credit, and Banking, vol. 14, no. 4, part 1
(November 1982), pp. 435-454.

then the risk exposure of the FDIC's insurance fund from a single bank is a function
of both the riskiness of the bank's assets
and the degree of contagion in the banking
system. In such a scenario, the cost to the
FDic of bank A's failure includes any
losses to the FDIC from banks that fail as
a result of bank A's failure.
Therefore, it is clear that interbank
exposure increases the risk to the FDIC
from a single bank. Because contagion
effects are one form of risk that the FDIC
cannot diversify away in its portfolio, interbank exposure increases the total risk
exposure of the FDIC to the banking
industry.
The second undesirable effect of interbank exposure is its effect on the FDIC's
ability to dispose of failed institutions without extending forbearances to uninsured
creditors and stockholders. The FDIC is
faced with a set of constraints that may
prevent it from closing an insolvent bank:
information and staff constraints, the
implicit and explicit reserves in the FDIC's
insurance fund, and political and legal
constraints+
It is clear that an increase in
interbank exposure (and contagion in general) increases the severity of each of these
constraints. For example, with high levels
of interbank exposure, the information
the FDIC needs to close an insolvent
institution includes the condition of the
institution and the impact of its failure on
other banks.
To find a leading example of how interbank exposure affected the way a failing
bank was handled by the bank regulators,
one has to look back no further than July
1984, when concerns about interbank
claims played a role in the decision to bail
out Continental Illinois Bank and Trust
Company of Chicago (Continental). In testimony before the House Banking Committee's Subcommittee on Financial
Institutions, Supervision, Regulation and
Insurance, then-FDIC Chairman William
Isaac stated that one factor that prompted
the bailout of Continental was the FDIC's
concern about the impact Continental's
failure would have on small banks with
interbank exposure to Continental. Isaac

states, "Hundreds of small banks would
have been particularly hard hit. Almost
2,300 small banks had nearly $6 billion at
risk in Continental; 66 of them had more
th n their capital on the line and another
113 had between 50 and 100 percent. "6
But was Isaac's statement correct? Later
"11~lvsis showed that it was unlikely that
(e than a dozen or so banks would have
falied as a result of allowing Continental to
fail. In a report to the same House Subcommittee on Financial Institutions,
Supervision, Regulation and Insurance,
Congressional staff found that even if Continental's losses totaled 60 percent of
assets, only 27 banks would have failed,
and only 56 banks would have experienced
losses between 50 and 100 percent of their
capital, if Continental had been allowed to
fail. Using a more realistic, but still high,
loss rate of 30 percent of assets, they found
that only six banks would have failed, and
only 22 would have experienced losses
between 50 and 100 percent of their capital, if Continental had been allowed to
fail.? Nevertheless, it is clear that the
FDIC's perception of interbank-exposure
risk reduced its capacity to dispose of
Continental in a manner that protected
only insured depositors.

5. See Edward]. Kane, ''Appearance and Reality in
Deposit Insurance: The Case for Reform," Journal of
Banking and Finance, vol. 10 (1986),pp.175-188.

6. William M. Isaac, Testimony before the House
Committee on Banking, Finance and Urban Affairs'
Subcommittee on Financial Institutions, Supervision, Regulation and Insurance. Inquiry into Continental Illinois Corp. and Continental Illinois
National Bank, October 4, 1984 (98th Congress, 2nd
session). Washington, D.C.: Government Printing
Office, 1985, pp. 457-491.

A Measure of Interbank Exposure
in the Fourth District
1he measures of interbank exposure that
a be constructed from publicly available
data are flawed in many ways." Currently,
it is not possible to construct measures of
interbank exposure that include all of its
sources. For the interbank-exposure
items
that can be constructed, the data are highly
aggregated, making it impossible to get an
accurate measure of an individual bank's
interbank-exposure
risk. Therefore, this
exercise in measuring interbank exposure
in the Fourth District is done with three
purposes in mind: 1) to demonstrate how
one would go about measuring interbankexposure risk, 2) to get an overall impression of the level and direction of aggregate
interbank exposure in the Fourth District,

and 3) to point out the glaring deficiencies
in the data publicly available to construct
measures of interbank-exposure
risk.
The data used in the study are "call
report data" taken from the Federal Financial Institutions Examination Council's
Reports of Condition and Income (call
reports) from March 1984 through March
1986. This sample period was chosen
because there was a major revision of the
call reports in March 1984 and because we
are interested in the direction of aggregate
interbank claims since the bailout of Continental in July 1984.
The banks in the sample are grouped
into four subsamples on the basis of the
call report forms they file. Banks that file
Report 31 are the banks in the Fourth
District that have foreign and domestic
offices. They also tend to be the largest
banks in the District. The remainder of the
banks file one of three reports based on
asset size: banks filing Report 32 have
total assets of at least $300 million; banks
filing Report 33 have total assets of at least
$100 million, but less than $300 million;
and banks filing Report 34 have total
assets of less than $100 million. Of the 564
banks in the sample in March 1986,15 filed
Report 31, 39 filed Report 32, 116 filed
Report 33, and 394 filed Report 34. In
March 1984, 15 of 594 banks filed Report
31,31 banks filed Report 32,96 filed
Report 33, and 452 filed Report 34.
To measure interbank exposure in the
Fourth District, we selected four categories of interbank risk: cash and balances
due from depository institutions (CBDI),
loans to depository institutions (LDI),
acceptances of other banks (AOB), and
federal funds sold and securities purchased under agreements to resell (FFS).
Our measure of total interbank exposure,
TOTExp, is the sum of CBDI, LDI, AOB,
and FFS (see box 1).

TOTEXP is not an all-inclusive measure
of interbank exposure, however: it omits
potentially important sources of exposure,
such as stock and subordinated debt of
other banks and loan participations sold
with recourse. These and other possible
interbank-exposure items were omitted
because they are not readily available to
us from our data source." Although we
missed some interbank-exposure items, we
believe that TOTEXP picks up the lion's
share of interbank exposure in the asset
portfolio.'?

7. See U.S. Congress, Staff Report to the House
Committee on Banking, Finance and Urban Affairs'
Subcommittee on Financial Institutions, Supervision, Regulation and Insurance. Inquiry into Continental Illinois Corp. and Continental Illinois
National Bank, ibid., pp. 418-445.

9. Off-balance-sheet risks, such as interest-rate
swaps, are additional sources of interbank-exposure
risk in the banking system that are captured by the
reporting schedules that banks currently file with
their regulators.

8. Good measures of interbank exposure can be
constructed from examination data when the bank
examiners specifically seek out this information.

Box 1

Definition of Variables

CAPITAL
CBDI

= Total equity capital.

Cash and balances due
from depository
institutions.
CBDIC = CBDI/CAPIT AL

LDI = Loans to depository
institutions.
LDIC LDI/CAPIT AL

AOB = Acceptances of other
banks.
AOBC = AOB/CAPITAL
FFS = Federal funds sold and
securities purchased
under agreements to
resell.
FFSC
FFS/CAPIT AL

=
TOTEXP = CBDI + LDI + AOB + FFS
TOTEXPC = TOTEXP /CAPIT AL

We construct the variables in box 1for
the entire sample and for each subsample.
The variables are constructed both at the
group level and at the individual bank
level. The final variables constructed CBDIC, LDIC, AOBC, FFSC, and
TOTEXPC - are the interbank-exposure
variables (CBDI, LDI, AOB, FFS, and
TOTEXP) divided by total equity capital.

The variables are constructed as ratios of
exposure to capital, because the risk we
are concerned with here is the risk of
capital impairment. The group aggregate
interbank-exposure ratios are plotted over
the sample period in figures 1through 5.
Overall, the CBDI exposure of Fourth
District banks has fallen since the Continental Illinois crisis. Figure 1shows that
CBDIC in the Fourth District is generally
lower in March 1986 than in March 1984
for all five aggregate groups. The decline
in the aggregate CBDIC ratios in figure 1
appears to be driven by a shift in the
distribution of the CBDIC ratios at the
individual bank level. For example, in
March 1984,31.99 percent of Fourth District banks had CBDI exposure exceeding
100 percent of capital, and 10.44 percent
had CBDI exposure in excess of 200 percent of capital. In contrast, in March 1986,
25.71 percent of Fourth District banks had
CBDI exposure exceeding 100 percent of
capital, while 4.97 percent had exposure of
more than 200 percent of capital.
Figure 2 shows the pattern of LDI
exposure for the Fourth District: LDIC is
the highest for Report 31 banks and the
lowest for Report 34 banks. From March
1984 until March 1986, LDIC has remained
fairly constant for Report 33 and 34 banks,
has fallen for Report 31 banks and all
reporting banks, and has risen for Report
32 banks.
Figure 3 illustrates the changes in the
interbank-exposure ratio AOBC over the
sample period. For all of the bank groups,
AOBC is a relatively unimportant source of
interbank exposure. AOB is less than 10
percent of capital for every aggregate
group in every quarter and is lower in
March 1986 than it was in March 1984 for
each group.
FFSC is plotted in figure 4. As one
might expect, this variable shows the
greatest variation of all of our interbankexposure ratios. The seemingly erratic
behavior of FFSC may be due in part to

10. There is a form of interbank exposure (some of
it offsetting) on the liability side of banks' ledgers,
including, for example, claims due to other banks.
Such exposure, also referred to as funding risk,
increases the contagion risk of banks' funding
sources. For simplicity and manageability, and
because funding risk is already a widely recognized
and researched problem, we excluded liability items
and concentrated on interbank asset exposures only.

5. See Edward]. Kane, ''Appearance and Reality in
Deposit Insurance: The Case for Reform," Journal of
Banking and Finance, vol. 10 (1986),pp.175-188.

8. Good measures of interbank exposure can be
constructed from examination data when the bank
examiners specifically seek out this information.

Box 1

Definition of Variables

CAPITAL
CBDI

= Total equity capital.

Cash and balances due
from depository
institutions.
CBDIC = CBDI/CAPIT AL

LDI = Loans to depository
institutions.
LDIC LDI/CAPIT AL

AOB = Acceptances of other
banks.
AOBC = AOB/CAPITAL
FFS = Federal funds sold and
securities purchased
under agreements to
resell.
FFSC
FFS/CAPIT AL

=
TOTEXP = CBDI + LDI + AOB + FFS
TOTEXPC = TOTEXP /CAPIT AL

Percent of capital

3.0Figure
2.5

-- '-

••...•.

F'igure 2

1.5

1 Cash and Balances Due

1.0

Loans to Depository Institutions
,,\
\

\
\

'- --

---

1.5
0.5
1.0

................ ...... .•

. ...

.•

- --

. ..................... ..

0.5I~Q-~~~~--:::':-:--~'::--~--=-:::-----::~-~IQ
1986
Percent of capital

Percent of capital

l.lr-----------------------.
Figure 4 Federal Funds Sold and Securities

0.10......----------------------.

Figure 3

Acceptances of Other Banks

0.08

----,.~

0.06

,. '-

Under Agreements to Resell

" ,

0.04

0.02

Purchased

........

'--- -- ......

••...
••........

_--------------

O.OOI~Q-~;::----;;b:--±--+"~~L:::----;~--;;I;;::-----t,IQ

0.5I""Q-~"""'----:::!-:'--~---:'::""'----::""""'----:~-~"""----:-I.IQ
1986

1986

Percent of capital

5~,...._-~-=,...._~,...._~-~=_-------,
Figure 5

Total Interbank Exposure

--..........

••... "

•...

- •.... ----

-, -,

---___
____
.........
___

'- -

Banks filing
Banks filing
Banks filing
Banks filing
All reporting

Report
Report
Report
Report
banks

31
32
33
34

--...••... ~,-------------~
..
.
.. .. .. .. .• .. .. .• .. .. .. .. ..
.. .. .. .. .. .. .. .• .• .. .. .. .. .. ..

SOURCE: Federal Financial Institutions
Reports of Condition and Income.
IQ
1986

Examination

Council's

the short maturity of FFS assets. Because
FFS tend to be very short-term assets, the
numbers reported on the day of the call
report may not be representative of the
true FFS position of the banks in the

sample."
Although this problem may influence
the numbers, it should not dominate the
trends for the groups or for individual
banks. It is more likely that the movements in the FFSC over time are driven by
interest rates and by the availability of
profitable investment opportunities in
securities and in the banks' home markets.
The trend upward for the Report 33 banks
since March 1985, and for Report 34 banks
since June 1985, may be due to the second
factor. That is, the decline in interest rates
that probably is driving down the exposure
for the Report 31 and 32 banks is dominated by the reduction in profitable investment opportunities for small banks in their
local markets.
TOTEXPC, the sum of the specific
interbank-exposure
ratios, is plotted in figure 5. TOTEXPC follows the same pattern
as CBDIC for all of our aggregate bank
groups. Overall, TOTEXPC has fallen for
the largest banks in the Fourth District
(Report 31 and 32 banks) and has risen
slightly or stayed the same for the small
banks in the Fourth District (Report 33
and 34 banks). The decrease in TOTEXPC
for the large banks tends to reflect a
decrease in CBDIC, LDIC, and FFSC over
the sample period. For the small banks,
the rise in FFSC offsets decreases in
CBDIC and LDIC.
One problem with using group data is
that group trends can be dominated by the
behavior of a small number of banks. To
find out if this is a problem, we examined
the trends in interbank exposure using
individual bank data. For all of the
interbank-exposure
categories, this analysis supports the conclusions drawn using
the groups.
Before one reads too much into the
relationships in the figures, we must point
out several caveats with the results. First,
the numbers reflect the aggregate inter-

bank exposure and do not take into
account possible diversification of the
exposure. A bank could have a very high
exposure to other banks in the banking
system, but very little exposure to anyone
bank. Such a bank would have less
interbank-exposure risk than a comparable
bank with less exposure to the banking
system, but with a high level of exposure
to a single bank or to a small group of
banks.
Second, with currently available data,
we cannot determine riskiness of the interbank claims. There is less reason to be
concerned about a bank's interbank
exposure to a sound and conservatively
managed bank than the same level of
exposure to one of the "high fliers" of the
banking or thrift industries. Third, interbank claims on the liability side of the
balance sheet offset some of the asset
exposure. Finally, we cannot determine the
duration of the exposure. Banks with a
high level of interbank exposure concentrated in assets with very short maturities
have less interbank-exposure risk than
banks with the same level of interbank
exposure concentrated in assets with
longer maturities.
Overall, interbank exposure, as defined
in this study, does not seem to be a problem for banks in the Fourth District.
Aggregate exposure ratios, as well as the
majority of individual bank exposure
ratios, do not appear to be at levels that are
high enough for concern, and there is a
general downward trend in our measures
of interbank exposure for banks in the
Fourth District as a whole.
However, as we readily admit, the measures that we are able to construct from
call report data are so crude that our
interpretation of the results is based more
on instinct than hard evidence. On the
other hand, it is clear from our study that a
few banks in the Fourth District have an
aggregate interbank exposure high enough
to warrant closer scm tiny at the time of
their next examination.

Conclusion
Interbank exposure is a form of contagion
risk that has significant public policy
implications for the safety and soundness
of the banking system. We present arguments and anecdotal evidence supporting
two basic hypotheses. The first is that high
levels of interbank exposure reduce the
safety and soundness of the banking system. This contagion risk increases the
probability that a single bank failure, or
the failure of a limited number of banks,
would result in a series of bank failures.
Our second hypothesis is that interbank
exposure affects the ability of the FDIC to
use market discipline as a constraint on
banks' risk-taking. A reduction in the independence of bank failures increases the
constraints on the FDIC's ability to dispose
of insolvent banks without extending forbearances to the bank's uninsured depositors, general creditors, and stockholders.
Our analysis suggests that the federal
banking regulators should place more
emphasis on improving the measurement
of interbank exposure, and should analyze
more carefully the relationship between
this exposure and the health of particular
banks in the banking system. Currently,
the most detailed information about interbank exposure comes from bank examination data. By modifying call reports or
setting up a separate reporting schedule,
interbank exposure could be used as part
of an early-warning system to trigger
bank examinations. Obviously, extensive
research should be done before any regulatory limits are developed for interbank
exposures of various kinds.
This Economic Commentary presents a
measure of interbank exposure for banks
in the Fourth Federal Reserve District
from March 1984 until March 1986.
Interbank-exposure
ratios formed on
aggregated data indicate that the overall
level of interbank exposure in the Fourth
District has declined from March 1984 to
March 1986. The same ratios formed on an
individual bank basis support this conclusion. Overall, the evidence suggests that
interbank exposure is not a serious problem in the Fourth District.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

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ll. A possible solution to this problem is to use the
quarterly average FFS position of the bank from the
call reports.
Material may be reprinted provided that the
source is credited. Please send copies of reprinted
materials to the editor.

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Cleveland, OH 44101

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Full text of Economic Commentary (Federal Reserve Bank of Cleveland) : Interbank Exposure in the Fourth Federal Reserve District, August 1, 1987

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