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Indicators, perform ance, and
p o licy in the 1 9 3 0 s and today
N A F T A : a review of the issu es
R educing cred it risk in
over-the-counter derivatives
Index for 1992


Indicators, perform ance, and
p o licy in the 1 9 3 0 s and to d a y.......................................................................2
Robert D. Laurent

In both the recent past and the early 1930s there were
sharp cuts in interest rates and weak economic growth.
The author discusses similarities and differences
between the present and the 1930s and concludes that
in such periods, broad monetary aggregates such as M2
are better indicators than interest rate levels or term
spreads for formulating monetary policy.

N A F T A : a review of the is s u e s .....................................................................12
Linda M . A g u ilar

The author discusses the potential benefits to
the U. S. and the Seventh District of the new trade
agreement and examines the issues concerning
U.S jobs, rules of origin, and the enviromnent.

R educing credit risk in
over-the-counter d e riv a tiv e s..........................................................................21
John P. Behof

The dramatic growth in the use of derivatives has
raised concerns about increased risk in the global
financial system. The author discusses the benefits and
costs of methods for dealing with increased credit risk.

Index for 1992

Karl A. Scheld, Senior Vice President and
Director of Research
Editorial direction

Carolyn McMullen, editor, David R. Allardice, regional
studies, Herbert Baer, financial structure and regulation,
Steven Strongin, monetary policy,
Anne Weaver, administration

Nancy Ahlstrom, typesetting coordinator,
Rita Molloy, Yvonne Peeples, typesetters,
Kathleen Solotroff, graphics coordinator
Roger Thryselius, Thomas O’Connell,
Lynn Busby-Ward, John Dixon, graphics
Kathryn Moran, assistant editor


January/February 1993 Volum e X V lIJs s u e


the Research Department of the Federal Reserve
Bank o f Chicago. The views expressed are the
authors’ and do not necessarily reflect the views
of the management of the Federal Reserve Bank.
Single-copy subscriptions are available free
of charge. Please send requests for single- and
multiple-copy subscriptions, back issues, and
address changes to Public Information Center,
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Articles may be reprinted provided source is
credited and The Public Information Center is
provided with a copy o f the published material.
ISSN 0164-0682

Indicators, perform ancei
and policy in the 19 3 0 s
and today

Robert D. Laurent

Recent economic growth has
been sluggish despite persis­
tent attempts to stimulate the
economy. The apparently
unresponsive nature of the
economy is quite unusual in recent history,
leading observers to search back in history for
similar periods that might help explain the
anomaly of the present. This article compares
monetary policy and economic performance in
the current period with monetary policy and
economic performance in the 1930s. The arti­
cle argues that the current period is in a number
of important respects qualitatively, if not quan­
titatively, similar to the early 1930s. In particu­
lar, the last three years are similar to the early
1930s in having the absence of strong economic
growth, sharply lower short term interest rates,
widening spreads between long term and short
term interest rates, and stronger growth in the
monetary base (a narrow monetary aggregate)
than in the broader aggregates (M2 and M3).1
Of course, these two periods are also quite
different in a number of respects. For example,
the decline in national income was much steep­
er in the 1930s and broad velocity (the ratio of
GNP to broader monetary aggregates) declined
in the 1930s but not in the current period. This
article argues that the aforementioned similari­
ties between the two periods suggest that in the
current period, as in the 1930s, there is likely to
be a stronger correlation between economic
growth and the broader aggregates, such as M2
and M3, than either the narrow aggregates, such


as the monetary base and M1,2or interest rates
and interest rate spreads. Hence, in the current
period, the broader aggregates probably deserve
greater weight than the narrower aggregates, the
short term interest rate level, or interest rate
spreads in the formation of monetary policy.
The present environment

Recent years have witnessed unusual eco­
nomic weakness, though not because the epi­
sodes of actual economic decline have been
unusually severe. Three consecutive quarters
of falling real GNP is not at all unusual in the
post-World War II period, nor is the total de­
cline of 1.9 percent in real GNP from the sec­
ond quarter of 1990 to the first quarter of 1991
especially severe. Indeed, the cumulative de­
cline in real GNP over that period is actually
milder than the average decline of 2.6 percent
experienced in the preceding six recessions.
Rather, the period has been unusual because of
the length of time over which there has been an
absence of strong economic growth. Eleven
consecutive quarters of real GNP growth of less
than 3 percent annually has not occurred in the
entire period since 1947 when quarterly GNP
data was first available.
The recent economic weakness is even
more unusual because it has persisted despite
actions by the Federal Reserve that would have
usually stimulated the economy. Since April
1989, the Fed has made 24 consecutive cuts in
Robert D. Laurent is a senior econom ist at the
Federal Reserve Bank of Chicago. The author
thanks Steven Strongin and Carolyn M cM ullen for


its target fed funds rate, reducing it by 675 basis
points to its current level of 3 percent. The
funds rate has been lowered by nearly as much
at other times in the post-World War II period,
but never to its present low levels. As Figure 1
shows, the funds rate has not only fallen sharp­
ly, it is presently at its lowest level in nearly 30
The recent behavior of the funds rate in the
post-World War II era is unusual in yet another
respect. As Figure 1 also shows, every previous
recession in this period began with the funds
rate either rising or close to its peak level, indi­
cating that the Fed was seeking to tighten mon­
etary policy at the time these recessions began.
In contrast, the recent recession began more
than a year after the Fed had started to lower
the fed funds rate from its February 1989 peak
(the NBER dates the cyclical peak in the econo­
my at July 1990). This indicates that not only
was the most recent recession not the result of
intentional Fed actions but that Fed moves that
would otherwise have produced a stronger
economy were offset by other factors.
Figure 2 reveals another aspect of interest
rate movements that has been unusual. The
reduction in short term interest rates has been
accompanied by a relatively minor decline in
long term rates. As the Figure indicates, while
the fed funds rate has fallen nearly 700 basis
points since spring 1989, the 30 year Treasury
bond rate has declined only about 140 basis
points. As a consequence of these relative



movements, the spread between the long term
Treasury bond rate and the short term overnight
fed funds rate has expanded to over 450 basis
points, the widest level in the entire post-World
War II period, and most likely in all U.S. histo­
ry. Typically, the wider the spread, the greater
the subsequent growth in economic activity, so
the recent exceptionally wide spread in combi­
nation with generally weak economic activity is
also unexpected. The weak recovery from the
recent recession relative to the recovery from
other recessions, despite the historically wide
spread, can be seen clearly in Figure 1.
During the last three years there has also
been rapid growth in some of the narrower
measures of money. The monetary base and
M 1 (both relatively narrow measures of money
compared to the broader measures M2 and M3)
have grown at annual rates of 9.3 and 8.5 per­
cent respectively over the last three years.
These growth rates are above the average
growth of 7.2 and 6.6 percent for the monetary
base and Ml, respectively, in the last three
decades. The growth in M 1 has been particu­
larly rapid in the last two years, when it grew
by 10.7 percent while the monetary base grew
by 9.3 percent. Typically, one would expect
rapid growth in the monetary aggregates to be
associated with strong growth in the economy.
So once again, the combination of the rapid
growth rates in the narrow monetary aggregates
and the absence of strong growth in the econo­
my is very unusual.



Recent term spread (1959Q1-1992Q3)
20 r

bond rate


___I___I___I___I___I___I__ l___l___I___I___l___l__ I___I___I___I___I___I___I___I__ I___I___I___I___I___I___I___I___i i i i i i
NOTE: The fed funds rate is calculated on a bond-equivalent basis.

Similarity to the 1930s
The analysis above indicates that the most
unusual aspect of recent economic performance
is the combination of the absence of strong eco­
nomic growth along with a sharp reduction in
short term interest rates and rapid growth in the
narrow monetary aggregates (the monetary base
and Ml), conditions that one might ordinarily
associate with a stimulative monetary policy and
strong economic growth. As already noted, the
eleven consecutive quarters since first quarter
1989 of less than 3 percent annual GNP growth
is unique over the period in which quarterly GNP
data is available. It is likely that one would have
to go back to the 1930s, and specifically the
years from 1929 to 1933, to find such an extend­
ed period without at least one quarter of strong
growth. This is not to say that the economy has
experienced, or will experience, an economic
decline like the 1930s. While both periods
lacked strong growth, the actual performance
was substantially different in the two periods.
The magnitude of the decline experienced in the
early 1930s dwarfed the 1.9 percent decline in
real GNP from third quarter 1990 to first quarter
1991. As the name sometimes given to the earli­
er period—the Great Depression—implies, this
period may well have been the most severe epi­
sode of economic decline in U.S. history. From
1929 to 1933, real GNP fell by more than 30
percent. The decline in income during the cur­
rent period was much less severe than during the
1930s, in part because of government programs








started after the Great Depression, such as unem­
ployment insurance and social security. These
programs should keep expenditures up during
periods of slower economic growth, thus helping
to dampen economic downturns.
Figure 3 shows that, like the present period,
a sharp fall in short term rates was also a charac­
teristic of the early 1930s. Monetary policy of
this period did not focus on the federal funds rate,
because, among other reasons, the interbank
market for overnight funds was not well devel­
oped at the time. Consequently, Figure 3 plots
the overnight call rate on security loans. From a
level of more than 8.5 percent in the third quarter
of 1929, the rate declined to a level of less than
l.O percent in the second half of 1933. The focus
of monetary policy in this earlier period was
much more directed towards the discount rate.
Over this same time span, the discount rate was
lowered from 6.0 percent to 2.0 percent, and in
the interim had briefly gone as low as l .5 per­
cent. In the 1930s, as in the recent period, the
decline in short term rates was not only sharp, but
took rates to historical lows. Indeed, both the
call money rate and the discount rate were taken
to lows that had not been seen before in U.S.
history and, with the exception of the late 1930s,
have not been seen since.
Also similar to recent experience, the sharp
decline in short term rates in the 1930s was not
matched by a decline in long term rates. From
fall 1929 to spring 1933, while call money rates
were declining by more than 750 basis points,



1930s term spread (1925Q1-1940Q4)

government bond rates declined by only 48
basis points to 3.20 percent. As can be seen in
Figure 3, this had the effect of steeply widening
the term spread. The term spread in 1933 was
wider than it had been at any time in the previ­
ous 80 years.
Perhaps the most important similarity
between the current period and that of the
1930s is the combination of sharply reduced
short term rates and weak economic perfor­
mance. If one assumes, as the great majority of
observers do, that the effect of monetary policy
can be gauged by looking at movements in
short term interest rates produced by the mone­
tary authority, then a very important conclusion
emerges. Monetary policy in these two periods
must have been ineffective, since short term
rates were lowered so much and the economy
remained weak. In the period of the 1930s this
is exactly the conclusion that most observers
drew from the sharp fall in short term rates to
very low levels and the very, very weak perfor­
mance of the economy. This view of the time
that monetary policy was ineffective was cap­
tured in the aphorism that “you can’t push on a
string” and came to dominate monetary eco­
nomics for decades after the 1930s.
In the present period as well, some observ­
ers have concluded that monetary policy is
ineffective against the problems presently af­
flicting the economy. Viewed from the point of
view of interest rates, this view seems reason­
able, given the fact that the reduction of 675



basis points in the fed funds rate has not result­
ed in strong economic growth and that this
interest rate now stands at only 3 percent.
Besides the similarity in interest rate be­
havior between the present period and the early
1930s, there was also rapid growth in the mone­
tary base, one of the narrow monetary aggre­
gate measures. Figure 4 plots the growth rate
of the monetary base and a broader measure of
money comparable to the current M2 over the
period from 1925 to 1940. Note that after
1930, growth in the monetary base was very
rapid. Both in the 1930s and in the recent peri­
od some have interpreted the rapid growth in
the monetary base as an indication that mone­
tary policy was stimulative, perhaps too stimu­
lative. Since the monetary base includes re­
serves held by depositories (banks and S&Ls),
some observers interpret the monetary base as
containing the “raw material” out of which
depositories are able to extend credit by making
loans or buying securities. In this view, rapid
growth in the monetary base increases the pos­
sibility of subsequent rapid, perhaps too rapid,
expansion in money and economic activity.3 It
was just such a view that prompted the Fed in
1936 and 1937 to double reserve requirements
in three steps, thereby initially cutting sharply
the high level of excess reserves and reducing
the possibility of any potentially excessive
future expansion in money. As Figure 4 shows,
the monetary base and money in fact slowed
sharply in late 1937 and early 1938. However,



Year over year growth in money and the monetary base (1925Q1-1940Q4)
growth rate

Milton Friedman and Anna Schwartz.

it is possible in the current period, as well as in
the 1930s, to explain the more rapid growth in
the narrower monetary aggregates in a way that
does not imply monetary policy has been too
stimulative, or even stimulative at all.

Gauging the effect of monetary policy
The previous discussion makes it clear that
while there are many similarities between the
behavior of interest rates and narrow monetary
aggregates in the 1930s and the present period,
the conclusion that monetary policy was inef­
fective in these two periods depends crucially
on the assumption that the effect of monetary
policy (that is, its impact on future economic
activity) can be accurately gauged by looking at
interest rate movements or movements in the
narrow monetary aggregates. In particular, a
key assumption, both now and in the 1930s, in
the prevalent view that monetary policy is
ineffective in stimulating the economy is that
the effect of monetary policy can be accurately
gauged simply by looking at the level, or
changes in the level, of short term interest rates.
It is clear that the monetary authority uses the
short term federal funds rate as a tool to imple­
ment monetary policy. It is also clearly true
that a lower fed funds rate means a more stimu­
lative monetary policy than a higher fed funds
rate under the same set of economic conditions.
But it does not necessarily follow that a lower
fed funds rate necessarily means an easy, or
even easier, monetary policy if other economic


conditions change as well. There are other
possible gauges of the effect of monetary policy
for which there is substantial support, and
which do not necessarily indicate that an easier,
or more stimulative, monetary policy was im­
plemented in these two periods and found inef­
fective. For example, broad money growth is
probably the most prominent alternative in
monetary theory to interest rates as a gauge of
the effect of monetary policy. In this view the
monetary authority uses movements in the short
term federal funds rate as a tool to implement
monetary policy, but growth in broad money is
a better gauge of the effect of monetary policy
on future economic activity.
Indeed, in the decades following the 1930s,
one of the major debates in macroeconomics
was the issue of how to gauge monetary policy
and its effectiveness. A major issue in that
debate was whether money or interest rates
provided a better gauge of the effect of mone­
tary policy. Today, a measure of growth in real
M2—a broader aggregate than M 1 or the mone­
tary base—is included in the index of leading
indicators,4 and the Fed presents targets for
growth in the broader money measures (M2 and
M3) in reporting to Congress on its future plans
for monetary policy. If one looks at growth in
these broader monetary aggregates, it is possi­
ble to argue that monetary policy was not as
easy as an examination of interest rates or nar­
row money measures would indicate in either
the more recent period or in the 1930s.


Recent money behavior
Figure 5 shows the year over year behavior
of three money measures over the last three
decades. The data in the Figure indicate that,
for most of the period since 1959, growth rates
in all three of the money measures have fluctu­
ated together. However, in the period since
1980, the behavior of money has varied consid­
erably, depending on the measure one exam­
ines. The narrow measure of money (Ml) has
recently shown one of its highest growth rates
while the broader measures (M2 and M3) have
shown the weakest growth in the more than
thirty years plotted. Even among advocates of
gauging monetary policy by money growth
rates, there has been some debate as to which of
these money growth rates is more indicative of
the effect of monetary policy.5
There are some reasons to believe that the
broader aggregates may be better indicators of
the effect of monetary policy than the narrow
aggregates, particularly under current condi­
tions when interest rates have declined sharply.
First, as already noted, the presumption appears
to be that the broader aggregates are better
indicators since real M2 is included in the index
of leading indicators and the Fed chooses tar­
gets for M2 and M3, but not Ml. Recent expe­
rience also indicates that the broader aggregates
are likely to be better indicators. Since 1991,
M1, the narrow aggregate, has grown at a much
faster rate than M2 or M3, while the economy
has experienced very slow growth. This al­
ready suggests that M2 and M3 have been bet­



ter indicators of economic growth than Ml dur­
ing the recent period.6
Theoretical considerations also suggest that
in the current situation of sharply falling short
term interest rates, the broader money measures
are likely to provide better gauges of the effect of
monetary policy than the narrow money measure.
Its advocates accord money a prominent role in
monetary policy because changes in money are
usually considered to be changes in supply im­
pacting on an unchanged demand for money. In
this view, an increase (decrease) in money repre­
sents an excess (deficiency) of money balances
and leads to an increase (decrease) in spending
and economic activity. However, if the change
in money is produced (or matched) by a change
in the quantity of money demanded by the public
under current economic conditions, then the
change in money balances would not represent an
excess or deficiency and would not affect spend­
ing. This makes it important to understand
whether a change in a money measure might
have been produced (or matched) by a change in
the demand for that money measure.
Notice in Figure 5 that M 1 growth has be­
come quite erratic in the 1980s. It has tended to
be high when short term rates are falling (for
example, 1985-1986, 1989-1992) and low when
short term rates are rising (for example, 19871989). To understand this, consider the impact of
a fall in short term interest rates on the various
monetary aggregates. The fall in short term
interest rates lowers the opportunity cost of hold­
ing very liquid deposits like transaction deposits,


inducing holders of investment type deposits
(for example, time deposits) to switch into
transaction type deposits (for example, demand
deposits or other checkable deposits). This
shift in demand toward transaction type depos­
its has the effect of raising M 1, however, since
the increase in M 1 was in response to increased
demand, it does not increase economic activity,
according to the above view. Notice, however,
that the shift in demand to transaction type
deposits does not affect a broad aggregate that
includes both transaction type and investment
type deposits. This suggests that a shift in
demand between transaction type and invest­
ment type deposits is likely to affect the quanti­
ty of a narrow aggregate more than that of a
broader aggregate. For this reason, one would
expect movements in the broader aggregates to
be more insulated from these shifts in demand
produced by interest rate movements, and
hence provide more accurate gauges of excess­
es or deficiencies in deposit balances and more
accurate indicators of future spending and eco­
nomic activity.
A shift in demand by the public, as de­
scribed above, from investment type deposits
(which typically have no reserve requirements)
to transaction type deposits (which typically
have reserve requirements) increases required
reserves. If the Fed is trying to achieve a level
of the fed funds rate, then it must increase re­
serves in response to this shift to prevent an
increase in the funds rate. The data in Figure 6
show that growth in the monetary base has


tended to move with growth in M 1 (the devia­
tions that occur primarily reflect discrepancies
between the growth rates of currency and trans­
action type deposits). As already noted, some
observers have interpreted the recent strong
growth of the monetary base as an indication of
a very expansionary monetary policy, but this
strong growth is merely the necessary conse­
quence of a shift from investment type deposits
into transaction type deposits and the fact that
the Fed is trying to achieve a certain level of
the fed funds rate. If, as indicated above, the
increase in transaction type deposits resulting
from a shift in demand is not expansionary,
then neither is the resulting expansion in re­
serves. So, the rapid growth in the monetary
base does not indicate an expansionary policy
in this situation.
M on ey in th e 1 930s

Data on most measures of money were not
available during the 1930s, but numbers con­
structed since then indicate that again there
are a number of monetary policy parallels be­
tween the earlier period and the present. The
data presented in Figure 4 show that the period
from 1929 to 1933 was one of very weak
growth in money. Over this period a broad
monetary aggregate, roughly comparable to
M2, declined by nearly a third. Even after
taking account of falling prices, the real value
of the money stock declined from 1929 to 1933.
So, as at present, despite the sharp fall in short
term interest rates over this period, broad mon-


ey measures suggest that monetary policy was
not at all easy.
The data in Figure 4 also show, as noted
earlier, that while broad money was falling in
the earlier period, the monetary base was actu­
ally rising. From 1929 to 1933, this measure
increased by slightly more than 20 percent.
Though it is not clear that anyone at the time
argued, as at present, that the growth of the
monetary base indicated an expansionary mon­
etary policy, it is illuminating for the present
situation to examine the circumstances of the
earlier deviation between growth in broader
money measures and the monetary base. Just as
in the present situation described above, the
earlier deviation arose out of a shift in public
preferences. The source and consequences of
the shift in the public’s money holding prefer­
ences was even clearer then than it is now. A
massive wave of bank failures caused the pub­
lic to sharply shift its preferences from bank
deposits to currency. This shift can clearly be
seen beginning in 1931. Given this increased
desire for currency, the increases in the mone­
tary base (where currency accounts for a much
larger component than it does in broad money)
were not indicative of an expansionary policy.
But the shift in the composition of the mone­
tary base from reserves to currency, and the
threat of possible future bank runs, had the
effect of inducing banks to reduce the supply of
bank deposits and the broad aggregates. This

supply effect, reducing the broad aggregates,
was, in the theoretical framework of money
advocates described earlier, a sign of a tighter
monetary policy.
A factor which affects the relation between
money and income marks an important distinc­
tion between the 1930s and the present period.
In the early 1930s, prices were falling sharply,
which meant that the real return to saving by
holding currency or deposits was high, even at
the low levels of nominal interest rates at the
time. This increased the public’s desire to save
in the form of money, which reduced spending
and income, resulting in a decrease in velocity
(the ratio of GNP to money) even for a broad
aggregate that includes both currency and
bank deposits. This meant that in the 1930s,
income declined even more than broad money
did. In the recent period, velocity has not de­
clined, that is, income has not declined relative
to the broader monetary aggregates as it did in
the 1930s.7



C o nd itio n o f th e b an kin g system and
deposit insurance

Even if the weak growth in broader money
explains the sustained weakness in economic
activity in these two episodes sixty years apart,
the question remains why such sharp cuts in
short term interest rates failed so uniquely and
dramatically in these two episodes to produce
stronger money growth. The most likely an­
swer lies in a factor, introduced just above, that
is perhaps the fundamental underlying similari­
ty between the present period and 1930s: the
amount of pressure on the banking system. The
depositories that create money are under more
pressure now than at any time since the 1930s.
More depositories (banks and thrifts) have been
closed in the last three years than at any time
since the 1930s. In addition, increased capital
requirements and tighter regulation have made
even solvent depositories less willing to provide
credit (and therefore create money) than would
typically be the case under the same economic
and interest rate conditions. This pressure on
the depositories that create money has the ef­
fect of working in opposition to the stimulative
thrust on money of lower short term interest
rates. This means that the same reduction in
the funds rate does not have as great an impact
on money and, therefore, economic activity as
it typically would.
The greatest difference for monetary policy
between the present situation and the 1930s is
unquestionably the existence of deposit insur­
ance. By removing the risk of depository fail­
ure from depositors, it has prevented any shift
by the public from deposits into currency and
the potential problems such a shift could create
for monetary policy. But deposit insurance has
also helped to hide the economic forces at work
in the current period. It does this by essentially
removing the pain previously felt by depositors
in the closing of insolvent depositories and the
contraction in the money stock, and by separat­
ing in time the point at which an institution
goes insolvent and the point at which the mon­
ey stock contracts. The closing of an insolvent
institution still contracts money as it did in the
1930s, but the cause and effect relationship is
more difficult to see.
The absence of deposit insurance in the
1930s explains one other great difference be­
tween that period and the present. As a result
of bank runs that occurred in the absence of
deposit insurance, banks in the 1930s sharply


increased their demand for excess reserves in
order to convince depositors not to withdraw
their funds. Excess reserves increased from
about 60 million at the end of 1930 to about 6.8
billion a decade later. This sharp increase, along
with the very low level of short term interest
rates, helped lend credibility to the view that
monetary policy was ineffective during this
period. One could argue that even if the mone­
tary authority had tried to increase the money
stock, any increase in reserves would have gone
into excess reserves without increasing the mon­
ey stock. Whatever the merits of the argument
in the 1930s, it is clear that such an argument is
not credible now. Because of deposit insurance,
depositories do not need to worry about runs,
thus they have no reason to increase excess re­
serves as banks did during the 1930s. At present
there appears to be a no more than normal de­
mand for excess reserves on the part of deposito­
ries, and so a further increase in reserves, other
things being equal, would lead to both a lowering
of the fed funds rate and an further increase in
the money stock.
C onclusion

The analysis above indicates that, from a
monetary policy perspective, the present period
seems somewhat unusual within the post-World
War II era, and that it bears more qualitative, if
not necessarily quantitative, similarities to the
period of the early 1930s. The most immediate
apparent similarity between the two periods is
the combination of sharply lower short term rates
and the absence of strong economic growth. If
one believes that the effect of monetary policy
can be determined simply by movements in short
term interest rates, then it is easy to conclude
that monetary policy has been ineffective in both
of these periods. However, there are measures of
broad money growth that can be interpreted as
indicating that monetary policy was not easy
over these two periods. In both of these periods
there was substantially stronger growth in the
narrow monetary aggregates than in the broad
aggregates. The article argues that shifts in
demand induced by the sharp fall in short term
interest rates are particularly likely to render the


narrow monetary aggregates less reliable than
the broader monetary aggregates as gauges of
monetary policy in such periods of sharply
falling short term rates. However, unexpected
shifts in demand for money (whether broad or
narrow) remains a problem in interpreting the
impact of given money changes on economic
activity. By producing changes in velocity (the
ratio of GNP to money) these unexpected shifts
in money demand produce unexpected shifts in
GNP. The velocity of narrow money measures
decreased in both the 1930s and the recent
period, but velocity of the broader money mea­
sures in the two periods differed sharply. In the
1930s, the velocity of broad money fell, while
in the recent period it has risen. To the extent
that the demand for money (whether broad or
narrow) is difficult to predict, velocity is diffi­
cult to predict and, consequently, it is difficult
to predict income using broad money. Never­
theless, while there is considerable uncertainty
in the use of any indicator, recent experience
and historical analysis suggest that the broad
monetary aggregates deserve greater weight
than either the narrow aggregates or the level of
short term interest rates in predicting future
economic growth.
This still leaves open the question of why
such sharp reductions in short term interest
rates failed to stimulate broad money growth in
only these episodes, some 60 years apart. The
article argues that the fundamental similarity
between these two periods was the severe stress
experienced by money creating depositories.
The closing of insolvent depositories, the in­
creased regulatory pressure, and increases in
the demand for capital all combined to weaken
the normal stimulative impact of a given cut in
short term interest rates. Achieving the same
growth in the broad monetary aggregates re­
quires much sharper cuts in short term interest
rates in these circumstances. This article also
argues that the existence of deposit insurance in
the current period is the most important differ­
ence between the current period and the 1930s
and has caused the consequences of depository
pressures to manifest themselves in much dif­
ferent ways than they did in the 1930s.


'The monetary base is the sum of currency and reserves
held at the Fed. Another narrow monetary aggregate, M1,
is the sum of currency, demand deposits, other checkable
deposits, and travelers checks. M2 is M 1 plus savings
deposits, small denomination time deposits, general pur­
pose and broker/dealer money market mutual funds, and
overnight repos and eurodollars. M3 is M2 plus large time
deposits, institution-only money market funds, and longer
term repos and eurodollars.

initially (May 1975) real Ml was the monetary aggregate
inserted into the index of leading indicators, but since
March 1979 real M2 has replaced real Ml.
5In contrast to the view of the Shadow Open Market Com­
mittee already noted in footnote 3, Milton Friedman (1992)
advocates M2 as an indicator of the effect of monetary
w o recent studies that appear to support the superiority of
M2 over M 1 in the recent period are Hess and Porter (1992)
and Eugenie, Evans and Strongin (1992).


2M 1 is the sum of currency, demand deposits, other check­
able deposits, and travelers checks. Ml is smaller than M2
or M3 but larger than another narrow aggregate—the
monetary base.
3For such a view, see the Shadow Open Market Committee

7A number of recent studies examining the behavior of
velocity (income relative to M2) have been published in the
Federal Reserve system. See Feinman and Porter (1992),
Carlson and Samolyk (1992), Carlson and Byrne (1992),
Duca (1992), Higgins (1992), and Motley (1992).

Carlson, John D., and Katherine A.
Samolyk, “The M2 slowdown and depository
intermediation: implications for monetary poli­
cy,” Economic Commentary, Federal Reserve
Bank of Cleveland, September 15, 1992.
Carlson, John D., and Susan M. Byrne, “Re­
cent behavior of velocity: alternative measures
of money, Economic Review, Federal Reserve
Bank of Cleveland, First Quarter, 1992.
Duca, John V., “The case of the missing M2,”
Economic Review, Federal Reserve Bank of
Dallas, Second Quarter, 1992.

Friedman, Milton, “Too tight for a strong
recovery,” Wall Street Journal, October 23,
1992, p. A 14.
Hess, Gregory D., and Richard D. Porter,
“Comparing interest-rate spreads and money
growth as predictors of output growth: granger
causality in the sense Granger intended,” manu­
script forthcoming in the Journal of Economics
and Business, 1992.
Higgins, Bryon, “Policy implications of recent
M2 behavior,” Economic Review, Federal Re­
serve Bank of Kansas City, Third Quarter,

Eugeni, Francesca, Charles Evans, and
Steven Strongin, “Making sense of economic
indicators: a consumer’s guide to indicators of
real economic activity,” Economic Perspec­
tives, Federal Reserve Bank of Chicago, September/October 1992, pp. 2-31.

Motley, Brian, “Would new monetary aggre­
gate improve policy?,” Federal Reserve Bank
of San Francisco Weekly Letter, Federal Re­
serve Bank of San Francisco, No. 92-38, Octo­
ber 30, 1992.

Feinman, Joshua D., and Richard D. Porter,
“The continuing weakness in M2,” Finance and
Economics Discussion Series #209, Board of
Governors of the Federal Reserve System,
Washington, D.C., September 1992.

Shadow Open Market Committee, “Policy
statement and position papers,” William E.
Simon Graduate School of Business Adminis­
tration, University of Rochester, September 2930, 1991




N A F T A : a review
of the issues

Linda M . A g u ilar

Because the United States is
Mexico's largest trading part­
ner and Mexico is the United
States' third largest trading
partner, Mexico’s economic
ups and downs are felt by many U.S. industries.
The five largest U.S. exports to Mexico in 1991
were electrical machinery, nonelectrical ma­
chinery, transportation equipment, chemicals,
and primary metals; totaling slightly less than
two-thirds of manufacturing exports to Mexico
that year. And the interdependence between
the two countries is growing. In 1971, the U.S.
provided 61.4 percent of Mexico’s imports and
received 61.6 percent of its exports. By 1989,
those numbers had grown to 70.4 and 70.0,
respectively. As illustrated in Figure 1, U.S.
exports to Mexico rise and fall with the Mexi­
can economy. During the 1970s, growth in
U.S. exports was closely aligned to Mexican
gross domestic product (GDP)—that is, changes
in Mexican GDP were met by roughly an equal
change in U.S. exports. But by the 1980s, the
relationship had changed. As Mexico’s econo­
my expanded or contracted, U.S. exports in­
creased or decreased by a greater amount. For
example, in 1986, Mexican GDP declined 25.4
percent; U.S. exports declined 45.4 percent.
It seems plausible to conclude that U.S.
policies that stimulate growth in Mexico could
quickly benefit the U.S. One such policy is the
proposed free trade agreement between the
United States, Mexico, and Canada known as
the North American Free Trade Agreement
or NAFTA (see Box 1 for an overview of
NAFTA). The potential benefits of a regional


trading bloc to these nations are enormous. In
1990, the combined GDP of the three countries
was $6.2 trillion, a full $221.3 billion greater
than the European Economic Community’s.
Thus, all three countries would benefit from
reduced costs, more competitive prices, and
greater global trading power.
This article examines the trade relationship
between the U.S. and Mexico1over the last few
years, and discusses the potential benefits to the
U.S. and the Seventh District of NAFTA. It
also explores three of the issues negotiators
faced during their eighteen months of negotia­
tions that are of particular concern to the Sev­
enth District: U.S. jobs and worker retraining,
rules of origin, and the environment (that is,
water and air quality).
T rade in itia tiv e s in M ex ic o

During the early 1970s, Mexico’s econom­
ic and trade policies were considered protec­
tionist. Foreign investment was restricted and
many industries were state owned. Imports
consisted primarily of industrial supplies, capi­
tal equipment, industrial and nonauto transpor­
tation equipment, and transportation parts.
Exports were primarily agricultural and manu­
factured goods. Manufactured goods were
derived largely from the “maquiladora” plants:
foreign owned (mainly U.S.) plants that bring
unfinished parts and components into Mexico
Linda M. Aguilar is a regional economist at the
Federal Reserve Bank of Chicago. The author would
like to thank William Testa, Carolyn McMullen, and
Kathryn Moran for their helpful comments
and insights.


Im p a ct on th e
S even th D is tric t

for final processing and assembly prior to reex­
port into the United States (see Box 2 for an
overview of the maquiladora program).
The rise in world oil prices during the
1970s prompted Mexico to develop its huge oil
reserves. These reserves, in turn, served as
collateral for substantial loans from the rest of
the world, and in particular, U.S. banks. Ex­
ports of petroleum and petroleum products
soared, reaching 75.3 percent of general exports
in 1982. But by the early 1980s, world oil
prices had topped out, and Mexico could no
longer service its debt. New loans to Mexico
ceased. Prodded by economic decline, the
Mexican government implemented bold eco­
nomic reforms which stabilized the economy,
reignited economic development, and opened
new horizons for trade and investment. In
1986, Mexico joined the General Agreement on
Tariffs and Trade (GATT) and reduced its
tariffs from levels of 100 percent, in some cas­
es, to a maximum of 20 percent, which was
even lower than the GATT maximum allowable
tariff of 50 percent.2 In addition, Mexico
opened up foreign investment in many sectors
and privatized many of its former, state-con­
trolled industries. By the end of the 1980s,
Mexico realized it would be necessary to solidi­
fy its new position as a growing and prosperous
economy by integrating itself more closely, in
particular through trade, with its two northern
neighbors, the U.S. and Canada.



Although the benefits of
NAFTA to the U.S. at the regional
level are difficult to determine,
the Seventh District, which en­
compasses most of the states of
Illinois, Indiana, Michigan, and
Wisconsin and all of Iowa, should
realize benefits through increased
exports to Mexico.
Of particular significance to
the U.S. and the Seventh District
has been the growth of U.S. man­
ufacturing exports to Mexico. As
a region, the five District states
increased their manufacturing
exports to Mexico 90 percent over
the 1987-1991 period; U.S. manu­
facturing exports increased 130
percent over the same period.
Also, roughly half of all manufacturing exports
to Mexico over this period were in machinery
and transportation equipment, two capital
goods producing industries that form the cor­
nerstone of the U.S. and, in particular, the
Midwest economies (see Box 3 for recent
trends in manufacturing exports to Mexico for
the District).
In 1991, exports to Mexico of these two
capital goods comprised 68 percent of Seventh
District manufacturing exports and 53 percent
of U.S. manufacturing exports. The importance
of these goods to a growing economy is signifi­
cant. In order to grow, a developing country
needs to build factories, housing, and schools.
To support this growth, there must be an infra­
structure consisting of roads, airports, sewers,
etc. For Mexico, imports of machines and
transportation equipment3 have comprised any­
where from 30 to 55 percent of total commodi­
ties imports over the last 20 years. It would be
safe to assume that this trend is likely to contin­
ue, particularly in the short run, with or without
NAFTA. As Mexico develops, the demand for
goods produced in the Seventh District, namely
machinery and transportation equipment, and
the benefits to the District, will also grow.
Labor issues

Among those voicing the strongest reserva­
tions about free trade with Mexico are U.S.
factory workers, mainly because they fear that
U.S. companies, seeking lower labor costs, will


transfer factory operations to Mexico where
average compensation costs are far less than
their U.S. counterparts (See Table 1). While
studies have shown that wages are not necessar­

ily the driving factor in location decisions, it
must be recognized that they represent a large
share of manufacturing costs. For example,
wages of production workers, excluding white


An overview of NAFTA and the trade agreement process
In February 1991, the United States, Mexico,
and Canada agreed to begin negotiating a free trade
agreement, at the request of M exico’s President
Salinas. An agreement among the three countries is
expected to benefit all, although at possibly very
different levels, and eventually allow each trading
partner roughly equal access to the others’ markets.
Formal negotiations began in June 1991, and on
August 12, 1992, it was announced that an agree­
ment had been reached.
B e nefits o f fre e tra d e

The direct benefit o f free trade derives from
the nearly complete elimination of tariffs between
free trade partners. It is expected the U.S. will
benefit1 through expanded trade with a large and
growing market, increased competitiveness in world
markets, and more investment opportunities for
U.S. firms. Mexico will benefit from more open
and secure access to its largest market, the U.S.;
increased confidence on the part of foreign firms to
invest in Mexico; a more stable economic environ­
ment; and the return o f Mexican owned capital.
Canada’s benefits are mostly in the form of safe­
guards: maintaining its status in international trade;
no loss of its current trade preferences in the U.S.
market; and equal access to M exico’s market.
While NAFTA will, on net, benefit each nation, it is
not a win-win situation for everybody. It produces
both winners and losers among industries and occu­
pations; and it must deal with such issues as worker
displacement and rules o f origin, as well as address
issues such as the impact of free trade on the envi­
ronment (that is, air and water quality).
The U .S . tra d e a g re e m e n t process

Under the directive o f the Trade Act of 1974,
once the U.S. has decided to enter free trade negoti­
ations with a country(s), the President submits a
formal request to Congress requesting authority to
negotiate with the proposed trade partner(s). Under
the act’s “fast track” authority, Congress has 60
legislative days to approve or reject the request.
During this period, congressional committee hear­
ings are held to solicit comments and testimony
from interested parties. If the request to negotiate
an agreement is approved, the negotiations can
begin but must be completed within 2 years. Once


the negotiators prepare a final agreement, it is sub­
mitted to Congress for approval and it must be ac­
cepted or rejected as is. That is, no amendments or
revisions are allowed. If approved by Congress, the
President then signs the agreement and the terms and
timetables agreed to by the trading partners can be
The N A FT A agenda

In agreeing to participate in a free trade agree­
ment, the U.S., Canada, and Mexico developed an
agenda o f specific trade policies on which the three
countries were to agree. The three countries also
agreed to address issues and concerns that each coun­
try may have about the others’ current and future
trading policies. Towards that end, working groups
were formed to negotiate the following issues:
Market access
Tariffs and nontariff barriers
Rules o f origin
Government procurement
Trade rules
Subsidies; countervailing and antidumping duties
Health and safety standards
Intellectual property
Dispute settlement
N e g o tia tio n results

When the agreement was announced on August
12, the following details, by industry, were provided:
Autos— Mexican tariffs were reduced from 20 to
10 percent immediately on autos and on most auto
parts within 5 years; NAFTA completely eliminates
auto tariffs in 10 years; eliminates export quotas and
performance requirements on foreign owned manu­
facturing facilities in Mexico; eliminates duties on
three-fourths o f U.S. parts exports within 5 years;
and eliminates Mexican import restrictions on buses
and trucks within 5 years. To qualify for duty free
trade, autos must contain 62.5 percent North Ameri­
can content.
Textiles and apparel— NAFTA eliminates barri­
ers to trade on over 20 percent o f U.S. textile and


collar jobs, accounted for 20.5 percent of value
added by U.S. manufacturers in 1990.
In addition, U.S. workers’ fears are not
entirely unfounded. U.S. companies with for-

apparel exports; eliminates barriers on another 65
percent over the next six years; and provides strong
rules of origin in order to qualify for duty free status.
Agriculture— one-half of U.S. exports to Mexi­
co will be duty free immediately, with remaining
goods to be tariff free within 15 years.
Energy and petrochemicals— NAFTA allows
private ownership and operation of electric generat­
ing plants for self-generation, cogeneration, and
independent power plants; provides immediate ac­
cess to trade and investment for most petrochemi­
cals; and allows U.S. firms to negotiate directly with
Mexican purchasers o f natural gas and electricity and
to conclude contracts with PEMEX, M exico’s state
run petroleum company, or CFE, M exico’s state
owned electricity firm.
Electronics and telecommunications— NAFTA
eliminates most Mexican tariffs on telecommunica­
tions equipment, computers and parts, and electronic
components immediately with complete elimination
within 5 years.
Financial services— U.S. banks and securities
firms will be allowed to establish wholly owned
subsidiaries with transitional restrictions to be
phased out by January 2000.
Insurance— existing joint ventures will be al­
lowed 100 percent ownership by 1996; new entrants
can obtain majority ownership by 1998; and all
equity and market share restrictions will be eliminat­
ed by 2000.
Investment— Mexico will eliminate export
performance requirements and domestic content
rules for U.S. firms operating in Mexico.
Land transportation— U.S. trucking firms will
be allowed to carry international cargo to the contig­
uous Mexican states by 1995 with cross border ac­
cess to all of Mexico by the end of 1999.
Environment— U.S. environmental, health, and
safety standards will be maintained, with states and
local governments having the ability to increase
standards as needed; NAFTA preserves international
treaty obligations such as trade limits on protected
species and permits more stringent standards to be
imposed on new investment.
'Benefits to each of the three trading partners are credited to
Hufbauer and Schott (1992).



eign affiliates in Mexico increased employment
from 1977 to 1989 by 146,000 workers (or 39.4
percent) at the same time that employment in
foreign operations of U.S. companies world­
wide declined by 8 percent (see Table 2). In
particular, employment has grown rapidly in
electronics industries and in transportation with
each of the Big 3 automakers having auto or
truck assembly operations in Mexico. These
two industries accounted for 47 percent of
employment of U.S. operations in Mexico
in 1989.
While these figures document the job flight
to Mexico, it is important to note that other
forces are also dislocating American workers,
including the movement of production to other
low wage countries, such as Taiwan and Singa­
pore, by both domestic and foreign companies.
Thus, U.S. jobs lost to Mexico might instead
have been moved to another low wage country
rather than remaining in the U.S. In fact, some
business and labor representatives believe that
open borders with Mexico have, so far, helped
preserve jobs in the U.S. that would have other­
wise been lost overseas. It is argued that, in
some instances, access to low wage labor in
Mexico has sustained the U.S. share of such
production in the face of foreign competition,
and may be the advantage U.S. companies need
to remain price competitive in world markets.
Some supporters of NAFTA4 even argue that
protecting jobs in industries in which the U.S.
does not hold a comparative advantage makes
both the U.S. and Mexico less prosperous. U.S.
jobs “saved” in one industry are merely jobs
lost in other industries.
From a U.S. perspective, Mexico’s grow­
ing economy, together with NAFTA, may have
a positive effect on the U.S. economy. A recent
Commerce Department report indicates that in
1990, exports to Mexico supported 538,000
domestic jobs and that for every 10 jobs direct­
ly supported (for example, manufacturing jobs),
another 19 more jobs (such as supplier jobs) are
indirectly supported.5 Also, most studies of the
impact of NAFTA on U.S. industries agree that
industries with increased export potential will
be winners (including chemicals, plastics, ma­
chinery, and metals) and other industries, espe­
cially those that have been tariff protected
(such as citrus crops, sugar, apparel, and furni­
ture) will be losers. However, on net, the U.S.
will likely realize only small or negligible in­
creases in production.



Hourly manufacturing compensation costs for production workers





1 985-1988









----------- U S. d o lla r costs-








(---- A n n u a l % change in U.S. d o lla r costs ----- )

M exico





SOURCE: U.S. Dept, of Labor, Bureau of Labor Statistics, International Comparisons of Hourly
Compensation Costs for Production Workers in Manufacturing, 1991 - Report 825.

W o rk e r re tra in in g and o th e r assistance

domestic auto industry, that have and are un­
dergoing deep disruptions.
Officially the Big 3 automakers support “a
well crafted NAFTA” and expect that increased
trade with Mexico “could result in expanded
export opportunities for U.S. vehicle and parts
manufacturers.”6 Underlying this statement is

Although NAFTA will be phased in slowly
over many years, it is likely to accelerate the
labor market upheaval that certain industries
and local areas have already experienced. Par­
ticular regions, including the Midwest, are
highly concentrated in industries, such as the


An overview of the maquiladora program
The maquiladora program was initiated in 1965
by the Mexican government in response to the can­
cellation by the United States of a prior work pro­
gram, called the bracero program, that allowed Mexi­
can workers to cross the border for seasonal work.
The maquiladora program allows 100 percent foreign
ownership o f a firm located in Mexico for the pur­
pose of manufacture and assembly of products for
export. In the original program, imports used in
processing were not subject to Mexican tariffs pro­
viding they were 100 percent reexported. Recent
changes to the program allow a portion of the goods
to be sold in the domestic market. Only the value
added in Mexico (that is, labor costs and domestic
parts) are subject to import tariffs upon reentry.
Also, machinery or other items used in the production
are exempt from Mexican import tariffs.
The textile industry was the first industry to use
the maquiladora program but over time, other laborintensive industries such as electrical components,
furniture, and transportation equipment also opened
factories in Mexico. Originally, maquiladoras had to
be located along the Mexican border, but that restric­


tion is no longer in force. By 1990, 470,000 work­
ers, including both production and administrative
workers, were employed in maquiladoras.
Most maquiladoras are U.S. owned, but there
are a few Canadian, Japanese, and European opera­
tions as well. Due to the present state of the U.S.
economy, more applications to build maquiladoras
were received from non-U.S. companies in 1991
than from U.S. companies.
While NAFTA will eventually remove most
tariff and nontariff barriers to trade between the
U.S. and Mexico, the fate of the maquiladoras is
uncertain. The theory that more U.S. plants will
relocate to Mexico to take advantage o f lower Mex­
ican wages is not necessarily sound. For one, as the
Mexican economy grows, the wage gap will eventu­
ally decrease. Also, other factors, such as infra­
structure and natural resources, play a large part in
location decisions. On the other hand, Mexico is a
large and growing market, and the decision to relo­
cate to be closer to a firm’s market will become a
factor in favor o f either relocating or expanding



Employment of U.S. nonbank foreign affiliates
Y ear

M e x ic o

C anada

All co un tries

N o n -M e x ic o

A s ia /P a c ific

-— Thousands o f workers




6,8 26.6






6,6 40.2

6,1 69.9


90 0.6










6,4 17.5

5,9 87.5


6,4 19.3

5,9 5 3 .4





6,2 50.2

5,8 08.3





6,2 96.6

5,8 58.5




96 5.5

6,4 03.5

5,9 43.4





6,6 21.4

6,1 05.6




-1 1 9 .1

-5 7 5 .3

-7 2 1 .0



-1 1 .2

-8 .0

-1 0 .6


% ch an g e



SOURCE: Department of Commerce, Bureau of Economic Analysis.

the expectation that the potential of the Mexi­
can market is so large that American operations
will expand significantly to accommodate it.
Even so, U.S. labor lobbied hard to have
worker displacement addressed and job retrain­
ing included in NAFTA negotiations. While
the Bush administration does recognize that
job replacement is likely to occur and recogniz­
es the need for job retraining, no formal pro­
gram was included in the proposed NAFTA.
However, shortly after the NAFTA agreement
was completed, President Bush proposed a
five year, $3 billion per year job training initia­
tive, of which $2 billion per year would be
earmarked for dislocated workers. This plan,
called the New Century Workforce proposal,
would replace the current Economic Disloca­
tion and Worker Adjustment Assistance
program, as well as the Trade Adjustment
Assistance Act, and would require congression­
al approval.
Rules o f o rig in

“Rules of origin” is a trade term which
defines the minimum percentage of a country’s
exported product that must be produced or
substantially transformed within the border of
the exporting country (also known as “local
content”). The term “substantially trans­
formed” means that products that use foreign
inputs must go through considerable change



(for example, a raw material being processed
into a finished good) in order to be used in
an export to a free trade partner. The reason
for this rule is to limit a country involved in a
free trade agreement from using cheaper,
foreign parts in its exports and then using its
favorable tariff arrangements to avoid higher
import tariffs.
While all industries are concerned with this
issue, the domestic auto industry, headquartered
in the Seventh District, had proposed that a
strong rule of origin apply to the automotive
industry. In addition to a lengthy phase-in
period designed to protect companies with
existing operations in Mexico, the Big 3 auto­
makers had suggested that the rules of origin be
more stringent in an agreement with Mexico.
In the U.S.-Canada free trade act, auto related
rules of origin are applied to each plant, with a
current minimum of 50 percent local content
required. For the U.S.-Canada-Mexico agree­
ment, the Big 3 had suggested that each compa­
ny, rather than each plant, be allowed to aver­
age the local content requirement, with GM
suggesting a 60 percent requirement, and Ford
and Chrysler proposing 70 percent.7 NAFTA
proposes a 62.5 percent local content rule for
passenger vehicles and 60 percent for other
vehicles and auto parts based on net cost (total
cost less royalties, sales promotion, and packing
and shipping).


BOX 3

Seventh District manufacturing exports to Mexico
Over the 1987-1991 period, total export ship­
ments from District states grew from $35.5 billion
to $52.9 billion. Exports to Mexico grew by $1.5
billion over this period, or from 4.8 percent o f total
manufacturing exports to 6.2 percent.

The five largest industries by shipment value to
Mexico from District states in 1991 were transpor­
tation, machinery except electrical, electrical ma­
chinery, primary metals, and fabricated metals.
These five industries increased exports to Mexico
by $848 million over the
period, comprising 55
Recent trends in District manufacturing exports
percent o f total manufac­
(Millions o f dollars)
turing export growth.
% of District
% of District
District exports to
Mexico grew in other
industries as well. For
example, in 1987, exports
Food and tobacco
o f textiles and apparel to
Textiles and apparel
Mexico comprised only 1.7
W ood and furnitu re
percent o f total textiles and
Publications and printing
apparel exports. By 1991,
exports to Mexico had
Petroleum refining
grown to 18.3 percent of
total textiles and apparel
exports. Likewise, wood
Stone and glass
and furniture exports grew
Prim ary metals
from 1.3 percent to 6.1
Fabricated metals
percent; rubber exports
from 3.5 percent to 9.0
M achinery, except electric
percent; fabricated metals
Electrical m achinery
from 1.2 percent to 5.7
percent; and primary met­
M easuring instrum ents,
als from 6.6 percent to 9.7
m anufacturing
percent. Measuring instru­
ments and miscellaneous
manufacturing was the
'The amounts in this column represent the percent of total District exports of each
only industry that experi­
industry that are exported to Mexico. For example, in 1987, District exports of food
enced a decline in exports
and tobacco to Mexico represented 3.6 percent of total District exports of food and
tobacco to all foreign countries.
to Mexico over the period.

E n viro n m en tal issues

A third issue addressed by NAFTA was the
environmental impact of increased production.
Environmental concerns usually were voiced
by three interest groups; environmentalists,
industry sectors concerned about losing their
jobs to low cost Mexican labor, and industry
sectors that stand to gain from increased trade
with Mexico.
Environmentalists fear that increased trade
with Mexico will expand already problematic
environmental conditions, such as air and water
pollution, and increase health and safety con­
cerns for workers caused by lax (or nonexistent)


enforcement of health and safety standards.
These concerns are not only for the Mexican
workers, but also for the spillover effects in
many U.S. cities along the U.S.-Mexico border.
For example, those concerned by this issue cite
the Mexican maquiladora program that brought
thousands of Mexican workers and their fami­
lies to Mexican border towns without adequate
infrastructure to house and feed them. This
resulted in substandard living conditions in the
Mexican towns and in pollution of the ground
water and air of both the Mexican towns and
the American towns just north of the border.


Industries concerned about losing their jobs
to Mexican workers have embraced the environ­
mentalists’ cause and are suspicious that U.S.
and foreign companies will relocate to Mexico
to avoid their own countries’ antipollution laws.
The environmentalists also fear the U.S. may
relax its own laws to remain competitive.
Industries that stand to gain from NAFTA
point to the recent progress Mexico has made
towards cleaning up its environment. For exam­
ple, the Mexican government has lowered the
lead content of petrol, closed some of its worst
factories, and passed new environmental laws
modeled after U.S. laws. In addition, one study
of the environmental impacts of NAFTA sug­
gests that because of Mexico’s abundance of
labor, it is likely that the types of industries that
will open or relocate to Mexico will be more
labor intensive than capital intensive, resulting
in less energy use and less hazardous waste.8
Environmental concerns prompted the Unit­
ed States to develop an action plan that directed
the Environmental Protection Agency to meet
with their Mexican counterparts to ensure that
comprehensive environmental, safety, and
health standards and enforcement measures were
included in the agreement. In the Bush adminis­
tration’s 1993 budget proposal, $241 million is
requested for border cleanup, nearly double that
of fiscal year 1992. However, in a recently
submitted environmental plan, no new cleanup
funds beyond 1993 have been requested.9 Other
U.S. agencies, like the Food and Drug Adminis­
tration, the Department of Agriculture, and the
Department of Labor, also were directed to

participate in the negotiations to ensure that all
U.S. environmental concerns were addressed.
The proposed NAFTA includes a section on the
environment that stresses no reduction in cur­
rent standards and a move towards harmoniza­
tion of standards among the three trade part­
ners. This agreement is the first trade agree­
ment to specifically address the environment.
C onclusion

The potential for the U.S., Canada, and
Mexico to become the world’s largest regional
trading bloc will enhance all three countries’
ability to prosper and compete. Mexico will
most likely benefit the most from its new stand­
ing as a North American trading partner. Its
recent moves towards international market
liberalization and economic reform have al­
ready begun to change the world’s view of
Mexico in terms of trade and investment; NAF­
TA will solidify it. The U.S. will benefit not
only in terms of increased exports, but also
from better and more open relations with Mexi­
co in areas such as drug enforcement and illegal
However, widespread U.S. support for
NAFTA will depend on how well the negotia­
tors were able to protect the wide array of U.S.
interests, particularly as they relate to rules of
origin, worker retraining and dislocation pro­
grams, and the environment. If it is to receive
broad based support, the costs and benefits of
NAFTA must accrue to those directly affected,
rather than unfairly burden or protect the few.

'Because the United States and Canada already have an
existing free trade agreement, this article will focus on
U.S.-Mexico trade relations.

4McTeer (1991), p. 6.

2T h e lik e ly im p a c t o n th e U n ite d S ta te s o f a f r e e tr a d e a c t

6Chrysler, Ford, and General Motors (1991).

w ith M ex ic o ,

5Davis (1992), p. 2.

United States International Trade Commis­

sion, pp. 1-2.

7Chrysler, Ford, and General Motors (1991).

3Because of the use of different data sources, the term
“capital goods” as it relates to exports from the U.S. and
imports to Mexico is not totally comparable.

8Grossman and Krueger (1991).
9Stokes (1992), p. 507.

Davis, Lester A., U.S. Jobs Supported by Mer­

Grossman, Gene M., and Alan B. Krueger,

chandise Exports, U.S. Department of Com­
merce, April 1992.

“Environmental impacts of a North American
free trade agreement,” National Bureau of Eco­




nomic Research working paper series, No. 3914,
November 1991.
Hufbauer, Gary Clyde, and Jeffrey J. Schott,

“North American free trade: issues and recom­
mendations,” Institute for International Trade,
March 1992.
McTeer, Robert D., Jr., “Free trade will

bring better jobs,” The Southwest Economy,
Federal Reserve Bank of Dallas, September/
October 1991.

Position of Chrysler, Ford, and General Motors
on the Key Objectives of the North American Free
Trade Agreement, paper submitted to the U.S.
Trade Representative, Motor Vehicle Manufactur­
ers Association of the U.S., Inc., Sept. 9, 1991.
Stokes, Bruce, “On the brink,” National Journal,

February 29, 1992, p. 507.
United States International Trade Commission,

The likely impact on the United States of a free
trade act with Mexico, February 1991.

The 29 th A n n u a l Conference on Bank Structure a n d Competition, M ay 5-7, 1993

A n Appraisal
The Federal Reserve Bank of Chicago will hold
its 29th Annual Conference on Bank Structure and
Competition at the Westin Hotel in Chicago, IL,
May 5-7, 1993.

I the impact of capital requirements on bank
I the consolidation movement in banking with
emphasis on megamergers

Attended each year by several hundred academics,
regulators, and financial institution executives, the
conference serves as a major forum for the exchange
of ideas regarding public policy toward the finan­
cial services industry.

The first day of the conference will be devoted
to technical papers of primary interest to an
academic audience while the final two days are
designed to appeal to a more general audience.
Invitations to the 29th Bank Structure Confer­
ence will be mailed in mid-March.

The central theme of the 1993 conference will
be an appraisal of the Federal Deposit Insurance
Corporation Act of 1991- Topics featured at this
year’s conference will include:
S FDICIA’s impact on the banking industry
B the future status of the banking industry and
its insurance fund
5 the regulation of interbank exposures arising
from the trading of derivative and foreign
exchange products


If you are not currently on our mailing list or
have changed your address and would like to re­
ceive an invitation to the conference, please send
your name and address to:
Public Information Center - 3 rd floor.
Federal Reserve Bank o f Chicago,
P.0. Box 834, Chicago, Illinois
6 0 6 9 0 -0 8 3 4


Reducing credit risk in
over-the-counter derivatives

John P. Behof

During 1992. there has been
much discussion of the stagger­
ing size and dramatic growth in
the use of derivative and off
■ balance sheet financial prod­
ucts and the potential risks these products
present to the global financial system. A num­
ber of events in particular have led to greater
concerns surrounding management of credit risk
arising from derivative and off balance sheet
products. While the term “derivatives” is used
to describe a variety of nontraditional financial
instruments such as interest rate swaps, financial
futures, and options, most risk concerns are
focused on the proliferation of over-the-counter
(OTC) products which bear direct counterparty
credit exposure. OTC derivatives include a
myriad of swap and option products linked to
interest rates, currencies, equities, and commodi­
ties. Unlike exchange traded futures and options
contracts with margin requirements, OTC off
balance sheet products incur credit risk due to
the potential default of the counterparty prior to
contract maturity.
The bankruptcy of Drexel Burnham Lam­
bert and the subsequent failures of the Bank of
New England, Development Corp. of New Zeal­
and, and British & Commonwealth Merchant
Bank caused many market participants, especial­
ly corporations, European users, and investment
funds, to restrict their OTC derivatives credit
exposure to only AAA and AA firms.1 The
more recent bankruptcies of Olympia & York
and other corporate entities with fairly substan­
tial derivative books further illustrated the dan­
gers in conducting OTC derivatives business



with weak corporate counterparties outside of
the interbank arena.
Besides the actual bankruptcies that have
occurred, many other firms have been down­
graded recently, causing credit sensitivity in
OTC derivatives to increase substantially. Other
factors contributing to the recent credit concerns
include the increasing complexity and maturity
of the deals, the increased participation of weak­
er corporations, uncertainty about legal reme­
dies, and increased difficulty in judging the
creditworthiness of derivatives users due to
current accounting rules.2
These credit constraints have the potential
to impact the number and nature of market par­
ticipants as well as impede the dramatic growth
of off balance sheet financial products. Major
commercial and investment banks that have
been downgraded have already lost market share
and fee income from high margin corporate
customers that are in some cases authorized to
deal with only AAA or AA firms. The remain­
ing AAA and AA market makers are also reduc­
ing their exposure to the downgraded firms,
threatening the ability of lesser rated entities to
participate in these markets safely and profit­
ably. These pressures could trigger a migration
to exchange traded markets, especially in light of
the fact that recent regulatory changes will likely
John P. Behof is a Senior Examiner in the Depart­
ment of Supervision & Regulation at the Federal
Reserve Bank of Chicago. The author is especially
grateful for assistance by Barbara Kavanagh, Fi­
nancial Markets Officer. The author would also
like to thank Herbert L. Baer, Garrett Glass, John
Stocchetti, and Ken Wiersum for their insightful


allow futures exchanges to list OTC products as
well as the already listed contracts which can be
used as substitutes.3
As a result, derivative market participants
have devised new methods for dealing with
increased credit risk as well increased usage of
more established methods. These may generally
be divided into the following categories: (a)
formation of a special purpose vehicle (SPV) or
special operating subsidiary with a higher credit
rating than the parent; (b) collateralization of
credit risk; (c) cash settlements, assignments,
and unwinds; (d) netting of obligations, both
bilaterally and multilaterally; and (e) third party
“portfolio” support, such as pool insurance,
letters of credit, or guarantees. Some credit
reducing techniques, such as bilateral netting and
collateral agreements, have been used for years
by a minority of counterparties to aid in their
execution of trades with each other. Others,
such as SPVs and multilateral netting are more
recent innovations. The successful implementa­
tion of any of these credit reducing techniques
will determine whether these markets experience
continued growth or stagnate under the weight
of credit constraints. This article will describe
and analyze some of the more notable attempts
at reducing credit exposure in derivatives.
Special purpose vehicles

The use of special purpose vehicles (SPVs)
as a credit enhancement in derivatives is in some
ways analogous to securitization. Over the past
five years, several institutions of less than AAA
rating have found securitization to fund certain
assets to be cost effective. In a traditional secu­
ritization structure, a separate organization,
usually a trust, is established to isolate the assets
in question from the overall risk of the origina­
tor. Establishing corporate separateness is es­
sential for three reasons: to allow the SPV to
obtain a separate, higher rating; and to insure
that, in the event of bankruptcy or insolvency of
the parent, the SPV could avoid having its assets
and/or cash flows made part of the bankrupt
parent by “substantive consolidation;” and to
assure the parent’s creditors or regulators that
there is no recourse to the parent.
A classic securitization is the conveyance of
a pool of assets to the trust, with the credit risk
of the pool partially insured by a mechanism
such as a reserve for losses, letter of credit, etc.
In the case of derivatives, SPVs have generally
been established to isolate a product line pro-


spectively. A review of two SPVs established to
date by major investment banking firms illus­
trates this.
Both Goldman Sachs Equity Markets L.P.
and Merrill Lynch & Co. have established and
capitalized SPVs to improve their trading prod­
ucts’ capabilities. In each instance, the parent
company has contributed significant capital to
the newly formed entity. Both SPVs obtained
AAA ratings whereas the parent firms had A+
senior unsecured debt ratings. The level of
capitalization in each, together with certain other
steps taken to effect corporate separateness and
contain the level of credit and market risks in­
digenous to the portfolios, allowed the SPVs to
attain separate, higher ratings.
In the case of Goldman Sachs, GS Financial
Products International, L.P. (GSFPI) takes the
legal form of a limited partnership. It was ini­
tially capitalized by a parental contribution of a
portfolio of in-the-money yen denominated
options and warrants on the Nikkei 225 stock
index valued at approximately 9.3 billion Japa­
nese yen. In the case of Merrill Lynch, Merrill
Lynch Derivative Products, Inc. (MLDPI) is a
legally independent subsidiary capitalized via
$300 million in common stock issued to Merrill
Lynch and a $50 million preferred stock issue
placed with a third party. With each vehicle,
additional elements are present to insure corpo­
rate separateness that include all or some of the
following: some element of management and
directorate independence, operating and ac­
counting safeguards, and ongoing, independent
audit or third party oversight.
Credit and market risk associated with the
SPVs existing and/or prospective business is
limited by setting certain preestablished parame­
ters within which business will be conducted.
Counterparties need to meet certain de minimus
standards designed to insure diversification and
to limit risk taking. These include the credit
rating of counterparties, exposure to an individu­
al counterparty, limits on aggregate exposure to
a class of a given rating category, and limits on
diversification of country risk by country of
origin of counterparty. Credit quality can also
be maintained through various capital targets
which become increasingly restrictive as coun­
terparty ratings decline and probability of default
Equally important are the terms of such
other factors as market, currency, and/or interest


rate risk exposures. MLDPI is chartered to enter
into interest rate and currency swaps, caps and
floors, and interest rate options. Each swap
MLDPI enters into with a customer will be mir­
rored by a swap with the opposite payment char­
acteristics from Merrill. MLDPI will therefore
not be directly exposed to fluctuations in interest
rates or exchange rates.4 Since Merrill’s rating
of A+ makes it the lowest rated counterparty
conducting business with MLDPI, the latter is
protected by a requirement that Merrill collater­
alize its net position with MLDPI. The ability to
provide collateral on a net basis is one reason
SPVs are more attractive than executing separate
collateral agreements with each counterparty.
As of this writing, there are several com­
mercial banks contemplating the establishment
of SPVs in the form of operating subsidiaries to
house at least a portion of their derivatives busi­
ness. The creation of SPVs by banks raises
several new regulatory issues.
(a) Bankruptcy remoteness: in the case of a
commercial bank, the issue is whether, in the
event of insolvency of the associated bank, the
Federal Deposit Insurance Corporation (FDIC)
would recognize the derivatives subsidiary as
being a separate entity or instead consider it part
of the institution in receivership. As of this
writing, it is unclear whether the rating agencies
will rate bank derivative product subsidiaries
AAA without some form of assurance from the
FDIC that they will in fact be treated as “bank­
ruptcy remote.”
(b) Capital adequacy: clearly the Merrill
Lynch and Goldman SPVs were begun with
substantial capital contributions from their par­
ents. The ability of commercial banks to con­
tribute such sums and remain adequately capital­
ized as independent entities will be subject to
review. In addition, movement of collateral
from the bank to the SPV will be required in the
event the value of the bank’s position deterio­
rates or if one of the SPV’s counterparties is
downgraded. In the proposals to date, the deriv­
ative subsidiaries are structured as operating
subsidiaries of the commercial bank so that any
equity contributed to the subsidiary could be
“recaptured” in the accounting consolidation
process. The question becomes one of whether
consolidation of allocated capital should be
permitted for risk capital adequacy purposes.
(c) Preemption of the FDIC and unsecured
creditors: the question arises of whether unse­



cured creditors of the bank establishing the de­
rivatives operating subsidiary are effectively
disadvantaged by a portion of capital being
allocated to the subsidiary. In the case of com­
mercial banks, the ultimate unsecured lender
could be the FDIC.
The proponents of bank SPVs recognize
these issues as important, but believe they are
not exclusive to derivative subsidiaries for the
following reasons. First, the establishment of
bankruptcy remote entities by banks is not a new
concept and the legal precedent for corporate
separateness is well established. Second, the
consolidation of nonderivative operating subsid­
iaries for the “recapture” of risk based capital is
a regularly accepted practice, except for bank
holding company subsidiaries (Section 20 sub­
sidiaries) that are involved in “bank ineligible”
securities underwriting activities which have
been allowed by the Federal Reserve Board on a
limited basis since 1987.5 However, the combi­
nation of a bankruptcy remote entity which is
also an operating subsidy is a new concept.
Finally, the preemption of the FDIC and other
unsecured creditors can be accomplished effec­
tively through a number of other collateralized
activities already conducted by banks, including
exchange trading, unilateral, bilateral, and multi­
lateral collateral agreements, as well as repur­
chase agreements and membership in clearing­
houses. For example, if a bank were taken over
by a government agency, it is unlikely the agen­
cy could repudiate an obligation to a third party
and expect that party to return the collateral it
held as security for the obligation.
Although SPVs are in their infancy, market
participants note that each of the vehicles estab­
lished to date are reported to be successfully
booking business with coiporate users and OTC
market participants. However, two negatives of
SPVs have been noted. First, some corporations
do not believe the AAA SPVs are truly AAA
and will “look through” the vehicles to the par­
ent’s credit rating. Second, some corporations
are not agreeing to have their trades reassigned
out of the SPV in the case of their own down­
B ilateral n e ttin g

Banks and other derivative market partici­
pants have been more aggressively pursuing
netting agreements, both bilateral and multilater­
al, as a reaction to credit concerns. The ability
to net obligations within product groups, such as


foreign exchange and interest rates commodities,
has been the focus of the vast majority of these
attempts, although cross product netting between
derivative types is becoming more prevalent.
For example, if Bank A was owed a net present
value of $50 million on interest rate swaps by
Bank B, but owed $25 million in currency op­
tions to Bank B, netting the two obligations
would reduce credit risk by half. Some cross
product netting agreements have gone so far as
to include the netting of nonderivative obliga­
tions such as loans with net derivative balances,
but these are very rare. Some large banks have
indicated that having derivative bilateral netting
agreements with approximately a dozen large
counterparties could reduce credit risk by as
much as 50 percent.
Bilateral netting agreements can generally
be divided into four categories: netting by nova­
tion, close out netting, payment netting, and
cross product netting.
Netting by novation

Netting by novation refers to a legally bind­
ing netting where matched pairs of trades be­
tween counterparties are superseded by subse­
quent trades—in effect, a running balance is
operative.6 The Financial Institutions Reform,
Recovery, and Enforcement Act of 1989 (FIRREA) specified several “qualified financial
contracts” and how netting of these contracts
would be treated in receivership or conservatorship for U.S. depository institutions. This al­
lowed institutions to comfortably participate in
written novation agreements for most derivative
contracts with U.S. depository institutions with­
out much worry of regulatory repudiation.
Netting by novation has been popular with
foreign exchange contracts because large num­
bers of matched trades typically exist (same
currency, same settlement date, same counter­
party), although spot foreign exchange was not
specifically mentioned in FIRREA. In interest
rate products and other OTC derivatives, howev­
er, netting by novation is less common since
trades with matching terms are more unusual.
Since principal is not exchanged, it is the period­
ic payments that fall on the same settlement date
within the same product line which are novated.
It would appear, however, that the desire to
utilize netting by novation in a credit sensitive
environment may encourage more standardiza­
tion in these products.


Regulators have expressed concern that the
large growth in outstanding notional principal
value in derivative markets has been accompa­
nied by a commensurate amount of growth of
the risk in these markets. The trend toward
netting schemes, however, has the power to
reduce real credit risk relative to the size of
notional values. Using the outstanding notional
principal as a proxy for risk will become even
more tenuous as legally enforceable netting
environments proliferate. In countries where it
is known to be enforceable, netting must be
viewed as a powerful credit enhancer and may
become even more prevalent in the years ahead.
Close out netting

Close out netting is a netting procedure
which becomes operative only in the event one
or both of the counterparties defaults on its obli­
gations or a triggering event takes place, such as
a downgrade. Although close out netting agree­
ments used to be mostly stand alone agreements,
they are increasingly becoming part of master
agreements. The current International Swap
Dealers’ Association (ISDA) master agreement,
a bilateral agreement typically used between
interest rate derivative counterparties, defines
the methodology by which all contracts between
the party and the counterparty will be netted to a
single number in the event of a default. In addi­
tion, the standard swap agreement has a provi­
sion which states that a default on any single
swap or derivative obligation between the coun­
terparties triggers termination of all derivative
contracts between the counterparties, thus pre­
venting “cherry picking” (that is, demanding
payment for trades with positive mark to mar­
kets and reneging on trades with negative mark
to markets) by counterparties. Once termination
is triggered, all positions are marked to market
and any payments owed to the defaulting party
are netted against payments owed by the default­
ing party before settlement is made.
Changes in the bankruptcy laws in the Unit­
ed States in 1990 made close out netting in de­
rivatives standard procedure for corporate enti­
ties, while the FDIC Improvement Act of 1991
(FDICIA) clarified the enforceability of close
out netting and netting by novation in deriva­
tives for depository institutions. By being even
more specific about the protection from cherry
picking by regulatory conservators and counter­
parties, FDICIA improved what FIRREA had
begun. Since FIRREA states that close out


netting will be accomplished using net present
values, it lessened significantly the credit risk
associated with long term financial contracts.
FDICIA does not limit the netting procedures to
“qualified financial contracts” like FIRREA,
thereby opening the door for cross product net­
ting of financial contracts with other more tradi­
tional obligations. FDICIA does, however,
contain stringent documentary requirements for
counterparties, consistent with FIRREA and the
Bankruptcy Code for corporations.
Payment netting

Payment netting or “position netting” is an
unwritten arrangement between two counterpar­
ties to net the payments arising from two or
more derivative transactions on which payments
are due on the same day. A written agreement to
net payments would be considered netting by
novation. In either case, the underlying credit
risk from mark to market values is unchanged,
because they remain legally obligated for the
gross transactions.7 The number of settlement
messages are also reduced, as are the amount
of funds needed for routine settlements. The
value of informal payment netting is unclear,
however, because whether it is legally binding
remains untested.
Cross product netting

As previously mentioned, netting across
derivative product categories has been experi­
mented with for the last several years, while
netting derivatives with nonderivatives is just
beginning. For example, suppose XYZ Corpo­
ration has an exposure to Bank A. In order to
ensure that Bank A could perform, it grants a
loan or credit line to XYZ Corporation. The
loan or credit line would be in the same amount
as the exposure, with the credit line only being
drawn upon by Corporation XYZ if Bank A
appeared to be in trouble. With a cross product
netting agreement, if Bank A is taken over by a
federal agency, Corporation XYZ’s exposure on
the derivative would be netted against the loan,
and therefore the net exposure would be elimi­
nated. Although potentially a powerful credit
enhancer, this type of arrangement may face
criticism as it could strain bank liquidity when it
was needed most. Surely, as this type and other
types of cross product netting schemes come to
light in the next few years, there will be much
debate as to whether their benefits are out­
weighed by other risks they may introduce.



The legal im p lica tio n s o f
b ila te ra l n e ttin g

The legal enforceability of bilateral netting
agreements is paramount in order to effect any
risk reduction in the case of counterparty bank­
ruptcy. It has been substantially enhanced in the
U.S. by recent amendments to the United States
Bankruptcy Codes (1990), FIRREA, and FDI­
CIA for depository institutions. The ability of
conservators to cherry pick has been severely
restricted in the U.S. by these legislative chang­
es, but only if written bilateral netting agree­
ments exist. Section 212 of FIRREA states that
no person will be prohibited from exercising his
or her right to net obligations of any qualified
financial contracts with depository institutions in
conservatorship or receivership. FIRREA de­
fined qualified financial contracts as any securi­
ties contract, commodity contract, forward con­
tract, repurchase agreement, swap agreement,
and any similar agreement.8
Despite the legal changes incorporated in
FIRREA and the bankruptcy code, some uncer­
tainty remained. For example, since the quali­
fied categories were so broadly defined, it was
never made clear whether spot foreign exchange
contracts were included. In addition, it was also
never made clear whether netting would be
permitted across categories of individually quali­
fied contracts. FDICIA’s approach, however, is
to look at the type of contracting party, not the
contract. Any kind of agreement between finan­
cial institutions in which parties agree to net
positions subject to certain contingencies would
be considered a qualified netting contract. Un­
der FDICIA, the Federal Reserve Board may
determine what is a financial institution and is
currently determining whether insurance compa­
nies, swap affiliates of broker-dealers, nonbank
subsidiaries of banks and bank holding compa­
nies, or other entities will be included in the
Outside of the U.S., the legal enforceability
of netting is not as straightforward. The Lamfalussy Committee on Interbank Netting
Schemes concluded in its 1990 report that bilat­
eral master agreements and other bilateral net­
ting by novation or current account agreements
are likely to be enforceable in countries where
the 1988 Basle Accord is in effect.1 The ISDA
has obtained legal opinions from counsel in
Belgium, Canada, France, Germany, Italy, Ja­
pan, the Netherlands, Sweden, and the United


Kingdom indicating that netting provisions con­
tained in bilateral master agreements were likely
to be upheld in each of those countries." Unfortu­
nately, constructing legally enforceable netting
agreements, considering the sometimes conflict­
ing legal structures of different countries, is often
at odds with the attempts to standardize such
agreements. Also, because so few derivative
firms have gone bankrupt, different degrees of
comfort are taken from reasoned legal opinions,
especially when the more esoteric derivatives are
involved and countries with less clear legal prece­
dent are involved. In addition, regulatory authori­
ties have expressed concern over the enforceabili­
ty of netting agreements during an international
financial crisis, which would have potentially
widespread systemic implications.
Although they can be somewhat expensive
and difficult to execute, bilateral netting agree­
ments are gaining popularity as an immediate
remedy to credit constraints, particularly since
multilateral clearinghouses appear to be a year or
two away from establishment. Until recent intro­
duction of more standardized documents, stan­
dardized bilateral netting agreements were usually
customized documents or somewhat customized
versions of the ISDA master agreement which
were negotiated by the attorneys from each coun­
terparty. As bilateral netting agreements have
gained popularity, more standardized agreements
are appearing. ISDA has developed a standard­
ized bilateral close out netting agreement which is
part of the so called multiproduct master master
agreement which has recently been completed.
Other agreements used in the market which have
provisions for bilateral netting include the Interna­
tional Currency Options Market Master Agree­
ment and Guide (ICOM), the New York bank
foreign exchange master, the PSA agreement for
bond options and repurchase agreements, the
cross border Canadian foreign exchange agree­
ment, and FXNET. In addition, the ICOM group
is preparing an agreement for foreign exchange
spot and forward transactions which will include
netting provisions. None of these netting docu­
ments has yet emerged as a clearly preferred
document within the financial industry.
C o lla te ra l p ledg ing fo r OTC d erivatives

Recently, many interbank derivatives market
participants have established unilateral and bilat­
eral collateral agreements or margining agree­
ments among themselves and with corporate
counterparties. In short, bilateral collateral agree­


ments require two way movement of assets, that
is, the positions are marked to market and the
debtor counterparty pledges cash or securities to
the contra counterparty. Unilateral agreements
require one counterparty to deliver collateral on
trades with negative mark to markets but not the
other, presumably because one counterparty is
less creditworthy. Theoretically, if the debtor
counterparty that pledged collateral was to de­
fault, the contra counterparty would take posses­
sion of the collateral. This system is analogous
to the futures exchanges’ mark to market system.
In a futures system, participants with positive
mark to market positions receive cash. Under a
collateral agreement they are pledged assets.
Bilateral collateral agreements have become
popular with downgraded interbank participants
because they allow them to continue to trade
among themselves, while capping, or limiting,
attendant credit exposure; unilateral agreements
have allowed weaker corporations and thrifts to
participate in OTC derivatives. In general, the
highest rated interbank players (AAA, AA) have
preferred to trade among themselves and with
highly rated corporations and have not to date
been active in establishing interbank collateral
agreements. Recently, however, more highly
rated participants have been attracted to the
concept in order to facilitate trades with lower
rated counterparties and increase volume with
higher rated counterparties.
One question is whether the cost of collater­
alizing losing trades would prohibit widespread
acceptance of the concept. Investigation shows,
however, that the cost can be made manageable.
Several cost cutting methods are in use.
(a) High thresholds for movement of collateral
(usually several million dollars) eliminate the
need to move collateral in the case of small
losses. High thresholds decrease the proba­
bility that collateral will move, but allow for
protection against large credit losses and
reduce costs significantly. In many cases, the
counterparty with the higher credit rating may
have a higher threshold or point at which
collateral need be pledged than the lower
rated counterparty. This system of uneven
thresholds allows lower rated interbank par­
ticipants to avoid unilateral collateral agree­
ments. Uneven thresholds also allow for the
possibility that the lower rated bank may
receive collateral. In cases where creditwor­
thiness is of great concern, a negative thresh­


old is established. Collateral is pledged on an
existing deal in which the debtor’s mark to
market value approaches zero but is not yet
negative. When a negative threshold is in
effect, some initial collateral may be required
on day 1 because the mark to market value
would already be near zero for the weaker
counterparty on the day the contract is exe­
(b) Triggering events such as rating agency
downgrades or lower capital ratios can be
used to initiate collateral movements. This
type of advance agreement can reduce sub­
stantially the operational costs of moving
collateral regularly while maintaining signifi­
cant protection from losses.
(c) Commingling of funds allows the collateral
recipient to earn some interest on the collater­
al to defray the cost of its collateral outlays.
In this respect, cash collateral is treated like a
pledged bank deposit and security collateral
would be available for repledging by the
holder. However, some collateral agreements
prohibit repledging of securities or commin­
gling of funds.
(d) Security substitution or rehypothecation
provides even greater flexibility and less cost.
For example, debtor counterparties may use
term repurchase agreements (repos) to obtain
collateral, that is they would make a short
term loan to a third party and receive securi­
ties as collateral for the loan. These securities
would then be pledged to the derivative con­
tra counterparty as collateral on the derivative
position, which could be long term. With
rehypothecation, the debtor may substitute
alternate securities or cash with the derivative
contra counterparty when the repo term is up
or at any time, thus allowing the most cost
effective use of collateral. The following
example illustrates these transactions.
Suppose Bank A is the debtor counterparty
and must pledge collateral to the contra counter­
party (Bank B). After comparing all the interest
rate swap contracts between Bank A and Bank
B, Bank A has a negative mark to market of $12
million with Bank B. (In other words, interest
rate movements since the time of initially enter­
ing into these contracts have been in favor of B,
thereby leaving it with credit risk exposure to
Bank A.) The collateral threshold, however, is
$10 million. Bank A is therefore required to



pledge $2 million collateral to Bank B. Bank A
could deposit $2 million cash in a bank account
at Bank B and earn the interest. Bank A could
also send securities that it already owns.
Those already collateralizing transactions
believe that the collateral agreements described
above would be enforceable in a bankruptcy
proceeding, especially in the case where securi­
ties are used. In fact, banks sometimes avoid
using cash as collateral even when it is more
economical because of the greater uncertainty of
retrieving the cash in the event of a default. The
greatest uncertainty lies in the case when excess
collateral has been delivered to a counterparty
with a positive mark to market that subsequently
defaults. If cash collateral is used to fulfill the
debtor counterparty’s obligations, any claims for
any “excess” cash resulting from revaluing the
contracts could be viewed as an unsecured claim
by a bankruptcy court. When securities have
been used as collateral, the excess amount seems
less likely to become an unsecured claim be­
cause securities are easier to trace and to identify
than cash. Therefore, it is presumed that excess
collateral in the form of securities would be
easier to retrieve in the case of bankruptcy.
To enhance the enforceability of collateral
agreements, a security agreement addendum
may be attached to the customer master agree­
ment. The agreements are generally customized.
If all trades made between the two counterpar­
ties within a particular product group are net­
ted—that is, all cities, branches, subsidiaries, or
affiliates—then the collateral agreement would
reflect this and thus avoid sending collateral to
one location while receiving collateral from
another. Similarly, cross product netting agree­
ments may be considered in the collateral agree­
ment. If swaps and option activity is netted
across foreign exchange, interest rate, equity,
and commodity derivative products, then mov­
ing collateral for one group of products while
offsetting values were available from another
product group would be unnecessary.
To improve efficiency in the delivery and
receipt of collateral, counterparty agreements
will specify minimum increments of collateral to
be moved. In other words, rather than move
collateral daily, it would only be moved when
the mark to market value deteriorates by a set
amount (for example, $1 million). Minimum
increments save staffing costs, wire fees, and
other fees. The combination of high thresholds


and high increments can lower the cost of a
collateral program while maintaining consider­
able protection against large credit losses. This
valuable credit enhancement is attained with
daily monitoring of both mark to market and
collateral values, but infrequent movements of
In addition to thresholds, increments, trig­
gering events, and substitution provisions, the
collateral or security agreement will generally
also specify the types of securities, whether
haircuts or reductions will be applied to their
current value, the rates of interest that will be
paid to the party posting collateral, and the time
frame within which collateral must be delivered.
Collateralizing or margining of losses in the
OTC derivatives markets will undoubtedly grow
as a means to deal with credit concerns, unless
multilateral clearinghouses come into promi­
nence or credit concerns ease. The cost of col­
lateral programs will be minimized by the cost
cutting methods outlined above, as well as by
achieving economies of scale upon greater ac­
ceptance of collateral programs. The growth of
collateral agreements will certainly be furthered
by the trend toward standardized master agree­
ments for derivatives, which will help save the
costs of completely customized agreements.1
M a rk to m a rk e t s e ttle m e n t and
d is cre tio n a ry cash s e ttle m e n t

Mark to market settlement is also used by
counterparties to reduce bilateral credit expo­
sure. In this case, two counterparties agree to
periodically send cash to cover negative mark to
markets in much the same manner that futures
exchanges require full and immediate payment
to cover losses incurred. The counterparty with
the positive mark to market takes actual owner­
ship of the cash and therefore legally erases the
obligations of the debtor counterparty. Unfortu­
nately, this requires both parties to continuously
agree on the value of the position, which can be
difficult for complex contracts. Also, it is more
costly to the debtor counterparty because no
earnings on the transferred assets can be accrued
as in collateral arrangements. In general, coun­
terparties are somewhat reluctant to agree to
cash settlement because the benefits of such a
system are more skewed toward the counterparty
with the positive mark to market than collateral
systems and the costs are higher to the debtor.
Some master agreements now include triggering
events which require mark to market settlement


in the case of a downgrade of the less creditwor­
thy counterparty or, in some cases, either coun­
Whereas mark to market settlements require
periodic payments on losses for ongoing con­
tracts, discretionary cash settlement agreements
permit early termination of existing contracts at
a predetermined settlement date. At the outset
of a 5 year contract, for example, the two coun­
terparties would agree to actually settle up after
2 years and terminate the contract at the discre­
tion of either counterparty. If the fixed settle­
ment date passes, however, without either party
exercising the settlement option, the contract
must then be held to maturity. The methodology
of marking the position to market would be
agreed to at the outset. Discretionary cash settle­
ment can be appealing since risk can be elimi­
nated at an agreed upon date, and the cost of
periodic mark to market payments or periodic
collateral movements can be avoided. This is
particularly useful when credit concerns for long
term contracts are particularly acute.
As mentioned above, in both mark to mar­
ket settlement and cash settlement agreements
the counterparties must clearly articulate the
means for calculating the cash settlement
amount either in an appended schedule to the
standard agreement or in some other document
governing the relationship.
N e ttin g services and clearinghouses

In order to aid the operational aspects of
private bilateral agreements, several bilateral
netting services have sprung up which provide
“matching services.” The two most prominent
of these systems are called FXNET Ltd. and
SWIFT Accord, which match outstanding trans­
actions between two counterparties and replace
them with a single settlement amount at the end
of the day.1 Both systems avoid the telecommu­
nication and systems costs and the inefficiencies
of matching trades in each individual back of­
fice. Both systems are informational intermedi­
aries and as such do not own the trades submit­
ted or become involved in the settlement, which
is up to the individual participants. FXNET
Ltd., in operation since 1985, is owned by a
consortium of 12 of the world’s top twenty
banks, for which Quotron Systems Inc. is the
manager. Trades entered through FXNET are
bilaterally netted. SWIFT Accord is owned by
the Society for Worldwide Interbank Financial
Telecommunication, which has a financial com­


munications network covering 3,000 financial
institutions in 72 countries.
Currently, there are also two notable at­
tempts underway to establish multilateral netting
systems or clearinghouses for foreign exchange
and eventually other derivatives. The credit
enhancement advantages enjoyed by such ar­
rangements are: 1) netting amongst several
counterparties rather than each individually
yields great operational efficiencies and reduces
payment flows substantially; 2) the clearing­
houses may provide limited guarantees to the
trades; and 3) the clearinghouses will act as a
central conduit for payments and potentially
reduce settlement risk. These clearinghouses
will have to be approved by the host central
bank as well as meet the standards of the group
of central banks whose currencies are involved.
One of the two attempts to establish multi­
lateral netting is being organized in North Amer­
ica. This clearinghouse will involve two U.S.
and six Canadian banks (First National Bank of
Chicago, Chase Manhattan Bank, Bank of Mont­
real, Bank of Novia Scotia, Canadian Imperial
Bank of Commerce, National Bank of Canada,
Royal Bank of Canada and Toronto Dominion
Bank). In 1992, the members of the North
American Clearing House began using a central­
ized facility to match and bilaterally net trades.
In 1993, the clearinghouse is scheduled to begin
providing multilateral netting by novation of
foreign exchange trades. It may eventually
expand to include currency option and other
derivatives. The North American clearinghouse
will be counterparty to all matched trades in
order to maintain the legal discipline of nova­
tion. It will net trades for settlement and mark to
market. The clearinghouse will attempt to con­
trol the daily movements of all currencies so as
to create a delivery versus payment settlement
system. Clearinghouse members will be respon­
sible for covering another member’s default,
with the loss sharing formula based on bilateral
credit exposures, not volume. Therefore, there
will be concentration exposure, counterparty
exposure, and liquidity limits in place to control
the risks associated with single or multiple de­
The other multilateral netting system under
development is called the European Clearing­
house Organization (ECHO) which is owned by
fourteen European banks and is currently expect­
ed to be operative in early 1994. Its policies and



procedures will be similar to the North Ameri­
can initiative with some important exceptions.
The legal basis will not be novation but “open
offer,” under which any two members’ trades
will belong instantly to the clearinghouse with­
out initial reference to clearinghouse limits.
Over 20 currencies will be involved rather than
the seven major currencies outlined in the North
American plan. Access to ECHO will be limited
to the SWIFT Accord trade confirmation system.
ECHO will be based in the UK and therefore the
Bank of England will be the lead oversight orga­
C onclusion

Depository institutions and other derivative
market participants have reacted to increased
credit risk and risk sensitivities by creating inno­
vative and powerful credit enhancers and by
greater utilization of credit reducing techniques
that already existed. SPVs have the potential to
alleviate credit concerns for certain classes of
market participants who insist on dealing with
only the highest rated entities. The successful
experiences to date and the fact that the rating
agencies will likely ease restrictions as they
become more comfortable with the concept
suggest that use of SPVs will increase in the
future. SPVs are not a panacea for credit risk,
however, and therefore will likely be just one
methodology among many. Furthermore, regu­
latory concerns in commercial banking concern­
ing deposit insurance and risk based capital may
prevent commercial banks from establishing
SPVs or may require a less capital intensive
Bilateral collateral agreements have great
potential to alleviate credit concerns, especially
in light of the fact they do not require regulatory
or rating agency approval and thus can be used
immediately. Although once thought to be cost
prohibitive, collateral users have indicated the
use of cost saving mechanisms such as thresh­
olds brings down the costs to acceptable levels.
The use of more standardized agreements will
also lower the cost and time involved in negoti­
ating customized agreements for each individual
counterparty. Therefore, it is likely that bilateral
collateral agreements will grow rapidly in the
near future.
The increased use of bilateral netting be­
tween counterparties is inevitable in the years
ahead, with or without collateral movement.
Although there is much potential in the countries


where netting is believed to be enforceable, the
success of the various initiatives to promote
enforceability around the world will make for
even greater potential. The increasing use of
standardized cross product netting, especially
across derivative product lines, will further in­
crease the potential of bilateral netting to ease
credit concerns.
Multilateral netting schemes have great
credit reducing potential for derivatives and
already have made progress in overcoming
many obstacles in their development. However,
delays in launching have prevented the systems
from helping to ease the current wave of credit
sensitivities and limited product coverage will

impede their usefulness in the near term. When
fully operational, however, they have great po­
tential for becoming one of the most important
credit reducers of the future.
Although this article has focused on SPVs,
collateralization programs, and netting schemes,
it was noted that other techniques such as peri­
odic settlement and close out mechanisms are
continually being implemented. Other credit
reducing techniques include guarantees, assign­
ments, and private portfolio insurance. Contin­
ued growth in derivatives, together with ongoing
credit quality concerns and regulatory scrutiny
of these markets may be expected to give rise to
even more innovative proposals.

'Liebowitz, (1992).

9Emert (1992).

2"Credit implications for firms that use derivatives,”

l0"Report of the Committee on Interbank Netting Schemes
of the central banks of the Group of Ten Countries,” Bank
for International Settlements, Basle, November 1990, p. 16.

M o o d y 's S p e c ia l C o m m e n t, M o o d y ’s I n v e s to r s S e r v ic e ,

November 1991, p. 2.
’U.S. Congress (1992).
4"Moody’s rates the counterparty risk of Merrill Lynch
Derivative Products, Inc. Aaa,” M o o d y ’s S p e c ia l R e p o r t ,
December 1991, p. 1.
5F e d e r a l R e s e r v e B u lle tin


6Novation is defined in footnote 6 of Annex 3 of the 1 9 8 8
B a s le A c c o r d as “a bilateral contract between two counter­
parties under which any obligation to each other to deliver
a given currency on a given date is automatically amalgam­
ated with all other obligations for the same currency and
value date, legally substituting one single net amount for
the previous gross obligations.”
7"Report on netting schemes,” Bank for International
Settlements, Basle, February 1989, p 12.

1 "Treatment of bilateral master agreement netting under
the 1988 Basle Accord on International Convergence of
Capital Measurement and Capital Standards,” Letter of
Mark C. Brickell, Chairman, International Swap Dealers
Association, to Richard Farrant, Chairman, Committee on
Off Balance Sheet Risk Supervision, Bank for International
Settlements, August 15, 1991, p. 5.
l2Wiersum and Stocchetti (1992).
' '"Banks eye forex matching systems,” W a ll S tr e e t
Volume 9, Number 2, p. 46.

Com ­

p u te r R e v ie w ,

l4"North American foreign exchange multilateral netting
project status report,” October 21,1992, International
Clearing Systems, Inc., Chicago, pp. 18-19.
l5"ECHO plans new netting scheme,” F u tu r e s a n d O p tio n s
Futures and Options World, Ltd., London, July 3,
1992, p. 12.

P lu s,

8U.S. Congress Financial Institutions Reform, Recovery,
and Enforcement Act of 1989, Pub. L. No. 101-73, 212(a),
103 Stat. 183 and 239, 1989.


Baer, Herbert L., and Douglas D. Evanoff,
“Payment system issues in financial markets that
never sleep, Economic Perspectives, Federal
Reserve Bank of Chicago, November/December
1990, pp. 6-12.

of the Central Banks of the Group of Ten Coun­
tries,” (the Lamfalussy Report), the Committee
on Interbank Netting Schemes, M.A. Lam­
falussy, Chairman, Basle, November 1990.

Bank for International Settlements, “Report
of the Committee on Interbank Netting Schemes

________________________ , “Report on
netting schemes,” (the Angell Report), prepared
by the Group of Experts on Payment Systems of



the Central Banks of the Group of Ten Countries,
Basle, February 1989.
_______________________ , “The supervisory
treatment of netting under the 1988 Basle Accord
on Capital Standards: an issues paper,” prepared
by a group of technical experts of bank superviso­
ry authorities of G-10 countries, April 21, 1992.
“Bankruptcy treatment of swap agreements and
forward contracts,” Report from the Committee on
the Judiciary, House of Representatives, 101st
Congress, Second Session, May 14, 1990.
“Banks eye forex matching systems,” Wall Street
Computer Review, Volume 9, No. 2, April 1992,
pp. 45-52.
“BIS risk based capital Guidelines,” speech by
R.H. Farrant, Bank of England, Deputy Head of
Banking Supervision, to the ISDA Annual Gener­
al Meeting, March 13, 1992.
Credit Comments, “Credit Sensitivity Spurs
Enhanced DPC Growth,” Standard and Poor’s
Creditweek, May 18, 1992, pp 35-84.
Emert, John, “Issues involving netting of deriva­
tives and foreign exchange transactions,” Citi­
bank, N.A., September 2, 1992.
“ECHO netting - multilateral FX netting in Eu­
rope,” discussion document, London, March 1991.
“ECHO plans new netting scheme,” Futures and
Options Plus, July 13, 1992, p. 12.
Federal Reserve Bulletin, 473, 1987.
Liebowitz, Michael, “Can the triple-A subs live
up to their billing?,” Investment Dealers’ Digest,
November 2, 1992, pp. 16-24.
Moody’s Press Release, “Moody’s assigns Aaa
ratings to debt obligations of GS Financial Prod­
ucts International, L.P., New York, March 23,
1992, pp. 1-3.
“Moody’s rates the counterparty risk of Merrill
Lynch Derivative Products, Inc. Aaa,” Moody’s
Special Report, December 1991.



Moody’s Special Comment, “Credit implica­
tions for the firms that use derivatives,” Moody’s
Investors’ Service, November 1991.
Patrikis, Ernest, T., and Karen Walraven,
“The netting provision of the Federal Deposit
Insurance Corporation Improvement Act of
1991, ” Futures International Law Letter,
May 1992.
Sarwal, Arun, and Tremble, Kerry, “Happi­
ness is a full net”, Euromoney, April, 1991,
pp. 34-36.
“Swap and think,” Risk, Volume 5, Number 3,
March, 1992.
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under the 1988 Basle Accord on International
Convergence of Capital Measurement and Capi­
tal Standards,” Letters of Mark C. Brickell,
Chairman, International Swap Dealers Associa­
tion, Inc., to Richard Farrant, Chairman, Com­
mittee on Off-Balance Sheet Risk Supervision,
Bank for International Settlements, October 24,
1991 and August 15, 1991.
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Subcommittee on Courts and Administrative
Practice, Committee on the Judiciary, 101st
Congress, First Session on S.396 - A Bill to
Amend Title II of the United States Code, The
Bankruptcy Code Regarding Swap Agreements,
April 11, 1989.
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Futures Trading Practices Act of 1992,” Con­
gressional Record-House, HI0915, October 2,
____________________ , Financial Institution
Reform, Recovery, and Enforcement Act of
1989, Pub. L. No. 101- 73, 212(a), 103 Stat. 183,
Wiersum, Ken, and Stocchetti, John, “Hedg­
ing counterparty risk: the ins and outs of collat­
eralized swaps,” Business International Money
Report, May 25, 1992, pp. 206-208.





Market value accounting for commercial banks
Thomas Mondschean.................................................................................... ........................Jan/Feb


Determining margin for futures contracts:
the role of private interests and the
relevance of excess volatility
James T. Moser............................................................................................. .......................Mar/Apr

2 -1 8

Ex ante risk and ex post collapse of
S&Ls in the 1980s
Elijah Brewer


and Thomas N. Mondschean...................................... .......................Jul/Aug

2 -1 2

Derivative markets and competitiveness
Janet A. Napoli............................................................................................. ........................Jul/Aug



Monetary policy with uncertain estimates
of potential output
Kenneth Kuttner.................................................................................................................... Jan/Feb

2 -15

Making sense of economic indicators:
a consumer’s guide to indicators of
real economic activity
Francesca Eugeni, Charles Evans, and Steven Strongin........................ .......................Sep/Oct


Liquidity effects, the monetary transmission
mechanism, and monetary policy
Lawrence J. Christiano and Martin Eichenbaum................................... ........................Nov/Dec

2 -1 4


State and local governments’ reaction to recession
Richard H. Mattoon and William A. Testa............................................ .........................Mar/Apr


The 1990 Clean Air Act: a tougher regulatory
challenge facing Midwest industry
Donald A. Hanson........................................................................................ ........................May/Jun

2 -18

Producer services: trends and prospects
for the Seventh District
William A. Testa........................................................................................... .......................May/Jun


Can the states solve the health care crisis?


Mattoon...................................................................................... ...................... Nov/Dec

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