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J U L T /H U U U 9 I 133U ECONOMIC PERSPECTIVES FEDERAL RESERVE BANK OF CHICAGO Contents In te rn a tio n a l c re d it m a rk e t c o n n e c tio n s ....................................................................................... 2 Steven S trongin What happens in the world markets is a lot more important to us than it used to be—but no more complicated, if you know what to look for B an kin g 1 9 8 9 : N o t q u ite a tw ic e -to ld t a le ............................................................................................... 11 Eileen M alo ney and G eorge G regorash Take some mixed numbers and a few deteriorating markets, add credit quality worries and regulatory changes, combine with ongoing structural developments, and you get banking’s 1989 ECONOMIC PERSPEC TIV ES JULY/AUGUST 1990 Volume XIV, Issue 4 Karl A. Scheld, Senior Vice President and Director of Research ECONOMIC PERSPECTIVES is published by the Research Department of the Federal Reserve Bank of 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, Federal Reserve Bank of Chicago, P.O. Box 834, Chicago, Illinois 60690-0834, or telephone (312) 322-5111. Articles may be reprinted provided source is credited and The Public Information Center is provided with a copy of the published material. Editorial direction Edward G. Nash, editor, David R. Allardice, regional studies, Herbert Baer, financial structure and regulation, Steven Strongin, monetary policy, Anne Weaver, administration Production Nancy Ahlstrom, typesetting coordinator, Rita Molloy, Yvonne Peeples, typesetters, Kathleen Solotroff, graphics coordinator Roger Thryselius, Thomas O ’Connell, Lynn Busby, graphics Chris Cacci, design consultant, Kathryn Moran, assistant editor ISSN 0164-0682 In te rn a tio n a l c re d it m a rk e t c o n n e c t io n s Some test cases show how credit markets couple and decouple constantly, creating a complex web of international financial relationships Steven S trongin International credit markets create a sense of mystery that few economic institutions can match. As the old joke goes, “ Only two economists under stand international finance—and they dis agree.” Today that sense of mystery has be come more frustrating. International events now generate immediate and obvious conse quences in U.S. markets on a daily basis. Early morning business broadcasts report over night events in foreign markets in detail and with an urgency that a decade ago would have been reserved for wars or diplomatic crises. While it is easy to see that events move around the globe through the international markets as one market closes and the next one opens, it seems to work differently every time. One time, Japanese rates go up and U.S. rates go up in lockstep and the analysts discuss how world credit markets have become “ a single market, each market tightly coupled with its international counterparts.” The next day, Japanese rates go up while U.S. rates fall and the analysts talk about shifts in investor prefer ences and political uncertainties and theorize why the markets have become “ decoupled.” The importance of the links between the international credit markets are self-evident in today’s highly integrated financial world. Every two weeks on the CHIPS wire, the fi nancial link between London and New York, there are enough credit flows between the two countries to purchase the combined GNPs of both countries. However, these links are slip pery, appearing to defy normal notions of logic and consistency. It sometimes seems as if the international markets have a will of their own. Indeed, analysts often talk of the market doing such and such as though it were a sentient being instead of an organized exchange where investors buy and sell. In truth, there is very little mystery and the mechanisms that control the linkages be tween markets are actually quite simple. Sup ply and demand work much the same way in international credit markets as they do in any other market. The impression that the markets are mysterious is an illusion created by the large number of things going on at any one time. Press explanations of international credit markets, perhaps due to some misguided no tion of simplicity, often leave out key details and baffle the observer. Much like the magi cian, the pundit, by keeping part of the action obscured, leaves the audience open-mouthed with disbelief at the conclusion. This article explores the relationship of highly integrated credit markets to provide a better understanding of exactly what is going on in international credit markets. It does so by examining four cases that are constructed with only one factor changing. It then shows that by mixing the four types of events ana lyzed it is possible to understand more fully how international markets’ linkages operate and why those linkages often produce seem ingly inconsistent outcomes across time. The 2 ECONOMIC PERSPECTIVES Steven Strongin is an assistant vice president and senior econom ist at the Federal Reserve Bank of Chicago. The author thanks Kenneth Kuttner and Hesna Genay fo r their helpful comments. cases are similar to current events, but are sim plified to make the analysis clearer. Some readers may find that the hypotheti cal cases presented both oversimplify the pres ent structure of international markets and over state the degree of integration that actually exists. This is done on purpose. The point is that even in such a hypothetical world, where markets are completely integrated and efficient, international markets will still not march in lockstep and that important information is lost by reducing our world view to “ one world market.” However, after the four cases are presented, it is argued that almost any realworld international credit shock can be viewed as a combination of the four presented. In each case the question asked is, how are U.S. markets affected by foreign events? In each case a specific country is treated as the rest of the world. In the first case, for example, Japan is so designated. This in no way affects the analysis. It does, however, simplify the exposition. A sho rt n o te on ja rg o n Writing on international markets is filled with terms that seem to shift meanings with the seasons. In this article, jargon is kept to a minimum, but some of the most overused terms are kept in order to provide the reader with some notion of how these terms may or may not apply to actual events. The definitions of the slipperiest terms follow. Coupled markets are markets which move together in lockstep; for example, if Japanese rates go up by 2 percentage points, then U.S. rates will go up by 2 percentage points. Weakly coupled markets are those that always move in the same direction, both up or both down, but not necessarily in the same incre ments. Decoupled markets are markets that someone once claimed were coupled, but move in opposite directions in response to some spe cific event or over some period of time. The market refers to the short-term debt market of the given country. Thus, the U.S. market would be the market for short-term debt denominated in dollars and sold in the U.S. The German market would be the mar ket for short-term debt denominated in marks and sold in Germany. The special require ments for comparing markets denominated in different currencies is discussed in an ac companying box. FEDERAL RESERVE BANK OF CHICAGO Case 1: Jap an tig h te n s c re d it Assume an action by the Bank of Japan that restricts credit in Japanese markets. The result: World interest rates rise, in response to a reduction in world credit supplies. This key outcome can be seen in Figure 1. The economics of this are simple supply and demand. The world supply of credit is simply the sum of the credit supplied by each country at a given rate of return. In this case, S u P P ! y World = S U P P ^ U S + SuPP^Japan- World demand is the sum of the demand within each country: Demandso rld = D em an US + Demand.Japan . .. d. W Viewed as a single world market, a reduc tion in Japan’s supply of credit directly re duces the world supply of credit. It should be noted at this point that the r in Figure 1 and all subsequent figures is the risk-adjusted (includ ing exchange-rate risk) real return on capital. It must, thus, be equal or nearly equal across nations. At various points, it will be important to draw a distinction between this rate and the observed nominal rate which is affected by country-specific risks and inflation expecta tions. The use of r in this form is really an assumption that international markets are wellintegrated and efficient. For the countries in question, this is probably a reasonable assump tion (see accompanying box for a more indepth analysis of this issue). 3 Adding up quantities of credit across nations There are a number o f ways o f thinking about international markets that look very different for mally, but are actually the same once you brave the mathematics. In the accompanying analysis sub stantial use is made o f supply and demand analysis. Supply and demand has a long and venerable tradi tion in economics, but in the international case it glosses over two fairly important issues. First, how do you add quantities o f credit that are valued in both yen and dollars, sometimes hedged, some times not? Second, how do you compare interest rates across countries when the debt instruments are valued in different currencies and subject to differ ent risks and taxes? The full answer to these ques tions is clearly beyond the scope of this article, but the problems, at least for the cases discussed in this article, are not that difficult. International finance typically concerns itself with questions about the efficiency o f international credit markets, where very exact and precise treat ment of inflation and tax differentials are neces sary, and measurement o f risk is the keystone o f the analysis. In this article, we are trying to understand how events in one country’s credit market can affect the credit market in another, and how changes in relative risk affect international markets. Thus, we can deal with these very difficult issues of international finance by assuming that international markets are efficient and by reducing the problem to the essentials o f changes in the cost o f capital and real flows o f capital. Nevertheless, some ex planation of how this is done is appropriate. Central to understanding how we can add yen markets and dollar markets together without getting deeply mired in issues of currency valuation is the observation that credit markets are actually goods markets seen though the veil of money. Credit relates directly to the goods that are purchased. You supply credit if you consume less than you make. You demand credit if you consume more than you make. Anything more complicated can cels out when the accountants finish counting. Thus, from an international perspective a country that produces more than it consumes is a net exporter of goods as well as credit and a coun try that produces less than it consumes will be both a net importer of goods and capital. The supply of credit can be thought o f as the excess supply of goods and the demand for credit as the excess demand for goods. So when we add up the credit demands in two countries we are adding up the excess demand for goods and the excess supply of goods. It doesn’t really matter if a ton of steel is valued in yen or in dollars, it is still a ton of steel. Clearly, countries produce and demand differ ent goods. Some goods are only internal to the country, such as land, and some goods are difficult to move from one country to another, such as legal services. Nevertheless, from the standpoint of international trade the adding up is valid. It is, after all, only the unconsumed traded goods that move between countries and match to the interna tional credit flows. These other technical issues simply demonstrate why currency valuation is so complicated, since it is in the process of currency valuation that all technical issues are balanced out with movements in the international goods markets. They also show why simple notions o f purchasing power parity seldom work. In the end, international credit flows match international goods flows. Nobody borrows money just to hold it. If the foreign credit is used to buy imported goods, this is obvious. If the foreign credit is used to buy securities (Japanese purchases o f U.S. Treasury bills for example) or domestic goods, then they are supplying cash or credit to someone who will buy other goods. If the country as a whole is consuming more than it makes, even tually those borrowed funds will be used to buy foreign goods. ( “ G oods” here is used in a general sense of all goods and services, as well as sales of assets.) In other words, you make what you can. You trade for what you cannot make. And only then do you borrow. And then it can only be to buy something that someone else makes. In the official trade accounts, there is a differ ence between the current account in goods and services and the capital account. This number is labeled statistical discrepancy and represents the limitations o f the trade statistics, not any real eco nomic phenomenon. 4 ECONOMIC PERSPECTIVES Com paring interest rates across nations To examine comparable interest rates, you have to reduce the price o f credit to the opportunity cost o f capital in international markets. In terms of real performance, the important question is the cost of investing in new capital. So the r in a supply and demand context is the cost o f buying credit in order to finance capital acquisitions in a given market. What is the relationship between the do mestic nominal rates we observe in the market and the opportunity cost o f capital? The answer is complicated, but not hopelessly obscure. Risk factors, taxes, and inflation all play a role in comparing debt instruments across countries. Inflation and taxes are conceptually the simplest problems to address. Rates should be compared on an after-tax basis. After all, the real cost o f capital is what is costs after the government has taken its share of the profits. Unfortunately, it is rarely possible to calculate an after-tax return because the tax codes are suffi ciently complicated that the after-tax rates differ from individual to individual, let alone country to country. Luckily, for most purposes we can ignore the tax effects, because there are no differences between funds raised domestically and those raised in foreign markets. Interest costs may be deducted from income regardless o f the source o f funds. So as long as the tax codes are not changing, the tax effects act as a constant or nearly constant distor tion between observed U.S. rates and foreign rates, a kind of slow-moving fudge factor. Taxes can be extremely important over the long haul, but are rarely important over the short spans of time in which credit markets typically operate. Large changes in tax laws are an exception, but they luckily do not happen often and usually cause only a short-term breakdown in the relationships dis cussed in this article while the markets adjust. Inflation needs to be dealt with more directly. Investors care about real returns, not nominal ones. Since the actual return on investment is the return after taxes and inflation, investors are interested in the expected return net o f inflation and taxes. Thus, in a very simple world of constant marginal taxes and constant inflation, a country’s real rate of interest must be adjusted for its rate of taxation and inflation by the following formula: r = (1-t)(i-7t) where r is the real after-tax rate o f interest; i is the observed nominal rate o f interest; n is the rate of inflation; and t is the tax rate. In the real world, taxation is much more complicated although it can usually be ignored for our purposes. Expected inflation is much more volatile and unfortunately not directly observable. Nevertheless, there is a broad notion in the equation that, as long as nomi nal rates increase to fully reflect expected inflation, there is no effect on real rates. This is a good start ing place for analysis. Put simply, if the inflation in one country goes up and nominal rates also go up by the same amount, the actual cost o f capital is unaffected and there are no real economic effects. Mathematically, if i and n go up the same amount, r is unaffected. Depending on tax issues and other factors this may not always be strictly true, but, given the general level o f precision in these models, it is a good working assumption and for most o f the observed inflation rates in major industrialized countries fairly accurate. Risk is a more subtle problem. Taxes, cur rency valuations, and inflation do not stay the same. FEDERAL RESERVE BANK OF CHICAGO As a result, investors require compensation for the risk they assume in a given debt instrument. Inter national rates can only be compared when the dif ferences in relative risk have been taken into ac count. A country where risks are greater will have to pay more for international funds. Risk can take many forms: worries about central bank behavior, taxes, or simple liquidity worries. The key thing to understand about these poten tial problems is their effects on credit flows. An ticipated inflation, for example, will raise nominal rates and leave real rates unchanged producing no effect whatsoever on the graphs in the article. The risk o f a sudden increase in inflation, on the other hand, will raise real rates and scare away credit, since the suppliers of credit will demand compen sation for the potential of inflation. If there is a chance that there will be a sudden increase in the price level due, for example, to a currency conversion as is occuring in Germany in 1990, nominal rates will rise to reflect the expecta tion o f higher inflation. If the inflation does not occur, lenders will profit and borrowers lose. If the inflation does occur the opposite takes place— borrowers gain and lenders lose. The un certainty about inflation makes debt contracts in that particular currency more risky. As a result, investors will prefer other currencies at the margin, regardless o f which side o f the contract they intend to be on. Moreover, since lenders tend to be more mobile in terms o f switching from market to mar ket, this will cause rates to rise in the riskier mar ket. From the standpoint o f the borrower, one way to think of this is that in order to achieve the same level o f risk, it would be necessary to pay both for the expected inflation and for a currency hedge where the cost of the currency hedge is directly related to the amount of uncertainty. In general, the way to separate events that affect international credit markets from those that do not is to examine the risk faced by international investors in a debt contract denominated in one currency relative to another. If the event raises the relative risk, then real effects on international credit flows are likely to follow. Risk-induced changes cause investors to favor one country over another and create real changes in the relative cost of capital. In the pure inflation case, investors simply require an adjustment in the interest rate to compensate for inflation. This is exactly offset by the borrowers’ ability to pay back their debts with cheaper inflated currencies. Infla tion only causes a change in the units of measure but risk of inflation changes the actual costs. This is made more explicit in Cases 3 and 4. 5 The analysis of each country’s individual market is somewhat more complicated. For example, the supply within each country’s market is not what that country supplies, but the world supply minus the credit demanded by all other countries. Supplyus = Supply wrld Demandj^n. o The reason is that, within a country, capi tal is supplied both to foreign borrowers and domestic borrowers. Available to domestic borrowers is the domestic credit that remains in the U.S. plus what is left over from foreign markets. Each country can only borrow what other countries do not. Thus, in Figure 2, the reduction in Japan’s supply of credit enters the U.S. market as a reduction in U.S. supply. The inclusion of the rest of world demand assures us that after the fact r will remain the same across nations. Before examining some of the further implica tions of a Japanese tightening it will be useful to introduce the second case to provide a basis for comparison. Case 2: G e rm a n y needs m o re c ap ital In Figure 3, the German panel shows the demand shift in German markets. This is identical to what the world market supply and demand diagram would look like. However, in the U.S. panel the shift is in the supply curve. This follows from the country-specific supply equation described in Case 1 adapted here for the German case. Supplyus = SupplyWrld - DernandG ian . o em y From the U.S. standpoint, there has been no demand shift; there has been a reduction in the available world supply of credit. Intui tively, the U.S. experiences this reduction, not because the world supply of credit is less, but because less of the world supply is available after Germany finishes its borrowing. Thus, the credit market consequences in the U.S. are the same as in the Japanese case in which the actual supply of credit was reduced. For the U.S. credit markets, it does not matter whether there has been a reduction in world supply of credit or an increase in world demand for credit. In both cases, rates rise to equalize the return to capital across countries. These two cases are not completely identi cal, but from the standpoint of the U.S. credit markets their outcomes are the same. Case 2 follows the recent pattern of events in Eastern Europe. Assume Germany faces a substantial increase in its opportunities for profitable investment and thus increases its demand for credit. In terms of world supply and demand, this is a simple increase in de mand and raises world interest rates. But, analyzing the effects in each market individu ally shows a different picture. In both cases, U.S. growth will be lower because of higher credit costs. However, in the German case there will be increased export demand, which will offset part or all of the effect from higher interest rates. In the Japa- 6 ECONOMIC PERSPECTIVES Seco n d ary o u tco m es: Cases 1 & 2 FIGURE 3 When Germany demands more credit, U.S. credit supply drops Germany nese case export demand will fall, which will reinforce the higher interest-rate effects. The differences in the two cases arise from the fact that world supply and demand for goods and services are different in each case. In the German case world demand for goods is higher, while in the Japanese case world demand for goods is lower. As a result, world and country-specific inflation pressures will be higher in the German case, while in the Japanese case inflation pressures will be lower. But, in terms of nominal interest rates, the German case will cause a somewhat greater rise in U.S. interest rates. This occurs because inflation, due to increased world demand for goods, and the real cost of capital are moving in the same direction. In the Japanese case, the reduced inflationary pressures will slightly offset the real interest-rate increases. The effects on profits and the stock mar ket are also different. In both cases higher rates cause future profits to be discounted more heavily, but in the German case this is offset (perhaps more than offset) by higher expected profits. In the Japanese case ex pected declines in profits cause an even deeper decline in stock values. Exchange-rate effects are the same in Cases 1 and 2, but the mechanisms are quite different. If exchange rates are viewed as the relative price of two currencies, then in the German case the mark rises because there is greater demand for marks, due to higher real growth and the subsequent increase in demand FEDERAL RESERVE BANK OF CHICAGO United States for transactions deposits in Germany. In the Japanese case, the yen rises because its supply has been reduced. So, despite the fact that the channel is quite different in each case, a rise in rates causes the foreign currency to appreciate. (It should be noted that in both cases U.S. interest rates rise and the dollar falls. The positive interest-rate-to-currency effects are limited to the originating country. They are exactly opposite for the receiving country— the U.S.) This interest-rate-to-exchange-rate rela tionship, which could be called the “ normal” relationship, is reversed in Case 3. Case 3: In vesto rs lose fa ith in Jap an Assume that international investors lose faith in the ability of Japan to maintain the steady growth and generally orderly markets it is famous for. Such a loss would in turn cause investors to demand higher risk premiums for investing in Japan. In terms of the previous diagrams, the original equilibrium in both countries is the same, but now the supply of credit in Japan falls while the supply of credit in the U.S. increases, as in Figure 4. As a result, r is no longer the same in both countries, but is lower in the U.S. than in Ja pan. The reason for this has to do with the way r is constructed. In the previous cases, r was adjusted for all risk factors so that returns were equalized across nations. In this case, the adjustments are made for conditions prior to the shock, but afterwards an additional 7 FIGURE 4 Loss of confidence in Japan produces credit rate differential Japan United States premium is necessary to adjust for the now higher risk in Japan. Quantitatively, the new risk in Japan makes investors want a higher return for bearing that risk. The exact pre mium is the difference between the new U.S. rate and the new Japanese rate, (|) percentage points in Figure 4. Operationally, investors’ willingness to lend to Japan is reduced by < relative to their |) new willingness to lend to the U.S., that is, previously they would lend to Japan if r was higher in Japan and to the U.S. if r was higher in the U.S. Now they will lend to Japan only if r in Japan is at least (J) percentage points higher than in the U.S. In order to examine later events, both the Japanese supply and demand curves would both need to be shifted straight up by (j) to match the U.S. curves in terms of r. This upward shift will then re-equalize the risk factors and incorporate the market’s current assessment of the relative risks of Japanese versus U.S. securities. This is, in essence, ex actly how the risk-adjusted curves are derived in the first place. As a result of the shift in relative real rates, a number of consequences occur which are quite different qualitatively from the previ ous cases of increases in foreign rates. Lower U.S. rates cause U.S. growth to increase. Higher Japanese rates make Japanese growth fall. The increased growth in the U.S. causes an increase in the demand for money in the U.S., while reduced Japanese growth lowers the Japanese demand for yen. Thus, while Japanese interest rates rise and U.S. interest rates fall, the dollar appreciates. This is ex actly contrary to the previous two cases, but makes perfect sense. If Japan is seen as risk ier, it both devalues the yen and raises Japa nese interest rates. Thus, it begins to be clear how the link ages between markets can create very different results at different times. Events such as those in the first two cases, when the supply and demand for credit within one country change, cause rates to move together world-wide and the currency of the country whose rates went up first to appreciate. In this third case where investor preferences between countries change, the exact opposite happens. Rates move in op posite directions and the currency of the coun try whose rates increase actually depreciates, contrary to the normal notion of higher rates meaning higher values for currency. An inter esting irony is that so-called domestic events such as those in Cases 1 and 2 produce what appears to be tightly coupled world capital markets, while truly international events such as those in the third case produce the appear ance of decoupling. Just within the context of these three very simple cases it is clear that strong international linkages are consistent with almost any pattern of interest rate and currency movements de pending on what type of events precipitate the changes. It isn’t that the rules change, it’s that different types of events lead to different out comes. Hardly a surprising result. 8 ECONOMIC PERSPECTIVES Case 4: C o u n try -s p e c ific in fla tio n The cases until now have covered basic ways in which changes in one country or in vestors’ views of that country can have effects on other countries. The last case spends a little time on a change that does not have im portant international implications but that is often thought to be very important. Assume that, due to reunification, Ger many will have an increase in its price level of 10 percent over 5 years. Obviously there will be some risk associated with this that will cause effects similar to those analyzed in Case 3. Beyond the risk effect, however, there is very little effect in terms of international capi tal flows. In the supply and demand diagrams used in this article, r is adjusted for known differ ences in inflation and expected changes in exchange rates. In the case of a perfectly anticipated increase in inflation as assumed in the present case, all that happens is that nomi nal rates in Germany rise by an average of 2 percentage points a year for 5 years to cover the additional inflation (Forward exchange rates will incorporate an additional average 2 percent a year depreciation to adjust future exchange rates to the greater inflation as well.) Nothing else changes. Therefore, the diagrams do not change. The reason for this is that investors care about the purchasing power of their invest ments, not about the number of pieces of paper they have at the end of the day. As a result, as long as nominal rates rise enough to cover inflation, nobody cares. Investors are compen sated by the higher rates, borrowers are willing to pay the new higher rates because they will pay off their loan with cheaper currency. It all cancels out. Nominal rates in Germany change and the mark depreciates in the future when the inflation actually occurs, but that’s all that happens as long as German rates adjust to compensate fully for inflation. To the extent that German monetary au thorities do not fully adjust short-term rates to accommodate the increase in inflation there will be some additional consequences. This is exactly the mirror image of Case 1 where Japan tightens credit. The failure to let rates fully reflect the rise in inflation is the equiva lent to lowering rates by easing the supply of credit and real rates fall. Thus, the value of the mark would fall and world real rates would FEDERAL RESERV E BANK OF CHICAGO decline. This is a simple illustration of the fact that constant short-term rates do not al ways mean constant policy. P u ttin g it all to g e th e r The four cases examined were each de signed to highlight specific aspects of the transmission of credit market shocks through international markets. The real world is, of course, far more complicated. However, by taking the examples described above and ap plying them to a real-world case, it should become clear why the descriptions of interna tional market behavior in the business press can often be seriously misleading and seem ingly inconsistent. Take the case of the release of new CPI numbers in the U.S. Suppose those numbers come in below expectations and this is taken as a sign that inflationary pressures are less than had previously been assumed. The analy sis in Case 4 would suggest that this would cause U.S. nominal rates to fall by precisely the reduction in inflationary expectations. Real rates would remain the same both in the U.S. and in foreign markets as well. The dol lar would remain steady as neither the supply nor demand for money in the U.S. or anywhere else would have changed. (There could even potentially be a small rise in the dollar because inflation acts as a small tax on non-interest bearing types of money and the reduction in inflation would generate a small increase in the demand for U.S. currency.) With U.S. interest rates falling, foreign rates steady, and the dollar steady or rising, the markets would be said to be decoupled. In reality, the response would be more complicated. The reduction in inflationary expectations would have an impact on ex pected monetary policy. Depending on current policy, it would either reduce the pressure to tighten or generate some expectation of lower rates. In either case it would create the expec tation of a larger-than-expected supply of credit in U.S. markets. This would generate effects that mirror those in Case 1. World rates would fall as easier U.S. monetary policy would increase the world supply of credit. Thus, rates would fall everywhere, although nominal rates would fall more in the U.S. than in foreign markets due to the lower inflation. In addition, the dollar would fall due to an expected increase in the supply of dollars 9 relative to foreign currencies. Thus, if the Case 1 effects dominate, the markets would be said to be weakly coupled. If, for political reasons, the lower inflation made it likely that many of the world’s central banks would engage in a coordinated easing, then both foreign and domestic rates would fall together and the markets would be said to be tightly coupled. The dollar would rise rather than fall because other central banks would also be increasing the supply of their currencies, but only the U.S. would have lower inflation expectations to offset this effect. Further complicating this situation, if the coordinated actions were viewed as inappro priate by the markets because of the substan tial inflationary pressures that might, for ex ample, occur in Germany, German rates could actually rise due to the increased risk in hold ing German securities, as described in Case 3. In such a case, Germany would be said to have become decoupled from the rest of the interna tional market. Yet, in all of these possibilities interna tional markets have been treated throughout as one integrated market. The problem with all this talk of coupling and decoupling is that it misses the richness of the dynamics of the international credit markets. The four simple cases presented in this article are capable of displaying an enormous range of outcomes depending on how they are mixed. It is not that what is going on in international credit markets is so complicated; it is that so many different things can happen at the same time that disentangling the effects of a specific event is nearly impossible. C onclusion While it is not possible fully to discern what effects international events will have on U.S. markets, the surface randomness of market responses should not be all that disturbing. It is important not only to keep track of what the markets are doing, but why they are doing it. Almost any specific international financial market shift in exchange rates or interest rates can be explained by more than one combination of the cases described above, which cover changes in both the supply and demand for credit as well as changes in relative preferences of investors between countries and the effects of inflation. However, the real economic conse quences differ significantly depending on sources of the international disturbances. Thus, while international markets have become in creasingly important for our economy and for the process of policy formation, the lack of a clear simple relationship between events in for eign markets and our own economy means that foreign developments have to be analyzed in terms of their likely sources and consequences and do not, in themselves, tell us very much. Unfortunately for proponents of interna tional coordination of monetary policy, this means that international market movements do not map smoothly into policy actions. Seem ingly equivalent market movements can have radically different implications for individual economies and thus require substantially differ ent policy actions. It is only by examining the sources of international developments and projecting their effect on the various affected economies that policy implications can be determined. REFERENCES Caves, R.E., and R.W. Jones, World trade and payments, Little Brown, Boston, 1973. Dornbush, R., “ Money, devaluation, and nontraded goods,” Scandinavian Journal of Eco nomics, Vol. 78, No. 2, May 1976, pp. 255275. Frenkel J., and H.G. Johnson, The monetary approach to the balance of payments, George Allen and Unwin, 1975. of the exchange rate,” in The economics of exchange rates, Jacob A. Frenkel and Harry G. Johnson (eds.), Addison-Wesley Publishing Company, Reading, PA, 1978, pp. 97-116. Mussa, Michael, “ The exchange rate, the balance of payments, and monetary and fiscal policy under a regime of controlled floating,” Scandinavian Journal of Finance, Vol. 78, No. 2, May 1976, pp. 229-248. Hodrick, Robert J., “ An empirical analysis of the monetary approach to the determination 10 ECONOMIC PERSPECTIVES B a n k in g 1989: N o t q u ite a tw ic e -to ld ta le Events in 1989 resembled those of 1987 in banking, but the differences were significant— and the stakes were higher Eileen M alo ney and G eorge G regorash In some ways, U.S. bank performance in 1989 seemed a replay of 1987. Less devel oped countries (LDC) loan provisions at larger banks, a swift equity market correction, and dramati cally weakening real-estate markets in distinct geographic regions left analysts borrowing adjectives and analyses from two years prior. But similar as events were to 1987’s, 1989 put its own particular twist on things. Indeed, it is the structural differences in the banking envi ronment between 1987 and 1989 that have been most instructive. These ongoing changes include the passage of the Financial Institu tions Reform, Recovery and Enforcement Act (FIRREA) and the new risk-based capital guidelines. The LDC provisioning was least surpris ing and reflected U.S. banking’s recognition of and adjustment to the debt-service difficulties of Latin America. These adjustments demon strated the banking system’s ability to weather a major-league difficulty in measured fashion over a number of years without systemic dis ruption, but the return to reserve building and Latin-induced earnings diminution at the larger banks strongly signalled that the prob lems with LDC debt are far from resolved. The stock-market correction in October likewise burst the bubble of the optimists who wished to dismiss increased market volatility as a minor disruption in an increasingly ra tional game of global capital market integra tion. The impact on banks of the 1989 break was twofold. A slowdown in deal generation FEDERAL RESERVE BANK OF CHICAGO and the market’s appetite for risk lessened the immediate appeal of securities underwriting while lower bank stock valuations dampened external capital enhancement prospects. The real-estate implosion in New England signalled that the credit excesses experienced in the Southwest may not have been an aberra tion but rather may reflect a fundamental flaw in the concept of deposit insurance. All told, banking in 1989 laid to rest any notion that the difficulties of prior years were one-time events. They were all, in fact, only facets of a more fundamental problem—credit quality. C re d it q u ality: The h e a rt o f th e m a tte r At first glance, asset quality for the na tion’s banks showed only a moderate weaken ing in 1989 compared to 1988. Within these numbers however, are more sobering trends. The ratio of delinquent-loans-to-total-loans, the first indicator of credit quality problems, was higher in each quarter of 1989 compared to the year-ago quarter. Over the year, higher delinquencies translated into higher nonper forming assets. While the ratio of nonperforming-assets-to-total-assets had been declin ing each quarter since the latter half of 1987, it began inching upward in the first quarter of 1989 and continued to increase in small incre ments throughout the year. Eileen Maloney is a senior financial analyst and George Gregorash is an assistant vice president in the Department of Supervision and Regulation at the Federal Reserve Bank of Chicago. Research assistance was provided by Dylan McMahon-Schulz. 11 In addition, the mix of problem loans changed in 1989. Problem real-estate loans, which had always been the largest piece of the total, now hold an even larger share. Delin quent real-estate loans rose in each quarter of 1989 as did nonperforming real-estate assets. This was particularly true in the latter part of 1989. While real-estate problems were again a troubling influence on bank performance in 1989, the deterioration was not concentrated in one geographic region as it was in the South west in 1987. Rather, by year-end 1989, the weakness was beginning to spread throughout the U.S. Delinquent loans (30 to 89 days past due) in the U.S. increased for all size groups of banks both in dollars and ratios in the last quarter of 1989. Based on frequency distribu tions in which individual, rather than aggre gate, bank ratios are plotted, the increase in delinquent loans appears to be broad-based. The aggregate ratio of delinquent-loans-tototal-loans (DEL) for U.S. banks increased to 1.88 percent at year-end, up from 1.82 percent in the third quarter and 1.67 percent at yearend 1988. Delinquent real-estate loans increased in all size groups of banks and for all regions except the Southwest. Consumer delinquen cies were also higher for all bank size groups and regions. However, this increase was offset by declines in ‘other’ loan delinquencies, which include loans to depository institutions and foreign governments. (See Figure 1.) These higher delinquency levels portend larger bank loan-loss provisions to cover developing problem credits. The delinquent real-estate loan increase accounted for 82 percent of the 1989 fourthquarter increase in total delinquent loans. U.S. real-estate loan delinquencies rose to 0.82 percent of total loans from 0.75 percent for the third quarter, up from 0.71 percent at year-end 1988. Real-estate delinquencies were higher in all regions in the fourth quarter with the exception of the Southwest and West where they declined modestly. The Northeast and the Southwest both reported delinquent-realestate-loans-to-total-loans of 1.03 percent for fourth quarter 1989. However, the Southwest ratio represented a quarterly decline of 6 basis points while the Northeast ratio increased by 14 basis points over the period. At year-end 1988, this ratio had been 3.82 percent for the Southwest and 0.52 percent for the Northeast, compared to 0.87 percent for the U.S. as a whole. Contrary to the fourth-quarter delinquent loan increase, U.S. nonperforming assets de clined very slightly during the fourth quarter of 1989. Nonperforming assets the year before had totalled $64.6 billion. With the deteriora tion in various real-estate markets in 1989, nonperforming assets were nearly back to the 1987 level of $72.2 billion. The U.S. nonperforming-assets-to-total-assets ratio (NPA) declined from 2.30 to 2.23 percent in the last quarter of 1989. (See Figure 2.) This was due in part to a 2.9 percent increase in total U.S. assets in the last quarter of 1989. This down- FIGURE 1 Delinquent loans—U.S. banks percent of total loans 12 ECONOMIC PERSPECTIVES FIGURE 3 ward trend in the NPA was evident in all bank size groups and all regions of the country ex cept the Northeast where NPA rose to 3.39 percent from 3.31 percent in the third quarter as a result of deteriorating real-estate credits. Note, however, that the 1989 NPA levels for both the eastern half of the U.S. and the nation were higher than 1988. (See Figures 3 and 4.) Record fourth-quarter net loan chargeoffs also helped reduce the U.S. NPA. Histori cally, fourth-quarter chargeoffs increase from the prior quarter. However, fourth-quarter 1989 chargeoffs rose 70 percent over the third quarter to $8.6 billion as compared to a 41 percent increase to $4.9 billion in 1988. The fourth-quarter increase was the major driving force behind the annual net chargeoff increase to $20.9 billion for 1989 versus $17.5 billion for 1988. Fourth-quarter 1989 commercial loan losses were $3.2 billion, which contributed to a decline of $1.1 billion in nonperforming commercial loans. Likewise, loan losses on foreign government loans were $2.6 billion, which contributed to a $1.6 billion decline in nonperforming ‘other’ loans (these include LDC loans). Real-estate loan losses totalled $1.2 billion for the fourth quarter of 1989. FEDERAL RESERVE BANK OF CHICAGO These losses mitigated the nonperforming realestate loan increase. The shape o f th in g s to com e? The real estate woes have continued to grow as delinquent real-estate loans continued to increase and then moved into non-perform ing assets. Exacerbating this trend is the fact that real-estate loan growth is outpacing the growth of other loan categories and may trans- 13 late into future problem loans. In fact, the concern over the deterioration of real-estate credits is illustrated quite well in the nonper forming asset data. Nonperforming assets include not only nonperforming loans but also OREO (other real-estate owned, including foreclosed properties). The components of nonperforming assets exhibited vastly different characteristics. Fourth-quarter 1989 OREO increased $0.9 billion to $12.5 billion while U.S. nonperforming loans declined $1.3 bil lion. Despite the massive net loan chargeoffs, which resulted in fewer nonperforming loans overall, U.S. nonperforming real-estate loans increased $1.2 billion in the fourth quarter of 1989. The greatest portion of emerging problem real-estate loans was concentrated in the Northeast. During 1989, the Northeast’s non performing real-estate loans grew 148 percent, or $5.2 billion, to $8.8 billion. In the fourth quarter alone, the region’s nonperforming realestate loans increased $1.7 billion, primarily at the large banks. This increase was partially offset within the U.S. by declines in such loans at banks in all size groups in the Midwestern and Western regions. Over the year, U.S. nonperforming realestate loans increased $6.0 billion to $21.1 billion while OREO rose $2.2 billion to $12.5 billion. As a result, nonperforming real-estate assets accounted for 47 percent of all U.S. NPA at year end 1989 compared to 40 percent at year-end 1988. The Northeast’s nonper forming real-estate assets to NPA rose to 35 percent from 18 percent a year ago. In addi tion, the Northeast region accounted for 20.6 percent of all U.S. OREO at year-end 1989, up from 10.7 percent a year ago, and 9.8 percent in 1987. In contrast, the Southwest region accounted for 22.3 percent of all U.S. OREO, down from 27.3 percent a year ago, and 30.1 percent in 1987. Fourth-quarter net loan chargeoffs rock eted to $8.6 billion compared to $4.9 billion a year before. However, fourth-quarter loan-loss provisions of $9.2 billion barely exceeded the loan losses. As a result, the aggregate U.S. loan-loss reserve level was roughly unchanged at 2.63 percent of loans, despite increasing credit quality problems. This trend was true for all bank size groups. However, the 2.63 percent reserve level represents an increase over 1988’s level of 2.39 percent and indicates that reserve build ing took place during the year. The regions re flected their own economic climates. For the Northeast, which has struggled to deal with emerging real-estate and continuing LDC problems, the ratio of loan-loss-reserves-tototal-loans rose marginally in the last quarter of 1989 to 4.14 percent compared to 3.18 percent at year-end 1988. In contrast, the Southwest, which continued to make progress on credit quality problems, increased their loan-loss reserve ratio by a fifth in the last quarter of 1989 to 3.40 percent of loans. Loan-loss reserve levels currently are considered part of an institution’s tangible capital. U.S. tangible capital remained nearly flat from 1988 levels at 7.79 percent of assets. Dollars of tangible capital however, increased $14.5 billion over the year. Combined with a small decrease in dollars of nonperforming assets, the U.S. ratio of nonperforming-assetsto-tangible-primary-capital declined from 27 percent in 1988 to 23 percent in 1989. How ever, the differing regional economic condi tions were apparent again with notable in creases in the Northeast and decreases in the Southwest. (See Figure 5.) Even as real-estate delinquent and nonper forming loans increased, real-estate loans continued to grow. In 1989, U.S. real-estate loans increased 13.1 percent while total loans grew 6.7 percent. This trend was evident in all regions and in bank size groups with assets over $100 million. The portion of real-estate 14 ECONOMIC PERSPECTIVES loans that exhibited the greatest growth was 14 family unit residential loans. At year-end 1989, real-estate loans comprised 37 percent of the U.S. loan portfolio compared to 35 percent the year before. (See Figure 6.) For the multinational banks (those over $10 billion in assets, which hold 36 percent of all U.S. banking assets and comprise 0.3 per cent of all banks), relating real-estate loan growth to total loan growth may not tell the entire story. In 1989, total loans grew 5.1 percent for these banks while off-balance-sheet items (which include loan commitments, standby letters of credit, foreign exchange contracts, etc.) grew nearly 32 percent. In 1989, off-balance-sheet items for all U.S. banks were 138 percent of total assets, up from 112 and 101 percent in 1988 and 1987 respec tively. For the multinational banks, these numbers increase dramatically. The respective percentages of off-balance-sheet items to total assets at year-end 1989, 1988, and 1987 were 346, 273, and 246 percent. (See Figure 7.) N e w p ro d u cts, g re a te r risk The 1980s saw a rapid evolution of new and sophisticated financial products. There has been an explosion of highly leveraged transactions, increased holdings of junk bonds, participation in sophisticated financing and hedging instruments, and a decrease in tradi tional loan arrangements, particularly at large banks. Unfortunately, there is no historical means to measure the risk of these new instru ments. They have not yet been through a complete business cycle and the rapidity at which they multiply and transform make it difficult to monitor and assess risk. The in creased risk of some of these instruments has left some of the larger banks open for possible downgrading by the rating agencies. The riskbased capital guidelines being implemented from 1990 to 1992 will take these off-balancesheet items into account by including them in the calculation of equity ratios. The majority of the multinational banks have correspond ingly strengthened their capital ratios to meet these guidelines, although most adjustments occurred in 1988. Bank loan portfolios are now riskier not only because of the proliferation of these new products but also because of the greater lever age in the economy. The nation is currently in its eighth year of economic expansion. During FEDERAL RESERVE BANK OF CHICAGO that time, consumers and corporations alike have taken on additional debt. Should interest rates rise dramatically or the economy deterio rate in any significant manner, questions as to the financial stability and flexibility of these borrowers will certainly arise. S even th D is tric t tren d s b e tte r In 1989, credit quality measures in the Seventh Federal Reserve District (which con sists of portions of Illinois, Indiana, Michigan, Wisconsin and all of Iowa) reflected those of the U.S. but the trends were not as severe. DEL grew 3.5 percent in the fourth quarter of 15 Banking 1989: A market view Bank stock price performance in 1989 can be summed up in two words: asset quality. In gen eral, those banks with weak asset quality underper formed the market while banks with stronger asset quality outperformed the market. As seen in the graph, a portfolio o f ten super-regional bank stocks outperformed a portfolio o f ten money-center banks in the stock market during 1989. By using Ordinary Least Squares regression, the performance o f individual firm share values can be evaluated relative to the market (S&P 500) and the rest o f the financial industry (NYSE Financial Index). That is, the effects o f the changes in the market’s perception o f the individual firms are separated from the effects o f the changes in the market’s perception o f the value o f the stock mar ket as a whole and o f the value o f the financial in dustry (made up o f finance, insurance, and real estate companies) specifically. Thus, the model produces a return adjusted for market risk and industry risk. The model is constructed using actual firm data and market returns (change in the firm’s stock price, adjusted for dividends and stock splits) for 1988 to determine the relationships between the firm and market returns and the firm and industry returns. These values are then used to calculate the expected daily return in 1989, given the S&P 500 and the NYSE Financial Index return. This ex pected return is then compared to the observed return to determine the deviation of the actual performance from the expected levels. These deviations are cumulatively summed over the year to show risk-adjusted performance over time. A v erage performance is calculated for money-center banks and super-regional banks by selecting ten from each group, summing over the individual per formance o f each, and dividing the result by ten. While weak earnings undoubtedly hurt the performance of some bank stocks, investor con cerns about weakening asset quality appeared to drive bank stock price movements in 1989. The asset quality concerns were centered in two areas: HLT (highly leveraged transactions) lending and real-estate lending. The worries over HLT lending primarily affected money-center banks, while realestate concerns affected both money-center and super-regional bank stock performance. These worries were precipitated not only by the perceived risk of these types of lending, but also by what drove the banks to increase their levels o f such loans, namely the narrowing spreads in commercial lending and other traditional sources o f income brought on by increased competition. As the Figure indicates, the average perform ance o f the share values o f the ten money-center 16 Risk-adjusted BHC portfolio performance— money centers vs. super-regionals relative change 1989 banks decreased fairly consistently throughout the year relative to the market and the industry. Though not shown here, individual plots o f nine of the ten firms included in the sample resulted in curves that were similar in shape and direction to the graph shown here. The lone money-center bank that outperformed the market did so primarily on the strength o f its asset quality, despite weaker earnings. Several other money-center banks re corded improved earnings over 1988 but suffered in the stock market due to asset quality concerns. These concerns grew in the fourth quarter, particu larly after the market break on October 13. As a group, super-regional bank stock per formance was more diverse. Several super-regional banks were plagued with similar asset quality concerns and tended to underperform the market, while those super-regional banks with stronger asset quality generally outperformed the market. While the asset quality worries began affecting money-center performance during the second quar ter, super-regional bank credit quality concerns did not surface until September. Individual plots o f the ten super-regional banks indicate that seven of the banks trailed the market from September to Decem ber, at which time super-regional bank stocks began staging a comeback. In fact, individual plots o f all ten banks were positively sloped in December. In summary, the stock market seemed to focus on the effect that asset quality might have on future earnings while discounting current earnings to some degree. An early look at 1990 performance suggests that asset quality remains a high priority among investors as those banks with weaker asset quality continue to struggle. — Philip M. Nussbaum ECONOMIC PERSPECTIVES 1989 compared to a 5.6 percent increase for the U.S. As in 1987 and 1988, the District’s ratio of DEL was the lowest of all Districts in the nation. Still, this ratio grew from 1.17 percent in 1988 to 1.29 percent in 1989. Pastdue real-estate and consumer loans contributed greatly to the fourth-quarter delinquent loan increase, but were partially offset by declines in commercial and ‘other’ delinquent loans. (See Figure 8.) The delinquent loan ratio increased in the fourth quarter in all District states except Iowa where the ratio declined from 1.28 to 1.19 percent. Primarily as a result of asset growth, Dis trict NPA was down just slightly, to 1.14 per cent, from year-end 1988. NPA levels rose over the year for Indiana and Michigan pri marily due to higher nonperforming real-estate assets. (See Figure 9.) Whereas U.S. NPA ratios showed fairly steady deterioration over the year, District NPA exhibited more volatil ity. Thus, the improvement in this ratio for the fourth quarter was all the more noticeable. Fourth-quarter Seventh District NPA de clined from 1.30 percent in the third quarter to 1.14 percent, almost one half the U.S. level. (See Figure 10.) This decline, in both dollar values and ratios, was seen in all size groups and in all states and reflected a stronger eco nomic base in the Midwest compared to the U.S. as a whole. As with the U.S., the lower levels of nonperforming loans were due to substantial fourth-quarter loan losses. District nonperforming commercial and ‘other’ loans declined $165 million and $396 FEDERAL RESERVE BANK OF CHICAGO FIGURE 9 Nonperforming assets—Seventh District percent of total assets IL IN IA Ml Wl Seventh District million, respectively. The declines were the result of fourth-quarter loan losses for commer cial ($214 million) and ‘other’ loans ($535 mil lion). District real-estate loan losses totalled $44 million and were a much smaller portion of total loan losses than in the U.S. Contrary to the U.S., District nonperforming real-estate loans declined $78 million over the quarter. However, OREO increased $101 million. As a result, nonperforming real-estate assets ac counted for 39 percent of all District NPA at year-end 1989 compared to 31 percent last year. P rob lem c red its seep in to p ro fits After rebounding strongly in 1988, the banking industry’s financial performance in 17 1989 was marred not only by further LDC writedowns, but also by domestic asset quality. The full-year 1989 return on assets (ROA) for the U.S. was 0.50 percent versus 0.84 percent for 1988 and 0.13 percent for 1987. (See Fig ure 11.) In 1987, 17 percent of U.S. banks lost money. One-third of these banks were located in the Southwest. In fact, in this region alone, over 40 percent of the banks lost money in 1987. In contrast, 11 percent of U.S. banks reported losses in 1989; 29 percent of those with losses were still located in the Southwest. In each of the past three years, earnings trends varied based on bank size. (See Figure 12.) On a year-to-year basis, the community banks (those with assets under $1 billion) continued the improvement begun in 1987 with annual ROAs rising from 0.63 percent in 1987, to 0.77 percent in 1988, to 0.84 percent in 1989. Net interest margins improved slightly, along with ‘other’ discretionary non interest income. Expense and loan-loss provi sion levels were generally flat. Fourth-quarter 1989 earnings for U.S. community banks were better than those of the year-earlier quarter but also, and more impressively, better than those of the previous full year. Compared to 1988, large banks had sub stantially lower ROAs for the year. As in 1987, earnings were hurt by higher provision ing for domestic credit quality problems and for LDC loans. To some extent, the Latin-debt situation has improved as evidenced by the newly restructured and negotiated debt ac- 18 FIGURE 12 Return on assets—by asset size group percent of average assets 1.5 Seventh District 1 iS -1.47 < $1 bil. $1-10 bil. > $10 bil. cords. But, concerns remain about the long term debt service capacity of certain Latin American countries. Although multinational banks in particular set aside large LDC provi sions in 1989, their future earnings could be further pressured because, as a group, their ratio of LDC-provisions-to-LDC-loans contin ues to lag their European counterparts. The disproportionate weight of the larger U.S. banks stands out in the ROA numbers. The ROA for the U.S. for fourth-quarter 1989, at 0.29 percent of average assets, was roughly one-third the 0.93 percent reported for fourthquarter 1988. The year-ago quarter, however, was abnormally high due to record earnings of large banks, which received a substantial boost from past-due Brazilian debt interest pay ments. While provisions had the greatest effect on large-bank earnings, fourth-quarter profitability was also hurt by narrowed net interest margins and higher expenses. The earnings decline was tempered for multina tional banks by higher noninterest income. The 26-basis point increase from the third quarter to 2.18 percent in the fourth quarter was attributable mainly to higher ‘other’ dis cretionary noninterest income, followed by foreign exchange and trading account gains. ECONOMIC PERSPECTIVES Large banks in particular have been gener ating less of their income from the traditional banking business of intermediation. The wide array of financial intermediaries is narrowing as regulated banking powers increase. Conse quently, competition has escalated as these participants vie for a limited amount of busi ness and has resulted in the creation of new products. This dependence on nontraditional sources of income has continued to grow. Noninterest income for multinational banks was 1.77 percent of average assets in 1987, 1.85 percent in 1988, and increased to 2.01 percent in 1989. Earnings for U.S. regional banks (those with assets between $1 and $10 billion), fluc tuated year-to-year for many of the same rea sons as the multinational banks. Deteriorating credit quality resulted in larger provisions. Overhead costs, net interest margins, and non interest income were flat over the year. None theless, noninterest income has grown for these banks, as well, from 1.44 percent in 1987, to 1.49 percent in 1988, and to 1.51 percent in 1989. The mediocre earnings in 1989 did not impair the dividend payout rates of the large banks. Dividends equaled 116 percent of 1989 net income, compared to 47 percent in 1988. The higher level of retained income in 1988 led to sizable increases in tangible capital levels for these banks in that year. That was not the case in 1989. With less income re tained, and slower growth in loan-loss reserve levels, tangible capital levels were only slightly higher at year end 1989 compared to year-end 1988. Full-year 1989 Seventh District ROA of 0.95 percent was down slightly from the 1.04 percent reported in 1988 but was much better than the 0.28 percent reported for 1987. (See Figure 13.) As in the rest of the nation, com munity bank earnings improved over the year while large-bank earnings were pressured by higher domestic and LDC provisions. The ROAs for the District states varied year-toyear primarily due to fluctuating noninterest income and provision levels. Nonetheless, the reported ROA levels are quite respectable, particularly when compared to the U.S. On a regional basis, ROAs were down from a year ago for the Eastern areas of the U.S. but higher for the Midwest, Southwest, FEDERAL RESERVE BANK OF CHICAGO FIGURE 13 Return on assets—Seventh District percent of average assets and West. (See Figure 14.) The earnings trends were similar to those in the size group data, with the level of loan-loss provisions, (an im portant measure of credit quality) having the largest impact on earnings. Provisions for 1989 increased over 1988 in all regions except, nota bly, the Southwest, where provisions fell from 1.23 percent of average assets to 1.13 percent. (See Figure 15.) The Midwest, which includes the Seventh District, had the lowest annual pro visions of all regions at 0.49 percent, reflecting better credit quality due to the diversified eco nomic base and the continued improvement of the region’s agricultural banks. 19 Post gam e FIGURE 15 Provisions—by region percent of average assets North- Mid- Southeast Atlantic east 20 Midwest South- West west U.S. U.S. bank performance in 1989 appeared a replay of 1987, as both foreign and domestic credit quality considerations again reduced earnings. But both advancing interstate con solidation at home and increased integration abroad signalled a different environment in which to consider these events. The 1990’s will be a time of reckoning if regional pockets of recession grow and as the structural changes that have occurred since the early 1980s take full effect. Expertise, some degree of risk taking, better capitalization, and capable management will separate the partici pants from the bystanders. Like a batter faced again with the same count, but later in the game, the banker faces familiar challenges in 1990 but with fewer options ... and more profound consequences. ECONOMIC PERSPECTIVES Cassette tapes are available for GAME PLANS FOR THE HOs THE 26TH ANNUAL CONFERENCE ON BANK STRUCTURE AND COMPETITION, CHICAGO, ILLINOIS, MAY 10-11,1990 Thursday Sessions May 10.1990 Friday Sessions May 11,1990 FRB 001 WELCOMING REMARKS (Silas Keehn); CHALLENGES TO REGULATION IN THE 1990S (Alan Greenspan) FRB 007 JAPANESE BANKS: EMERGING GLOBAL COMPETITORS JAPANESE BANKING: ISOLATION TO GLOBALIZATION (Thomas F. Cargill, Shoichi Royama); ANALYZING HIDDEN CAPITAL AT JAPANESE BANKS (Edward J. Kane, HalukUnal, Asli Demirguc-Kunt); COST OF CAPITAL FOR BANKS IN INTERNATIONAL COMPETITION (Robert N. McCauley, Steven A. Zimmer) FRB 002 THE SUPER-REGIONAL CHALLENGE (Charles T. Fisher III, Dennis C. Bottorff, John B. McCoy, 0. Jay Tomson) (two cassettes) FRB 003 LUNCHEON ADDRESS: THE FUTURE STRUCTURE OF THE FINANCIAL SERVICES INDUSTRY (J. Richard Fredericks) FRB 004 FIRREA: IMPLICATIONS FOR THE U.S. FINANCIAL SYSTEM (James R. Barth, Bert Ely GaryG. Gilbert, KennethE Scott, Leonards. Simon)(two cassettes) FRB 005 SESSION A: THE FUTURE ROLE OF COMMERCIAL BANKS IN COMMERCIAL LENDING (Rafael Scolari, Christopher L. Snyder, Jr., Michael Woodhead) FRB 006 SESSION B: INTERSTATE ACQUISITIONS COMPETITIVE EFFECTS OF INTERSTATE BANKING: THE IMPACT ON BANK ACQUISITION MARKETS(J. Amanda Adkisson, Donald R. Fraser); MERGER PREMIUMS IN THE INTERSTATE BANKING CONTEXT (Larry A. Frieder, Phillip N. Petty); THE CONSEQUENCES OF INTERSTATE BANKING DEREGULATION FOR COMPETITION, THE STRUCTURE OF SERVICE MARKETS, AND THE PERFORMANCE OF INTER STATE FINANCIAL-SERVICE FIRMS (PeterS. Rose) FRB 008 EUROPE 1992 BANKING STRUCTURE AND BANKING STABILITY AFTER 1992 (Forrest Capie, Geoffrey Wood); EC 1992: THE FINANCIAL COMPETITIVENESS IMPLICATIONS (Robert H. Dugger, Cynthia A. Glassman, Charles F. Haywood, Robert W. Strand) FRB 009 LUNCHEON ADDRESS: FINANCE IN THE ’90s (Paul J. Collins) FRB 010 GLOBALIZATION AND PUBLIC POLICY (Moderator: Silas Keehn; Panel: Richard L. Thomas, William J. Brodsky, Stephen H. Axilrod, Edward J. Kane) To order tapes, at $12.00 per cassette, please contact: FRB Cassettes, c/o Teach’em Inc. 160 East Illinois Street Chicago, Illinois 60611 To order by phone: Toll-free (outside Illinois): 800 225-3775 in Illinois: 312 467-0424 FEDERAL RESERVE BANK OF CHICAGO FEDERAL RESERVE BANK OF CHICAGO 21 CURRENT RESEARCH As part of the ongoing research at the Federal Reserve Bank of Chicago, there are in-depth studies available on a variety of topics. Recent studies have covered such timely issues as bank deregulation, banking risks, the infrastructure, foreign trade policy, unemployment insurance, and regional development. The STAFF M EM ORANDA series were occasional papers prepared by members o f the Re search Department for comment and review by the academic com munity. Although the series was discontinued in December 1988, a limited number of the studies are still available. A few recent pa pers included: Implications of Large Bank Prob lems and Insolvencies for the Banking System and Economic Policy. George G. Kaufman (SM -85-3); The Impact of Branch Banking on Service Accessibility. Douglas D. E vanoff (SM -85-9); Banking Risk in Historical Perspective. George G. Kaufman (SM -86-3); Net Private Investment and Public Expenditure in the United States 1953-1984. David Alan Aschauer A Note on the Relationship be tween Bank Holding Company Risks and Nonbank Activity. Elijah Brewer III (SM -88-5); Is Public Expenditure Productive? David Aschauer (SM -88-7); Commercial Bank Capacity to Pay Interest on Demand Deposits: Evidence from Large Weekly Reporting Banks. Elijah Brewer III and Thomas H. Mondschean (SM -88-8); Imperfect Information and the Permanent Income Hypothesis. Abhijit V. Banerjee and Kenneth N. Kuttner (SM -88-9); Does Public Capital Crowd Out Private Capital? David Aschauer (SM -88-10); Imports, Trade Policy, and Union Wage Dynamics. Ellen Rissman (S M -8 8 -1 1). Copies o f the WORKING PAPER SERIES and STAFF MEMORANDA , as well as a (SM -87-10); complete listing o f all studies and their availability, can be ordered from the Public Infor motion Center, Federal Re serve Bank o f Chicago, P.O. Box 834, Chicago, Illinois, 60690-0834, or telephone (312)322-5111. Risk and Solvency Regulation of Depository Institutions: Past Poli cies and Current Options. G eorge G. Kaufman (SM -88-1); Is Government Spending Stimula tive? David Aschauer (SM -88-3); 22 ECONOMIC PERSPECTIVES The WORKING PAPER SERIES includes research studies covering three areas—regional economic issues, macroeconomic issues, and issues in financial regulation. Cur rent research has studied a number of areas, such as: Macro Economic Issues Regional Economic Issues (W P -89-19); Industrial R&D An Analysis of the Chicago Area. Alenka S. G iese and Investment Cyclicality in Manufac turing Industries. Bruce C. Petersen W illiam A. Testa (W P-87-3); and W illiam A. Strauss (W P-89-20); Metro Area Growth from 1976 to 1985: Theory and Evidence. W il Unit Roots in Real GNP: Do We Know, and Do We Care? Lawrence liam A. Testa (W P-89-1); J. Christiano and Martin Eichenbaum (W P-90-2); Unemployment Insurance: A State Economic Development Perspective. W illiam A. Testa and Natalie A. Davila (W P-89-2); Determining Manufacturing Output for States and Regions. Philip R. Israilevich and W illiam A. Testa (W P-89-4); The Opening of Midwest Manufac turing to Foreign Companies: The Influx of Foreign Direct Investment. Alenka S. G iese (W P-89-5); A New Approach to Regional Capital Stock Estimation: Measurement and Performance. Alenka S. G iese and Robert H. Schnorbus (W P-89-6); Why Has Illinois Manufacturing Fallen Behind the Region? W illiam A. Testa (W P-89-7); Theory and Evidence of Two Com petitive Price Mechanisms for Steel. Christopher Erceg, Philip R. Is railevich and Robert H. Schnorbus (W P-89-9); Regional Energy Costs and Business Siting Decisions: An Illinois Perspective. David R. A llardice and W illiam A. Testa (W P-89-10); Construction of Input-Output Coef ficients with Flexible Functional Forms. P.R. Israilevich (W P-90-1); Regional Regulatory Effects on Bank Efficiency. D ouglas D. E vanoff and Philip R. Israilevich (W P-90-4). Back of the G-7 Pack: Public Invest ment and Productivity Growth in the Group of Seven. David A. Aschauer (W P-89-13); Trade Policy and Union Wage Dynamics. Ellen R. Rissman Money Supply Announcements and the Market’s Perception of Federal Reserve Policy. Steven Strongin and V efa Tarhan (W P-90-3). Issues in Financial Regulation Technical Change, Regulation, and Economies of Scale for Large Com mercial Banks: An Application of a Modified Version of Shepard’s Lemma. D ouglas D. Evanoff, Philip R. Israilevich, and Randall C. Merris (W P -8 9 -1 1); Reserve Account Management Be havior: Impact of the Reserve Ac counting Scheme and Carry For ward Provision. D ouglas D. Evanoff (W P -89-12); Are Some Banks Too Large to Fail? Myth and Reality. George G. Kaufman (W P-89-14); A Model of Borrowing and Lending with Fixed and Variable Interest Rates. Thomas Mondschean (W P -89-17); Do “ Vulnerable” Economies Need Deposit Insurance?: Lessons from the U.S. Agricultural Boom and Bust of the 1920s. Charles W. Calomiris (W P-89-18); The Savings and Loan Rescue of 1989: Causes and Perspective. George G. Kaufman (W P-89-23); The Impact of Deposit Insurance on S&L Shareholders’ Risk/Return Trade-offs. Elijah Brewer III (W P -89-24). FEDERAL RESERVE BANK OF CHICAGO 23 ECONOMIC PERSPECTIVES BULK RATE P u blic Inform ation C enter F ederal R eserv e B ank o f C h icago P .O . B o x 8 3 4 C h ica g o , Illin o is 6 0 6 9 0 -0 8 3 4 U.S. POSTAGE PAID CHICAGO, ILLINOIS PERMIT NO. 1942 Do N o t F orw ard Address C o rrec tio n Requested R eturn P ostage G uaranteed FEDERAL RESERVE BAN K OF CHICAGO