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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
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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
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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

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).

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.

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.

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-

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

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.

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

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.

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

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-

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

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

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

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

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

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-

FIGURE 12

Return on assets—by asset size group
percent of average assets

1.5

Seventh District

-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.

Post gam e
FIGURE 15

Provisions—by region
percent of average assets

North- Mid- Southeast Atlantic east

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

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);

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

ECONOMIC PERSPECTIVES
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Full text of Economic Perspectives (Federal Reserve Bank of Chicago) : July/August 1990, Volume XIV, Issue 4

FRASER